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John Kozey is Director of Research at KnowVera, LLC, where he oversees research and trading of algorithmic trading strategies. Prior to that, as a Senior Analyst at Thomson Reuters, he produced reports blending fundamental and technical analysis for actionable ideas. John was also Equity... More
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  • R.R. Donnelley Text Analysis Scores Poorly

    Idea of the Week: A New Twist in Text Analysis

    Abstract: The risk of information overload has never been higher; failing to keep track of all the data companies generate increases the risk of falling into a value trap. StarMine's Text Mining Credit Risk Model helps in rapidly assessing that data to help identify companies like R.R. Donnelley that demonstrate characteristics associated with those value traps.

    The stock market has been on the rise in recent weeks, but the same can't be said of the level of conviction on the part of investors. If you find yourself worried that you might be missing some crucial piece of data or insight into one or more of your portfolio companies, you are far from alone. It doesn't help, either, that these days simply keeping abreast of all the information about those portfolio holdings is far more demanding a task, much less winnowing through it all in quest of a piece of data that might not even be there - but that if it is, might warn you of otherwise hidden risks. Bulls and bears alike may be forgiven for feeling like another species altogether - a deer in the headlights.

    R.R. Donnelley (RRD.O) may be a case in point. The company is best known in the business world for printing telephone books; on Wall Street, it's known as a favorite target of short-sellers, with 28% of its shares outstanding sold short. The shorts appear to have plenty of reason for concern. Historically, Donnelley has been a cash cow, but in recent quarters, its cash flow from operations has lagged compared to its net income.

    Donnelley's debt to equity ratio skyrocketed to 328% at the end of 2011 from 153% the prior year. Another concern is the $1.22 billion underfunded pension obligation, which accounts for 115% of equity. Moreover, shareholder equity dropped due to acquisition-related write-offs. Donnelley's operating profit margins have fallen steadily from their recent highs of 10% in the fourth quarter of 2008, and while they now appear to be inching their way higher, currently at 7.7%, remain below the industry median.

    But given that Donnelley trades around $11, 24% below where it started the year: the chart below clearly demonstrates why this is a stock that may well look "cheap" to bargain hunters. Long-only value managers may find the stock alluringly inexpensive. Could the shorts be wrong? Certainly, after its long slide (see Figure 1), the stock appears "cheap"; the StarMine Intrinsic Valuation model ranks the company in the top 5% of all North American companies. Of course, these investors are all well aware that there's a risk that a stock which appears attractive may prove to be a value trap, but trying to figure out which company documents might contain crucial information is, in many cases, a hit or miss proposition.

    Figure 1: RR Donnelley's (RRD-O) decline may entice "value" buyers.

    Part of the problem is that investors don't always have the right analytical tools to help them manage all the data that contains clues to whether companies like R.R. Donnelley are values - or value traps. Although designed as another way to assess the probability of default of a company more effectively than the Altman Z-score, the newly-released ((JOHNNY, PLS LINK NEWLY-RELEASED TO THE PRESS RELEASE THAT SOMEONE WILL SEND YOU))Text Mining Credit Risk (TMCR) Model may help point out which documents may warrant a more intensive and thoughtful scrutiny on the part of interested investors, as they may hold the clues as to whether the company is either a bargain or something that is cheap for a very good reason. While it is designed to alert investors of credit-related dangers and the prospect of future defaults, it also has utility value for analysts and portfolio managers trying to better grasp the risks associated with investing in the company's equity.

    Fundamental analysts pride themselves in uncovering material information in text documents, whether these are news items, brokerage firm research reports, SEC filings or transcripts of quarterly earnings conference calls. The Text Mining model adds a quantitative element to this historically qualitative activity by identifying the most important documents out of the hundreds or even thousands that an investor may have to scour for clues. It does this by scoring each one from a bearish one to a bullish 10.

    In the case of RR Donnelley, the company's overall TMCR score shows a low 5 on a 1-100 scale (See Figure 2, below). While the company scored 32 out of a 100 on the StarMine model's broker research component, it fared far worse on the model's three other components. It scored only 9 on earnings call transcripts, and merely 1 or 2 out of a possible 10 on the four most recent documents. (Those scores might well prompt a curious potential investor to click on the documents themselves, to get a better understanding of just what comments the model views as being so worrying.) The News component also scored poorly, only 3 out of 100, with all the documents in view scoring 1 out of 10. The same is the case for the company's recent filings: the overall score is a mere 7 out of 100, with the two most recent documents ranking 1 out of 10.

