Tag Archives: green

Smead Capital Q3 Shareholder Letter

Summary David Dreman’s Red Room and Green Room provides a useful framework for thinking about investments. We argue that a new “Beige” room representing passive investments should be added to the construct. We conclude that the Green Room still offers the best approach for the long-duration investors. The inevitability of market fluctuations caught up with the U.S. stock market and the Smead Value Fund (MUTF: SMVLX ) in the third quarter of 2015. The fund fell 5.93%, while the S&P 500 Index fell 6.44% and the Russell 1000 Value Index fell 8.39%. We were pleased with how our portfolio held up in the decline, but are realistic with our investors about the likelihood that there are periods when our fund will either decline in value and/or underperform the indexes we measure ourselves against. We used the declining prices in the quarter to reduce the number of companies we own and to raise the quality and cheapness of our holdings. Our stocks that contributed the most alpha in the quarter were H&R Block (NYSE: HRB ), NVR (NYSE: NVR ) and Chubb (NYSE: CB ). H&R Block announced a massive stock-buyback totaling 35% of outstanding shares and a Dutch-auction tender offer for $1.5 billion of its shares. NVR has continued to have the wind behind them as home building recovers from a population-adjusted depression in household formation and home buying from 2007-12. Chubb was taken over by Ace LTD at a sizable premium and was sold during the quarter. Among the worst drags on performance was Tegna (NYSE: TGNA ), which fell sharply after splitting from Gannett. Tegna’s ownership of network-affiliated TV stations got caught in cord-cutting and advertising revenue competition fears. We find this ironic. As the value of cellular spectrum increases and a blowout political advertising season looms in 2016, we get very excited about their future. Even today, 55% of adults in America use local TV news as their prime form of news. PayPal (NASDAQ: PYPL ) suffered from its popularity prior to the split with eBay (NASDAQ: EBAY ). Many major companies covet their 75% share of the secure online payments market and it has corrected along with other stocks with above-average P/E ratios. Navient (NASDAQ: NAVI ) disappointed investors during the quarter. They have experienced unusual loan losses in their portfolio and we sold the stock during the quarter. The Red, Green, and Beige Room One of the great investing books of the last 40 years was David Dreman’s, Contrarian Investment Strategy . He started it by telling of a hypothetical gaming casino with two separate, but adjoining, rooms: the red room and the green room. The red room was packed with people and excitement and almost every day someone hit a huge jackpot setting the building on fire with electricity. Every seat was packed, others waited their turn to play and the anticipation was palpable. Yet most of the players left the casino each night without their money, because the odds were stacked heavily in the house’s favor. The green room was relatively quiet and included many empty seats. Players sat patiently and most of them had amassed large chip stacks. Virtually nobody hit it big each day, but through patience and odds stacked heavily in their favor, most the participants in the green room created wealth. In the last 20 years, we think a new room should be added to Dreman’s imaginary casino. We call it the “beige” room. This room is filled with investors who had the natural reaction to bad experiences in the red room, but lacked the patience to succeed in the green room. In this room, you will find participants in passive indexes. Additionally, we think stock market difficulties since 2000 triggered former green room participants to lose their patience, thus contributing to the popularity of being average. Dreman was trying to explain the difference between investing in common stocks based on excitement about future prospects versus buying stocks based on value or intrinsic value. This has been over-simplified by using monikers such as growth stock and value stock. For the sake of our discussion, let’s say that a value stock is one priced below the average stock and a growth stock is one priced above the average. The most common averages used are the price-to-earnings ratio (P/E) and the price-to-book ratio (P/B). Every academic study we’ve seen shows that over one, three, five and seven-year time periods, the cheapest stocks outperform the average and most expensive stocks. The most famous of these studies are the ones in Dreman’s book (see below), Fama and French’s P/B study and Francis Nicholson’s study from 1937-1962. Dreman used P/E quintiles, while Fama and French used P/B ratios and both studies rebalanced at the end