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2013 IGT ANALYST DAY

Our takeaways from the IGT Investor Day

 

 

Takeaways

  • Focus of presentation was on the online side of the business and on making mature business segments more profitable
  • Use DoubleDown to test content earlier on in the development cycle which should help them increase the number of hits that come onto the slot floor
  • Interstate jackpot - approved in NV but nowhere else so far.  It will be a state-by-state approval process.  It will take some time before they get any benefit from this. Interstate jackpot are already allowed between tribal gaming facilities.

 Patti S. Hart (CEO)

  • Patti's stock is vesting this week and she's not selling
  • Claim that they are the system of choice for new openings.  Not sure that that is true.
  • Focusing on equity accretion and returning money to shareholders is a priority.  Targeting a 2% dividend yield.
  • When they think about growth, they think share gains - not just new jurisdictions and finding new players
  • Claim that NA ship share was 40% in 2013, 36% in 2012, 32% in 2011, and 29% in 2010
  • Mentioned Novamatica as a top 4 global competitor
  • Should wrap up $200MM buyback by year end
  • They picked some select metrics to compare themselves to:  S&P 500, of course, for a favorable comparison
  • 3-5 year growth projection
    • +15% growth in online and social (mobile is where the growth is)
    • Real money gaming:  +10% (Canada, NJ, DE, Italy Spain)
    • International:  +7-9% (Philippines, Macau, Greece, Italy, Japan, Brazil) 
    • North America: +1-3%
  • Greece:  thinks that it could be like Canada / Illinois for them. Spending a lot of time there.
  • Really focused on growing their international share where they are under represented.  Was just in Panama.
  • Focused on harvesting the NA business for cash. (MA, NY, MD, TX, FL) 
  • Strategy:  Content focus and distributing across distribution platforms (i.e. multi channel content distribution (mobile)) and finally maximizing shareholder value. 

Eric Tom (VP Global Sales) with customer panel

  •  Tribal casinos are 1/3 of their customer base
  • Guest panel:
    • Rhonda Garvey:  VP of BcLC egaming
    • Matt Harkness:  COO of Four Winds Casino
    • Brian Hoeffner:  VP of Gaming at Casino del Sol.
    • Rob Miller (Miller Companies - also founder of gaming capital group, Oklahoma Financing); he's now the top operator in IL
    • Mohegan Sun COO : Ray Pineault
  • What needs to happen to accelerate replacement?
    • Economic improvement
    • Competition
    • Discount bundling helps
    • Proof of ROI
  • Thoughts on IGT's competition and how it's been impacting ASPs
    • Likes competition and the lower ASP.  Buying from small customers is always a little risky from a content standpoint.
    • More competition means more innovation and more pricing competition. Worried about longevity of small manufacturer machines and fresh content. Like being able to keep games on the floor longer with more conversions.
  • Thoughts on the amount of licensed brands to choose from
    • No such thing as too much choice
    • Like being able to swap out titles on the fly as performance wanes- especially if the slot manufacturers want to keep floor share
  • Thoughts on the next big trend in gaming
    • Mobile gaming and not just from a gaming standpoint but also from an account mgmt program and rewards program
    • Mobile wallet vs the current system of transferring money.  Lots of cost savings for operators if this happens.
  • Licensed and leased products vs owned
    • Looked at the net profit. Participation must perform at least 1.25-1.3x that of an owned game.
    • IRR based decision
  • What influences their buying decisions?
    • Sales force relationship and helping them navigate the product available
    • Knowing that they are buying a machine that a supplier can support for 7-10 years
  • Biggest competitive threat
    • In IL, they need to worry about BYI.  Lots of small players have failed. Spielo is a distant 4th. WMS is ok too.
    • BYI is a formidable competitor for them
  • What timeframe and metric do they evaluate their games on?
    • Net win but also looked at coin in and min / max bet, hold % etc to tweak those behind the scenes metric Usually takes about 3 months to evaluate a machine.
    • In IL, machines need to perform at a higher average bet since they have limited machines per location and limited hours of play.  Loves IGT minimum bet dynamics.
  • Player demographics for online
    • Challenged in getting a younger player and how to get that casual player.  Also using online as a theatre for the land-based casino.  For younger players, content is everything.  Velocity of change needs to be rapid. Having north of 30% growth in their online biz this year. Not seeing any cannibalization. Familiarity of content online also helps them in Iand casinos.
  • Feel like online will help grow the gaming market vs cannibalize it.  Players are already playing on illegal sites. Online social site are a customer acquisition strategy for them.
  • (BCLC) - Trying to have a common CRM/rewards program:  feel like when they have a player online and offline, that they can drive an incremental 20% from players.
  • Casinos differentiate themselves through superior guest service 

