Negative Ghost Rider, the pattern is full

This post is little more than a victory lap so please feel free to stop reading now.

Something strange happened yesterday. In the morning I was looking through data from the past two debt ceiling clusterfucks trying to think of an ideal way to structure a trade for a potential impasse. Having remembered that the US sovereign CDS curve had some wild fluctuations the last two times I focused on another possible flare up on the front end. This is a rather illiquid little backwater and a truly useless market for anyone actually trying to hedge risk on a treasury portfolio, but it’s a fun spot for doing some punting.

As it stood this morning 1y CDS were at 13bps with a 6bp spread on the bid ask and 5y CDS were at 24bps with a 4bp bid ask spread. Both of these levels were significantly below their (short) historic averages.

Since I can’t trade these in my PA, my desk doesn’t actively take risk in these instruments, and our clients don’t particularly care for small illiquid trades I thought I would share my thoughts on twitter.

I was happy that a number of people thought it was an interesting trade and got a few follow ups on the matter but most people just thought it was a halfway funny joke about Top Gun.

Then at the end of the day I was going through my pricing rundowns and I saw that this happened.

1y CDS had shot up by 45bps since the morning. Upon further examination I noticed that the aforementioned 1-5y spread went from 11bps to an all time record of -28bps. As shown below this is a 5.9 standard deviation event, and if you believe that derivative pricing follows a normal distribution this is something that should be seen once in every 300 million observations.*

And here’s the one day change for the curve.

I am going to run with the assumption that I just happened to have timed this recommendation perfectly, but I will hold out an inkling of hope that just maybe someone who reads my tweets banged this level and moved the market.

*If you think illiquid derivatives follow normal distribution patterns you should stay away from them, as well as any other assets that might prove too complicated for you.

The Limit of Fundamental Analysis: You

The other day, my friend Eddy Elfenbein wrote a post entitled “The Limits of Fundamental Analysis,” which made some good points (as he most always does), but in so doing, made far too broad and thus inaccurate a conclusion. The premise is (and I welcome Eddy to correct me if I’m off-base) that in some circumstances, fundamental analysis is inappropriate, such as when dealing with transformational businesses like Amazon was (is), cyclical firms, leveraged firms, firms with varying earnings quality, etc. The thing is, we can – and do (try to) – adjust for all of these things – and more – when performing a proper fundamental analysis! I’m going to attempt to show how, by making relatively small changes to a few key assumptions (sometimes even just one number will do!) in a simple DCF framework, we can grossly change not just how much we think a stock is worth, but why it’s worth that price, as well.

Fundamental analysis, by definition, involves examining the industry in which a firm competes, the regulatory/legal environment, the market for a firm’s goods/services, the goods/services themselves, the firm’s financial condition/performance, strategy, capital structure, reliability of financial statements/accounting controls, and several other factors, not only currently, but in the past and, more importantly, the future as well. Fundamental analysis isn’t just looking at a few ratios on Yahoo Finance or Finviz or whatever and concluding a company is a good (bad) investment based on valuation, liquidity, solvency, and/or other metrics. That can be the starting point for narrowing down firms which are more (less) likely to be worth investigating further, given a finite amount of time to allocate to identifying and researching ideas which we hope will help us invest wisely.

A quick tangent: If you’re not in the markets to invest, you are in the markets to gamble. This is not up for debate, it just is; if you find or fancy yourself a gambler, save the trouble and head to your closest casino where they’ll be more than happy to separate you from your presumably hard-earned money quite expeditiously (you may even get some “free” food and drink out of it). If you’re not sure whether you’re trying to invest or gamble, just put your money under your bed until you figure it out, you’ll be doing yourself a favor. If you’re interested in making good investment decisions, this is where the fun starts…

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Seeking Part-time Interns for Fall/Winter

Since I started Stone Street Advisors LLC’s internship program, I’ve largely been impressed with the talent we’ve attracted, and proud of the positions our interns have landed after working with us. Alas, as each moves on to bigger things, it comes time again to recruit two more part-time interns for the fall semester, hopefully working through winter and perhaps into spring, as well.

Unlike the vast majority of internships, everything from our recruiting process to training to responsibilities have been carefully designed & implemented to prepare you for ultra-competitive positions at the best firms in the world. Below, I’ll describe these things, and upon consideration, you are welcome to apply.
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A Few Thoughts on Domestic Inflation

Yesterday a far more talented sell sider than myself @barnejek in a discussion on the relentless rise in US real rates over the past two months sparked this post at BI and it lead to continued discussion on twitter and a few more posts about the recent fall in inflation rates. I took a few issues with it and received many questions so it’s far too much for twitter.

First and foremost the tweet makes no sense because inflation in the US has been stubbornly low for the past two decades, so unless you think it’s going lower from these current depressed, generationally low, levels saying goodbye to inflation is ridiculous. If however, that is your actual opinion please reach out in the comment section I would be thrilled to enter a swap to that effect.

