Takeaway: Current Investing Ideas: FDX, HCA, HOLX, MD, NKE, MPEL, SBUX, NSM, WWW
The latest comments from our Sector Heads on their high-conviction stock ideas.
NSM – Nationstar Mortgage shares have performed well of late on the back of a stabilization in mortgage rates precipitated by Bernanke’s dovish commentary regarding tapering, and comments made on the JPMorgan and Wells Fargo 2Q13 earnings conference calls about wanting to sell some of their mortgage servicing books.
Bernanke’s comments put downward pressure on long-term interest rates, including mortgage rates. This improves the outlook for mortgage refinancing volume, which is a core business for NSM. It’s important to note, however, that while a substantial portion of NSM’s earnings come from mortgage origination, most of which is refinancing-driven, most of their refinancing business isn’t traditional refinancing at all, it’s HARP refinancing. HARP is a federal refinancing program for borrowers who are underwater on their mortgages and cannot refinance through conventional means because their loan-to-value ratios (LTV) are too high to meet traditional underwriting criteria. HARP refi volume is less rate-sensitive than traditional refi volume because borrowers have no other options and are typically at rates well above current market rates.
JPMorgan and Wells Fargo’s comments about selling a portion of their servicing book is good news for NSM. There are three primary companies in a position to acquire the bulk of those servicing assets, NSM, Ocwen (OCN) and Walters (WAC). Historically, the purchase of bulk servicing assets from large banks has been very accretive for these companies. Case in point, when NSM bought $215 billion in servicing UPB from Bank of America at the start of 2013, they raised their 2014 EPS guidance to $5.60-6.50 from $3.30-3.80.
TRADE: In the short-term the market will trade NSM inversely to long-term interest rates.
TREND: Over the intermediate term, we expect 2Q earnings to be beat Street expectations when the company reports in mid-August , which should be a positive catalyst for the stock to move higher.
TAIL: In the long-term, there is still a tremendous opportunity for non-bank servicers like NSM 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 – Health Care sector head Tom Tobin expects accelerating revenue growth at Mednax going into the second half of 2013 and sees little risk to second-quarter results. MD’s patient volume is tied primarily to births, but has leverage to surgical procedures through its anesthesiology practice. Tobin expects an uptick in pricing as Medicaid Parity is implemented in more states, enabling MD’s primary care services to be reimbursed at higher rates.
Tobin’s proprietary Birth Regression Model suggests births will accelerate into Q3, providing additional revenues. On the acquisitions front, MD stepped up their acquisition pace in Q2, which we expect to continue through 2013 since the company’s acquisitions to-date have lagged its acquisition guidance for 2013.
HCA – The Q2 2013 earnings season is near the midpoint, having gotten off to a very rocky start with negative pre-announcements from THC, CYH and ISRG, and weak-looking physician survey data from JP Morgan. But as more reports come out, says Health Care sector head Tom Tobin, the quarter is shaping up reasonably well against the early wall of negative sentiment. Many more companies are reporting accelerating revenue, says Tobin.
This week HCA Corp peers UHS and LPNY reported sequentially better admission trends, and several orthopedic and cardiology medical technology companies also showed evidence of sequential acceleration in their US business – significant for HCA which derives some 35% of inpatient revenues from these two areas. Tobin is beginning to do additional research on Accountable Care Organizations, created by the Affordable Care act. Though still a very small part of the medical sector, data suggest these ACOs have been successful in reducing ER and inpatient admissions. Tobin says “ACOs could become a headwind that diminishes our optimism” for HCA. “So far that doesn’t appear to be the case,” he adds, “but we are watching.”
HOLX – Health Care sector head Tobin’s new OB/GYN survey indicates patient volume appears to be stable to improving, which agrees with his thesis for rising physician patient traffic in 2013. Hologic preannounced 2Q13 (F3Q13) EPS results slightly ahead of consensus, suggesting the secular decline in Pap tests from the new Cervical Cancer Screening Guidelines are not an obstacle the company cannot overcome. And HPV testing remains underutilized, which should help mitigate the Pap headwind.
This week, HOLX received FDA Approval for its HPV assay for its PANTHER platform, allowing HOLX to further penetrate the HPV market, potentially leading to share gains. HOLX is facing intermediate headwinds, which Tobin believes are manageable, and are less important than the longer-term tailwinds from its mammography business and the ACA Insurance Expansion in 2014.
FDX – Industrials sector head Jay Van Sciver sees FedEx stock easing a bit this week, “likely because the market has yet to hear any news on prospective activist involvement,” he says. When rumors started sizzling around FDX two weeks ago, Van Sciver laid out a substantive case for activist involvement in a well-attended conference call, which may have solidified market expectations around the idea of an activist approaching the company. Van Sciver’s analysis of the timing indicates that, if there is an activist lurking, confirmation could be evident fairly soon.
