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A Fork In The Road For XIV

Summary Investors are currently torn between fear mongering pundits and semi-positive economics. An update on the contango and backwardation strategy. The longest period of backwardation in over four years has ended, for now. It has been a very interesting couple of weeks in regards to contango and backwardation. Unlike most of my readers, I don’t get the real time view of the market since I am in the classroom all day. I get a few minutes to check at lunch and that sums up my daily view of the market until around 8pm. My preferred strategy here to profit from the increased volatility has been the contango and backwardation strategy. You can find a detailed description of that strategy, with back testing, here . I always find it fun to go back and read my past writings. When I first started writing for Seeking Alpha, I really wasn’t that great. I believe I had to edit my first article around five times before they agreed to publish it. That is life. Pick yourself up and try again. When I first introduced this strategy on Seeking Alpha, I pointed out that it would not win 100% of the time. Because we are using contango and backwardation as entry and exit points, the strategy becomes difficult when you have futures that consistently bouncing into and out of backwardation. There are two basic options to overcome this problem: Continue on with the strategy. Remember that this strategy will historically protect you from severe losses. Move away from the strategy by holding your position. If you have a long-term positive view for the market and the economy, then you may want to buy and hold a short position in volatility rather than continuing to trade into and out of positions. Before entering these trades you should be fully aware of your potential risks verses the reward. Moving Forward I have stated this previously and it is now being confirmed in the markets. The VIX Index and VIX Futures have moved away from their historically low range. In the short-term I would expect futures to begin trading more towards the historical mean. Take a look at the chart below: (click to enlarge) The VIX will move through cycles of higher and lower ranges of volatility. Historically when the VIX trades in the 10-13 range for an extended period of time, it is followed by a prolonged period where the median VIX will move to a 17-25 range. In periods of economic distress or turmoil that range can be much higher. Let’s look at the VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ: XIV ) as a basis for discussion here. We know that XIV is driven by the first and second month’s contract within the VIX futures. If the front month’s contract were to fall to 13 from here, that would represent a theoretical gain of around 30% considering all factors. However, if the front month contract were to fall to 17 than XIV would experience a theoretical gain of around 12%. In both cases you would have the added benefit of contango to compound your gains over time. This would make your actual gain larger than what I am reporting for illustration purposes. Over the long-term XIV needs healthy levels of contango to build value and cannot just depend on falling futures contracts. When assessing risk and reward you need to factor in a potential sea change in the median level of the VIX futures. As you can see below XIV is only off about 17% from six months ago despite experiencing a severe haircut. All of this is can be attributed to the wealth built from contango. See below: We have just experienced the longest period of backwardation in over four years: (click to enlarge) Other events that could affect XIV and volatility The Senate and House are currently debating the next potential government shutdown which is scheduled for the end of this month. This would provide a healthy dose of volatility and negatively impact XIV. The larger question here is, is this now how the United States government operates now? I have written past articles, which have been mainly brushed to the side, on government debt levels. I believe our debt is unsustainable with current levels of economic growth. Ultra low rates have helped our interest payments. I would be more optimistic about our government debt if we had respectable politicians who could put their personal agendas aside and come together to actually solve problems. Much of what I see is theater and kicking the can down the road. For example, the current solution to the government shutdown is to pass a measure to get us to December. Slow growth is now the new normal. This has been confirmed by The Fed and recently several CEOs have come on record as stating the same. The concern with slow economic growth and low inflation is that it doesn’t take much to turn the tide the other way. These are larger economic problems that require us to come together and create solutions that last longer than two months. Conclusion For now, the days of ultra-low volatility are gone but not forgotten. Like the business cycle it will always come back around. Whether that will be in a couple months or several years remains to be seen. I remain optimistic on the U.S. economy and hope that Washington has the will power to create long-term optimism through compromise. We need to help foster genuine sustainable growth. Bubbles create great opportunities for us volatility traders, but hurt real people. We may get into a longer period of contango this week that would again align your trading with the contango and backwardation strategy. However, if the market remains choppy we could be moving between the two often. You will have to make a personal decision on how you want to proceed with your investments. Follow me here on Seeking Alpha for regular volatility updates and news you can use. As always, feel free to leave your professional comments below. We always create some great discussions. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in XIV over 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: The author reserves the right to trade into and out of any products mentioned here and generally will not post exact positions or trades in real time. The author does not give individual buy/sell advice.

