As witnessed in October, financial asset prices continue to rise, as a result of the Federal Reserve’s actions. However, in November, the Federal Reserve changed their market supporting actions. Earlier this month, the Federal Reserve committed to (and started) buying $60 billion per month of US Treasuries (T-Bills). These proceeds will provide free bank reserves (simply, more reserves allow more lending) to the largest banking institutions in the country. If you are saying to yourself, “this sounds like Quantative Easing (“QE”),” you are not completely wrong. Fed Chair Jerome Powell will refuse to call it Quantative Easing, but free reserves to our largest domestic banks does sound like QE.
As witnessed in recent history, when our Central Bank provides free reserves to banks, the cash has a way of finding its way to financial assets (stock market, real estate, etc.), thus increasing their prices. While the stock market was higher at the end of November there was a week (week of November 18th) where the S&P 500 was lower. This weekly loss broke a 6-week win streak for the widely followed domestic index. What makes this weekly loss thought provoking is that the Federal Reserve’s balance sheet fell for the first time in 12 weeks that week. During the 3 other weeks in November, the Federal Reserve’s balance sheet grew, and the markets were higher. While representing a small sampling, we do have several years of data where one could draw the relationship between the Federal Reserve’s Permanent Open Market Operations and financial asset prices.
The 3rd quarter earnings season has largely ended (over 95% of S&P 500 companies have reported as of this letter) and there were a couple of interesting and noticeable trends.
a. First, the separation in performance of S&P 500 companies made and lost a lot of wealth for investors as markets have punished companies who missed expectations.
S&P 500 companies that posted better than expected sales or earnings per share (EPS) averaged share price appreciation of 1.7% and 1.4%, respectively, on the trading day after the earnings announcement. If an S&P 500 company was able to beat on both EPS and sales expectations, their stock price on average increased by 2.2% the following trading day. For companies that were less fortunate during the 3rd quarter and reported top (sales) or bottom (EPS) line misses, their share price felt the heat from the market. Companies who missed their EPS expectations generally traded lower by 3.0% the following day. If a company missed its sales expectations, their stock price was lower by 1.1% on average. If you were an S&P 500 company that missed on both sales and EPS expectations, your stock price fell on average by 4.6%, the following trading day. In summation, the market is much less forgiving to underperformers.
b. Second, the 4th quarter and 2020 outlooks from management teams across the entire S&P 500 are more pessimistic than recent market performance indicates. During the 3rd quarter earnings season, companies were more likely (3 to 1 ratio) to reduce their 4th quarter EPS guidance versus improve, while the odds were a little more than 2 to 1 to reducing their 2020 bottom line expectations. On the top line, S&P 500 companies’ 4th quarter sales guidance were 2 times more likely to be reduced (versus raised) matching their 2020 sales guidance expectations. Leadership teams continue to project slower business and declining earnings, but the investing public remains resilient.
Please review the following updates from some of the existing positions that we manage:
AGNC Investment Preferred Stock— (Symbol: AGNCO and AGNCN): AGNC, one of the largest mREITs (Mortgage Real Estate Investment Trust) in the world, reported third quarter earnings of $0.59 per share, excluding non-recurring items, which was $0.09 better than the S&P Capital IQ Consensus. Commentary from management centered around Fed operations providing liquidity. “In addition, following a dislocation in government repo markets, the Fed added substantial liquidity to the funding markets beginning in mid-September through its open market operations. The Fed also subsequently announced its intention to continue its open market operations into 2020 and expand its balance sheet through the acquisition of Treasury bills beginning in mid-October and extending through at least the first quarter of 2020,” said Gary Kain, AGNC’s CEO and CIO. We are comfortable with the preferred stock in the company. We believe that this specific position on the capital structure with $9 Billion of common equity below provides us material protection.
Enviva Partners Bond— (CUSIP: 29413XAB3): Mentioned as a possibility in October’s letter, our Enviva Partners debt position was called early. On November 15th, the wood pellet provider announced a $450 million private placement with the intention of calling our bonds, (due in November of 2021) early. As per the terms of the prospectus governing our bonds, the redemption price will be $1,021.25 plus accrued and unpaid interest up until the date of the redemption, December 16th. We will look to hold the bonds until the redemption date.
B. Riley Financial Senior Bond (Symbol: RILYL): In an interesting turn of events, the company decided not to retire our bonds due in 2021. This decision marks a reversal of the company’s previously announced plan to retire these bonds after the successful debt raise in late September. In late October, the company announced an acquisition of 6 retail brands that will act as a foundational investment for the company’s brand investment portfolio. B. Riley intends to grow licensing revenue from the brand holdings to support their current dividend strategy.
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