Edge and Odds

The enemy of knowledge is not ignorance, it’s the illusion of knowledge (Stephen Hawking)

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so (Mark Twain)

Edge and Odds

Invest with smart knowledge and objective odds

NEW$ & VIEW$ (16 SEPTEMBER 2015): Fed Up or Not?

FED UP…

Sales at retailers and restaurants have recovered after a bumpy start to the year, posting a 0.2% monthly gain in August and a 2.2% annual increase, the Commerce Department said Tuesday.

Excluding gas, retail sales rose 0.4% in August and a solid 4.4% over the year.

Non-Auto less Gas, Building Supplies & Food Services, so called core sales that feed GDP, rose 0.4% (2.8% YoY) and are up at a 5.3% annualized rate in the last 3 months.

Few parts of the U.S. economy better illustrate the benefits and perils of the Federal Reserve’s near-zero interest-rate policies than the auto industry, and few will be as exposed to the fallout if central bank officials decide this week to end America’s seven-year era of rock-bottom borrowing costs.

Auto debt owed by U.S. households in the second quarter this year rose above $1 trillion for the first time, fueling car purchases and a Lazarus-like revival for an industry brought down by the 2007-2009 financial crisis. (…)

What happens next for the industry depends a great deal on how aggressively the Fed moves. If it raises rates slowly, then froth in the industry—including a profusion of subprime borrowing—could end up hurting borrowers and lenders. If it moves aggressively, it could take a big bite out of sales. (…)

In the U.S. car capital, the auto explosion has helped reduce the unemployment rate in the Detroit metropolitan area to 5.8% in July from more than 16% in 2009. Among other hopeful signs: Whole Foods Markets, the upscale chain, opened a store in midtown Detroit. Bidding wars have replaced home foreclosures in some suburban neighborhoods. And car makers are paying hourly workers profit-sharing bonuses as high as $9,000 a year.

“It really is a boom,” said Ellen Hughes-Cromwick, an economics professor at the University of Michigan in Ann Arbor and former chief economist for Ford Motor Co. “If you came here and you compared it to what happened in the late 1990s, it is exactly the same.” (…)

Employment agencies for retailers and logistics companies say they are having trouble finding warehouse workers to stock early holiday inventory and employees to train for work in fulfillment centers, where holiday orders will be packed and shipped.

(…)  As a result, retailers and delivery companies expect to have to raise starting pay in some places. (…)

Starting warehouse wages, which have been stagnant for years, have been rising by about $1.50 to $3 an hour to attract workers in some markets, according to logistics staffing firm ProLogistix. The firm said that in this holiday season, temporary jobs—especially at e-commerce companies—start in a range of between about $11 and $13.50 an hour, up from between about $9 and $11, though it varies significantly by region.

Ozburn-Hessey Logistics LLC, a third-party logistics provider, is raising its hourly wages by about 10% in some markets to compete for talent in e-commerce hot spots, such as around Louisville, Ky., and Memphis, Tenn., where UPS and FedEx, respectively, operate some of their biggest package-sorting hubs. (…)

The United Auto Workers union reached a tentative labor deal with Fiat Chrysler Automobiles NV that will eventually remove a controversial two-tier wage system that pays newer hires less than more-experienced co-workers doing the same jobs, according to people familiar with the agreement.

Under the current arrangement, newer factory employees earn about $9 an hour less than more senior employees, a point of friction for many rank-and-file workers. The new structure will eventually phase out the two classes of wages over time, the people said.

Pay for entry-level workers hired after 2007 is currently capped at $19.28 an hour. The new deal would raise that pay ceiling after a number of years closer to $25 an hour, the people said, though the precise time frame and dollar amount couldn’t be learned. Veteran workers earning more will keep their wages until they no longer work for the company, leaving the other wage as the new pay standard for auto workers going forward, the people said. (…)

Fiat Chrysler is the smallest and least profitable of the Detroit Three car makers. With about 45% of its hourly workforce earning the lower wage, the company has a labor cost advantage of about $9 to $10 an hour over rivals GM and Ford, putting it more on par with Asian rivals such as Toyota. (…)

…OR NOT

(…) The layoffs disclosed Tuesday are in addition to a 55,000 head count reduction that the company previously announced. (…)

Industrial production, which measures output in the manufacturing, utilities and mining sectors, fell a seasonally adjusted 0.4% in August from July, the Federal Reserve said Tuesday. It was the sixth time in eight months that the measure fell from the previous month.

