Tag Archives: investing

Fed Rate Hike Wait May End Today: ETFs To Gain And Lose

After keeping the interest rates at near-zero levels for seven years, the Fed is expected to exit the historic loose monetary policy era at the FOMC meeting to be concluded later today. Per the latest Wall Street Journal poll, about 97% of the economists believe that the Fed will raise rates today while the rest expect the Fed to wait until next year. The probability of a lift-off today is 87% as per private economic forecasters and 83% according to CME Group. Since the Fed has indicated a gradual path for rates hike, the market is speculating at least a quarter percentage point increase in interest rates today. The Fed officials gave strong signals of a December lift-off in recent months. This is especially true, as the U.S. economy has now emerged from the financial crisis and the Great Recession, and is on a firmer footing. With back-to-back months of solid jobs growth, unemployment rate at a seven-year low and moderate inflation, chances of the first rate hike in almost a decade is now looking more real. Additionally, stepped-up economic activities, rising business and consumer confidence, increasing consumer spending, and recovering housing fundamentals will continue to fuel growth in the world’s second largest economy. Further, major headwinds that have plagued the financial market seem to have faded with substantial positive developments in the global economy. In particular, the Chinese economy is showing signs of stabilization while the Japanese and European central banks have ramped up more stimulus measures to revive their economies. Given the improving fundamentals, the historic turn is widely expected, but a collapse in oil prices, which is raising fears of deflation, is weighing heavily on the Fed action. That being said, several ETFs are in focus on the upcoming Fed decision. A few ETFs will be rewarded if the Fed raises rates or signals a hawkish outlook while a few will be severely impacted. Let’s have a look to those: ETFs to Gain SPDR S&P Regional Banking ETF (NYSEARCA: KRE ) A rising interest rate scenario would be highly profitable for the financial sector as a whole. This is because the steepening yield curve would bolster profits for banks, insurance companies and discount brokerage firms. In particular, the ultra-popular KRE, having an AUM of $2.7 billion and average daily volume of 4.7 million shares, will benefit the most. The product follows the S&P Regional Banks Select Industry Index, charging investors 35 basis points a year in fees. Holding 93 securities in its basket, the fund is widely spread out across each security with an equal-weight approach of around 1%. The product has a Zacks ETF Rank of 2 or “Buy” rating with a High risk outlook. PowerShares DB USD Bull ETF (NYSEARCA: UUP ) Rising interest rates will pull in more capital into the country and lead to an appreciation of the U.S. dollar. UUP is the prime beneficiary of a rising dollar as it offers exposure against a basket of six world currencies – euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc. This is done by tracking the Deutsche Bank Long U.S. Dollar Index Futures Index Excess Return plus the interest income from the fund’s holdings of U.S. Treasury securities. In terms of holdings, UUP allocates nearly 57.6% in euro while 25.5% collectively in Japanese yen and British pound. The fund has so far managed an asset base of $1.2 billion while it sees an average daily volume of around 2.1 million shares. It charges 80 bps in total fees and expenses, and has a Zacks ETF Rank of 3 or “Hold” rating with a Medium risk outlook. Deutsche X-trackers MSCI EAFE Hedged Equity ETF (NYSEARCA: DBEF ) The diverging policy in the U.S. and the rest of the world will definitely compel investors to recycle their portfolio into the currency-hedged ETFs. For those seeking exposure to the developed market with no currency risk, DBEF could be an intriguing pick. The fund follows the MSCI EAFE U.S. Dollar Hedged Index and holds 931 securities in its basket, with none accounting for more than 1.92% share. The product is skewed toward the financial sector with one-fourth of the portfolio while consumer discretionary, industrials, consumer staples and healthcare round off the top five with double-digit exposure each. Among countries, Japan takes the top spot at 24%, closely followed by the United Kingdom (18%), Switzerland (10%) and France (10%). The ETF has an AUM of $13.0 billion and trades in solid volume of more than 4.1 million shares a day. It charges 35 bps in fees per year from investors and has a Zacks ETF Rank of 3 with a Medium risk outlook. iPath U.S. Treasury Steepener ETN (NASDAQ: STPP ) As yield rises, bonds and the related ETFs fall. But this product directly capitalizes on rising interest rates and performs better when the yield curve is rising. The ETN looks to follow the Barclays U.S. Treasury 2Y/10Y Yield Curve Index, which delivers returns from the steepening of the