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Why Exelon Corporation Will Outperform The Market In 2015

The strong rally in utilities will continue into 2015, despite statements to the contrary from analysts, as the sector is still strongly undervalued relative to the market. Exelon combines an attractive valuation with strong price momentum and EPS growth. We expect the stock to outperform the market by 8.7% over the next 12 months. Entergy Corporation, Hawaiian Electric, and Westar Energy are other electric utilities that look poised to outperform the market in 2015. A) Introduction The Utilities sector surprised many by posting the best price performance in the market in 2014. Electric utility companies were a particularly strong subset of the sector, posting an average gain of 31% during the course of the year. At this point, many investors are questioning whether the current rally will continue, especially with rising interest rates on the horizon (high interest rates hurt utilities). On Wednesday, Michael Purves, the head of equity derivatives research at Weeden & Co, advised investors to “start to take profits given the run is getting long in the teeth.” Contrary to common sentiment, we feel the sector’s momentum and growth should serve a signal of further outperformance, as the sector is still strongly undervalued relative to the overall market. Investors unfamiliar to our style of analysis should know that we solely look at metrics that have a long historical track record of predicting stock returns. We’ll first analyze how the overall Utility sector stacks up to the other nine sectors in ten metrics that have been academically shown to predict returns. Then, we’ll look into which stocks within the Electrical Utility industry group look poised to lead the group, again looking at value, momentum, and earnings. B) Top-Down Analysis of the Utility Sector In deciding whether to invest in certain utility stocks, it is critical to first look at how the overall sector stacks up relative to other sectors in value, momentum, and growth. The table below shows how the sector compares to other sectors in five valuation metrics that have been academically proven to predict returns: (click to enlarge) Source: QuantifiedAlpha.com The utilities sector looks the most attractive of any of the sectors on a book value basis, with the sector’s average price/book ratio of 2.22 being the lowest of any of the sectors. The sector looks relatively attractive on both a revenue and earnings basis, with a sales yield of 49% and earnings yield of 3.6%. Even with the big rally, the average utility stock pays a 3.4% dividend, good for third behind the Energy and Telecom sectors. Undervalued stocks tend to outperform the market, and using the average amount of excess return generated by these factors historically, our algorithms estimate how much. Overall, we expect the average utility stock to generate 1.31% of alpha attributable to value, over the next twelve months. Next, we analyze how the sector is doing on a growth & momentum basis: (click to enlarge) Source: QuantifiedAlpha.com As we said before, the utility sector has performed the best over the last twelve months, gaining 25% on average. It is the second best performing sector over the last six months, behind the Health Care sector, gaining a shade under 9%. The sector falls in the middle of the pack in average annual EPS growth, growing 18%. The sector is also in the middle of the pack in financial efficiency, returning an average of 2.8% on assets and 9.8% on equity. Each of these five metrics has been academically shown to predict stock returns, with the two price momentum metrics being the most important. Overall, we expect the average utility stock to generate 1.33% of alpha attributable to growth over the upcoming twelve months. C) Group Leaders Now that we’ve analyzed the sector on a top-down basis, we’ll now look at which stocks within the electric utility industry group look poised to lead the group. Below is a table showing which stocks in the group are the most undervalued: (click to enlarge) Source: QuantifiedAlpha.com As we can see, our top five most undervalued electrical utilities include Entergy Corporation (NYSE: ETR ), Exelon Corporation (NYSE: EXC ), Portland General Electric Company (NYSE: POR ), American Electric Power Co. (NYSE: AEP ), and Westar Energy (NYSE: WR ). Each of these companies has a sales yield (inverse of Price/Sales) over 45%, which is way above the overall market average. Each of these stocks sport similar earnings and dividend yields, each of which are again much higher than the overall market averages. These stocks also look attractive on a book value basis, with none of the company’s having a price/book ratio over 2. Overall, Entergy