MPEL – Melco Crown Entertainment shares have rebounded on the backdrop of strong demand in the face of reported economic softness in mainland China. If one is bullish on Macau, and we are, then one must be bullish on this Macau pure play. Overly negative reactions to the Chinese macro, GDP and credit conditions especially, have rightfully lessened in magnitude and duration in recent years.
Investors are coming around to our thesis that Macau remains the only gaming market in the world with excess demand. More people want to visit Macau more often but cannot due to visa restrictions and infrastructure unsuitability. Transportation infrastructure and access to Macau will improve dramatically in the coming years while the Chinese government has shown a willingness to relax the visa scheme in times of slowing demand. The result is a large cushion available to soften any drop in demand.
Meanwhile, Macau is tracking for another double digit same store revenue growth month here in July with little let up for the rest of the year. MPEL is uniquely positioned to capitalize on said growth through market share gains and low investor expectations over the near-term and new development over the intermediate term. Somehow the stock trades at only 9-10 EV/EBITDA – the lowest among its peer group - despite not Macau income tax on gaming profits. A strong upcoming Q2 earnings announcement and likely positive earnings revisions leave the multiple looking even more attractive.
With no net debt and huge free cash flow, MPEL will fund it’s high returning development internally and should be able to pay a dividend and/or buyback stock without adding significant leverage. A fast growing, free cash flow generating, and dividend paying company is a multi investor class story – highly unusual in any industry and especially in the world of leisure.
WWW – It’s time for some basic math and an accountability check on Wolverine World Wide, says Retail sector head Brian McGough. At the start of the year, the company said the following about the recent ‘PLG’ acquisition (Sperry, Saucony, Keds, Stride Rite) and its impact on earnings. ‘Included in the fiscal 2013 guidance is GAAP accretion from the PLG acquisition in the range of $0.40 to $0.50 per share. Given the seasonality of the PLG brands, we expect modest accretion in the first fiscal quarter, slight dilution in the second fiscal quarter, strong accretion in the third fiscal quarter, and modest accretion in the fourth fiscal quarter.’ Says McGough, this means the first and second quarter roughly wash each other out and most accretion comes in 2H, which makes sense because a) the seasonality of the business lends itself to higher profitability in the second half, and b) the deals that WWW is striking with international distributors are cumulative in nature, and pick up over time as it relates to impact on the P&L.
Now, with the first half of the year already put to bed, WWW has realized $0.58 per share in accretion from the acquisition. That should be great, says McGough. But the company managed to convince Wall Street analysts that 2H would now be dilutive to earnings. Huh? How could that logically and mathematically be possible?
McGough thinks it’s smoke and mirrors. WWW is saying that it pulled forward some demand from 3Q into 1Q, and that it pushed some costs from 2Q into 3Q – and as such, what was the most accretive period of the year becomes dilutive. It’s ironic that the company does not identify what those shipments and are, or quantify how much they are impacting its financials.
McGough thinks this is another example of the company artfully managing the Street’s expectations. McGough continues to like WWW because of the TAIL opportunity, with TRADE and TREND looking solid as well due to the earnings upside that we expect in 2H13.
SBUX – Restaurants sector head Howard Penney was one of the first Wall Street analyst to cover Starbucks at the time of the IPO. Penney recalls how negative remarks in his early coverage occasioned a call from SBUX founder and CEO Howard Schultz, inviting Penney to visit the fledgling chain’s locations. Walking through the company’s operation step by step, Penney was treated to a seminar in Schultz’ philosophy and SBUX’ business model and became a believer. Now, decades after that encounter, SBUX continues its successful expansion both at home and in Asia and has managed to take advantage of every new technology, from the internet, to the latest apps, making the company both a mature cash cow and a dynamic growth story. Penney says “there is not a better-managed consumer company out there.”
NKE – Retail sector head McGough issued his Investing Ideas Stock Report on Nike this week. Click here for the full report.
Macro Theme of the Week – Hedgeye’s Q3 Macro Themes, Part 2
Hedgeye’s Q3 2013 Macro Themes call introduced three major themes our Macro team has identified as significant drivers of investment strategy for the current quarter. Last week’s Investing Ideas featured the first theme, #RatesRising. This week we continue to the second of three major themes, #DebtDeflation.
As a reminder, here are our Q2 Macro themes and a brief take on how they played out:
- #StrongDollar – The Dollar continues to reverse what has been a forty-year slide. Renewed strength in the currency keeps pushing ahead despite Bernanke’s policy statements designed to weaken the Buck.
