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Valuation Dashboard By Industries: Energy And Materials, October 2015

Summary 4 key fundamental factors are reported across industries in Energy and Basic Materials. They can be used to assess the valuation status of an industry relative to its historical average. They can also be used as a reference for picking quality stocks at a reasonable value. I started in September 2015 a monthly series of articles giving a valuation dashboard by sector of companies in the S&P 500 index (NYSEARCA: SPY ). The idea is to follow up a certain number of fundamental factors for every sector, to compare them to historical averages. This article is the first one of another series going down at industry level in the GICS classification. It covers Energy and Basic Materials. The choice of the fundamental ratios used in this study has been justified here and here . You can find in this article numbers that may be useful in a top-down approach. There is no due diligence, analysis, recommendations, or lists of individual stocks to consider. To make a complete picture by sticking a “bottom-up” under the “top-down”, you have to navigate in articles written by industry experts. Here is the link to articles tagged by sector. Methodology Four industry factors calculated by portfolio123 are extracted from the database: Price/Earnings “P/E”, Price to sales “P/S”, Price to free cash flow “P/FCF”, Return on Equity “ROE”. They are compared with their own historical averages “Avg”. The difference is measured in percentage and named with a prefix “D-” before the factor’s name (for example “D-P/E” for the price/earnings ratio). The methodology is quite different from the S&P 500 dashboard. In some industries, S&P 500 companies are very few, so mid- and small caps are included here. Also, the fundamental industry factors are not median values, but proprietary data by the platform. The calculation aims at eliminating extreme values and size biases, which is necessary when going out of a large cap universe. The drawback is that these factors are not representative of capital-weighted indices. They may be very useful as a reference values for picking stocks in an industry, but are less relevant for ETF investors. Industry valuation table on 10/26/2015 The next table reports the 4 industry factors. For each factor, the next “Avg” column gives its average between January 1999 and October 2015, taken as an arbitrary reference of fair valuation. The next “D-xxx” column is the difference between the historical average and the current value, in percentage. So there are 3 columns relative to P/E, and also 3 for each ratio. P/E Avg D- P/E P/S Avg D- P/S P/FCF Avg D- P/FCF ROE Avg D-ROE Energy Equip. & Services 17.2 24.2 28.93% 0.81 1.73 53.18% 10.58 35.34 70.06% -6.2 7.34 -184.47% Oil/Gas/Fuel 19.65 18.53 -6.04% 2.06 3.35 38.51% 20.11 29.03 30.73% -6.59 4.47 -247.43% Chemicals 19.61 18.48 -6.11% 1.46 1.21 -20.66% 34.93 25.37 -37.68% 8.68 6.74 28.78% Constr. Materials 34.81 21.44 -62.36% 1.33 1.16 -14.66% 65.74 40.5 -62.32% 12.38 5.77 114.56% Packaging 20.11 17.96 -11.97% 0.91 0.61 -49.18% 21.67 20.09 -7.86% 18.77 8.34 125.06% Metals&Mining 21.49 19.83 -8.37% 1.55 2.65 41.51% 16.77 25.53 34.31% -19.32 -8.6 -124.65% Paper&Wood 26.08 21.27 -22.61% 0.75 0.72 -4.17% 20.16 22.81 11.62% 9.09 4.99 82.16% Valuation The following charts give an idea of the current status of Energy and Materials industries relative to their historical average. In all cases, the higher the better. Price/Earnings: Price/Sales: Price/Free Cash Flow: Quality Relative Momentum The next chart compares the price action of the SPDR Select Sector ETF in Materials (NYSEARCA: XLB ) and Energy (NYSEARCA: XLE ) with SPY. (click to enlarge) Conclusion Both sectors are in a downtrend, in absolute and relative to the broad market. At the industry level, Energy Equipment & Services, Oil/Fuel/Gas and Metals/Mining look undervalued relative to their own historical averages for several factors, but they are in negative territory for quality. At the opposite, Chemicals, Construction Materials and Packaging are above their historical average in quality, but overpriced for the 3 valuation factors. No industry in these two sectors looks very attractive. However, comparing individual fundamental factors to the industry factors provided in the table may help find quality stocks at a reasonable price. A list of stocks in energy and basic materials beating their industry factors is provided on this page . If you want to stay informed of my updates on this topic and other articles, click the “Follow” tab at the top of this article. You can choose the “real-time” option if you want to be instantly notified.

