Johnson Controls: Automotive Batteries and HVAC Make Strange Bedfellows

Johnson Controls is an industrial company with diverse interests in automotive, heating and air conditioning. Johnson Controls is really three companies in one. Already one of the leading automotive seating and interiors suppliers, Johnson Controls continues to diversify. Growth in its building efficiency and power solutions group helps offset vicious cyclical declines in the automotive experience group.

The automotive segment contributed 51% of fiscal 2013 sales, down from 69% in fiscal 2005, which shows the company's increasing diversification.

Building efficiency in fiscal 2013 was a $14.6 billion business, contributing 34% of sales compared with 21% in fiscal 2005. The 2006 acquisition of York, manufacturers of heating and air conditioning equipment, made Johnson Controls a much larger player in HVAC equipment and service. This depth allows the company to market itself as a one-stop shop for service, controls, and equipment, which differentiates JCI from other large providers. Eighty-three percent of segment sales come from repeat business, but the company seeks to increase its exposure to more profitable HVAC product sales for a 50/50 product and service segment mix.

Power solutions is highly profitable, with 15% of fiscal 2013 sales and an operating margin over 15% in fiscal 2013. The segment has 36% share in the lead acid automotive battery market. This business is also a good diversifier because 80% of segment sales are to the replacement market, which makes battery demand more inelastic and gives the company strong pricing power. Johnson is the dominant player in start-stop vehicle technology thanks to its leading position in absorbent glass mat AGM batteries. Power solutions should benefit from automakers needing more fuel-efficient vehicles to meet environmental regulations.

There is tremendous growth and profit potential in AGMs because the batteries sell for twice the price of a normal lead acid battery. AGMs also generate 50% better profit margin. European auto production is forecast to increase the use of advanced lead acid batteries, such as AGMs, to 75% by 2015 from 40% in 2011. North American auto production is forecast to increase advanced lead acid use to 59% by 2015 from nearly zero in 2011. Globally, management expects start-stop to be 50%-60% of powertrains in new vehicles by 2020, up from 14% in 2012.

At the current price and a 15% anticipated EPS growth rate, JCI is trading below its earnings growth rate with a 2014 PE of 13.  JCI has been paying a dividend for decades and the current price offers a dividend yield of 2.0%.  JCI has a 5-yr dividend growth rate 7.9% and a 3-yr growth rate of 13.5%.  Management recently announced a dividend increase of 16.1%.  However, reported EPS over the same timeframe have been rather flat, mainly due to restructuring charges. 

JCI has a price target of $56, about 35% above its current price of $41.  While EPS have been stagnant over the past few years due to restructuring and charges, management should be about complete with its realignment of their businesses.  The underlying strength in the automotive and construction industries should help turn earnings around.   After being negative in 2010 and 2012, Free Cash Flow (operating cash flow minus capital expenditures) turned positive in 2013 to the tune of over $1.3 billion, and continues positive YTD.  Management believes free cash flow could top $2.0 billion by the end of 2016.

From Morningstar’s JCI report:

Johnson Controls has 15,000 HVAC service providers, making it 3 times the size of the second-largest player.
More governments wanting green buildings and the company's unique ability as a one-stop shop will keep the building segment growing and profitable, especially in emerging markets.
Increases in lead prices are mitigated by the fact that 100% of the lead price pass-through has been standard contracting with battery retailers for more than 70 years.
The company still gets about half of its sales from the very cyclical auto industry, and the market perceives it as an auto-parts supplier.
Commercial property servicing is very fragmented, and it could take time to capture significant share in the middle-market segment.
About 20% of battery sales are to automakers, which further exposes Johnson Controls to declines in auto production.

Investors looking for a high quality industrial company for the long term should review JCI.  Stock valuations have been consistently near the top of our universe.  More information can be found in JCI’s most recent investor’s presentation:

http://www.johnsoncontrols.com/content/dam/WWW/jci/corporate/investors/2014/JPMorganAugust2014.pdf

First appeared in the Oct 2014 issue of My Investment Navigator newsletter
Thanks for reading,  George Fisher

Lockheed Martin's Growth Fueled by Net ROIC of 30%

The world’s largest defense contractor offers dividend growth above inflation expectations and a yield higher than the current 30-yr Treasury.    Lockheed Martin (LMT), with $45.4 billion in revenues, has a 5-yr average dividend growth of 21% and a current yield of 3.5%.

A good description of the company is from their website:

LMT is a global security and aerospace company principally engaged in the research, design, development, manufacture, integration, and sustainment of technology systems and products. The Company also provides a range of management, engineering, technical, scientific, logistic, and information services. It serves both domestic and international customers with products and services that have defense, civil, and commercial applications, with its principal customers being agencies of the United States Government. It operates in five business segments: aeronautics (31% of 2013 sales), missiles and fire control (17%), mission systems and training (16%), information systems and global services (18%), and space systems (18%).

 LMT manufactures the newest jet fighters, F-35, and its fortunes will pivot on this important defense business, both in the US and abroad. 

 Dividend increases have been fueled by an 8% earnings growth and a payout ratio that has expanded from 30% of earnings to 53%.  While unsustainable at this growth rate, a long-term dividend growth matching its earnings growth of 8% would remain a respectable combination. 

 LMT should not be considered a value selection as it is trading at a PE of 18 with an underlying growth rate of 8%.  Share prices are up 12% from early August, and up 50% over the past year, substantially outperforming the market.  However, LMT has been a solid dividend payer with a lower-than-market beta of 0.72.    

