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All posts for the month December, 2014

As the UK braces itself for the previously undiscovered natural phenomenon of a “weather bomb”, known locally as winter, the UK banks are preparing for their own chill wind, as stress test results are due next week. While these tests tell us little about what will actually happen in the next crisis, which no one seems able to forecast very far in advance, they do reveal how the regulators view the sector and hence will have an impact on the returns of banks and their shareholders.

The UK’s stress tests are designed to be harsher and more relevant than the EU stress tests that four listed UK banks have already passed. In practice, this means higher loss ratio assumptions for exposures to households and to mortgage debt in particular. Household debt is just under 100% of GDP, a substantial portion of mortgages are high debt to income loans and with 65% of mortgages on a variable rate, the UK is more susceptible to rising interest rates than comparable economies. This has led to lots of chatter that Lloyds is most likely to be blown off course next week, but do the actions of market participants suggest that they are battening down the hatches?

The Cost of Credit

We would expect the first signs of worry to show in the CDS market, where creditors insure their loans to companies. Should the stress tests reveal banks to have less capital than previously assumed, then the courses of action open to the firms are shrinking, disposals and ultimately equity raising. None of these are good for the ability to repay debt and interest, hence the cost of insuring debt measured by the CDS should be rising if investors fear a disappointing outcome.

Lloyds’ CDS has narrowed 7% in the last five days and 25% over the past month. This means a lower cost to insure the bank’s debts and hence a greater degree of comfort about its credit worthiness. At 44 bps the cost is at extremely low levels relative to peers across Europe, as shown in the chart below. Any rise post the stress test results is more likely to be due to the extreme relative levels that Lloyds has fallen to, rather than because of the outcome of the tests themselves.

image2014-12-10 13-42-59

The CDS of Barclays and RBS are both even further below the average relative level than that of Lloyds, while HSBC is mid range and Standard Chartered at elevated relative levels. The Asian focused group also has the highest cost of credit among UK banks. As Standard has no UK household debt exposure, the threat of the UK stress tests is highly unlikely to be the cause of this.

Option Markets

Standard Chartered also exhibits high absolute and relative volatility, which is a measure of the range in which the share price is expected to trade three months hence. The average European bank is expected to trade +/-14% by mid March, which is the same as for Barclays. Uncertainty at Standard Chartered is slightly higher than this, while RBS is lower and HSBC markedly so. Lloyds has no liquid, exchange traded options market.

Overall option investors do not appear to be expecting problems for UK banks through the festive season and beyond and RBS actually trades at an unusually low level of implied volatility compared with Europe as a whole.

Declining Short Interest

Short interest in all five banks has fallen over the past week and the drop at Standard Chartered over the past month is one of Europe’s most extreme examples of factor divergence from share price, which is also down over the period. Short interest is up 10% in a week at TSB, which is the purest banking play on UK households, but which was over capitalised on listing and where the major issue is most probably the difficulty of making a decent near term return on its balance sheet. Consensus RoA for 2015 is 0.2% and RoE 4.7%, compared with UK banks’ averages of 0.5% and 9% respectively. Lloyds has the highest forecasts on both measures.

A Greek Tragedy would be more stressful

Annual stress tests enable regulators to find work for their armies of post crisis recruits and to claim that they are vigilant in their oversight of the banking sector. The outcomes of these tests are always likely to be less than satisfactory, because the precise nature and timing of the next downturn is not known in advance, nor do we know how consumers and banks will react and interact when that crisis arrives. Any assumptions are simply that and have to be shoehorned into whichever models are flavour of the month.

What the stress tests do show us is how concerned regulators are likely to be when reviewing banks and in particular allowing them to pay dividends and make acquisitions. On this front RBS might appear to have the greatest immunity, because if it pays a dividend in the next 12 months, analysts only expect the most paltry of payouts. Standard Chartered and HSBC have the highest yields at over 5.6% each, while Barclays and Lloyds are in the 3.5-4.0% range. All the dividends are comfortably covered by earnings forecasts.

However much media and analyst attention is drummed up by the stress tests, investors across asset classes are approaching this event with a distinct air of benign neglect. The risk in Europe appears to be another wave of uncertainty and credit contraction brought about by the sudden Greek election. Whether Mario Draghi has German permission to use the big gun in battling deflation should European politics take a turn for the worse (in market terms), is likely to have a greater bearing on UK bank share prices than the Bank of England’s annual number crunching fest.