NorthWestern Corp. Looks Cheap, But It Will Likely Look Even Cheaper Later

Summary Electric and natural gas utility NorthWestern reported Q2 earnings that beat slightly on adjusted EPS, despite missing big on revenue. The company has expanded its renewable energy capacity in recent years to take advantage of its service area’s abundant hydro and wind resources. The company’s share price has also declined YTD even as its acquisitions have supported its earnings. While NorthWestern’s shares appear to be undervalued, there is a substantial risk that a strong El Nino will reduce hydro output and natural gas demand in its service area. I recommend that potential investors wait for adverse weather impact to provide a more attractive buying opportunity before initiating a long investment in NorthWestern. Northern Plains electric and natural gas utility NorthWestern Corp. (NYSE: NWE ) reported Q2 earnings in late July that beat slightly on EPS despite missing substantially on revenue. The company’s share price has largely declined in 2015 to date after racking up six straight years of steady gains (see figure). Interestingly, the company’s earnings haven’t slowed even as its share price has, suggesting that bearish investment sentiment resulting from a looming interest rate hike by the Federal Reserve is the cause of the latter’s poor performance. NorthWestern has been investing heavily in renewable energy in recent years, acquiring hydro and wind capacity in Montana and South Dakota, respectively. These acquisitions have coincided with falling energy prices and the prospect of weather-related disruptions to supply, however. This article evaluates NorthWestern as a potential long investment in light of these broader macroeconomic and weather conditions. NWE data by YCharts NorthWestern at a glance Headquartered in Sioux Falls, South Dakota, NorthWestern operates electric and natural gas segments that serve utility customers in Nebraska, South Dakota, and Montana. Its electric segment utilizes a mixed portfolio of coal, natural gas, hydro, and now wind to generate electricity that it transmits and distributes to 416,000 customers in all three states. The electric segment has been expanding its renewable generation capacity of late, purchasing 633 MW of hydroelectric capacity in Montana in late 2013 and agreeing to purchase 80 MW of wind power in South Dakota last July. The recent wind purchase, which is expected to close in Q3 with a price tag of $143 million, also includes the rights to a co-located 50 MW expansion site. These acquisitions will allow NorthWestern to easily meet the renewable portfolio standards in Montana and South Dakota, the latter of which is non-binding. Roughly half of the company’s total generation capacity is either renewable or in support of renewable capacity. The company’s natural gas segment transmits and distributes natural gas to 276,000 customers across its service areas. The segment is unique in that it also produces much of the natural gas that it distributes to its customers. It produces enough natural gas to meet 25% of its needs in Montana, for example, and is investigating potential acquisitions in the current low-price energy environment that will allow it to increase this share to 50%. Q2 earnings report NorthWestern reported Q2 revenue of $270.6 million, up 0.1% YoY and missing the analyst consensus estimate by a substantial $45.8 million (see table). The company attributed its low numbers to the presence of warm weather during the cold part of the quarter, which reduced its natural gas retail volumes by 14% compared to the previous year despite an increase to its customer numbers over the same period. Higher temps were prevalent across its service area, with the company reporting 16% fewer heating degree-days in total. These factors ultimately caused the natural gas segment’s revenue to decline by 15% compared to the previous year. The electric segment offset some of this decline, reporting a 7.5% YoY increase to its own revenue on higher retail rates and customer numbers. NorthWestern Corp. financials (non-adjusted) Q2 2015 Q1 2015 Q4 2014 Q3 2014 Q2 2014 Revenue ($MM) 270.6 346.0 312.9 251.9 270.3 Gross income ($MM) 191.0 233.6 204.9 157.3 157.8 Net income ($MM) 31.0 51.4 37.2 30.2 7.8 Diluted EPS ($) 0.65 1.09 0.85 0.77 0.20 EBITDA ($MM) 97.9 119.7 88.7 61.0 55.5 Source: Morningstar (2015). The company’s gross income came in at $191 million, up from $158 million YoY, as its cost of revenue declined by more than revenue on lower energy prices (see figure). The natural gas segment reported a 9.4% YoY decline to gross income, as the presence of reduced demand and its reliance on own production to meet much of this demand limited the decline to cost of revenue. This was more than offset by the electric segment, however, which reported a 31% YoY increase to its own gross income. Much of this increase was the result of generation from its Montana-based hydroelectric capacity showing up on its income