yield curve through a notional rolling investment in U.S. Treasury note futures contracts. The fund takes a weighted long position in two-year Treasury futures contracts and a weighted short position in 10-year Treasury futures contracts. STPP charges 0.75% in fees and expenses while volume is light at around 1,000 shares a day. Additionally, it is an unpopular bond ETF with an AUM of just $2.6 million. ETFs to Lose SPDR Gold Trust ETF (NYSEARCA: GLD ) Gold will continue to remain under immense pressure as higher interest rates would diminish gold’s attractiveness since the yellow metal does not pay interest like fixed-income assets, and the product tracking this bullion like GLD will lose further. The fund tracks the price of gold bullion measured in U.S. dollars, and kept in London under the custody of HSBC Bank USA. It is the ultra-popular gold ETF with an AUM of $21.6 billion and average daily volume of around 6.1 million shares a day. Expense ratio came in at 0.40%. The fund has a Zacks ETF Rank of 3 with a Medium risk outlook. iShares Mortgage Real Estate Capped ETF (NYSEARCA: REM ) Mortgage REITs could be in more trouble if the Fed starts raising rates as short-term rates would rise faster than the long-term rates, thereby leading to a tight spread and lower profits for mREIT companies. REM is the most popular mortgage REIT ETF with an AUM of $819.2 million and average daily volume of less than 1 million shares. The ETF tracks the FTSE NAREIT All Mortgage Capped Index and holds 38 securities in its basket with large allocations to the top two firms – Annaly Capital (NYSE: NLY ) and American Capital Agency (NASDAQ: AGNC ). These firms collectively make up for 26.4% share while other securities hold no more than 8.5% share. The fund charges investors 48 bps a year in fees and has a Zacks ETF Rank of 3 with a Medium risk outlook. iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA: HYG ) The high-yield corner of the fixed income world is the most watched area ahead of the Fed meeting. This is because the exit from the rock-bottom interest rate policy would raise yields on the Treasury notes, thereby fading the sole lure of the high-yield bonds. HYG is the largest and most liquid fund in the high-yield bond space with an AUM of over $14.4 billion and average daily volume of around 9 million shares. It charges 50 bps in fees per year from investors. The fund tracks the iBoxx $ Liquid High Yield Index and holds 1,009 securities in the basket. Effective duration and average maturity came in at 4.340 and 5.44 years, respectively. The ETF has a Zacks ETF Rank of 4 or “Sell” rating with a High risk outlook. iShares MSCI Emerging Markets ETF (NYSEARCA: EEM ) The end of a cheap and an abundant dollar era would pull out more capital from the emerging markets, stirring up concern for most nations. Additionally, a prolonged weakness in commodities has been dampening the appeal for these markets. The most popular emerging market ETF – EEM – tracks the MSCI Emerging Markets Index and charges 68 bps in annual fees from investors. Holding 846 securities, the product is widely spread out across various securities with none holding more than 3.51% of assets but is tilted toward the financial sector at 27.5%, followed by information technology (21.2%). Among the emerging countries, China takes the top spot at 26.3% while South Korea and Taiwan round off the next two spots with double-digit exposure each. The fund has a Zacks ETF Rank of 3 with a Medium risk outlook. Original post

Why PE Ratios Are Not A Good Measure Of Value

Summary PE ratios are commonly used as a metric to determine “value”. However, PE ratios are unreliable for a number of reasons and earnings actually have no correlation with valuations. Return on invested capital is a better measure of value and has significant correlation with valuation. We’ve pointed out the flaws in the price to earnings (PE) ratio many times before. Chief among these flaws is the fact that the accounting earnings used in the ratio are unreliable for many reasons: Accounting rules can change, shifting reported earnings without any real change in the underlying business. The large number of accounting loopholes makes it easy for executives to mislead investors. PE ratios overlook assets and liabilities that have a material impact on valuation. It should come as no surprise that empirical research shows accounting earnings have almost no impact on long-term valuations. No Correlation Between Earnings And Value If accounting earnings actually drove valuations, then companies with high EPS growth should command higher multiples, and companies with low or negative EPS growth should have lower PE multiples. As Figure 1 shows, this correlation is nearly nonexistent. Figure 1: EPS Growth Has Almost No Impact On Valuation (click to enlarge) Sources: New Constructs, LLC and company filings. The r-squared value of 0.0006 in Figure 1 shows that EPS growth over the past five years explains less than one tenth of one percent