Tag Archives: seeking-alpha

Valuation Challenges When PEs Are Expanding: 2 Examples

One hallmark of this secular bull market is expanding PE/cash flow multiples. Thus valuations based upon recent historical multiples can be deceiving. I give an example from one stock and one broad ETF. Everyone knows we have been in a cyclical bull market since the spring of 2009. I have argued elsewhere we are now in the early stages of a secular bull market that should continue well into the next decade. One argument supporting this view is to point out that the PE compression which characterized the earlier years of the 21st century has ceased. I shall illustrate this with a few charts shortly. Why is this important to investors? Many analysts judge the attractiveness of the market or a particular stock by comparing PE multiples (or cash flow multiples) with traditional and recent (say, the past decade) multiples. A stock selling at 45x earnings when historically it commanded a multiple closer to 18x is likely to be overvalued and less attractive as an investment or source of dividend income. If we are in a period of rising multiples, however, comparing current PEs to those of the past few years may make companies appear overvalued, when in fact they remain attractive investments going into a brighter future. We can use Teleflex (NYSE: TFX ) as an example. The Value Line chart below shows that TFX traditionally has commanded a cash flow multiple of 10.5x. Well above this (e.g. 2007) was an attractive time to sell, below it (e.g. 2003 and certainly 2009) were great entry points. What should we make of the current multiple, which is closer to 20x cash flow? (click to enlarge) source: Value Line The quick conclusion is that TFX is overvalued and buyers should not pull the trigger. But what if we are in a period of rising multiples, for reasons i made clear yesterday ( here )? This is even more likely given that medical technology is an emerging super field and has been a market leader for several years now. Combining fundamental analysis with charts and some technical snooping might shed more light, and useful trading information, on this challenge. The chart below shows that TFX has been in a bull market since 2009 and ascending in a broad channel as shown in white. If you look at the white channel, TFX touched the upper boundary (it was “overvalued”) in April of this year. But instead of selling off and churning like it did for almost two years back in 2010, the shares have worked their way higher. Maybe we should assume the price range is better defined by the red channel now. Oddly enough, that also suggests it is now fully valued. But the point where a prospective buyer might want to reacquire the shares is quite different. If the higher evaluation (red channel) mode is now in force, that price is approaching $100 as the new year unfolds. Using the old valuation channel, a buyer wouldn’t be interested until the price falls well into the $70s. This might be mere curve fitting but for the fact that broad indexes and ETFs such as the S&P500 Trust (NYSEARCA: SPY ) show almost exactly the same phenomenon. Compare the white and red channels in SPY below. (click to enlarge) source: freestockcharts.com Is this new channel reflective of higher valuations? Yes: (click to enlarge) source: etrade . While some expansion might have occurred in the early years of the bull market because earnings (the denominator in PE) are lagging indicators, it certainly is not the case now: corporate earnings growth is strong. And likely to get stronger! Already third quarter GDP growth came in at 5%, and second quarter GDP was revised higher. The full effect of lower oil prices still has to fully work into the economy, and the fiscal prudence of a Republican House (and now Senate) seems destined to continue. While it may be an ad hoc/seat of the pants process, investors would be well advised to revise their tolerable PE/cash flow multiples on stocks higher in the next few years. Get ready to buy Teleflex shares if a correction brings prices back to the high nineties.

