“The great thing about fact based decision is that they over rule the hierarchy.”
Jeff Bezos knows a thing or two about making decisions. In 1994 after making a cross country drive from New York to Seattle, he made the decision to write up a business plan. To undertake this cross country drive, he made a decision to leave a “well-paying” job. The little company that Bezos was developing a business plan for was Amazon.com and the rest, as they say, is history.
At the time, Bezos combined two facts that helped him overcome the establishment. The first was that the internet was growing in leaps and bounds. The second fact was that the U.S. Supreme Court had ruled (in Quill Corp V. North Dakota) that online retailers would not have to collect sales taxes in states where they lacked a physical presence.
This series of decisions paid off handsomely for Bezos as he is now worth an estimated $25.2 billion. Meanwhile his company Amazon.com has a market capitalization of more than $135 billion and generates more than $65 billion in annual revenues. Frankly, it kind of makes me want to quit my job and go for a drive!
Former Harvard President Larry Summers made a big decision late Sunday to withdraw his name from consideration to replace current Federal Reserve Chairman Ben Bernanke. Now technically speaking, the fact that five Democrats intended to vote against him in committee kind of forced his hand, but nonetheless a decision was made.
In the short run, Mr. Market viewed this development as somewhat positive as stocks were up broadly with the SP500 up 0.57%. (Strangely, the bell weather master limited partnership, Kinder Morgan Partner (KMP), underperformed and was down -1.50%.) President Obama then chose to come out and spoil the Wall Street party as Obama indicated he will not negotiate an extension of the U.S. debt ceiling as part of the budget fight.
Slight digression, yes the debt ceiling debate is looming again. As Yogi Berra said, this is déjà vu all over again. You may recall, in 2011 Congress raised the debt ceiling to $16.7 trillion, an increase of over $2 trillion. Currently, based on projections from the Treasury department, the federal government could hit the debt ceiling as soon as mid-October.
In the chart of the day, we highlight a chart from the Bipartisan Policy Center that shows that the debt ceiling is likely to be breached to between October 18th to November 5th. Technically speaking, the United States hit its debt limit on May 19th, but as my colleague Christian Drake has written about, via a number of extraordinary measures, the ceiling has been extended, but these measures will run out at some point in the time frame noted above at which point the federal government will only have enough tax revenue to cover about 68% of its bills.
Incidentally, and for those that don’t have their calendars in front of them, the “X-date” is just over a month away. And just think, most investors are worried about who is going to be the next Chairman / Chairperson of the Federal Reserve! Given the uncertainty around the direction of policy, a looming fiscal crisis, and the fact that U.S. equities have performed quite well in the year-to-date, it should be no surprise that some savvy investors like Stan Druckenmiller are indicating they are largely underinvested.
We certainly get the risks, but one point that has and will continue to benefit equities, is bond outflows. Since May we have seen $116 billion fixed income fund outflows, which is the largest absolute bond outflow in history.
Interestingly though, as our Financials team pointed out yesterday, as a percentage of beginning fixed income assets-under-management, the current 2013 draw down is the smallest in history on a percentage basis. The 2013 running outflow has been just 2.9% of outstanding bond funds, well below the past outflows in 2003-2004 where 5.0% of outstanding bond funds were redeemed and the 14% of bond funds that were drawn down in the 1 outflow. So while there are certainly risks looking for equities, the continuation of bond outflows will be a meaningful tailwind.
Nonetheless, many of the large investors we speak with remain focused, and rightfully so, on the direction of leadership at the Fed. Given this focus, I thought I’d highlight a few fun facts about the Fed:
1) The greatest long term period of economic growth in the United States was between the Civil War and 1913 when there was no Fed.
2) Prior to the creation of the Federal Reserve, the estimated rate of inflation in the United States was 0.5% and it is estimated to be at 3.5% in the ensuing century.
3) The permanent income tax was introduced in the same year as the Federal Reserve.
4) In 1913, Congress promised that if the Federal Reserve Act was passed it would eliminate the business cycle.
5) The value of the U.S. dollar has declined, by some estimates by more than 95% since the Fed was created.