of each year. They argued that excess return could be had by simply starting the year with the cheapest stocks in the S&P 500 Index and replacing the ones which found favor during the year with the latest ones to find the doghouse. These studies led to the “Dog’s of the Dow” strategy, where an investor purchases the 10 cheapest stocks in the index based on dividend yield (another measurement of cheapness). We found Nicholson’s study (see below) even more fascinating because his portfolio was static. It showed that cheap stocks at the beginning not only outperform in the next 12 months, but that their outperformance continues on for seven years. We like to say that cheap stocks are the gifts which keep on giving. Warren Buffett, the number one disciple of the father of value investing, Benjamin Graham, started out being a green room common stock investor and continues to do so in the private equity realm as well. In the 1960s, he ran into his investing partner, Charlie Munger. Mr. Munger advocated for a qualitative addition to these quantitative strategies. He and Buffett believe that the long duration investor, with great patience, can benefit from owning very high quality businesses purchased at a time of distress. They believe that the primary responsibility of the wise long duration investor is to wait until a splendid business gets in the doghouse due to a bear market in stocks or a temporary corporate stumble. Then they pounce on that opportunity by “backing up the truck” and loading up on shares. Munger’s theory was proven correct in a seminal study done by Ben Inker at Grantham, Mayo and Van Otterloo (see below). His study showed that certain qualitative characteristics like low leverage, high and sustainable profitability, low earnings volatility and low volatility in stock trading have proven to add alpha over long durations. We at Smead Capital Management start our research by leaning toward Dreman’s study, because “valuation matters dearly.” We love Nicholson’s study because the seven-year holding period shows that you can own businesses for a long time and keep your portfolio turnover down. Turnover is a huge annual tax on large-cap equity portfolios and the cost averages 81 basis points or 0.81% annually among large-cap U.S. equity funds. However, we at Smead Capital are risk averse and recognize that human nature gets in the way of holding businesses for a long time, especially in the low-quality arena. This is where Munger and Inker, with their focus on high-quality, come into play and how we seek to reduce portfolio risk proactively. In late 2008, after getting clobbered all year, we received many calls to the effect of “Bill, we know you want to own stocks for a long time and we believe in what you are doing. But shouldn’t we get out of the way of this decline in case we have a total economic meltdown like in the 1930s?” Our answer was simple. The only “safe” alternative was investing in Treasury bills/bonds or government-insured certificates of deposit. We pointed out that the merit of those “safe” investments was the backing of the U.S. government. Our government’s guarantee is no better than its ability to collect income taxes. Those taxes are paid by the largest companies in the U.S. and their employees. Therefore, the safety of Certificates of Deposits and T-bonds came from the safety provided by the qualitative characteristics of the stocks in our portfolio. Selling quality stocks at a time of distress was an especially bad idea, in our opinion. What does the red room look like today? It is filled with investors seeking above-average returns by paying extremely high P/E and P/B ratios for companies with perceived “bright” futures in an attempt to hit the jackpot. Red room regulars are excited about social media, internet-based information/advertising, online shopping, fast food, cloud computing and the “sharing” economy. It is enough to make you want to open a bureau in Silicon Valley. What is going on in the beige room lately? The beige room (index investing) has a tendency to work great in an uninterrupted bull market like the one we enjoyed from March of 2009 to the peak in the summer of 2015. There is historical evidence of the index becoming overloaded with shares of the previous era’s most successful companies, ala tech stocks in 1999. In effect, valuation works against the index when it has been particularly effective in the prior five to ten years. The S&P 500 Index has enjoyed the tailwinds of its overweight position in multinational companies, who drafted on emerging market growth in staple products, heavy industrial infrastructure investments in China and technology purchases everywhere. Since we are of the opinion that the U.S. economy will do better in the next ten years as compared