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The Portals of Discovery

This note was originally published at 8am on August 12, 2014 for Hedgeye subscribers.

"Mistakes are the portals of discovery."

- James Joyce

 

There is nothing like a mistake to enhance our learning.  At times, defining a mistake can be a nuanced exercise.  For stock market operators, though, a mistake is very easy to define.  Simply: if a stock price goes against you meaningfully and over a sustainable period, you are wrong.

 

The most successful investors are often those investors that are effective at both learning from and minimizing their mistakes.  Many successful portfolio managers implement a stop loss so as to ensure that their mistakes are minimized. Others buy value plays with little perceived downside to minimize mistakes.

 

About a year ago, we introduced Hedgeye’s Best Idea list.  The idea of the list was to focus our research team on developing deep dive investment ideas with asymmetric reward characteristics. Overall, the list has had some really strong performers.  Not surprisingly we’ve also had some stocks that have not performed very well.  Due to a light global macro calendar this morning, we are going to do a deep dive on one of our very public “mistakes”.

 

Back to the Global Macro Grind . . .

 

Yesterday, one of our Best Ideas, Short Kinder Morgan Energy Partners (KMP), went against us and decidedly so.   Rich Kinder, the CEO and Company’s namesake, decided to consolidate the group of companies that existed under the Kinder Morgan umbrella.  In the announced deal, KMI, the C-Corp GP, will acquired its two MLPs, KMP/KMR and EPB in a ~$71B transaction comprised of 56% KMI equity, 38% assumed debt, and 6% cash.  

 

On one hand, it is worth applauding Kinder for this move.  After a long and successful run, we thought he was out of tricks, but he wasn’t. On the other hand, in implementing this dramatic corporate restructuring, Kinder readily acknowledged our thesis, which was that transparency was limited, cost of capital was very high, and growth options were limited for the Kinder Morgan complex.  And by bidding for our favored short of the group, KMP, at premium, he also marked the idea against us by about 15%.

 

It doesn’t matter that we’ve had some great calls on other MLPS, such as Linn Energy (LNCO) and Boardwalk Partners (BWP), on KMP we are now seriously in the red.  As always though, the question is what to do with the stock from here (even if you have been long and taking the other side of our trade it is worth considering).  As my colleague Kevin Kaiser writes:

 

“On 2014 Pro Forma (“PF”) metrics, we have PF KMI valued at 17x EV/EBITDA, 24x EV/EBIT, 27x market cap/pre-tax earnings. If we strip out the E&P segment at a $5.5B valuation ($1.0B of EBITDA x 5.5x multiple), PF KMI Midstream is valued at 19x EV/EBITDA. On an absolute basis, the valuation multiples are very high, in our opinion (19x EBITDA for a capital intensive, fully-taxable, highly-leveraged business), but even relative to peers, PF KMI seems mispriced here. EPD – which is not subject to federal income taxes – is valued at 17x EV/EBITDA, two EBITDA turns below PF KMI Midstream”

 

Combined with this egregious valuation is the more interesting point of KMI’s ability (or inability) to pay out its massive distribution going forward.  As Kevin also writes:

 

“On a cash flow basis, assuming a full tax shield, PF KMI will generate ~$5.3B/year in operating cash flow. Run-rate total CapEx is ~$4.1B/year (excluding Trans Mountain), putting run-rate, pre-tax Free Cash Flow at $1.2B, or $0.56 per PF KMI share. PF KMI is trading at a 1.4% pre-tax FCF yield. Its annual distribution burden will be $4.3B starting in 2015, putting its annual funding gap around $3.1B. These are rough metrics, but a good guide for how much capital PF KMI will need to raise on a go-forward basis.”

