Student Loans: Absolute Returns Mislead Absolutely

I grew up in a household that was very fiscally responsible. My father instilled at an early age the power of saving and investing. If I accumulated $50 in allowance he would be willing to match my savings.For a nine year, old, or any investor for that matter doubling your return annually is quite impressive. For my birthday, every year my grandfather would give me a $100 savings bond, which now that I think of it, I have no idea where those went. When I was seventeen years old I began a Roth IRA, and when I was nineteen I purchased equity in my first company that went bankrupt (GT Technologies). Not only was I encouraged to save but my parents always preached the importance of paying your debt. Even to the point where having debt was like subscribing to the Black Plague. Even if debt couldn’t wipe out one third of the European population it could definitely wipe out a large portion of the stock market (i.e. Long Term Capital Management had liabilities over $100 billion, this translated to an effective leverage ratio of more than 250-to-1 and a government bailout of multiple banks). As a recent college graduate, I have my first bout with debt in the form of student loans.

As 2016 comes to an end, most recent collegiate graduates are familiar with the statistics revolving around student loans: In the United States there is approximately $1.26 trillion in total US student loan debt, 44.2 million Americans had student loan debt, student loan delinquency rates are around 11.1%, and average student loan payments for borrowers aged 20 to 30 years amount to $351 per month (Student Loan Hero). According to Student Loan Hero, the debt statistics by student loan status are as follows:

• Loans in repayment – $468.1 billion; 15.7 million borrowers
• Loans in deferment – $101.7 billion; 3.4 million borrowers
• Loans in forbearance – $102.8 billion; 2.7 million borrowers
• Loans in default – $63.2 billion; 3.9 million borrowers
• Loans in grace period – $42.6 billion; 1.7 million borrowers

It’s no secret that students have become increasingly dependent on student loans to fund their four years at both public and private schools. The Class of 2016 graduate has $37,172 in student loan debt, up six percent from last year and the 2017 student loan debt is only expected to increase. With more of an emphasis on the importance of college education, it seems that these costs won’t be going away anytime soon. With over $1 trillion in government funded student loans there has been a misguided hope of debt forgiveness. The impact of student loans is one of reasons Bernie Sanders was a popular candidate. In a current low-growth, low interest rate economy, these debt forgiveness programs could even be harmful to the people they’re meant to help. Ohio University developmental economist Julia Paxton states:

“One of the problems of debt forgiveness is that it sets a precedent that similar loans in the future will also be forgiven. Although the loans are allocated toward education, money is fungible and will have the net impact of increasing the spending ability of students in other areas of their lives. As the expectation of repayment obligation falls, borrowers may enter into a situation where they take on higher levels of debt and take more risks. This will lead to a weakened ability to repay, creating a vicious cycle that hurts the financial sector and the credit ratings of the borrowers.”

And with a Precedent-Elect that aims to lower taxes and increase infrastructure spending, the ability for government funding of tuition will be increasingly sparse. While the idea of young Americans entering into the work force with mountains of debt is in no way uplifting, awareness of the loan management strategies helps to alleviate the load.

From the first student loan meeting to your last payment you hear the same advice: Make your loan payments fit your budget even if that means student loan refinancing, have a debt management strategy, focus on long term planning and find the payoff date, avoid repayment programs, pay off higher interest rate loans first, private loans offer less flexibility, etc. etc. The list goes on and on, but one of the most worn out pieces of advice is to pay off your debt early. In my household, this has been a common theme emphasized by my parents. My sister paid off her $17,000 in eight months, saving approximately $7,000 in interest that she would have accumulated if she followed the ten-year payment plan. Using a basic loan amortization schedule, a $25,000 student loan with 5.0% interest with a 10-year payback period would cost $208 a month. By paying $700 a month instead of $288 enables the borrower to repay the loan in just over 3 years. By paying the principal down more quickly, you would be paying lower interest charges. By paying extra, the entire loan would cost $27,000 rather than $31,000. While it seems like a no brainer to pay off debt early, an intelligent investor knows that single-minded returns tend to mislead and absolute returns mislead absolutely.

Would you rather invest in a security that offers 5% or 8% returns, ceterus paribus? Any rationale investor would choose the latter. As you look at your personal and financial goals, it’s time to compare interest rates. Is paying off student loans early right for you or should you focus on your saving goals and invest in the ever enticing stock market. If you have an interest rate over 5%, you may want to make paying off debt your main priority. High interest rates can tack on a lot of extra money to your balance, making the repayment period even longer. But if you have a low interest rate—especially around 2%—you may be able to get better returns on your money in the stock market.  With investing, you take advantage of compound interest and put your money to work for you over time. Both options have there benefits and depend on the risk tolerance of the borrower.

Pros of Waiting to Payoff Loans and Investing

• Compounding interest and higher investment returns
• Many employers match investments in 401K
• Invest in tax advantage retirement accounts (i.e. Roth IRA, 401K)
• Could receive tax deductions on student loans
• Potential student loan forgiveness programs

Pros of Paying Off Student Loans Early

• Guaranteed return
• Many investments are taxable at a higher rate (15% if you are in a 25% or higher tax bracket)
• Clean Conscious
• Good Credit Score!

As for myself, I am comfortable prepaying an interest rate of 5% on my student loans and forgoing a rigorous investment plan. On Friday December 17^th, the Dow Jones had risen 10% for 2016 and continues to approach 20,000. Wall Street forecasts for 2017 are unsurprisingly bullish as the year ends on a strong note. While there is a chance that markets will continue to outperform in 2017, major indices continue to appear overvalued. While I will pay off my loans as soon as possible, I also set aside money to max out my 401K, add to my Roth IRA, and include a safety net in case of emergencies. So whether you choose to pay off your student loans early or to invest your money, continue to make minimum payments toward your federal loans, and choose a repayment term that works for you.

 

http://www.bankrate.com/finance/college-finance/repay-college-loans-fast-1.aspx#ixzz4TmC7uSWW

http://www.nytimes.com/2016li12/16/your-money/wall-streets-annual-stock-forecasts-bullish-and-often-wrong.html?

https://studentloanhero.com/calculators/student-loan-payoff-vs-invest-calculator/

 

Black Swan: Chasing Volatility

The Chicago Boards Options (CBOE) describes the volatility index as “a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices”. The VIX was inducted in 1993 and since then has been considered a premiere benchmark to express investor sentiment and market fluctuation. After investors expressed interest in trading securities related to the measure of volatility, VX futures were introduced in 2004 and options in 2006. Since then various leveraged and non-leveraged ETFs tracking the VIX have also been integrated into the market once again holding the attention of investors.

VIX is calculated by “averaging the weighted prices of the S&P 500 index (SPX) puts and calls over a wide range of strike prices” or the square root of the 30-day variance of the S&P 500 rate of return multiple by 100. The 30-day variance looks at the sum of squared standard deviations around the S&P 500 within the 30-day period. These variance prices can be estimated by looking at the forward prices of SPX options because “the forward price of the strip represents the market’s risk-neutral expectation of that variance”. It is a general assumption based on the premiums investors pay on either the right to buy or sell stock.