 Helping long-term eps growth has been a reduction in shares outstanding.  Over the past 10 years, LMT has reduced share count by 28% - from 443 million shares outstanding in 2004 to 319 million currently.  This has help drive both eps and share prices higher. The combination of dividend growth and share reductions is a double positive for long-term shareholders.  It should be anticipated LMT will continue this trend.

 Management has one of the highest and most consistent returns on invested capital (ROIC) at a whopping 34% to 43%, with a 6-yr average of 37%.  Based on a cost of capital of 7.3%, management generates an eye-popping 30% net ROIC annual return.       

Analysts at Stifel upgraded shares of LMT to Buy from Hold and raised the stock's price target to $220. Joseph DeNardi stated,

“We believe the cash flow generation outlook for Lockheed’s core business, combined with the expected cash recovery from its pension over the next several years, should support continued growth in the company’s dividend and share repurchase activity to a degree that will differentiate it from its peers.”

Other highlights include: Defense spending bottoming in fiscal year 2015.  Analysts anticipate growth in F-35 sales as production rates increase.  DeNardi believes Lockheed is the best way to play what it see as a challenging but stable outlook for defense budgets.

Equity income investors looking for strong dividend growth with current yields competitive with long treasuries should review LMT.  However, share prices are currently overvalued and capital gains may be hard to come by from here.  Waiting a bit for a pullback, and buying the dip, should be the most prudent approach to this dividend growth machine.

 First appeared in the Oct 2014 issue of My Investment Navigator newsletter. 
Thanks for reading,   George Fisher

Which Equities Should Perform Better in Times of Higher Inflation and Why Should I Care?

One aspect of rising interest rates is the fight to control inflation.  As history demonstrates, loose monetary policy leads to too many dollars chasing too few goods, creating upward pressure on inflation.  In the previous piece, Atlanta Federal Reserve Bank’s Mr. Dennis Lockhart stated that a prominent risk of low interest rates is an uptick in inflation.   As the chart at the end shows, interest rates are set to rise in 2015 and continue into 2016, but if the Feds are already behind the curve and if rates do not rise sufficiently to curb inflation, it will once again creep back into our everyday lexicon.

There are sectors of the economy that historically do better with a touch of inflation and positive real interest rates.  While the list is not meant to be exhaustive, we hope to touch on a few sectors and which stocks in our universe may be poised to benefit from this environment.

Commodities and basic materials usually react favorable with a touch of inflation and usually rise with it over time.  Glencore (GLNCF) is a trader and miner of industrial chemicals.  BHP Billiton (BHP) is a global miner of industrial commodities as well. Southern Copper (SCCO) is a major global miner of copper.  

 Financial firms with fixed income investments, especially international finance and insurance, should experience an uptick in investment income as rates improve.  Berkshire Hathaway (BRK-B) has less of its investment portfolio invested in bond than its peers do.  Buffet prefers equities and entire businesses than purchased a portfolio of fixed income investment.  While this has worked to its favor as equity markets have outpaced the bond markets over time, other insurance companies may see a bigger boast in their investment income.  Power Corp of Canada (POW.TO, PWCDF) owns a majority percent of Power Financial/Sun Life of Canada.  Although a substantial chunk of fixed assets held by AFLAC (AFL) are in Japanese and European fixed income markets, higher income from its US bond portfolio should boost earnings.   Lincoln National (LNC) should benefit as well.

Real Estate usually increases with rising inflation. Both rents and home/commercial prices trend higher with the inflation rate.   Many REITs should perform adequately, however rising interest rates may pressure competitive yield offered by REITs.  Established triple-net REITs, such as National Retail Properties (NNN) or Reality Income (O), are structured to pass along increases in operating costs to their tenants. 

Gold is usually mentioned as benefiting from inflation.  The S&P Gold ETF (GLD) and various gold miners should rise as gold’s price tracks inflation numbers.  Gold mining mutual fund Tocqueville Gold (TGLDX) should benefit from inflation.   Gold mining and energy income fund Gabelli Global Natural Resources (GGN) offers a 10% distribution (mainly categorized as return of capital) and should benefit as well.     

Oil and natural gas prices will move higher along with inflation.  Suncor (SU), Dorchester Minerals (DMLP), and Total (TOT) should respond favorably.

Floating rate bank loan mutual funds will increase their income as higher interest rates and inflation take hold.   Fidelity Floating Rate High Yield Income (FFRHX) and Oppenheimer Senior Floating Rate (OOSYX) are two examples of funds that hold variable rate bank loans. 

Investors should care because inflation will become a headline event not too far into the future, and when it happens, it could be too late to move into these inflation-sensitive investments. Do not be like the Feds and become behind the inflation-curve. 

First appeared in the Sept 2014 issue My Investment Navigator
Thanks for reading and your interest,  George Fisher

 

   

 

FS Investment Co went from being privately-held to the 4th largest publically traded co. in its industry-overnight

FS Investment Co (FSIC) went from being privately held to the fourth largest publicly traded company in its industry – overnight. FSIC was spun off from Franklin Square Holdings, a private investment company.  FSIC is a Business Development Company BDC and supplies capital for smaller companies looking to raise equity and debt.  By market capitalization, FSIC is the 4th largest BDC out an industry consider to total 41. 

Before the Great Recession, BDCs were very popular with investors due to their high yields and unique expose to growing companies.  However, as many businesses began to fail, BDCs ran into severe trouble and were unable to collect on their debts. Most lost money, experienced rapid declining book values, and failed to make money for longer-term investors.  A good example is American Capital LTD (ACAS).  A $10,000 investment in 2004 would have been worth $416 or less during much of 2009.  Currently, the $10,000 would be worth $15,000 vs. $22,000 if invested in the S&P 500.     

