Altimetry High Alpha

Wall Street Has It All Wrong With These Two Stocks

Editor’s note: Nothing makes a stock move faster than a quarterly earnings report…

If a company beats Wall Street’s expectations, its stock goes up. And if it doesn’t, the stock goes down… sometimes significantly in a single trading day.

But as our good friend Professor Joel Litman has noted over the past few weeks, “as reported” numbers like this often contain flaws that can mislead investors…

Тoday we’re sharing two recent examples uncovered by Joel’s remarkable system. As you’ll see, his team’s efforts to level the playing field for everyday investors can lead to opportunities you might otherwise ignore…

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When Bill Bowerman and Phil Knight founded Blue Ribbon Sports in 1964, they had no idea what they were about to start…

Now known as Nike (NKE), the company started the sportswear revolution.

Before Nike started making athletic shoes, there was very little progress in the market.

It’s hard to picture a world without innovative sportswear. Imagine LeBron James running up and down a basketball court in a pair of Converse All Stars.

Nike has managed to stay ahead of the curve with its shoes. In the 1970s, it was the Cortez. The ’80s brought the Air Force 1 and the Air Jordan. To this day, Nike has continued to release signature shoe after signature shoe.

And the sportswear revolution isn’t limited to shoes… Every time Michael Jordan would show up in a new warmup outfit, fans would line up to buy the full look.

Athletic clothes are becoming more popular – and acceptable to wear – off the field. In 2016, the term “athleisure” finally joined the dictionary. The sportswear revolution is here to stay.

I try to live by the “health is wealth” doctrine. And I believe you can’t have a strong mind without a healthy body. Despite a sometimes hectic travel schedule, I try to get to the gym whenever time permits, at whatever hotel fitness center might be around.

Visiting so many different gyms, I do notice some trends in sportswear. Several watershed moments leading up to the current athleisure trend come to mind for me…

The first pair of Nike running shoes.

The popularity of Adidas’ three stripes.

The comfort and practicality of compression shorts.

In the mid-1990s, a former college football player named Kevin Plank took the moisture wicking material from his compression shorts and fashioned it into an undershirt for football players. The style was a hit… and apparel maker Under Armour (UAA) was born.

Under Armour gained quick popularity with football players… But Nike and Adidas were close behind.

Today, all three companies work in similar ways. They make a full line of sportswear, shoes, and gear for just about every sport. They endorse the best athletes in the world. Adidas backs soccer greats Lionel Messi and David Beckham. Nike sponsors LeBron James and soccer star Cristiano Ronaldo. Under Armour signed NFL quarterback Tom Brady and basketball player Stephen Curry.

However, having the best athletes doesn’t mean you have the best company…

Under Armour announced its second-quarter results in July, and the numbers did not look good. The company missed on its earnings and revenue targets, and management guided expectations down for the rest of the year.

This news added to concerns about the company’s ability to execute. Under Armour has historically lagged its competitors in efficiency, advertising, and innovation.

The stock fell 15% in the hours following the announcement. Worse yet, shares are down roughly 30% since their July 29 peak.

But things are not as bad as they seem. Take a look…

Investors fear Under Armour is failing. When looking at the company’s recent return on assets (“ROA”), it seems like they’re right… Under Armour’s ROA fell below its cost of capital in 2017, and it has remained at 3% since.

Luckily for Under Armour, this does not tell the right story.

We specialize in “Uniform Accounting” – a more reliable way of looking at companies than the generally accepted accounting principles (“GAAP”) and International Financial Reporting Standards (“IFRS”) accounting policies.

When we apply our Uniform Accounting metrics, the distortions from as-reported accounting statements are removed – including lease capitalization versus expensing, treatment of goodwill, and excess cash – and we can see that there is hope for Under Armour…

The two panels in the above chart explain the company’s historical corporate performance levels in terms of ROA and asset growth (dark blue bars) versus what sell-side analysts think the company is going to do in the next two years (light blue bars) and what the market is pricing in at current valuations (white bars).

Traditional accounting metrics (orange bars) can distort how investors view a stock. Without understanding a company’s true profitability, it’s impossible to properly analyze its stock.

