Fed Freak Out

As we approach the end to an incredibly strong first half of the year, the Dow posted its worst day of the year with a 354-point drop. That’s a 2.3% decline, and we saw similar action with the S&P 500 and NASDAQ. There were a couple of key reasons for today’s sell-off, one we’re hearing about nonstop and one that got very little attention today but could prove more serious in the long run.

The reason we’re all hearing about is the Fed’s announcement yesterday that its quantitative easing (QE) could be cut back by the end of the year and possibly come to an end next year. The talk of tapering wasn’t as much of a surprise as the possibility that QE could be done by this time next year. The Fed said that downside risks to the economy and the employment outlook have lessened, setting the stage for winding down the program.

It’s important to remember that any cutback in QE would be dependent on further strengthening of the economy, and in his press conference, Chairman Ben Bernanke clarified for the first time what he would consider to be enough of an improvement to begin cutback on asset purchases (currently $85 billion a month), citing an unemployment rate goal of 7%. Since the current rate is 7.6%, it will be at least a few months before we reach this level, which means that QE will likely be around in some form through the second half of this year.

This did not offer much solace to the bond market, as the yield on 10-year Treasury bonds reached 2.31% yesterday and moved over 2.4% today – the highest level of the past 12 months. Interest rates will be key to the market’s movement as QE unwinds.

The tapering of QE will continue to be the biggest question facing investors in the second half of the year. We’ll have to watch closely when it is likely to begin, the extent to which the program is cut back, and the impact on interest rates. For now, it is critical to remember that the scenario laid out by the Fed yesterday is merely a possibility; it is not set in stone. Bernanke has also made it clear on previous occasions that ending QE prematurely would jeopardize the economy, and with some of the recent economic data weakening a bit, the timing is still very much up in the air. It’s possible that the Fed will have to wait until 2014 to begin tapering QE, and at that point, it would fall to Bernanke’s successor to wean the market off the stimulus it’s become addicted to.

The other big reason for today’s sell-off got drowned out by all of the QE talk, and that is a couple of potentially serious issues with China. First, China’s flash Purchasing Manager’s Index (PMI), which is an indicator of manufacturing activity, fell to 48.3, its lowest level in nine months. And second, the rate on intraday bank loans between Chinese banks surged to 12.33% amidst a growing cash crunch. Banks are also asking for money from the People’s Bank of China (PBOC), and they’re not getting it yet.

This is something you often see during financial crises, but China isn’t at that point yet, and the current situation there can be reined in. Still, their banking systems have come under fire by Fitch Ratings recently, and there are likely a good deal of bad loans on the balance sheet of Chinese banks, considering the vast amount of  investment made in that country in the past years.

Fortunately, most of our Breakout companies have little, if any exposure to this situation. Warren Resources (WRES) is the one company that could be affected by China’s problems, given that oil prices have dropped due to declining demand from China. I’ll be watching to see if there is any likely impact on WRES’ earnings. However, WRES is very cheap at current prices, and I was encouraged that the stock hung in there reasonably well today.

I also believe that our current stocks are well equipped to handle the expected rise in interest rates. The market needs to adjust to the fact that rates will be higher, and that’s what we’re seeing right now. There will be more bumpiness along the way, but the fact is that the market knew this was coming and was not banking on 2% 10-year Treasury yields forever. And if the economy is truly strong enough to start to unwind QE, growth will help offset the higher rates.

Sell-offs are never fun, but to be honest, a correction is both natural and healthy at this point, given the strong gains this year that have come despite limited growth in earnings. At the moment, I expect the market to find support no lower than 1560 on the S&P 500, where it traded just two months ago. Here in Breakout Stocks Under $10, we want to use weakness as buying opportunities. I’ll be watching quality stocks that moved up out of our target zone in the latest run, and we’ll be ready to grab them should they come back to us. We’ve been preparing for this volatility by locking in profits that could become vulnerable, and I expect us to get more exciting opportunities to put that money back to work.

The Impact of Rising Rates on BZ and MFI

Boise Inc. (BZ) stock has performed well over the last month. It has given some of those gains back in recent days, and I continue think the stock is a good buy if you can pick it up under our $8 buy limit. The market hopes that cost rationalizations recently taken by management, along with an improving economy, will lead to better earnings. Although BZ has $765 million in long-term debt, it should not be affected by a rise in interest rates when the tapering of quantitative easing (QE) begins. This is in part because $600 million of the debt carries an average fixed rate of 8.5%, above current market rates for a company with BZ’s financial profile. Hopefully, this debt will be rolled over at a lower rate by the company when it comes due. In the meantime, management will continue to use their cash flow to reduce the debt load, which I feel is the best use of capital for the company at this time.

