OUTSIDE THE BOX



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A long-awaited stock-market rotation back to value stocks might benefit oil and gas companies in the short-term, but long-term there are concerns about the sustainability of the energy industry as it now exists. The sector’s woes are such that at the end of August 2020, energy stocks accounted for just 2.6% of the S&P 500 (SPX) , down from more than 16% in 2008. 

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The systemic risk surrounding energy companies due to climate change underscores the difference in approach between active managers and their index-fund counterparts and large retirement funds, as well as the tools active managers can use to make a persuasive case for meaningful change. While active fund managers increasingly are avoiding the energy sector and its risk of permanent capital impairment, many passive-fund investors recognize that as universal owners of the market and, by default, the economy, they have a stake in encouraging a successful energy-sector transition to renewables.

Eschewing the entire industry is short-sighted and misguided. While some investors have divested from fossil fuels, many continue to hold these investments in the hope of driving change through engagement. Active managers, drawn by seemingly low valuations, are engaging alongside them, with the combined weight of their collective voices leading to better reporting and some shift in strategy towards redirecting capital expenditure to renewables. The challenge will be if the change being supported by engagement will be enough to avoid fossil fuel stocks becoming “value traps.”

Read: This is the hottest social issue that U.S. companies are discussing

Active managers have distinct advantages when it comes to proxy voting and engagement, the most obvious being that active managers have a far smaller number of securities to cover than a passive manager. Further, through their research processes, active managers can incorporate

The MLP sector has been one of maximum pain for investors. Such long and brutal bear markets often tend to produce conditions for maximum returns for sectors. Often, not always though. We have stated our bias here previously, and the MLPs investors will be best served by sticking to quality and avoiding common shares. Preferred shares and baby bonds where feasible offer the best possible risk-adjusted returns, in our view.

But what if we are wrong? What if the sector has bottomed and the market has discounted the tremors ahead? In that case, which is the best way to play the sector? We recently highlighted two funds in this space (see here and here), and neither of them come close to the one we are about to talk about today.

The First Trust MLP & Energy Income Fund (FEI) is one of the best-performing MLP funds and is shockingly ignored. This “not-so-well-known” closed-end fund invests in the MLP sector using one of our favorite strategies. It uses covered calls to reduce volatility and enhance returns. We have always deployed options in our own trades, and they are the single best “free” source of alpha there is. They act to reduce volatility and also help investors buy low and sell high (not a marijuana reference).

The Fund

FEI has managed to do something rather extraordinary from the point of view of the common investor. It has taken leverage, within a sector that has gotten decimated, and managed to outperform non-leveraged passive ETFs like ALPS Alerian MLP ETF (AMLP).

ChartData by YCharts

That is a truly outstanding achievement from the point of view of the common investor, but one we predicted as the fund was busy selling covered calls in a thoughtful manner. FEI delivered -47.79% over the last five years

This column assumes that ETFs are the primary investment tool for the reader.

Please see my weekly market summation for a review of the macro-economic environment and general macro-level market trends.

Investment thesis: the macro-averages are now in a bullish posture; it’s a good time to take a new position. But be careful; defensive sectors are starting to rise, indicating traders are a bit more cautious.

Let’s start by looking at last week’s market activity, beginning with the treasury market:

TLT 5-day

The treasury market moved lower on Monday and then traded sideways for the rest of the week. Volatility was higher on late Tuesday and Wednesday as the market digested the whipsaw activity regarding additional fiscal measures. Also note the sharp sell-off and subsequent rally on Friday, likely due to additional fiscal talk.

SPY 5-day

SPY trended higher for the entire week as shown by the central tendency line in blue. t took the index an entire day to recover from Tuesday’s sell-off, but it did recover.

IWM 5-minute

I noted in my weekly round-up that smaller-caps led the market higher this week. Notice that IWM had a very strong move higher earlier in the week. This explains why small caps did so well last week.

