Tag Archives: ideas

Targeting 35% Upside For The AES Corporation

Summary We are adding the AES Corporation to our “buy” list. Both the fundamental and technical analyses indicate a potential for a 35% gain over the next few years. The key risk is our assumption that cash flows do not materially deviate from their long-term uptrend. Introduction The AES Corporation (NYSE: AES ) has been exposed to a number of headwinds recently, most notably falling energy prices across the globe, rapidly appreciating U.S. Dollar and weak demand coming from the emerging markets, particularly Brazil, Argentina and Colombia. The most recent negative surprise was the Q3 revenue miss of as much as $1.5bn, which prompted the management to revise down their 2016 earnings guidance below analyst estimates. Cost cutting measures have been put forward to offset the macroeconomic headwinds by 2018 and we see them as a necessary adjustment. It is difficult to judge whether they work out as planned, but it is encouraging to see that the leadership is taking the appropriate steps to keep the business viable. Furthermore, Andres Gluski (the CEO) emphasized their focus on free cash flow as a source of shareholder value, and we believe that this is an appropriate measure for estimation of AES Corporation’s long-term investment value. Valuation Our valuation model for AES is based on the company’s ability to generate cash. The key measure of cash flows that we use is free cash flow, which is the total cash inflow from operations minus the dividends and capital expenditure outlays. This is effectively the amount of “excess” cash that the company is making and therefore accruing to its lenders and shareholders. While we do look at historic cash flows, cash flows projections are of crucial importance because markets are forward looking. Our estimated cash flows for the next 10 years are simply based on the previous trend, as we do not have access to analyst estimates for AES. After 10 years, we assume that the growth rate of cash flows falls back to its previous trend and remains on it for the next 10 years, after which it normalizes towards the sustainable rate of 3.9% per annum, based on the average real GDP growth over the last 15 years and the average inflation rate of 2%. The chart below shows the historic (blue line) and projected free cash flows (red line). (click to enlarge) To calculate the total value of the firm, we discount the projected cash flows and the company’s terminal value by its weighted average cost of capital ( OTC:WACC ). Our estimate of AES’s cost of debt is 7.28%, based on their interest expense and amount of debt outstanding in the last fiscal year. The cost of equity is calculated using the 10 year treasury yield as the “risk-free” proxy plus the implied equity risk premium of 9.13% times the historic beta of 1.1675 for the stock. Some of the other key metrics summarized below: •Beta = 1.17 •ERP = 5.98% •Cost of Debt = 7.28% •Cost of equity = 9.13% •Debt to Assets = 54.45% •WACC = 7.73% •Current Price = $9.9 •Fair Price = $26.52 (167.9% return) After discounting the projected free cash flows and the company’s terminal value in 10 years’ time, we subtract the current value of debt and arrive at the total equity value of 17,887,985, which equates to $26.52 per share. With today’s share price at $9.9, re-pricing towards the estimated fair value would require a return of 167.9%. The green line in the below chart represents the estimated “fair value” per share, with the dashed lines showing the upper and lower bounds of the confidence interval based on stock’s volatility. (click to enlarge) Relative Valuation American Electric Power Company (NYSE: AEP ), Pinnacle West Cap. (NYSE: PNW ), Firstenergy (NYSE: FE ), Nrg Energy (NYSE: NRG ), Consolidated Edison (NYSE: ED ), Cms Energy (NYSE: CMS ), Dte Energy (NYSE: DTE ), Entergy (NYSE: ETR ), Nextera Energy (NYSE: NEE ), Dominion Resources (NYSE: D ), Xcel Energy (NYSE: XEL ), Exelon (NYSE: EXC ), Ppl (PP and), Pg&E (NYSE: PCG ), Pub.ser.enter.gp. (NYSE: PEG ), Edison Intl. (NYSE: EIX ), Southern (NYSE: SO ), Teco Energy (NYSE: TE ), Pepco Holdings (NYSE: POM ), Eversource Energy (NU) are AES’s closest peers within the S&P 500. The table below can help us understand AES’s valuation in relative terms. Table 1: Relative Valuation Table, S&P 500 peers AES AEP PNW … Median Lower Quartile Upper Quartile PE 11.60 15.10 17.20 … 16.90 13.23 20.50 PC 2.48 6.31 6.33 … 6.31 4.81 6.83 PB 1.63 1.58 1.57 … 1.61 1.56 1.75 ROE 17.02 10.13 9.46 … 10.13 9.08 11.51 EPS Growth (5 year) -1.03 2.39 39.79 … 1.03 -1.73 6.80 Beta 1.17 0.58 0.72 … 0.59 0.55 0.69 AES Corporation benefits from very low price multiples, which indicates that the bad news are already in the price. price to earnings ratio of 11.6x is below the lower quartile for the group (13.2x). The same is the case for the price to cash flow and price to book multiples, currently standing at 2.5x and 1.6x, respectively. (click to enlarge) Even more importantly, the price to book ratio of 1.6x looks very attractive in the context of the return on equity of 17.0%. The chart above shows that this makes the company look significantly undervalued relative to peers, given the current industry relationship between this price multiple and underlying profitability. The stock looks attractive from the technical perspective as well. While in the short term the price could fall to as low as 8.6%, a failure to break below this level would confirm the wedge-like formation in play, targeting roughly 35% upside, depending on the timeframe. While a potential break below the support would imply further short term weakness, we see current price as an opportunity to buy due to the 2.5 times greater upside. Of course, if rate hikes in the U.S. push the U.S. dollar higher, investors will need to exercise more patience until the target is reached. (click to enlarge) Conclusion In summary, the company leadership has already taken action to counter the unfavorable impact of macroeconomic developments across the globe. The cost cutting measures that are aiming to support the free cash flow generation through 2018 may or may not work as planned, but investors should focus on risk management and diversification rather than crystal ball gazing. Our discounted cash flow model indicates roughly 35% upside (the lower end of the fair value range, the conservative target), which is also supported by long-term technicals. AES Corporation looks significantly undervalued relative to peers as well, thereby ticking all our boxes. As a result, we are adding this stock to our “buy” list today.

