Annual Review: This Week’s Updates, Disney, Five Below, and Options Speculations

by Travis Johnson, Stock Gumshoe | January 19, 2018 11:09 am

Real Money Portfolio Updates for this week

I’m full into “Annual Review” mode now, when I make sure to take a good hard look at each holding in my portfolio — some of my positions are very long-term oriented and don’t often come to mind except as thoughts of, “yes I’ll probably still hold this one pretty much forever” wash through my mind, but I do promise to take a look at each stock at least once a year (most of them, of course, generate some blatheration from me throughout the year as well).

Sometimes these annual reviews cause me to do some significant rebalancing, or to change my mind about a stock and sell or grow a position… sometimes they’re just a reason to check and make sure that the company is still doing what I expect it to do. But in a few cases, as now, there are holdings in my portfolio where I have to (gasp!) do something — mostly because I’m holding all or part of my position through options that expire.

So, in the interest of being clear for folks who have asked about my January options that are expiring (since options expiration day is, well, today), I’ll post the updates on those positions now, as the market opens, so you can have a little time to think about them if you happen to be holding similar positions.

First, the easy ones: These speculations didn’t work, and they are expiring worthless for a 100% loss…

Vanguard REIT (VNQ)
Jan 2018 $96 Call

iShares High Yield IBOXX (HYG)
Jan 2018 $80 Put

Those two were part of a small speculation I made back in May [1]that the yields for junk bonds and REITs were way out of line with each other — and that it was likely that either the HYG price would drop or the REIT price would rise to get those back to their previous relative yields. That didn’t happen… HYG fell a little, but not nearly enough, and VNQ fell even further. A reminder that macro forecasting is hard, and if I can’t resist making such bets in the future I should at least keep them small and relatively painless, as this loss is. (JD)
Jan 2018 $50 Call
Jan 2019 $30 Call
Jan 2019 $70 Call

January 2018 option contract closed out of the money for a 100% loss, is still a buy in my mind and I continue to have 2019 option positions that are larger, both in the money and out of the money.

The 2018 contract was a speculation that shares would bounce back pretty quickly from the fall they took a few months ago. They have, but not far enough — I also hold some January 2019 options at both $30 and $70 which are doing well enough to easily make up for the loss on this shorter-term speculation… at least so far. I’m likely to take some profits from those longer-term positions at some point in the relatively near future if JD shares continue to be happy in the next few months (generally, with longer-term options speculations my strategy is to take partial profits on the way up if the position is extremely profitable, since options profits can easily disappear if you get greedy and the stock hits a soft patch at the wrong time).

I’m still quite optimistic about both and Alibaba at this point (I also hold a long-term BABA call option position), and consider both to be high-risk buys. Both obviously very richly-valued growth stocks with high risk, both because of their rich valuations and because they are almost entirely China-focused (they are among the class of the China tech sector, to be sure, along with Tencent and Baidu and a few others, but will still be swayed both by investor sentiment about China, and by any regulatory or economic changes that are felt in that country… where systemic risk from consumer and corporate overleveraging and opaque government priorities is quite high).

And now, the current option positions that are expiring but do have some value, and my updates on those companies…

Walt Disney (DIS)
Jan 2018 $100 Call

Option position closed, opened a new equity position with a ~2% buy at $110.

I’ve had a position of one sort or another in Disney for a couple years, but my equity holdings were stopped out during one of the periods of ESPN panic last year — and this position in January 2018 options was, at the time, looking like it would expire worthless as well.

Then along comes the proposed acquisition of most of the Fox entertainment holdings, and Disney becomes clearer about sharing their “direct to consumer” strategy, and another Star Wars movie does well, Black Panther sets presale records about a month before that blockbuster comes out, and, well, whaddya know… Disney is somewhat liked again, if not loved, and these options are worth something. So what to do?

I still like the Mouse House, and I think the Fox acquisition is likely to be a huge positive for them in terms of leveraging content and taking control of Hulu as a platform for competing with Netflix… and, not least, because it means Bob Iger will stick around for longer. No one turns a story into a powerful brand as well as Disney, and that’s clearly the main reason to own the stock for the long term, with Star Wars and Pixar and Marvel and now 21st Century Fox (assuming the deal goes through) all generating more and more powerful stories.

The financials remain reasonable, with a pretty rational reckoning for the impact of cord-cutting now in the estimates, I think, and ESPN showing some signs of resiliency as viewership remains strong both on cable and directly… though it is clearly a “blue chip” and is not a cheap stock. They will benefit some from the tax cuts, both because stimulating the US economy is generally good for entertainment companies (more folks go to Disney World, maybe they’ll see Black Panther three times instead of twice, etc.) and because they pay a fairly high tax rate (32% last year, roughly, though that wasn’t all corporate income tax and wasn’t all at the US federal level). My guess is that the impact in 2017, were the tax cuts in place then, would have been a boost of close to 10% for net income… and 2018 was already expected to be a growth year, but the estimates for 2018 earnings only went up by about 3% following the passage of the tax cuts, so I suspect the full impact of tax cuts is not really in those estimates yet. Either that, or I’m guessing high.

