October 11, 2016
by Todd Shaver | Oct 11, 2016 | 11am News Flash
Twilio: (TWLO: $52, down 14% yesterday)
Twilio fell the most since it started trading in June after the mobile and web-applications maker said the company and select shareholders will sell more stock. Despite Monday’s drop, Twilio is still up more than 250% since its IPO at $15 in June, closing up at $29, up 92% the first day. Now is the opportunity we’ve been waiting for to invest.
Twilio is a rare opportunity to invest in the only pure-play Platform-as-a-Service (“PaaS”) provider that is taking large slices of the Communications Software market, which IDC estimates to reach $46 billion in 2017. This new greenfield opportunity is being called Communications-Platform-as-a-Service (“CPaaS”). Twilio is known as the cloud-based category leader in CPaaS.
Riding the wave of the app and developer economy is a great place to invest. The clear growth in cloud computing is widely recognized. High-growth trajectories from Amazon Web Services (AWS), Microsoft Azure, Google Cloud, and Salesforce.com’s PaaS reflect the paradigm shift in how developers are building applications.
What does all that PaaS and CPaaS jargon mean in layman terms? The Information Technology (IT) department across Corporate America is undergoing a massive transformation. Historically, companies used to build out internal IT departments with staff and equipment. Right now, everything is shifting to the cloud. Instead of purchasing all the equipment to store data, the process is being run through massive data storage centers made available through the cloud for a simple license fee that scales up and down with volume. Instead of hiring a team of mobile software developers, the process is taking place through open sourcing the projects through the cloud, again on a pay-as-you-go basis. Twilio is leading the trend with a tight grip on communication services. Specifically, Twilio enables developers to build, scale, and operate real-time communications within software applications – to include SMS (texting), voice, video, and authentication.
The company is led by Jeff Lawson who is low-key and personable, but high in engineering intensity and entrepreneurial discipline. He is brilliant, and we at The Bull Market Report believe in him and hold him in high regard. You WILL hear more from this man and this company in the future.
Why is Twilio’s platform considered to be the leader? Listen to this: Twilio has 30,000 customers - from small developers to large enterprises - who use Twilio to power some 75 billion annual connections that reach 1 billion devices. Match.com makes matches without revealing phone numbers; Airbnb sends rental notifications, and the American Red Cross deploys volunteers, all through Twilio. ING, the European banking giant, recently announced it was closing down 17 hardware and software systems across its global call centers and replacing all of it with Twilio. Twilio’s largest customer, WhatsApp, uses them to verify customer accounts and logins. Apps from Lyft, Expedia, Netflix, Coca-Cola, Salesforce and the New York Times all have Twilio inside. The company saw 70% growth last quarter.
Here is more about the business model. The revenue model is transactional. Twilio largely prices its products on a transactional usage-based model. For example, its voice business is priced on a per-minute basis, while its message business is on a per-message sent basis. Programmable video is priced per gigabit. The reality is that Corporate America wants a scale-up/scale-down service on a pay-as-you-go basis, so the entire technology industry is just going to have to get used to no longer having the degree of revenue visibility that once existed.
Due to the nature of the business model, we look at revenue growth as the key indicator of business momentum. The outlook is exciting. There is substantial growth opportunity ahead through international expansion, adding other enterprise customers, and the roll-out of new products. While Twilio has been experiencing high revenue growth running 80-90%, there is strong likelihood for continued explosive growth, primarily via expanding the business internationally, which accounted for just 14% of revenue in 2015. Twilio began investing in Europe only in 2014 and Asia just in 2015 and has already yielded strong results. These geographic regions are just getting going. Additionally, Twilio is gearing its sales force to pursue business with a greater number of enterprise customers such as ING and Nike, where the more big names the company can win the more likely we are to see trickle-through effects in terms of enterprise-level retention rates.
The financial picture calls for the major inflection point to come in 2018. Twilio did $167 million in sales last year, up from $90 million the year before. At its current growth rate Twilio would hit a $1 billion annual run rate in the second half of 2018. Lawson calls telecommunications services a trillion-dollar market, with big portions of it poised to migrate from hardware to software. Following Twilio’s total revenue growth of 88% YoY in 2015, consensus estimates call for growth to decelerate to 50% per year in 2016-2018 but we think they can outdo these estimates. By 2018, management has committed to be EPS, operating cash flow, and free cash flow positive. This inflection point considers ongoing investments to build out partnerships that will support the future of the company.
Customer concentration risk* is among the single biggest concerns investors currently have. In 2015, Twilio’s 10 largest customers contributed 32% of total revenue. A meaningful though undisclosed revenue contribution came from just two customers – WhatsApp and Uber. These two customers, however, have very different profiles and it is important to understand the nuances. The bottom line is that investors will just have to live with the customer concentration until the business can grow out of it. WhatsApp is a mobile instant messaging platform with approximately 1 billion users globally and was acquired by Facebook in 2014. WhatsApp has been a Twilio customer for about four years and was a customer before Facebook purchased it. WhatsApp uses Twilio for both voice and messaging.
Uber uses Twilio’s Programmable Voice products to enable voice calls between the driver and the rider, uses Twilio’s Programmable Messaging products to notify riders of an approaching ride or to engage drivers during increasing demand, and finally uses Twilio’s Authy product to authenticate phone numbers of new users.. Overall, both the relationships with WhatsApp and Uber appear to be on solid footing.
The other main concern is the long-term competitive threat of Amazon’s AWS. However, AWS, the leading cloud platform, is not currently a competitor. Should AWS decide to provide a competitive cloud platform for communications, it would pose a threat to Twilio’s business but that talk is just speculative. Twilio has noted that it has a “great” relationship with Amazon, which is an investor in Twilio. In July, Twilio announced that it now “helps AWS extend text message delivery for SNS customers.” AWS VP of Mobile and IoT Marco Argenti commented, "AWS believes in the value of efficient, scalable technology solutions that can elevate the developers' role to concentrate on building great applications, rather than managing infrastructure. We are thrilled to be working with Twilio, and we'll continue to work together to help empower developers to communicate with their users seamlessly across devices." All in all, we find some comfort in the close relationship the two companies currently share.
BMR Take: Twilio is not cheap, trading at 12x 2017 sales, relative to its peer group average of around 4x. However, Twilio is better positioned than all its peers by a large distance as a pure play in CPaaS, an explosive growth opportunity. We believe Twilio is on the path to ultimately produce annual sales greater than the current market cap of $4.4 billion with sales this year of $315 million. The timeline is a ways out, but the recent sell-off is an opportunity to invest in this powerful, explosive company.
*Note that we at The Bull Market Report do not view the customer concentration as a worrisome issue. With growth as noted above, we don’t see it as a threat to the well-being of the company.
And one more thing. The world is always looking for The Next Big Thing. Twilio just might be a candidate for this exciting category.
September 19, 2016
by Todd Shaver | Sep 19, 2016 | Monthly Newsletter Daily 6am if new
The Week Ahead
It was a week of ups and downs last week, with the Nasdaq up big, due to Apple and other Tech, and two out of the three major indices ending flat. There is clear confusion. World class investors at the Delivering Alpha Conference hosted by CNBC in NYC this week could not even agree which way the market is heading. While volatility has started to rise, we believe the moderation that was seen toward week end reflects a wait and see attitude surrounding what the Fed will do next week at their meeting. The probability for a rate hike is only 20%, but we are bracing for a potential surprise, as the Fed needs to prove to the market that it will hike rates, counter to low market probabilities, in order to demonstrate that they are leading the market and not the other way around. With all the volatility and uncertainty, we continue to stress top quality stocks as the place to be.
Here is How Last Week Progressed:
Monday (9/12) – S&P 500 +1.8%
— Markets rallied after Friday’s big selloff. Goldman Sachs issued a report calling for last week’s bond market selloff, triggered by UK concerns and Japan monetary policy, to extend into the 4th quarter, with US Treasuries reaching 2% by year-end (currently 1.69%).
— In Energy, a ratings agency issued a new report discussing how recovery rates for 15 US exploration and production bankruptcies averaged a “catastrophic” 20% last year, well below the historical average of 60%. (So out of those that go bankrupt, lenders are getting back just 20 cents on the dollar vs. 60 cents. Not good.)
— In Financials, Wells Fargo (WFC: $45, down 7% last week)admitted to secretly creating millions of bank and credit card accounts over the past five years without their customers’ knowledge or consent. An entire arm of the bank was fired over the matter and the stock is down sharply.
Tuesday (9/13) – S&P 500 -1.5%
— Monday’s recovery turned wobbly as concerns of general global economic conditions are increasing.
— The Delivering Alpha Conference in NYC hosted some of the brightest and richest minds in investing. Billionaire Paul Singer issued cautionary words for the path ahead discussing how it’s a very dangerous time in the global economy and global financial markets, adding that gold was under-represented in investors’ portfolios. Billionaire Ray Dalio warned that the current environment is analogous to the 1935 to 1945 period in America where we reached the limits of central banking’s ability to stimulate the economy and raise global asset prices.
— A US think tank warned that Australia has about six weeks or so to turn their situation around or face a massive hit to property valuations.
— Another Fed president has decided to call it a day. President of the Atlanta Fed Dennis Lockhart announced he will be stepping down on February, 2017.
Wednesday (9/14) – S&P 500 -0.1%
— Markets stood still.
— Goldman Sachs issued reports reducing their odds for a hike next week to 25% from 40% previously.
— CNBC hosted numerous conversations about the volatile mechanics of the stock and bond markets simultaneously selling off over the past week.
— In Healthcare, an undercover investigation by the Government Accountability Office found that 100% of their fictitious enrollees were able to sign-up and maintain Obamacare coverage and taxpayer subsidies despite submitting fictitious documents and/or refusal to submit any documentation at all.
Thursday (9/15) – S&P 500 +1.1%
— The morning began with news of the biggest German M&A deal in history. Monsanto accepted Bayer’s takeover offer for $66 billion creating an agriculture giant.
— More concerns about markets soon followed. Former Fed Chairman Allen Greenspan made public comments discussing how this is the worst economic and political environment that he has ever been remotely related to, noting that the U.S. is headed toward stagflation. New data soon after the statement confirmed Greenspan’s concerns.
— Year-over-year growth in Retail Sales rose just 1.9%, which represented the weakest level since March’s plunge and is now worryingly in historical recession territory.
Friday (9/16) – S&P 500 -0.9%
— Market performance was soft into the weekend. In Autos, just weeks after warning that sales had reached a plateau, Ford is now warning investors that operating profit will fall in 2017 and as a result the company is relocating small car production to Mexico.
— In Transportation, bankrupt shipping giant Hanjin said that as of this morning it had 93 vessels, including 79 container ships, stranded at 51 ports in 26 countries.
— Gearing up for next week’s Fed meeting, former Fed leader Ben Bernanke was out with some noteworthy comments foreshadowing the future path of interest rates in the US – negative! Specifically, he said, “The fact that negative rates would be temporary and deployed only during severely adverse economic conditions, would be an advantage. Like quantitative easing, which was also unpopular in many quarters, a period of negative rates would probably be tolerated by politicians if properly motivated and explained.”
Bull Market Report Companies and Commentary
Microsoft (MSFT: $57) Microsoft is a high quality bellwether. Recent reports indicate that channel partners* see strong business trends for the company’s Cloud product, Azure. Azure is a key pillar of expected EPS growth embedded in consensus forecasts. Accordingly, it is a good sign to hear that Azure is on track with expectations.
* A channel partner is a company that partners with a manufacturer or producer to market and sell the manufacturer’s products, services, or technologies, usually done through a co-branding relationship. Channel partners may be distributors, vendors, retailers, consultants, systems integrators (SI), technology deployment consultancies, and value-added resellers (VARs) and other such organizations.
To be more specific, channel partners are seeing strong sustained growth for Microsoft Cloud products, with a couple of partners underscoring a pronounced uptick with respect to Azure. One partner recently observed a renewed push by Microsoft to make inroads into the federal government vertical with its government Cloud. Lastly, a few channel partners referred to overall softness in their legacy Microsoft practices, partially driven by a faster-than-expected transition into the Cloud. This should be read as good news. Basically, the use of office desktop products is slowing because companies are transitioning to the Cloud.
