Friday File — Brands, Hospitals and the Yuan

by Travis Johnson, Stock Gumshoe | August 16, 2015 12:15 pm

A few relatively brief things for you today — updates on the flailing ICON and the high-yield MPW, and a few thoughts on “macro” panics in the market.

First, the ugly — checking in on Iconix (ICON), which I last looked at a few months ago. The stock has gotten cut in half just since then (and fallen further still since I first wrote about it in April). What’s going on with this speculation?

Well, the SEC is working with them to see if they should have consolidated the results of their foreign joint ventures last year, and the CEO (and founder) resigned (following the resignation of the CFO a few months earlier that got people nervous), and the the interim CEO has lowered guidance for the year — so boom, stock craters. So we have both real reasons (lower earnings and cash flow expectations for the year) and fear-based reasons (did all those C-suite people resign because something ugly is happening under the hood, or just because they wanted to or, perhaps, thought the business was weakening).

If you don’t know ICON, this is a brand company — they own mostly fashion brands for men and women, along with a few housewares brands, often brands related to or started by celebrities to monetize their fame by selling sparkly dresses or jeans at Wal-Mart or Kohl’s but also some higher-fashion brands, some athletic brands (Umbro and Pony and Starter and Danskin) and a few entertainment brands, primarily the Peanuts gang (and, new this year, Strawberry Shortcake). They aren’t cutting edge fashion brands, and they’re not generally high-growth products (other, perhaps, than Peanuts this year), but many of their brands have been proven to have pretty consistent cash flow as big box stores look to differentiate their fashion offerings.

If you came to this story anew today, without the baggage (like the kind I carry) of knowing that the stock was in the $30s three months ago, you’d probably be at least a little bit interested — at least, if you’re tempted by cheap stocks with potential catalysts. The company has cut guidance, though some of that is because of their expectations shifting for the Peanuts movie this fall and moving some of that expected revenue to 2016 (mostly because of international release dates — the movie won’t come out in every country at the same time), but they are expected to generate quite a bit of cash this year — and as a royalty business, their margins tend to be very high. They are expecting licensing revenue for the year of at least $410 million, free cash flow of at least $170 million, and earnings per share of at least $2. That sounds pretty impressive for a company that has a market cap (now, after the collapse) of only about $650 million, and a share price of about $13.50.

So that’s the good news — it looks pretty cheap, and I’d argue that it’s oversold (no surprise there, since I also liked it in the low $30s and high $20s before some of the recent bad news came out) … particularly since there doesn’t seem to be any likelihood, at least according to management, that any restatements of their 2014 filings as regards joint ventures will impact their current-year earnings in a meaningful way. The overhang that we knew about back in April, the relatively slow pace of growth combined with the substantial amount of convertible debt on their books and the necessity to continue making brand acquisitions if they’re to grow, is still there — but the debt burden looks substantially larger since the equity is worth so much less right now. The convertible bonds are due in 2016 and 2018, and they’re obviously less of a burden now than they were nine months ago because the share price is less than half of the “conversion” price… though of course, Iconix also spent a lot at the time of these convertible financings to hedge the dilution risk, so the impact is muted. Their stated intention has been to refinance these bonds, but if the shares are still well below $30 in a year refinancing them should be actually pretty cheap — they might be able to effectively pay back the bondholders at 50-75 cents on the dollar (I haven’t studied the terms and I’m not an expert on converts, I just browsed through them again this morning — but that’s how it appears to me).

At this point, clearly, ICON appeals most to those who like to dig in the rubble — for “falling knife catchers” only, and any investors who follow any kind of stop loss strategy, even up to a very wide 50% trailing stop loss, would have sold by now. I thought about buying a little bit personally last time I wrote about it, and thankfully (in retrospect) didn’t do so, but since I don’t follow a strict stop loss strategy for the stocks I cover (more on that in a moment), we actually have to think about them… what do we see when we look at this as a brand new company?

