Financial Research
Signal from Noise
- Signal from Noise
Deutsche Bank is priced very cheaply compared to its main competitors. It also is in a turnaround and had its first profit in many years; we think more profitable quarters lie ahead. The stock, we believe, presents a significant opportunity, particularly given its last earnings beat. Germany's largest lender posted a full-year net profit of 113 million Euros compared to an expected loss of 201 million euros. Similarly, the bank netted a 51 million euro profit in the fourth quarter compared to what analysts thought would be a 325 million loss. This is even more incredible given that the company is undergoing aggressive restructuring, which was the primary reason for its 5.7 billion loss in 2019. It did better in a pandemic year than a normal one! Higher revenues and cost-cutting more than offset a rise in loan-loss provisions due to the virus. The positive momentum makes the bank's Price/Book of .35 seem like a bargain. Source: Seeking Alpha One thing that has been true during the pandemic-induced global depression on both sides of the Atlantic that was not true in the Global Financial Crisis is that large banks have been crucial in mitigating the effects of economic devastation rather than being a source of it. Deutsche Bank (DB) was an essential part of the German Government’s response, as were many American banks in the distribution of stimulus, working with distressed lenders and other similar activities. Deutsch Bank has passed a real-life stress-test with flying colors, has managed impressive growth in a domestic negative rate environment, has much more limited credit risk than even its American peers (who are valued far higher), and has seen an impressive and well-managed come-back of its previously beleaguered investment bank. In addition to this, management has proven quite adept at making significant cost cuts, shedding problematic bad bank assets and subsidiaries, and stabilizing its funding costs. S&P just upgraded the bank's credit outlook. Barclays upgraded soon after. Funding costs had already come down to around the cost of peers before this positive development. Source: Bloomberg A Euro-Epicenter, Contrarian, and Value Stock There are a few major reasons we like this stock. Is it essentially a European 'Epicenter' stock with incredibly low valuation risk compared to its peers? Yes, it certainly is that. However, we also think it makes an additional portfolio addition for a few reasons, particularly on market days like today when we are all reminded that visceral pain volatility can cause. The bank has most likely seen it through the worst of the pandemic; Germany is less dependent on tourism than its southern counterparts. The German credit assets that DB has on its books are pristine compared to portfolios of American credit card debt. Did Deutsche Bank also pass all of its restructuring plan goals with flying colors? Yes, it did, and we always love to see that. In addition to this, though, the vast majority of the recent outperformance was due to the investment bank. While DB retains enormous amounts of traditional banking assets, compared to its peers, the investment bank is more critical to underlying profitability. The IB performance was outstanding in 2020, and while some bears might expect it to return close to 2019 levels, we think it is more likely that DB has increased its market share and will maintain IB revenues higher than pre-COVID levels. This, we believe, gives it more counter-cyclical resilience than its European peers. The 'virtuous cycle' predicted by CFO von Moltke appears to be coming to fruition as funding costs go down, profits go up, which then, in turn, inspire funding costs to reduce even further. It looks to us like the firm's cost of funds will continue reducing to pre-pandemic levels, directly impacting profitability positively. The reputational damage done in the 2008 crisis has begun to recede in America. Still, amongst investors, European banks and DB have been persona non grata, as evidenced by the change in Price/Book over ten years. However, DB's management has significantly turned the picture around over the last year and has met or exceeded every single target concerning its aggressive restructuring plan, as showed above. Source: Seeking Alpha Many of the issues people associate with European banks have never been problems the German Bank, whose native culture is stern and conservative in terms of credit risk. The question of this bank was always achieving profitability and revenue growth. It has clearly turned the corner and answered this question in a way that pleases the market. The investment bank languished over previous years as the bank's cost of funds went materially above its peers. This can be a death sentence in investment banking and was likely the reason for the dismal returns over recent extended periods. As we’ve shown, this has begun to reverse, as evidenced by the bumper-year that their IB just had. It significantly outperformed expectations throughout 2020. We believe the outperformance will continue and that this will be returned to shareholders. What About The Technical Picture? Deutsche Bank (DB) has performed well this year and has come significantly off its’ COVID-19 lows. We took a look at it from a technical perspective and found some interesting insights. We think the name has a negative recency bias, which negatively affects the price and sentiment around the stock, but we think this will reverse. Very few analysts have a buy rating on the stock, which is a contrarian positive for us, particularly after looking at the bottom-up picture and success the bank has had under incredibly trying circumstances over the past year. Management is engaged, accountable, and on-track. Technical analysis suggests that the next level of upward resistance will be at $31. So, we think there’s much upside in this name and its early days in a 'Cinderella' story. Source: Bloomberg Risks And Where We Could Be Wrong The investment banking business is a difficult one, and fortunes can turn quickly. We would say this is a significant risk. Suppose the activity that DB was earning fees from and the volatility it was successfully trading subsides. In that case, profitability may take a hit, mainly since the investment banking business is primarily responsible for recent outperformance. The business's accrual side still faces a negative rate environment and an uncertain economic picture; however, we think it is likely the German bank is more insulated from these risks than its Southern peers. Any re-emergence of European sovereign debt issues will probably weigh heavily on the bank, but again, less so than similarly sized peers from less financially stable nations.
- Signal from Noise
Market Discounts Recession; GDP, EPS Growth Worries Mount
– Our base case is U.S. virus peak in May and SPX bottoms around 2200-2400 – Now market doesn’t care that pandemic growth seems to be slowing in some places – PMs seem to have written off 2020 and look to 2021, but EPS visibility low Source: FSInsight, Bloomberg Having lived through three bad bear markets, I thought I’d seen everything. But the rapid demise of stock prices in this one is nothing short of astounding. These are historic times. There are two things investors are afraid of, both of which remain hard to handicap, the extent of the coronavirus spread and the eventual knock on economic effects. The S&P 500 index is down over 29% since the Feb. 19 high of 3386. What’s been baffling is that there are incipient signs the COVID-19 virus is coming under control in many of the hardest hit places. As I’ve noted before, China, where the virus originated, is already showing lower infection and death rates, as is South Korea. While you won’t see that in the screaming headlines, there are some who think the pandemic will slow. For example, Israeli Nobel Laureate Michael Levitt said recently that “the end of the pandemic is near.” Now increasing talk like that should stabilize the stock market—eventually. However, and this is a big however, there’s been significant damage to the investor psyche—no matter how obvious it becomes that the pandemic is over—and that could go on for a while. That is worrying short term. Investors should look dispassionately at the market, but that is hard to do and at times like these when often sentiment wins out. There’s an old Wall Street saying about bear markets, “When you should be buying, you won’t.” I’m convinced that in the three to five-year time frame this is a buying opportunity, but the fear factor is too high for many to overcome. And that’s understandable. I believe the coronavirus scare, though serious, has been overhyped and that in a few month’s time we will all be wondering why the market took it so badly. That doesn’t mean the broad market will recover and old high of 3386 on the SPX certainly looks a long way off now. Unfortunately, the knock effects—again something I’ve written about previously—have already become a self-fulfilling prophecy in the oil market, where crude prices have plunged to $25 per barrel from over $60 a few months ago, on fears of a glut and lower energy consumption globally. While that might help consumers, it won’t help an already beaten up oil sector or their creditors, or employment levels. That will begin to affect the industries that sell to oil companies and car companies, and so on and so on, until the economy as a whole is hurt. Not to sound callous but stock prices probably reflect a declining profit growth much more than coronavirus itself, even though the latter started the whole thing rolling downhill. The market just wants it all to stop and no one knows when that’s going to happen. There could be a negative wealth effect. People have lost gobs of money in their stock accounts and 401ks. That hurts and could put a damper on consumer activity for a while, particularly if the market doesn’t stabilize. The bears are piling on as for the first time in many years—for most of them—their predictions have come true. The market is desperately trying to estimate what this means for the global and U.S. economic growth, as well as profits. Here again there’s little data that can be said definitive, particularly as the outbreak hasn’t completely finished. The estimates vary widely. Goldman Sachs, the investment bank, for example said Monday that its U.S. GDP growth forecast for the 1H20 was reduced to zero, with a decline of 5.0% for the second quarter. Ian Shepherdson, chief economist at Pantheon Macroeconomics, in a note to clients on Monday night said a 10% drop in possible in 2Q20 after a 2% drop in 1Q20. Ouch. Others, however, don’t see it that bad. For example, The Wall Street Journal recently reported that its monthly economists’ survey expects, on average, gross domestic product to contract to 0.1% in 2Q vs a previous projection of 1.9%. They see growth of 1.2% this year, down from 1.9% Annual growth was 2.3% in 2019. Just for comparison, Bespoke Investment Group says 5% declines are rare. Since 1950, there have only been six prior quarters where GDP declined by 5% or more with the most recent being back in December 2008. Moreover, all those six quarters contractions of 5% or more were either immediately preceded or followed by another quarter of negative growth averaging a decline of over 2%. My colleague Tom Lee has a base case that sees 65% probability of a U.S. peak case rate in May with a 2%-3% hit to 2Q GDP. That suggests an SPX level of 2200-2400, roughly where we are now. Source: FSInsight, Bloomberg It’s difficult to estimate what this means for EPS of the SPX in 