“The market is smarter than you will ever be, with its combined knowledge of all participants. Pay attention to the signs. Be quick to admit that you’re wrong. Don’t be afraid to miss something.”
-Yra Harris, Praxis Trading
That quote comes from my “other” favorite book on markets, Inside the House of Money, which is a series of candid interviews with a number of highly-regarded Global Macro Risk Managers (Daniel Kahneman’s Thinking, Fast and Slow forms the other half of my 1A/1B compromise). Harris – a veteran of the trading floor pits at the CME for over three decades – had that to say about the merits of gleaning critical information from market prices.
I make it a point to pay as little attention as humanly possible to the #OldWall’s financial media outlets, so I don’t know much about Mr. Harris’ current views and biases on the markets. I do, however, know that we @Hedgeye subscribe to the same philosophy of recognizing that we’re not smarter than the market. Indeed, having been football or hockey jocks at an institution like Yale has taught us all we needed to learn about not being the “smartest guy in the room”.
Whether you’ve watched us compete in this game for the past five years or you’ve been trialing our research for five days, you’ll quickly arrive at the conclusion that last price tends to dictate our interpretation of the fundamentals. But, obviously, markets oscillate on a day-to-day and week-to-week basis, so we employ a three factor (i.e. price, volume and volatility) quant model to contextualize market trends across three distinct investment durations:
- TRADE: 3 weeks or less
- TREND: 3 months or more
- TAIL: 3 years or less
If a particular security or asset class is Bullish TRADE (i.e. last price is above the TRADE line), we’d argue that the market is in agreement with the positive fundamental view(s) emanating from the bull camp with respect to the most immediate-term of durations. The same can be said of Bullish TREND setups vis-à-vis the intermediate-term duration and Bullish TAIL setups vis-à-vis the long-term duration. The inverse of this interpretation (i.e. Bearish TRADE/TREND/TAIL) holds true as well.
We believe that it is our job as macro analysts to collect and piece together any relevant economic data with the intent of forming a fundamental view on a particular market or asset class. Often times, however, our biases don’t agree with said market’s risk management setup – i.e. the research is bullish when the market setup is bearish, or vice versa.
Prior to putting any risk on, investors generally have the option of dismissing the aforementioned setup as “being early” – at least until they get tapped on the shoulder! When, however, the position is already on the tape and has positive P&L and it starts to trend counter to one’s preexisting and subsequently reconfirmed fundamental view, we’d argue that said investor is late – i.e. he or she is #MissingSomething with respect to the fundamental story.
To better illustrate this lesson in Global Macro Risk Management, let us turn to a discussion of our preexisting bullish bias on the dollar-yen cross with respect to the intermediate-term TREND and long-term TAIL durations and on the Japanese equity market with respect to the intermediate-term TREND duration.
We’ve been out front of consensus making these calls – very loudly in the yen’s case – since SEP and NOV of last year, respectively, but, for those of you who may be new to the thesis, our subsequently reconfirmed fundamental view is as follows:
- While enthusiasm for the Abenomics agenda may come and go in the immediate-term, we believe investors are broadly underestimating the structural impact of imposing a +2% inflation target and +3% nominal growth target in Japan. To put that in context, the trailing 10Y averages for these metrics are -0.1% and -0.5%, respectively. Japanese policymakers have a lot of hay to bale on the monetary easing front if they are to even sniff their lofty targets within the proposed 2Y time frame.
- Assuming Japanese policy stays the course and our view that the US economy has finally turned the corner from a growth perspective is ultimately proven prescient, a compressing real interest rate differential will also put pressure on Japan’s currency from a capital flows perspective. Consensus expects real 2Y JGB rates to hit -2.5% by EOY 2014 (down meaningfully from -0.4% by EOY 2013); this compares to a forecast of -1.3% for real UST 2Y rates by EOY 2014 (down slightly from -1.1% by EOY 2013). More importantly, this inflection is also being confirmed in the swaps market: 2Y swap rates in Japan are now trading at -1.57% on a real basis (subtracting the 2Y breakeven rate from the swap rate); that compares to -0.88% for the US. As recently as mid-MAR, those metrics were meaningfully inverted at -0.10% and -1.98%, respectively!
- In the context of intermittent spikes in volatility in the bond and forex markets, we have maintained that the risk-adjusted outlook for Japanese stocks is decidedly less sanguine than consensus assumes given the reflationary tailwind of currency debasement. The caveat here is that this headwind can be offset via absolute returns that are now likely to be increasingly predicated on economic and fiscal reforms (corporate tax cuts, labor market deregulation, fiscal consolidation, etc.), as well as large-scale portfolio rebalancing by Japanese households. To that tune, only 6.8% of Japanese household financial assets are held in equities vs. 14.4% for the Eurozone and 32.8% for the US.
