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Allocation Strategy During The Corporate Debt Hangover

Are corporations in great shape? Three consecutive quarters of declines in earnings suggest that they are not. Worse yet, record high leverage coupled with close-to-record low interest coverage indicate stress within corporate balance sheets. Beginning with the “profit recession,” it has become fashionable to describe the deterioration as a function of the price collapse in oil and gas. However, that assessment fails the sniff test on three different levels. One, six of the ten S&P 500 economic segments share in the year-over-year earnings contraction, not the energy sector alone. Second, if one excludes energy as an outlier on the negative side, one would be obliged to throw away super-sized contributors like healthcare on the positive side of the ledger. In doing so, the profit picture still appears weak. A third reason that it is foolish to dismiss energy earnings? Analysts made the same mistakes prior to the economic downturns in 2001 and 2008. It was short-sighted to toss the technology sector in the dot-com collapse. It was irrational to exclude financials in the banking crisis. It follows that it would be just as insular to ignore the influential energy segment when evaluating corporate profitability today. Perhaps more troubling is the erroneous belief that corporations have improved their balance sheets since the Great Recession. In truth, U.S. companies have doubled their total debt levels since 2007, while simultaneously finding it more difficult to pay interest expenses on outstanding obligations. According to Investopedia , the interest coverage ratio determines the ease or difficulty by which a company can service its existing debt. The ratio is calculated by dividing a company’s earnings before interest and taxes (EBITA) by the company’s interest expenses for the same period. The higher the ratio, the less burdened by borrowing costs a company is; the lower the ratio, the more onerous the debt expense is for a company. Now take a look at the charts below. Total leverage by U.S. “investment grade” (IG) corporations has catapulted through the proverbial roof. Leverage does not matter as long as companies can service the debt, right? Unfortunately, investment grade interest coverage is back to levels not seen since 2009. If one shifts to corporations on the world stage, the picture becomes more nebulous. Consider the net debt-to-earnings (EBITA) at global companies. This measure looks at the number of years, theoretically speaking, that a company would require to pay obligations back. And right now, according to Standard & Poor’s, net debt-to-EBITA in 2015 at 3.0 was the highest since 2003. That’s not all. Analysts typically regard a ratio below three as “safe.” With the average global company straddling the fence between safe and not-so-safe, what does that tell investors about the financial health of the world’s corporations? Why should anyone focus on all the debt talk surrounding the world’s corporations? Don’t they always find a way to right their respective ships? Well, for one thing, if a company has money left over after it services its debt obligations, it cannot necessarily expand its business in productive ways, including research, development, human resources acquisition, marketing and so forth. We’ve already seen the most recent reading of the Institute For Supply Management (ISM) Non-Manufacturing Index hit its lowest level since March of 2014 (55.3). That’s not encouraging, even if it shows expansion in the services arena. In a similar vein, it is highly discouraging to witness carnage in the capital goods arena. It would seem that companies are unwilling and/or do not have the discretionary dollars to invest in tangible assets to produce goods or services such as office buildings, equipment and machinery. Maybe debt is taking a nasty toll after all. (See the chart below.) So how might one invest in an environment where corporate and government debts have skyrocketed, asset prices have hit extremes and the Federal Reserve is committed to raising borrowing costs? Former PIMCO “guru” Mohamed El-Arian has finally decided that 25%-30% in cash is the best way to survive what he anticipates will be better buying opportunities down the pathway. For my clients at Pacific Park Financial, Inc., we began making the tactical allocation shift in June of 2015 – seven months ago. We downshifted from 70% growth (e.g., large-cap, smaller-cap, foreign, etc.) to roughly 50% growth (high-quality, low volatility large-cap stocks). We moved from 30% income (e.g., short, long, investment grade, higher-yielding, etc.) to approximately 20%-25% investment grade income. With cash or cash equivalents approximating 25% – safer harbors such as the SPDR Nuveen Barclays Short-Term Municipal Bond ETF (NYSEARCA: SHM ) as well as money market vehicles – we reduced volatility while awaiting better buying opportunities. While I expect the corrective activity that began in May of 2015 to continue, my clients understand that I seek to reduce risk, not eliminate it. It follows that current stock exposure at 45%-50% does not represent a mindset of “shorting” or being out of equities completely. For the most part, we have been out of foreign positions and smaller U.S. companies for quite some time. Nevertheless, we maintain an allocation to equity ETFs via funds like the iShares MSCI USA Quality Factor ETF (NYSEARCA: QUAL ) and iShares USA Minimum Volatility ETF (NYSEARCA: USMV ). The bond story is remarkably similar. Rather than pursue cross-over corporates or high-yield or even long-term investment grade corporates, we have stayed near the middle of the curve with funds like: (1) the SPDR Nuveen Barclays Municipal Bond ETF (NYSEARCA: TFI ), (2) the Vanguard Total Bond Market ETF (NYSEARCA: BND ), (3) the iShares 7-10 Year Treasury Bond ETF ( IEF) and (4) the iShares 3-7 Year Treasury Bond ETF (NYSEARCA: IEI ). There are those who crave a bit more potential than cash or T-bills. For those folks, rather than “shorting,” we employ multi-asset stock hedging. We’ve picked up some of the assets in the FTSE Multi-Asset Stock Hedge Index , including the yen, gold, and zero-coupon treasuries. Make no mistake about it, however. The cash that had been raised in 2015 has multiple purposes. It provides a measure of comfort when stock volatility surpasses norms. In addition, cash offers one the ability to acquire “buy low” value propositions. Even now, there are folks with excess cash who might want to examine a dividend aristocrat like Aflac (NYSE: AFL ). With a trailing P/E of 10, a forward P/E of 9, a dividend yield of 2.9% and a price from mid-2014, you may decide the rewards are worthy of the risk. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships

Should You Bet On Airlines ETF Despite Mixed Earnings?

The airline stocks have been highfliers since the second half of 2015 on dirt cheap oil prices and encouraging fundamentals. Earnings picture was also pretty decent for the space. Higher margin, lower debt, surging ancillary revenues and a host of modifications in operations helped the sector gain altitude (read: Highflier Airlines Earnings : Time for JETS ETF ). As a result, the pure-play aviation ETF U.S. Global Jets ETF (NYSEARCA: JETS ) lost just 5.5% (as of January 21, 2016) after accounting for all the global market issues. This was quite respectable when compared with the 11.7% losses put up by the broader market ETF SPDR S&P 500 ETF (NYSEARCA: SPY ) in the same timeframe ( read: The 13 Best and Most Interesting ETFs to Launch in the First Half of 2015 ). In such a backdrop, all eyes were fixed on airlines earnings this season. But sadly, major carriers fell shy of investors’ expectations. Greenback strength appears to be main reason behind this underperformance. Q4 Results in Detail The season unveiled with Delta Air Lines (NYSE: DAL ) missing on both lines in Q4 of 2015. Results were hurt by the strength in the U.S. dollar, with foreign currency movements having an adverse impact of $160 million. However, Delta’s shares added 3.3% despite the earnings miss in the key trading session of January 19. This is because the company, the bottom line of which grew 51% year over year on low oil costs, expects to generate over $3 billion in savings in 2016 on steeply plunging oil prices. This Zacks ETF Rank #1 (Strong Buy) stock has a Zacks Momentum & Value style score of ‘A’ and a Growth score of ‘B’, at the time of writing. United Continental (NYSE: UAL ) also came up with soft Q4 results this month as both earnings and revenues miss. Adjusted earnings were up substantially year over year on lower fuel costs. Revenues declined 3% on lower passenger revenues. Cargo revenues were also downhill while the other revenues improved 10.9%. However, its indicators are promising with a Zacks ETF Rank #2 (Buy), and Value score of ‘A’ and Momentum score of ‘B’. Shares also added modest gains of about 0.5% to close January 21, the day it reported earnings. Yet another leading U.S. carrier Southwest Airlines Co. ‘s (NYSE: LUV ) fourth-quarter 2015 bottom line matched the Zacks Consensus Estimate while the top line missed the same. But investors should notice that revenues grew 7.5% year over year helped by 3.3% and 119% expansion in Passenger and Other revenues, respectively. This Zacks ETF Rank #1 stock also boasts hopeful indicators of Momentum score of ‘A’ each and a Value score of ‘B’. LUV was up 0.5% post reporting earnings. Though these heavy-weight companies underperformed on earnings, the sector has seen sturdy performances by others. Alaska Air Group Inc. (NYSE: ALK ) reported earnings (on an adjusted basis) of $1.46 per share in the fourth quarter, beating the Zacks Consensus Estimate of $1.43. Earnings increased 55% year over year. Revenues of $1.38 billion were in line with the Zacks Consensus Estimate. The top line grew 5% on a year-over-year basis. The company also hiked its quarterly dividend by 38% to $0.275 per share. This star performance within the struggling pack offered the stock over 8.1% gains post earnings. ALK has a Zacks ETF Rank #1, a Value and Growth scores of ‘B’ and a Momentum score of ‘A’. Should You Buy JETS? By now, one must have realized from the indicators that the mood in the airlines industry is upbeat. The sector is in the top 4% category of the Zacks Industry Rank at the time of writing, giving strong cues of the upcoming flight in the entire industry. However, as company-specific risks seem higher, investors might play the trend via basket approach to tap the entire potential of the space. And to do so, what could be a better option other than the JETS ETF? The $46.8 million-fund holds over 30 stocks in its portfolio and is concentrated on a few individual securities, as it allocates about 70% to the top 10 holdings. American Airlines (12.46%), Southwest Airlines (12.37%), Delta Airlines (12.13%) and United Continental (10.54%) are the top four elements in the basket. Alaska Air holds the ninth position in the fund with 3.74% weight. The product charges 60 bps in fees. Link to the original post on Zacks.com

