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To Hike or Not To Hike: The Fed’s Big Decision

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This Wednesday, the Fed released its latest meeting minutes which give us a look into the their thinking on the state of the economy. Until recently, it had been assumed by most economists and analysts that the Fed would (finally) make its long-anticipated interest rate hike in this September’s upcoming meeting.

However, doubts have seeped in during recent days. First, China announced a surprise devaluation of their currency last week. While small in scale, the devaluation shows that the world economy is continuing to slow. Some are saying that China has fired the first shot in a “currency war”. Even if it’s nothing so serious, raising interest rates and applying contractionary pressure to the economy as China undermines the US’ economic position with a weaker currency could backfire.

Then, Wednesday morning, the government released new CPI inflation figures that showed inflation, contrary to expectations, had slowed substantially last month.

The Fed has a mandate to balance inflation and employment. It is supposed to encourage as much employment as possible without inflation overheating – generally a 2% inflation target is the standard. With inflation cooler than expected and below the Fed’s target, that gives it more room to delay, potentially, the rate hike until December.

And the release of the Fed minutes Wednesday showed that the Fed is wavering on whether to hike or not. One member of the Fed board is ready to hike immediately, but was willing to wait one more meeting. The Fed committee as a whole though found that “economic conditions warranting an increase in the target rate for the fed funds rate had not yet been met.”

Given that the economic momentum since that meeting which generated the minutes has been negative, I’d be surprised if the Fed sees enough evidence to feel compulsion to hike in September. So, it’d seem like the play now is to position ourselves for a no hike in September, high probability of a hike in December outcome.

For traders with a shorter-term outlook, the play here is to buy assets with high leverage to interest rate changes. Many of these sectors have already been generally beaten down in recent months, in expectations of a hike, and could enjoy healthy bounces following a Fed no-move in September.

In particular, I’m looking at REITs – such as the iShares U.S. Real Estate ETF (IYR). This fund owns a basket of real estate investment companies that make their profits borrowing at (hopefully) low interest rates and collecting rent that exceeds interest and leaves plenty for substantial shareholder dividends. Their business model works better with low interest rates. The ETF’s shares are down close to 10% since their 2015 peak, and now yield a healthy 3.6% annual dividend.

A more conservative way to play the trend is to take a look at utilities. Unlike REITs, these businesses are not so sensitive to interest rates. However, many yield-hungry investors own utilities as a bond-like substitute, since utilities tend to pay more interest than bonds nowadays but remain low risk. Since utilities are regulated businesses and customers will keep using electricity regardless of how the economy fares, these are extremely reliable businesses.

However, utility shares have fallen on concerns that rising interest rates will encourage investors to dump their utilities and buy bonds in their place. This selloff has cause shares of the Utilities Select Sector SPDR ETF (XLU) to be down close to 10% from the year’s peak as well. At present, the ETF yields a solid 3.4%.

Finally for investors seeking a more aggressive Fed play, one should consider the most beaten-down assets. Oil in particular is one place that could benefit substantially if the Fed remains on hold. Oil prices, down 60% now from last year’s peak, could rebound smartly once selling pressure abates.

While a Fed no-decision wouldn’t change the underlying dynamics for the commodity itself, the adding of more liquidity into the capital markets would encourage more risk-taking, and give more margin for speculators to try to find the bottom on oil. Particularly with bets against oil hitting extremes, the stage is set for a share reversal in the oil pits should the Fed ease up on its monetary policies in September.

Finally, foreign stocks – particularly in smaller emerging markets – would benefit from a Fed no hike. The US dollar has soared this year, causing routs of foreign currencies. This has led to panic selling of foreign shares and triggered rounds of austerity and belt-tightening across the developing world.

One way to play this would be in the iShares Latin America 40 ETF (ILF). Its shares are down from 45 to 25 over the past year, and are down 20% just this summer. This ETF would likely see a sharp rebound should the Fed not raise interest rates.

The next Fed interest rate decision will be announced September 17th. Stay tuned, there will be plenty of opportunities in the wake of their move.

It’s Time To Take A Look At Barrick (ABX)

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Barrick Gold (ABX) is the world’s largest gold mining company. Despite a tremendous drop in the past years, from its all-time high around $50/share in 2011 to $8/share, it remains the biggest player in its industry sporting a $9 billion market cap.

Gold has had a rough run of it lately, falling from its all-time peak of $1900/oz down to $1100/oz today. Barrick has dropped with the tide, its high debt load being a key problem for the company’s outlook. The company’s debt is a real concern, and until recently, I felt shares were not yet a bargain.

