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Can Oracle (ORCL) Surprise Estimates in Q1 Earnings?

Application software provider, Oracle Corp.ORCL is set to report fiscal first quarter 2016 results on Sep 16. Last quarter, it posted a 9.76% negative surprise. The company has posted an average negative earnings surprise of 2.47% over the past

Finding Bargains Among Emerging Markets Bond CEFs

Summary The discounts associated with emerging markets CEFs are at historic highs, with many discounts over 2 standard deviations from the mean. Emerging markets CEFs have been significantly more volatile than their ETF counterparts. ESD, EMD and MSD had the best risk-adjusted performance among the CEFs analyzed. Over the past several weeks, I have been writing about potential bargains among Closed End Funds (CEFs). This week I will continue the series by analyzing the risks and returns associated with Emerging Markets (NYSE: EM ) Bond CEFs. Before jumping into the analysis, I will provide a quick review of some of the characteristics of this asset class. The term emerging market refers to securities domiciled in a country that is considered to be emerging from an under-developed economy to a more mainstream environment. These countries are typically in Africa, Eastern Europe, the Middle East, Latin America, and some Asian countries. Many of these economies depend on either exporting commodities or providing services to the more developed world. There are several subclasses of EM bonds. For example, EM bonds may trade in either the currency associated with their country or trade in U.S. dollars. In addition, EM bonds may be corporate bonds or government treasuries (which are usually referred to as sovereign debt). Some of the reasons for investing in the bonds of emerging markets include: EM bonds offer higher yields than comparable bonds from developed countries. As the credit worthiness of an emerging economy improves, the rating of the bonds may improve leading to capital gains. EM bonds rise and fall due to local conditions, which may not be in sync with the U.S. market, thus offering diversification. If the EM bond is denominated in local currency, there is a potential for additional appreciation due to currency fluctuations. Of course, depreciation is also a possibility (which has happened recently). Since many EM bonds are thinly traded and are available only on local exchanges, it is difficult for individual investors to purchase these bonds individually. The easiest way to invest in this asset class is to buy funds. Exchange Traded Funds (ETFs) are the most popular vehicle with some ETFs trading over 700,000 shares per day. However, Closed End Funds (CEFs) are an alternative choice. The closed nature of these CEFs makes it easier for the manager to invest and hold limited liquidity assets without having to worry about cash inflows and outflows. However, the downside of CEFs is that the price is based on market action, which can wreak havoc when the asset falls from favor. This has been demonstrated with a vengeance since the second quarter of 2013 when talk of the Fed increasing rates led to a collapse of prices of these CEFs. As prices deteriorated, the discounts of these CEFs widened to historical large levels, many over 18%. This is evidenced by a large negative Z-score, a statistic popularized by Morningstar to measure how far a discount (or premium) is from the average discount (or premium). The Z-score is computed in terms of standard deviations from the mean so it can be used to rank CEFs. A Z-score lower (more negative) than minus 2 is a relatively rare event, occurring less than 2.25% of the time. However, in today’s environment, most of the EM CEFs have a one year Z-score of negative 2 or lower, which illustrates the current lack of demand for these CEFs. There are several reasons that investor lost confidence in emerging markets: The dollar has been in a bull market, which means that emerging markets currencies are becoming weaker versus the dollar. The Fed may finally begin to tighten in the near future, which will again strengthen the dollar. Commodities are in a bear market and many emerging market economies depend on the sale of commodities. When commodities swoon, so do these economies, putting pressure on their bonds. China is the largest emerging market and turmoil in China has crushed some of the lesser economies Has the rout in emerging markets gone too far? I believe in the wisdom of Warren Buffet when he opined: “Be greedy when others are fearful.” I am not clairvoyant and have no idea how long it will take the EM bonds to recover. Some bonds may default, but on a whole I believe a diversified basket of EM bonds will be a smart investment. If you decide to invest in this type of bond, the question is: what are the “best” funds to purchase? There are many ways to define “best.” Some investors may use total return as a metric but as a retiree, risk is as important to me as return. Therefore, I define “best” as the asset that provides the most reward for a given level of risk and I measure risk by the volatility. Please note that I am not advocating that this is the way everyone should define “best”; I am just saying that this is the definition that works for me. This article will compare the risks and rewards of EM bond CEFs. I will use a 5-year time frame and require that the selected funds trade an average of 50,000 shares or more per day. Based on these criteria, I included the following CEFs for my