to the last ten years, we contend that the index is at a disadvantage because nearly half of its revenue comes from abroad. Lastly, there are some pretty persuasive arguments which surround the idea that index returns will be in the 6% area going forward. These theories take into account dividends that are lower than historical averages and interest rate increases over time which would reduce historically high profit margins. Our opinion is that the beige room is appropriate for those who are incapable of investing in the green room or unable to figure out whom is. Owning U.S. large-cap equity for a long time is preferable to most other liquid investments and you can get average performance from an attractive asset class in the beige room. Where are folks congregating in the green room? They are rummaging around in financial service companies like banks and insurance, which have low P/E and P/B ratios. The death of traditional media and advertising is a foregone investor conclusion and the lowest P/E and P/B ratios lists are sprinkled with TV content and broadcasting companies, network-affiliate station owners and newspaper/magazine publishers. We are always on the lookout for companies on the cheapest list which meet our eight criteria for stock selection because valuation matters dearly, we want to own companies for a long time and to do that we must own very high quality companies. Thank you for your ongoing confidence in our methodology. The information contained herein represents the opinion of Smead Capital Management and is not intended to be a forecast of future events, a guarantee of future results, nor investment advice. The Smead Value Fund’s investment objectives, risks, charges and expenses must be considered carefully before investing. The statutory and summary prospectuses contain this and other important information about the investment company, and it may be obtained by calling 877-807-4122, or visiting smeadfunds.com . Read it carefully before investing. Mutual fund investing involves risk. Principal loss is possible. As of 09/30/2015 the fund held, 6.02% of NVR Inc., 5.61% of Amgen Inc., 5.17% of Tegna Inc., 5.04% of Berkshire Hathaway Inc. Class B, 5.01% of American Express Co., 4.81% of JPMorgan Chase & Co., 4.42% of Bank of America Corp., 4.34% of H&R Block Inc, 4.33% of Aflac Inc., and 4.29% of Wells Fargo & Co. Fund holdings are subject to change at any time and should not be considered recommendations to buy or sell any security. Current and future portfolio holdings are subject to risk. The S&P 500 Index is a market-value weighted index consisting of 500 stocks chosen for market size, liquidity, and industry group representation. The Russell 1000 Value Index is an index of approximately 1,000 of the largest companies in the U.S. equity markets; the Russell 1000 is a subset of the Russell 3000 Index. The Russell 1000 Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell 1000 companies with lower price-to-book ratios and lower expected growth values. Price/Earnings (P/E) is the ratio of a firm’s closing stock price and its trailing 12 months’ earnings/ share. Price / Book (P/B) is the current price divided by the most recent book value per share. Alpha is the excess return of a fund relative to the return of its benchmark. Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), a model that calculates the expected return of an asset based on its beta and expected market returns. A Dutch auction tender for public offer is a structure in which the price of the offering is set after taking in all bids and determining the highest price at which the total offering can be sold. In this type of auction, investors place a bid for the amount they are willing to buy in terms of quantity and price. Small- and Medium-capitalization companies tend to have limited liquidity and greater price volatility than large-capitalization companies. Active investing generally has higher management fees because of the manager’s increased level of involvement while passive investing generally has lower management and operating fees. Investing in both actively and passively managed funds involves risk, and principal loss is possible. Both actively and passively managed funds generally have daily liquidity. There are no guarantees regarding the performance of actively and passively managed funds. Actively managed mutual funds may have higher portfolio turnover than passively managed funds. Excessive turnover can limit returns and can incur capital gains. Frank Russell Company is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell ® is a trademark of Russell Investment Group. The Smead Value Fund is distributed by ALPS Distributors, Inc. ALPS Distributors, Inc. and Smead Capital Management are not affiliated.