tops out as the value leader of the group, with our algorithms expecting the stock to generate 5.8% of value alpha over the next twelve months. With that being said, each of the five stocks is expected to significantly outperform the market due to their attractive value. Next, we’ll see which stocks are leading the sector in growth and momentum: (click to enlarge) Source: QuantifiedAlpha.com As we can see, our top five strongest growth electrical utilities include ITC Holdings Corp. (NYSE: ITC ), Hawaiian Electric Industries (NYSE: HE ), MGE Energy (NASDAQ: MGEE ), Northeast Utilities (NYSE: NU ), and Exelon Corporation. After a slow start to the year, Hawaiian has had a very strong second half of the year (+40%). Exelon has been the best performer over the past year, gaining 44%. Exelon has also had the strong EPS growth of the five, growing annual EPS by 41%. ITC Holdings tops the group in profit efficiency, returning 5.2% on assets and 21% on equity. Overall, ITC is expected to outperform the market the most owing to its growth profile over the upcoming twelve months (4.76%). Exelon is the only stock that made it onto both group leaders lists. Next, we’ll look at which stocks have been performing best relative analyst earnings expectations: (click to enlarge) Source: QuantifiedAlpha.com We’ve found through historical back testing that stocks that beat earnings estimates consistently, are extremely likely to keep beating estimates. This is crucial as stock prices can experience wild swings in price depending on how earnings come out relative to expectations. Hawaiian Electric has the best track record, having beaten EPS estimates by 12% last quarter (6 straight beats) and revenue estimates by 8% (2 straight beats). Edison International (NYSE: EIX ) has the best track record for EPS, having beaten the Wall Street consensus EPS estimates 8 times in a row. PPL Corporation (NYSE: PPL ), Westar Energy, and NextEra Energy (NYSE: NEE ) are names we haven’t seen yet, that have all outperformed expectations as well. D) Conclusion Now that we’ve analyzed the sector as a whole and the individual group leaders in the group, it is time to see which utility stock comes out on top. The table below shows the electric utility stocks we expect to outperform the market the most: (click to enlarge) Source: QuantifiedAlpha.com Exelon comes out on top on our list, with our algorithms expecting the stock to outperform the overall market by 8.73% over the next twelve months. Exelon combines strong value with solid momentum and EPS growth. Entergy, Hawaiian Electric, and Westar Energy are other stocks that were featured earlier in the article that also look very attractive. While American Electric Power is featured at #4 on our overall leader board, we advise investors to stay away from the stock as it has been missing analyst estimates recently (hence the one star Earnings Strength rating). Though the Utility sector outperformed the general market during 2014, we feel the sector is still relatively undervalued and certain names look very attractive.

Absolute Momentum Revisited

Trend following based absolute momentum, also known as time-series momentum, is the Rodney Dangerfield of investing. It “don’t get no respect.” Absolute momentum is little known and hardly used by investors. Yet it can be a very powerful tool, leading to both enhanced return during bull markets and reduced risk during bear markets. The more common type of momentum, based on relative strength, has little or no ability to reduce bear market drawdown. It may even increase volatility and downside risk. As I show in my book, Dual Momentum Investing , using both absolute and relative momentum simultaneously is the best approach in that it lets you benefit from the return enhancing characteristics of both types of momentum while incorporating the risk reducing benefits of absolute momentum. But absolute momentum has possible uses on its own for those who simply want to limit the downside risk and enhance the expected return of single assets or fixed portfolios. That is why I wrote the paper, “Absolute Momentum: A Simple Rule-Based Strategy and Universal Trend-Following Overlay,” which is now included as Appendix B in my book. I show how absolute momentum can be applied to a number of different indexes and assets, as well as to some common portfolio configurations, such as balanced stock/bond or simple risk parity portfolios. Absolute momentum is easy to calculate and apply. It is positive if an asset’s excess return (return less the Treasury bill rate) over a specified look back period is positive. One then holds that asset until absolute momentum turns negative. In my paper, I use data going back to January 1973, since bond index began at that time and international