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Emerging Markets ETFs: It’s Not All About The Dollar

Conventional wisdom has dictated that a large part of the problems being faced by emerging markets stocks and exchange traded funds are attributable to the strong U.S. dollar. The strong dollar suppresses commodities prices, a vital revenue driver for scores of developing governments from Moscow to Sao Paulo. California-based Research Affiliates is the index provider for scores of well-known smart beta ETFs, including the PowerShares FTSE RAFI Emerging Markets Portfolio. By Todd Shriber, ETF Professor Conventional wisdom has dictated that a large part of the problems being faced by emerging markets stocks and exchange traded funds are attributable to the strong U.S. dollar. On the surface, the reasoning makes sense. Over the past year, the Vanguard FTSE Emerging Markets ETF (NYSEARCA: VWO ) and the iShares MSCI Emerging Markets ETF (NYSEARCA: EEM ) , the two largest emerging markets ETFs by assets, are off an average of 24.8 percent while the PowerShares DB US Dollar Index Bullish Fund (NYSEARCA: UUP ) , the U.S. Dollar Index tracking ETF, is higher by 11.6 percent. The strong dollar suppresses commodities prices, a vital revenue driver for scores of developing governments from Moscow to Sao Paulo. Making matters worse is the perceived impact of the mighty greenback on dollar-denominated emerging markets debt . According to a recent note by Research Affiliates : According to a popular story, the strength of the U.S. dollar and the expected interest rate hikes by the Fed could trigger a new wave of troubles for emerging economies. ‘If history is any guide,’ writes Xie (2015), ’emerging markets are headed for trouble as the dollar strengthens.’ Because of currency mismatches on their balance sheets, weak commodity prices, and deteriorating market sentiment, emerging market economies should be at risk of reenacting the Asian and Russian crises, perhaps on a larger scale. Smart Beta ETF California-based Research Affiliates is the index provider for scores of well-known smart beta ETFs, including the PowerShares FTSE RAFI Emerging Markets Portfolio (NYSEARCA: PXH ) . PXH has not been immune to the downdraft that has slammed emerging markets ETFs as the fund has tumbled 34.8 percent over the past year. On the other hand, PXH offers significant leadership potential if, and admittedly it is a big “if,” emerging markets equities earnestly rebound. Consider that if the Federal Reserve raises interest rates, another factor widely cited as a problem for developing economies, it may not be all bad news for emerging markets stocks. Notes Research Affiliates: Yet higher interest rates can be good news if they signal stronger economic performance. Solid growth rates tend to be associated with higher interest rates-this is the meaning of a real shock-and the rest of the world can benefit from strong U.S. growth. Indeed, the United States is still the world’s largest economy, and an improvement in U.S. economic performance should pave the way for expansion at the global level. PXH’s underlying index selects the ETF’s nearly 340 holdings based on book value, cash flow, sales and dividends. The dividend emphasis leads to a trailing 12-month yield of 3.33 percent, or 86 basis points higher than the comparable metric on the MSCI Emerging Markets Index. With a price-to-earnings ratio of just under 11.5, the $326.5 million PXH jibes with the notion that emerging markets equities are currently inexpensive, though that is partly attributable to slack earnings growth throughout developing economies. Part of the silver lining revolves around the fact that developing economies are not as vulnerable to financial shocks today as they were in the 1990s. Notes Research Affiliates: We can start by noting that some emerging central banks have actually cut their benchmark rates over the last year or so (e.g., Mexico, Thailand, Chile, South Korea, Poland, and Hungary). This is a noteworthy change with respect to the past, when these banks would typically increase interest rates in order to defend their currency from a sharp depreciation. Instead, nowadays these banks are fighting falling rates of inflation and production growth and, as in the developed markets, they tend to do so by easing liquidity conditions. Hence, weaker currencies should be seen as being part of their broader policy goals, somewhat as they are in Japan and the Eurozone. Asian countries combine for half of PXH’s weight while the ETF allocates over 21 percent of its weight to Brazil and Mexico, Latin America’s two largest economies . Disclaimer: Neither Benzinga nor its staff recommend that you buy, sell, or hold any security. We do not offer investment advice, personalized or otherwise. Benzinga recommends that you conduct your own due diligence and consult a certified financial professional for personalized advice about your financial situation. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (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.

