#$so

In the weekly bar chart of the Utility Sector Index (UTY) above, seasonal strength (lower pane, shaded in yellow) typically begins following an early or mid-March bottom and usually lasts through early October although the bulk of the move is typically done sometime in May or early June (blue arrow).

Image Source: Benson Kua

If you want more of Mr. Nelson’s thoughts every month, please consider the Nelson Exclusive here (limited availability). 

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By The Valuentum Team

Kinder Morgan is on its way to righting its debt problems, and we love it!

When the US government seemingly raises the so-called debt ceiling every few months, how can the public view towards massive leverage and effectively being unable to repay future obligations without making significant changes hold a stigma? In many ways, it has now become “okay” to be buried under mountains of debt. Is it now the norm? Each citizen in the US, for example, owns a piece of its country’s $19.3 trillion national debt, amounting to a whopping $60,000 per person, and this number is growing. That means that each new baby born in America is saddled with $60,000 in debt at the very moment life begins. It’s sad.

But even if this alone is not a big enough national crisis, most Americans have found a way to the debt punch bowl anyway, whether it be of the credit card or auto-load variety, or even the more sanguine mortgage and student-loan burden, the latter of significant political concern, “Debt, Debt and More Debt (April 2016).” How therefore can Americans point fingers at corporates or master limited partnerships (MLP) and real estate investment trusts (REITs) that are beholden to issuing more and more capital, taking on more and more debt, and then spending excessively when it comes to paying out massive cash distributions, when their own fiscal house is not in order? Excessive risk-taking and the “quick buck,” after all, have become a part of American society, at least if the housing crisis of late last decade is any indication. In this day and age, can Americans truly decipher what acceptable levels of leverage are?

Valuentum published a recent piece showing the reported net-debt-to-EBITDA figures in the energy master limited partnership arena recently, and the leverage levels continue to be striking, “Distributing Truth on MLPs (July 2016).” Kinder Morgan (KMI) and Energy Transfer Equity (ETE) ended 2015 with net debt positions of ~$43 billion and $36 billion, reflecting reported leverage of ~6+  and 7+ times, respectively. Though no single metric such as net-debt-to-EBITDA can judge credit quality by itself, generally speaking, to earn investment-grade marks in most cases across the global credit universe, an entity’s reported debt-to-EBITDA ratio is generally below 2 (that’s 2 -- and generally for strong companies with solid free cash flow in excess of cash dividends paid). For most MLPs, retained cash flow measures (or the percentage of cash flow generation an MLP “retains” after paying distributions relative to its net debt position) reveal that credit quality is very poor, at best.

In this light, we maintain that the little “blip,” which most described as a “sky is falling scenario,” that we witnessed with respect to energy MLPs (AMLP) in 2014-2015 will be nothing compared to a true crisis that we believe has only been delayed, not canceled. Market participants have become so used to more and more capital, more and more debt, that they think this is a normal way of doing business -- taking out massive leverage, paying out cash distributions in excess of what is generated in operating cash flow less organic maintenance and growth investment. Successful businesses aren’t walking the equivalent of financial tightropes. In many ways, it’s a crisis of understanding as much as it is a debt crisis. Can investors truly be blamed though? After all, look at what they are being fed on television, for example.

You may have heard of the American reality television series, Shark Tank, which paints entrepreneurs as “winners” when they land a “capital raise” from Mark Cuban or Kevin O’ Leary or Barbara Corcoran or any one of the other stars on the show. Entrepreneurship is not about raising a bunch of capital -- or taking out a bunch of debt. In fact, there’s really nothing entrepreneurial about that at all. Trust me -- anyone can give away a bigger piece of their company in an equity stake or take on more debt and/or royalty payments (future cash obligations). It’s about what you do with that capital that matters. You’ll note the capital-raise cycle is what MLPs and REITs (VNQ) specialize in--these structures issue more and more equity, diluting existing shareholders, and layer on more and more debt because they retain negligible cash flow. Even one of our favorite REITs, Public Storage (PSA) recently changed its long-standing policy of avoiding corporate debt. Everyone these days is getting drunk off the debt punch bowl!

