Successful short-selling is more complex than just being “the opposite of long investing.” Shorting goes against the general upward trend in stock prices and against human nature that strives for making companies run better. But as long investors, we can use these short-selling risks to our advantage.
In this issue, we feature six stocks that have large short interest yet have pending turnarounds that could force short-covering.
Cabot Turnaround Letter 919
In This Issue
Short Sellers
Brexit Stocks
Recommendations:
Buy: Trinity (TRN)
MPO Update
News Notes & Performance
WHERE SHORT-SELLERS COULD BE WRONG
While most investors select stocks that they believe will increase in price (being “long” a stock), short-sellers are hoping the price goes down. Motivations for short-selling include: betting against over-priced stocks with weakening fundamentals, hedging against another stock (pair trading/merger arbitrage), betting against possibly fraudulent accounting, riding a stock’s downward momentum, and speculating on a macro trend (broad market decline, changes in commodity prices, etc). Successful short-selling is more complex than just being “the opposite of long investing.” Shorting goes against the general upward trend in stock prices and against human nature that strives for making companies run better.
Moreover, short-selling involves special risks. Critically, not only are the losses theoretically infinite (you can only lose 100% of your long investment, but a wrongly shorted stock can keep appreciating forever), a short position often carries high on-going costs such as paying a stock’s dividends and broker interest and fees. In addition, the short seller is required to borrow the stock they are selling from another holder. If the lender wants the stock back, the short-seller has to scramble to find a new lender or else replace the stock (buy it) at what may be an inopportune time. Given these and other hurdles, there are very few consistently successful short-sellers. Even the top hedge funds recognize that shorting stocks entails unusual risks. That’s one reason why The Turnaround Letter avoids the field and why most other investors should, as well.
However, as long investors, we can use these short-selling risks to our advantage. If a contrarian stock has a large short interest (the amount of a company’s stock that is sold short) and begins to show signs of a turnaround, short-sellers will quickly “cover” their shorts (buy the stock back), which can provide a sharp boost to the near-term share price. As a turnaround becomes more enduring, short interest can evaporate, providing a tailwind to the share price.
Several Turnaround Letter recommended names currently have large short interest positions: GameStop (at 57%), Chesapeake (20%), Washington Prime Group (30%) and Mattel (22%) Sometimes, it is also useful to know which names don’t have large short positions, like Newell (8%), Blue Apron (7%) and Kraft Heinz (2%).
Listed below are six stocks that have large short interest yet have pending turnarounds that could force short-covering. We focus only on credible companies where short-sellers are betting that near-term fundamentals and sentiment will remain weak. Potential buyers should note that these stocks can be volatile and may continue to weaken if other short sellers follow the momentum downward.
Albemarle – Shares of this specialty chemical company have fully unwound their steep run-up into late 2017 and now trade at their early 2011 price. Investors have lost some faith in its lithium business (the world’s largest), despite its wide profit margins and healthy secular growth driven by batteries. Management has improved the company’s strategic focus and remains disciplined with both expenses and capital spending, thereby helping to support share repurchases and dividend increases. Following a positive Q2 earnings report, Albemarle raised its full-year guidance. The balance sheet is only modestly levered, and the share valuation looks very reasonable.
Cloudera – While rapid obsolescence makes technology company turnarounds particularly difficult, we are intrigued by the situation at Cloudera. Shares of the “big data” firm have plummeted more than 50% from their 2017 IPO price as the company struggles with strong competition. However, its large valuation discount relative to peers, potentially fixable issues from its recent $3 billion Hortonworks acquisition, the 9.5% stake held by Intel, changes in top management, a pending major product upgrade and the secular growth tailwind in the sector provide meaningful appeal. More directly, activist Carl Icahn has recently taken an 18% stake and now holds two board seats. It seems likely that at least one of these catalysts will lead to a higher stock price.