We like that trend. We are fine with the legacy Microsoft business declining if the customers are moving to the Microsoft Cloud. It’s quicker and better, and a higher valuation is applied by the Street for the Cloud versus the desktop business
While Microsoft’s Azure product faces fierce competition from Amazon’s comparable AWS offering, one channel partner noted that Microsoft’s head start in the market with Office 365, along with their inherent long term relationships in Enterprise IT gives Microsoft a slight advantage in the Cloud space as compared to Amazon.
In fact, there is currently talk of an enormous energy conglomerate that has physical data centers in multiple countries which they are finding incredibly difficult to manage and scale and hence is thinking of moving to a Cloud infrastructure model. While this company has engaged both Microsoft and Amazon, the company appears to have a preference to go with Microsoft Azure because of the long standing relationship with Microsoft. This case study reinforces the storyline that Microsoft has created enough of a reputation now so that Amazon doesn’t seem like the only company in the public Cloud space.
BMR Take: The Cloud business is booming. Microsoft’s Azure product is recording revenue growth of greater than 100% a year. Channel partners are suggesting momentum is building. We view Microsoft as a high quality portfolio holding with an attractive dividend yield and substantial upside ahead.
Facebook (FB: $128) Weak sentiment surrounding the stock presents a buying opportunity. Facebook has delivered three consecutive quarters of 60%+ ad revenue growth, with an acceleration in four of the past five quarters. Street estimates have an upward revision bias with the 2017 consensus EPS having increased 35% so far this year. The overall lack of enthusiasm is reflected in the lower forward PE multiple and creates an opportunity.
One debatable topic right now is ad growth. Despite management’s caution on the 2Q16 earnings call, ad loads still have room to increase. Ad loads are a less significant growth driver of EPS estimates than many appreciate. Street estimates now call for slowing ad load growth to around 10% this year and actually declining in 2017-2018. Though there are several levers for management to focus on to drive improvement. For example, the company is currently working on ad targeting, relevancy, formats, and profitability in ways that don’t alter the user experience. Facebook still has opportunity ahead for ad load growth despite the recent near term headwinds.
Another debatable topic right now is engagement. Despite a small sequential drop in 2Q16 daily and monthly active users across all regions, the overall ratio of daily to monthly active users remains steady at 66%, which highlights the stickiness of the customer base. Moreover, Facebook’s share of US mobile Internet time of 13% is 2x greater than Snapchat, Twitter, Instagram combined, which highlights how healthy engagement remains. Recent product changes such as prioritizing friends and family in the Facebook and Instagram feeds and the launch of Instagram Stories may acknowledge shifting usage and increased competition, at least in certain demographics, but we expect Facebook to remain innovative on products. We are not concerned about a slight slowing of engagement.
BMR Take: We think weak sentiment surrounding ad growth and engagement presents a buying opportunity. Street price targets are as high as $170, framing the compelling upside potential. We added the stock in February at $97, and we are approaching our Price Target of $140. We are pleased.
Tesla (TSLA: $206) Tesla released an Autopilot update announcing advanced signal processing capabilities for its radar, which can now act as a primary control sensor and does not require the camera to confirm visual image recognition. It is just another sign of the transformational shift in auto manufacturing, where Tesla is leading the way,
Digging into the new technology a bit, the software upgrade collects more data in order to better determine the risk of a collision and prevent unnecessary braking. All very exciting stuff. In fact, just in the past few days at Ford’s annual investor day, Chairman Bill Ford acknowledged that “the technology is here in the world of autonomous driving, but there are a lot of things to work through and we have something to learn from every competitor [inferring Tesla]”. This was quiet the notable endorsement for the direction Tesla is heading.
Note that Robert W. Baird set a $338 price target on Tesla on Monday. FBN Securities upped their price target from $260 to $275 and gave the stock an outperform rating. Morgan Stanley reaffirmed an equal weight rating and set a $245 price target. Six research analysts have rated the stock with a sell rating, 13 have a hold, 10 have a buy rating and two have assigned a strong buy to the company. The consensus target price is $253.
BMR Take: We view the AutoPilot announcement as a positive that shifts focus back to Tesla’s core competitive advantage as a leader in the development, distribution, and monetization of ground-breaking automotive technologies. With that said, we await more news of the Gigafactory progress; the progress of the integration of SolarCity into the future of Tesla; and how in the world they can deliver on the 400,000 orders for the new Model 3 (for which they received $400 million in cash from the down payments.) These are the big picture items. And again, Tesla is RISKY. The stock could go to $400 in the next year or two, or it could go to $70. Or both. This one is volatile and not for the faint of heart.
Visa (V: $82) We have seen some big headlines in the stock market in recent weeks, but this company just quietly continues to perform. We want to be sure this stock doesn’t fall off your radar.
There are several catalysts that appear to be pushing stronger top line revenue growth including improved cross-border volumes, new deal wins (Costco, USAA), price increases (adds 100 bps to the growth rate), and accretion from the Visa Europe deal.
On cross-border volume, Visa is optimistic about improving trends as oil and the stronger US dollar comparables ease. Visa isn’t seeing any pricing pressure on cross border fees and is seeing significant growth in online commerce (the growth of digital grows at double the rate of offline). Cross border is 6-7x more profitable than domestic transactions.
Another big opportunity coming out soon is their entering the China market. Although there is no specific timeline yet, there is a big future opportunity to process Chinese domestic volumes and more Chinese cross-border transactions. In fact, some analysts size the opportunity to be $3 billion of revenue by 2020. Currently, Visa is focused on adding-single branded Visa cards to the Chinese market, while the cobrand relationships move towards expiration.
BMR Take: Visa is a very steady business model and a proven stock. The global opportunity to convert cash to electronic forms of payments remains lucrative. We continue to view this stock as a long term core holding.
Qualcomm (QCOM: $63) With all the news out on the Apple iPhone 7 launch, we can’t overlook the implications to Qualcomm. Eyes are on the Intel baseband share of the iPhone 7 business because the remaining share falls to Qualcomm.
Multiple reports have surfaced claiming to be able to discern the amount of share that Intel has taken in the iPhone 7. It is a bit premature to make a pronouncement on this, given that Apple is likely only slowing letting Intel into their phones. Either way, the impact is confined to only a 65% subset of iPhones that are non-CDMA* capable. Moreover, it is very likely that Apple is very slowly introducing Intel into the product line, considering recent major disruptions others in the industry have experienced, like with Samsung’s recent migration to a new chip stumbled.
*CDMA stands for code division multiple access, which is a channel access method used by various radio communication technologies. It often determines what network (Verizon, AT&T, etc.) your iPhone will work on).
To be clear, Qualcomm is expected to continue to hold 100% share in CDMA capable smartphones. According to industry estimates, CDMA capable smartphones represented 30% of total iPhone unit volume over the past 12 months and 35% in the 2nd quarter. As referenced above, the 65% of 2Q unit volume that was not CDMA capable is where Intel is possibly taking share. Some more aggressive expectations presume Intel may take the lion’s share of this 65% bucket. However, more in-depth analysis from industry experts points out that it is entirely possible that even where Apple is using Intel they may also be using Qualcomm in the same model. Bottom line, the Intel versus Qualcomm market share discussion in the iPhone remains pure speculation at this point, but is a must-watch trend going forward.
The most important trend to watch, however, is overall smartphone demand which remains strong.
BMR Take: We continue to like the prospects for the Apple ecosystem, which includes Qualcomm. Moreover, shares look attractive here with a 3.3% dividend yield. Qualcomm is a cash machine riding the smartphone wave to higher levels.
Home Depot (HD: $126) Management was on the road these past two weeks meeting with investors. Several favorable takeaways on the business surfaced. The Western part of the US continues to see strength, as Home Depot attributes it to more than just a California story, with a mini Silicon Valley forming in the Northwest states and great momentum around this build out. Phoenix is also improving and they believe there is a strong upside to the market based on how much there is left for that housing market to appreciate to reach the prior peak. Home Depot generates 1/3rd of its sales in the West.
Management highlights that the Pros customer base (professionals) are a little less price conscious given that they want to be able to know their costs and seem to have less patience for following promotions. Recall that 40% of sales is generated by the Pro customer.
Lastly, management noted that their second half guidance is not just based on the strength of the housing market but also feedback from the Pro customer base; that the project pipeline is strong for at least the next six months. Management noted that the Pros are taking vacations for the first time in years based on the healthy labor market.
BMR Take: Solid trends are seen over at Home Depot. The implications are good for the broad economy and stock market. We continue to favor this blue chip.
Gilead Sciences (GILD: $79) We thought we would give you some news on recent upgrades and research reports have been issued on Gilead. A large bank in Germany issued a buy rating and a $112 price target on the stock. Barclays reaffirmed an overweight rating. RBC Capital Markets set a $105 target price on Gilead and gave the stock a buy rating. Morgan Stanley has a price target of $103. Nine research analysts rate the stock with a hold, 18 have a buy and two have issued a strong buy rating on the company. The company has a consensus rating of Buy and a consensus price target of $105.
Gilead last posted its earnings results on July 25th. They reported $3.08 EPS for the quarter with revenue of $7.8 billion. On average, equities analysts predict that Gilead Sciences will post $11.80 for the current year.
The business also recently announced a quarterly dividend, to be paid on September 29th. The $1.88 annualized dividend produces a yield of 2.4%, paying out just 17% of earnings. There is plenty of room for growth in the dividend here.
Hedge funds and other institutional investors have recently added to their stakes in the company. Norges Bank acquired a new position in Gilead valued at about $1.3 billion. Bank of Montreal acquired a new position in Gilead Sciences during the second quarter valued at $430 million. Capital World Investors boosted its position in Gilead Sciences by 28% in the second quarter. They now own stock valued at $1.3 billion. Investec Asset Management acquired a new position during the first quarter of $280 million. Finally, Parnassus Investments CA boosted its position by 45% in the second quarter. Parnassus now owns $700 million. 78% of the stock is owned by institutional investors and hedge funds.
BMR Take: The stock has a market cap of $102 billion and a price-to-earnings ratio of 7. The stock is grossly undervalued and we expect the stock to go back to the triple-digit level late this year or next.
Upcoming Economic News
It is a very light week for economic news. The focus will be on the FOMC statement out Wednesday. The probability of a rate hike is just 20% with >50% odds that a hike will not occur until December. But who knows! Yellen now has Bernanke in her corner prescribing possible negative rates.
Under Armour Update:
Kevin Plank, CEO and Founder of Under Armour (UA: $39) announced that he will be selling 2.1 million shares of stock starting in October. A subscriber wrote in and asked our opinion of the situation, as he thought this was a bad thing.
Here’s what we wrote back:
“Hi Samuel –
“We generally don’t mind if executives sell stock. Plank currently owns 34 million shares of the company’s Class B stock, 135,000 shares of Class A stock and 34 million shares of Class C stock, representing 65% of the voting power in the company. So 2 million shares is a small part of his holdings. He is just diversifying.”
That’s how we feel. Of course, we secretly wish we had 2 million shares to sell of our own, and we admire Plank and all the others that have created all of the amazing companies out there, like Amazon and Facebook and Google, and so on. This is America. The entrepreneurs and the risk takers shall reap the rewards. Again, we would not even blink a negative eye over this CEO selling a small part of his stake in the company. Bill Gates has been selling 20 million shares a quarter since 2002. Wow. And we still love Microsoft.
THE APPLE CORNER
Apple had a great week. The stock was up $12, or 11%, closing at $115. I hope you are listening to us here at The Bull Market Report as we’ve been pounding the table on Apple for months! The stock saw its strongest four-day streak in over two years and is destroying short sellers who bet against it. The newest fuel was Apple’s announcement that initial quantities of the iPhone 7 Plus have sold out globally. Sprint said sales set records, far out-pacing sales of the iPhone 6 two years ago. That sent the stock up 3% on Thursday, after a 3% rise on Wednesday.
It was the strongest 4-day percentage increase since 2014, when Apple shot 13% higher over four days after the company increased its share buybacks and announced better-than-expected quarterly result.
Apple was responsible for much of this week’s gains in the Dow Jones Industrial Average. If Apple had been unchanged this week, the Dow would have been down 0.1%, instead of the 0.2% gain it recorded.