Pioneer High Income Trust’s 45% Premium Looks Ripe For Contraction In 2015

Summary PHT’s 45% premium is three standard deviations above its 1-year average premium. NAV performance has struggled this year, while the market price has increased 12%. 20% of PHT’s portfolio is invested in energy-related securities, increasing the portfolio’s risk. Overview: The Pioneer High Income Trust (NYSE: PHT ) is a high yield bond closed-end fund with a solid track record and a strong management team. High yield funds have struggled recently, as slumping oil prices have raised concerns that highly levered energy companies could default on their debt. Energy companies have been some of the largest issuers of high yield debt in recent years. Expectations of rising interest rates in 2015 have also pressured the high yield market. PHT’s strong performance and high yield have caused shares to trade at a persistent premium since 2009. The fund has a five-year average premium of 23.53%. Recently, the premium has expanded. PHT’s price performance has remained strong, while the underlying NAV performance has struggled along with its high yield peers. The premium has increased to 45.54%. This premium is near the highest ever for this fund and looks vulnerable to a pullback. Key Investment Highlights: High Premium: PHT is currently trading at a 45.54% premium to NAV. This is significantly higher than its 1-year average premium of 29.05% and its 5-year average premium of 23.53%. Evidence of the wider than normal discount, the Z-Statistic of 3.20 shows the current premium is trading more than 3 standard deviations wider than normal. High Yield Performance: Spreads on high yield bonds have contracted as the Fed’s zero interest rate policy has driven investors to reach for yield. Spreads have started to widen as investors contemplate higher interest rates and the potential for increased defaults. These factors have pressured the returns of high yield bonds. PHT’s premium has grown during the years since the financial crisis, driven by consistent strong returns. If returns from high yields are pressured, it is likely PHT’s premium will be pressured as well. Energy Exposure: PHT has significant exposure to energy-related high yield bonds in its portfolio. As of 9/30/2014, 20.02% of the portfolio is invested in energy related holdings. For comparison, the iShares iBoxx High Yield Corporate Bond ETF (NYSEARCA: HYG ) currently has 13.47% of its assets invested in the energy sector. If energy prices remain compressed, PHT’s performance may suffer. Key Investment Risks: Continued Economic Recovery: High yield bonds tend to have strong performance during economic recoveries due to lower default risk. If the economy continues to chug along, high yield bonds may show strong performance, allowing PHT to continue to trade at a significant premium. Energy Price Recovery: A recovery in energy prices would relieve concerns of energy company defaults, allowing energy-related bond prices to recover. Due to PHT’s exposure to energy-related issues a recovery in energy prices would benefit PHT’s NAV performance. Key Portfolio Metrics: Premium/Discount: 45.54% Z-Statistic 3.20 Market Distribution Rate: 9.46% Current Monthly Distribution: $0.1375 Average Earnings/Share: $0.1200 Average Earnings/Distribution: 87.27% UNII Per Share: $0.2238 Effective Leverage: 30.42% Effective Duration: 3.06 Performance: Using ETFs with a similar investment objective can give a good comparison to evaluate management’s performance. HYG is a widely used high yield bond ETF that offers a good comparison for PHT. PHT has a long track record and compares favorably to HYG over the 3- and 5-year periods based on both price and NAV performance. The 10-year track record of 10% per year is attractive and shows the strength of this fund. However, PHT has underperformed over recent time periods likely due to the fund’s riskier holdings and higher energy exposure. The recent divergence between NAV and market performance is what has driven the premium. Data as of 12/26/2014 Source: Morningstar Premium/Discount: (click to enlarge) Source: CEFConnect The fund closed 12/26/2014 at a 45.54% premium to the NAV, or underlying value of the portfolio. This is above the 52-week average premium of 29.05%. The recent divergence between NAV performance and market performance has driven the premium higher. PHT has a strong performance track record that has caused the fund to trade at a persistent premium since 2009. However, the current premium is very high for this fund and investors may want to look elsewhere for their high yield exposure at least until the premium drops down below historical levels. Expense Ratio: PHT pays 