In spite of what we’ve outlined as arguably the most credible and well-articulated bull case for both the USD/JPY cross and Japanese equities, both are broken from an immediate-term TRADE perspective and flirting with breakdowns on our intermediate-term TREND duration as well. The risk management levels to watch on that front are as follows:
- USD/JPY (last price = 96.77): Bearish TRADE = 97.72 and Bearish TREND = 97.13 (a few days young; needs to hold below TREND for a few weeks to confirm the move… if confirmed, we would certainly alter our fundamental bias)
- Nikkei 225 (last price = 13,519): Bearish TRADE = 14,091 and Bullish TREND = 13,336
Profit taking, generally disappointing 2Q earnings and waning international investor sentiment for Abenomics are all credible theses that support a Bearish TRADE setup in both markets. We haven’t come across anything credible that would fundamentally support a confirmed Bearish TREND setup in the USD/JPY cross, which we believe will continue to determine the direction of the Nikkei until it eventually becomes obvious to Japanese equity investors that inflation is not growth (the trailing 1Y and 3Y correlation coefficients between these two markets are +0.96 and +0.97, respectively).
But, as highlighted above, just because we haven’t formed a coherent fundamental story that supports the quantitative risk management setup in both markets does not mean the underlying fundamentals themselves cease to exist. So either we’re #MissingSomething or this is all just one big head-fake as weak hands are shaken out of the trade.
Let us know what you think.
Our immediate-term Risk Ranges are now as follows:
UST 10yr Yield 2.57-2.73%
Keep your head on a swivel,
THE MACAU METRO MONITOR, AUGUST 12, 2013
CAESARS SELLS $438MM MACAU GOLF COURSE TO PEARL DYNASTY Bloomberg, Reuters
Caesars Entertainment has agreed to sell a golf course in Macau to Pearl Dynasty Investment Ltd for $438 million, effectively giving up obtaining casino operating rights in Macau. CZR expects net proceeds of about $420 million from the disposal, which it will use to fund capex or buy back debt, it said in a filing. CZR expects the completion of the sale to Pearl Dynasty to be completed in the fourth quarter.
NEW RULES SOON ON PUBLIC OFFICERS WHO FREQUENT CASINOS Channel News Asia
Public officers who visit the casinos in Singapore frequently or buy annual casino entry levy will soon need to declare these actions. Deputy Prime Minister Teo Chee Hean, who is also Minister-in-charge of the Civil Service, announced this in Parliament as he spoke about the integrity of the public service amid a spate of recent lapses.
Former assistant director at the Corrupt Practices Investigation Bureau (CPIB), Edwin Yeo, was charged last month with criminal breach of trust involving S$1.7 million. Part of the money he allegedly misappropriated was used for gambling at the Marina Bay Sands casino in Singapore.
GUANGDONG CONFIRMS HUMAN H7N9 INFECTION CASE Xinhua
A human infection with the H7N9 strain of avian influenza was confirmed in south China's Guangdong Province, Guangdong's health department said Saturday. Sample of a 51-year-old woman surnamed Chen tested positive for the H7N9 virus at the Chinese Center for Disease Control and Prevention on Saturday, confirming the results of tests conducted by the Guangdong provincial center for disease control and prevention on Friday. Chen is in critical condition.
In July, the Chinese mainland reported a single H7N9 avian flu case in which a patient from north China's Hebei Province was diagnosed in Beijing, bringing the total number of infections on the mainland to 133. Of the cases, 44 have ended in death, according to the the National Health and Family Planning Commission.
CHINESE OFFICIALS SPENDING ARE CLOSELY MONITORED Xinhua
Chinese Premier Li Keqiang ‘s policy on major measures to reduce government spending has been effectively implemented and will further intensify supervision and investigate problems related to the implementation of the regulation. Spending by central government departments has dropped 1.6% YoY since the implementation of the policy.
SINGAPORE'S ECONOMY GROWS 3.8% ON-YEAR IN Q2 Channel News Asia
According to The Ministry of Trade and Industry (MTI), Singapore's economy grew by 3.8% YoY in 2Q 2013. It is the strongest growth in three years and a hefty improvement from the 0.2% growth recorded in 1Q 2013. As reported earlier, the ministry had upgraded the GDP forecast for 2013 from 1% to 3%, to 2.5% to 3.5%.
The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.
LONG SIGNALS 80.35%
SHORT SIGNALS 78.44%
Takeaway: We’re not professing the validity of the bull case, but are simply pointing out that sub-$13, a bull case does not even appear to exist.
