Below are Hedgeye analysts’ latest updates on our nine current high-conviction long investing ideas and CEO Keith McCullough’s updated levels for each.
We also feature three recent institutional research notes that offer valuable insight into the markets and the global economy.
Trade :: Trend :: Tail Process - These are three durations over which we analyze investment ideas and themes. Hedgeye has created a process as a way of characterizing our investment ideas and their risk profiles, to fit the investing strategies and preferences of our subscribers.
- "Trade" is a duration of 3 weeks or less
- "Trend" is a duration of 3 months or more
- "Tail" is a duration of 3 years or less
CARTOON OF THE WEEK
TLT & EDV | Adding XLU
(We added Utilities Select Sector SPDR ETF (XLU) on Friday.)
What a week it’s been for investors with large allocations to slow-growth, yield-chasing instruments. The iShares 20+ Year Treasury Bond ETF (TLT) declined nearly -2% WoW; that decline was overshadowed by a near -3% drop in the Vanguard Extended Duration Treasury ETF (EDV) and was matched by the Utilities Select Sector SPDR Fund (XLU) – which we are adding to investing ideas today.
Leaks and loose-lipped lunches from sources close to the Fed – including former Chairman Ben Bernanke – confirmed that the FOMC is preparing to remove the “considerable time” language from its guidance on interest rates at or shortly after its SEP 16-17 meeting. Recall that previous FOMC statements have suggested that normalization of the Fed Funds Rate would come a “considerable time” after tapering had concluded.
Given consensus expectations that still call for compounding 3% real GDP growth, quarterly, as far as the eye can see, investors interpreted this catalyst as decidedly hawkish in that it perpetuated expectations for a rate hike(s) sooner than what was then priced into the market – i.e. from JUL/AUG of 2015 to JUN/JUL of 2015.
While today’s retail sales data is resoundingly supportive of these expectations, we continue to think US economic growth is poised to slow as we traverse through the back half of 2014. One month does not a trend make, however, as both domestic consumption and employment data are now breaking down from a trend perspective.
That, coupled with both #GrowthSlowing and fears of deflation in the Eurozone weighing on European rates (which, in turn, drags down US Treasury rates in the process) is supportive of our outlook for US rates – i.e. lower, not higher, from here with respect to the intermediate term.
Our immediate-term risk for the US Treasury 10Y Yield is 2.33% to 2.58%. Given where rates are today (i.e. at/slightly above the top end of that range) we think it’s a GREAT spot to gross up your exposure to the aforementioned slow-growth, yield-chasing trade.
That means get out there and buy yourself some TLT, EDV and now XLU. Don’t get caught on the same side as consensus when the tide turns!
FXB: How closely the GBP/USD is holding on to polls on Scottish Independence! We maintain our long call in the cross going into voting on September 18th.
This week three polls showed slight favor to the NO camp, and the GBP/USD saw a rally (but was down -60bps week-over-week)
- Survation: 53% NO vs 47% YES
- YouGov: 52% NO vs 48% YES
- ICM/Guardian: NO 51% vs YES 49%
Critically, these results are in contrast to last weekend’s poll release from YouGov that showed for the first time a slight majority favoring independence, or 51% YES to 49% NO, which carried the GBP/USD down -1.7% for the week.
Also note, UK bookmaker Betfair says the “No” vote is trading at 80% probability.
Setting aside the polls and betting markets, the most notable reasons for Scotland to stay a part of Great Britain are related to the Scottish economy itself. We’ve outlined a number of major risks to the Scottish economy should the Scots pursue independence, including:
- Currency – UK politicians have stated that Scotland could not use Sterling. The country would have to issue its own currency
- Central Bank – until the formation of a central bank there is no backstop for sovereign debt
- Massive Capital Flight –investors could pull money out of Scottish banks en masse that would destabilize the financial system
- EU Membership – it’s unclear if an independent Scotland would be granted EU membership, which could have huge trade implications
- Regulation – uncertainty if banks would remain regulated under the UK regulatory authority? Tax and trade regulations also uncertain
- Economic Drag – prominent financial firms likely to move to London
- Budget – the Institute for Fiscal Studies pointsout that Scotland's Deficit could be 4.6% if independent. Low credit quality could negatively impact debt raises, and push the country's debt and deficit levels higher, a vicious cycle.
