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The Icahn Lyft
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Episode 7 | Carl Icahn, Part 2
This Week on Wall Street
Market Win Streak Ends Amid Greece Anxiety, China Volatility
After shunning the “sell in May, go away” mantra for most of the month, stocks experienced a Memorial Day hangover to end a four-week win streak. Major US indexes fell for the second straight day Friday with the S&P and Nasdaq suffering matching 0.6% declines to end the week down 0.9% and 0.4%, respectively. However, for the month the S&P still registered a 1.1% gain, while the Nasdaq outperformed with a 2.6% advance.

US 10-year treasury bond yields fell 0.9% on the week back to 2.1% in a flight-to-safety trade, perhaps suggesting investors expect the data-dependent Fed to be more patient in the midst of a patch of soft economic data. The German 10-year bund yield, meanwhile, fell back to a paltry 0.5%.

US corporate headlines

The bellwether Dow Transports remain the most troubled sector of the market as the index fell 2.2% on the week and 3.4% for the month. Semiconductors were the strongest sector in May, with the PHLX Semiconductor Index surging 8.6% amid news Avago Technologies (AVGO) is in advanced talks to acquire Broadcom (BRCM). AVGO and BRCM shares rallied 7.8% and 21.8%, respectively, on the news.

M&A appetite remains high in this low-interest rate environment. Time Warner Cable (TWC) showed no emotional scars from its dalliance with Comcast (CMCSA) as it was acquired for $78.7 billion by Charter Communications (CHTR). The deal unites the second and third largest US cable providers to take on top-dog Comcast, but the deal will no doubt go under the regulatory microscope after the prospective Comcast-Time Warner merger was scuppered over anti-competitiveness concerns.

US economic data
 
This week brought one of the worst batches of economic data since the Great Recession. First quarter GDP’s second revision clocked in at -0.7% versus the originally reported +0.2%, representing the first US GDP contraction since Q1 last year. A larger trade deficit, smaller inventory accumulation and weaker consumer spending, blamed in part on a harsh winter, weighed on US economic growth.
 
Real final sales declined 1.1%, marking the biggest drop since a 3.3% decline in Q1 2009. Chicago PMI contracted for the third time in four months, coming in at 46.2 versus expectations of 53.0.
 
Bucking the gloomy trend were housing and consumer sentiment data. Pending home sales rose 3.4% to hit their highest levels since May 2006 while new home sales climbed 6.8% to a seasonally adjusted annual rate of 517,000. The S&P/Case-Shiller Home Price Index rose 4.1%. Consumer confidence climbed to 95.4, while The University of Michigan’s consumer sentiment climbed to 90.7 after a mid-month 88.6 reading.
 
Europe
 
Anxiety over the lack of tangible progress in bailout negotiations between Greece and its Eurozone creditors served another scapegoat for the late-week selling. Concerns are growing that both parties in the Greek bailout negotiations grow more willing to let the troubled country default on its debt.

While Greece’s Economy Minister Giorgos Stathakis said his country will make next Friday’s 304 million Euro debt payment to the IMF, bank deposit outflows in Greece are accelerating and have fallen to decade-low levels. Wide-ranging differences of opinions remain between Greece and its creditors. While there has been posturing at each stage of the bailout negotiations, sentiment is growing that "this time it’s different."

Switzerland suffered an unexpected GDP contraction due to major export problems arising from the Swiss Franc’s record rise following January’s surprise de-pegging from the Euro. UK GDP, however, grew for the ninth straight quarter, its longest streak since 2008.
 
Asia
 
China's stock market suffered an alarmingly volatile week as Credit Suisse warned about bubble-like conditions following this year’s precipitous rise in the face of mediocre economic readings. As we discussed at length in last week’s newsletter, while a crackdown on corruption has led to a downturn in Macau gambling revenue, it appears financial markets have morphed into the preferred arena for financial risk-taking.

After a strong start to the week, the Shanghai composite tumbled 6.5% Thursday to erase prior gains, and was down around 5.0% on Friday before paring losses to finish only marginally lower. Domestic and foreign investment, much of it on margin, in the Chinese markets has been massive, prompting many equity brokers to raise margin requirements. Repurchase operations by the People's Bank of China also triggered concerns that the central bank may curtail its monetary easing program.