Let’s pull the lens back to the 2-week time frame:

IEF 2-week

During the last two weeks, the treasury market has clearly trended lower, as shown by the 200-minute EMA (in magenta). The ETF has gapped lower twice and then consolidated sideways.

QQQ 2-week

While larger caps are higher, their respective charts are messier. QQQ – which has led the markets higher for most of the post-lockdown rally – is struggling. It’s also been prone to sharper, higher-volume sell-offs.

IJH 2-week

In contrast, smaller caps have stronger charts. Mid-caps have a solid uptrend

Back in March, in a Herculean effort to create liquidity, the Federal Reserve pledged a multi-trillion dollar expansion of its balance sheet through the purchase of a broad swath of securities. In September Chair Jay Powell declared that interest rates would stay at or near zero through 2023.

This largesse has finally come to REITs. Here are just a few recent examples of the action.

HTA

Earlier this month, Health Trust of America (HTA) announced issuance of $800MM 2.00% ten-year notes. They will use the proceeds to redeem $300MM 3.7% notes due 2023, reducing annual interest expense by $5.1MM (increasing income by $0.0233/share). On 9/22 they increased their dividend. On 9/23 they reinstated a $300MM share repurchase program which will further increase FFO/share.

HR

On 9/18 Healthcare Realty Trust (HR) announced the issuance of $300MM 2.05% Senior Unsecured Notes due 2031. Simultaneously, they announced the redemption of $250MM 3.75% Senior Notes due 2023. While the 1.7% lower coupon of the new notes will save them ~$4.2MM/annum in interest expense ($0.031/share), the $21.5MM early extinguishment charge HR will take in the 4th quarter makes the maneuver look a little dubious.

DLR

Even bolder, On 09/07, Interxion (Digital Realty’s recently acquired European unit) announced a strategic land acquisition in Madrid. On 09/09, they acquired Altus IT to establish a business presence in Croatia. On 09/14, they simultaneously announced the redemption of €300MM 4.75% Guaranteed Notes due 2023 and that they would pay for the redemption with the issuance of €1.05B super cheap, long dated debt. Not done yet, and this is where it gets really interesting, on 09/15 they announced the redemption of Digital’s 5.875% Series G Preferred Stock.

UMH

On August 20 UHM Properties (UMH), a small cap REIT in the manufactured housing sub-sector, announced the completion of a $106MM

DUBAI (Reuters) – Dubai’s non-oil private sector expanded for a third consecutive month in September as it continued to see a modest improvement in business conditions, a survey showed on Sunday.

FILE PHOTO: A general view shows the area outside the Burj Khalifa, the world’s tallest building, mostly deserted, after a curfew was imposed to prevent the spread of the coronavirus disease (COVID-19), in Dubai, United Arab Emirates March 25, 2020. REUTERS/Tarek Fahmy/File Photo

The seasonally adjusted IHS Markit Dubai Purchasing Managers’ Index (PMI) rose to 51.5 in September from 50.9 in August.

The sector emerged from three months of contraction in June, when it settled at the 50.0 mark that represents no change.

The coronavirus crisis has badly hit vital economic sectors of Dubai, the Middle East trade and tourism hub.

While the data was below July’s reading and markedly below the series average of 54.7, it “indicated stronger increases in both output and new business across the private sector in September,” the report said.

“September PMI data finalised a third-quarter period of modest economic recovery in Dubai,” said David Owen, economist at survey complier IHS Markit.

The output sub-index rose to 53.8 in September from 52.7 in August. It peaked at 56.1 this year in July.

“On the downside, the PMI has failed to lift off or signal any strong rebounds in output so far, with firms often initiating price cuts in order to drive sales higher. Meanwhile, employment data signalled a cautious outlook as firms often shed workers to manage cost pressures and enable discounting,” Owen said.

The United Arab Emirates, with a tally at more than 105,000 infections and 443 deaths, has seen the number of daily new coronavirus cases surge over the past two months.

Business sentiment for the next six months improved slightly in