Below are Hedgeye analysts’ latest updates on our ten current high-conviction long investing ideas and CEO Keith McCullough’s updated levels for each.
*Please note that we added Legg Mason (LM) and Consumer Staples (XLP) to Investing Ideas earlier this week. We have removed Utilities (XLU).
We also feature two institutional research notes, as well as Keith McCullough's Friday morning macro call, all of which offer valuable insight into the markets and 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 | XLP
A Big Week For TLT and EDV; Rotating Out of XLU into XLP
Deterioration is the key takeaway from this week’s US economic data. We have placed investors in Quad #4 on our GIP model, which suggests that both economic growth and reported inflation are slowing domestically. As you can see, recent surveys and high frequency economic indicators support this hypothesis:
- Markit Composite PMI slowing in SEP: 58.8 from 59.7 in AUG
- Chicago Fed National Activity Index slowing in AUG: -0.21 from 0.26 in JUL
Given last week’s slowing rate of improvement in rolling NSA Initial Jobless Claims at -4.6% YoY from -9.7% in the prior week, we expect Q3 to continually reflect a deteriorating labor market, which should perpetuate expectations for a marginally dovish Fed among investors. Moreover, housing data remains unsupportive of further policy tightening. Total existing home sales fell for the first time in five months as sales declined -1.8% MoM against downwardly revised July figures, and down further to -5.3% YoY in AUG from -4.5% YoY in JUL.
Add that to severely declining economic production factors – such as Durable Goods slowing to 8.9% YoY in AUG from 33.7% in JUL, as well as Capital Goods (non-defense, ex-aircrafts) slowing to +7.5% YoY from 8.5% in JUL – and it’s easy to see why we think investors are decidedly better off in safe, long duration assets.
Our intermediate-term downside risk for the US Treasury 10Y is 2.42%, and after peaking at 2.61% last Wednesday, bond yields have fallen to 2.53%. Our backtest studies show long-duration Treasuries rally strongest when domestic economic growth slows. As far as the eye can see in a falling interest rate environment, we think here is a great spot to increase your exposure to slow-growth, yield-chasing trade and remain long of defensive assets like long-term treasuries and Consumer Staples – which work decidedly better than Utilities in Quad #4.
Simply put, stay long TLT, EDV, and rotate into XLP.
With the Scottish vote on independence now officially in the rear-view mirror, the GBP/USD was relatively flat on the week.
Over the medium term, we continue to like the cross based on what we see as relatively healthy underlying fundamentals for the country in 2H (to propel strong UK = strong Pound), versus our forecast for decelerating growth trends in the U.S. and Eurozone, combined with dovish policy expectations from central bank heads Mario Draghi and Janet Yellen.
Bank of England (BOE) Minutes continue to show 2 votes (out of 9) to increase interest rates (by 25bps) from the Governing Council. We expect this marginally more hawkish tone taken together with the outperformance of UK growth over the US and Eurozone in 2014 to push the GBP/USD higher.
Has the largest FX move since 1997 in the USD over the summer manifest?
With our internal GIP model (Growth/Inflation/Policy) signaling a deceleration in both growth and inflation in the Eurozone and the U.S., central planners will have the stage to talk down their currencies (which they will do – people like the limelight). We concede to the difficulty in front-running the policy response when Draghi and Yellen are confronted with similar situations, but we have no reason not to expect relative dovishness from the Fed when GDP estimates are too high and inflation is tracking below the Fed’s target.
The negative correlation risk embedded in the USD vs. the commodities complex as a whole means that the downward move in gold and the USD appreciation can reverse quickly, and in lockstep. The bond market and equity divergences continue to confirm the #GrowthSlowing theme in the U.S.
In the depths of the last recession, hospital debt was a yoke for the equity as tight credit markets and leveraged balance sheets (3-4x EBITDA) prevented hospitals from refinancing or rolling over their debt. As a result, and like many other companies during this time, their stocks were priced to go out of business. Since then, the relationship between high yield debt and hospital equity prices has been positive, and reasonably strong despite the occasional intra-quarter decline.
However, since HCA preannounced positive 2Q14 guidance in mid-July, we have seen a multi-standard deviation breakdown in this correlation. High yield spreads have widened on the back of increased equity market volatility, yet HCA stock continued to power higher on momentum fueled by a series of brokerage upgrades. So now we must ask ourselves… is this divergence a warning sign or an indication of a permanent change in trend?
We have reinserted shares of Legg Mason back onto our Investing Ideas list as the stock is again fulfilling our quantitative requirements as well as still screening positively on a fundamental basis. We recently spent some time with LM management during their investor day and came away with a few positive take aways that augur for further upside.
Firstly, despite two recent acquisitions, we were reassured that the company will continue on its robust buyback program which is an important exercise as it has the potential to reduce the largest percentage of shares outstanding in the group. By our calculations, LM can reduce 6% of its shares outstanding, well above the industry average of 2%, which takes some of the risk out of volatile investment flows driving the stock.
On the topic of flows however, Legg is putting up much improved results, just reporting its best monthly result in 7 years which signals that the improved performance at the manager is translating into net new client wins.
With the stock still under owned and still under marketed (only 5 Buy recommendations from 18 analysts) we continue to view the stock as a good long position and calculate far value at $57-58 for Legg stock currently.
While no actionable news this week, we did collect several data points that concern Owens Corning:
- U.S. Building Permits for August increased 5% year-over-year continuing a positive trend YTD after the winter slowdown.
- New Home Sales for August were up 18% month-over-month double and 16% year-over-year digits driven by sales in the West and the South.
- The recent fall in gas prices, while great for us at the pump, is a headwind for the roofing industry. An increase in oil and subsequently fuel prices help the roofing industry price increases “stick.”
- Nonresidential demand indices, the Architectural Billings Index (ABI) and the Dodge Construction Index both decreased from their post-financial crisis highs month-over-month at 55.8 to 53 and 126 to 114 respectively in August. Both indices tend to be noisy so we look at the longer term trend, which is still positive. A reading below 50 for the ABI and ~100 for the Dodge Construction Index would concern us.
In summary, while we do not get overly excited or nervous about one data point, we reaffirm our stance on Owens Corning expanding its margin in both its insulation and composites businesses as residential and nonresidential constructions spending moves to normalized levels.
We have no update on shares of Och-Ziff this week but have plans to meet with their senior management over the next few weeks that should give us a solid understanding of what to expect for the rest of the year.
Restoration Hardware CEO Gary Friedman disclosed this week that he had purchased nearly $2 million in stock. It’s not often that you see a CEO of a mid-cycle growth company buy back into a company 2 years after cashing out on an IPO. We think this is more than just a strategic play by the CEO to allay market fears after a $0.03 beat in the quarter and a miss on the top line. Instead, we think it shows a commitment to the long term plan.
In our model that equates to the addition of 1.2mm square feet of new selling space over the next 5 years, a 25% CAGR on the top line, while taking EBIT margins from 8% up to the mid-teens. Added all up that equates to a 50% earnings CAGR.
We fully acknowledge that the slope of a multi-year earnings growth story is not linear – especially for an early-cycle transformational story like this. There will definitely be some bumps in the road along the way as the company transforms its retail footprint and expands its product assortment across new categories. But we feel comfortable with the set up headed into the 2nd half of 2014. RH continues to be our favorite name in Retail.
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Keith McCullough's Morning Macro Call 9.26.14
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