- #GrowthAccelerating – Hedgeye has tracked significant growth in a number of key sectors, including declining unemployment, strength in the housing market, and an upturn in the birth rate, reversing a forty-year decline and leading to a boost in new household formation.
- #EmergingOutflows – The BRICs are BROKE, even “stable” countries like Turkey, and “friendly” countries like Jordan and Egypt are in the grip of unrest. The US remains the safe haven.
The Hedgeye Edge
The manic media makes its living largely on headlines, rarely on analysis. The “news cycle” is such that we forget major events after a day or two as we rush madly to the next unbelievably nasty story. This pattern dominates the financial markets too, where not only journalists, but financial analysts and investment professionals all rush into a Chicken Little panic around single data points. “Housing starts disappoint,” says one ominous headline, and the stock market dips. “Corporate earnings season opens on a high note,” says another, leading to a new closing high in the S&P.
In case you were wondering, the casino really is rigged.
The big players are making their money not on investment acumen, but on volatility. Case in point: Earlier this week the Commodities Futures Trading Commission (CFTC), the UK Financial Conduct Authority, and exchange operator CME Group all fined NJ-based Panther Energy Trading for market manipulation. Panther allegedly used “spoofing,” a ploy in which high-speed trading computers enter huge numbers of orders into the market, then cancel them just as quickly. The flood of orders gives the impression of high demand. This moves prices and draws legitimate buyers and sellers to the trade in question, all without the “spoofer” committing a dime. In this case, Panther was trading oil contracts.
The Wall Street Journal reports that, in one instance, Panther netted a cumulative profit of $370 dollars on a total of 17 trades. This is a game of immense volumes of electronic orders being sent out, and razor-thin margins. The CFTC says that Panther’s automated system cancelled 98% of more than 400,000 orders transmitted to the exchanges during the period under review, citing this as evidence that the orders were not legitimate, but were intended to game the system.
This has been going on for a long time, and in every market in which you have your hard-earned bucks invested. In all US regulated markets, it is illegal to enter an order with the intention of canceling it, specifically to prevent this type of manipulation. Traders who play this game insist that their algorithms (“algos,” in Street jargon) are supremely sensitive to shifts in the market, and that orders self-cancel in hair-trigger response to changing market conditions. Regulators say that is nonsense: the algorithms flood the market with the appearance of activity then, once the actual buyers or sellers are drawn in at the algo trader’s target price, the algo trader enters his actual order and slithers away with the profits.
If it takes 17 trades to make $340, just imagine what it must have taken Panther to earn the $1.4 million in alleged improper profits the CFTC is forcing it to disgorge.
Mind you, this is the one scam regulators were able to catch.
With the markets essentially rigged against the individual investor, Hedgeye counsels patience. Unlike the manic media (which must sell air time) or manic Wall Street bankers (who must sell stocks), our analysis doesn’t focus on a number, but rather on rates of change. What this means is you can take more time in between transactions. We think it also dramatically increases your odds of being right. For every metric we analyze, every market, we look at the slope of the line. Slope, as we recall from middle school algebra, is the change in Y over the change in X or, more as Mr. Nissen used to say (8th grade) “rise over run.”
For Hedgeye, doing “Good Macro” is less about the absolute level of a single number than it is about changes in the slope of the line. A short term trader has to make accurate calls on how the market will react around measures like earnings, and vague phenomena like testimony from the Fed chairman. Macro succeeds, not by pegging Good / Bad, but by forecasting Better / Worse. We don’t try to hit the bull’s eye each time; we need to clearly understand the shape of the target.
So, for every metric we analyze, every market, we look at the slope of the line, the cumulative rate of change over time in key indicators. An old Wall Street adage says “The trend is your friend,” and an important corollary is that over time, phenomena tend to revert to the mean. This means that forces moving in a direction tend to keep moving in that direction until they run out of momentum. Think of an aircraft carrier running full steam ahead, then cutting its engines. And, once momentum winds down, things they tend to go back to looking the way they have looked historically.
As Hedgeye CEO Keith McCullough has pointed out numerous times of late, historical rates on the 10-year Treasury bond average over 6%. So while the recent move from below 2% to around 2.5% has traders spooked, rates could double from here and still remain well below the historical average. This means you don’t have to rush out and buy every time stocks tick up in price. You have time. You have time to assess, time to plan, time to identify attractive sectors with sustainable growth, and time to allow the investment themes in your portfolio to mature.