Ormat Technologies Is An Unrecognized Alternative Energy Play

Summary Geothermal is a small but fast-growing and important part of the growing alternative electricity generating space. Ormat is an industry leader with significant new capacity coming online. The Ormat Energy Converter technology is a patent protected process that gives the company a competitive advantage in the space. We believe that ORA will eventually be valued like the high-yielding electric utilities as it boosts its dividend payout with strong free cash flow growth. Ormat Technologies (NYSE: ORA ) is a global leader in geothermal energy technology, which we think will be a net market share adder over the next half decade. The path towards expanded margins and stronger earnings growth has become more clear, which we think should re-rate the shares higher over the course of the next year. We think the company has completed a significant amount of strategic initiatives over the last year which is unlocking substantial shareholder value. Those key catalysts, which we believe should reward shareholders, include: Share exchange completion with Ormat acquiring parent company in order to get listed on the TA-25 Index. Underlying growth in the space should realize a double-digit CAGR through 2020, propelling earnings. Its patented Ormat Energy Converter technology provides a competitive advantage. Company Description The company is the leader in the geothermal and recovered energy power generation business. The company builds and operates environmentally-friendly geothermal and recovered energy-based power plants, typically using equipment that it designs and manufactures. Most of the operating portfolio is in the US, Kenya, and Guatemala. The firm has a ~80% market share in the geothermal binary power market segment. The company has two reporting segments: electricity revenues and product sales. Electricity revenue represents two-thirds of revenue and 63% of operating income. The company has 50 years of experience in the space and owns and operates approximately 650 MW of power generation. (click to enlarge) Source: Corporate Presentation Long-Term Opportunity Potential We think geothermal is an overlooked area of alternative energy investment that holds many of the strong properties that are sought after by both investors and power generation companies. The essential properties of geothermal technology tap the heat from the Earth that escapes through various fissures as gas or water. Hydrothermal geothermal-electricity generation is derived from naturally occurring reservoirs of heat that are formed when water comes in contact with hot rock or through “escaping” heat of 300 degrees or more. The heated water rises to the surface and is extracted through geothermal wells, typically located within a few miles of a power plant. The key is if natural ground water sources and reinjected, extracted geothermal liquids are adequate to continuously replenish the geothermal reservoir creating a long-term renewable energy source. Geothermal in the US currently generates approximately 13 GW of geothermal energy. This is enough electricity to power approximately 20 million US homes, but represents just 0.2% of global electricity generating capacity with very low penetration. In the last year, the globe added 700 MW of additional capacity in 2014. Third-party forecasts as well as the Geothermal Energy Association (GEA) predict 10%-12% annual growth through the end of 2020. Bloomberg predicts that by 2030, capacity will grow to 40 GW, representing 270% capacity growth over the next eighteen years. Even with that massive growth, the percentage of power generated from geothermal would still be less than half a percent. The reason for the growth is the base-load potential of the source, meaning that it has a long-life potential (~30 years) and is cost competitive with coal and gas. Source: Bloomberg Energy Finance 2013 Proprietary Technology In Binary Plants A Differentiator Binary power plants are operated using the Organic Rankine Cycle where heat is transferred to a fluid at constant pressure. The fluid is then vaporized and then expanded in a vapor turbine that drives a generator, producing electricity. The company has proprietary technology that can be used in binary power plants to recover energy generation to capture unused heat derived from the industrial processes. This can be converted into electricity using the Rankine system. Ormat has a proprietary system called the Ormat Energy Converter which fulfills this purpose in both binary and REG systems. The whole system has been designed by Ormat including the turbines, pumps, and heat exchangers, as well as formulation of organic motive fluids, all of which are environmentally friendly. The company also patented and developed GCCU power plants in which the steam first produces power in a backpressure steam turbine and then is condensed into a binary power plant, producing additional power compared to conventional methods. We think ORA’s technology has a number of competitive advantages compared to its competition. Conventional steam plants can consume a substantial amount of water, causing depletion of aquifers. In the US, most of the natural geological geothermal energy plants and sources are in the West, namely Nevada, California, Arizona, Utah and Idaho. These are areas where water is a valuable commodity, meaning water-saving technology is far superior to conventional steam methods. ORA’s binary technology also has lower visual impact which can be aesthetically unappealing to residents in the localities. Traditional steam models have to have large cooling towers which emit exhaust plumes during cool weather. Ormat’s technology does not have emissions when using its geothermal fluid technologies. Other competitive strengths include