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Misguided, Flawed D.C. PSC Decision Will Not Derail The Exelon-Pepco Merger

Summary On August 25, the Public Service Commission of D.C., led by Chairwoman Kane, denied the Exelon-Pepco merger application; Pepco shares plunged 16.5%. The application review process lacked fairness, public interest factors misconstrued by the commission, and Chairwoman Kane failed to hold good faith negotiations. Exelon is likely to pursue legal action, and is in a good position to prevail. Public Service Commission of D.C. Denies The Exelon-Pepco Merger Application In what is being called one of the most misguided and inherently flawed decisions in the Public Service Commission of the District of Columbia’s 102-year history, the Commission denied the application for the proposed merger of Exelon (NYSE: EXC ) and Pepco (NYSE: POM ). The Commission, led by Chairwoman Betty Ann Kane, issued a press release and a summary of the decision suggesting the Commission held a thorough proceeding that began with the initial application on June 18, 2014. Over 14 months later, after reviewing submissions and comments and holding hearings, the Commission decided to deny the application and declared that “this decision is forever.” Unfortunately for Chairwoman Kane, such a bold statement is not based on fact, and exceeds the established authority of the Commission. (click to enlarge) (Source: Public Service Commission of D.C. website ) Since announcing the $6.8 billion transaction on April 30, 2014, Exelon and Pepco collectively have spent a tremendous amount of resources to secure all required regulatory approvals, and until August 25, had been successful in meeting the demands of all stakeholders in various jurisdictions. In order to close the transaction, Exelon has had to negotiate complex agreements with local regulatory agencies and commit to additional funding initiatives that total in the hundreds of millions, and has had to agree to other conditions. Through this lengthy process, Exelon and Pepco received regulatory approval from all of the following agencies: Virginia, New Jersey, Delaware, Maryland, and the Federal Energy Regulatory Commission. The only agency to deny the application was the District of Columbia, on August 25. (Source: Exelon Investor Presentation, April 30, 2014) Following the unusual and terse decision by the Commission, Exelon has announced that it is reviewing all of its options, and there are many options available to the company. The outcome of the Exelon-Pepco merger is far from over, and will likely lead to a lawsuit filed by Exelon against the Public Service Commission of D.C. A lawsuit by the company would have a very good chance of succeeding, which may lead to a negotiated settlement with the Commission. A negotiated settlement was always the option that was in the best interest of all parties, including the Commission, ratepayers and community activists. However, Chairwoman Kane’s unwavering political ideology and personal preference for dealing with the existing ownership and managerial structure of Pepco ultimately prevented the outcome that is in the public’s best interest. The very troubling aspects of the flawed decision by the Commission will likely be the center of attention over the next several weeks, and will be scrutinized in the Courts. Among the most egregious missteps by the Commission include: A Deeply Flawed Process in Reviewing the Application : The Commission decided early on that it did not favor the merger for reasons discussed at length here , and the proceedings held were merely a formality for a decision that had been made months ago. Rather than holding fair and objective proceedings, the Commission, working closely with the Office of People’s Counsel of D.C. , delayed as long as possible before issuing its final ruling that it had determined long ago with the hope that another jurisdiction or a legal action may unravel the transaction. This did not happen, so the Commission obscured their biased and subjective decision under a “public interest” theory. A deeper understanding of the public interest in the District of Columbia shows that the merger is a tremendous opportunity to help a vast number of poor and middle class inner city families. Commissioner Willie Phillips acknowledged this when he stated, “I am disappointed in the loss of many opportunities that could have achieved benefits for our local communities and across the region.” (click to enlarge) (Source: Public Service Commission of D.C. website) The Commission’s Reasoning to Support Decision is Inconsistent and Unsound, and Does Not Reflect the Economic Reality in the District of Columbia : The Commission refers to its statutory obligation and the seven public interest factors that must be considered and weighted to reach its decision, but it fails to acknowledge the economic reality of the District, which is essential in the first public interest factor. The District’s government, public officials, and regulators have continually failed to address the needs of inner city minorities, and the Commission’s August 25th decision is another example of this failure to serve in the public interest. Commissioner Willie Phillips would be the first to acknowledge this significant shortfall of the District’s