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Do Your Alternative Investments Have The Right Fit?

By Richard Brink, Christine Johnson Investors who chose alternatives for downside protection in recent years have been frustrated with their performance. We think the problems were an unfavorable market environment and the unique challenges of manager selection for alternatives. In May 2013, the market’s “taper tantrum” in reaction to announced changes in U.S. monetary policy pushed bond yields up; stocks stumbled briefly before continuing to pile up strong returns. For many investors, this heightened concerns about extended market valuations and an impending interest-rate increase. Taking a page from the typical playbook, many investors looked toward long/short equity strategies and nontraditional bonds as ways to protect against potential market downside. But in 2014, playing defense didn’t pay off: U.S. equity markets gained another 14% and bond yields fell. Long/short equity strategies, on average, returned 4%. That experience left many investors disappointed with alternatives-both equity-oriented and fixed income-oriented. It hardly came as a surprise when investors shifted money out of alternatives early in 2015, moving it into core fixed-income funds and international equities-mostly through passive exchange-traded funds (ETFs). The Long-Term Value of Alternatives We think investors were right in looking to alternatives for protection against potential downturns. Alternatives have provided better returns than stocks, bonds or cash over the past 25 or so years, with less than half the volatility of stocks ( Display ). And long-term data show that incorporating alternatives in a traditional portfolio may enhance returns and reduce risk. If that’s the case, what went wrong in 2014? We think the problem was twofold. First, a good portion of alternatives’ poor performance stemmed from the multiyear, largely uninterrupted bull-market run. This extended rally rendered the long-term benefit of “hedging” with alternatives somewhat moot. Second, many investors bought the right idea of alternatives: participation in all markets with downside protection. But in many cases, they didn’t buy the specific behavior in an alternative that was the best fit for their portfolio and risk/return preferences. It’s not an easy selection process. There are thousands of different alternative strategies to choose from and a lot of dispersion among managers within alternative categories. It’s not enough to simply buy a top performer from a seemingly relevant category. It’s critical to have specific characteristics in mind: Exactly how much downside protection do you want? And how much participation in up markets are you looking for? Once you know your objectives, you can start doing the homework to zero in on a strategy and manager that aligns with them. What’s in an Alternative Category? Everything One of the challenges to finding the right fit is that alternative categories have a lot more variety than their traditional equivalents. They just don’t provide as much help in narrowing down the decision. Take Morningstar indices. They have about 40 different categories for traditional, or long-only, equities. There are categories for different geographies, market capitalization ranges, styles and even sectors. For long/short equities, there’s only one category. If an investor wants to find the right long/short equity strategy, it takes a lot of legwork to uncover the one with the best fit. Without that, investors are at the mercy of manager dispersion. Three Levers That Create Manager Dispersion What creates such big dispersion among alternative managers? We think three levers are at play: style, market risk and approach. We talked about the first lever already: the traditional style buckets of geography, investment approach, market capitalization and industry/sector make for a lot of differences. The second lever is how much overall market risk and sensitivity a manager has-a lot or a little-and how much it varies depending on conditions. The third lever is the approach a manager uses to create the portfolio’s overall market exposure. For example, does the manager use cash, market hedges or short positions in individual stocks? What mix of these instruments does the manager use, and in what environments? All three elements and their combinations can vary to define your experience with a specific alternative manager’s approach. Conducting three-dimensional research to gain a clear understanding of the levers-and which settings are best for you-is the key to choosing the right alternative manager. And the need to make that choice is rather pressing today, in our view. There aren’t a lot of broad cheap areas in capital markets today, and we expect more modest returns and higher volatility ahead for both stocks and bonds. Relying on broad market returns alone isn’t likely to be as rewarding in the years to come, and alternatives can play a key role in enhancing a portfolio’s risk/return profile. The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