Capacity utilization, which measures industrial slack, fell to 77.6% in August from 78% in July.

Meanwhile, industrial production for July was revised up to a 0.9% rise from an initial estimate of 0.6% growth.

Manufacturing output, which accounts for almost three-quarters of overall industrial production, fell by 0.5%, driven by a 6.4% drop in production of autos and auto parts after an increase in July of more than 10%. Manufacturing output was up 1.4% in August from a year earlier.

  • U.S. Business Inventory Total Rises

Total business inventories edged up 0.1% in July (2.6% y/y) after a 0.7% advance in June, revised slightly from 0.8% reported initially. The resulting 3-month growth was 3.0% (AR), down from 5.0% in June. Total business sales also increased 0.1% in July (-2.7% y/y), less than June’s 0.3%, which was revised from 0.2% reported before. July’s 3-month growth rate was 3.1%, compared to 5.0% in June. The overall inventory/sales ratio was 1.36 in July, the same as in June, which was revised down from 1.37.

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The Empire State Factory Index of General Business Conditions remained negative during September, nearly the weakest reading since the recession. The latest figure of -14.67 compared to an unrevised -14.92 in August. These diffusion indexes were the lowest since April 2009. The latest disappointed expectations for -3.0 in the Action Economics Forecast Survey. The data are reported by the Federal Reserve of New York and reflect conditions in New York, northern New Jersey and southern Connecticut.

Based on these figures, Haver Analytics calculates a seasonally adjusted index that is compatible to the ISM series. The adjusted figure eased to 44.9, also a six-year low. (…)

New orders and shipments also were close to the lowest levels since 2009, while vendor delivery speeds quickened to the fastest pace this year.

(…) Prices received fell into negative territory, also for the first time since 2009.

Expectations for business conditions also deteriorated to the lowest positive level since January 2013. A sharply reduced 39.6% of respondents expected improvement. Each of the component series deteriorated m/m.

Empire State Manufacturing(Doug Short)

  • Worries Rise Over Global Trade Slump A sharp drop in global trade growth this year is underscoring a disturbing legacy of the financial crisis: Exports and imports of goods are lagging far behind the pace during past expansions, threatening future productivity and living standards.

For the third year in a row, the rate of growth in global trade is set to trail the already sluggish expansion of the world economy, according to data from the World Trade Organization and projections from leading economists. Before the recent slump, the last time trade growth underperformed the rate of an economic expansion was 1985.

Since rebounding sharply in 2010 after the financial crisis, trade growth has averaged only about 3% a year, compared with 6% a year from 1983 to 2008, the WTO says.

Economists blame the slowdown on many factors, from China’s shift away from certain kinds of manufacturing to a decline in international investment. They also point to a dearth of major new trade agreements and the erection of trade barriers after the 2008 downturn, as well as a newfound reluctance by companies to source products and components far from home. (…)

For the first seven months of 2015, U.S. exports dropped 5.6% to $895.7 billion. The value of South Korean exports shrank a revised 14.9% in August from a year earlier, the sharpest fall in six years, as shipments to China dropped. Chinese imports in August fell 13.8% in dollar terms from a year earlier, after an 8.1% decrease in July. (…)

Eurozone Inflation Slows Unexpectedly in August Growth in labor costs dipped across the bloc, increasing the likelihood of more ECB stimulus

The annual rate of inflation declined to 0.1% in August from 0.2% July, the European Union’s statistical office said Wednesday. That marks a downward revision to Eurostat’s flash estimate of 0.2% and pushes annual inflation further away from the ECB’s target of just below 2%. (…)

There were more signs of easing inflationary pressure Wednesday, as Eurostat reported slowing growth in labor costs across the bloc. Eurozone labor costs, for every hour worked, rose 1.6% in the second quarter from the same period last year. Gross wages rose 1.9%, while non-wage costs were up 0.4% over this period. In the first quarter, labor costs had increased by 1.9%.