Short Interest movers: Bouygues, Rotork, Bollore, Elekta

Director Buys/Sells: Bunzl, Weir Group, Adecco, Swiss Prime Site

CDS spread movers:  Imperial Tobacco, Old Mutual, Michelin, Natixis

Implied Volatility movers:  Fiat, Fugro, Wereldhave, Mediobanca

Stocks trading unusually High Volume today

…and names in the news today…

…and finally those with High Volume traded yesterday 

6 most positively ranked stocks
 6 most negatively ranked stocks Short Interest

Significant risers in past week*

Significant fallers in past week*

*D next to flag denotes dividend

Director Dealings

Recently Reported Priority Trades

STOCK

BUY / SELL

DIRECTOR JOB TITLES

Day Reported

WEIR LN Buy Non-Executive Director Monday 8th
ADEN VX Sell Executive Director / Committee Monday 8th
BNZL LN Sell Group Director Monday 8th
SPSN SW Sell Non-Executive Board Member Monday 8th
UHR VX Sell Executive Director / Committee Friday 5th
KBC BB Sell Independent Director Friday 5th
DGE LN Sell President (division/unit/region) Friday 5th

CDS

Significant fallers in past week

Implied Volatility

Significant risers in past week

Significant fallers in past week

What to watch for on Wednesday…

Short Interest movers: Bankinter, EDF, Intesa Sanpaolo, Remy Cointreau

Director Buys/Sells: Seadrill, Ratos, Smith, Gemalto

CDS spread movers: Swiss Life, SKF, Wendel, Lloyds Banking Group

Implied Volatility movers:  Enel, Wereldhave, Stmicroelectronics, Fismidth and Company 

Stocks trading unusually High Volume today

…and names in the news today…

…and finally those with High Volume traded Friday

6 most positively ranked stocks
 6 most negatively ranked stocks Short Interest

Significant risers in past week*

Significant fallers in past week*

*D next to flag denotes dividend

Director Dealings

Recently Reported Priority Trades

STOCK

BUY / SELL

DIRECTOR JOB TITLES

Day Reported

RATOB SS Buy Key Executive Friday 5th
SMDS LN Buy Non-Executive Director Friday 5th
SDRL NO Buy Chairman of the Board Friday 5th
SLHN VX Buy Executive Director / Committee Thursday 4th
LONN VX Buy Executive Director / Committee Wednesday 3rd
GTO NA Sell Executive Vice President Thursday 4th
SIK VX Sell Executive Vice President Thursday 4th
RUI FP Sell Managing Partner Tuesday 2nd
FP FP Sell CFO Tuesday 2nd

CDS

Significant risers in past week

Significant fallers in past week

Implied Volatility

Significant risers in past week

Significant fallers in past week

What to watch for on Tuesday…

Crude oil has fallen to a five year low, despite US Commodity Futures Trading Commission data showing that short bets contracted and long ones expanded in the week to December 2. The new low has taken its toll on oil and related stocks, but has also pushed the biggest beasts in the oil fields to unprecedented valuation premia to their Energy sector peers. Exxon, BP and Shell are all trading at record relative valuations, with the red flags that this entails cropping up all over OTAS.

Noted value investor Neil Woodford has taken aim at the two UK listed majors, claiming that both are over distributing and that their dividends are at risk. Meanwhile, here at OTAS we have written previously about Exxon.

RDSA yields 5.6% on a 12 months forward basis, which is within the normal range for the stock, while BP yields 6.2%, which is elevated compared to normal relative to the sector. Certainly the idea that BP could be relatively expensive on an EBITDA basis and yet relatively cheap on a dividend basis suggests that Woodfood is correct to challenge analysts’ assumptions.

image2014-12-8 11-46-43

The table above from the Dividend Analysis page in OTAS for BP shows that while BP has failed to generate sufficient free cash flow to cover its dividend for the past four years, and that in three out of the four free cash flow was negative, analysts expect this situation to reverse in the next two forecast years.

A look at the Earnings & Valuation page in OTAS shows that BP’s EPS is forecast to decline at around 4% p.a. over this period, while sales are forecast to fall at twice that rate. EBITDA margin is expected to recover from a low of 8.5% in 2013 to 10.6% by 2015, surpassing the 2012 level. On this basis, free cash flow is expected to turn positive and thereby justify forecasts for a steadily rising dividend per share.

It is very common for analysts to assume rising margins. Across the MSCI EU markets the average forecast sales increase for 2015 is 3.2%, while the forecast earnings growth is 15.9%. Widespread margin expansion is also expected in the US, Japan, Asia ex Japan, India, Brazil and Mexico. Only in Hong Kong, China and Turkey should sales outpace earnings, while Russian estimates are barely over 1% on both counts.