 

In the Early Look today, we’ve included two charts.  The first chart is a comp table that Kinder Morgan showed in their presentation yesterday comparing KMI against blue chip companies with growing dividends.  Included in the table are companies like McDonald’s, Cisco, Altria and so on.  The title of the table is quite explicit, “KMI Compares Favorable to its Mid-Stream Energy Peers and S&P 500 High Dividend Companies.”  Since the Company is guiding us to 10% dividend growth and a yield of 4.5%, on these basic metrics, KMI does look great!  But beauty, as always, is in the eye of the beholder. 

The Portals of Discovery - KMI Table

 

In the second chart in today’s note, we’ve included, “The Comp Table KMI Didn’t Publish.”  In this table we look at payout ratios, valuation metrics, and leverage ratios.  Far be it from us to question someone who yesterday made more money then we will perhaps every make, but we do think it is important to consider KMI’s risk profile in the context of some basic financial metrics.

 

The Portals of Discovery - COD KMI Comp Table

 

Now perhaps we’ve lost all credibility because we didn’t see this corporate restructuring coming (we thought Kinder Morgan was in a proverbial box), but if you are contemplating owning KMI here, you do need to take the Company’s advice and look at your options, like S&P 500 high dividend companies. 

 

On a basic level, would you rather own a company like Cisco that grows its dividend at ~7.9%, trades at ~6.0x EBITDA, and has $30 billion in net cash, or a company with the financial profile of KMI that trades ~19.0x EV/EBITDA, has debt/EBITDA at 5.5x, and has a dividend payout ratio of 130 – 200%.  Perhaps we are just simpletons, but to us the answer is obvious.

 

Keep your head up and stick on the ice,

 

Daryl G. Jones

Director of Research


CHART OF THE DAY: Hedgeye Housing Compendium, Not Good

Takeaway: We look at everything in rate of change terms. The color coding of red means bad.

CHART OF THE DAY: Hedgeye Housing Compendium, Not Good - Compendium 082614


Party Time!

“Party like it’s 1999!”

-Prince

 

With Total US Equity Market Volume down -35% versus its 2014 average yesterday, breadth weak (only 59% of stocks were up on the day), I kind of felt bad. As my fishing buddies know, I like to party – but that was a pretty underwhelming “SPX 2000!” party.

 

Cause they say two thousand zero zero…

Party over, oops out of time

So tonight I’m gonna party like it’s 1999

 

In other news, Amazon is buying Twitch for $970M in cash this morning and Morgan Stanley is going to take Hubspot (HUBS) public. US initial public offerings (in both number of issues and dollars raised) for 2014 are now at their highest level since the internet bubble (1999). No worries.

 

Party Time! - prince 1999

 

Back to the Global Macro Grind

 

I’ve had an interesting career in that I’ve had the opportunity to be held accountable to risk managing two epic US stock market bubbles (1999 and 2007). Newsflash: as you are hitting the highs, almost everything looks like a long and your shorts suck.

 

Then, one by one, this thing called the cycle comes along and starts to take down some of the early cycle stocks. While I am sure being long Go Bro (GPRO), FireEye (FEYE), or Biotech (IBB) was fun yesterday, the Transports (IYT), Semis (SMH) and Housing (ITB) stocks were actually down.

 

Unlike high-short-interest momentum stocks that were up on the latest central plan to ban European economic gravity, some of these early cycle sectors were down on reality:

 

  1. US Markit PMI reading for AUG slowed to 58.5 (vs. 60.6 in JUL)
  2. US New Home Sales for JUL slowed -2.4% m/m (slowing for the 2nd straight month)

 

To be fair, despite falling interest rates, not as many Americans are either able or in the mood to lever themselves up on a new home these days. With cost of living running right around the all-time highs, many of your median income earning neighbors are broke too.

 

Rather than rant qualitatively about how bad housing demand is, today I have attached the Hedgeye Housing Compendium as the Chart of The Day. Since we look at everything in rate of change terms, the color coding of red means bad.

 

But, Keith, dude, look at the no-volume-squeeze in spoos – how bad is bad?