Now that said, at least one company is starting to sober up: Kinder Morgan. After it stretched too far when it consolidated its risky MLP structure, the company took on a whopping amount of debt, which became a big factor behind its recent dividend cut. On July 10, however, Kinder Morgan announced a deal with Southern Co (SO) where it sold a 50% stake in the 7,600-mile Southern Natural Gas pipeline system, receiving proceeds of $1.47 billion, which could be used to help pay down debt, and dare we say, pave the way for the company’s dividend to return to expansion. Though Kinder Morgan and the credit rating agencies make a variety of adjustments when arriving at a representation of leverage, Kinder Morgan CFO Kimberly Dang has suggested that leverage could fall to 5.3 by the end of 2016, below the company’s previous target of 5.5. Kinder Morgan continues to work to get its financial house in order, and we love it!

On January 21, 2016, Barron’s profiled the work of Valuentum’s President Brian Nelson on Kinder Morgan and his call that the company could rally 44% higher from the mark of nearly six months ago. With shares of Kinder Morgan now at ~$20 each, Mr. Nelson’s target at the time, it looks like his upside call on Kinder Morgan has largely played out, too. If you remember, Mr. Nelson called the collapse in Kinder Morgan’s shares in June 2015 when they were exchanging hands at ~$40 each. Let’s revisit what Barron’s wrote about Valuentum’s bullish call on Kinder Morgan in January of this year (source):

“Brian Nelson...who generated scorn from Kinder fans for turning bearish on the stock in a much-discussed … piece Thursday that is quite positive.

“We’re starting to like what we’re hearing from management, and we again applaud the executive team because we think they understand the issues and are working toward a solution,” he writes. “On the conference call, the team made it very clear to investors that the dividend is not a driver behind the intrinsic valuation of equities, but that it is an output of the free cash flow generating capacity of the entity, or at least it should be.”

Last June, this column generated a slew of negative reader reaction for citing a piece by Nelson, the president of Valuentum Securities, who stated the ”five reasons why we think Kinder Morgan’s shares will collapse.” …

… In June, Nelson wrote that “Kinder Morgan may turn into one of the worst-performing companies this year and into 2016,” adding that he was removing the stock from his firm’s Dividend Growth portfolio.

When Nelson slammed the stock, it was trading at $40. In the following months, it fell 70% to yesterday’s close of $12.01 following a drop in oil prices that Kinder bulls said wouldn’t seriously hurt a midstream energy player.

In December, the company did something the fans said was not going to happen; it slashed its dividend, by a whopping 75%. Barron’s followed that news with a piece that remained skeptical about the stock.

Nelson’s timing in June was impeccable, given how far the stock fell in subsequent months. One could argue that his latest piece is a little slow off the blocks, given that the stock has had a nice run already on the latest earnings results.

But the Nelson piece, which is quite detailed in its financial analysis and measured in its praise, suggests that more good news could be in store for the company and stock. He writes that the stock’s fair value, based on his analysis, is $20 a share, a full 44% higher than it is trading at now.

Coming from Nelson, a knowledgeable student of the stock and an investor who has shown a willingness to bet in both directions -- and who has largely been proved correct -- that carries some weight.”

We continue to include shares of Kinder Morgan in the Best Ideas Newsletter portfolio. We trust you continue to enjoy our work at Valuentum. If you want more of Mr. Nelson’s thoughts every month, please consider the Nelson Exclusive here (limited availability). Thank you for reading!

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Utilities showing strength is a defensive investment move. Or so the story goes. Whether you believe that or not it is happening right now. I wrote about Southern Company ($SO) earlier today as an example. Another that is looking good is American Electric Power ($AEP). The chart below shows the price action in American Electric Power since September 2013, when it made a short term bottom.

Since then it rose to a peak in early 2015 and then started a 12 month rounded pullback. At the bottom it had retraced about 56% of the leg higher form September 2013. Now it is making higher lows against the resistance at 59.60. This sets up for a possible entry into the stock. The full rise and rounded pullback creates an AB=CD pattern that targets a move to about 75.70.

The trigger to participate in this move is a break of that resistance at 59.60. The last higher low at 57.50 makes for a natural level for a stop loss on the trade and only risks about $2 against a possible reward of $18. But it is even better than that. The stock pays a 3.8% dividend ($2.24 annually), to get you comfortable with waiting. Watch for earnings are coming up on January 28th.

Southern Company, $SO, went through a nearly year long bottoming process in 2015.  Focusing on the movement since August it had built an ascending triangle against resistance at 46.50 until it broke to the upside just before Christmas.  Since then it has consolidated the break out in a tight range between 46.50 and 47.50.  