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Thumbs up Thumbs down S&P 500 Flagging

BUY LOW, SELL HIGH: Buying Canadian Banks (September 2015)

This is a new feature in Bearnobull. From time to time, I will write on situations which I consider compelling, either buy or sell, based on valuations. These will always be securities that I personally buy or sell, the write-ups being essentially my own reasoning behind the moves, for my own benefit but which I dare to share. Anybody who acts on these would be well advised to do his/her own research and to read the disclaimer to this blog.

Note: Many additional supporting charts for this analysis are available in Bearnobull’s Library (with the usual restriction).

BUYING CANADIAN BANKS

Canadian banks are among the best run banks in the world, operating in an oligopolistic environment and supervised and regulated by a conservative Federal Government agency. Here’s the rundown on the sector’s current valuation:

  • The absolute median P/E on trailing EPS is 10.2x, at the low end of a 20-year range of 10-15 excluding recessions (next two charts courtesy of CPMS/Morningstar)

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  • Net operating margins are near their 2011 all-time high. Margins are FIVE times higher than in 1994 and 26% higher than their 2005 previous peak.
  • Median Price to Book Value at 1.3x is also a the low end of its 20-year range of 1.17x (2009 trough) and 2.7x (2006). Since 2010, P/BV has fluctuated between 1.2x and 2.0x.
  • Median ROE, the main driver for P/BV, is currently 13.6%, in the middle of its 20-year range of 9%-18%. On a cap-weighted basis, ROE is 16.2% as the two largest banks have sustained high ROEs: CIBC: 19.9% and Royal: 18.7%, both banks being heavily sensitive to Canada as opposed to the other 3 largest banks (BMO, TD and BNS) which have more meaningful foreign activities.
  • The average dividend yield is currently 4.6%, weighted down by TD’s 3.9%. RY’s is 4.4% and the other 4 banks are at 4.8%. Except for the 2008-09 financial crisis, this is the highest dividend yield on Canadian banks in 20 years. Since 2010, the range has been 3.7-4.7%.
  • Canadian banks never cut dividends (only National Bank cut it in 1983 and 1992-93). Banks generally hike their dividends every second quarter.
  • EPS are growing nicely this year. Even TD and BNS, facing tougher conditions in their respective markets, have increased their earnings.

In all, this is a great opportunity to buy some of the best banks in the world at bargain prices. Canadian banks are down 14% (weighted) from their April 2015 peak and are down 11% YoY. Canadian bank stocks have fluctuated in a pretty constant range of –10% and +25% price swings on a YoY basis since 1987.

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Why are they so cheap?

U.S. hedge funds have this recurring tendency to see Armageddon hitting Canadian banks every once in a while. It just does not happen because Canadian banks are much better run, much better capitalized and much better supervised than U.S. banks. One trader wrote last March:

It is a true statement that Canadian banks have never blown up. Ever. Don’t you think that’s weird? Every other developed country in the world has had a banking
crisis at one time or another. Not Canada. Never happened. So you can look at this one of two ways:
1. Past performance is no indicator of future results.
2. They are due.

How about a third way? Canadian banks are very conservatively run. And resilient as BMO Capital Markets put it after the banks released their Q3 results in August::

“resilient /rɪˈzɪlɪənt/ adj. able to withstand or recover quickly from difficult conditions.” Oxford English Dictionary.

