HMTV: A Compelling Play in Hispanic Media

I am still working on formalizing this story but I wanted to get the idea out ASAP in light of a major development at the company this week with regard to my thesis….

Company Name:  Hemisphere Media Group (HMTV)

Current Price:  $10.13                       Target Price:  $14.00 (38% upside)    Market Cap: $445mm

LTM Revenue: $95mm                       LTM EBITDA: $41mm (43%)          52 Wk Range: $9.09 -17.79

My view: I estimate that HMTV’s core business as it is today is worth approximately $9/share including a liquidity discount ($7.50 downside case) for the limited trading volume in the stock. At this level, the price implies the option on future growth can be bought for ~$1.15. That is the cheapest opportunity an investor will ever find to invest alongside a top notch private equity team with this type of growth potential in the underlying business. Further, given that there isn’t a single major brokerage firm on the Street that covers this stock, it is still very much an emerging story.

I have an 18 month price target of $14-16. For the record, I am long HMTV.

Company Description

US-based cable and broadcast television company focused exclusively on the US Hispanic and broader Latin American markets. The company was IPO’d in April by Intermedia Partners, a media focused PE firm. Intermedia still owns a ~58% stake. They’ve also installed their own management team – the same team that grew Telemundo from $700mm to $2.7bn in EV in four years. They’re now looking to grow the Hemisphere franchise via a roll-up acquisition strategy. I expect their acquisition focus to initially center around unique content and then broadening out over time to include other tv assets.

Hemishphere owns 2 key assets – WAPA and Cinelatino.

• WAPA consists of 2 networks. WAPA PR – the leading Puerto Rican broadcast station for 4 years running with 32% market share. Competitive advantage stems from the development of its own, locally targeted content whereas the 2 other stations (Univision and Telemundo) redistribute US content which is primarily geared towards Mexican viewers. This is a major difference in this market. #1 shows in 8 time slots. WAPA America leverages WAPA PR’s success by redistributing content to Puerto Ricans and Caribbean Hispanics in the US – the 2^nd largest segment of the US Hispanic population.

• Cinelatino is the #2 Nielson-rated Spanish language movie network in the US targeting the Hispanic population broadly. It is distributed by all major cable/satellite providers in the US as well as in 15 Latin American countries. Its competitive advantage stems from a unique content library which includes exclusive ownership rights to ~70% of all major Mexican box-office releases since 2006. Plan to implement an ad supported model in 2014.

Investment Thesis

Advertising

–       Hispanic cable viewership accounts for 19% of subscribers yet Hispanic targeted advertising represents only 10% of corporate ad spending. Ad spend should converge over time towards viewership.

Subscriber growth

–          Pay tv penetration in Latin America more broadly is expected to grow 17% between 2012 and 2016 with cable subscriber growth increasing by 30%.

–          Given Cinelatino’s current penetration level of 21% in Latin America, there are substantial opportunities for continued subscriber growth both from increased penetration rates as well as an expanding market generally.

–          Underfollowed – Not a single major brokerage firm covers it.

Underlying these fundamentals, management has proven experience in building out a similar franchise and their majority ownership stake reflects serious conviction in their go-forward roll-up acquisition strategy.

In addition to a majority stake by Intermedia and large personal blocks owned by management, several hedge funds also own a significant chunk of the float – namely Luxor and Hawkeye Capital. This is well-informed smart money.

I believe the recent sell off was sparked largely by Puerto Rican sovereign concerns (and exacerbated by a lack of liquidity) yet this situation poses little risk to HMTV. First, the Island has been in recession since 2006 yet the company has continued to grow. Advertising will not stop because the public sector stumbles. Further, if the market was to contract, HMTV would be the last portion of their budget advertisers would slash given the company’s position as the dominant media outlet in PR. Finally, research indicates that cutting ad spend during downturns leads to lower market share when the economy rebounds. Therefore, I see this as an attractive point to a very “cheap” growth story.

To be clear, this is still a risky play. The stock is illiquid, trading an average of 25k shares per day. But there are numerous days in which it trades below 10k. Significant gaps up and down are common.

Notably, this past Wednesday (10/23) it traded over 1.1mm ahead of the news on Thursday that Nick Valls from Telemundo has been hired as EVP of Advertising.

I estimate that HMTV’s core business as it is today is worth approximately $9/share including a liquidity discount ($7.50 downside case), which implies the option on future growth can be bought for $1.15. That is the cheapest opportunity an investor will ever find to invest alongside a top notch private equity team.