Apple on Tuesday made available new software (at no charge) for iPads and iPhones bringing huge enhancements to Messages, Maps, Siri, Photos, Apple Music, News, and more. This is what customers love about the company. And this is what WE at The Bull Market Report love about the company.
BMR Take: The stock trades at a PE of 14 times its past 12 months of earnings compared with 20 for the S&P 500. Will we see new highs ($134) in the stock by Christmas?
Good Investing,
Todd Shaver
Editor in Chief
September 11, 2016
by Todd Shaver | Sep 11, 2016 | Weekly Newsletter 7pm Sunday
The Week Just Past and the Week Ahead
A sharp sell-off on Friday has rattled confidence. This was the first time in over two months that the S&P 500 moved more than 1% in a day. There are several driving forces. Due to a wave of profit warnings, the consensus expectations for a second half EPS recovery is now being reset lower. Moreover, the ongoing interest rate hike debate saga continues. While economists who watch Yellen conclude that she is signaling the Federal Open Market Committee will start raising rates in June, the futures market indicates no such thing. Bloomberg's World Interest Rate Probability function, which is based on futures trading data, sees only a 17% probability that the top end of the Fed's target range will go up at or before the June meeting of the rate-setting committee. Bottom line, new concerns that a rate hike is in the cards this month was a factor to the sharp market movements seen on Friday. We are not at all surprised to see the markets fade from recent all-time highs. While there may be more volatility ahead this week, our bias is to stand by ready to buy and scoop up our favorite stocks. This week we highlight Microsoft, Facebook, Alphabet, and Twitter.
Here is How Last Week Progressed
Monday (9/5) - S&P 500 -0.1%
Traders returned from vacation to find S&P futures flat, oil and the dollar lower, and a flurry of M&A activity. In fact, analysts at Morgan Stanley caved on their bearish call by raising their 12-month price targets for the S&P 500 – base case from 2200 to 2300, their bear case from 1600 to 1800, and their bull case from 2400 to 2500. For the bull case, Morgan Stanley left their EPS outlook essentially unchanged, but raised the multiple from 18x to 19x to yield their new 2500 bull target.
Tuesday (9/6) - S&P 500 +0.2%
Abysmal Class 8 truck net orders came out and continued to just get worse with each passing month. August net orders were down over 25% compared to last year. In fact, the level of trailing 12-month net orders is the lowest since 2011 with the annual change trend line now in negative territory for 18 consecutive months. The truck order data combined with Institute of Supply Management data that is flirting dangerously with recession levels are painting a very concerning picture about the core health of parts of the economy. Separately, billionaire Mark Cuban publicly stated that he has no doubt the market will tank if Donald wins. Could we see a Brexit like sell-off in the US should Trump win?
Wednesday (9/7) - S&P 500 +0.1%
Quant strategies on Wall Street are increasing in popularity. Did you know that the signals picked up by many quant strategies were able to get many investors out of oil prior to the massive sell off? Accordingly, we note that JP Morgan’s head quant has released a new report saying that the recent period of record calm across asset classes is about to end, warning of an increase in realized volatility, correlations, and tail risk* in September and October.
* Tail risk is something that is unlikely to happen - but still could. Broadly speaking, a tail risk is an event with a small probability of happening, says Bob Conroy, professor of finance at the University of Virginia Darden School of Business. “In every event there are tails; there are really good things that can happen and really bad things.”
Thursday (9/8) - S&P 500 -0.1%
Total consumer credit rose by $17.7 billion in July, up from last month's $14.5 billion, and above the $16.0 billion expected, as US consumers continued to get increasingly more indebted. However, while the credit spigot appears to be fully functional once again, it does not explain the disappointing car sales numbers in recent months, which prompted Ford earlier this week to warn that US car sales have now hit a plateau. Moreover, there are already concerning signs of credit performance. In July, 60 day subprime loan delinquencies were up 13% on a month-over-month basis and were up 17% compared to the same month last year. Prime delinquencies were up 12% on a month-over-month basis and were up 21% compared to the same month last year. Ouch.
Friday (9/9) - S&P 500 -2.5%
Markets were in a turmoil as the S&P moved more than 1% in a day for the first time in over two months. In fact, it was the 11th biggest jump in VIX in history, as August saw the volatility at a 2-year low. (The VIX (^VIX) was up 40% to 17.50 from 12.51.) What is going on here? Among other issues, we note deteriorating earnings expectations as the second half earnings growth rate pick-up baked into consensus appears to now not be materializing. This week we observed a wave of profit warnings from some large- and small-cap companies including Ford Motor, Barnes & Noble, Tractor Supply, SuperValu, Sprout’s Farmers Market, Pier 1 Imports, General Mills, HD Supply Holdings and Dave & Buster’s.
Separately, the ongoing stream of cautious data points continues to flow. Last week, we learned that PIK Toggle note* issuance is growing sharply. Looking back, the 2007 ramp in PIK Toggle note issuance was a pretty good indicator that the high-yield market was frothing over and the party was near an end. After all it's probably not a good sign when a market completely loses discipline to the point of rushing to hand out nearly $20 billion to companies that are basically admitting they may not even be able to afford the interest on the loan.
* A payment-in-kind bond, where the issuer has the option to defer an interest payment by agreeing to pay an increased coupon in the future. It is a sign that the company is having trouble repaying its debts. It's financing for companies undergoing a bankruptcy / restructuring process. The very nature of the loans is risky.
The Bull Market Report Companies and Commentary
Microsoft (MSFT: $56, -3% for the week) Microsoft is a high quality bellwether. Recent reports indicate that channel partners* see strong business trends for the company’s Cloud product, Azure. Azure is a key pillar of expected EPS growth embedded in consensus forecasts. Accordingly, it is a good sign to hear that Azure is on track with expectations.
* A channel partner is a company that partners with a manufacturer or producer to market and sell the manufacturer's products, services, or technologies, usually done through a co-branding relationship. Channel partners may be distributors, vendors, retailers, consultants, systems integrators (SI), technology deployment consultancies, and value-added resellers (VARs) and other such organizations.
To be more specific, channel partners are seeing strong sustained growth for Microsoft Cloud products, with a couple of partners underscoring a pronounced uptick with respect to Azure. One partner recently observed a renewed push by Microsoft to make inroads into the federal government vertical with its government Cloud. Lastly, a few channel partners referred to overall softness in their legacy Microsoft practices, partially driven by a faster-than-expected transition into the Cloud. This should be read as good news. Basically, the use of office desktop products is slowing because companies are transitioning to the Cloud.
We like that trend. We are fine with the legacy Microsoft business declining if the customers are moving to the Microsoft Cloud. It’s quicker and better, and a higher valuation is applied by the Street for the Cloud versus the desktop business
While Microsoft’s Azure product faces fierce competition from Amazon’s comparable AWS offering, one channel partner noted that Microsoft’s head start in the market with Office 365, along with their inherent long term relationships in Enterprise IT gives Microsoft a slight advantage in the Cloud space as compared to Amazon.
In fact, there is currently talk of an enormous energy conglomerate that has physical data centers in multiple countries which they are finding incredibly difficult to manage and scale and hence is thinking of moving to a Cloud infrastructure model. While this company has engaged both Microsoft and Amazon, the company appears to have a preference to go with Microsoft Azure because of the long standing relationship with Microsoft. This case study reinforces the storyline that Microsoft has created enough of a reputation now so that Amazon doesn’t seem like the only company in the public Cloud space.
BMR Take: The Cloud business is booming. Microsoft’s Azure product is recording revenue growth of greater than 100% a year. Channel partners are suggesting momentum is building. We view Microsoft as a high quality portfolio holding with an attractive dividend yield and substantial upside ahead.
Facebook (FB: $127, +2%) Weak sentiment surrounding the stock presents a buying opportunity. Facebook has delivered three consecutive quarters of 60%+ ad revenue growth, with an acceleration in four of the past five quarters. Street estimates have an upward revision bias with the 2017 consensus EPS having increased 35% so far this year. The overall lack of enthusiasm is reflected in the lower forward PE multiple and creates an opportunity.
One debatable topic right now is ad growth. Despite management’s caution on the 2Q16 earnings call, ad loads still have room to increase. Ad loads are a less significant growth driver of EPS estimates than many appreciate. Street estimates now call for slowing ad load growth to around 10% this year and actually declining in 2017-2018. Though there are several levers for management to focus on to drive improvement. For example, the company is currently working on ad targeting, relevancy, formats, and profitability in ways that don't alter the user experience. Facebook still has opportunity ahead for ad load growth despite the recent near term headwinds.
Another debatable topic right now is engagement. Despite a small sequential drop in 2Q16 daily and monthly active users across all regions, the overall ratio of daily to monthly active users remains steady at 66%, which highlights the stickiness of the customer base. Moreover, Facebook’s share of US mobile Internet time of 13% is 2x greater than Snapchat, Twitter, Instagram combined, which highlights how healthy engagement remains. Recent product changes such as prioritizing friends and family in the Facebook and Instagram feeds and the launch of Instagram Stories may acknowledge shifting usage and increased competition, at least in certain demographics, but we expect Facebook to remain innovative on products. We are not concerned about a slight slowing of engagement.
BMR Take: We think weak sentiment surrounding ad growth and engagement presents a buying opportunity. Street price targets are as high as $170, framing the compelling upside potential. We added the stock in February at $97, and we are approaching our Price Target of $140. We are pleased.
Alphabet (GOOG: $760, -2%). Building on the discussion above surrounding the booming Cloud business, Google’s efforts with its Cloud product Google Cloud Platform (GCP) are gaining momentum. We think there is plenty of room in the massive end market for several winners, so we do not view Google’s progress as a negative for Microsoft.
GCP is getting more aggressive and gaining traction in part due to a renewed focus and alignment with heavier investment and financial commitment with over $1 billion in acquisitions in the past year. In summary, the narrative around GCP being a distant third place in the public Cloud race may start to improve going forward.
Channel partners say that Google is targeting a select number of marquee Silicon Valley prospects, including a few that might be Amazon AWS displacements. GCP may soon make some material product announcements. Some partners are saying that GCP is hiring sales reps aggressively and the consensus view is that GCP is trying to win on its products and infrastructure, not on price.
Most firms still see GCP well behind AWS and Azure in the large enterprise market, with a less mature sales effort and premium service suite. That said, it is now believed that a $400 million revenue run-rate estimate for GCP in 2016 might be too low and that it could be closer to $750 million. On its 2Q16 call, Google called out the Cloud as the primary driver of the re-accelerating growth for Licensing and Other revenue, the first time the business has been mentioned in such manner.
BMR Take: Google Cloud Platform is a small but growing part of the Google investment thesis. We put it in the bucket of Google businesses with potential upside surprise versus consensus thinking. We would be buyers of Google all day long.
Twitter (TWTR: $18.11, -7%). Shares rose in the last week of August on rumors of a take-out, but the Board met on Thursday and thereafter communicated there were no offers to buy the company on the table right now. Accordingly, Twitter is now left (again) to deal with proving out their business model independently. Some analysts are now saying that if CEO Jack Dorsey can’t fix the business model in the next few quarters, he should volunteer to step down.
Shareholders want Twitter to become one of the first news sources users turn to. Many social media users see what Twitter provides as a basic necessity of an emerging digital age. Users offer unpaid labor hours to create content, which generates data that can be recorded, measured, and sold. They believe the trade is fair. Twitter maintains extensive databases of this information to exploit the content. The key will be figuring out how to satisfy shareholders for playing matchmaker without disturbing the part of the model that is working.
BMR Take: We see value in the Twitter platform. The company continues to take efforts to improve the model, with recent emphasis on live-streaming technology and new partnerships with the NFL and other sports leagues. While we likely won’t see a near-term takeout at a sizeable premium, we still see lots of opportunity ahead.
Upcoming Economic News
This week we have a few Fed governors speaking on Monday at various conferences. Then a wave of data comes out Thursday. We hope to see stable to healthy Retail sales figures and some signs of stabilizing weakness in the Industrial sector. Any pick-up in inflation figures would also be a positive. The Fed is in a real bind if the aforementioned trends go the opposite direction because they would then be having to raise rates into an incrementally worsening economic situation. Doing so could produce lost confidence in the Fed, which could have more of an effect on markets than even the math of the rate hike. Stay tuned.