    Figure 2. StarMine Text Mining Credit Risk Components for RR Donnelley (RRD-O)

    One example of the kinds of wording that can generate a low score and alert investors to problems within the company comes in the form of an August 2, 2012 earnings call transcript. That includes a question from an analyst to management about debt reduction plans and potential bond buybacks of their high-yield debt. (See Figure 3, below.) The specific words used in that document meant that it scores a bearish 2 on a scale of 1-10.

    Figure 3. StarMine Text Mining Credit Risk "Transcripts" component analysis ranks the August 2, 2012 release a low 2, on a scale of 1-10.

    (see link above for text section)

    Arguably, the steep declines in Donnelley's share price may mean that the bear case is already priced into the stock, while a rebound in the U.S. economy may help buoy the company's fundamentals and help rout the short sellers. But the fact that Donnelley's dividend yield stands at 9% today, at a time when those of more blue-chip "cash cow" companies are at half that level or even less, is another red flag. So the low score on the StarMine Text Mining Credit Risk Model may give investors a reason to pause and contemplate the possible consequences of an investment in what may turn out to be a value trap.

    Long-only investors may use this kind of text-mining tool to identify avoid potential value traps; others may find it useful in identifying opportunities for short sales. Text mining has been a valued and valuable tool for quantitative hedge fund managers, in particular, for several years, and now it is demonstrating its utility for fundamental managers as well, whether used as a screen or to provide a "check" on a manager's instincts or impressions. Although the text mining credit risk model can't be seen as a "single decision" tool on whether to buy or short R.R. Donnelley's stock, it can provide a research shortcut, one that may help persuade risk-averse investors to pause on the sidelines - at least until that ranking improves.


    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Tags: RRD
    Sep 28 5:42 PM | Link | Comment!
  • Continuation Pattern Points To 10-Year Treasury Yield Testing July 2012 Lows

    Article text goes here...

    Continuation Pattern Points to 10-Year Treasury Yield Testing July 2012 Lows

    The end of the third quarter sees the 10-year U.S. treasury yield at around 1.63%. According to Fibonacci analysis and a candlestick continuation pattern, one can infer that rates would continue their recent declines to test and possibly displace the recent low close of 1.39%.

    This Fibonacci analysis uses closing prices: the closing low yield on July 24 of 1.39 and the closing high yield on September 14 of 1.87% were used as the endpoints. One possible explanation for the run-up after the September 13 FOMC expanded QE could be that Treasuries were swapped in exchange for mortgage debt, which may appreciate more as the result of the announcement.

    From the chart one can see that the 50% retracement of the low to high move is at 1.63%, just above the closing low of 1.61% of September 26, which marks the low end of the recent pullback in yield.

    Market moves higher are considered strong if the pullback after a strong rally in fact would reverse sooner than hitting the 50% retracement level, as seen here. Not that hitting 50% is all that bad, although not hitting it is considered even better. The fact that rates are forming a rectangular pattern is interesting. Technicians consider rectangles as "continuations" of the prior trend. In this case the trend in rates is heading lower, so the ultimate breakout should be on to the downside.

    How far can the yield fall? Again, technicians will take the distance of the initial move down and extend that amount to determine a low objective. From the high close of 1.87 to the recent low close of the continuation pattern of 1.61 on September 26 is a 0.26 move. Subtracting that amount from the 1.61% low implies a 1.35% objective, which is close enough to the July 14 low close of 1.39. Continued QE certainly doesn't hurt the chances of rates moving lower in the future.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Sep 28 5:20 PM | Link | Comment!
  • Gold-On Might Be A Better Bet Than Risk-On For QE3

    Abstract: When the Federal Reserve announced its prior rounds of quantitative easing, one of the consequences was a slump in the price of gold relative to stocks. The early response to QE3, however, suggests that this time may be different, and that it's possible gold may still shine.

    See the video and read the text article here:

    If you still find yourself struggling whether you're more comfortable being "risk on" or "risk off" in the stock market these days, it might be time to consider something entirely different: the "Gold on" trade. "Gold on" - being long gold- has proven to be a strategy that has beaten the S&P 500 ever since the financial crisis began in 2007.

    Investors have struggled in vain for centuries to pin some kind of real value to gold. While that still isn't possible - gold's value is in the eyes of investors - one picture sums up its importance to investors since stock prices peaked in October 2007. That is the yellow line in the chart below, which plots the performance of the precious metal in absolute terms (indexed to 100) as represented to by the SPDR Gold Trust ETF (GLD.N) over that period. Gold has marched upward in a nearly steady line, while the green line representing the performance of the S&P 500 index has straggled along, only recently returning toward 2007 levels. Only the interventions by central banks and sovereign government in the economy have interrupted gold's advance, and then only temporarily.

