Monster Mash

by Ralph Cole, CFAExecutive Vice President of Research

Monster Mash

No holiday better describes earnings season than Halloween.  When companies announce earnings, investors are hoping for treats but often times end up getting tricks. In our view, improving corporate earnings are the catalyst to improving stock market returns in the coming year. As we close out the best month for the stock market since 2011, we should review some of the tricks and treats of earnings season.

Treat

Apple reported earnings earlier this week and beat expectations on almost every level. IPhone sales continue to grow at a robust pace around the world. The company sold 48 million iPhones in the third quarter, up 22 percent from last year. Analysts expect the company to sell 79 million iPhones in the final quarter of the year.  Average selling prices of the phones continue to rise, which enhances profitability and will lead to $60 billion in free cash flow this year alone.

Tricks

As expected, the energy sector has had a rough time of it this earnings season. Earnings for the S&P 500 energy sector were expected to be down 73 percent this quarter and that indeed has been the case. During these distressing times all companies begin to dramatically scale back investment and reduce headcount. We feel that higher quality companies with good assets, low debt levels and quality management teams will benefit from the eventual rise in oil prices.

Trick and Treat

In no place is the bifurcations of earnings season more evident than in footwear. Nike reported earnings that beat analyst estimates by 12 percent and the stock responded with a nine percent pop the next day. Nike also reported a solid outlook for the coming quarters as well. Sketchers, on the other hand, tricked investors and missed earnings by a whopping 21 percent last week and the stock dropped 31.5 percent with the news.

Why have stocks responded so positively to a mixed earnings environment? Expectations for third quarter earnings had been lowered so much that companies have been able to meet and often beat those reduced forecasts. Also, the much advertised slowdown in China has not had as big of an impact on earnings as investors feared. While the investment slowdown in China has hurt some industrial companies, the Chinese consumer has actually helped the likes of both Apple and Nike.

Takeaways for the week

• There have been more treats than tricks this earnings season which has driven the S&P 500 higher by nine percent this month
• Earnings season continues to be very volatile and stock selection has been key

Disclosures

Earnings In Focus

by Shawn Narancich, CFAExecutive Vice President of Research

More Than Meets the Eye

While US stocks have remained in a trading range through the first third of earnings season, what lingers beneath the surface belies a market near recent highs. Set against a quiet week on the economic news front and at a time when the Greek melodrama is again fading from the headlines, investors put their full attention into discerning the health of corporate America. As measured by the market capitalization of reporting companies, this past week marked the most significant period of the second quarter earnings season. Though a plurality of those delivering numbers are beating bottom line estimates, revenues are coming in much more mixed given continued headwinds from the stronger dollar and weakening growth in China. Indeed, the Red Giant confirmed the latter earlier today by reporting surprisingly week manufacturing numbers that furthered the sell-off in commodities, rallied the dollar, and boosted bonds.

Not Sleepless in Seattle

In an earnings report that bore some resemblance to Google’s expense-driven earnings beat last week, internet commerce mainstay Amazon.com proved that even it can make money when it stops spending so much. Revenue growth has never been the problem for the folks headquartered in the Emerald City and, on that measure, Amazon continues to excel, reporting accelerating revenue growth that beat estimates.  What was somewhat surprising is that Jeff Bezos’s gang allowed some of the top-line largess to the bottom-line, reporting perhaps the most celebrated $92 million profit ever.  Once again, shorts betting against Amazon got hammered, as the stock surged 10 percent on the news in an otherwise down market. Although a resulting net profit margin of 0.4 percent is certainly not what most companies aspire to, it helped create $22 billion of wealth for Amazon’s shareholders today. For our part, we continue to avoid companies trading for 372x estimated earnings.

Not to be outdone by its Seattle neighbor, consumer darling Starbucks also delivered an upside earnings surprise, reporting that its new mobile ordering initiatives are helping drive traffic and boost same-store sales, which surged 7 percent. On the back of healthy top line growth that translated into a 24 percent earnings gain, Starbucks investors were greeted with further gains in the stock.

An Apple Bitten

In contrast to the wealth created by Seattle-based firms this week, Apple ceded some of its prodigious market value on reduced revenue guidance tied to moderating iPhone sales. While 33 percent quarterly sales growth for a company of Apple’s size is nothing short of extraordinary, when you get to be a company with annual sales approaching $230 billion, it’s only natural for investors to question what a company like this can do for an encore. For our part, we continue to view favorably the prospects of this reasonably valued technology titan.

Our Takeaways from the Week

• A heavy week of corporate earnings produced mixed results for investors

• Concerns about a slowing China continue to weigh on commodity prices

Disclosures

Wired and Connected

by Jason Norris, CFAExecutive Vice President of Research

For technology junkies, the Re/code conference in Southern California is one of the highlights of the year. It is a broad mix of public and private companies speaking on innovation today and what the future holds -- from automobiles and wireless to media and culture.