Looking at the most recent years, Under Armour is more profitable than investors think… Its ROA actually bottomed out at 6% in 2017, improved to 8% last year, and is forecast to be around 7% this year.

Investors were concerned Under Armour wouldn’t be able to improve ROA above its cost of capital. But as it turns out, the company’s ROA never fell below its cost of capital.

The market punished Under Armour without good reason. Investors thought their fears were coming true, but it was just unclear accounting.

The market overreacted.

Investors missed out on signals that the company is already rebounding, and its performance was never as bad as expected to begin with.

Standard accounting metrics once again misled investors and created too much noise in the market.

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Wall Street Is Missing Out on This ‘Streaming Wars’ Winner

There are as many streaming services today as quality TV shows…

Between names like Apple TV+, Disney+, HBO Max, AT&T TV Now, NBCUniversal, and Discovery, you may soon be paying more than $50 a month just on streaming services.

But there’s an equally difficult decision you need to make… Before you can catch up on the latest episodes of Planet Earth or The Simpsons, you need to pick a streaming device.

Obviously, you can watch most of these on your phone or computer with no problem. But when it comes to watching streaming services on your TV, your set-top box won’t cut it anymore.

The options are nearly endless. Besides pricey smart TVs, you can pick from the big-name Amazon Fire Stick, Google Chromecast, or Apple TV, among others.

But when you need something in the middle, the best option is often from Roku (ROKU).

As I’ll show you, this streaming-device maker is a much stronger company than Wall Street realizes.

And when the “streaming wars” recently took a dramatic new turn, the bad press buried this incredible opportunity even deeper…

Roku regularly dominates the “best of” lists from the folks at tech-focused websites like Wired, Wirecutter, and CNET. It offers the Streaming Stick+ that plugs into your TV, a standalone hockey-puck size Ultra model, and even its own smart-TV software.

But when viewed through a traditional accounting lens, Roku looks like a terrible company. Its as-reported ROA is negative.

Of course, as I said earlier, my team and I specialize in Uniform Accounting – a more reliable way of looking at companies than the accepted accounting policies.

If we look at Roku’s cleaned-up numbers, we can see it is a profitable business…

When we apply our Uniform Accounting metrics, we remove the distortions from as-reported accounting statements – and we can immediately see that Roku has a much stronger ROA than the market realizes.

And the fact is, this is a much more valuable number for investors… If you would have realized this discrepancy in December 2018 and invested in ROKU, you’d be up almost 300% today.

That’s the power of Uniform Accounting.

Roku’s triple-digit rebound from its December lows makes no sense for a business that is supposedly losing money year after year. It only makes sense when you know the company’s real numbers.

Not only is Roku profitable today, but it has actually been profitable for as long as it has been a public company…

The panel above explains Roku’s historical corporate performance in terms of ROA (dark blue bars). Broadly speaking, the company has seen ROA grow from 4% in 2015 up to peak 20% levels in 2018.

Roku makes great products in a successful niche. And it’s likely to win even as other companies like Amazon (AMZN), Disney (DIS), HBO, and Apple (AAPL) battle each other in what the media is calling the “streaming wars.”

Now, if you’ve been paying attention to the markets, you might be wondering what’s happened recently. Despite its overall spectacular gains this year, Roku’s stock has gotten crushed in recent weeks.

That’s because its competitors know how much they have to lose… And several of them announced new product launches that caught the market’s attention.

These included cable giant Comcast (CMCSA), the loser of the streaming wars. Last month, it announced it was offering its Xfinity Flex streaming box to Internet-only subscribers for free, after charging $5 a month previously.

Social media giant Facebook (FB) also announced its second attempt to enter the streaming wars. It released a $149 “Portal TV” streaming device that will ship later this year.

Of course, Facebook released a video and chat “smart speaker” last year… to crickets. And Comcast’s free offering is one of dozens of streaming boxes available.

Competition from giant media companies is nothing new for Roku. It has been competing against pricey smart TVs, the Amazon Fire TV Stick, Google’s Chromecast, Apple TV, and others… for years.