The Relationship of the SPX and the VIX^® Index

Below is a chart found on Bloomberg, originally cited from the CBOE site, showing the relationships between the S&P 500 and the VIX index since its induction in 1993. Most investors consider VIX to be an inverse of the S&P 500, representing both fear in the market and a bearish sentiment. During periods of market turmoil, as in the 2008 credit crisis the VIX sharply rises as the S&P 500 falls. One of the biggest questions people generally ask is: Why does the volatility index not increase when the S&P 500 increases on surging volume. In my opinion there are two main reasons: The options that comprise VIX are actually overweight puts than calls, which gives it a negative delta. Due to this negative delta, it is difficult for the VIX to go up when the S&P 500 goes up. Secondly, market corrections will generally result in a quick, sharp selloff of assets while the S&P 500 will generally rise in a slow, controlled manner; this has been the case recently as the S&P 500 has risen above 19,000 for the first time ever, gradually increasing since 2008 with few corrections in between. To summarize, investing in volatility generally means you’re taking a short position on the S&P 500.

I discuss this topic because right now volatility is historically cheap. August 2016 was the least volatile of any 30-day period in more than two decades. Only five days during the most recent stretch saw the S&P 500 move by more than 0.5% in either direction, the lowest since the fall of 1995. The trading inactivity has continued since January as the Federal Reserve continues to avoid raising rates (which will probably change in December) and investors waited to see what would happen in the election. Alas Trump won, and the stock market kept on truckin, just like Casey Jones, driving that train forward high on a euphoric cocaine. Wouldn’t it make since to buy some type of security representing volatility? I mean despite the recent market activity don’t people usually preach ‘buy low, sell high’? With the accessibility of ETFs tracking VIX, your average joe investors are able to think about purchasing these current sedated market conditions.

UVXY

I first heard about UVXY in my equity investments class at Wake Forest. The class was participating in a portfolio management challenge pitting different teams against each other to see who could earn the highest rate of return during the semester. One of my teammates suggested that we invest in UVXY on the basis that it would be a good hedge against any market downturn– it was January 2016 at this time so markets were uncertain as China’s currency crashed and the Fed raised rates. It seemed like a good idea at the time, but as the semester got further under way the losses on UVXY continued to increase. It’s safe to say we didn’t win the competition, but it did compel me to look into the mechanics of the strange ETF.

The ProShares Ultra VIX Short-Term Futures (UVXY) is a doubled levered ETF tracking the VIX. According to its prospectus the value of UVXY is closely tied to twice the daily return of the S&P VIX Short-Term Futures. Every day the index changes, tracking a different set of VIX futures contracts as older contracts expire and investors roll-over to new contracts. Like a stock, UVXY’s shares can be split or reverse split. UVXY is unique in that it reverse split five times in its first four years of existence – a feat that may be a record in the ETF realm. The last reverse split was 5:1.

Recently markets have hit a brief period of euphoria as Trump’s nomination leads to speculation that there will be less financial regulation, increased spending on US infrastructure, and an easing of fiscal policy. The Dow has climbed relentlessly, rising over 19,000 for the first time since its induction and we are in one of the longest bull markets in US history. Any rational investor with an attention span longer than a gold fish remembers the 2008 recession and knows that this rally may be too sweet to last. Some heralds keep crying that asset prices are overvalued and a bubble is brewing, inflated by the Feds easy monetary policy.  As an investor, it seems tempting to jump into a product tracking VIX, especially because volatility indicators are so low.

When I originally saw UVXY, it seemed like a no brainer. When the markets tank, these long volatility positions are perennial powerhouses. Data for the 2011 correction shows that UVXY’s value went up 550% in a few months and UVXY’s percentage moves averaging -5.96 times the S&P 500’s percentage move. The record one-day VIX jump so far was a 59% jump in February 2007. If I buy UVXY now at such a low rate I could easily double my returns if I just waited for the next correction. Unfortunately, nothing’s ever free and there’s a lot more to this security than the eye can see (Phonetically that sentence was brilliant).

These geared funds surge when there is a spike in volatility but this appreciation is very short-lived and always leads to all-time trading price lows. The chart above shows the shocking truth about UVXY and how the fate is sealed for this ETF. These ETFs just went from perennial powerhouses to landslide losers due to one simple anomaly: Contango. Contango refers to when current futures prices are less than the expected future spot price.  More simply stated, an investor pays higher prices for options that have more distant expiration dates. The counterpart of Contango is Backwardation. Backwardation occurs when the futures price of a commodity is lower than the spot price today. There is a higher demand to hold commodities contracts today compared to paying for the contracts at a later date. Backwardation aligns with bearish market sentiment – the price of the commodity is expected to be less in the future. Backwardation is beneficial when investors take net long positions as the futures prices are expected to converge (rise) toward the spot price. Contango markets are unloved by holders of long-only index products because of the negative yield encountered when expiring contracts are replaced by forward-month deliveries. Index funds, of course, must maintain constant exposure to their component futures. Holding futures into an expiration month creates a delivery risk, so part of a index’s methodology specifies protocols for rolling futures positions forward. To roll a long position, the soon-to-expire contract that is converging on the current spot price is sold as the distant delivery is simultaneously purchased at a higher price. The UVXY is always going to be heading toward zero with the reverse splits being continuing to artificially prop of the price. Another way to look at it is if Proshares had not reverse split UVXY it would now be trading at $ 0.0000167 per share.

 It’s easy to conclude that if you plan on going long on UVXY then you better hold the position for no more than a week or be able to time the next catastrophic event. Otherwise stay away. So the next question is why not short UVXY if it is almost definitely decreasing in price. Well, many investors do, and come away with decent returns. Shorting UVXY is difficult though because you will need margin capabilities and it can be a crowded, illiquid market. Finally, you do not want to be on the wrong side of an instantaneous jump in volatility. In the event of a calamity resulting in a market crash the upside for volatility would be endless while the downside for short-sellers would be devastating.

 

http://www.cboe.com/micro/vix/vixintro.aspx

http://www.wsj.com/articles/its-getting-scarily-quiet-in-the-stock-market-1471889703

Fed Rigging Payroll “It’s A Trap!”

(This post is two weeks delayed. No Wifi in my new apartment. Too LOFTY of a goal)

The Federal Reserve has become very successful at dominating market headlines in the past couple of weeks while failing to convince anyone that their monetary policy is going to elicit change. Starting with Janet Yellen’s speech at Jackson Hole on August 26^th, investors have been lined up hoping that the Fed Chairman or any of the economic data released in the past two weeks would provide insight into the likelihood of a 2016 rate hike. Unsurprisingly, the Fed managed to weave a web of ambiguous rhetoric. Yellen made no promises, said nothing definitive, and she made sure to quell any fears of a low growth economy. Yellen cautiously worded her speech, “While economic growth has not been rapid, it has been sufficient to generate further improvement in the labor market… … Indeed, in light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months.” Well done Janet. Her performance was impressively neutral (bland as always) ensuring that her words couldn’t be warped to create any real news. The speech briefly sent US stocks down and bond yields up, but the only takeaway was that the Fed believes there to be a lower equilibrium interest rate than in the past.