Conclusion: There are more cross-currents swirling around JCP right now than at any time since the story thrust itself into the mainstream back in the summer of 2011. But we think it’s key to draw a dividing line between today’s sheer lack of debate around any potential earnings power – ever – and reigniting a debate around what JCP could become and ultimately earn under a real leader. We’re not professing the validity of the bull case, but are simply pointing out that sub-$13, a bull case does not even appear to exist.
Let’s make one thing absolutely clear. The way that Ackman is going about communicating proposed changes to the management team at JCP is self-serving and irresponsible – at least the way that I (McGough) am looking at it. But the reality is that the end result – that CEO Ullman needs to be replaced with someone that can actually drive this business forward with a transformational vision and an executable plan – is the right one.
We’re on record back in April in saying that the JCP Board was either six months too late in firing Johnson, or six months too early. It should have acted based on his pricing miscues back in the fall and into holiday (probably not the right move), or based on the outcome of his new shop-in-shop rollout (which wouldn’t have been known until 2H of this year).
So what did we get? We got Ullman. The former CEO – the one that is really really good at discounting below-average product to average Americans. Howard Shultz of SBUX can get on CNBC all he wants and rave about how great a leader Ullman is (he did this last week), but Ullman’s track record for creating value is horrendous. Yes, he made a good move towards stabilizing JCP’s balance sheet, and sales are less horrible under Ullman than they were under Johnson.
But the reality is that Ullman is beginning to behave like he is going to be at the company for a while, which is inconsistent with the purpose for bringing him on as abruptly as the Board did back in April. And that’s just not good. Since he was named CEO the stock is down 18.9% while the S&P is up 7.8% -- and that’s only four months.
There’s one major thing that people need with this story – and that’s someone who can stand up and lead all constituents (customers, employees, vendors, creditors, and investors) to believe what they (at least partially) believed 12-18 months ago – that this is a company that can return to an $18bn sales base at a minimum, and eye something above $2.50 in EPS power.
We’re not saying that it can happen at JCP. But today, no one is even making the argument anymore. The debate isn’t even alive! THAT’s what’s represented in a $12.86 stock price.
Our point here is that one press release can be a big first step toward changing all that. And that’s an announcement that a person with a vision for what JCP ‘could be’ is anointed with the confidence and respect of the Board to step in and get the job done.
Ironically, we think that the right answer is something pretty darn close to what Johnson was trying to accomplish. Is the right number of stores 400 remodels instead of 800? Perhaps. Is the cadence of the roll-outs slower than Johnson planned? Yes. Are certain high-end brands that JCP had planned not appropriate for the JCP customer? Yup. But directionally, the idea was probably the right one.
The bottom line here is that based on the current management team and lack of long-term vision to create value in a rapidly changing retail climate, we have zero confidence that this is a story that has any staying power, and will not otherwise go the way of Sears.
Our gut says that we’ll get a significantly better management team in place (note Perry Capital going as far to note that it wants FL's Ken Hicks in the CEO role when it filed its 7.26% position on Friday). The pressure on a management change seems to be like a balloon under water that is about to burst.
So as it relates to the stock, if we have to look at it based on what we have today, JCP is as unexciting (and risky) as it gets. But when we think of a new management team coming in and at least firing up a (currently nonexistent) debate on earnings power, the stock looks interesting to us under $13.
JCP: Hedgeye Sentiment Monitor Shows That Investor Sentiment Is About As Bad As It Can Get
Takeaway: Current Investing Ideas: NSM, MD, HCA, HOLX, FDX, MPEL, WWW, NKE and SBUX
The latest comments from our Sector Heads on their high-conviction stock ideas.
NSM – Nationstar Mortgage delivered much better than expected 2Q13 earnings when they reported on Tuesday. The company earned $1.37 per share on a GAAP basis vs expectations for $0.90, and adjusted for the BofA portfolio pre-loading of expenses, the earnings were $1.50 per share. Revenues also handily beat estimates coming in at $603mn vs expectations for $521mn. While they kept their 2013/2014 earnings guidance unchanged, they raised their bulk pipeline acquisition guidance from $300Bn to $400Bn and raised their flow pipeline estimate to $55Bn/year from $40Bn/year. We think that additional servicing portfolio acquisition announcements will catalyze both NSM and the group (OCN & WAC) on the long side in the back half of this year. In total, the industry raised its expectations for pipeline acquisitions by $145Bn in just the last 90 days, 70% of that increase came from NSM.
TRADE: In the short-term, the market will likely trade inversely NSM to long-term interest rates in the absence of other data.