analysis: MS Emerging Markets Domestic (NYSE: EDD ). This CEF invests in emerging market domestic debt and sells for a discount of 18%, which is a much larger discount than the 5 year average discount of 10.1%. The one year Z-score is minus 2. This is the only leveraged fund that invests exclusively in local currency debt. The fund has 46 securities, almost all in sovereign debt. Even though the bonds are from emerging markets, about 67% are actually investment grade (BBB or higher). The fund invests in a wide range of countries including Brazil (16%), Mexico (16%), South Africa (16%), Malaysia (15%), Poland (14%) and Turkey (14%). The fund utilizes 31% leverage and has an expense ratio of 2.2%. The distribution rate is 12.5 %, which is funded by income with some Return of Capital (NYSE: ROC ) in one quarter over the past year. The Undistributed Net Investment Income (UNII) is negative and is large when compared to the distribution, which is a concern. MS Emerging Markets Debt (NYSE: MSD ). This CEF sells for a discount of 18.5%, which is a larger discount than the 5 year average discount of 10.8%. The one year Z-score is minus 2.6. The fund has 115 holdings, with about 51% in sovereign debt and 46% in corporate bonds. Virtually all the bonds are denominated in U.S. dollars. Geographically, the holdings are distributed among a large number of countries including Mexico (13%), Indonesia (11%), Venezuela (7%), and Turkey (7%). About 41% of the bonds are investment grade. MSD uses 8% leverage and has an expense ratio of 1.2%. The distribution is 6.6% with no ROC. Western Asset Emerging Markets Debt (NYSE: ESD ). This CEF sells at a discount of 18.3%, which is a larger discount than the 5 year average discount of 8.6%. It has 240 holdings with 51% in sovereign debt and 42% in corporate bonds. The assets are distributed among several countries including Mexico (13%), Indonesia (11%), Turkey (7%), and Venezuela (7%). About 69% of the portfolio is investment grade. The fund uses 16% leverage and has an expense ratio of 1.2%. The distribution is 9.1%, consisting primarily of income and some ROC (about 10% of the distribution). UNII is negative but is less than one month distribution. Western Asset Emerging Markets Income (NYSE: EMD ). This CEF sells for a discount of 18.5%, which is a larger discount than the 5 year average discount of 8.6%. The one year Z-score is minus 2.2. The fund has 235 holdings with 53% in sovereign debt and 42% in corporate bonds. About 73% of the holdings are investment quality. The assets are distributed among several countries including Mexico (12%), Indonesia (9%), Turkey (9%), Netherlands (6%), and Peru (5%). The fund utilizes 14% leverage and has an expense ratio of 1.3%. The distribution is 8.5%, consisting primarily of income with about 30% ROC but the UNII is positive. Global High Income Fund (NYSE: GHI ). This CEF sells for a discount of 13.6%, which is a larger discount than the 5 year average discount of 7.3%. The one year Z-score is only minus 0.1. The fund has 308 holdings, with 66% in sovereign debt and 26% in corporate bonds. All the holdings are denominated in U.S. dollars. The holdings are distributed among a large number of countries including Brazil (11%), Turkey (7%), Indonesia (8%), Mexico (6%), and Russia (5%). About 38% of the holdings are investment grade. This fund does not use leverage and has an expense ratio of 1.4%. The distribution is 10.9%, consisting primarily of income and ROC. The ROC occurred in about 60% of the months over the last year and comprised about 30% of the distribution. The UNII is positive. Templeton Emerging Markets Income (NYSE: TEI ). This CEF sells at a discount of 17%, which is a larger discount than the 5 year average discount of 1.5%. The one year Z-score is minus 2.4. This fund has 119 holdings with 56% invested in sovereign debt, 24% in corporate bonds, and 13% in short term debt. The securities are distributed across many countries including Iraq (11%), Indonesia (11%), Zambia (10%), Hungary 990%), and UAE (8%). The fund does not utilize leverage and the expense ratio is 1.1%. The distribution is 8.1%, consisting of income with no ROC. For comparison, I will also include the following ETF: iShares J.P. Morgan USD Emerging Markets Bond (NYSEARCA: EMB ). This ETF is a passive fund that tracks an index made up of U.S. dollar denominated emerging market bonds. The country allocations are rebalanced monthly, based on the amount of outstanding debt. The fund has 287 holdings with 78% in sovereign debt and 21% in corporate bonds. About 62% of the portfolio is investment grade. The holdings are spread across a large range of countries including Russia (6%), Philippines (6%), Turkey (5%), Indonesia (5%) and Mexico (6%). Overall, 28 countries are represented. The fund has an expense ratio of 0.40% and yields 4.5%. To assess the performance of the selected CEFs, I plotted the annualized rate of return in excess of the risk free rate (called Excess Mu in the charts) versus the volatility of each of the component funds over the past 5 years. The risk free rate was set at 0% so that performance could be easily assessed. This plot is shown in Figure 1. Note that the rate of return is based on price, not Net Asset Value (NYSE: NAV ). (click to enlarge) Figure 1. Risk versus reward over the past 5 years. The plot illustrates that the CEFs have booked a wide range of returns and volatilities over the past 5 years. To better assess the relative performance of these funds, I