Investing | Margin Rich

Potential Snapback or Another Sign of Market Deterioration

Posted on August 6, 2015 by Margin Rich

Look out below!

Disney (DIS) took a header yesterday. I’ve written about these moments before for various high-quality stocks. Inevitably, every year like clockwork the stock markets decide to put high quality businesses on sale in an overreaction to this, that, or the other. The reason for Disney’s 9% nosedive was a falloff in top lines from analyst expectations and fear for their cable revenues. Utter nonsense.

Last time I checked Bob Iger was still running the place. This man cut his teeth at Capital Cities and is as gifted as they come in the media executive space. Just look at his track record since taking over. By fully capitalizing on the cheap-money era, Iger has guided Disney into 3 of the smartest acquisitions that could possibly be conceived. They picked up Pixar, Marvel, and Lucasfilm. These 3 properties will generate tens of billions in licensing revenues and over the next couple of decades will have cash flowed billions of dollars with all the ways the IP can be distributed. And because this quarter only saw $13.1B in revenues as opposed to an expected $13.2B, Disney is somehow 10% less valuable in a single day? Weighing and voting, weighing and voting.

Disney is a high-quality choice for a long-term addition to a retirement portfolio. It generates immense amounts of free cash flow and possesses arguably the most recognizable portfolio of multimedia assets in the world. I’m a fan of the company’s tremendous cash generating abilities, however, even after the 9% drop today they are still richly valued by virtually any standard utilized.

What needs to be ascertained is whether the move down was the beginning of a stronger move lower or an overreaction? Is yesterday’s selloff an opportunity to add to a portfolio? How ripe is a snapback trade, potentially?

Let’s look at the facts about Disney’s fiscal Q3 results. They beat on earnings which were up 13% from Q3 in 2014. The YoY revenue comparable from end of Q3 2014 to end of Q3 2015 saw a 5% rise in topline, despite analyst projections. Who cares about Wall St. analysts? They are literally paid to miss the mark and then sell their misses like it’s valuable knowledge to the investing world. For the nine months ending, revenues and earnings are also up nicely. Free cash flow is down quarter over quarter but still up for the nine months ending over last year so I wouldn’t be surprised to see another year of over $6B in free cash flow.

One of the major worries about Disney is the falloff in broadcasting revenues and how they can adapt ESPN’s model to the cord-cutting trend. My stance is who cares? Is it really worth worrying if Iger is going to figure out how to fully monetize ESPN and the other broadcast assets in light of the shifting environment for cable revenues? The answer is no because Disney is just milking the current model for all that it’s worth. They’ll adapt with the cultural and secular shifts in consumer trends and continue to generate incredible income from their broadcasting portfolio for years to come.

A gambler may want to consider playing the snapback with an aggressive option strategy as asset managers potentially step in to buy Disney shares in what could be perceived as an overreaction by Mr. Market. However, breadth has been severely deteriorating underneath the market. Additionally, AAPL may have set an example for what may occur. Observe the chart below.

Despite the current VIX reading, there is a lot of fear in the market. Sentiment readings have made it palpable. Now you have two mega-sized conglomerates showing incredibly weak market action. Is the price action of AAPL and DIS a precursor to something larger? Something of the summer of 2011 variety? Hell, I don’t know. Who does? If you want some actionable advice, I’d say do what the pros do and wait for confirmation. Trying to trade in front of a trend change has depleted the bank roll of many a trader. If you want to trade the potential of a snapback without waiting then I’d suggest keeping a tight stop on whatever medium you use. For longer term allocation, if you liked DIS at $120 but were waiting for a better entry, well then I’d say a quick 10% haircut is a better entry. Remember, DIS is richly valued right now and rightfully so in light of their IP and cash flows.

There are plenty of ways to gamble long or short on the current price action in Disney, hopefully making traders dreams come true.

Geological Assays, Biological Assays, Speculating Like an Ass, Hay! – Part 1

Posted on June 12, 2015 by Margin Rich

Two sectors of the equity markets that always attracts free-wheeling speculative capital like a moth to a light is early-stage biotech and junior precious metals companies. This will be a two-part posting; the first for biotech and the second for precious metals. Like I did for the “Sample ETF Portfolios”, I’ll keep separate running portfolios for the sectors against benchmark ETFs, leveraged ETFs, and stocks.

As I’ve stated in a previous post, I think biotech could end up in a huge, mega blow-off due to the M&A activity that will continue to get larger and more irrational as the equities bull market ages. Another reason M&A activity will spike is because the players who have access to easy credit to fund a debt driven shopping spree will want to get their hands on as much capital as possible before conditions tighten. Double-digit returns are obviously a whole lot easier on purchases with WACCs that are sub-4 or 5%.

I thought that biotech may be leading a potential larger market sell-off but the sector continues to show resilience. Right now IBB is consolidating and has bounced off the 50 and 100-day EMAs with ease during its ascent in 2015.