2020. It will likely be lower than the $163 last year. But how much lower? Guidance is coming down and that will continue. One silver lining is that smart managements will take the opportunity to kitchen sink any and all corporate problems into 1Q and 2Q EPS, corona related or not. But I’m getting ahead of myself. Given the over 30% drop, it seems to me the market has already discounted a terrible 2020 earnings. History suggests a permanent 30% drop in EPS isn’t rationale. Likely, institution al investors are already looking at 2021 EPS. If COVID-19 continues to be a serious pandemic with a long trajectory then here are some stocks whose businesses I think could outperform in terms of EPS and perhaps their stock prices as well. They run from healthcare to videogames. (See chart nearby.) (The writer currently owns GILD shares.) Where I could be wrong: The coronavirus spread is unpredictable and its mortality rate could worsen appreciably. It could take much longer than expected to be contained. Bottom Line: The stock market has taken a hammer blow and it will stabilize when coronavirus cases peak and when we have a clearer idea of 2020-21 SPX EPS. Prior “Signals” Date Topic Subject / Ticker The Signal 3/11/20 Market COVID-19 COVID-19 Worry Overblown; Market Discounts Recession 3/4/20 Stock iHeartMedia (IHRT) iHeartMedia Stock Could Rise on Cost Cuts, Digital Revenue 2/26/20 Market South Korean Stock Market When Virus Fears Ease, Hard Hit Korean Stocks Look Cheap 2/19/20 Q&A Atlantic Investment Management Atlantic’s Concentrated Approach Yields Strong Returns 2/12/20 Stock Casper Sleep (CSPR) Casper Stock Might Not Let You Get a Whole Lot of Sleep 2/5/20 Stock Arch Coal (ARCH) After Sentiment Plunge, Arch Coal Stock Looks Inexpensive 1/29/20 Sector Healthcare Healthcare Looks Inexpensive; Some Healthy ETFs to Play 1/22/20 Stock Spirit Airlines (SAVE) Why Spirit Airlines Shares Could Take Off in 2020 1/15/20 Market 4Q19 EPS Season Market to Focus on SPX EPS Growth after 4Q19 EPS Season 1/8/20 Stock Alibaba (BABA), Tencent (700 HK) Alibaba, Tencent Look Attractive on Strong Growth Potential 1/2/20 Stock 2019 Report Card Signal From Noise 2019 Picks: 74% Win Rate, Beat SPX 12/26/19 Market Stock Market 2020 2020 Could Be the Year “Animal Spirits” Return to Equities 12/18/19 Stock Ulta Beauty (ULTA) Ulta Beauty Shares Whacked 35%; Stock Looks Cheap 12/11/19 Market UK Stock Market Conservative Election Win Should Boost Lagging UK Stocks 12/4/19 Stock Capri Holdings (CPRI) Capri Holdings Recovery, Makeover Could Send Stock Higher 11/27/19 Style Value When a Value Stock Is a Value Trap
- Signal from Noise
Six Flags (SIX) Is An Industry-Leading Re-Opening Play With Potential For Upside Surprise
Six Flags (SIX) reported earnings on February 24th. The company outperformed expectations. The loss of a dollar a share was roughly in line with estimates, while Its revenue loss was significantly less than expected by consensus. Other positive undercurrents in this earnings report suggest that the nadir of the crisis for theme parks, in North America at least, has passed. That’s good news for Six Flags since its’ facilities blanket the continent. The company recently announced it plans to open all 26 locations in the coming season. Consumers flush with stimulus coming out of a depressing and trying period marked by detachment from the experiential economy seem poised to answer the company’s invitation. Source: Six Flags Investor Relations Despite the obvious financial hardship with missing a season due to a global pandemic, many metrics appear to indicate that when consumers do come back at the levels, or in excess of them, that were common prior to the pandemic they will be spending more. This is not an incredibly difficult business to understand; a lot of customers will be coming to the company’s parks as long as progress on the virus isn’t significantly reversed and by the looks of it they will be spending more than they have in the past when they do. This appears to be at least partially a result of adept management and product refinements like significantly upgrading dining options and also facilitating contactless payment. Pent-up demand meeting a streamlined operation is the primary thrust of why we like the stock, but there’s also a great management team leading the firm and a convergence of once-in-a-lifetime factors that make us believe this coming season will be one to remember from an earnings perspective. Source: Company Reports, Q4 Strong Consumer Plus Improving Healthcare Situation Equals Happy Shareholders The strength of the US consumer going into what is looking like will soon be a post-pandemic economy is sure to raise many boats. Still, we think industries like theme parks and other luxuries necessarily foregone during the past year's trials will especially benefit, as will risk-adjusted returns. After all, we think as a general principle, a lot more people would be amenable to funnel cake and roller coasters than, say, staying at home and watching Netflix on your Peloton. Get the point? We are on the verge of a sea-change in consumer psychology; the over-spending on goods that marked the pandemic will likely reverse in favor of services, particularly those of an experiential nature. Indeed, there is pent-up demand for gathering, interaction and fun as there should be, and we think that this demand paired with a robust US consumer balance sheet means upside surprise in the company's most significant KPIs is far more likely than not. Source: SeekingAlpha Humanity has been through one of the most traumatic and unsettling episodes of the modern age. The product Six Flags is offering is in this light more appealing than it was prior to this catastrophe. Even more so when you consider the extensive, consumer-informed, improvements they have made to their product. This paired with the largest footprint in the industry makes us think SIX is a pretty safe re-opening play and that it’s more likely the stock is headed toward 10-year highs instead of toward the prices marked in the crescendo of simultaneous global lockdowns. While some operators like DIS and Universal have a high-volume singular model with limited geographic reach, even in the event of some setbacks with the healthcare situation SIX is better positioned to collect revenue from parks in areas where outbreaks aren’t prevalent. This is simply not an option for many operators if a region like Southern California becomes subject to an outbreak. We think that macro-level spending on the products of ‘Epicenter’ stocks will be significantly higher than in regular times. Perhaps no product better exemplifies this desire, which we think will surprise the upside. Millions of parents are likely eager to take their long-isolated children out for a day or weekend of outdoor fun. The safety of the experience being offered by Six Flags also seems to us to exceed many of their competitors, and the sheer number of their parks gives them a competitive advantage over peers. SIX operates more parks than any company in the world and thus benefits from geographic diversity that other significant operators do not. We monitor healthcare data and the pace of vaccinations exceptionally closely, and developments are overwhelmingly positive. Some investors may question whether or not the stock has run up too far already and whether it's time to take gains. We want you to remember that the run-up in the stock price has happened in anticipation of this moment. Six Flags is on the verge of re-opening nearly all of its properties. The company's management is convinced that pent-up demand paired with their impressive belt-tightening and modernization during the downtime should result in some highly profitable quarters on the horizon, as are we. Have a Touching and Touchless Outdoor Day With Family and Friends When you think of the indirect competition of their parks like movie theaters, restaurants, vacation-travel, and even home-entertainment and then take into account the touchless experience introduced by management as well as the outdoor nature of their theme parks, you can see why millions of Americans may be attracted to this activity as one of their first re-engagements with the experiential economy. When you consider the location of Six Flags park and the populations that live within 100 miles, it is easy to see why the risk for attendance seems to be to the upside. Our Head of Research, Tom Lee, coined the term 'Epicenter' stocks in the heat of the crisis. The term refers to companies that have been closest to the economic and social consequences of the COVID-19 Global Pandemic. Our 'Epicenter' stock picks have generally focused on the strongest and best-managed players within the most adversely affected industries. Six Flags (SIX) is a perfect example of a stock meeting these criteria. Theme parks, by some measures, were the most adversely impacted industry since operators are heavily dependent on the peak-season for the vast majority of revenue. In the case of Six Flags, during normal operating years, 75% of revenue is earned between Memorial Day and Labor Day. Similarly, labor expenses are concentrated during these periods. Thus, missing a season can put a poorly managed or overly leveraged operator out of business quite quickly. Six Flags should know, in 2009, market conditions much less devastating to the bottom line drove the company into bankruptcy. The company has weathered the worst crisis in the industry's history and used the interruption as a springboard to accelerate already-needed changes to boost brand-value, attendance and slash operating expenditures. Many 'Epicenter' industries that may have been behind the curve technologically have used the do-or-die nature of the situation to radically streamline their businesses in ways that naturally align with shareholders' incentives. Six Flags will be implementing a new CRM system that should boost sales and season passes. The company is also experimenting with using its enhanced surveillance and technological monitoring of the park to experiment with dynamic staffing. Their staff levels will now respond in real-time to guest traffic. Simple improvements like this in the single-segment business make a big difference, particularly if they converge with the flush balance sheet of stimulus-rich consumers who have cabin-fever. Total attendance declined 79% in 2020, and the company's cash position and debt schedule are all well-in-hand. The fact that the company is in as strong a position as it on the verge of the 2021 peak season is a testament to the competence of the management team led by Mike Spanos. In the second quarter of 2020 demand was at 25% of previous levels, in Q3 it was at 35% of previous levels. In the most recent quarter capacity of operating parks got up to 51% from previous levels. Do you see a pattern? So do we, and we think it’s just getting started. In addition to the aforementioned bullish harbingers hedge funds appear to be increasing exposure to SIX as well. Source: Tipranks. com Risks and Where We Could Be Wrong The key risk here is obviously any reversal in the vaccination timeline or any setbacks with regards to new variants of COVID-19. The financial condition of the company is pretty strong considering. Consumers seem poised to actively re-enter the market for the newly enhanced and improved Six Flags product. However, the future earnings of this company are about as closely correlated to the path of the virus as can be. Setbacks with regards to the healthcare situation will likely adversely effect price whereas better than expected outcomes will be supportive of continued appreciation.