Here are Hedgeye’s Macro Themes for Q3 2013:
Our themes are simple. The dollar has been strengthening. Meanwhile housing, employment and consumption have all been surprising to the upside – not major blow-out numbers, but the slope of the line in the US economy is definitely in the direction of Growth.
Last week, we discussed the first of our three Macro Themes, Rates Rising. This week, we move on to
Total debt outstanding worldwide is three times total equity. Pay attention to that figure. It’s really important. It has created a massive Supply / Demand mismatch as global bond markets contract, and investors look to move their money out of debt and into equities. This is further skewed by excess demand for US equities in global portfolios, versus those of other national markets. As the Emerging Market trade has faded, as Europe meanders aimlessly, and as Asia looks like crumbling (watch for our next Theme), US equities are the only game in town. And yet, there aren’t anywhere near enough US equities to satisfy global demand. In fact, total supply of equity shares has been in decline as the domestic IPO market has remained soft and companies have accelerated buybacks in an attempt to reward shareholders and manage earnings.
Fixed income markets have always been massively bigger than the equity markets, and through the bull market in bonds –now well into its second generation – this seemed perfectly sensible. On their investor education website, SIFMA (the Securities Industry and Financial Markets Association) says total daily trading volume for 2009 was $104.9 billion for US equities, versus $814 billion for US bonds.
But individual investors have developed a fondness for equities. We suspect this is because people believe they understand how a business works: you have an idea, you invest in your idea, your idea either succeeds or fails. Americans are drawn to entrepreneurs. We are a nation built on initiative and ingenuity and even if our purchase of 100 shares of Microsoft won’t help Bill Gates change the world, we buy in no small part because we are believers in the capitalist system.
We also suspect that people trust entrepreneurs more than they trust the government. If you give Steve Jobs $1,000 and he loses it, you have faith that at least it was lost in an honest effort to create a game-changing new product. If you give the government $1,000…
This seems to be borne out by individual investor data from the US Census Bureau. In 2010, Individual Investors (“Household Sector,” which includes individual investors and also counts non-profit organizations) owned $8.5 trillion in equities, but only $1 trillion in Treasurys, $1 trillion in muni bonds, and $2 trillion in corporate and foreign bonds. More than 2 to 1 stocks over bonds. Individual investors are surely suffering from historically low interest rates (as Keith points out, Bernanke is the only Fed chairman in history who never once raised interest rates) and despite hiccups along the way, their faith in the equities markets appears largely unshaken. Note that fear over entering the market at new highs does not equate to aversion to the stock market – if anything, it is remorse about not having been in much earlier. We expect surges to yet higher highs as individuals gird their loins and plunge into the stock market at ever higher levels.
Deflating the Great Deflators
Contrary to nervous policy pronouncements, from a macroeconomic perspective, deflation is not historically associated with social disaster. A recent study spanning 180 years, in 17 countries, found no correlation between deflation and economic depressions – but found depressions more associated with inflation. This may have you wondering why our first theme #RatesRising sounds so positive. It is because the current rise in rates is Mean Reversion – the bond market has been exhaling for nearly four decades. Now it is pausing to take a deep breath. On historical averages, there’s plenty of room to expand – up to around 6.5% on the 10-year Treasury – before anything resembling inflation fears enter the picture. If anything, the coming upturn in rates could prove the Sweet Spot for economic growth.
Meanwhile, our Macro analysis shows every major inflation-related asset class is a bubble that has already popped. Remember that most “Smart Money” isn’t that smart – they merely rush to buy what has already worked. Investment assets are what economists call Giffen Goods: the higher they go in price, the more people rush to buy them. Sound crazy? Who’s managing your money?
Now that the trend in bonds has reversed, you should expect the outflows to be just as poorly planned as the inflows were. The winding-down of bond portfolios will probably end in an explosive rush for the exits, though we can’t say when that is likely to occur. But it appears that this risk is already alive and well in the bond markets, as even media talking heads are now pontificating about the “reversal of the thirty-year bull market in bonds.” (Says Jackie Gleason, “Be kind to the people you meet on the way up… ‘cause you’re gonna meet the same people on the way down!”)
The latest figures indicate that bond investors are catching their breath, with large slugs of cash going into money market funds. But money markets with a near-zero yield are not an acceptable final destination for most investors – particularly for institutional managers who must be fully invested, and who have performance benchmarks to meet.
The Wall Street Journal reports (25 July, “Bond Investors Turn To Cash”) that “an estimated $6.3 billion came out of stock mutual funds in June,” but like Punxsutawney Phil, individual investors glimpsed their own shadow in the declining bond markets and “moved $7 billion back into US stock mutual funds in the first two weeks of July.” Note that the sell-off in stock mutual funds helped drive the S&P 500 index from over 1651 in mid-June, to 1573 on June 24th. By July 1st it was already back up to 1614, on its way to closing out the second week of July at 1682. This means many investors took losses as they liquidated, then missed gains when they piled back in.