statement; the segment’s gross income remained flat if this income source was excluded. The segment’s gross margin (gross income/operating revenues) did increase from 58% to 71% over the same period, however. Henry Hub Natural Gas Spot Price data by YCharts NorthWestern’s net income rose to $31 million from $7.7 million in Q2 2014, resulting in a diluted EPS of $0.65 versus $0.20. Much of the increase was the result of an insurance settlement payout, without which the company’s net income was $23 million on an adjusted basis versus $9.8 million YoY. Adjusted diluted EPS came in at $0.48, up from $0.25 over the same period and slightly beating the consensus estimate of $0.45. The company increased its quarterly dividend by 20% to $0.48 on the strength of its performance (resulting in a 3.8% forward yield), which also saw its free cash flow increase to $26.3 million from -$48.0 million YoY. Finally, management also took advantage of a favorable interest rate environment to refinance $150 million of debt due in 2016 with $200 million of 10- and 30-year mortgages at a substantially lower rate. Outlook NorthWestern’s decision to add wind capacity should prove to be a smart investment moving forward. The North Plains is one of the windiest places in the U.S. on a sustained basis (see figure) and has been home to much of the nation’s rapid wind farm growth over the last decade as a result despite its plentiful access to cheap natural gas and small population. The company’s service area overlaps with abundant wind resources and I wouldn’t be surprised to see it take advantage of the additional 50 MW capacity option in the event that Congress extends wind’s Production Tax Credit. Wind energy has been one of the few resources to prove competitive with fossil fuels in recent years and NorthWestern has additional backup natural gas capacity available to support such an expansion. In the shorter term, it remains to be seen how accretive the acquired capacity will be to the company’s earnings, as this will ultimately depend on South Dakota’s rate case decision that is due by the end of 2015. Source: EIA (2012). The company is also pursuing $100 million of additional natural gas investment so that it can supply 50% of the natural gas that its customers in Montana consume. It expects to incur roughly $1.5 billion in additional capex through the end of 2019 that will support future rate increases. The majority of these expenditures will be spent on infrastructure maintenance and upgrades. One area that investors should keep an eye on is the state of the economy in the company’s service area. The large fall to the price of energy that has occurred across the board since the second half of 2014 has negatively impacted the Northern Plains’ economy in the form of higher unemployment rates (see figure), which has benefited in recent years from the exploitation of unconventional fossil reserves. While NorthWestern’s customer numbers have yet to reflect this recent weakness by declining, multiple quarters of low energy prices could ultimately cause these numbers to plateau or even fall, offsetting some or all of the positive impact of rate increases on the company’s earnings. Montana Unemployment Rate data by YCharts Weather factors present the largest headwinds to NorthWestern’s earnings over the next few quarters, however. The West Coast drought that has been capturing headlines over the last year has also been appearing as far east as Montana. As of this month the western half of the state is classified as either “Moderately Dry” or “Severely Dry”, while much of the eastern half of the state is classified as “Slightly Dry.” Management stated during the Q2 earnings call that the drought conditions weren’t affecting its hydro operations in the state yet due to the fact that its capacity is widely distributed across the state. The drought conditions are of concern, however, because they are likely to grow worse over the next two quarters. NOAA recently announced that an especially strong El Nino is developing and, given its magnitude, it is now expected to last through the spring. Past El Nino events have resulted in reduced precipitation in Montana, as the winter storm track has been pushed into the south half of the U.S., with levels falling to an average of 75-80% between November and March of those experienced in normal years (see figure). Reduced river levels resulting from lower snowpack development can cause hydro generation to fall sharply, much as is already occurring in California. This, in turn, leads to higher average variable power costs that limit EPS, especially if not offset by higher rates. Source: NOAA . Compounding the potential impact of El Nino on Montana’s hydro generation this winter and spring is its impact on winter temperatures in NorthWestern’s service area. Past El Ninos have resulted in higher-than-normal temperatures in Montana, South Dakota, and north Nebraska, reducing the number of heating degree-days experienced during the winter and