AB Analytical Services

A look at Q3 Equity Returns

The 3rd quarter was one that saw an obviously quite strong continuation of Q2 trends in general, but the performance wasn't as uniform as in the 2nd quarter.  As you can see in the table below, which allows us to look across capitalizations by sector, there were some stellar performers as well as some really weak areas.  I have color-coded the entries to reflect relative performance of the sector to the overall index price return, with a 5% differential for Q3 and a 7% differential for the YTD:

First, looking at the overall returns, the Mid-Caps trounced both the smaller and larger stocks once again.  Russell data confirmed this trend yet again.  On a YTD basis, the performance has been stellar.  For the quarter, "Value" beat "Growth" across capitalizations, though "Growth" maintained its clear year-to-date lead.

Looking at the S&P 500, Energy stocks did poorly and remain one of the weaker groups YTD.  Clearly, this weakness is confined to the very largest companies, as Mid-Cap and Small-Cap Energy companies flew this quarter and are among the better performing sectors in 2009 for the S&P 400 and the S&P 600.  I pointed out this opportunity earlier this year but admit to jumping off the bandwagon way too early. In any event, the weakness in the S&P 500 Energy stocks is quite misleading, as the median returns on the quarter and YTD respectively are 19% and 37.5%.  The issue is that 3 of the largest members, all integrated oil companies and representing currently over 1/2 the market cap of the sector, are still down YTD. 

Materials had a great quarter across the board, and the sector is one of the strongest thus far in 2009.  Not a single stock declined on the quarter. This sector is highly leveraged typically, and it looks like the best names this quarter and this year are the ones that performed the worst last year.

Industrials performed better for Large-Caps than the smaller companies, with 10 of the 56 names, including the very largest, General Electric (GE), up in excess of 40%.  Interestingly, the sector remains a laggard YTD, especially in Small-Caps.  I believe that there may be an opportunity in some of the smaller names and have my eyes on a few.  One factor may be the recent weakening in the dollar leading to some macro trades that have helped bigger stocks but not the smaller ones.

Consumer Discretionary, which was so hot early in the year, did a nice job in essentially keeping pace to slightly outperforming.  Some of 2008's biggest dogs continue to put up very strong returns.  It is very clear in the chart below that the bigger the fall, the higher the bounce:

Consumer Staples had a lackluster quarter, not surprisingly given the big rally.  Interestingly, the Small-Caps have been a strong performer on the year.

Healthcare was relatively weak in all market caps and remains far behind the benchmarks on a YTD basis.  I have a very high weighting towards Small-Cap Health and am hopeful that this sector becomes better appreciated for its strong balance sheets and potential growth.

Financials were the best Large-Cap sector.  While the smaller companies did well during the quarter, they remain very weak  on a YTD basis.  Representing over 17% of the total index, S&P 600 Financial stocks could be ready to play some catch-up this quarter, as they are down YTD still.

What can one say about Technology?  The sector kept pace during the quarter and remains exceptionally strong on the year.  With strong balance sheets and high international exposure, it's not surprising that the sector continues to draw a lot of focus.

Telecommunications Services, outside of the S&P 500 members, is a tiny component of the indices. 

Utilities have been poor performers across market capitalizations.  In addition to higher Treasury rates this year, there has been some concern about regulation.

Disclosure: None

8 Small-Caps Below Book Value with Net Cash

Those who follow my work know that I spend way too much time running screens on the weekends.  My goal is to find new ideas.  I run various types of screens, looking across broad market capitalization ranges or within sectors or even narrow industries.  Many of the screens are value-focused, others pursue growth.  I tweak my screens, and I try to come up with new ones.  The screen I ran today extends upon some screening I was doing at the end of last year within the Consumer Discretionary sector, which was laden with companies trading below tangible book value.

Today, I applied several of those parameters to the broad market and tried to hone in on companies that not only have strong balance sheets but that appear to have weathered the storm.  While the 8 names I am about to share are up a lot this year, they were down a lot last year and appear to be cheap yet.  Lots of people like to buy value stocks when they are beaten down, but prices 50% higher aren't necessarily bad prices.  In the case of this group, they fell pretty much with the market last year, about 47% on average.  While they have rallied 57% on average in 2009, they are still down over the past 21 months.  While I know only one of these companies very closely, the group certainly appears to be worth investigating.

