Improving Trends In The U.S. Economy

Most would accept that the macroeconomic environment in the U.S. is improving. For example, unemployment is slowing declining, although is still far from 2008 levels (see below). Assuming this trend continues, it creates an opportunity for stocks leveraged to U.S. consumer spending to potentially outperform the broader market. When talking about the typical U.S. consumer, bear in mind that disposable income per person is approximately $32,000 on average, with a savings rate of roughly 5%. When looking for opportunities, the products and services that will benefit from an improving consumer need to be both relatively inexpensive and discretionary.

U.S. Unemployment Rate 2008-present

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Four Criteria To Determine Fit With The U.S. Consumer Opportunity

The sort of investments that benefit from the strengthening U.S. consumer have the following attributes:

• U.S. focused - clearly any exposure outside the U.S. isn't bad per se, but

Typically, the US stock market performs particularly in January, roughly 2% better than any other month, on average. The market performs so well, in fact, that it's unlikely to be a random event, particularly because it can be explained by tax loss selling as retail investors realize tax losses before the end of the fiscal year, which pushes prices down in December only to rebound in January. More specifically within the January effect, it is the smaller stocks that have been beaten down over the past year which tend to do especially well in January. Therefore, we ran a stock screener, combined with some basic fundamental analysis and determined that Apco Oil and Gas (APAGF), Monster Inc (MWW), Deckers Outdoor (DECK), FNB Corp (FNB) and Tempur-Pedic (TPX) are all attractive investments to take advantage of the January effect should it happen in 2013.

Market Returns By Month

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City Telecom (CTEL) is an extremely risky stock and recent annual reporting has shed more light on the current state of the business. As I have detailed before, City Telecom has sold its telecom operations to invest heavily in a TV content business. This means City Telecom is essentially a start up, and the dividend is likely to be eliminated for the next three years due to lack of profits and high investment. The stock is trading at 163x recurring sales. City Telecom does not have a TV license at the time of writing and will likely burn through its cash balance in under four years. Of course, the substantial investment to get to a free TV business could ultimately pay off, but the next three years are likely to be bumpy at best for City Telecom investors. Those investing for the currently high-dividend yield should look elsewhere.

5-Year

Summary

For income focused investors, the new spin-off Kraft Foods Group (KRFT) offers an attractive, and likely sustainable, dividend yield. Though the yield is high, the payout, which I estimate at $2.00 per year, is justified by historic earnings and cash flow. The company's portfolio of brands is not the most glamorous but many are household names with dominant share in their categories.

Context

Old Kraft is now split in two, the bulk of the business is now named Mondelez (MDLZ) and the U.S. retail grocery foods business has been spun off under name Kraft Foods Group and the ticker KRFT, which is the focus of this article. The old Kraft has outperformed the S&P 500 in the run up to the spin-off.

Old Kraft vs. S&P 500

May-Sept 2012

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^INX data by YCharts

A Confusing Spin-Off

This spin-off is particularly confusing because the Kraft

The home security company, ADT (ADT) is scheduled to spin-off from Tyco (TYC) in October 2012 and join the S&P 500 index. This reverses Tyco's acquisition of the company in 1997. This article looks at the company's strategy, then determines its valuation.

Why Spin-Offs Are Worth Exploring

As Joel Greenblatt has written in his book You Can Be A Stock Market Genius, focusing on special situations such as spin-offs can be a way to outperform the broader market. Credit Suisse have quantified this intuition here, showing that the median spin-off outperforms the market by 22% in year one, though it is a volatile strategy so risk is also relatively high, though many spin-offs do very well there are also several that perform very poorly.

Background on ADT

ADT has 25% share in the highly fragmented residential and small business security market worth about $13B, with 1-2% market growth

The best investment cases are relatively simple, and I believe this is the case with E*Trade (ETFC). The market assumes the home loan portfolio will continue to reduce E*Trade's earnings, and in fact this view has been justified for half a decade. However, I believe, as soon as next calendar year, the losses may be a much smaller drag on earnings. The reduction in these losses could ultimately lift the stock as much as 122%. However, the valuation is very sensitive to the valuation of the loan portfolio and the stock is risky as a result.

A Brief Summary of E*Trade

E*Trade has essentially two operations:

• A highly profitable, well branded and innovative platform for online trading
• A poorly regarded portfolio of home loans that have dragged down earnings for the past 5 years.

The results from the home loans have been so bad for so long that the

Summary

Earlier in the year I recommended City Telecom (CTEL) as an attractive Hong Kong company listed in the US as an ADR (ADRs offer an easy way to buy stock in non-US companies). However, since then the company has undergone a dramatic change. City Telecom has sold its entire telecom business to CVC, and issued a special dividend with some of the proceeds from the sale. City Telecom is now a cash-rich media start up, focused on production of TV content, such as a drama and news programming. It is interesting to see such an abrupt change from a relatively well established company, and this creates substantial risk for investors.