That’s true of a lot of stocks, I expect, they are clearly valued more richly now, in anticipation of tax cuts helping the bottom line and general “animal spirits” rising because of a perception of a “corporation-friendly” government in Washington, but the actual analyst estimates do not yet incorporate the full effect of tax cuts in most specific companies. That means there is probably some potential for upgrades and positive attention for specific stocks as those adjustments are made, even if tax cuts are already “in the market.”

Right now, Disney has a forward PE of about 16, and analysts believe that earnings growth will average 8% a year over the next five years — so it’s right at that top end of “fairly valued” on a PEG Ratio basis at about 2.0 (meaning you’re buying at a PE ratio that’s about twice the growth rate — many folks consider PEG ratios between 1-2 to be in the “fair to attractive” neighborhood). That sounds better than it would have a few years ago, because the PE ratios of all stocks have gotten so high as the market has risen, but it’s still not necessarily cheap. It is, though, quite low for Disney historically — over the past 30 years Disney has always traded at at least a slightly higher trailing PE than the overall market, with the exception of 2009… and, more recently, 2016 and 2017, when it has traded as low as about 80% of the S&P’s PE ratio. I think the asset quality makes it reasonable to assume that DIS should again trade at a premium to the market in the future — Disney has a truly unique business and a unique hold on global culture.

That’s not a reason to go crazy buying shares of Disney, which will almost certainly go down if the whole market goes down… but the Fox deal appeals to me with its potential to leverage growth a bit more, and I think Disney is the only studio and content creator that can effectively compete with Netflix going forward, so there is as much room for a positive catalyst as there is for negatives from the trend of “cord cutting”. The biggest risks on the entertainment side are probably cost-based — the incredible wave of creative output in Hollywood is now fueled by huge and earnings-agnostic companies like Netflix and Amazon who are focused on growing viewership, and that pushes costs of production higher for creative work (and, as we’ve seen with ESPN, pushes rights fees for sporting events higher). It’s hard for a company that’s judged on its profits, like Disney, to compete with a company that doesn’t care about profits, like Amazon… but I think that hurts the smaller players much more than it hurts industry giant Disney.

What do I do then? I’m going to exercise part of this position. As of yesterday’s close, I sold half of my options (at a loss), and exercised the other half to open another DIS position — which ends up being a fairly large position for me, almost 2%, which is a bit more than I’d typically commit to a first purchase, but I have a pretty good comfort level with the company and have followed it for a long time. I’ll record that impact on the close of the options trade in the Real Money Portfolio, so the DIS position is technically a purchase at $100 but I’ll enter it at the market price of about $110 for that renewed position.

Five Below (FIVE)
Jan 2018 $60 Call

Options contract for January was closed with a small gain of about 18%, and I’ve now grown this to a near-2% portfolio position by more than doubling the equity stake, average cost basis roughly the same as my first purchase, back in December, at $66 and change.

And I have a similar situation to Disney, though much shorter in the brewing time, in my Five Below options. I bought shares in FIVE last month[2] because I like their growth trajectory and the huge runway for future growth they have as they build out their store base — combining a rapidly rising store count with strong same-store-sales growth can lead to really fantastic returns for a good retailer, and it certainly appears that FIVE is just that, with their ability to consistently appeal to fad-driven teen shoppers and their parents and thrive in a retail landscape that often seems hopeless in the shadow of Amazon.

So that’s why I bought the shares, with the intention of adding more to the position. I also entered into an in-the-money options speculation at the same time, because I thought there was a decent chance that the stock would take off before I got comfortable enough to build my position to be a little larger… mostly because I thought FIVE would be a large enough beneficiary of tax cuts that analysts would be likely to raise their forecasts pretty aggressively.

That has happened to some degree, but the company came out with a “preannouncement” that failed to quite match analyst expectations for the holiday quarter or to specifically raise expectations for 2018 (though there’s no reason why they’d have to jump the gun on that), and the stock gave up some of the quick surge it had seen through the holidays. This was a very small distinction, but it doesn’t take much to take a growth stock off the rails for a little bit — analysts had been forecasting full year earnings per share (their fiscal year ends January 31, so it’s not over yet) of $1.80, and the company simply reiterated that the earnings would be “near the high end” of the previous guidance (which was $1.72-1.79).