of the difference in price between stocks in the S&P 500. Stocks can see their PE multiples expand and contract in a manner that has almost nothing to do with changes in EPS, which makes looking at these metrics a poor indicator of valuation or future returns. The Market Cares More About ROIC Many other studies have found the same lack of correlation between earnings growth and stock price. Instead, we find that valuations tend to be driven largely by return on invested capital ( ROIC ). Figure 2 shows that ROIC is highly correlated with Enterprise Value/Invested Capital (a cleaner version of price to book). Figure 2: ROIC Is The Primary Driver Of Stock Price (click to enlarge) Sources: New Constructs, LLC and company filings. ROIC explains nearly two thirds of the difference in valuations between various companies. That means companies that can improve their ROIC are more likely to grow their stock price in the market. Short Term Vs. Long Term Drivers “But wait!” you might be saying. “I know accounting earnings have an impact on valuations. I’ve seen stock prices rise and fall dramatically based on a company’s quarterly earnings report.” This is true. It’s clear that headline numbers can have an immediate and sometimes dramatic influence on stock prices. The key word in that sentence is “immediate”. A big increase in EPS might drive short-term gains in stock prices, but it won’t create long-term value. To understand the cause of this divergence, you have to understand the different types of investors in the market. Brian Bushee from the Wharton School of Business wrote an excellent paper back in 2005 that highlighted the behavioral differences among institutional investors. His research found that: 61% of institutional investors are “Quasi-Indexers”. They hold many small stakes with low turnover, so they have little impact on market valuations. 31% of institutional investors are “Transients”. They have small stakes but a high turnover, so their high volume of trading can impact valuations in the short term. 8% of institutional investors are “Dedicated”. They take large stakes and hold them for a very long time. These are the investors that drive long-term valuations. A big earnings beat might cause a lot of “Transient” investors to buy that stock, pushing up the price, but most of these investors will sell their stakes not long after, pushing the price back down. They can create spikes, but their impact on the long-term performance of the stock is next to nothing. Instead, it’s that small percentage of “Dedicated” investors that are responsible for the majority of long-term performance. These are highly sophisticated individuals that take a long time evaluating stocks before taking large positions that they hold through bouts of volatility. Why You Have To Look At The Balance Sheet And Cost Of Capital The central flaw of the PE ratio holds true for many of the other common ratios such as: Enterprise Value/EBITDA Price to Earnings Growth (PEG) Price to Operating Cash Flow Price to Sales All of these ratios ignore the cost of the capital that the company uses to drive profits. To understand why cost of capital is so important, imagine this hypothetical scenario: you have an infinitely wealthy investor who is willing to offer you an unlimited source of equity capital. You take the money from this investor and put it in a low-yielding savings account. The more money you take from this investor, the more your interest payments, or “earnings”, will grow, but you’re not actually creating any value. In fact, by earning such a low return on that money compared to what they could earn elsewhere, you’ve actually destroyed value. The use of these flawed metrics perpetuates the irrelevant distinction between growth and value investing . Earnings growth without an ROIC above the weighted average cost of capital ( WACC ) destroys value, and value without growth limits upside. While ROIC is, by far, the most important driver of value, it is not the only factor. One must also consider revenue growth and duration of profit growth, i.e. growth appreciation period ( GAP ). These three drivers comprise everything that defines the profitability and, therefore value, of a company. PE and PEG are driven by these drivers, not the other way around. The same concept applies to companies that grow EPS by deploying capital at suboptimal rates of return. As we discussed in ” The High-Low Fallacy “, an acquisition can be accretive to earnings but destructive to shareholder value. Recent Danger Zone pick Expedia (NASDAQ: EXPE ) has managed significant EPS growth through $3.2 billion in acquisitions, but these acquisitions have actually hurt the long-term interests of shareholders by earning an ROIC that falls short of WACC. For that reason, investors need to be looking at ROIC rather than EPS, and they need to recognize that a PE multiple tells you next to nothing about the actual value of a stock. Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, style, or theme.