All that changed, however, in July, as Barrick shares plunged from $10 to $7 in the space of just three weeks.

Despite the latest plunge in the share price, the company’s core business seems to be stabilizing. The company produced 1.4 million ounces of gold in Q2, and is on pace to produce about 5.5 million ounces for the year. It is producing at $895/oz all-in cash cost, leaving significant space between the cost of production and the current $1100/oz gold price. And that cash cost was down smartly from the $927 it cost the company to mine an ounce of gold in Q1.

Barrick was profitable in Q1 and lost just one penny per share in Q2 of this year; its operations are going fairly well despite the low current gold price. And the company managed to put up $525 million in operating cash flow in Q2 – a solid jump from the $316 million it managed in Q1. The company ended the quarter with $2.1 billion in cash on hand, plenty to weather any near-term storms.

Furthermore, the company is continuing to execute on its long-term turnaround strategy that will ensure the company’s survival through the current doldrums.

This strategy is focused on several points, all of which will shore up the balance sheet. The company is selling off non-core assets, it reduced the dividend, it will be cutting the long-term debt load by $3 billion, and it is reducing expenses by a hefty $2 billion target for 2016.

The dividend cut was disappointing for long-term shareholders but for new owners, it’s a clear positive. The dividend going forward will be 2 cents per quarter/8 cents per year. This amounts to a 1.2% yield, and is reasonable given the company’s current headwinds. While a dividend is nice, the real upside here comes when the gold cycle turns upward and Barrick shares double off the bottom.

Barrick is selling off assets to raise cash. The cash is being used to reduce the debt load. Already, the company has paid off $250 million in debt during the first half of 2015. And this rate promises to increase, since the company just finalized a deal that will bring them a more than $600 million upfront payment for a royalty stream on their Dominican Republic-located Pueblo Viejo mine.

Barrick gets $610 million in cash now, plus a portion of the spot price for the gold and silver produced at Pueblo Viejo. In all, the deal gives Royal Gold (RGLD), the buyer, 7.5% of the gold and 75% of the silver from the mine for the first several years of production at a sharply discounted price, and then 3.75% and 37.5% of the silver from the mine thereafter.

While this deal may benefit Royal Gold in the long run, particularly if the prices of gold and silver rise substantially, it gives Barrick a large sum of capital now which it can use to shore up its liquidity and pay off a good chunk of debt.

This royalty stream comes on top of the company’s recent move to sell 50% of its Zaldivar Copper mine in Chile for $1 billion in cash. With the price of copper plunging (it has a much uglier chart than gold), this seems like another sound move.

While cutting the dividend, selling assets and reducing headcount seem like discouraging moves, it all makes sense with a long-term perspective. As the world’s largest gold miner, Barrick is taking the painful but necessary steps to ensure its survival.

When the cycle turns – rest assured, it will – Barrick will still be the world’s most important, turning out 6 million ounces a year at less than $1,000 per ounce. Should gold turn back up to say, $1,500/oz, Barrick would be positioned most favorably to capitalize. The asset sales and dividend cut may seem ugly in the present, but in the long run, Barrick is making exactly the right moves. Buy the shares now, when the gold sector turns upward, you’ll have a big winner on your hands.

Greece And The Euro: Third Bail-Out Agreement Update

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Around a month ago, it looked like Greece was on the verge of leaving the EU. The German finance minister said that Greece needed to spend five years without the Euro, a move that would have certainly become permanent. Despite a deal for a bail-out being in the works, it seemed unlikely that Greece would agree to the terms set by the EU.

Despite this, Greece has now confirmed that a bail-out has been agreed. The $95 billion fund will be given to Greece over the next three years. This is now the third bail-out handed to Greece since 2010. While the deal is not completely set in stone yet, only countries with large economies will be able to block the deal. Germany seems to be all in favor of the bail-out deal and smaller countries do not have the economy to block the deal.

How Will The Greek Bail-Out Work?

Greece will get its first payment by August 20th. The $14.4 billion will be used to claim back the bonds that are currently held by the European Central Bank. After this, Greece will get another $10 billion which will be handed over to the European Stability Mechanism. They will use this money to help get the banks in Greece damaged by the crisis up and running again. This will be followed by another payment towards the end of the year for the Greek banks, which will complete the first round of money for the bail-out.

Why Is The IMF Not Involved?

