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Pair Trading Opportunity – AGL Resources And Piedmont Natural Gas

Summary Two deals in the same sector with similar conditions and similar payment methods — the perfect situation for implementing a pair trading strategy. Because of regulation, this will be a very long process. So the pair trading strategy is more profitable than a classic merger arbitrage. In my opinion, if the authorities block one of the transactions the other merger will automatically have a lot problems. This risk should be hedged. I have to admit it: I hate mergers with a lot of regulatory conditions and economic intervention . I’m not a lawyer, so I’m not an expert in terms and conditions and I avoid these transactions. However, we can sometimes see very good opportunities in the M&A markets because of similar deals pursuant to the same antitrust approvals. On Aug. 24, 2015, Southern Company (NYSE: SO ) and AGL Resources (NYSE: GAS ) announced a merger agreement. Sometime later, on Oct. 26, 2015, Duke Energy (NYSE: DUK ) and Piedmont Natural Gas (NYSE: PNY ) approved another merger agreement with similar terms and conditions. Both transactions will be paid in cash, and their size is comparable: $12 billion and $6.7 billion, respectively. In this article, I will only assess the terms and conditions of both mergers. If you want to understand more about the financial performance of the companies, check our these articles: Buyers Duke is the largest electric utility in the United States. It serves 7.3 million customers, located in the Southeast and Midwest. It has an enterprise value of $88.01 billion and $1.38 billion cash on the balance sheet; its ROA is 2.83%. You can check some more numbers here. Source: I nvestor Presentation . It is a mature company, with an interesting dividend yield as well as a high payout ratio: Source: Investor Presentation. You can only see this type of payout ratio in mature industries. Merger arbitrage analysts might say that they like this transaction or not, but the fact is that the sector is in a phase of consolidation and mergers will occur. Southern serves more than 4.5 million customers, and it is the leader in the southeast portion of the United States. It has an enterprise value of $67.48 billion and $1.12 billion in cash; its ROA is 3.74%. You can check some more numbers here. Source: Investor Presentation . I would like to mention that the buyers are very big players. Their size is comparable, and the only difference is that they operate in different areas. The negotiation process with the authorities will be the same. Because of this fact, the merger spread should be similar. Targets and Transitions Benefits Piedmont has one million customers in portions of North Carolina, South Carolina, and Tennessee. It has a better ROA than its acquirer (3.54%), and it is also more than 10 times smaller than Duke. The transaction is an interesting move. Duke’s objective is to enhance its regulated business mix. What’s more, this merger creates a strong platform for future growth. AGL is based in Atlanta. It provides energy services to 5.5 million utility customers (including over one million retail customers served by the SouthStar Energy Services joint venture). Its ROA is 3.84%, which is better than that of the buyer. This transaction is a little better than the other one. It is accretive to ongoing EPS in the first full year, and it will create a strong credit profile. Source: Investor Presentation . Overall, the targets are very similar. It looks like a copied transaction, both in size (“same customer base”) and in value. As mentioned earlier, because of this fact the merger spread should be approximately the same. Terms, Conditions and Timing If you are interested, you can read the merger agreement of Duke’s transaction here and that of Southern here . Both mergers are pursuant to the shareholders’ approval. I did not read about any shareholders complaining about the price paid. So, I’m not worried about these conditions. It is more important, in this case, to assess the regulatory conditions. Southern’s transaction is subject to the following regulatory conditions: – The receipt of antitrust clearance in the United States (Hart-Scott-Rodino Act) – The approval of the FCC – The approval of the California Public Utilities Commission, Georgia Public Service Commission, Illinois Commerce Commission, Maryland Public Service Commission, New Jersey Board of Public Utilities and Virginia State Corporation Commission and other approvals required under applicable state laws. Source: Merger Agreement. Duke’s transaction is subject to the following antitrust conditions: – The receipt of antitrust clearance in the United States (Hart-Scott-Rodino Act) – “The merger is subject to the approval of the NCUC. The Company and Duke Energy expect to file in or around January 2016 a joint application for approval by the NCUC of the merger. Section 62-111(a) of the North Carolina General Statutes provides that no merger or combination affecting