Financials

  • Gaming operations  
    • Recognize that this business is under duress.  Partly offset revenue losses with better margins and reduced capex dramatically over the last 3 years.  If you look at gross margin less capex, their modified FCF has grown.
    • They are really encouraged by their new products this year.  Unlockable content on games - think that this is a real opp to reduce costs and increase box longevity.  Power bucks jackpots- more frequent jackpots.  They can now do interstate jackpots for the first time and on/off line jackpots.  
    • Continue to focus on content for localized markets, i.e. locally attuned content. 
  • Online gaming
    • Social gaming can help them test games before going into market in land-based casinos. 
    • They have 1.7MM users.
    • NJ update:  9 sites have launched, 50k registered to play.  IGT's approach to NJ is like a cable channel for them.  20 slot games available; nearly 5MM wagers placed; IGT content viewed as superior to others;  So far in NJ, there are 3 sites that are outperforming materially.
  • Feel like it's all about eliminating friction points in gaming.  Social will let them get customer reviews earlier in the developmental cycle.
  • Now over 40% of IGTs workforce is tied to equity performance vs just a handful before.  75% of their employees now like working at IGT and would recommend working there.

Q & A

  • Think about products across silos like i-Gaming vs NA sales.  People are also really interested about play testing on Double Down. 
  • They are really bullish on international but timing is vague.  On Macau, they believe that they have a good shot of winning some systems and making slot sales.  Italy will come online in the tail end of 2014/ early 2015 (wasn't this supposed to have happened a few years ago?)
  • Player acquisition benefits on DoubleDown are a new area of business for them
  • In NJ, they will take a cut of the wagers
  • How will they make money in CA as they are legalizing online poker?  It's not really where you make money.  Rake based and no loyalty. Still thinks that CA has some hurdles to overcome.  Thinks customers want to have a poker option but want to play other games.  They will not participate in Poker-only markets. Don't think that you can really make money.
  • From a capex perspective, it will be back-ended this year with the introduction of a new cabinet.  Investors should be happy if they exceed capex because it means that they found a place to profitably invest it.  Capex will be roughly flat YoY and a little back-end weighted.
  • New market opportunities
    • Feel that Greece will be a Canadian like size opportunity in each tranch. Best guess it's a 2014/2015 event for IGT.
    • Macau: 6 new casinos are coming
    • Italy:  Step one is distributing content on their machines (60% of the install base is eligible) - daily fee model.  Will go live in June.  And the a year later, they have a chance to introduce their boxes.
  • MGM and Wynn have their systems in Macau
  • DoubleDown isn't "whale-like."  Clearly, a smaller number of the 1.7 million people that come to their site actually wager. The players by their nature are casual.  She avoided the 80/20 question.
  • DoubleDown's differentiating quality is the continuous addition of new content. Expect their competition to be stiff.
  • Interstate jackpots are a huge opportunity

INITIAL CLAIMS, CONFIDENCE & RETAIL SALES: POSITIVE MOMENTUM

Takeaway: A trifecta of positive domestic macro updates this morning. Retail sales, Confidence, and Initial Jobless Claims all solid.

Despite the volatility and persistent distortions in the Initial Jobless Claims data over the last few months, the underlying trend in the labor market remains one of steady improvement.  Our Financials team breaks down this morning’s claims data in further detail below.

 

Elsewhere in domestic macro today, advance Retail Sales and Bloomberg’s weekly read on Consumer Confidence both came in strong. 

 

RETAIL SALES:  This mornings advance estimate of Retail Sales out of the Census Bureau reflected a positive October revision and strong November sales data across the various index aggregates.  Headline and Core retail sales accelerated on a MoM, YoY, and 2Y basis with furniture and electronics driving strength in the control group.  No need to over analyze this one – a solid report for the ~20% of the economy that is retail sales.  A granular breakdown of the data in the table below. 