As I said before, the conservative play is to simply buy and hold onto this bull and ride it for what it’s worth, bucking and all…but conservative isn’t fun. Yeah, yeah, I know that prudent capital allocation is not supposed to be fun. It’s about responsibly stewarding capital into intelligent investments to outperform the markets over the long term. Fine, but there isn’t a speculator, investor, or market player alive today that doesn’t get a thrill out of watching their holdings outperform the market. With that in mind let’s look at how we’ll construct a speculative portfolio of biotech stocks.

Now I’m not a biotech expert by any means. I gave up trying to cash in on the next big thing in medicine last decade in and around the time every American became an expert in real estate. For the most part, that’s been the right move but there’s always opportunity costs. In February of 2012, a friend asked for my opinion on PCYC when it was trading for a little under $20. He had shared with me some quality insight into the potential value of the company but my bias caused me to advise on passing on it. This was even after the deal with J&J. My name is Mud.

This was a ten-bagger mistake by allowing my previous experiences to misguide. Speculating in biotech is a slippery slope, though. One can get a taste of easy, probably lucky profits and think the process can be replicated, only to have hopes and trading account balances dashed.

Which is why we’ll simply piggy-back the experts. Baker Brothers and Orbimed are two of the premier investment operations that specialize in biotech. Orbimed possesses approximately $15B in assets under management. Baker Brothers manages slightly less but has a higher profile with the public, especially after their huge billion-dollar gains in Synageva and Pharmacyclics in 2015.

It’s the old 13-F strategy made a little simpler. Instead of combing through their 13-F’s at the SEC site, I just hit the NASDAQ instead. There you’ll find the institutional portfolios, free of charge, of both Baker Bros. and Orbimed. They are updated as of Q1 2015. My logic is to simply cross-reference Q1 additions for each fund of the same companies, whether they’re a new position or an increase to an existing holding. The thesis being that if it’s good enough for both these guys then it’s good enough for me.

Bear in mind this is generally not a sound way to invest by any means. Sure there are dozens of sites dedicated to cloning professional portfolios by using 13-F filings, but blindly following a pro is just unsound. It always pays to conduct thorough due diligence. Gleaning ideas to further research is very different from blindly following a respected professional into a position. The thing about 13-Fs is that you never know how the pro is actually playing the position. How are they hedging? Are options involved? You just never know. With that being said…

The following are the stocks we’ve come up with from cross-referencing the Q1 additions.

This will not be a real-money portfolio for me, however, I reserve the right to position as I see fit should I be so inclined. If you want to take a flyer, without putting in any work, at higher biotech returns as M&A finally supercharges the sector then this little portfolio is as good a gamble as any. We’ll run this portfolio against five other investment options for biotech exposure.

The first option will be IBB, the all-weather biotech ETF with the most assets under management that has extensive coverage and great liquidity. IBB will be the benchmark. The next option will be LABU, which is the Direxion Daily 3x leveraged ETF of the S&P Biotech Select sub-index. This is our leveraged play without the margin. It’s very new; less than a month old. Trendy ETF creations that hop aboard trains which have already left the station have had a fairly consistent tendency to signal that the destination may soon be reached. As noted countless times though, “soon” is a relative term.

The third and fourth biotech investment options are the BioShares ETF offerings from LifeSci Index Partners. Paul Yook is the co-founder and portfolio manager for LifeSci. He came from Galleon as a portfolio manager and analyst. Despite the downfall of Galleon’s founder, it was still one of the more powerful hedge funds during its prime. You can garner some additional knowledge via this May ETF Reference interview with Yook. The thing that is nice about these two particular ETFs is that LifeSci offers two levels of risk. They offer BBC which takes positions in biotechs at the clinical trials level and has the potential for higher reward. Then there is BBP which only “invests in biotechnology companies with lead drugs already having received FDA approval.” In theory, BBP should reduce some of the risk and volatility compared to BBC.

The final investment option will be Ligand (LGND). They are basically the only publicly traded royalty play in biotech. They’re essentially modeled after the natural resources royalty players. Think Franco Nevada or BP Prudhoe Royalty Trust but with a wide-ranging portfolio of medicinal therapies at varying levels of clinical stages. LGND possesses a portfolio of over 120 partnered programs with biotech players ranging from the highly speculative to the most established in pharma. A position in Ligand is a bet on management’s competence to expose investors to some of the best profit generating opportunities in biotech while de-risking the investment, so to speak.

Be warned though, LGND has seen its share of volatility. Yes, it has treated shareholders exceptionally well for those who have been able to buy and hold over the last 5 years, but it hasn’t exactly been a one-way ticket to Profitsville. There’s been a few stops to Correctionville along the way including a recent 45% haircut through most of 2014.

None the less, as the only royalty option in the biotech sector I still want to track it against our speculative portfolio, volatility-warts and all.

I’ll post portfolio updates once a month. You’ll see a new link on the Marginrich.com home page around the beginning of next month. The tracking page will maintain nominal dollar gains and percentage gains as well. They’ll look exactly like I what used before with the Sample ETFs.