early spring. Montana has historically experienced the warmest temperature increases during El Nino events, especially in Q1. The impact of El Nino on NorthWestern’s earnings could be significant, as Q4 and Q1 have historically been when the company has earned the large majority of its annual earnings (see figure). Weak winter and spring demand for natural gas resulting from a historically strong El Nino would likely cause the company’s earnings to fall on a YoY basis, especially if it coincides with higher average variable power costs resulting from reduced hydro generation. NWE EPS Diluted (Quarterly) data by YCharts Valuation The consensus analyst estimates for NorthWestern’s earnings have remained relatively flat over the last 90 days. The consensus an analyst estimate for diluted EPS in FY 2015 has fallen slightly from $3.17 to $3.16 while the estimate for FY 2016 has increased slightly from $3.38 to $3.41. Based on a share price at the time of writing of $50.80, the company’s shares are trading at a trailing P/E ratio of 19.2x on an adjusted basis and forward ratios of 16.1x and 14.5x, respectively. The forward ratios have fallen significantly since peaking at the beginning of the year and are approaching multi-year lows (see figure). Even accounting for bearish sentiment on utilities resulting from a likely interest rate hike by the Federal Reserve before the end of the year, NorthWestern’s shares appear to be undervalued at present on the basis of the consensus analyst earnings estimates. That said, the estimates for FY 2016 in particular have not fallen over the last 90 days even as meteorologists have increased the expected strength and duration of the El Nino event in Q4 2015 and Q1 2016. NWE PE Ratio (TTM) data by YCharts Conclusion NorthWestern Corp. reported Q2 earnings that beat slightly on EPS despite missing big on revenue. The news briefly interrupted a steady decline to the company’s share price, although it has since re-approached its YTD low. Meanwhile, the company’s earnings have marched steadily higher, as it has invested in new capacity while also benefiting from reduced energy costs, resulting in share valuations that are approaching multi-year lows. While it is tempting to recommend the company as a long investment on those grounds alone, potential investors should be aware that meteorologists expect this year’s El Nino to be historically strong through spring. Historically, weather conditions in the company’s service area have been both warmer- and drier-than-normal during past El Nino events, indicating that there is a strong likelihood that both hydro output and natural gas demand will be reduced during the important Q4 2015 and Q1 2016 earnings periods. I encourage potential investors to wait for potentially disappointing earnings in the coming quarters resulting from adverse weather conditions to provide a better buying opportunity.

The Active Share Debate: AQR Versus The Academics

By Jack Vogel, Ph.D. There is an interesting discussion in the geeky world of academic finance literature between the intellectual muscle at AQR and academia. The discussion revolves around the following question: ” Does Active Share matter? ” This is an important topic for active ETFs and Mutual Funds in the marketplace. The original paper on this measure was written by Cremers and Petajisto and was published in the Review of Financial Studies in 2009 (top finance journal). Links to the paper can be found here and here . The abstract of the paper is the following: We introduce a new measure of active portfolio management, Active Share, which represents the share of portfolio holdings that differ from the benchmark index holdings. We compute Active Share for domestic equity mutual funds from 1980 to 2003. We relate Active Share to fund characteristics such as size, expenses, and turnover in the cross-section, and we also examine its evolution over time. Active Share predicts fund performance : funds with the highest Active Share significantly outperform their benchmarks, both before and after expenses, and they exhibit strong performance persistence. Nonindex funds with the lowest Active Share underperform their benchmarks. Main Finding of the paper: For non-index funds, the higher the active share, the better the performance. We tend to agree, as we have talked about diworsification in the past. However, just because a manager creates a more active portfolio (a necessary condition for outperformance ), this doesn’t imply an active manager will actually have outperformance. The team at AQR (Frazzini, Friedman, and Pomorski), in a forthcoming article in the Financial Analyst Journal (link to the paper is here ), address this question. The abstract is the following: We investigate Active Share, a measure meant to determine the level of active management in investment portfolios. Using the same sample as Cremers and Petajisto (2009) and Petajisto (2013) we find that Active Share correlates with benchmark returns, but does not predict