Retirement Portfolios – Volatility, Taxes, And Risk

Summary This article refines a previously-presented method for qualifying investment portfolios as suitable for retirement. It uses simple formulas for the effect of taxes on returns and volatilities, which leads to a surprising result: an investor in a higher tax bracket can accept a lower volatility. The method also extends the previous analysis to cover more volatile portfolios, such as those trading XIV and VXX. Introduction A previous article introduced a method for comparing investment portfolios based on back-test results. It considered a recently-retired person who: – Invests an initial amount at the start of retirement, – withdraws a percentage of the initial amount each year, adjusted for inflation, and – holds a portfolio with an expected volatility and return for the duration of their retirement. The previous article showed how to make a go/no-go decision about investing in a portfolio, based on its expected after-tax annualized return, after-tax annualized volatility of returns, and historical inflation. However, back-tests provide pre-tax returns and volatilities, not after-tax figures, and the current level of inflation remains below the mean historical level. To improve the usefulness of the method, this new article shows how to decide whether to invest in a portfolio based on its expected pre-tax returns and volatilities, and based on other-than-historical inflation rates. As before, this article defines risk as a number with direct impact on the retiree, the chance of running out of money during retirement; rather than as a more abstract number, the annualized volatility of returns. A prudent retiree would first seek to reduce risk, the chance of running out of money, to a negligible level. That ensured, the retiree would next seek to increase the portfolio’s balance at the end of retirement to leave a legacy. Simulation method As in the previous article, this analysis uses a Monte Carlo simulation tool at portfoliovisualizer.com to test the risk of a portfolio with a given volatility and return. Table 1 shows the input parameters for the simulation. For each volatility shown in the table, the analysis tried various values of expected return until the simulation output showed a 99% probability of success. This means that at the preset annual withdrawal and volatility settings, 99% of Monte Carlo trials showed a positive balance at the end of retirement. In other words, the retiree did not go broke. The expected return setting that yields 99% probability of success represents the average annualized return necessary throughout retirement to reduce risk to a negligible level at the given settings for annual withdrawal and volatility. Defining negligible risk as 99% probability of success (1% risk) seems appropriate considering the severity of the consequences of running out of money. The simulation tool also provides a median end balance, the retiree’s legacy at the end of retirement in 50% of Monte Carlo trials at the given withdrawal rate and volatility settings, and at the expected return necessary for 99% probability of success at those settings. The simulator shows median end balance discounted for inflation, and therefore expressed in the same dollars as the initial invested amount at the start of retirement. This procedure yielded (volatility, return) pairs at 1% risk of going broke for withdrawing an inflation-adjusted fixed amount annually, equal to 3% of the initial amount. It also provided the median end balance at this volatility, return, and withdrawal rate. Simulation results The simulation tool provided the results in Table 2, where: “Median annual return” = (Median end balance / Initial amount)^(1/30)-1. This gives the median annual rate of return during retirement after inflation and withdrawals at the selected withdrawal rate, the selected volatility, and the rate of return required to reduce risk to 1%. Consider, for example, a portfolio with 15% volatility – similar to the historical volatility of the S&P 500 index. Suppose inflation remains near zero. Table 2 shows that a retiree would need an average annual return of 12% in this portfolio for an acceptable risk of going broke. If the portfolio in fact delivers this 12% return, year after year, then the investor will benefit from a median return after withdrawals of 9%, and the original investment of $1M will rise to a median legacy of $13M at the end of retirement. While this median performance seems more than adequate, remember that there remains a 1% chance of leaving no legacy at