So there you have it; multiple ways in which to capitalize on what could be an explosive rise in biotech as M&A potentially rages out of control. If you’ve missed this several hundred percent move off the 2009 lows, then here is a perfect opportunity to get positioned for the final blow-off which should come just as it always does for every biotech boom. I don’t think this blow-off is imminent so please don’t misunderstand what has been written. I just feel very strongly that biotech M&A will catapult returns in the sector based on what we’ve seen in every other boom over the last 15 years. The timetable, as with all speculation, is the real question. This portfolio will be tracked indefinitely until we see signs of a legitimate trend-ending correction. Come back often to track the results.

One final note before signing off. For the truly conservative investors out there who visit this site, I just wanted to offer a quick update on one of the funds that I highlighted in my post regarding the emergency fund. It would appear that now may be an opportune time to position into the muni-bond closed-end funds. My preference happens to be NEA but there are a multitude available. Most of them happen to be at their 52-week lows in regards to their respective discounts to NAV. The 10-year Treasury yield is bumping up into what appears to be stiff resistance while at the same time hitting a 61.8% retracement off the Dec. 2013 highs to the Jan. 2015 lows. Additionally, NEA has retraced 38.2% off of its Dec. 2013 lows to Jan. 2015 highs while currently trading in a price range where it has tended to bounce off of. Three out of the last 5 times we saw the price action dip like this to the $12ish range we saw a relatively quick bounce back up into the $14ish area. The two times NEA went lower than $12 and took longer than normal to bounce back up over $14 were aberrant situations like the GFC of 2008 and the huge muni-selloff of 2013. It looks like a good time to take advantage of some great tax equivalent yield with the potential for some decent share price gains.

Value of Increasing Portfolio Cash Levels

Posted on May 19, 2015 by Margin Rich

There are essentially two major views on cash in one’s portfolio. One view, which is predominantly held, is that cash yields nothing and thus must be allocated into an asset that does yield. The other view is that cash provides the ability to strike when value opportunities arise, and that ability is virtually priceless when the blood is running. What would you have given to have a warchest full of cash to deploy in March of 2003 or March of 2009?

The Spring 2015 edition of Columbia Business School’s (“CBS”) student-led value investing newsletter, Graham & Doddsville, profiled Matthew McLennan of First Eagle Investment Management, the house that Jean-Marie Eveillard built. By the way, Graham & Doddsville is published 3 times a year in the winter, spring, and fall. The newsletter contains interviews with investment pros, highlights of the CBS program, and investment theses by students. It can be a tad redundant of a read, much like Marginrich.com, but every now and then you can glean some quality insight from the interviewees.

McLennan shared some valuable insight on the value of cash, eloquently stating:

We can’t predict what the future will bear. At First Eagle, we view cash as a residual of a disciplined underwriting approach and as deferred purchasing power…We don’t feel the need to force cash to work just because it is a zero-cent yield today, because the return to cash has two components: it has the current yield, and it has the option of redeployment in distress. We feel, given the state of the financial architecture, there will be more windows of opportunity over the coming years to buy businesses that offer potential return hurdles in windows where the markets are less complacent.

It’s this option of redeployment why cash warrants a higher allocation right now. The spectrum of investors is vast with varying risk tolerances, varying asset levels, varying time tables, etc. Whether you’re a professional or an amateur, there is enough compelling evidence to espouse this view. Let’s start with valuations.

Sure, the major US stock market indices are hitting new all-time highs but the price action looks weak, and that’s on the back of some of the highest levels in history of current valuations. Traditional valuation methodologies such as the CAPE and Tobin Q are at levels only seen in 1929, 2000, and 2007. Does that not concern you?

Doug Short provides charts that depicts the CAPE, which he calls P/E 10, and Q plus the Crestmont P/E and S&P 500 regression from its price. One chart that particularly captures the moment in valuations, allowing for some perspective, is the Average of the Four Valuation Indicators with the standard deviations highlighted. Observe:

What immediately jumps out about the chart is that we are currently two standard deviations above the mean for the average of these four indicators, and we are also at a level higher than where we were at right before the Great Depression.

So what! This time is different, right? We’ve got interest rates at basically zero and quantitative easing in Europe and Japan after having just finished in the US. With rates at the zero bound and QE occurring in the most major of markets, equities appear “fairly” valued. Which begs the question, then what is extremis? Is it 10% higher from current price levels on the S&P 500? 20% higher? 30%? Who’s to say? Certainly not the overwhelming majority of professionals. There will be some that nail the top; statistically it’s inevitable. However, the preponderance of evidence unequivocally shows that the professionals are as ignorant about the future of stock market price levels as the people who unfortunately rely on their opinions. They have no idea when the music will stop which is why they keep dancing and dancing and guiding the public to do the same.

Let me provide you with a perfect example. Here’s a December 2007 article from Bloomberg Business(pre-BusinessWeek acquisition, hence the references) titled Where to Put Your Cash in 2008. In it, seven stock market analysts were polled including some from the largest banks on Wall St. The list includes Chief Investment Officers or Chief Equity Strategists at banks such as Citigroup, BofA, and BNY Mellon. Here is where each member of the poll stated they thought the S&P 500 might be trading at by the end of 2008, 1. 1,520 2. 1,675 3. 1,680 4. 1,700 5. 1,675 6. 1,625 7. 1,700; for an average of 1,653.