I will be keeping a close eye on the company’s uncoated free sheet business over the next few quarters. I want to make sure the weakness doesn’t become more than what I currently anticipate, but I do expect BZ’s cost reduction to help cushion the fall. For now, the stock remains very cheap at 5.3 EV/EBITDA. Buy BZ below $8.

MicroFinancial (MFI) could be impacted by rising interest rates in a good way. The company’s primary asset is an investment in leases of $159.2 million, and its chief liability is a line of credit used to finance the leases of $69.2 million. The interest rate on the line of credit is tied to the prime rate, which is short-term in nature and should rise when short-term rates increase. However, keep in mind that while the Fed may end QE, it has said short-term interest rates will not rise until at least 2015. I do not expect MFI’s earnings to be harmed by rising rates through next year.

In addition, management may be able to more than make up for increased funding costs by raising the rates implied in each of the leases, which are around three to four years in length. Of course, this would depend on demand and competitive conditions, but it is quite possible that MFI could be helped by higher rates, given that the value of their leases is so much greater than the amount outstanding on their line of credit.

Although MFI continues to be penalized by the decline in lease originations from last quarter, which could have been based on a statistical quirk of many lower-priced lease originations, the total amount of leases completed and the pipeline remains strong. I look for the company’s investment in leases to expand going forward. Meanwhile, MFI’s market capitalization of $105 million is only $30 million greater than the $75 million value of the company’s leases less all liabilities. This makes MFI a very cheap stock, given the current good credit conditions, future growth prospects and 12% return on equity. The company also offers an attractive 3.4% dividend yield. MFI remains a good buy under $8.50.

MEIP and CRY Begin Testing

MEI Pharmaceuticals (MEIP) announced that their first patients have been treated in a Phase II clinical drug trial with the lead drug candidate Pracinostat in combination with Vidaza (in patients with previously untreated intermediate-2 or high-risk myelodysplastic syndrome (MDS)). The trial is designed to compare the safety and effectiveness of the combination versus treating MDS with Vidaza alone. An earlier pilot test of the combination showed that eight out of nine patients responded to the treatment, including seven patients who achieved either complete remission or complete remission with incomplete blood count recovery. This is the first in a series of Phase II trials the company is planning; a multicenter trial will be underway by June 2014 with data expected by December 2014.

If data is strong from the current Phase II test, it should serve as a catalyst for the stock.  As I have mentioned before, positive news is what moves early-stage companies like MEIP. Buy MEIP below $7.25 for a target of $13.

CryoLife (CRY) announced on Wednesday that it had received approval from the FDA to begin testing its hemostat compound PerClot, which is used in surgical procedures in the U.S. CRY has been selling PerClot globally since the fourth quarter of 2010, and its sales were up 34% in the first quarter. With the hemostatic estimates expected to rise from $889 million in the U.S. in 2012 to $1.1 billion in 2014, PerClot in the U.S. offers a significant opportunity for CRY. Management hopes to begin testing by the fourth quarter of this year, and have approval by 2015. I look for the stock to begin picking up steam as the company continues to perform well. Continue to hold CRY for our target of $7.50.

Breakout News & Notes: ISSC and TLF

Innovative Solutions and Support (ISSC) has fallen after some of the excitement over the company’s major contract win at Delta Airlines wore off, and because there has not been another new major win announced. Aside from the Delta contract, which will help ISSC a few years down the road, the company’s existing operations are improving dramatically, and further increases in earnings are likely. The stock price will also be supported by the buyback recently announced by management, and ISSC’s solid balance sheet, with $1.60 a share in net working capital. Continue to buy ISSC under $8.00.

Tandy Leather Factory (TLF) adopted a rights agreement designed to prevent an unsolicited takeover of the company. I have mixed feelings about the agreement, given that this could be a sign that management is not willing to negotiate with a potential suitor who intends to pay a fair price in an acquisition. This is something I’ll continue to watch. Looking at the company itself, I still like TLF because of its good recent earnings and favorable valuation. Continue to buy TLF under $8.00; our target is $10.50.

Sincerely,

Hilary Kramer
Editor, Breakout Stocks Under $10