Says Keith, pay attention to the slope of the line – in the broad economy, and in the markets. If it is positive, stay with it. If it is negative, stay clear. Near-term market moves are based on a number, which is why stocks jump or collapse quickly on news. But they often reverse just as quickly, as opportunistic short-term traders “play the dip,” or “play the pop.” Intermediate- and long-term market moves are based on sustainable trends. Our job here at Hedgeye is to find investment sectors with favorable trends.
This brings us back to the Debt Deflation theme.
We believe bond investors will have to capitulate once they acknowledge that the generational bull market in bonds is really at an end. Fund managers can’t keep all their cash in money markets. They will have to find other asset classes – and as they start moving towards them, you should expect the boat to rock. As high as the equities markets have moved, they could trend significantly higher. SIFMA’s figures indicate there is about eight times the daily trading volume in the bond markets as in equities. Imagine the impact of an extra $800 billion added to each day’s trading in the equities markets.
On Hedgeye’s macro charts, nearly every major investment class that is not plain ol’ US equities is broken: gold, ETFs, 10-year Treasurys, junk and other high-yield bonds. Even high-grade corporate bonds and Treasury inflation-adjusted TIPS have broken their trend lines. Outside our borders, Emerging Market debt, says Keith, is “just plain scary.”
Bullish equity analysts say this is a “deep” rally. Equities are trending up across the board, with mid- and small-cap stocks propelling the broad averages higher. We read this as an indication that there aren’t enough equities to satisfy demand. Just as there was a distortion in the junk bond segment, as yield-hungry managers drove the yield on risky bonds down to near-investment grade levels, there is a distortion in the risky end of the equities markets, driving prices beyond historical measures.
Hedgeye counsels our subscribers to buy stocks for the right reasons – and be patient. If the world’s bond investors turn to the US equities markets, as we believe they must, you’ll see just how good a Friend the Trend can be.
Tune in next week for Japan.
Sector Spotlight – Financials: Muni Makes the World Go ‘Round
Since joining Hedgeye less than two months ago, Financials senior analyst Jonathan Casteleyn has already made a significant contribution to our process. Jonathan will be featured in an introductory presentation scheduled for Monday where he will provide a deep look into the asset management companies in his space.
Meanwhile, he had a few insights to share regarding the Big Story in the munis space: the Detroit bankruptcy.
Casteleyn notes there were big muni outflows over the last couple of months, based on the rate-rising, Fed tapering story. Over $66 billion had been redeemed from bond investments in a five-week period, the biggest drawdown since the financial crisis of 2008. This includes the week ending June 26th which saw $28 billion in bond market outflows, the biggest one-week outflow ever recorded. And note that the only other drawdown of similar magnitude – the 2008 crisis period – saw the Lehman bankruptcy and “uncertainty as to the survivability of the US financial system.”
“Predictions of a collapse or meltdown of the municipal bond market have never played out,” says Casteleyn, “due to a misunderstanding of U.S. municipal finance.” Despite occasional high profile failures over the past 40 years – from the $2.5 billion default of the AAA-rated Washington Public Power Supply System in 1982 (affectionately known as “Whoops”), to Orange County CA in 1994, to Jefferson County AL in 2011 – the investment grade segment of the munis market has experienced relatively low default rates.
Casteleyn cites a study by S&P that found investment grade corporate bonds defaulted at a rate of 4.21% during 1, versus investment grade muni defaults at 0.16% during 1 (meaning the study excluded WPPSS, for example). Even at the BBB rating, the lowest rung of the investment grade range, muni bonds had a default rate of 0.37%, versus corporates at over 8%.
Municipal credit is different from Treasury debt. It is structured in a way that it generally has limited “rollover risk,” meaning municipalities generally don’t need to scramble to issue new bonds to pay off the old ones. Moreover, state and local governments have the authority to raise taxes and fees to meet operating costs and service their debt. Bankruptcies are also rare because a municipality must have specific statutory permission from its state to file for bankruptcy, and even when a bankruptcy is authorized, there is no liquidation of assets but only restructuring and reorganization.
No Mo’ Town
Detroit is the largest U.S. city to file for bankruptcy, though Michigan’s courts have yet to rule on the city’s eligibility for bankruptcy protection. Casteleyn says the Motor City announcement was anticipated by market participants and consequently is not to be viewed as a systemic event. Detroit suffered a 60% population decline of since 1950 and the city has 80,000 abandoned structures, so the latest development can hardly have been a surprise.