And it has still been churning out profits… Yet most investors don’t see this. They can’t – because they’ve been misled by bad accounting policies.

I look at Wall Street’s reaction as an opportunity…

Roku has been profitable for as long as it has been a public company. An extra competitor in the streaming wars won’t change that.

The recent price drop only sweetens the deal for investors. Take this as an opportunity in a company that Wall Street doesn’t understand.

If you’re willing to exploit it, you could make six times your money, according to the Boston finance professor who just discovered it. The last time he found a situation like this, you could have made 1,100%.

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Editor’s note: Joel recently went on camera to demonstrate his powerful “Investment Truth Detector.” Together, he and Porter showed thousands of viewers how to pinpoint which stocks could soon double your money or more. We’ve made a replay available for the next few days. But don’t delay… It goes offline Monday at midnight. Learn more here.

Even Smart Activist Investors Don’t Always Get It Right

By Joel Litman – Altimetry’s High Alpha newsletter

At the height of the dot-com bubble, Internet darling AOL could do no wrong…

When the company announced it was joining with media conglomerate Time Warner in January 2000, many people thought the merger was a smart move. AOL would gain access to Time Warner’s content and cable network, and Time Warner would take advantage of the Internet revolution by merging with a high-flying dot-com company. The massive, $110 billion deal closed a year later in January 2001.

At the time of the announcement, AOL stock traded for more than $110 per share. But within two years, shares plummeted more than 50%… dropping to less than $50 by January 2002 as the dot-com bubble burst.

He explains the full details here.

It didn’t take long for the deal to be panned as one of the worst deals of all time. AOL’s attempt to diversify its revenue model was unsuccessful, as its core business faded away. Time Warner’s thoughts that a connection to the online world would revolutionize its business also came to nothing.

Within 10 years, the two companies parted ways. Time Warner spun off AOL for $2.6 billion. Everyone hoped to put the memory of the new media/old media tie-up behind them.

So when AT&T (T) announced it was acquiring Time Warner for $105 billion in 2016, everyone was nervous that they had traveled back to 2000 again. The deal closed last year, and Time Warner was rebranded as WarnerMedia.

Over the subsequent three years, AT&T’s stock has been flat… even after a long drop from early 2017 to the end of last year and a recent move higher in 2019.

AT&T’s flat stock price has made investors impatient. They can tell that the market has not agreed with either the Time Warner merger or AT&T’s 2015 DirecTV acquisition.

Investors’ disappointment with AT&T’s strategy is apparent when looking at how cheap the stock is trading for. The market-average price-to-earnings (“P/E”) ratio for the company is 20. Today, AT&T is trading at a cheap ratio of 10.4…

The poor stock performance and the low valuation led Paul Singer – head of the $35 billion activist-investment firm Elliott Management – to push AT&T to make changes last month.

Based on Time Warner’s merger history, one might assume Elliott wants AT&T to abandon WarnerMedia. But instead, Elliott has set its sights on the company’s DirecTV acquisition. The firm wants AT&T to spin off DirecTV.

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Elliott is hoping that by having AT&T improve its strategy, the market will start to react. Valuations will rise, as will the stock.

The only issue is, the market may not hate AT&T’s current strategy. The as-reported P/E for AT&T is low, but as-reported financial data can be misleading and unreliable.

That’s why we use Uniform Accounting metrics to simplify and standardize financial analysis. With Uniform Accounting, distortions and discrepancies like treatment of goodwill and expensing versus capitalizing leases are removed.

With a “Uniform” view of AT&T, we can immediately see the company isn’t trading at a 50% discount to the market as a whole – it’s trading much closer to market-average valuations. Take a look…

The dark blue bars in the above chart represent AT&T’s Uniform P/E. Instead of trading at a ratio of 10.4 – as traditional metrics would have you believe – we can see the company actually trades at a ratio of 18.1. This is much closer to corporate averages.

Elliott may think it’s creating value by pushing AT&T to spin off DirecTV, but that might not boost AT&T’s stock from its current position around market-average multiples.

Looking at the company’s returns and what the market is pricing in shows a similar conclusion…

The two panels above explain the company’s historical corporate performance levels.

