In This Issue:
Emerging Markets
Year-end Trading
Recommendations:
Buy: Vodafone
Sell: Advance Auto Parts
News Notes & Performance
Emerging Markets - An Emerging Opportunity?
A long-time adage says that when the United States sneezes, the rest of the world catches a cold. Recently, though, as the United States slows modestly after an extended period of Olympian-quality health, emerging market stocks seem to have caught something worse than a cold. Since its January peak, the widely-watched iShares MSCI Emerging Markets ETF (EEM) has declined 22% while the S&P500 has weakened by about 8%. Over longer periods, the EEM remains unchanged since 2007 while the S&P500 has nearly doubled. Investors haven’t given these markets much credit for a long time.
Some causes of the recent weakness include rising U.S. interest rates, the strong U.S. dollar and the trade-reducing effects of the U.S.-China trade war. These headwinds dampen emerging economies’ growth, which depend on global trade and dollar-driven financing.
Also restraining the group’s performance are sharp declines in the mega-cap Chinese tech stocks, due to over-valuation, tighter regulations and concern over monetary conditions. Discouraging economic policies in Turkey and Argentina have weighed on emerging market sentiment, as well.
However, overall conditions remain favorable in emerging economies. Economic growth is estimated at about 4.4% next year, while inflation (often a scourge) appears subdued below 3.5%. Deeper integration with rest of the world has generally improved governance, while companies increasingly are larger, more global enterprises less vulnerable to their local economies. The sharp decline in oil prices is positive for nearly all emerging market countries, which tend to be heavy energy importers. And, over time, global supply chains that pull away from China may move into other emerging market countries, bolstering their growth prospects. Over the long run, the developing world offers the potential for faster growth.
While not at Baron Rothschild’s 18th century “buy when there is blood in the streets” level, sentiment toward emerging market equities is depressed. Not only have the stocks been weak, but valuations are modest at 11.9x for the EEM. We think these markets are worth a closer look.
Investing directly into emerging market companies is not a familiar exercise for most investors (including us), so we recommend investors consider diversified exchange traded funds (ETFs). For more aggressive investors, regional or country-specific ETFs can offer some appeal. Investors should be aware that emerging market investments can be more volatile and carry higher risks than developed market equities.
Listed below are six ETFs that offer investors exposure to emerging market equities. Subscribers many also want to explore the numerous other related ETFs to further tailor their exposure.
iShares MSCI Emerging Markets (EEM) – Often considered the go-to vehicle for emerging market equities, this $29 billion in assets ETF includes over 800 large and mid-sized companies in nearly 25 countries. Investors should be aware of the high expense ratio (.68%) and concentration in China (31%), including Tencent at 4.4% weight.
Vanguard FTSE Emerging Markets ETF (VWO) – Some investors prefer this over the EEM given its lower expense ratio (0.14%) and larger $74 billion (assets) size. Its performance closely matches the EEM although it holds over 4,640 stocks. Like the EEM, it has a high concentration in Chinese companies (34%), with its top ten holdings comprising about 19% of its portfolio, including a 4% position in Tencent.
SPDR S&P Emerging Asia Pacific ETF (GMF) – This ETF offers a way for investors looking to focus on China and other Asia Pacific equities. Its high 45% weight in Chinese stocks has weakened its year-to-date performance, down over 15%, yet offers the potential for sharp gains should the concerns lessen. While geographically concentrated, its highest company-specific exposure is a relatively low 6.1% (Tencent Holdings) as it holds over 760 equities. Its expense ratio is a reasonable 0.49%.
India Fund (IFN) – With $620 million in assets, the closed-end India Fund is actively managed by the respected Aberdeen Standard Investments. Like most closed-end funds, it trades at a discount (about 13.5%) to its net asset value. While its expense ratio of 1.26% is high compared to ETFs, it offers the potential to benefit from better company-specific holdings and a general return to favor of Indian companies compared to broad-based ETFs, particularly as oil prices stay weak.
Mexico Fund (MXF) – Founded in 1981, the Mexico Fund is one of the longest-running closed-end funds on the market. It holds a fairly concentrated portfolio of 27 Mexican equities, although it is diversified across a broad range of industries. The fund trades at a 13.5% discount to its net asset value, and carries a 1.62% expense ratio.
iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB) – One of the largest emerging market bond investments at nearly $15 billion, the EMB fund holds 420 government and agency bonds from dozens of countries. Most of its holdings mature in more than five years, offering higher yields (5.1%) yet also increasing its sensitivity to changing interest rates and credit quality. Its expense ratio is a reasonable 0.40%.