    Now, four days after the latest Federal Reserve intervention - an open-ended commitment to stimulus as long as the jobless picture is as gloomy as it appears today - something seems to be different. In contrast to prior periods during which the Fed intervened - depicted on the chart below - stocks do not appear to be outperforming gold. Perhaps this is a signal that this onetime obstacle is no longer a factor to which investors must give as much weight as they once did?

    Figure 1.

    To represent the performance of gold, we selected the SPDR gold ETF; had you invested $100 in this exchange-traded fund five years ago, it would be worth about $225 today. Meanwhile, the same $100 invested in the S&P 500 would leave you with, well, pretty much nothing more than the same $100 - and then only if you reinvested all the dividends you earned over that period, as Datastream charts suggest.

    To get further insight into the periods during which gold outperformed stocks during this five-year time frame, we dug more deeply. The chart below displays the result of our inquiry, with a rising orange line identifying points where gold was beating the S&P 500, while a falling line signals a period when that trend was reversed.

    Figure 2.

    Going back to late 2008, when the Federal Reserve announced its first round of quantitative easing (an event marked by the first vertical red line), it's easy to see that gold was trouncing the S&P 500 up until that point; even though the price of gold was actually declining in absolute terms, the fact that stocks were in the midst of a rout made gold's performance look relatively strong. The announcement of the first round of quantitative easing in late November - a $600 billion package - reversed the trend for about a week. After that, investors resumed their aggressive buying of gold, spurring a sharp jump in the gold/S&P 500 ratio. That ended on March 18 2009, when the Fed announced a $900 billion expansion of QE1. That kind of significant announcement often causes strong trends to reverse, although that is most clearly seen in hindsight. But after the end of QE1 on March 31, 2010, financial markets got nervous once more - and once more, gold outperformed stocks.

    Then came Fed Chairman Bernanke's famous speech hinting at a second round of quantitative easing at the Fed's annual conference in Jackson Hole, Wyoming, in late August 2010. In the wake of that event, gold and the S&P 500 generated roughly even returns - until QE2 itself ended on June 30, 2011. Then, once again, gold ruled the roost - at least until the central bank announced Operation Twist, an attempt to drive down longer-term interest rates. That program's debut marked the recent peak in gold prices.

    Other factors have been contributing to the stock market's gains since Operation Twist began earlier this year, ranging from the stronger dollar to fresh hope that European Union politicians and policymakers might save nations on the eurozone's periphery such as Greece and Spain from complete economic collapse, while preserving the European Union.

    A stronger U.S. dollar buys more gold (or, alternatively, it takes fewer dollars to buy the same quantity of gold) and a Reuters poll of the three-month forward Euro versus the dollar earlier this month shows that the dollar continues to hover at around a median $1.22 per euro, not radically different from the rate seen in July before ECB president Mario Draghi issued his now-famous pledge to defend the euro at all costs.

    Reuters Poll: three-month forward Euro vs. U.S. dollar

    That kind of dollar/euro exchange rate doesn't augur well for economic trends in Europe as compared to the U.S., with a stronger dollar forecast for today and into the new year. To the extent that the Reuters poll is correct in suggesting that the euro will be weaker next year, that sentiment may well help support the price of gold. But what about the upside for U.S. stocks? The current forward P/E ratio for the S&P 500 according to Datastream is 12.6, and just below its 12.9 median value over the past five years of the financial crisis (Figure 3). One may well wonder how much more the P/E may expand in this environment, in the absence of some sort of topline revenue growth.

    Figure 3.

    There are a number of reasons that it makes sense to own gold at today's prices. The precious metal is perceived to be a store of value in the event of a financial market meltdown or an economic collapse. Gold also is an asset that typically gains ground alongside inflation (the logical ultimate consequence of so much stimulus) and a weaker U.S. dollar (ditto).

    Counter-arguments for stocks continuing to outperform gold include the Federal Reserve's open-ended commitment to stimulus ("non-sterilized QE") and its willingness to continue printing money until employment levels are satisfactory once more. Moreover, there are signs of some economic improvement from around the globe, including Europe and China.

    Over the last five years, gold has beaten stocks in periods preceding major fiscal and financial announcements by central banks and sovereign governments. In light of the fact that the S&P 500 has climbed 15% since its low June 4, 2012, the signs seem to indicate that gold may continue to outperform stocks in the future - at least, as long as we continue to see none of the responses to central bank interventions that have characterized other Federal Reserve quantitative easing measures, which in previous interventions took the gold versus S&P 500 ratio lower.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Tags: GLD, SPY, Gold, Stocks, S P 500, QE, QE3
    Sep 19 4:50 PM | Link | Comment!
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