Saturday, September 11, 2010

Fishing for value - some good picks in retail

Since hitting their highs in March-April, the retail sector has taken a strong beating over the past several months. A significant correction was bound to happen since the uptick in the first 3 quarters in stocks in this sector was way too steep to be sustainable! However, by any stretch of logic, the current valuation levels are too low, unless you are a firm believer of a clear double-dip recession.

Let's start with the economy - as i opined in my last article, there are simply no clear indicators of a double dip - despite the fact that employment stats would remain depressing for quite some time. Recent indicators on home sales, manufacturing and retail have been very mixed too, indicating a slow but choppy recovery. Neither the government nor the private sector can afford a double dip at this point, and given the speed with which stakeholders have acted to quell any fears of a slip-back in to recession, there is little reason to worry about a double-dip actuyally happening. More over, many real indicators are so depressed that there is not too much room to move down from here. Given this, I would put my bets on at least a minor-to-moderate rally in the retail sector over the next quarter, especially with back-to-school and holiday seasons perking up sales.

In fact, August numbers from several retailers beat analyst expectations, helped by increased promotions, and a pickup in back-to-school sales. Overall same-store sales (Retail Metrics index culled from 30 retailers) rose 3.5% as against an analyst expectation of 2.8% - this is the first time since Q1 that there has been a positive surprise. Several retaliers had positive same-store sales suprises - from Costco (7%) to Nordstrom (6.3%) to Zumiez and Wet Seal, numbers were good pretty much across the board, though not for all names.September results will be critical to guage overall trend, as the back-to-school season is the next biggest period after the holiday season, and is often a good barometer of Q4 peformance. Just looking at the lines in front of retailers like ANF, M, JCP, it is hard to doubt the fact that it is going to be a better Q3 and probably an even better Q4. My wife went in for the Macy's one-day sales today here at Boston, and from her words, it feels like it's Thanksgiving weekend already - clearly there is enough steam left in consumer spending to present positive surprises on currently depressed expectations!

Some names are interesting in specific:American Eagle (AEO), Aeropostale (ARO) are decent picks to ride this season, given current valuation levels. However, among all the good picks, i would put my money on JCP and KIRK.

JCP is trading close to its 52-week low at about 21, and not too far from its 5 year low. At a P/E of ~16+, with its value-for-money merchandise positioning, i do not see much of a downside. If initial back-to-school trends are an indication (August sales up 2.3% as against an analyst estimate of 1.6%), it should see reasonably healthy Q3 numbers and a good Q4. Given the choppiness of the market and the high stock beta (1.7), i would not bet on near-term options though...would either go long on the stock or Jan '11 options. From a timing perspective, note that Q3 results will be out in mid-November.

KIRK is trading at 12+, close to its 52-week low of ~10 and far below its high of 25.3! Given the spread and uniqueness of the merchandise they carry, i would jump on this stock at its current P/E of sub-7! The stock has been hammerred badly ever since May primarily because same-store and overall numbers failed to keep the abnormal growth trend shown over the previous year. Q2 2010 revenue numbers were only 2% higher Y-o-Y and same-store numbers were only 1% higher...it was a case of expectations going way above normal, and a correction to reflect reality - however, the downward correction has been clearly overdone, and i would bet on a level of atleast 16-17 by Q4. As mentioned earlier, i would rather go long on the stock or longer-term options as against near-term options. Again, from a timing perspective, note that Q3 results will be out in mid-November.

Friday, July 2, 2010

Volatility still rules - but do we need to necessarily be on cash?

Ever since Q1 '10 calm was broken by the Greek crisis, markets have struggled to remain steady. VIX, VSTOXX and other volatility indices around the world are near 52-week highs and there is a very heavy sense of uncertainty across markets globally. The DJIA has already fallen close to 9% from the 10,500 levels in early January to 9600 levels as of today. Emerging market indices have also been as badly affected - the MSCI emerging market index for example is down over 8% YTD and the Shanghai index is down over 27%! It is perhaps safest to be in cash during this period of high volatility; but there might be an attractive risk-return play at current market levels.

