by Tsachy Mishal, Capital Observer
Earlier in the week I outlined the difficult environment facing value investors. Finding new investments meeting a value criteria has not been easy after a nearly tripling of markets in less than five years. A couple of months ago my cash pile was growing as many of my investments reached their target and I could not find new investments to replace them. Much to my own surprise I have recently been able to put money to work and am excited about my portfolio. Four of my investments, which I will outline, have catalysts coming up in the first quarter of 2014.
Two of the investment ideas came along as a result of tax loss selling. Tax rates have gone up this year and many market participants have large gains. Those looking to offset gains with losses have very few choices this year, so a small group of losing stocks have bore the brunt of this selling. Tax loss selling is similar to forced selling in that sellers are not basing their sell decision on the merits of the stock. The good news is that there are less than four trading days left in the year and tax loss selling will soon be over. The other two ideas are are long/short ideas with company specific catalysts. Without further ado here are my four investment ideas:
Catalyst: Announcement of new CEO
Bill Ackman took an activist position in Air Products and Chemicals earlier this summer. He was quickly able to gain board seats and remove the CEO. Normally, this would cause the stock to fly but due to the adverse publicity Bill Ackman has received from Herbalife and J.C. Penney the stock has barely outperformed its peers. Bill Ackman has had many successful activist campaigns and a small handful of failures. Air Products and Chemicals has a lot more in common with his successful campaigns.
Air Products has strong, recurring free cash flow that is being masked by a capex binge. Only $300-$350 million of Air Product’s $1.52 billion a year in capex is maintenance capex, while the rest is expansion. New plants take three years before they are built and operating at the capacity needed to create strong cash flow. The benefits of the capex binge of the past few years has not been realized but will be realized over the next few years, resulting in higher cash flow. The new CEO is likely to reduce capex spending on new projects and direct more of free cash flow to investors.
Air Products has the lowest margins in its industry. It largest competitor, Praxair, has margins nearly 50% higher. There is a lot of room for cost cutting and increased sales productivity to improve margins. With modest margin improvement and the realization of the benefits of their capex binge, Air Products could see over $14 in free cash flow per share annually some time in the next few years.
Many people I have discussed Air Products with have been scratching their heads as to why Bill Ackman has chosen the company. Bill Ackman has still not laid out a detailed case for this purchase,as he is likely waiting for the new CEO to be announced. A new CEO has not been chosen yet but is likely to be chosen in the first quarter of 2014. The appointment of the new CEO is likely to act as a catalyst for the stock as the new CEO lays out his strategy and Bill Ackman lays out his investing case. I am long APD / short PX ARG
Catalyst: End of tax loss selling
I recently laid out a detailed case for owning Annaly Capital Management. In summary, Annaly trades for an unwarranted 20% discount to book value. Annaly has lowered leverage, hedged and diversified into commercial mortgage backed securities. Annaly is positioned well to withstand future interest rate increases with minimal damage to book value. I believe the reason for this deep discount is primarily end of the year tax loss selling and the fear of the effects tapering will have on Annaly’s book value. Tax loss selling will soon end and as time passes the market will eventually become more comfortable with the effect tapering has on Annaly’s book value. I am long Annaly.
And, Here are my final two picks:
Catalyst: Aggressive share repurchase plan starting in Q1 2014
I laid out a detailed case for owning Eastman Chemical in late October. In summary, over the past decade Eastman has transformed itself from a maker of commodity chemicals into a specialty chemical maker with among the highest margins in the group. Specialty chemical makers tend to trade for a large premium to their commodity peers yet Eastman is among the cheapest stocks in its sector. Eastman has one of the highest free cash flow yields, lowest P/Es and lowest EV/EBITDA ratios in the chemical sector.
Eastman has spent the past few quarters paying down debt that resulted from an acquisition and will be done paying it down by the end of 2013. I believe that starting in the first quarter of 2014 Eastman will direct free cash flow towards shareholders in the form of an aggressive share repurchase.
Eastman management has stated numerous times that they will use their balance sheet and ample free cash flow to reach their earnings goal of $7 in 2014 and $8 in 2015. They have also said that acquisition targets are too expensive now, which points towards share repurchases to increase earnings. Management also mentioned in passing on a recent webcast that share repurchases have a larger effect on EPS when done earlier in the year. This leads me to believe that Eastman will start repurchasing shares aggressively in the first quarter of 2014, getting the ball rolling on a re-rating of the stock. I am long EMN short ALB CE DD DOW FMC
Catalyst: End of tax loss selling
Municipal bond closed end funds (muni CEFs) are down as much as 30% from their highs in some cases. Fed tapering and headlines from Puerto Rico and Detroit have brutalized the municipal bond market and muni CEFs even more so. This leaves many muni CEFs trading at high single digit discounts to NAV and yielding nearly 7%, which is the taxable equivalent of over 10%.
I believe that scary headlines like those in Puerto Rico and Detroit are outliers. For the most part municipal finances have improved over the past year as tax receipts have grown along with the economy. One could even argue that municipal bonds value versus treasuries should be higher than ever as tax rates are higher so the tax advantage has grown. Municipal bonds offer the best after tax, risk adjusted return of any asset class. Once tax loss selling ends the market should begin to recognize this. I am long NRK VMO VKQ PMO NAN
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