all. Each row in Table 2 represents a hypothetical portfolio. Each portfolio has the same 1% risk of going broke, but the portfolios with higher volatility require higher annual returns to reduce risk to that level, and as a consequence, investors benefit from higher median annual returns, and their heirs should benefit from greater legacies. An investor who chooses a higher-volatility portfolio at the same level of risk should expect to experience a jumpier account balance and to leave a greater legacy. Effect of inflation Chart 1, graphed from Table 2, shows how annual return required for 99% success probability increases with volatility. A portfolio with annual return on or above the line has acceptable risk. The lines in Chart 1 can be considered “lines of equal risk,” or in this case, “lines of 1% risk.” The difference between the two lines in Chart 1 is close to the mean historical inflation rate (4.18%). Over the range studied here, the annual return required for 99% success probability can reasonably be estimated as the zero-inflation annual return (lower line in Chart 1), plus the expected inflation rate. For simplicity, the remainder of this article assumes zero inflation, which is close to the situation today. Chart 2, also graphed from Table 2, shows how median annual return (and therefore the investor’s legacy) also increases with volatility. As explained above, each row in Table 2 gives returns for a different volatility, but all rows have the same 1% risk. Similarly, all points on the same line in Chart 2 have the same 1% risk. For these curves, annual return was selected to reduce the worst-case risk to 1% at a given volatility and withdrawal rate. Chart 2 shows that for two portfolios with equal risk, an investor leaves a larger legacy by selecting the portfolio with higher volatility, provided that it delivers the required higher return. Chart 2 also shows, like Chart 1, that the difference between the two curves is close to the mean historical inflation rate (4.18%). Over the range studied here, the median annual return with inflation can reasonably be estimated as the zero-inflation median annual return (lower line in Chart 2), plus the expected inflation rate. Required pre-tax return Until now, the analysis has not considered the effect of taxes. The required return as a function of volatility in Chart 1 must apply to after-tax returns and volatilities, because those are what affect the balance in the retiree’s account. This begs a question, what are the corresponding pre-tax volatilities and returns? Define “Rtn” as the required annual after-tax return for a given after-tax volatility (“Vol”), that is, the annual return required for 99% probability for reaching the end of a 30-year retirement, making 3% annual withdrawals, and assuming zero inflation. At a marginal tax rate “Tax,” the after-tax return: Rtn = (1-Tax)*PreRtn, where PreRtn is the pre-tax return (Equation 1). The after-tax volatility is reduced by the same ratio: Vol = (1-Tax)*PreVol, where PreVol is the pre-tax volatility (Equation 2). Equation 2 holds true for volatility because volatility is a standard deviation (“σ”), and for a random variable X and a constant m: σ(m*X) = m*σ(X). For example, at a tax rate of Tax = 50%, for a portfolio to provide an after-tax volatility of Vol = 15% and an after-tax return of Rtn = 12%, it must have a pre-tax return of PreRtn = Rtn/(1-Tax) = 24%, but it can have a pre-tax volatility as high as PreVol = Vol/(1-Tax) = 30%. Table 3 and Chart 3 show after-tax and pre-tax (volatility, return) pairs for 1% risk. The after-tax volatilities and returns come from Table 2, and the pre-tax volatilities and returns come from applying the simple equations in the preceding paragraph to the after-tax figures. Table 3 and Chart 3 provide pre-tax figures for 50% and 25% marginal tax rates: For example, in Chart 3, portfolio “K” has 45% after-tax volatility, which, from Chart 1, requires 67% after-tax return for 1% risk. With 25% tax, this corresponds to pre-tax volatility of 60% and pre-tax return of 89%. With 50% tax, this corresponds to pre-tax volatility of 90% and pre-tax return of 133%. Back-test results are pre-tax. By the way, these stratospheric volatilities and back-test returns are included here for exceptional strategies, such as those trading derivatives of derivatives (XIV and VXX). Charts 3b and 3c show an expanded view of more usual volatilities and returns. Consequently, Charts 3, 3b, and 3c provide an investor with a way to qualify a portfolio for retirement – it must fall above the line in these