6) There have been 10 recessions since 1950 (arguably many Fed induced).
I borrowed some of these points above from a blog called End of the American dream and, as we touched up on in the past, it kind of begs the question, as Bezos would say, as to whether the best fact based decision is to overrule the Federal Reserve hierarchy in its entirety. Based on the points above, ending the Fed wouldn’t be the worst decision the Federal Government ever made.
Our immediate-term Macro Risk Ranges are now as follows:
UST 10yr Yield 2.80-2.98%
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research
Today at 11:00am EDT the Hedgeye Consumer Staples team hosts an expert call on electronic cigarettes featuring Brent Willis, a leading consumer products executive and Chairman and CEO of Victory Electronic Cigarettes.
- Toll Free Number:
- Conference Code: 946694#
Materials: CLICK HERE
Mr. Willis will contribute his expertise to Hedgeye's ongoing research on the electronic cigarette category.
KEY CALL TOPICS WILL INCLUDE
- The industry landscape: What does the future hold for e-cigs?
- Key metrics to evaluate the industry
- Competition in the marketplace
- Big vs Small: E-cigarette companies take on Big Tobacco
ABOUT BRENT WILLIS, CEO OF VICTORY ELECTRONIC CIGARETTES
Mr. Willis is an accomplished executive in the consumer packaged goods industry. Prior to directing a number of companies in which he remains a significant private equity investor, Mr. Willis served as the CEO for Cott Corporation, the world's largest retailer-brand beverage company. He previously was the Global CCO and President at InBev, where he developed and implemented the strategies that led the Company to become the world's largest beer company. Prior to creating InBev, Mr. Willis was a President in Latin America for The Coca-Cola Company, where he led the most successful turnaround in the company's history and won recognition as one of Latin America's top senior executives. Mr. Willis has also served as senior marketing executive for Kraft Foods, Inc., with wide operational and strategic responsibilities. Mr. Willis is a graduate of West Point and a decorated Army veteran, where he attained the rank of Captain.
ABOUT VICTORY ELECTRONIC CIGARETTES
Victory Electronic Cigarettes describes itself as "dedicated to providing a cleaner and healthier alternative to smoking and is one of the leading companies in this rapidly emerging and fast-growing industry. The Company began online sales in 2012 and expanded to retail early in 2013. Since that time, the growth rate of the firm has been exponential. Victory offers consumers a full product portfolio that incorporates the highest quality and latest technology, and has been ranked superior for real tobacco taste amongst major brands. Recently public through a reverse merger, Victory's new but experienced management team is positioned to leverage its clearly differentiated and well-recognized brand. Victory is well positioned with an established online presence and a low-cost infrastructure to accelerate growth and drive significant value for its shareholders. Victory is listed on the OTC market under the ticker ECIG."
Disclosures: Victory (ECIG) is a newly-public company with limited trading history and liquidity. Hedgeye has no investment opinion on Victory and no current plans to publish research on the company. Certain Hedgeye executives may become involved in a transaction with Victory or related entities.
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Takeaway: Slightly smaller bond outflows for the week ending Sept 4th but still over $6 billion left fixed income funds. Equity ETFs got hit hard.
This note was originally published September 12, 2013 at 07:49 in Financials
Investment Company Institute Mutual Fund Data and ETF Money Flow:
Equity mutual fund inflow accelerated week-to-week to $903 million for the 5 day period ending September 4th, up from the $300 million inflow the week prior
Fixed income mutual fund outflows also improved but still resulted in a $6.7 billion withdrawal by investors, an improvement from the $9.1 billion draw down last week
Within ETFs, passive equity products experienced an outsized redemption of $11.3 billion, the second week in three weeks with over a $10 billion withdrawal. Bond ETF flows snapped into positive territory week-to-week with a $2.4 billion inflow this week compared to the $935 million outflow last week
For the week ending September 4th, the Investment Company Institute reported improvements in both equity and fixed income mutual fund flows however with bond trends simply booking a smaller outflow. Total equity fund flow totaled a $903 million inflow which broke out to a $1.5 billion inflow into international equity products and a $694 million outflow in domestic stock funds. These trends were an improvement from the prior week's total equity fund inflow of $300 million. Including this acceleration in stock fund flows, the year-to-date weekly average for 2013 now sits at a $2.6 billion inflow for total equity mutual funds, a substantial improvement from the $3.0 billion outflow averaged per week in 2012.