A business description is found on their website:

FS Investment Corporation is a publicly traded business development company (BDC) focused on providing customized credit solutions to private middle market U.S. companies. We seek to invest primarily in the senior secured debt and, to a lesser extent, the subordinated debt of private middle market U.S. companies to achieve the best risk-adjusted returns for our investors. In connection with our debt investments, we may receive equity interests such as warrants or options.
FSIC is advised by FB Income Advisor, LLC, an affiliate of Franklin Square Capital Partners, a leading manager of debt-focused alternative investment funds, and sub-advised by GSO/Blackstone Debt Funds Management LLC, an affiliate of GSO Capital Partners, the credit platform of Blackstone. 

 Of interest to investors is the connection between FSIC and Blackstone (BX), one of the largest investment, hedge fund and private-equity managers.  The majority of FSIC loans (76%) are variable rate with an average maturity of 2020 and the average credit rating of its 125 portfolio companies is B3.  

FSIC could be substantially overpriced if the 9.3% current yield is unsustainable.  The monthly dividend is $0.88 annualized, and a $0.10 special dividend was recently announced.  The dividend is supported by the company’s portfolio of loans with an average interest rate of 9.9%.

As the overall interest rate environment remains low, these loans are at risk of being refinanced at lower rates, reducing income for FSIC.  In addition, the advisory fees charged by Franklin Square and BX are around 2.0%, expensive for the assets managed - $4.2 billion.   

 BDCs with longer operating histories include Triangle Capital (TCAP) with an 8.1% yield and PennantPark Investments (PNNT) with an 11% yield.  While their industry was collapsing around them during the financial crisis, these two companies did not cut their dividends.  All BDC investors should appreciate this important trait. 

The bottom line for FSIC is that there may be better avenues for generating above average income and the risks associated with FSIC are not necessarily fully compensated by a 9.3% yield.

More information on FSIC can be found in their investors presentations:

http://www.fsinvestmentcorp.com/investor-relations/presentations-and-reports

First published in the Sept 2014 issue of My Investment Navigator
Thanks for reading, George Fisher

Suncor: If It's Good Enough for Warren Buffett, It Should be Good Enough for You

Suncor (SU) is the largest Canadian oil company, but not quite large enough to be included with the Big Seven Sisters.  (The phrase was coined in the 1950s, referring to the largest seven global oil companies of the time.  The original group comprised Anglo-Persian Oil Company (now BP); Gulf Oil, Standard Oil of California (SoCal), Texaco (now Chevron); Royal Dutch Shell;  Standard Oil of New Jersey (Esso) and Standard Oil Company of New York (Socony) (now ExxonMobil)). 

During the obligatory disclosure period at the end of each quarter, Berkshire Hathaway (BRK.B) revealed it initialed a position in SU by purchasing 17.7 million shares.  While still rather minor at just 1.2% of SU shares outstanding, the investment of $500 million is no small potatoes, even for Mr. Buffet.  Shares are up nicely to $41 from a purchase price of between $27 and $32. 

Suncor is an investment that is depended on its 100-yr potential of oil reserves locked in the Oil Sands.  While the firm also produces oil from conventional offshore drilling along the Canadian East Coast and in the North Sea, the majority of its production will come from oil sands.   

SU had a rough 2nd quarter 2014 with write-downs of some of its projects.  The company wrote down $223 million in Oil Sands projects following a review of certain assets that no longer fit Suncor’s revised growth strategies. SU also incurred $297 million charge against the company’s Libyan assets due to continued political unrest.

The company said production volumes from the Oil Sands operations increased to an average of 378,800 barrels per day in 2Q14—compared to 276,600 bpd in the same quarter last year.

Quarterly production volumes for the Exploration and Production segment decreased to 115,300 barrels of oil equivalent per day (or boe/d).  Production volumes were 190,700 boe/d in the same quarter last year, but included conventional natural gas assets recently sold. 

Suncor’s cash cost of production is around $12 per boe offshore in the Maritimes, $6 in the North Sea, and $32 in the oil sands.   While operating costs are higher, the future of the company is based on achieving higher production volumes from their sands projects.  

The investment trade off with Suncor is accepting higher operating costs in exchange for higher production reserves. SU owns 37 yr. Proven and Probable Reserves compared to 19.7 yrs. for Apache (APA) and 13.5 yrs. for Total (TOT).  The amount of estimated recoverable oil in the area of SU’s assets could contain as much as 22.5 billion barrels, which could sustain 500,000-boe production for over 100 years.  Below are two graphs from Suncor’s investor presentation outlining planned production growth and historic operating costs from their oil sand projects:

suncor1.jpg

suncor2.jpg

Since 2011, SU has generated $8.3 billion in free cash flow, or operating cash flow less capital expenditures.  An important consideration in the oil business is the high cost of capital expenditures needed to offset production declines.  Apache generated $0.5 billion in free cash flow and Total $4.1 billion during the same period.

Management has earned a 12-month return on invested capital of 7.75%, and is about the industry average of 8.76%.  Operating margins of 16.1% are above industry average of 10.2%. 

Suncor pays a dividend of $1.03 a share and offers a 2.5% yield. The dividend was recently raised by 22% and marks the 12 straight year of dividend increases.  With a payout ratio of 30%, future dividend increases should track long-term earnings growth rate of 8%.

