Richard Fisher thinks the Fed needs to let go of its accommodative monetary policy because the low interest rates and abundant cash are giving investors "beer goggles."
Valuation concerns, particularly in social media and biotech, remain an issue for many, and a number of investors also expect volatility to rise over the next six months.
Potentially undervalued Lakes Entertainment and Federal Agricultural Mortgage have a lot of cash on hand and tend to rise with the VIX.
On Wednesday, Dallas Federal Reserve Bank President Richard Fisher told an audience at USC that the Fed should make major adjustments to its monetary policy in the coming months. The combination of low interest rates and an abundance of money, Fisher argued, has given investors "beer goggles," leading them to buy investments that aren't really worth buying, including excessively expensive stocks. Citing an improving job market and the dangers of the Fed's measures, Fisher recommended the central bank shrink its portfolio by tapering its reinvestment of maturing securities and gradually raise the interest rate by early next year.
A day earlier, Fed Chairwoman Janet Yellen testified to the Senate Banking Committee, and the Fed's report that accompanied her remarks also commented on the overvaluation of stocks. However, unlike Fisher, the report only noted that smaller biotech and social media firms still appear to be "stretched in their valuation."
For many, overvaluation isn't limited to smaller firms but applies to whole industries. Although the weeks-long biotech and Internet sell-off has ended, 80% of participants in a recent Bloomberg poll still felt Internet and social media stocks are in a bubble or nearing "unsustainable levels."
While the Fed has yet to reveal when it intends to raise the interest rate, companies' cash holdings should be examined closely given that the hike is, relatively, around the corner and will result in higher borrowing costs. A look at most recent cash and short term investments relative to average operating expenses (taken from the last five quarters) shows how many quarters a company can survive without generating new revenue, as long it maintains its average operating expense. Companies with high Cash/Avg Operating Expense ratios are potentially less risky during business downturns than those with lower ratios.
Lakes Entertainment Inc. (NASDAQ:LACO), a developer and manager of Indian-owned casino properties in the US, has a Cash/Avg Operating Expense ratio of 11.29, meaning that the company could go 11.29 quarters without generating revenue and still have enough cash to cover its average quarterly operating expense. From the quarter ending March 30, 2013 through the quarter ending March 30, 2014, Lakes Entertainment's average quarterly operating expense was $7.54 million. At the end of the latter period, Lakes Entertainment's cash and short term investments totaled $85.07 million.
Federal Agricultural Mortgage Corp. (NYSE:AGM), a provider of agricultural real estate and rural housing mortgage loans in the US, has a much higher Cash/Avg Operating Expense ratio of 24.75, meaning that the company's cash could cover 24.75 quarters of average operating expenses and no revenue. Federal Agricultural Mortgage's average quarterly operating expense over the last five quarters was $35.01 million, and its most recent cash and short term investments were $866.59 million.
Both stocks also have a positive correlation to the VIX, meaning that the stock's price tends to go up when the VIX rises, and are undervalued per the PEG ratio. In a different Bloomberg poll, 67% of respondents said that they expected the VIX to rise within the next six months. Lakes Entertainment's correlation with the VIX has been at 0.548 over the last 60 days. Within the same period, Federal Agricultural Mortgage's correlation has been at 0.681, which means it benefits more from a rise in the VIX than Lakes Entertainment.
The prevalence of high P/E ratios has called attention to stock valuations, so a potentially undervalued stock may be considerably attractive to investors. Lakes Entertainment currently boasts a PEG ratio of 0.47, and Federal Agricultural Mortgage's PEG ratio stands at 0.74.
Additionally, a look at Lakes Entertainment's balance sheet reveals that the company's debt levels are considerably lower than its peers. After rising 352.88% between Q1 and Q2 2013, Lakes Entertainment's long-term debt has decreased for the last four consecutive quarters, falling from $13.36 million at the end of Q2 2013 to $9.95 million at the end of Q1 2014. Similarly, the company's total debt shot up 256.67% between Q1 and Q2 2013 but has declined for four straight quarters, sliding from $15.23 million to $11.27 million. Fellow resorts and casinos companies Isle of Capri Casinos (NASDAQ:ISLE), and MTR Gaming Group (NASDAQ:MNTG) currently have much higher debt levels as evidenced by their Long-Term Debt/Equity and Debt/Equity ratios.
Lakes Entertainment's Long-Term Debt/Equity is 0.08 and its Debt/Equity is 0.09 whereas Isle of Capri Casinos' debt ratios are 54.95 and 54.96, respectively, and MTR Gaming Groups' debt ratios are 2797.00 and 2797.00, respectively. On the plus side, Isle of Capri Casinos has reduced its long-term debt and total debt over the last four quarters, bringing both down from $1.17 billion to $1.07 billion. MTR Gaming Group, on the other hand, has increased its debt during that same interval. At the end of Q2 2013, MTR Gaming Group's long-term debt and total debt stood at $557.77 million; by the end of Q1 2014, both rose to $559.36 million.
Meanwhile, Federal Agricultural Mortgage has very high debt levels, which have increased steadily over the last four quarters. The company had $5.34 billion in long-term debt and $12.13 billion in total debt at the end of Q2 2013. By the end of Q1 2014, Federal Agricultural Mortgage's long-term and total debt had risen to $12.7 billion. In the most recent quarter, the company's Long-Term Debt/Equity and Debt/Equity ratios were both 41.58. Many of the company's direct competitors are private, so information pertaining to their debt levels isn't readily available. But Fidelity shows that the company's Long-Term Debt/Equity for the most recent quarter is 1648.66% vs. a thrifts and mortgage finance average of 18.88%, and its latest Debt/Equity is 4056.08% vs. an industry average of 29.57%.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: Kapitall is a team of analysts. This article was written by Mary-Lynn Cesar, one of our writers. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.