TREND: Over the intermediate term, the stock will trade around announcements of servicing acquisition deals. We think NSM remains well positioned here, alongside Ocwen and Walters.
TAIL: In the long-term, there is still a tremendous opportunity for non-bank servicers like Nationstar to roll-up the servicing business. NSM is well positioned to be a prime beneficiary. We continue to think consensus earnings estimates remain too low for 2013/2014.
MD – After Mednax reported earnings last week, Healthcare sector head Tom Tobin continues to fine tune his model. Tobin is looking for next week’s results from the latest Pregnancy and Delivery survey as he tracks his developing Birth Rates Recovery theme. The lion’s share of MD’s revenue growth is from acquisitions, and a variety of factors influence usage rates – both at MD’s existing operations and at potential target companies. This week’s Sector Spotlight, focused on Healthcare, discusses Tobin’s unique analysis of how regulatory factors can restrict growth.
HCA – Healthcare sector head Tom Tobin updated his model and outlook for HCA Corp after the company reported this week, saying “there were a few highlights from the quarter that we found most promising.” Pricing from commercial insurers improved 6.1% and appears on an upward trend. Tobin believes the Hospital industry is looking forward to a long trend of rising pricing power. The industry is consolidating for a host of reasons. Tobin notes the State of Massachusetts Attorney General issued a study in 2010 on hospital pricing. The AG’s conclusion was that the only driver of pricing was market share, something the rising tide of hospital consolidation will surely produce.
HOLX – It’s been a busy week for Hologic: A new CEO, lower guidance for the coming quarter, and significant acceleration in their Breast Health business, and HOLX did just enough to keep the stock price moving higher. Healthcare sector head Tobin cites recent conversations with a few institutional clients who have shared some of the more negative views emanating from Hedgeye’s competitors – many among the analyst community have a decidedly negative view of HOLX’s future. Tobin readily acknowledges the challenges facing HOLX, but he says “I don’t see many asking about their opportunities either.” Tobin’s monthly OB/GYN survey has been launched. He’ll be looking to the update early next week for some visibility into both the opportunities and the challenges facing HOLX.
FDX – Industrials sector head Jay Van Sciver notes that Deutsche Post, the owner of global express carrier DHL, just reported strong Express segment margins, on lower air volumes. A restructuring of the Express operation is a substantial part of Van Sciver’s long thesis on FedEx, and he says DHL’s restructuring success should be seen as a road map for FDX.
MPEL – Gaming, Lodging and Leisure sector head Todd Jordan says Melco Crown Entertainment delivered another strong quarter this week, beating consensus expectations. The beat was clean and healthy – volumes and hold percentage were better than expected. Jordan expects continued strong growth out of the Macau market. With 100% exposure tied to Macau, MPEL should be a prime beneficiary of the market dynamics there. Jordan notes that MPEL reported positive net cash at the end of Q2, increasing the possibility of a dividend and/or share repurchase announcement by the end of the year. Returning cash to shareholders would widen the shareholder base considerably by providing investors with a growth and income profile.
WWW – Retail sector head Brian McGough is on vacation this week.
NKE – Retail sector head Brian McGough is on vacation this week.
SBUX – Starbucks blew away expectations in 3Q13 and remains one of the best pure plays on global growth in the restaurant space. The bullish factors we are focused on include rapid unit growth in China, expansion into new segments of the global food and beverage industry and a coffee tailwind that appears to be getting stronger. But, perhaps most impressive of all is the effective innovative initiatives of the management team, which has allowed the company to consistently stay a step ahead of their competitors and a couple of recent announcements really enhance this view.
SBUX recently announced their decision to partner with Danone, in order to create a line of yogurts to be sold in company and grocery stores. By joining the thriving market for yogurt, the company hopes to strengthen their broad-based appeal and drive incremental traffic – both of which we believe will materialize. And, in another move expected to be well-received by consumers, Starbucks has partnered with Google to provide wireless internet service at all U.S. locations. The WiFi service is expected to be 10x faster than the current service provided by AT&T and will take 18 months to rollout across all domestic locations.
In our view, Starbucks is one of the best, if not the best, run companies in our space. Yes, sentiment and valuation remain high for SBUX, but so does our conviction in the stock.
Macro Theme of the Week – August Doldrums
Judith Rossner’s novel August depicts a co-dependent relationship between a messed-up young woman and her equally messed-up psychoanalyst. Its title refers to the dreaded annual hiatus when New York’s shrinks depart en masse for the Hamptons, the Vineyard, or Points West, leaving their analysands to languish for a month.
Let’s say your shrink is among those who are away for the month. An outside observer, noticing that you are suddenly free on Wednesdays from 7:00 to 8:00, and can now go to dinner, a movie, or a free concert in Central Park, might assume that you are no longer in therapy. Everything’s fine now. No need to worry.