More information can be found in the most recent Suncor investor presentation: 

http://www.suncor.com/pdf/SU_IR_Q2_2014.pdf

First published in the Sept 2014 issue My Investment Navigator
Thanks for reading,   George C. Fisher

ITC Holdings: An Unconventional Utility with Oversized Growth Prospects

 

ITC Holdings (ITC) is a mid-cap regulated electric utility with substantial growth prospects not seen elsewhere in the sector. ITC is expected to grow earnings by 13% a year, more than double the utility sector’s 4% to 6% growth rate. ITC focuses solely on federally regulated (Federally Energy Regulatory Commission FERC) transmission assets where allowed return on investment is higher than the typical state-regulated assets. The difference is federally regulated usually allows for about 12% to 13% return on equity vs. the most recent quarter’s rate case average for state regulated allowed return on equity of 10.5%.

Translating this into potential profits – for every dollar ITC invests in transmission assets, the allowed return is between 14% and 23% higher than the average utility investment whose rates are regulated by state agencies. The company just announced a $4.5 billion capital expenditure budget for the next 5 years. This should drive earnings higher by 11% to 13% annually as these assets become included in its rate base calculations. Net Property, Plant and Equipment should double in size from $4.8 billion to over $9.3 billion by 2018.

The stock has had an impressive run over the past year, rising from $30 to $37. ITC is up 23% over the previous 12 months while the S&P Utility ETF (XLU) is up 5%. Price targets range from $41 to $48, leaving plenty of room for future shareholder returns. There are currently 156 million shares outstanding, which is low for the sector, even after a 3-1 stock split (remember those?).

Over the past few years, the stock has had several uninterrupted moves higher. After collapsing in the 2009 market meltdown from $17 to $7, the stock rose nonstop back to $17 in 2010, paused a bit to $15, then rose to $26 in 2011. The stock paused again between $25 and $22, and then ran up to $32, paused again, then climbed to $35 in 2012/2013. Recently, the stock fell back to $31, and then charged up to its current $37 as the stock split was announced. Share prices would have to drop below $34 to signal a break in the most recent up trend.

The dividend yield is quite low for a utility, as ITC has been plowing investable cash back into its cap ex program. The current yield is only 1.5%, but dividends are expected to grow by 10% annually over the next few years. Dividend growth investors should be savoring this growth rate.

ITC may be considered to be fully valued and future capital gains will come from higher earnings and dividends. ITC is trading at a PE of 25, vs its previous 5-yr high of 23 and price to cash flow ratio is double industry valuations. With a low payout ratio of 36%, higher earnings and an expansion of the payout ratio will support higher dividends over the long-term.

Starting a beginning position in ITC, with the concept of adding to shares over time, would make a timely addition to the utility allocation of your portfolio.

Disclosure: Long ITC and ITC is followed by My Investment Navigator Newsletter.  First published in the May 2014 issue of MyInvestmentNavigator.com newsletter.

Update:  The FERC recently reduced the allowed ROE for electric transmission assets.  With incentives for being an independent company, ITC should earn 11.47% ROE, down for a range of 12.16% to 13.88%.  ITC should be eligible for the highest allowed ROE of its peers. 

Thanks for your time and interest in My Investment Navigator,
George C. Fisher, Founder and Publisher

Are Bond Fund Exit Fees In Your Future?

While not getting much mainstream press, the Fed may be thinking about what will occur as interest rates increase and its effect on the value of bond mutual fund prices.  From a Barron’s article, June 21 Up and Down Wall Street:: 

“The Federal Reserve is floating a trial balloon, or at a minimum give bond investors a “heads up”.  It might be well that the Federal Reserve appears to be thinking about the consequences of the end -- and eventual reversal -- of its massive experiment in monetary stimulation. Last week, the Financial Times reported that the central bank is mulling exit fees on bond mutual funds to prevent a potential run when interest rates rise, which, given the ineluctable mathematics of bond investing, means prices fall. Quoting "people familiar with the matter," the FT said that senior-level discussions had taken place, but no formal policy had been developed.
Those senior folks apparently did not include Fed Chair Janet Yellen. Asked about it at her news conference on Wednesday, she professed to be unaware of any discussion of bond-fund exit fees, adding that it was her understanding that the matter "is under the purview" of the Securities and Exchange Commission.
That nondenial denial leaves open the possibility that some entity in the U.S. financial regulatory apparatus is indeed mulling bond-fund exit fees. The Financial Stability Oversight Council established by the Dodd-Frank legislation oversees so-called systemically important financial institutions, or SIFIs, which include nonbank entities. And, indeed, the FSOC has considered designating asset managers as SIFIs, as Barron's has noted previously.”

http://online.barrons.com/news/articles/SB50001424053111903927604579628353649352222

Remember that in the jaws of the last financial crisis, a run on money market accounts during the fall of 2008 caused the Feds to alter money market fund status by temporarily guaranteeing them, equaling the protection of FDIC-insured bank savings accounts.  This temporary guarantee expired in Sept 2009. 

An exit fee for bond fund sales might be an attempt to stem potential fund outflows as rates increase.  While most commentators do not believe this will actually happen, it is important for investors to take notice of the Fed’s worry.   

Most of us have some bond funds and it essential for investors to understand the “interest rate risk” and its potential impact on that specific fund.  While seemingly a complex calculation, it is actually quite easy.  Most of the complicated math has been done for you and is reflected in two important bond fund fundamentals.   These are “Average Maturity” and “Average Duration”.