stock index data began close to it in January 1970. Elsewhere in my book, I also use January 1973 as the start date for my analysis, since my book’s featured Global Equities Momentum (GEM) model relies on the same fixed income and international stock indexes. Those wanting to see additional momentum result history can consult the references I give in the book showing attractive profits from relative strength and absolute momentum back to 1801 and 1903, respectively. However, I now think it would be a good idea now to extend my back testing of absolute momentum, since I learned that some investors are especially attracted to absolute momentum for several reasons. First, absolute momentum trades less frequently then dual momentum, which may be important for taxable accounts. Absolute momentum applied to just the U.S. stock market gives mostly long-term capital gains from stocks. The second reason absolute momentum may be worth looking at in more depth is that some investors have only a single investment approach that they are comfortable using. They may want to hold a portfolio that focuses solely on value plus profitability (see my earlier post, ” Value Investing Redux “), quality, hedge fund cloning, stock buy backs, dividend appreciation, micro caps, or other factors. So I think it would be helpful to see how absolute momentum looks when applied to aggregate U.S. stocks using the long-term Kenneth French data library that is available online. I compare 10 and 12 month absolute momentum filters to commonly-used 10 and 12 month simple moving average filters from April 1927 through December 2014, a period of 87 years. When we are out of stocks, assets are invested in one month Treasury bills. Here are the results with monthly readjusting of positions without transaction costs: Abs12 MA12 Abs10 MA10 US Mkt ANN RETURN 11.06 9.76 11.45 9.77 11.74 ANN STD DEV 12.53 12.83 12.88 12.50 18.70 ANN SHARPE 0.57 0.46 0.58 0.48 0.41 MAX DD -43.98 -48.22 -41.44 -56.62 -83.70 These are hypothetical results and are not an indicator of future results and do not represent returns that any investor actually attained. Please see our Disclaimer page for additional disclosures. (click to enlarge) We see that absolute momentum gives very attractive results compared to both buy and hold and the use of moving averages. Absolute momentum shows higher returns and Sharpe ratios, as well as lower maximum drawdowns, than comparable moving averages. In addition, moving averages have approximately 50% more trades and more false whipsaw signals than absolute momentum. So if we were to account for transaction costs, absolute momentum signals would look even more attractive compared to their moving average counterparts. Because of the additional transactions, moving averages are also not as tax efficient as absolute momentum. Dual momentum is still the premier momentum strategy for most investors, but absolute momentum may be a valuable tool for many others.

Top Investments For 2015

2014 Year in Review Well 2014 turned out to be another interesting year. It was a strong year for investment returns despite numerous issues going on around the world. China is clearly slowing down, Europe is facing deflation, and Russia annexed Crimea. As I said last year, uncertainties are always abound but capitalism continues to unleash human potential. Commodities and oil & gas in particular got slammed again in 2014, following up on steep losses in 2013. I have been recommending that investors avoid commodities for a couple years now ( Canada – Headed for a Crash & Canada: A Storm Brewing in China ). Also I have commented numerous times on how the high oil prices don’t make sense ( Saudi America & US Oil and Gas Drilling ). Before discussing what oil did in 2014 and last year’s market returns, I want to remind readers of what I said last year at this time ( Top Investments for 2014 ). I find it remarkable how oil prices have held up in 2013. US oil production has been off the charts, going up in a parabolic curve. US dependence on foreign oil fell to a 27 year low ( Click Here ). In 2005, the US imported 60.5% of their oil requirements and last year that fell to only 34%. This is a result of the shale oil revolution in the US where oil production is up 46.5% or 2.36 million barrels a day since 2007. If oil prices fall in 2014 that will be another significant headwind for the Canadian economy. Fellow Canadians could have benefited from the fall in commodities by not owning Canadian Dollars. Canadians who invested in the US not only realized out sized gains this year, they also realized foreign currency gains that contributed an additional 7% to their returns. I figured it was only a matter of time before oil fell and boy it did fall off a cliff in 2014. Similarly, the