On the fixed income side, outflow trends continued for the week ending September 4th with the aggregate of taxable and tax-free bond funds combining to lose $6.7 billion in fund flow. The taxable bond category specifically shed $4.7 billion in the most recent period versus the $6.3 billion loss last week. Tax-free or municipal bonds continued their sharp outflow trends losing another $2.0 billion in the week ending September 4th, continuing its trend from last week which experienced a $2.9 billion outflow. Franklin Resources (BEN) continues to have the most exposure in our coverage group to declining Municipal bond trends with over 10% of its assets-under-management in the tax-free category. The 2013 weekly average for fixed income fund flow has now drastically declined from 2012, now averaging a $324 million weekly outflow this year, a far cry from the $5.8 billion weekly inflow averaged last year.
Hybrid funds, or products that combine both fixed income and equity allocation, continue to be the most stable category bringing in another $263 million in the most recent weekly period although dipping below the $1 billion weekly inflow level for the first time in 8 weeks. The year-to-date weekly average inflow for hybrid products is now $1.6 billion for '13, almost a 100% increase from 2012's $911 million weekly average.
Passive Products - A Big Equity ETF Outflow versus a Stable Fixed Income Inflow:
Exchange traded funds experienced mixed trends for the week ending September 4th with a massive equity outflow and a stable fixed income inflow. Equity ETFs lost $11.3 billion, the second biggest equity ETF outflow in 5 years next to the $12.9 billion outflow two weeks ago and only the 11th negative week in the 36 weeks of 2013. Despite this week's outflow, 2013 weekly average equity ETF trends are averaging a $2.6 billion weekly inflow, an improvement from last year's $2.2 billion weekly inflow average.
Bond ETFs conversely had an improvement week-to-week with a strong $2.4 billion inflow, the biggest fixed income ETF inflow in 8 weeks, which compared to last week's $900 million outflow. Despite this improvement in the most recent period the 2013 weekly bond ETF average is now just a $345 million inflow for bond ETFs, much lower than the $1.0 billion average weekly inflow from 2012.
HEDGEYE Asset Management Thought of the Week - The Bigger Base of Numbers:
Despite the $116 billion fixed income fund outflow that has occurred since the end of May, the largest absolute bond outflow in history, we point out that on a percentage of beginning fixed income assets-under-management that the current 2013 draw down is the smallest in history on a percentage basis. The 2013 running outflow has been just 2.9% of outstanding bond funds, well below the past outflows in 2003-2004 where 5.0% of outstanding bond funds were redeemed and the 14% of bond funds that were drawn down in the 1994-1995 outflow. 1999-2000 experienced a similar 5.0% redemption of outstanding bond funds, inline with the 2003-2004 fixed income sequence.
In our recent initiation of the asset management sector, we forecasted that a $1 trillion shift out of bonds and into equities could occur (this would include ETFs and single holdings of individual bonds in addition to bond funds) taking in consideration that bond outstandings in the U.S. are at new record highs and that modified duration, the return of volatility in fixed income, and the lack of liquidity in the bond markets would dislodge the asset class. The enclosed links present this initiation again:
Jonathan Casteleyn, CFA, CMT
Joshua Steiner, CFA
Takeaway: When MLP investors wake up, there could be hundreds of billions racing for the exit, all at once.
Editor's note: What follows below is Hedgeye's "Investing Term" of the week which was a part of this past weekend's "Investing Ideas" research product. "Investing Ideas" is designed for the savvy, longer-term self directed investor looking for fresh, exciting long-only opportunities. For more information please click here.
INVESTING TERM – MASTER LIMITED PARTNERSHIP
Hedgeye’s senior energy analyst, Kevin Kaiser, has gotten plenty of publicity over his analysis of oil and gas Master Limited Partnerships – MLPs. This week Charlie Gasparino interviewed Kaiser about his recent bearish report on Kinder Morgan Energy Partners (KMI), the granddaddy of all energy MLPs.