The important takeaway is the topic of interest rate hikes is starting to gain traction, even within the inner circle of the Fed.  How are you preparing for the next move up in the interest rate cycle and how will it affect your finances?

First published June issue of  My Investment Navigator newsletter
I appreciate your time and interest in My Investor Navigator,
George Fisher, Founder and Publisher

Goldman Sachs Moves Up The Date For the Demise Of The Bond Market - The Modified Taylor Rule and Eurodollar Futures Agree

From a Marketwatch news article published July 6, 2014:

LONDON (MarketWatch) -- Goldman Sachs now believes the first hike in the U.S. federal funds rate will come in the third quarter of 2015, rather than in the first quarter of 2016. The changed forecast comes in response to "the cumulative changes in the job market, inflation, and financial conditions over the past few months," chief economist at Goldman Sachs, Jan Hatzius, said in the note from Sunday. The revised forecast is close to current market expectations, but Hatzius said the change is important because it is the first time since the crisis that Goldman Sachs has moved forward its rate-hike expectations. "We view this as an illustration of the substantial progress that the U.S. economy has made in overcoming the fallout from the housing and credit bubble," he said. Goldman Sachs now expects the funds rate to rise gradually back to 4% by 2018.”

http://www.marketwatch.com/story/goldman-sachs-brings-forward-forecast-for-first-us-rate-hike-2014-07-07?siteid=yhoof2

Seeking Alpha’s reading of the Eurodollar futures seems to agree with the Goldman Sachs’ belief and offered the following news headlines on July 7, 2014:

“Checking Eurodollar futures for expectations of tighter monetary policy, they've backed off a bit from rate hikes as well, the June 2016 contract ahead by four basis points, but still pricing in a Fed Funds rate about 130 basis points higher in two years then it is now.”

http://seekingalpha.com/news/1833425-treasury-yields-reverse-post-employment-report-surge

The current yield curve for US treasury notes/bonds is below.  Based on the curve, the 10-yr is yielding 2.65%, 20-year is yielding 3.21%, and the 30-year is yielding 3.47%

Yield Curve July 5, 2014, www.treasury.gov

Yield Curve July 5, 2014, www.treasury.gov

If 10-yr rates are expected to increase to 4.0% and based on the same yield curve slope, one should expect yields to increase to 4.56% on 20-yr and 4.82% on 30-yr, for a net increase of 1.35% across the board.  

Below is a graph of historic 2-yr and 10-yr rates going back to 2004.  As shown, before the 2008 financial debacle, both 2-yr and 10-yr rates were in the 4.0% range, and it was not until the easy money of the past few years that rates dramatically declined.

http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/Historic-Yield-Data-Visualization.aspx

In addition, the Modified Taylor Rule adds another layer of agreement with rates climbing dramatically after 2015, as shown below.  The chart outlines how the Modified Taylor Rule has mirrored the Fed Funds rate from 1985 to the current crisis’ beginning in 2008. 

Modified Taylor Rule and Fed Funds Rate.  www.brookings.edu

Modified Taylor Rule and Fed Funds Rate.  www.brookings.edu

“A simple, but highly effective way of transforming output gap estimates into monetary policy comes from the Taylor Rule, which is based on John Taylor’s 1993 paper Discretion Versus Policy Rules in Practice. It calculates a recommended federal funds rate based on only three variables: the amount of slack in the economy; the deviation of inflation from its target; and the neutral interest rate described above. While there is much disagreement about the exact definition of these variables and the appropriate weights on them, the modified Taylor Rule depicted in Figure 3 seems to do a very good job at modeling Fed behavior.

The modified Taylor Rule suggests that the fed funds rate should’ve been cut well below zero during 2008 and should remain negative today. Since it is very difficult to charge negative interest rates, the Fed came up with alternate policies, such as expansion of its balance sheet to initially ease up frozen credit markets in 2008-09, then to lower longer-term interest rates as well as encourage credit creation and risk taking today. Though the latest jobs report of weak payrolls but a lower unemployment rate present a confusing picture of the economy, the modified Taylor Rule currently recommends that since the economy is recovering and starting to eat into the spare capacity - as evident by the declining unemployment rate - interest rates should not be as negative as before.

Using the latest FOMC Economic Projections (Table 1) in combination with the CBO’s estimate of potential, we can attempt to forecast monetary policy going forward (see the right hand side of Figure 3). The modified Taylor Rule forecasts that the Fed will start raising interest rates at the end of 2014, and the funds rate should be above 3% by the end of 2016.”

More information on the Modified Taylor Rule can be found here:

http://www.brookings.edu/blogs/up-front/posts/2014/02/07-strong-correlation-cbo-projections-fed-actions-coheng

http://en.wikipedia.org/wiki/Taylor_rule

http://web.stanford.edu/~johntayl/Papers/Discretion.PDF

A inescapable fact is that bond prices in the secondary market react inversely to interest rate movements.  As interest rates go up, bond prices go down; as rates go down, bond prices go up.   So what does this mean for bond investors?  In a short sentence – it means a massacre of long bond prices is in the offing.  IF  the yield curve does not steepen and IF  long rates are held to only a 1.35% increase, the following ETF/bond funds will decline by the following percentages: 

ZROZ PIMCO 25 Year+ Zero Coupon Treasury Bond will decline by 37.15%

EDV Vanguard Extended Duration Treasury Bonds will decline by 33.75%

TLT iShares 20 Year+ Treasury Bond will decline by 22.1%

TLH iShares 10-20 Year Treasury Bond will decline by 13.1%

IEF iShares 7-10 Year Treasury Bond will decline by 10.2%

Below is a Morningstar graph of the cumulative inflows and redemptions of bond vs. stock funds for the 5-years from 2008 to 2013.  As shown, the inflow for bond funds is about five times the outflow of stock funds. 