Some Thoughts on the Markets
With Gary Jefferson
UBS Financial Services, Inc.
For the past several quarters "bad news" has been treated by the market as a good thing; i.e., no rate hike and a continuation of easy money. A well-known research firm on the Street has used an equation for this scenario for a couple of years: "Low interest rates + no recession = stock market gains."
However, according to the Stock Trader's Almanac, "The market is now navigating the weakest part of the calendar year, September. Since 1950, September is the worst performing month of the year for DJIA and S&P 500. Even in election years the month has been challenging. Once tans begin to fade and the new school year begins, fund managers tend to clean house as the end of the third quarter approaches, causing some nasty selloffs near month-end over the years…….."
Thus, investors should not be surprised to see a pullback in the market as we go through the month. We would view it as a buying opportunity ahead of the expected year-end rally fueled by improving earnings in both the 3rd and 4th quarters.
Meantime, the experts are all over the board:
Goldman Sachs says a bear market is inevitable. The bank contends that: “There are only three possible ways forward for the market. Firstly, there is the “Reflation” option, which sees inflation reignited, but bond yields rising too, hurting stocks and bonds. The second option is “Stagflation,” which would send yields higher because of rising inflation, but a lack of growth would hurt stocks. And thirdly, “Fat and Flat,” which is basically a continuation of the status quo, but accompanied by weakening earnings, reversing investor sentiment, and falling prices."
Morgan Stanley’s equities team has just gone on the record calling for a jump in the S&P 500 over the next year. The bank now thinks the S&P 500 will rise to 2,300 within 12 months.
A lot of people are worried because of the fresh highs at which the S&P 500 is trading, [this was written before Friday’s rout!] but in a recent article Bank of America argues that now is a great time to buy stocks. The bank runs a “Sell Side Indicator” which measures the bullishness of Wall Street analysts. That indicator is now sitting at its lowest sentiment reading since 2013. Basically, BOA's summary of the situation is: “Historically, when our indicator has been this low or lower, total returns over the subsequent 12 months have been positive 100 percent of the time, with median 12-month returns of more than 27%.”
In the real scheme of things, however, the whole Fed question shouldn’t be a big deal for folks making long-term investment decisions. What difference does it make whether the Fed announces a quarter of a percent increase in rates today, in December or some future date? Higher rates may become problematic for several industries, but given Yellen's clear indication that she will raise rates very slowly, we are nowhere near problematic interest rates and likely will not be for a long time to come. And, at this juncture, we still don't see the U.S. heading for a recession, although we certainly need to see some evidence fairly soon that 3rd quarter earnings are picking up some momentum.
We would modify the equation referred to above: "Historically low interest rates + improving corporate earnings + no recession = a rising stock market."
BMR Take: Well said, Gary Jefferson. Friday was a bad day, but the sun will come up Monday and the United States economy will continue pumping out goods and services, and entrepreneurs will continue building new ideas and creating wealth. We want to be fully invested in high quality stocks. If you are nervous about the markets and want to reduce risk, look at the High Yield Portfolio. These stocks have been knocking the cover off the ball, many of them are up over 10% this year, and all are paying from 4% to 10% dividends on top of the rise in prices – just absolutely stellar overall returns.
HIGH YIELD CORNER
Has the Bottom Finally Fallen Out of the Market?
Friday’s correction turned into a self-reinforcing bear market, with the S&P 500 closing down over 2%. Keep in mind this was a short trading week because of Labor Day, and Tuesday and Wednesday were particularly slow-action markets. That makes the downturn on Friday more worrisome.
What exactly caused the downturn? Most financial pundits are citing rate hike fears, after Eric Rosengren, president of the Boston Federal Reserve, hinted at the chance of an increase in interest rates in the near term. This is a significant development, because Rosengren has been one of the more dovish Fed officials, so his caution about the need to raise rates suggests the Fed really is getting serious about raising.
Why did that cause stocks to fall? Simple: With higher interest rates, there will be more of an incentive to buy U.S. Treasuries, and people will sell stocks to buy those Treasuries. At least, that’s the theory. But note that moves to higher interest rates in the past have not always correlated with a steep fall in stock prices, so this logic isn’t as certain as many market participants assume. In fact, we have said many times before that in more than half of the cases of the first or second interest rate raise by the Fed, the stock market is higher one year later.
However, interest rate hikes have a much more direct impact on the debt market, and this is where high yield investors need to stand up and pay attention.
Higher interest rates will do many things to debt markets. For one, higher interest rates will make existing notes and bonds less valuable. Secondly, higher interest rates could cause companies to default more.
Are debt markets ready for an interest rate hike? The answer is yes, somewhat. Corporate bonds fell significantly in value at the end of 2015 as investors prepared for rate hikes. As those hikes were delayed this year, the market realized it had oversold bonds and we saw a huge increase in the price of corporate bonds, especially junk bonds and high quality funds like our own favorites: Pimco Dynamic Income Fund (PDI: $28, down 3%) and AllianzGI Equity & Convertible Income Fund (NIE: $18.60, down 2%). Both of these funds had a bad week and underperformed the S&P 500, but are up 8% and 4% respectively over the last six months. That’s excluding dividends - PDI’s yield is 9% and NIE’s is 8%.
What now? The real key right now is buying dips. It seems that the market is just starting a correction, and this could easily last another few weeks. High yield defaults continue to rise, which is a good enough reason for junk bond markets to continue to correct. This trend has been ignored by the market for months now, which again suggests a correction can continue for a while. One way to think about this is to focus on the "BofA Merrill Lynch US High Yield Option-Adjusted Spread,” an ugly name for a simple concept but an economic metric tracked by the Federal Reserve. This measures the difference between average junk bond yields and the yield on a U.S. government bond. The lower the number, the more investors are willing to pay for junk bonds. When the number gets too low, it usually suggests junk bonds are overpriced and will fall in price as the market realizes it has gotten too greedy and ignored risks too much.
This number has fallen to its lowest point in a year, although junk bond defaults are at their highest point in a year. This is a clear disconnect, and the market is likely going to focus on this for a while, possibly producing a massive sell-off in high yield followed by a recovery.
Does this mean we recommend selling the AllianzGI and Pimco funds? Absolutely not. For one, these funds are not entirely in junk bonds; Pimco’s fund focuses on mortgage-backed securities (where default rates are falling), and AllianzGI has a lot of equity holdings.
Of course both will be hurt as the market focuses on risk and begins panic selling, so prices may go down in the short term. But the fundamentals are strong on both, so it is likely that their prices will recover whenever the market realizes it has gotten too nervous about rate hikes. On top of that, an interest rate hike’s impact on equities and MBS’s is much less significant than on high yield bonds, which have much of this risk already priced in over the last two years anyhow. With that in mind, the long-term risks are minimal even as the market is getting extra nervous.
Does this mean buy the dip? Simply put, yes. But no one will be able to call a bottom, so a systematic approach to adding to high yield positions probably makes sense over the next few weeks. If your favorites go down 2%, buy a little more. If it goes lower from there, buy a little more. When things calm down, these stocks will come bouncing right back.
What about other high yield sectors? The now infamous growth in REITs throughout 2016 has reversed, and the SPDR Dow Jones REIT ETF (RWR: $97) was down 4% over the past week. That may continue as the rate hike fears cause weakness in high yield sectors, but there is little reason to believe the best quality REITs are suffering any fundamental weakness in their operations or are likely to be unable to continue to pay out and grow dividends to shareholders.
Similarly, BDCs were down 2%, as we see from the UBS Etracs BDC ETF (BDCS: $22), but that is actually slightly better than the S&P 500. BDCs have been less exposed to moments of market panic in 2016 after their severe underperformance in 2014 and 2015, but there is no guarantee that will continue. Non-accruals* have become less of a concern for BDCs right now, but if junk bond defaults are rising, debts to smaller companies are likely to rise even more. If a surprising growth of non-accruals hits BDCs, this sector could face a more severe downturn. We aren’t seeing this yet, but focusing on quality is important here. That is why we still see Main Street Capital (MAIN: $34, down 1%) as a strong hold.
* Nonpayment of an interest payment due on a debt.
The Apple Corner
We think about Apple (AAPL: $103, down 4%) all the time and have had some thoughts about the recent new product announcement that some say was a bit flat. We agree to a certain extent, but we also are believers in not changing a good thing. The iPhone 7 looks like the 6, although the insides were beefed up a great deal – it’s faster and offers more storage. The Watch came out with a new version and is now fully waterproof. We could go on here for 10 more pages about the new products, but we will let you scour the web for more details if you like. You can start here if you haven’t done so already:
http://www.Apple.com Suffice it to say that the iPhone 7 will sell in big numbers this fall and Christmas, generating more profits and more cash to the bottom line for the company. And knowing the company the way we do, we wouldn't be surprised to see more exciting products announced sooner rather than later.
Additionally, with Friday’s sell-off it makes us think about how much Apple could go down from here. Here’s our take: It is unlikely that the stock can go down too far. Sure, if the market goes to 16,000, then we all have problems, and Apple will go to $90 again and maybe lower. But that cash cushion is unmatched in the annals of Wall Street. They literally have $42 a share in cash. (We know most of it is overseas, but with the EU’s demand of Ireland to get $14 billion from Apple in back taxes is spurring talk in Washington of allowing repatriation of the $3 trillion or so of cash that US companies hold overseas. This is a good thing.)
So for every share you own at $103, 41% is in cash. Now Apple management is not stupid. They will figure out a way to monetize the cash – through buying technology; buying people; buying income producing assets (companies); buying back stock; increasing the dividend; and a host of other ways you and I haven’t thought about yet. We believe in Apple management .
Under Armour Update:
Kevin Plank, CEO and Founder of Under Armour (UA: $38, flat) announced that he will be selling 2.1 million shares of stock starting in October. A subscriber wrote in and asked our opinion of the situation, as he thought this was a bad thing.
Here’s what we wrote back:
“Hi Samuel –
“We generally don’t mind if executives sell stock. Plank currently owns 34 million shares of the company’s Class B stock, 135,000 shares of Class A stock and 34 million shares of Class C stock, representing 65% of the voting power in the company. So 2 million shares is a small part of his holdings. He is just diversifying.”
That’s how we feel. Of course, we secretly wish we had 2 million shares to sell of our own, and we admire Plank and all the others that have created all of the amazing companies out there, like Amazon and Facebook and Google, and so on. This is America. The entrepreneurs and the risk takers shall reap the rewards. Again, we would not even blink a negative eye over this CEO selling a small part of his stake in the company. Bill Gates has been selling 20 million shares a quarter since 2002. Wow. And we still love Microsoft.
That’s all for this week.
Good Investing,
Todd Shaver
Editor in Chief
August 28, 2016
![The Bull Market Report for August 29, 2016]()
by Todd Shaver | Aug 28, 2016 | Weekly Newsletter 7pm Sunday
The Week Ahead
This week marks the end of August and the beginning of September. We are expecting a very eventful back half of the year. We are watching everything about the Presidential election. The Fed’s comments at the Jackson Hold conference this past week alludes to what is shaping up to be another rate hike in December. Back to school and the holidays are key spending seasons for consumers, where we suspect this year’s results will show the strength of this economic expansion on the consumer side. The market is down slightly from record highs compared to last week, which if anything explains why we favor stock picking at this time as compared to just taking on broader market exposure. This week we highlight Facebook, Devon Energy, Brookdale Senior Living, and Sprouts Farmers Market.
Here is How The Major Indices Performed Last Week
Here is How Last Week Progressed
Monday (8/22) - S&P 500 flat
--- Pfizer (PFE: $35), still stinging from its foiled mega-acquisition with Allergan (AGN: $238) earlier in the year, announced it would acquire prostate-cancer drug maker Medivation for $82, a 21% premium, in a $14 billion deal.
--- Italian Prime Minister Matteo Renzi hosted German Chancellor Angela Merkel and French President Francois Hollande on an island off the coast of Naples ahead of September's EU summit, which was called to discuss reverberations from the Brexit vote, which we highlight because Italy and France possibly leaving next is a critical inflection point to the future of the EU.