Well, we see an overlevered balance sheet, so they do need access to the capital markets for either new equity or refinanced debt by early next year, particularly if they have any intention of growing (which means either investing in their brands by stepping up marketing, or buying new brands). The first convert matures next Summer, but they won’t want to wait until the last minute. We also see declining earnings, partly because they aren’t likely to be manufacturing extra earnings through joint venture deals (selling off or partnering regional rights to brands, for the most part) this year and partly because they are having trouble in a couple “real” areas: their mens fashion brands are not performing very well; and the big box stores who sell a lot of their brands (JC Penney, Wal-Mart, Kohl’s, K-Mart) are struggling or closing stores and generating lower royalties for Iconix. And I expect they’re also being pretty aggressive about lowballing their earnings expectations — since there’s so much bad news and turmoil in management anyway, might as well try to get expectations lower.

So I have to be at least a little bit consistent and acknowledge that the story is a very different one than I expected, and investors are terrified of ICON right now — which means, if I misunderstood the potential that much back in April, I should remove it from consideration and put it on the “sell” list until we know a little bit more, even though I’m tempted to buy what looks to me today like an overreaction.

You will continue to make your own decisions about your own investing, of course, but I’m giving the market the benefit of the doubt and moving to a “wait and see” status — I suspect that things have gotten so bad with management credibility and worries about possible accounting problems (and increasing reliance on the success of the Peanuts film, given some of their fashion brand weakness) that the stock, even if it does report good news (like, if they’re able to hire a fantastic new permanent CEO, or have a good back-to-school season with Candies or their other brands that gives investors reasons to be more confident in the core business) will probably not spike dramatically higher right away… with the earnings decline expected this year I think that if something good happens to stabilize the stock or improve my confidence, we ought to have time to get back in to the shares at a reasonable price.

If you’re at all confident in management and think that they’re essentially dropping all expectations to batten down the hatches, then you might be more optimistic and confident enough to buy here — the cash flow is fantastic for a company this size, even though it’s lower than expected, the debt will probably not be too difficult to refinance if cash flow stays solid, and some of the brands, like Peanuts, obviously have substantial enduring value… I’m just trying to be conservative. I’m horribly tempted to buy collapsed stocks that still have good free cash flow, but there are enough little red flags here that I’m fighting my instincts by being cautious and waiting for more news.

In other news, my favorite hospital REIT Medical Properties Trust (MPW) has had a rough few weeks — but just this week they got financing on good terms, which had been a worry for me after their failed equity fundraising of a couple weeks ago… so my confidence is at least partially restored, and I bought a bit more.

Particularly worth noting is that they funded a large part of their expansion financing needs (not all of it, to be sure) at a decent rate for seven years (4%), but also that they funded it in Euros — which helps to ameliorate the currency impact of their substantial presence in Germany and their smaller presence in Spain, Italy and the UK. This means they’re making some strategically important decisions for their overseas expansion, financing euro-denominated acquisitions and investments with euro-denominated debt, which reduce the risk that huge currency swings will cause a serious problem for their balance sheet (like, if their German rehab hospitals keep earning the same amount in euros, but the euro falls in half against the dollar — if the debt were in dollars, that would be a crisis, with some of the debt in euros the impact is far more muted… though it would, of course, still hurt earnings to some degree).

That makes me feel a little better about the currency risk, in addition to giving me more comfort about their ability to continue to roll financing to fund the substantial expansions that have been underway. It’s certainly risky — it might be that I’m missing something, or that interest rate changes will hit MPW harder than I expect if and when interest rates do start to rise more meaningfully, but I still consider them to be well-managed and in a growing sector, and they’re now trading at an extremely high yield of 7.5%. I added a small bit to my holdings — even if 10-year treasuries go crazy and return to a more normalized interest rate (like 4-5%), a solid non-cyclical REIT with the ability to pay that high a yield and grow the dividend (albeit slowly) is compelling. If equity financing continues to be available for MPW, which from the failed equity offering a couple weeks ago seems largely to be a matter of REIT sentiment, then this is a very solid, focused health care REIT that trades at a substantial discount to the sector. My buy today was small, but the stock is close to my initial buy price now (though the yield is higher, thanks to rising dividends) and I’d buy more if I didn’t already have a substantial position — that isn’t to say that the price can’t come down, because the big swings on interest rate sentiment have a good chance of hitting essentially all REITs in the year to come, but the high yield, expected dividend increases, and sector focus are all compelling for me at this price (around $12).