the ease of operation and low maintenance. This is derived from the lack of contact between the turbine blade and geothermal fluids, which tends to have a corrosive effect. Instead, the company’s technology passes the fluids through a heat exchanger, which creates less friction and can withstand corrosive fluids better. We think its moat and competitive advantages are a strong positive on the shares. Between the focus on geothermal binary and recovered energy generation, ORA’s proprietary energy conversion technology and its global expertise separate it from the competition. Margin Expansion Story Underway The business lends itself to significant scale advantages with margins growing to 36.4% last year and 37.3% over the trailing twelve-month period. EBITDA margins are up to 47.8%, up 1,000 bps over fiscal 2013. We think margins should continue to expand bolstered by the electricity segment which has several natural advantages to scale. Some of that margin expansion will come from stronger pricing per MWh. We think the expansion of new capacity over the next two years along with increased utilization should help the segment achieve 40%+ gross margins on an annual basis. The product segment is also seeing much strong margins growing from 27% to the current 38.4%, a significant increase. The business can see more lumpy margin expansion and contraction depending on product mix and EPC service. We think it’s an important driver of the value-add in the business as it’s far superior to other alternative power companies like solar and wind. State And Federal Push Into Renewables Renewable portfolio goals have been set in 40 states which require state-based utilities to generate or import a certain percentage of their electricity from renewable energy or recovered heat sources. California, for instance, established one of the first renewable portfolio standards which requires 25% of electricity generation and usage by renewable, and 33% by 2020. Another state, Hawaii, has an ambitious goal of achieving 100% renewable energy generation by 2045. Hawaii has a significant amount of geothermal activity which can utilize Ormat’s technology, and we believe that it will be a significant contributor in the portfolio of renewable power generation. As costs of renewable energy generation continues to come down and when factoring in ancillary costs of CO2-emitting power generation, we think states will continue to raise renewable standards and goals towards at least 50%. Depending on the location, geothermal will likely be an important part of that renewables portfolio. Remember, geothermal power generation does not need to be the majority or even one of the top three sources for Ormat to see a significant boost in revenue. The Federal government does not have a set renewable portfolio goal, but through the EPA, has been pushing up renewable usage through the implementation of additional regulations onto CO2-emitting power generation, namely coal. This was done by the Obama administration in 2013 which directed the EPA to create new pollution standards for new and existing power plants. In this clean power plan, the goal is to cut carbon emission from the power sector by 30% below 2005 levels nationwide by 2030. Movement towards renewables, while not explicitly cited, is a key factor in achieving those ends. Valuation The shares amid the global sell-off trade at just 9.6x ttm EV/EBITDA, which we believe is a discount given the shift towards higher-margin electricity segment revenue generation. We used a sum-of-the-parts analysis of the business to more accurately assess the value of the shares. The electricity segment is similar to many of the publicly-traded utilities that are power generators. The only real difference is the source of the power generated coming from geothermal rather than coal or natural gas. Using the public utilities as comps, the shares are trading at a slight discount to others like PPL Corp. (NYSE: PPL ), NRG Yield, Inc. (NYSE: NYLD ), TerraForm Power (NASDAQ: TERP ), and NextEra (NYSE: NEE ), but ahead of some other peers like TransAlta (NYSE: TA ), AES Corp. (NYSE: AES ), and Abengoa (NASDAQ: ABGB ). The peer group comps have a median average of 8.9x, which is slightly ahead of the ntm EV/EBITDA ratio for Ormat at 8.5x. We think that the product segment is holding back the consolidated ratio, but given the growth in the business’s margins, we think that could be changing. In addition, we see the electricity segment as gaining scale which is expanding its margin significantly towards 40%. As such, we do think the consolidated multiple should expand towards 9.0x. We applied a 5.5x multiple to the product segment, which we think is fairly conservative, but given the size of the business, it’s not a significant driver to the consolidated multiple. On the electricity side, the margins should be at least in line with the comps. We could make the argument that the electricity segment should receive a premium valuation and that the product multiple is too conservative. We estimate $285 million in EBITDA net of the company’s Northleaf JV ownership. We think the shares are worth $42 using those fairly low multiples. Conclusion We believe Ormat is an ignored alternative energy company. While the market seems to cater towards the solar and wind companies, we think the geothermal space is actually superior to the economics of those two alternative energy segments. We think the shares are worth approximately $42 and that the long-term trends within the space are very strong. The company is bringing on significant new capacity over the next two years while it becomes more efficient and gains scale, boosting its margins and profitability. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (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.