It is important to understand macro trends at this point:

Europe
Budget tightening prompted by high deficits will cause restrained growth/slow down across Italy, Greece, Spain, UK; and this would mean subdued growth in the near term for the Euro region as a whole. However, valuations across Europe are at one of the most attractive levels in the last decade [STOXX (P/E - 12.1), FTSE (P/E - 13.2), DAX (P/E - 14.5) etc], and hence there is little room for heavy downward correction in the short-term. Also, the quickness of response from Euro region countries during the Greek crisis earlier this year showed that there is enough governmental support to prevent any drastic fall out.

China
Property price pressures will continue to affect China. However, the correction in the market YTD have dragged valuations on the Shanghai index to less than 17 times reported earnings, compared with 37 times in July 2009. This is while economic growth is still expected to be 10.2 percent in 2010 and over 9 percent in 2011! Thus, there is not enough fundamental pressure to push stocks downward - and an upward correction in this quarter is highly likely. In fact, many investment banks including Morgan Stanley, BNP Paribas SA and Nomura Holdings have predicted that stocks will rally - especially since China’s recent decision to end the yuan’s two-year 6.83/dollar peg to the dollar will help curb inflation and asset bubbles.

Other emerging markets
Most other emerging markets have dropped heavily YTD too, except India (BSE Sensex) which has stayed closed to
neutral). Brazil’s Bovespa index dropped over 10 percent YTD and Russia’s Micex slipped over 8.5%. However, economic growth projections are still strong across most emerging markets, ranging from 3% in Russia to 9%+ in India. And its
important to note that most of these (except perhaps Russia) are cases where growth is driven by domestic demand and not necessarily deeply tied to global trade flows.

US
Job growth in the US is still constrained with unemployment rate projected to stay in the high 9% range till end of 2010 and probably well in to 2011. Partly due to the same, the housing market would continue to face pressures - the recent bill (to extend the date for the 8K rebate to Sep) not withstanding. However, projected economic growth across Asian and Latin American markets should continue to drive manufacturing exports. Banking balance sheets are much cleaner too - though regulatory pressures to add capital would continue, increased trading revenue due to high volatility, gradual pick up in consumer and corporate credit, and a moderate revival in the wealth management space, would help earnings. Retail stocks should also look up after the heavy sell off during last 2 months, which have left valuations at very attractive levels.

Thus, there clearly are enough factors to sustain market volatility - risk of further sovereign downgrades in Europe, potential of aggravated property price corrections in China, speed of US economic growth and job creation, sustainability of growth in other emerging markets etc. Any balanced investment strategy should hence favor heavier weightage towards cash. However, there are more valuation and macro economic factors pointing to a market reversal than a continued downturn. It is definitely not an easy call considering the continued volatility, but a thought-out riks-reward play should favor going long on emerging markets and the US. Index bets are safer than individual stock bets due to aggravated volatility though.

Sunday, May 16, 2010

Financial stocks - Trouble is not over yet!

After a couple of weeks where every one was more focused on the VIX and the VSTOXX than any thing else, it is interesting to sit back and try predict where the markets are going to move for the rest of the year. We can be sure about a few things - the European debt crisis is far from over, property (and hence stock) price correction in China still has quite some way to go and the banking sector in US and Europe hasn't seen the last of regulatory changes! Considering the above, any long-term directional strategies are prone to extreme volatility...it's much safer to sit on cash and watch from the sidelines! But, if you have the appetite and energy to track and play index funds, there is more money to be made than any other time - provided one doesn't get greedy enough to try and catch the rock bottom or time the peaks!