Within her explanation of the “monetary policy toolkit”, or of the very few tricks they still have up their sleeves, Yellen provided very little detail regarding future changes to the inflation-targeting framework. Remain skeptical, don’t be the fool who falls into the trap created by fools.

The biggest economic report came last Friday on September 2^nd. The reason the total Non Farm Payroll report is so important is because it may be the last shred of proof that the Fed is ‘data-dependent’. Yellen and her posse love citing the unemployment rate and the labor participation rate as reasons for why the economy is rock-solid. Going into Friday I was skeptical that the labor report would produce any noteworthy results. Why? With the presidential election coming up in the near future there is little room for error for each candidate. One of the strongest arguments for another Clinton presidency (besides the obvious one of Trump being a lunatic) is the low unemployment rates under Obama, and how that would continue if another democrat took office. The point is, the Obama administration is currently rigging the non farm payroll reports. They want the reports to be satisfactory enough so that the economy looks strong. At the same time, they can’t be too good or else the Fed would have to raise interest rates which would cause a prick in an inflated bubble right before the election.

Total nonfarm payroll employment increased by 151,000 in August, and the unemployment rate remained at 4.9 percent, according to the U.S. Bureau of Labor Statistics. Both the labor force participation rate, at 62.8 percent, and the employment-population ratio, at 59.7 percent, were unchanged in August. In August, 1.7 million persons were marginally attached to the labor force, about the same as a year earlier. Among the marginally attached, there were 576,000 discouraged workers in August, little different from a year earlier. This jobs report was about as exciting as Rosie O Donald’s sex life à very round numbers with very little movement up or down. So the government did their job and the chances for a September hike dropped significantly. But that doesn’t mean there isn’t some dissent within the Federal Reserve community. Boston Fed President Eric Rosengren said in a speech on Friday September 9^th that “gradual interest rate increases might be in order with the U.S. economy at full employment and that low interest rates were increasing the chance of an overheated economy.”

Let’s check out the other numbers that have been released since Jackson Hole. Whether good or bad, there’s a decent chance that the Fed hasn’t even taken a look at these numbers yet.

 Consumer Confidence Index – August 30^th

The CCI which had decreased slightly in July, increased in August. The Index now stands at 101.1 (1985=100), compared to 96.7 in July. Short-term expectations regarding business and employment conditions, as well as personal income prospects improved, suggesting the possibility of a moderate pick-up in growth in the coming months.

US Markit Services PMI – September 7^th

At 51.0 in August, the seasonally adjusted Markit final U.S. Services Business Activity Index dropped from 51.4 in July but remained above the 50.0 (no-change value) for the sixth consecutive month.

Contrasting the Consumer Confidence Report, the weaker-than-expected PMI report sends a downbeat note on economic growth in the third quarter. According to the Markit release the services PMI as well as the manufacturing PMI are pointing to an annualized GDP growth rate of 1%. With low growth and inflationary pressures subdued, the Fed will hesitate to be hawkish in the near future.

ISM Manufacturing – September 6^th

The August PMI registered 49.4 percent, a decrease of 3.2 percentage points from the July reading of 52.6 percent. The New Orders Index registered 49.1 percent, a decrease of 7.8 percentage points from the July reading of 56.9 percent. The Production Index registered 49.6 percent, 5.8 percentage points lower than the July reading of 55.4 percent.

These numbers all came in surprisingly weak with the August PMI value of 49.4 being considered in contraction mode.

NMI  registered 51.4 percent in August, 4.1 percentage points lower than the July reading of 55.5 percent. This represents continued growth in the non-manufacturing sector at a slower rate. The Non-Manufacturing Business Activity Index decreased substantially to 51.8 percent, 7.5 percentage points lower than the July reading of 59.3 percent, reflecting growth for the 85th consecutive month, at a notably slower rate in August.

The NMI represents growth (or lack-there-of) in the service sector. Two weeks before the FOMC policy meeting this paints a very bleak picture. Will the Fed cite this as the reason for not hiking rates? Will the claim they are data-dependent? Or will they ignore this horrible piece of data in order to paint a prettier picture of the US economy before the election?

Tune in next week to find out what happens next.

 

ttps://www.conference-board.org/data/consumerconfidence.cfmhttps://

http://www.markiteconomics.com/Survey/PressRelease.mvc/6805ea86f91a414f832731e9f506d942

Day-Dreaming on a Plane

Approximately one year ago, my family and I were returning home to Arizona from Colorado. We had just spent a weekend at our cabin in the isolated Poudre Canyon which is host to trout with whirling disease, a rock shaped like a sleeping elephant and the semi-docile spirit of my great grandfather who likes to peruse the cabin grounds during the late hours of the night. I think everyone, including my usually composed mother, was nursing a hangover on the flight back to our home in Scottsdale. The four-day trip was marked by an atmosphere of jubilance and excessive celebration as we christened my sister’s newly engaged fiancé into the Ammons family (they were wed a few weeks ago from today). I knew he would assimilate well when I saw that he wasn’t traumatized by my dad’s befuddled hootin’ and hollerin’ or my mom’s inebriated peppiness. There was a lot of dancing on the tables, strumming on the guitar, and the losers in Backgammon only expressed a tiny bit of animosity.

On the flight back I took refuge in my preferred window seat where I sat by a tall, lanky man who seemed to be in his mid-fifties. He initiated the conversation, with much of the first fifteen to twenty minutes being controlled by small talk as I eagerly peered out the window. Slowly, we started finding small similarities between us helping to build rapport. We talked about Wake Forest, finance and he provided me with advice on how to navigate the ‘real world’. This man, who later introduced himself as John, kept me wide-eyed with his adventurous anecdotes that provided color to what would have been a rather dull plane ride. John was an explorer and outdoorsmen. He climbed every major peak in the world including Everest, Kilamanjaro, and K2. John was also an avid heli skier which involves jumping out of helicopters onto back country ski slopes. There was no doubt that this man was arrogant, relishing in the ability to impress an impressible young professional such as myself. I also fueled the fire; unafraid to encourage him to talk about his accomplishments (listening to his stories seemed better than getting frustrated at being unable to complete the medium difficulty Sudoku puzzle in the in-flight magazine).

Later in the flight, I found out that John went to Colorado College. “Colorado College!” I exclaimed, “Both of my parents went to CC! And my sister… and my cousin… and now that I mention it I had an aunt and uncle attend there also”. He seemed less enthusiastic than I would have thought, as most people love talking about their alma mater. After some prying I discovered that he graduated in 1981. Quickly trying to do some mental math, attempting to emulate the great Sherlock Holmes, I proudly deduced that my parents graduated around that time. “Do you know Anne and Dave Ammons?” I eagerly inquired. He did know them, maybe too well, as I would later find out from my mother that his advances on her may have been too forward.