High Yield In Focus: 9.53% From Suburban Propane Partners

Summary Suburban Propane Partners is not impacted by commodity downturns. The company has a capital-light business model. Growth opportunity is limited, but SPH can increase distributions via accretive acquisitions. Suburban Propane Partners (NYSE: SPH ) is an MLP that markets and distributes energy products. In addition to propane, the company also sells fuel oil and electricity. As a reseller of energy, the company was not dramatically impacted by the recent commodity downturn. Given that SPH hasn’t missed a single dividend over the past 10 years and has grown the distribution from $0.6125 per quarter in 2005 to $0.8875 per quarter today (45% increase), would now be a good time to buy the stock at a yield of 9.53%? Largely A Propane Business Propane accounts for the highest percentage of the total revenue, coming in at 83%. The propane segment also constituted more than 100% of the total operating income in 2014. How is that possible you ask? That’s because other segments are actually losing money on a GAAP basis. For example, the “All Other” segment has been losing money for three years in a row ($17 million in 2012, $26 million in 2013 and 2014). Evidently, although the company offers a variety of products, the core business still revolves around the sale of propane. Propane use is heavily dependent on the weather. To illustrate, the company sells approximately two-thirds of its retail volume from October to March (the cold months). Of course, this means that warmer weather will directly affect the bottom line. This will introduce some uncertainty to our cash flow in the short term, though this fluctuation should even out in the long run when colder weather returns. Financials The company generated $226 million of operating cash flow ($248 million after adjusting for working capital changes) in 2014. This amount was very close to the company’s distribution of $211 million. This means that the company is pretty much paying out everything that it earns, which is great for income investors. Unlike other popular MLPs (e.g., midstream), the company’s operations are not capital intensive. There are no pipelines to be laid or other growth projects that would require large capital spending. This has allowed the company to keep net maintenance capital expenditure at around $20 million per year. So we have a capital-light company that is generating high cash flows. But growth opportunity is rather limited. Let’s look at the chart below. Although revenue has increased significantly, the growth was not attained organically. Jumps in revenue in 2004 and 2013 can be attributed to the acquisition of Agway Energy and Inergy Propane, respectively. But this should not faze you, as the company has increased normalized operating cash flow per share from $2.41 in 2004 to $4.08 in 2014. Ultimately, dividends depend on cash flow generation, and the fact that these acquisitions were accretive means that the company could afford to increase dividends. So the question is, can the company continue to make accretive acquisitions? The answer is quite complicated, as it depends on a multitude of factors, including but not limited to the skill of the management and the existence of opportunities. We can somewhat gauge the former by looking at how major acquisitions have turned out. Judging by the outcomes described in the previous paragraph, the management seems to have made the right decisions. As for the existence of opportunities, this is completely out of management’s control and depends on market sentiment. When assets are valued cheaply, it creates opportunity. Unfortunately, we don’t know when and how it will happen, so this is a big question mark. One thing we do know is that the management is looking for acquisition opportunities, as they’ve stated that they “seek to extend our presence or diversify our product offerings through selective acquisitions.” The fact that the management looks for “businesses with a relatively steady cash flow” should also provide you with some assurance. Another question you may have is that if the company is paying out everything in cash, where is it getting money to complete acquisitions? Well, management completes deals by raising additional debt and equity. For example, for the recent Inergy acquisition worth $1.8 billion, the company raised $1 billion in debt and paid the rest with cash and stock. The debt may seem high, but the company earns more than enough to cover the interest expense. Looking at the chart below, we can see that the interest coverage ratio has generally been above 1.5x. If we add the non-cash expenses back, the cash coverage ratio would be even higher. This means that the company should be able to maintain the current capital structure. Takeaway The company runs a stable business and sells a product that will always be in demand. Its operation is not capital-intensive, allowing it to pay out much of its operating cash flow. While you shouldn’t expect an increase in dividends without an acquisition, the company is capable of maintaining the current distribution. Keep an eye on acquisition announcements; if history is a good indicator, you should expect dividend increases to follow. However, even if we look at the stock right now, it is hard to argue with its current yield. If you are satisfied with a near-10% yield, then now may be a good time to consider Suburban Propane Partners for your portfolio. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Malaysia: Truly A Bear Market

The Trend Is Your Friend for the Malaysia’s stock market and currency. Sell the iShares MSCI Malaysia ETF on worsening economic fundamentals, worsening technicals and worsening sentiment. The looming unwind of the global carry trade and a relatively pricey valuation for EWM means a further 20% drop in price by year end is highly likely. Malaysia is in big trouble. Its currency and stock markets are in bear markets with no sign things getting better any time soon. First of all, the country has weak economic fundamentals. Analysis by the Malaysian Institute of Economic Research, dated 4h August 2015, shows that the important indicators of consumer confidence, retail trade, employment and residential property are all pointing to weaker economic growth conditions. Then there is the country’s deteriorating terms of trade situation. In 2014 commodity exports accounted for 26% of exports and 18% of GDP. With palm oil, crude and refined products and natural gas, Malaysia’s key export commodities all heading lower, this is putting pressure on Malaysia’s fiscal situation. But don’t lower commodity prices hit many emerging markets? Yes, but in actual fact Malaysia is the only country within the Association of South East Asian Nations region that does not benefit from lower oil prices. This means that Bank Negara the country’s central banks will likely need to ease, weakening the ringgit further. This would be a bad development for the iShares MSCI Malaysia ETF (NYSEARCA: EWM ). The ringgit which is at ten year lows and broke though the key technical level of 3.7 ringgits to the dollar is in a strong bear market and monetary policy divergence is set to make the currency weaker. (click to enlarge) Although a weaker currency could help exports in theory, Malaysia has little room for credit expansion to spur domestic consumption and investment. According to the IMF Malaysia’s debt to GDP stands at 165% – one of the highest of all emerging market countries. This means the ” monetary transmission mechanism ” by which lower policy rates should help economic conditions may not be very effective. With EWM dropping from its 52 week high $16.32 to below $12, hasn’t the market already priced in a lot of these negative factors in already? I don’t think so – with a trailing P/E ratio of 16 times, the market is not cheap. Additionally, Malaysian stocks are highly susceptible to a de-rating once the Fed raises interest rates and fast money investors with their global carry trades accelerate their unwinding of risky asset holdings. That’s because as funding costs creep up for carry trades, the risk return of carry trades in Emerging Markets looks increasingly less favorable, and with fast money investors all conscious of the positioning of other like-minded investors it’s likely that they will be inching nearer to the exit door in order to get out first. This situation and a potential rush to sell could lead to a self-fulfilling prophecy in so many of the higher risk and especially commodity linked markets like Malaysia. For EWM the $12 mark was also a key technical level, as it has been both a support and resistance level several times since 2007 – see chart below. The next key technical level appears to be $10. (click to enlarge) Furthermore, global investors have no doubt been troubled by the ongoing scandal in Malaysian politics concerning the Prime Minister Najib Razak’s personal finances. At a time when Japan is steadily improving its corporate governance, other Asian countries need to do everything to keep up on this front because unlike Japan, countries like Malaysia are unable to implement quantitative easing without spurring massive inflation. The key risk to my thesis is if oil prices were to rally hard or if the policy divergence between the Fed tightening and Bank Negara’s likely easing were to turn around. These two scenarios would alleviate the economic fundamentals somewhat and support a market valuation of 16 times earnings in my view. However, I view this outcome as very low probability. The bottom line is Malaysia is a falling knife. There is no catalyst on the horizon which suggests attempting to pick a bottom could be successful. Investors with the ability to short, should short EWM. Long only investors who want exposure to Asia can find better alternatives. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in EWM over the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.