We notice a similar complacency of late in the financial media. Many folks accept this as the summer doldrums, but we suspect it may be the media’s inability to adjust to “normal” news, from the relentless onslaught of vertigo-inducing stories that have bombarded us into a state of sensory exhaustion.
Maybe they’re just feeling logy, with the heat and all.
We are in the heart of the Dog Days, the period from about mid-July to late August that the ancient Romans identified with the Dog Star, Sirius. Hedgeye CEO Keith McCullough – who starts his workday at 4:01 AM, even in August – was wondering aloud the other day how so many financial media pundits could look out at the global marketplace and say “the markets are flat, there’s nothing going on.”
First of all, the markets being flat is hardly what one could call a Steady State. Deriving the conclusion that “there’s nothing going on” from the data point that market prices are the same pre-open as they were at yesterday’s close is like getting to the stadium at the close of the seventh inning, seeing “0-0” on the scoreboard, and saying “Oh good. We didn’t miss anything!”
Despite the sweaty summer slog, there are a few things going on in the world. Some of them make perfect sense to us. A few don’t.
As of this week Hedgeye has carried a zero asset allocation to commodities for over 100 days (and counting!) On Tuesday, gold closed down for the sixth straight day – its longest decline since May – before taking a recovery gasp in Wednesday’s session. Gold market observers say consensus is that the Fed will end its stimulus program sooner, rather than later, and the specter of rising interest rates makes Treasurys more attractive than commodities.
Similar forces seemed at work in oil, as a Merrill Lynch analyst said rising prices would soon hit a wall – a prediction that was accommodated in short order as WTI promptly reversed its upward trend. Sometimes it seems portfolio managers can’t think for themselves (... ya think??) and are all waiting for permission before they make a trade.
If you’ve been following Hedgeye’s Macro work, you will recognize that all this retrograde motion in commodities is in response to continued forward motion in the economy as jobs, births, new family unit formation, and housing continue on an upward trend.
Financials sector head Josh Steiner says credit was the biggest catalyst to earnings in his sector in the second quarter. And guess what? “The first month of 3Q is showing a comparable tailwind.” This week’s unemployment print resumes the trend of accelerating improvement, after last week’s mild easing. And as people return to employment their credit improves – even if it’s only part-time work. Steiner says “the trend of accelerating improvement in the labor market is profound,” and loan demand is firming, with the most recent Senior Loan Officer Survey showing its strongest quarterly growth in a year.
In the housing market, Steiner says demand should continue strong and is not troubled by the “slowdown” from over 20% growth in the homebuilders in Q1 to “only” over 10% growth currently. The simple fact remains that new household formation continues, and available housing has not kept pace. There’s still plenty of room to grow.
Home buyers have already rotated back to demanding “non-traditional” and sub-prime loans – and banks are already willing to make those loans as credit standards continue to ease at the major mortgage lenders. Steiner is keeping a finger on the pulse of total bank loans industry-wide, watching for the slope of growth to accelerate. Senior US macro analyst Christian Drake says this will be a key inflection point, as banks’ willingness to extend credit is a leading indicator for net new credit creation, which is in turn a fundamental anchor for economic growth.
Drake says the Fed’s Q3 Senior Loan Officer Survey (a busy time for a week when there’s “nothing going on”…) shows continued strengthening in both Loan Demand and Credit Availability. In addition for increasing demand for real estate financing, the survey reveals stronger consumer demand overall, including autos – and note that, just as with residential mortgages, banks are already lowering their lending standards for auto loans too. Commercial real estate demand is stronger, as is demand for commercial and industrial loans.
Steiner sees mortgage applications softening a bit, and believes they will likely remain quiescent until September. As a play on the continued housing rebound, Steiner prefers financial firms to the homebuilders – as see his update on Investing Idea NSM – and will keep his eye out for buying opportunities in the sector.
Perhaps the biggest takeaway here is the seasonal nature of employment data – if you read nothing else in this sleepy week, read these words: Seasonal adjustments to employment and unemployment numbers distort the data. Again: Seasonal adjustments to employment and unemployment numbers distort the data. Steiner has identified a pattern, with seasonal adjustments representing a headwind to jobs data through the summer – making growth look less robust than the non-seasonally adjusted numbers indicate. Come September the effect reverses, and seasonal adjustments act as a tailwind – making the adjusted numbers look better.