government. We are surprised that Commissioner Joanne Doddy Fort does not also recognize the overwhelming lack of commitment by the Mayor and public officials to improving the lives of inner city minorities. Exelon’s commitment to local communities would provide substantial resources to those in need, and it is inexplicable that an activist Chairwoman Kane would allow her political ideology to prevail over the public interest. For example, in Maryland alone, the company agreed to spend “$66 million for residential rate credits, and $43.2 million for energy efficiency initiatives – 20 percent… dedicated to limited-income programs… $14.4 million in Green Sustainability Funds for Prince George’s and Montgomery Counties, and $4 million for sustainable energy workforce development programs.” The District has the ability to work with Exelon to provide similar initiatives for its citizens, but has thus far failed to make the commitment. The Commission’s Lack of Willingness to Negotiate in Good Faith and Failure to Act in the Public Interest : It is highly unusual for a single agency to outright deny an application for a transaction without holding significant negotiations with the applicants. The Commission merely dismisses the discussions and indicates “there was no settlement brought to the Commission that would have evidenced general agreement on those mitigating factors which would have satisfied the concerns of the parties.” Its stance on a settlement shows there was not a sincere attempt to engage Exelon and work together to the benefit of the public, ratepayers, and local communities. We believe that it is unlikely that the Commission’s decision will stand in a court of law, and in our view, Exelon will be successful in challenging the inherently flawed process of the Commission in reaching the erroneous decision. Shortly after the decision was announced, Exelon responded , “We continue to believe our proposal is in the public interest and provides direct immediate and long-term benefits to customers, enhances reliability and preserves our role as a community partner. We will review our options with respect to this decision and will respond once that process is complete.” It’s possible that the two sides will still reach a settlement prior to lengthy court proceedings, particularly since the Commission was deeply divided in its initial decision, and many of the flaws are now being exposed. Potential Outcomes for Shareholders of Pepco Pepco’s stock is now trading at $23.22 per share, and is up over 3% today. In our view, Exelon will file with the Commission within 30 days to reconsider its decision, and from there, if unable to reach a settlement with the Commission, the company will pursue legal action to have decision overturned. The best-case scenario is obviously a negotiated settlement, as the transaction would close relatively quickly, perhaps 30-45 days from now. But we think the probability of this outcome occurring is low (~10%). It is unknown how long a legal action would take, but we think Exelon has a strong case for the aforementioned reasons and would ultimately prevail, although this would likely happen in 2016. In our view, this scenario has an approximately 60% probability of occurring. (click to enlarge) (Source: Nasdaq) If Exelon were to suffer a defeat in the courts or decided to abandon the transaction if negotiations failed (30% probability), we would expect Pepco to trade anywhere from $19 to $21 per share. Given these potential scenarios, we will not add to our position at the current price. However, Pepco will continue to pay a dividend, and we will re-evaluate once Exelon decides on which option it will pursue to overcome this recent setback. Disclosure: I am/we are long POM. (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.

The Sky Seems To Be Falling. What Now?

Summary Understanding portfolio risk in the context of net worth. Assessing the cause of current distress. Discussing what to do in times of distress. Every successful investor should have a good idea of his asset allocation and risk tolerance in order to manage active market exposure accordingly. I consider an affluent investor with 40% net worth in real estate, 40% in an actively managed portfolio, and 20% in cash and other liquid assets to be prudent and well balanced. But in times of distress like the past few days, the actively managed portfolio becomes the center of focus. Understanding portfolio risk in the context of net worth I find volatility of a portfolio best describes its risk. Most commonly used volatility is in fact the annualized standard deviation of portfolio returns on a daily or monthly basis. I personally run an enhanced equity portfolio with roughly 30% volatility, which is about twice of the S&P 500 index volatility, and has generated about 40% annualized returns in the last six years. Assuming returns are normally distributed, an easy way to quantify 30% volatility is the following: With 68.2% probability, the annual portfolio return will be in the range of up +30% and -30%; With 13.6% probability of each, the annual portfolio return will be between +30% and +60% or between -30% and -60%; With 2.3% probability of each, the annual portfolio return will be up or down more than 60%. As you can see, with volatility of an actively managed portfolio