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Pair Trading Opportunity – AGL Resources And Piedmont Natural Gas

Summary Two deals in the same sector with similar conditions and similar payment methods — the perfect situation for implementing a pair trading strategy. Because of regulation, this will be a very long process. So the pair trading strategy is more profitable than a classic merger arbitrage. In my opinion, if the authorities block one of the transactions the other merger will automatically have a lot problems. This risk should be hedged. I have to admit it: I hate mergers with a lot of regulatory conditions and economic intervention . I’m not a lawyer, so I’m not an expert in terms and conditions and I avoid these transactions. However, we can sometimes see very good opportunities in the M&A markets because of similar deals pursuant to the same antitrust approvals. On Aug. 24, 2015, Southern Company (NYSE: SO ) and AGL Resources (NYSE: GAS ) announced a merger agreement. Sometime later, on Oct. 26, 2015, Duke Energy (NYSE: DUK ) and Piedmont Natural Gas (NYSE: PNY ) approved another merger agreement with similar terms and conditions. Both transactions will be paid in cash, and their size is comparable: $12 billion and $6.7 billion, respectively. In this article, I will only assess the terms and conditions of both mergers. If you want to understand more about the financial performance of the companies, check our these articles: Buyers Duke is the largest electric utility in the United States. It serves 7.3 million customers, located in the Southeast and Midwest. It has an enterprise value of $88.01 billion and $1.38 billion cash on the balance sheet; its ROA is 2.83%. You can check some more numbers here. Source: I nvestor Presentation . It is a mature company, with an interesting dividend yield as well as a high payout ratio: Source: Investor Presentation. You can only see this type of payout ratio in mature industries. Merger arbitrage analysts might say that they like this transaction or not, but the fact is that the sector is in a phase of consolidation and mergers will occur. Southern serves more than 4.5 million customers, and it is the leader in the southeast portion of the United States. It has an enterprise value of $67.48 billion and $1.12 billion in cash; its ROA is 3.74%. You can check some more numbers here. Source: Investor Presentation . I would like to mention that the buyers are very big players. Their size is comparable, and the only difference is that they operate in different areas. The negotiation process with the authorities will be the same. Because of this fact, the merger spread should be similar. Targets and Transitions Benefits Piedmont has one million customers in portions of North Carolina, South Carolina, and Tennessee. It has a better ROA than its acquirer (3.54%), and it is also more than 10 times smaller than Duke. The transaction is an interesting move. Duke’s objective is to enhance its regulated business mix. What’s more, this merger creates a strong platform for future growth. AGL is based in Atlanta. It provides energy services to 5.5 million utility customers (including over one million retail customers served by the SouthStar Energy Services joint venture). Its ROA is 3.84%, which is better than that of the buyer. This transaction is a little better than the other one. It is accretive to ongoing EPS in the first full year, and it will create a strong credit profile. Source: Investor Presentation . Overall, the targets are very similar. It looks like a copied transaction, both in size (“same customer base”) and in value. As mentioned earlier, because of this fact the merger spread should be approximately the same. Terms, Conditions and Timing If you are interested, you can read the merger agreement of Duke’s transaction here and that of Southern here . Both mergers are pursuant to the shareholders’ approval. I did not read about any shareholders complaining about the price paid. So, I’m not worried about these conditions. It is more important, in this case, to assess the regulatory conditions. Southern’s transaction is subject to the following regulatory conditions: – The receipt of antitrust clearance in the United States (Hart-Scott-Rodino Act) – The approval of the FCC – The approval of the California Public Utilities Commission, Georgia Public Service Commission, Illinois Commerce Commission, Maryland Public Service Commission, New Jersey Board of Public Utilities and Virginia State Corporation Commission and other approvals required under applicable state laws. Source: Merger Agreement. Duke’s transaction is subject to the following antitrust conditions: – The receipt of antitrust clearance in the United States (Hart-Scott-Rodino Act) – “The merger is subject to the approval of the NCUC. The Company and Duke Energy expect to file in or around January 2016 a joint application for approval by the NCUC of the merger. Section 62-111(a) of the North Carolina General Statutes provides that no merger or combination affecting a public utility may be made through acquisition or control by stock purchase or otherwise without written approval from the NCUC. Under this statute, such approval shall be given if justified by the public convenience and necessity. The Company is a public utility under North Carolina law and two of Duke Energy’s subsidiaries are also public utilities under North Carolina law. Source: Merger Agreement. I do not think that any merger arbitrageur will tell you the outcome of these mergers. It is a very technical question that you might only be able to answer if you have worked approving mergers for a while. So I would not implement a classic merger arbitrage strategy here. I do not like gambling. The pair trading strategy that I will explain below reduces the exposure to these regulatory risks. Overall, the mergers will take a long time because of these regulatory conditions. Both transactions are said to close in the second quarter of 2016. Pair Trading Strategy and Conclusion Duke will pay $60 per share in cash, so the merger arbitrage spread is 5.24% ($60/$57.01 (close on Dec. 11, 2015) – 1). What’s more, we have to include four quarterly dividends paid by Piedmont (0.33 per share; I included the fourth quarterly dividend of 2015 but not that of 2016). So, the merger contribution is $61.32, and the calculated spread is 7.56% ($61.32/$57.01 – 1). Southern will pay an amount of $66.00 per share in cash, so the merger arbitrage spread is 5.21% ($66/$62.73 (close on Dec. 11, 2015) – 1). However, if we include the four quarterly dividends that AGL distributes (0.51 per shares), the merger contribution becomes $68.04, and the calculated spread is 8.46%($68.04/$62.73 – 1). The most recent evolution of the calculated spread can be seen in the following figure: Source: Maudes Capital. I would like to mention that the spread of both companies is somewhat correlated. It makes sense because of the facts explained above. In the future, the evolution will be similar so that you can perfectly implement a pair trading strategy. Today, I would buy PNY shares, and use the same amount of money to short sell GAS. You can make more than 1% return in a short period of time. The best thing in this idea is that you eliminate the regulatory risk included in both transactions. If one merger does not close, the other merger will have a lot of issues as well, and the spread will be enlarged. This means that you hedge the loss in one merger with the gains in the other transaction. To make a long story short, these transactions have a lot of regulatory conditions, and the classic merger arbitrage strategy is not a good idea. The pair trading strategy provides a better risk/return ratio. What’s more, both mergers are necessary moves in the same sector, and therefore good M&A ideas. I believe that both transactions will close, but I do not like playing with regulatory conditions. So, I prefer to hedge the risk. Note: At the moment there are some other merger arbitrage and pair trading investments like this one — you can read about them here , here , and here .

