Verdmont Capital

Thursday, May 21, 2015

Alibaba Group (BABA:$90.70) - Good for a Trade

We believe that BABA is a good trade here.

The stock is breaking out after a period of consolidation post IPO in September 2014.

BABA – September 2014 to Present
Source: Verdmont Capital S.A., Bloomberg

Arguably, the selloff since going public and the sloppy trading over the past few months has been a good thing. The market had time to work out some of the over exuberance associated with going public and the stock has moved into stronger hands.

We saw a similar situation play out with Facebook (FB:$80.55). The company went public on tons of hype and then started to sell off. This lead to depressed sentiment with the belief that the company was another tech sector disaster in the making. FB based out over a few months, then broke higher as it went from a show me stock to the real deal.

Below is a chart of 1) FB from its IPO date + 1 year 2) FB from IPO date to now.

1) Facebook (FB:$80.55) – From IPO Date + 1 Year
Source: Verdmont Capital S.A., Bloomberg

2) FB – IPO to Present
Source: Verdmont Capital S.A., Bloomberg

A huge positive is that the breakout in BABA is consistent with improving company prospects. It usually works out well for investors when technicals and fundamentals are lining up together.

You can see in the below chart that BABA has been beating estimates over the past few quarters, at an increasing rate of positive surprise. In other words, the company appears to be gaining momentum relative to expectations. 

For an overview of recent results and a snapshot as to where the surprise is coming from, please see the following Stifel Nicolaus note https://stifel2.bluematrix.com/sellside/EmailDocViewer?encrypt=b2bd3607-190c-462b-a296-8b9fd5c08326&mime=pdf&co=Stifel&id=EquityResearch@stifel.com&source=mail . As always, thanks to Stifel for their quality research.

BABA – Actual EPS vs. Estimates
Source: Verdmont Capital S.A., Bloomberg

It is also encouraging that BABA is currently trading at a steep discount to analyst price targets.

We always take analyst price targets with a grain of salt. Trying to forecast a share price to the penny one year out is a mugs game.

That said, we do appreciate when the share price is trading at a steep discount to aggregate analyst price targets. When you are looking at dream stocks, or idea stocks, we find comfort that a group of 20 nerds believe in the business model. It certainly isn't a guarantee, but it suggests we are not missing any fatal factors right out of the gate.

BABA – Aggregate Analyst Price 12M Price Target vs. Share Price
Source: Verdmont Capital S.A., Bloomberg

The fact that Chinese equities have been on a tear also lends support to our trade call. Remember that 85% plus of BABA's business is in China. If Chinese equities are rallying, it could be pointing to an economic turnaround in the region.

More importantly, due to recent weakness, BABA has only traded in line with the overall Chinese stock market since going public. This is another indication that the stock is no longer an overhyped sloppy pig.

BABA vs. Chinese Equities – Since BABA IPO
Source: Verdmont Capital S.A., Bloomberg

In terms of multiples, yeah, they are lofty. But no more inflated than other stocks in the sector. Our call to buy BABA is largely a momentum call, so valuation metrics are not a key factor. That said, we take comfort in the fact that BABA is not priced to the moon compared to its industry group. In fact, the company is trading at a discount to its peer group average across many key metrics.

BABA – Valuation Comps
Source: Verdmont Capital S.A., Bloomberg

So, we think BABA is a good trade here and investors should play the breakout.

We are never wrong, but if we happen to be for the first time ever on this call, you should bail if stock fails to hold ~$86.50/sh. If you are more of a believer in the space and have a longer term view, you could use the ~$80/sh range as a stop, which is the floor of the recent trading channel.

Source: Verdmont Capital S.A., Bloomberg



Monday, May 18, 2015

What may Trigger a "CRASH"

Bank of American recently came out with the 5 "CRASH" catalysts, which are outlined at the bottom of this note.

"CRASH" is an acronym they are using to describe the conditions that would cause a significant correction in asset prices.

There is also a graph contained in their piece that shows how much investment interest there has been in yield enhancing products. No one knows exactly what a debt bubble looks like, but it must look something like that.