 

INITIAL CLAIMS, CONFIDENCE & RETAIL SALES: POSITIVE MOMENTUM - Retail Sales Nov

 

CONFIDENCE:  After acutely tanking into and through the government shutdown in October, consumer and business confidence remained universally depressed across survey readings through November.  Early December readings out of Bloomberg and the University of Michigan suggest that hangover is lifting. 

 

The preliminary December reading from the Univ. of Michigan saw confidence improve +7.4 to 82.5 with the current conditions index leaping back towards mid-year highs.   

 

Similarly, this morning's bloomberg consumer comfort reading improved again sequentially to -30.9, nearly back to pre-October levels.  Absent another ‘exogenous shock’ and with the labor market improving and fiscal policy uncertainty ebbing on the margin, the path of least resistance for confidence appears to be higher.

 

INITIAL CLAIMS, CONFIDENCE & RETAIL SALES: POSITIVE MOMENTUM - Confidence Table 

 

- Hedgeye Macro 

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INITIAL CLAIMS:  The One Chart That Best Explains the Situation

The chart below sums up the dynamic in the labor market quite well. It's a raw chart of NSA 1-week claims and it shows the mismatch the labor department's data is currently reflecting.

 

In 2008, 2009, 2010, 2011 and 2013 this last week was one in which claims historically surge, reflecting the seasonal layoffs following black Friday. 2012 was offset by a week making the comparability poor.

 

Just by eyeballing the chart, however, it looks pretty clear to us that the trend of steady improvement remains very much in place. There's no change to our view based on this most recent labor market datapoint.

 

INITIAL CLAIMS, CONFIDENCE & RETAIL SALES: POSITIVE MOMENTUM - JS 1

 

The Data

Prior to revision, initial jobless claims rose 70k to 368k from 298k WoW, as the prior week's number was revised up by 2k to 300k.

 

The headline (unrevised) number shows claims were higher by 68k WoW. Meanwhile, the 4-week rolling average of seasonally-adjusted claims rose 6k WoW to 328.75k.

 

The 4-week rolling average of NSA claims, which we consider a more accurate representation of the underlying labor market trend, was -13.1% lower YoY, which is a sequential deterioration versus the previous week's YoY change of -21.2%

 

INITIAL CLAIMS, CONFIDENCE & RETAIL SALES: POSITIVE MOMENTUM - JS 2

 

INITIAL CLAIMS, CONFIDENCE & RETAIL SALES: POSITIVE MOMENTUM - JS 3

 

Joshua Steiner, CFA

 

Jonathan Casteleyn, CFA, CMT

 


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INITIAL CLAIMS: POSITIVE MOMENTUM IS ALIVE AND WELL

Takeaway: There's no indication of softening in the labor market based on the most recent data.

The One Chart That Best Explains the Situation

The chart below sums up the dynamic in the labor market quite well. It's a raw chart of NSA 1-week claims and it shows the mismatch the labor department's data is currently reflecting. In 2008, 2009, 2010, 2011 and 2013 this last week was one in which claims historically surge, reflecting the seasonal layoffs following black Friday. 2012 was offset by a week making the comparability poor. Just by eyeballing the chart, however, it looks pretty clear to us that the trend of steady improvement remains very much in place. There's no change to our view based on this most recent labor market datapoint.

 

INITIAL CLAIMS: POSITIVE MOMENTUM IS ALIVE AND WELL - 5

 

The Data

Prior to revision, initial jobless claims rose 70k to 368k from 298k WoW, as the prior week's number was revised up by 2k to 300k.

 

The headline (unrevised) number shows claims were higher by 68k WoW. Meanwhile, the 4-week rolling average of seasonally-adjusted claims rose 6k WoW to 328.75k.