a public utility may be made through acquisition or control by stock purchase or otherwise without written approval from the NCUC. Under this statute, such approval shall be given if justified by the public convenience and necessity. The Company is a public utility under North Carolina law and two of Duke Energy’s subsidiaries are also public utilities under North Carolina law. Source: Merger Agreement. I do not think that any merger arbitrageur will tell you the outcome of these mergers. It is a very technical question that you might only be able to answer if you have worked approving mergers for a while. So I would not implement a classic merger arbitrage strategy here. I do not like gambling. The pair trading strategy that I will explain below reduces the exposure to these regulatory risks. Overall, the mergers will take a long time because of these regulatory conditions. Both transactions are said to close in the second quarter of 2016. Pair Trading Strategy and Conclusion Duke will pay $60 per share in cash, so the merger arbitrage spread is 5.24% ($60/$57.01 (close on Dec. 11, 2015) – 1). What’s more, we have to include four quarterly dividends paid by Piedmont (0.33 per share; I included the fourth quarterly dividend of 2015 but not that of 2016). So, the merger contribution is $61.32, and the calculated spread is 7.56% ($61.32/$57.01 – 1). Southern will pay an amount of $66.00 per share in cash, so the merger arbitrage spread is 5.21% ($66/$62.73 (close on Dec. 11, 2015) – 1). However, if we include the four quarterly dividends that AGL distributes (0.51 per shares), the merger contribution becomes $68.04, and the calculated spread is 8.46%($68.04/$62.73 – 1). The most recent evolution of the calculated spread can be seen in the following figure: Source: Maudes Capital. I would like to mention that the spread of both companies is somewhat correlated. It makes sense because of the facts explained above. In the future, the evolution will be similar so that you can perfectly implement a pair trading strategy. Today, I would buy PNY shares, and use the same amount of money to short sell GAS. You can make more than 1% return in a short period of time. The best thing in this idea is that you eliminate the regulatory risk included in both transactions. If one merger does not close, the other merger will have a lot of issues as well, and the spread will be enlarged. This means that you hedge the loss in one merger with the gains in the other transaction. To make a long story short, these transactions have a lot of regulatory conditions, and the classic merger arbitrage strategy is not a good idea. The pair trading strategy provides a better risk/return ratio. What’s more, both mergers are necessary moves in the same sector, and therefore good M&A ideas. I believe that both transactions will close, but I do not like playing with regulatory conditions. So, I prefer to hedge the risk. Note: At the moment there are some other merger arbitrage and pair trading investments like this one — you can read about them here , here , and here .

Melt-Up Or Meltdown?

Summary U.S. market capitalization weighted indexes have outperformed in 2015. The largest U.S. capitalization stocks have melted up, and this trend forged ahead in 2015. Under the surface, the meltdown of out-of-favor assets has accelerated. Either a broader melt-up or meltdown scenario remains a probable outcome. A large cash weighting and an exposure to out-of-favor assets (a barbell approach) is an ideal portfolio strategy for this environment. “A dramatic and unexpected improvement in the investment performance of an asset class driven partly by a stampede of investors who don’t want to miss out on its rise rather than by fundamental improvements in the economy.” – Definition of “Melt Up” from Wikipedia “A rapid or disastrous decline or collapse” – Definition of “Meltdown” from Merriam-Webster “To buy when others are despondently selling and to sell when others are avidly buying requires the greatest fortitude and pays the greatest ultimate rewards.” – Sir John Templeton – 1958 Introduction I have written two articles on the stealth U.S. bear market on Seeking Alpha in 2015. In part one of this series, authored on July 9th, 2015, I examined building negative divergences in the U.S. stock market, and those divergences ultimately foreshadowed the August market sell-off. In part two , authored on December 1st, 2015, I highlighted two distinct markets under the surface of the U.S. stock market, profiling the “Winning” and “Losing” companies, and their distinctive stock prices. The conclusion of that piece suggested buying the “Losers” and selling the “Winners”, which, as a contrarian, I have openly advocated for over the last several years, with little success thus far, and a whole lot of pain. Third Avenue confirmed last week that this advice remained too early, as credit markets continued to seize up, with high-yield bond prices undercutting their August lows. As yield-chasing and bottom-fishing investors continue to be