AT&T’s return on assets (“ROA”) and asset growth (dark blue bars) are compared to what sell-side analysts think the company is going to do in the next two years (light blue bars) and what the market is pricing in at current valuations (white bars).

At current valuations, the market (white bars) is expecting AT&T to see its ROA stay flat at the higher end of historic levels – around 6%. The market is anticipating the combined AT&T, WarnerMedia, and DirecTV business will see synergies and is paying for those expectations.

If Singer and Elliott Management are successful in getting AT&T to spin off DirecTV, it isn’t clear that will cause the stock price to rise significantly.

Often times, following activist investors can yield big returns, as they seek to change businesses. But even the smartest investors can get things wrong from time to time, if they’re using GAAP accounting to come up with their analyses.

Altimetry’s High Alpha Newsletter | This Misunderstood Market Is Creating a Big Opportunity

By Joel Litman – Altimetry’s High Alpha newsletter

Yesterday, we discussed why concerns about an imminent recession are misplaced. Thanks to the drop in the cost for corporations to refinance their debts since early 2019, debt maturities are starting to be pushed out. And without a debt crunch, there’s no risk of a recession.

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But even corporations’ reported costs to borrow overstates how risky corporate debt is. This is particularly true for debt with the largest yields.

Market credit default swap (“CDS”) metrics are driven by investor demand, which is driven by how credit looks based on as-reported accounting figures.

The big credit-rating agencies – Moody’s, S&P, and Fitch – all use traditional accounting metrics when analyzing a company’s credit risk. So do Wall Street analysts.

Because of this, their conclusions on credit risk lag reality.

Once we apply our Uniform Accounting metrics, we can calculate what credit risk really is for a company. We call this metric “intrinsic CDS,” or iCDS. The chart below highlights the iCDSs broken into three buckets: investment grade (“IG”), crossover (“XO”), and high yield (“HY”), plus the risk-free rate (“RFR”). The real credit risk companies are facing is even lower than CDSs show you…

Our iCDS takes into account the real risk factors impacting each bucket of companies to understand what their real costs to borrow should be, based on that risk.

For the less volatile companies (IG and XO), intrinsic cost to borrow looks more or less the same as the current market costs for these companies to borrow. The market is correctly pricing their low and declining credit risk.

However, looking at the riskiest group of companies (HY), we can see something very powerful…

The market is overstating credit risk for HY companies.

While the market cost to borrow for an average HY company is around 4% right now, the intrinsic cost to borrow is around 3%. In the bond world, a percentage-point difference like that between market values and where a bond should trade is massive.

HY bonds are where most credit crises start. These are the companies closest to the cusp of bankruptcy and corporate restructuring at any given moment. Because of that, they are a particularly important canary in the coal mine for the economy as a whole.

If HY bonds are flashing an “all clear” signal – which they are today – that is a huge positive by itself… But when we’re seeing signals that credit risk is even lower than the market realizes, that lowers the risk of a credit crunch and recession even more.

And that’s before we even get into what it means as an opportunity for investors to buy individual high-yield credits, because they’re being overcompensated for the risk they are taking when they buy those bonds. This is also something we’ve seen Porter Stansberry highlight with his bond work at Stansberry Research.

We already know that the risk of a recession is much lower than many on Wall Street are claiming, just by understanding how important the refinancing market is to economic growth.

But by using Uniform Accounting, we can see even more… Not only is the risk of a recession overstated, the actual risk of HY corporates – the highest-risk businesses – is even lower than the market realizes. As the market adjusts to this reality, it will give even more tailwinds to the refinancing cycle, extending out the risk of a recession to 2022 – if not even further.

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Altimetry’s High Alpha Newsletter | The Next Recession Begins on This Date

Joel Litman – Altimetry’s High Alpha newsletter

Earlier this year, we headlined our January report for our institutional investors: “A RECESSION IS COMING… in 18 months to two years if trends do not change before then.”

Trends have changed significantly in the past nine months.

Many market strategists, financial journalists, and regular investors are calling for a recession by the end of 2019 or sometime in 2020.