Investors are plowing into every yield enhancing product they can to earn a few extra basis points. We have written in the past that REITS are insanely overvalued and over owned. Investors are buying them with no clue about the massive risks they are taking. When the REIT you hold falls -40% during the next correction, as they did in 2008, that extra 80 basis points you are getting right now will seem ridiculous in hindsight.

Ultimately, each of the "CRASH" factors outlined by Bank of America, all come back to liquidity in the system. At Verdmont, we have long believed that the party will be over when real rates approach ~1.5-2.0%. In other words, when the cost of money begins to outpace global growth.

Each of the last systemic events going back 30 years involved rising real rates. In the past, real rates approaching ~3-4% was enough to cause the savings & loan crisis, the Mexican peso crisis LTCM, the tech correction, the 2003 housing crash and the 2008 credit crisis. Given that the system is more levered than ever, it is questionable if it can even sustain a ~1.5-2.0% real yield. Global growth is forecast at a modest 1.5%, even with all the liquidity out there.

Note in the below chart, that real rates in the States are actually approaching 1%. You will also see that the equity market has had a diminishing ability to shoulder a certain level of rates. This makes intuitive sense because the level of debt in the system has been rising substantially.

MSCI World vs. US Real Rates – 1989 to Present
Source: Verdmont Capital S.A., Bloomberg

With real rates rising, the global economy had better start accelerating in order to support the increasing cost of debt.

________________________________________________________________________________________

Bank of America just named the 5 'CRASH' catalysts most likely to spark a global market slump
Bank of America Merrill Lynch (BAML) analysts just flagged five factors that could cause a "cleansing drop in asset prices."
They've even given the possible catalysts a catchy acronym: "CRASH."
Each factor is an assumption of a consensus in the market that if overturned could spark a slump.
Here are the "CRASH" indicators to watch, with some snippets of text from the note itself:
  • Consumers: US consumption data has been unexpectedly weak in recent months. "Few are positioned for a contagious sell-off in US dollar, bonds & stocks if US GDP growth were to stumble once again in Q2 & Q3."
  • Rates: If inflation picks back up quicker than expected, the low and stable interest rates most investors are expecting might not be a given, and a surge would be destabilising.
  • A-shares: China's surging stocks provide BAML some reasons to worry. "Investors are not positioned for full-blown policy failure in China. Chinese growth expectations may be weak, but the A-share market hardly portends a collapse in Chinese activity."
  • Speculation: "There is a risk that investors, in particular systematic macro funds, have crowded and levered positions that do not assume a rise in cash rates."
  • High yield Markets scrambling to find investments with decent yields, given low interest rates around the world, "remains the biggest Achilles' heel for positioning," according to BAML.
On the last point, the bank has illustrated the surge into high-yield investments, compared with safer and lower-yielding assets like inflation-protected US bonds (TIPS):
Bank of America Merrill Lynch

Thursday, May 14, 2015

The Commodity Complex Offers Good Relative Value : Buying Deere & Company (DE:$90.61)

Commodity Comment – Playing Short Term Strength

We saw an interesting chart from BCA this week that shows the price performance of the US dollar and oil during periods in which oil inflation has fallen by greater than -40%. It gives you a gauge of how prices are currently tracking relative to past corrections of a sizeable magnitude.


Recent strength in commodities is largely attributable to a drop in the US dollar, with a modest kicker from improving European sentiment and reduced concern about a hard landing in China. So, your US dollar view is critical to your commodity view, more so than ever. 

Oil is a great example of this, as much of its performance has been directly tied to the US dollar. Oil price action is very important, as it tends to lead the overall commodity complex.

WTI Oil vs. US Dollar – 2 Years
Source: Verdmont Capital S.A., Bloomberg

In terms of the US dollar, the general consensus is that the Fed will start chatting up a rate rise again, heading into September. That is really the zillion dollar question and virtually impossible to know. In a recent FOMC meeting discussing the Fed's stance on short term rates, Janet Yellen said, "just because we removed the word 'patient' doesn't mean we're going to be impatient." When the Fed doesn't even understand what they are saying, how can we?

The inability to guess what US policy makers will do next is THE risk in the market at the present time. Each asset class, whether it is equities, fixed income, real-estate or commodities, is completely levered to where interest rates and the US dollar go.