The International Monetary Fund will no doubt remember all the trouble they had in 2010 with the first Greek bailout. The IMF insist that they will not offer bail-out help unless it looks likely that the debt of a nation can be sustained. That wasn’t the case in 2010, but the IMF offered a contribution, a decision they have struggled with ever since. They will be understandably reluctant to get involved with this third bail-out.

Germany may not be too sure about having the IMF involved either. For them, having the IMF contributing has both an upside and downside. The upside is that they can be quite strict when it comes to the terms of a bail-out and the enforcing of debt payment. Germany would be happier if the IMF were in charge rather than the European Commission. The downside is that the IMF want countries inside the Eurozone to increase the amount of debt relief money they are offering. Considering that the Germans feel they are contributing more than enough, having the IMF calling the shots would not be in their best interests.

What Will Happen In Greece?

This remains to be seen. The Greek Prime Minister Alexis Tsipras now has to deal with a split in the ruling Syriza party. Many parliamentary members of the party are upset that Tsipras went to the EU with a clear plan for negotiations, only to allow the EU to impose strict sanctions. Tsipras may have to endure a vote of confidence in parliament, which could well trigger another election. The outcome of that could well determine how this bail-out takes place. The people of Greece will just have to hope that politics does not get in the way of their country getting on the road to recovery.

This Investment Is Off Target

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Skepticism is justified given the recent run-up in shares of Target (TGT). Shares are up more than 30% over the past year, beating both the market and direct competitors such as Wal-Mart (WMT) by a fat margin.

However, a deeper dive into Target’s business shows reason to question the rise. While Target has a fine brand, a long history of growing its dividend, and runs a well-liked chain of stores, its stock price appears to have gotten well ahead of its fundamentals. Several glaring negative points dampen the company’s outlook.

First and foremost is the embarrassing fiasco that was the Canadian expansion. Target bought out Zellers, a chain of 124 existing stores largely in mediocre locations. Target rebranded the stores and analysts hoped that Target would be able to – at last – spread its powerful American brand abroad.

Instead, it ended as a $7 billion failure. Target Canada filed for creditors’ court protection – the equivalent in Canada of Chapter 11 bankruptcy and closed all its Canadian stores. Just 26 months after it arrived, Target came limping back to the states with its tail between its legs and $7 billion poorer.

To put that in perspective, Target’s whole market cap is just $50 billion. As such, the company piddled away 15 percent of its entire valuation in a disastrously-managed international expansion. Stated another way, the company wasted 4 years worth of its annual dividend payments on its Canada misstep. For yield-seeking investors who own the stock largely because it’s a Dividend Aristocrat that pays a reliable dividend, that’s a sorry waste of funds that could have gone to shareholders.

Moreover, it serves as a reminder of the low ceiling on Target’s business. If they can’t cut it in Canada, they certainly aren’t going to have success in more volatile emerging markets. While Wal-Mart is out trying to conquer the globe – stores in 27 countries and counting – Target is stuck being a #2 player in its domestic market with no prospects for international expansion.

Furthermore, Target is still weighed down by the disastrous hacking scandal from 2013. In the weeks following Thanksgiving of 2013, hackers broke into Target’s database and took information on 110 million(!) Target customers. That’s more than 1 out of every 3 Americans. The hackers got access to names, addresses, phone numbers, and e-mail addresses.

Target’s same-store sales dropped significantly following the scandal, and for obvious reasons, customers continue to be wary of shopping through Target’s online website. As of December 2014, only 37% of Americans had visited Target’s website or a physical store in the preceding month, down sharply from 53% in 2007.

Over the past decade, the company’s net income margin has fallen by more than half, dropping from 4.5% to 2%. That means the company is only earning a net profit of 2 cents on every dollar of product it sells, whereas it used to pocket almost a nickel. Similarly, the company’s earnings, which topped out at more than $3 billion in the early 2000s has fallen to just half that today.

Shares topped out in 2007 at $70 each before dropping during the Great Recession. Until late 2014, shares lingered well below that figure – as you’d expect with its profit margin and earnings falling.

However, optimism on the new CEO, the closure of the failed Canadian experiment, and investors’ general desire to chase higher-yielding stocks irrespective of underlying fundamentals has bolstered Target shares recently. Now they sit near their all-time high despite an eroding, or at best flat, business. I’d say it’s a pretty easy choice: Sell here and roll the profits into Wal-Mart or another such retailer whose shares have already sharply fallen from its 52-week highs.