I have an 18 month price target of $14-16. For the record, I am long HMTV.

The Midstream “Emerging Markets”

I have long since been bullish on the prospects for the MLP sector as the domestic oil and gas boom continues to plow ahead. Regular readers are very familiar with Plains All American (PAA), my preferred play in this space.

MLP’s continue to be incorrectly associated with fixed-income investments that are susceptible to higher rates. This is an old view that is no longer valid in the current environment, particularly in PAA’s case. 

PIMCO recently put out an interesting piece on the future of the domestic oil and gas industry going forward that I thought was worth sharing.

Some key takeaways from the article:

• In our opinion, the midstream energy sector will grow more quickly than the overall U.S. economy over the next several years, which will provide continued support for current fundamentals.
• North American crude oil production is expected to increase at an average of 10% per year from FY2013 through FY2017.
• Bentek estimates that from 2013–2020, approximately 50% of all incremental global crude oil production will come from North America, totaling 4.5 million barrels per day, with four key producing regions the primary sources of the increase: 1) South Texas’s Eagle Ford Shale, 2) North Dakota’s Bakken Shale, 3) West Texas’s Permian Basin and 4) Western Canada.
• Due to ample access to capital, increased productivity and added drilling infrastructure, we believe production growth in Texas, North Dakota and Western Canada should grow 10% per year over the next 3 years.
• Overall, the emerging trends in North American energy, and especially in crude oil production, are likely to have dramatic ripple effects on U.S. manufacturing, foreign policy, defense spending, current account balance and the looming budget deficit.

In my opinion, the recent Fed tapering induced sell-off has created an attractive entry point for PAA here as the stock has not participated in the rally of the last month. Additionally, it has bounced nicely off its 6 month lows for the third consecutive time. But the sell-off was really unjustified for a number of reasons.

MLP’s continue to be incorrectly associated with fixed-income investments that are susceptible to higher rates. This is an old view that is no longer valid in the current environment, particularly in PAA’s case. The company is experiencing the best operating environment it has ever seen. Rising rates will not inhibit their ability to grow in the least with such strong tailwinds behind them. Further, management has proven their commitment to returning money to shareholders through consistent distribution growth. And given the operating outlook, they should continue to be able to grow the payout for years to come. So, at best, PAA is more akin to a floating rate investment, as opposed to the classic fixed rate context in which MLP’s have historically been viewed.. with significant equity upside to boot.

I added to my core PAA position last week. I don’t expect it to be a home run, but in this lackluster environment of minimal top line growth, political discourse, and expectations for the economy to continue to “muddle along”, there are few better places for patient investors to be right now in my opinion.

Point, counterpoint

A few posts ago I laid out my view of the market arguing that the general risk/reward trade-off in the stock market had shifted to the point in which the prospect of additional upside was outweighed by the prevailing risks on the horizon over the next few months. Indeed, the wide swings in sentiment through late summer underscored the uncertainty. Stocks did pullback, with the S&P falling to 1630 in late August. However, some of the grinding issues that were hanging over the market have since been at least watered down to some degree. Yellen looks certain to be the next Fed chief, Germany overwhelmingly re-elected Merkel, and interest rates have retreated from their recent highs. Meanwhile, the market has clawed back its losses to remain essentially flat, hovering right around the 1700 level. Sentiment still remains mixed but the wide divergences we saw a month ago seems to have abated somewhat. I am admittedly surprised by how quickly we recouped those losses and while I still maintain that, at this stage, the risks outweigh the potential for further gains over the next few months, the market’s recent resilience should not be discounted.

Since that post, I had the pleasure of attending a speech by Jim Paulsen from Wells Capital Management in which he decreed a markedly more upbeat view of the market and the economy. Since I first began following him in 2010, Paulsen has been a staunch bull throughout all of the obstacles we have overcome. I’ve come to respect his views and his ability to maintain a long-term outlook in spite of all the noise present in the markets over the last 3 years so I thought it worth sharing his perspective here. Below is my summary of his outlook.

• Although the current recovery is slow, it is not significantly different (in terms of a rebound in GDP growth) than other recoveries since the mid-80’s when growth in the working age population began to slow
• Since then, unemployment and consumer confidence have peaked and bottomed respectively, well after the official end of recessions (granted, we’ve only had 3)
• For the first time in a long time, housing and manufacturing are both rising while overall corporate profits are already 25% above their previous peak
• The ongoing energy boom is providing unexpected “dividends” and inflation looks set to remain subdued
• Growth in the private economy has consistently been stronger than the comprehensive headline numbers suggest and consumer confidence is at its highs…
• Meanwhile, fiscal policy has been a significant drag, taking roughly 3 percentage points off of GDP in the last 12-18 months.
• What he describes as Real Pent-up demand, which includes both the public and private sectors, has been consolidating since 2000 and looks poised to break out to new highs.
• The common thread that brings all of this together is rising confidence which, given the pent up demand in the economy, is close to propelling the economy into sustainable growth mode… and interestingly, he sees tapering as inconsequential to this thesis.