A select few even suggested the recession has already started.

A few weeks back, we wrote about the real trigger for recessions. We mentioned that there’s no chance for a recession without a credit crunch caused by borrowers who are stuck with debt they can’t refinance or retire.

We said to keep your eyes on 2021, when U.S. companies’ obligations begin to exceed their cash flows.

But now, we have good news. We’re moving our expected timeline for the next recession. We now believe there is even more life left in the current economic cycle.

While the U.S. has a big debt headwall coming in 2021, that can change when U.S. corporations refinance their debt.

That wasn’t happening last year or earlier this year… but it’s exactly what we’ve been seeing recently. And it’s been speeding up in the past few weeks.

There’s a simple reason we’re seeing a renewed interest in refinancing…

After rising massively in 2018, the costs for corporations to borrow have fallen.

We look at the credit default swap (“CDS”) as a good proxy for how much it costs corporations to borrow. A CDS is a contract that acts like insurance for bonds. If a company can’t pay its debts, a CDS ensures that the owner of the debt gets paid.

Much like health and property insurance, the higher the risk, the more expensive it is to insure. As such, in times of elevated credit risk, a CDS skyrockets in price.

Leading up to the Great Recession, the value of the CDS market ballooned to more than $62 trillion. Much like trying to purchase insurance midway through a car collision, it became impossible to buy reasonably priced CDS…

The “price” of a CDS roughly matches the cost of a company to borrow, above the cost for the U.S. government to borrow – the risk-free rate (“RFR”). If we add together the risk-free rate and a company’s CDS, we can understand how much the all-in cost is for a company to borrow money. And if we add up that number for all the companies that have CDSs, we can understand how much it costs in aggregate for corporations to borrow.

The chart below highlights CDS prices plus the RFR over the last decade. CDSs are broken into three buckets: investment grade (“IG”), crossover (“XO”), and high yield (“HY”).

IG companies are the largest, safest, and most stable public companies, while HY companies are the smallest and riskiest. So it makes sense that HY CDSs are always more expensive than IG ones, and XO CDSs are always in the middle.

As you can see, the cost to borrow for all types of credit is significantly lower than it was in 2010, as we were coming out of the Great Recession.

Companies used those lower costs to consistently refinance their debt maturities. It made sense. When companies “roll out” their debt this way, they get to delay repaying it and see interest expenses decline or, at worst, stay flat.

Then in 2018, something changed. The refinancing market dried up. Companies weren’t as active refinancing their debts. The cost for them to do so had risen significantly…

First, the Federal Reserve was actively hiking interest rates, with four rate increases in 2018.

And the underlying CDSs for corporate borrowers were rising too, as perceptions grew that the bull market was running out of steam. The cost to borrow for IG companies rose from around 2% to 3.5% in 2018 through early 2019. The cost to borrow for HY businesses jumped from 3.5% to 5.5%.

Companies saw these interest-rate increases and paused their refinancings. That’s how the debt-maturity headwall in 2021 got so big earlier this year.

But in recent months, we’ve seen a big inflection… which caused the refinancing market to return. It’s why we think debt-maturity headwalls that had been looking material for 2021 are likely to be pushed out to 2022 and beyond.

Without those debt-maturity headwalls in 2021, there’s no risk of a recession.

The rise in the cost to borrow in 2018 has completely reversed itself. Thanks to the Fed cutting rates and CDS levels moderating, the cost to borrow is roughly in line with what it was from 2014 through 2017, when the refinancing market was strong.

And that’s not the end of the story…

Tomorrow, we’ll detail how Uniform Accounting gives us an even stronger “all clear” signal… and points us to the highest-yielding opportunities that are far safer than Wall Street would have you believe. We’ll have more details here tomorrow morning.

While I don’t believe we’re on the brink of a recession today, the next few months might be a sideways market… and in this environment, stock pickers are going to do well.

In my brand-new Altimetry’s High Alpha newsletter, my team and I are focused on the best companies that can break from this sideways trend and outperform in the months ahead. You can learn more about our strategy – and a subscription to High Alpha – by clicking here.