I’d be remiss not to mention the positives, as it isn’t all bad news for Target. First up is the new “City Target” initiative. It’s getting positive feedback – particularly for the inaugural Boston location – and it may give Target a big leg-up against its biggest competitor. Wal-Mart has largely been locked out of the urban market, both due to size constraints and due to political opposition to its brand.

Target’s only serious domestic competitor, Wal-Mart, is thought to be an inferior store by most customers. Target is able to charge significantly higher prices for many of its products than Wal-Mart without hurting sales. In particular, the store is viewed as having better clothing and a much stronger pharmacy.

Still, that’s not enough to justify Target trading to all-time highs with its underlying business so weak. With its brand damaged from the enormous hacking scandal and the possibility of international growth now on ice, there’s simply not enough reasons to stay long Target. This $79 level is a good place to take profit.

Kinder Morgan: Is It Finally Time To Buy?

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Kinder Morgan (KMI) is a very attractive stock on at least one basis. The company currently pays $1.96/share per year in dividends, working out to a 6% dividend yield. In a world of zero interest rates, that’s a rather generous payment.

What’s better, the company has promised to grow the dividend at a 10% annual rate out through 2020, which would take the dividend to $3.16/share over the next five years. Based on the current $34/share price, that’s a yield of more than 9%. Juicy.

Since May though, it hasn’t been all roses for Kinder Morgan’s shares. They’ve fallen from $44 to $34 during that time. Clearly the market is showing some skepticism toward the company’s outlook.

Some of that decline can be attributed to general weakness in the energy sector. Oil prices are falling again, hitting new post-2009 lows, and it’s clearly weighing on sentiment.

But some of the decline is specific to Kinder Morgan. Previously, its shares had held up despite energy’s struggles last winter. Kinder Morgan likes to remind investors that it is not particularly exposed to energy prices. Its business is largely driven by volume; they get paid for product passing through their pipelines regardless of the end value of the oil or natural gas using their system.

The company estimates it loses $10 million in distributable cash flow per $1 fall in the price of oil. Based on the $50/barrel or so drop from last year’s pricing, that’s $500 million slashed off Kinder Morgan’s cash flow that they can pay to shareholders. Given that the company pays about $4 billion a year in dividends, $500 million is a sizable hit to the company if oil prices stay this low, but it isn’t a knockout blow by any means.

So energy prices aren’t enough to take down the Kinder Morgan structure. The bigger concern at this point is financial leverage. Kinder Morgan is running around 7 times net debt to annualized EBITDA, based on results for the first half of the year. That’s rather aggressive. Looking at other energy firms that trade at this strained debt/earnings level, one wonders if Kinder Morgan will be able to maintain its investment grade debt rating. The company’s debt is currently at BBB-, just one notch away from being lowered into junk territory.

This is a pivotal challenge for Kinder Morgan. The company has $21 billion in construction backlog. Backlog are projects that it intends to buildout to generate future earnings growth and support the promised dividend increases. However, the company needs access to further cash to be able to build out its backlog. $21 billion is no small sum.

The company can, and periodically does, raise more money selling stock. However, it would be hard to get anywhere close to the required $21 billion from the equity market without severely impacting the company’s share price. Thus, the better solution for the company is to take out more debt to build new projects. This would become much more difficult and expensive if the company could not maintain its investment grade credit rating.

Keep in mind with oil prices where they are now, the company generate very little free cash flow beyond merely what is necessary to pay the dividend.

By no means is the picture all bad, however. Richard Kinder has established a tremendous industry track record, and he continues buying more shares in the company. Insider buying is always a good sign, particularly in a battleground stock.

And while the company is financially strained with lots of debt, its core operations remain firmly profitable and largely untouched by the ongoing energy bust. The company has many one-of-a-kind assets and is a key piece of the overall American energy infrastructure. That is to say, the company isn’t going anywhere despite the near-term problems in the industry.

So is the stock a buy today? It’s certainly a better deal now at $34 than it was at $44 not all that long ago. It’s still a risky play here though. Until we see how the energy sector bust plays out, it is hard to call a bottom on shares.

If prices stay low, Kinder Morgan will likely struggle to fund its backlog, maintain existing operations, keep growing the dividend as planned, and hold on to its coveted investment-grade rated debt. Any uptick in the energy sector could resolve this issue quickly, however.

While the 6% current yield and 9% promised future yield are enticing, I’d hold off until shares fall a little more and/or oil prices turn upward. There’s no rush to buy the stock with the prospects for the next few quarters still so murky.