Anybody recall right off the top of their head where the S&P 500 closed on December 30th, 2008? It was 890. 890!!! Even the most pessimistic of the 7 missed the mark by a whopping 42%. That is egregiously inaccurate for some of the most allegedly well-informed and experienced market forecasters. And what’s worse, these calls were made in December of 2007 well after the market had begun to turn down and create a lower-high. Now of course, hindsight is 20/20 and maybe BusinessWeek excluded any bearish pollings which may have been more accurate, but the fact is these chiefs help in the decision making of multi-billion dollar organizations with multi-billion dollar portfolios.

Many pros utilize statistical models that provide a false sense of security; not just the pros but the academics masquerading as professionals at the world’s central banks and asset management houses, too. They think everything in the world is simply a matter of accurately determining the mathematical expression of potential and probable outcomes. Because as long as you can assess portfolio risk via language like this,

then the world is your oyster. Recall 1998 and the wrench that LTCM threw into the equity markets thanks to its genius partners who could quantify anything and everything in the world so profits were guaranteed. More recently in 2007, every financial house and shop knew risk was mitigated because the statistical models quantitatively guaranteed it. Human behavior simply cannot be accurately quantified with any long-term consistency and the markets consistently forget that. If that were not the case then IBM would be the most successful hedge fund in the world with Watson precisely quantifying all human risk variables and factors to own the world of speculation.

The so-called smart men don’t have any better knowledge of the future than some guy off the street. The future cannot be statistically quantified within an if/then statement. The rationale of the central planners and economists is consistently, “If this then that”, but the world is not tied up and wrapped up so neatly with a bow on it. The same can be said for our economy and financial markets.

People think that the people at the top have all the answers and will provide fair warning for everyone, but that’s not the way it works and people’s incessant memory loss of all things financial prove that out. You don’t know when a component of your car’s engine is going to malfunction. It just happens. Same goes for the economy and the markets. Along will come an unforeseen event i.e. black swan i.e. fat-tail that will critically damage the component of the engine causing the machine to breakdown. Let me remind you, that the same people that stewarded the financial crisis of 2008 are still in power at all the major private, public, and government entities.

I don’t mean the same people in the literal sense, but the same kinds of individuals. All without extra sensory powers of foresight and omniscience. They continue to utilize the same models that have been so greatly leaned on since the 90’s. The kind of statistical models that say “Oh, this event could only occur once in every 10,000 years so we have nothing to worry about regarding the management of our risks.” When the next downturn comes along, and it will because cyclicality is but one of nature’s simple inevitabilities, all these smartest-people-in-the-room types will be poring over their models and wondering how such a deviation from the standard could have caught them unawares.

Don’t be caught in the same trap that ruined the financial portfolios for so many investors on the brink of retirement. Now is the time to prepare yourself, because your RIA or whoever else you entrust your financial future to will not be able to safely shepherd you through the next financial crisis. They can’t. It’s virtually impossible due to career risk, fund charters, and the greed of maximizing assets under management.

There will of course be the small cadre of asset managers that go to cash early by tactically liquidating the portfolio and placing intelligent counter bets to strategically capitalize on the next great dislocation; in the process becoming hailed as new gurus. However, the financialization of our economy has driven so much talent into the markets that it’s statistically impossible for most money managers to not lose big. Inherently, the players in the field know and understand this but the people placing their hard-earned money with these players generally do not share the same level of comprehension.

I’ve been sharing my thoughts for some time now on the potential benefits of raising cash levels. I don’t think it’s alarmist. I continue to think it’s prudence. I’m not saying exit the markets. Just start to build cash levels. Examine the chart below with the obvious benefit of hindsight.

Let us assume the next great dislocation takes the S&P 500 down by 50%. This assumption is based on the approximate haircuts of 47% and 56% in 2000 and 2007, respectively. For the sake of the illustration, let me also generously give the S&P 500 another 30% of upside from current levels. That would put the S&P 500 at about 2,770. Halve it and you have 1,385 which is still 35% lower from current levels, a bear market by any standard but the 50% markdown would be avoided for a portion of holdings. Then with valuations in the trough, one can begin to selectively capitalize. All the variables are unknowable. It’s a simple exercise for the sake of illustrating the value of having cash available at the appropriate moment in time.

As previously stated, if you think leaving your hard-earned money in the hands of a professional will protect you, you are mistaken. Chuck Jaffe, MarketWatch columnist, penned a recent article which imparts this very notion. The piece’s opening headline states, “Only four funds have beaten the S&P 500 for the last eight years.” That’s four as in you can count the number of actively managed funds on one hand that can beat a simple index of the S&P 500 over the last eight years. Those four funds are all in healthcare, which means it has taken the tailwinds of what is arguably the strongest demographic opportunity for the next 10 to 15 years to beat a simple index.