Our view continues to be that the No vote will prevail and the British Pound will rally accordingly.
We also think that given the weak nature of the Scottish economy and the fact that 2 out of every 3 Scots are on some form of social welfare, over the long run a Great Britain without Scotland might actually be a stronger economy and certainly more healthy from a fiscal perspective. So on some level, perhaps the British Pound is in a win-win situation given its recent sell off. A No vote leads to a relief rally and a Yes votes leads currency traders to assess United Kingdom’s much improved fiscal health without Scotland, which leads to a long term tail wind for the Pound.
Heads you win, tails you win. We like that set-up.
GLD: The market has clearly positioned itself for a Fed rate hike and a stronger U.S. dollar. With gold being the commodity most tightly correlated to the outlook for the U.S. dollar, a USD breakout makes data-supported, logical sense to us. While we were firmly on top of the observable macro factors driving domestic and European growth (which are both slowing), we underestimated ECB President Mario Draghi’s hand in the central bank-fueled currency war.
On March 6th the EUR/USD hit its YTD top when Draghi hinted at a rate cut by saying, “There is consensus [among the ECB Committee] about being dissatisfied with the potential path of inflation.”
Since the May 6th YTD highs in the EUR/USD:
The relationship here is self-explanatory. At two points over the summer, Draghi took deliberate policy steps to devalue the EUR/USD. Anchoring on the FACT that the price of Gold is directly related to the outlook for the USD, the FOMC meeting next Wednesday the 17th is the next catalyst.
Refreshed daily, our real-time view on both Q3 and full year 2014 growth estimates remain meaningfully divergent from consensus (the Fed and sell-side macro).
We expect incremental divergence in this view to warrant an easier Fed.
If a pile of cash and a pot of gold sat on a table, we’ll take the Gold prior to the spotlight shifting from Draghi to Yellen.
HCA: What a difference a week makes. Investors have tuned out last week’s UHS commentary regarding a sequential slowdown in volume and tuned into positive utilization and growth comments made by HCA at a conference earlier in the week.
In fact, this was enough to warrant major brokerage firm’s increase their price targets to where we have been since Q2, in the mid-$80s. That being said, any price in the $80s, to us, implies a fair valuation and with a series of difficult comps ahead of us the asymmetric return setup we saw when first adding to HCA to Investing Ideas is waning.
After a pickup in July, results of our August physician survey point to slower patient volume in August. The three-month average trend is now negative for a second month, despite being less bad on the margin. Crux of the weakness stems from Midwest region, which experienced the largest decline. South and West regions continue to be strong where HCA has the greatest presence. Despite being up 46.3% YTD, we can continue to favor HCA on the long side and will be monitoring the data closely for signs of weakness as we move closer to our target.
OC: Owens Corning has been a problematic "value" position on this list and a performance disappointment in 2014. While we despise losing, it is an unavoidable reality in capital markets. When evaluated independent of performance, we think that shares of OC are likely to prove strong performers over the next year or two from current levels. That said, for taxable investors with a loss, it might be worth exploring recognition of a tax loss with a tax expert, possibly re-entering OC after qualifying.
We have expected OC’s insulation division to move to profitability, revealing the value of this unit in the transition. The insulation division has historically had mid-teens margins and we expect it to again show that level of profitability. We have also expected a rebound in profitability in the Composites segment. Oddly, we got those two catalysts right, with the shares underperforming anyway.
What we did not fully anticipate was a decline in profitability in the Roofing segment and the resultant loss of investor confidence in that business’s prospects. Unfortunately, a lack of storm activity and other factors led to lower than expected volume and weaker pricing in 2014, particularly relative to very strong 2013 results. As we see it, the decline in margin in the roofing segment raised the prospect that this industry was ‘broken’, which is to say that the previous price discipline had been lost. We do not believe that to be the case.