YieldCo Index ETF: The YieldCo Model Breaks – It’s A Bigger Lesson Than You Think

YieldCos were supposed to do for utilities what LPs did for energy companies. The potential appeared huge, with increasing investment in renewable power. Only the model just broke, and Global X YieldCo Index ETF is the evidence. The postmortem here is more instructive than you may think. Investors appear to always be on the lookout for the next big thing that will make them rich. Wall Street, meanwhile, is always ready to sell investors something that appears to meet that desire. Only time and time again, the opportunity doesn’t pan out. YieldCos are the current asset melting down. The Global X YieldCo Index ETF (NASDAQ: YLCO ) is proof of it. What’s the bigger picture lesson? What’s a YieldCo? A YieldCo is basically a company created or spun off by another company with utility assets that it would like to sell, but not necessarily lose control of. The YieldCo raises capital in the markets by issuing shares and debt, and then buys the assets of its erstwhile parent. The assets usually come with long-term contracts, so the revenues are reasonably certain to materialize, and the parent normally has operational control. The allure for investors is a stated goal to pay out large, growing distribution streams backed by more acquisitions. If this sounds roughly similar to the model that pipeline owners have used in the limited partnership space for years, it should. That’s basically the building block on which YieldCos have been created. It sounds like a win for everyone involved. Only, there’s one small catch. Access to capital markets. Talk about timing Wall Street’s financial alchemists have a habit of pushing things too far. And YieldCos now appear to be falling into that category. The best example I can provide is YLCO, an ETF that came public in late May of this year. Its shares have fallen by nearly a third since that point. YLCO stands as a warning to investors to not get caught up in the hot new thing. That can be hard to do, I know. Hot new things always seem to come with really compelling stories about how they are a “can’t lose” investment. Which is why you should always ask yourself why something you are looking at could blow up on you. In the case of YLCO, the answer to that is pretty clear: the fund would tank if the YieldCo space in which it invests doesn’t hold the promise that Wall Street believes it does. However, that’s not a deep enough answer, and it would be too easy to glass over the issue and stop there. After all, YLCO is buying a basket of YieldCos, which reduces risk through diversification. That’s why you need to go further and ask: What would kill a YieldCo’s potential? And could that happen across the YieldCo space? We know the answer now Looking at these questions in reverse order, we know that the chances of a broad YieldCo meltdown was pretty high. But what was the problem on the individual company level? The answer is access to capital. For a company that pays out most of its revenues to investors via distributions, growth has to come from acquisitions. But acquisitions can only happen if the company can sell more debt and equity at decent prices. If investors aren’t willing to provide that capital at desirable rates, the YieldCo loses its ability to grow. That will likely lead to a stagnant distribution and even fewer reasons for investors to buy its shares. The parent company, meanwhile, is stuck with a child that isn’t nearly as desirable to have around. And more or less everybody winds up a loser. For evidence of this take a look at the current troubles of NRG Energy (NYSE: NRG ) and NRG Yield (NYSE: NYLD ). NRG Yield makes up around 7.5% of YLCO, by the way. Commenting on NRG Yield, credit watcher Moody’s is taking a dim view of the future. Moody’s vice president Toby Shea noted, “The review for downgrade is prompted by NYLD’s lack of access to the equity markets due to the large, approximate 30 percent fall in its stock price in recent months. The ongoing inability to access the equity market creates uncertainty regarding the company’s financial strategy going forward.” Basically, the model is broken. Don’t stop there But what are the real takeaways? First, Wall Street’s hot new products are often better for Wall Street than main street and shareholders. I don’t want to be cynical, but this is as true today as it has always been in the past. And I find it hard to believe the future will be any different. It’s difficult, but try to keep this in mind whenever you see something new offered up as the next big thing. Second, YieldCos are probably not worth owning right now. And clearly, neither is YLCO. The risks far outweigh the rewards for all but the most aggressive investors. Third – and this is the one you really need to think about – what about other companies that have business models built on accessing the capital markets for growth? Limited partnerships are the most salient example, since they are facing their own demons right now. But they aren’t the only ones. For example, Student Transportation Inc. (NASDAQ: STB ) is rolling up the school bus space. But if it couldn’t access capital markets, its growth prospects would quickly fade. Then there are real estate investment trusts, or REITs. As a whole, I wouldn’t be too concerned about REITs. But not all REITs are created equal. I doubt that an industry leader like AvalonBay Communities (NYSE: AVB ) will be completely shut out of the capital markets. But what about apartment competitor NexPoint Residential Trust (NYSE: NXRT ), which is a relatively new entrant buying up second-tier assets with the intent of sprucing them up? It’s already leaning hard on the debt markets, if it can’t do that anymore, what does it do for growth capital? These two companies obviously sit at opposite ends of the spectrum, but there are variations all along the way. It’s worth taking a moment to ask the question for both new companies like NXRT, and also more established names – just in case. Stapled Shares One of the reasons why I brought up Student Transportation is because it came to market in a very different form. At the IPO, it was a stapled share, essentially pairing a share of stock with a piece of debt. The distribution was a combination of dividend and bond interest. It was a hot Wall Street idea not too long ago, meant to sate investors’ desire for income. Only, it didn’t work out as planned. And now most, if not all, of the handful of companies that came out as stapled shares have either gone away or converted their shares to plain old regular stock. The end result was usually a dividend cut for shareholders on top of capital losses. I watched stapled shares come and go. I owned a few. I got burned. It’s one of the reasons why I’ve been sitting on the sidelines with YieldCos. And why I’m watching single family home REITs with extreme interest, but I’m not buying any. Too new, too much of a fad, and the model could break down. It’s better to give Wall Street’s big ideas time to prove themselves. You certainly could miss out on gains, but you’ll also protect yourself from ideas that end up enriching Wall Street at your expense. YLCO is a symptom of a bigger issue, but it offers up an important lesson. Could YieldCos work out in the long run? Sure. Could YLCO turn out to be a great income opportunity in the ETF space? Yes. But for anyone who bought into the YieldCo story early, things aren’t working out quite as planned right now and there’s real potential that the idea is fatally flawed. It’s hard to resist the temptations of Wall Street, but when it comes to new things (corporate forms, IPOs, new products like esoteric ETFs) you are far better off stepping back and waiting. At the very least, take the time to consider what happens if the rosy projections offered up don’t pan out. In other words, always look for a reason why you shouldn’t buy something as you are reveling in the reasons why you want to.

