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The PowerShares S&P SmallCap Utilities Portfolio ETF – Simply Energetic

Summary Very Concise with some excellent defensive holdings. Low beta, good average cash flow and dividends. Also has the potential for capital appreciation. Recent events have put investors on the defensive against the increasing potential of a global economic contraction. It might be a good idea for the individual investor to channel funds towards defense, too. However, as it is with financial markets, the flight to safety will inevitably drive ‘defensive’ asset prices up and thus valuations beyond what is sensible. So how may the individual investor play defense without over paying? There just might be a solution. What drives utilities in the first place? The Housing market does, for one! Since new construction, either single family homes or multiple unit construction require utility services, particularly, gas, water, electricity and data , the recovering U.S. housing market has given a boost to the utility sector. According to the U.S. Department of Housing and Urban Development 883,000 units were complete in 2014 and the annualized 2015 rate, based on July data, will result in a seasonally adjust rate of 987,000. Further, it’s important to observe that utility service isn’t simply a ‘one-time-installation’. It is the unit dwelling, itself, generating revenue for the utility for decades, as long as it’s occupied. (click to enlarge) The PowerShares S&P SmallCap Utilities Portfolio ETF (NASDAQ: PSCU ) is a top performer in its ETF class. So straight away, it seems as though there’s uniqueness in the theme not found in other funds. Although uniqueness may be a winning quality in the arts and sciences, investors require more substance. So then, what makes this fund a good performer? According to Invesco : … The PowerShares S&P SmallCap Utilities Portfolio ((fund)) is based on the S&P SmallCap 600 ® Capped Utilities & Telecom Services Index … …companies are principally engaged in providing either energy, water or natural gas utilities, as well as services designed to promote or enhance the transmission of voice, data and video over various communications media, including wireline, wireless (terrestrial-based), satellite and cable … The interesting feature is that the fund meets its objective with only 20 holdings (as of mid-September). Before going into the individual holdings, it’s worth noting the subsector allocations. Data from Invesco With a mere 20 companies, it seems superfluous to analyze the ten heaviest weightings. It’s worth noting that 52.489% of the fund is concentrated in its top 7 holdings. Also, upon careful examination of the individual company businesses, there are few ‘pure-play’ utilities in the fund. For example, Piedmont Gas (NYSE: PNY ) is a ‘pure-play’ in natural gas, distribution pipeline and storage, including LNG. Piedmont is the heaviest weighted of the fund’s holdings at 9.964%, contributes a 3.47% dividend, has a P/E of 21.15, a price to book multiple of 2.14, price to cash flow of 10.74 and a high but sustainable payout ratio of almost 72%. American States Water (NYSE: AWR ) is more typical of the basic utility providers in the fund, distributing water through its pipeline network, which includes wells, reservoirs, and water treatment facilities. However, it also diversifies into electrical transmission infrastructure and a gas fueled electric generating plant. AWR provides a 2.26% dividend, with a P/E of 24.5, price to book of 3.10 times, price to cash flow of 14.16 times and a payout ratio of 52.49%. On the extreme end there’s Avista Corp (NYSE: AVA ) which comprises 4.54% of the fund’s total holdings. Although its primary business is to provide natural gas and electricity services , it also has real estate investments, provides venture capital and sheet metal fabrication for electrical enclosures, digital device parts, as well as parts for renewable energy systems and the medical industry, and lastly investments in mining. (According to Reuters, these ‘sub-segments’, “… do not form part of any reporting segment …”). Avista pays a 4.20% dividend, a P/E ratio of 17.57%, a price to book multiple of 1.29, a price to cash flow multiple of 7.69 and has a high but sustainable payout ratio of just over 72%. Piedmont, American States Water and Avista are in the top half of the fund’s weightings. Interestingly, all the telecoms are in the