The Week Ahead
We are a little over three weeks away from election day. So much is in the balance for the stock market. Clinton represents the status quo of US monetary, fiscal, and foreign policy. Trump is heading in a different direction with billionaire brainpower. We know from what happened with Brexit that the numbers out of the polls are just guesses, and uncertainty will linger until the final vote is cast and counted. Whatever happens will matter, a lot. The US is an economic giant in the world. Our interest rates aren’t negative. Our trade policies influence nations. The impact of Trump or Clinton will reverberate across the globe. All eyes are glued the United States and who we vote to lead our country for the next four years.
The Week Just Past
US fiscal position deteriorating as deficit grows. One week after the US Treasury revealed that total US debt in fiscal 2016 rose by $1.4 trillion, the third highest annual increase in history, and hitting an all-time high of $19.6 trillion, this week it also revealed that in the fiscal year ended September 30, the US budget deficit grew by $590 billion, a 34% spike compared to the post-crisis low of $440 billion in fiscal 2015, despite the Treasury enjoying a healthy surplus of $33 billion in the month of September. The latest figures show that the government is borrowing 15 cents of every dollar it spends.
US deficit widening due to out of control spending. Government spending went up almost 5% to $3.9 trillion in fiscal 2016, but revenues stayed flat at $3.3 trillion. Of the $3.9 trillion in outlays, Social Security was by far the biggest spending item, at $915 billion. But more importantly, in fiscal 2016 the deficit was 3.2% of GDP, compared to a deficit of 2.5% of GDP a year earlier, which was the first increase in the deficit as a share of GDP since 2009.
US GDP outlook is not good. There was much excitement when just two months ago, the Atlanta Fed revealed that its original Q3 GDP "nowcast" was showing an economy growing at a whopping 3.8% - a welcome reprieve for an economy which has barely been able to rise above a stall speed 1% GDP in the first half. Alas, since then things have deteriorated, and quite rapidly in recent days, because just one week after the Atlanta Fed slashed its GDP estimate to a low of 2.1%, this week it took it down to even less, or the lowest it has been to date, a paltry 1.9% and 50% lower than the original estimate. So taking all the data we have on hand as of this moment, we get that the US will grow at just 1.4% in 2016. Never in history have stock prices been able to go up while GDP growth rates decelerated for very long.
Billionaire investor Ray Dalio is warning of a major bond market bubble. The thesis is that since interest rates are so low, bond prices are at the far end of the upper bound. Dalio’s point is this: “It would only take a 100 basis point rise in Treasury bond yields to trigger the worst price decline in bonds since the 1981 bond market crash. The 100 basis point rise would drive bond’s to lose roughly $2.4 trillion of market value.” Whoa! Mrs. Yellen is between a rock and a hard place.
BMR Companies and Commentary
Facebook (FB: $128, flat for the week)
Facebook Workplace has arrived. Facebook announced the official launch of Workplace (formerly Facebook at Work), now available to any company or organization. Workplace is a communications network platform for work focused on facilitating interaction, collaboration, and sharing. Workplace includes core Facebook features such as News Feed, Groups, Live, Reactions, Search, and Trending posts, as well as new Workplace-only features such as a dashboard with analytics and integration, multi-company Groups, and identity providers to enable integration with existing IT systems.
While Facebook dominates the social segment, the enterprise network segment has yet to crown a clear leader. LinkedIn could be considered a competitor to some extent given the enterprise/social crossover, though LinkedIn has more of a public networking focus than a specific internal product for enterprises.
While Facebook is new to the segment, Workplace already has 1,000+ organizations and 100,000+ user-created groups in the testing phase, and Facebook’s 1.7+ billion underlying social user-base provides a broad canvas to encourage more enterprise adoption.