The target on the break of the triangle is a move to 51.  That would put it back at the higher resistance from December 2014 and February 2015, but below the peak that started 2015.  Despite the current consolidation, the Bollinger Bands® squeezing suggest a break is imminent.  The RSI is bullish and the MACD flat after a short pullback, suggesting that break would be to the upside.

There is resistance at 47.50 and 47.75 before 48.60 and 49 followed by 49.65 and 50.40 then 51 and 52.25.  Support lower comes at 46.50 and 45.85 followed by 45.30 and 44.30.  Short interest is low at 2.3% and the company is expected to report earnings on February 3rd.  The stock will also go ex-dividend February 11th paying 54 cents, or at a rate of 4.60%.  

The options chains show monthly expirations, with the February chain covering the earnings date.  All of the Put open interest is below the price while the Call open interest is spread from 44 to 49.  The size on the call side is bigger by a factor of 2.  March expiry is just opening, and moving out to May sees the majority of open interest above and on the call side at the 50 Strike.  

Southern Company, Ticker: $SO

Trade Idea 1:  Buy the stock on a move over 47.50 with a stop at 46.50. A straight stock trade.

Trade Idea 2:  Buy the stock with a February 47/44 Put Spread selling a May 49 Covered Call (15 cents for the collar). Adds a collar for protection through earnings.

Trade Idea 3:  Buy the February 47/49 Call Spread (80 cents). A defined risk trade, with a 2.5:1 reward to risk ratio.

Trade Idea 4:  Buy the February 47/49 Call Spread and sell the February 45 Put (39 cents). Adds leverage to the controlled risk trade.

Trade Idea 5:  Buy the February 47/49 1x2 Call Spread and sell the February 45 Put (19 cents). More leverage and a possible maximum 10.5:1 reward to risk ratio.

After reviewing over 1,000 charts, I have found some good setups for the week. These were selected and should be viewed in the context of the broad Market Macro picture reviewed Friday which, closed the January options expiration and the worst two week start to a year ever, yet with equity markets looking like they are not done falling yet.

Elsewhere Gold is biased higher in its downtrend while Crude Oil consolidates in its downtrend. The US Dollar Index continues to move sideways but with an upward bias while US Treasuries are biased higher.  The Shanghai Composite and Emerging Markets are biased to the downside with the Chinese market possibly ready to consolidate.

Volatility looks to remain elevated and with an upward bias keeping the bias lower for the equity index ETF's SPY, IWM and QQQ. Their charts agree and look better to the downside on both the daily and weekly timeframes.  The IWM crossed into a bear market and looks the worst. The QQQ is down over 15% but still holding best over the August and September lows, while the SPY has held the closest to its all-time high but is precariously perched heading into the week. Use this information as you prepare for the coming week and trad'em well.

By Rupert Hargreaves

Dividends are a key part of most investors’ financial strategy. However, not all dividends are created equal, and chasing yield can often end in tears.

To help investors select the best income stocks, Société Générale publishes a monthly income screen, highlighting the best dividend stocks in developed markets based on a number of quality criteria. The bank also publishes a high dividend risk screen, which picks out those companies that are most likely to cut their dividends in the near future.

The December results of these two screens can be found here; hopefully, they will help you improve your investing process to some degree.

In addition to the two monthly dividend screens, SocGen also publishes a more comprehensive Global Income Investor report, which details the drawbacks, benefits and risks of income investing. Below are some of the key takeaways from the report, along with some top income picks.

Dividends: The biggest driver of equity returns

It’s no secret that dividends are the most significant driver of equity returns over the long-term. Dividend reinvestment is key to wealth creation and bypassing this step can severely impact your long-term returns.

For example, SocGen’s figures show that since 1970 US equities with dividends reinvested have produced an annualized real return of 5.2%. However, if dividend payments were spent instead of reinvested over the same period, the average investor’s real return would be 3% per annum. Excluding dividends entirely, equities have produced an annualized real price return of only 2.2% since 1970. The compounding effects of the dividends really do dominate returns in the long run.

Finding the best dividends for the long-term isn’t an exact science. A high dividend yield isn’t always the better dividend yield as SocGen’s data shows.