I admit he makes a compelling argument (trust me, it’s even more so in person!). And he is certainly coming at it from a different perspective than most market prognosticators. However, this year’s gains have come almost exclusively on the back of multiple expansion. That leaves me to wonder if these points haven’t already been priced in. Shouldn’t we be concerned about labor force participation being at all-time lows and the absence of top line growth from Corporate America? In my opinion, there is still a strong argument that stocks are fully valued today, having already discounted this growth potential. At some point, the economy needs to justify these market levels before we can move to the next stage of discounting future growth.

A taper tantrum?

After all the hype in the lead up to today’s Fed meeting, the FOMC surprised markets in dramatic fashion this afternoon by keeping its bond buying program steady. I have argued extensively in this blog over the last 6 weeks that the underlying economic data did not support the case for tapering. Further, the impending budget/debt ceiling debates seemed to also be clear hurdles to a September taper. Nonetheless, the Fed continued its taper rhetoric and seemed intent on reducing its bond purchases in spite of the data. Against that backdrop, my central argument was that the Fed viewed the risks of continued QE as too high. 

However, today’s news further complicates the investment landscape. As taper talk filtered through the markets, the prevailing view that began to take shape was that tapering signified a return to more sustainable growth. Thus, investors gradually became more comfortable with the idea and many saw it as a bullish sign. Yet, with the Fed standing pat, stocks are at record highs and the 10 yr is at 2.70. So how do you reconcile the “taper is good” logic with today’s rally when the Fed didn’t move? It seems as though “bad news is good news” again… especially in light of the fact that the Fed also downgraded its growth outlook. However, the worrying aspect of the lower growth outlook is not so much the news itself (the Fed has long since been more optimistic than the private sector), but rather the potential for an erosion of the FOMC’s credibility. After all, they presumably started the taper dialogue for a reason. And the prevailing view was that their reason was grounded in improved prospects for the economy. So today’s decision to lower their growth outlook suggests creates a whole host of other questions. First, the Fed may have been to quick to embark down the taper path in the beginning (ie. they overestimated the economy’s growth prospects). Or, the downgraded growth outlook could also be seen as reinforcing the argument that the Fed sees the risks of continued QE as becoming too high. That is, their initial reasoning for the taper was to lower systemic risk. If that was the case, then tapering has only be delayed. Either way, the Fed has left the markets confused in their attempt to broach the subject of unwinding QE. Therefore, today’s rally is likely not sustainable and should be taken with a grain of salt. To be sure, there was a lot of short covering.

Amid all of the TV banter floating around today, I have heard one very insightful explanation for the Fed’s decision from Brian Jacobsen of Wells Fargo Advisors. Jacobsen points out the numerous references the Fed has made to restrictive fiscal policy, both in today’s statement as well as in the lead up to the meeting. Given that Washington is soon set to begin the debt ceiling debate in earnest, it is very plausible that the Fed wanted to wait to see how those negotiations shake out before adjusting its policy. If true, tapering could well be back on the docket next month at the October meeting. Notably, given the Fed’s lower growth forecast today, this view is consistent with the idea that the original rationale for the taper discussion was heightened risk.

I still maintain that the fundamentals don’t warrant an immediate taper. Further, at these levels, valuations appear pretty full and thus I will continue to hold a larger than usual cash position until the risk/reward trade-off becomes more balanced or until the fundamentals confirm the valuations. In the meantime, I expect it to be a bumpy ride.

Dazed and Confused?

In light of the recent mixed economic data and geo-political events, the stock market has been characterized by significant swings in sentiment. The prevailing attitude in June was decidedly bearish as the Fed announced its intent to taper. Indeed there was hardly a bull to be found as investors shunned risk broadly, dumping both stocks and bonds. The VIX hit 20 and the yield on the 10y treasury proceeded to nearly double from its May levels. Yet in spite of higher rates, stocks staged a significant rebound in July and into August as sentiment quickly swung back to the bullish side after the Fed’s initial taper shock wore off.