- Signal from Noise
Real Networks: From Cautionary Tech Tale to AI Multi-Bagger
We are professional stock-pickers. While we may often recommend larger names, we always are on the lookout for small-cap, high alpha opportunities to provide for our subscribers. While there is a more significant amount of risk in small-cap stocks, appropriately sized positions that maintain portfolio diversity can provide solid risk-adjusted returns. Real Networks (RNWK) is a tiny name with no sell-side coverage and a complicated history that impedes investor attention from the exciting parts of the business. Thus, we’ve endeavored to make this article a comprehensive source of information on the stock and its uniquely experienced management. Source: Company Reports Real Networks is a small-cap name with a very outsized history. While this stock may look like a low-dollar, high-risk name with poor prospects, we took a closer look. After nearly being de-listed following a long, losing slog in digital media the company has done a true pivot toward exciting technology. In addition, the financial momentum is all moving in the right direction. After shedding Napster the company’s profit margin is 77%. EBITDA loss has been moving in the right direction for six consecutive quarters and the company will likely be cashflow positive next reporting period. Valuation looks low when compared with peers and the positive product developments. Source: SeekingAlpha The problematic legacy assets that investors hated have been dealt with by management. The exciting areas of free-to-mobile gaming and computer vision are set to become future cash cows. They grew at a more than healthy 110% over the last year. SAFR, their biometric facial recognition platform is in exploratory phases with the US Airforce, NTT Docomo in Japan, and T-Money in South Korea. It is landing new security clients on a regular basis and researching and collaborating to expand use-cases into healthcare, gaming, and education. The main reason we like this obscure stock has nothing to do with its history but is rather this exciting new product. While free-to-mobile gaming is an earner, we think SAFR is the potential homerun. It appears to have incredible upside potential, high-profit margins, and a plethora of use cases in the area of computer vision/facial recognition (really, it's the area of machine learning and artificial intelligence). In addition to strong prospects and positive financial momentum, the company’s management team appears to have the willingness, experience, and unique expertise to hit a home-run in their new growth areas. This stock has many intersecting things we like about it. It’s surveillance and security component make it adjacent to our 2021 Investing Theme of Rising Violence in the USA. The company has made impressive efforts to pivot toward healthcare during COVID-19 and is the only off-the-shelf, commercially available facial recognition platform that can recognize users through masks. One of our ‘Granny Shots’ themes focuses on investing in companies that provide and benefit from AI and automation. Conditional access to office buildings and healthcare use cases as a result of COVID-19 have only increased the commercial viability for the company’s computer vision product. It is not hard to see applications proliferating on an exponential basis as augmented reality and the 4th industrial revolution create new utility. There are rumors the company will be adding temperature sensing abilities to the platform, which would obviously be highly useful. Look at what Remark Holdings (MARK) price/sales ratio is to give you an idea of where the valuation of this stock is headed in the event of commercial success. Source: SeekingAlpha Seattle’s Best: Great Management Meets Commercially Viable AI Opportunity Despite recent rumblings of companies and employees moving to Texas and Florida, Seattle and Silicon Valley remain the undisputed centers of technology innovation in the world. They have different strengths and weaknesses in terms of the types of companies they produce. There is much literature on the differences you’ll find between Silicon Valley and Seattle we even found a cool infographic. One common thing observed by multiple VC’s is that entrepreneurs from Seattle tend to be better executers and those from Silicon Valley are better at ‘chest thumping’. Another emerging difference in Seattle, long-known for its dominance in cloud computing, is the edge that regional-hub is developing in machine-learning and artificial intelligence. This will serve Real Networks as it expands its product. The company’s turnaround harkens back to the ‘roll-up-your-sleeves-and-do-it’ attitude that was pervasive in the late 90s when it was one of the hottest places to work in tech. Indeed, the infectious energy at the company spawned a lot of the region’s most successful entrepreneurs. The story of how a company founded in 1994 as Progressive Networksby a former Microsoft executive to distribute political content eventually revolutionized the internet, fell out of favor and tried to reinvent itself until the brink of being de-listed is a fascinating one. Everyone loves an underdog. Instead of failing it resurrected itself as a leader in artificial intelligences application to biometrics. Along the way in this story, CEO Rob Glaser took on Microsoft and Bill Gates and won a $761 million settlement from his former employer and the man who passed him up to head up media efforts at Microsoft. So, to put it lightly the management team at Real Networks are no slouches. Mr. Glaser was once known as one of the leading billionaires in Tech and for his progressive politics. He was once one of the top donors in the Democratic party and has progressive credentials and government connections (US Senator Maria Cantwell is a Real Networks alumni) that should serve the company very well as it pursues federal contracts and image-conscience corporate clients. Indeed, it already has. Setelsa Security selected SAFR based partially on the ethical considerations that went into the platform’s development and its lack of bias compared to other platforms. The glory was short-lived as the immense commercial concessions he secured from Microsoft would soon be worthless in the face of Apple's superior platform and strategy. This is not typically the type of history management teams have in hot areas like emerging AI applications. Still, we think the company's dynamic CEO's seasoned management experience and connections should only work in the company's favor compared to the typical ‘start-up’, which is really what the growth businesses resemble in terms of upside, but with the downside mitigated by a stalwart management team that knows how to survive. In one light, Rob Glaser can be seen as a cautionary tale of late 90s excess, the guy who could only make it work with Tony Fadell, the iPhone's god father, for six weeks because of his bull-in-a-china-shop management style. On the other hand, it's impressive he kept this unlucky internet pioneer alive in the face of the documented unfair competitive pressures his platform was subject to. Cracking the B2C code at the convergence of media and the internet was never easy. We think this latest pivot, if nothing else, will be informed by experiences and relationships of a man who has one of the most storied Seattle tech careers of the 1990s boom. You can bet that when Amazon received complaints about its facial recognition software’s bias problem from shareholders (a problem RNWK’s platform doesn’t have) that senior folks at Amazon, including perhaps Mr. Bezos, became interested in what was going on in Rob Glaser’s shop. This should give you an idea as to the type of upside potential RNWK has. As Rob Glaser put it, in congruence with Seattle’s characteristic entrepreneurial humility, he sees the ‘largest, most robust, and most diverse commercial pipeline’ associated with the company’s computer vision advances since his early days in streaming. We think it could be a homerun for the minority owner of the Seattle Mariners. The experience from being in the trenches in some of the Technology industry's most storied and prolific battles seems to be a significant asset of Real Networks that many may miss given the first layer of information readily available on the company. The company’s CEO was also partner at an influential Seattle venture firm, Accel Partners. The start-up, entrepreneurial energy Mr. Glaser brings is supplemented by the board as well. Source: Company Reports When we think of the rise of technology in the latter part of the 20th century, we often remember the history from the winners' perspective. We point out to our subscribers that even though most of the stocks eventually went to zero in the height of the web boom, the ones that didn’t (the household names that changed all our collective lives forever) were more than enough to compensate for the loss. It is a rare thing indeed for a stock to have survived despite being on the wrong side of the powerful commercial forces that led to the most valuable companies in the world’s history. It's a testament to the company's espirit de corps and pro-innovation environment that it has survived the tumult since its heyday. Suppose you could get access to a hot Seattle AI startup as cheaply as you can with acquiring RNWK shares; you probably would. Instead of some kids with no management experience at the helm, you have one of the founding fathers of the digital media revolution. This is how we think of this investment, and if it didn’t have a scarlet letter in the tech world, it would likely be valued far higher. The company's foremost growth opportunity is a proven technology with many competitive advantages and is in the early stages of what could potentially be widescale commercial deployment. Risks and Where We Could Be Wrong There are always plenty of risks that could derail a small-cap stock whose primary profit engine is basically a captive technology startup. One of the primary risks we would see is that another entrant beats them in the race for technological superiority. This risk seems relatively low right now as customers seem to love and prefer their platform over others. Another key risk, which this company is well acquainted with, is how consumers will respond to the product. Backlash against facial recognition has already occurred in other contexts, but the company already seems to enjoy a reputation as leading the industry on ethical issues and lack of bias. Prior “Signals” DateTopicSubject / TickerThe Signal02/11/21ETFS&P High Beta ETF (SPHB)SPHB: Getting to Alpha By Way of Beta02/05/21StockExxon-Mobil (XOM)Why Exxon-Mobil Is A Buy Despite Mixed Earnings01/28/21SectorEnergy GICS-1 (XLE)If You Like TSLA’s 2020 Performance, Try The Energy Sector01/15/21StockFord (F) ‘Epicenter’ Stock With EV Upside and Great Management11/05/20StockIngalls & SnyderDespite Gyrating Markets, This Manager Returned 40% in ‘1910/21/20Stock10-K Filings Part 3Other Voices: Why Reading 10-K Filings Is Crucial; Part 38/19/20Stock10-K Filings Part 2Other Voices: Why Reading 10-K Filings Is Crucial; Part 28/6/20StockTruist Financial (TFC)Never Heard of Truist? This Bank Stock Could Rise Up to 30%7/29/20StockWeight Watchers (WW)Weight Watchers Can Continue to Outperform Post COVID-197/22/20StockXilinx (XLNX)If EPS Rises to Pre-Covid-19 Level, XLNX Could See Old Highs7/15/20StockMarket ConcentrationNarrow Mkt Rally Fuels Worry; We Expect Cyclicals To Join7/8/20StockSEC FilingsOther Voices: Why Reading 10-K Filings Is Crucial; Part 17/1/20StockSimply Good Foods (SMPL)Post-COVID-19, Simply Good Foods Stock Looks Appetizing6/24/20StockLam Research, Applied MaterialsLam Research, Applied Materials Set to Reap IoT Harvest6/17/20StockNordic Semiconductor (Nod. NO)Continued IoT Growth Good News for Nordic Semiconductor6/10/20StockHelmerich & Payne (HP)Helmerich & Payne Stock Could Energize Your Portfolio
- Signal from Noise
SPHB: Getting To Alpha By Way Of Beta