While this coincidence alone is worthy enough to write a blog post on, I want make it more applicable to the finance / networking spectrum. One of the most compelling topics that John and I discussed on the plane, and the reason that I’m writing about this almost a year later, included his current business ventures and investments. He placed great emphasis on his energy investments, claiming that he had invested in the only technology that provided an alternative to fracking. While it could have been his ego talking, John smugly told of how this tech was more efficient, cheaper, and environmentally friendly than fracking. ‘Geese’, I thought, ‘if it’s as great as he says it is then why haven’t I heard about this energy initiative sooner and why is the market not blowing up about this?’ Well, the conversation reached a stopping point soon after. I didn’t question him further, and he didn’t go into too much detail. After he reunited for a brief awkward interaction with my parents in the terminal, we separated on our own separate paths.

John’s description of his new environmentally sustainable oil initiatives left me with nothing more than a day-dream. As my interest in the commodities industry grew, I would always wonder what would happen if that kind of technology took off, and if I had been a part of it. Currently in a job with an average salary and little room for mobility within the company, day-dreaming about being at the forefront of a booming oil market has become more and more frequent. Finally, I decided if there was even the slightest chance of getting involved in this venture, why not take it? I’m at the age where I can take risks and every day that I spend in corporate audit severely decreases my chances of becoming a multi-millionaire. So I decided to send an email to John. The contents looked something like this:

“This is a stretch, I understand that. There’s a slim chance that you are even still working on this venture or that you remember who I am. But if there is even the slightest possibility for me to break into a creative VC environment, then I will pursue it. I’m extremely ambitious and motivated to become more knowledgeable about the industry. I can be an asset providing assistance with market research, M&A valuation, budgeting, and client services. I’m at an age where I’m willing to take high risks and I am extremely hungry to succeed.

Even on a short flight, I recognized that you have a great deal of experience and business acumen and I feel I could learn a lot from you. If you have any work for me, if there is any chance for me to be involved in these energy initiatives, please let me know. You won’t regret it.”

Bold. Straight-forward. A little melodramatic. I understand that the email expressed an unnecessary sense of urgency. But even after a year, John did respond. He sent me an article on the Plasma Pulse technology that is being developed and hopefully will be marketed on a large scale to oil companies. This technology is able to revive wells after the fracking effect begins to fade. With increased fracking regulation in some US states such as California, there is potential for this project to expand.

Now, there may be no way for John to get me involved in this business. I don’t have any experience in the oil industry and only have three months of professional experience (in Corporate Audit nonetheless). Who knows, maybe this two-hour plane flight could have a huge impact on my life. Regardless, this narrative is a wonderful example of the importance of networking, taking advantage of life’s chances, not being afraid to take risks, and the benefits of sharing a few drinks with a stranger on an airplane.

Oil Will Drop to $40 Before Rising to $50

Oil has dropped about 13% since its high of $51.67 in early June. On Friday NYMEX September crude fell 56 cents at $44.19/b. ICE September Brent settled down 51 cents at $45.69/b. The US Dollar Index reached 97.5 Friday, its highest level since March 10. A stronger dollar makes fuel imports more expensive for holders of other currencies. The Brexit vote raised concerns about European economic strength.

My last report on oil occurred in early June as futures prices broke the $50 mark for the first time in a rally driven by a US decrease in production and a weakening dollar. I claimed that it was highly unlikely for oil to rise to $60 because of three reasons: Middle Eastern production, temporary outages, and the Bullwhip Effect. Saudi Arabia, who is very capable of operating in a low price scenario, showed no signs of slowing down and Iran is determined to rapidly ramp up their production. Nigeria and Canada’s outages helped spark a rise in oil prices, but the effect of those short-term catastrophes is waning. All eyes have been on US production, gasoline inventories and demand, and the overall economic outlook. And sure enough as oil prices rose US energy companies eagerly watched the futures ticker, salivating over the idea of $60/b. Cautiously optimistic, production has continued to decrease, but the opposite is true for active rigs revealing that US companies are more adept at operating in a low-cost environment and are tempted to revamp operations.

Nigeria and Canada

The outlook for these two past market movers is split. The Nigerian oil industry risks sinking deeper into crisis in the months ahead with more disruptions to oil output and exports as the government’s dialogue with militant groups has failed to curb violence in the Niger Delta. Some 700,000 b/d of Nigerian oil output is currently shut-in due to the latest wave of attacks on pipelines and other production facilities in the Niger Delta region, the state oil firm NNPC said Thursday, taking production to around 1.5 million b/d. Nigerian officials hope that production will normalize soon but these seems increasingly unlikely.

Canadian companies are slowly showing signs of life after the wildfires that plagued multiple oil sites abated. The number of oil and natural gas wells drilled in the second quarter of 2016 in Canada fell 58% but there are some signs of resurrection. Three leading oil sands producers — Cenovus Energy, Canadian Natural Resources and a joint venture between ConocoPhillips and Total E&P Canada — have remained on track to add a combined raw bitumen production capacity of over 300,000 b/d by late 2017. Drilling activity is also expected to be maintained in the Montney and Duvernay. According to the CEO of Canadian drilling company Precision “We have started off [Q3] with 29 rigs each in Canada and the US and our hope will be for the rig fleets to remain in service. With a few more dollars of increase in [the] oil price, we will move up nicely, and in the WTI $60/b to $65/b range, we can expect all our 200 rigs to be contracted”.

US Production

Falling US crude production and inventories have offered support for the market despite the recent drop below $50.

The July Short-Term Energy Outlook (STEO) forecasts crude oil production from the Lower 48 states to continue to decline through the rest of 2016, then level off in the first and second quarters of 2017. This production forecast is predicated on the WTI price forecast in STEO, which rises from an average of $47/b in third-quarter 2016 to an average of $50/b in second-quarter 2017. Crude inventories fell 2.34 MMbbl last week, according to the Energy Information Administration.

Despite decreasing production drilling rigs targeting crude in the U.S. rose by 14 to 371, after 27 were added since the start of the month, Baker Hughes Inc. said on its website Friday. While declines from existing wells are expected to result in a net decrease in production, increased drilling and higher well productivity are expected to soften the decline. The new-well oil production per rig through July 2016 averaged 796 b/d in the Bakken region (within the Williston Basin), 983 b/d in the Eagle Ford, and 470 b/d in the Permian, according to EIA’s latest Drilling Productivity Report.

 

Also US gasoline inventories stood at 241 million barrels the week ended July 15, a 12.1% surplus to the five-year average for the same time of year, according to Energy Information Administration data.

 

So What Does All of This Mean?

US data remained the key driver in oil prices for the past month or so. The lower production provided optimism for both investors and companies alike. The ambiance surrounding the black-gold elites improved to be less depressing and more forward-looking. Halliburton CEO Dave Lesar said Wednesday, “Today our customers are thinking about growing their business again rather than being focused on survival.” It only seems logical that while US production helped ignite the rally, any signs of weakness or supply gluts will drastically lower prices. Ceterus Paribus, in a best case scenario, with Russia, Iran, Nigeria, and Canada’s storages remaining the same then that leaves the US to decrease production. Rig counts, gasoline inventories, and increased optimism show that the US may not be so aggressive in curbing output. With the peak driving season considered to be ending in September look for a glut either on the crude or refined sides leading to $40 prices.