A Fundamental Shift

It is worth emphasizing just how extreme this change is. For any business to sell virtually all its productive assets and then take the cash to do something else (albeit in a somewhat related

Recommendation

Orchard Supply Hardware (OSH) is very cheap on most metrics relative to larger peers. Though the company is an unseasoned spin-off with some uncertainty ahead of it, and significant leverage, it could perform well as same store sales growth continues. Those with risk tolerance and believe in the sector may consider re-allocating some exposure from the larger players to Orchard Supply.

Context

Lowe's (LOW) and Home Depot (HD) are both performing well this year, with Home Depot significantly ahead of the market, and raising guidance, and Lowe's broadly in line with it.

However, after a spin-off earlier in the year, there is another player in the space at a potentially more attractive valuation. It is tiny in relative terms, only about 1% the size of its larger competitors and operates in California rather than nationally. In addition, it is dealing with increased costs as a result of the spin-off

After speculation earlier in the year, Cincinnati Bell Inc. (CBB) has announced that it intends to spin-off its data center colocation division, CyrusOne. This is a potential source of upside because your typical telco, such as Cincinnati Bell, trades at around 0.5-1.5x sales. However, comparable companies to Cyrus One trade at 6x sales. CyrusOne may only represent about 10%-20% of Cincinnati Bell's business, but the IPO could help Cincinnati Bell by crystallizing the value in the fast growing data center colocation business.

Of course, some of this value has already been realized, as this IPO has been rumored for a while, and the stock is up 30% vs. the S&P 500 YTD. In addition, the IT hosting sector may not quite deserve the lofty valuation multiples it is currently getting, but nonetheless further upside for Cincinnati Bell ahead of the IPO seems probable.

Details Of The Spin-Off

CyrusOne

WPX Energy (WPX) is an American natural gas exploration and production company with significant ownership of a South American energy company, Apco.

In January 2012, WPX was spun off by Williams (WMB). This is good news because spin-outs generally tend to outperform the market by 22% in their first year. In addition, WPX appears cheap relative to the broader natural gas sector on a fundamental basis. WPX is trading below its fair value and the valuations of peer companies. This is one case where it's cheaper to buy natural gas on the stock market than to get it out of the ground. Additionally, I believe natural gas may be cheap, albeit on a long term view.

The attractiveness of spin-offs

A spin off is where a company separates part of its business and lists it on the stock market as a separate company. Spin-off companies often outperform the broader

Phillips 66's (PSX) Q2 2012 earnings were up 40% year-on-year on an adjusted basis, with very strong refining margins, and refining profit up 70% year-on-year, somewhat offset by higher corporate costs post-spin and weaker midstream profitability due to natural gas pricing. The company announced a significant buyback and is still undervalued relative to its intrinsic value with 21% upside; a transportation MLP later in the calendar year remains a potential catalyst.

Buyback announcement - 4.1% of market cap

Phillips 66 announced a $1B share repurchase program; this would be 4.1% of total market cap if implemented in full (though repurchases seldom are), and complements the company's 2.2% yield and Trainer refinery disposal for $230M - all these actions are recently announced and testimony to Phillips 66's emphasis on shareholder value creation. This is in line with the spirit of ConocoPhillips (COP) - the company Phillips spun-off from.

No new

If you were are Sara Lee shareholder for the last month post spin-off you have owned shares in Hillshire Brands (HSH). Here we review key metrics on the stock to assess its valuation relative to other meat producers as well as the general trends for the stock. We conclude the stock is unattractive.

Key Metrics

Company	Hillshire Brands (HSH)	Hormel (HRL)	Tyson (TSN)
Market Cap ($B)	3.0	7.4	5.5
Price To Earnings (TTM)	8.5	16.1	9.2
Sales Growth (MRQ)	+2.4%	+2.7%	+3.3%
Operating Profit Growth (MRQ)	-13.5%	+8.8%	-0.3%
Operating Margin	10%	9%	3%

source: Yahoo Finance, company reports

An Acquisition Target?

Hilshire Brands is less than half the size of the others by market cap, leading some to conclude it is an acquisition target. This might make most sense for Tyson, moving it from commodity lines to higher margin products, since Hillshire owns the strong Jimmy

Alexander & Baldwin, Inc. (ALEX) has spun off its shipping business effective July 2, 2012. The shipping business, Matson Navigation Company, now trades under the ticker (Matson, Inc.: MATX).

Matson: Activities and the Jones Act

The easiest way to understand Matson is by looking at shipping routes (below). Matson is a Hawaiian business with over a century of history and serves the Hawaiian islands and Guam, linking them with both the U.S. west coast and China.

The Jones Act requires that ships operating between U.S. ports have U.S. ownership, management, crew, ships and are even repaired with U.S. steel. This creates relatively protected markets for operators, such as Matson, enabling them to charge a significant (2x-3x) premium over routes between countries that aren't subject to the Jones Act.

To underline its strong market position, Matson was able to raise prices earlier this year.