We get many questions about the best Epicenter stocks to buy. We recommend that our subscribers get diversified exposure to the Epicenter trade by using the Invesco S&P 500 High Beta ETF (SPHB). The fund contains a significant amount of our ‘Epicenter Trifecta’ stock picks. The selection criteria are pretty simple for this ETF; it selects the 100 stocks with the highest beta over the previous 12 month period out of the S&P 500. So, even though this is a specific way to get access to Epicenter stocks, the diversification it provides is also appealing. The nature of beta and correlations was significantly changed by the advent of the first pandemic in the era of globalization. About 7% of the entire US economy is what we could call 'social distancing casualties.' While these stocks were expected to go to zero potentially, they have instead proven their survivability and dramatically cut costs to maintain solvency. They will thus have higher EPS potential than consensus expects. Source: SeekingAlpha A one month Total Return Chart of the SPHB, SPLV, and S&P 500 illustrates quite nicely the current dynamic with beta in the market. When there is turmoil or uncertainty related to COVID (or Reddit in late January's case), capital flees high-beta for assets less susceptible to the harsh downside moves of a market fixated on when economic normalization can begin. As volatility increased, it significantly underperformed; as it decreased, it begins to outperform again. The stock market is now highly correlated to healthcare outcomes. As far as exogenous threats to the stock markets go, the suspension and depression of economic activity associated with a global pandemic are about as severe as it gets; particularly for the Value/Cyclical names that make up the Epicenter cadre of stocks. However, because the downside is very nasty when adverse healthcare developments occur, they also should expose investors to great risk-adjusted returns when the virus is finally vanquished. We have several reasons to believe the 'Epicenter' stocks will outperform based on historical data. Firstly, their margins are near the lows achieved during the financial crisis and will snap back similarly. Secondly, when real interest rates are historically this low, the 'Epicenter' sectors tend to outperform. Thirdly these stocks are hedged against inflation risk. Finally, anomalous VIX behavior in 2020 suggests that volatility will collapse in the following years, beginning in 2021. When this happens, the 'Epicenter' aka. Value/Cyclicals tend to outperform dramatically. 2020 Was About Symmetry, 2021 Will Be About Cycle Reversion Source: Fundstrat, Bloomberg, Factset At the beginning of the crisis, we noted that even if all these businesses failed due to the tragic events that 93% of the US economy would remain unscathed. Well, these companies didn’t die. They survived the unthinkable. Thus, their equity valuations should particularly appreciate when the pent-up demand and celebratory environment coalesce in what we believe will be the biggest boom-cycle of the 21st century so far. We also think that the ultra-cyclical nature of this comeback will immensely benefit the Value/Cyclical stocks that primarily make up the class of stocks we refer to as Epicenter. Just as the symmetry and prices were predicted by historical data, we believe that 'Epicenter' stocks will have an even more remarkable margin comeback. There are many reasons to believe their recovery would exceed that of 2008; a recessionary environment not marked by the dramatic interruptions in demand we see adversely affecting specific industries. Source: Fundstrat, Bloomberg, Factset Our Head of Research, Tom Lee, coined the term “Epicenter” stocks. This category is essentially comprised of those equities that were closest to the economic and social consequences of COVID-19. Perhaps it is easy to forget how precarious many investors thought the future was for these names. Some may be wondering if they’ve had a high enough run; we believe that the outperformance of high-beta stocks (in a post-COVID-19 market) has only just begun. Why do we say this? For the same reason, our Head of Research, Tom Lee, made his great call in March 2020, because we rigorously and religiously analyze data to try to listen to what the sum of the available information tells us. Source: Fundstrat, Factset This data seems to tell us that the margins of 'Epicenter' sectors have likely bottomed and will begin reverting to more normal levels fueled both by cyclical forces and the do-or-die cuts that were necessary for these companies to survive. “Easy Money” Real Interest Rates At Multi-Decade Lows Historically the 10Y is above the nominal rate of GDP growth. However, that is not currently the case. We anticipate the real interest rate will be around -6% from 2020-2023. This is very easy money and is supportive of asset prices. Similarly, we think that US households are synthetically short equities since the vast majority of their allocations have been into bonds. As the alpha generated by these high-beta names becomes undeniable in the face of economic re-opening, we expect many investors will chase the outsized returns and drive prices even higher. We think the low-real interest rate environment is supportive of our thesis. Source: Fundstrat, Bloomberg, Factset Asset Heavy Companies Serve as Good Inflation Hedge Many investors have had to 'dust-off' inflation playbooks because it hasn’t been a severe threat to returns in decades. We think that many 'Epicenter' companies are asset-heavy, meaning the value of these assets will go up in a reflationary environment. Think about proven oil reserves on an energy balance sheet or a loan-book value during an expansionary cycle. These assets’ value will increase. Coincidentally, Energy and Financials, two of the hardest-hit sectors, are the primary sector components of the S&P High Beta ETF (SPHB). Source: Fundstrat, Bloomberg Normalization of Volatility Suggests Outperformance of SPHB Components If you’re looking at the historical performance of SPHB, you'll notice that its performance differs over various time periods. Over some periods, you would be better off owning the S&P 500 outright than owning the SPHB. We showed you the performance over the last month but now look at performance over other periods. Source: SeekingAlpha You can see in the analysis across multiple periods that essentially, since COVID-19, there has been much alpha in the SPHB. However, when you look at the 10-yr price-performance, you can see you were not compensated well for the risk you were taking over that period. Investors who have enjoyed significant returns and hold SPHB at an All-Time-High may be rightfully asking if there's still room to run. We think the answer, given the historical volatility data, is a resounding yes; there is still much room to run. The VIX was highly anomalous in 2020 and spent most of the year in backwardation across its term structure. This literally means, counter to the typical relationship that volatility has with time, that investors expected more volatility in the short-term than further out ahead. We use the 4M-1M VIX as a proxy for the type of market inversion that only occurs during periods of extreme stress. The anomalous VIX term structure's duration suggests to us that a collapse in volatility is imminent. Historically, when volatility has collapsed, this means that you get compensated way better for the risk you are taking in high-beta names. In other words, to get to alpha during times of low volatility, which we anticipate will soon be upon us, go through beta. Source: Fundstrat, Bloomberg Risks and Where We Could Be Wrong Obviously, the biggest threat to our thesis that high-beta stocks will outperform as volatility collapses is if volatility for any reason does not collapse. We see the biggest risk to our thesis materializing is clearly either interruption of the progress in mass-vaccination campaigns or the emergence of variants on a scale that can significantly reduce immunity and lead to new outbreaks. However, we monitor virus data quite closely and there appears to be a more negative sentiment than is reflected by the current organic breakdown in new cases, deaths and hospitalizations. Even so, COVID-19 is an incredibly mysterious disease and we remain humble and vigilant to the many future prospects that could result in volatility continuing to remain elevated. Prior “Signals” DateTopicSubject / TickerThe Signal02/05/21StockExxon-Mobil (XOM)Why Exxon-Mobil Is A Buy Despite Mixed Earnings01/28/21SectorEnergy GICS-1 (XLE)If You Like TSLA’s 2020 Performance, Try The Energy Sector01/15/21StockFord (F) ‘Epicenter’ Stock With EV Upside and Great Management11/05/20StockIngalls & SnyderDespite Gyrating Markets, This Manager Returned 40% in ‘1910/21/20Stock10-K Filings Part 3Other Voices: Why Reading 10-K Filings Is Crucial; Part 38/19/20Stock10-K Filings Part 2Other Voices: Why Reading 10-K Filings Is Crucial; Part 28/6/20StockTruist Financial (TFC)Never Heard of Truist? This Bank Stock Could Rise Up to 30%7/29/20StockWeight Watchers (WW)Weight Watchers Can Continue to Outperform Post COVID-197/22/20StockXilinx (XLNX)If EPS Rises to Pre-Covid-19 Level, XLNX Could See Old Highs7/15/20StockMarket ConcentrationNarrow Mkt Rally Fuels Worry; We Expect Cyclicals To Join7/8/20StockSEC FilingsOther Voices: Why Reading 10-K Filings Is Crucial; Part 17/1/20StockSimply Good Foods (SMPL)Post-COVID-19, Simply Good Foods Stock Looks Appetizing6/24/20StockLam Research, Applied MaterialsLam Research, Applied Materials Set to Reap IoT Harvest6/17/20StockNordic Semiconductor (Nod. NO)Continued IoT Growth Good News for Nordic Semiconductor6/10/20StockHelmerich & Payne (HP)Helmerich & Payne Stock Could Energize Your Portfolio
- Signal from Noise
Why Exxon Mobil (XOM) Is Still a Buy Despite Mixed Earnings
Last week we discussed why we considered the energy sector one of our top three sector picks for 2021. We also added America's largest oil company, Exxon Mobil (XOM), to our 'Granny Shots' portfolio. We wanted to focus on a single-stock idea this week from the sector we recommended last week. We believe energy will significantly outperform consensus expectations. Thus, it should be no surprise that we think a massive oil major with the unique advantages and assets that Exxon has, in addition to a high dividend, should do very well if our thesis about the energy sector is correct. Look what happened when the VIX had its biggest three-day collapse ever; energy led the way. That should give you an idea of how it will perform when the market feels the all-clear is given to get ‘risk-on’ when the virus is vanquished. Exxon beat on earnings earlier this week and narrowly missed revenue. Nobody likes to see a $19 billion write-down but items like these often mark the bottom of a bad period. In Exxon's case, the impairment reflects a change in strategy that we believe significantly benefits shareholders, a new hyper-focus on low-cost, high margin capital expenditure projects that should generate a lot of free-cashflow within years, not a decade or more. We think that several powerful cyclical forces are moving in Exxon's and the price of oil's favor. We also believe there is a possibility that a commodities super-cycle is starting. If it is, one thing is clear from the ground-up changes XOM made during the depths of this pandemic-induced crisis; if oil prices are at their current levels or higher in the coming quarters, Exxon shareholders will be substantially rewarded. We see ample evidence that oil and natural gas demand and thus prices will move upward. Our data team compared recent gains in energy with past bull markets and this is what they found. Source: Bloomberg, FAMA, and Fundstrat Why We Think Exxon Is a Granny Shot We have added Exxon Mobile to our 'Granny Shots' portfolio because its periods of outperformance are correlated with the type of PMI-recovery activity that we are currently seeing, and we believe the company's valuation is historically low and will revert to the mean, meaning it comports with our Style Tilt toward Value/Cyclical stocks. The fact that the company has a reasonable path to defending its very attractive 7% plus dividend should support the stock's price from a demand perspective. However, the core feature of our thesis is increasing demand for the company’s products. Sometimes a stock goes up not because it has a flashy new management team or is involved in shiny new industries featured in SPACs. Sometimes a company does well simply because of what it has, what it can do, and how much people need it. We elaborated on how the institutional Fear of Missing Out (FOMO) could further bolster our thesis last week. Source: Company Reports, Q4 Exxon Mobil’s post-COVID-19 market-cap of around $200 bn is deceivingly low, particularly in a world where Game Stop briefly became a Fortune 500 company. The sheer scale of the amount of assets, the number of places they are in, and the number of people involved directly and indirectly with this company's value chain is incomprehensible. A simple fact of the cyclical