actual fund returns ; within individual benchmarks, it is as likely to correlate positively with performance as it is to correlate negatively. Our findings do not support an emphasis on Active Share as a manager selection tool or an appropriate guideline for institutional portfolios. Main point of the paper: Active share should not be used as a manager selection tool. Basically, for a given index, they find that active share cannot be used as a reliable tool to identify out-performance. So is Active Share a waste of time? As Lee Corso says every Saturday morning during College Gameday, “Not so fast!” The two authors of the original paper, Martijn Cremers and Antti Petajisto were quick to shoot down the AQR findings. Here is the executive summary from Antti Petajisto: All of the key claims of AQR’s paper were already addressed in the two cited Active Share papers: Petajisto (2013) and Cremers and Petajisto (2009). 1) The fact about the level of Active Share varying across benchmarks has been widely known for many years. Its performance impact was explicitly studied and discussed in the first drafts of Petajisto (2013) back in 2010, and the performance results remained broadly similar. The reason for the apparent discrepancy is AQR’s choice of summarizing results by benchmark, which effectively gives the same weight to the most popular index (S&P 500, assigned to 870 funds) and the least popular index (Russell 3000 Growth, assigned to 24 funds), which is not sensible as a statistical approach. 2) The issue about four-factor alphas varying across benchmark indices does nothing to change the fact that higher Active Share managers have been able to beat their benchmark indices. However, it does raise an interesting point about the four-factor approach to measuring performance, and in fact my coauthors and I wrote a long and detailed paper about this exact issue first in 2007 (published later as Cremers, Petajisto, and Zitzewitz (2013)). 3) AQR’s researchers argue that there is no theory behind Active Share and they remain mystified by the differences between Active Share and tracking error. It is unfortunate that they have entirely missed the lengthy sections of both Active Share papers that discuss this exact topic: pages 74-77 in Petajisto (2013) and sections 1.3, 3.1, and 4.1 in Cremers and Petajisto (2009). The short answer is that Active Share is more about stock selection, whereas tracking error is more about exposure to systematic risk factors. So clearly ignoring large and essential parts of the original Active Share papers is simply not the way to conduct impartial scientific inquiry. If that executive summary wasn’t scathing enough, Martijn Cremers actually wrote a paper titled ” AQR in Wonderland: Down the Rabbit Hole of ‘Deactivating Active Share’ (and Back Out Again?) ” Here is the abstract: The April 2015 paper “Deactivating Active Share”, released by AQR Capital Management, aims to debunk the claim that Active Share (a measure of active management) predicts investment performance. The claim of the AQR paper is that “neither theory nor data justify the expectation that Active Share might help investors improve their returns,” arguing that previous results are “entirely driven by the strong correlation between Active Share and the benchmark type.” This paper’s first and main aim is to establish that the AQR paper should not be interpreted using typical academic standards. Instead, our conjecture is that this AQR paper falls into a wonderfully creative but altogether different genre, which we label the Wonderland Genre, as its main characteristic seems to be “Sentence First, Verdict Later.” For example, the results in the AQR-WP cannot be taken at face value, as the information that is not shared reverses their main conclusion. Secondarily, we consider the plausible claim that benchmark styles matter and find that controlling for the main benchmark style, the predictability of Active Share is robust. While Active Share is only one tool among many to analyze investment funds and needs to be carefully interpreted for each fund individually, Active Share may indeed plausibly help investors improve their returns. Thirdly and finally, we impolitely consider why AQR may not be a big fan of Active Share by taking a look at the AQR mutual funds offered to retail investors. We find that these tend to have relatively low Active Shares, have shown little outperformance to date (with performance data ending in 2014) and thus seem fairly expensive given the amount of differentiation they offer. So who is the winner in the debate? The answer is both are probably correct at some level. More concentration (less diworsification) probably has higher active share and in the past had higher returns. However, one cannot just take any random selection of stocks and expect to outperform, the style of the investment matters, which was AQR’s argument (we prefer Value and Momentum ). Let us know what you think! Link to the original post on Alpha Architect