0.60% of daily managed assets to Pioneer Investment Management for investment management. The annual expense ratio for PHT as of 3/31/2014 was 1.04. This is a relatively low fee for a high yield closed-end fund. The fee is particularly attractive when considering the strong work that management has done over time. Distribution: PHT pays a monthly distribution of $0.1375/share. The distribution equates to an annual distribution yield of 9.46% based on current market prices and 13.77% based on NAV. PHT’s earnings only cover 87% of the distribution. The fund does have $0.2238 in UNII so the distribution shouldn’t be at risk for a while. If interest rates remain low, PHT may have to reduce its distribution in the future. Leverage: PHT employs leverage through a margin account with Credit Suisse. The fund borrows at three-month LIBOR plus 0.70%. This is a relatively low cost form of leverage in the current market. This does cause concern over the long-term cost of leverage. If interest rates rise, it could increase the cost of leverage to the fund since PHT doesn’t have fixed cost leverage in place. Liquidity: PHT is a moderately sized CEF with $496.37 million in net assets. PHT has 80,000 shares traded on average a day. This represents $1.4 million in daily volume at current prices. This is reasonable liquidity for a CEF and should allow investors to fill orders without problems. It is always wise to use limit orders to purchase or sell shares of closed-end funds, as the bid/ask spread can be wide. Management: PHT is managed by Pioneer Investment Management, a wholly owned subsidiary of UniCredit S.p.A. Pioneer is a well respected fund family with significant fixed income resources and a long track record. The fund appears to be in good hands. Portfolio: Geographic Allocation Source: Pioneer as of 11/30/2014 Most of PHT’s portfolio is based in the United States. PHT has assets invested in several other countries, but none of these countries make up more than 5% of assets. Sector Allocation Source: Pioneer as of 11/30/2014 PHT has broad sector exposure, but the majority of the portfolio is invested in U.S. high yield corporate bonds. One area to watch is the exposure to event-linked bonds. Many of the event-linked bonds in the portfolio are catastrophe bonds. Several of Pioneer’s other funds have significant exposure to catastrophe bonds. These bonds can offer non-correlated high yields, but investors should be conscious of the risks of investing in these bonds. Of particular interest is their non-correlation with high yield bonds. The exposure to catastrophe bonds isn’t high enough to cause concern here, but should be watched to make sure it doesn’t increase over an individual’s risk tolerance. Credit Ratings Source: Pioneer as of 11/30/2014 As would be expected, PHT is mostly invested in high yield bonds. The fund is on the riskier side with 28% of the portfolio invested in CCC rated bonds. Maturity Breakdown Source: Pioneer as of 11/30/2014 The portfolio is invested in relatively short-term bonds. Only 5.7% of the portfolio matures beyond 10 years. The short maturity should help reduce portfolio volatility. However, short maturities increase the risk that yields will not be maintained when proceeds from maturing securities are reinvested. Source: Pioneer as of 11/30/2014 PHT has a diverse portfolio with 363 different securities. The top ten holdings represent only 9.50% of the total portfolio. The portfolio turnover has been low. PHT had a 16% turnover as of 9/30/2014. The highest portfolio turnover in the past five years was 30%. Strategy: PHT’s primary investment objective is to seek high current income with a secondary objective to seek capital appreciation. The fund is able to invest up to 50% of the assets in illiquid securities. The fund is also able to invest in securities of issuers that are in default or that are in bankruptcy. Tax Issues: As of September 30, 2014, the fund had $12,223,142 of net unrealized appreciation in the portfolio. These gains are offset by $46,261,236 in capital loss carryforwards. Conclusion: PHT is a strong fund with capable management. However, the current premium to NAV reduces the attractiveness of the investment at this point. Additionally, portfolio risks don’t appear to be accounted for in the market price. Higher interest rates could pressure high yield returns. The fund’s high exposure to energy related holdings could hurt performance if oil prices remain depressed. If negative NAV performance continues, the fund’s premium would likely erode. This is a fund that I would avoid until there is a significant reduction in the premium.

How Strong Is SCHV? I’m Considering It As A Core Holding.