energy business is that revenues increase when prices do. So does the value of this behemoth's tremendous assets, including the largest proven oil and natural gas reserves in the world. Exxon has an edge over competitors in the more environmentally friendly natural gas business as well. Source: SeekingAlpha As you can see, current valuation levels are low and imply that the stock is a bargain. We will show you how powerful an upside surprise could be below. We think a fairer valuation for XOM would be the levels of around five to seven years ago. We think it will revert to those levels in coming quarters. We’ve also confirmed that XOM is in a technical uptrend. Exxon’s Coronavirus Remodel Most folks who are not acquainted with the oil and gas industry don’t realize that the Upstream segment is a tiny portion of revenues for the oil majors, despite being the more externally visible and politically charged side of the business. Exxon Mobil has the upper hand over all its competitors in the quality and profitability of its upstream projects. While Capex has been slashed dramatically at the firm, the per capita levels do not match rivals. Exxon has used this crisis to focus its Capex on the lowest cost and highest margin projects. The drop-off in CAPEX across the industry could very well result in diminishing supply that is felt across the market. In this future price environment, Exxon will thrive in all business segments and will likely be able to grow its market-share, and maybe margins, within downstream and chemicals. The firm estimates that by 2025 nearly half of its free-cash-flow will be derived from these newer projects. By far, the downstream segment is the most significant portion of Exxon's revenues and where the opportunity for future margin expansion and growth lay. Exxon has made significant improvements in this area that were accelerated by the crisis. We think things will improve from here. The action taken to steer the ship during this unprecedented down cycle will likely result in significantly higher than consensus profitability. Exxon has invested heavily in its already superior refining capacity; which should boost long-term margins. This will be supported by an anomalously robust post-pandemic boom likely accompanied by a significant price appreciation in commodities. Look at the effect even seemingly insignificant increases in downstream margins have on the implied share price. Source: Trefis Source: Trefis For a company whose primary business, at the operational level, uses highly complex machinery and processes to undertake some of the most logistically impressive tasks achieved by human beings on Earth, our bull case is surprisingly simple. We think the reflationary forces and pent-up demand means that risks to Exxon, which are very clearly laid in terms of the underlying price of commodities is clearly to the upside. We focused on some evidence of accelerating growth of GDP to support this in our article on energy last week. The energy business is increasingly cyclical, established larger players like Exxon have a significant advantage in an uptrend, and most importantly, Exxon has taken some very hardline cuts both in labor and capital expenditures that will not only increase EPS potential but will also boost margins since the firm has scrapped all upstream projects that are not highly profitable and insulated against low prices. While the free cash flow has suffered in past quarters because of this, enough so that the dividend was not able to be covered out of it, the cyclical upswing, reflationary forces, and the cuts and innovation necessary to survive the worst downturn in memory should make this 'dinosaur' more Jurassic Park and less museum fossil (think of a cyclically empowered T-Rex chasing the bears away). We understand the secular challenges facing energy, and we also know that it is a late-stage industry. We also cannot find any plausible scenario in which peak oil is not in the future; fossil fuels will still be the lifeblood of important economic activity for decades. Source: Energy Information Administration Risks and Where We Could Be Wrong The primary risk to the positive future we see for Exxon Mobil’s share price is any interruption of the timeline on vaccinations and the path toward a full-recovery from COVID-19. The recent announcement by the Biden Administration that new strains are virulent and might potentially evade the immune response and current vaccines highlights how stark and serious this risk could be. Our positive forecast for Exxon Mobil is contingent upon a significant demand recovery occurring with economic normalization. Any unforeseen variable that delays this reality will result in lower periods of demand for oil and should undermine the price of the commodity. Political risk is deemed by us to be relatively low. However, if the pro-environmental forces are able to drive a more aggressive regulatory approach, then that would also mitigate the stock’s upside. Prior “Signals” DateTopicSubject / TickerThe Signal01/28/21SectorEnergy GICS-1 (XLE)If You Like TSLA’s 2020 Performance, Try The Energy Sector01/15/21StockFord (F) ‘Epicenter’ Stock With EV Upside and Great Management11/05/20StockIngalls & SnyderDespite Gyrating Markets, This Manager Returned 40% in ‘1910/21/20Stock10-K Filings Part 3Other Voices: Why Reading 10-K Filings Is Crucial; Part 38/19/20Stock10-K Filings Part 2Other Voices: Why Reading 10-K Filings Is Crucial; Part 28/6/20StockTruist Financial (TFC)Never Heard of Truist? This Bank Stock Could Rise Up to 30%7/29/20StockWeight Watchers (WW)Weight Watchers Can Continue to Outperform Post COVID-197/22/20StockXilinx (XLNX)If EPS Rises to Pre-Covid-19 Level, XLNX Could See Old Highs7/15/20StockMarket ConcentrationNarrow Mkt Rally Fuels Worry; We Expect Cyclicals To Join7/8/20StockSEC FilingsOther Voices: Why Reading 10-K Filings Is Crucial; Part 17/1/20StockSimply Good Foods (SMPL)Post-COVID-19, Simply Good Foods Stock Looks Appetizing6/24/20StockLam Research, Applied MaterialsLam Research, Applied Materials Set to Reap IoT Harvest6/17/20StockNordic Semiconductor (Nod. NO)Continued IoT Growth Good News for Nordic Semiconductor6/10/20StockHelmerich & Payne (HP)Helmerich & Payne Stock Could Energize Your Portfolio
- Signal from Noise
If You Liked TSLA’s 2020 Performance, Try The Energy Sector (XLE)
What could one of the most neglected and abandoned sectors in the S&P 500 possibly have in common with TSLA? Well, despite a litany of differences we think XLE will be a top performer in 2021 for a very similar reason to why TSLA was one of the best performers in 2020; institutional Fear Of Missing Out (FOMO). TSLA was responsible for nearly three quarters of the Russell 1000’s gain at a point last year and most Russell 1000 money managers had zero exposure to it. The subsequent rush into TSLA caused by not having one of the top performers in institutional portfolios was one of the primary drivers behind the stocks’ parabolic price-surge of 2020. Source: FSInsight Given that energy’s sector-wide valuation is near replacement cost and the surviving companies have had to significantly boost operating leverage to survive, we think that Energy may provide some of the most compelling opportunities of 2021. The fact that many institutional investors have a zero-weighting combined with the positive and powerful cyclical economic forces likely to emerge in the near future makes this one of our top three recommended sectors for the coming year. The rush of institutional investors to get into one of the best performing sectors causes prices to move higher and faster than almost any other market force. Thus, we think you want to be OW or at least neutral energy to capitalize on the collapse in Equity Risk Premia (rise in valuation) that could very well be around the corner for the energy sector. Many accredited investors have made the decision that Energy, one of the consistent underperformers of the last years, ultimately was so insignificant that they could afford to put a zero-weighting in the sector in favor of larger, alpha-seeking positions in the Amazons, Googles and Apples of the world. All of these stocks comprise a greater proportion of the S&P 500’s market-cap individually than the entire Energy Sector. Despite this low weighting, the performance of energy stocks in the first two weeks of the year gave preview to why the situation could change quickly, particularly if perceptions on the healthcare situation are more negative than the reality, which may be the case. If energy, ends up comprising a substantial portion or majority of the S&P 500’s gains for the year, institutions will have no choice, as they did with TSLA, but to pile in quickly in order to provide acceptable returns to their clients. No one wants to be without a chair when the music stops. Similar to TSLA in 2020, the pile-in that occurs in energy when the commodity super-cycle that has recently been predicted kicks in, we believe this institutional FOMO will cause significant price appreciation of strong equities in the energy sector, and likely the sector as a whole. Source: Fundstrat Inflation Risk Is Likely to The Upside, Commodities Super-Cycle Beginning? Talk of a new commodity super-cycle and ample indicators of reflationary forces are in the air. There is a very baseline piece of logic to our contrarian bullish call on energy; despite all the exciting developments in Electric Vehicles and renewables the upcoming economic boom will be powered primarily by oil, or not at all. Many of the supply-side restrictions when coupled with the cuts energy firms have had to make; like laying off 14% of permanent employees in 2020, will produce greater EPS. Additionally, CAPEX has significantly declined which could lead to supply issues over the medium-term. These issues would likely boost the margins of domestic producers. The much-decried anti-energy policies of the Biden administration are actually supportive of part of our bull-thesis; the administration will act in ways that will diminish the supply but restrictions will not be so excessive as to force preliminary extinction. The recent revocation of the Keystone permit and forbidding drilling on Federal lands support this. The energy sector has at least one great cycle ahead of it yet. Energy is an ‘Epicenter’ sector. It is also the hardest hit of the ‘Epicenter’ sectors. While there are certainly many idiosyncratic risks to the sector, we also think it may be a leader in gains for several reasons. Rising inflation expectations are certainly a positive for energy. A bet on ‘Epicenter’ is implicitly a positive beta bet on rising inflation. If you are worried about inflation you want to be overweight ‘Epicenter’, and Oil and Gas companies benefit two-fold, as their high asset intensity, including in oil reserves, serves as a natural hedge against inflationary forces. On a more secular level, we think macro-forces attracting capital to equities in favor of bonds will re-rate the entire P/E ratio of the S&P 500 higher; energy having one of the lowest valuations will likely be a leader in this general move higher as leaner and meaner corporate entities with greater earning power come up against higher-than consensus demand paired with supply constraints. Alt. Data, Accommodative Monetary Policy, And Potential Supply Constraints Support Bullish Thesis We looked at some alternative data from China. This is provided DeepMacro and measures NO2 levels YoY, which is a proxy for manufacturing activity. As you can see, it is accelerating and looks likely to pass November levels; this would also support the conclusion that GDP growth is accelerating and has not yet peaked. This in conjunction with dovish Central Banks and ample fiscal support from governments suggests inflation could be higher than expectations. ISMs and PMIs have also been largely positive and in some cases well-above consensus estimates. This suggests that GDP growth has not yet peaked, but is still accelerating. The implications of this and other pieces of positive economic data are that the demand for oil over the coming quarters could be significantly higher than consensus expects. Another bullish factor for Energy that many folks may have missed is that many major players in the industry used COVID-19 to accelerate investments in automation and technology that should enhance profitability, especially when paired with the deep cuts these companies have had to make to survive their worst down-cycle in a long time. Many players have begun 'variablizing their fixed costs. Source: HP Company Reports How Long Do Bull Markets In Energy Typically Last? Energy stocks had a great start to the year and experienced some volatility in the second half of January. However, we think it is very early innings for the energy rally, and we had our data science team compare recent relative performance to other bull markets. The implication seems pretty clear. If you believe energy will outperform and will be a major beneficiary of inflation and supply constraints, which we do, then it seems pretty clear from historical data that its a good possibility there is plenty of upside left for Energy in 2021. Source: FSInsight, Bloomberg and FAMA Risks And Where Could Be Wrong Political risk in the United States could end up being higher than the current situation and balance of legislative power would suggest. Also, if the Federal Reserve begins implementing ‘Climate Scenarios’ in its supervisory stress test, it could further alienate the industry from capital it will likely need. However, GOP opposition to this has already been publicly stated. We also think at the end of the day, the Federal Government has very little interest in creating the significant employment and regional disruptions that would occur as a result of too stringent a regulatory approach to an Energy industry that just survived a once-in-a-generation crisis. Our Favorite Energy Stocks Source: FSInsight
