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Friday, August 13, 2010

JPM's high free cash flow, low PE names

Equity markets faltered in the past week, as the specter of slower growth (last Friday’s labor report, Fed action Tue, CSCO comments) mixed with disinflation concerns (Treasuries seeing new low yields) fuel the uncertainty that has been a headwind for equities. And with a flick of the switch, investors went “risk-off” but with a twist: corporate credit, both investment grade and high-yield, hit fresh highs, MBS rallied, while equities sank 3.7%. Those in the deflation/double-dip camp simply point to the low 2.72% on the 10-year Treasury—but that is misleading, since Treasury yields reflect both the economy and monetary policy. It appears the Fed would like to see a lower 10-yr yield— it forces investors to seek duration or risk. Already we are seeing all-time low yields in high-grade debt, almost record-setting low yields in high yield, and potentially a major refinance wave in mortgages. All of this ultimately has positive implications for equities:

(I know you bears need everything spelled out twice for you--so in  case you missed the highlighted names, just follow the rifle of beret wearing young  lady!)

#1: LOW 10-YR DRIVES FURTHER RALLY IN CORP. CREDIT: FOR FIRST TIME IN HISTORY, THE YIELD ON HY BONDS COULD DIP BELOW S&P 500 EARNINGS YIELD, PUSHING CORPORATES TO FUND RECORD 75%-80% VIA DEBT MARKETS (vs. EQUITIES). A strong rally has ensued in corporate credit, with investment-grade YTW 4.41% (see Figure 3) basically an all-time low, and high-yield bonds YTW at 8.3%, within 30bp of the April 2010 levels. By comparison, the S&P 500 earnings yield is 8% (NTM EPS of $88), which is the narrowest spread EVER between HY and S&P 500, which has averaged 510bp since ’87. The extremely low debt funding costs are not lost on corporates. Recently, equity is now only 15%-20% of all capital issuance, the lowest levels ever (Figure 6). Ultimately, this implies lower equity dilution, particularly compared to the ’50s and ’70s, when equity issuance diluted EPS returns (Figure 8). Based solely on lowering borrowing costs 100bp (excluding benefit of no EPS dilution), this adds $3.50 to S&P 500 EPS ($542 debt per share X 100bp X 65%).

#2: 2.75% 10-Yr TO DRIVE 30-YR MTGE BELOW 4.5%, $900B TO $4T IN REFI. ~$40B IN ANNUAL HH SAVINGS. The drop in 10-yr yields could trigger a large mortgage refinance boom. Our MBS team believes the 30-yr fixed rate mortgage will dip below 4.5% (lowest since the ’60s) with about $934b of recent-vintage mortgages (after 2008) qualified to refi. We estimate that across all existing mortgages, as much as $4T could refi. The estimated annual drop in interest costs would be $38b per year (see Figure 10).

#3: HISTORY SHOWS 10-YR AT 2.7%-3.2% IS NOT ASSOCIATED WITH LOW GDP GROWTH NOR DEFLATION. We took a look at the 3 times since 1900 when the 10-yr was 2.7%-3.2% – 1900-02, 1933-35, and 1952-58 (see Figure 11). Real GDP averaged 5.1% (Figure 12); inflation 1.7% (Figure 13); S&P 500 P/E 13.9X (see Figure 16); and annual equity returns 10.2% (Figure 17). In other words, this supports our argument that a low 10-yr does not rule out improving equity returns. We would rather the market smell reflation, but a low 10-yr is not necessarily deflationary.


MARKET STRATEGY: LOW FOR YEAR HAS BEEN 7/1. 24 COS W/HIGH FCF BUT LOW P/E. The 3.7% decline in equities in the past week is disappointing. However, we see the growing relative value chasm between corporate credit and equities as resolving favorably for equities. We identified 24 companies with high FCF yields and low P/E, using the following criteria: (i) FCF yield >8%; (ii) P/E <11x; (iii) EPS positive in ’10E/’11E; (iv) rated OW by JPM; (v) Mkt cap >$3b. The avg FCF yield is 12% and P/E 9.6X. The tickers are: TRW, AET, M, CEPH, FCX, UNH, APOL, ENR, ASH, RTN, ALV, NWL, CI, DISH, CA, NSM, AMGN, LMT, DV, MRVL, HPQ, DAL, MYL, and RIMM.

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