Bond Fund Inflow vs Equity Fund Outflows 2008 to 2013 www.morningstar.com

Bond Fund Inflow vs Equity Fund Outflows 2008 to 2013 www.morningstar.com

What to do?

The first step is to determine your personal interest rate risk by fund or ETF.  Morningstar.com on its quote offers the average duration, or the ratio of rate sensitivity, for almost all bond funds and ETFs.  To calculate a specific bond fund’s interest rate exposure, multiply the anticipated rate movement by the duration.  For example, ZROZ has duration of 27.5 and the example above is a 1.35% rise in rates.  Multiply 27.5 x 1.35 = 33.75, or a decline of 33.75%.

While floating rate ETFs and funds have no duration as they reflect the current rate environment, duration of 4.0 or less would be considered low. The easiest means of lowering duration would be to shorten maturity exposure.  

Bond investors are facing a difficult choice – reduce short-term income by moving out of higher yielding, longer term and higher duration investments.  Which is better for you 1) reduce your income over the next few years or 2) experience a considerable loss of principal?  It is like the deciding the better of two evils.

I appreciate your time and interest in My Investor Navigator,
George Fisher, Founder and Publisher

What is under that FIG leaf? Distributions and more distributions

Fortress Investment Group (FIG) is a controversial hedge fund manager that either analysts love or they hate.  A share price at $7.50 and a dividend yield of 4.5% would seem to reward shareholders with a longer-term horizon.  However, FIG is not without issues.

A good two sentence overview from their press release:

Fortress Investment Group LLC is a leading, highly diversified global investment firm with approximately $62.5 billion in assets under management as of March 31, 2014. Founded in 1998, Fortress manages assets on behalf of over 1,500 institutional clients and private investors worldwide across a range of private equity, credit, liquid hedge funds and traditional asset management strategies.

Like many of its peers in the alternative investment field, Fortress Investment Group is structured as a LLC, much like a MLP, where unit holders receive a K-1 tax form. 

FIG generates revenue based on fees charged for their investment services.  As shown below, the bulk of AUM, along with revenue growth is in its fixed income programs. Going forward, this segment should continue to be the driver for growth in AUM to over $115 billion by 2017. 

The following chart taken from its 1st qtr. 2014 press release outlines the major business sectors by Assets Under Management (AUM). 

 

Chart-AboutFortress_Overview_OurBusinesses.gif

The latest investor presentation dated 2013 can be found in the link below:

http://shareholders.fortress.com/Cache/1001183295.PDF?Y=&O=PDF&D=&fid=1001183295&T=&iid=4147324

Earnings per share are expected to increase from $0.80 per unit in 2013 to between $0.94 and $1.28 by 2017.  Distributions are expected to grow from $0.30 per unit, for a 37% payout ratio, to a minimum of $0.55, for a 58% payout ratio, in that timeframe as well.  Consensus price targets range from $10.50 to $11.50, but FIG has a high beta at 2.5, so investors could expect a volatile ride up.

While these estimates vary widely, it is important for investors to understand the structure and use of units as a management compensation vehicle.  FIG has two classes of units, Class A and Class B.  Class A is publically traded while Class B, also known as Operating Group Units, is not. Class B units are owned by management and are a used as an important compensation tool.  Not only do they receive equal distributions, but B units are sometimes bought back by the firm, or are swapped, directly or indirectly, for publically traded A units.   For example, in March 2014, FIG announced that it will sell 23.2 million newly issued Class A units in a secondary offering, with proceeds used to buy Fortress Operating Group Units from management. At $7.50 a share, the value of the purchase of Class B units would be around $175 million.  As of the end of the 1st qtr, there were 229 million Class A and 226 million Class B shares outstanding.  As shown, management owns a substantial percentage of total units outstanding  and this ownership provides them with a valuation of $1.7 billion of units and an annual income flow of $67 million.

Management is definitely on the same page as us lowly Class A unit holders.

Credit Suisse offers an interesting thesis:

Our Outperform Thesis: We remain Outperform on the FIG stock given that (1) FIG has almost $3 per share in net cash/investments. We think FIG will look to return capital to shareholders as their illiquid PE and credit fund investments on B/S return capital to LPs (which includes FIG). This will be source 1 of dividends going forward. (2) We estimate FIG will earn between $0.50 and $1.40 per share over the next five years and will target a dividend payout of earnings (source 2) around 50-80% (with a larger dividend payout occurring in 4Q – starting in 4Q14). So after adding dividend source 1 and 2 – we think FIG may be returning a very large amount of cash to shareholders over the next five years ($2.50 to $4.00 range or ~45% of current share price). (3) We think the core FIG business (x-the large excess capital balance) is worth about ~$11-12 - supported by $8-9 in value from mgmt. fee-based revenues (~$0.40 in normal year x 20x multiple – these fees are growing quickly and generally have very high persistency) and $3 in value for performance-fee-based EPS (~$0.50 in norm year x 6 multiple).

On the other side of the fence, Morningstar offers a down-in-the-mouth assessment of FIG in their most recent review.