Après nous, le deluge? Year-end trading opportunities for bargain hunters
With apologies to Madame de Pompadour after her king’s setback in the Battle of Rossbach in 1757, the unfortunate turn of more recent events in the stock market could be creating at least a modest flood of opportunity for contrarian investors. This may be particularly true as we approach year-end, when artificial selling pressure, created by investors tossing their losers, offers some unusual short-term bargains. Here at The Turnaround Letter, even we can be tempted to briefly set aside our intense focus on long-term business fundamentals and underlying valuations when shorter-term bargains appear. A primary source of artificial selling pressure is the tax code. By selling losers, investors can generate taxable losses to offset other gains, saving on tax payments. The strong gains in the stock market in recent years means investors may have significant gains to offset. Similarly, many investors flush out their losers to create a fresh psychological start for the new year. These can push already weak stocks down further. Portfolio window-dressing by professional investors creates another source of artificial selling pressure. These managers would rather not show their clients and consultants that they held some big losers, so they sell them in November and December to keep them out of year-end reports. Once the selling pressure ends with the new year, many of the previous year’s worst performing stocks bounce upwards, sometimes sharply. Nimble investors can capture some of the bounce before longer-term fundamentals and valuations take over after a month or so. Investors can also use the opportunity to start new positions in attractive longer-term investments. Described below are eight stocks that have some of the worst returns year-to-date. All are in the S&P 500, and represent a diverse roster of promising bounce candidates. Some of our Recommended List stocks have some bounce potential, as well. We would include McDermott International, Conduent and General Electric, all currently rated BUY. If you have not yet taken a position in these stocks, or would like to add, this could be a good time to do so.
Affiliated Managers Group (AMG) – Like many investment management firms, AMG has suffered from outflows as clients increasingly migrate toward index products. Also, many of its products invest outside of the U.S. where market returns have been weak. AMG shares have lost close to half their value this year and now trade at the same price as they did in 2012. Yet, AMG has capable leadership that oversees a diversified and high-quality stable of top investment managers in public and private equities and alternative investments, including the innovative AQR Capital Management. Its unique boutique model helps preserve its profits while keeping its managers motivated to produce strong returns. AMG’s balance sheet is sturdy, supported by strong free cash flows.
Applied Materials (AMAT) – This company is perhaps the premier producer of equipment that makes semiconductors. As chips become almost impossibly small and complex, Applied’s market position continues to strengthen. Secular growth in chip demand is likely to remain robust, driven by the ever-increasing need for computing power. However, the industry is cyclical, with investors worrying about gluts in several types of chips. AMAT shares have fallen over 40% from their peak earlier this year. Applied is led by the highly-regarded Gary Dickerson, has a robust balance sheet with over $4 billion in cash nearly offsetting its modest amount of debt, and is highly profitable. Coty (COTY) – Hopes were high when Coty announced in 2015 that it would acquire Procter & Gamble’s cosmetics brands for $12 billion. However, the merger was a struggle from the start, taking nearly 16 months to close, followed by a difficult integration. Further, consumers have been leaving Coty’s mass-market products for more upscale brands. All this has pulled its shares down to less than half their $17.50 IPO price. A new CEO, who successfully integrated Douwe Egberts’ large coffee acquisition, has recently joined. At about 10.5x EBITDA and offering a 5.8% dividend, it wouldn’t take much for these shares to return to fashion.
Halliburton (HAL) – One of the largest providers of services to oil and gas drillers, Halliburton has been pressured by softening demand and pricing. The sharp fall-off in oil prices has compounded investor worries about Halliburton’s prospects, especially in North America. HAL shares, down over 40% from their early 2018 highs, are approaching their lows following the 2014 oil price crash. Yet, the company remains a pre-eminent supplier in a critical industry, while the global demand for oil isn’t going away anytime soon. Halliburton’s operations are highly profitable, backed by a well-capitalized balance sheet.
IBM (IBM) – Investors are losing patience with this former technology icon as it continues to struggle with weakening revenues. After steadily falling from over $215, IBM’s shares dropped nearly 25% since early October, capped by surprise and frustration over long-time CEO Ginny Rometty’s massive $34 billion deal to acquire cloud-computing firm RedHat. Few investors since 2009 have a profit in IBM shares, leading to perhaps an “easy sell”. Nevertheless, with sentiment and valuation at low levels, the shares could be poised for a rebound, supported by the appealing 5.3% dividend yield.
The Kraft Heinz Company (KHC) – After the profit margin enhancing 2015 merger, Kraft Heinz has fallen on less-favorable times. Like many food companies, Kraft Heinz is suffering from sluggish revenue growth and lower profits. KHC shares have dropped by a third this year and by nearly half since reaching over $95 in early 2017. However, the company’s issues aren’t existential, as its profits and cash flow remain sturdy and its balance sheet is healthy. The management is capable and focused intently on reinvigorating its revenue growth. Deal-oriented 3G Capital and Berkshire Hathaway remain major shareholders, which may mean another margin-enhancing acquisition is in the company’s future.