Here are US benchmark real rates and their ramp up since April. I’ve been saying for the past seven months that short 5y TIPS was the best trade on the planet as they had all the overvalued characteristics of USTs but with positive carry. I still like the trade but the recent run up in the inflation expectation component of it looks overdone. As such I find it hard to see inflation going any lower from here.

Here’s the benchmark breakevens where the move has been just as staggering, the two year most notably is off 114bps.

US inflation levels are quite low. PPI leveled off last month but CPI and PCE both surprised to the downside. Luckily, this trend looks to have reversed last month.

Inflation will be supported by the recent climb in wages which were the input most severely impacted by the payroll tax increase. If I had to peg the soft inflation from the spring to one thing, that would be it.

It is important to look at wages coupled with consumer credit which was also continued to expand.

The most stable of the bunch core PCE has a good long term track record with the 5y UST, where the recent rise in yield points to upward pressure.

Last month’s CPI reading looked like a fluke to anyone who follows it.

The reading was inconsistent with the data from PriceStats (formerly the billion prices project) where prices have been rising for weeks.

Case-Shiler showing CPI should face continued pressure from rising home prices and rent equivalents.

Lastly to show just how overdone the move in short term inflation expectations has become here’s crude oil charted against the 2y breakeven. Since it factors so heavily into both consumer and producer inflation it has had a great predictive factor.

That said, my base case if for inflation rates moving significantly closer to the Fed target of 2% over the next 6-9 months.

Quick Observations on JOSB, GPS

Wednesday night (6/5/2013) I needed to track down a specific pair of jeans in my very specific size. My build notwithstanding, the closest place I could find them was in Denville, NJ Banana Republic at the Shoppes at Union Hill, a semi-kind of upscale-ish, well-polished shopping center. I have a few quick observations/comments/questions based on this one experience, in no particular order:
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FT Alphaville CFA Meme Contest Silver Medal for Dutch Book!

The Financial Times’ great Alphaville division held a semi-quasi-formal-ish CFA exam meme contest, in which our man Dutch Book participated. Result: Silver medal (although I think he should have easily won the gold with his submission!). Stone Street Advisors: Winners at the research and meme game. (non-official motto).

Here’s Dutch’s second-place submission:

#SoMuchWin

Congratulations to Dutch Book & best of luck on the exam, which he’ll no doubt ace.

–JT

When Life Kicks You In The Butt…

My friend, my mentor, and one of our SSA teammates is in a bit of a squeeze. Per his last semi public update:

“I have a stage 2heartblock which causes me to blackout when I get dehydrated. happened Saturday morning on my way to play golf. I was taken to ER and given to IV drips. Was ok yesterday, but was in bad shape this am. So I’m currently at NYU Hospital being monitored.”

If that doesn’t scare the ever loving shit out of you to he point of action, you are a sick bastard.

While GTJ has some insurance $, anyone who knows how these things work knows damn well the $1,000′s accumulate extremely fast. I’m not asking for a Billion (we’d accept most of it though) but I want everyone who follows him on twitter, and reads his posts here and elsewhere to pray or do whatever you believe in that he’s healthy asap. We, no, I am not asking for any donations, but I will consider an offer if that is the way you want to play it.

My Friend, my Mentor, and again, My Friend is in an unenviable condition. Please do whatever you can to help.

Information @ StoneStreetAdvisors dot com.

I will match any donations as well as I can; any additional monies will go into a newly established charity which will be used for similar situations; zero will come to me or my firm.

Please wish him well, if you don’t have the money.

Jordan S. Terry
Founder & Managing Director
Stone Street Advisors LLC

Put Me in Coach!

Quick Thesis: Coach, Inc. (NYSE: COH) is solid free cash flow story which many investors have overlooked as they focus on the newly public (and faster growing) Michael Kors (NYSE: KORS). The primary concern is that sales will continue to decline and the multiple contraction at Coach will not be short lived as KORS takes share. While KORS trades a premium multiple and is priced for perfection, COH has been left for dead. The stock sits 36% below its 52 week high after missing 2nd quarter earnings on slowing sales. Current multiples make COH a compelling “value” story – with a market cap of $14.4 billion and trading at 13.6x and 8.1x consensus EPS and EBITDA
estimates, respectively, the stock trades at historically low levels. Continue reading

Three Bearish Charts for Equities

First off let let the record show that equities are by no means my area of expertise, but I thought this was worth sharing and too long for twitter.

This week three of my favorite correlations for US equities in different risk areas ended up significantly disconnected from the levels where the SPX is currently trading. Because of this I decided to enter into a short term risk reversal on Thursday.