The aftermath of the 2008-09 financial crises has changed Fortress Investment Group permanently, and we don't think for the better. We believe Fortress' reputation was severely damaged as the firm used side pockets to prevent redemptions on its most illiquid investments and suspended redemptions at its major Drawbridge Global fund at the height of the crisis. These actions as well as poor returns angered investors, who pulled out billions in capital over the next few years.

Fortress' struggles mean that its outlook is very different from many of its peers. The company raised only about $9 billion in new capital for its alternative funds over 2011-13. This level of fundraising is far lower than peers that raised several times more in new capital and consequently have stronger growth prospects. Believing that the firm will continue to face challenges with client inflows, we anticipate that Fortress will struggle to raise enough capital to offset our forecast level of redemptions and realizations as its funds age. As a result, we expect alternative assets to reach just $43 billion in 2017 from $40 billion in 2014, leaving the majority of Fortress' most valuable assets under management and earnings power to be largely stagnant in the near future.

Instead, we think the bulk of Fortress' growth over the next few years will come from its traditional fixed-income business, Logan Circle, which was acquired in 2009. We expect AUM for the segment to reach about $36 billion in 2014 and $70 billion in 2017, which will be roughly 60% of Fortress' total AUM and far greater than 2009's $11.5 billion. Inflows will be driven by fund performance, which is in the industry's top quartile, but Fortress earns only about 14 basis points (versus 150-200 basis points plus performance fees at its alternative funds) on the capital. Separately, the company recently hired a group of managers who have experience managing $20 billion of equities, believing it can charge investors 60 basis points to participate in the new strategy. However, given the significant difference in fees, we still expect the contributions of this segment to be around 10% of distributable earnings in 2017.

I fall on the side of Credit Suisse and think the current price offers adequate future total returns. With a payout ratio in the 50% range and high-end earnings estimate of $1.28, the distribution could grow to $0.64 a unit.  With a payout ratio of 80% and low-end earnings estimate of $0.95, the distribution could be $0.76 a unit.  Either way, the yield on cost could explode from a current 4.5% to between 7.5% and 10.0%.  

Oh, by the way, the firm has $2.2 billion in cash and investments and $1.2 billion in liabilities.  This equates to net cash and investment assets of $2.83 per unit, or about 37% of the current share price. Looking for a future high-yielder with additional capital gains potential?  FIG may fit the bill.

Disclosure: I am long FIG and the company is followed by MyInvestmentNavigator.com monthly newsletter.  FIG currently carries a rating of Full Speed Ahead.

I appreciate your time and interest in My Investor Navigator,
George Fisher, Founder and Publisher

 

Man-o-Man, Based on these guys, I would never take my advice

There are a growing number of websites that offer to rate specific analyst's and blogger's stock picks. One such site is tipranks.com.  A detailed description of their service is available on their website.  So, I did what any self-respecting financial writer would do – I looked up my performance on TipRanks.com

I have the unique situation of writing for Seeking Alpha from Feb 2010 to Feb 2012 using my given name.  Due to compliance issues, during the later days of being a RIA from Sept 2012 to March 2014, I wrote using the pen name Jon Parepoynt.  Therefore, I looked up both authors.

The various options for searching performance is “stock ratings automatically closed at “1 qtr., 1-yr., or 2-yr.”  Comparisons are available using “S&P 500, Sector, or None” . 

When selecting “2-yr timeframe” and “None”, George Fisher generated a 16.3% average return per recommendation with a 31 out of 44-success ratio, or 70%.  However, when compared to the S&P 500, the results plummeted to -4.1% average return above the S&P and a 20 out of 44-success ratio or 45%.

When selecting “2-yr timeframe” and “None”, Jon Parepoynt generated a 12.2% average return per recommendation with a 40 out of 48-success ratio, or 83%.  However, when compared to the S&P 500, the results plummeted to -2.3% average return above the S&P and a 28 out of 48-success ratio or 58%.

I reviewed my own rating and found it obviously quite disappointing.  As author George Fisher, I was rated #2019 and as author Jon Parepoynt I was rated #2469 out of 3233 bloggers tracked compared to the S&P.    Man-o-man, I would never take my own advice.

TipRanks.com website has been discussed on the contributor forums of Seeking Alpha.  One contributor contacted TipRanks.com to clarify their measuring methodology and below is the reply, as posted on the forum:

I understand there is a thread on SeekingAlpha regarding TipRanks and I would like to explain a bit how experts performance are measured. I would appreciate it if you could publish this on the thread so all the dear contributors will get answers to their questions.

Before I dive deep into the calculations, I would like to point out that TipRanks is here to let laymen investors know who they can trust there are 3100 sell side analysts 3200 bloggers (out of which 800 are from SA) and it is amazing to see that average bloggers performs so much better than an average sell side from Goldman Sachs.  And our users love the fact that they can easily find rock stars from blogs and see what they have to say as experts.

Our measurement system was developed by a leading professor of Finance from Cornell University called Roni Michaeli who is an industry leader in performance research and published hundreds of academic articles in the field of analyst performance.

When our machine detects a recommendation to Buy a stock, we "virtually" buy it, but we also buy relevant benchmarks, the SPY and an ETF of the sector of the stock recommended….When a blogger recommends a stock we will close his position either after the time defined or if he writes another article about the stock (if it is a buy and then a buy we will close first position and open a new one, and the performance of both "buy" calls will be added to his portfolio).

We also measure success rate which is the number of stocks who had positive return in case of no benchmark or outperformed the benchmark if a benchmark is chosen.

