Don’t Be Fooled: The Euro Will Take Us All Down

We closed the ZION position on October 3, 2019. A copy of the associated Position Update report is here.

Do not be fooled by the recent stock market run-up. Think of it as a set-up for a fall. Do not be fooled by how long insolvent organizations can perpetuate the poor capital allocation and spending decisions that created their insolvency. The euro is not that different from Enron, Worldcom or the Madoff fund. All of these organizations were able to pretend they were profitable or solvent long after they were insolvent. The euro has the distinct advantage of support from central banks around the world, but printing money, as I explain below, does not create solvency. It only delays the inevitable, albeit for a bit longer than accounting manipulation and ponzi schemes delay their inevitable implosion.

Investors need to pro­tect their port­fo­lios from the even­tual eco­nomic decline that will stem from the euro debacle.

The shell game in Europe is end­ing and mar­kets are yet to dis­count the struc­tural decline in the pro­duc­tiv­ity of economies around the world. These declines result from large-scale mis-allocation of cap­i­tal over the past sev­eral years and in the present.

And when I write “protect” your port­fo­lio, I mean take a net short posi­tion as I have in my port­fo­lio. Click here for a detailed expla­na­tion of why being net short is the best way to make money now.

When­ever a gen­eral mar­ket decline is on the hori­zon, the best pro­tec­tion is short­ing super expen­sive stocks with lit­tle under­ly­ing eco­nomic value. In other words, the stocks that will fall the hard­est are those whose eco­nomic earn­ings are already too weak to sup­port over-extended val­u­a­tions. I rec­om­mend short­ing the fol­low­ing stocks because they all have sky-high val­u­a­tions and low returns on invested cap­i­tal (ROIC), which, in these cases, result in mis­lead­ing earn­ings (account­ing earn­ings diverg­ing from eco­nomic earnings):

1. Valeant Phar­ma­ceu­ti­cals Inter­na­tional [VRX]
   • Cur­rent val­u­a­tion ($46.21) implies 16% com­pounded annual growth in after-tax cash flow (NOPAT) for 20 years
   • Low ROIC at 4.4% ver­sus weighted aver­age cost of cap­i­tal (WACC) of 8.1%
2. Dig­i­tal Realty Trust [DLR]
   • Cur­rent val­u­a­tion ($63.50) implies 18% com­pounded annual growth in NOPAT for 20 years
   • Low ROIC at 5.9% ver­sus WACC of 8.6%
3. Zion Ban­cor­po­ra­tion [ZION]
   • Cur­rent val­u­a­tion ($16.09) implies 14% com­pounded annual growth in NOPAT for 20 years
   • Low ROIC at –2.7% ver­sus WACC of 12.0%

Com­pare the expected growth rates to his­tor­i­cal organic growth rates and your jaw will drop, espe­cially for ZION.

Another com­par­i­son, the cur­rent val­u­a­tion of the S&P 500 (at 1,248) implies just 9% com­pounded annual growth for 20 years. How­ever, the S&P, accord­ing to our model, actu­ally gen­er­ates sig­nif­i­cant prof­its with an ROIC of over 20%, mak­ing it eco­nom­i­cally prof­itable. The com­pa­nies above are not cur­rently prof­itable, which makes mar­ket expec­ta­tions for future profit growth that much more dif­fi­cult to meet.

I also rec­om­mend avoid­ing or short­ing the ETFs and mutual funds below because they hold sig­nif­i­cant posi­tions in the stocks above and get my “very dan­ger­ous” pre­dic­tive fund rat­ing.

1. CGM Trust: CGM Realty Fund [CGMRX]- allo­cates 5% to DLR
2. Saratoga Advan­tage Trust: Finan­cial Ser­vices Port­fo­lio [SFPAX] — allo­cates 4% to DLR
   • Same applies to the B, C and I classes of the fund
3. Pow­er­Shares KBW Bank Port­fo­lio (KBWB) — allo­cates 3% to ZION
4. John Han­cock Invest­ment Trust II: John Han­cock Regional Bank Fund [FRBAX] — allo­cates 3% to ZION
   • Same applies to the C and F classes of the fund
5. Touch­stone Funds Group Trust: Touch­stone Mid Cap Fund [TMAPX] – allo­cates 3% to VRX
   • Other classes of the fund get a “dan­ger­ous” rat­ing instead of “very dan­ger­ous” because of their lower total annual costs.

Dis­clo­sure: I am short VRX, DLR and ZION. I receive no com­pen­sa­tion to write about any spe­cific stock, sec­tor or theme.