The markets are cyclical and what was old is new and what is new is old. The sun may wane on indexing for a time and active stock picking may get revitalized. If you intend to be one of those stock pickers then it is imperative to have the cash available for opportune investment. I’ll share what I feel is a poignant quote from Charlie Bilello, of Pension Partners, that summarizes the value on boosting cash levels in one’s current portfolio. In the article, Bilello is referring to the ATAC rotation strategies that Pension Partners advise on and utilize, however the sentiment is equally applicable to what has been articulated in this post. To wit(emphasis mine),

Similar to the mid to late 1990’s the last few years have featured runaway gains in U.S. equities. Any strategy that was built to minimize downside over this time has dramatically underperformed as there has simply been no downside to capture. While some would view this as flaw in these strategies it is the only way they can work over time. In order to minimize downside you have to be willing to give up upside in return, and by extension this means underperforming during runaway phases in bull markets. There is no other way if your primary goal is to protect capital. The tide always turns and while out of favor today, preserving capital and managing risk will be back in vogue once more, but only after the declines occur.

Brush up on your valuation skills. The sacrifice of modest current returns versus potential outsized losses while waiting for the inevitable fire sale makes cash a superior asset. Set aside the ingrained notion of maintaining a current unproductive asset bearing debasement losses for the simple notion of sometime in the near future you could be buying the most productive businesses or assets on the planet for 40 to 60 cents on the dollar. Will we get another crack at the beginning of a true secular bull market beginning with a CAPE in the single digits? Possibly, but I’ll take a CAPE in the teens just as well and I’ll want to have the ammo available when such fortuitous circumstances(for some) arise.

Update: 5/22/2015
I readily and regularly admit to not exactly being an intellectual heavyweight, so here’s an interview with Nassim Taleb from the Swiss website Finanz und Wirtschaft. They consistently feature quality international pieces from international guests. In the article, Taleb(a legitimate intellectual heavyweight) shares many of the same sentiments expressed in this post; just to add a touch of support to the claims.

Spinoffs – A Review of Energizer

Posted on April 6, 2015 by Margin Rich

Spinoffs have long been a hedge fund favorite for arbitrage opportunities. That was of course before the days of derivative structures that allow asset managers to take on and hedge risk in countless ways, and not necessarily in the most intelligent fashion. A spinoff is still a good opportunity and there are more than a few academic studies, mostly from the 80’s and 90’s, that provide evidence behind the strategy of investing in spinoff opportunities.

Reading academic reports, even when one is engaged in the content, can at times be like watching paint dry whilst watching Empire by Andy Warhol in the background. However, Joel Greenblatt, one of the most successful hedge fund managers of all time, dedicated an entire chapter to spinoff opportunities in his classic book on speculation, You Can Be A Stock Market Genius. He takes a light-hearted approach to sharing his successful experience with spinoffs. You get the first-hand account of a true professional who has made money strategically utilizing spinoff situations as opposed to the dull but factual report of some PhD who’s never worked a day in the private sector.

Had to dust off my old copy to share some of his stuff but in chapter 3, Chips Off the Old Stock, Greenblatt covers the basics of speculating in spinoff situations while covering several working examples with Marriott, Home Shopping Network, Sears and a few others. He also goes over rights offerings with a Liberty example as anyone familiar with John Malone knows he loves to complicate things with a rights offering. Want an abridged version of how Malone made so much damn money transitioning to Liberty? Have a read of the end of chapter 3 in Greenblatt’s book.

Greenblatt sites a 25-year 1988 Penn State study to support the efficacy of investing in spinoff situations. In summary, the study found that spinoff companies outperformed the S&P 500 by approximately 10% per year in the first 3 years as a solo company. Additionally, the remaining parent companies also outperformed their respective sectors by 6% annually in that 3-year window when the spinoff occurred. That’s high outperformance by any measure. Greenblatt succinctly and eloquently states that:

If you accept the assumption that over long periods of time the market averages a return of approximately 10 percent per year, then, theoretically, outperforming the market by 10 percent could have you earning 20-percent annual returns. If the past experience of these studies holds true in the future, spectacular results could be achieved merely by buying a portfolio of recently spun-companies. Translation: 20-percent annual returns — no special talents or utensils required.

For the ETF-everything crowd, there’s even an offering for you which will allow you to outsource your intellectual efforts in case you’re not so keen on sifting through any Form 10s. Guggenheim offers the Beacon Spin-off Index (CSD), with approximately half a billion in AUM. If you’re already familiar with the offering then you know that results have been less than exciting compared to the picture Greenblatt painted, but such is the case when using an ETF instead of digging in and conducting your own due diligence. Below is a chart of performance since inception. It is easy to see the tight correlation of CSD’s (candlesticks) performance to the S&P 500 (blue dash), however since The Great Recession, it has consistently outperformed the S&P 500 by a couple of percentage points. Not exactly the stuff that makes up 20% annual.

You Can Be A Stock Market Genius is 18 years old. Many of the academic studies regarding spinoffs are equally as old or older. This means the data and situations covered came long before massive quantitative easing, ZIRP, high-frequency trading, and after Gramm-Leach-Bliley; four of the biggest reasons there is wide-scale questioning of true price discovery in most markets. Despite one’s perceptions of a skewed marketplace, the markets are still functioning and there is money to potentially be made, which brings us to Energizer.