Fossil – Sometimes considered a prime example of secular decline, trendy watch producer Fossil is seeing an uptick in its outlook as its management is more aggressively addressing its challenges. Three promising recent changes include its entry into smart watches (touchscreen “wearables”), a sizeable cost-efficiency program and the addition of Kevin Mansell, former CEO of retailer Kohl’s, to the board of directors. Also, insider buying has recently picked up. The remarkably inexpensive valuation adds to the potential upside.
Haverty Furniture Companies – This 125-year-old company is a popular destination, both in-store and on-line, for consumers looking for high-quality home furniture at respectable prices. Results earlier this year stoked investor worries about weaker sales and margins, partly due to supply chain disruptions related to tariffs (about 35% of their product is made in China). However, recent results indicate this problem is abating as Haverty’s capable management makes adjustments, backed by the tailwind from the strong economy. The company recently raised its dividend and expanded its stock buyback program. Haverty Furniture is debt-free, with $56 million in cash, and owns 40% of the real estate under its stores, providing solid asset and valuation support.
Papa John’s Pizza – We’ve highlighted this company in the past, and it has shown up again on our short interest screen. The nation’s fourth-largest pizza chain has suffered from the fall-out of its former chairman/CEO’s reputation-damaging behavior. However, led by activist Starboard Value, Papa John’s fortunes are looking better, particularly with last week’s appointment to CEO of Rob Lynch, the successful head of restaurant chain Arby’s. The company has sizeable challenges, especially from changing consumer preferences that lean away from sit-down pizza stores as well as rising competition from an ever-expanding menu of food delivery choices. However, continued good news should push out those betting against the company.
Signet Jewelers – With 3,300 stores across the United States, Canada and the United Kingdom (under a number of well-known brands, including Kay, Zales, Jared and others), Signet is the world’s largest retailer of diamond jewelry. Signet shares have declined sharply from their peak of over $150 in late 2015 following the unraveling of strong sales growth driven by over-zealous in-house customer financing. The stock also suffered from online competition and ethics problems of the former CEO. However, the troublesome credit business was divested and a nearly all-new senior leadership team led by the respected new CEO Gina Drosos is working to reverse the company’s ailing fortunes. Signet reports on September 5th, which may produce sizeable near-term volatility in the shares.
IS IT TIME TO ENTER INTO “BREXIT” STOCKS?
Sooner or later, the United Kingdom (England, Scotland, Northern Ireland and Wales) will leave the European Union, of which it has been a formal member since the 1992 Maastricht Treaty. (Great Britain’s exit from the EU is thankfully shortened to “Brexit” in common parlance). Brexit is significant: a third of the island nation’s economy is export-related, with about half of that involving the EU. Nearly every aspect of its citizens’ daily lives is touched by this relationship.
Anticipating the potentially recession-producing effects of the departure, the London-based FTSE stock index has gained only 12% since the June 2016 referendum, lagging major European indices and the S&P500. While its mix of companies is somewhat different from other country’s indices, British shares are cheap at 17.5x trailing earnings, below peer multiples of 19x-20x. The FTSE’s 5.1% dividend yield towers over other index yields. Similarly reflecting the worries: the British pound has fallen 18% against the dollar and the euro.
Also not helping British stocks is the uncertainty surrounding the structure and timing of Brexit. Government officials have made little progress toward defining the post-separation terms on tariffs, medical supplies, food regulations, financial transactions, airline flights, personal travel and countless other import/export rules. Several deadlines – not to mention prime ministers – have come and gone. Currently, it appears that a “hard Brexit” (one without any agreement with the EU, relegating Britain to outsider status) on October 31st is the most likely outcome.
While we have no idea when or under what terms a Brexit will occur, or even if a Brexit of any kind is a sure thing, we think there may be some investment opportunities amidst the fear. Some stocks may already be over-discounting a difficult post-Brexit environment. It is possible that the weaker British currency will stimulate stronger exports. A potential broad-scope trade deal with the United States may foster growth. And, in the three-plus years since the referendum, companies may have been preparing, leaving much less downside risk to their fundamentals when Brexit actually happens.