 

The 4-week rolling average of NSA claims, which we consider a more accurate representation of the underlying labor market trend, was -13.1% lower YoY, which is a sequential deterioration versus the previous week's YoY change of -21.2%

 

INITIAL CLAIMS: POSITIVE MOMENTUM IS ALIVE AND WELL - 1

 

INITIAL CLAIMS: POSITIVE MOMENTUM IS ALIVE AND WELL - 2

 

INITIAL CLAIMS: POSITIVE MOMENTUM IS ALIVE AND WELL - 3

 

INITIAL CLAIMS: POSITIVE MOMENTUM IS ALIVE AND WELL - 4

 

INITIAL CLAIMS: POSITIVE MOMENTUM IS ALIVE AND WELL - 6

 

INITIAL CLAIMS: POSITIVE MOMENTUM IS ALIVE AND WELL - 7

 

INITIAL CLAIMS: POSITIVE MOMENTUM IS ALIVE AND WELL - 8

 

INITIAL CLAIMS: POSITIVE MOMENTUM IS ALIVE AND WELL - 9

 

INITIAL CLAIMS: POSITIVE MOMENTUM IS ALIVE AND WELL - 10

 

INITIAL CLAIMS: POSITIVE MOMENTUM IS ALIVE AND WELL - 11

 

INITIAL CLAIMS: POSITIVE MOMENTUM IS ALIVE AND WELL - 12

 

INITIAL CLAIMS: POSITIVE MOMENTUM IS ALIVE AND WELL - 13

 

INITIAL CLAIMS: POSITIVE MOMENTUM IS ALIVE AND WELL - 19

 

INITIAL CLAIMS: POSITIVE MOMENTUM IS ALIVE AND WELL - 14

 

Yield Spreads

The 2-10 spread rose 1 basis points WoW to 255 bps. 4Q13TD, the 2-10 spread is averaging 237 bps, which is higher by 3 bps relative to 3Q13.

 

INITIAL CLAIMS: POSITIVE MOMENTUM IS ALIVE AND WELL - 15

 

INITIAL CLAIMS: POSITIVE MOMENTUM IS ALIVE AND WELL - 16

 

 

Joshua Steiner, CFA

 

Jonathan Casteleyn, CFA, CMT

 


Pair Trade: Long Lorillard (LO) vs. Short Philip Morris (PM)

As we head into year-end, one pair trade we like in particular is long LO and short PM (Note: LO is already in our portfolio; we’re waiting on price with PM).

 

Below is a breakout of the two names:

 

Lorillard:

  • Outperformance based on an advantaged cigarette portfolio and leading share in the e-cig category.
  • Continued strong demand for its full-flavored offerings and dominant share of menthol (~85% of its portfolio). Both are contributing to volume outperformance versus the industry (in the last quarter LO’s vol. +3.5% versus industry’s avg. -4%).
  • Growth in menthol supported by positive demographic shifts to the menthol category:
    • According to 2012 data from the National Survey on Drug Use and Health (NSDUH), over the last decade, the number of adult African-American menthol smokers has increased at a 2% CAGR, and at a 7% CAGR for Hispanics.  As of 2012, this equates to 84% of African-American smokers smoke menthol; the figure for primary menthol smokers among Hispanics is 47%.
    • Over the last decade, the adult African-American smoking population has increased at a 0.4% CAGR, whereas the adult Hispanic smoking population has increased at a 0.3% CAGR. We expect these trends to continue which should support the outperformance of LO’s menthol portfolio.
  • Lorillard continues to push gross profit margins higher through pricing and cost savings, improving 80bps to 37.1% in the quarter.  
  • The domestic retail share of the menthol market rose to 40.4%, an increase of 0.8 share points versus the prior-year quarter.
  • We’re bullish on Lorillard’s rollout of “Newport Gold” – a non-menthol compliment to “Red.”
  • We expect the FDA to punt on banning menthol cigarettes over the intermediate term given the lack of definitive and recognized studies that menthol is more harmful than non-menthol cigarettes. We also believe that the EU Parliament’s decision to ban menthol does not provide a useful guide to FDA policy given the sheer market size difference (Menthol = 31% of the U.S. cigarette market vs. 1-2% in Europe).
  • E-cigs: Lorillard was the first Big Tobacco company to market with the acquisition of “Blu” branded e-cigs in April 2012 for $135MM.
  • Despite only representing 4.9% of the portfolio, last quarter Blu saw strong sales growth of 11% quarter-over-quarter (+350% year-over-year) to $63MM.
  • LO CEO Murray Kessler’s e-cig strategy appears to forgo short-term profits for long term gains: he sold e-cigs at break-even in the quarter and was able to boost Blu’s market share to 49% from 40% in the previous quarter. We expect similar trends as LO attempts to capture brand loyalty. Over time, we do think that e-cigs can be margin-enhancing to the combined cigarette category.
  • The company became an international e-cig dealer through its purchase of UK-based SKYCIG in October 2013 for £30MM in cash, plus an additional £30MM to be paid in 2016 based on the achievement of certain financial benchmarks.
  • SKYCIG is a three year old company with ~ 300,000 users in the UK (there exists around ~ 10MM smokers in the country) that also happens to have nearly identical branding to Blu.
  • LO is trading above our intermediate term quantitative TREND level of support. We see the stock appreciating to $60 to $65 over the intermediate term.