BMR Take: While it is unlikely Workplace moves the needle any time soon, Facebook has already disclosed that companies such as Starbucks have embraced the technology. This all fits into our longer term thesis that there are multiple untapped potential revenue sources in opportunities like Messenger, WhatsApp, Live Streaming, Search, and Workplace to name a few. $140 price target.
PayPal (PYPL: $39, down 1%)
PayPal reports 3Q16 results on October 20th. We expect good results. To be specific, we expect PayPal to report revenue growth of at least 17% and EPS of $0.34. In addition to a good 3Q16 performance, we anticipate a positive outlook for the holiday season.
We expect positive results to be driven by strength in payment volume (that is, the amount of money people are sending through PayPal’s network). And we see continued strong mobile growth, driven largely by the recent acquisitions of Braintree and Venmo, which are each focused on delivering innovative mobile technologies in payments.
One focus area that continues to get attention from investors is the financial implications of new agreements with Visa and MasterCard. The new agreement with Visa was announced along with last quarter’s earnings. In between now and then, the MasterCard agreement has been finalized. Investors want to hear about how much higher the costs will be for PayPal in the new contracts. What we mean is that PayPal has to pay Visa and MasterCard when PayPal users send money using their Visa or MasterCard plastic. Contracts just renegotiated with Visa and MasterCard raised costs for PayPal. Specifically, each transaction is now a higher fee. Investors also want to know if margins are still going to be acceptable. We think so. We just need management to say it so that the overhang goes away. We’re not really concerned because having access to Visa and MasterCard business could be absolutely huge for the company.
BMR Take: We like PayPal’s exposure to the rapidly growing online payments landscape, and believe it is positioned well to sustain mid-teens revenue growth. We believe PayPal’s scale and mobile transaction trajectory can sustain a growing network effect. The company is generating $2.5+ billion of free cash flow per year available for M&A and other value-driving initiatives. We find the stock compelling at this level as we look for the stock to get to our $50+ price target.
Netflix (NFLX: $101, down 3%)
We think Netflix is ultimately heading to $200 based on 20x a 2020 EPS outlook of $10. However, Deutsche Bank initiated the stock with a Sell rating and a $90 price target this week. We recap their call below so you have all the information. We believe you should side with us because there is a lot of money to make if we are right.
The report admits to be positive on the business and but cautious on the stock. Netflix has a long runway for growth due to its first mover advantage and self-reinforcing model.* They say and we agree, that increasing content and user experience investment drives subscriber growth and pricing power, which funds further content and user experience investment. The report doesn’t take issue with the business model, but only the valuation on the stock, saying this is a very long duration, high multiple investment with market expectations that appear too high through 2020.
* The self-reinforcing model entails increasing content, and user experience investment drives subscriber growth and pricing power, which funds further content and user experience investment in an endless loop of growth.
Folks, they have been saying this same thing about Netflix’s valuation for years. The business is doing so well, that is why the valuation is high, unless you are telling us the business is turning south. In our view the valuation is going to stay where it is. The business is heading in a healthy direction.
The report argues there is no take-out value*, specifically citing that nobody on the speculative list of buyers would have an interest. This list includes among others Disney, Amazon, and 21st Century Fox. They say severe economic/earnings dilution would be a major obstacle to a potential combination. They say there would be 25% EPS dilution for Disney. This is all true we must admit. But we don’t really care. You don’t need a take-out to do well in your investment as we like Netflix on a standalone basis.
* The estimated value of a company if it were to be taken private or acquired.
Netflix’s pivot to original programming, the development of its own in-house studio, the growth in aggregate studio output, and the size of Netflix’s programming budget all mitigate the apparent risk from Amazon, Hulu, and local international players increasing their subscription video on demand programming spend. This is the sell report’s argument not ours. This seems like a reason to own the stock not sell it, don’t you agree?
BMR Take: Netflix has a long runway for growth due to its first mover advantage and self-reinforcing model. The business is firing on all cylinders. Don’t pass on this just because it’s not a thrift store cheap stock. We like Netflix and have a $133 target price on the stock.