Investment Activity And The Illusion Of Control In Exchange For Low Real Returns

Study after study shows that more investment activity is correlated only with higher fees and lower real, real returns. Activity is the illusion of control in exchange for lower real, real returns. You don’t want to be irrationally long term, which usually results in huge amounts of short-term permanent loss risk. But you also don’t want to be so short term that you take no risk. The best way to reduce taxes and fees in your portfolio is to take a long-term perspective. Again, a multi-year or cyclical time frame blends perfectly with maximizing your real, real returns. I take a cyclical view on things. This means I can sometimes go years without making big changes in my views or portfolio. This is a very intentional construct, and I think it’s one that most people should adhere to. After all, you don’t want to be irrationally long term , which usually results in huge amounts of short-term permanent loss risk. But you also don’t want to be so short term that you take no risk. As we find with so many things in life, moderation is the key. Hence, my cyclical or multi-year perspective on things. Resolving this temporal problem isn’t the only reason for this, though. We know that taxes and fees are two of the most important frictions in a portfolio. And the best way to reduce taxes and fees is to take a long-term perspective. Again, a multi-year or cyclical time frame blends perfectly with maximizing your real, real returns . Of course, this is easier said than done. We live in a world dominated by “What have you done for me lately” narratives. And worse, we are confronted with our own biases that make us feel comfortable when we’re doing something. After all, letting your portfolio float in the wind feels very uncontrolled, and oftentimes, uncomfortable. Activity is the way in which we try to “control” the markets. Of course, you can’t control the decisions of other market participants. And study after study shows that more activity is correlated only with higher fees and lower real, real returns. Yet, the allure of greater control pulls us in. Activity is the illusion of control in exchange for lower real, real returns. Luckily, there is a happy medium here. There is no need to be irrationally long term or short term. But it takes a great amount of discipline to reject the illusion that activity creates control. For most, that illusion (and the sales pitch of “market-beating returns” that often goes with it) is too enticing to reject.

Myopia & Market Function

Benartzi defines myopic loss aversion as making “investment decisions based on short-term losses in their portfolio, ignoring their long-term investment plan.”. Myopic loss aversion can arise when investors check their account balances or the prices of their holdings which thanks to technology has become increasingly more convenient to do. We know that there will be future bear markets and probably another crisis or two in most of our lifetimes. By Roger Nusbaum AdvisorShares ETF Strategist The Wall Street Journal posted an article written by Shlomo Benartzi who is a professor at UCLA specializing in behavioral finance. The article primarily focuses on the behavioral problems, like myopic loss aversion, that can arise when investors check their account balances or the prices of their holdings which thanks to technology has become increasingly more convenient to do. Benartzi defines myopic loss aversion as making “investment decisions based on short-term losses in their portfolio, ignoring their long-term investment plan.” Benartzi cites that the stock market has a down day 47% of the time, a down month happens 41% of the time, a down year 30% of the time and a down decade 15% of the time. We’ve talked about this before going back before the crisis albeit with some different wording. Before and during the last major decline, as well as many times since then, I’ve said that when the market does take a serious hit that it will then recover to make a new high with the variable being how long it takes. While this seems obvious now it is one of many things frequently forgotten in the heat of a large decline. Additionally we know that there will be future bear markets and probably another crisis or two in most of our lifetimes. And those future bear markets/crises will take stocks down a lot which will then be followed by a new high after some period of time. This is not a predictive comment this is simply how markets work with Japan being a possible stubborn exception that proves the rule. It took the S&P 500 five and half years to make a new nominal high after the “worst crisis since the great depression.” If you are one to use some sort of defensive strategy, it is hopefully one that you laid out when the market and your emotions were calm and your strategy probably doesn’t involve selling after a large decline. My preference is to start reducing exposure slowly as the market starts to show signs of rolling over. Very importantly though is that if you somehow miss the opportunity to reduce exposure, time will bail you out….probably. I say probably based on when a bear market starts in relation to when retirement is started. If a year after retiring, a 60% weighting to equities that cuts in half combined with a life event at the same time that requires a relatively large withdrawal (this is not uncommon) it will pose some serious obstacles. I think the best way to mitigate this is, as mentioned, a clearly laid out defensive strategy but not everyone will want to take on that level of engagement. In that case it may make sense for someone very close to retirement and having reached their number (or at least gotten close) to reduce their equity exposure. Not eliminate, but reduce. Back to the idea of myopic loss aversion and how to at least partially mitigate it. Knowing how markets work and then being able to remember how they work will hopefully provide an opportunity to prevent emotion from creeping in to process and giving in exactly as Benartzi describes.