Pair Trade: Long Lorillard (LO) vs. Short Philip Morris (PM) - vvv. LO

 

 

Philip Morris:

  • PM is plagued by a series of headwinds. To wit: a weak macro environment, challenging FX, excise tax hikes, and volume declines in key geographies.
  • While last quarter the company saw the top line perform in line with consensus, and showed a big improvement sequentially of +0.1% versus -2.5% in Q2 2013, Q3 was against a very easy comp of -5.3% in Q3 2012. We see tougher comps ahead.
  • PM is taking volume declines: last quarter -5.7% was a deceleration vs the previous quarter’s -3.9% and underperformed the industry’s -4%. We expect Philip Morris has taken much of its pricing and will struggle to stem volume declines.
  • We expect weakness in core geographies to continue to weigh on results, not least of which is the EU which is forecast to be down -7% to -8% in 2014. France has been a negative outlier and we continue to believe that the tax policy of President Francois Hollande will impair consumer confidence.
  • PM will also be hit with increased excise taxes in key geographies like Russia (the impact to volume est. -9% to -11%) and the Philippines (no guidance, could be larger than Russia),
  • Philip Morris recently disclosed that there has been an uptick in illicit trade, which we expect to push higher alongside additional tax hikes. 
  • In December, PM announced that it is acquiring a 20% interest in Russian Megapolis Group for $750M. Longer-term, we believe this is positive for the company (Russia is the world’s second largest market behind China and Megapolis handles 70% of Russia’s cigarette volumes through its distribution agreements).
  • PM also announced in late November that it will accelerate the launch of an electronic cigarette to mid-2014 (versus previous guidance of 2016/7) at a cost of $100MM.
  • We see 2014 setting up to be a year of investment (Russian acquisition and e-cig platform) and 1H results to drag in concert with this investment and the continuation of broader macro headwinds.
  • The level of uncertainty in PM’s earnings power has been clearly reflected in its EPS guidance: the company has revised its 2013 guidance lower over each of the last three straight quarter this year! Consensus is currently at $5.57 for 2014.
  • PM is trading below our intermediate term quantitative TREND level of resistance. We’ll be managing its trading range on the downside.

Pair Trade: Long Lorillard (LO) vs. Short Philip Morris (PM) - vvv. PM

 

Matthew Hedrick

Associate


ICI Fund Flow Survey - Year-To-Date Tallies Display Great Rotation Underway

Takeaway: Redemptions continued in bonds last week and equities had slight inflows. YTD the rotation is underway with bond outflows and equity inflows

Investment Company Institute Mutual Fund Data and ETF Money Flow:

 

Total equity mutual fund flow for the week ending December 4th was $1.9 billion, a below average weekly inflow for stock funds this year but none-the-less a slightly positive indication. Within the total equity inflow result, domestic equity mutual funds lost $1.0 billion, the second consecutive weekly outflow in U.S. stock funds with International equity funds posting a $2.9 billion inflow, on par with last week. Total equity mutual fund trends in 2013 however now tally a $3.2 billion weekly average inflow, a complete reversal from 2012's $3.0 billion weekly outflow 

 

Fixed income mutual funds continued persistent outflows during the most recent 5 day period with another $4.4 billion withdrawn from bond funds. This week's draw down improved slightly sequentially from the $4.7 billion outflow the week prior but ongoing redemptions have now forced the 2013 weekly average for all fixed income funds to a $1.2 billion outflow, which compares to the strong weekly inflow of $5.8 billion throughout 2012