at 30%, the chance of a significant drawdown within a year is still fairly high. However, keep in mind, you ought to view your net worth as a whole when determining risk tolerance. With the portion of an actively managed portfolio at 40% of the net worth, assuming other assets are relatively stable, the actual volatility of your net worth is only 12%, significantly lower than viewing the active portfolio as an isolated entity. We all enjoy upside volatility, but sporadic downside volatility is fair play. Most market participants are prepared to endure such risk in search of long-term profitability. Assessing the cause of the current distress I believe the current selloff has sentimental, rather than fundamental, drivers. Aside from some weakness in the Chinese economy, the global economy is tracking reasonably well with Europe finally starting to emerge from the shadow of sovereign debt crisis. However, U.S. equity markets had sustained several years of stellar performance without correction. Wary of the sustainability of global growth, investor sentiment was gradually shifting towards the defensive side. At this point, it is difficult to assess whether the selloff was triggered by the nearing of Federal Reserve rate hike, or by the recent yuan devaluation by the People’s Bank of China. In addition, the Chinese government’s inability to stem losses in the equity market casts doubt on its ability to navigate through the current softness in its economy. The selling accelerated through the negative feedback loop in various markets. It is most likely an aberration, rather than the start of a bear market. It may take a few weeks for the markets to work out the kink. Investors are also eagerly anticipating what and when central banks’ next moves will be. Meanwhile, doing nothing is not the best course of action. Don’t panic, let’s discuss what to do in times of distress 1) Assessing portfolio risk Evaluate your portfolio and determine if you have too much risk exposure. If you do have too much risk, a straight-forward action is to cut positions proportionally across the board. Even if your exposure is on target, it may make sense, in times of distress, to take some chips off the table in case the selloff intensifies. Keep the powder dry and wait to add back the exposure at more attractive levels. 2) Hedging with equity index futures Even though it is often wise to hedge actively managed portfolios with correlated index options to extract alpha, it is typically not feasible in distress, simply because the elevated implied volatility makes purchasing options cost prohibitive. At one point, the implied VIX touched 50% during the session on Monday, while it traded mostly between 12.5% and 25% over the past few years. Index put spreads may be a possibility as we will discuss below. However, if you don’t have time to do a detailed portfolio analysis, and feel there is too much risk, you can immediately take some market risk out of your portfolio by shorting, say, S&P e-mini futures. Each e-mini has a notional size of close to $100,000, shorting 10 e-minis will take out close to $1,000,000 long market exposure from your portfolio. This method is extremely helpful during potential market bounce after the selloff, especially if you are not convinced of its short-term sustainability of the rebound. It would have worked perfectly during the 4% bounce this morning (Tuesday). 3) Hedging with high-beta names During the selloff of the last few days, high flyers such as Netflix (NASDAQ: NFLX ) and Tesla (NASDAQ: TSLA ) started to show cracks. What goes up a lot could come down hard in a selloff as many momentum chasers will be the first ones to liquidate their portfolios. This makes high flyers the perfect candidates for portfolio hedges. Nevertheless, shorting high flyers could expose you to unquantifiable risk. It is not for the faint of heart. However, buying put spreads on high-beta names could be an attractive way to hedge the overall exposure in the portfolio. An example today is: Buy NFLX Sept 18 $100-strike put for $7 each; Sell NFLX Sept 18 $85-strike put for $3 each. You pay $4 for this put spread, and it is the maximum you can lose; but you could make $11 if NFLX is below $85 at the option expiry on September 18. Although the implied volatility for the higher strike option is likely inflated, the implied volatility of the lower strike option should be even more elevated due to the “skewness” (email me if you want to learn more about this) of the option. If you are proficient in options, you may also sell Sept 4 $90-strike put instead and roll it forward on or near September 4 for more flexibility in assessing on-going market conditions. 4) Treating distress as a godsend in re-allocating portfolio We all have companies we follow and wish owning them at cheaper prices. You know what, now is the time! In times of distress, company stocks are often sold indiscriminately by agitated investors, creating incredible buying opportunities. Use some of your dry powder and dip your toe in the water to acquire a few quality names. Better yet, sell some losers in your portfolio and pick up a few winners on fire sale. It will certainly pay off when markets return to normal. Disclosure: I am/we are short NFLX, TSLA. (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.