According to SocGen’s research, on average, the spread between the expected dividend yield (the payout analysts expect) of a particular stock, and the realized yield (the payout that investors actually receive) starts to widen above 4%. In other words, if a stock’s expected dividend yield is greater than 4%, the chance of the actual payout being less than the market expects, increases with every 100bps increase in yield, as the chart below illustrates.

SocGen’s evidence shows that high dividend yields should be avoided and that includes the constituents of the FTSE World High Yield index, which has consistently produced a realize yield below what has been expected. Many of the stocks in the index yield more than 4%.

Dividends: Look for quality

SocGen looks for four factors when trying to identify dividend cuts. The first two factors are both market-based specifically, a poor 12-month share price performance and high share price volatility. The second two factors are related to the company’s financial situation namely, reduced profitability (low ROE, ROA, and high accruals) and a weak balance sheet.

The three factors the bank believes do not help predict dividend cuts are:

Earnings or free cash flow cover

Three, five or ten-year dividend track record

Historical dividend growth

SocGen’s preferred methods of calculating a company’s balance sheet strength and quality, (as a result its dividend sustainability) are the Merton model (balance sheet strength) and Piotroski F-score.

The Merton model looks at the equity of a firm as being a call option on the firm’s assets. SocGen employs the model to determine a company’s ability to service its debt, meet its financial obligations and to gauge the overall possibility of credit default. Companies with the highest Merton model scores have produced the best returns for investors over the long-term with the least volatility.

Also, the evidence shows that the shares of companies with higher F-scores have outperformed those of lower quality peers.

A dividend screen

Based on all of the above, SocGen has put together an income screen for searching out the best income stocks in the world. To qualify for the screen companies must have a market cap greater than $3bn with Merton score in the top 40% of the universe, a Piotroski score of > 7 and a dividend yield of >= 4%. Companies no longer qualify if their Merton score declines, their Piotroski score falls below 3, and their yield falls to less than 3.5%.

Since 1989 this screen has produced some impressive results:

And the companies that currently qualify for SocGen’s income screen are shown below:

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35 months. That’s about how long it’s been since the market pulled back at least 10%, which is an eyebrow-raising stretch of time. Take a look at the market each year going back to 1980 and you’ll find that the S&P 500 has averaged an intra-year drop of a little over 14%. Yet, here we are approaching three full years of a largely uninterrupted climb.

Is history telling us the stock market is due for a correction?

Be Prepared, Not Concerned

I’d classify the market’s behavior as uncommon or maybe even a little curious, but certainly not “concerning.” There have been a few periods like this one where the market charged higher and went years before pausing to pullback somewhere in the 10 – 15% range. The mid-90’s were a good example, and the market even went about three years in the 2002 – 2007 bull market without dipping more than 10%. Corrections, by definition, follow no clear pattern, are unpredictable, and pretty much come and go as they please. To say that a correction is around the corner — on the basis that we haven’t had one in years — is just as likely to be wrong as it is right.

But, history tells us we should at least be prepared. We’ve experienced a sharp pullback each year from 2010 – 2012, with the market resuming its upward course after only a few months. Since 2012, the closest thing to a correction we’ve seen was last year when the market fell about 7%, but it was so light few people even remember it.

The S&P 500 Has Not Corrected More than 10% Since 2012

The relevant pullbacks seen so far in this bull market, go as follows (to note, these are price returns and do not include dividends):

2010 – a sharp dip of around -16% from April to June, with the market ultimately finishing about 13% higher for the year.

2011 – roughly -19% correction from May to mid-August, with the market finishing flat on the year.

2012 – the market pulled back approximately 10% from April to June, but recovered to finish up about 13%.

2014 – a decline in the neighborhood of 7% over a month in the fall, with the market posting an 11% gain on the year.   

If we omit 2014 from the conversation (since it wasn’t a real correction), it appears that this bull market has had a preference for pulling back in the summer months. With summer approaching, you may start to hear pundits calling for the ‘overdue’ pause. Don’t get too stirred if you do. Remember, as I said before, corrections by nature are unpredictable and don’t announce their arrival, so anyone calling for one has little basis for which to do so.  

3 Lessons to Remember About Corrections

1) Corrections are Short, Sharp and Sometimes Scary – this makes them noticeable, and can cause many investors to wonder if a 10% decline will turn into a 30% bear market that lasts years. That means emotion can enter into the decision-making process, for which investors have to be careful. A sharp pullback is often times just a normal – even healthy – part of a bull market. The key is having confidence in your longer-term outlook for stocks.