- Signal from Noise
Ford (F): A Flagship ‘Epicenter’ Stock With EV Upside and Great Management
In a world where Elon Musk is building electric cars and spaceships and launching his cars into space with his spaceships, Ford may seem like your father's grand-fathers, and you can't say this for many companies, but maybe even great-grandfather's stock. We think this sentiment couldn't be further from reality. Aside from ample idiosyncratic tailwinds, which we will discuss further below, we also believe that Ford is bringing to fruition the fate we have predicted for so many ‘Epicenter' stocks; booming post-pandemic demand for their products, significantly better operating leverage, and thus earnings per share, and the type or do-or-die cuts and restructuring that only true crises can engender. Ford has an exciting lineup of new models, credible plans to expand internationally, has made impressive and tangible strides in innovation, and its prodigious lending arm, Ford Credit, just had its best year in well over a decade. The last point: Ford’s massive financial services subsidiary has been the lynchpin in bearish arguments for why the company would falter. In what will likely be a very hot post-pandemic economy with a steepening yield curve, this supposed albatross will likely create significant upside that is not predicted by historically informed forecasts. Everybody knows the dated narrative still pervasive among some investors; the Big Three of the American auto industry are uncompetitive, saddled with expensive legacy costs and dilapidated factories, and late to the party on electric vehicles. The narrative almost has a 'Fall of Rome' quality to it—Of course, once Rome stopped paying off the Visigoths (Or the UAW in Detroit’s case), it fell. Investors who lump Ford into this narrative would have been wrong for decades now. If you examine Ford’s financial statements closely, you'll see that their worst quarter of the pandemic was fortuitously hedged by a $3.5 billion gain from investments in AI and self-driving technology. Does that sound like a management team that has allocated capital poorly? Last quarter, the company reported that it had organic margin expansion via rising prices because of unexpectedly healthy demand. Its new products are in even higher demand than existing ones. Thus, this trend will likely only accelerate as the pandemic recedes, and Ford's primary consumers have their balance sheets bolstered with robust stimulus. This suggests that historically informed forecasts for demand are likely too low. Source: Trefis, Thinkorswim As you can see, with slightly more optimistic assumptions than those which are informed by historical data, the implied valuation is significantly augmented. New Product Lineup: BEVs (Battery Electric Vehicles) Are Great Alone, But Better with ICE (Internal Combustion Engines) Our Head of Research, Tom Lee, got his start as a wireless analyst in the 1990s, and he has said that he sees multiple parallels between electric vehicles now and wireless in the nascency of his career. So, we undoubtedly have faith in electric vehicles’ eventual dominance. That doesn’t mean there isn’t exuberance in some names. With Ford, you get a two for one. Not only are you getting exposure to the multiple-expanding, very 'growthy' electric vehicle market; you are also getting a flagship 'Epicenter' stock that is poised to outperform the market because of a once in a lifetime cost reset. This, coupled with the impressive and trustworthy management, which the current products reflect, makes us think that Ford still has much upside even though it is near new highs for the year. The pace of EV’s gains in market-share will eventually be heightened by multiple secular tailwinds. Right now, there are still many obstacles to achieving the type of full-scale ICE substitution that some valuations would suggest; one of them is the power grid's inability to support such a reality currently. The point is that particularly in the domestic American market, which is by far Ford's largest, demand for old-fashioned gas burners will remain foreseeably intact. Even if you’re worried about that trend in the future, Ford seems to be on top of it. The all-electric Mustang Mach-E just won the award for Best SUV of 2021, and the F-150 simultaneously won for Best Truck, the first time two of the three awards have gone to the same brand since 2014. The new lineup of Ford Broncos is already saturated with pre-orders, and post-COVID-19 consumer trends actually appear to work in Ford’s favor. It will be poised to grow its base business in ICE in size and profitability while also being a major player in the shift to all-electric (including the all-electric F-150). This goldilocks zone that Ford occupies means reaping great margins from very in-demand and high-margin ICE models while also being exposed to EV’s ascent. Ford can do better than many people think in the EV world for a few reasons. Firstly, Ford still qualifies for the $7,500 tax credit that TSLA has long-since outgrown. This will have a measurable effect on a product subject to very elastic demand, particularly when the quality is now confirmed to be about equivalent to chief competitors (and is already profitable for the company). The other thing is that many Americans still don’t want to buy an electric vehicle. We think Ford’s bet that they can entice consumers to give electric a chance using flagship brands and high-quality vehicles while also taking the company to have recurring revenue streams from software and AI is exactly what the company should be doing. This should positively affect Ford's multiple over the coming years. Source: Company reports. Valuations for auto manufacturers are notoriously discounted due to the ever-present risk of fickle consumer attention to brands and products. Ford has suffered as much from this over the years as any automaker. Still, it’s the impeccable management team and steady, transparent strategy seems to show that leadership is ahead of the curve and has the re-invigoration of one of America's most treasured brands well-in-hand. Exciting Management at Ford We are fans of the record and energy that Ford’s new CEO, Jim Farley, brings to the table. Farley, whose first cousin is the late, great Chris Farley from SNL, is an absolute car fanatic whose first conversation with Bill Ford upon exploring his potential ascent to the top job was telling the company’s patriarch that a condition of him accepting was that he is not prevented from his dangerous hobby of racing cars. He may understand the relationship between vehicle and consumers better than anyone in Detroit since Lee Iacocca. Jim Farley may not build spaceships, but nobody in the world knows how to sell cars better. In fact, some of Toyota's most impressive inroads against the American automakers were at his direction; he led the formation of Toyota's luxury brand, Lexus, and led marketing efforts on some of their best-selling vehicles. Betting against Jim Farley and Ford's most exciting lineup in years seems unwise to us. Farley is the guy who can finally make Ford shine. A Toyota man running Ford, we like the sound of that. The Bottom Line Ford is one of our ‘Trifecta’ Epicenter stock picks, meaning that all three of our research departments recommend it. We see it benefitting from the same forces that attract us to 'Epicenter' and multiple idiosyncratic factors unique to Ford. The company’s valuation risk is significantly less than all-EV companies and we think its Price/Cashflow and Price/Book indicate that the stock is still a bargain even at new highs. Source: Morningstar Where We Could Be Wrong Ford recently had to shut down production in some factories due to a shortage of microchips. Shortages in other components and rising commodity prices could hurt margins. However, our thesis's largest risk is still the unpredictable path of COVID-19. Since production has already been shut down for significant periods this year, further delays in production or the failure of the demand to continue recovering because of adverse healthcare outcomes are primary risks. Disclosures This research is for the clients of FS Insight only. For additional information, please contact your sales representative or FS Insight at /. Conflicts of Interest This research contains the views, opinions and recommendations of FS Insight. At the time of publication of this report, FS Insight does not know of, or have reason to know of any material conflicts of interest. General Disclosures FS Insight is an independent research company and is not a registered investment advisor and is not acting as a broker dealer under any federal or state securities laws. FS Insight is a member of IRC Securities’ Research Prime Services Platform. IRC Securities is a FINRA registered broker-dealer that is focused on supporting the independent research industry. 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Notable compliance policies include (1) prohibition of insider trading or the facilitation thereof, (2) maintaining client confidentiality, (3) archival of electronic communications, and (4) appropriate use of electronic communications, amongst other compliance related policies. FS Insight does not have the same conflicts that traditional sell-side research organizations have because FS Insight (1) does not conduct any investment banking activities, (2) does not manage any investment funds, and (3) our clients are only institutional investors. This research is for the clients of FS Insight only. Additional information is available upon request. Information has been obtained from sources believed to be reliable, but FS Insight does not warrant its completeness or accuracy except with respect to any disclosures relative to FS Insight and the analyst's involvement (if any) with any of the subject companies of the research. All pricing is as of the market close for the securities discussed, unless otherwise stated. Opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The opinions and recommendations herein do not take into account individual client circumstances, risk tolerance, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies. The recipient of this report must make its own independent decision regarding any securities or financial instruments mentioned herein. Except in circumstances where FS Insight expressly agrees otherwise in writing, FS Insight is not acting as a municipal advisor and the opinions or views contained herein are not intended to be, and do not constitute, advice, including within the meaning of Section 15B of the Securities Exchange Act of 1934. All research reports are disseminated and available to all clients simultaneously through electronic publication to our internal client website, fsinsight. com. Not all research content is redistributed to our clients or made available to third-party aggregators or the media. Please contact your sales representative if you would like to receive any of our research publications. Copyright 2020 FS Insight LLC. All rights reserved. No part of this material may be reprinted, sold or redistributed without the prior written consent of FS Insight LLC.