(*refer to how bad the US economy was getting in Q3 of 2007 when the SP500 didn’t stop going up until October for details)

 

Oil, Corn, and Wheat are straight down now, but for those of you still paying all-time-highs in US Rents (34% of Americans rent and rent represents 29% of the median consumer’s cost of living), and drinking coffee or eating meat, please ignore the following commodity update:

 

  1. Coffee prices up another +0.6% yesterday to +65.1% YTD
  2. Cattle prices up another +0.4% yesterday to +13.3% YTD
  3. Wheat prices down another -1.7% yesterday to -10.4% YTD

 

Yep, if you want to be bullish on the US Consumer (after 62 months of US economic expansion) as Boris (Woody Allen) said in Love and Death, “wheat – all there is in life is wheat” (VIDEO https://www.youtube.com/watch?v=Tt2JVOrAZGU).

 

If you’re not into cream of wheat, both the CRB Food Index and the Long Bond (TLT) are +16% YTD, btw. That certainly crushes being long early cycle growth style factors in US Equities like Housing and the Russell 2000 (IWM).

 

Oh, and then there’s what got this party started yesterday in US Equity Futures – moarrr central planning from the Europeans. How’s that follow through, worldwide, looking this morning?

 

  1. Most of Asian Equity markets were down overnight (China -1%, Japan -0.6%, Indonesia -0.6%, India -0.4%)
  2. All of the European major equity indices are failing @Hedgeye TREND resistance
  3. The consensus hedge (SPX Index and Emini futures and options contracts) isn’t up

 

Even if the SPX was up, I wouldn’t entirely disagree with the why. Don’t forget that the SP500 looks as slow-growth-yield-chasing as it ever has, and while I much prefer being long the Long Bond (TLT) than SPY in 2014, I’m more focused on shorting early cycle small-mid-cap stocks.

 

If your boss is forcing you to buy something at the all-time highs in SPY, I’d opt for being long big to mega cap liquidity. Why? That’s easy. When this bubble starts to blow (up), you want to be able to get out.

 

From my analysts, here’s a Top 3 list of big caps that both they and my risk management signals still like:

 

  1. Capital One (COF) – Josh Steiner
  2. HCA Holdings (HCA) – Tom Tobin
  3. Texas Instruments (TXN) – Craig Berger

 

If you want to lever yourself up long on early cycle small-mid caps and/or European equities here, have at it! It’s a party. “Say it one more time – two thousand zero zero …” and it’s time to party like we are running out of time.

 

Our immediate-term Global Macro Risk Ranges are now:

 

UST 10yr Yield 2.34-2.44%

SPX 1

RUT 1135-1172

DAX 9

VIX 11.21-13.37

EUR/USD 1.31-1.33

 

Best of luck out there today,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Party Time! - Compendium 082614


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August 26, 2014

August 26, 2014 - 1

 

BULLISH TRENDS

August 26, 2014 - Slide2

August 26, 2014 - Slide3

August 26, 2014 - Slide4

August 26, 2014 - Slide5

August 26, 2014 - Slide6

 

BEARISH TRENDS

August 26, 2014 - Slide7

August 26, 2014 - Slide8

August 26, 2014 - Slide9

August 26, 2014 - Slide10

August 26, 2014 - Slide11
August 26, 2014 - Slide12


LOOKING FOR ANSWERS? LET THE QUANT GUIDE YOU

Takeaway: Use our quantitative signals below to help guide your thought process on what are currently macro’s most challenging questions.