Why buybacks matter

Dividend yield is often analyzed by investors before a purchase, but buybacks, despite being a similar means of returning cash to shareholders, get less respect. I've written before about what buybacks imply at the sector level. This analysis focuses at the stock level, by looking at some of the companies that did the largest buybacks last year relative to their market cap.

The Top 10 S&P 500 Companies By Buyback Yield (2011)

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source: Factset

Are any of the top 5 companies interesting to investors?

Molex (MOLX) stands out for its incredible buyback yield in addition to a dividend yield of 3.6% and 14.6x P/E. The company makes interconnectors and has generated free cashflow for the past 3 years. However, the company appears reasonably valued, but not excessively cheap and the sustainable advantage of the company is not readily apparent, in addition last quarter

The launch and subsequent traction of the Fiat's (FIATY.PK) Fiat 500 may have negative impacts for Ford (F), given Ford's popular Fiesta model and desire to grow outside the US in the smaller car segment.

Ford does not disclose how many Fiestas they sell but in a recent SEC filing mentioned that "B-segment platform (Fiesta, B-MAX, EcoSport, etc.) is providing an annual platform volume of greater than 2 million." Given that Ford's total volume in 2011 was 6 million, small cars are a significant part of Ford's business.

The Strategic Importance of Small Cars To Ford

Ford's "One Ford" strategy involves significant focus on emerging markets. This is understandable given Ford's profits are largely made in the US today. In fact in 2011, 98% of Ford's automotive profits came from the US. In order to succeed in emerging markets, Ford must produce smaller cars. Smaller cars also tend to

Here we analyze fundamental and growth metrics for the major U.S. soft drink names to determine the most attractive current investment opportunities.

Soft drinks are an attractive sector

Soft drinks represent an attractive, defensive segment for investors. Barriers to entry are high because of the significant fixed costs involved in building brands through advertising and the challenges of creating a distribution network. Looking at an ETF which tracks the sector as well as other food and tobacco companies (iShares S&P Global Consumer Staples Sector Index - KXI), the outperformance on a 5 year basis is clear, perhaps in part because the consumer companies tend to offer both a healthy dividend yield combined with stock repurchases (see detail here), but also because consumer goods tend to outperform at times of poor overall market performance.

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KXI data by YCharts

4 Options For Investors

Within soft drinks, investors have

Phillips 66 (PSX) will announce two pieces of positive news for investors this year: 1) a stock repurchase program and 2) an MLP of their transportation assets. I've written previously that I believe Phillips 66 is undervalued and these events may go some way to realizing that value and building confidence a 2-month-old spin-off.

The Detail Of The Disclosures

Recent conference presentations by Phillips 66 imply two positive events for the stock before the end of the calendar year. This analysis draws primarily on company presentations from the Citi Global Energy Conference on 5 June 2012, transcript here, and UBC Global Oil and Gas Conference on 24 May 2012, transcript here.

Specific Quotes

Perhaps the two most interesting statements were from Greg Garland, the CEO and Chairman, at the Citi conference.

Firstly, around buybacks:

You'll see us step out with share buybacks. At some point this year

Oil, as expressed by the United States Oil Fund (USO) and natural gas, as expressed by the United States Natural Gas Fund (UNG) are long-term substitutes. Oil trades, based on 25 years of data, at approximately double the energy equivalent price of natural gas. However, the spot oil price is now approximately six times the spot natural gas price, using energy equivalent prices. This relative cheapness of natural gas relative to oil is unprecedented in 25 years. This may means the long-term relationship has broken down based on new means of natural gas production, but I suspect there is a fundamental case for gas to outperform oil on a medium term basis.

Now, that does not mean oil will fall and/or natural gas will rise overnight, for example see here for a broadly similar argument made in 2009 which is no less valid than this one, but has

Sentiment analysis is starting to get academic and public attention. Though the field is emerging, sentiment around Apple (AAPL) may be starting to turn and this may prove to be a negative for the stock.

The growing importance of behavioral finance

Knowing what other people think is a valuable part of the investing process. Indeed, building on the work of Kahneman and Tversky, behavioral finance is growing in importance. Behavioral finance is an evolving field, but one key element is that people are not always rational economic agents and don't always make decisions in a purely mathematical way based on calculated analysis.

Leveraging social media to determine investor sentiment

As a result, mining social media presents one an opportunity to do this. For example, various academic papers such as this one have found that negative sentiment expressed through social media (in this case worry, anxiety and fear) can be

As Phillips 66 (PSX) emerges a public company after the ConocoPhillips (COP) spin off and starts presenting on the conferencing circuit various catalysts are emerging that may help unlock upside in the stock or hurt performance. The most favorable is the formation of a MLP for transportation and logistics assets, which may help give transparency to those assets to investors. There is also a chance of increased pipeline investment before the end of the year, as a short term drain on cash, this is less likely to help the share price in the near term. On a longer term view, Phillips 66 may look to buy out joint venture partners, but it doesn't appear to have the liquidity to do that for at least the next few years, these may be a positive for the share price by removing a lack of control premium on those assets, given that control