We then run a Z test on the success rate meaning that the more the data is significant the more weight the expert is getting (e.g. if someone has 10 out of 10, he is not as good as someone who has 75 out of a 100 even though the first one has 100% success rate and the second has only 75%)

These 2 factors are combined into a single ranking which is displayed by the amount of stars.  Our platform was awarded twice as the best of show on Finovate for its power and innovation and there are many thousands of happy users using it on a daily basis.  It is a powerful tool to research stock and filter out underperforming analysts when using analyst consensuses, which institutional investors use as a benchmark. bWe were also offered many times to close the platform for individuals and provide it only to professional money managers and refused to do so, arguing that our vision is to empower the main street.

I would be happy if you could publish this on the thread to clarify the questions some contributors might have.  Sincerely,  Uri.

So, I dug a little deeper and decided to upload my own portfolio based on the specific advice as offered by tipsrating.com.  The site does allow for review of each data point they analyze with the date and share price.  I use the premium service at Morningstar.com to track my personal portfolio and to evaluate portfolio construction.   

 I uploaded into the M* portfolio tracker the same buys as listed on TipRanks.com, using a cumulative $2,000 per recommendation.  If there were three recommendations offered, the portfolio would be credited with three $2,000 purchases on the day each recommendation was made. The difference between TipRanks and M* was most interesting.  Needless to say, there is some stark and distinctive variances.

Using the M* portfolio analysis tools, each position as described by TipRanks was added.  There were two companies that were bought out: Thomas and Betts was bought by ABB for a substantial gain of 200% and CHG was purchased by Fortis at a 30% profit.  Both of these were stock mergers and the site had difficulty correctly accounting for the shares.    Three positions were closed.  There were some discrepancies in prices quoted in the linked article and on the site, such as DMLP was quoted as $15.16 when the actual market price for the day was $20.50. 

First off, according to M*, the performance of the 44 Jon Parepoynt selections were “1-yr” 16.6% total returns, and a “Since Purchased Annualized” total return of 17.1%.  M* also offers a “Personal Total Return” calculation that incorporates the timing within the month of deposits/buys into the portfolio, and is a bit higher at 18.4% and 21.6% respectively.  According to M*and using the M* US Market Index as a benchmark, the index returned 16.2% and 18.9% respectively. Below is their return performance graph.

Jon Parepoynt Performance Sept 2012 to May 2014

Jon Parepoynt Performance Sept 2012 to May 2014

Combining the 44 recommendations of Jon Parepoynt and the 48 recommendations of George Fisher brought the number to 92 specific recommendations in 59 different companies.  Adding these specific recommendations together would produce the following M* performance chart:

Combined George Fisher and Jon Parepoynt Performance Feb 2010 to May 2014

Combined George Fisher and Jon Parepoynt Performance Feb 2010 to May 2014

There are two very important differences with these comparisons. The first is the concept of price-returns as offered by TipRanks.com and the total returns offered by M*.  The second is the asset allocation.  M* offers their calculation combining both capital gains and income while tipranks.com offers price-based capital gains only.  The portfolio income is $6,600 annually, for a current yield 2.8%.

The second major difference is asset allocation.  The 59 companies with 92 transactions nowhere near duplicated the sector represented in the index.  Below is a sector breakdown of the final portfolio as offered by M*. 

Sector Allocation of the 56 companies in the Combined portfolio

Sector Allocation of the 56 companies in the Combined portfolio

As shown, there are large gaps of underweighted sectors and substantial overweighting of others.  Specific stock recommendations are not necessarily made to conform to asset allocation parameters and focusing on certain sectors, such as utilities, will skew both investor expectations and performance. 

Probably the most interesting aspect with tracking of my recommendations is the omission of about 2/3 of the articles published on Seeking Alpha.  I have a combined total of almost 300 articles published since 2010 and TipRanks.com offers a link to 92 articles While not all 300 are specific stock recommendations, there are more offerings than listed on TipRanks.com

On second thought, I guess I would take my own advice – and do.  However, I will not publish a continuum of all 300+ articles, as these 92 should suffice.

Below are the positions in the combined portfolio, from M*:

Performance by position and purchase date for Combined portfolio

Performance by position and purchase date for Combined portfolio

Disclosure: I am long CBI, NFG, ITC, RICK, DMLP, RYN, UTX, BGCP, SO, ETP, SE.  All long positions are followed by MyInvestmentNavigator.com monthly newsletter.

Update June 1:  I received the following email from TipRanks:

"Hi George,

My name is Gilad Gat and I’m the CTO of TipRanks.  I read with great interest your  article on MyInvestmentNavigor.com.  I wanted to make a few clarifications as to our performance measurements.

My goal is to clarify and to get your perspective so we can fine-tune and perfect our methodology.

·        To measure stock ratings we use the EOD price on the day of the recommendation. We have started an internal committee on this and are considering using the opening price of the day following the recommendation. Would be interested to get your thoughts on this.

·        For S&P-500 we use SPDR S&P 500 (ticker SPY) which also incorporates the dividends of the S&P-500 companies.

·        Stock prices used by our engine are taken from Xignite, a leading financial provider recommended by Nasdaq.

·        For sector benchmarking we use the sectors from Yahoo! Finance, we will likely switch to sectors definitions by Xignite during the month of June.

·        Performance is measured on a per-rating basis, not as a portfolio (i.e., no rebalancing and re-investment of dividends).

·        My team will evaluate the two companies that have been bought-out to verify we deal with such cases correctly.

Please feel free to contact me directly with any question, comment or concern."

 
 
I appreciate your time and interest in My Investor Navigator,
George Fisher, Founder and Publisher