Our role is to comment on the trends in observable market factors rather than to make explicit forecasts and one thing that we observe about BP is that it has not been able to cover its dividend when oil prices were far higher than they are today.

One other thing we note is that at the current record relative valuation, BP is trading at levels that it has scaled only once before, immediately prior to a marked decline in relative ranking caused by a sharp fall in the stock price.

image2014-12-8 11-50-5

Shell at least managed to cover its dividend, just in 2011 and again in 2012, before falling back last year. Once again analysts envisage this situation changing, with reasonably covered forecast dividends the norm. Meanwhile, sales growth is forecast to be -6% p.a. and EPS growth +2% p.a. through 2015.

Shell’s relative valuation is at record levels, as it was in mid January 2012, immediately before a reduction in valuation caused by a sharp fall in the stock price.

image2014-12-8 11-51-33

Hindsight may be the greatest investor, but the past is not a perfect guide to the future. What we can say with a degree of certainty is that it is most unlikely that the oil majors will hold their high relative valuations to the sector should the oil price recover. If it does not recover there may well be a reappraisal of the cash flow forecasts for both BP and Shell and ultimately a revision of the dividend forecasts for both names.

Exxon meanwhile has covered its dividend with earnings and free cash flow for at least the last four years and is forecast to continue to do so. The yield is a more modest 3.1% than that ostensibly on offer at BP and Shell. Exxon’s relative valuation is however, as high as it has been since June 2009. The stock fell 20% over the next year.

Short Interest movers: Bpost, EDF, Thomas Cook, Balfour Beatty

Director Buys/Sells: Reckitt Benckiser, Statoil, Nestle, Skanska

CDS spread movers:  Eni, Bank of Ireland, Wendel, HSBC

Implied Volatility movers:  Enel, Mediaset, Finmeccanica, Saipem

Stocks trading unusually High Volume today

…and names in the news today…

…and finally those with High Volume traded yesterday 

6 most positively ranked stocks
 6 most negatively ranked stocks Short Interest

Significant risers in past week*

Significant fallers in past week*

*D next to flag denotes dividend

Director Dealings

Recently Reported Priority Trades

STOCK

BUY / SELL

DIRECTOR JOB TITLES

NO. OF DAYS AGO (incl. weekends)

RB/ LN Buy CFO 1
STL NO Buy Director 1
NHY NO Buy Director 1
MOR GY Buy Executive Board 2
NESN VX Sell Director 2
SKAB SS Sell Executive Vice President 2
SCHP VX Sell Executive Director / Committee 2
KNEBV FH Sell Executive Vice President 2

CDS

Significant risers in past week

Significant fallers in past week

Implied Volatility

Significant risers in past week

Significant fallers in past week

What to watch for on Monday…

Principle Strategists (aka Prop Traders) listen up! I am about to show you how to make a lot of money, very quickly. For those who just want to trade better, and save your PM and/or firm money, you should also probably take note, as this could one day save you the hassle of redoing your CV. So keeping this simple let us begin…

This morning I decided to rank the Stoxx 600 by those stocks seeing the biggest price move relative to the opening print. Hermes looked pretty interesting. Usually we expect the sector to be dragged up somewhat as well, but here Hermes was massively outperforming the sector/basket. Look at the green line in the cool return drawing below. This basket we speak of is comprised of companies like L’Oreal, Swatch, LVMH, Puma, Christian Dior and Richemont, with some maths thrown in for optimisation (i.e. the kind of efficiency we here at OTAS cannot get enough of).

Did anyone spot the spread blowing out from 08:45 onwards? No? Man, I almost feel sorry the poor sucker who lifted the offer at the intraday high…but not quite ;) Look at the chart on the far right. This was an early indication of buyers, who so far had lifted the offers with a pickup truck, pulling away. Maybe someone just finished an order, albeit somewhat aggressively. Who knows, the point is volume started to flatten out around these levels, spread had widened, and the return just looked plain toppy compared to the basket. Sellers would have been encouraged to boost their participation rate and buyers to switch to passive mode (i.e. reduce POV).

image2014-12-5 11-7-42

And BOOM…I only wish I had left my TradeShaper Alerts panel open because this would have pinged me, highlighting the move vs. the basket, as well as the spread blowing out.

image2014-12-5 11-8-9

Funny thing is, I haven’t even bothered to see what the news flow out in Hermes is. Imagine what a seasoned trading veteran, the type with Church’s brogues and a Hermes tie can achieve with such awesome technology. Value added.