Economic risk: SPX has lined up very well initial jobless claims for the past 5+ years but has recently overshot by quite a bit

High quality risk: the BAML Global Financial Stress Index, which attempts to measure stress in areas such as solvency and liquidity, price momentum, and short term volatility. This is the first time it has broken significantly below equities in over two years.

Low quality risk: the Markit CDX North America High Yield Index tracks CDS for 100 non investment grade debt issuers. This has been an extremely tight relationship and was the straw that broke the camel’s back for me.

It might be worth keeping an eye out for a minor correction.

Fear Not Every Penny Stock

A lot of people, finance professionals/academics and amateurs alike, will tell you that investing in penny stocks is inherently and necessarily risky, primarily by virtue of generally having small market capitalizations (e.g. below $100 million) and low stock price (e.g. below $5 in the U.S.) As I mention in all of my reports and articles on penny stocks, the lower the price, smaller the market cap, and lower the trading volume, the more susceptible the stock is to manipulation by unscrupulous types, typically using so-called “pump & dump” or “short & distort” schemes. Luckily, these risks can be minimized by using stop/limit (instead of market) orders along with proper position sizing relative to average volume to limit your downside risk and/or lock in profits. This, however, is not a column about trading (although that’s part of the process), it’s about fundamentals of business and investing, and that’s where I want to focus today.

So, now that we know how to (try to) minimize our risks on the trading side, how do we manage the risks associated with the underlying business? First, it depends on how one defines risk, or more accurately, what risks one is able to identify. Just because a penny stock is a small/micro-cap and/or development/transformation stage company doesn’t mean you can’t apply some of the same analytical techniques we use for larger companies to identify risks and determine if a given stock is worth your investment dollars. Interestingly, even the SEC has this to say about the risks of micro-cap stocks, emphasis mine:

“While all investments involve risk, microcap stocks are among the most risky. Many microcap companies tend to be new and have no proven track record. Some of these companies have no assets or operations. Others have products and services that are still in development or have yet to be tested in the market.”

This is a bit of an overgeneralization lacking nuance, but many penny stocks are fundamentally quite similar to the private early-stage companies that venture capitalists and angels invest in; The SEC’s comments could easily apply to both early-stage public and/or private endeavors. Harvard Business School senior lecturer Shikhar Ghosh has some very interesting stats and perspective on start-up/early-stage business failures. Barring outright fraud (more on this later), the reasons and frequency cited for business failure are probably not too much different for early-stage public firms than for private ones (not sure of data on this, but that’s the topic for another article).

So, how do we determine if it’s worth investing in a given penny stock? Generally, I prefer a primarily bottom-up approach with a healthy amount of deference to the top-down, regardless of market cap, and I think such a combination works especially well for penny stocks. Recently, a client hired us to research a volatile micro-cap penny stock, Nuvilex (NVLX) . I’m not going to get into too much detail about the specific project, but I want to use the company/research approach to illustrate how disciplined investors can separate the wheat from the chaff when it comes to penny stocks.

At first, I was skeptical of Nuvilex (not a surprise occurrence as I’m a skeptic first all the time); micro-cap stock, very volatile, very low price, barely any revenue, generally terrible financial statements, and a strange operating history spanning a decade and a half. The more research I did, though, I realized – again, barring outright fraud – the company’s technology has enormous potential. A simple Porter’s Five Forces analysis is always a good way to start, on any stock/company, again any market capitalization.

On a 1-10 scale I’d give Nuvilex a 7.5-8.5 on the five forces based on the public information I’ve reviewed. Regardless, this company, on a stand-alone basis, could change the way cancer, diabetes, and other horrible diseases are treated if not cured. Additionally, it’s a play on the inevitable paradigm shift in medical technologies coming from cell therapy and stem cell advancements. Bottom-up meets top-down; easy, right? Wrong!

Just because from 30,000 feet everything seems promising, we have to get a little closer to ground level, lest we miss something obvious like shady management, impossible financials, etc. I actually found it somewhat reassuring to see Nuvilex’s financial statements seem accurate compared to the story woven by management; many pump & dump, “fraudcap” (colloquialism for fraudulent or otherwise questionable micro-cap stocks) companies file SEC reports that make absolutely no sense given the market/industry and the idiosyncratic attributes of the company in question. Nuvilex’s tech has intellectual property protection, plenty of publications, accomplished leadership, and technology that could help extend if not save lives. When I was looking for competitors, I found one that explicitly disclaimed responsibility for all IP violations and said any issues were their customers’ problem. Amazing, no? Moving on…

The key takeaways here are 1. Don’t judge a book by its cover (or a stock by its price/market cap, 2. Most people don’t have a clue about investing (even some professionals), so beware word of mouth “advice,” 3. Always do your diligence and be on the lookout for shady #’s and characters; if it seems too good to be true, it probably is.

As always,

CAVEAT EMPTOR