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The Trouble With Momentum – And What To Do About It

Summary Growth stocks have outperformed value stocks in recent years, which is shining a spotlight on momentum. Unlike other investment factors, the momentum premium has been persistent since it was identified by financial academics in the 1990s. We believe that combining momentum with value and other factors within a multi-factor framework is a compelling way to address the challenge of tapping momentum profitably in a growth portfolio. It’s no secret that growth stocks have outperformed value stocks in recent years. For example, in the two years from September 1, 2013 to August 31, 2015, large cap growth stocks (as measured by the Russell 1000 Growth Index) returned 14.7% annualized vs. 9.6% annualized for value stocks (Russell 1000 Value Index). This pattern of outperformance has shone a spotlight on momentum , an investment factor that works particularly well in growth-stock investing. But making money by identifying growth stocks with momentum characteristics isn’t as easy as it sounds. In this column, I will explain why and briefly describe how Gerstein Fisher addresses some of the problems inherent in tilting a growth stock portfolio to momentum. Momentum: a Persistent Investment Factor First, let’s define what we mean by momentum. Momentum is the tendency for winning stocks (that is, stocks that have outperformed the market over the past three to 12 months) to keep winning and losing stocks to keep losing. First identified in papers co-authored in the early 1990s by Sheridan Titman, one of our Academic Partners, the momentum factor would seem to refute the weak form of the Efficient Market Hypothesis, which asserts that stock prices reflect all available information and that past price movements should be unrelated to future average returns. Momentum suggests that prior movements in price are in fact related to expected stock returns – that security prices essentially have memory, which students of statistics will recognize as serial correlation. Since those landmark studies in the 1990s, a number of other academic papers have established that a momentum strategy works not only in equity markets around the world (with the notable exception of Japan’s) but also in several other asset classes, including currencies and commodities. At Gerstein Fisher, we find that a momentum tilt works at least as well in our multi-factor real estate investment trust (aka REIT) portfolio as in our US and international growth equity strategies. Exhibit 1 shows the compound annualized returns from 1927 to 2014 for 10 portfolios formed on momentum (defined here as the one-year return skipping the most recent month). Investing in the highest past one-year return (i.e., highest-momentum) stocks generated a 16.9% annualized return, while the lowest decile of momentum lost 1.5% per year. Note the steady improvement in performance as momentum increases. (click to enlarge) Moreover, unlike some other investment factors identified by financial academics, momentum has remained remarkably robust and persistent. For instance, since the size premium for small cap stocks was identified in the early 1980s, it has shrunk dramatically (see my recent column for more on this phenomenon: ” Is the Small Cap Stock Premium Disappearing? “); similarly, the value premium has also sharply declined since Fama and French published their pioneering paper on it in 1992. Quite possibly, once seminal research is available in the public domain, quantitative investors target and thereby reduce the available premiums, although they still exist. But momentum seems to be different: our research shows that the strategy has remained profitable, generating a momentum premium of five to seven percentage points* even years after Prof. Titman’s groundbreaking papers in the 1990s. The Challenge for Momentum So if all of this academic and empirical evidence for momentum is present, then what’s the problem? For one thing, momentum stocks are also subject to short-term reversals, the tendency for stocks that have risen relative to the rest of the market in the last month to underperform those that have fallen relative to the rest of the market (for more on this topic, see our recently posted paper: ” Do past returns predict future returns? Evidence from Momentum and Short – Term Reversals “). In addition, the discipline and emotion-free decisions required to hold high-momentum winners and cut low-momentum losers every month are behaviorally difficult for many individual investors to make. Most importantly, there is a very large issue with turnover and transaction costs (and tax liabilities, if held in a taxable account) with a momentum growth stock portfolio. In short, without rules for controlling portfolio turnover, transaction costs will quickly devour a premium from a tilt to momentum (a monthly rebalanced, long-only momentum strategy may have a turnover of about 300%, implying a holding period of around four months). We believe that an effective approach to addressing the problem of excess turnover is by combining momentum, a so-called fast-moving factor, with value (which we may define, for instance, as a tilt to higher book-to-market stocks than the Russell 3000 Growth Index), a slow-moving factor. Combining these two negatively correlated factors in one portfolio provides factor diversification, which is a good thing since there are pronounced and different cycles to different factors. But we also find that by combining the signals of value and momentum, we can slow down portfolio trading dramatically and improve risk-adjusted performance, both relative to the index and compared to the sum of standalone value and momentum strategies-a typical advantage of a multi-factor strategy in one portfolio. We will soon publish our research on the optimum way to combine momentum and value in an academic journal. In the meantime, I invite you to read our working paper: ” Combining Value and Momentum “. Conclusion Growth stocks – and momentum – have been the source of strong performance in the stock market. The momentum premium is palpable but difficult to tap profitably in a growth portfolio. We believe that combining momentum with value and other factors within a multi-factor framework is a compelling way to address this challenge. *The momentum premium is defined as the returns of the highest 30% of large cap US stocks rated by momentum less the return of the lowest 30% of stocks rated by momentum. Data on momentum decile portfolios are taken from Ken French’s website. 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. I have no business relationship with any company whose stock is mentioned in this article.