Think about it: at the end of the year, both adjusted and non-adjusted numbers should be the same. In order for seasonal adjustments to work their way through the calendar, the get eventually has to give. Steiner’s work shows that the data starts giving in September. So note to all media talking heads who stay in bed until 9 AM (sorry, Al Roker!) – lots of sleepy folks will be surprised by how robust the jobs recovery looks in the fourth quarter. If you’ve been reading Steiner’s work, you won’t be one of them.
The Rest of the World
Senior analyst Matt Hedrick has a “special relationship” with the UK, having been fundamentally bullish on the economy since his European update “Where Does Europe Go From Here.” This week, new Bank of England Governor Mark Carney offered what could be the first clear and transparent guide to monetary policy, saying the BOE will not raise interest rates or revise its asset purchase program – the across-the-pond version of Fed chairman Bernanke’s QE – until unemployment falls to 7%.
Hedrick writes “Carney noted that 7% should be viewed as a ‘way-station’ for the Monetary Policy Committee to reconsider its policy stance, and not an outright target for the unemployment rate.” It seems Carney has learned a thing or two from watching the Master in action. Where Bernanke finds himself saying “Well, I didn’t mean I wouldn’t buy anything ever again,” Carney’s statement provides sufficient pre-obfuscation that he should be able to hide behind it all the way down to at least 6.5% unemployment. The UK was the first country to impose austerity to improve its fiscal balances. Says Hedrick “the economy is seeing positive inflections and momentum” with improved consumer sentiment, PMI and retail sales figures, as well as industrial production and housing.
While we’re visiting the Commonwealth, senior analyst and Asia-watcher extraordinaire Darius Dale asks “Will the Rupee meet its (new) maker?” Raghuram Rajan, India’s brand-new central banker (do you still think there’s nothing going on this week?) is a professor at the University of Chicago, former chief economist at the IMF, and has advised the World Bank, the government of Sweden, and the US Federal Reserve. Rajan has worked in the past to combat weakness in India’s currency. Says Dale “the Rupee may finally catch a bid in a way that is negative for Indian equities and Rupee-denominated fixed income (Hint: rate hikes.)” Indian policymakers “are cognizant of the dangers to future growth posed by an increasingly hawkish cost-push inflation outlook,” meaning Rajan may seek to stimulate demand (“demand-pull” is the other side of “cost-push” inflation) by strengthening the currency.
Dale believes higher Indian interest rates are in the offing, guided by a world-class economist with global cred – note that tightening measures have already led two of India’s largest non-state banks to increase their base lending rates. While he’s at it, we wonder whether Rajan’s Chicago School experience will also incline him to free up the Indian markets for foreign investment. All right, one revolution at a time.
Meantime, you can relax. It’s the dog days of summer… ain’t nothin’ goin’ on in this town…
Sector Spotlight – Healthcare: Just Say No-Bama!
People need to be protected from Bad Actors. And none of us has the expertise to protect ourselves against every type of harm. That’s where the government comes in. At a minimum – and many would prefer the government remain at that minimum – the job of government is to protect its citizens from crime, war, and reasonably preventable social ills, such as financial markets fraud and the spread of tuberculosis.
Regarding the Healthcare sector, the wealthiest nation in the world has about as good a record providing health care for all its citizens as it does convicting financial executives for the broad spectrum of frauds that precipitated the Financial Crisis.
As with the financial marketplace, US healthcare does not suffer from a want of legislation, regulation, or oversight agencies. In a piece last month (“Regulators Are Bad For Business”) Healthcare sector head Tom Tobin wrote, “If I was running a hospital company that had regulators at the door, the first thing I would do is stop doing whatever it was they were interested in.” This behavior, though eminently reasonable, almost inevitably leads to a measurable decline in revenues, a phenomenon Tobin says he would find some other way to explain rather than “We stopped doing the thing that the regulator thinks is shady.”
Tobin’s approach masks a profound truth. When regulators go after a practice within a given industry, they first crack down on the bigger, high-visibility players in a group. Others take note, and soon the entire group has reduced, or completely halted the practice in question. This doesn’t mean it was not a good practice. It merely means prudent managements decline to be the test case for a new regulatory sweep. This behavior leads to depressed revenues throughout the sector – which in turn permits, or convinces, managements to blame the recent decline in revenues on a weak operating environment.
For context, in 2002 a group of hospitals were accused of systematically overbilling Medicare. This led to close scrutiny of “outlier payments,” amounts hospitals are reimbursed when actual costs exceed the Medicare expected cost standards. The proportion of outlier payments for the key category of coronary bypass surgery fell from 13%, in 2000-2002, to 8% in 2003-2006. Note, too, that better overall quality of care is directly associated with significant reductions in cardiac surgery. But hospitals make more money on surgery – especially if they overbill – than on enhanced routine care. This appears to be a critical observation, because surgeries represent half the total cost to Medicare of in-patient services, with cardiac surgery being the most expensive category.