Welltower (HCN: $70, up 1%)
Welltower has pulled back from highs, but we like the shares still. The company owns one of the largest portfolios of healthcare real estate in the country and has established a track record as good operators.
Acquisitions are propelling earnings higher. Welltower has been one of the largest acquirers in the healthcare space, purchasing almost $25 billion of assets since 2007, or about $2.5 billion annually. So far this year, Welltower has closed or announced another $1.6 billion of acquisitions. Management’s agreement to acquire $1.15 billion of senior housing assets
Senior housing has rebounded, and as the company continues to invest in the this market, concerns about supply growth around the country seems to have paused. After putting up below-average growth in 2015, Welltower has delivered same store net operating income growth of 4.8% year-to-date in its portfolio. Moreover, Welltower’s portfolio has outperformed its peers in the space as the top 25 markets have only 2.4% inventory growth.
BMR Take: Welltower is on track to deliver EPS of $4.60 this year heading modestly higher over the next several years. This more than supports the current dividend of $3.44, which offers an attractive 5% dividend yield. Accordingly, we see compelling value here. We have an $84 price target on the stock. And note that this is no small company – the market cap is $25 billion. Very solid.
Mazor Robotics (MZOR, +7%)
Mazor reported earnings this week. There is a lot to like. Below we recap some specifics.
Mazor is at a key inflection point. While revenue in the 3rd quarter was a little light versus some estimates, the 25 orders received in the quarter represent a significant increase. To put this in perspective, the company sold 25 systems worldwide in 2015.
While quarterly revenue still remains a bit lumpy, this phenomenon now relates to easily explainable facets of the company's transition to its next stage of growth with Mazor X and the Medtronics partnership.
Customers are already beginning to pre-order the Mazor X system based on positive experiences during early training events. Medtronic ordered 15 Mazor X systems during the quarter. Four were delivered and revenue was recognized on three systems. Importantly, these are training systems that sell roughly at cost, which impacts revenue this quarter, but is a planned part of fully developing the Medtronic partnership.
The installed base increased to 130, from 96 in the prior year, up 35%. The majority of growth was driven in the U.S., where the installed base of 80 systems grew over 40% YoY from 56 systems in 3Q15. The international installed base grew 30%, to 52 systems.
The Mazor X system will be commercially launched at the North American Spine Society (NASS) meeting later this month in Boston. The meeting will be held from October 26-29.
BMR Take: This quarter’s results tell the story. The business is doing very well with upcoming catalysts. $27 price target.
Apple (AAPL: $117, up 3%)
We bet you didn’t hear the news: Batteries in the Samsung Galaxy Note 7 phone are exploding. Seriously, they are blowing up. Customers are returning the device and new orders have stopped. In fact, the company has discontinued the Note 7.
This is good news for Apple. As large carriers in the US like AT&T, T-Mobile, and Verizon stop replacing Galaxy Note 7 phones with new ones, Apple stands to gain incremental market share.
AT&T is offering to replace Note 7 phones with different models. T-Mobile is allowing customers to exchange their phones for a different model or get a refund. Verizon also stopped offering replacement Note 7s to customers.
Whether Samsung’s woes with the Note 7 turn out to be a significant increment to Apple’s earnings depends on how quickly the battery charging issue can be resolved. Third party estimates had called for 14 million Note 7 phones to be sold between August and December before the battery issue emerged. With the damage to Samsung’s brand, it sure seems like users may prefer to switch over to the Apple ecosystem.
BMR Take: The Samsung event is just icing on the cake. We like Apple for the potential upside from 1) continued long-term opportunity in China, 2) potential share gains from the release of a lower-end iPhone, 3) strength in the upcoming iPhone 7 cycle, and 4) optionality in cash balance. We like Apple at this level. $140 price target.