Blanket Equity Coverage Through ETFs

Exchange Traded Funds are a liquid investing tool. Costs per 10,000 dollars index funds are extremely low. Portfolio construction will play the entire U.S. market, and a sweeping international option. Turbulence in the global equity markets has investors reviewing their portfolios. Retail investors subscribe to the belief that the best way to minimize losses is diversity and low fees. I’d like to review my personal holdings with you, as an option for investors seeking a diversified foundation of funds which all have low fees. I invest in the 5 ETFs, with minor overlap, and allocate 20% to each. Holding these index funds will allow you to have sweeping coverage of the U.S. market, including a broad international fund. Vanguard Total Stock Market ETF (NYSEARCA: VTI ) ” The Fund employs an indexing investment approach designed to track the performance of the CRSP US Total Market Index, which represents approximately 100% of the investable U.S. stock market and includes large-, mid-, small-, and micro-cap stocks regularly traded on the New York Stock Exchange and Nasdaq. The Fund invests by sampling the Index, meaning that it holds a broadly diversified collection of securities that, in the aggregate, approximates the full Index in terms of key characteristics. These key characteristics include industry weightings and market capitalization, as well as certain financial measures, such as price/earnings ratio and dividend yield.” Fee – .05% annually. VTI allows investors access to 3,816 stocks of all market caps, and has outperformed the S&P since 2005. Vanguard Small-Cap Growth ETF (NYSEARCA: VBK ) ” The Fund employs an indexing investment approach designed to track the performance of the CRSP US Small Cap Growth Index, a broadly diversified index of growth stocks of small U.S. companies. The Fund attempts to replicate the target index by investing all, or substantially all, of its assets in the stocks that make up the Index, holding each stock in approximately the same proportion as its weighting in the Index.” Fee – .09% annually. Hunting for news on small companies can be can be difficult. This fund gives investors access to this market through a basket of 738 small cap stocks. Vanguard Mid-Cap ETF (NYSEARCA: VO ) “The Fund employs an indexing investment approach designed to track the performance of the CRSP US Mid Cap Index, a broadly diversified index of stocks of mid-size U.S. companies. The Fund attempts to replicate the target index by investing all, or substantially all, of its assets in the stocks that make up the Index, holding each stock in approximately the same proportion as its weighting in the Index.” Fee – .09% annually. Reinforcing your base position in mid-caps through VTI, this is where the high flying stocks are located. The index again protects investors against massive losers, while benefiting from the high fliers. This fund has 369 stocks between 2-10 billion market cap in its portfolio. Vanguard Mega Cap Growth ETF (NYSEARCA: MGK ) ” The Fund employs an indexing investment approach designed to track the performance of the CRSP US Mega Cap Growth Index, which represents the growth companies, as determined by the index sponsor, of the CRSP US Mega Cap Index. The Index is a float-adjusted, market-capitalization-weighted index designed to measure equity market performance of mega-capitalization growth stocks in the United States. The Fund attempts to replicate the target index by investing all, or substantially all, of its assets in the stocks that make up the Index, holding each stock in approximately the same proportion as its weighting in the Index.” Fee – .11% annually. This fund has 150 stocks and contains the big blue chips over 200 billion in market cap. Vanguard Total International Stock ETF (NASDAQ: VXUS ) ” The Fund employs an indexing investment approach designed to track the performance of the FTSE Global All Cap ex US Index, a float-adjusted market-capitalization-weighted index designed to measure equity market performance of companies located in developed and emerging markets, excluding the United States. The Index includes approximately 5,550 stocks of companies located in 46 countries. As of October 31, 2014, the largest markets covered in the Index were Japan, the United Kingdom, Canada, Switzerland, and France (which made up approximately 16%, 15%, 7%, 6%, and 6%, respectively, of the Index’s market capitalization). The Fund invests all, or substantially all, of its assets in the common stocks included in its target index.” Fees – .14% annually. An all in one stop for your international exposure. This fund employs roughly 60% of its assets into industrialized nations, the rest into emerging markets. This portfolio construction will give investors sweeping coverage of the United States, and minor exposure into the international markets. If you’re rebalancing your portfolio, this may be a good place to start. From this portfolio, investors can begin adding individual stocks and sector based ETFs to compliment. Investors being hurt in these multiday declines should consider redesigning their portfolio construction. Begin with these ETFs, branch off slowly, and this recovery will be more than breaking even. Disclosure: I am/we are long MGK, VO, VTI, VXUS, VBK. (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.