The Week Ahead
  • Monday: Personal Income and Outlays, ISM Manufacturing Index
  • Tuesday: China composite PMI
  • Wednesday: International Trade, Eurozone Composite PMI
  • Thursday: Jobless Claims
  • Friday: Employment Situation (US non-farm payrolls and unemployment rate), EU Q1 GDP growth 
Episode Playback
Icahn Explains What He Learned from 'Losing It All'
Did you miss Sunday's show featuring part two of our interview with legendary investor Carl Icahn? Watch all segments, extended interviews and web extras at WallStreetWeek.com 
Episode Feature
The Icahn Lyft
The Icahn Lift: the rise in a stock’s price that occurs when legendary investor Carl Icahn reveals a new position in the company. The phenomenon occurs due to Icahn’s track record of identifying attractive investments, unlocking shareholder value and improving investor confidence.

For example, when Icahn tweeted out news of a "large" position in Apple Inc. (NASDAQ:AAPL) on August 13, 2013 the stock jumped 5%, adding $12.5 billion to its market cap. When he disclosed a 10% stake in Netflix Inc. (Nasdaq:NFLX) on October 31, 2012, the stock jumped 14%. In both cases, the Icahn effect was not transitory – Apple is up nearly 100% and Netflix almost 1000% since he disclosed the respective positions. 

His career could never be characterized as mundane, but the latest chapter might be the most intriguing of all: Icahn’s investment in aptly-named Lyft. His $100 million infusion into the ride-sharing service—which directly competes with the richest private equity-backed company in history, bitter rival Uber—arouses curiosity because it breaks the mold of his archetypal investment target.

Like most activists, Icahn typically operates from a value investing perspective when analyzing potential opportunities in public companies. As Jeff Smith asserted in Episode 4 of Wall Street Week, activist targets often aren't that novel and occur in boring companies that simply are not firing on all cylinders due to mismanagement. However, in recent years Icahn, with investments in emerging companies like Netflix, has shown an ability to adapt in order to maintain his position as Wall Street’s alpha dog. His investment in Lyft represents the next step in that evolution. 

As is the case with all of his investments, Icahn was motivated to invest in Lyft because he simply saw it as a “tremendous bargain.” There is no doubt about Uber’s dominant position, but Icahn believes there is “room for two” in the car-on-demand space. Given that the “sharing economy” is perhaps only just beginning to scratch the surface of its disruptive potential, it’s no wonder Icahn was fascinated by Lyft’s modest $2.5 billion valuation relative to $50+ billion “unicorn” Uber.

Given Uber’s well-publicized PR problems, owning the well-run second fiddle, which plays foil by emphasizing customer service for both drivers and passengers, is not a bad position in which to be. Fellow Lyft investor and venture capital behemoth Andreesen Horowitz, with which Icahn has sparred in the past, compared Lyft’s strategic market position to that of customer-focused Southwest Airlines and Virgin America relative to bottom-line fixated legacy airlines. In a statement following Icahn’s Lyft announcement, though, Marc Andreessen intimated the feud is water under the bridge: “All’s fair in love, war and ride-sharing.”

The validation that comes with Icahn’s endorsement is a major boon to Lyft as it looks to keep up in the capital-raising arms race with Uber. Although the size of his investment in Lyft, $100 million, is small by his standards (by comparison his stake in Apple is nearly $7 billion) the effect it has on the company could exceed that of any of his previous ventures.

While Icahn’s involvement with Lyft carries considerable surface-level allure, understanding the implications of the rise of a sharing economy is perhaps more important for investors. Financial markets are largely, but not perfectly, efficient, and in order to outperform conventional wisdom, investors need to employ second-level thinking.

Warren Buffet says, “It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” While his logic is sound, the only way to identify a mispriced asset is to judge its valuation relative to consensus expectations. Technology companies are often hard to value, for example, because their growth is non-linear and hard to forecast. Likewise, it’s often hard to predict how an entrenched industry will be affected by disruptive new technology.

Especially in the regards to companies like Lyft, Uber and Airbnb, which are private and inaccessible as investments for a wide swath of the public, second-level analysis represents the only value added. For example, Uber and Lyft dramatically increase car use efficiency and thus ownership rates, which has widespread implications for the auto industry. Automakers, car rental companies, oil companies and businesses down the supply chain will see increasing adverse effects.