If there is one sector to avoid jumping in to invest at this point, it is financials. A combination of factors would make good returns on equity extremely difficult to achieve in this sector. A simplistic way to look at how ROE can be impacted for this sector is the way Dupont model looks at it:
Return on Equity = Net Income/Equity = Net Income/Sales * Sales/Assets * Assets/Equity

Factor 1 - Corporate and investment banks would be forced to move out of more and more of their propreitary trading functions out of the banking entity if not stop some forms of propreitary trading altogether. The recent news on Goldman stopping prop trading on CLOs should come as no surprise. Though the regulation to carve out swap desks from FDIC-covered entities would probably not see the light of the day (and would be a shame if implemented!), there is still the looming possibility of regulatory restrictions forcing banks to curtail some of their most lucrative revenue streams. If not regulatory changes, the very fact that the more complex, and hence in most cases more profitable, instruments would face higher capital charges would force banks to be much more selective in the new product area than they ever have been. Winning banks would however find a way to manage capital risk and liquidity risk well while still forging ahead with products that provide greater-than-normal returns. That's why GS and JPM are still good bets in the medium term despite any negative publicity and legal risk that stares in their face!

Factor 2 - Key drivers for this factor goes hand in hand with some of the drivers from factor 1. The ability to increase sales on assets is severely constrained if banks are forced to depend more on revenue streams from traditional net interest and fee income streams. Trading shops get an unfair advantage in this area - though covering settlement risk and liquidity risk are more important than ever, banks with strong trading desks would continue to exploit volatility to generate maximum spread revenue from trading across different asset classses, while locking up poportionately lower capital than traditional banking functions. Though the last couple of quarters saw low volatility and hence lower spread income than the same period in 2009, the spike in volatility (which i bet is going to sustain itself for some time) would boost trading revenues again for the best trading desks in the industry. Traditional financial entities focused on retail and commercial lending, asset management or for that matter trust and custody, would on the other hand face severe challenges to increase sales on assets. Asset managers would especially see more and more end customers preferring less-lucrative passive strategies instead of higher-spread active strategies. Again, GS, JPM and maybe even MS has an advantage.

Factor 3 - This is an area where every one from the best to the worst in the industry would be hard hit. There simply is no more appetite for abnormal leverage - Tier 1 capital as a proportion of total capital would need to increase significantly from current levels. This combined with the fact that Tier 1 would be defined much more striclty - no hybrid instruments, netting of minority interest components etc for example - would force several banks to raise more capital. The recent directive from the Swiss government to UBS and CS for curtailing risk taking and increasing capital (www.bloomberg.com/apps/news?pid=20601110&sid=aCGxFLs8FV64) is a sign of things to come in this area. There are some analysts who have predicted that US and European banks would have to raise over USD 250 bn in additional capital over the next 12-18 months to meet more stringent rules on risk weighting assets and Tier 1 capital as a proportion of total capital.

A combination of these factors would make it extremely difficult for most, if not all banks, to maintain and increase ROE at or above the pre-crisis 15%+ levels. This, combined with lower options for fueling top line growth, would mean that there is not much room for share prices to go up! I would still bet on GS in specific since it is going to be new product ingenuity and smart strategies that are going to be even more important for driving shareholder value in the immediate future.

But, if governments and regulators go ballistic and blame banks for all the ills in the world (the Greek PM blaming US and European banks for 'misleading them' for example!!), God help even Goldman! It is difficult to find any logic in any kind of mob-mentality driven regulatory action though - blaming Goldman or Citi or JPM for making some propreitary profits on shorting MBS while some clients lost money on it is like blaming your stock broker for increase in value of his personal portfolio while you suffered losses on yours!! It's you who got to take care of your own money! Just to make it clear, i am not talking about asset managers here, but the traditional sell-side part of the industry.

Having said that, GS at 140 or even C at sub-4 is still defintely worth putting your money in!

Saturday, April 10, 2010

High-risk (yield) debt markets - Swing back to irrational exuberance?