Against this evolving backdrop, I sold a significant amount of my positions in early August. The market had had a good run and with the increased uncertainty on the horizon around the budget debate, debt ceiling negotiations, Fed policy, German elections, etc., the risk/reward tradeoff appeared less favorable than it had in quite some time. Better to take some profits and wait for clearer direction with stocks looking fully valued given the market’s run-up and the inability of earnings to keep pace. Further, top line growth was still elusive making future earnings expectations seemingly ripe for a downward adjustment. Finally, the last wild card was higher mortgage rates and their impending effect on the housing market.

Syria then entered the picture denting investor enthusiasm and promptly pushing the VIX back above 17. Since then, military actions have been delayed and the prevailing view on QE is that, although the Fed seems intent on tapering, it will do so in a very gradual manner, at least initially. All the while, the VIX has fallen back to 14 and treasury yields have retreated from their recent highs above 3%. Along with the stabilization of the macro outlook for the very short term, the market has resumed its rise with the S&P 500 close to regaining the 1700 level.

From a data perspective, the employment picture remains cloudy with labor force participation at 35 year lows. The ISM manufacturing index hit a 3 year high and the non-manufacturing index rose to its highest since 2005. However, the road remains bumpy as reflected by today’s fall in consumer sentiment, which marks the lowest reading since April, and disappointing retail sales, although autos continue to be a bright spot.

Meanwhile, market sentiment consists of fairly divergent views among investors. In a recent report, Baird highlights the extent of diverging sentiment citing relatively low put/call ratios on the CBOE, neutral sentiment as measured by the AAII and NAAIM surveys, and increasingly bearish sentiment from the institutional space based on Ned Davis polls. Collectively, the sentiment data is reflective of the uneven recovery / economic data and ongoing political risks which all continue to paint a confusing investment picture.

The preponderance of earnings data from Q2 was relatively subdued. Stripping out Financials, earnings growth was marginally negative driven by lower numbers from Tech, Energy, and Materials. In the meantime, estimates for the last half of the year have started to come down and could potentially continue to decline from here. In my opinion, top-line growth will be required from this point in order for valuations to continue to expand from here. And thus far in the recovery, revenue growth has been a key missing link (although earnings have improved markedly on the back of efficiency efforts from Corporate America).

So to summarize, we have dodged a couple of macro bullets for now, economic data continues to be sporadic, investor sentiment is as mixed as it has been perhaps all year, and equity valuations look relatively full. To me, all of this suggests ongoing consolidation as the macro picture continues to take shape, the Fed begins to taper, and second half expectations get adjusted. The market will likely be characterized by continued whipsaw action as the budget and debt ceiling talks gain steam. Interest rates have probably peaked for the near term as the market has become more comfortable with tapering and the growth outlook remains benign.

Amidst this backdrop, I advocate remaining on the sidelines and using pullbacks to re-build positions as earnings and growth expectations come down, which they seem certain to do. I would expect negative events to hit stocks broadly while positive developments will probably lead to more concentrated buying in individual stocks.  Thus, aggressive investors looking for tactical plays could take advantage of low implied volatility levels to buy puts here as there is a reasonable argument that volatility is underpriced given the long list of potential negative catalysts on the horizon. From a long’s perspective, the current environment suggests that we are increasingly in a stock pickers market because going forward, growth appears as though it will come in pockets.

As this process unfolds, the risk/reward tradeoff will intermittently shift back to more palatable levels making certain sectors and stocks attractive again. Among those I’ll be watching are my favorite MLP’s and tech, which has been beaten up but is beginning to show signs of turning. Should we come through the next 6 weeks without any major setbacks, tech could be one of the larger beneficiaries in Q4 and into 2014.

The US Energy Landscape

Several months ago I wrote about the broader implications of the domestic energy boom on US foreign and fiscal policy, arguing that the shale boom will continue to be underpinned by positive factors in both of those areas.

In a recent FT article, that issue was explored further in light of the recent developments in Syria. That article supports the idea of US domestic energy policy as a growing foreign policy tool in an ever increasing complex international context.

Tom Donilon, formerly Obama’s National Security Advisor, characterized shale as a “transformational moment” and went on to say:

“Sanctions against Iran were more successful than people thought they would be because we were able to replace the lost supply in world markets and thus get co-operation from China and India and others,” says Jason Bordoff, a former senior White House official now at the Center on Global Energy Policy at Columbia University.

“We could pull 1.5m barrels per day off the market without causing a spike in prices, which would have hurt our economy and helped Iran.”