Last week was a really interesting week for us. Specifically a number of important developments occured that were either directly counter to our existing macro themes, or generally outside the scope of those themes, including but not limited to:

 

  • The US Dollar Index advancing +1.1% WoW to decisively above our TAIL risk line of ~81.50
  • WTI and Brent Crude Oil falling -2% and -1.3%, respectively… both are decidedly broken on our immediate-term TREND and long-term TAIL durations
  • Gold falling -2% WoW into a range where it is likely to test its TREND line of support at $1271/ozt.
  • Financials (XLF) and Consumer Discretionary (XLY) leading the rally in domestic equities at the sector level (alongside Materials) at +2.4% and +2.3%, respectively… both sectors remain are now bullish on our immediate-term TRADE and intermediate-term TREND durations
  • The S&P 500 developing a markedly positive correlation to the USD (DXY) of +0.87 on a trailing 3-week basis, up from +0.19 and -0.29 over the past 6 weeks and 3 months, respectively
  • Draghi’s remarks being significantly more dovish than Yellen’s at Jackson Hole
  • Pretty darn good domestic high-frequency growth data, including:
    • Initial Jobless Claims ticking down to 298k
    • CPI responding to deflation across key commodity markets by slowing in JUL  – albeit marginally – to +2% YoY and +9bps MoM
    • Markit Flash Manufacturing PMI ticking up in AUG to the level in four years
    • Philly Fed Index ticking up in JUL to the highest level since MAR ‘11
    • Housing Starts jumping +15.7% MoM in JUL to 1.093M SAAR, the second-fastest pace since mid-2008
    • Existing Home Sales climbing +2.4% MoM in JUL to 5.15M SAAR, the fastest pace since SEP ‘13
    • AIA Architecture Billings Index ticking up to 55.8 in JUL, the highest level since 2007

 

In the context of all that, I had an extremely thoughtful discussion with an even more thoughtful portfolio manager late in the week. The discussion centered on the following questions:

 

  1. At what point does commodity deflation become a consumption tax cut for the US consumer? Moreover, what wins out in your GDP forecasts: real-time economic tailwinds or difficult compares?
  2. Because the compares in the CPI model get markedly easier throughout 2H14, what would prevent the market from overacting to hawkish CPI prints and pulling forward their “dots” as opposed to pushing them out over the next 3-6M?
  3. With the exception of Retail Sales and Housing, the 3-6M trend across many domestic high-frequency growth indicators remains positive from a 2nd derivative perspective. Even if every single data point slowed sequentially from here, doesn’t that mean it will take at least 2-3M before one can show definitively (i.e. with the preponderance of reported data) that growth is officially slowing on a trending basis?
  4. If that is the case, doesn’t this rally in the USD have legs – if only in the form of a massive, but meaningful head fake?
  5. How worried should investors be about Europe?

 

Obviously these are very difficult questions and we won’t even pretend to claim we have all the answers readily available. What we do have are robust quantitative tools to guide our internal discussions and workflow. In the context of the aforementioned deluge of puts and takes, we thought we’d share some of those signals with you.

 

Looking to our Tactical Asset Class Rotation Model (TACRM) we see that:

 

  • At 28% and 25%, respectively, EM Equities and Fixed Income & Yield Chasing remain the #1 and #2 weights in volatility-adjusted optimized asset allocation. This essentially means an investor would do best to allocate $0.28 and $0.25 per every $1 of incremental capital to the extent he/she is seeking the highest risk-adjusted, intermediate-term return profile across the spectrum of liquid global macro assets. (slide 4)
  • Optimized per historical backtest data, current levels of relative momentum across the six primary liquid asset classes call for investors to increase their exposure to EM Equities and Fixed Income & Yield Chasing, at the margins (unchanged since early-MAY and early-DEC, respectively). This would be in lieu of DM Equities (hello Europe), FX, Commodities and Cash. (slide 4)
  • TACRM averages three z-scores of volume-weighted price data across three independent durations to form its composite view of price momentum at the single security level, otherwise known as a Volatility-Adjusted Multi-Duration Momentum Indicator (VAMDMI) . Of the bottom 20 VAMDMI scores across the universe of global macro ETF exposures, there are five foreign currency ETFs and 10 commodity ETFs. Perhaps the most noteworthy extreme signal among the top 20 VAMDMI scores is the fact that the US Dollar (UUP) currently has the highest VAMDMI score in the sample of nearly 200 ETFs. (slide 11)
  • The dramatic loss of momentum across European Equities, FX and Commodities has caused the pool of available investments to become increasingly constrained over the past 3-6M, effectively forcing investors to flock into EM Equities, Fixed Income & Yield Chasing and Cash. (slide 12-13; 9)