MLPs are favored by investors looking for safe, above-average returns. This includes a large percentage of folks in, or nearing retirement. And there’s no denying that many MLPs have provided impressive returns for the last decade or more. It has been a popular sector. According to the National Association of Publicly Traded Partnerships, the total MLP market is over $440 billion, of which $395 billion, or 89%, is in energy and natural resources. We estimate that some 70% of the holders of MLPs are retail investors.
Investors (“unitholders”) in an MLP, like shareholders of a public company, exercise no control over the business and have no liability beyond the amount of their investment. (Hence “limited” partners.) The partnership is managed by the General Partner – usually a separate legal entity that makes the business decisions and hires and directs management.
Unitholders receive regular cash distributions, which are generally specified in the partnership documents. The tax code allows certain companies, especially those in oil and gas production and transportation, to operate as MLPs, which exempts their income from most state and local taxes. This leaves a pool of cash for distributions to unitholders. The GP receives cash incentive payments when distributions are made, based upon the total amount of LP distributions. The bigger the distribution, the bigger the payment to the GP. And MLPs have a pattern of increasing payments, with the result that the GP takes in larger payments. Depending on whether you are a cynical stock analyst, or the GP, this is either a vicious cycle, or a virtuous one.
MLPs have many of their own accounting metrics. They have been permitted – we would say “incentivized” by a supine Congress and comatose regulators – to apply subjective accounting standards not in conformity with GAAP (Generally Accepted Accounting Principles, the fundamental standard metrics on which all businesses report their financial results). Companies generally use non-GAAP accounting if the result is justified by the unique realities of their business, and non-GAAP reports are sometimes presented alongside a GAAP near-equivalent, to permit clear comparison.
MLPs report an item called Distributable Cash Flow (DCF), which is the mother of all non-GAAP metrics. Logically, DCF is the money left over after paying the expenses of running the business. But as managements must smooth quarterly payments, and often increase them, the job of managing DCF can become far more important than the job of actually running the operating business.
Every MLP puts a slightly different spin on how they report DCF. Some of their measures appear vague, opaque, misleading, or simply wrong. Among the problems Kaiser identifies are: accounting for hedges on oil and gas production, accounting for the cost of acquiring other companies to capture their cash for distribution payments, and accounting for the cost of repairing and maintaining capital equipment such as pumps and pipelines.
Use of non-GAAP reporting could substantially understate the actual cost of doing business, and the MLPs often compound the issue by adding back expenditures to their stated asset base. Certain MLPs report capital expenditures as “expansionary,” when in reality a lot of the spending is basic maintenance without which their business would literally dry up.
These issues appear especially in “upstream” MLPs that produce oil and gas. Upstream MLPs got in trouble in the 1980s when many of them borrowed heavily to buy producing properties that were running dry, then were hit with price volatility and inefficient hedging markets. Upstream MLPs fell out of favor and were replaced by Midstream MLPs, middlemen who transport oil and gas through their pipelines. In the media debate around Kaiser’s latest research, you may have heard folks say “these companies are a toll road: they get paid every time something travels along their route.” That’s mixing apples and oily oranges.
“These companies” – the ones Kaiser is focused on – are upstream MLPs; their own oil and gas sales revenues are a critical part of their revenues. They must actually produce oil and gas, they must hedge efficiently, and the energy market has to be willing to pay a price that allows them to book a profit. They also really need functioning pipelines to deliver their production, and if Kaiser’s analysis is accurate, some of these pipeline MLPs may be starving their infrastructure of critical maintenance capital.
The upstream MLP segment has had a terrific run. Kinder Morgan has routinely been praised as one of the top companies in US industry, with good reason. Its founder and CEO, Richard Kinder, is an acknowledged giant among business leaders and a multi-billionaire who receives $1 a year in total compensation as CEO of Kinder Morgan. Since its creation in 1997, Kinder Morgan has provided approximately a 25% compound annual average total return to its unitholders. When Kaiser’s report on Kinder came out, the stock price sagged. Richard Kinder showed his faith in the operation, plunking down $18 million to buy half a million units in the open market.