Quickly managing volatility risk exposure across an Equity Portfolio based on a change in market sentiment is not always a simple process but one that money managers need to consider. Time and effort is invested in Portfolio construction and the investment strategy should define returns, however, hidden factors may heavily affect performance in periods of market uncertainty. Implied Volatility is one of the key market observables in OTAS Core and can be used to manage risk aversion.

Consider the STOXX 600, moves like yesterday which saw an aggressive leg down across European indices in response to non-commitment from Mario Draghi and the ECB for immediate QE prompted a -1.3% retracement in the main index. If investors believe this is the beginning of a more general trend they may wish to exit those stocks which have higher perceived risk and seek those stocks whose share prices are less liable to large price fluctuations.

After its recent spike the current median Implied Volatility* across the STOXX 600 is 21.8, which is right back in the middle of its 1 year range. Ranking the index by the current level of (3 month) volatility identifies those stocks whose share price risk is greatest .

* Median of those stocks which have Implied Volatility data in OTAS Core.

image2014-12-5 10-41-58

Perhaps unsurprisingly, the top 15 names ranked in terms of highest volatility are dominated by Oil sensitive names and Peripheral Banks.The  icon further indicating extreme relative highs versus their respective sectors.

Re-ranking the list highlights those shares with very low perceived share price risk currently. Sector dispersion is high in these names although Insurance names feature significantly among those with low volatility.

image2014-12-5 11-45-5

Investors looking to reduce volatility across a Portfolio(or Index) but maintain exposure to a theme may want to consider reducing/underweight holdings in Banco Intesa, Raiffeisen and Unicredit and re-invest/overweight into Hannover Re, Zurich Insurance or Munich Re.

Short Interest movers: Ashtead Group, Elekta, Boss, BP

Director Buys/Sells: BP, Schibsted, Assa Abloy, Securitas

CDS spread movers: KBC Group, Vodafone 

Implied Volatility movers:  BG Group, Aryzta, Adidas, Trelleborg

Stocks trading unusually High Volume today

…and names in the news today…

…and finally those with High Volume traded yesterday 

6 most positively ranked stocks
 6 most negatively ranked stocksShort Interest

Significant risers in past week*

Significant fallers in past week*

*D next to flag denotes dividend

Director Dealings

Recently Reported Priority Trades

STOCK

BUY / SELL

DIRECTOR JOB TITLES

NO. OF DAYS AGO (incl. weekends)

WHA NA Buy Supervisory Board 2
OCDO LN Buy Non-Executive Director 6
BP/ LN Sell Vice President 1
SCH NO Sell Other Manager 1
SECUB SS Sell Beneficial Owner (Investment AB Latour) 2
ASSAB SS Sell Beneficial Owner (Investment AB Latour) 2
SIK VX Sell Executive Director / Committee 3
DLN LN Sell Independent Director 3

CDS

Significant rise in past week

Significant fall in past week

Implied Volatility

Significant rise in past week

Significant fall in past week

What to watch for on Friday…

Short Interest movers: Banco Intercontinental Espanol ‘R’, Antofagasta, Smiths Group, Vinci

Director Buys/Sells: Atlantia, Infineon Technologies, Cairn Energy, Anheuser-Busch Inbev

CDS spread movers: Vodafone, Deutsche Post, Gecina, Stora Enso ‘R

Implied Volatility movers: Statoil, DNB, Anglo American, Siemens

Stocks trading unusually High Volume today

…and names in the news today…

…and finally those with High Volume traded yesterday 

6 most positively ranked stocks
 6 most negatively ranked stocks Short Interest

Significant risers in past week

Significant fallers in past week

Director Dealings

Recently Reported Priority Trades

STOCK

BUY / SELL

DIRECTOR JOB TITLES

NO. OF DAYS AGO (incl. weekends)

ATL IM Buy Managing Director 2
CNE LN Buy Non-Executive Director 2
IFX GY Buy CFO 2
HUSQB SS Buy Key Executive 5
SPX LN Buy Non-Executive Director 6
ABI BB Sell President 2
ULVR LN Sell CEO (division/unit/region) 5
INCH LN Sell Managing Director 5
DWNI GY Sell Chairman of the Supervisory Board 5

CDS

Significant rise in past week

Significant fall in past week

Implied Volatility

Significant rise in past week

Significant fall in past week

What to watch for on Thursday…

Re-rating, a rising dividend yield, falling short interest and a marked drop in the cost of credit define the best performing US stocks in 2014. But which of these factors were the ones to watch, and which were a red herring? OTAS uncovers the answers before selecting a list of stocks most likely to outperform in 2015.