Yet, despite unique factors in this devastated city, investors will likely take away the message that yields don’t compensate for the risk in the $2.7 trillion muni market. The outflows that started the first week of June have run for 7 weeks, totaling $56 billion. This compares to the prior 52 consecutive weeks that experienced over $230 billion in inflows, while muni yields held at the long term average since 2009. Casteleyn expects the lack of confidence in the tax-free market to continue in the short term. Financials sector head Josh Steiner says the “fear kicker” from the Detroit bankruptcy could eventually provide a “dip-buying” opportunity for muni investors, though he wouldn’t rush out just yet.
Casteleyn says muni market problems can arise from a host of causes, ranging from mismanagement, to just plain bad luck. Muni problems are rarely related to broader concerns in the credit markets, but investors are likely to respond to Detroit’s bankruptcy by dumping more muni issues, with outflows likely to continue through the summer. Casteleyn will host a deep-dive call with institutional clients next week, reviewing asset management firms whose operations are most likely to be affected by moves in the munis market. Watch for our coverage of what is sure to be an informative call.
Investing Term – Risk-Free Rate
Investors used to use US government debt as a benchmark, calling the return on Treasurys the “risk-free rate of return.” If your experience of the Fed is limited to the tenure of Alan Greenspan and Ben Bernanke, you might conclude that government-issued debt (a) is not without risk, and (b) doesn’t really offer a “return.” From our perspective, you would be right.
Time was when 10-year Treasury bonds yielded 6% or more. In fact even three-month T-Bills – yielding effectively zero today (0.02%) – hit a high yield of 9.14% in 1989. The theory was you need a return of 1 ½ times that Risk-Free rate to make it worth the risk of investing in equities. The rationale? Treasurys are safe, and the return on Treasurys is safe. Treasury interest payments are also exempt from state and local taxes, though taxable at the federal level. (The federal government and the states have agreed not to tax one another’s bonds, which is how munis can pay “triple tax-free” interest.) With Treasurys at 6%, said the theory, an investor needed a solid expectation of a 9% annual return on common stocks in order to accept the added risk. Otherwise they should continue to sit in Treasurys.
Now the Risk Free rate no longer offers any profit potential. It no longer keeps pace with inflation, and the long-running Fed trashing of the Dollar has raised concerns that Treasurys might no longer be the global go-to investment – and downgrading the US’ debt didn’t help matters.
Debt Deflation, promoted by the Fed, has created a one-sided investment market. Stock buyers are delighted – or envious – as the stock market continues to churn to new highs. But the individual investor no longer has a comfortable source of ready liquidity that money market and bank accounts should provide. Bernanke’s clearly articulated objective in continued lowering of interest rates was to stimulate the stock market. As a matter of policy, the Fed purposely took away the Risk-Free Rate, forcing Americans to take on more risk than they wanted in order to just stay even.
Those of us who have been through more than one economic cycle occasionally pause to marvel at the undoing of societal norms. Drivers used to be instructed to drop back one car’s-length on the highway for every ten MPH of speed. They now routinely hug the car in front of them, even at speeds in excess of 70 MPH. Notions of “privacy” are divided into pre-Facebook, and post-Facebook, with the older norms deemed “quaint” and somewhat laughable. These are but two examples of risky behavior that have quickly replaced moderate levels of caution.
We are willing to expose ourselves to the threat of death on the freeway, of having a wilderness of strangers track our every waking moment for their own profit (though not the government, even for our protection). In this Brave New Normal World, the Fed’s long-term policy objective was to induce Americans to set aside notions of investment risk and go “all in” in equities.
Risk is now Free. Welcome to the new Abnormal.
Takeaway: Growth, growth, growth – if you can find it, buy it.
(Editor's note: What follows below is a brief excerpt from Hedgeye's Morning Newsletter written by Hedgeye CEO Keith McCullough. If you would like to learn more about Hedgeye's products please click here.)
The Russell 2000 clocked another all-time closing high yesterday of 1054 (+24.1% YTD) as mostly every growth stock that beats toned down expectations rips to new YTD highs. Slow growth investor T-Bonds were down (again). This remains a growth investor’s market.
Growth, growth, growth – if you can find it, buy it – that’s not just a progressive message that stands in stark contrast to the fear-mongering one that is getting pummeled (VIX -29% YTD), it’s a good way to live your life. In order to grow, you need to embrace change.
What’s interesting about being long growth is that not all “growth” investors have actually agreed with it, yet. That said, it’s important to remember that we’re all storytellers – and the market doesn’t care about our own individual versions of the story.