AmerisourceBergen (ABC: $80, up 1%)
Shares have been lagging. A number of pressures in recent quarters caused this year’s EPS guidance to be reduced. There is no more meaningful concern than the epidemic of concern over pricing throughout the Healthcare ecosystem (Think Mylan – down to $37 from where we removed it at $45).
There are still concerns about EPS risk linked to deteriorating pricing power for each of the major three pharmaceutical distributors. Specifically, at one point, AmerisourceBergen had indicated that it assumed 10-12% price increases in 2017 similar to 2016 levels. However, recent commentary indicates that all manufacturers, not just AmerisourceBergen, are showing a bit more caution in the way they approach pricing. In fact, there has also been some evidence of manufacturers deferring price increases at this point in the year versus what they might have seen in other years. Ouch!
BMR Take: The company still holds firm in aiming to meet its long term aspirational goal of 15% EPS growth of which 10% is organic. Though the timeline is not until 2018. The 2017 EPS outlook only calls for 4-6% growth. So be patient! $125 price target.
Upcoming Economic News
MONDAY, OCTOBER 17
Industrial Production & Capacity Utilization – September
Time: 9:15 am
Forecast: 0.2% industrial production, 75.6% capacity utilization
Industrial production is forecast to expand in September after declining by the most in five months in August. Both the production and new orders components of the September ISM Manufacturing Index turned positive after sliding in the previous month, an indication that both current output and demand are moving higher. Further positive monthly results will be needed to confirm an industrial sector rebound after manufacturing output fell year-over-year in both July and August.
TUESDAY, OCTOBER 18
Consumer Price Index – September
Time: 8:30 am
Forecast: 0.3% overall, 0.2% core
Rising gasoline costs can lead the September Consumer Price Index to its largest gain in five months. Though potential supply cuts from OPEC nations are pressuring fuel costs, gasoline at the recent $2.24 per gallon trails the current expansion’s high by 43%. One area where consumers have faced consistently rising prices is housing; the cost of shelter rose 3.4% year-over-year in August.
THURSDAY, OCTOBER 20
Existing Home Sales – September
Time: 10:00 am
Forecast: 5.33 million
The pace of existing home sales may show little change in September as limited supply is holding back transactions. Declines in the Pending Home Sales Index in three of the past four months warn that momentum for homes sales will not form in the near-term. The inventory of existing homes available for sale is equivalent to 4.3 months at August’s sales pace, well behind the historical average of 6.1.
Leading Indicators Index – September
Time: 10:00 am
Forecast: 0.2%
The large increase in the ISM Manufacturing Survey’s reading on new orders can lift the Leading Indicators Index in September. Both the Manufacturing and Non-Manufacturing indices from the ISM posted sharp turnarounds last month, easing concerns about potential slowdowns in hiring and output. An economic expansion of consistent but not overly rapid growth can support sporadic moves to tighten monetary policy.
The Options Corner
Here’s a simple option purchase that you might find interesting. With Bristol Myers-Squibb (BMY: $50, down 10%) down from recent highs, and the selling way overdone in our opinion, you might be interested in a way to take a position in the company without having to put up much capital. Or if you already have the stock you might want to average down a little. Additionally, there is great leverage in options as you will see in a minute, but also note, that there is risk.
You can do this by buying the January 2018 option, also known as a LEAP. The $45 option is selling for $8.50 and this gives you the right to buy the stock at $45. Thus if the stock goes to $53.50 you break even on the trade. We like the company expect to see the stock at $60 sometime next year and if the stock were to go to $62, you would double your money.
The risk is if the stock stays where it is or goes to $45 or lower by the end of the life of the option. If that happens, your investment goes to zero.
So, there you have it: a short and sweet option example for you.