An Update On CEMIG – The Storms Are Getting Stronger

Summary Political and economic uncertainties do not aid CIG’s position and potential. The three hydro plant concessions are definitely lost and new terms could be agreed, but the cost of this is uncertain. Brazil is the world’s 8th largest economy by GDP and thus there should be a turnaround, and CIG is a great play to grasp that turnaround. The long term potential downside is getting smaller (25%) and the potential upside is getting bigger (600%). Introduction About two months ago I wrote an article about Companhia Energética de Minas Gerais (NYSE: CIG ). The stock price at the moment of writing that article was US$3.3. I assumed that the downside risk was down to US$2.24 and deferred buying in order to wait for better opportunities. At the moment the price is US$1.93 with the low of the year at US$1.81. It was a good call not to buy two months ago. In this article I want to discuss the possible effects of the new developments that happened in the last two months and see if the falling knife can fall lower or it is time to start buying in. Latest news and developments In August CIG reported Q2 results. Figure 1 shows that the net revenue increased but EBITDA and net income were down. Figure 1 CIG’s Q2 results (click to enlarge) Source: CIG’s investor relations The main issue for the decline in net income was a lower spot price and a big increase in financing costs. In figure 2 we can see the development of the interest rate set by The Central Bank of Brazil Monetary Policy Committee (COPOM). Figure 2 Interest rate – Brazil from 2005 to 2015 (click to enlarge) Source: Tradingeconomics The current set interest rate is very high with a goal of curbing the high inflation in Brazil. The high interest rate affects CIG by lowering its cash flow and net income. Figure 3 shows that the cost of debt is going up but the debt to equity ratio is stable. Figure 3 CIG’s cost of debt and leverage ratio (click to enlarge) Source. CIG’s investor relations. The increase in the cost of debt resulted in a 60% increase in interest expenses in relation to the previous 1H , from R$654 million to R$1,067 million. All these negative effects did lower the net income in Q2 but the total net income in 1H 2015 is 1.5% higher than in 1H 2014, from R$1,990 million to R$2,018 million. Unfortunately this is not of the greatest importance to international investors because if we translate the results into US currency the net result is lower by 39% in comparison to last year, from US$850 million to US$525 million. In figure 4 you can see the depreciation of the Real in relation to the US dollar. Figure 4 Brazilian Real per 1 USD (click to enlarge) Source: xe.com I believe such a chart is the nemesis for every investor because of the uncertainties that it brings with. Nobody can know how low can the Brazilian Real go in relation to the US dollar and when will it hit bottom. As a normal consequence of the falling currency and high inflation the downgrade Brazil got from Standard & Poor’s should not be a surprise to anybody. The fear and uncertainty concerning Brazil plus the junk rating the country got make it difficult for investors to assess the risks and estimate future scenarios. Apart from political and economic issues, we must not forget the legal issues related to CIG. Legal issues and news in Q3 In July Fitch downgraded CEMIG to AA- with a negative outlook and CIG definitely lost the concessions of the three hydro plants that were under dispute with the government. CIG will appeal but let us not rely on that. If the government provides CIG favorable new conditions, they will continue operating the plants but that is something we will know more about in the near future. In any case CIG will have to find ways to cover the 35% to 45% of revenues that were coming from the three hydro plants. CIG’s management is already looking for ways to grow in the future despite the loss of the concessions and one example of that is the cooperation with SunEdison (NYSE: SUNE ) and the possibility to develop solar power plants in the future. One of them is the R$ 4 billion solar plant in the state of Minas Gerais with one of the best solar radiation factors in the world. This is also an opportunity to lower the hydrological risks attached to the weather and rainfall. CIG has also shown interest in the new transmission lines that will go through the state of Minas Gerais. The company added 120,000 new customers in the first half of the year and it won a dispute with the government to prevent the adjustment of the Energy Reallocation Mechanism about the sharing of hydrological risks of hydroelectric plants. Good news is that recently the Federal Audit Court authorized the government to renew for 30 years the concessions of electricity distributors whose contracts expire between 2015 and 2017. Fundamental perspective The current book value is R$11.19 per share translates to US$2.84. With the current inflation being 11% in Brazil and the rapid depreciation of the currency, this number cannot