punished, the world’s central banks, with the notable absence of the Federal Reserve (who may have to shift course from their tightening rhetoric very soon), remain poised to inject further liquidity into the system. The end result is that more than any time in recent history, the markets are dually poised for a climatic melt-up or meltdown scenario. Proponents of the melt-up scenario will argue that many investors who capitulated in 2008 and 2009 remain out of the market, providing a wall of worry to climb. Advocates of the meltdown scenario believe that stock market divergences have been developing for years, setting the stage for a historic unwind, as low-conviction investors bail out of their thinking that stocks are the only game in town. Which direction will the market break, and how should investors position their portfolios? Thesis Melt-up and meltdown scenarios are equally plausible for U.S. equity investors. Thus, a barbell approach, where a high cash weighting is combined with extreme out-of-favor assets remains the best approach. QQQ> SPY> RSP> IWM In the U.S. stock market in 2015, a bigger market capitalization has correlated very positively with outperformance. This can be illustrated by looking at the performance of the PowerShares QQQ ETF (NASDAQ: QQQ ), which is designed to track the performance of the NASDAQ 100 Index, which counts five of the world’s ten largest market capitalization companies among its largest holdings, Apple (NASDAQ: AAPL ), Alphabet (NASDAQ: GOOGL ), Microsoft (NASDAQ: MSFT ), Amazon (NASDAQ: AMZN ), and Facebook (NASDAQ: FB ). These aforementioned companies are weighted more heavily in the PowerShares QQQ ETF, than they are in the S&P 500 Index, as measured by the SPDRs S&P 500 ETF (NYSEARCA: SPY ), and their weightings in the respective indexes are responsible for a large portion of the outperformance of the QQQ (up 8.06% YTD) over the SPY (down 0.35% YTD) as shown in the charts below: An equal-weighted version of the S&P 500 Index, which is represented by Guggenheim S&P 500 Equal Weighted ETF (NYSEARCA: RSP ), is disadvantaged by its lower relative weighting to the biggest market capitalization companies, and it is down over 4% in 2015. Moving further down the market capitalization spectrum, U.S. small capitalization stocks, which are prominently measured by the Russell 2000 Index, represented by the iShares Russell 2000 ETF (NYSEARCA: IWM ), are down over 5% in 2015. From the charts above, clearly the performance of the U.S. stock market in 2015, has been heavily influenced by investor flows and fund flows to larger companies, who are perceived to offer an attractive combination of safety and growth potential in a slowing global GDP world economy. AAPL, AMZN, GOOGL, FB, MSFT = Amazing It cannot be overstated how important Apple, Amazon, Alphabet, Facebook, and Microsoft have been to the performance of the U.S. stock market in 2015. These five stocks and one other, Netflix (NASDAQ: NFLX ), have accounted for the vast majority of the market capitalization gain in the S&P 500 Index, and the resilience of their stock prices in the face of broader market weakness, has kept the market capitalization indexes from showing far greater losses on a year-to-date basis. Visually, the contrast of their stock charts is stunning to see, so I have included charts of AMZN, GOOGL, and MSFT as follows: By itself, Amazon has added $150 billion dollars in market capitalization in 2015. That is amazing, especially when it was viewed as overvalued by a majority of investors entering 2015. The ominous takeaway from the dominance of a handful of stocks is that this concentrated leadership often marks the tops of bull markets, and one only has to look back to March of 2000, when six stocks accounted for the entirety of the gain of the S&P 500 Index, to see a similar, negative reference point. A Meltdown Alongside A Melt-Up? While the broad market averages bounced back strongly following their August 2015 lows, high yield bonds, as measured by the SPDR Barclays High Yield Bond ETF (NYSEARCA: JNK ) and iShares iBoxx High Yield Corporate Bond Fund (NYSEARCA: HYG ), only managed a weak recovery, and have subsequently made new lows as shown in the charts below: Many analysts have attributed the unrelenting sell-off in high-yield bonds to the ongoing carnage in the commodities sector, specifically the energy market, which had extensively used high-yield financing. The fall of oil, as measured by the United States Oil Fund (NYSEARCA: USO ), seems to add credence to this thought process. Crude oil, which is down nearly 50% in 2015, after a difficult 2014, and natural gas, which is represented by the United States Natural Gas Fund (NYSEARCA: UNG ), down nearly 50% as well, which is shown in the chart below, both demonstrate how difficult the operating environment has been for energy firms. The end result is that stocks like Chesapeake Energy (NYSE: CHK ), the second largest natural gas producer in the U.S, and a major oil producer, with some of the best land acreage in the