 

ETFs experienced mixed trends in the most recent 5 day period, with equity products seeing slight inflows and fixed income ETFs seeing moderate outflows week-to-week. Passive equity products gained $207 million for the 5 day period ending December 4th with bond ETFs experiencing a $331 million outflow, an acceleration from the $251 million redemption the 5 days prior. ETF products also reflect the 2013 asset allocation shift, with the weekly averages for equity products up year-over-year versus bond ETFs which are seeing weaker year-over-year results

 

With year-end tallies almost complete with only 2 full work weeks left in 2013, we have compiled the annual totals from the ICI for mutual fund results and also from Bloomberg for ETF production throughout 2013. In the Hedgeye Asset Management Thought of the Week below, we outline the resurgence in stock fund inflows, the emerging outflows in bond funds, and the record years for equity ETF inflow and commodity ETF outflows


 

ICI Fund Flow Survey - Year-To-Date Tallies Display Great Rotation Underway - ICI chart 1

ICI Fund Flow Survey - Year-To-Date Tallies Display Great Rotation Underway - ICI chart 2

 

 

For the week ending December 4th, the Investment Company Institute reported slight equity inflows into mutual funds with over $1.9 billion flowing into total stock funds. The breakout between domestic and world stock funds separated to a $1.0 billion outflow into domestic stock funds and a $2.9 billion inflow into international or world stock funds. These results for the most recent 5 day period within stock funds were bifurcated, with the outflow in domestic stock funds below the weekly average of a $551 million inflow and with world stock fund production slightly above the $2.6 billion weekly inflow average. The aggregate inflow for all stock funds this year now sits at a $3.2 billion inflow, an average which has been getting progressively bigger each week and a complete reversal from the $3.0 billion outflow averaged per week in 2012.

 

On the fixed income side, bond funds continued their weak trends for the 5 day period ended December 4th with outflows staying persistent within the asset class. The aggregate of taxable and tax-free bond funds booked a $4.4 billion outflow, a slight sequential improvement from the $4.7 billion lost in the 5 day period prior. Both categories of fixed income contributed to outflows with taxable bonds having redemptions of $3.0 billion, which joined the $1.3 billion outflow in tax-free or municipal bonds. Taxable bonds have now had outflows in 23 of the past 27 weeks and municipal bonds having had 27 consecutive weeks of outflow. While the sharp redemptions that marked most of the summer and the start of the third quarter have moderated, the appetite for bonds has hardly rebounded. The 2013 weekly average for fixed income fund flows is now a $1.2 billion weekly outflow, a sharp reversal from the $5.8 billion weekly inflow averaged last year.

 

Hybrid mutual funds, products which combine both equity and fixed income allocations, continue to be the most stable category within the ICI survey with another $894 million inflow in the most recent 5 day period, although the past 2 weeks have been below year-to-date averages. Hybrid funds have had inflow in 25 of the past 27 weeks with the 2013 weekly average inflow now at $1.5 billion, a strong advance versus the 2012 weekly average inflow of $911 million.

 

 

ICI Fund Flow Survey - Year-To-Date Tallies Display Great Rotation Underway - ICI chart 3

ICI Fund Flow Survey - Year-To-Date Tallies Display Great Rotation Underway - ICI chart 4

ICI Fund Flow Survey - Year-To-Date Tallies Display Great Rotation Underway - ICI chart 5

ICI Fund Flow Survey - Year-To-Date Tallies Display Great Rotation Underway - ICI chart 6

ICI Fund Flow Survey - Year-To-Date Tallies Display Great Rotation Underway - ICI chart 7

 

 

Passive Products:

 

 

Exchange traded funds had mixed trends within the same 5 day period ending December 4th with equity ETFs posting a slight $207 million inflow, a drastic drop from the $11.4 billion subscription the week prior. The 2013 weekly average for stock ETFs however is still a $3.3 billion weekly inflow, nearly a 50% improvement from last year's $2.2 billion weekly average inflow.