--- Bank of America published analysis looking at the "what if" scenario of the increasingly discussed credit market bubble, but found that as long as rates rise gradually rather than sharply concerns are overblown.
Tuesday (8/23) - S&P 500 +0.2%
--- Billionaire Jeff Gundlach at DoubleLine Capital reiterated expectations for a Trump victory, which will likely mean a Brexit-like selloff for stocks, but ultimately massive new fiscal programs for roads, airports, and the wall. He also stressed how his now 100% net short position is focused on shorting stocks that are believed to be safe, but not safe at all.
---Pension funds in Hawaii and South Carolina have adopted a new strategy, in their thirst for yield that involves selling puts, which highlights an extreme thirst for yield to the point of taking on terrible risk/reward, a behavior that many are saying is reminiscent of 2006.
--- The census reported that in July, the US saw a whopping 654,000 new home sales, up 12%, from the prior month and higher by 31% from a year ago, smashing expectations.
Wednesday (8/24) - S&P 500 -0.6%
--- We learned that 8 out of 12 regional Fed Presidents voted to hike the discount rate in July, which was 1 shy of last November.
--- Illinois' biggest public pension fund, Teachers Retirement System, may have to lower its expected rate of return, which would cripple the state's already fragile finances, warned Governor Rauner, which we highlight as just the surface of major pension issues widespread across the country.
--- According to the Tennessee insurance commissioner, the Obamacare exchange in Tennessee is very near collapse as insurers are imposing nearly 60% premium hikes and pulling back on coverage areas which could leave certain counties with no health insurance.
Thursday (8/25) - S&P 500 -0.1%
--- According to the latest Fitch auto subprime report, things in the auto subprime space are progressively deteriorating, with subprime 60+ day delinquencies in July rising 13% from last month to 4.6%.
--- Subprime Asset Backed Securities annualized net losses hit 7.4% in July, which was an increase of 17% from last month and 28% from last year.
--- Separately, in yet another stunning example of the unintended consequences of minimum wage hikes, restaurants in Washington DC are slashing jobs, as the data show that DC restaurant jobs were down in 5 out of the past 6 months, which hasn’t happened in 25 years.
Friday (8/26) - S&P 500 -0.2%
--- This was the biggest day of the year for our central bankers at the Jackson Hole conference occurred. Goldman published a kneejerk response to Yellen’s speech, which discussed her to be so hawkish that it raised their odds for a September rate hike from 30% to 40%.
--- Alternative analysis from Macquarie proved a thoughtful explanation, saying that the conventional wisdom prevailed on Wall Street, namely that Yellen's speech is a whole lot of nothing and likely didn’t change any minds on expectations for a rate increase this year, with December still most likely the next hike followed by two hikes next year.
--- Beyond interest rate talk, the conference kickstarted a number of other new debates, perhaps most interesting is the St. Louis Fed President calling out how Fed GDP forecasts keep trending down as actual GDP keeps running below trend, which raises an array of issues much more important that the timing of the next rate hike.
The Bull Market Report Companies and Commentary
Facebook (FB: $125, +1%) We are bulls on Facebook for many reasons we have given you these past seven months. We are very pleased with revenues and earnings and their takeover of mobile. However, one of the bear cases on Facebook is that ad revenue may shift away from the company as the users of connected devices are increasingly tired of dealing with bad ads. We’ve all experienced a lot of bad ads - ads that obscure the content we’re trying to read. Ads that slow down load times. Ads that try to sell us things we have no interest in buying. Bad ads are disruptive and a waste of everybody’s time.
To hold onto market share, it is critical that Facebook’s products and services address this real problem users are having. Competitor Google is taking steps through banning certain types of ad words. Now recently we note Facebook is moving forward as well. Facebook recently announced the expansion of tools given to users to control their advertise experience, as well as providing an updated approach to ad blocking.
Going forward, Facebook users now have more control over their experience, which helps them improve how to determine what ads to show. Specifically, ad preferences are easier to use. Users can now outright stop seeing certain types of ads. For example, if you don’t want to see ads about a certain area like travel or cats, you can remove the interest from your ad preferences. People can also now elect to stop seeing ads from certain businesses or organizations. These improvements are designed to give people even more control over how their data informs the ads they see.
BMR Take: All in all, the new developments Facebook recently provided users should drive reduced ad blocking usage, ultimately protecting Facebook’s market share. You may consider this stretching for results, but we consider it important that management sees these things and acts. Yes, they act. With Facebook’s user base at 1.15 billion on average for June, increasing a very healthy 17% from a year ago, there is nothing more important for Facebook than to keep them happy and engaged. We see further upside ahead for the stock.
Devon Energy (DVN: $44, flat) Devon Energy’s CEO is scheduled to present at an investor conference on Sept 7th. Investors have a number of concerns about the company’s near-term prospects. However, we think the conference is a catalyst to build investor confidence.
Let’s review where we are. The company has reported a loss of over $9 billion in the last three quarters and the losses are expected to continue. Consequently, in order to offset losses, the company has had to sell $3.2 billion in assets in the first half of this year, and additional asset sales are likely coming into the second half. Fortunately, the company’s liquidity situation is strong. The company has $1.7 billion of cash and no debt due within the next 12 months. If oil prices hold up, there appears to be a path forward to returned glory for Devon Energy, which could result in substantial upside for shareholders from here.
Why stay the course? Devon is a leading exploration and production player. Its premier asset portfolio is concentrated in top tier locations (namely Canadian heavy oil, the STACK, Rockies Oil, Eagle Ford, Barnett Shale, and the Delaware Basin). There is a deep inventory of future opportunities. The current portfolio mix is balanced 35% gas, 44% oil, and 19% Natural gas liquids. Management believes the entire inventory is positioned well on the cost curve to turn profits at a $50 price for oil. In particular, management continues to see +30% IRRs in select areas (like the Delaware Basin, the STACK, and Eagle Ford). Most importantly, management is standing by ready to step on the accelerator when the industry imbalances stabilize and return to growth mode.
BMR Take: As the oil industry recovers, we see substantial upside ahead for Devon. The company has a premier asset portfolio with $7.5 billion of liquidity to make it through the downturn. Stay the course.
Brookdale Senior Living (BKD: $17, flat) Investors have their worries ranging from a lack of confidence in management, the 2016 guidance outlook, current leverage, and the pending supply of new unit inventory coming online in 2016 and 2017. However, management is taking more decisive action to lower leverage and to reposition the operating model. Moreover, we see a path for substantial upside for shareholders as integration issues subside, the portfolio is rationalized, and operating margins improve.
We dug into one issue, occupancy rate commentary, to further explain what is driving the lack of confidence in management. Specifically, on its 2Q16 earnings call, management stated that average June consolidated occupancy was “nearly back to January 2016 levels”. This sounds positive, but as in the fall of 2015, management is referencing an average that does not match data provided in quarterly releases. This is really uncommon to be frank. Management needs to get it straight and talk about the numbers they put on their press release. Without giving you all the confusing numbers, basically the reported figures on the press release are trending to flat to down slightly, but the more important calculation that management is using to run the business is showing sharper declines.
BMR Take: We see many levers for upside here even though management is not helping us out. We can’t give them a free pass forever, but with many analysts valuing the shares around $30 or nearly double the current price, we see reason to stick around. But with that said, we are watching closely.
Sprouts Farmers Market (SFM: $23, +2.3%). There is significant runway ahead for Sprouts. One comparison investors are drawing is to Shoppers, which saw revenue steadily grow from $3 billion to $12 billion over a 20 year period. Everybody from management, to investors, to the analysts are saying there is a similar greenfield opportunity ahead for Sprouts.
Sprouts will open 36 stores this year. The company sees an ongoing 14% square footage growth rate ahead. What is fueling the expansion? The Sprouts brand. Consumers across demographics are coming to the store because they are interested in health and wellness and nutrition, and Sprouts’ market position as “healthy living for less,” is really resonating with people across the country.
The stores are very profitable. Management is tells investors to expect 35-45% cash on cash returns when they deploy shareholder capital to a new store at this time. Behind the impressive figures is a business model that is now dialed in running both operationally efficient and capital efficient. In fact, the business is able to maintain a price premium of 20-25% above peers due to a streamlined operating process refined over a number of years to now include monitoring on a weekly basis the total basket in fresh inventory relative to key competitors on a market by market basis.
BMR Take: If you think healthier eating for less is the future, then this is a great bet. We are in this one for the long haul. Let management go to work opening and running the stores. We expect solid results ahead.
Upcoming Economic News
The focus this week is on the jobs numbers out Friday. We are looking at an economy with an unemployment rate below 5%, but very weak labor force participation of just 63%. Average earnings are rising just slightly and the number of hours worked per week is running flat. When you step back and think about our country’s current situation of below trend GDP, ultimately we are going to have to work at improving all the different levers we can. Monetary policy has been the sole focus, but we need to be discussing real fiscal reforms. We need to take a look at how we can improve the labor force participation rate and number of hours worked per week. More people working more hours equal more output. All of this is possible as we move into the last half of 2016. 2017 could be a good year as well.
Silver Wheaton and Barrick Gold
These two stocks are The Bull Market Report’s counter strategy stocks. But they had a bad week. The saying goes that if the world is falling apart, you want to own gold and silver. What does it mean to say the world is falling apart? Well, there is no answer to that - you have to have your own definition. The way we see things, everything is just wonderful, just wonderful out there. We are trying to use a little humor here, because as we know there are a MILLION challenges out there right now (the election, ISIS, Brexit, China imploding, Wall Street at highs that can only go lower. We hope you get the picture here.) Yet despite of all this, the market goes higher. After all, where else can you put your money? (That’s what everyone says.) So why wouldn’t the stock market go to 20,000 and higher? (We are actually believers in this theory. Where ELSE can you put your money?)
OK, back to silver and gold. Gold is at $1324 an oz., up from $1050 at the beginning of the year. Silver is at $18.66 an oz., up from $13.70 at the beginning of the year. Will they go higher as the world implodes? Well, yes….. assuming the world implodes. But we don’t think this will happen. The “world” wants commerce; it wants peace; it wants a safe environment for its kids. We are optimists and we believe the “world” will make it. We believe the world will survive and THRIVE.
But if this happens, then theoretically interest in gold and silver will wane. We’ll see.
At the moment, Silver Wheaton (SLW: $27, down 9%) is up 37% from the $19 when we added it in early May, just four months ago. Our target is $33, but our Sell Price is $26. We’ll have to honor that so we don’t give away all of our gains. If it closes below $26 in the coming days and weeks, we are out.
Same story with Barrick Gold (ABX: $18.22, down 12%). We added the stock at $11 in February and it is now up 63% at $18.22. Our Target is $18. We hit it. But it was at $22 in July and again early this month, so we hate to give back any more profits. We are going to remove it here and lock in this amazing gain.
What should you do? That is up to you of course. The stock WAS at $50 in 2011. If the world implodes, Barrick is going to $30 and $40 and maybe back to all-time highs above $52. But even if the world calms down, Barrick Gold has gone through a lot of heavy fiscal changes for the good. Cash is up ($2.4 billion); debt is down (but still $9 billion). Revenues are steady now at a run-rate of $8 billion; and profits are back. So there is an argument to be made to hang in there with the company and watch and wait. We don’t tell you what to do at The Bull Market Report. We give you the facts and our opinions. Ultimately it is up to you.
Options Corner
LET’S COVER THOSE CALLS
Last week we gave you two great examples of how to buy high-quality stocks, Microsoft and Apple, using longer term options (LEAPS*) that expire in January 2018. (Note that the 2019 options will start appearing in September and October. Keep your eyes peeled on your Yahoo options site:
http://finance.yahoo.com/quote/AAPL/options?p=AAPL&date=1516320000
Last week we discussed how you can buy a deep-in-the-money option on Apple for $1,700, controlling 100 shares worth $10,900, (or 10 options for $17,000 controlling 1000 shares worth $109,000.) This week we will show you how to get some money back for those options. In fact, if you are diligent you can get ALL of your money back. How can you do that? By selling calls against the long LEAP* that you bought.