industry, has seen its shares devastated, down over 78% in 2015. Even better operators, like Antero Resources (NYSE: AR ) have lost over 50% of their market capitalization. The energy unwind has even spread to solar companies, which seemingly have the world’s political tailwinds at their back. This is best evidenced by the dramatic decline in SunEdison (NYSE: SUNE ), a company I recently authored a contrarian article on , whose shares have fallen precipitously since making their highs in July of 2015. The high-yield bond market, commodities, and a large number of dislocated stocks clearly show that there has been an ongoing meltdown, which has been partially obscured by the outperformance of a narrow group of mega capitalization technology stocks. A Fork In The Road With a large number of stocks already in their own bear markets, which can be defined as being off 20% from their highs, but the broad market indexes still far from a bear market, what is the best course of action for investors? There are two possible, probable scenarios that are as different as night and day. First, in an optimistic light, the correction in asset markets may have already run its course. If the market leadership stocks can simply tread water, any improvement in the economically sensitive, out-of-favor sectors of the market, could initiate a rotation that propels broad market indexes to new highs, climbing the proverbial wall of worry. Market analysts that reference this scenario, often recall an overvalued market getting more overvalued, similar to the NASDAQ market in 1998 to 2000. This is the melt-up scenario. The second scenario is decidedly more bearish. Its interpretation would be that the weakness in commodity prices is foreshadowing the next recession. Thus, high-yield bonds, at their current levels, could be fairly priced, not mispriced, and if that is the case, they are indicative of a fair value of 1,650 for the S&P 500 Index, which would be an 18% decline from its closing price on December 11, 2015. Under this scenario, with valuations where they are today (see the below chart from Ned Davis), the markets could gather momentum on the downside, so the ultimate sell-off could cut much deeper, hence the risk of a meltdown. (click to enlarge) The Barbell Approach On December 7th, 2015, I authored a portfolio strategy article on Seeking Alpha, which has generated a terrific commentary section, titled “Why A 90% Cash Portfolio Will Probably Outperform”. In this article, I investigated the merits of an extreme portfolio approach given the uncertain environment, where 90% of an investor’s portfolio was kept in cash, and the remaining 10% was invested in a concentrated portfolio of deep-value, distressed equities. The graphic I produced to illustrate the merits of the portfolio is replicated below: (click to enlarge) On December 7th, 2015, I also lau nched ” The Contrarian “, a p remium research service on Seeking Alpha. As part of my research service, I have several model portfolios that I am tracking with real-world transactions, so that readers can see a working example of my portfolio theory. One of the portfolios I am tracking with positions is the “90/10 Portfolio”, which I am posting an update on today. With the S&P 500 Index retreating 3.7% for the last week, the “90/10 Portfolio” was actually positive for the week. While admittedly this is a small sample size, it shows the benefit of this extremely conservative/aggressive approach. Conclusion Large-capitalization stocks are the locomotive that keeps pulling an otherwise unhealthy market train forward up a steep hill. Active managers continue to struggle, as has been the case for nearly this entire seven-year bull market, as a narrower and narrower group of stocks have led the market averages higher. The negative divergences could be signaling the start of a significant downturn, or the general apathy and frustration towards a large swath of individual stocks could signal a significant wall of worry to climb in the future. The prevailing thought in the markets is akin to this quote from Steven Roge, in the previously linked Bloomberg piece on Third Avenue, “The past few years (have not) been a good time to be a contrarian investor…Investors in that group have been trying to catch a falling knife that keeps on falling.” Reversion to the mean is one of the most powerful forces in the financial markets. Today, a reversion to the mean in the broad market indices would imply seven years of zero-to-negative returns. For out-of-favor assets, however, a ‘reversion to the mean’ trade could spark a powerful upside move that is unexpected given the current headwinds facing the out-of-favor companies. A barbell approach works in this environment. From my perspective, for the first time since 2009, it is an ideal time to be a contrarian, and today that would mean a barbell approach heavily weighted towards unloved assets, like cash, and out-of-favor equities, like commodity stocks. For more information , please peruse my research in “The Contrarian”.