Listed below are some stocks that have suffered in the pre-Brexit market but that we consider post-Brexit bounce candidates. They are all London-listed companies that have liquid ADRs or trade directly on major US exchanges. (Some less-liquid stocks may have more exposure – please ask us for a list if you’re interested). We have set aside majors like British Petroleum and AstraZeneca, as they are truly global companies with less Brexit risk, although they may be modestly pressured by index investors who avoid the entire British market.
Kingfisher – While it is one of the world’s largest home improvement retailers, Kingfisher still generates over half of its profits in the UK. Its shares fell sharply following the referendum and have continued to weaken. While a sluggish European economy has also weighed on the shares, Kingfisher’s most recent quarter showed promising improvement. Trading at only 3.3x EBITDA and carrying more cash than debt, the company appears to be discounting a dour post-Brexit environment.
Legal & General Group – One of Britain’s largest life insurance companies, Legal & General’s fortunes are somewhat tied to the interest rate environment, which is likely to be lower post-Brexit. Its real estate portfolio also makes it one of the largest UK land owners, which might be pressured in a post-Brexit recession. Not surprisingly, its shares fell sharply after the referendum, and after a bounce have slid back to near post-vote lows. However, the UK remains a vibrant home for international capital, and the company’s £1.1 trillion (assets) investment management business diversifies its profits across global markets. Legal & General has also made operational adjustments to mitigate some of the Brexit risk.
Lloyds Banking Group – As one of the UK’s largest banks, Lloyds is exposed to a weakening of the economy, potentially lower post-Brexit interest rates and any migration of financial activity away from London. Lloyd’s shares fell about 35% after the referendum and have continued to fall. Yet, the bank is producing healthy results, has plentiful capital with extra credit reserves, and trades at less than 1x tangible book value while currently paying a 6.5% yield.
Persimmon – Persimmon is one of the UK’s largest homebuilders. Its shares fell over 40% after the referendum passed, and have essentially unwound all of the subsequent rebound, reflecting its heavy exposure to both a national recession and likely higher imported raw material prices. However, the company sells homes with perhaps the lowest average prices of any major UK homebuilder, has taken steps to secure its supplies and might benefit from further reductions in interest rates. Persimmon is solidly profitable, is debt-free and carries £483 million in cash. Although the company sets its dividend rate based on its profit outlook (it would likely be cut if earnings fell sharply), it has been steadily increasing the dividend in recent years, which currently provides an attractive 12.5% yield.
Wm Morrison Supermarket – Morrisons is the UK’s fourth largest supermarket chain. With its revenues generated entirely in the UK while many of its products are sourced in Europe and elsewhere, it’s not surprising that its shares fell sharply after the referendum. Following some strength into 2018, the shares have declined again to post-referendum lows. However, the company has had considerable time to adjust its supply chain, and it has a profit-boosting initiative underway while it is also expanding its productive ordering service through Amazon Prime. At 5.4x EBITDA, and sporting a 6.8% yield, these shares look oversold.
Purchase Recommendation: Trinity Industries, Inc
Background: Trinity Industries is one of the largest producers of railroad cars, with roughly 36% share of the North American new-build market. The company is also one of the largest railcar lessors, with a fleet of over 124,000 cars. With its roots in Trinity Steel, which incorporated in 1933 and produced steel tanks for the petroleum industry, the company expanded into a wide range of steel-based products, entering the railcar production business in the 1960s. Last November, Trinity spun off most of its non-railcar operations as Arcosa (NYSE: ACA).
Trinity’s shares have declined sharply since their peak in 2014, down nearly 50% after adjusting for the spin-off, compared to a 46% increase in the S&P 500. Investors worry about slowing demand for railcars from the effects of the trade war with China, the expanding role of Precision Scheduling Railroading (PSR), and a potential economic recession. These concerns are exacerbated by the 80% decline in Trinity’s railcar manufacturing profits from their peak 2015 level, reflecting diminished demand for coal and metal ore cars. In the most recent quarter, Trinity turned away considerable new business as it was below its profit threshold, stoking further worries about industry conditions. The market views Trinity’s prospects as worrisome at best.