And speaking of buying falling knives, I want to let you know that I am trying to open my mind to more formulaic trading — or, more specifically, less emotional decisionmaking about selling stocks. I know that a great many of you are firm believers in setting trailing stop losses for your investments, and that there is some justification for that (particularly for people who are also disciplined about reinvesting that money into suitable investments within some reasonable time frame, not just getting scared out of stocks altogether). We also ran an interesting guest article from Tim du Toit[1] earlier in the Summer about the academic research supporting stop losses, if folks are curious about the rationale for these risk-limiting trades.

So I’m going to test something.

I don’t like the logic of a flat trailing stop, either the traditional 15-25% trailing “stop loss” order or the non-trailing stop (ie, sell if it falls 10% below my entry price), in part because every stock is very different and some stocks can easily move 15-25% up and down several times a year without any real fundamental changes in the company. I’m also not interested in committing to a stop loss strategy for the most volatile tiny stocks that I speculate on sometimes — for those, the only real risk management strategy that works is either a huge trailing stop, like 50% or more, or simple position sizing (don’t speculate with more than you can afford to lose — as in completely, 100% lose) — if you’re speculating on something that might take several years to come to fruition, then the pricing of that stock, whether it’s a junior gold explorer or a very small company that’s building a brand or an early stage biotech (for example), is likely to move in broad swings of irrational optimism and pessimism… I’m not going to become a trader who tries to ride those swings very aggressively.

But I’m intrigued by the various stop loss services that use technical analysis and an analysis of a stock’s volatility to set “smarter” trailing stops — stops that alert you when the stock drifts out of what might be a “normal” range and, perhaps equally importantly, that give you some guidance on re-entry using the same kind of logic.

So in the interest of learning more about this kind of formulaic loss-mitigation, I’m going to be a guinea pig for Trade Stops (tradestops.com), one of the two relatively well-known services. They are not an advertising partner, and I paid for my membership, so I’ll hopefully be relatively unbiased when I look at the results as they hit my portfolio.

I will share what happens with the stocks I look at and, as this is a test to see whether I’m better off with my own brain or with a system, will go “halfsies” in my personal portfolio — for most of the stocks I own (not those hyper-volatile speculations, but pretty much everything else), I will test this out and honor the “Smart Stops” with half of my position, then check up on it as the year goes on and see how that performs, whether I would have been better off with my (sometimes extreme) patience in the face of a falling share price, or whether cutting losses works better for me. I’m planning to try this for at least a year, but we’ll see how it goes. This does go against much of what I believe, so it will be tough — if Facebook, for example, falls to $70 it’s going to hit the trailing “smart stop” and I’ll sell half — but if nothing fundamental has really changed about the business I’m going to think it’s a red-hot buy at that price.

I’ll also keep track of and share, as seems relevant, the Tradestops assessments on the stocks I track for the Irregulars, so you can get an idea — whether or not I personally decide that there are fundamental reasons to close out a position — of what the signals say about those stocks.

When it comes to Medical Properties Trust (MPW), that’s grandfathered in — I looked over the situation and decided to buy some shares before deciding to commit to the Trade Stops strategy for part of my portfolio, but the assessment from Trade Stops for MPW today is that the stock had already triggered its smart stop by closing outside the expected volatility range… and that if investors have a good reason for investing now, they will set a firm stop using that volatility range (they call it the “volatility quotient” or VQ), so the stop loss order for MPW goes in at $10.09 (I’m being arbitrary and using the price from a week ago, when I wrote about MPW most recently and started looking into the stock again). If it hits that stop from here (which is also a price that the shares haven’t seen in almost three years), I will stick with my “follow Trade Stops” experiment and sell half of my position. Even if it causes me to gnash my teeth.

Iconix, by the way, is a no-no for Trade Stops — they hit any kind of possible stop loss ages ago and they’re still unwelcome in that universe. It will take a while for a new calculus to evolve about the stock, I imagine, as they set a new trading range. Assuming, of course, that they don’t snap back quickly — and my guess is they won’t, not unless the Peanuts movie gets phenomenal “buzz” and gets investors excited going into the Fall.