be of any guarantee to us. A deeper look at the balance sheet shows that long term assets are R$23 billion, short term assets R$13.5 billion, while long term liabilities are R$13.5 billion and short term R$ 9.4 billion giving a good debt to assets ratio of 0.61. As a business like CIG is capital intensive and difficult to replace; thus we can assume that there is real value behind CIG’s books. As a very conservative estimation we will take 50% of the current book value to be the value under which CIG should not go, thus $1.4. Earnings for the last four quarters are at R$3,146 million, which translate to US$800 million or US$0.64 per share. If the management keeps the dividend payout policy of 25%, then it should result in a US$0.16 dividend per share. But I would not bet on that because of the deteriorating financing circumstances in the Brazilian financial markets. Two scenarios for CIG’s stock I will start with the negative scenario. The current earnings are US$0.64 where we have to deduct the effect of the loss of the three concessions that should cut about 50% of that. Higher financing costs are also an issue because the current financing costs are 50% of net income thus if they continue to increase as they increased in the last quarter, they could quickly take another 50% of earnings. In a worst-case scenario earnings could go down to US$0.16 or even go to zero for a period. The risk of lower earnings with a risky political and economic situation could bring the value of the stock even lower than the levels it is now. We cannot know how low will the market go or where will the Real stop its decline in relation to the US dollar, and the negative ratings for both Brazil and CIG are a tough storm to withstand for every investor as there might be more institutional selling along the way. Further economic pressure and depreciation could lower the price of the stock, but I do not believe it to be much because CIG is a very important business in Brazil. I will put my long-term downside risk to the conservative book value of $1.44. This makes the potential downside 25%. In the short term it could go anywhere due to panic in the emerging markets. The second scenario is a brighter one and more long term orientated. Brazil and CIG are getting cheaper and cheaper and we are talking here about the world’s 8th largest economy. The fact that it is so cheap at the moment will certainly increase foreign investments and increase exports as soon as the political situation stabilizes. Also if we look at CIG from a pure business perspective, the increase in the number of customers plus the plans for future growth through more distribution and solar shows that CIG is a good company. The future plans and possible long term turnaround in Brazil make CIG a good long term opportunity, but the investor must be willing to take 25% or more downside risk due to the deteriorating political and economic situation in Brazil. From just attaching the trailing earnings to a PE ratio of 10 we get a price of US$6.4 that gives us a 330% upside. CIG’s stable economy dividend policy is to payout 50% of earnings that would currently be US$0.34 giving a 17.5% dividend yield at current prices and 5.3% at US$6.4. If the situation in Brazil changes or stabilizes, the currency strengthens, interest rates fall and CIG shows a bit of earnings growth, we could see earnings at US$1.28 – that attached to a PE of 10 gives us a price of US$12.8. That is a potential long-term positive return of 663%. Conclusion I reiterate my standing that investing in CIG is a pure bet on Brazil and its currency. Every investor should estimate what is his best strategy in such cases. The easiest thing to say is not to catch falling knives but if you do not try the potential upside is lost. Remember to be greedy when others are fearful and be fearful when others are greedy. I will compare CIG to other opportunities and then make a decision about investing. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CIG 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. Additional disclosure: This article was provided for informational purposes only. Nothing contained herein should be construed as an offer, solicitation, or recommendation to buy or sell any investment or security, or to provide you with an investment strategy, mentioned herein. Nor is this intended to be relied upon as the basis for making any purchase, sale or investment decision regarding any security. Rather, this merely expresses my opinion, which is based on information obtained from sources believed to be accurate and reliable and has included references where practical and available. However, such information is presented “as is,” without warranty of any kind, whether express or implied. The author makes no representation as to the accuracy, timeliness, or completeness of any such information or with regard to the results to be obtained from its use should anything be taken as a recommendation for any security, portfolio of securities, or an investment strategy that may be suitable for you.