Analysis: The market’s near-term worries offer investors the opportunity to participate in this high-quality company’s solid long-term prospects. Trinity’s leadership is strategically redefining the company, narrowing its focus to improve its capital and operational efficiency and putting greater emphasis on returning capital to shareholders. Last year’s repurchase of $430 million in shares and the spin-off of its Arcosa operations were only the first steps along this path.
A top priority is growing their lease fleet to capture leasing’s recurring profits and help stabilize Trinity’s overall cash flow stream. Another priority is expanding its maintenance services operations. Not only is this a source of stable profits, but it also reduces Trinity’s per unit maintenance costs and furthers their strategy of providing a full ecosystem to tighten their relationship with customers. Additionally, the company is streamlining its temporarily elevated corporate overhead.
Management targets an 11-13% return on equity by 2021, which implies a 32% increase compared to this year’s estimated return.
Supporting their plans are industry conditions that appear to have stabilized and recently slightly improved to around 46,000 orders for this year, which is only about 10-15% above replacement demand. Trinity expects to deliver 18% more cars this year than last year, and management reiterated their 2019 guidance for a 70% or more improvement in earnings. Backing their optimism, they raised the quarterly dividend by 31% earlier this year, which now provides a 3.9% yield.
Helping to spur management’s heightened shareholder focus is the involvement of respected activist ValueAct Capital. This fund took an initial 6.8% position in 2016. Since then, it has raised its stake to 18% and has a representative on Trinity’s eight-person board.
While cyclical risks remain, Trinity’s renewed focus on profits and shareholder value should provide solid value for long-term shareholders.
We recommend the PURCHASE of shares of Trinity Industries (TRN) with a $26 price target.
OTHER RATINGS/PRICE TARGET CHANGES
With Midstates Petroleum now being part of Amplify Energy (AMPY), we are retaining our Buy rating with a new price target for Amplify shares of $9.50. The newly-combined company will be led by Amplify’s management, who expects the company to generate positive free cash flow, augmented by an operations cost-cutting program. With its reasonable amount of debt and relatively low-risk oil field development strategy, the company plans to return much of its free cash to shareholders. We anticipate that the company will also use some of its balance sheet capacity to acquire selective oil field assets that produce sizeable cash flow. The $.20/share quarterly dividend, which the management believes is a long-term sustainable rate, provides a generous 13.9% yield.
NEWS NOTES:
GameStop is scheduled to report its earnings next Tuesday, September 10. While the stock has unfortunately fallen sharply since our recommendation, the story is becoming quite interesting. Last week, Michael Burry, of “The Big Short” fame, has taken a 3% stake in the company and subsequently released his letter to management highlighting the very unusual valuation of GameStop shares.
The situation is this: at the current $4/share price, the company’s market capitalization is about $360 million. The company’s estimated $480 million in cash on hand is enough to repurchase 100% of its currently outstanding shares and still leave $120 million left over. GameStop could still readily service its entire $468 million in debt from recurring cash flow.
With its new CEO having apparently started initiatives to reduce costs and improve its on-line presence, GameStop presents an intriguing situation for long investors even while short-sellers have shorted over 50% of its outstanding shares. One of the biggest risks we see to the near-term GameStop turnaround is that it spends its cash hoard on a major acquisition, a risk that Dr. Burry highlighted in his letter.
GameStop’s earnings report will be worth a close look.
After a brief pause for August vacations, our new Members-Only Podcast resumed last Friday with commentary on GameStop, some financial history and a light-hearted suggestion for resolving Brexit.
Our new website, however, remains on vacation, with an updated go-live date for some time in September. Please watch your email for new log-in instructions. The upgrade provides a more user-friendly, visually-appealing experience.
PERFORMANCE
The tables below and on the next page show the performance of all of our currently active recommendations, plus recently closed out recommendations.