calculated the Sharpe Ratio. The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 1, I plotted a red line that represents the Sharpe Ratio associated with EMB. If an asset is above the line, it has a higher Sharpe Ratio than EMB. Conversely, if an asset is below the line, the reward-to-risk is worse than EMB. Note also that Sharpe Ratios are not meaningful if a stock has a negative return. Some interesting observations are evident from Figure 1. The CEFs were substantially more volatile than the ETF. This was expected since CEFs are actively managed, may use leverage, and may sell at discounts or premiums. All of these attributes tend to increase volatility. The EM CEFs did not have great performance over the period. EM bonds have been in a bear market since 2013 and the prices associated with CEFs decreased faster than Net Asset Value . Since EMB is an ETF that does not sell at a discount, EMB has much better risk-adjusted performance than any of the CEFs. Looking only at the CEFs, MSD had the best performance followed by ESD and EMD. The other three CEFs were underwater for the period. Next I wanted to see if the diversification promised by these emerging markets bonds lived up to expectation. To be “diversified,” you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. I calculated the pair-wise correlations associated with the selected funds. The results are provided in Figure 2. As is evident from the figure, these CEFs provided relatively good diversification with correlations in the 50% to 60% range. Thus, these CEFs did provide good portfolio diversification. (click to enlarge) Figure 2. Correlation over past 5 years. The 5 year look-back data shows how these funds have performed in the past. However, the real question is how they will perform in the future when the bull market in EM debt returns. Of course, no one knows, but we can obtain some insight by looking at the most recent bull market period from March 2009 to January, 2013. Figure 3 plots the risk-versus-reward for the funds over this bull market time frame. (click to enlarge) Figure 3. Risk versus reward during a bull market As expected, all the funds had excellent performance over this bull market period. The CEFs all had higher absolute returns than EMB but were also significantly more volatile. When volatility was taken into account, EMB was still a leader in risk-adjusted performance. However, during the bull market, EMD matched EMB in risk-adjusted performance and ESD, TEI, and MSD were not far behind. EDD and GHI continued to lag the other funds. Bottom Line If you are a risk-adverse investor who wants to diversify into emerging market bonds, EMB would be your best bet. However, if you want to take advantage of the wide discounts associated with CEFs, I would recommend ESD, EMD and MSD. These three CEFs had good performance over the entire 5 year period plus will likely excel if the bull returns. When this asset class returns to favor, I would expect the discounts to revert back to the mean and this would provide some capital gains to go along with attractive distributions. But beware, emerging markets CEFs are not for the faint hearted. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ESD,EMD, MSD over the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Investing While Guarding Against Extensive Vertical Losses

Summary Portfolio Manager and economist John Hussman warns that “extensive vertical losses” can follow a partial recovery from a correction similar to our recent one. One way to remain invested while guarding against extensive vertical losses is with the hedged portfolio method, which we outline here. We also present an example of a hedged portfolio designed for an investor with $200,000 who is unwilling to risk losses greater than 20%. Hussman Says We’re Due On Twitter (NYSE: TWTR ) earlier this month, the pseudonymous Florida-based trader StockCats shared the following chart, first posted a year earlier: The next day, the creator of the image, portfolio manager, Stanford Ph.D., and former finance professor John Hussman responded: In his next weekly market commentary (“That was not a crash”), Hussman updated his bearish sentiment: The market decline of recent weeks was not a crash. It was merely an air-pocket. It was probably just a start. Actual market crashes involve a much larger and concerted shift toward investor risk-aversion, which doesn’t really happen right off of a market peak. Historically, market crashes don’t even start until the market has first retreated by 10-14%, and then recovers about half of that loss, offering investors hope that things have stabilized (look for example at the 1929 and 1987 instances). The extensive vertical losses that characterize a crash follow only after the market breaks that apparent “support,” leading to a relentless free-fall that inflicts several times the loss that we’ve seen in recent weeks. If you were certain Hussman was right that the recent correction has just been an “air pocket,” and we’re due for worse, then an appropriate course of action might be to get out of the market. But as strong a case as Hussman makes, he’s been making a similar one for years. And even he doesn’t go so far as to predict exactly when he expects we’ll get the crash we’re due to get. So we’re left with the question of how to invest given the uncertainty of whether the long bull market will resume or we’ll soon be faced with Hussman’s ominous “extensive vertical losses.” Dealing With Uncertainty One way to