2) Trying to Time a Correction is Risky – the corrections in 2010, 2011 and 2012 each lasted about 3-4 months which, in terms of most investor’s time horizons, is an extremely small window of time. Remember too that many investors will sell after stocks have already fallen 10%, when fear sets in. That’s usually around the time when the market swiftly recovers, which can adversely impact that investor’s long-term returns – in addition to potentially racking up transaction costs.

3) Corrections, by Definition, Exist in Bull Markets – this may seem like I’m stating the obvious, but if there’s one thing we actually know about corrections, it’s that they are going to happen. We just don’t know when and for how long. In many cases, simply acknowledging that corrections “come with the territory” of equity investing will help you apply patience and a steady hand when they do arrive.

The Bottom Line for Investors

My outlook for stocks remains positive for the year, meaning that if we were to see a few months of downside volatility I think it would just be temporary — a correction. That is not to say I think a pullback will happen this summer or even this year. There is simply no way to know. I would just encourage investors to think about the medium to longer term trajectory of stocks if/when some bumpiness hits, especially given the fact we haven’t seen a real correction in three years. It might not feel so familiar given the recent strong performance of the market, but being unfamiliar doesn’t make it unprecedented.  

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Past performance is no guarantee of future results. Inherent in any investment is the potential for loss.

Zacks Investment Management, Inc. is a wholly-owned subsidiary of Zacks Investment Research. Zacks Investment Management is an independent Registered Investment Advisory firm and acts an investment manager for individuals and institutions. Zacks Investment Research is a provider of earnings data and other financial data to institutions and to individuals.

After yesterday's 1.4% advance, the utilities sector once again took the lead as the best performing major sector in the U.S. market in 2014.  I discussed the technical situation in last month's MorningWord, when the Dow Jones Utility Index broke out to a new all-time high:

Dow Jones Utility Index monthly chart, Courtesy of Bloomberg

As part of the back and forth action in the utilities sector in the past few months, both implied and realized volatility have gradually inched higher as options traders re-priced the market after the breakout:

30 day implied volatility in blue, 10 day realized volatility in white, Courtesy of Bloomberg

While most assets have implied volatility near multiyear lows, the utility sector is an outlier in that options prices are near the middle of the 2 year range.

Given the outperformance in the sector and the technical situation, I wanted to take a brief look at the largest stocks in the sector.  The 5 largest components are DUK, NEE, D, SO, and EXC.

Those 5 components should be considered in two separate groups. NEE, D, and SO are the three growth stocks, where EPS is 40-100% higher over the past 10 years, and the stocks' valuation on a Price/Book basis is between 1.75 and 3.50.  On the other end are DUK and EXC, which are the cigar butts of the group.  EXC annual EPS has actually contracted over the past 10 years (and has been very volatile in the process), while DUK EPS is up about 20% in the past decade.  EXC and DUK both have a P/B ratio in the 1.2 to 1.3 range.

Some of the relative strength or weakness among the utilities can be attributed to geographic disparity.  NEE is based in Florida, a major growth market, and has benefitted from a higher growth in demand than utilities in other areas.  SO is headquartered in Georgia, and Dominion is in Virginia and North Carolina.  All 4 of those states have had above average population growth over the past 5 years (see the list of population growth by state).  Meanwhile, Excelon operates primarily in Illinois and Pennsylvania, where the population has hardly grown.  Duke is based in North Carolina as well, though its operations are more diversified.

In terms of management prowess, NEE looks like the standout of the group, as EPS has grown in each year since 2005.  Moreover, the company is making a strong push in wind and solar power plants in the U.S.  Though the renewables segments are still a small part of the overall business, the long-term prospects look encouraging.

However, valuation for the growth stocks, NEE, D, and SO, is significantly higher than EXC and DUK, and also quite a bit higher than the historical valuation of NEE, D, and SO.  That is of course an indication of the conducive market backdrop over the past few years, and the search for yield that has led so many investors to the utilities sector.

At this juncture, I'd still rather buy the consistent performers, like NEE and SO, and possibly hedge some of the risk of a breakdown in the utilities sector as a whole with farther dated XLU puts.