In order to narrow the universe, this is what I did (and why):

• Market cap:  $100mm to $2bln (my definition of small-cap)
• YTD Price Return > 0 (eliminate poorly performing stocks)
• Book Value <1 and TBV < 1.2  (potential downside protection)
• Forward PE < 25 (profitable and not excessively valued)
• Net Debt <0 (downside protection)
• ROE (Trailing 4Q) > 0 (weathered the storm)

Here are the results:

The list is sorted by economic sector, with 6 of the 10 sectors represented.  Before sharing some brief thoughts on each one, I wanted to share some general observations.  First, while the PE ratios are somewhat elevated vs. the market and relative to their 5-year medians, I believe that the explanation is depressed margins.  Note that the P/S ratios are all at a discount to their 5-year medians.  Second, I included a measure of BV relative to the 10-year median P/B ratio to see if any of these "always" trade below book value.  As you can see, each of the 8 stocks is trading below its long-term median, with most trading substantially lower.

Gulf Island Fabrication (GIFI) is involved in off-shore platforms, primarily in the Gulf of Mexico but with 1/4 of its business international.  Though the company is debt-free, it slashed its dividend 90% earlier this year.  Capex has been rather lumpy for the company, though they have cut it sharply this year.  I note the backlog is shrinking rapidly.  Here is a link to their website.

Kaiser Aluminum (KALU) has rallied back strongly with the commercial aerospace sector.  The company, which came out of bankruptcy in 2006, has evolved from a mining company to a fabricator.  Kaiser began paying a dividend in 2007 and has hiked it each year, offering a current yield of 2.6%.  While there are 5 institutional holders who owned in excess of 5% as of 6/30, it is worth noting that the union owns 24%.  Here is a link to their website.

Griffon Corp (GFF) is a holding company with three unrelated businesses, all of which are about the same size in terms of sales.  Their Clopay Building Products is a residential garage door manufacturer.  Clopay Plastics Products sells specialty plastic into a broad array of markets, including baby diapers and surgical gowns.  Telephonics, which is actually growing due to homeland defense and border security, makes radar equipment that is sold globally.  The company raised a war-chest with a rights offering last September ($246mm) at 8.50, selling to an affilliate of Goldman, Sachs, which subsequently reduced its stake rather dramatically to a still substantial 17%.  While they certainly enhanced their balance sheet, they doubled their share-count.  In a strange governance twist, the CEO, who joined in 2008, is the son-in-law of the Chairman-of-the-Board and had previously served as President for Wynn Resorts.  He joined with a golden parachute package that pays $13mm.  Seems like the CEO might have been brought in to get this one sold.  He also owns 2% of the company.  Here is a link to their website.

You are probably familiar with Footlocker (FL), the old Woolworths.  My son is a big fan of their direct-to-consumer CCS.  I am not sure why this one is so inexpensive.  The company pays a 5% dividend (though that is about all of FCF), hiking it every year since implementing it in 2002.  Shoe-stores have been doing fairly well recently (pent-up demand), especially athletic wear.  From what I can tell, investors aren't keen on the heavy mall focus of this company.  Here is a link to their website.

Shoe Carnival (SCVL) has been one of my best investments this year, and I continue to hold it in an account I manage as well as in my Top 20 Model Portfolio (6% position).  I have written about the company on several occasions, most recently contrasting it to a peer and before that more in depth.  I visited a store near my house recently - not my kind of place at all, but I can see how it appeals to their target market.  With large inside ownership and a much improved inventory situation, I like it here.  Here is a link to their website.

Specialty Underwriters' Alliance (SUAI) was really cheap.  This provider of niche property & casualty insurance was engaged in a proxy battle when another company, Tower Group (TWGP) entered the fray and acquired them.  It looks like they are getting a pretty good deal, so it might be worth checking out.  Here is their website.

Mercer Insurance Group (MIGP) is a more traditional P&C company focused on small and medium-sized businesses in the West and in NY/NJ/PA.  Their investment portfolio is very high quality.  The company has 19% insider ownership as well as a 10% ESOP stake.  Here is a link to their website.

The last company is Comverse (CMVT), the Israeli software company leveraged to communications.  The company hasn't filed with the SEC in quite some time - 2005. Let's just forget about this one!

So, the screen kicked out several names, some of which aren't really investable.  I know and like SCVL.  A few others look interesting.  In any event, screening is always a step and not a conclusion, so treat these as ideas and not recommendations.
 

Disclosure:  Long SCVL in a portfolio I manage

Chasing the Market: Smaller Laggards

Is this what you are looking for?

Playing "Catch-up"?  My article from last weekend, "15 Stocks Having a Tough Quarter, But Worth a Look" drove the most traffic to my websites in over a year.  It tells me that the crowd is looking for beta, not alpha.  There's probably a whole other story here, but rather than talk about why I think everyone is downright silly chasing stocks, I will offer more ideas to investigate.