The article goes on to note:

“US shale knowhow can also be a useful export. The administration has been working with countries including Poland, Ukraine, Jordan, China and Mexico to help them develop their shale resources so they can meet more of their own energy needs from domestic production rather than from Russia, Iran or other potentially unfriendly countries.

The shale boom is creating jobs and profits and boosting tax revenues. As Mr Donilon says: “A country’s political and military primacy depends on its economic vitality.”

 However, the opportunity is certainly not without its own challenges :

“Yet as America’s confidence in its energy resources climbs ever higher, there is a danger of the optimism running ahead of reality…

“It would be wildly irresponsible to make defence policy decisions based on the assumption that the US is going to be energy self-sufficient in 10 or 20 years,” says Michael Levi of the Council on Foreign Relations. “If that turns out to be wrong, it could be disastrous. One of the big lessons here is: don’t be too confident.”

Nonetheless, this is clearly an opportunity that the US cannot afford to squander. The long-term investment thesis for energy infrastructure remains as robust as ever. Indeed, the US is in the process of a massive re-tooling of its pipeline networks to accommodate new sources of oil and gas which is flowing in new directions. My preferred means of playing this trend remains the pipeline MLP’s, which offer high, tax-advantaged yields that will grow over time as more infrastructure continues to come on line in the future. Stay tuned for an update on PAA, my preferred MLP, in the coming days.

Ticker Taper and the Job Market Pendulum

One thing has become clear over the last month or so – the Fed seems intent on tapering QE. However, the underlying reason for their desire to taper is far less obvious. In reality, the timing of the taper is of little importance in terms of long term implications for markets. Nonetheless, volatility will persist as traders continue to try to gauge when the great taper will actually begin.

The important factor within this debate is the signal the Fed ultimately sends when it does taper. Will it be due to a fundamental belief that the economy can stand on its own two feet? Or rather, that the risks are beginning to outweigh the benefits of further QE? Thus far, the market seems to be discounting the latter possibility… which makes the Fed’s ultimate signal even more important.

Today’s jobs report was far from encouraging with poor internals and significant downward revisions to the two previous reports. But, in reality it will have little bearing on the FOMC’s decision – as it should. The Fed looks at the data in its entirety over a long period of time. Trends are important. Individual data points far less so.

And the recent trend in the labor market is far from obvious. The unemployment rate continues to decline, yet the internals are anything but robust. There has been much discussion of late regarding the declining labor force participation rate. Some of the decline is attributable to retiring baby boomers, which the Fed has acknowledged in the past as an expected and normal effect. The question is, how much of the decline is due to the baby boomer effect and how much is the result of an ongoing struggle within the prime age working population.

Bill McBride of CalculatedRisk.com posted an interesting piece today on that topic. A key issue he points out is the continued decline in the participation rate among 25-54 year olds. McBride says:

“Since the participation rate declined recently due to cyclical (recession) and demographic (aging population) reasons, an important graph is the employment-population ratio for the key working age group: 25 to 54 years old.

In the earlier period the employment-population ratio for this group was trending up as women joined the labor force. The ratio has been mostly moving sideways since the early ’90s, with ups and downs related to the business cycle.

The ratio was unchanged at 75.9% in August.  This ratio should probably move close to 80% as the economy recovers, but that also requires an increase in the 25 to 54 participation rate.

The participation rate for this group declined to 81.0% in August.  The decline in the participation rate for this age group is probably mostly due to economic weakness (as opposed to demographics) and this suggests the labor market is still very weak.”

McBride shows a good chart of both of these metrics over time. Since 2008, the decline in the 25-54 yo participation rate has clearly accelerated. The worrying aspect is that, based on the data, it doesn’t appear to be bottoming.

Check out the rest of McBride’s analysis, including some great charts and in-depth commentary at: http://www.calculatedriskblog.com/2013/09/employment-report-comments-more-graphs.html#ljteR1JYRXxfeH0U.99

More on the Great Taper Debate

Last week was a big event for Fed watchers. The FOMC kept its statement largely unchanged from the previous month although there were a few subtle changes of note. The jobs report on Friday showed an increase of 162k and another down tick in the unemployment rate to 7.4%, the lowest reading since December 2008. However, labor force participation declined by another 0.1% and weekly earnings fell as a result of fewer hours worked and lower average earnings. So where does that leave us in terms of the Great Taper debate?