OK, to review. You decide to buy the Apple January 2018 100 call. (This gives you control of Apple at a price of $100 a share.) Last week it was priced at $17. Apple was down $2.40 this week to $107, so the options dropped a bit as well, to $15.50. So how to you get back some of the cost of the option that you just paid $15.50 for? You sell an option against it. There are lots of choices of course. The easiest, requiring the least amount of “work” would be to sell a January 2018 call, say the $120 or the $130. The $120 would give you $6.50 reducing the cost of your long option to $9.00. If the stock goes to $120 or higher by January 2018, your option will be worth $20 ($120-$100) and since you paid $9 for it, your return would be over 100% in less than a year and a half, with Apple going to $120, a rise of 12%. Could Apple go to $120 from here? Only YOU can answer that! Of course, you don’t participate or profit in anything over $120. If the stock goes to $140, your return is exactly the same as noted above.
So maybe you think Apple can get to $130. Then don’t sell the $120, sell the $130 call. The January 2018 130 call will get you about $4, reducing the cost of your option to $11.50. If Apple goes to $130, the long option you bought would be worth $30, for a return of 160%.
Now, if you want to tweak things and look for a higher return from this trade, you will have to spend more time doing so. But your return could be a lot higher. For example, instead of going all the way out to January 2018 and selling a call, you could sell the January 2017 call first. When that expires, you can sell the April or July call, and so on. It’s too complicated to explain here, but your broker can help you, or you can write us at Info@BullMarket.com. Many investors have gotten the cost of their option down close to zero over an 18 month time frame. Now THAT’S exciting. BUT – it takes work AND there are many more ways for the trade to go sour. These are the challenges, of course, when you are trying to produce a triple or quadruple using options, when a stock goes up just 20-30%. Did we say this trade is risky? OK. It sure is. Please consult a professional broker for advice .
*LEAP – an option that expires in January that has a life of more than six months. Thus the January 2017 options aren’t LEAPs anymore. They are just options. The January 2018 options are LEAPs. It’s kind of silly really – there is no difference at all. So why do they try to confuse us?
Thoughts from Gary Jefferson
UBS Securities
First Vice-President, Investments
Fully invested portfolios have enjoyed a rare summer rally that has the major averages recording new all-time highs during the month of August. Very few pros, however, have had their Buy Lights on solid green during the past few months and so investors with cash shouldn't feel left out or underinvested. This market is simply not acting normally. It's more like "Dang the fundamentals - full speed ahead!"
The most recent Atlanta GDPNow forecast is for GDP to grow about 3.5% in the 3rd quarter. That's good – but remember, 1st Qtr GDP grew a measly 0.8% and 2nd Qtr GDP barely beat that at 1.2%. So, if 3rd Qtr hits its number, the average for the year would then be 1.9% -- not so good. Thus, to get GDP growth above 2% for the year the economy has to expand by an average of 3% in both the 3rd and 4th quarters. That's doable. But to get growth above 2.5% for the year (still fairly pathetic at this stage of the "recovery") growth would have to average 4% for the next two quarters. That’s probably not going to happen.
This rally has mostly been on the backs of central bank shoulders and low inflation as opposed to stellar earnings. Yet, as of August 16th, 74% of all stocks are above their 50-day moving averages. Fundamental rules of gravity say that shouldn't be the case with 2% or 2.5% GDP growth. We think there are companies which are generating outstanding earnings growth and they should continue to do well. Conversely, those which are not should at some point lose support. The result is that the market "average" may not be able to keep tripling the average GDP growth. Cost cutting and share buybacks can only work for so long. We are already hearing a lot of the pundits declaring that we are in a classic "stock-picker's market".
We'll just sum it up with a reference you’ve heard before but which is ever more important in today’s market: Investor's daily chore: "Stay with dividend growers and good stock pickers.” Using companies with a long history of growing dividends – and reinvesting those dividends - has been one of the surest ways to accumulate wealth in the stock market. And in today's market, picking stocks which can maintain solid earnings growth should provide much better than average potential returns.
[Thank you Gary.]
So, where do we find those stocks?
Have you checked out The High Yield Portfolio lately?
Go here: https://www.bullmarket.com/high-yield
The Bull Market Report High Yield Portfolio follows stocks that pay from 4% to 11% dividends. Most are paying 6% and 8% but listen to this: Here are the returns the stocks themselves have made: 13%, 15%, 13% 18%, 34%, 8%, 12%, 10%, 8%, 15%, 16%. This is not counting dividends. So you have 11 stocks that are paying above-average dividends averaging 7% and you have these same 11 stocks that have risen in price since we added them of an average of (exactly) 11%. Since most of these stocks were added since The Bull Market Report was reincarnated in January, you are looking at annual returns of 20% or so, PLUS the average 7% dividends.
Thus, if you are worried about the stock market climbing this wall of worry and the “worry” is getting to you and outweighing the fact that we are within a whisker of all-time highs, then take a look at the High Yield portfolio. It will ease your mind to know that a stock like Annaly (NLY: $10.78, down 1%) has been paying a dividend of 10%+ since 1997 through bull and bear markets, and high and low interest rate environments. Are they going to keep paying their 11% dividend? No one knows; but you have to admire their track record and it gives you a strong sense that they can continue for the years ahead.
You remember what Annaly does, right? They invest their capital into Fannie Mae and Ginnie Mae securities, leveraging their capital 4-5 times. They invest in securities of the US Government – not much risk here. The risk, the pundits say, is if short-term interest rates spike up. This is true, but in general, rates don’t jump 1% or 2% in short periods of time. It usually takes months and years for rates to move this much higher. And if rates do move up, mostly long rates go up too, thus providing more opportunity for Annaly to lock in even larger spreads.
We like the company, their concept of producing profits; we believe in management – most have been with the firm for 10-20 years; and we believe they can continue to pay double-digit dividends with the stock itself staying in double digits.
And without further ado, here is…
THE HIGH YIELD CORNER
The market’s turn downward continued this week, as the S&P 500 fell slightly. Part of the problem is the Federal Reserve. Janet Yellen hinted at an interest rate hike Friday as GDP growth was revised down to 1.1% for the second quarter. The GDP data wasn’t much of a surprise, but Yellen’s words were. As a result, the market fell from green to red after she spoke as investors fretted about what higher interest rates will mean for the stock market.
The theory is this: With higher interest rates on U.S. Treasuries, conservative investors will leave stocks and go into government bonds. Such a move would lead dividend growth stocks and large caps most vulnerable, which is why the market fell a bit for the week.
One would expect a similar, even more violent response from high yield investments. At least that’s one theory for the monstrous return high yield stocks have offered this year. Because many investors jump into these assets to reach for yield since they cannot get above-inflation returns from Treasuries, if Treasuries go up they will lose their appetite for junk bonds, BDCs, REITs, and MLPs. That’s the idea. The reality is more complicated.
High yield bonds closed the week flat, as evidenced by the SPDR Barclays Capital High Yield Bond ETF (JNK: $37), which actually closed flat for the week. The fund’s over 6% yield remains durable, and investors continue to have an appetite for high risk corporate bonds. This is even more astounding since default rates are up for junk bonds - over 5% - and expected to rise to over 6% by the end of the year. So why isn’t everyone selling in a panic?
The same question should be asked about BDCs. The UBS Wells Fargo BDC Index (BDCS: $22) closed the week up 1%, rising strongly on Friday, where it picked up most of this week’s gains. BDCs lend to small and medium-sized companies at high interest rates - usually in excess of 8%. They also borrow money through the bond market to fund those lending activities. Higher interest rates will make their expenses go up, and higher defaults from companies will make their revenues go down. This should be a cause for panic selling, so why did BDCs show continued strength this week?
The conundrum over junk bonds and BDCs is easily explained if we look at things from a broader perspective. Both asset classes fell dramatically in the last year, and junk bonds still haven’t recovered from a year ago. BDCs haven’t recovered from the beginning of 2015. In fact, the market knew about the defaults and risks of higher interest rates long ago. Remember, Yellen hinted at interest rate hikes in early 2015. The actual timeline of those rate hikes has been delayed, meaning the market over-discounted BDCs and junk bonds in anticipation of those rate hikes.
Likewise, the rate of defaults, while rising, has been a known factor in the market for years. Defaults have been steadily climbing since 2014, and the market knows this is a reality. The discounting of junk bonds has already taken this into account. Unless default rates rise higher than expected - which has not yet happened - there’s no reason to sell off junk bonds.
This is why both asset classes are doing much better in 2016 than one would intuitively expect. The bigger conundrum for the market is elsewhere, with REITs and MLPs.
Let’s start with MLPs. The Alerian MLP ETF (AMLP: $12.55) ended the week down 1%. Year-to-date the ETF is up 4%, which is good, but nowhere near as good as The Bull Market Report’s high yield picks such as Digital Realty Trust (DLR: $99, up 30% YTD) and Main Street Capital (MAIN: $34, up 17% YTD).
We stand by these picks and our recommendation earlier this year to look beyond the MLP world for income for one simple reason: commodity prices. Oil has been volatile but has not really seen an improvement year-to-date, and constant shifts in oil and natural gas prices simply make MLPs a rocky ride. If you want to ride that volatility, you should be compensated for it by a higher yield, but AMLP’s 8.9% yield isn’t good enough, as it’s on par with Main Street and is less than other Bull Market Report picks. This week’s weakness in MLPs confirms our recommendation to stay away.
Now when we look at REITs, things look even more complicated, but in a good way. The SPDR Dow Jones REIT ETF (RWR: $99) closed the week flat, but has fallen 3% in the last month and is down a bit from its top at $104. Compare that to our preferred REIT Omega Healthcare Investors (OHI: $36, flat), which is up 4% over the past month. REITs have had an incredible year due to the yield-reaching of income hungry investors, but some have done better than others. Selective purchases are key here. Omega remains up moderately YTD, compared to a REIT like CorSite Realty (COR: $78) which is up over 37% YTD. Such a run-up has made some REITs too expensive, but Omega’s strong management, high dividend coverage, and lower price growth YTD make it a good buy right now.
Looking forward, we will need to see how the market interprets the Fed next week while also looking for more clues from the job market about third quarter GDP growth. Nonetheless, things look solid for much of the high yield world, and we’re happy to continue recommending selective, high-quality assets in this corner of the market.
By Michael Foster
The Bull Market Report High Yield Research Expert
Let’s Look Closer at Main Street Capital
Main Street is a Business Development Corporation (BDC) that has been quite successful of late. It’s payout structure is different than most. It pays out 18.5 cents PER MONTH and then twice a year issues a special dividend of 24.5 cents. Thus it makes 14 payments a year totaling $2.77, for a return of 8.1%. Note that the monthly dividend was just upped from 18 cents. And the company said this: Including all dividends declared to date, Main Street will have paid $18.33 per share in cumulative cash dividends since its 2007 IPO at $15.00 per share. Now that’s quite a statistic!
Baird raised Main Street’s price target from $36 to $37, not a terribly big deal, but maintains the company's Outperform rating. Baird noted the company’s continued differentiated operating strategy, allowing it to take in attractive risk-adjusted returns. They said: "Unlike the majority of its BDC peers, Main Street does not rely on outside sponsors to generate investment opportunities and instead sources its deal flow internally. By being able to employ customizable one-stop financing solutions for its portfolio companies, MAIN is able to benefit from attractive risk-adjusted pricing and terms on its investments."
Furthermore, Baird said that Main Street's heavy exposure to senior secured debt investments allowed its capital structure to afford "some downside protection, while at the same time, the meaningful equity component of this portfolio provides the opportunity for significant capital gains. Their dividend payout provides an attractive 8% yield. With a sizable liquidity position, healthy asset quality, and the likelihood for continued investment growth and realized portfolio gains, we feel confident Main Street can maintain and grow its dividend over time."
BMR Take: We agree with Baird. If we are looking for yield, we are reaching for Main Street. At a $2 billion market cap, the company isn’t huge, but certainly has room to growth both its stock and its dividend.