charts that corresponds to investors’ marginal tax bracket. If an investor used the lines in the previous article (which were after-tax lines) to qualify a portfolio based on back-tested volatility and return (which are pre-tax figures), this would have been too stringent a qualification test. In effect, the investor would have required a return above the green line in Chart 3, when a return above the yellow or red line would have sufficed. To take inflation into account, the investor needs to shift the curves in Chart 3, 3b, or 3c upward by the expected inflation rate. Chart 3b shows an expanded view of the low-volatility part of Chart 3: Chart 3c shows an expanded view of the midrange of Chart 3: Charts 3, 3b, and 3c show that at a given back-test volatility – which is a pre-tax volatility – the required back-test return – which is a pre-tax return – is lower for a higher tax rate. This non-intuitive result occurs because taxes not only reduce returns, but also reduce volatility. When an investor does poorly, so does the tax collector. Effectively, the tax collector shares the investor’s risk along with the investor’s returns. This analysis has other interesting (and perhaps non-intuitive) consequences: Consider a strategy with back-tested (pre-tax) average annual return of 25% and volatility of 40%. Row F in Table 3 shows that this has acceptable risk for an investor in the 50% tax bracket, but row H in Table 3 shows that it is too risky for an investor in the 25% tax bracket. This investor needs the tax collector to share more of the risk. Now, consider a strategy with a back-tested (pre-tax) average annual return of 20% and volatility of 40%. Rows F and H in Table 3 show that this is too risky for an investor in either tax bracket. However, if that investor keeps 25% of the retirement account in that portfolio and 75% in cash at zero return and zero volatility, the account would have a pre-tax return of 25% * 20% = 5% and a pre-tax volatility of 25% * 40% = 10%. Rows B and C in Table 3 show that this is enough return at this volatility to reduce risk to an acceptable value for an investor in either tax bracket. Discussion and conclusion Investors could use this method to qualify portfolios for retirement investments, based on back-tested returns and volatilities, and taking taxes and inflation into account. The method extends to cover unusually volatile portfolios: even those with 50% volatility can provide acceptable risk after taxes and inflation, provided they maintain acceptable returns. This opens a door toward including non-traditional portfolios – such as those trading VXX and XIV – in a prudent retiree’s account. This method is subject to the classical limitation of back-tests: they do not consistently predict future results. Most investors will want to maintain a mix of qualified portfolios, including a traditional core. Acknowledgement: The author thanks Dr. Toma Hentea for reviewing and clarifying the article. Appendix: Alternative calculations with a pseudo-Sharpe ratio Although Charts 3, 3b, and 3c provide enough information to make a go/no-go decision about investing in a portfolio, there is another method for looking at the data. Both methods reach the same decision in the same situation. For the second method, portfolio back-tests provide not only (volatility, return) pairs, but they also provide a ratio of annualized return to annualized volatility. This is similar to a Sharpe ratio, except it assumes a risk-free return of zero (close to the situation today). Table 4 and Chart 4 show the required return/volatility for 1% risk, using the data from Table 3. Chart 4 shows that the required return/volatility ratio (“pseudo-Sharpe ratio”) for 1% risk increases with volatility over the range studied. It also shows that the pseudo-Sharpe ratio required for a given portfolio (“A” through “L”) does not change with the investor’s tax situation. This follows directly from equations 1 and 2, because volatility and required return change by the same proportion when changing tax situations. Like Chart 3, Chart 4 provides an investor with a method to qualify a portfolio – its pseudo-Sharpe ratio must fall above the curve in Chart 4 for that investor’s marginal tax bracket. Chart 4b provides an expanded view of the lower-volatility part of Chart 4: Charts 4 and 4b show that at a given back-test volatility, the required back-test pseudo-Sharpe ratio for 1% risk is lower for a higher tax rate. As in Charts 3, 3b, and 3c, this occurs because the tax collector shares the investor’s risk along with the investor’s returns.