In that last article, I narrowed the 40 stocks in the S&P 500 down QTD, leaving just 15 companies worth investigating.  Today, I will offer up the same screen but on the Russell 2000, but I tightened it up to restrict to companies with cash in excess of debt.  I also eliminated any company with estimates declining in excess of 10%.  The data is as of Tuesday's close.  Here it is:

Most likely, you aren't too familiar with most of these companies.  I know a few of them.  In the Industrials, I actually own Met-Pro (MPR) in an account I manage and both the Top 20 Model Portfolio and the Conservative Growth/Balanced Model Portfolio.  Buckle (BKE) had a stellar year in 2008 and is strong this year as well.  I saw that they jacked the dividend the other day.  WD-40 is one that you may know.  It is a bit too slow of a grower for me, but it has a long history of above-market dividend yield. 

In the Healthcare sector, which covers about 1/2 the names, I will point out ICU Medical (ICUI).  Some of you may know that I have had a lot of interest in the Med-Tech sector, specifically in high GM stories like this one (with predominantly consumables).  This one is run by George Lopez.  He is an amazing guy, but not the comedian that I like so much (the Mexican Bill Cosby).  I digress...

Big picture, this list was roughly unchanged in price in 2008 during the mother of all bear markets, and it is down just slightly.  Some of these stocks are probably correcting mistakes from last year, but some are probably just correcting period.  If you are looking for potential long ideas, all of these stocks are in uptrends and probably worth a look.

Disclosure:  Long MPR

15 Stocks Having a Tough Quarter But Worth a Look

The S&P 500 ended moved into the green in May and has never looked back.  So far in Q3, it's up a whopping 16.8%, even better than Q2's 15.9% total return.  Despite the large advance, 40 of the members are actually down QTD.  Thinking that there might be some opportunities from the long side, I wanted to take a closer look, so I created a screen in StockVal to narrow the list.  Here is how I constrained the group:

• 50dma > 200dma (maximum 10%)
• PE F12M <120% of 5yr Median
• Net Debt to Capital < 60%

The first constraint is to assure that the trend is up but it isn't overextended.  The second constraint makes sure the PE isn't super-inflated.  The final factor kicks out balance-sheet disasters.  Here are the 15 stocks:

Note that several different sectors are included (7 out of 10).  As a group, these stocks are certainly lagging the market this year, but they did better last year for the most part.  The group also has a lower PE than the market in general.  I also included a measure of earnings revisions.  In general, the group isn't seeing large negative revisions that are driving the price declines, as the median is about unchanged.

Running through the list, I do have a few observations.  The lone Industrial stock, Stericycle (SRCL), is certainly a defensive stock.  The lone Consumer Discretionary stock, Family Dollar (FDO), has pulled back recently after being up strongly in 2008.  This stock looks very inexpensive to me - I recently added it to the Conservative Growth/Balanced model portfolio. 

There are several Healthcare stocks on the list.  LabCorp (LH) and Quest Diagnostics (DGX) are down a bit this year after being down just slightly last year, with investors somewhat concerned about reimbursement.  Gilead (GILD) was up last year, but it has retreated this year and is at the lowest PE in quite some time.  St. Jude (STJ), which has been at 38 for six years, is on my watchlist.  It sure seems inexpensive.  I recently added Becton Dickinson (BDX) to the Conservative Growth/Balanced model portfolio too.  Analysts were caught off guard when the company indicated that 2010 EPS wouldn't benefit from the currency hedging that helped boost 2009.  I like the broad product portfolio and the high international exposure.

I don't really have too much to say about the two Finance names that made the list.  Electronic Arts (ERTS) seems rather inexpensive considering its large cash hoard and its decade-low PE.  Akamai (AKAM) is one that I own both in a portfolio I manage as well as my Top 20 model portfolio (up 54% YTD).  Verizon (VZ) made the cut, but I am suspicous.  Finally, there are three Utilities that probably merit a look.

Many of these stocks are defensive and have given up some ground as investors have become a bit bolder.  It probably makes sense to take a closer look at these names, as they could play catch-up if the market continues its strong bid or come back into favor if it pauses or retrenches.

Disclosure:  Long AKAM in a portfolio I manage

Time to Take a Swing at Callaway Golf Company?