Evaluating Enterprise Risk For Alternative Investments

Enterprise risk includes all of the factors that can affect an enterprise: market factors, reputation, regulation, compliance, operations, and legal risk are among the most prominent. Enterprise risk analysis , which uses stress tests and scenario assessments to estimate investment risks across asset classes, has become increasing popular with institutional investors, who understand the impact enterprise risk can have on their portfolios. But while enterprise risk analysis works well with traditional asset classes, using enterprise risk analysis on alternatives – such as hedge funds, private equity, and real estate – presents challenges. This, at least, is the view of BNY Mellon (NYSE: BK ) and affiliate HedgeMark, as articulated in their January 2016 white paper Considering the Alternatives: A Practical Look at Enterprise Risk Analysis and Alternative Investments . The paper explores the impact of incorporating alternative investments into enterprise risk analysis and looks at how different approaches to data management can impact the resulting conclusions. Evaluating Risk Across the Portfolio “With a sharper focus on risk by regulators and other stakeholders, many institutional investors seek a fuller picture of how risk operates across investments within an entire portfolio,” said Frances Barney, head of Consulting-Americas for Global Risk Solutions at BNY Mellon, in a recent announcement. “Data is getting more and more critical and investors need to be informed and comfortable with the assumptions of their risk assessment, otherwise, they can come out of it with a false sense of security about their portfolio.” The paper’s key findings and insights into best practices include: A “granular approach” to risk evaluation is preferable, with position-level information for all asset classes “the gold standard.” This kind of position-level transparency, liquidity, and control may be available in dedicated managed accounts and liquid alts, as well as traditional hedge funds. Information accuracy is obviously important, and that’s why the paper argues for single-vendor sourcing of investment data. Using a single vendor promises uniform data, whereas drawing data from multiple sources increases the likelihood of errors. Different approaches to data management can lead to different conclusions about risk. Having a different approach for each asset class can be problematic, which is why many firms are establishing a Chief Risk Officer position to evaluate risks across all asset classes. Consistency is especially important in light of the regulatory environment. Some regulators already require reports on stress testing and scenario analysis, through Form PF for U.S. investment advisers to hedge funds; and pursuant to Solvency II for insurance companies, and UCITS for European investment funds. “We’ve learned the most crucial component is the veracity of the underlying data, which becomes even more important and difficult to manage as more opaque assets are held in the portfolio,” said Ms. Barney. Jason Seagraves contributed to this article.