Summary I’m taking a look at SCHV as a candidate for inclusion in my ETF portfolio. The risk level is great, though the high correlation to SPY shouldn’t be a surprise. The ETF has fairly decent yields and a great composition of companies. I’m not assessing any tax impacts. Investors should check their own situation for tax exposure. Investors should be seeking to improve their risk adjusted returns. I’m a big fan of using ETFs to achieve the risk adjusted returns relative to the portfolios that a normal investor can generate for themselves after trading costs. I’m working on building a new portfolio and I’m going to be analyzing several of the ETFs that I am considering for my personal portfolio. One of the funds that I’m considering is the Schwab U.S. Large-Cap Value ETF (NYSEARCA: SCHV ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification to reduce my risk level What does SCHV do? SCHV attempts to track the total return of the Dow Jones U.S. Large-Cap Value Total Stock Market Index. At least 90% of funds are invested in companies that are part of the index. SCHV falls under the category of “Large Value”. Does SCHV provide diversification benefits to a portfolio? Each investor may hold a different portfolio, but I use (NYSEARCA: SPY ) as the basis for my analysis. I believe SPY, or another large cap U.S. fund with similar properties, represents the reasonable first step for many investors designing an ETF portfolio. Therefore, I start my diversification analysis by seeing how it works with SPY. I start with an ANOVA table: (click to enlarge) The correlation is about 98%. That’s simply too high to provide a very meaningful diversification benefit. I measure risk with the standard deviation of daily returns. It isn’t perfect, but it works fairly well for my purposes and seems to hold up over time. Because the correlation is very high, the standard deviation of returns will be a fairly significant factor. Standard deviation of daily returns (dividend adjusted, measured since January 2012) The standard deviation is great. For SCHV it is 0.7027%. For SPY, it is 0.7300% for the same period. Since SPY usually beats other ETFs in this regard, I’d look at that standard deviation level as being fairly favorable. Of course, since SPY and SCHV hold several of the same companies a high correlation was pretty much a given. Since the Value side of the index should have more stability and less risk, the findings are in line with my expectations. Mixing it with SPY I also run comparisons on the standard deviation of daily returns for the portfolio assuming that the portfolio is combined with the S&P 500. For research, I assume daily rebalancing because it dramatically simplifies the math. With a 50/50 weighting in a portfolio holding only SPY and SCHV, the standard deviation of daily returns across the entire portfolio is 0.7128%. The value side of the index (which SCHV is tracking) has been outperformed by the growth side of the portfolio. I would expect that to usually happen during a bull market. When a bear market occurs, I would expect the value side to hold up a little better. Since I believe in being fairly defensive about protecting capital, the value side is more appealing to me. Why I use standard deviation of daily returns I don’t believe historical returns have predictive power for future returns, but I do believe historical values for standard deviations of returns relative to other ETFs have some predictive power on future risks and correlations. Yield & Taxes The distribution yield is 2.33%. The SEC 30 day yield is 2.52%. I’m pretty comfortable with this ETF as an investment for retirees so far. In my opinion, it is a fine investment for younger investors as well. I have quite a while to go before retirement, but I still like healthy dividend yielding companies. Investors concerned about tax consequences should seek advice from someone knowledgeable about their tax situation. Expense Ratio The ETF is posting .07% for an expense ratio. This is great expense ratio. I treat the expense ratio as a very important metric when considering an investment. I want diversification, I want stability, and I don’t want to pay for them. Market to NAV The ETF is at a .02% premium to NAV currently. In my opinion, that’s not worth worrying about. It is practically trading right on top of NAV. However, premiums or discounts to NAV can change very quickly so investors should check prior to putting in an order. Largest Holdings The portfolio isn’t really top heavy. There are no holdings over 4%, but I still could go for slightly more diversification. With so many companies over 2%, the low standard deviation speaks to the stability of the companies within the ETF. (click to enlarge) I love having Exxon Mobil (NYSE: XOM ) as the top holding in the portfolio. I want exposure to gas because high gas prices can slow down the rest of the economy. In my opinion, it is hard to make an argument for any portfolio (under modern portfolio theory) that does not contain at least some exposure to gas prices. In my opinion, XOM is a reasonably safe way to get that exposure. You may notice Chevron is also in there. I think that is great as well. I don’t want to hold just one of the major gas companies. In my opinion, this is a fairly solid lineup. I’m still uncomfortable with Verizon (NYSE: VZ ) because I don’t like that industry in the current environment. However, at less than 2%, I have no problem with including it in a long term ETF position. When the industry becomes attractive again, it should be a great company to hold. Conclusion I’m currently screening a large volume of ETFs for my own portfolio. The portfolio I’m building is through Schwab, so I’m able to trade SCHV with no commissions. I have a strong preference for researching ETFs that are free to trade in my account, so most of my research will be on ETFs that fall under the “ETF OneSource” program. I’m finding SCHV pretty attractive and will consider giving it a niche in my portfolio. The size of the position depends on if I decided to use it as a core holding in place of SPY or SCHB. In that scenario, it could end up with a position as large as 20 to 25%. Otherwise, I would probably aim for something around 10%. Before I make a final decision I’ll need to run some analysis on complete potential portfolios. One way or another, my complete portfolio will include strong exposures to large cap U.S. companies and to heavy dividend paying companies.