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Why We Love This Guy Named Rich

Author: Shon Tran

WHY WE CHOOSE KMI

The collapse of oil prices was clearly the biggest surprise to commodity and financial markets in 2014. Few people could believe that just last summer black gold reached its peak at $107 before plummeting to $44 in January. Despite oil’s recent recovery to around $55, market participants who invested in energy stocks still have tremendous ground to make up.

KMI is outstanding in the oil industry

The oil industry suffered a catastrophic event in 2014, but not all companies in the industry succumbed to the same fate. There are some players with solid fundamentals and less exposure to commodity prices that remain outstanding. One such company is Kinder Morgan, Inc. (NYSE:KMI). KMI is the largest energy infrastructure company in North America with 80,000 miles of pipeline in operation. About 85% of its cash flow is fee-based, which exemplifies its extremely low exposure to falling energy prices. Most of the remaining 15% of their cash flows are hedged. Imagine a business operating a toll road. Would a sharp increase in petrol prices adversely affect that company’s performance? Some drivers would likely find alternative transportation to counter the price storm, but those drivers would certainly account for just a small percentage of the whole.

At Phoenix Capital, we began researching KMI in June 2014 at the recommendation of one of our executives based in Houston, Texas. We were immediately impressed with its sound fundamentals and ambitious business expansion plans. Those expansion plans went into action in early 2015 with the $3 billion acquisition of Hiland Partners in North Dakota’s Bakken shale formation. Hiland Partners is a pipeline and logistics company founded by Continental Resources Chief Executive Officer Harold Hamm. Hiland was sold to KMI at a distressed price when Continental came face to face with the oil price collapse.

A strong point for KMI is its high dividend payment plan, which represents a dividend yield of about 4.4%. This figure is considerably more attractive than the 3.3% from Exxon Mobile, the company with the industry’s largest market capitalization (KMI ranks 4th in market capitalization with $87 billion).

Kinder Morgan raised its quarterly dividend by 10% in February to $0.45 per share, for a dividend yield of about 4.4%. Ultimately, the company plans to increase its dividend by 10% annually over the next five years, and the projected 2015 payout currently stands at $2.00 per share. This dividend growth will be supported internally by the company’s $17.6 billion five-year project backlog as well as by continued growth in North American hydrocarbon production, and externally from acquisitions of distressed businesses in the industry.

We all like a game where the insiders have their own skins on the line. Over the past 2 years, KMI’s CEO and Chairman, Richard Kinder, has accumulated stock in KMI worth nearly $100 million, and he recently bought $4 million more. In total, the CEO possesses nearly 245 million shares worth 11.37% of the firm’s value. His enormous ownership and ultra long-term vision for KMI is very important and often underestimated in the investment and energy industries.  Rich Kinder “saw” the future many times in the oil and gas space and positioned his company accordingly to reap the rewards. Since last February, company insiders have bought a net 812,599 shares worth over $33 million at today’s prices.

High performance in tumbling market

We began accumulating KMI stock on July 25th, 2014 at the average price of $38.89, and we consider KMI as a core investment in our Global Growth & Income Fund. Upon receiving some market confirmation following our initial entry, we tried to get more exposure to KMI, especially when the stock showed some signs of a temporary pullback stemming from the dramatic decline in oil prices in October 2014. Due to our fund’s percentage limits on any long position on one stock, we used options to enhance our bet on the position. On the 9th of October, we sold a deeply out-of-the-money option contract at the exercise price of $55, expiring in January 2016 at a premium of $19.26. Based on the premium of $15.45 that ended March 25th, 2015, we generated a return of 20% for the derivative position along with more than 5% from our long position on underlying assets, a handsome return for an 8-month holding period.

KMI’s performance looks stronger if we examine some benchmarks. First, compared to the S&P 500, which has broken the all time highs time and time again over the past 6 months, KMI has outperformed significantly. Specifically, in the past 6 months KMI has gained 7.27% compared to just 4.01% for the S&P 500 in terms of price return. In the same period XLE, an ETF representing the energy industry, has plunged nearly 16%. With dividends reinvested taken into account (around 2.2% for a 6 month holding period), the margin becomes much wider.