Leveraged/high-yield market prices have risen up drastically over the last 6 months, prompting questions on whether the industry is again building up some of the toxicity that caused the previous melt-down. Reports show that leveraged loan prices rose to as high as 92 cents on the dollar per the S&P U.S. Leveraged Loan 100 index, the highest level since late 2008. Global high-yield debt sales has touched over USD 90 bn this year while US issuances have crossed USD 70+ bn, over 5 times 2009 levels for the same period. In line with high demand for leveraged loan issues, spreads have dropped to record lows, with below-CCC categories trading at just over 9 percent - as compared to the long term average of 12+ percent. Also, the trend has not been limited to issuers from specific sectors, but pretty much across the manufacturing and services spectrum.

Though the economy is definitely better placed now as compared to 2009, it is difficult to imagine that risks associated with the most risky borrowers have dropped that low, especially at this stage in the economic cycle...assuming there in fact is a correlation the market is placing between risk and return!

Just to prove a point, let's take a look at a another activity that is not directly tied, but driven by some of the same growth fundamentals - Leveraged Buy Outs (LBOs). LBO funds have raised the least capital over the latest period since 2004 and large funds including those from Caryle and Madison Dearborne have struggled to close LBO funds. Average fund raising length for buyout funds seeking more than $1 billion is as high as 19 months now as compared to 16 months in 2009 and less than 5 months in 2004, per Bloomberg reports...deal closures have been even slower, resulting in firms sitting on massive piles of uncommitted capital. It is safe to argue that there is greater investor sophistication and 'better' due diligence that happens as part of LBO fund raising and deal closure as compared to traditional credit market activity. Also, given the fact that LBO deals arguably involve better reference credit as compared to that associated with high-yield issuers in the primary market, indicators from a tepid LBO market do not augur well for the high-yield credit market. Unless there is a perverse logic that issuers with the highest risk will see faster pick-up in activity during a period of weak economic growth! Just to clarify, I agree there is no direct correlation in the reference entities for credit in both cases (high-yield credit markets and LBO deals), but it should be the same fundamentals - economic growth and recovery prospects - that logically should underpin both markets.

Perhaps, capital market participants have extremely short memory spans - as this article on a recent BCG study points out,
(http://www.businessspectator.com.au/bs.nsf/Article/Boston-Consulting-Group-investment-banks-revenue-G-pd20100325-3V3FW?OpenDocument),
sliding revenues are possibly making profit-driven firms focus on the next stop for immediate super-profits...despite all the talk on risk-aligned performance measurement and deferred bonuses!

Thursday, April 1, 2010

View on April earnings calls - Financials

Quite unlike what many (myself included) expected, markets have continued to rally over the
past couple of weeks. Though not unidirectional through the period, the DJIA has inched almost close to the 11K mark and emerging market indices have continued to rise...the MSCI emerging markets index in fact shot up 1.3%+ yesterday! I still hold on to the view that there has been too much-too fast in terms of market rebound and a short-term correction is imminent.

Having said that, there are some interesting picks worth looking among financial stocks -
with a bunch of earnings announcements expected the weeks of April 12 and 19. Let's take a quick look:

  • JPM/JPMC - Earnings expected 14th April. Trading at 45 levels, close to the 52-week high of 47.5 and 5-year high of 52.6. P/E at 20. Though Jamie Dimon's shop weathered the crash better than most others, most of the upside has been factored in and i don't think there is still enough upside left medium-term. However, trading and asset management revenues should look up though credit card losses may moderate profits. Neutral/no directional view.
  • BAC/Bank Am - Earnings expected 16th April. Trading at 17-18 levels, close to the 52-week high of 19.1; 5 year number not relevant due to equity dilution post bail-out. P/E NA. Bank Am should show significant gains due to trading and investment banking revenues and loan loss provisions should be tempered enough to beat street estimates. Bullish - can touch 20 post-earnings - watch May strike 17 call options.
  • BK/BNY Mellon - Earnings expected 19th April. Trading at 30-31 levels, close to the 52-week high of 33.6, 37% below 5-year high of 49. P/E NA. Custody segment should show growth while international revenues will gain from Mellon's share of business. BNY also has lower loan loass provisions as compared to some of its peers. Bullish - watch May strike 30 call options.
  • C/Citi - Earnings expected 19th April. Trading at 4 levels, away from the 52-week high of
    5.4; 5 year number not relevant due to equity dilution post bail-out. P/E NA. Though the US Treasury has announced its intent to sell of its Citi stake (27 and odd %) this year, 7.7
    billion shares on a daily volume of 500 million+ shouldn't cause undue pressure on shares.
    It is reasonable to expect loan loss provisions to moderate & investment banking revenues to climb...though credit card losses can still renmain at high levels. Citi might show good
    margin improvements due to cost rationalization too. Bullish - May strike 4 call options at
    ~0.25 is a good bet.
  • GS/Goldman - Earnings expected 20th April. Trading at 170 levels, down from its 52-week high of 193, 25% below 5-year high of 229. P/E of 8.5. Higher fixed income revenues, higher trading revenues in general, stronger M&A and advisory revenues etc should continue to propel growth - though it's difficult to replicate '09 numbers due to lower market volatility/lower spreads. Bullish - May strike 175 call options at ~5.1 is a good bet
  • SS/State Street - Earnings expected 20th April. Trading at 45 levels, down from its 52-week high of 56, 43% below 5-year high of 78. P/E of 13. Custody and outsourced securities services should show strong growth while asset management should see gains due to a market trend favoring exchange traded funds. Loss provisions associated with conduits should taper down. Bullish long-term - May strike 44 call options at ~2.7 is a good bet.
  • WFC/Wells Fargo - Earnings expected 20th April. Trading at 31 levels, close to its 52-week high of 32 and 21% below 5-year high of 39. P/E of 18. Wells does not have a strong trading desk, and on the other hand has a loan portfolio heavy in optional ARMs and commercial mortgages. This doesn't provide enough reason for any optimism in the short-medium term, and considering current levels, there is a very strong chance of downward movement in the stock price. Bearish - May strike 31 put options at ~1.2 is a good bet.
  • CS/Credit Suisse - Earnings expected 20th April. Trading at 51 levels, down from its 52-week high of 60, 32% below 5-year high of 75. P/E of 10. Apart from gains due to significantly reduced exposure to leveraged finance, commercial & residential mortgages, CS should see gains in wealth management, clearly an area which continues to show long-term growth. Neutral-to-bullish - watch May strike 50 call options.

Having said that, it is safer to take bullish bets closer to the earnings dates since a downward market correction (long over-due) might put overall selling pressure interim.

Sunday, March 21, 2010

Unsustainable rally and valuations - a correction on the way?

A look at how some of the retail picks from my last blog performed clearly indicates the rally that this sector has seen in the past month or so.
Walmart from 52.90 to 55.34; March 52.5 options - from 1.4 to 2.9
JCP from 24.89 to 31.42; March 26.0 options from 0.7 to 5.4.
ROST from 46.43 to 54.07; March 45 options - from 2.2 to 8.8.
KIRK from 16.67 to 20.07; March 17.5 options - from 0.5 to 2.5.

Though some of the above are longer-term value plays too, i believe the sector in general has seen too much of a rally considering how fundamentals driving the sector has moved - (un)employment levels, wages...and consumer confidence as a leading indicator. The same probably applies from a broader market perspective too - we have seen a steep rally from early year lows and the DJIA has already touched close to 10,800, a massive rebound from the 6500 levels touched at its worst point. Fundamental indicators on the other hand have yet to show sustained improvement:
  • Job losses have significantly reduced from 300K per month levels 6 months back to sub-100K per month levels; however that's only arresting the decline and not really driving positive growth
  • Manufacturing & supply side indices have not budged a lot over the past 6 months - the ISM PMI index for example has only inched up from 52.5 levels 6 months back to around 56. More importantly, there has been some deterioration over the past 2 months
  • Housing market inventory remain reasonably high at 7-8 months of sales nationally and hasn't budged from that levels for the past 6-9 months. This is despite continuation of the tax credit in to 2010.
  • Personal consumption expenditure has improved, but consumer confidence indices are not showing sustained improvement
  • Bank lending/credit has still not improved significantly over the past 6 months