bottom half of the fund’s weightings. Only three of the 7 telecom holdings pay dividends. Top Half Holdings Type Weight Market Cap (billions) Yield P/E Beta Payout Ratio Piedmont Gas, Storage 9.964% $3.123 3.47% 21.15 0.47 71.98% UIL Holdings (NYSE: UIL ) Electric and Gas 8.986% $2.719 3.60% 23.23 0.47 41.37% Southwest Gas (NYSE: SWX ) Gas, Construction 8.621% $2.607 2.92% 18.85 0.63 52.90% Northwestern Corp (NYSE: NWE ) Electricity and Natural Gas 7.906% $2.391 3.78% 15.05 0.52 73.30% New Jersey Resources (NYSE: NJR ) Gas and renewables 7.866% $2.379 3.45% 15.72 0.57 50.23% Consolidated Communications (NASDAQ: CNSL ) Network, Video, Voice, Data, Landline 4.59% $1.005 7.79% N/A 0.74 N/A American States Water Water, Electric infrastructure 4.556% $1.475 2.26% 24.49 0.56 52.49% South Jersey Industries (NYSE: SJI ) Gas and Electric 4.554% $1.636 4.21% 15.23 0.73 62.93% Northwest Natural Gas (NYSE: NWN ) Gas and Electric 4.544% $1.217 4.18% 24.14 0.30 49.89% Avista Corp Electric, Gas, RE, Venture funds, metal manufacturing 4.54% $1.957 4.20% 17.57 0.57 72.29% All Tabled Data From Reuters, YaHoo! and PowerShares The lower half weightings of the fund contains those Telecommunications Services. Lumos (NASDAQ: LMOS ) , 1.42% of total holdings contributes a 4.66% dividend yield to the fund. Lumos provides mainly fiber optic infrastructure for voice, data, IP service and also provides wireless. The company as a low P/E of just over 13 times, a price to book of 2.7 times, price to cash flow of 4.14 and a low payout ratio of 32.61%. Generally, it focuses on the fiber optic backbone and related services. On the other hand Atlantic Tele-Network (NASDAQ: ATNI ) , at 4.06% of the fund, is a holding company providing land-line, wireless telephony, data, DSL and provides electricity through solar power generation. Further, Atlantic Tele-Network services the Caisos, Turks, Aruba, Guyana and the U.S. Virgin Islands. ATNI does not contribute a dividend to the fund. The company has a P/E of 35.21, price to book of 1.74 times and price to cash flow of 11.68. It has revenues of about $353.57 million with 8.5% year over year revenue growth. Bottom Half Holdings Type Weight Market Cap (billions) Yield P/E Beta Payout Ratio Laclede Group (NYSE: LG ) Gas 4.537% $2.252 3.54% 16.03 0.36 42.55% El Paso Electric (NYSE: EE ) Electric, Renewables 4.493% $1.431 3.33% 17.61 0.32 56.51% Allete (NYSE: ALE ) Water, Electric, Renewables, Coal 4.422% $2.360 4.18% 16.10 0.74 61.20% Atlantic Tele-Network Wireless, Wired, Broadband, International and Domestic 4.061% $1.202 1.75% 35.21 0.96 55.37% 8×8 (NASDAQ: EGHT ) Telecom, Telephony, Video Cnfrc 3.813% $0.739 0.00% 536.29 0.41 0.00% Cincinnati Bell (NYSE: CBB ) Telecom, VOIP, Wireless 3.71% $0.719 0.00% 5.96 1.17 0.00% Iridium (NASDAQ: IRDM ) Satellite, global communications 2.851% $0.651 0.00% 11.82 0.87 0.00% General Communications (NASDAQ: GNCMA ) Wireless and Landline Tel 2.748% $0.694 0.00% N/A 1.31 0.00% Spok Holdings (NASDAQ: SPOK ) Enterprise Communication Solutions 1.817% $0.352 3.05% 19.15 0.70 58.57% Lumos Networks Fiber optics, VOIP 1.42% $0.276 4.66% 13.93 0.01 32.61% All Tabled Data From Reuters, Yahoo! and PowerShares Only four of the 20 holdings do not pay a dividend, yet the average yield of the dividend paying companies is just over 3.00% and has an average payout ratio of 41.70%. The average market capitalization is indeed in the ‘small-cap’ range at $1.559 billion and the fund has low volatility with an average beta of 0.62 and the shares are marginable With the exception of 2015, the fund’s share price has had respectable, steady returns. The fund’s P/E is 19.99, has 400,000 shares outstanding and has a low trading volume. Lastly, the fund is currently trading at a discount to its NAV and the 0.29% total expense ratio is well below the ETF industry average of 0.44%. The point of the matter is that PSCU is concise with some pretty smart picks, has a good dividend yield, is mainly in a defensive sector, yet has potential for capital appreciation through its telecommunication service holdings, yet is a relatively lightly traded fund. Period YTD 1-Year 3-Year 5-Year Inception 4/7/2010 Share Price -6.34% 2.25% 9.96% 12.56% 10.67% All Tabled Data From Reuters, YaHoo! and PowerShares It seems to be the type of defensive investment that will perform reasonably well in both good and bad economic cycles and in particular a fund that may serve as a long term holding.