Clean Energy Fuels: Consider On The Drop

Summary CLNE shares have lost 46% of their value in the past year despite negotiating the drop in natural gas prices smartly as it has improved both its revenue and margin. CLNE’s volumes delivered have been increasing and the trend will continue in the future as natural gas is a cheaper fuel to run trucks as compared to diesel. The increase in natural gas demand is expected to provide a boost to prices going forward, but the fuel will still have a positive differential over diesel. CLNE’s customers in both the transit and refuse markets have been adding more natural gas trucks and this will act as a tailwind by increasing the addressable market. The past one year has turned out to be very difficult for Clean Energy Fuels (NASDAQ: CLNE ) on the stock market. The company’s stock price has taken a beating as the price of natural gas has dropped steeply in the past year. In fact, last quarter, Clean Energy’s revenue was down 11% year-over-year as low fuel prices affected its top line performance negatively to the tune of $5.6 million. Why Clean Energy’s drop is not justified However, I think that the 46% drop in Clean Energy’s shares in the past year is a bit harsh, especially considering the fact that the company has been able to actually improve its financial performance in the past year. This is shown in the following chart: Henry Hub Natural Gas Spot Price data by YCharts As seen above, Clean Energy’s top line performance has improved despite difficult conditions. This can be attributed to the fact that Clean Energy is seeing an increase in volumes delivered of natural gas as customers are still adopting natural gas-powered vehicles despite the drop in diesel prices. Looking ahead, it is likely that Clean Energy will continue to see an improvement in both volumes and its margins. Let’s see why. More volume and margin growth ahead Natural gas enjoys an advantage over diesel when it comes to running natural gas truck fleets in terms of both costs and emissions. This is the reason why Clean Energy is seeing an increase in gallons delivered even though diesel prices have dropped rapidly in the past year. In fact, Clean Energy saw its transit customers add more than 224 buses to their fleets in the previous quarter. This represents natural gas fuel consumption of 3 million gallons annually. On the other hand, waste haulers such as Republic Services (NYSE: RSG ) have also been enhancing their natural gas fleets. In 2015, Republic has increased its CNG fleet by 130 trucks. Looking ahead, by the end of the year, Republic plans to add 150 more trucks to its fleet. This is despite the fact that the cost of a natural gas conversion kit is $50,000 more than a diesel truck. Now, the fact that Clean Energy’s customers are still adopting natural gas trucks despite the drop in diesel prices is not surprising, as natural gas is still a cheaper fuel when compared to diesel. This is shown in the chart below: (click to enlarge) Source: Clean Energy Fuels investor relations Looking ahead, I won’t be surprised if Clean Energy’s volumes continue improving as the adoption of natural gas vehicles gains more momentum. As per Navigant Research , “global annual NGV sales are expected to grow from 2.5 million vehicles in 2014 to 4.3 million in 2024.” More importantly, apart from volume growth, Clean Energy is also focused on reducing its expenses. The company has reduced its selling, general, and administrative expenses by over 16% as compared to last year. Also, it has reduced its capital expenditure by more than 58% to $26 million in the first six months of the year as compared to the prior-year period. As a result of these moves, Clean Energy has been able to improve its EBITDA by $3 million as compared to the first quarter and $2.1 million from the prior-year period. More importantly, this improvement in EBITDA has been achieved despite a double-digit drop in revenue from last year. Thus, Clean Energy is following a smart two-pronged approach to grow its business – first by increasing volumes and second by lowering costs. However, Clean Energy will need a boost from better natural gas prices in order to enhance its financial performance. Higher natural gas prices are a possibility The Energy Information Administration expects natural gas prices to improve in the future due to an increase demand in both domestic as well as international markets. In a reference case study, the Henry Hub natural gas spot prices are expected to rise from $3.69 per MMBtu in 2015 to $4.88 per MMBtu in 2020, followed by $7.85 MMBtu in 2040 as shown in the charts below. Source: EIA The expected increase in natural gas pricing is not surprising as global gas demand is expected to grow 51% by 2035. The increase in demand will be driven by an increase in consumption from the power and industrial sectors. New gas-fired power plants are being built to meet the increase electricity demand and existing plants are being converted from burning expensive and polluting oil products to cheaper, cleaner natural gas. So, this switch from coal to gas-fired power plants will increase demand for the fuel, thereby leading to higher prices. More importantly, despite the expected rise in natural gas pricing, the fuel is expected to be cheaper than diesel. This is shown in the chart below: Source: Westport Innovations Thus, as seen above, the differential between gas and diesel price is expected to favor the former in the long run, and this will aid Clean Energy’s growth. Conclusion Clean Energy Fuels has been beaten down badly in the past year, but the drop seems unjustified. The company has been able to do well in a difficult end-market environment and its outlook looks strong as well. Hence, in my opinion, the drop in Clean Energy’s shares in the past year is an opportunity to buy as the company could do well in the long run on the back of improving NGV adoption and an expected rise in natural gas pricing. Thus, investors should consider the drop in Clean Energy’s shares as a buying opportunity since the stock could deliver upside in the long run. 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.