- Signal from Noise
Despite Gyrating Markets, This Manager Returned 40% in 2019
Signal from Noise Question & Answer articles are published occasionally as we run across investment themes and stock ideas relevant to subscribers. It’s our intention to familiarize you, if briefly, with the views of successful investment managers or analysts, some you might have read about, but, more importantly perhaps, some you might not have. This week’s Q&A was conducted recently with Marshall Kaplan, Senior Vice President at Ingalls & Snyder, an NYC-based investment advisor and broker dealer with $4 billion in AUM. He has 39 years of investment industry experience and leads the Fundamental Equity Advisors (FEA), an investment management team formed in October 2010 at Morgan Stanley. FEA joined Ingalls & Snyder in 2018. Marshall joined Smith Barney in 1983 as a Portfolio Analyst, where he created and managed that firm’s Equity High Net Worth and Portfolio Management programs and served on its Global Investment Committee and Global Portfolio Committee. Please describe briefly the history of FEA. The Ingalls & Snyder (FEA) team consists of lead portfolio manager Marshall Kaplan, Rochelle Wagenheim and Michael Nelson. Prior to our tenure at Morgan Stanley, FEA managed model portfolios at Citigroup from 2002 through September 2010. What has been your performance this year vs. peers and the market? For 2019 the Ingalls & Snyder Fundamental Equity Advisors All-Cap portfolio was up 40.47% gross of fees, +38.75% net, versus the Russell 3000’s return of 31.02%. The Ingalls & Snyder FEA SMID Core portfolio increased by 36.82% gross of fees, +35.24% net, versus the Russell 2500’s return of 27.77%. Through 3Q 2020, the All-Cap strategy has gained 5.96% gross of fees, +5.0% net, versus 5.41% for the benchmark. The weak performance of Small/Mid-Cap stocks has caused our SMID strategy to decline by 6.54% gross of fees, -7.37% net, versus a drop of 5.82% for the benchmark. Over the last three years, gross of fees, our All-Cap strategy is up 11.24%, +10% net, and our SMID strategy has advanced by 5.79%, +4.6% net, on an annualized basis. Smaller capitalization issues have underperformed their larger cap brethren over this period. What are the main contributors to that 2019 performance? In recent years, particularly in 2019, we’ve had success in the Information Technology and Healthcare sectors. For example, in Healthcare, critically important products and services offered by life science and diagnostic companies have recorded impressive organic growth. In the IT sector, we’ve had strong interest and success in the Payments & Processing space. Software and service companies also had stellar performance last year. From time to time, we discover “special situations” that meet our investment criteria, and last year a manufacturer/seller of mechanical and electronic security products and solutions helped our performance. Describe briefly the fund’s investment stock picking thesis? We use a bottom-up fundamental approach focusing on risk management and capital preservation. We seek to identify undervalued equities by focusing on companies possessing strong or positively inflecting free cash flow, attractive valuations, changing internal dynamics, potential for expanding profit margins, market share growth opportunities, and strong management. We analyze a company’s financial flexibility, earnings quality, valuation, business model and competitive position. Broader industry trends, relative growth, and investor sentiment are also evaluated. We utilize an independent forensic accounting firm to evaluate a company’s earnings quality and validate the team’s internal analysis. Each FEA team member brings unique industry experience and skills to the process, while leveraging a common, time-tested approach to investing. We’re all generalists, and potential investments are analyzed by all team members. Our team is unconstrained by style boxes and ideas may come from a variety of resources including industry conferences, contacts, proprietary screens, Street research, management calls, etc. Investor sentiment also plays an important role in our overall process. How does this method distinguish itself from conventional methods? Marshall Kaplan We employ a multi-faceted approach to managing risk. Our intense focus on risk management utilizes a premier independent forensic accounting firm as well as the use of a partial-position strategy. This sets us apart from other managers. In addition, the close monitoring of individual securities and sectors (and weightings), and liquidity management all help support our goal of creating an “all-weather” portfolio. Each member of the team is personally invested in our strategies, ensuring that we are aligned with our clients’ interests How about a few stock picks? Vertiv Holdings (VRT) is a structural winner, we think. It is a global leader in design, manufacturing, and servicing of critical digital infrastructure that cools and maintains electronics that process, store, and transmit data. We view Vertiv as a mission-critical partner to data centers, communication networks, and commercial & industrial companies worldwide. Our outlook is driven by the secular uptrend in global data usage, a sticky customer base (switching costs are high) and material margin expansion potential. We like the company’s recurring revenue stream, more than 60% of sales, and strong management team. At approximately 15x consensus estimates of $1.15 a share for 2021, the shares trade at a modest P/E to Growth (PEG) ratio of 0.34. Evercore Inc. (EVR) has been a core holding for several years. The company is an independent investment bank with 80% of revenue from Merger & Acquisitions advisory fees and the remainder from Investment Management. We believe the stock will benefit from stronger M&A activity next year, driven by economic recovery and strong demand for restructuring activity. We view the shares as attractively valued, and the recent dividend hike gives us increased conviction that business trends are poised to improve. The shares trade at only 11x consensus 2021 EPS estimates of $7.23. Teleflex (TFX) is another core holding for us. The company develops, manufactures, and supplies single-use medical devices. Teleflex has consistently delivered impressive organic growth, maintains strong cost controls, and has a healthy balance sheet. Management has a strong track record of making accretive acquisitions while also divesting lower growth businesses, driving a favorable mix shift in margins. We believe growth prospects for the company’s Urolift and Vascular Solutions businesses remain compelling and expect upside to current estimates. In our view, Teleflex represents an attractive candidate for a larger medtech company. With forecast growth of 22% and 17%, respectively, for 2021 and 2022, the shares trade at 24.7x consensus 2021 estimates, a slight discount to its historical median. Disclosure: Any FEA opinions expressed in this material are only current opinions and while the information contained is believed to be reliable there is no representation that it is accurate or complete. Members of FEA own shares of the companies specifically mentioned in this material. Gross returns do not reflect the deduction of any expenses. Net returns reflect returns after deduction of expenses such as charges for transaction costs, investment management/advisory fees, custody and applicable administrative expenses or wrap fees that may incorporate such expenses.
- Signal from Noise
Other Voices: Why Reading 10K Filings Is Crucial; Part 3
(This report is part of our occasional Other Voices format, as we run across interesting investment ideas or practices from outside our firm. Today’s piece is written by David Zion, founder of the Zion Research Group, an independent research firm focused on accounting and tax issues, and his colleagues Ravi Gomatam and Ben Wechter. This report is excerpted in part from Zion’s annual 10-K Checklist, which includes tricks of the trade, potential red flags, questions to ask and common-sense tips to help you navigate the 10-K filings.) They aren’t fun to read, but SEC documents are crucial to a complete understanding of the company whose shares you are considering. Buying a stock without reading the 10-K is like driving to an unknown destination without a map. You can do it, but it’s better with navigation. Zion Research Group is expert at deciphering corporate SEC filings. To help you navigate this thicket, we are running excerpts from Zion’s reports about 10-Ks. This is the third of three. Footnotes Financial statements are a good place to start your analysis, but you need to dig deeper to make sense out of them and that's where the footnotes come in to provide more context and detail. Remember that when you are going through the footnotes, keep asking yourself if the company's disclosures are clear and in plain English or are they confusing and complex. If a company wants a premium valuation, it needs to provide you with premium disclosures. The following is what to look for. Significant Accounting Policies: We’ve started year three of the “Three Great Years of Accounting Changes”. Revenue recognition (2018), leases and hedge accounting (2019), followed by credit losses (2020). As companies get closer to applying a new rule, they should provide better info (i.e., SAB 74 disclosures) about the potential impact. In our view, the biggest impact of an accounting rule change is the potential changes in behavior it can spark. Investors may gain some new insight about the risks, growth and claims on future cash flow, which could change how they view the underlying economics of the business and how they value the company. Corporates might do things differently, too. Watch out for changes in accounting policy... Of course, companies may change how they account for things even when not forced to by the FASB. Pay extra close attention to these types of changes: did the company get more/less aggressive, did they pull closer/farther away from their peers, will their results more/less closely track the underlying economics? Red Flag: Not understanding a footnote after reading it three times. Instead of ignoring accounting rule changes, we’d suggest asking yourself eight questions, The Ocho. (See below.) 1. Does the new rule better reflect the underlying economics? Does that affect how you view the business? 2. What adjustments (if any) do you need to make to your model? Are you looking at minor tweaks or a major rebuild? 3. Were you already factoring this issue into your analysis (e.g., leases)? Does the new rule change your approach? 4. Will non-GAAP numbers change as a result? Will the Street look at the company any differently? 5. Do you need to fix your quant screen so that it’s not sending misleading signals? 6. Does the change make it easier/harder to compare companies both within the U.S and around the world? 7. What changes in corporate behavior do you expect because of the new rule (are those good business decisions or just meant to paint a prettier picture)? Will that change the underlying economics of the business? 8. Are the debt covenants based on frozen GAAP or floating GAAP? If a change in GAAP sparks a covenant default (possible under floating GAAP), would it create an event of default or does it require the covenant to be renegotiated? Below is an abbreviated list of potential footnote items that Zion Research Group recommends that investors study closely. Space doesn’t allow us to list them in their entirety, but readers can get the full picture at Tax Are today’s low tax rates sustainable? Probably not. How to value NOLs. Post TCJA, the net operating loss (NOL) related tax shield is less valuable due to the lower tax rate. How does the company make money? You need to determine if the revenue recognition pattern matches up with how the company does business with its customers. Questionable Judgement Calls: New revenue recognition rules provide plenty of room for management judgment which could be used to manage earnings. Do those judgments match the economics of the business?. Financial Instruments When stock prices fall, there’s some accounting consequences. For example, changes in the fair value of equity securities (typically less than 20% stakes) now run through earnings. Foreign Currency FX risk, FX hedging, FX accounting are all complex. Focus on two things (1) impact of FX on business fundamentals and (2) impact of FX on the value of the business. Leases Most leases are now on balance sheet but they might present surprises. Pensions/OPEB When analyzing pensions, take three steps: (1) Health (2) Cost and (3) Risk. M&A There are lots of games companies can play with purchase accounting. For example, watch out for large chunks of purchase price allocated to goodwill, is that what they are buying or an attempt to make the transaction appear more accretive. Derivatives & Hedging Hedging costs are worth keeping an eye on. Stock Comp Make sure you capture two things in your analysis: (1) options and restricted stock are a claim and (2) future grants are a cost of doing