Mohawk Industries (MHK) – Mohawk is the world’s largest flooring company, with global sales of its carpeting and tiling for residential and commercial spaces approaching $10 billion. Concerned over the slowing housing market and rising commodity costs, investors have aggressively sold MHK shares, which are down nearly 55% year-to-date. Mohawk remains highly profitable, generates considerable free cash flow and has only a modest amount of debt, most of which isn’t due for at least four years. The company is well-managed, and its high-quality production and distribution, along with targeted capacity increases, positions it well for the future.
PG&E (PCG) – This San Francisco-based electric and gas utility company is facing potentially crippling legal liabilities from the devastating California wildfires. Its already-weakened shares fell by more than 50% in early November. Bankruptcy (which would likely wipe out shareholders) is a real possibility. However, as the underlying utility business is reasonably healthy, any meaningful relief from the courts or regulators could provide a sharp lift to PCG’s shares. Currently the size of the liability is unknown and depends on proof that PG&E’s equipment caused the fires. Helping to buttress a case for relief are the political difficulties of forcing rate-payers to shoulder the liability as well as the risk of knock-on effects across the entire California utility industry.
Purchase Recommendation: Vodafone Group plc
Background: Vodafone is one of the world’s largest mobile telecom companies, with over 400 million customers in more than 80 countries. A quarter of its revenues are generated in emerging economies. Based in England, Vodafone was formed in 1983 within Racal Electronics, a military radio company, and launched the UK’s first cellular network in 1985. The company has expanded its global reach through numerous acquisitions, including the world’s largest merger, with Germany’s Mannesmann in 2000 for $203 billion. In 2014, Vodafone sold its 45% stake in Verizon Wireless for $130 billion and returned $85 billion to shareholders.
Vodafone has fallen out of favor with investors. Its London share price has fallen 33% from its 2014 high, while the dollar-based ADRs have fallen over 50%. Even adjusting for the large Verizon Wireless dividend, both Vodafone equity prices are unchanged in nearly 20 years.
Investors’ concerns center around the company’s uninspiring near-term revenue and EBITDA growth prospects, particularly as it struggles with heavy competition in Italy and Spain. Another frustration is the company’s history of overpaying for otherwise strategically smart acquisitions, particularly as it seeks to consolidate its internet, cable, fixed-line and wireless services. Vodafone’s pending $20 billion acquisition of Liberty Global’s cable TV and broadband operations in Germany and eastern Europe has met with mixed reviews.
Vodafone’s $36 billion in net debt also weighs on investors, as do concerns about its ability to sustain its dividend, currently yielding a generous 8.2%.
Analysis: Despite its recent history, Vodafone’s prospects are improving. Its recent firsthalf results were better than expected, and management increased its full year guidance for EBITDA and free cash flow. Its EBITDA margin has expanded for four consecutive years. A new CEO, Nick Read, who previously was the CFO, brings considerable operational experience from his days heading Vodafone’s Africa, Middle East and Asia Pacific businesses. His turnaround plan focuses on improving execution and organic revenue growth, simplifying and improving the company’s commercial businesses, and reducing leverage while sustaining the dividend. The company is exploring asset sales, potentially including its cell tower operations, likely worth over $12 billion.
Importantly, Vodafone’s network upgrades, converged services and digitalization efforts, as well as its cost-efficiency improvements, should boost customer retention and profits. Unlike some competitors, Vodafone has no plans to spend on developing or owning media content
While large in absolute size, the company’s debt is more reasonable when compared to its $15+ billion in EBITDA and $6+ billion in free cash flow. Its $21 billion cash hoard provides additional safety. Vodafone shares trade at less than 6x EBITDA, offering investors the potential for significant upside as well as an attractive dividend.
We recommend the PURCHASE of shares of Vodafone Group (VOD) up to 32.
Sale Recommendations: Advance Auto Parts
Advance Auto Parts – The shares have been strong, and we believe the valuation now reflects the strong fundamental improvements in the business. Therefore, we are changing our rating to SELL.
NEWS NOTES
Weatherford’s steady revenues and rising earnings show that its cost-cutting program is working. However, its cash flow improvements are slower than planned as inventory remains high and some divestitures are delayed. This is pressuring its highly leveraged balance sheet, driving many investors to throw in the towel. On November 12, we lowered our Buy limit to 3 and now consider WFT shares to be speculative.
PERFORMANCE
The tables below and on the next page show the performance of all of our currently active recommendations, plus recently closed out recommendations.