Early last week I argued that the Fed’s recent round of clouded rhetoric could be a sign of growing discomfort within the FOMC with respect to the risks of continued QE. After the latest round of data and the Fed’s statement, that argument still warrants significant consideration by investors. My view is that when the taper begins will be a signal as to the Fed’s rationale for doing so. Given the underwhelming economic data of late, I would argue that the sooner the taper begins, the more likely it is that the underlying reason is due to the FOMC’s perception that the risks outweigh the benefits. 

Indeed, the latest jobs report, while not dire, certainly suggests a continued slow grind for the labor market. That is, the status quo of the last year or so remains firmly intact. And last week’s report clearly didn’t do anything to add support to the view that tapering is warranted due to underlying economic momentum. In that vein, the Committee also reiterated that “fiscal policy is restraining growth.” Perhaps the most notable change in the Fed’s latest statement is that Bullard didn’t dissent. He has gone on record for some time now voicing concerns regarding the persistently low level of inflation (currently running at about 1%) relative to the Fed’s target of 2%. Altering the statement to explicitly acknowledge that fact is likely what kept him from casting another dissenting vote. But the implications of that change are more profound than they might seem at first glance because deflationary concerns would argue for continued – even additional – QE. In total, none of this is likely to sit well those FOMC members in the taper camp.

In my last post I argued that if there is in fact an underlying shift beginning to take shape within the FOMC on the issue of the costs and benefits of continued QE, it would not be taken lightly by the market once that possibility became widely appreciated. To be clear, the Fed certainly appears as though it wants to taper in spite of data that suggests otherwise. And all indications suggest the market still believes the Fed is on track to begin doing so in September. But from my perspective, the key question here is why they are tapering? If the data doesn’t support the need to do so, then the idea that the risks to continued QE are beginning to outweigh the benefits should surely be seriously considered.

PIMCO’s El-Erian has suggested that the Fed is likely trying to shift the market’s focus from the future path of QE back to the future path of its policy rate. This argument seems very plausible given the risks associated with being “forced” to taper. If the Fed does see the need to taper because the risks now outweigh the benefits, the sensible move would be to try to reassure the market that policy was going to remain very accommodative for an extended period. Indeed, that view is consistent with Bernanke’s deliberate attempts to ensure markets that tapering should not be viewed as hitting the brakes (ie. tightening), but rather simply as letting up on the accelerator.

So while forward guidance has been a key policy tool for the FOMC, it would become the primary policy tool going forward under a monetary policy regime that excluded QE. In that scenario, the Fed’s hope would be that by refocusing the market’s attention on its “low for long” outlook, a disorderly selloff would be less likely to ensue as investors adjust their actions in a post-QE.

However, the Fed’s task becomes increasingly complicated the longer this issue remains outstanding. For one, the sooner the market digests the reason for the taper, the less painful will be the associated re-pricing process.

Yet, timing is another complication here because days after the next FOMC meeting, Germans will go to the polls to elect a new chancellor. Merkel is expected to be re-elected but if the liberal Social Democrats win, the policy outlook for Europe becomes more uncertain in what has recently been a subdued European environment. On the other hand, waiting until December pushes the taper decision right up to the point at which Bernanke hands over the reins to his yet to be determined successor. One would think that the Fed would prefer to have as much continuity as possible around the exit to QE.

Ultimately, I believe that when the taper begins will be a signal as to the Fed’s rationale for doing so. The underlying data – dismal growth, a still fragile job market, and below target inflation – doesn’t support the need to taper. Thus, I would argue that the sooner the taper begins, the more likely it is that the underlying reason is due to the FOMC’s perception that the risks outweigh the benefits.

Throw all of this into the macro “stew pot”, along with increasing unrest in the Middle East and China’s slowdown, and you have a significantly riskier macro environment than we did heading into the summer.

On the Fed, Taper Talk, and Monetary Policy

The Bernanke Fed has been characterized by excellent communication of its economic outlook, the risks to that outlook, and its policy stance. Bernanke pioneered the use of forward guidance as a policy tool amidst the most challenging policy-setting backdrop in modern history, a welcome change from the Greenspan era, by clearly outlining his views and by introducing new channels through which to communicate with the markets (eg. Fed press conferences, use of policy thresholds, etc.). And while QE has long since been a controversial topic in terms of its costs and benefits, the Fed has collectively done a great job of navigating the communication challenges associated with QE while being careful not to back itself into a corner with respect to its policy choices. Until recently…

During the last few months, this hallmark of clear, cohesive communication has given way to a confusing round of policy views and a more clouded outlook. Here is a brief re-cap of some notably diverging views out of the FOMC as of late:

May FOMC statement: The Committee said that it “continues to see downside risks to the economic outlook.” These comments seemingly indicated that QE was set to remain on its current course.

