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Notes On The SEC’s Proposal On Mutual Fund Liquidity

I’m still working through the SEC’s proposal on Mutual Fund Liquidity, which I mentioned at the end of this article : Q: Are you going to write anything regarding the SEC’s proposal on open end mutual funds and ETFs regarding liquidity ? A: …my main question to myself is whether I have enough time to do it justice. There’s their white paper on liquidity and mutual funds . The proposed rule is a monster at 415 pages , and I may have better things to do. If I do anything with it, you’ll see it here first. These are just notes on the proposal so far. Here goes: 1) It’s a solution in search of a problem. After the financial crisis, regulators got one message strongly – focus on liquidity. Good point with respect to banks and other depositary financials, useless with respect to everything else. Insurers and asset managers pose no systemic risk, unless like AIG they have a derivatives counterparty. Even money market funds weren’t that big of a problem – halt withdrawals for a short amount of time, and hand out losses to withdrawing unitholders. The problem the SEC is trying to deal with seems to be that in a crisis, mutual fund holders who do not sell lose value from those who are selling because the Net Asset Value at the end of the day does not go low enough. In the short run, mutual fund managers tend to sell liquid assets when redemptions are spiking; the prices of illiquid assets don’t move as much as they should, and so the NAV is artificially high post-redemptions, until the prices of illiquid assets adjust. The proposal allows for “swing pricing.” From the SEC release : The Commission will consider proposed amendments to Investment Company Act rule 22c-1 that would permit, but not require, open-end funds (except money market funds or ETFs) to use “swing pricing.” Swing pricing is the process of reflecting in a fund’s NAV the costs associated with shareholders’ trading activity in order to pass those costs on to the purchasing and redeeming shareholders. It is designed to protect existing shareholders from dilution associated with shareholder purchases and redemptions and would be another tool to help funds manage liquidity risks. Pooled investment vehicles in certain foreign jurisdictions currently use forms of swing pricing. A fund that chooses to use swing pricing would reflect in its NAV a specified amount, the swing factor, once the level of net purchases into or net redemptions from the fund exceeds a specified percentage of the fund’s NAV known as the swing threshold. The proposed amendments include factors that funds would be required to consider to determine the swing threshold and swing factor, and to annually review the swing threshold. The fund’s board, including the independent directors, would be required to approve the fund’s swing pricing policies and procedures. But there are simpler ways to do this. In the wake of the mutual fund timing scandal, mutual funds were allowed to estimate the NAV to reflect the underlying value of assets that don’t adjust rapidly. This just needs to be followed more aggressively in a crisis, and peg the NAV lower than they otherwise would, for the sake of those that hold on. Perhaps better still would be provisions where exit loads are paid back to the funds, not the fund companies. Those are frequently used for funds where the underlying assets are less liquid. Those would more than compensate for any losses. 2) This disproportionately affects fixed income funds. One size does not fit all here. Fixed income funds already use matrix pricing extensively – the NAV is always an estimate because not only do the grand majority of fixed income instruments not trade each day, most of them do not have anyone publicly posting a bid or ask. In order to get a decent yield, you have to accept some amount of lesser liquidity. Do you want to force bond managers to start buying instruments that are nominally more liquid, but carry more risk of loss? Dividend-paying common stocks are more liquid than bonds, but it is far easier to lose money in stocks than in bonds. Liquidity risk in bonds is important, but it is not the only risk that managers face. it should not be made a high priority relative to credit or interest rate risks. 3) One could argue that every order affects market pricing – nothing is truly liquid. The calculations behind the analyses will be fraught with unprovable assumptions, and merely replace a known risk with an unknown risk. 4) Liquidity is not as constant as you might imagine. Raising your bid to buy, or lowering your ask to sell are normal activities. Particularly with illiquid stocks and bonds, volume only picks up when someone arrives wanting to buy or sell, and then the rest of the holders and potential holders react to what he wants to do. It is very easy to underestimate the amount of potential liquidity in a given asset. As with any asset, it comes at a cost. I spent a lot of time trading illiquid bonds. If I liked the creditworthiness, during times of market stress, I would buy bonds that others wanted to get rid of. What surprised me was how easy it was to source the bonds and sell the bonds if you weren’t in a hurry. Just be diffident, say you want to pick up or pose one or two million of par value in the right context, say it to the right broker who knows the bond, and you can begin the negotiation. I actually found it to be a lot of fun, and it made good money for my insurance client. 5) It affects good things about mutual funds. Really, this regulation should have to go through a benefit-cost analysis to show that it does more good than harm. Illiquid assets, properly chosen, can add significant value. As Jason Zweig of the Wall Street Journal said : The bad news is that the new regulations might well make most fund managers even more chicken-hearted than they already are – and a rare few into bigger risk-takers than ever. You want to kill off active managers, or make them even more index-like? This proposal will help do that. 6) Do you want funds to limit their size to comply with the rules, while the fund firm rolls out “clone” fund 2, 3, 4, 5, etc? You will never fully get rid of pricing issues with mutual funds, but the problems are largely self-correcting, and they are not systemic. It would be better if the SEC just withdrew these proposed rules. My guess is that the costs outweigh the benefits, and by a wide margin. Disclosure: None