In my normal weekend activities of running through several screens, I noticed that Callaway (ELY) (7.50, $484mm) is one of the few companies in Consumer Discretionary that still trade below tangible book value (though it really doesn't - see below).  I am not a golfer, and I have never looked that closely at this company until today.  I intend to add it to my secondary watchlist and to try to get a better understanding of the "drivers".  Kidding aside, while this one appears to be very cheap, it has gone nowhere for the past 15 years.  Take a look at what hitting the wall looks like:

The company has grown sales at an annualized rate of just 7% over the past 15 years, a time when golf has exploded.  In the bottom panel, you can see that as sales stagnated, margins cratered progressively over time.  In the panel below, you can see that the stock bottomed well after the rest of the market:

In early June, the company slashed its dividend.  Since 1997, it had paid a constant .28 per share annually, but, in order to conserve cash, it lowered the payout to just .04.  An even bigger sandtrap for investors was the $140m convertible preferred that was priced the following day.  Facing a liquidity issue that had been clearly pressuring the stock, the company used the proceeds to pay off its entire short-term debt.  This move must have been quite embarassing to management, as the company had been acquiring shares from the time current CEO Fellows arrived in 2005 (with no debt on the balance sheet) through 2007.  Fellows had served as CEO of Revlon in the late 90s, where clearly he learned about employing financial leverage.  It looks like the stock took a month or so to digest this news, which was bad short-term (dilution) but clearly positive longer-term by eliminating the liquidity risk.  Interestingly, its large shareholders added during Q2 (especially AXA and Fisher, its 2nd and 4th largest), though Allianz, previously its largest holder, puked out its entire stake.  Now the stock looks to be recovering, as it has forged through the conversion price for that offering (7.05). 

If one includes the preferred as converted shares (additional 19.9mm shares), the common stock is currently valued at about $633mm compared to equity of $697mm and tangible equity of $522mm.  The chart below, which is a bit off because it doesn't include the preferred shares, shows that this is a cheap as this stock has been in the past decade:

Cheap is nice, but it isn't sufficient.  The company will report a loss this year, with the cost of the preferred equity (.09 per share) as well as weak business trends contributing.  Analysts do forecast a strong recovery over the next two years, but these are the same guys who were predicting that the company would earn over $1 this year as recently as January.  The preferred stock can be called (and the dividend cost eliminated as it is converted to common) if the stock closes above 10.53 for 20 out of 30 days.  One positive that I note is that the company has substantial exposure outside the U.S. (50%).  The bulk of sales come from clubs, but even sales of balls have been hammered.  The company cites pricing primarily and share loss as a secondary cause to this 20% YTD decline.  According to the company, it has gained share in clubs.

For all the talk of innovation, I note that the company historically spent 5% and now spends 3% on R&D.  The company has certainly moved to cut costs, even before sales turned down, so any sort of improvement in demand should really help EPS.  Management doesn't have a lot of skin in the game, with CEO Fellows at just 1.2% and the entire team and the Board at under 3%.  It is worth noting that the Chairman of the Board has purchased stock and excercised options in the past few months.  Short-interest is quite high at almost 8mm shares, but it seems as if a portion of it is against the convertible preferred stock.

All in all, I find this to be cheap enough to merit watching a little more closely.  I don't have a lot of confidence that this is the management team to make the company better - they are still in the box as far as I am concerned for placing the shareholders in harm's way by leveraging the balance sheet with short-term debt.  I wish I had been paying attention to the story back when they diluted massively, but there is probably still some upside despite the 50% rally off the low. 

Disclosure:  No position

Natural Gas: Extreme Contango Suggests Caution for E&P Companies

The price of Natural Gas is hovering just below $3, which is about the median price over the past two decades.  Or is it?  While the spot price has garnered lots of headlines recently for its collapse, the future price has declined much much less so.  The quoted price for a year from now is above $5.  Here is the history since 1990:

Clearly the spot price is very depressed relative to the future price.  In fact, it is at a record percentage differential.  In the chart below, I have divided the one-year forward price by the 1-month forward price.  The mean spread has been 6%.  You will see I included lines for +/- 2 standard deviations as well.  The current relationship is more than 4 standard deviations from the mean:

At this point, I need to alert the reader that I am approaching this from the view of a generalist.  Embarassingly, given that I am both a native Texan for my first 18 years as well as a resident for the past 15, I have never evolved into much of an expert on oil or gas despite my increased efforts over the past several years.  I do know enough to get myself into trouble! 