That’s the best way to describe the Q3/15 results of the Canadian banks. The results were generally better than expectations and the industry’s operating EPS were up 5% year over year, and the industry delivered an operating ROE of 16.2%, down from 17.6% last year; ROA was 84 bps, down from 89 bps last year. The “Big 6” CET1 ratio was a solid 10.2% up from 9.8% last year but flat sequentially as good internal capital generation was offset by growth and the FX impact of a depreciating Canadian dollar. Three key highlights from this quarter (for individual bank summaries refer to Appendix B) are:

  • Canadian Resiliency. The Canadian Banking segment, which accounted for 49% of the industry’s bottom line and where the “Big 6” enjoy an unfair advantage, had 5% higher earnings from last year on resilient volume growth of ~5%, positive (albeit marginally) operating leverage, and sequentially better risk-adjusted margins (stable to improving spreads and credit costs).
  • Revenue Resiliency. Notwithstanding the continued headwinds of a low rate environment (~50% of industry revenue is spread based), the industry was able to deliver a 6% year-over-year top-line growth, a testament to the diversified business model of the banks (across geographies and revenue sources).
  • Credit Resiliency. It was another good credit quarter with industry PCL ratio of 29 bps, which compares with a 20-year average of 40 bps. Given the precipitous drop in oil prices, all the banks provided updates on their direct and indirect oil and gas lending exposure, with CM going as far as quantifying potential stress losses from a prolonged period of low oil prices. Higher credit costs are inevitable but not imminent.

Buying Canadian banks here provide a cheap way to participate in potential trend changes in the next year with minimal capital risk and dividend income in the 4.5% range. All Canadian bank stocks would benefit if oil prices were to firm up and/or if Canadian housing remains solid and/or if the Canadian recession risk subsides. Also, TD and BMO allow participation in the U.S. banking business. Finally, BNS is a conservative way to invest in a potential turn in emerging markets through its exposure in Mexico and a few other Latin American countries.

Oil and Gas Risk

All the banks commented on their direct and indirect lending exposure to declining oil prices. All noted that continued low prices may lead to additional but manageable loan losses. (BMO)

BMO summarized each bank direct and indirect exposure to oil and gas:

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The BMO analyst went on to stress test the EPS assuming $30 oil for 3 years finding that the range of losses would be 3-4% of his 2016 estimates.

Housing Risk

Shorts on Canadian bank stocks are almost exclusively American investors. Their memories of the U.S. housing debacle are still alive and are easily transposed to the Canadian scene when they see Canadian house prices and consumer debt. This next chart has probably triggered a lot of shorting action, even though both “debt” and “income” are defined in much different ways in the U.S. and Canada.

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Without going into all the details, Gluskin Sheff’s David Rosenberg did the calculations on an apples-to-apples basis which makes the Canadian ratios still elevated but much less dramatic.image

I am not suggesting that banks are not assuming much mortgage risk, but the facts are that there are a number of structural issues that differentiate the Canadian and U.S. housing markets such as, among many others, the facts that 55% of residential loans (45% of total loans) are fully insured, Canada has more prudent underwriting standards with a single regulator and banks require low Loan-to-Values ratios (homeowners’ equity as a share of real estate is 70%). Also, keep in mind that Canadian banks are not involved in the subprime market.

These BMO Capital charts illustrate how Canadian banks have improved their loan management, reduced their risk exposure while improving their returns over time:

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The main risks for Canadian banks are a full fledge recession and/or a rapid rise in interest rates. While Canada is technically in recession because of the impact of oil on Western Canadian provinces, the rest of the country is doing better and will keep Canada from having a traditional recession. The silver lining is that Canadian interest rates are not about to rise meaningfully. Lastly, there is a political risk over the shorter term if the Conservative Party is defeated in the October elections. Current polls indicate a 3-way split in Parliament seats with more than a month to go.

For investors, the combination of lower oil prices and relatively elevated house prices and consumer debt have created enough anxiety so that Canadian banks valuations have become very compelling. Over the last 59 years, Canadian bank stocks have had only 14 negative years from a total return viewpoint.

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It is pretty rare that one can buy high quality companies at bargain basement valuations with 4.5% fairly secure dividend yields.