deal with this sort of uncertainty is to invest in a handful of securities you think will do well, and hedge against the possibility that you end up being wrong. That approach is systematized in the hedged portfolio method, which we detailed in a previous post (“Backtesting The Hedged Portfolio Method”). One advantage of the hedged portfolio method is that it can accommodate a broad range of risk tolerances. Below, we’ll recap how you can build a hedged portfolio yourself (or for a client), and present an example of a hedged portfolio created for an investor with $200,000 to invest who can’t tolerate a drawdown of more than 20%. Risk Tolerance, Hedging Cost, And Potential Return All else equal, with a hedged portfolio, the greater an investor’s risk tolerance – the greater the maximum drawdown he is willing to risk (his “threshold”) – the lower his hedging cost will be and the higher his expected return will be. An investor who is willing to risk a 20% drawdown is in good company. Several years ago, in one of his earlier market commentaries , portfolio manager John Hussman had this to say about 20% drawdowns: “An intolerable loss, in my view, is one that requires a heroic recovery simply to break even… a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally).” Essentially, 20% is a large enough threshold that it can reduce the cost of hedging, but not so large that it precludes a recovery. Constructing A Hedged Portfolio The process, in broad strokes, is this: Find securities with high potential returns (we define potential return as a high-end, bullish estimate of how the security will perform). Find securities that are relatively inexpensive to hedge. Buy a handful of securities that score well on the first two criteria; in other words, buy a handful of securities with high potential returns net of their hedging costs (or, ones with high net potential returns). Note that when creating a hedged portfolio for an extremely risk-averse investor, such as in this case, the second criteria (“inexpensive to hedge”) will outweigh the first (“high potential returns”) because it may not be possible to hedge the securities with the highest potential returns against such small declines. Hedge them. The potential benefits of this approach are twofold: If you are successful at the first step (finding securities with high potential returns), and you hold a concentrated portfolio of them, your portfolios should generate decent returns over time. If you are hedged, and your return estimates are completely wrong, on occasion – or the market moves against you – your downside will be strictly limited. How To Implement This Approach Finding securities with positive potential returns For this, you can use Seeking Alpha Pro , among other sources. Seeking Alpha articles often include price targets for long ideas, and you can convert these to percentage returns from current prices. But you’ll need to use the same time frame for each of your expected return calculations to facilitate comparisons of expected returns, hedging costs, and net expected returns. Our method starts with calculations of six-month potential returns. Finding Securities That Are Relatively Inexpensive To Hedge For this step, you’ll need to find hedges for the securities with positive potential returns, and then calculate the hedging cost as a percentage of position value for each security. Whatever hedging method you use, for this example, you’d want to make sure that each security is hedged against a greater than 4% decline over the time frame covered by your potential return calculations. Our method attempts to find optimal static hedges using collars as well as protective puts. Buying Securities That Score Well On The First Two Criteria To determine which securities these are, you may need to first adjust your potential return calculations by the time frame of your hedges. For example, although our method initially calculates six-month potential returns and aims to find hedges with six months to expiration, in some cases the closest hedge expiration may be five months out. In those cases, we will adjust our potential return calculation down accordingly, because we expect an investor will exit the position shortly before the hedge expires (in general, our method and calculations are based on the assumption that an investor will hold his shares for six months, until shortly before their hedges expire or until they are called away, whichever comes first). Next, you’ll need to subtract the hedging costs you calculated in the previous step from the potential returns you calculated for each position, and sort the securities by their potential returns net of hedging costs, or net potential returns. The securities that come to the top of that sort are the ones you’ll want to consider for your portfolio. Fine-Tuning Portfolio Construction You’ll want to stick with round lots (numbers of shares divisible by 100) to minimize hedging costs. Another fine-tuning step is to minimize cash that’s left over after you make your initial allocation to round lots of securities and their respective hedges. Because each security is hedged, you won’t need a large cash position to reduce risk. And since returns on cash are so low now, by minimizing cash, you can potentially boost returns. In this step, our method searches for what we call a “cash substitute”: that’s a security collared with a tight cap (1% or the current yield on a leading money market fund, whichever is higher) in an attempt to capture a