AGL Energy Is Hitting The Sweet Spot Right Now

Summary AGL Energy’s net income and free cash flow look uninspiring, but one needs to dig deeper to find the true story. The net income was negatively impacted by an impairment charge whilst almost half of the capex consists of growth capex. Using the sustaining capex and taking AGL’s cost reduction plans into consideration, the company is trading at a 2018 FCF yield of 8-9% and that’s quite appealing. Introduction Very few people might know AGL Energy ( OTCPK:AGLNY ) ( OTCPK:AGLNF ), but this $7.5B market cap company is one of the largest electricity and gas providers in Australia. It trades in energy, but also creates its own power through its renewable and non-renewable power plants. Surprisingly, there’s a decent volume in shares of AGL Energy on the company’s OTC listing, but I would obviously strongly recommend you to trade in the company’s shares through the facilities of the Australian Stock Exchange. As you can imagine, the ASX offers much more liquidity as the average daily dollar volume in AGL Energy is $25M. The ticker symbol is AGL . 2015 was a tad better than expected… I was really looking forward to see the final results of AGL Energy’s financial-year 2015 (which ended in June of this year). We already knew that year wouldn’t be a good year when discussing the net profit, as the company had to record an A$600M ($420M) impairment on some of its (upstream gas) assets. This impairment charge was due to delays in starting up the gas production as well as a lower expected gas price. This obviously meant the book value of those assets might have been overly optimistic, so an impairment charge was the right decision. (click to enlarge) Source: Annual report And indeed, even though the revenue increased by 2% to A$10.7B ($7.5B), the EBITDA fell by a stunning 40% to A$946M. As there’s of course still the usual depreciation expenses and interest expenses, the net profit fell by almost 62% to just A$218M ($145M). Ouch! (click to enlarge) Source: Annual report Even the cash flow statements were a bit uninspiring. The operating cash flow was A$1.04B, and after deducting capital expenditures to the tune of A$744M, the net free cash flow was approximately A$300M ($210M). All this sounds pretty boring and uninspiring, but I prefer to look to the future instead of at the past. But the 2016-2018 period will contain some very nice surprises From this year on, there will be numerous improvements. First of all, the net income will sharply increase again as I’m not expecting to see much more impairment charges. That’s very nice to keep the mainstream investors happy, but my readers already know I care more about cash flow statements than about net income, so I dug a bit deeper, and I’m extremely pleased with what I discovered. Of the A$744M in capital expenditures in FY 2015, only A$395M ($275M) of that amount was classified as “sustaining capex” . As it’s essential for cash flow statements to find out what the normalized free cash flow is, one should only use the sustaining capital expenditures and exclude the growth capex. So if I’d to deduct the A$395M from the A$1,044M in FY 2015, the adjusted free cash flow increases to almost A$650M ($455M). But there’s more. AGL Energy remains on track to complete the objectives it has outlined to reduce costs by FY 2017. AGL’s plan consists of cutting operating costs in, for instance, IT and supply contracts whilst on top of that, the sustaining capital expenditures will decrease from A$395M in 2015 to A$315M in FY 2017. This would increase the adjusted free cash flow by approximately A$200M per year to A$850M ($600M). And keep in mind this doesn’t take the organic growth into consideration, as I’m expecting the company should be able to increase its revenue and operating revenue (whilst reducing the operating costs and sustaining capex). Source: Company presentation And this really puts AGL in an enviable position. The net debt/EBITDA ratio as of at the end of its financial-year 2015 was acceptable at 2.4, but this should start to drop extremely fast as the EBITDA will increase whilst the net debt will be reduced. In fact, even after paying a handsome 4% dividend yield. According to my calculations, in FY 2018, AGL Energy should have a net adjusted free cash flow after paying dividends of approximately A$400M, and this will probably be used to reduce the net debt (which will have a snowball effect as it will reduce the company’s interest expenses, increasing the net operating cash flow). It will also be interesting to see how AGL intends to spend the US$850M in cash flow it expects to generate through asset sales. Investment thesis So yes, AGL Energy’s 4% dividend yield is safe and will very likely be increased in the future. Don’t let the low net income fool you, the cash flow statements are explaining this story much better and the adjusted free cash flow is definitely sufficient to cover AGL’s dividend expenses. I’m also really looking forward to see if the company can indeed reduce its operating costs and sustaining capex, because if it would effectively be able to do so, AGL is trading at an expected free cash flow yield of 8-9% by FY 2018. I’m keeping an eye on AGL Energy and might pull the trigger during a weak moment on the market. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Can You Bet On Duke?

