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ITC Holdings To Join Utility Industry M&A Wave

ITC Holdings announces strategic review that includes a sale of company; stock soars 12.8%. We believe transaction is likely at $44-$47 per share, as strategic bidders National Grid, Iberdrola, and Berkshire Hathaway participate in competitive bidding. ITC Holdings is attractive target with $120-$160 billion capital investment opportunity, unique regulatory structure; Merger approval process may be shorter than other industry M&A deals. Shareholders in ITC Holdings (NYSE: ITC ), a leader in electric transmission in the US, saw its stock soar 12.8% from Friday’s close to $38.04 per share following an announcement that the board is reviewing its strategic options. The possibilities under consideration include a sale of the company, and we believe, for several reasons, that an outright sale of ITC Holdings to a strategic bidder is a highly probable outcome. We are currently in the middle of a significant M&A boom in the power and utility industry: Over $45.4 billion in deals were announced in the third quarter of 2015. This quarterly total exceeds the total transaction value of announced deals in the prior four quarters combined by over $7 billion ($38.3 billion in total from Q3 2014 to Q2 2015). Among the largest announced deals were the acquisition of Oncor Electric Delivery from the bankrupt Energy Future Holdings for $12.6 billion, Southern Company’s (NYSE: SO ) $12 billion acquisition of AGL Resources (NYSE: GAS ) ( as discussed here ), and the $10.4 billion acquisition of TECO Energy (NYSE: TE ) by Emera ( OTCPK:EMRAF ). (click to enlarge) Source: PwC report on Power and Utility Industry, October 2015. The recent wave in M&A activity in the regulated power industry is precipitated by a change in market dynamics from higher operating and maintenance costs and increased capital investment requirements. The costs of new utility construction and facility improvements continue to march upwards, as expense for labor and building materials rise. While allowed rate increases have been able to offset a considerable portion of these costs, rate increases for customers have been under pressure from a lower cost of capital in a low interest rate environment. With this underlying shift in the market taking place across the industry combined with stagnant demand for many utilities in their existing territories, several companies are looking beyond their own market to expand their customer base and generate economies of scale through operating efficiencies. These factors have served as the catalyst for several strategic acquisitions over the past twelve months including the larger deals announced in the third quarter as well as transactions as Exelon’s (NYSE: EXC ) $6.8 billion purchase of Pepco Holdings (NYSE: POM ). We anticipate that these industry factors will continue to drive consolidation and M&A activity is likely to remain robust through 2016. (click to enlarge) Source: ITC Holdings investor presentation, Edison Electric Institute 50th financial conference, November 8, 2015. With this industry backdrop, we believe the Board of ITC Holdings is making a shareholder-friendly decision in reviewing all of its strategic alternatives at this time and the Board appears to be taking the first steps in fulfilling its obligation to pursue value-enhancing action when the opportunity arises. Over the past three months, ITC Holdings’ stock has traded in the $31-$33 per share range and as much as 31% below its 52-week high trading price of $44 per share. This underperformance is very discouraging for long-term shareholders and many patient investors may be ready to cash out of their holdings at the right price. (click to enlarge) Source: ITC Holdings investor presentation, Edison Electric Institute 50th financial conference, November 8, 2015. It is our view that putting the company up for sale now would deliver the greatest value for ITC Holding shareholders. We believe that a sale of ITC Holdings would result in an all-cash transaction with consideration worth between $39 to $47 per share. Our valuation is based on a PE multiple of 18.5x to 22.5x on projected 2016 earnings per share of $2.10. This PE multiple range is consistent with multiples seen on recent transactions in the regulated power industry. Furthermore, the typical premium over the unaffected stock price we have seen is 20% to 40% which would imply a transaction value of $39 to $45 per share. In our view, the high end of these ranges would represent tremendous value for shareholders and exceed the all-time high trading price for ITC Holdings. From the standpoint of the strategic bidders believed to be interested in ITC Holdings, there are many compelling reasons to acquire the company and pay top dollar. One of the most attractive aspects of ITC