Good Investing,
Todd Shaver
The Bull Market Report
August 21, 2016
![The Bull Market Report for August 29, 2016]()
by Todd Shaver | Aug 21, 2016 | Weekly Newsletter 7pm Sunday
The Week Ahead
We see the week ahead as “The calm before the storm.” We expect a quiet and peaceful period as many are still out on vacation, earnings season is said and done, and the schedule of major market events is light. These are the dog days of the summer. However, very soon, back to school go the kids, back to peak capacity it will be for Wall Street trading desks, back to Presidential debates on TV, and back to the usual frenzies the financial media outlets love to stir up. With so much happening from Presidential politics, to the Fed’s monetary policy experiment, to record highs for the major indices, there is just no way the markets will remain this quiet for much longer. We strongly believe that there remains money to be made in equities. This week we highlight Apple, Home Depot, Splunk, Gilead and Annaly.
Here is How The Major Indices Performed Last Week
Here is How Last Week Progressed
Monday (8/16) - S&P 500 +0.3%
The value of negative yielding bonds in the world rose to $13.4 trillion from $13.1 trillion a week ago. Italy, Spain, and now Portugal are all running above 10% of total assets invested in their own sovereign debt, a very concerning signal for European banks. Short interest in the S&P tumbled to three year lows. Billionaire David Tepper of Appaloosa Management commented that confused central bankers are distorting bond yields which has been affecting equities in a negative way.
Tuesday (8/17) - S&P 500 -0.5%
The US dollar fell to a 3-month low as rate hike odds pulled back. Core CPI remained above the Fed’s mandated 2% for the 9th consecutive month. Housing starts jumped on a spike in rental units, as permits declined. The US industrial production index slumped to the longest non-recessionary contraction in history; notably the softness began at the time the Fed ended QE3. Intermodal freight carloads took their first dip in 25 quarters. The Port of Long Beach reported an 8% drop in container volumes from last year.
Wednesday (8/18) - S&P 500 +0.2%
After several quarters of deteriorating results, US retail giant Walmart (WMT: $73, $230 billion market cap) beat EPS estimates, but more importantly guided to a higher profit outlook for the year, as comparable sales in the US remained positive for the 8th consecutive quarter and are not expected to taper off as some feared. Separately, while the relentless decline in Caterpillar retail sales has been occurring for 44 consecutive months, the latest July data was downright disappointing with North American machine sales down 20% after falling 12% in June. Not good.
Thursday (8/19) - S&P 500 +0.2%
Billionaire Paul Singer of Elliott Management declared that we are in the biggest bond bubble in world history due to the unprecedented actions of central banks. Money flows into emerging markets are at a record pace. Money flows out of Europe for the 28th consecutive week also set a record. Corporate defaults so far this year are up 57% with the only higher period being 2009. Companies in the Energy and Natural resources industries account for more than half of the defaults.
Friday (8/20) - S&P 500 -0.2%
New British Prime Minister Theresa May said that “Article 50”, which is the legal execution of Brexit, may be triggered before April in order to occur prior to French and German elections. It is expected that there will be two years of negotiations after the trigger, which will be when we learn of all the specific details of what UK’s withdrawal from the European Union will look like and mean. Oil prices rose not on fundamentals, but rather on what the Saudi officials are saying about production forecasts. Cathay Pacific (the airline) reported weak earnings due to collapsing corporate travel in China. The Vancouver housing market in Canada fell 20% from the last month, finally confirming concerns there are serious problems ahead for Canada’s real estate market.
The Bull Market Report Companies and Commentary
Home Depot (HD: $136, -1%) Home Depot recently reported 2Q16 EPS of $1.97, which was on par with the Street’s expectations, driven by solid sales growth and operating expense leverage. Sales increased 6.6% from last year with comparable same store sales up 4.7% (US comps were up 5.4%.) Gross margin was flat from last year at 34%. There was a 22 basis point gross margin headwind (a negative) related to the acquisition of Interline, a home repair and maintenance product line. However, gross margins did benefit from more favorable supply chain and rebate costs. Total expenses as a percent of sales showed a 40 basis point improvement, which is a good thing when you can grow revenue but holding fixed costs steady.
2016 EPS guidance was adjusted upward to $6.33 from $6.27 with comparable same store guidance of an increase of 5%. Overall, performance at Home Depot remains strong. In fact, June and July trends were stronger than expected and management described August as “very pleasing”, which points to upside to third quarter results. Looking ahead, the key questions are how the sector can perform into year end, relative to very strong year-ago results and how the broader housing cycle will perform from here. We don’t see any signs of weakness on either front.
BMR Take: We remain positive on the fundamental trends driving business performance. We see further upside potential in the stock.
Splunk (SPLK: $65, +1%). Splunk is scheduled to report second quarter earnings after the markets close on Thursday. The whisper on Wall Street is that channel checks on sales force productivity indicate that the consensus could prove conservative. Specifically, the Street’s $110 million license revenue estimate implies a mid-single digit decline in productivity, whereas channel checks indicate that performance of flat to slightly positive growth could be in order. This implies potential upside on license revenue, which translates into modest upside to operating income and EPS relative to Street estimates.
So what are the channel checks? An analyst at a Wall Street research firm conducted a round of conversations with resellers, technology partners, industry consultants, and customers, where the dialogue pointed to Splunk witnessing healthy demand. There was feedback of very healthy uptake of the company’s newer premium applications (ITSI and UBA), which should help support the top line over time even as the company continues to drive down cost of ownership for customers. Moreover, partners called out a number of larger deals, with a few transactions above the seven figure mark.
BMR Take: A good round of channel checks is the basic blocking and tackling of quality research. Admittedly, the outcome is not always as expected. But we do like what Wall Street is saying about the upcoming quarter verifying our existing admiration for the company.
Gilead Sciences (GILD: $81, +2%). Year-to-date Gilead is down 20% versus the S&P 500, up 6%. Wall Street is not happy and is now calling for action. Specifically, there is growing discussion about pushing Gilead to split into two pieces: the HIV and HCV (hepatitis C) franchises. (Gilead’s HCV drugs, Sovaldi and Harvoni, proved to be breakthrough therapies. They managed to report cure rates up to 99%.) Consensus says the plan to split the business is a good idea and moving forward would be applauded. The hyper focus on HCV is thought to be distracting. The HIV business is thought to be materially undervalued and robust. We are very positive on a potential breakup if it were to occur, as tearing HIV and HCV apart will require little – just replication of sales forces, commercial infrastructure, administrative efforts, and virology R&D, so the lost synergies are manageable. Some say that the two business have synergies from being run together so if you split it up, it will introduce more costs.
If it’s not possible to split up the company, then an alternative could be to work on better highlighting that the HIV business is growing well. Perhaps some of the non-core assets could be sold. On a standalone basis the HCV business is thought to be worth around $65 per share, but that's without a few products with bright futures (If you want to do more reading on the topic, google “1/d unboosted integrase and TAF/Emtriva.”) These products should be worth about $25 a share, so this would get the shares to above current value, ($90), leaving all the other businesses as upside to the current valuation in a split or asset sale.
Piper Jaffray has placed a price target of $108, up from the previous target price of $80 to Gilead. They have a Buy rating on the stock with an expectation of an upside trend due to its robust and competitive drug pipeline. They feel that a 10 PE is warranted, up from 7, and if this happens, you are looking at a 40% rise from the current price.
BMR Take: We see a possible catalyst emerging for Gilead with this growing discussion around business reorganization as well as the new drugs noted above. While shares are underperforming year-to-date, we would hold on and add to positions.
First Solar (FSLR: $38, down 2%) had its price target lowered by Goldman Sachs from $67 to $58 on Tuesday. They have a Buy rating on the stock. Per our News Flash on August 10th, we are buyers of this stock. It may take many moons for it to start moving again, but we have faith in the industry and this company in particular. We are glad to see that Goldman Sachs does as well.
Annaly Capital Management (NLY: $10.94, down 1%) was down a little this week. But in our opinion it is just noise. The stock is paying an 11% dividend with a market cap of $11 billion. We talk to people here in Aspen and around the country all the time about Annaly. Many investors have “gotten it.” But many can’t believe what the company is doing and has done. Annaly has been doing this since 1997, paying a dividend that has ranged from 10% to over 20%. They use leverage to make this happen and this is why some people shy away from the stock. They used to use a lot more, but are much more conservative in their use of leverage than in the late 90s and 00s.
Here’s how they do it: They take their capital and buy Fannie Mae, Ginnie Mae and Freddie Mac securities that are backed by the full faith and credit of the United States. These securities are paying between 2 and 3%. Then they go out and borrow up to five times their capital and buy additional Fannie securities, and collateralize their borrowings with these same securities. This allows them to borrow at rock-bottom rates of well less than a half of one percent. The spread between borrowing and the yield they get for the Fannies, multiplied by a factor of five allows them to produce a net profit of 12-13%, and after expenses they can pay an 11% dividend.
Is there risk? Of course. Any stock paying more than 3-4% involves risk. But they have been doing this for 20 years through bull and bear stock markets and bull and bear debt markets. They are the masters of controlling risk. And every time there is a hint or discussion of higher rates the stock goes down a bit because investors think their cost to borrow would go up. But rates have been going down for 29 years! This is not a misprint. But the risk is misplaced with Annaly because if rates were to go up, they would go up slowly and in actuality, higher rates are good for Annaly. Why? Because the Fannies Maes they buy would be paying a higher rate.
And think about this. If investors buy the stock, two things happen. The stock goes up and the dividend rate goes down. If the stock goes to $12 in a year, that’s a 9% return and if you add the 11% dividend that gives you a 20% return, plus you are locked in with the 11% dividend, even though the yield might go down to 10%. Get it?
BMR Take: Reread the four paragraphs above! Do you think we like Annaly? Or not?
Upcoming Economic News
We are very focused on the US GDP outlook. The Fed’s expectations for growth currently shows 2.2% in 2016, 2.2% in 2017, 2.0% in 2018, and 2.1% in the longer run after 2018. However, the Fed has moderately been lowering expectations for some time. The second quarter is seasonally slow so the 1% growth result likely to be reported this week is not particularly concerning at first glance.
However, what is concerning is that the Fed’s GDP outlook calls for essentially unchanged conditions for the foreseeable future. Over long periods of time financial markets are anything but smooth and predictable. With some pockets of the economy under stress, as we have been highlighting in The Bull Market Report, we have a watchful eye on the Fed's GDP outlook. We are concerned a more sluggish GDP scenario could unfold than what they are predicting. It is very unclear how the Fed could address such a situation considering interest rates are already set near the zero level. We are worried that an out-of-position Fed could compound the negative effect to markets if we do see a GDP slowdown.
The Apple Corner
Apple (AAPL: $109, up 1% for the week) is worth $10 billion shy of $600 billion - still the largest market cap in the world. Lately the stock has been doing well, up from $97 on July 26th, a short three weeks ago. As we like to say, the stock has been trickling up. And this on no significant news. Ah – the news. In Apple’s case, no news is good news. Why? Because we KNOW that by just doing what they do they will generate news IN DUE TIME. The iPhone 7 is coming in September. We KNOW this. Will be write about it incessantly? NO. Because everyone else will write about it. But we know when it comes it will be BIG. Right before Christmas so that people can open their wallets to buy the best and greatest technology on the planet. They will sell MILLIONS of iPhones. Should we speculate on how many? No need to. But every new buyer will open up an iTunes account and buy music; and every new buyer will start buying apps in the App Store and Apple’s cash hoard will grow. (It is currently at $232 billion and growing by about $1 billion every eight or nine days.)
BMR Take: Are we buyers? Do we like the stock. You bet. We still believe the all-time high of $134 is sitting there waiting to be reached. When will this happen? Could be this year; could be next year. We would even be happy in early 2018. If the stock hits $140 in 2018 giving you a 28% return (plus the 2% dividend), would you be happy with that? Well, WE WOULD!
The Apple Corner – Take Two
As has been widely reported, Apple is working on a car through Project Titan. We know that working on a product doesn't always result in a product launch, but nonetheless, reports suggest that the company has over 1,000 people working on Project Titan. Apple has around 18,000 employees in research and development out of 115,000 employees in total. If you assume most of the people working on Project Titan are engineers, it would mean that about 5-6% of the company's research and development group is working on this. Apple put Bob Mansfield in charge of the project in July after the former head left in January. Mansfield has been an executive at the company since 1999 and previously worked on iPod and Mac hardware. Initial reports suggest that the car has a "target ship date" of 2019. We think it is more likely in 2021.