 

 

http://www.platts.com/news-feature/2016/oil/african-energy-outlook/index

http://www.platts.com/latest-news/oil/calgary/canadian-q2-oil-gas-drilling-falls-57-signs-of-21050812

http://www.eia.gov/petroleum/weekly/

http://www.bloomberg.com/news/articles/2016-07-21/oil-heads-for-weekly-loss-amid-ample-u-s-crude-fuel-stockpiles

Please Don’t Become a Magikarp

These past few weeks are a testament to the average person’s 7-second attention span or however short it is… I was too distracted to read the whole article. Apparently our attention span loses in length even to that of a goldfish. Undoubtedly, the increased dependence on digital processing, social media, and smartphones have allowed us to no longer need to sustain focus for a long period of time. Why commit things to memory when you can look information up in a matter of seconds? Many people get their news from Twitter, short articles, or horrifyingly enough from Facebook. This inability to retain bits and pieces of fact or fiction gathered from various media sources has proved very resourceful recently. Because if humanity were able to maintain a grasp on current events then surely they would go mad. Shootings in Orlando, bombings in Iraq, five police officers dead in Dallas, the massacre in Nice, a military coup in Turkey. If any sane man or women had the capacity to dwell on our world’s reality then they would be crushed by the burdens of human emotion: Surprise, empathy, grief, animosity, and anger. But posting a quick blurb on Facebook is perfect for relieving your conscious while creating the perception that you give a shit. Maybe it’s a blessing. What other choice do we have than to get on with our own lives?

Current events aside let’s turn this goldfish into a Magikarp. For those of you who aren’t avid Pokemon fans a Magikarp is a Pokémon resembling an orange fish. It is about as useless as the Federal Reserve’s monetary policy. I’m assuming that this Magikarp also has a longer attention span than humans and embodies so many of the faults of this digital age. Because while we choose not to remember the atrocities committed, the victims that need our help, or the political and economic instability ravaging our countries at least we can focus what little attention that we have on PokemonGo. According to Wikipedia, “The game allows players to capture, battle, and train virtual creatures, called Pokémon, who appear on device screens as though in the real world. It makes use of GPS and the camera of compatible devices.”  In the two weeks since PokemonGo has been released it has acquired more users than Twitter, sucked up more Smartphone time than Facebook, with the system briefly shutting down because of the high amount of users. People are roaming the streets staring down at their Smartphones looking to catch the next big Pokémon. The amount of time and energy going into this game are astounding and they provide the perfect escape for people who just can’t handle real life. In some instances it is just plain cowardly.

The Nintendo stock price is flourishing, almost doubling in the past two weeks. They are about to launch a $35 wristband to notify when Pokémon are near. With just $273 million in earnings in 2015, if 5% of users bought this wristband they would generate $1.75 billion in revenue. This is just the tip of the iceberg as Nintendo plans on expanding into other gaming worlds such as Mario and Zelda.

The “Magikarps” of the investing world seem to have even shorter memories then the millions of Smartphone users. This week was capped off by good news in the retail sector.  Sales rose 0.6% in June from May, which was far above the 0.1% consensus from the Street. Sales rose in virtually every category, even department stores. The only categories to see sales drop were clothing stores and restaurants and bars.

While people are claiming this bodes well for the economy they forget that May’s initial report was revised down significantly, from a gain of 0.5% to only 0.2%. So the June number, assuming it too isn’t revised, is just an offset of what now appears to be a mediocre May.

The other recent good news came from the June jobs report. The consensus was for 180,000 jobs to be created and the range went from a low of 130,000 to as high as 235,000. The actual number came in at 287,000, over 100,000 jobs above the average consensus. While great numbers I would advise investors to remain cautiously optimistic. Don’t just shrug off the downward revision for the already bad number from May, making it even worse. Initially that number was 38,000 jobs and now it’s just 11,000 jobs. So about 70% of the jobs disappeared.

Euphoria set in this week as US stock markets reached record highs. The Dow Jones ended at 18,513 at the closing bells on Friday. There was a quote in the WSJ that made me cringe. Some analyst claimed that “the market is solid, which means the economy is solid”.  We are in the midst of the second longest bull run in US history spanning seven and a half years. Easy monetary policy was the solution to the Great Recession in 2008 and has continued despite the Feds claims that they will raise rates. The flow of money from central banks in Japan and Europe has resulted in a selloff of Treasury Bills all over the world creating inflated assets, most notably stocks in bonds. With negative yields investors were actually paying to lend money to Berlin on the 10-yr German Bund. With such low returns where else can you put your money but the stock market? The Federal Reserve has been inflating their balance sheet for so long now while experiencing diminishing returns in economic growth. It seems obvious that this money that they’ve been injecting into the markets is not stimulating the working class but is going right back into equities creating a nice big bubble. No matter what the Fed says they can’t raise rates because they realize that the natural brain chemistry of our economy is now wired around easy money; it’s not so easy to quit this type of heroin. The reason the stock market went up this week is because people realize that the strong jobs number does not mean the Fed will raise rates. This paradox of record low interest rates and record high stocks is here to stay.

With a desperate search for adequate returns in this environment there are still places to go. A good place to start would be to protect against inflation through commodities, high-yield bonds, REITs, emerging market equities, and Munis.

This week’s rally did result in a selloff of T-bills with yields rising from 1.547% from 1.366%. With low yields, Treasuries may still not be a bad buy.

Even though a $10,000 investment produces a paltry $158 in annual interest income, returns of bonds have been higher than they were in the past. While many investors focus on the nominal yield they don’t take into account the “real yield” or the yield less the CPI. Currently with low inflation there may be some money to be made. Would you rather have a bond that is yield 1.55% with 1% inflation which equals .55% (Pretty bad I know) or a bond that yields 3% with 4% inflation providing negative returns.

This misperception is known as the “money illusion.” According to Barrons, “The term was coined by Irving Fisher, an economist at Yale University, in his 1928 book of the same name. Fisher defined it as “the failure to perceive that the dollar, or any other unit of money, expands or shrinks in value.”” In the money illusion, nominal figures jump out more vividly than real numbers.

We live in a world where very few people are willing to forgive but are very skilled at forgetting. People can barely predict the direction of the market in a year’s time, much less a week, or even seven seconds. Don’t be a Magikarp, keep your head up, and explore the data from all angles to succeed in today’s market.

On Compromise: My grandfather’s take on the polarization of America

Bob Natiello WG56

On Compromise

When asked, “Just exactly what are your politics,” I always answer with a unique expression of neutrality. “I’m a member of the Algebra Party,” I state. “Whatever you do to one side of the equation, you have to do to the other.”