Tobin’s review of long-term hospital utilization data shows that the US hospital industry has enjoyed average annual growth of 3% over the past two decades. The only negative periods showed in the quarters immediately after the Outlier Scandal broke. This analysis is important in light of recent weakness in certain companies who are under regulatory scrutiny – and who are experiencing marked declines in admissions. Tobin posits that a sort of “market reflexivity” could be at work today: certain companies are under scrutiny over admissions policies and billing practices – leading other companies to become more circumspect, leading to more conservative intake and billing standards, leading to a decline in revenues.
Tobin says the sheer volume of regulatory inquiries and investigations hitting the sector today seems massive compared with any historical period, so it’s anybody’s guess which subset of Healthcare companies might next be cowed into reducing their revenues, rather than face the likelihood of audits, fines, and court battles. Tobin doesn’t attribute political motive to this phenomenon, at least not yet. But new laws generate new regulations, and the implementation of Obamacare – coupled with the confirmed role of the new Consumer Protection Bureau – should continue to give rise to a logjam of regulatory inquiries. This scenario would tend to be broadly negative for stock prices in groups that become identified as under scrutiny for certain problems.
Even without the costs of regulatory scrutiny, there are real costs associated with the ACA. Projecting a number of possible scenarios, including whether the current Employer Mandate waiver becomes permanent, Tobin estimates that people shifting their coverage from Employer-Sponsored Insurance (ESI) to the Exchanges could add as much as half a trillion dollars in costs over the first ten years. Tobin says very small changes appear to have a significant impact. Even under his most modest scenario, federal spending rises by 38%. In sum, Tobin expects little in the way of concrete contribution to the overall Medical Economy from ACA through 2014, though he does see the potential for significant increases in spending, either by consumers, or by the taxpayer, in the role of Insurer of Last Resort.
Speaking of taxpayers, Congress just voted itself a subsidy to help its members and their staffers buy insurance on the Exchanges. In the best tradition of Sauce For The Goose, Sauce For The Gander legislation – so rarely seen in Washington – Congress passed the ACA in 2010, including an amendment that booted Congress and their staffers out of the best health plan available in America at the time, the Federal Employees Health Benefits Program. Instead, Congress and staff must purchase insurance on the Exchanges, just like the rest of us.
Well, not exactly like us. Because under the new arrangement, the federal government will give them a subsidy to cover most of the costs of the new coverage.
This is not actually so unique. Under the ACA many employers will find it cheaper to pay an additional salary gross-up to cover the employees’ cost of participating through an exchange, rather than provide an ESI plan covering all employees. But note that in this particular case is that you are the employer.
The Congressional outcome was a game of Chicken that failed. Republican senator Grassley tacked on the amendment, arguing that if Obamacare was good enough for We The People, it should be good enough for those who Advise and Consent. And wouldn’t you know it… the Democrats went ahead and passed it!
Today the argument is that, if we don’t offer Congress and their staffers more money, they’ll leave. Congress rushed the deal through, afraid of – are you ready for this? – a Capitol Hill “brain drain.” We could live with that. As in the movie “Young Frankenstein,” those brains are “rotten! rotten! rotten!” In the movie, at least they were professional comedians.
Investing Term – Private Equity
“Private-Equity Payout Debt Surges,” read the lead story in Tuesday’s Wall Street Journal Money & Investing section. We were confused to read that “Equity” is paying out “Debt.”
It turns out Private Equity firms are “adding debt to companies they own to fund payouts to themselves at a record pace,” says the Journal, afraid that a sharp rise in rates in imminent. The Journal reports that $47.4 billion in new debt has been taken on by PE portfolio companies since the beginning of this year, solely for the purpose of paying dividends up the food chain.
If you are a normal person (meaning, for example, you don’t work on Wall Street) you might still be confused. How does Debt turn into Dividends? you might ask.
The traditional definition of Dividend is a division of profits from operations of a company. A portion of the profits is kept in the company’s bank account to provide working capital – that portion is called Retained Earnings which, curiously for a financial term, precisely and clearly defines exactly what it is. The rest of the profits are distributed to shareholders – the firm’s equity owners – in the form of Dividends.
We never much liked the practice of borrowing money to pay dividends. Most companies require a resolution of the board of directors to undertake such a move – pledging equity in the company against a loan whose proceeds will immediately be distributed to shareholders doesn’t look like a conservative business practice. But corporate governance can take on whole new layers of meaning in the world of Private Equity, where the managers of the PE firm itself are also on the boards of the portfolio companies.