May Minutes: Weeks later in the FOMC minutes it was revealed that “a number of participants expressed willingness” to reduce QE as early as June if the data warranted it. This marked a seemingly significant change in policy stance from the May statement and sparked a sell-off which persisted into June as investors pared back risk in anticipation of a change in the asset purchase program.

June FOMC statement: Labor markets have shown “further improvement in recent months” and the FOMC indicated that downside risks have “diminished.” Again, a notable shift from the May statement which reinforced the view that asset purchases could be close to being reduced.

June Press Conference (6/19): Bernanke reiterated that policy was not on a pre-set path and that asset purchases could be reduced or maintained as the data evolves – seemingly backpedalling from the upbeat tone of the statement. This dichotomy of paths for future purchases confused markets and the sell-off resumed. Subsequently, several Fed members came out trying to clarify the Committee’s intentions. Kocherlakota of the Minneapolis Fed went so far as to say that the Fed could improve its communication approach.

June Minutes (released 7/10): “several” members thought asset purchases should be slowed soon, while “many” thought further improvement in the jobs market was warranted. These jobs-related comments seemed to be at least somewhat at odds with May’s minutes. But at the same time, “about half” of the broader FOMC group, thought that asset purchases could potentially be concluded entirely by the end of the year.

Boston Speech (also 7/10): Meanwhile, Bernanke says “highly accommodative monetary policy for the foreseeable future is what’s needed.” And that the 7.6% unemployment rate likely “overstates the health of the labor market.”

Congressional Testimony (7/17): Bernanke’s dovish tone persists as the Chairman again points to labor market issues and the underemployment problem.

Markets have largely stabilized since this series of comments, although the tone has darkened. However, based on this rhetoric, it appears as though the Fed may in fact be becoming more divided on the costs and benefits of prolonged QE. Indeed, Mohammed El-Erian of PIMCO has suggested that the Fed may be seeing the risks to further QE beginning to outweigh the perceived benefits. Interestingly, this view has not been as widely discussed in the financial press as one might have anticipated given the dramatic effects it would have if a shift was in fact underway.

To be sure, much of the volatility of late has stemmed from confusion around the differences between a reduction in bond purchases and a tightening of monetary policy. But, that is an issue about the market’s perception of the meaning of tighter policy (which economists can easily differ on), rather than a question about the Fed’s economic outlook. Further, it seems unlikely that the act of addressing that distinction would lead policymakers down such diverging paths before coming to an answer. The Fed’s exit strategy has been an important part of the conversation from the beginning. So it is from this frame of reference that I believe the recent communication breakdown may in fact be indicative of an underlying shift within the Fed on the topic of QE.

If there has in fact been a shift in the mindset of FOMC policymakers on this point, it would imply that the Fed does view QE as necessary for the foreseeable future but that that aid is now becoming too costly to provide. This news would make the volatility of the last two months seem like child’s play. So the Fed would have to play its hand very, very carefully in terms of how it couches its view and what it would do to provide support from that point. Given these risks, it is unlikely that a concrete change in in the asset purchase program is near. Rather, a shift in this context would merely mark an inflection point on the QE pendulum.

Another outlier in this debate is the Fed’s persistently upbeat forecast for growth for the remainder of the year. The FOMC has been more optimistic than the private sector for quite some time now. And thus far, their optimism has not been validated by the data. Yet, if they reduce their forecasts without altering their rhetoric on QE, they implicitly imply that QE will remain on the same trajectory.

The final wrinkle in all of this is that Bernanke is on his way out. Over the last week this has been the major Fed-related topic debated in the press. And it further complicates the market’s ability to anticipate future policy actions because that obviously depends on who will be at the helm. Yellen, who has been very supportive of QE, would essentially be a continuation of the Bernanke Fed. Summers would represent the biggest change – and risk – from the market’s perspective because he has gone on the record as being more skeptical about the merits of QE. Geithner would be somewhere in the middle, but he is probably closer to Yellen than Summers.

This week’s Fed meeting certainly won’t shed any light on who might be next in line. However, it will be interesting to see if Bernanke & Co. continue to try to clarify their future intentions or if they opt to let things be for the moment. Either way, the prospect of cracks within the Fed’s QE foundation shouldn’t be underestimated. It is a scenario that appears to be underappreciated by markets and that is the worrisome aspect here. Fortunately, even if a shift is underway, it would likely take some time before it resulted in actionable change as members continue to make their case to their colleagues and debate next steps. Nonetheless, even a hint of such a shift would lead to a significant re-pricing across global markets.