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THE HEDGEYE EDGE
Nike is the largest and most profitable brand in this GDP+ global growth industry. The self-imposed barriers to entry make it exceptionally difficult for anyone, anywhere to compete with Nike. The cost structure is simply too high. It controls about 50% of the US athletic footwear market, and about 15% of apparel. Its’ share outside the US is about 25% footwear, and 6% apparel.
Nike’s ownership of the supply chain offers exceptional flexibility during virtually every global economic climate, which not only self-perpetuates its growing market share, but also lowers the volatility of its earnings base. For examples, the US retailers that sell Nike can allocate up to 65% of inventory purchases to Nike. Most factory partners in Asia allocate near 100% of floor space to Nike. Who do you think holds the cards at each end? Nike is almost NEVER ‘surprised’ by a business-damaging closed-door decision by a retailer or sourcing partner. This allows it to always be on offense in driving its business, and in maintaining a margin premium versus competitors.
One of the biggest parts of the investment case for Nike is, unfortunately, something that requires a very big leap of faith on the part of the investor. That is, crediting Nike for driving innovation beyond the intermediate modeling time frame with product innovation that even the savviest consumers (and Wall Street analysts) cannot conceive of yet.
For example, people were asked three years ago if Nike had the capacity to change up the footwear manufacturing model such that the product is manufactured on a loom (i.e. a machine) as opposed to an assembly line of workers, most would say ‘No’. Yet today, Nike’s business is being driven by innovative products like FlyKnit, which is, in fact, manufactured on a machine similar to a cotton loom, and other products like Nike+ Fuel that digitizes a consumers’ movements and creates an on-line community of brand-loyal consumers. These are just a couple of examples of things that other brands literally cannot do without destroying their margin structure, or completely recapitalizing their balance sheets.
INTERMEDIATE TERM (TREND) (the next 3 months or more)
NKE set beatable EPS expectations on its recent earnings call, which sets up a nice timeline of events. 1) A positive earnings report in September, 2) a long-awaited analyst meeting at HQ in Oct, and 3) benefit from price increases to take us through the end of the calendar year. Visibility is less certain as 2014 starts out, but then we start the ramp up to World Cup in Brazil. While soccer is a notch above Bass Fishing in the eyes of the US sportsman, the reality is that it is the biggest sport in the world by a country mile, and the World Cup is second only to the Summer Olympics (also in Brazil, but in 2016) in popularity. Simply put, the intermediate-term outlook for Nike is a good one.
LONG-TERM (TAIL) (the next 3 years or less)
Nike’s TAIL story is slightly boring, but that’s not a bad thing. In fact, we’d argue that boring and consistent is a multiple-enhancer. The reality is that the company has a defined plan to drive high-single digit sales growth on a global basis, and then trade off Gross Margin and SG&A in a given year to leverage its top line to low-mid teens operating profit growth. Then tack on the fact that Nike has a free cash margin in excess of 9%, the company has enough free cash to repurchase enough stock to drive another 5% EPS growth each year. Add it all up and we feel comfortable banking on at least 15% EPS growth each year. That’s not half bad for a large cap growth company that dominates a global duopoly.
ONE-YEAR TRAILING CHART
Takeaway: Interest rate volatility is declining as investors accept economic reality and the positive implications of #RatesRising.
This note was originally published July 23, 2013 at 15:54 in Macro
“What the *&%! Just Happened” headlined yesterday’s release of GMO’s quarterly investment letter. While the title is probably accurate in capturing the prevailing, post-Taper announcement sentiment of the larger investment community, that the initial inflection in a bond bubble 30Y’s in the making occurred with some price convexity, and not a wimper, shouldn’t be particularly surprising.
In fact, if you have been long U.S. growth for the last 8 months, the Taper announcement itself was more a confirmation of economic reality than a prodigious central planning event. The acceleration in the domestic macro data since late November and the slow creep higher in the 10-2 spread were heralding some measure of a policy shift.
In so much as a widening in the yield spread <--> expectations for QE Taper <--> Improving Domestic Macro, is a transitive relationship, the recent “bear steepening” in rates should be taken as positive confirmation of an improving domestic growth outlook. This first step function move higher in yields is simply the market adjusting to the positive gravity of the domestic economic data and the implications of a sober policy response.
In essence, the initial move in rates represents the ball under water moving towards being only half-submerged.
From here, particularly given the Fed’s much communicated ‘data dependency’, the next 100+ bps higher should be viewed more as a growth dependent return to interest rate normalcy than a tightening in the conventional sense. If the fundamental data is such that the controlling, dovish contingent at the fed is willing to signal a rate increase - even a small, gestural increase - we’d argue that pro-growth exposure should continue to outperform in the run-up to that event.