Source: Yahoo Finance

Compared to other midstream operators such as Williams Companies (WMB), Spectra Energy (SE), and ONEOK (OKE), Inc., KMI has shown solid relative strength in stock performance in the past 6 months. Although midstream operators are not directly exposed to the decline in oil price, their performance has also been affected due to the hardships faced by upstream producers. This can be seen in the poor performance of the three companies mentioned above. In the past 6 months, OKE has lost nearly 30% in value while WMB and SE have slid 13.07% and 8.62% respectively. KMI performance has been smoother than any companies operating in the oil industry. One would be hard pressed to find a company comparable to KMI that could generate positive returns with the oil market in the midst of a black swan.

Source: Yahoo Finance

Anti-fragile stock

It is not a coincidence that KMI can perform much better than other industry incumbents. The difference between KMI and the rest can be understood when looking at charts for 1-year return. Oil pipeline stock accelerated for more than one year before oil prices began tumbling in early September. Before the oil crisis broke out, KMI actually underperformed its peers in the industry, which implied more momentum for other stocks in its pricing. KMI has chosen a steady development path with steady annual growth over the past 3 years. They have created a combination of organic and external growth through acquisitions strictly in North America. They have focused exclusively on the pipeline segment, specifically midstream targets while other competitors have diverged their operations upwards in the value chain. OKE and WMB have expanded many exploration and production projects, which exposed them to commodity price risks. The projects implemented by those companies must be delayed, pending the recovery of oil prices.

KMI’s solid fundamentals are creating anti-fragility in their operations. This means they will not only survive when black swan events happen but will also emerge as a winner. One of the main reasons for the decline in oil prices last year was the dramatic increase in oil supply from the US. Recent statistics have shown that US daily crude oil supply increased from 7.9 million barrels in January 2014 to 9.2 million barrels in January 2015. The increase in oil supply from the US has had negative effects on nearly all oil players in the world but has become a positive for pure midstream players operating in the US. Companies operating in the pipeline industry with less exposure to commodity price risk have become winners in the market, with KMI being one such winner.

Source: Yahoo Finance

Still more space for expansion

Is there still time for investors to jump on the bandwagon? Absolutely. The current price still does not reflect the growth potential that comes from both organic and external forces like business acquisitions of distressed midstream operators. Most security firms have agreed on a low-end valuation for KMI of $47, which is more than a 12% potential return from where it sits currently. With capital gains aside, one must like the dividend yield of 4.4% in such a low interest rate period. If you take into account 10% dividend growth compounded annually, KMI could touch a cumulative dividend growth of 61% in the next 5 years. That would bring an investor a new yield of nearly 7%.

KMI’s real growth could be magnified even more if they are able to find additional distressed acquisition targets stemming from the oil price crisis. Based on our own analysis, Spectra Energy could be one such target for KMI.

If the Spectra acquisition is realized, KMI will become a strong option for income-oriented investors. Spectra is a midstream player similar to KMI. However, they are complimentary to each other rather than being competitors due to the fact that Spectra’s business primarily involves natural gas and NGLs.  Thus, it would not be a big regulatory issue if a merger were to occur–some asset sales is a given, of course.  Spectra has some incredible assets, just like KMI, although they have quite a bit of manageable debt, which happens to be a common feature in the industry.  Spectra owns Spectra Energy Partners (SEP), Union Gas in Canada, half of DCP Midstream and much more. Its backlog and growth projects are estimated at $35 billion, a dollar amount twice that of KMI’s backlog.  If this backlog was under KMI’s roof on top of a natural gas pitch, KMI could easily go to Europe and borrow cheap, almost free money to expand and conquer.  In the coming years, Spectra will be the growth and KMI the slow and steady safety net, and as a result the KMI-SE umbrella may well be bigger than ExxonMobil.