Holdings is the significant future infrastructure requirements. Management estimates an investment in upgrades of $120 – $160 billion will be required through 2030 driven by an aging infrastructure and regulatory and compliance investments. The opportunity to put well over a hundred billion in capital to work and earn a decent return on the invested capital for the foreseeable future will appeal to the larger strategic acquirers such as National Grid (NYSE: NGG ), Iberdrola ( OTCPK:IBDSF , OTCPK:IBDRY ), Berkshire Hathaway ( BRK.A , BRK.B ) Energy, and NextEra Energy (NYSE: NEE ). Additionally, the unique regulatory structure that ITC Holdings is subject to is a very attractive characteristic of the company and provides ITC Holdings with an advantage over other potential acquisition targets in the regulated power industry. ITC Holdings is regulated at the federal level by the Federal Energy Regulatory Commission and the agency acts in setting the rates for the company’s vast electric transmission assets that span the U.S. Midwest. As a result of this regulatory structure, the regulated return on equity for ITC Holdings has consistently exceeded that of its state-regulated peers by as much as 200 basis points. We believe there is also a transaction-specific benefit of the unique regulatory structure The downside risk for ITC Holdings shareholders (and any shareholder of a utility company that is acquired) is the complex regulatory approval process of an acquisition. The unpredictable and often politically-charged process has delayed some transactions for several months. The average length from announcement to completion of an acquisition in the power and utilities industry is nearly 8 months between 2009 and 2013. As many investors in recent M&A deals will attest, the figures for 2014 and through the third quarter of 2015 are likely higher. For example, the proposed Exelon-Pepco transaction has been pending for over 19 months and may finally be approved as we approach the two-year anniversary of the April 2014 acquisition announcement. (click to enlarge) Source: Deloitte Center for Energy Solutions. Understandably, this burdensome process may deter a potential acquirer from pursuing a negotiated agreement. However, for ITC Holdings, we do not believe this will hold true. In our view, a proposed transaction may not have to receive the approval of each state jurisdiction in which ITC Holdings’ electric transmission subsidiaries operate. We believe approval of the Federal Energy Regulatory Commission and the Federal Antitrust authorities would satisfy the company’s statutory requirements. According to ITC Holdings’ most recent 10-K filing, state regulators’ authority and scope of oversight is quite limited: “The regulatory agencies in the states where our Regulated Operating Subsidiaries’ assets are located do not have jurisdiction over rates or terms and conditions of service. However, they typically have jurisdiction over siting of transmission facilities and related matters as described below. Additionally, we are subject to the regulatory oversight of various state environmental quality departments for compliance with any state environmental standards and regulations.” In our view, the FERC will have jurisdiction, from a power and utility industry standpoint, over the approval of any proposed transaction and would make the determination of the competitive effects of a merger and the long-term impact on the ratepayers. While the state jurisdictions may be involved in a regulatory review, we do not expect a state agency within the power industry to be in a position to make a binding decision as to the competitive effects of a proposed transaction. This unique regulatory structure therefore avoids a potential “DC Public Service Commission”-type disruption to a merger approval process where a small, activist group minimally impacted by a large multi-jurisdictional merger has the ability to delay the process or extract additional financial benefits from the parties. In conclusion, we believe a sale of ITC Holdings in the range of $39-$47 per share is in the best interests of shareholders and is a very likely outcome of the Board’s current strategic review. Based on the attractive characteristics and prospects of ITC Holding, we believe there will be active and competitive bidding by large strategic players in the regulated power industry and the results will be a final transaction price in the $44-$47 per share range. As such, we expect the power and utility industry consolidation will show no signs of slowing in 2016. And importantly, in contrast to several of the current prolonged transactions, we believe a proposed acquisition involving ITC Holdings will navigate the complex regulatory process successfully and in a more appropriate timeframe. 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.