A year ago, Energizer Holdings (ENR) announced they would be splitting the company in two. The company believes it has reached critical mass for its two operating segments and that each unit would benefit as a stand-alone operation. Everyone knows that Energizer makes batteries, including the Eveready brand, as well as various lighting devices as part of their Household segment. What is less well known is their Personal Care segment which manufactures razors, sun block, feminine products, and various baby care products. Both segments produce quality operating margins but Personal Care has become the revenue leader for the company due to some bolt-on acquisitions in conjunction with overall declining demand in the alkaline battery space. Have a look at Personal Care’s competitive positioning in its respective product categories, courtesy of their February CAGNY presentation:

Even though Gillette’s grip on the razor space is massive, Schick’s entrenched position at number 2 in the world allows for some impressive cash flows. Additionally, holding the number 1,2, or 3 brands in the rest of the product categories has Personal Care, which will be renamed to Edgewell subsequent to new Energizer’s spinoff, well positioned to continue generating solid free cash flows. One of the current Energizer Holdings stated focus areas for management is free cash flow. In fact, a handy chart is provided right on the 2nd page of the most recent 10-K that shows the last 5 years’ worth of the company’s free cash flows (FCF).

With long-term debt of around $1.8 billion, we’re only talking about three and a half years for total payoff at current debt levels with this sort of consistent FCF generation. Additionally, in the shareholder letter on page 3, the CEO refers to the importance of maximizing free cash flow for any business while discussing the FCF results under the company’s working capital initiative. Earlier in the decade, ENR began to focus on reducing working capital to help maximize FCF. For initiative purposes, the company adopted a proprietary metric, “Adjusted NWC”, in which they strive to lower net working capital. Typically, for working capital, investors utilize the current ratio to help ensure efficient allocation of resources. Specifically, Energizer is focused on the reduction of receivables minus accrued liabilities, and inventories minus accounts payable. Accounting details aside, intentions are to generate higher free cash flows to increase shareholder value and you really can’t ask for much more from a corporation’s management. Here’s a slide, also from the February CAGNY presentation, illustrating the point:

We now know we have company management publicly aligned on shareholder-friendly initiatives, so let’s go over some of the particulars of the spinoff. Edgewell’s ticker will be EPC while the Household brands will maintain the Energizer name and continue to trade as ENR. For convenience and clarity, I will simply refer to each new company as their ticker symbol and if needed will refer back to the current combined company as Energizer Holdings.

The spinoff will be a 1 for 1 share distribution in a very straight-forward, tax-free separation without a convoluted package of rights offerings or tax strategies. The Form 10 is the document where anyone can review the details of the spinoff. For some, combing through the Form 10 can be the most cumbersome part of analyzing a spinoff transaction, however, so much of the content is simply boilerplate legalese that it doesn’t take as long as one might think to go over the entire document. Energizer Holdings filed an amended Form 10 on March 25th of this year and it runs 212 pages, but again, don’t let that length inhibit you if you really want to scrutinize the potential of the deal.

Energizer Holding’s listed reasons for separating the companies are just more basic boilerplate corporate speak: “focus on distinct commercial opportunities, allocation of financial resources, management focus and separate capital structure, targeted investment opportunity, creation of independent equity currencies.”

Great, but let’s take a look under the hood of the SpinCo., which is new Energizer (ENR). Edgewell (EPC) will technically remain as the “parent” company. In the Form 10, SpinCo. prepared financial results for a year-end as of September 30th, 2014 as if the company already split as of October 31st, 2014. Let’s first examine ENR’s top line over the last 3 years.

So if this is your first time seeing ENR’s sales results, you’re probably thinking “Whoa!” Where’s the growth? Decreased net sales for the last 3 years with a total failure to generate any organic growth, which is an unaudited metric that corporate managements usually take extra care to positively affect. But wait, it gets worse.

You can see that the trend in the top line was already flattening from 2010 to 2011 precipitating the decline that really kicked in in 2013. This slowing can be interpreted in two ways. One is that the business is stodgy and its main product line, alkaline batteries, lacks innovations to carry it forward into the evolving universe of devices. Or, the lack of sales growth is only temporary as management allocates greater resources to R&D to spark innovation across the product lines. Additionally, growth could be purchased through intelligent bolt-on acquisitions that work to enhance the culture of free cash flow growth. ENR’s free cash flows in conjunction with access to low-cost capital will provide management with flexibility to explore this option down the road.

The production of FCF by ENR has been a bit choppy the past few years but the average has still been about $200M a year.

None the less, ENR is producing declines in revenues and profits across all geographic segments around the world. Additionally, SG&A continues to be higher than what I would like from a focused management with this particular expense category coming in at $391M as of September 30th, 2014. Making SG&A approximately 21% of net sales, which in my opinion is bit high but I understand separation costs and the working capital initiative have bitten into this area. We’ll partially chalk it up to a cost of building capital efficiencies.