Though my words are nothing more than a personal refusal to commit to one particular party, they seldom fail to draw looks of suspicion. You can’t be neutral, their eyes say. You have to choose one side or the other. Yet recent Gallup polls show that the percentage of voters who call themselves Independents has grown to 43%. In the same time frame, the percentage who say they’re Democrats has dropped from 36% to 30%. The percentage of voters defining themselves as Republicans has also fallen, but by a more modest two points: 28% to 26%.

These declines in party allegiance show a distinct change in the body politic. Today, more voters identify themselves as Independent than as Democrat or as Republican. A nagging discomfort with government is behind this shift, political scientists say—an obvious failure of our leaders to get something done.

In her recent book, Penn president, Amy Gutmann offers her insight into the root cause of these feelings. With co-author, Dennis Thompson, she cites failure to compromise as the culprit that prevents us from moving ahead. Even when compromise might favor a common good—improved education or a fairer tax code, for example—politicians on both sides seem unwilling to yield their cherished beliefs in favor of cooperation. In an interview on CBS’s 60 Minutes, John Boehner, the former Speaker of the House, gave this answer to Lesley Stahl’s question about compromise, “I reject the word.” I believe this unyielding partisan mindset keeps our nation from reaching consensus.

A major reason behind this intransigence is the media. They’ve taken the simple act of changing one’s mind, redubbed it “flip-flopping” and virtually criminalized it. In such an adversarial atmosphere, what politician—of either stripe—would dare compromise? Concede a point to your opposition by backing off, and the media will skewer you for backing down.

In the coming 10-day stretch from July 18th to 28th, both parties will have completed their quadrennial conventions in Cleveland and Philadelphia. Before the delegates settle down to contemplate their sweeping November victory, they might seriously consider this Gutmann/Thompson advice: partisan dominance is not the way to eliminate gridlock. Compromise is. Politicians can extricate our nation from the mire of the status quo if they see compromise not as defeat, but as victory for both sides. The below sonnet uses poetry to make the point. When both sides compromise, both sides can claim victory.

 

On Compromise

I fear our leaders and their rigid minds

Unbending, taut and loath to compromise.

I dread the mindset that so often blinds

Their thinking—and their rush to polarize.

Can they not join to seek the common good?

No crime exists in seeing eye-to-eye.

Why can’t they fuse their aims as leaders should?

And to their endless combat bid goodbye.

When prized beliefs can yield to middle ground

The dry-rot status quo can be dismissed.

When seeds of conflict find no fertile mound

Then progress can take root and growth persist.

When leaders meet halfway, their journey’s done

And then both sides can claim their victory’s won.

Fireworks on the 4th… But not in America

The 4th of July is a remarkable holiday where we celebrate the traditions inspired by our Founding Fathers. The values inculcated from an early age include economic prosperity, democracy, hard-work, and equality. Unfortunately we haven’t really had time to celebrate many of these traditions especially in the financial markets. In the past two weeks all eyes have been on Britain and their referendum to leave the European Union. While there are many possibilities that the UK are considering taking, including establishing another referendum, the uncertainty has decimated the British pound and the more risky assets. But I’m not here to discuss Britain because honestly I find the excessive coverage to be quite vexing. With people so focused on what’s happening overseas there has been little reaction to the United States economic data recently released. While there were very few positive or negative shocks embedded in the data in the month of June, the results seem to be pointing toward a somewhat disappointing second quarter.

GDP:

June 28th

The real GDP was adjusted for a third price estimate with an annual rate of 1.1 percent in the first quarter of 2016, according to the Bureau of Economic Analysis. This was an increase from the second estimate of 0.8 percent.

Originally the GDP numbers reflected more spending on household services, notably on health care and on housing and utilities. The upward revision to real GDP growth moved due to upward revisions to exports and to business investment which was countered by downwards revisions in consumer spending.

 

Corporate Profits:

June 28th

Corporate profits increased 1.8 percent at a quarterly rate in the first quarter of 2016 after decreasing 7.8 percent in the fourth quarter of 2015.

Profits of domestic financial corporations decreased $11.3 billion in the first quarter, compared with a decrease of $24.0 billion in the fourth. Over the last 4 quarters, corporate profits decreased 4.3 percent.

Click to access gdp1q16_3rd_fax.pdf

Markit Manufacturing PMI:

July 1st

U.S. manufacturers indicated a slight rebound in production volumes during June, helped by the fastest rise in new work since March. However, the latest survey signaled that growth momentum remained relatively subdued in comparison to its post-crisis trend, which the PMI Index registered to be 51.3 in June, up from 50.7 in May and the highest reading for three months.

A rebound in export sales provided a boost to manufacturers’ workloads in June. Moreover, the increase in new orders from abroad was the fastest since September 2014.

The latest reading rounds off the worst quarter for goods producers for six years and with the continuing uncertainty throughout the global markets the outlook for Q2 doesn’t seem to bode well for exporters.

Producers are struggling in the face of the strong dollar, the energy sector decline and
presidential election jitters. With companies searching for any type of stability amid a volatile market, heightened tensions between the UK and the European Union are likely to unsettle the global business environment further in coming months.

https://www.markiteconomics.com/Survey//PressRelease.mvc/6af4890597674e268079c8acfd3446e7

 

Markit US Services PMI

July 6th

The US Services PMI index increased to 51.4 in June, up fractionally from 51.3 in May. The seasonally adjusted Markit U.S. Services Business Activity Index signaled a further marginal expansion of service sector output.

While rising, the PMI index was hit hard in May and still borders contraction levels (under 50.0). The service levels for the month of June continue to corroborate poor economic prospects in the second quarter. The deflated business confidence and heightened economic uncertainty had acted as a brake on growth in June. Furthermore, the balance of service providers expecting a rise in business activity during the next 12 months reached a fresh survey-record low in June.

Commenting on the PMI data, Chris Williamson, Chief Economist at Markit said:
“Rebound, what rebound? The final PMI numbers confirm the earlier flash PMI signal that the pace of US economic growth remained subdued in the second quarter. While volatile official GDP numbers are widely expected to show a rebound from a lacklustre start to the year, the PMIs suggest the underlying malaise has not gone away. The surveys point to an annualized pace of economic growth of just 1% in the second quarter.”

One piece of good news: New work received by service providers expanded at a moderate pace in June, and the latest upturn was the fastest since January. Much of this was due to an increase in orders that needed to be filled. However, the rate of expansion remained weaker than its post-crisis trend.

https://www.markiteconomics.com/Survey//PressRelease.mvc/bb8b2e3e686e4869894f8c7ac6ab4108

 

UK PMI Services Index:

July 5th

Growth over the second quarter as a whole was the weakest since the first quarter of 2013 when the current upturn began. Moreover, the 12-month outlook was the darkest since December 2012. Companies often reported that uncertainty linked to the EU referendum had weighed on workloads and incoming new business. The data collection window for the June survey was 13-28 June, with 89% of responses received before 24 June.

The Business Activity Index fell from 53.5 in May to 52.3 in June, matching April’s 38-month low and signaling a relatively weak rate of growth in UK services output.
Economic growth slowed to just 0.2% in the second quarter, with a further loss of momentum in June as Brexit anxiety intensified.