If the Fed remains accommodative, they will continue to fuel dislocations in the market. Conversely, they must be keenly aware that even a marginal rise in interest rates could cripple over indebted households and governments. Raising rates would also contribute to a sustained rise in the US dollar, which would hurt corporate profitability in the States.

For the time being, we can only go off of what we know, which is: 1) history suggests that the Fed is reluctant to raise rates and will do anything they can to avoid it. 2) Global central banks are all in the midst of various stimulus programs i.e. Japan, Europe and China. 3) Global nominal GDP growth is still outpacing the cost of money (one big carry trade). 4) With central banks remaining accommodative, the probability of a debt induced systemic event remains relatively low (when real rates begin to approach GDP growth, see you in Hell).

Given what we know, you should still be taking risk in the market because now is the time to make money, before we slip into the dark ages. The next logical question is, should we own commodities and related equities?

The canned answer is, "yes, of course, it pays to diversify, China is growing, blah, blah." You can phone your Royal Bank broker to hear that jabber. In the real world, if you are actually putting your own money in the market, the answer is a little less clear. 

On the one hand, commodity plays have taken it on the chin and the overall market remains accommodative, which can back you into a bullish stance. On the other, the US has shot most of its stimulus arrows, whereas other central banks are still in the middle or infancy stages of their easing programs. This puts upward pressure on the US dollar, which is a major headwind for the commodity complex.

All in all, we think we could have a pocket of strength in commodities and related equities. The US dollar will ultimately move higher against the world's major currencies, but weak economic data in the US will enable policy makers to remain dovish for longer than expected.

If you are making a relative call on commodity plays vs. the broad stock market, then the bullish case becomes even that much more compelling.

The difference in performance between the asset classes has been sizeable, which typically isn't sustainable as market drivers tend to have stocks and commodities move together over time.

Powershares DB Commodity Index vs. MSCI World – 5 Years
Source: Verdmont Capital S.A., Bloomberg

BHP vs. MSCI World Index – 5 Years
Source: Verdmont Capital S.A., Bloomberg

The broad equity market is going higher because it is either sniffing out a solid economic backdrop in the future, or, it is massively artificially inflated. 

Under either of these scenarios, you can make a call that commodities are attractive in relation to the broad equity market. If the equity rally is for real, then commodities certainly have to follow stocks higher as global growth picks up. If the ongoing equity rally is bogus, then the commodity complex offers downside protection due to the fact that is has already discounted a slew of bad news. Not to mention the fact that "hard assets" tend to do better during times of global instability.

Based on the above logic, we have started buying various commodity names for the first time in a while. We have also gone overweight commodities in our managed investment accounts to express our view.

Deere & Co (DE:$90.61)

We have been following Deere ever since Caterpillar (CAT:$88.44) beat on earnings last quarter. When an oversold sector starts to beat depressed estimates, it often foreshadows a turn in sentiment.  

We had been waiting to pull the trigger on Deere, planning on buying it when it went to new highs. We are taking a position earlier than expected because we believe that Deere should rally on the US dollar selloff, CAT strength, the oil rebound, cyclical stock leadership and stabilizing grain prices. Deere is also trading at very cheap multiples, which is incredibly hard to find in this market.

Deere should follow the agribusiness sector to new highs.

Market Vectors Agribusiness ETF vs. Deere – 3 Years
Source: Verdmont Capital S.A., Bloomberg

DE has underperformed the broad equity market by a wide margin.

Deere vs. MSCI World – 3 Years
Source: Verdmont Capital S.A., Bloomberg

DE trading multiples are at trough levels on an absolute basis and relative to the market.

Deere Trailing P/E and P/E relative to the S&P 500 – 10 years
Source: Verdmont Capital S.A., Bloomberg

We would buy Deere at these levels with the expectation that the stock breaks to new highs. We would employ a stop in the range of $87/sh, which is slightly below recent support and where the stock was trading before the CAT Q1 earnings beat.

Deere – 5 Years
Source: Verdmont Capital S.A., Bloomberg

Wednesday, May 6, 2015

Real Estate Investment Trusts (REITs) - Dreadful Prospects - EQR ($72.21), HTA ($24.85)

The following article is a good snapshot of recent REIT performance. http://www.marketwatch.com/story/behind-the-great-reit-sale-2015-05-05?link=MW_popular

REITs have done amazingly well given that yields have surprised to the downside. They have also benefited from a wave of “enhanced yield” investing and related products. The search for yield has driven credit related products to all-time highs as investors venture into unfamiliar segments of the market to boost investment income.