The stock price is now back to essentially what I paid for the stock, though EPS estimates for next year have come up and that forward PE has, as anticipated, come down from the low 30s to the high 20s, but the stock has not reflected that — so perhaps it was baked in to some degree, or perhaps investors just aren’t willing to take a huge chance on this one when earnings don’t come out until late March… even though I’d say that the announcement last week significantly de-risked the earnings (we know they’ll be at the top of their forecasted range, at a minimum), the risk is really that they might offer guidance that’s lower than investors hoped. Part of the risk is in guessing whether they will have a relatively soft growth year like 2016, where comparable sales were only up about 2%, or a strong year like 2017, when comps were up about 6% — those comparable sales numbers provide the leverage on top of the new store growth, which is the real driver of sales growth (they’re planning 125 stores for 2018, so roughly a 20% increase in the store count, and they open stores cheap, with a quick payback of less than a year on the cash costs of building out stores… and have no debt).

I continue to like everything I’ve seen with FIVE since buying shares, so I’ll let the options position close out at roughly a wash and will concurrently increase my equity position — so that holding is more than doubled now and represents just under 2% of the portfolio . That’s a fairly aggressive position for me when it comes to a relatively small, volatile and richly valued growth stock, and I’m mindful of the fact that any kind of economic softness will be hard on such stocks (dollar stores, in general, surged back quite quickly after the last recession, rebounding much more quickly than the overall market… FIVE is not really the same as the dollar stores, they’re more trend-driven and teen-focused, but it’s the closest comparison and we’ll probably still have teenagers next time there’s a recession). But businesses that are growing their store count this aggressively and generating an immediate profit on each new store don’t come along very often, so I’m willing to pay a high price for that — particularly because I have essentially no other exposure to retail in my portfoliio.

Xylem (XYL)

Xylem shares were added to the Real Money Portfolio yesterday at just under $71, roughly a 1% position.

I also, as those who were watching would have noticed yesterday, added a new stock to the portfolio this week — I bought shares of Xylem following some research that I did on a teaser pitch about the stock[3]. Xylem is a water equipment and services company, offering a wide variety of equipment (pumps, etc.) and, increasingly, “smart” equipment (smart meters, leak-detection algorithms, etc.) for industrial and municipal customers. They are acquisitive, and I bought because they’re doing a good job of acquiring companies (for cash, using debt and cash flow instead of stock) and turning those acquisitions into growth in a consolidating industry. There are several other interesting companies in the space, but none match Xylem for the combination of valuation and growth expectations… at least, not the ones that are already of an appreciable size, as Xylem is, and with a strong customer base in place that makes each acquisition more valuable.

The company was a spinoff from ITT back in 2011, in the last wave of ITT disgorgements (there have been several — remember the 1970s, when ITT seemed to own everything?), and it has bee moribund for quite some time, not really generating any growth… then the oil crash jolted them awake a bit, as I imagine things, and caused them to strategically push for growth with some acquisitions and a push more into services and high-tech equipment, in part to replace the nice boost that all the water and pumping equipment makers were enjoying from the shale oil bonanza until oil prices collapsed in 2014.

So the story I tell myself about this one is that they’re reorganized and restructured for growth, with a strong focus on municipal and industrial water treatment equipment and, increasingly, “smart” and networked equipment that makes water use far more efficient, and they’re growing both organically, as investment continues in fixing and upgrading water systems, and through more acquisitions… and, in a possible juicing of future returns, might see some benefit as the oil and fracking business has picked up again. They’re expensive, but high quality, and they can grow.

The other stock in this sector that has tempted me is the much smaller and more value-priced Mueller Water (MWA), which is trying to do something similar in building out a “smart” water control business from what is really an “old school” manufacturing company that dominates one small sector: fire hydrants. They have a huge installed base of hydrants around the country, and also specialize in other heavy iron valves and such, and they also had a pretty good year last year as municipalities did some upgrading… and have pretty high growth estimates from analysts.

My main concern on the “smart” side is that Mueller might not be able to get much traction with what is a relatively small portfolio of products — companies who can sell more products that can work with each other, potentially like Xylem, will have more market power in developing and establishing market share in whatever new standards of internet and “smart” connectivity are used by water systems. It’s harder for smaller companies to break in to the big picture thinking for major water systems, though that doesn’t mean they wont’ sell a lot of fire hydrants — or that they can’t leverage those hydrants to include “smart” leak check equipment and sneak in the back door that way. But on paper, Mueller is the one company in the water equipment sector that is profitable, relatively inexpensive, and expected to grow roughly as fast as Xylem, so folks who like the continuing push for water infrastructure investment but can’t stomach Xylem’s current valuation might find MWA more appealing… and I will keep an eye on the stock as well, though I’m not currently buying it.

  1. small speculation I made back in May :
  2. bought shares in FIVE last month:
  3. some research that I did on a teaser pitch about the stock:

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