Have The Volatilty ETFs Turned A Corner?

Summary Trying to play US equity volatility has been really tough for retail investors in recent years. Over the past four years VIXY and VXX are both down over 58%. Volatility has increased in other areas of the capital markets which is a positive sign long-volatility ETFs. Trying to play pure volatility as a retail investor is tough. Not only can you not invest directly in the widely watched VIX, but ETFs that attempt to track the VIX end up with a substantial tracking error. This occurs because volatility ETFs such as the ProShares Vix Short-Term Futures ETF (NYSEARCA: VIXY ) track an index made up of VIX futures. When future prices are in contango (as is usually the case for VIX futures), this creates a negative roll yield that eats away at the ETFs price. Over the past four years, VIXY is down 58.6%. The iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA: VXX ), which tracks the same index as VIXY, is down 58.5%. Out of 1081 ETFs that have at least four years of trading history, VIXY and VXX have had the 6th and 7th worst performance over the past four years, respectively. With that nasty backdrop the silver lining is that for the first time in quite a while there are indications that pure play volatility investments could begin to pay off. In general, greater volatility in one segment of the capital markets tends to lead to overall greater levels of volatility in all segments of the capital markets. For example. a month ago junk bond spreads widened out to multi-year highs and look to be on the verge of making new highs very soon. As the chart below shows, greater volatility in the bond market tends to coincide with greater volatility in the equity markets. (click to enlarge) (click to enlarge) Volatility among major currency pairs has also been substantially higher in 2015 than the majority of the last several years. FX volatility has been pointing to increased equity volatility for quite some time. Equity volatility in other parts of the world is on the rise. The VDAX, which is similar to the VIX but for the German equity market, broke out to a multi-year high a month ago. Macro risks around the world are on the rise. The Citi Macro Risk Index “measures risk aversion in global financial markets”. It tracks various CDS spreads, credit spreads, swap spreads and implied volatility across FX, equity and swap rates. As this index rises, the perceived amount of risk in the global financial system increases. After falling for most of the year, this index is sharply higher over the past six weeks. Finally, on a relative point and figure basis, both the VIXY and VXX have recently broken though a firm resistance line that has been in place for four years and they both seem to have been in a basing formation for about the past 18 months. If this base can hold than there is a tremendous amount of potential upside for VIXY and VXX. VXX relative point and figure chart VIXY relative point and figure chart The original posting of this article can be found here . All data was created by the author and sourced from Gavekal Capital, MSCI and FactSet.

Short-Selling: What Are You Optimizing?

Summary What separates investing from gambling? Positive expected value. Short-selling has a negative expected value – more negative than some casino games. What are you optimizing? In theory investing is about optimizing return, but many investors’ behavior suggests they are optimizing/minimizing something else. For some heavy short-sellers, it’s intellectual stimulation. I don’t think short selling is right for me or most investors, but this is just my still-evolving opinion. Full disclosure: I’ve never shorted a stock in my life. As such, I’m probably terribly biased and not credible. Short selling is betting that a stock or security will go down. Instead of buying low and selling high, you first sell high and then buy low. You do so by borrowing someone else’s shares when you initially sell and then replacing those shares later on by buying them. For reasons I will explain in this article, I don’t think most investors, including myself, should engage in short selling. Some should, but even for those for whom short selling (“shorting”) is appropriate, it probably should not be used as a primary strategy. This argument has been hashed out many times. I could repeat what’s been discussed many times. For example, when you engage in shorting your upside is limited and downside unlimited – the unfavorable reverse of going long. Instead, I will focus on what I see as the most important points for me and perhaps where I’ve added some original thought. When you short-sell a stock, the odds are against you What separates investing from gambling? Sure, investing isn’t done in a casino, it’s much more calculated, there’s far more money in it, etc. The biggest difference though, is that when you gamble, there is a negative expected value – the odds are against you. The casino takes a cut. When you invest, there is no golden rule saying it has to be a favorable bet, but equities in the US have been increasing rather consistently for over 150 years (see Jeremy Siegel’s excellent book Stocks for the Long Run ). Studies of “rules-based” systematic investing styles like buying the lowest 10% of the market by EV/EBIT and rebalancing annually will often include the returns of the opposite decile (the highest 10% of the market by EV/EBIT in our example). The idea is that the larger the gap in returns between the two poles, the more predictive value the metric has. So what’s the point? Well when you look at these studies, it’s surprisingly hard to find one where the worst decile is actually delivering negative returns. This is significant because it means that stocks don’t only appreciate