There Is No Defense Of Closet Indexing

Closet indexing occurs when a high-fee mutual fund or ETF promises to be able to “beat the market”, charges a fee premium relative to its benchmark and then largely mimics the performance of the benchmark. This is a tremendous problem for investors, because they usually end up paying hefty fees in exchange for empty promises. When I review client portfolios, I find that an alarmingly high number of them hold closet index funds (before I release these demons into the netherworld). I bring this up in response to a piece today on Morningstar titled ” In Defense of Closet Indexers “. The subtitle is “They are no worse (or better) than other forms of active management”. There are two issues here I’d like to highlight: The false dichotomy of “passive” versus “active” creates confusion from the start. The financial industry seems very confused on this subject, thanks to unclear academic literature on the topic. We tend to assign the term “active” to funds that are literally more active. By this definition, Warren Buffett is a “passive” investor, because he doesn’t often change his portfolio. This is obviously ludicrous. The correct definition of passive is a strategy that tries to capture the market return, versus the active investor who tries to be able to beat the market return. But since we all deviate from global cap weighting (the one true benchmark of outstanding financial assets), we are all active investors. In a world of low-fee indexing, this distinction has become increasingly muddled by market commentators. The Morningstar article defends high-fee active management based on a false dichotomy. This debate is not about “active” and “passive”, it is about the efficiency in which we are active. The core of the defense in the article is the fact that four of American Funds’ U.S. stock funds have bested the S&P 500 over the last 15 years. This is true, but none of them have bested the S&P on an after-tax and fee basis in the last 1, 3, 5 or 10 years. In fact, many of those funds have dramatically underperformed after taxes and fees over these periods, as you can see in the figure below (I wasn’t sure which funds he was referencing, but the following six funds are US equity-heavy). So yes, if you had the foresight 15 years ago to pick those funds, then you “beat” the S&P 500, but if you were an investor who bought one of these funds at any time in the last decade, you bought a fund that gave you 95% of the S&P 500 correlation with a lower after-tax and fee return. And given the propensity for investors to chase returns, it’s almost certain that the vast majority of the people who own these funds have not captured that 15-year outperformance. In other words, most of the investors in these funds have invested in a closet index and not benefited from it. (click to enlarge) In general, I agree with the cited academic paper referring to closet index funds as a “gigantic mis-selling phenomenon”. I don’t think we should ban these funds, as the paper asserts, but I do think we need to properly assess this problem so investors can make better-informed decisions. We still siphon way too many billions of dollars into investment firm coffers for no good reason. That’s money that is directly harming your retirement and livelihood. There is no practical defense of this.

December Update – ETFReplay.com Portfolio

The ETFReplay.com Portfolio holdings have been updated for December 2015. I previously detailed here and here how an investor can use ETFReplay.com to screen for best performing ETFs based on momentum and volatility. The portfolio begins with a static basket of 14 ETFs. These 14 ETFs are ranked by 6-month total returns (weighted 40%), 3-month total returns (weighted 30%), and 3-month price volatility (weighted 30%). The top 4 are purchased at the beginning of each month. When a holding drops out of the top 5 ETFs, it will be sold and replaced with the next highest ranked ETF. The 14 ETFs are listed below: Symbol Name RWX SPDR DJ International Real Estate PCY PowerShares Emerging Mkts Bond WIP SPDR Int’l Govt Infl-Protect Bond EFA iShares MSCI EAFE HYG iShares iBoxx High-Yield Corp Bond EEM iShares MSCI Emerging Markets LQD iShares iBoxx Invest Grade Bond VNQ Vanguard MSCI U.S. REIT TIP iShares Barclays TIPS VTI Vanguard MSCI Total U.S. Stock Market DBC PowerShares DB Commodity Index GLD SPDR Gold Shares TLT iShares Barclays Long-Term Trsry SHY iShares Barclays 1-3 Year Treasry Bnd Fd In addition, ETFs must be ranked above the cash-like ETF (NYSEARCA: SHY ) in order to be included in the portfolio, similar to the absolute momentum strategy I profiled here . This modification could help reduce drawdowns during periods of high volatility and/or negative market conditions (see 2008-2009), but it could also reduce total returns by allocating to cash in lieu of an asset class. The cash filter had been in effect since July 2015, but this month four new positions will be added. The top 5 ranked ETFs based on the 6/3/3 system as of 11/30/15 are below: 6mo/3mo/3mo PCY PowerShares Emerging Mkts Bond VNQ Vanguard MSCI U.S. REIT LQD iShares iBoxx Invest Grade Bond TLT iShares Barclays Long-Term Trsry SHY Barclays Low Duration Treasury (2-yr) Thus, the portfolio will purchase PCY, VNQ, LQD, and TLT. In 2014, I introduced a pure momentum system, which ranks the same basket of 14 ETFs based solely on 6-month price momentum. There is no cash filter in the pure momentum system, volatility ranking, or requirement to limit turnover – the top 4 ETFs based on price momentum are purchased each month. The portfolio and rankings are posted on the same spreadsheet as the 6/3/3 strategy. The top 4 six-month momentum ETFs are below: 6-month Momentum TLT iShares Barclays Long-Term Trsry VNQ Vanguard MSCI U.S. REIT PCY PowerShares Emerging Mkts Bond LQD iShares iBoxx Invest Grade Bond This month SHY will be sold and the proceeds used to purchase LQD. The updated holdings for the pure momentum portfolio is below: Position Purchase Price Purchase Date Percentage Gain/Loss Excluding Dividends PCY 27.65 8/31/2015 0.94% LQD 115.91 11/30/2015 0.00% VNQ 79.89 10/30/2015 -0.63% TLT 122.74 10/30/2015 -1.05% Disclosure: None