 

Looking to our S&P 500 Industry Divergence Monitor:

 

  • Industries that have lagged in the YTD, including Retail, Homebuilding, Home Improvement, Home Furnishing, Construction & Engineering and Steel are among those industries leading the bounce from the AUG 7 lows.
  • Only four industries have declined in price since AUG 7: Oil & Gas Drilling, Coal Miners, Gold Miners and Paper & Forest Product Producers.
  • Up +14.2% from the AUG 7 lows, Airline stocks have led the rally, followed by Home Entertainment Software and Home Improvement Retail.

 

LOOKING FOR ANSWERS? LET THE QUANT GUIDE YOU - S P 500 Industry Divergence Monitor 1

LOOKING FOR ANSWERS? LET THE QUANT GUIDE YOU - S P 500 Industry Divergence Monitor 2

LOOKING FOR ANSWERS? LET THE QUANT GUIDE YOU - S P 500 Industry Divergence Monitor 3

LOOKING FOR ANSWERS? LET THE QUANT GUIDE YOU - S P 500 Industry Divergence Monitor 4

 

Again, we thought we’d share these nuggets not as conclusions, but as perspective into our evolving thought process. Signals like these will continue to guide our interpretation of the fundamental data, as well as our expectations for said fundamentals.

 

It’s worth noting that have not changed our fundamental views; nor are we looking to do so at the current juncture. If, however, we were to do so in the coming months, that process would undoubtedly start with a deeper understanding of the answers to the aforementioned questions.  

 

Lastly, for those of you looking for fundamental analysis with respect to the aforementioned questions, we highly encourage you to review the following research notes:

 

 

As always, please feel free to reach out with any follow-up questions and we’ll be more than happy to help. Have a great evening,

 

DD

 

Darius Dale

Associate: Macro Team


Expert Call: Coffee Outlook in 2015 and Beyond

On Thursday, August 21st, we hosted a call with Judith Ganes-Chase, founder and president of J. Ganes Consulting, an independent agricultural softs commodities research and consultancy firm. Judy worked on the sell-side for 20 years before founding J. Ganes Consulting in 2001. A replay link to the call is included below with a brief summary:

 

Call Replay

 

Judy acknowledged that Brazil has a cyclical pattern of coffee production (one year up, one year down). However the scale of Brazil’s shortfall in the coming years will be unprecedented: She emphasized that this is the first time we are looking at a two-year production deficit.

Judy proceeded to outline three unusual weather scenarios that occurred earlier this year:

  1. Late Winter Frost: Brazilian winter (November-December) mild frost lowered crop quality
  2. Severe Drought: Drought and lack of moisture in tree root system from January-March during the vegetative period
  3. Heavy Rainfall: Late timing of heavy rainfall knocked flowers off trees, reducing the available volume for harvest
  • In her prediction prices could easily move much higher: Brazil will not produce enough volume in 2015-2016 to meet the global market demand for Arabica coffee.
  • Consensus expected 53-64 million bags of Arabica to be produced, but less than 46 million bags will come out of Brazil this year.  
  • Dire outlook into next year: Next year aggregate demand is expected to be around 34 million bags. However due to a current stock deficit and severe crop damage, Brazil’s production yield will be just 27 million bags in 2015.
  • Nobody to pick-up the slack: Not enough capacity from other countries to cover the expected crop shortage of Arabica coffee in Brazil.
  • How High Can Prices Go?: $2.75 to above $4.00/kg. There will likely be a spike in prices for Arabica, and a higher basis for other grades of coffee. We can expect some read-through after the assessment of the third or fourth bloom in the coming weeks.

Please feel free to reach out with additional questions.

 

Ben Ryan

Analyst 


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