 Natural gas is a growth play relative to oil. It may not look like much now, or even by 2020, but at the current rate and if coupled with more US exports, growth of natural gas and the increasing need for its infrastructure are only logical.  After all, Kinder Morgan is founded upon natural gas.  {And its terminals business is a whole other growth story…that plays superbly into natural gas and exportation.}

Trading the World’s Biggest Trend

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Over the past several months it has become increasingly clear that the US dollar has been the best house in an otherwise bad neighborhood. At Phoenix Capital we have been both a vocal proponent and a benefactor of this notion. There are several factors that support our stance on USD.

First, is the status of the US dollar as the world’s reserve currency. This has held true through the best of times, and the worst of times. Looking back at the 2008 recession, not only did the US dollar remain strong, it reached record highs through the tough times. Fast-forward to 2014 and the dollar rose significantly against all major currencies including the Euro, the British pound, and the Yen. In 2014 the dollar even surpassed levels we saw in 2008 and has remained strong early in 2015. While all of this has been happening, Phoenix Capital has been holding USD as a significant portion of our hedge fund portfolio.

There has been a distinct timeline of events that reinforced our initial justification for the position and allowed us to even amplify it. We began buying PowerShares DB US Dollar Index Bullish (UUP) towards the end of August 2014. Not long after that, the Euro began a decline coupled with rising U.S. bond yields. We continued to buy aggressively through September, and low and behold, the dollar continued to strengthen against other global currencies.

By November, US QE began to wind down and crude oil was well into a slump that it remains in today. All the while, the dollar increased in value, soaring to new peaks as crude oil and industrial metals both plummeted. Our last purchase of UUP was in December, and from there we have sat back and enjoyed the ride.

Our trading decisions in the case of UUP were not solely motivated by macro factors but were also based on support from some key historical data and statistics. At Phoenix Capital, we use a statistical methodology laid out in “The Big Trade: Simple Strategies for Maximum Market Returns” to support our market timing hypothesis. This strategy dictates that after choosing a fundamentally sound security or ETF, we use its past movement in different time frames to enter the market with confidence supported by clearly defined probabilities.

Our first purchase of UUP was made on Aug 28th, 2014. Based on weekly statistics with observations of high price, low price, opening price and closing price, we were able to craft some useful statistics. We noticed the price of UUP had been oscillating around 21.70 for the two weeks prior to entry, but this was followed by a distinct change when the week of the 18th closed at $21.94, indicating an upward trend.

One upward bar is not enough, however, and we needed more confirmation of a sustainable upward trend. The following Monday, August 25th closed at $22.00, thus exceeding the previous week’s high. From our historical data of a 476-day period for UUP, Mondays very often set a low for the week. Based probabilities derived from this data we could positively conclude that this week as a whole would likely mark a second-consecutive week of upward movement for UUP.

Upon choosing the week of the 25th as an opportune time to enter the market, we then moved forward with the next steps in “The Big Trade” methodology. The 25th opened at $22.00 and we waited for an incremental move to define the entry, but $22.00 remained the price at close. In cases where Monday is the week’s low, we have found a high probability that the week’s high will then fall on either Thursday or Friday. Based on this, we entered at the average price of $21.985 on Wednesday of that week. At this time, we were prepared to take a 10% stop-loss if the trend were to reverse. However, from the initial entry the stock has continued increasing and we have continued to build up our position to where it currently sits.

Moving forward, we anticipate this position to remain strong in the near future. The Federal Reserve recently announced their intentions to refrain from raising interest rates until “further improvement” is seen in the US economy. Many are interpreting this as saying we will have several more months of low rates.

But just how much longer can we expect the USD bull market to continue? There are certainly signs indicating that the bull run is nearing its tail end. First, the current USD rally has well exceeded its historical averages. Dating back to the 1970’s, USD rallies average 20% and last under one year. The current bull run has seen the USD rise 25% since June 2014. If we consider the low in April 2011 as the starting point this rise becomes roughly 40%.

In addition, one could argue that the dramatic downtrends we have seen recently in EUR and JPY as a result of aggressive QE policies are coming to an end. Historically, the anticipation period leading up to QE implementation, and the period when that QE is initially implemented are the times marked by the most significant downtrends. A period in which the currencies level out typically then follows these downtrends. If the EUR and JPY do level out, this will mean less significant gains for UUP, especially considering the significant weight carried by JPY and EUR within UUP.