business. Don’t ignore the stock comp cost, especially when management tells you to. Shareholder's Equity Buying back stock to offset earnings dilution is not always a great idea. In theory, companies should buy back stock when it's cheap, but in reality, they tend to buy back the most shares when stock prices are at their highs. EPS There are a few different share counts. If you are looking for the shares outstanding, check the front page of the 10-K. Keep in mind that's not the same as the basic share count, which is the weighted average of the shares outstanding for a period (quarter, year). The company will provide a table that takes you from basic to diluted shares. Inventory Companies don't disclose too much about inventory nowadays. We'd suggest monitoring the components (raw materials, work-in-process, finished goods). For example, rising finished goods might signal an expected increase in demand or the company is stuck with inventory it can’t sell. PP&E Don't ignore impairment charges. Sure, there's no impact on current period cash flows, but it does reflect management's expectations for lower future cash flows (does that change your expectations?). Prior “Signals” DateTopicSubject / TickerThe Signal8/19/20Stock10-K Filings Part 2Other Voices: Why Reading 10-K Filings Is Crucial; Part 28/6/20StockTruist Financial (TFC)Never Heard of Truist? This Bank Stock Could Rise Up to 30%7/29/20StockWeight Watchers (WW)Weight Watchers Can Continue to Outperform Post COVID-197/22/20StockXilinx (XLNX)If EPS Rises to Pre-Covid-19 Level, XLNX Could See Old Highs7/15/20StockMarket ConcentrationNarrow Mkt Rally Fuels Worry; We Expect Cyclicals To Join7/8/20StockSEC FilingsOther Voices: Why Reading 10-K Filings Is Crucial; Part 17/1/20StockSimply Good Foods (SMPL)Post-COVID-19, Simply Good Foods Stock Looks Appetizing6/24/20StockLam Research, Applied MaterialsLam Research, Applied Materials Set to Reap IoT Harvest6/17/20StockNordic Semiconductor (Nod. NO)Continued IoT Growth Good News for Nordic Semiconductor6/10/20StockHelmerich & Payne (HP)Helmerich & Payne Stock Could Energize Your Portfolio6/3/20OptionsVan Hulzen Asset ManagementFor Income Seekers, Why Covered Calls Top Junk Bond ETFs5/27/20StockJP Morgan Chase (JPM)Why JPMorgan Chase Belongs in Portfolios Post-COVID-195/20/20StockHorizon (HZNP)Horizon Therapeutics Is Inexpensive; 2 Drugs Show Promise5/13/20StockBank OZK (OZK)‘Plain Vanilla’ Bank OZK Could Be Long Term Opportunity Disclosures This research is for the clients of FS Insight only. For additional information, please contact your sales representative or FS Insight at /. Conflicts of Interest This research contains the views, opinions and recommendations of FS Insight. At the time of publication of this report, FS Insight does not know of, or have reason to know of any material conflicts of interest. General Disclosures FS Insight is an independent research company and is not a registered investment advisor and is not acting as a broker dealer under any federal or state securities laws. FS Insight is a member of IRC Securities’ Research Prime Services Platform. IRC Securities is a FINRA registered broker-dealer that is focused on supporting the independent research industry. Certain personnel of FS Insight (i.e. Research Analysts) are registered representatives of IRC Securities, a FINRA member firm registered as a broker-dealer with the Securities and Exchange Commission and certain state securities regulators. As registered representatives and independent contractors of IRC Securities, such personnel may receive commissions paid to or shared with IRC Securities for transactions placed by FS Insight clients directly with IRC Securities or with securities firms that may share commissions with IRC Securities in accordance with applicable SEC and FINRA requirements. IRC Securities does not distribute the research of FS Insight, which is available to select institutional clients that have engaged FS Insight. As registered representatives of IRC Securities our analysts must follow IRC Securities’ Written Supervisory Procedures. Notable compliance policies include (1) prohibition of insider trading or the facilitation thereof, (2) maintaining client confidentiality, (3) archival of electronic communications, and (4) appropriate use of electronic communications, amongst other compliance related policies. FS Insight does not have the same conflicts that traditional sell-side research organizations have because FS Insight (1) does not conduct any investment banking activities, (2) does not manage any investment funds, and (3) our clients are only institutional investors. This research is for the clients of FS Insight only. Additional information is available upon request. Information has been obtained from sources believed to be reliable, but FS Insight does not warrant its completeness or accuracy except with respect to any disclosures relative to FS Insight and the analyst's involvement (if any) with any of the subject companies of the research. All pricing is as of the market close for the securities discussed, unless otherwise stated. Opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The opinions and recommendations herein do not take into account individual client circumstances, risk tolerance, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies. The recipient of this report must make its own independent decision regarding any securities or financial instruments mentioned herein. Except in circumstances where FS Insight expressly agrees otherwise in writing, FS Insight is not acting as a municipal advisor and the opinions or views contained herein are not intended to be, and do not constitute, advice, including within the meaning of Section 15B of the Securities Exchange Act of 1934. All research reports are disseminated and available to all clients simultaneously through electronic publication to our internal client website, fsinsight. com. Not all research content is redistributed to our clients or made available to third-party aggregators or the media. Please contact your sales representative if you would like to receive any of our research publications. Copyright 2020 FS Insight LLC. All rights reserved. No part of this material may be reprinted, sold or redistributed without the prior written consent of FS Insight LLC.
- Signal from Noise
Other Voices: Why Reading 10-K Filings Is Crucial; Part 2
(This report is part of our occasional Other Voices format, as we run across interesting investment ideas or practices from outside our firm. Today’s piece is written by David Zion, founder of the Zion Research Group, an independent research firm focused on accounting and tax issues, and his colleagues Ravi Gomatam and Ben Wechter. It is excerpted from Zion’s annual 10-K Checklist, which includes tricks of the trade, potential red flags, questions to ask and common-sense tips to help you navigate the 10-K filings.) Few investors other than Warren Buffett, perhaps, enjoy reading SEC documents, but they are crucial to a complete understanding of the company whose shares you are considering. Buying a stock without reading the 10-K is like driving to an unknown destination without a map. You can do it, but it’s better with navigation. Zion Research Group is expert at deciphering corporate SEC filings. To help you navigate this thicket, we are running excerpts from Zion’s reports about 10-Ks. This is the second of three. Financial Statement Analysis, Just Do It. When the team at Zion Research Group are doing a Deep Dive on a company, they'll read the 10-K from start to finish. If you want to narrow your focus, old fashioned financial statement analysis is a good place to start (e.g., common size financial statements, free cash conversion, working capital trends, etc.). Zion uses a variety of tools to evaluate earnings quality. But they always start with their Red Flag Finder. Give them a shout if you’d like to see it for your portfolio or coverage universe. Look for changes in financial statements (out with the bad in with the good). Did a line item suddenly appear or disappear? Keep an eye out for reclassifications. Are bad things getting shifted out of the line items that the Street pays attention to while good things are getting shifted in? Name that auditor. A change in auditor is a potential red flag, especially if the company is just shopping around for a better audit opinion. Remember, auditors now file Form AP (Auditor Reporting of Certain Audit Participants) with the Public Company Accounting Oversight Board (PCAOB). The form discloses the name of the engagement partner for audit reports of public companies and information about other firms that helped-out on the audit. So, the next time you see a company run into some accounting trouble, find out who signed that audit report. He/she may have also done work on the audit of a company in your portfolio. Critical audit matters (CAM) will make their debut for most large accelerated filers in the 2019 10-K’s. As discussed in their September 6, 2019 blog post, Critical Audit Matters: CAMtastic Stuff Coming Soon to an Audit Report Near You, CAMs are matters communicated to the audit committee that “relate to accounts or disclosures that are material to the financial statements and involve especially challenging, subjective or complex audit judgment.” Zion suggests comparing CAMs to the company’s disclosures (e.g., critical accounting estimate); differences could be red flags. Balance Sheet Looking for a high-quality balance sheet. In Zion’s view, a high-quality balance sheet is when the assets and liabilities are fairly stated, the company has enough liquidity, manageable asset/liability mismatches, a straightforward capital structure and not too much leverage. Simple ratios like the current ratio (current assets / current liabilities) and debt to equity are a good start. ✓ Asset/liability mismatches can be a problem. Zion suggests monitoring them especially when no one else is. For example, short-duration liabilities funding long duration assets may not cause too many problems during a normal economic environment but come crisis time, they could be crippling (if you know about a mismatch beforehand, you can be nimble and act accordingly before crisis strikes). Quant alert: Growing liabilities (debt). The new lease rules resulted in balance sheet growth in 2019, as both assets (right to use leased asset) and liabilities (lease obligation) landed on balance sheet. A bit further down the road (in 2022), the FASB’s project to “simplify” accounting for converts will increase the amount of debt on the balance sheet and reduce interest expense (bringing it closer to cash interest but further from economic cost); see Accounting Ch-Ch-Changes. Income Statement Earnings quality is key. High quality earnings are sustainable and generated by the core business (low quality are not). Look out for disconnects, like earnings growing faster than cash flows, receivables growing faster than sales, gross margins falling but operating margins are growing, earnings not being converted into cash, etc. ✓ Higher quality = higher multiple. Is the market paying more/less for the earnings stream relative to peers, does that reflect higher/lower quality earnings? If you adjust earnings to better reflect economic reality (e.g., strip out the impact of more aggressive accounting), what type of multiple does the stock price imply? Does the stock still look cheap? Cash Flow Statement Focus on cash flow quality. Are the cash flows driven by recurring operating activities core to the underlying business or is it non-operating, non-recurring stuff? For example, is the cash flow growth coming from selling more widgets or is the company just putting off paying its bills or has it stepped up receivable sales (there's only so long that can last)? ✓ Sources and uses of cash. Zion would prefer that companies provide direct method cash flow statements where you would see sources and uses of cash by different types of business activity. That might provide a better view of whether or not the cash flows are being generated by those areas where the company has a competitive advantage. While you’re waiting for a direct method cash flow statement (don’t hold your breath), you need to do some work to get at the real operating cash inflows and outflows (e.g., strip out financing and tax related items that currently show up in cash flow from operations). ✓ Will the real free cash flow please stand up? What's the real free cash flow after adjusting for stock comp related buybacks and acquisition spend? What appears to be strong free cash flow on the surface may look quite a bit weaker after making a few adjustments. Statement of Changes in Shareholder's Equity It’s the forgotten financial statement. Use it to track changes in the underlying components of equity (i.e., book value), like additional paid in capital, retained earnings, treasury stock, accumulated other comprehensive income (AOCI), etc. ✓ But look elsewhere. If you want more information on share buybacks, check out Item 5 (Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities) under Part II of the 10-K.