better than cash return while keeping the investor’s downside limited according to his specifications. You could use a similar approach, or you could simply allocate leftover cash to one of the securities you selected in the previous step. Calculating An Expected Return While net potential returns are bullish estimates of how well securities will perform, net of their hedging costs, expected returns, in our terminology, are the more likely returns net of hedging costs. In a series of 25,412 backtests over an 11-year time period, we determined two things about our method of calculating potential returns: it generates alpha, and it overstates actual returns. The average actual return over the next six months in those 25,412 tests was 0.3x the average potential return calculated ahead of time. So, we use that empirically derived relationship to calculate our expected returns. Example Of A Hedged Portfolio Here is an example of a hedged portfolio created using the general process described above by the automated portfolio construction tool at Portfolio Armor . With that tool, you just enter the dollar amount you are looking to invest (in this case, $200,000) and the largest drawdown you are willing to risk (your “threshold” – in this case, 20%), as in the image below, and the tool does the rest. Note that we left the “tickers” field blank above, because, in this case, we’re going to let the site pick all of the securities for us. But you can also start with your own investment picks when using this tool. We shared an example of that in a recent article (“Building a Bulletproof Stock Portfolio”). A couple of minutes after clicking the “create” button above, we were presented with the portfolio below, which was generated with data as of Friday’s close. Worst-Case Scenario The “Max Drawdown” column in the portfolio level summary shows the worst-case scenario for this hedged portfolio. If every underlying security in it went to zero before the hedges expired, the portfolio would decline 18.92%. Negative Hedging Cost Note that, in this case, the total hedging cost for the portfolio was slightly negative, -0.01%, meaning the investor would receive a few dollars more income in total from selling the call legs of the collars on his positions than he spent buying the puts. Best-Case Scenario At the portfolio level, the net potential return is 15.16%. This represents the best-case scenario, if each underlying security in the portfolio meets or exceeds its potential return. A More Likely Scenario The portfolio level expected return of 6.10% represents a more conservative estimate, based on the historical relationship between our calculated potential returns and actual returns. Each Security Is Hedged Note that in the portfolio above, each of the four primary underlying securities – Abiomed (NASDAQ: ABMD ), BofI Holding (NASDAQ: BOFI ), Expedia, Inc. (NASDAQ: EXPE ), and Sketchers, USA (NYSE: SKX ) – is hedged with an optimal collar capped at its potential return, and Amazon (NASDAQ: AMZN ) is hedged as a cash substitute, with its cap set at 1%. Hedging each security according to the investor’s risk tolerance obviates the need for broad diversification, and lets him concentrate his assets in a handful of securities with high net potential returns. Here’s a closer look at the hedge for one of these positions, ABMD: As you can see in the first part of the image above, ABMD is hedged with an optimal collar with its cap set at 21.92%, which was the potential return Portfolio Armor calculated for the stock: the idea is to capture the potential return while offsetting the cost of hedging by selling other investors the right to buy ABMD if it appreciates beyond that over the next six months. The cost of the put leg of this collar was $3,600, or 9.42% of position value, but as you can see in the image below, the income from the short call leg was $2,600, or 6.80% as a percentage of position value. Since the income from the call leg offset some of the cost of the put leg, the net cost of the optimal collar on ABMD was $1,000, or 2.62% of position value.[i] Note that, although the cost of the hedge on this position was positive, the hedging cost of this portfolio as a whole was slightly negative . Why These Particular Securities? As of Friday, all of these securities ranked among the top six names in the site’s universe when ranked by potential return net of hedging costs. Possibly More Protection Than Promised In some cases, hedges such as the ones in the portfolio above can provide more protection than promised. For an example of that, see this instablog post on hedging the iPath S&P 500 VIX ST Futures ETN (NYSEARCA: VXX ). Hedged Portfolios For Even More Risk-Averse Investors The hedged portfolio shown above was designed for a small investor who could tolerate a decline of as much as 20% over the next six months, but the same process can be used for investors who are more risk averse. We presented an example of that in a recent article (“An Alternative To Cash For Risk-Averse Investors”). Note: [i] To be conservative, the net cost of the collar was calculated using the bid price of the calls and the ask price of the puts. In practice, an investor can often sell the calls for a higher price (some price between the bid and ask) and he can often buy the puts for less than the ask price (again, at some price between the bid and ask). So, in practice, the cost of this collar would likely have been lower. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.