With this anxiety so prevalent before the referendum, I can’t imagine what the service index results are going to be like for July. It is unlikely that policymakers will wait for more data before unleashing additional monetary stimulus. There will definitely be more policy action taken in the next few weeks, as investors fear holding volatile positions in the market and as UK continues to search for new leadership.

https://www.markiteconomics.com/Survey//PressRelease.mvc/b93210b9d29a440383344176b79696c2

 

US Trade Deficit:

July 6th

The trade gap rose 10.1% from April, the largest rise since August, to a seasonally adjusted $41.14 billion, the Commerce Department said Wednesday. Exports of goods and services fell 0.2% while imports rose 1.6%. However, there is some optimism for Q2 as some economists believe that the headwinds of the strong dollar and the damaged energy sector are behind us.

http://www.wsj.com/articles/u-s-trade-gap-widened-in-may-1467808606

My Role Model: The American Renaissance Man

The abundant stream of blog posts finally dried up in these past two weeks.  I was on such a roll before I traveled to Charlotte for Bank of America Orientation and I continued my decline as I became acclimated to the first few days on the job in New York. To all of my fair-weathered fans who no longer provide me support, those who scoffed when they saw that I had yet to post a new article – I hope you suffer the same fate as Ramsey Bolton. To my endearing, eternally grateful fans that anxiously waited for me to share my revolutionary, enlightening financial knowledge, I express my dearest gratitude. Yes, believe it or not, sometimes I construct a reality where my blog is revered by many, detested by few, and read by even more. But alas, I shall remain bold in spirit and hope that my next post doesn’t scare you (do I mean myself?) away (if it hasn’t already). The first couple days at Bank of America left me with little desire to write about a finance related topic. With almost every article in the news covering all possible perspectives of Brexit there isn’t much to report anyway. However, the commute to and from New Jersey to my office inspired me to write about one of America’s most significant figures. One of the positives of traveling by the NJ transit is that I have had plenty of time to read about the great American President, Abraham Lincoln.

The biography Lincoln written by David Herbert Donald has been a thrilling read thus far. Donald’s detailed scrutiny into the life of ‘Honest Abe’ leads little to interpretation. After a few weeks of consistently reading this book I have yet to even get to his time as president. While I’m sure his career in politics and at the White House are compelling the truly motivating part of Lincoln’s life lies in the early stages of his adulthood. Lincoln embodied the spirit of a Renaissance man. In a way this post is a summary of all of the odd jobs worked by Abe on his way to Congress. But to me it is a lesson on how to balance working extremely hard while capitalizing on the opportunities life presents you.

When first my father settled here,

‘Twas then the frontier line:

The panther’s scream, filled night with fear

And bears preyed on the swine.

This poem was written by Lincoln when he visited his family’s home many years after his childhood. The future US President was originally a Daniel Boone, John “Grizzly” Adams type figure. He recalled that in his childhood “We all hunted pretty much all the time” and at the age of eight an axe for chopping wood was placed into his hands due to his large figure. Lincoln’s childhood haunted him for years to come as his mother Nancy passed away from sickness. In a morbid poem written when he returned to his neighborhood he wrote:

I range the fields with pensive tread,

And pace the hollow rooms,

And feel (companion of the dead)

I’m living in the tombs.

Even without the dark childhood memories, Lincoln was itching to leave his home in Little Pigeon Creek. He was obsessed with books, studying, and poetry. He felt compelled to move on and couldn’t be bound to hard manual labor that lacked any ambition and education. After leaving his home Lincoln moved to New Salem. In the next ten years he tried nearly every type of work offered in Illinois. This included carpenter, a ferry director, a store clerk, a post man, soldier, blacksmith, surveyor, lawyer and a politician. In one of his first positions Abraham Lincoln was an assistant at a saw mill. He was attentive, always chatting with customers and meeting new people. When he didn’t have work Lincoln would be studying some form of education. He had a sharp mind and was able to recall a fifty-six line poem from memory. But Lincoln wasn’t just an intelligent young adult intent on studying grammar or geometry. One of my favorite stories of Abe begins when the store manager brags to a rough group of wilder boys that Lincoln is one of the smartest and strongest men in New Salem. According to the anecdote:

“The Clary’s Grove boys called his bluff. They cared not at all about Lincoln’s mental superiority, but they dared him to test his strength in a wrestling match with their champion, Jack Armstrong… …In the collective memory of New Salem residents, the contest was an epic one, and various versions survived… (including) how Armstong’s followers threatened collectively to lick the man who had defeated their champion until Lincoln volunteered to take them all on, but on at a time”.

Lincoln proved that he not only was an intelligent fellow but that he also was tough, strong and courageous. These characteristics helped him become very well-liked in New Salem as one person remarked, “Lincoln had nothing, only plenty of friends”.

Later Lincoln enlisted in the Black Hawk War. The conflict began when the Black Hawk tribe returned to Illinois trying to reclaim their native land. Lincoln enlisted and was elected as a militia captain. While his service wasn’t necessarily heroic or worthy of any great stories it adds another badge to the chest of the future leader.

Lincoln continued partaking in odd jobs such as chopping wood and being hired as the service postmaster delivering mail to the surrounding community. He was a man of integrity who felt that it was his duty to assist his neighbors. When a person didn’t pick up their mail at the post office he would put the letters in his large hat and often times walk miles to deliver them in person. Throughout these years he was barely making enough money to get by.

I could go on and on about the different successes Lincoln had with various jobs and even his failures also. But the point that I’m trying to make is that Lincoln was so gritty. He rarely complained despite the poor living conditions, back-breaking labor, and having little money. He enjoyed the little things such as meeting new people, reading, debating and the occasional wrestling match. Through these interactions he created an opportunity for himself to be elected as a state legislator. He was self-taught in law and became one of the most well-known lawyers living in Illinois.

The man had so many skills. So many qualities that made him special. He was never entitled. Lincoln started out in a situation where the majority of people would aspire to nothing. The rest is history. This man is my role model because he was able to grind through his early years expecting nothing from anybody.

 

 

---

 

 

P.S. Lincoln was no Don Juan. He was insanely awkward around women and could barely talk to eligible ladies. He was gangly, dirty and always wore clothes that were too small for him. He often struggled in his pursuit for a wife. But in this regard he again persevered. He married Mary Owens who was described as, “a handsome young woman with black hair, dark eyes, fair skin, and magnificent white teeth. She impressed everyone with her gay and lively disposition…”. For myself, a man that has been single basically his whole life this is very encouraging.

 

Source:

Donald, David Herbert. Lincoln. New York: Simon & Schuster, 1995. Print.

Sindex: Crowd Retching Breath Sexies (Tobacco)

Tobacco Industry

It’s no secret that the entirety of the tobacco industry is in decline. With significant risks including cigarette-related taxes, the imposition of discriminatory excise tax structures, increasing marketing and regulatory restrictions, and health concerns relating to the use of tobacco products it is counter-intuitive that people are willing to invest in these companies. That being said if company has a heartbeat then it is possible find merit.