PFF: A Quick Way To Get Your Preferred Stock Exposure

Summary There are two issues with the ETF, one is a high expense ratio and the other is sector concentration. The geography exposure is not a problem for me, but I wouldn’t mind seeing a little more diversification. The fund offers negative correlation with at least one treasury ETF while delivering a beta of around .22. Many investors build their portfolio without any meaningful positions in preferred stock. The iShares U.S. Preferred Stock ETF (NYSEARCA: PFF ) is one quick solution to that problem. Expense Ratio The expense ratio on the ETF is .47%. I’d really prefer to see a lower expense ratio with long term holdings since the nature of preferred stock suggests positions would not need to be changed frequently. When I pulled up the turnover ratio for the portfolio, it was coming up as 13%. That is higher than I would have expected but not high enough that I would expect the high expense ratio to be necessary. This may simply be a case of an ETF in a niche market having a long track record (established in 2007) and high volume (over 3 million shares per day) being a position where it can demand a higher expense ratio. Largest Holdings The largest holdings of the ETF show a heavy concentration towards the financial sectors. It isn’t just the top 10 though, as you’ll see in the next section. The sector exposure for PFF is heavily concentrated on banks and “Diversified Financials.” Sector The sector exposure is extremely concentrated and that would be an area of concern for me. Since my goals in using preferred shares within a portfolio would be to diversify the risk factors for the portfolio, I would prefer to only need one ETF of preferred stock and to have that ETF bring in a substantially lower level of concentration. I don’t know what would cause the sector to tumble, but very heavy sector exposure leaves investors hoping no black swans appear. This is a risk I would prefer to avoid if possible. Since black swan events by their very nature are unpredictable, the most effective defense is simply to include substantial diversification. Geography The map below shows the geographic distribution of the holdings. I don’t see any problems here. It is interesting that the U.K. was showing up as more than 12% of the portfolio, but diversification is exactly what I was wanting. I’d be interested in seeing even more diversification here, but doubt it will happen. That could make PFF an interesting fit with an international bond portfolio. Building the Portfolio This hypothetical portfolio has a slightly aggressive allocation for the middle aged investor. Only 30% of the total portfolio value is placed in bonds and a third of that bond allocation is given to emerging market bonds. However, another 10% of the portfolio is given to preferred shares and 10% is given to a minimum volatility fund that has proven to be fairly stable. Within the bond portfolio, the portion of bonds that are not from emerging markets are high quality medium term treasury securities that show a negative correlation to most equity assets. The result is a portfolio that is substantially less volatile than what most investors would build for themselves. For a younger investor with a high risk tolerance this may be significantly more conservative than they would need. The portfolio assumes frequent rebalancing which would be a problem for short term trading outside of tax advantaged accounts unless the investor was going to rebalance by adding to their positions on a regular basis and allocating the majority of the capital towards whichever portions of the portfolio had been underperforming recently. (click to enlarge) A quick rundown of the portfolio The two bond funds in the portfolio are the iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSEARCA: EMB ) for higher yielding debt from emerging markets and the iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ) for medium term treasury debt. IEF should be useful for the highly negative correlation it provides relative to the equity positions. EMB on the other hand is attempting to produce more current income with less duration risk by taking on some risk from investing in emerging markets. The position in the iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ) offers investors substantially lower volatility with a beta of only .7 which makes the fund an excellent fit for many investors. It won’t climb as fast as the rest of the market, but it also does better at resisting drawdowns. It may not be “exciting,” but there are plenty of other areas to find excitement in life. Wondering if your retirement account is going to implode should not be a source of excitement. The position in the PowerShares Buyback Achievers Portfolio ETF (NYSEARCA: PKW ) makes the portfolio overweight on companies that are performing buybacks. The strategy has produced surprisingly solid returns over the sample period. I wouldn’t normally consider this as a necessary exposure for investors, but it seemed like an interesting one to include and with a very high correlation to SPY and similar levels of volatility it has little impact on the numbers for the rest of the portfolio. The core of the portfolio comes from simple exposure to the S&P 500 via the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ), though I would suggest that investors creating a new portfolio and not tied into an ETF for that large domestic position should consider the alternative by Vanguard, the Vanguard S&P 500 ETF, (NYSEARCA: VOO ) which offers similar holdings and a lower expense ratio. I have yet to see any good argument for not using or another very similar fund as the core of a portfolio. In this piece I’m using SPY because some investors with a very long history of selling SPY may not want to trigger the capital gains tax on selling the position and thus choose to continue holding SPY rather than the alternatives with lower expense ratios. Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. To make it easier to analyze how risky each holding would be in the context of the portfolio, I have most of these holdings weighted at a simple 10%. Because of IEF’s heavy negative correlation, it receives a weighting of 20%. Since SPY is used as the core of the portfolio, it merits a weighting of 40%. Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio and with the S&P 500 . Blue boxes indicate positive correlations and tan box indicate negative correlations. Generally speaking lower levels of correlation are highly desirable and high levels of correlation substantially reduce the benefits from diversification. Conclusion PFF has a positive correlation with each of the hypothetical holdings except for the treasury ETF which is interesting. Since PFF should have more duration exposure than IEF, but also more credit risk, there is some fairly solid diversification benefits here. The beta of only .22% is also excellent for indicating that PFF will fit very well within a portfolio. While EMB (emerging market bonds) also have a very low beta, PFF is has done it without having a positive correlation with treasury ETFs. That makes it a great fit for the more conservative investor that is holding more treasuries in the portfolio and less equity. The distribution yield on PFF is over 6%, so this is an option for solid income while maintaining a favorable risk profile. Ideally an investor would be able to combine this with a position in an emerging bond fund like EMB to avoid concentration of risk and then toss some higher dividend yielding ETFs in at the core position and offset the equity risk with some long term treasury exposure. In short, I’m not thrilled with the expense ratio but the fund fits very well within a portfolio. I would love to see more preferred share ETFs coming out to drive up competition and drive down expense ratios. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (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. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.