Despite all of this, it is our conclusion that the USD will remain strong at least in the short term. With that said, there is plenty of evidence to indicate that the party is nearly over. It is not too late to get in on the trend with a purchase of UUP, however one must monitor the situation closely in the coming months, and by as early as the beginning of 2016 we could all be singing a different tune.

The American Bull Market

U.S. stocks have been going up for six years now. That’s a lot longer than the typical bull market cycle, which usually lasts about 3.5 to 4 years. So how much longer can this upswing last?
There are plenty of reasons for investors to be nervous right now: the Federal Reserve is likely to hike interest rates soon and the strong U.S. dollar is hurting some companies that do a lot of business overseas, among other factors.
But here’s why I’m still bullish on America:
The Fed rate hike: Yes, the Fed is likely to raise interest rates in the coming months, but that isn’t necessarily a negative for stocks. In the last 20-plus years, the Fed has only had three major cycles of rising interest rates, beginning in 1994, 1999, and 2004 respectively. In each case, the stock market went up in the months before the interest-rate hike, had a short-term correction of roughly 7%, and then started going up again — with a significant rally after the correction.

A good example to consider is the bursting of the dot-com bubble in 2000. The Federal Reserve began raising interest rates in 1999 leading up to the impending recession.

What is interesting is that at that time, U.S. Treasury Bonds were facing an inverted yield curve, where the yield on short-term bonds was higher than the yield on long-term bonds. The previous nine recessions in the US were all preceded by yield curve inversion, with an average lead time of 14 months.

There are currently no signs of an inverted yield curve in US Treasury Bond yield, meaning that a relatively small, incremental rate hike by the Fed would do little to push towards an inverted yield curve. The Fed will almost definitely increase rates in small increments.

Fed rate hikes, if done incrementally, will not have an immediate negative impact on US equities in the current environment.

Consider tech stocks: Another factor to consider is stock market valuations.

On March 2, the Nasdaq hit the 5,000 mark for the first time since its all-time high in the year 2000. As we all know, this was quickly followed by a sharp decline and talk of a bubble. But the Nasdaq is still up over 3.5% for the year, and there are some important factors that differentiate this time from 15 years ago.

First, back in 2000, the Nasdaq was in the midst of the dot-com bubble, and companies trading on the index were clearly overvalued. In comparing the Nasdaq in 2000 to now, we can see that the 12-month trailing P/E ratio for the Nasdaq composite index was around 190 in 2000, while today it sits around 30. This same trend can be seen among some of the largest companies on the Nasdaq, including Microsoft (MSFT, Tech30), Apple (AAPL, Tech30), and Google (GOOG), all of whom have more grounded P/E ratios today than they did in 2000.

Apple in particular, which alone makes up just over 8% of the Nasdaq’s market value, appears to be of tremendous value, trading at a forward-looking P/E ratio of around 13. Similarly, Google and Microsoft, who each represent about 4% of the Nasdaq’s market value, are trading at forward-looking P/E ratios of 16 and 14, respectively. Together, these three companies account for over 16% of the index.

Low interest rates also allow companies to borrow cheap and create shareholder value via shareholder buybacks that might be more difficult in a high interest rate environment. In 2015 we have already seen share buyback announcements from several big players on the Nasdaq includingQualcomm (QCOM, Tech30), Gilead Sciences (GILD), and Comcast (CCV), to name a few. These three companies combine to account for nearly 5% of the Nasdaq. I don’t see this letting up.

Improving global economy: Looking internationally also gives more reasons for investors to remain bullish on U.S. equities. An aggressive quantitative easing (“QE”) policy is being implemented in Europe, which has resulted in a dramatic rise in equities. For example, the German DAX-30 indexcrossed the 12,000 threshold Monday after crossing the 11,000 level in January.

Similarly, Japan has stated its intentions to continue an aggressive QE policy in 2015, aiming to inject ¥6.65-trillion a month. With European and Japanese companies doing well, we can expect to see that money trickle into US equities as foreign sovereign funds begin investing into US equities.