So how can we be so negative on this company?
Kaiser’s analysis shows the MLP sector is fraught with accounting irregularities, all of which appear to be legal, and none of which appears to feature prominently on the radar of either Congress or the SEC. (Well, maybe Congress, considering the flow of campaign contributions and payments to lobbyists from the energy sector.) Among the most opaque and convoluted financial reporting, Kaiser’s analysis leads him to believe KMI’s true free cash flow is not anywhere close to the DCF number it reports.
Does this mean Kinder Morgan is a fraud? No, – they appear to be following the law to the letter. Does this mean the MLP sector as a whole is dishonest? Not at all. Particularly not on Wall Street (or in Washington), where the concept of “honesty” is on a par with the concept of “privacy” in the Age of Facebook (and the NSA.)
And it especially doesn’t mean that Kinder Morgan is about to spin, crash and burn. Kinder Morgan has produced outsize returns for an army of happy investors for a decade and a half, and there’s nothing to say that will stop today. But Kaiser is convinced it will ultimately stop. Like so many of the implosions we have seen in recent years, this will happen imperceptibly slowly – and then, all at once.
This is a huge story – there are some 100 energy MLPs. Kaiser has tackled five of them, and all have shown the same issues around transparency. There’s no immediate catalyst to make these stocks all go down. What there is, is – there are about $395 billion in natural resources MLP units held largely by individuals in, or planning for retirement. These are “safe” and conservative portfolios. What there is, is a large number of individual investors who sleep soundly at night, because they actually have no idea what they really own in their portfolios.
When they wake up, there could be hundreds of billions all racing for the exit, all at once.
Last Word: Just A Number
We haven’t overlooked the folks falling over one another to be the first to point out that Kaiser is “only” 26 years old, with the strong implication that, at that age, he should be seen and not heard. The rabbis of the Talmud observe that the finest old wines may be packaged in new containers and urge us to taste the wine, rather than criticize the barrel.
We note that at age 26, Napoleon saved the French Republic by single-handedly organizing the artillery defense of the Directorat. And it was purportedly at age 26 – or thereabouts – that Alexander sat and wept because there were no further worlds to conquer. Age is a number, not a measure of competence. Experience may be an excellent teacher, but most folks don’t pay attention in class.
Kevin Kaiser – and the rest of us at Hedgeye along with him – will either be right on this analysis, or we will be wrong. That’s a risk we take each day. To those who take exception with Kevin’s analysis, please show us where he’s wrong. We welcome the dialogue – it will make us better analysts. To those who publish snotty comments about Kaiser’s age, aren’t you ashamed for criticizing him over being something at age twenty-six that you were not?
- Moshe Silver
Moshe is a Hedgeye Managing Director and author of the Hedgeye e-book Fixing A Broken Wall Street
Below are key European banking risk monitors, which are included as part of Josh Steiner and the Financial team's "Monday Morning Risk Monitor". If you'd like to receive the work of the Financials team or request a trial please email .
European Financial CDS - Europe's financial system continues to heal. Swaps tightened notably last week with an average decline of 9 bps and a median decline of 10 bps. Spanish, Italian, French and German banks all saw swaps tighten sharply.
Sovereign CDS – Portuguese swaps remain one of the few areas globally that continues to show steady signs of deterioration. Portugal's swaps rose another 24 bps last week, bringing the spread to 557 bps. They were higher by 24 bps last week and are now up 122 bps vs the prior month. Elsewhere around the world, swaps were largely uneventful with the next largest move coming from Italy at +6 bps W/W.
Euribor-OIS Spread – The Euribor-OIS spread was unchanged at 13 bps last week. The Euribor-OIS spread (the difference between the euro interbank lending rate and overnight indexed swaps) measures bank counterparty risk in the Eurozone. The OIS is analogous to the effective Fed Funds rate in the United States. Banks lending at the OIS do not swap principal, so counterparty risk in the OIS is minimal. By contrast, the Euribor rate is the rate offered for unsecured interbank lending. Thus, the spread between the two isolates counterparty risk.
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