Apple could release some of its learnings before 2021 as it continues to develop its own car. For example, autonomous driving software could come out earlier. In terms of the market, BMW might be the best comp for what Apple could do with the car in a wildly successful long-term scenario. BMW sold 1.9 million vehicles worldwide in 2015. At a $70,000 average selling price, that would represent a $130 billion revenue opportunity for Apple. The bottom line is that the car, while it could still be scrapped, has the potential to be a true needle mover.
BMR Take: We continue to see long term upside for Apple from a wide range of areas, like Titan. With net cash per share of $43 and a 2% dividend yield, the value we see in the shares at current levels is compelling. By the way, in the second quarter Warren Buffett’s firm upped its Apple stake by more than 55%. Incredibly, Berkshire now owns $1.65 billion of Apple stock.
Some Thoughts from Gary Jefferson
Jefferson Financial Group
First Vice-President, Investments
UBS Financial Services, Inc.
Over the past few days we have reviewed several interesting market opinions. These two caught our attention.
Smart vs. Dumb Money. The assumption is that the smart money is "commercial" – i.e., these are real investors who hedge their company's positions, like airlines buying oil futures to hedge against rising oil prices. The dumb money is the large speculators. They include the trend-following hedge funds and traders that buy more as the trend goes up and then sell more as it goes down. The premise is that there is a good way to tell when major markets are getting ready to reverse - just look at the traders' position in the futures markets. When there are large and growing divergences between these two groups, a major reversal is coming. And, the smart money is called that because they are right a great deal more often than the dumb money. Today, the smart money in futures is extremely short in T-bonds, oil, commodities and stocks – (all at the same time.) The dumb money is near record long in most of these same areas. This is a huge divergence and is forecasting a major market reversal. (Dent Research 8/2/16)
[This is of course in the For-What-Its-Worth department. Otherwise known as food for thought.]
High Dividend, Low-Volatility Stock Bubble. It's general knowledge that high-dividend, low volatility shares have been one of the best winners of the past few years. The premise is that investors have withdrawn funds from safe bank accounts because they wanted to generate income of 3%-4% while being in the most stable securities that could generate such yields. This popular (and dangerous) method of investing has created valuations almost double the fair value for these stocks which are generally found in Consumer staples, REITS, Telecoms and Utilities. (We used to call these "widows and orphan" stocks). One has to also consider the fact that the total assets in one of the most popular low-volatility ETF's called the iShares Edge MSCI Minimum Volatility USA Fund (USMV; $46) have tripled in the past year. Like all past bubbles, no one can imagine that these kinds of securities can lose half or more of their value. When it comes to bubbles, historically it is the most wildly trendy and popular trades that have always proven to be disappointing.
The dumb money theory is interesting and we'll store that away in our tool box of market forecasting. There are literally dozens of valid methods upon which to base market valuations and forecasts, but we've never found one that could stand on its own. That's the reason for a well-stocked tool box. The time to get concerned is when several of these tools start signaling coming economic strains or market red flags. The most valuable forecasting tool for us has always been "earnings." Today, we believe the argument for remaining bullish still outweighs the bearish one, although that will be dependent on earnings forecasts continuing to be met.
We tend to agree with the overcrowding in the high dividend, low volatility area, although we are not so sure about it being in bubble territory. Investors are now faced with a scarcity of attractive asset choices, and they need to be made aware that these kinds of stocks can't be expected to hold valuations that become too high. In other words, investors may need to be a lot more realistic about the returns that can be achieved within traditional risk tolerance parameters regardless of how "safe" certain stocks seem to be.
High Yield Corner
The market’s appetite for high yield remains strong. While investors aren’t exactly insatiable when it comes to income, they aren’t shying away despite the now well-known fundamental and macroeconomic headwinds that threaten many high yield investments.
Let’s start with junk bonds. The iShares iBoxx High Yield Corporate Bond ETF (HYG: $87) ended the week up slightly and with little volatility. The beta for this ETF now stands at 0.47 - much lower than it has been in the past. As a measure of volatility relative to the market as a whole, beta tells us that the market sees half the risk in junk bonds as in the broader market.
How is this possible when Moody’s and others are warning that defaults are spiking? Simply put, the market feels they have already discounted the potential risk of defaults in junk bonds, and that the lows of February were an overreaction to a now well-known risk.
A similar attitude has evolved in the BDC world, as evidenced by the over 1% rise last week in the UBS Etracs BDC ETF (BDCS: $22). With an 8% year-to-date rise and a current dividend yield over 8%, this ETF’s performance reflects the market’s continued belief that BDCs can manage non-accruals and defaults in their portfolios.
As companies that manage loans to middle market companies, and which usually have no rating at all, BDCs are considered higher risk than junk bonds in that they carry a portfolio of loans that are likelier to default. BDC managers are there to make sure that doesn’t happen. They do this by selectively accumulating a portfolio of loans that are less likely to default, and pricing interest rates high enough to compensate for non-accruals should they come.
Main Street Capital. Some BDCs are better at this than others. The Bull Market Report favorite, Main Street Capital (MAIN: $34) is a prime example. This fund’s portfolio remains robust and has weathered the past year without a rise in non-accruals. Even as default rates have more than doubled in the past year in the junk bond market, Main Street’s theoretically riskier loans have not provided rising defaults at all. Of the last four quarters, net investment income has beat consensus three times and met expectations once. In fact, the company’s ability to beat expectations has improved in the last year, which is partly why the company has been trading near or at its 52-week high for a while now.
And an announcement from last quarter demonstrates the company’s continued ability to drive investment income with savvy investments. A couple weeks ago, Main Street announced it received its third license from the Small Business Association, which will allow it to make new loans worth $125 million to small businesses. While the concept of small business loans sounds risky in theory, Main Street has proven their ability to make these investments without suffering non-payments.
In its last quarter, Main Street had half of 1% of its portfolio in non-accrual status, which is far less than the over 5% default rate in the junk bond market. Clearly, management is doing its job of choosing loans that will reward shareholders, making it a continued hold for us even as its price tests new highs.
Junk Bonds. The need to stay diligent and avoid defaults is stronger than ever, especially as junk bonds remain overpriced and yields remain low. The best way to gain exposure to junk bonds and avoid defaults is to choose a diversified and actively managed fund that has some junk bonds, but that hedges this with exposure to other kinds of loans, providing a high and reliable level of overall income.
Pimco Dynamic Income Fund (PDI: $29) For a long time, we have recommended this one for the very reason note above. Unfortunately, this week the Pimco fund massively underperformed the junk bond market, losing 1% of its value. However, it still remains up 3% in the last month and up over 4% year-to-date. The fund’s 9% yield excluding special dividends is a good reason to keep the fund, and this is compounded by the fact that its high yield exposure is less than half of the fund, with mortgage backed securities - which have been a strong performer for years now - comprising the bulk of the fund.
We remain long this fund and recommend readers do the same. A correction in the junk bond market might hurt this fund in the short term, so be aware - but that correction might not come. The best course of action, then, is to hold and enjoy the fund’s income and buy on dips if those come. From a risk/reward standpoint, this investment far exceeds the potential of holding an index fund for junk bonds, which offers a lower yield and greater exposure to rising defaults.
Finally, a quick word on REITs: the SPDR Dow Jones REIT ETF (RWR: $100) lost nearly 2% this week as many REITs suffered after the Federal Reserve hinted that an interest rate hike is to come. If this does happen - which is not certain, since we’ve known the Fed to get skittish about rate hikes before - high yield instruments will be affected across the board. But no sector has done so well in 2016 than REITs, making them particularly susceptible. This is why Bull Market Report picks in the REIT space had a little trouble last week: Kimco Realty (KIM: $30)*, Government Properties Trust (GOV: $23), and Omega Healthcare Investors (OHI: $36) all fell over 2% this week.
*Note that Kimco Realty announced a public offering of $500 million aggregate principal amount of notes due 2026 at a coupon of 2.8% per annum with an effective yield of 2.9%, maturing in 2026. The company intends to use the net proceeds of approximately $490 million from the offering to fund the previously announced redemption of $290 million aggregate principal amount of its outstanding 5.70% Senior Notes due May 1, 2017, with the remainder to be used for general corporate purposes, including to pre-fund 2017 debt maturities, including $135 million of mortgage debt outstanding with an interest rate of 6.3%.
BMR Take: In the long run this is awesome news for the company. In the short run the stock sold off, which is normal Wall Street behavior. For us at The Bull Market Report we look at this as a buying opportunity. Smart investors always look to the long term benefits of news like this.
More declines may come for these REITs after the large increases we have seen in the past. Yet the fundamentals of each, especially funds from operation and dividend coverage, remain strong. For this reason we recommend holding Kimco and Omega Healthcare in particular. However, given the 25% capital gains that Government Properties has provided investors since The Bull Market Report recommended them in April, and given the potential risks in REITs broadly, we are lowering our Sell Price of this stock to $22, 4% below the stock’s current levels. Lowering your REIT exposure and taking some profits right now seems prudent, given the high yield and Federal Reserve risks.
The Options Corner
Deep In-The-Money Options
How would you like to own Microsoft (MSFT: $58, flat) for $10 a share instead of $58 a share? To buy 1000 shares would be $10,000 instead of $58,000. Well, with options you can do this. Risky? YES, it is risky. Why? Because if the stock goes down to $50 you would lose all of your money, $10,000. If you bought the stock and it goes to $50, you would lose $8,000, so in some respects these two scenarios are about equal. Of course, in the options case, you are investing just $10,000, and by buying the stock you are investing $58,000 – big difference.
How do you buy 1000 shares at $10? You buy 10 of the January 2018 $50 LEAPs (another fancy word for OPTION.) It is trading for a shade over $10. As you know, each option controls 100 shares. Thus 10 options would control 1000 shares at a price of $50. The stock is at $58 so the option is worth $8 intrinsically, and you are paying $10. You are paying $2 for the “time-value” of the option. Not bad really considering you have 17 months for this investment to work out.
OK, we discussed the downside above. What about the upside though?
What if Microsoft goes to $65 by January 2018? The options would go to $15, for an 50% return. The stock, up $7, would have returned 12%. Wow. What a difference. (BTW, the breakeven on this trade is $60 a share, just $2 higher, as the option will trade for $10, exactly what you paid for it.) Can we say we like this trade? Yes we can.
Could the stock go to $75? It’s quite possible given the low interest rate environment, giving folks very little places to put your money. So conceivably the Dow could go from its current level of 18,500 to 20-21,000 in the next 17 months. If Microsoft goes to $75, the options will trade for $25 ($75-$50). You paid $10 so your return would be 150%.
We at The Bull Market Report are big fans of deep in-the-money calls. Over the years we have invested in many high-quality stocks using this strategy. We had great success with Apple over the years. It works with growth stocks that have a growth spurt and that are generally priced high – in the triple digits. But it works for stocks prices at $10 and $20 and everywhere in between. You just need a stock that is going to shoot higher by 10 to 20% in a year or two. Please review the scenario above. We think it is quite solid. But try to poke some holes in it if you can, and then email us at Info@BullMarket.com.
What about a similar trade in Apple? With the stock at $109, you could buy the January 2018 $100 call for about $17, or $17,000 for 10 options. In this case, the option is worth $9 intrinsically, and you are paying $17. (Not as good as the Microsoft case. Why? Because the market perceives Apple to be more of a growth stock that has the potential to move a lot higher. The market perceives Microsoft to be slow and boring. But this is how to make big money in options – go against what the market thinks. (It’s also a way to lose big money too.))
The breakeven on the trade is $117, since if Apple goes to $117, the option will trade for $17 or higher. If it goes to $134 (the all-time high), the option will trade for $34, a 100% return (on a stock return of 23%.) How about the downside. If the stock goes to $100 by the expiration date, the option will go to zero, whereas if you bought the stock, you would be down just 9%. But the purchase price of 1000 shares would be $109,000 vs. the $17,000 you paid for the option. At $100, the stock trade would lose $9,000. Big difference.
That’s it for options this week. Write us and tell us what other types of options strategies you would like us to analyze. Info@BullMarket.com.
And a good options quote page is here:
http://finance.yahoo.com/quote/AAPL/options?p=AAPL&date=1516320000
We use it all the time.
Good Investing,
Todd Shaver
Editor in Chief