substantially on average, it’s also hard to find some that will go down at all. For myself and presumably many other investors, this odds-against-you fact is a total deal breaker. I remember in high school, I would print out the Las Vegas odds of each weeks NFL games and offer to do straight bets with anyone on any game so long as I had the favorite. I was okay with this activity because by picking the favorite without paying for it, I had a positive expected value – even though I didn’t know that term at the time. Several months ago, I was viewing the Ultimate Fighting Championship with family and someone suggested we bet on the fights. We would pool money and bet on who would win the fight and what round (or decision) they would win in The gamble was, on the surface zero-sum. No one was taking a cut of the bets. And I did research. I immediately pulled out my smartphone and looked up the favorite in each fight. I then looked up what percentage of UFC fights end by knockout versus decision. (click to enlarge) 41% of fights go to decision. Assuming a three round fight (most fights are 3 rounds, championship fights are 5), that 41% is significantly higher than the 25% it would be if each outcome were equally likely. So in each fight, I picked the favorite by decision with some confidence that I had a positive expected value. I won three out of the four fights we bet on. My approach to these situations where the game is explicitly zero or positive sum is in stark contrast to negative expected value situations. Casinos take a cut of all bets by structuring games such that odds are slightly in their favor. The lottery usually has a very negative expected value because: the winnings are taxed at the highest federal income rate and by your state as well municipalities take a huge cut (it’s a significant source of revenue for them) the advertised prize is not a present value, it’s usually a long-term annuity – taking the cash up front means getting far less there could be multiple winners that split the winnings, and the probability of this increases when the pot is large and many tickets are sold, offsetting the EV benefit of the higher pot. I’ve never engaged in these sorts of activities and would have a lot of trouble forcing myself to. It is counter to the investor mindset. But short sellers do just this. On average, they will lose money. The expected value is negative. The idea, though, is that by doing deep enough research and being opportunistic enough, they can make the expected value positive. This is tough for me to accept. First, the odds are dramatically against them on the surface. If stocks appreciate 9.5-10% a year in nominal terms, those odds are far worse for the short seller than some casino games. For example, in blackjack, the odds of you winning versus the dealer are 48%. Roulette is something like 47.4%. If stocks are appreciating 9.5-10% that’s the equivalent of ~45%. And that’s just the direct costs. Then there’s taxes, dividends you must pay on the shares you short, borrowing costs on hard to borrow stocks (unfortunately, many of the stocks with the best short cases have the highest borrowing costs because everyone wants to short them). This is somewhat offset by the fact that you can (I believe) use some of the cash you receive from the sale upfront for other things in the interim. I believe this depends on your creditworthiness as perceived by your broker, the size of the short sale relative to your assets, etc. Some brokers may require you to keep the margin in cash, which eliminates this benefit. The bottom-line: short selling is a negative expected value activity, so why do it? What are you optimizing? Value Investors Club is a great site. The quality of research is very high and there are some smart people on it – some of the smartest people in the investment industry, in fact. That’s why it confounds me that some of these investors are so short-focused. Some of these investors have written 25 articles and like 23 of them are shorts. Some of the smartest investors with the highest profiles are also heavy shorters. David Einhorn and Bill Ackman come to mind. Ackman now describes his firm as primarily long but opportunistically short, which may be the case, but historically he’s done a lot of shorting. I have a theory that these investors are attracted to shorting precisely because the expected value is worse than going long. It’s harder. It requires deeper research. It’s intellectually stimulating. It’s exhilarating. These things probably really appeal to smart people with a chip on their shoulders for some reason. But what is investing about? Is the goal of investing to optimize return or optimize intellectual stimulation? Most investors agree verbally that it’s all about return, but most don’t behave that way – and there are other examples. Obsessions over volatility, dividends, minimizing taxes, etc. are all examples of other things I’ve found many investors trying to optimize through their behavior. Buffett has said a few insightful things on this topic: “You don’t get points for difficulty” The mono-linked chain metaphor The one-foot hurdle metaphor It is certainly understandable that for investors capable of analyzing and understanding very difficult situations, it is challenging to focus on easy ones. Conclusions I have some other thoughts like the idea of specialization – maybe an investor, for some reason like a deep skeptical streak, is much better at shorting than going long – but they will have to wait for another post. This article is just me putting my thoughts to paper. At this point, I’m comfortable recommending that most investors (including myself) focus on positive expected value situations to optimize return and that means avoiding short selling.