Recent REIT weakness highlights the dangers of getting too aggressive towards this segment of the market. REITs are very volatile, which means that the extra spread obtained in buying them can disappear in a flash. If the price of your REIT falls -10%, which is commonplace, then the 2% yield enhancement you were looking for quickly becomes irrelevant.

Dow Jones Equity REIT Total Return Index (REIT) – 1 Year
Source: Bloomberg, Verdmont Capital S.A.

With yields and inflation expectations close to all-time lows, it is tough to pound the table on REITs. Both history and logic suggest that these factors will have to move the other direction at some point. When well-known investment managers like Warren Buffett and Bill Gross are warning people about credit bubbles, it should have REIT holders shifting in their chairs. https://www.janus.com/bill-gross-investment-outlook .

In tune with the above, it is important to point out that the REIT complex has been key benefactor of the policy induced global credit orgy. Although REIT performance can be attributed to different variables, at the end of the day, REITS area supercharged credit play. Comparing REIT performance to that of the Merrill Lynch Global High Yield & Emerging Market Bond Index serves to underscore this point.

Dow Jones Equity REIT Total Return Index (REIT) vs. ML Global HY and Emg Mkt Bond Index – 10 Years
Source: Bloomberg, Verdmont Capital S.A.

There are some positive elements to the REIT story, for example, REITs typically do well when inflation is rising modestly and the economy improves. This boosts housing values and bolsters rental income as wages and business activity rise. If you employ a goldilocks view towards the state of the US economy, then you could rationalize a REIT allocation to play those themes.

We have a more cautious view about the ability of policy makers in the US to engineer such a scenario given the imbalances in the system. In light of this, and the tremendous run that REITs have had, we need a greater reason to buy into the asset class at the present time. As the above chart illustrates, REITs fell north of -70% peak-to-trough during the 2008 credit crisis. This highlights that the extra spread obtained via an investment in REITs does not come without a significant boost to risk in your portfolio.

There are some decent REITs to trade when you feel that interest rates have made an interim top or that sentiment has swung too far the other way. For example, we like Equity Residential (EQR:$72.21) and Healthcare Trust of America (HTA:$24.85) as they operate in segments of the market with decent tailwinds. EQR is a play on increasing rental housing in the US and HTA on some secular healthcare related themes. 

That said, these names are trading very rich, which leaves little meat on the bone even if interest rates remain muted. For example, EQR is trading at record highs in relation to its price-to-FFO ratio. (Note: For a snapshot on how to value REITs, please view this article http://www.investopedia.com/articles/04/112204.as )

Equity Residential (EQR:$72.21) vs. Price-to-FFO Ratio – 20 Years
Source: Bloomberg, Verdmont Capital S.A.

In summary, be careful if you are reaching for yield in REITs. That segment of the market has been a direct benefactor of the imbalances that have been decades in the making. Whenever a fixed income product offers the potential for enhance yield, that means there is an increased level of risk. Given that interest rates remain close to record lows, coupled with the fact that REITs are very overvalued, investors should tread with caution. More than ever, your fixed income allocation should be focused on preserving capital as opposed to taking on risk for a few basis points.



Friday, May 1, 2015

Big Energy Companies are Beating Depressed Estimates - Energy Infrastructure is Looking Good - EMLP:$27.47, KMI:$42.95

We continue to favor the energy infrastructure plays in the US.

Huge secular tailwinds are underscored by limited transportation and storage capacity in light of surging US energy supply. Significant demand vs. limited capacity equates to ongoing profitability for pipeline, refining and storage related businesses. Elevated and rising refining margins in the US are symptomatic of what we believe is a sweet spot in the energy complex.

US Refining Margins – 3 Years
Source: Verdmont Capital, S.A., Bloomberg

In addition to elevated refining and transportation margins, oil trading remains quite profitable at the present time. During the acute stages of oil price volatility / weakness, the short end of the futures curve can become disconnected with the long end. Oil trading can be quite profitable during these periods as companies buy short dated oil and sell it farther out on the curve. Prices at the long end of the curve are typically more stable and a better indication of the long term fundamentals driving the oil market.