A few words from Gary Jefferson
Jefferson Financial Group
First Vice-President, Investments
UBS Financial Services
Last week the Jobs report came in a little low and we also had the third revision of 2nd Qtr economic growth – it showed that the economy grew 1.4% in the second quarter. We have been told daily that economists expect to see stronger growth return in the third quarter. Two unofficial projections of GDP show that the economy may have grown 2.2% in the 3rd Qtr. However, forecasts have come down steadily in recent weeks, and it's possible the official growth numbers could be a disappointment. (Source: Thomson Reuters)
So once again the question is, "What can we expect in the coming weeks?"
Volatility and more volatility seems a fairly safe answer. The markets are grappling with a lot of uncertainty, especially ahead of the November election. We also know that the Fed wants to raise rates before the end of the year. We now believe that will happen unless 3rd and 4th Qtr earnings completely disappoint. On top of that are concerns about oil prices and the global effects of Great Britain's exit from the European Union.
Overall, we can expect markets to remain on edge until these uncertainties sort themselves out, and be somewhat comforted in the sense that there still does not appear to be a recession on the horizon. One market expert recently described it like this: "Adding it all up I see a long term bull market that is being interrupted by a too close to call Presidential election. It says more range bound action until the election results are final. Then the bull market gets rolling into year-end with a touch of Santa Claus rally mixed in for good measure."
The Market still seems to be expecting a stocking stuffed with goodies instead of coal.
Under Armour (UA: $38.50, up 2%) was upgraded by analysts at Wells Fargo from a "market perform" rating to an "outperform" rating. They now have a $45 price target on the stock, up previously from $40.
Twilio (TWLO: $46, down 11%) We added the stock on Monday after the stock dropped from $60 to $52 due to some selling stockholders announcing that they would sell about $350 million of stock. It is a bit unclear but it appears that the company will be selling just $50 million of new stock to raise capital. Both of these announcements are not bad things. Selling stockholders do this all the time. The stock will just change hands and it is actually a positive, since the stock will be in new hands. The company selling stock is nothing new either. And in this case, $50 million is just a tiny amount.
So the selling is way overdone. Yes, the company is new but they are on a trajectory to becoming one of the fastest growing firms on the Street. They have 30,000 customers, which we think is quite an accomplishment. We would recommend buying more slowly at these new, lower prices, averaging down if you bought at the $50 level. The stock could go to $40 before the selling stops, but we expect the stock to be a lot higher in early 2017 as the world sees how fast the company is growing.
Brookdale Senior Living (BKD: $15.30, down 5%) hasn’t been acting well. We have a $15 Sell Price on the stock and things are getting tight here. If it hits $15 we are removing the stock from our Special Opportunities Portfolio and would suggest you move into Welltower (HCN: $69, flat). Welltower’s market cap is $25 billion compared to Brookdale’s $3 billion. Welltower has 1400 properties and is paying 4.9% in a dividend. We were looking for Brookdale to be a turnaround situation for us, but they haven’t turned, and in fact have changed our opinion on them recently as they continue to disappoint.
North Dakota Crude Production Falls Below 1 Million Barrels a Day
North Dakota oil production dropped 4.7% in August on a commodity price slump, falling below the one-million-barrel-a-day mark for the first time in more than two years, according to the latest data from the state’s Department of Mineral Resources.
Crude production dropped to 980,000 barrels a day in August, the lowest level since March 2014.
Most oil in North Dakota is extracted from shale rock formations by hydraulic fracturing, or fracking, where a mixture of water, sand and chemicals is pumped into rock formations to push oil out. The state’s production has become an important barometer for how U.S. shale producers are faring during a period of low oil prices
High Yield Corner
We’re getting closer and closer to the Fed’s long-awaited rate hike, and the markets don’t like it.
The S&P 500 fell 1% this week as investors geared up for December, where the rate hike is looking increasingly likely. We’re seeing the fallout already in interest rates, with the 10-year Treasury already yielding 1.8% - far above its recent historic lows, but still far below the 52-week high of 2.4% reached just about a year ago. We still have a long way for Treasury yields to rise, and with it some pressure on stocks broadly.