Stock Market Control

Summary History shows there is a one in three chance that stocks will drop each year regardless of whatever happened the prior year. We think there are certain things we can’t control in the stock market. We try to control what we own, how cheap it is, how often we make changes to our portfolio and quality from the companies we own. We saw the chart below in a recent Marketwatch.com column from Mark Hulbert. It shows the likelihood of the stock market going up or down in the next year, based on how it did the prior year: This got us thinking about what you can and can’t control in the U.S. stock market. After all, the reason that stocks outperform other liquid asset classes over long stretches of time is the uncertainty and variability of returns. Here is a short list of things, which can’t be controlled in the U.S. stock market: 1. Stock market results The chart shows that there is a one in three chance that stocks will drop each year regardless of whatever happened the prior year. We don’t think investors should buy or own common stocks if they feel emotionally ill-equipped to withstand a losing year. 2. Stock Market Volatility Even in good years, stocks can swing wildly from week to week and month to month. The average year sees a peak to trough decline of 10%, and we have seen a 20% or greater decline about once every five years on average. Twice in the last 16 years, we saw the S&P 500 Index decline by more than 30%. Granted, that is an unusual occurrence, since there have been only five such declines since 1940. We remember telling common stock investors near the bottom of the stock market in March of 2009 that it would likely take about four years to get their portfolio value back to where it was before the decline in 2008-09. Those courageous and patient investors have been well rewarded by the bull market since then. An owner of common stocks should expect gyrations as part of the price of admission and use holding periods, which allow for recovery and success. The wise investor seeks to use wide, sharp and emotional price swings in their favor. 3. Stock Market Unpredictability I am approaching my 36th year participating in the U.S. stock market and can say that nobody has proven any consistent ability to predict price moves in the indexes. I’ve read the prognostications of Joe Granville, Stan Weinstein, Marty Zweig, Comstock Partners, Robert Prechter, George Gilder, Nouriel Roubini, Meredith Whitney and numerous other very smart people in my career. The one thing they have in common is they attracted a large following after being very right on a major stock market prediction. However, doing so consistently is a bit like trying to find the pot of gold at the end of the rainbow. We recently read the musings of a highly respected asset allocation firm about their seven-year predictions of asset class returns. Their prediction for the U.S. stock market is extremely negative, which would scare a normal observer and could very well end up being valid. However, we have been reading their predictions for the last ten years and have seen their consistent pessimism for U.S. stocks. We also remember their optimism about emerging markets and commodities. Surely, these predictions from the last five years must have cost someone who followed their advice some serious money. 4. Relative Performance A study of the best stock picking disciplines of the last 60 years (Buffett, Neff, Templeton, Lynch and Carret) showed that they underperformed the S&P 500 Index 35% of the calendar years during their long and illustrious track records. We expect to be subject to those statistics at best and have very little control over which years we get beat by the index. Our goal is to beat the stock market over ten and twenty-year time periods and we believe those results would be unattainable if you try and smooth that truth. Things We Seek to Control We’re not about being glum or dour. We certainly believe there are things that investors can control. We’ve outlined three key tenets to consider when investing in common stocks. 1. Valuation Matters Dearly You can control which stocks you own, and you are free to emphasize stocks, which are cheap in relation to profits, free cash flow, dividends or book value. Studies show that results are improved over both short and long term holdings periods by constantly reemphasizing cheaper common stocks. This requires a contrarian nature, because when these common stocks are cheap their warts show easily. Therefore, you need to be lonely and courageous. 2. Activity Eats into Returns A wise financial advisor told us in early 2012 that a stock portfolio is like a bar of soap: the more you rub it, the smaller it gets. A 2013 study in the Financial Analysts Journal showed that the average turnover among U.S. large-cap equity funds has been 62% and it costs the average equity mutual fund in the database 0.81% (81 basis points) per year in returns. We seek to own securities for an average of over seven years and attempt to save significantly on trading costs by doing so. If you can control yourself and be very patient, we think you can improve long-term results. 3. Quality Adds Alpha and Promotes Patience Studies have shown that qualitative characteristics like a strong balance sheet, consistently high profitability and low earnings variability add to returns over long time periods. These qualities give owners more ability to stay put in bad stock market environments and/or when a company temporarily stumbles. Riding through thick and thin can be controlled and is augmented if there is no threat of one of your companies going out of business. Again, if you can control yourself, you can use long-durations to let quality help you overcome the forces you can’t control. Conclusion We make no effort to have any control over stock market results, volatility, unpredictability and relative performance. We haven’t got any special ability to know what stocks will do next year or how we will fare on a relative basis. What we do try to control is what we own, how cheap it is, how often we make changes to our portfolio (we subscribe to “lethargy bordering on sloth” – Warren Buffett) and what kind of quality we demand from the companies we buy and own. We do this based on our eight criteria for stock selection. In practicing our discipline, we seek high quality companies, purchased at bargain prices and have a desire to hold them for long time periods. In other words, we try to control ourselves, our portfolio and apply long-durational and favorable probabilities. The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Bill Smead, CIO and CEO, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.