The Fed And SLV – What’s Ahead?

Summary The FOMC is expected to raise rates this week. How will this decision impact SLV? Whether the Fed raises rates or not, isn’t the only issue to consider. The FOMC is expected to convene this week and decide whether it’s time to hit lift off and raise rates. While rates are still expected to remain low, even a modest hike of 0.25 basis points could be enough to send down the iShares Silver Trust ETF (NYSEARCA: SLV ). But the direction of the silver market won’t only rely on the whether the Fed raises rates or not. Other considerations also matter including what’s the trajectory of the future rate hikes, the wording of the statement, the revised outlook for next year, and Chair Yellen’s press conference just to name a few. How will the Fed expected hike move the price of SLV? Let’s breakdown what’s up ahead for SLV. Based on the implied probabilities , the market expects three rate hikes in 2015-2016 with a very likely hike in December – a little over 80% chance, the highest level in months. But with an 80% chance this still gives some room for uncertainty in the markets. (click to enlarge) Source: Fed-watch If the Fed does move along with the hike, it’s likely to bring down the price of SLV as it did back in the last FOMC meeting when the Fed stated it’s ready to raise rates in December. Is the market ready for a hike? When it comes to the reasoning for raising rates the Fed sees that the U.S. labor market is on course to full employment with unemployment rate at 5%, an average of over 200,000 jobs were added a monthly basis in 2015 and wage growth at 2.3%. Also, U.S. core CPI is at 1.9%, which isn’t far off the Fed’s 2% target . And the Case-Shiller home price index showed that prices have been steadily climbing in the past three years; while prices aren’t at record high levels of mid-2006, they are still high enough to sustain a rise in mortgage rates and weed out any possible bubbles that may be forming in the real estate market. The same could be said about the stock market. The flip side for keeping rates unchanged is that the labor market may not be in a good enough shape to sustain higher rates with “real unemployment rate” or U6 rate is close to 10% and participation rate remains low. Moreover, the expected rising cash rates will make it even harder for the Fed to reach its 2% inflation goal. And low commodities prices aren’t helping. Having said that, the Fed is still expected to raise rates this meeting. And higher rates won’t do any good for SLV. From the perceptive of the stronger U.S. dollar, a stronger dollar could push down SLV. After all, the rally of the U.S. dollar in recent weeks, up to the last couple of weeks, seemed to have contributed to the weakness of SLV, as indicated in the chart below. (click to enlarge) Source: FRED and Google finance Bear in mind, however, that the correlation between the two isn’t too strong at -0.26 during 2015. But the correlation has intensified lately: Over the past couple of months it reached -0.4. So keep an eye out for the direction of U.S. dollar, which is likely to keep rising if the Fed moves on with normalization. Beyond this time’s rate hike Looking beyond the expected rate hike, the Fed is likely to issue a statement with a dovish tone reiterating that future hikes won’t be every other meeting and will spread apart in 2016 – something that will be backed by the dot plot. Chair Yellen will also try to calm the markets by assuring the strength and stability of the U.S. economy and how another hike won’t be decided any time soon (the term “data dependent” will be thrown a lot – as it always is). The FOMC will also release its dot plot about the cash rate. Back in September, the FOMC anticipated rates will rise to 1.4% by the end of next year and 2.6% by the end of 2017. The trajectory of the cash rate could also have an impact on the direction of the price of SLV. On this issue, if the FOMC were to revise down its outlook about the cash rates, and it’s a very likely scenario, this could partly offset the adverse impact the rate hike in the upcoming meeting will have on precious metals prices. This could translate to keeping SLV from tumbling down in the coming months. Unless the Fed surprises the market, the short term outlook of SLV is still likely to be downward. The expected rise in the U.S. dollar could keep driving down SLV. On the other hand, if the Fed cuts down again its outlook for the cash rate in 2016 and beyond, this could, down the line, keep the price of SLV from further plunging in the medium term. For more please see: Will Higher Physical Demand for Silver Drive Up SLV?