The market for tobacco products has become extremely saturated. With declining sales due to the increased awareness of the negative health effects, companies such as Philip Morris International, Altria and Reynolds American are pursuing different growth strategies. The main avenues for value creation in this industry include research and development to find healthier alternatives to tobacco products, M&A, and providing ample dividends and share buybacks to entice shareholders.

 

Philip Morris (PM)

Until 2008, Philip Morris International (PM) was a wholly owned subsidiary of Altria Group, Inc. (MO). Since that time the company has been independent and is listed on the New York Stock Exchange. The rationale was that separating the international division would free up the company of any of the regulatory restraints in the United States. While Philip Morris and Altria offer some similar products under Marlboro they now operate using different supply chains in different geographic markets.

Philip Morris International had mixed results in the first quarter of 2016 throughout the different geographical divisions. Total PMI market share, excluding China and the U.S., increased by 0.2 percentage points to 28.7%, with organic cigarette volume down by 1.4%, due mainly to the Asia Region: Indonesia, Pakistan and the Philippines. This decline was partly offset by organic volume growth in the European Union and Latin American Regions.

One of the main positives was the strong cigarette volume performance from their international brands. The top seven brands grew volume with Marlboro and Parliament increasing by 1.1% and 5.9%, respectively. PMI is losing market share in countries such as Indonesia and Japan. They are attempting to counter the loss in market share by releasing innovative, risk-reduced products such as Parliament Crystal Blast e-cigs.

There has been exciting progress with iQOS commercialization and the continued Heatstick expansion in Japan. These products fall under the spectrum of Risk-Reduced Products that are at the core of new product development.

Philip Morris is raising EPS forecasts to an expected 10 – 12% for 2016 mostly due to the favorable currency conditions.

Perhaps the biggest reason investors buy tobacco stocks is due to the dividend yield. Since PMI spun off from Altria they have had eight consecutive dividend increases with a current payout ratio of 95.5%. The payout ratio, or the ratio of earnings to dividends paid to investors, is significantly higher than Altria’s ratio of 79.9%. However, PMI’s dividend per share of $3.51 barely exceeds Altria’s $3.40.

As you can see in the chart below since 2013 PMI has been significantly underperforming compared to the rest of the tobacco industry. Year over year the Q1 EPS decreased by 15.5% from a diluted EPS of $1.16 in 2015 to $.98 in 2016. PMI attributes this to a strong Q1 in 2015 and to an unfavorable currency. They make it sound like the unfavorable currency is a one-time charge as the make sure to include that the Adjusted EPS excluding currency is $1.17. This is the exact risk you’re buying into if you invest in an international company compared to alternatives such as Altria and Reynolds American. With quantitative easing in the EU and negative interests rates in Japan you better be prepared for volatile currencies if you want to invest in PMI.

 

Altria

From 2011 to 2015, Altria delivered total shareholder return of 205%, which far outperformed the S&P 500.

Altria’s 2016 first-quarter reported that diluted earnings per share (EPS) increased 19.2% to $0.62. Altria reaffirms its 2016 full-year adjusted EPS $3.00 to be approximately $3.05, representing a growth rate of 7% to 9% from an adjusted diluted EPS base of $2.80 in 2015.

During the first quarter, Altria repurchased 2.8 million shares at an average price of $59.81 for a total of $168 million.

Similar to Philip Morris, Altria’s most successful brand lies with the Marlboro cigarettes. Marlboro’s retail share remained at 44.0% in the first quarter. They also have been able to diversify into other areas both in and outside of the tobacco industry.

• Altria’s subsidiary Middleton reported that their cigar shipment volume increased 8.3% in the first quarter, driven primarily by Black & Mild in the tipped cigars segment.
• Altria’s main chewing tobacco brands Copenhagen and Skoal’s combined reported shipment volume increased 8.7%, partially driven by the national expansion of Copenhagen Mint. While they are attempting to diversify into non-tobacco related industries such as the wine industry these profits are still proving inconsequential.
• In the wine segment, Ste. Michelle grew net revenues in the first quarter of 2016 by 8.2% However, operating margins are approximately 20% which brings down the Altria average.

Smokeable products continue to be Altria’s biggest business at $16.4 billion in annual revenue, and this still makes up 87% of the company’s business. Second in size is smoke-less products, such as chewing tobacco. At $1.7 billion in trailing revenues, that makes up a further 9% of Altria’s business. As for the remaining 4%, that derives from Altria’s wine business — which contributed approximately $668 million over the past year.

Altria, due to its long tenure, has been even more consistent than Philip Morris in terms of dividends. They have increased their dividend 49 times in 46 years. During the third quarter of 2015, the Board of Directors approved an 8.7% increase in the quarterly dividend rate to $0.565 per common share versus the previous rate of $0.52 per common share. Altria Group, Inc. expects to continue to maintain a dividend payout ratio target of approximately 80% of its adjusted diluted EPS. Philip Morris’s dividend payout only increased by 2% in 2015. However, over the past five Altria has grown its dividend by 8% per year. By comparison, Philip Morris has been more aggressive. It’s increased its dividend by 11% per year.

Finally, Altria is a cash cow with their free cash flow increasing by approximately 24% from 2014 to 2015 and 37% since 2011. Meanwhile since 2011 Philip Morris’s cash flow has decreased by 3.9%.

 

So What Do I Like More?

Over the past five years Altria’s P/E ratio has averaged 18.48 compared to Philip Morris’s 16.94. While both companies aren’t inexpensive I believe that Price to Cash Flow is just as important in an industry with declining revenue. Altria’s P/CF of 21.2 appears more favorable. Despite Altria’s debt of $12 billion they still have a better interest coverage ratio than Philip Morris and they have avoided the currency headwinds applicable to their international counterpart. In the short-term if you think that the dollar’s strength will decline than Philip Morris will become a lot more appealing as their international sales currently generate weaker returns. But as I said earlier, currency volatility isn’t an extraneous cost and in the long run it has the potential to plague PMI returns.

For the Sindex I think that Altria is the better buy. I would pay the premium for a company attempting to diversify beyond risk-reduced products who is not fully dependent on dividend growth.

I am a firm believer in the concept of “go with what you know”. I think that you can identify a company that is about to ditch its cocoon and turn into a beautiful butterfly (not literally) without being fully dependent on fundamentals. Sometimes it is hard for analysts to take their eyes off the charts, stock tickers, and earnings reports and notice the trends right in front of them. Besides Marlboro I truly think that Altria has strong brands in high demand. I’ve noticed that in my generation alone Black and Mild’s and chewing tobacco are often used as substitutes to cigarettes because they are deemed “less unhealthy”. While almost certainly untrue, just like in the stock market, perception triumphs over reason.

 

http://investor.altria.com/phoenix.zhtml?src=leftnav&c=80855&p=irol-reportsannual

http://www.fool.com/investing/general/2015/02/09/better-tobacco-dividend-altria-or-philip-morris-in.aspx

http://financials.morningstar.com/cash-flow/cf.html?t=PM&region=usa&culture=en-US

http://financials.morningstar.com/cash-flow/cf.html?t=MO