As we’ve moved past the acute response phase, the market has seemingly come to accept and price in a reduced flow of fed stimulus. We detailed the implications of #RatesRising on our 3Q13 Macro Themes call last week. We’d highlight a couple of incremental events of the last week:
ACCEPTING REALITY: Measures of implied interest rate volatility in the options markets have dropped precipitously over the last couple weeks. Seemingly, the market has absorbed the acute impacts of the initial announcement with investor angst ebbing alongside initial portfolio re-adjustments.
TAPER TIMELINE: Alongside lower volatility and a newly range-bound 10Y, today’s main policy related headline from Bloomberg that the consensus expectation of economists for Fed tapering (to the tune of $20B) to begin in September is further evidence that the market is getting comfortable in delineating the impacts of tapering vs. tightening.
Given the practical aspects of implementing a tapering which, practically, means they will reduce the flow of purchases and subsequently monitor the impact before implementing incremental reductions, a September start makes sense. With Bernanke likely stepping down come January, initiating the reversal of unprecedented policy initiatives which he captained makes sense from a continuity and (Bernanke) legacy perspective. It also gives policy makers sufficient runway for scaling back purchases with an early eye towards a complete cessation come mid 2014.
Also, implicit in the reduction in QE purchases is that QE was, in some manner, successful in its objective. This gives the FED and QE as a policy some credibility should they need to re-accelerate easing at some point in the future.
SEASONALITY REMINDER: As it relates to the expectation for tapering to begin in September - recall that the seasonal distortion present in the reported employment and economic data will build as a headwind thru August before again flipping to a tailwind over the Sept-March period. Any prospective delay in tapering due to perceived/optical weakening in the data over the next 6 weeks should be short-lived as the impact of the distortion reverses come September. Further, any negative drag associated with reduced stimulus may be partially masked by the positive seasonal tailwind as we move towards year-end and through 1Q14.
(Not So) LATENT RISK: Duration (price sensitivity to interest rate movement) on 10Y treasuries remains near peak levels while high yield and IG spreads remain near trough levels. Despite the recent diminuendo in interest rate volatility, risk associated with another expedited back-up in yields remains very much alive across the fixed income spectrum.
Quantitative Setup: 10Y Treasury Yields remain in Bullish Formation (Bullish across TRADE, TREND, & TAIL Durations) with immediate support and resistance at 2.45% and 2.75%, respectively.
Christian B. Drake
This note was originally published July 22, 2013 at 17:10 in Consumer Staples
Kimberly-Clark reported 2Q EPS of $1.41 versus consensus $1.39 despite a miss on the top line. Management reaffirmed FY13 EPS guidance of $5.60-5.75. Per management, the impact of lower predicted sales growth is expected to be offset by higher cost savings and share repurchases.
We remain bearish on the name.
We believe the stock traded off today, despite the earnings beat, because of soft volumes in the U.S. and a looming miss or guide down in the back half of 2013. Management’s reiterated FY13 EPS guidance seems much, much less stable than it was three months ago; higher cost savings and share repurchases are set to fill the void being left by slower-than expected sales growth. With inflation sequentially accelerating and FX rates acting as a top-line headwind, we see downside risk to the company’s FY13 EPS estimates and would advise clients to continue to look elsewhere for exposure to consumer staples on the short side. We do not expect the market to pay 17x for earnings increasingly driven by cost savings and share repurchases. Below are the positives and negatives we took away from the quarter.
What we liked:
- Emerging markets have sustained strong volume growth
- The company is finding incremental cost savings (raised annual target by $50m to $250-350m) to drive EBIT growth
- Operating margin expanded by 90 bps to year-over-year to 15.5% despite no sales growth and commodity inflation
- KCI produced broad-based top line growth and operating margin expansion
What we didn’t like:
- Organic sales growth was dragged lower by negative volume growth in developed markets, particularly the U.S., Australia, South Korea
- U.S. personal care volumes declined despite negative product mix
- Management highlighted increasingly volatile macroeconomic environment, FX, and oil prices
- Big K-C I markets like Australia and South Korea experienced a slowdown in 2Q
- Negative 2Q FCF growth (-2.1%) with EBIT growth slowing to 5.8% from 15.6% in 1Q13 and 8.1% in 2Q12 (mgmt says cash flow to improve in 2H13)
- Valuation is rich – now important with increasing risk to the downside (or limited upside, at least) in earnings estimates
- Oil prices holding above $100 per barrel could push cost inflation above mid-point of company expectations ($150-250 million)
- FX rates holding current levels will likely result in EPS below mid-point of guided range
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