The below chart shows the current shape of the WTI Oil futures curve (orange) vs. 1 year ago (green). Note how prices at the short end of the curve have dropped substantially, whereas the long end has been relatively stable.  You can also see that the WTI oil curve at the present time is in steep contango, meaning short dated futures are trading at a significant discount to those farther out. This creates the opportunity for energy trading companies to buy near and sell far, locking in the price differential of the curve.

WTI Oil Futures Curve – Now (orange) vs. 1 Year Ago (green)
Source: Verdmont Capital, S.A., Bloomberg

Recent results from the integrated energy companies highlights our bullish view on oil trading and refining businesses. Exxon, BP and other large energy companies beat depressed earnings estimates this quarter. The big surprise came from the profitability of their refining, storage and trading businesses. Margins in these segments remain elevated and underappreciated by the market. This gives us confidence that recent strength in energy infrastructure companies should continue to play out.


Our favorite names to play these trends remains EMLP:$27.47 (https://www.ftportfolios.com/Retail/cef/cefsummary.aspx?Ticker=FIF) and KMI:$42.95 (http://www.kindermorgan.com/).

EMLP – 1 Year
Source: Verdmont Capital, S.A., Bloomberg

KMI – 1 Year
Source: Verdmont Capital, S.A., Bloomberg


Thursday, April 23, 2015

Know Your Index (TAN:$49.02), Hong Kong Listed Stocks are Going to the Moon

We have been looking at the Guggenheim Solar ETF (TAN:49.02), and wondering why the heck it has taken off.

TAN – 1 Year

We had been following TAN, looking at it as a potential short. Our logic was based on the view that solar budgets are due to be crimped as Governments go broke and hydrocarbons cheapen in relation to solar power. Thankfully we had held off.

Looking into what we are missing, it becomes evident rather quickly, that the HK listed names in the index have been distorting its performance. These names comprise a large chunk of the index and have all gone to the moon. Further evidence of how shifts in Chinese trading regulations are causing dislocations in the market.

Hanergy Thin Film Power Group (566 HK) – 1 Year

The above is a good example of how you might want to express a given investment view, however, you are exposing yourself to other themes you may not be aware of by taking a position in a basket of stocks. In other words, make sure you know your index, or you could get killed for the wrong reasons.

It also highlights how unhinged some of these Hong Kong listed equities have become. A lot more work needs to be done to determine how hollow the current rally is. On the surface, it seems destined to end in tears, as it is all fast retail money coming into the space.

Looking at the multiples of Hanergy Thin Film Power Corporation (566.HK), one can see we are quickly entering into no man’s land in terms of fundamentals.

Hanergy Thin Film Power Group (566.HK) Valuation – 1 Year

Like all manias however, which we believe this current rally can be classified as, it can continue much longer than anticipated. Chinese officials appear comfortable with the rally, and more importantly, have encouraged it by swaying people to shift out of real estate and into stocks.

This could end up being a massive positive for the broad equity market, if the liberalization of trading on regional exchanges in China is a precursor to the easing of restrictions on international investments. There is obviously tons of capital in China looking for a home, and were international trading to open up, it would be a boon for the entire market.

Alternatively, we could be a witnessing a massive policy misstep that is only creating another dislocation of capital in China. If this proves to be the case, watch out below.

Stay tuned.   

Monday, April 13, 2015

Guaranteed Investment Products - Do it Yourself!

A simple explanation of guaranteed investment products can be viewed in the following video:  


We have all heard the pitch associated with the many different vehicles out there that claim to provide you “exposure to equity market returns, while guaranteeing your capital.” There are a multitude of guaranteed products available, all with varying degrees of complexity, but they are all deviations of a relatively straightforward strategy.

It is easy to imagine why these strategies appeal to investors. Who wouldn't want equity returns with “no risk.” Like many “big bank” products offered in the market, they play on investors emotions and involve a splash of trickery. Why not cut these jokers out of the picture and do it yourself? Buy high credit quality bonds over a set period, and then buy a smaller percentage of an equity index or future and… Voila!  

You now have equity market participation with a capital guarantee.