How To Avoid The Worst Sector ETFs: Q4’15

Summary The large number of ETFs has little to do with serving your best interests. Below are three red flags you can use to avoid the worst ETFs. The following presents the least and most expensive sector ETFs as well as the worst overall sector ETFs per our Q4’15 sector ratings. Question: Why are there so many ETFs? Answer: ETF providers tend to make lots of money on each ETF so they create more products to sell. The large number of ETFs has little to do with serving your best interests. Below are three red flags you can use to avoid the worst ETFs: Inadequate Liquidity This issue is the easiest to avoid, and our advice is simple. Avoid all ETFs with less than $100 million in assets. Low levels of liquidity can lead to a discrepancy between the price of the ETF and the underlying value of the securities it holds. Plus, low asset levels tend to mean lower volume in the ETF and larger bid-ask spreads. High Fees ETFs should be cheap, but not all of them are. The first step here is to know what is cheap and expensive. To ensure you are paying at or below average fees, invest only in ETFs with total annual costs below 0.54%, which is the average total annual costs of the 196 U.S. equity sector ETFs we cover. Figure 1 shows the most and least expensive sector ETFs. ProShares and Direxion each provide two of the most expensive ETFs while Fidelity and Vanguard ETFs are among the cheapest. Figure 1: 5 Least and Most Expensive Sector ETFs (click to enlarge) Sources: New Constructs, LLC and company filings Investors need not pay high fees for quality holdings. The PowerShares KBW Property & Casualty Insurance Portfolio (NYSEARCA: KBWP ) earns our Very Attractive rating and has low total annual costs of only 0.39%. On the other hand, the Schwab U.S. REIT ETF (NYSEARCA: SCHH ) receives our Neutral rating due to its poor holdings. No matter how cheap an ETF, if it holds bad stocks, its performance will be bad. The quality of an ETFs holdings matters more than its price. Poor Holdings Avoiding poor holdings is by far the hardest part of avoiding bad ETFs, but it is also the most important because an ETF’s performance is determined more by its holdings than its costs. Figure 2 shows the ETFs within each sector with the worst holdings or portfolio management ratings . Figure 2: Sector ETFs with the Worst Holdings (click to enlarge) Sources: New Constructs, LLC and company filings PowerShares appears more often than any other providers in Figure 2, which means that they offer the most ETFs with the worst holdings. Our overall ratings on ETFs are based primarily on our stock ratings of their holdings. The Danger Within Buying an ETF without analyzing its holdings is like buying a stock without analyzing its business and finances. Put another way, research on ETF holdings is necessary due diligence because an ETF’s performance is only as good as its holdings’ performance. Barron’s agrees . PERFORMANCE OF ETFs HOLDINGs = PERFORMANCE OF ETF Disclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, sector, or theme.