falling Canadian dollar was another theme that continued in 2014. As I have said before, this is a great way to be short commodities since the Canadian dollar is very closely tied to commodity prices. I will be returning to both of these themes throughout this post. 2014 Market Returns Market returns were strong again, making it the sixth straight year of solid gains. Just like 2013, Canadian investors could have benefited from the drop in commodity prices by owning US companies, realizing over a 9% gain from the falling Canadian Dollar. I would still recommend avoiding Canadian dollars as the loonie will likely fall further in 2015 as our economy stalls. Last year I included this chart from JP Morgan that puts market returns into context: (click to enlarge) Commodities As already mentioned commodities got slammed this year. Below is a list of the damage. Oil and natural gas were both down significantly in 2014. Metals also fell as well as agricultural commodities. The only bright spots were the 3Cs – Cattle, Cocoa, and Coffee. For those wondering why oil was down, the answer is shown below. (click to enlarge) Source: Carpe Diem Blog Now if anyone would have said back in 2005 to 2008 that US oil production would rise by over 4 million barrels per day by the end of 2014, everyone would have considered them crazy. Look at that graph again, US oil production has almost doubled in 4 years. Let me say that again, oil production went up 4 million barrels per day in 4 years. That is an economic miracle and we should be thankful for the entrepreneurs who made this happen. To me this is the fantastic part of capitalism, as we all enjoy the benefits of what these entrepreneurs have created. For investors, the above graph shows 4 million reasons to avoid oil investments going forward. Don’t get me wrong there is money to be made in the oil, but just like airlines, it is hard to pick the winners from the losers. We are in the top of the first innings of the shale oil revolution and if you don’t think this isn’t a paradigm shift, you need to look at that graph again. In the words of Henry David Thoreau, “It’s not what you look at that matters, it’s what you see.” 2014 Stock Recommendations So how did the stock recommendations for 2014 turn out? Total returns include dividends and I also included what the total returns were in Canadian dollars (CAD). Overall the results were decent with the exception of Lightstream Resources ( OTCPK:LSTMF ) [TSE: LTS]. I have more to say about Lightstream below. Here is what those yearly returns looked like throughout the year. (click to enlarge) Looking at the graph, Lightstream was up over 40% in May before going on an epic slide erasing nearly all of the equity value of the company. Of course, I pick these stocks for fun and use the year end as arbitrary start and end points but much higher gains can be had for those who sell once the facts change or when the company approaches its intrinsic value. As I said last year, Bank of America (NYSE: BAC ) has been like shooting fish in a barrel. After being up 110% in 2012, it returned 34% in 2013, and returned a respectable 15% in 2014 (with dividends). Like last year, Bank of America is recommended once again for 2015. It is still selling below its intrinsic value. The same can be said for Citigroup (NYSE: C ). Citigroup’s poor returns in 2014 are mostly attributable to failing the Federal reserve’s stress test. That likely won’t happen again this year. Like Bank of America, Citigroup is once again recommended for 2015. POSCO (NYSE: PKX ) and Ezcorp (NASDAQ: EZPW ) are both very cheap and again recommended for 2015. POSCO, a steel producer, is still profitable but struggling to earn decent returns. The steel industry is over-capitalized, iron ore prices have plummeted and the outlook is uncertain. With a book value of $140/share and the current quote of $63.81/share, the stock is cheap. They are a low cost producer so they will be fine. Comments on Lightstream Lightstream was recommended last year but as some readers know I subsequently changed my mind on the company after reading the year end reserve report released in late March (I have made comments elsewhere on an internet investment forum). At the time when I recommended LTS, it was selling for $5.88/share. Looking back at 2012 (the most recent reserve report) they had spent just over $320 million in capital, added 27 million barrels of reserves, and the cost looked very reasonable at around $12 per barrel. I also did a quick and dirty analysis of the company’s proved reserve value and came up with a rough Net Asset Value (NAV) of about $9/share. This has been their NAV for a while, ever since I said it was a poor company back in 2010. (There are several other posts on there about PBN & PBG, If you want some fun reading… do a search on my blog as I had some interesting debates on the company in the past. Click here for an example. ) Anyway, once the reserve report and annual financial statements were released in late March, it became clear LTS had deteriorated significantly. First of all, they spent $719 million in capital in 2013 and added 12.3 million barrels in reserves, This gave them a finding and development cost of over $70 per barrel. That was only the beginning. Obviously, they spent a pile of cash and generated NO value. This can clearly be seen in the annual report where they wrote off the $1.4 billion in goodwill they were carrying. The annual report also revealed to investors how they justified the carrying amount of their assets on their balance sheet. A careful read would have found this comment buried in the details. In addition to discounted cash flows, the Company also considered a range of market metrics in assessing fair value less cost to sell for certain CGUs. Market metric information was obtained from recent transactions involving similar assets.” Ok, so they used “market metrics” to justify the fair value, not the reserve report which is as close to reality as you can get given the assumptions. Anybody looking to acquire a property would do the same analysis and also adjust for drilling opportunities. Market metrics is exactly what most of the people who invest in oil and gas do to justify their overvalued holdings. The problem is every property has different costs and netbacks, so blanket metrics do not work well. Going back to their reserve report, they had a pile of technical revisions and it really makes you question if management was being candid with shareholders. I would also add that the NAV got a 5% boost due to higher commodity prices. They won’t be getting that boost this year. Given the fact that LTS has a very short reserve life, the reserve value will take a huge hit. I have calculated this for LTS and I estimate a 50% haircut to their reserve value. The last thing I determined from the reserve report was that the NAV was less than $2/share after taking into account other assets and all liabilities. This result was based on the over $90 per barrel oil price used in the reserve report. So basically the company destroyed 60-70% of their value with a terrible return on a huge amount of capital. The capital is gone and the equity investors have lost their capital. Anyways, that is what happened to LTS this year. I actually spent a decent amount of time this year analyzing the reserves and asset values for 68 of the 108 oil and gas companies listed on the Toronto Stock Exchange. I didn’t find a single company to invest in. 2014 Other Recommendations For 2014 I also recommended IBM (NYSE: IBM ) in the Safe & Very Cheap category. Here are the results. Clearly the market is still worried about future of IBM. Most of what I have read is concern over IBM’s falling revenue. I really don’t understand what all the fuss is about. IBM has had flat revenue for 10 years. Revenue per share is up 6.5% over the past 10 years and as an owner that is what counts. Also, IBM has been shedding divisions that generate billions in revenue and generate little-to-no profits. That’s right, some lose money. IBM is currently selling one division that generates $7 billion in revenue but loses $500 million per year. I’m looking forward to the higher earnings when that earnings drag isn’t getting in the way. This is a common situation at many companies when you dig into the details. IBM falling 11% does bother me in the least. Revenue and earnings were higher on a per share basis in 2014. It now offers outstanding value. Top Investments for 2015 IBM (NYSE – IBM, $160.44) Ezcorp (NASDAQ – EZPW, $11.75) Bank of America (NYSE – BAC, $17.89) Citigroup (NYSE – C, $54.11) POSCO (NYSE – PKX (ADR), $63.81) If you want investment commentary on these stocks, see what I wrote last year ( Click Here ). For Canadian investors, I believe owning US dollars will once again be advantageous in 2015. I’ll likely discuss a few interested tidbits from the Ezcorp annual report next year. I’ll leave them for you to find. As mentioned last year, be sure to do your homework on any investment. The markets are at all-time highs and while that shouldn’t alarm you, it should invite caution. All of these companies have wide appreciation potential but anything can happen in the short term. All of the recommended companies have short-term headwinds that will clear over time. Cheers to another great year! Disclosure: I own BAC common, BAC Class A warrants, EZPW, & IBM. Editor’s Note: This article discusses one or more securities that do not trade on a major exchange. Please be aware of the risks associated with these stocks.