In the long term, however, it would be wise to be wary of the DAX and European equities, as equity markets are a poor reflection of economic health, and some leading indicators are showing German exports on the decline.

Strong dollar: Even the surging U.S. dollar probably isn’t as bad as some claim. In the days of globalization and the ease of outsourcing and cost cutting, there are countless ways for multinational corporates to cut costs and maximize profits. The concern of a strong U.S. dollar impacting multinational performance is surely overblown, and can easily be addressed by management rather than being cited as an excuse in quarterly reports and conference calls.

Investors should look to maximize current market trends with the dollar and U.S. equities. An effective strategy to do so might be to buy an S&P 500 ETF like SPY and to hold U.S. dollars.

http://money.cnn.com/2015/03/17/investing/stocks-market-2015-federal-reserve/

Order and Chaos: The Past Present and Future of Markets

In 1948 Claude E. Shannon published a landmark paper entitled “A Mathematical Theory of Communication”, detailing what we now know as information theory. Information theory aims broadly to quantify information in a way that allows us to understand the limits of compressing and storing data. Central to Shannon’s theory is the idea of information entropy. Information entropy in Shannon’s theory refers to the level of uncertainty contained within a particular message. A message containing more information will have higher entropy and thus creates higher levels of uncertainty. In other words, entropy is maximum when all outcomes are equally likely. Any move away from equally likely, or random, outcomes through the introduction of predictability lowers information entropy. Simply put – entropy is chaos, and the only way to combat chaos is through the introduction of probability. The universe is made up of information. The manifestation and interpretation of that information is accompanied by a certain degree of entropy. That is to say, the universe consists of events and outcomes. Some of these events are purely random, while some can be predicted with relative ease. We are constantly trying to construct models to predict the world around us and create order. Whether it is something as simple as gambling on a sporting event, or something slightly more complicated like constructing a financial model for a new business. We are always looking to compress information, and thus reduce uncertainty in the decisions we make. It is how we try to understand the world around us.

So how can all of this be applied to capital markets? To the untrained eye, the stock market might look like a world of uncertainty. In fact, one could argue that trends of increasing volatility and increasing trading volume have rendered markets more uncertain, or chaotic than ever before. Traders today often operate based on a host of patterns or models in an attempt to compress massive amounts of information. Unfortunately, more often than not such models are inherently entropic, and thus generate uncertain, or high entropy outcomes, in turn contributing to market chaos. A key theme within the various models used in the realm of financial markets is their lack of basis within the scientific method. This means that many models used to predict financial markets do not hold up under repeated trials, and cannot produce consistent results with any degree of certainty over periods of time. Technical analysis in particular comes to mind due to its reliance on subjective patterns. The issue with using subjectivity in an attempt to create order is that instead of bringing order to the system as a whole, it creates a ripple effect generated by the initial subjective, irrational decision, making the greater system more difficult to predict. A successful model will compress information in a way that creates orderly, probabilistic results. An interesting example to consider is the use of DCF analysis in constructing a valuation. The DCF approach compresses elements of past, present, and future performance effectively in generating a valuation based at least somewhat on probabilities. Where this falls short is the subjectivity of the variables input across different individuals constructing the valuation.

 

So, how can one reduce information entropy and make high probability trades? Through the use of models grounded within the scientific method that eliminate the randomness of subjectivity and operate based on probabilities. At Phoenix Capital we employ a high probability approach to trading. We monitor price moves for statistical significance, and use this information in buy or sell decisions. This strategy has yielded tremendous results, particularly in our positions in UUP and SPY. From August 2014 to February 2015, a span of 184 days, this strategy has yielded us a 12% return on investment.

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For more information, please contact Phoenix Capital at info@phx-cap.com.

The Big Trade Show – Value Investing Week

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Peter Pham is an author, international fund manager, and a registered financial director by the Cayman Monetary Authority (CIMA). In 2013 he published his first book entitled, The Big Trade: Simple Strategies for Maximum Market Returns. He currently manages the portfolio of a global hedge fund and runs an asset management company, Phoenix Capital.  (read more)

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