Market Lab Report – Premarket Pulse 12/14/15

Major averages took it on the chin Friday on higher volume. The S&P 500 and NASDAQ Composite both broke below major support levels as the S&P dove below its 200-day moving average and the NASDAQ its 50-day moving average. Oil and other commodities continued their downtrends due to lack of demand in the face of a looming global recession combined with oversupply as OPEC voted to maintain current production levels. High-yield “junk” bonds also had a nasty day as one major high-yield fund moved to liquidate while simultaneously blocking investors from redeeming their stakes in the fund. Thus the markets are suffering crisis situations on several different levels. Such days as that seen Friday have preceded eventual major sell offs in the US stock market that often materialize within a few months or less. The Federal Reserve concludes its meeting this Wednesday. The market assumes it will raise rates, but with the recent weakness in the markets and ongoing weakness in the global economy, the Fed may have no choice but to hold off on any rate hikes. Updates on the Models VIX Volatility Model based on long term tests shows substantial profits overall. That said, all strategies go through periods of drawdowns. Such periods fortunately have not lasted longer than typically a few months. The model’s current drawdown started in early September, shortly after the model was shared on the website. Here’s an update we provided on October 23: http://www.virtueofselfishinvesting.com/reports/view/important-update-on-vix-volatility-model-vvm Based on back tests going back many years, I expect this difficult period to come to an end sooner than later. That said, the past cannot always predict the future, so patience during prolonged periods of difficulty is warranted. VIX Volatility Model remains in cash for now as the markets have been very noisy. While constructive volatility can yield steep gains such as in 2011 or more recently earlier this year, it is best to wait out the brief periods where the model does not have the odds on its side. The model needs to see advantage before issuing a buy or sell signal. While US markets this year have been unusually trendless, much of it has been surprisingly profitable with respect to the model’s performance tests. While the model remains in beta for now, the last three signals occurred after the fail safes were implemented. Total loss was just -2.8%. It is constructive that members can see how the model performs under one of the most challenging environments. So despite the noisy markets, and despite the three signals being losers, the total loss came to just -2.8% as expected based on backtests. Meanwhile, the model has had healthy gains prior to August of this year in backtests after the fail-safes were worked into the strategy. While this year has been one of the most challenging for market timing and hedge funds of all stripes, such periods always come to an end. When it comes to the markets, the only thing that doesn’t change is change. MDM is longer term so to avoid getting whipsawed repeatedly, especially in a year such as this one, it stays on its signals longer than normal. Do look at its overall long term track record vs the Nasdaq and S&P 500 to gain a clearer picture on the models strengths and weaknesses. When it comes to catching intermediate to longer term trends, the model will get whipsawed like it has this year. Also, in the last couple of years, the markets have become far more manipulated by central banks thus shallow floors form even when all signs point to a much worse correction. Likewise, normal sustained uptrends have also been nearly non-existent. Sharp moves in either direction often come without warning off lows or off highs which explains why this year has been one of the most challenging in decades. Thus our greater focus on individual stocks and, more recently, the VIX Volatility Model given its performance up through August of this year with the implemented fail-safes. Note, the reports emailed out on the VIX model prior to the last three signals did not contain the implemented fail-safes as we have discussed in a prior VIX model update.