MPC: Mile Marker 26 – Reflecting on the Race

A colleague has recently challenged me to be more reflective of my trading process. From documenting the pre-trade thought process to how the thesis evolves during the life of the trade, all the way to the sell decision and beyond, it’s critically important to identify where your discipline tends to break down. In a perfect world, your thought process should constantly challenge your initial thesis amidst the evolution of the story.

MPC has been the biggest trade I’ve had on since starting this blog so it makes sense to start there. My initial thesis has been laid out in multiple posts, so I won’t revisit it here. But having recently exited the trade, this is a great time for reflection. Unfortunately, a casual reflection has already highlighted waning discipline in the later stages of the trade.

The lesson in this case is two-fold. 1) Don’t let a range bound stock frustrate you into selling calls on your entire position when you believe the fundamental story is still intact. Seems obvious but emotion clouds these facts all too often. 2) Recognizing when the story begins to get traction in investors’ minds should serve as an inflection point in your view of the trade. Re-visit your fundamental valuation of the company to avoid getting caught up in the hype. The selling point is likely not too far away.

When I first discovered MPC it was trading in the low 30’s. It was clear that the stock was significantly undervalued, but my conviction was immediately challenged by a dip into the mid-20’s. This drop coincided with the European stress of late summer 2011. I bought more as it rose back to $30, and at that point determined that the position was sized appropriately (~15% of my PA which is the upper limit I use (and sparingly so) for single stock positions). In time, the market began moving my way and from there, patience was the key to realizing the full potential of the trade. And that is where my discipline began to fade…

MPC’s volatility made it a great stock to use covered calls as a means of boosting returns and that strategy worked well while the stock bounced around from 30-40. But when the stock stagnated in the mid-40’s and low 50’s, I became overly aggressive with my call selling. With the benefit of hindsight though, this was precisely when the MPC story had begun to gain widespread acceptance in the market. Refining stories became pervasive on CNBC and in the press broadly, helped by activist investors JANA Partners who had advocated a spinoff of the company’s pipeline assets into an MLP. PIMCO and others went on record as holding long positions as well. But rather than sitting tight, I increased my short call positions (and the tenor of those calls) to the point where they covered my entire long position at 55 and 57.50 as the stock continued to be constrained in the low 50’s.

In Nov 2012 MPC broke out of its range rising to the low 60’s by January and then consolidated… briefly. I incorrectly read this consolidation as a top and thus left my calls intact, hoping the time decay would work in my favor and provide an opportunity to mitigate the losses on the calls – a ridiculous approach. From there, MPC went parabolic, blasting into the 70’s.

At this point I recognized my mistake, however, rather than simply taking the losses on the chin, I rolled ¾ of the short calls up a few strikes. This only delayed the inevitable and I quickly had to cover those calls as well. Covering was the right move from the beginning, but my discipline gave way to hopes for a pullback. The stock had jumped over 15% in a less than 2 months. But with the story now being a daily topic in the press, the momentum was undeniable. I had 25% of my position called away at a 15 dollar discount and took a decent loss on the remaining calls.

From that point though, I was free and clear with a still sizable long position and MPC ultimately hit 90. With the story now at fever pitch, I should have exited the trade. A move like that is unsustainable in the short term, and WTI-Brent spreads, a major catalyst for the trade in the beginning, were beginning to narrow (and have since reversed entirely). Interestingly, the analyst community was still incredibly bullish, raising price targets to over 100.

By this time though, the risk/reward had clearly shifted to the downside and I began to look for a way out. 90 proved to be a short-lived level and this further reinforced my view. I immediately sold another 50% of the position at 82.50. Given the volatility at that level, I was able to collar the remaining position between 75 and 82.50 and thus became content to wait and see how the story would unfold from there.With one last gasp, MPC jumped to 84-ish and the last of stock was called away. From there, it has since fallen back into the low 70’s.

MPC is still one of the best refining plays out there. They have one of the most strategically located asset bases of any refiner and the Texas City acquisition has bolstered their presence on the Gulf coast, which should prove to be one of the most fruitful regions within the refining space as more crude gets pushed south in time. But the story is much more complicated at these valuation levels.

I have not been an active long/short guy in the past, but this set up seems to lend itself well to that type of trade as a rising tide will probably not continue to lift all refining boats from here. I’m in the process of researching short candidates for the other side of this trade now. Stay tuned for more on that in the coming weeks…