Recent price increases (e.g. this price increase from GAF here) suggest to us that competitors still understand the importance of maintaining a cooperative (oligopolistic) pricing environment. Our recent distributor survey work also point to improved pricing in September from weak levels earlier in the year. While volumes in 3Q and 4Q are likely to remain poor, better pricing seems likely to alleviate concerns about price-based competition and, we would expect, lift shares of OC.
Investing in asset-rich, underperforming Industrials can require patience and strong stomach. We still believe that OC is an undervalued company, - rare in today’s market - that holders will be well rewarded for tolerating in coming quarters.
OZM: Shares of Och-Ziff (OZM) continue to trend water mainly on fears of a more intense regulatory environment. As highlighted in prior updates, we think the focus on the firm’s investment in a mining deal in 2011 during a controversial time is well discounted in shares as the item has been fully disclosed in the company’s financials and mentioned several times in major media outlets.
Currently shares continue to trade at no incentive fee multiple despite the main Och Multi-Strat fund being up over 2.0% year-to-date. The average incentive fee multiple has been 3.7x creating at least $1.50 per share upside in shares on our calculated incentive fee earnings of $0.40 for this year. This excludes the firm’s current dividend yield of over 6% for a total return opportunity of nearly 20% in the intermediate term.
RH: The minute we saw the Restoration Hardware's numbers, we were shocked, to say the least. Good EPS ($0.67 vs $0.64E consensus), but nowhere near where it should have been, and revenue well below our model (and just about everyone else’s). That didn’t sit well with us, a high-growth, high-multiple name like RH does not have the luxury of missing on the top line. That’s particularly true for us given that such a big part of our thesis is predicated on outsized revenue growth over time.
Our concern lasted about 15 minutes... until we a) realized precisely what drove the sales miss, b) determined that it is not symptomatic of an underlying problem, and c) quantified the impact. How we’re doing the math, the 7-week shift in the timing of RH’s Source Book drop cost between $12-$18mm in sales, or about $0.07-$0.10 per share in earnings.
In other words, excluding this event, the company would have printed a number of $0.74-$0.77. Our estimate for the quarter was $0.77 compared to the Street at $0.64. That’s big by any stretch. The stock is trading off moderately on this, but we think it will be very short lived. If RH didn’t have a shift in Source Book timing, the stock would be up $10 on this print.
All of that said, we clearly can’t ‘exclude’ this event. It happened, and there’s no taking it back. Some sales will be lost forever. But will there be a revenue push into 3Q? Yes. Did the company play down the impact it will have on the top line in 3Q? We think so.
Are we concerned about any management ‘execution issues’? Absolutely not. Let’s be clear, we think that it is management’s responsibility to anticipate timing shifts like this and communicate them to its constituents accordingly (including all of us). But this is a company that a) is pulling off one of the biggest real estate transformations the Retail landscape has seen in a decade, b) has reduced its mailings from 10 to 1 over two years, and c) doubled its product assortment from a year-ago (while simultaneously redesigning floorsets in all its stores). Think of any other retailer or brand. Nike, Kors, Lululemon, whatever… Now think of that company doubling its product assortment over two quarters. The complexity is staggering. All-in, we’re willing to give RH management a seven-week slide with revenue planning on this one, particularly given that Merchandise Margins are stellar and SG&A is so well-controlled.
In fact, Gary Friedman’s and Karen Boone’s poise and confidence came across as being in the top 5% of the 100+ names we tracked over this past earnings season. These guys are in control of the business. Period. Did we walk away thinking that there might be more quarter-to-quarter revenue oscillations as the company grows up? Yes, we did. But again, for a company that is going to add $3bn in revenue and another $8 per share in earnings, we’re pretty much OK with that. Maybe we give it a slightly lower multiple to account for the revenue volatility. But the aggregate value that should be created here is still astonishing. We’d buy this on the sell-off. We’d buy it without a sell-off.
We’re making minimal changes to our model. We think RH is a double over 12-18 months, and is likely to double again. RH is still our top idea, by a long shot.
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