Kidding aside, though, I think that the "consensus" thinking is that the spot price is depressed and the future price is more reflective of reality, and I have been questioning that notion.  A client of mine came back from EnerCom's Conference last month and shared his views.  It was then that I realized that the leading E&P companies are all telling a pretty similar story, and it doesn't bode well for the price of gas (and the value of their reserves).  Perhaps I am paying too much attention to the big Shale plays, but it appears that despite the plunge in gas prices, companies are cranking out the gas.  Natural gas is more plentiful than we have imagined, and technology makes it more accessible apparently.  If that's not enough, I read this week that Cheniere's (LNG) facility is importing gas despite the very low spot prices.  Demand is muted, and it could return, but the real story to me is supply.  Most commentary points to the large decline in drilling, citing the Baker Huges Rig Count data.  Below, you can see the plunge in North American Gas Rigs in operation:

 

This data can lead one to conclude that production must be plunging, but I wonder if a lot of the rigs are not the marginal ones.  Further, with horizontal drilling, I believe that the output per rig increases.  The plunge in spot prices is attributed to a short-term decline in demand and storage at capacity.  All we need is a hurricane or a cold winter or hot summer and everything will be fine!  In any event, I checked some data published by the Department of Energy and found that production in total has been rather flat.  For the first six months of the year, this is what it looks like:

• 2009:   10.515 TCF
• 2008:   10.213 TCF
• 2007:    9.328 TCF 

I also believe that we have a situation where reserves are growing rapidly.  I reviewed several conference calls from Q2 for the leading gas companies and find an alarming uniformity in what they had to say.  While spot prices are quite low and would seem to suggest lower production, they are cranking it out.  First, they need to crank it out.  All of these companies have significant financial leverage.  Second, due to hedging, they are actually very profitable.  This begs the question:  Who is paying $5 for gas a year out, and how long will they continue to do so?

Here are some quotes, all of which are from transcripts provided by Seeking Alpha.  I have included the link to the transcript in each case (click on company name):

Chesapeake Energy (CHK):  "...we expect to deliver 4% to 5% production growth in 2009, and 7% to 8% production growth in 2010, plus, increase Chesapeake's proved reserve, during '09 and '10, from 12 Tcfe to 16 Tcfe..." (CEO McClendon) and "...Finally, one note on cost trends. As you can see from our release, just about all of our production and other cash cost are down or at worst to flat from quarter-to-quarter. We continue to see some downward trend in drilling and completion costs as well..." (CFO Rowland)

Petrohawk Energy (HK):  "...our priorities are significant production growth and reserve growth..." (CEO Wilson) and "... Our production came in significantly over the high-end of guidance to 483 million a day..." (CFO Mize)

Southwestern Energy (SWN):  "...we will expect to have production growth of approximately 45% over the 2008 levels... During the second quarter of 2009 our horizontal wells had an average completed well cost of $2.9 million per well, average horizontal lateral length of 4,123 feet, and average time to drill to total dept of 11 days from reentry to reentry. This compares to an average completed well cost of $3.1 million per well, average horizontal lateral length of 3,874 feet, and average time to drill to total depth of 12 days from reentry to reentry in the first quarter of 2009." (COO Mueller) 

Ultra Petroleum (UPL):  "...Second quarter of 2009 was a difficult period for the industry, but Ultra delivered strong results. We established a new quarterly record for production of 44.5 Bcfe, an increase of 30% from second quarter 2008. At the same time we decreased our all-in-cost by 29% to $2.43 per Mcfe, and our cash costs also decreased to $1.42 per Mcfe... We ask Netherland Sewell to provide us with a mid-year proved reserve update using the more logical 2009 rules and unrestricted by us. The result is an answer almost twice what we reported at year end 2008... It is clear to us that we can grow annual production by 10% to 15% over our three-year planning period 2010 to 2012..." (CEO Watford)

XTO Energy (XTO):   "...natural gas production averaged 2.352 Bcf per day, 31% increase... Of this growth, 19% comes from acquisitions and 13% comes from development...If we look at our unit cost analysis and guidance importantly, and Keith will talk about this a little later, production expense was $0.94. That compares, per Mcfe, to $1.00 to $1.05 guidance, so a substantial improvement there, and we've lowered our guidance to $0.95 to $1.00 going for the remainder of the year..." (CFO Baldwin)

So, we have increasing reserves, increasing production, and decreasing costs from these leading developers of the Shale reserves.  None of this bodes well for future gas prices, though EOG Resources (EOG) CEO Mark Papa believes that the decline in Texas vertical wells will more than offset this dynamic, calling Texas "the 800 pound gorilla in the room ."  Absent a major change in our national energy policy that results in a massive effort to build gas-fired electrical power plants, I believe that supply will continue to dwarf demand.  Investors in the leading gas-focused E&P companies may want to keep an eye on that forward price that is enabling the companies to generate strong profits through their hedging activities.

Disclosure:  None