Summary There are multiple concerns with the company right now regarding lawsuits and blackouts, but this company is taking all the right steps towards clean energy to foster long-term growth. Focusing in on the stock’s current level after August/September volatility is key to deciding whether or not an entry point is plausible right now. It’s consistent dividend, but inconsistent cash flow is worrisome, yet I believe the company will pull through.. Duke Energy (NYSE: DUK ) is one of the most stable companies in my portfolio, but is starting to really look like a growth story based upon the ventures its undertaking. The stock rose quite confidently through August before getting hammered by speculation on the Fed in September. I view the mid-September bottom as the lowest level for the rest of the year, unless more Fed speculation develops. I’d argue that Duke is going to trend higher based upon internal factors now, as their shift towards clean energy is creating significant long-term growth opportunities. Performance It’s been a while since I last wrote on Duke, and probably fair enough considering it’s a utility company and its catalysts typically aren’t notable enough to reiterate on a short time frame. Duke, however, is special. This company is constantly in the news, whether it’s about the coal basin fines or its movement to get low-cost energy to east coast residents in a variety of ways, creating a lot of activity in the stock. You can view the YTD trend below: (click to enlarge) Source: StockCharts Growth Catalysts I use this company primarily as a safe investment because I believe utility companies, in theory, are very stable and predictable investments. While the YTD price trend won’t necessarily agree with me, Duke is starting to present itself as a great growth opportunity and to really clarify the forward-looking catalysts, I’m examining the following: Duke has applied for a permit to build a solar facility in Osceloa County in Orlando, FL by spring 2016. This solar facility is expected to bring 500 MW to the county by 2024, which makes it a very large-scale project. Duke is applying for a permit next month to build a natural gas plant in Asheville. It’s approval could come by the end of this year and would serve as a significant catalyst for the stock. They’re closing their already standing electric steam plant in Asheville (378 MW) and replacing it with this new plant, whose capacity is 650 MW. Since 2008, the company has spent $4 billion on wind and solar projects, which helps replace the energy needs of its customers as more coal-fired power plants are retired; while this is the more long-term direction of the company, but is a solid basis for those considering a long position Hurricane Joaquin could negatively impact the stock depending on the number of blackouts that occur and are attributable to Duke Expenditures to close the coal ash basins in an environmentally responsible manner will continue to occur, with the most recent payout being $7 million. They’re due to pay another $10-15 million by 2029 for this location. Fourteen total basins are required to be closed. The $90 million Indiana power plant payment has already been priced into the stock, in my opinion. Marginally lower utility rates for South Carolinians thanks to lower natural gas and lower coal prices. The finishing of several natural gas pipelines from the Marcellus is going to bring low-cost energy to east coast residents, allowing Duke to take advantage. These pipelines have been stalled from completion in the past, but are on track to finish by mid-late November. Keeping an eye on treasury yields is a good idea as these generally move in an inverse trend to utility stocks like Duke. As a further consideration, Duke has been one of the biggest movers on interest rate speculation in recent months and if interest rates do get hiked, Duke will see a noticeable pullback. I do not believe the Fed will hike rates in October, but there will still be added volatility as we near Yellen’s next speech. What’s notable about these growth catalysts is that Duke is moving away from harmful, nonrenewable energy sources towards cleaner fuels like natural gas and solar, which helps to not only make this company more of an ethical investment, but also helps it to reduce operating costs in the long-term and service a wider range of individuals. When you think about that value proposition, it’s hard to not justify an initial entry into the stock right now. From a financial standpoint, I think this company is heading into Q3 earnings with a lot of confidence. It has its highest TTM ROE in two years at 6.91%, and revenue, net income, and EBITDA are all up from a low Q1, which can springboard some easy growth rates for the next earnings report. Additionally, Duke is in constant conversation with federal and state governments about lowering the tax burden that they currently face. If this can retract even a percentage point, Duke is going to be in that much better position. Dividend Consideration The stock is currently yielding 4.67% and it’s worth noting that this is the 88th year in a row that Duke has paid a dividend, that’s nothing short of pure consistency. The dividend that was paid out on Sept. 16 was up 3.8% from the previous payout. Furthermore, the TTM payout ratio is 94.6% – that’s exceptional. The 5Y growth rate seems low at just 2.24%, but the payout is high enough to appease my concerns. Now, there are concerns about whether or not this company can continue to pay its high dividend given its current level of cash flows. OCF has been steady the last two quarters at $1.44 billion, and it’s worth noting that Q3 2014 showed the highest quarterly OCF in two years at $2.55 billion, which is going to create high expectations come the ER. FCF is unfortunately all over the place, due to their debt reduction/issuance activity, and is currently negative at -$212 million for Q2. TTM FCF is $797 million. Essentially, the company shells out anywhere from $551-$565 million in dividend payments every quarter and has not failed to pay these dividends in a very long time. Thinking that Duke may cut its dividend or not payout is not a current concern, despite less than ideal cash flows. Conclusion We’re a while out from the Q3 earnings report in the first week of November, we have a lot to consider about this company’s financial health and valuation. Current P/E is 18.29 which is above the industry average of 15.04, but I’d argue that this is very marginal, all things considered. Duke, to me, is a company that you place a long position into and let it sit and provide you a modest annual return and a good stream of consistent and growing dividends.