One of the most popular segments of the conference is Mary Meeker’s annual presentation of internet trends. Meeker is a partner at venture firm Kleiner Perkins; however, her thrust into the spotlight came about 20 years ago when she was an internet analyst for Morgan Stanley. The key point to her 190+ page slide deck was that the internet is still in its very early stages and mobile is becoming more of a dominant aspect of the web. While the consumer and businesses have been pushing the internet, there are several other areas of the economy where opportunities are still great. Government, education and healthcare are just a few examples of sectors that have not yet fully leveraged the internet.

As users, traffic, and transactions increase online – security becomes more of a focus. What has been a common news event of late, there are breaches at various institutions that can put both individuals and those entities at risk. The IRS unfortunately is the most recent institution to be significantly impacted. As more people connect to mobile devices, security and encryption are even more essentials. The chart below highlights time spent with digital media on different devices.

Accessing digital media continues to grow at a double-digit rates and the growth is primary coming from mobile. This growth in connectivity globally continues to benefit companies such as Apple, Samsung and Avago.

Increased transactions as well as a growth in private information shared digitally, specifically wirelessly, does increase the need for better security, as well as the opportunity for companies to analyze consumer behavior and offer personalized deals. These trends have resulted in chief information officers (CIOs) to forecast security and analytics spending to continue to increase as a percentage of information technology (IT) spending. Morgan Stanley released a survey earlier this week highlighting a 210 bps increase in the growth of network security spending in 2015 (12.8 percent up from 10.7 percent). To put in perspective, overall IT spending usually grows in the low-to-mid-single digits. Some beneficiaries of this trend would be Cisco, Checkpoint and Palo Alto Networks.

Watch What You Do

As consumer utilize more wireless devices and with the most recent launch of the Apple Watch, some legal issues become a bit fuzzy. In several states, it is against the law to use your wireless handset while driving. What if you are using your watch? This was the case in Quebec earlier this month where a watch owner was fined $120 for operating his watch while driving. As devices become more integrated, especially in cars, safety regulators are going to have a tough time keeping up.

Our Takeaways for the Week

• Mobile is becoming the dominant means of interent access
• Cybersecurity will be a theme for years to come

Disclosures

Taking a Bigger Bite Out of the Apple

by Jason Norris, CFAExecutive Vice President of Research

Apple reported earnings earlier this week. Due to recent strength in the stock, investors took profits. Specifically, sales grew 27 percent year-over-year, driven by 55 percent growth in iPhone revenues. This resulted in profit growth of 40 percent. These growth rates are very rare for companies with annual revenues over $200 billion and a market capitalizations (the share price multiplied by total number of shares outstanding) in excess of $700 billion. Therefore, sustainability does frequently come up.

On a similar note, with Apple’s market capitalization of $725 billion, it is now considered the highest valued company in the world. With that value, it is now 4 percent of the S&P 500, the most common equity benchmark. When active investors attempt to beat their benchmark, knowing some of the major constituents is critical for investment managers. In the case of Apple, if an investor believes that Apple is going to perform better than the S&P 500, they now have to allocate more than 4 percent of their portfolio to that stock. If they do not and Apple were to perform better than the S&P 500, investment managers will not keep up.

From a diversification standpoint, most investment managers are hesitant to hold positions greater than 4 percent, thus would now be underweight Apple. Since Apple is a very large component of the large-cap equity benchmarks, we recently reviewed the 10 largest actively managed core and growth mutual funds. For core managers trying to beat the S&P 500 when Apple is a 4 percent position, eight of 10 are underweight, and the other two are equal. When looking at growth managers when Apple is 7 percent of the benchmark (i.e., Russell 1000 Growth), nine managers are underweight and only one is equal. This data revealed that Apple is extremely underowned among the world’s largest mutual funds. If those funds were to move to an equal weight position relative to the benchmark, we would see over $29 billion worth of buying, which is roughly 235 million shares. Since we have a positive view on Apple, we believe this data is also positive.

Just like clockwork, this time of year the financial press will be prognosticating about the old adage, “sell in May and go away.” This comes to the forefront since equity markets often experience lackluster performance in the spring and summer months. However, it does not necessarily mean that investors lose money. Since 1978, from May to September, stocks median return was 3 percent, lagging the performance of equities from September to May. This has resulted in a median performance of 11 percent. We believe this doesn’t signal “a sell” since there are still positive returns to be had, just more potential volatility. The negative returns captured in the chart below are the result of two poor months, July and September.