Having said that about the US market, emerging market stocks have seen an even larger share of action, leading to valuations almost near unsustainable levels - especially considering risks associated with price bubbles (China), inflation (India), commodity prices/demand (Brazil, Russia) etc. Friday's move by the Indian central bank to raise repo and reverse repo rates show clearly that rate tightening and hence tempering of growth can be expected over the next 12 months...analysts in fact predict an over 200 basis point increase in bank rates in India over this period.

Considering this backdrop at this point in the economic cycle, there probably is more down side than upside from a short-term (3 month) perspective - except for financial sector stocks, there could be little positive news over and above what has been factored in to the recent rally. Prudence would demand pruning investments in emerging market picks, retail, real estate holding companies to name a few - all of which are slated for a correction.

Having said that, there still are some medium and large-cap picks in technology (ADBE is an interesting pick) , Consumer staples (GIS, CPB, DLM etc), Financials (like C) which can continue to deliver - but except for staples, its safer to wait than to jump in yet.


Monday, February 15, 2010

Some interesting retail option picks for Feb/March

Though the market's still catching up with New Year blues and the Dubai-Greece debt story, there has been little to change the belief that a fundamental improvement in business and consumer sentiment is still underway. Except for a few aberrations, statistics related to Industrial supply, inventory, home sales and retail spending has been showing clear signs of improvement. Though employment numbers are not picking up as fast as one would wish for, consumer confidence has clearly reversed the downward trend - I would hence see the recent DJIA fall to 10K levels as an opportunity to increase exposure to some retail stock plays.

Having said that, there's little reason to hurry and increase/build exposure to high-end retail...that is, I would still not bet on abercrombie or American Eagle or Saks at this point! In line with the notion of a new normal for the economy, i am willing to bet on a continued trend of increased spending on discount stores and value-for-money plays as against higher-end retail.

Some interesting picks in value-for-money retail players in the current market scenario:

Walmart @ 52.90 - 25% below 52 week high, P/E of 15.29 (PEG 5-year of 1.24) is interesting. Even after we move back to sustained positive economic growth, consumers would stick to their new found buying pattern. With quarterly results expected on Feb 18, March options at 52.5 are attractive at ~1.40. COSTCO is also attractive, but i am not as upbeat considerable its near its 52 week high and trades at a PE of 24 (PEG of over 1.5).

JCP @ 24.89 - 48% below 52 week high, P/E of 21.54 (High PEG though of 2.5+) might be worth a look. In line with its recent drop from the 35-levels, Godlman moved JCP to the buy list as of early January. Though it might not be a long-term bet, recent weakness means there's enough upside potential short-to-medium term. With quarterly results expected on Feb 19, feb options at 25.0 are attractive at 0.5 levels and March options at 26.0 are attractive at ~0.70.

I am even more bullish on two other niche plays - Ross Stores and Kirkland:

ROST @ 46.43 - 19% below 52-week high, P/E of 14.75 (PEG of 0.89!) is a strong pick. Their strong value-for-money positioning has led to an increasing base of loyal clientele, and i would bet on richer valuations. With quarterly results expected on Mar 18, March 45 options at 2.2 and March 47.5 options at 1.05 are attractive.

KIRK @ 16.67 - 16% below 52-week high, P/E of 11.89 (PEG of 1.01) is a very strong pick. With quarterly results expected on March 12, March 15 options at 2.2 (though they have doubled in the last week) and March 17.5 options at 0.50-levels are attarctive.