Be Brave: Assume Ultimate Risk

My favorite ragamuffins, Halliburton HAL , Freeport-McMoRan FCX and a bunch of MLPs do jitterbug 5% to 10% intraday, but they hang high above 12-month lows. After all, Nasdaq 100 Index rose 60% from its March nadir. They say entry points are half the battle. Maybe so. Prime growthies, like Apple AAPL , Amazon AMZN and Facebook, doubled since March. Let ‘em take a breather.

First, consider past year’s wreckage in cyclicals and a bunch of “also rans.” Stocks like General Electric GE , Macy’s M , Alcoa AA , U.S Steel and Plains Group Holdings (an MLP) trade mainly in single digits and collectively stand cut in half or more this year. Blood flowed profusely from airlines, now wards of the state, comparable with banks in the 2008 – 2009 mortgage paper white-out.

Categorically, cyclical paper carries balance sheets top-heavy in debt. Mainly, market value of debt exceeds market value of the underlying equity base. Makes it near impossible to raise new equity or additional debt. Somehow, American Airlines AAL raised serious money with a 6½% convertible bond. This is ultimate-risk paper, now trading below par.

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In 2009, Merrill Lynch, Bear Stearns and Lehman Brothers ran out of options to remain independent. Bank of America’s BAC $25 preferred stock traded at five bucks and American International Group AIG needed a liquidity lifeline of $100 billion from the U.S. Treasury.

This cycle, aside from Occidental Petroleum practically destroying itself by leveraging for an acquisition, polite paper like Exxon Mobil XOM , Schlumberger SLB , even Citigroup C were badly bruised when rising earnings expectations got crushed by cyclical forces, not management dynamics. Schlumberger dropped 70% from its high while the chart on Exxon Mobil is an expert ski slope. From its peak in the eighties, Exxon ticks in mid-thirties, its dividend no longer unchallenged.

Such big-cap paper was actively recommended by a positive analyst consensus a year ago. Activists like Carl Icahn bought a bunch of Occidental near its high and he suffers with it. Years ago, General Electric ranked among top 10 largest capitalization stocks in the S&P 500 Index. Its headman, Jack Welch, sported a revered name on the Street and in corporate boardrooms.

Some takeaways:  Beware of polite institutional paper. Remember, U.S. Steel, Alcoa, Delta Air Lines DAL , Boeing BA , General Electric, Macy’s, Ford Motor F and Wells Fargo WFC had their day. This list is long, but Ford and General Electric after their tortuous descent may carry price quality today. Each failed operationally to renew itself.

Today’s heroic performers like Tesla TSLA and Amazon wouldn’t exist if prime retailers had developed e-commerce capability and automobile makers prioritized electric car development. Combined market capitalization of Amazon and Tesla runs near $2 trillion. Macy’s and Ford count up to $26 billion. Management dynamics anyone?

My golden rule is at your first whiff of fish, check out. Forget what you’ve played and go on to something else. Maybe, the reciprocal of what you were fixated on. If basic industrials and energy plays are dead in the water own more growth stocks. When banks are wobbly, Apple is your polite growthie worth a shot.

Always, contrapuntal melody and staccato rhythm play in the market. When internet rates tick near zero, add high-yield bonds to your mix, particularly, when everyone fears business cycle risk on interest coverage, even for BB paper.

During low inflation, low interest rate settings, markets historically sell at 20 times earnings. Post Covid-19 this is what the market discounts currently. Growth stocks like Facebook, Alibaba BABA and Microsoft MSFT coast around 1.5 times the S&P 500 so playable.

Same goes for cyclicals when selling at big discounts to normalized earnings over a full cycle – good year – average year – bad year. The last great buying point for growthies occurred in 2014 when they sold at little or no premium to the market. Everyone worried about capital spending declines impacting tech, but it didn’t happen. Past five years, Microsoft and Amazon advanced over 300% while the S&P 500 gained a tepid 50%.

I love going against the grain to embrace a bunch of ragamuffins, but never just one or two plays. You want at least half-a-dozen unwanted, under-owned wallflowers. If wrong on timing, with a pricey entry point, go back to balance sheet analysis and determine how long your doggie can stay in business. If it’s just a year or even two years, check out. Ultimate risk belongs at the craps table.

Sadly, hardly anyone but high-yield bond players analyze corporate balance sheets. If there’s a massive goodwill line, take notice. Even Berkshire Hathaway sports much goodwill, some $70 billion, and recently wrote down part of its acquisition cost for Precision Castparts. It impacted Berkshire’s quarterly results. General Electric overpaid on many deals held for a decade or longer with too liberal accounting practices in place.

Not so strangely, the cycle hasn’t reversed as yet for oil service and copper plays, but it didn’t stop Freeport-McMoRan and Halliburton tripling off their lows. The market finally decided they had wherewithal to stay in business. I have no inkling when materials prices reverse themselves. My feel is no more than a year away, tied to development of a Covid-19 vaccine. Oil futures seem a leading indicator for recovery in commodities, but so far shed no light.

Currently MLPs, trading dolorously, down half or more from twelve-month highs, cry out for speculator reflection. Surely a proxy for oil futures. Oil at $40 a barrel adumbrates declines in pipeline throughput and a weakening rate structure. Maybe so, maybe no.

Questionable is whether MLP shareholder distributions are sustainable. Many MLPs pay out 100% of cash flow, some lesser amounts. There’s no institutional interest in this paper. Stocks jitterbug 5% to 10% intraday based on where oil futures tick. If you believe $40 is the base for oil, these babies are playable. I’ve stuck with those vagabonds I think payout distribution is sustainable. My horses are Enterprise Products Partners EPD , Williams and Magellan Midstream Partners MMP . Enterprise is the class act, with a conservative payout ratio, and yielding 11%.

Fair question is why not play big oil – say Exxon Mobil, trading down into low thirties, from $80? Let’s wait for Exxon to schmeiss its dividend in half. Even there, yield works out to 5% for this mid-thirties’ disaster. Playable, but too polite for my taste.

My darkest before dawn pieces of paper embrace American Airlines 6½% convertibles trading at $96 and Spirit AeroSystems Holdings bonds at $82. Liquidity lasts a couple of years, time enough for aerospace to right itself. For the faint-hearted, General Electric’s aerospace division is also a comeback-kid.

In financials, Citigroup is my go-to relative valuation play, but I see no near-term comeback in earnings for banking. Downside may be overdone relative to peers, but it’s selling at 15 times near-term earnings possibilities, so still pricey.

If a macro player, Nasdaq 100 beckons, not the S&P 500. The Street rarely remarks on its disparate performance to the S&P 500 which trails it badly since 2014.

Net, net, learn to like playing with fire, but carry plenty of staying power. Absent a high courage quotient, one-off investing is the hardest way to make money that exists. Let somebody else cry over Argentina, Puerto Rico and Venezuela. They’ve been basket cases for 50 years or more.

Sosnoff and/or his managed accounts own Halliburton, Freeport-McMoRan, Apple, Amazon, Facebook, American Airlines bonds, Citigroup, Ford Motor bonds, Wells Fargo preferreds, Alibaba, Microsoft, Enterprise Products Partners, Williams, Magellan Midstream Partners and Spirit AeroSystems Holdings bonds.

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