Source: FactSet

Our Takeaways from the Week

o   Apple continues to be an "underowned" stock which may provide outside buying power adding support to the name

o   While summer is often a results in lackluster equity period for performance, we don’t think investors should trade based on the calendar

Disclosures

Seasons

by Jason Norris, CFA Executive Vice President of Research

Seasons

The more things change, the more they stay the same. Five months ago, we rebuked the old Wall Street adage of “sell in May and go away” which, through the end of August, was a good call. From May 1^st to Aug 31^st, the S&P 500 was up just over 7 percent. However, just like clockwork, the month of September looks to be producing the same results it historically has. Since 1928, September is the only month out of the twelve that has an average negative return. With only a couple of trading days left, it looks like that trend will not be “bucked” this year. Even though there is still time to pull even, the end of the month is usually the weakest (see below).

Source: Renaissance Macro Research

Send for the Man

While this has been a bad week for stocks, it was also not a good week for healthcare mergers and acquisitions. On Monday afternoon, U.S. Treasury Secretary Jack Lew issued some administrative rules making it harder for U.S. companies to start inversion mergers. This type of merger allows a U.S. company to buy a smaller foreign company and relocate offshore to lower tax jurisdictions (see an earlier post for details). Most of these deals are centered in the healthcare space and while these changes will not stop potential inversions, they are designed to make them more difficult. For example, Medtronic is currently in talks to purchase Covidian (based in Ireland) and would use a meaningful amount of offshore cash to finance the deal. With these new rules, Medtronic would not have access to that cash without paying U.S. taxes. Therefore, they will have to look for other financing means, most likely debt, thus slightly increasing the cost. We still believe the deal will be completed, but it does show that the U.S. Treasury is adamant about changing this part of the U.S. tax code. AbbVie and Shire may also be affected; however, the tax benefits are not as meaningful and the gains from the Shire pipeline are significant enough to proceed.

Lesson Learned

Last week was not a good week for Apple. After announcing a record weekend of sales for the iPhone6 and iPhone6+ with over 10 million handsets sold (and this without shipping any to China), any good financial news was eclipsed by issues with the iPhone6+ bending and a botched iOS update. Investors didn’t have patience for the stock during the last few days. We believe that despite these hiccups, this iPhone launch will net over 60 million units this month, and based on pricing and component costs, should be accretive to gross margins.

What we know

• The trend of September probably won’t be broken and stocks will give back some of their summer gains
• Both buy and sell side analysts have been on the phone with their tax attorneys due to Secretary Jack Lew’s administrative order regarding inversions

Disclosures

Independence for Scotland and a UK haggis famine

by Brad Houle, CFA Executive Vice President

Haggis is a cuisine of Scotland characterized by Wikipedia as a savory pudding containing sheep's pluck (heart, liver and lungs) minced with onion, oatmeal, suet, spices and salt mixed with stock. It is traditionally encased in the animal's stomach and simmered for approximately three hours.

The often lampooned delicacy was featured in the 1993 film, “So I Married an Axe Murder,” staring Mike Meyers. In the comedy, Mike Meyers’ character of Scottish decent when as asked about his fondness for haggis responded, “I think it's repellent in every way. In fact, I think most Scottish cuisine is based on a dare.”

On September 18, a referendum for Scottish independence from the United Kingdom will be put to a vote. Recently, polls suggest that it will be a close outcome. This situation is creating uncertainty and we have seen the pound sterling weaken as a result. At stake is revenue from the oil-rich North Sea which has been greater than 2 percent of the UK's revenues down from over 6 percent of revenue in the 1980s. The North Sea fields are off the coast of Scotland and there is some question about which country would control the revenue after a split. There have been many comparisons of an independent Scotland and Norway based on the countries similar populations and potential energy wealth. While the North Sea fields are in a period of declining production, the revenue would be material to an independent Scotland.

If a vote for independence passes, the UK's fragile recovery from the financial crisis will be called into question. The UK economy has slowly been crawling out of the economic downturn of the Great Recession in a similar fashion to the U.S. A split-off of Scotland would potentially stall the recovery.

The pending referendum has also created uncertainty relative to business investments in that there is a question about the political landscape should a split occur. In a similar situation, Quebec had a referendum for independence in 1995 that failed. However, the uncertainty that it could occur again was at least partly responsible for an economic malaise in the province and reduced business investment.

In Spain, the region of Catalonia has a referendum in November of 2014 for possible secession.  The impact of this would be negative for Spain as its economy is in far worse shape than the U.S. and the UK.

While not a catastrophe in the making, an independent Scotland or Catalonia destabilizes what is a tenuous recovery in Europe. Most of Continental Europe is suffering from anemic growth, continued high unemployment, massive indebtedness and the specter of deflation.  Above all, the financial markets hate uncertainty and these types of changes are potentially disruptive to the European recovery.

Other Takeaways for the Week

• Apple introduced the iPhone 6, Apple Watch and Apple Pay this week, which were generally well received. The Apple Pay secure transaction using an iPhone rather than a physical credit card has the potential to revolutionize how items are paid for at retailers.
• The late Joan Rivers often used humor regarding her financial life as part of her act. One memorable quote that bears mentioning is, “People say that money is not the key to happiness, but I always figured if you have enough money, you can have a key made.”

Disclosures