Private Equity was traditionally the bailiwick of major institutions, and of really, really rich people. That has changed recently, as many of the biggest PE shops have created retail investor packages, permitting individuals to buy participation in chunks as small as $25,000, or even less.
(Tip to individual investors: any time a really rich person offers to let you invest alongside them, watch your semolians very, very closely. It’s really true that, if something were that good, they would keep it for themselves.)
The best PE firms create professional divisions of industry experts who devote substantial time and capital to operating their portfolio companies. Managers identify companies they believe they can bring to significantly greater levels of revenues and profitability. Unlike a stock market investment, which relies on the ability of management of the company you are buying, a PE investment relies on the expertise and other resources that the PE firm itself can bring to the target company.
Thus, a PE investor puts in an equity investment, which becomes working capital, then assigns its own management team to work with company management. The objective, as with a regular stock market investment, is ultimately to exit the investment at a profit. But in order to make that happen, the PE managers must actually make the company worth more than it was when they bought into it.
PE investments require a very long time horizon – it’s not uncommon for PE managers to require a ten-year lockup on investor funds, to give their management teams time to bring businesses to maturity. The WSJ reports (8 August, “Carlyle’s Results Disappoint But Fundraising Soars”) that today we are in “a sellers’ market for private-equity firms.” Carlyle reported that, in the second quarter, “it cashed out of investments at three times the rate at which it made new ones,” while raising $6.9 billion. Carlyle now has over $180 billion in Assets Under Management (AUM).
It is estimated that the total amount of capital in the PE sector is over $2 trillion, though since the industry is Private by definition, there’s limited transparency.
Some PE firms have gone public, including KKR, the Blackstone Group, and the Carlyle Group. After Blackstone CEO Steve Schwartzman received an especially large payout from his firm’s IPO, investors started wondering whether they had bought a participation in Blackstone’s future success, or merely paid for a share of the executives’ “golden bail-in,” as it appeared the executives of these firms got to cash in their chips, and still continue playing at a rigged table.
What do the PE firms do while they are looking for investment opportunities? The Journal reports that Carlyle has over $20 billion liquid, “ready to invest in its corporate buyout funds.” And until the funds are actually committed?
Here’s one of the niceties of being a PE manager. Your investors pay you a fee to manage their investment. And waiting for an opportunity is part of managing. Thus, when there was a dry spell in the markets in the aftermath of the Financial Crisis, many PE firms kept their powder dry, some of them for a period of years. But invested in an operating company, or just sitting in the bank, the PE manager draws a 2% management fee on AUM. Some observers say this led to a spate of sub-par deals in recent years. PE investors started complaining that their cash was dwindling – at least by 2% annually. It’s one thing to lose money on an investment. It’s quite another to lose money on a non-investment. The PE managers’ position was, “You pay us to manage your money properly, and in our opinion, the best place to hold your assets is in cash while we wait for opportunities.” It seems that, as many funds approached the end of their lock-up periods, the managers realized they would have to return uninvested cash.
Complete performance data is not available, since so much of the industry is private. Academic work using available data indicates that PE portfolio returns range from approximately equivalent to the S&P 500, to outperforming the S&P. There also seems to be a trend that venture firms – those that invest to build up their portfolio companies – have greater “performance persistence.” That means they tend to perform well for several reporting quarters in a row, as opposed to LBO firms, whose business is more focused on buying companies, then breaking them up to strip out assets and sell them off. LBO firms do not readily replicate successful performance, since they have to spend time in between successes hunting for the next target.
PE firms are forcing their portfolio companies to take on debt, in order to pay dividends to the PE firm investors. Some 60% of all debt issued by PE portfolio companies in July was used to pay dividends. Outstanding among these offerings were a group of companies issuing “pay-in-kind toggle” (PIK toggle) junk bonds. These are high-yielding bonds that allow the company to defer payments of interest to bondholders. Ultimately, the PIK piece means the investor may not receive cash, but may instead receive an equivalent value of equity in the issuing portfolio company.
Historically, junk-rated debt paid interest in the teens. With the overall crunch in interest rates, junk bond yields have fallen below ten percent. PIK toggle deals, generally considered among the riskiest, are down to yields as low as 7.5% or even lower. Commenting on one recent PIK-toggle issue, Moody’s wrote that the cash flow should give the company “the ability, if not necessarily the inclination, to delever modestly.”
This kind of closes the circle, transitioning your investment from “Private Equity,” to “Private Debt,” to “Private Junk.” Want to invest alongside the Big Boys? Make sure you do the math.
- Moshe Silver
Moshe is a Hedgeye Managing Director and author of the Hedgeye e-book Fixing A Broken Wall Street.
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