 

Bond ETFs experienced a moderate outflow for the 5 day period ending December 4th, with a $331 million redemption a sequential acceleration from the week prior which produced a $251 million outflow for passive bond products. Taking in consideration this most recent data, 2013 averages for bond ETFs are flagging with just a $253 million average weekly inflow for bond ETFs, much lower than the $1.0 billion average weekly inflow for 2012.

 

 

ICI Fund Flow Survey - Year-To-Date Tallies Display Great Rotation Underway - ICI chart 8

ICI Fund Flow Survey - Year-To-Date Tallies Display Great Rotation Underway - ICI chart 9 

 

 

Hedgeye Asset Management Thought of the Week: 

 

Some analysts as well as media outlets are still in denial about the start of a rotation from U.S. fixed income into U.S. stocks, however the debate in our minds is a short one. With only a few weeks left in 2013, we have compiled the year-to-date flow totals from the Investment Company Institute for mutual funds and from Bloomberg for exchange traded funds. The trends from our perspective are quite clear. Within mutual funds, the $1 trillion that has come into bond funds since 2008 (or the start of the Fed's quantitative easing program) has started to unwind with the first outflow in fixed income funds within the ICI data since 2007. The fixed income outflow of $63 billion through the first 49 weeks of 2013 still pales in comparison to the $303 billion inflow that came into fixed income last year in 2012 (can you say blow off top?) and also the record year of 2009 when the Great Rotation from stocks into bonds started and $379 billion came into fixed income funds. While the over $155 billion outflow in the back half of 2013 has been the sharpest bond outflow in history (most significant 27 week ouflow sequence), the first half of 2013 experienced nearly $100 billion of inflow into fixed income to net to the fairly insignificant outflow year-to-date of $63 billion currently. Our regression model of bond performance to bond outflows continues to forecast a total outflow of $200 billion through 2014 meaning that this current rotation from bonds into equities could have quite a tail to go.

 

Conversely, the nascent production in stock funds (while consistently dismissed) has been historically quite impressive being double that of the $74 billion that came into equity mutual funds in 2007. While the $159 billion running inflow into stock funds thus far in 2013 has had an international fund bend ($131 billion has gone into international stock funds versus just $28 billion into domestic equity funds), there is still ample reason to think that U.S. stocks can continue this turn in redemptions that has plagued them for all 6 years of ICI data before '13 (still record amount of cash on U.S. corporate balance sheets, generally low yields can allow stocks higher multiples, and the unwinding of the commodity super cycle and U.S. bond fund outflows needing to be invested somewhere). Bloomberg's annual tally of ETF information has equally interesting thematic value with the strong mutual fund trends in equities being validated on the stock ETF side, with another record year for ETF inflow (equity ETFs for 2013 have netted $173 billion in '13, higher than the $117 billion in '12 and a new record from the prior high of $127 billion in 2008). Fixed income interest in ETFs is matching its mutual fund brethren as well with passive bond products taking in a paltry $11.3 billion in 2013, a drastic drop from the record $56.4 billion last year (even the new fast growing ETF vehicle is not summoning up new interest from investors with the potential multi-year down cycle in fixed income). Commodity ETFs have had a year to forget with the formerly exuberrant gold market having been knocked down for a 20% plus loss and incrementally higher U.S. interest rates broadly supporting a higher dollar which has sent overall commodity indices lower. Commodity specific ETFs have had a record $25.1 billion redemption this year, the first negative year since the start of our data set in 2007, and a far cry from the formerly worst year of just a $600 million inflow in 2011.

 

We don't estimate that a substantial change from these current trends will occur until mid 2014 (these current themes are intact with forthcoming Fed tapering to continue to hurt the demand for fixed income and that U.S. stocks can at least have a positive start to 2014). Thus our favorite long idea remains T Rowe Price (TROW), a manager with industry leading equity performance to hoover up new industry equity flows and also a strong balance sheet to seed new products and also continue its streak of 26 consecutive years of dividend increases.

 

 

ICI Fund Flow Survey - Year-To-Date Tallies Display Great Rotation Underway - ICI chart 10

ICI Fund Flow Survey - Year-To-Date Tallies Display Great Rotation Underway - ICI chart 11

 

 

Jonathan Casteleyn, CFA, CMT 

 

 

 

Joshua Steiner, CFA


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