Should You Buy Value Stocks Today?

The third quarter was abysmal for stock markets. October has proven the pain short-lived. Growth stocks have outperformed value stocks. But value has the long-term track record of outsized returns. The typical investor is a notoriously bad timer at buying and selling. A good advisor helps limit emotion-driven mistakes. The third quarter is now on the books and it was an ugly one for stocks. The S&P 500 ( SPY , IVV ) fell 6.4% while the Russell 1000 Value ( IWD ), arguably one of the best indices to benchmark “value” stock performance, was down 8.4%. We commented last month, “We concede that there are plenty of reasons to hesitate, but we’re putting capital to work. The economic landscape in the U.S. remains favorable to equities and more importantly, ample long-term investment opportunities exist. … And that’s why we’re buyers.” At least for now, the recent turmoil has proved short-lived. The S&P 500 is up over 8.0% in October and the Russell 1000 Value has posted a similar gain. For the year, the S&P 500 has delivered a 2.5% gain, while the Russell 1000 Value returned negative 1.8%. Growth stocks are up over 6.0% in 2015. Value stocks’ year-to-date underperformance of growth stocks isn’t a new trend. It’s been a tough going for value for many years now. (click to enlarge) Since Black Cypress’s inception in the summer of 2009, over six years ago, growth stocks have outperformed value stocks by 23% — about 3.0% per year. Growth’s cumulative outperformance stretches back even further, all the way to the end of 2006 before the onset of the recent financial crisis. Growth has bested value by 5% per year for almost nine years. There are only two other instances in history where growth’s dominance reigned longer: the Great Depression (another financial crisis) and the technology bubble of the 1990s. Such multi-year value underperformance is unusual. Historically, it lasts a few years at most and growth’s cumulative gains are reversed over a one or two-year period. At least that’s the historical precedent. Since 1927, value stocks have returned an average 2.5% more per year than growth stocks. Academics call this historical outperformance of value over growth the “value premium”. And yet, while the value premium is a well-documented phenomenon, most investors fail to capture it. Owning an underperforming asset taxes one’s patience. Continuing to own it requires a deep conviction in one’s research as well as the emotional fortitude to withstand the frustration that comes with being at odds with the market. Most investors have neither. And therein lays the likely reason the value premium remains despite widespread knowledge of its existence: capturing it entails suffering through occasional periods of underperformance. Individual investors buy and sell at inopportune times, fund managers fear redemptions and hug their benchmarks, and advisors chase the hottest funds. And the value premium persists. One of the best studies to illustrate such bad investor behavior and its impact on performance is DALBAR’s Quantitative Analysis of Investor Behavior. This study doesn’t address the value premium in any way, but it is illustrative of investor actions and their effects, which makes it relevant to our discussion. The 2014 QAIB stated that over the last 30 years, investors in stock mutual funds averaged annual returns of 4.0%, while the S&P 500 averaged about 11.0%. That is, the very investors that were seeking equity market performance by buying stock mutual funds underperformed stock markets by over 7.0% per year. The culprit? Poor timing decisions. Investors — including individuals, advisors, and consultants — added to their stock positions at or near stock market peaks and sold near market lows. Investors also hesitated to invest again after markets bottomed. Investors are their own worst enemy. We choose to address these topics for two reasons. First, because we’re value-oriented investors and it has been one of the more inhospitable environments in history for our investment approach. In the last two years alone, growth stocks have outperformed value stocks by 9.0%. To say the least, it has been a challenge to provide outsized returns with our currently out-of-favor approach. And yet, despite the headwind of growth over value since our firm’s inception, our strategies have held their own with broad markets. Considering what we’ve been up against, including growth’s dominance as well as no opportunity to showcase our risk management practices in this ongoing bull market, we’re pleased with our results. And today, we think our portfolio is about as well-positioned against the market as it has ever been. Broadly, we like value’s prospects over the next five years. The second reason we delved into these topics is because one of the most important functions of an investment advisor is to provide a check on emotion-driven decisions. Coaching to buy, sell, and hold, and the timing of these recommendations, often goes overlooked in an advisory relationship. But it can be more important than security selection itself. Get an advisor you can trust if you’ve found yourself buying and selling for no other reason than emotion. You’ll save yourself some well-deserved self-ridicule and probably a lot of money too. Our portfolio is well-positioned to capture the value premium and to create excess value through our carefully selected individual company holdings in the years ahead. Is yours?