Stock performance in 2014 has been shaped by how stocks reacted to the sharp fall in oil prices, especially in November as the combined S&P 500 and Nasdaq re-rated sharply.

image2014-12-3 14-47-39

Avoiding the Very Worst Performers

The list of worst performing stocks is dominated by Energy and related names, but was there a way of avoiding them without a crystal ball on oil prices. Absolutely there was, as the median PE of the very worst performers across the two indices was 12.5 on January 1, compared with 16.9 for the other 500 names. Simply by eschewing stocks with a standout low PE, fund managers would have avoided the biggest fallers of the year.

Winners Look Like This

A common theme behind the best performing stocks has been re-rating, especially over the last month. However, the starting PE proved to be an unreliable guide to the stocks that were to do well. Grouping 500 shares into blocks of 50 ranked by YTD performance we see that the median PE of the blocks ranged from 16.2 up to 18.0, with no particular bias towards better or worse performing groups.

Equally, while the best performing shares saw a 25% rise in average dividend yield over the year, the average of the next 150 shares fell, while the yield on the two worst performing groups rose by more than even for the best performing. As yield is often the reciprocal of PE, the unpredictability of performance based on starting yield is not a surprise given our findings about valuation.

The other characteristics of the best performing shares were falling short interest and cost of credit. Short interest was less useful as a general guide to performance, because the next seven groups of 50 shares all saw rising short interest. However, the worst performers saw an average rise of 149%, much more than for any other group. In OTAS, we only flag the extreme moves in short interest relative to normal, both up and down, rather than simply ranking by the rate of change. It turns out that having a careful eye on this analysis throughout the year would have allowed investors to refine their portfolios to favor the very best performing shares over the very worst.

Change in CDS, or cost of credit, proved to be an important signal of where a stock was likely to end up in the YTD performance rankings. The top 150 stocks had an average fall in credit cost of 20% and the next 100 had an average single digit fall. The worst performing shares have experienced a 70% average rise in the cost of credit.

There is sound and backtested investment theory behind these findings and it these foundations that the OTAS flags are built upon. We expect rising stocks to have rising EPS estimates and falling short interest, cost of credit and implied volatility. We also expect the reverse to be true and flag as divergent the most extreme examples of stocks where these relationships do not hold across sectors and markets. We also expect the best performing shares to have rising EPS estimates, which we call positive EPS Momentum, and consider this to be the best indicator of a likely re-rating*.

Top Stocks for 2015

To uncover our list of top performing stocks we start by ranking all the S&P 500 and Nasdaq names on five criteria; PE, Dividend Yield, Short Interest, Implied Volatility and CDS. Any stocks without a value are accorded the median of the rest. Judging by the performance in 2014, selecting from the top 200 stocks from this list and avoiding the bottom 75, would create a conservative portfolio that we might expect to outperform modestly. However, there are three refinements that we are going to make.

Firstly, we add a ranking for EPS Momentum as a proxy for re-rating potential. With stocks at the highest PE since July 2007, we want to be focused on names with positive earnings revisions that at least have a chance of justifying prevailing multiples. Then we remove any with considerably above average CDS, both because this was a strong indicator of underperformance in 2014 and because it cuts a couple of real estate names from our list, where share prices are highly correlated with the cost of credit (and by extension, interest rates). Finally, following the wise words of Joel Greenblatt, who has far more experience in profiling stocks and selecting consistent winners, we exclude financials and utilities.

The remaining shares form a list of the top stocks for 2015, of which the top 10 are Simon Properties, Public Storage, Equity Residential, Abbott Laboratories, Altria, Lowe’s, Merck, Home Depot, Procter & Gamble and PepsiCo. We shall track how portfolios from the top and bottom of our list fare and report back periodically.

OTAS users may perform this or similar analysis at anytime, in order to refine a watchlist of chosen stocks by removing examples of extreme market risk, or increasing the weighting of those with low and falling risks. The list of top stocks will vary over time and the analysis can be repeated monthly or quarterly and used to build a portfolio throughout the year.

Good luck investing.

*PE measures the expected rate of future earnings growth and hence as estimates are revised upwards, investors are likely to accord a higher multiple to the companies where upgrades are considered sustainable. A strong proxy for sustainability is whether EPS Momentum is consistent or rising across the forecast years, as is the case in this example of Southwest Airlines, the best performing stock YTD.