Broadly - but not entirely. The Financial sector is poised to benefit, and the benefit seems to already be rolling in. Wells Fargo (WFC: $45, down 1%) reported earnings above expectations and a 2% increase in revenue despite the scandals that have caused the stock to plunge. Initially the stock surged on the news Friday, but erased those gains later in the day on broad market-wide weakness. It closed flat, and this should be instructive; a crisis-plagued financial firm is still able to deliver strong earnings with rising interest rates, and earnings are likely to go up for Wells Fargo and other financial firms. The opportunity to lend more aggressively with rising interest rates means these banks will be able to expand their operations and take on more risk. In short, if the Fed delivers on those rising interest rates, the Financial sector - currently one of the most beat up sectors in the market - will provide superior returns despite current low valuations.
This has a direct impact on one part of the high yield market: BDCs. It’s no surprise that this market was down a bit this week, but many people don’t understand why this happened. The UBS E-Tracs BDC ETF (BDCS: $22) fell 1% this week. The BDC universe is a diverse and complicated sector with many underperformers, which comprise the index that makes up BDCS. These underperformers are likely to do even worse in the future, because they will increasingly be competing with banks as interest rates go up. When rates rise, banks will lend more to small and medium businesses, thus competing in the Business Development Companies’ wheelhouse.
This dynamic is why we continue to like Main Street Capital (MAIN: $34, down 2.5%) even after its recent decline. We maintain our target price of $40 on the stock and recommend holding the stock even if it slides further with the BDC world. Our confidence remains steadfast that management is well-positioned and competent, and will be able to help make new deals that are profitable, and allow net investment income to pass through to investors through dividends. The 8% yield including special dividends and regular dividends is far from threatened, but the higher yield of some more risky BDCs is at much greater risk with the new competition from banks. So stay long Main Street Capital and avoid other BDCs.
Similarly, we remain constructive in selective parts of the junk bond market. Rising yields can have a bad impact on junk bonds and corporate bonds more generally, although we didn’t see that happening this week. The SPDR High Yield Bond Fund (JNK: $37) was flat this week and remains up 7% year-to-date. The junk bond market provides selective opportunities even as yields rise. We have seen bankruptcies rise considerably throughout 2016 and the market has priced this risk in, which means the risk of buying junk bonds now relative to the rising default rate is quite limited. (Most of the defaults have already happened and the risk was priced in a year ago. Buying at this level is less risky than in the past.) However, one needs to be selective about bonds, since indexes will include a lot of high-risk debt that actively managed funds can avoid.
This is the rationale behind our choice to buy Pimco Dynamic Income Fund (PDI: $28), although it must be admitted that this fund sees much greater volatility than the index fund. This is why the Pimco fund fell 1% this week and more declines may be forthcoming. But as we have repeatedly stated in this newsletter, this fund is poised to pay over $1 in a special dividend in December. The announcement is coming very soon, since November is just around the corner (the fund usually announces its special dividends in November), so we urge anyone long this fund to continue holding it even if it continues to underperform the index on a short-term basis.
Finally, to REITs. These have been a volatile roller coaster in 2016, providing strong outperformance followed by a sharp correction beginning this summer. Now the correction seems to have stopped, with the SPDR Dow Jones REIT Fund (RWR: $93) up 1% in the past week. Will this strength continue? Many are worried that rising rates will pressure REITs, but a lot of that happened in recent weeks and may already be played out. We don’t foresee great strength in the REIT universe, nor weakness either. In a market with limited market-wide buying or selling pressure, outperformers will be more desirable. This is why we continue to recommend holding Kimco Realty (KIM: $28, up 1%) and Digital Realty Trust (DLR: $92, up 3%), as the buying pressure for these stocks in particular is likely to prop them up no matter what happens to REITs more broadly.
Good Investing,
Todd Shaver
Editor in Chief
The Bull Market Report