One of the areas that has a tendency to get closely examined in a spinoff is executive compensation. How will pay be aligned with operational goals? Will those same goals be necessarily shareholder friendly? These are important questions to ask. More so I think with companies that utilize an excessive amount of share-based compensation and really dilute existing shareholders while the company may still be struggling to even generate a profit.

Happily that is not the case with Energizer Holdings and current executive compensation policies will roll out to new Energizer and Edgewell. Salaries for the CEO, COO, and CFO for new Energizer are reasonable with base salaries in the $400’s annually for the CEO and COO while the CFO is in the $300’s. Stock awards and short-term non-equity incentives i.e. cash bonuses will take the three of them up into the $1M to $2.5M range for total annual compensation. In a company of approximately 5500 employees and a stated goal of quality capital stewardship, I’m ok with the top 3 employees earning around $5M total for now. Again, the focus is on free cash flow while creating shareholder value and the retention of quality talent requires fair compensation in light of general employment market conditions.

Have a look at the Short-Term Incentive (STI) and Long-Term Incentive (LTI) plans for new Energizer executives, courtesy of the Form 10:

Executive STI:

Annual Cash Bonus Program – Annual cash bonuses to our named executive officers are based on a percentage of the executive’s annual salary, and adjusted based on performance on metrics determined by ParentCo’s NECC. The 2014 annual bonus program was designed to measure performance against four metrics:

• Adjusted EPS (30% of the named executive officer’s bonus target)
• Adjusted Operating Profit (30% of the named executive officer’s bonus target)
• Company-wide Three-Year Global Cost Savings (20% of the named executive officer’s bonus target)
• Adjusted NWC (20% of the named executive officer’s bonus target);

Executive LTI:

Continued enhancements to the long-term incentive program – Beginning in fiscal 2013, ParentCo’s NECC adopted three metrics for the long-term incentive program, replacing the Adjusted EPS metric used in past years. At the start of fiscal year 2014, ParentCo’s NECC reviewed the compensation elements and determined that the compensation elements adopted in fiscal 2013 continued to be consistent with ParentCo’s compensation philosophy and approved the same metrics for fiscal year 2014:

• adjusted return on invested capital (ROIC), to support ParentCo’s focus on cash flow, including improved working capital performance, and to emphasize the importance of capital allocation decisions;
• cumulative adjusted earnings before interest, taxes, depreciation and amortization (EBITDA), to emphasize growth in core operating earnings; and
• relative total shareholder return to further ensure that realized results are aligned with, and shareholder value creation results from ROIC and EBITDA can be further impacted by relative total shareholder return.

Margin Rich here again, for the cash bonuses the payouts aren’t simply based on earnings or profits. It’s earnings, operating profit aka cash from operations, company ability to reduce expenses, and working capital efficiency to help drive free cash flows. The stock awards are based on ROIC, EBITDA, and total shareholder return. These incentives seem quite shareholder friendly in light of the cronyism, greed, and career risk that runs rampant through the corporate world these days.

Ok, so I realize I’ve presented a little bit of a conflicting opinion here by pointing out the declines of the battery business but sharing appreciation for management’s focus on free cash flow and reasonable compensation packages for executives. The reason is because from a speculative standpoint, this spinoff can be approached in multiple ways. As a long-term investor, or at least 3-years according to the study, going long EPC and ENR provides what could be a solid opportunity to generate a market beating effort. Consider the pros: shareholder friendly management, great free cash flows, reasonable debt levels, and the tail-wind of the average performance of spinoffs according to several different academic studies. The cons: ENR’s declining revenues and profits, lack of innovation at ENR, and the negative perception that comes with the first two cons.

Notice I didn’t include Edgewell in the cons list as I think it may represent the better of the two opportunities. I suspect we may see the money management crowd attempt to short ENR while going long EPC, a classic arbitrage. Consider where the current combined company has seen its growth in the past 12 years. It’s in the personal care division through smart acquisitions. Observe:

Have a look at how Personal Care and Household have stacked up against each other in sales and profits for the last few years, via the most recent 10-K.

It’s plain to see where the growth and the slump has occurred within Energizer Holdings. This is why I think the short-term trade is to go long EPC and short ENR. The battery business may get sold off as investors vote with their feet behind the company’s declining earnings. Obviously, nobody has a clue as to how the market is going to react to the post-spun shares. Both could sell off indiscriminately or be bought in a frenzy. These are the obvious risks of speculating, but they’re worth reiterating time and again. Another risk to consider is the ticker-risk with EPC. ENR is the current ticker of Energizer Holdings and the spinoff of the battery business will maintain that ticker. As EPC will be the new ticker that shows up in the accounts of current shareholders of Energizer Holdings, EPC may get sold off indiscriminately despite its higher growth profile in sales and earnings.

There’s plenty to consider here if attempting to capitalize on the Energizer spinoff. This is just a light dusting of research that should be undertaken for an intelligent investment. There’s still cash flows to model. The patent portfolios are fairly significant and would require a detailed look, if possible, to gauge value. Additionally, the capital structure has still not been finalized for new Energizer. Always conduct a thorough analysis but you can see that a spinoff presents a fun opportunity to test your skills as an analyst and speculator. Bear in mind, the professional set has picked this opportunity apart and modeled it a dozen different ways so if any readers attempt to allocate capital on this play; don’t try to be too cute.