NRG Energy – Adding Value With A Business Restructuring

Summary NRG Energy’s dream of building one of the first integrated fossil fuel and clean energy businesses will go unfulfilled. NRG Energy plans to spit off its clean energy business in a few months time, forming what will be known as “GreenCo.”. While the fossil fuel and clean energy business have many synergies, a separation of these two businesses is likely more viable in the current investment atmosphere. NRG Energy’s clean energy business will have to compete with ultra-competitive solar companies as a standalone company, which could prove to be a large obstacle. Over the past few years, NRG Energy (NYSE: NRG ) has stood out in its attempt to become the first major integrated fossil fuel and renewable energy company. While the company has successfully integrated these two businesses to some extent, there have been many obstacles that have limited NRG Energy’s overall success in this endeavor. There are many aspects of the distributed solar business, in particular, that do not mix well with the traditional fossil fuel power business. While these two businesses are not at odds in theory, the relatively unproven distributed solar business has made investors wary. As such, the company decided to split off its clean energy business into what will be known as “GreenCo.” Here is a chart explaining why NRG Energy is planning to split off its clean energy business. (click to enlarge) Source: NRG Energy Integration Problems NRG Energy’s plan to integrate a large clean energy business was not flawed in theory. NRG Energy could use the comparatively vast resources from its fossil fuel business to help catalyze its burgeoning clean energy business. This would put the company at a financial advantage against pure play clean energy companies like Vivint Solar (NYSE: VSLR ). However, the downsides associated with such integration seem to be outweighing the benefits. One of the main problems with this strategy is that fossil fuel and clean energy investors are generally of different mindsets. Fossil fuel investors are usually more interested in more stable businesses, whereas clean energy investors are more interested in growth. While NRG Energy’s clean energy business has enormous growth potential, many fossil fuel investors are likely off-put by the segment’s more risky nature. On the flip side, many clean energy investors are likely put-off by NRG Energy’s relatively low growth fossil fuel business. While there are indeed many investors that find the combination of businesses attractive, it seems as if separating these two businesses would attract more investors on balance. In addition, both the fossil fuel and clean energy businesses require a huge amount of attention. Pure-play distributed solar companies like SolarCity (NASDAQ: SCTY ) already have their hands full just managing their specific businesses. In NRG Energy’s case, distributed solar is just one segment in a larger business portfolio. It is unlikely that the company would be able to invest the optimal amount of time and energy into all of its businesses. While many synergies certainly do exist in NRG Energy’s fossil fuel and clean energy businesses, it seems as though separating the businesses would unlock more value due to the combination of current investor sentiment and limited attention/resources. Pure-Play Approach NRG Energy’s pure-play approach will likely attract more investors over the long-run. However, this also means that its renewable spin-off will be competing against the likes of SolarCity, Vivint Solar, etc, with much less assistance. The big financial advantage of NRG Energy’s clean energy businesses will mostly disappear once the company is spun-off from its fossil fuels business(NRG Energy is planning to give the GreenCo a financial limit of $125M in 2016). With that being said, NRG Energy’s clean energy business is still doing relatively well, and will likely succeed even without the help of the company’s main business. NRG Energy believes that there is ~$1B that can be unlocked by spinning off its clean energy business, which could very well be true given the benefits of separation. As investors will likely favor this strategy, as was mentioned before, NRG Energy is likely going down the correct path. Shareholders should benefit from the company’s planned pure-play approach, especially given the increasing complexities of the clean energy business. While CEO David Crane’s integrated energy plan was sound in principle, it may have been too early to implement this as investors have not fully committed to the idea. Obstacles While there are definitely many positives associated with a clean energy spin-off, the company could find it difficult to adjust as a pure play. Also, the company may have more trouble financing its operations as was mentioned before. Whereas the NRG Energy’s clean energy business currently has an advantage in financing due to its relationship with NRG Energy’s fossil fuel business, this will no longer be the case after the spin-off occurs. Competing against well-established companies like SolarCity and Vivint Solar could prove to be more difficult than expected. Regardless, the distributed solar market in particular is still incredibly underpenetrated, which means that NRG Energy’s GreenCo has great growth opportunities. Conclusion While NRG Energy’s grand plan to integrate massive fossil fuel and clean energy businesses has been derailed, the company is still undervalued at a market capitalization of $5.1B . Given that most of the company’s growth potential lies in its clean energy segment, NRG Energy may no longer be undervalued after it splits off its clean energy business. In theory, the synergies of NRG Energy’s fossil fuel and clean energy business should have outweighed the negatives of such integration. With that being said, investors are still largely uncomfortable with this idea, thus making the planned spin-off a smart decision for shareholders.