What else is going on? In the big picture, the latest gnashing of teeth from the investing punditocracy has been about the Yuan — with markets panicking all week because of the fact that the Chinese Renminbi/Yuan exchange rate blipped up. Why, in a world where exchange rates fluctuate freely and sometimes dramatically, are we all worried about the Yuan? Mostly just because it’s a signal — a signal that the Chinese are worried about exports and therefore want to devalue their currency, and, since it’s China and the exchange rates are almost completely controlled by the government, their changes in policy can have an abrupt impact both on sentiment and on actual exchange rates.

I suspect many of you will disagree with me when I say this, but I don’t think the Yuan is a big concern. Yes, the exchange rate is changing, and that’s largely because China wants to help its exporters because their economy is lagging and they’ve been having a hard time sustaining both a property bubble and a stock market bubble so far this year… and I wouldn’t be investing a lot in Chinese companies, but I’m not doing that anyway (partly because I’ve been burned many times by management chicanery or obfuscation).

The notion that this should make the whole world shudder is a leap, however — the Yuan has been appreciating for a couple years because of political pressure from the US and others, and now it’s depreciating a bit again and making folks worry about currency wars again, but it’s still, aside from the US dollar, been one of the strongest global currencies, which has really impacted the performance of their economy because they have a current account surplus with essentially every other country in the world (they export more to everyone than they import, which means their products are less competitive as their currency rises).

It’s remarkable to me that China can manage such a massive economy with so much central planning, and it may well end very, very badly in a “hard landing” that may already be occurring — but not just because of small fluctuations in currency exchange rates. Really all this is, from my perspective, is China trying to distance itself a little bit from the strong US dollar — their effective peg to the dollar, with gradual strengthening in the Yuan in past years, means they’re effectively tying their slowing economy to a currency that’s in the process of starting to tighten, the opposite of what they want to do to stimulate the economy, keep the stock and property markets from collapsing completely, keep a billion people employed and satisfied, and remain the factory for the world.

It might mean big things eventually, but you’ll have to master chaos theory to know exactly what and when… this is just a surprise blip from a sudden move from a difficult-to-understand major but non-floating currency. And it should be a sign, I think, that those who fret about the Yuan taking over as the world’s reserve currency and shunting the dollar aside are doing a lot of premature worrying — if the Chinese leaders are focused on trying to control their currency and keep stimulating the economy, they’ll find that a lot harder to do the more they open up their currency to outside forces and let it float more fully… and, of course, you can’t have a real “reserve” currency if it’s controlled solely by politicians and doesn’t float in the open market or respond to market forces. The floating currencies have all gone down far, far more versus the dollar over the past year or two than the Yuan has in recent weeks, and some of the moves have been relatively abrupt as well (though they’ve mostly happened over weeks or months, since they’ve been market-based, not based on overnight decrees), and we’ve fretted about many of them, too. For small investors, betting big on currencies is usually foolish — think about real, sustaining value instead, and about the currency you’re going to need to spend your money in when you’ve sold your investments… even though we’ve had pundits predicting (and fearmongering about) the collapse of the US dollar for most of the past ten years, being overly exposed to any other currency during that time would probably have been a mistake. The claim that fiat currencies will all collapse and be replaced with some hard-asset-based currency system is logical but improbably — as long as we have politicians, they’re not going to want to tie their hands to the price of gold. It might be that we see the US Dollar replaced as the globe’s reserve currency by some mixture of currencies — but anyone buying just one currency today, unless they’re looking to be a “value” investor or catch a falling knife, would almost certainly buy the dollar.

Which is really a long way of saying, if you’re an individual investor who likes to speculate on individual stocks, that thinking too much about the “macro” picture will make you crazy… keep it simple, diversify around the world to at least some extent, invest in companies you understand that are tied in some way to economic trends that you feel you understand, and don’t try to out-fox the central bankers or George Soros by betting big on your logical (and sometimes politically motivated, if we’re being honest with ourselves) opinions about global macroeconomics and potentially destroying your portfolio. If you have to make a bet on what central bankers will do, and when, and what the European Central Bank or the Chinese government might do to swing currencies over a weekend, keep those bets small.

Endnotes:
  1. interesting guest article from Tim du Toit: http://www.stockgumshoe.com/2015/06/microblog-truths-about-stop-losses-that-nobody-wants-to-hear/

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