There are a multitude of sites that allow anyone interested to stay on top of spinoff opportunities. One of my favorites is SpinoffMonitor.com. You can also check out StockSpinoffs.com or StockSpinoffResearch.com. Energizer Holdings is widely followed, and again, it’ll be analyzed six ways from Sunday by every analyst and money management firm out there. For a fresh research opportunity, consider W.R. Grace, which will be splitting itself into two companies. Grace is a well-capitalized, diversified chemical manufacturer. Each new Grace company will be an upper-tier participant in its respective industry. Have fun and good luck.

Short-term Equity Risks Arising

Posted on March 26, 2015 by Margin Rich

Despite Wednesday’s(3/25/2015) market weakness on virtually nothing but fear, there is plenty of technical action showing that markets appear fine. The question is how reliable is the action. Breadth indicators across multiple indices are positive. Small caps are leading large caps. Consumer discretionary to staples are favorable. Rate sensitive ETFs(TLT & XLU) have been conducting basic retracements which is perfectly natural coming off their hard sell-offs, but I think their selling will resume which will continue to indicate higher risk appetites once stocks take a little breather of their own. If the equity markets do what I think they’re going to do, which is correct a little harder here in the near-term, then I suspect TLT and XLU will chop for a bit while stocks let off of a little steam.

Everybody has their own methodologies for reviewing the markets to get a feel for the probability of directional plays. I really like to use inter-market analysis to help me potentially sense where the greater market may be headed. I have been watching biotech very closely as it has been the hottest sector and a market leader for some time. Real weakness in biotech may be a precursor to overall market weakness. That action last week in IBB had me suspicious. To me it appeared to be a blow-off. Call it what you want, a throw-over or a bull-trap. Either way the price action raised my hackles and officially put IBB on my radar as a temporary short. Current price action in IBB and the S&P 500 may be proving that out.

Now clearly, biotech is in a raging bull market and has been for several years now. You don’t want to fight that trend. It’s better just to ride it upwards for continued profit, because it’s going to take a lot more M&A in that sector before we see a top in biotech. However, there was a bit of froth in biotech M&A during the first quarter of 2015. Observe the following chart courtesy of Reuters and just look at Q1’s performance amongst pharmaceutical companies compared to the last 5 years.

We haven’t seen that kind of aggression since coming off the lows of 2009. There’s been approximately $60B of M&A activity in pharmaceuticals to start 2015, which accounted for 10% of overall M&A activity in the quarter. Twenty-one billion alone of that $60B was done in the Pharmacyclics purchase by AbbVie. That also signaled to me a potential short-term top for biotech as J&J and AbbVie slugged it out for rights to the cancer-fighting company.

So the real question then is how is this information actionable? Well that depends on your appetite for risk and how you’re looking to allocate capital in the short-term or long-term. If you’ve been visiting this blog for a while then you’re well aware I’m always ready to roll the dice based on my ability to interpret market action. I think shorting biotech via IBB or XBI is a good opportunity. I could have positioned earlier, but I was waiting for the price action to confirm so as to hopefully avoid being whipsawed.

If any readers are inclined to risk come capital, I think that IBB’s price action has stated to market players that it looks good for a short-term short. A small bounce at this price point is likely; especially in light of that 4% down day. I suspect the bounce could move the share price back up into the $355 to $365 range giving weak hands sufficient room to liquidate. That liquidation could then kick off the next leg down in biotech. There is a very strong floor at $290 as that is where the current 50-month EMA rests, so any option players will want to factor accordingly. I’m not stating that I think IBB will definitely hit $290, just that it’s a strong price point of support.

If IBB’s share price creates un-compelling options price points for smaller traders, then the XLV is a solid alternative. It has higher relative strength due to the size and various types of non-biotech holdings, but XLV possesses sufficient exposure to biotech that it will correct as well and it’s options may allow for a wider range of speculators to employ strategies.

As for the larger market i.e. the S&P 500, I wouldn’t expect anything deeper than a 10% correction if even that deep. There’s strong support at its 50-month EMA, as well, which is currently at $1,987. A 10% correction would take us down to approximately $1,900, which is also a round-number “power line” that I see providing strong support. I also suspect that any sell-off would result in yet another V-shaped recovery so be prepared to remove any short bias as a new leg higher ensues for the S&P 500 and biotech. Remember, these are interpretations based on my inter-market analysis. There are plenty of breadth indicators putting a more positive spin on things.

The markets are tricky, rigged, and no place for the ignorant. Manage your risks accordingly and utilize any potential correction to get long. There is continued quantitative easing on a massive scale across the world and the Fed is still reluctant to raise rates just yet. Current liquidity levels and yield curves continue to put a wind in the sails of higher risk assets. As Q1 draws to a close, take a moment to review your portfolio and see where you stand in 2015.