Airbnb’s precipitous rise has already sent painful shockwaves through the hotel industry. Generally speaking, shifting demographics, slow wage growth, and millennials’ penchant for sharing and aversion to ownership could lead to depressed equilibriums in the housing market.

While the sharing economy is most visible in the business-to-consumer (B2C) context, business-to-business (B2B) markets are also discovering the benefits of sharing. Caterpillar-backed Yard Club, for example, builds online marketplaces for construction companies. Given the magnitude of construction costs, the growth in equipment rentals could have an even greater gross economic impact.

When someone with the stature of Carl Icahn steps out of his comfort zone to throw skin into the sharing economy game, it’s worthwhile to recognize the value of a healthy paranoia about the accelerating returns of technology. Sharing business models are still nascent and face regulatory hurdles, but the will of the people dictates that they’re almost certainly here to stay. Adapt, or be left driving on the wrong side of the street. 
Investment Primer
What are Options?
In Episode 7, Carl Icahn discussed his early years as an options dealer, so this week we decided to include a primer on options.
  
What is a financial derivative?
 
A derivative is a contract that derives its value from an “underlying” asset.
 
Derivatives are one of three main categories of financial instruments along with equities (stock, or ownership in a company) and debt (bonds/mortgages, or borrowed money). There are many different types of financial derivatives, including collateralized debt obligations (CDO), credit default swaps (CDS), mortgage-backed securities (MBS), futures and options.
 
Derivatives were initially created largely as a means for hedging against price volatility in underlying asset prices. For example, a corn farmer might sell corn futures contracts to lock in a fixed revenue for his harvest, while a livestock producer might buy corn futures to ensure a fixed cost for his feed. In this example corn is the underlying asset.
 
However, in modern markets derivatives have morphed into a popular means for leveraged speculation. Trading derivatives is highly risky and can involve the potential for loss of invested principal. 

What are options?

An option is a financial derivative that gives the buyer the right, but not obligation, to buy or sell an underlying asset at a specific price by a specified future date. There are two types of options: 1) calls, which give the buyer the option to buy shares, and 2) puts, which give the buyer the option to sell (or short sell) shares.
 
Options pricing
 
With an equity (stock) option the underlying asset is stock itself. In order to gain the option to buy or sell shares in the future, the buyer must pay the seller a premium. The premium is based on a number of factors including the length of the contract, strike price and volatility of the underlying asset. If the underlying asset increases in value at a rate above implied volatility, then the derivative of that asset is also likely to increase in price.
 
The expiration date can range from months to years in the future. The further out the expiration, and thus greater amount of time the stock has to reach your desired target, the more you have to pay for that option. 
 
Strike price is the price at which the buyer has the option to buy the underlying asset in the future. The strike price can be at, below or above the current price of the underlying. For a call buyer, the lower the strike price, the more expensive the option contract (because an investor would always like to be long from the lowest possible price).

In and out of the money
 
For call options, if you buy a contract with a strike price higher than the current price, it is referred to as “out of the money,” while if you buy a contract with a strike price lower than the current price, it is referred to as “in the money.” Out of the money options are cheaper and riskier (far out of the money options are likened to lottery tickets) while in the money options are more expensive and less risky. Also, the more volatile a stock, the more expensive its option premium, because the more likely it would be, for example, to reach an out of the money strike price. 

For example, a call option contract to buy Apple (AAPL) at $150/share by March 2016 would be more expensive than an option to buy it at $150/share by September 2015, because the stock has a longer time-frame to reach the strike price. A call option to buy Apple (AAPL) at $140/share by March 2016 would be more expensive than a call option to buy Apple (AAPL) at $150/share by the same date because the option comes at a more desirable (lower) price.
 
Options with options
 
After purchasing an option contract, the buyer then has three choices: sell the option contract to another person before it expires, exercise the option to buy shares on or before expiration, or let the option expire worthless. 
 
If you choose to sell the option in the open market prior to expiration, the price depends on factors like performance and volatility of the underlying asset during the period you owned the option.
 
If you choose to exercise an options contract, one contract represents 100 shares of underlying stock. So, if you buy 10 calls and choose to exercise those options on or before the expiration date, then you become the owner of 1,000 shares of common stock.
 
The option holder may choose to simply let the contract expire worthless rather than assume ownership of the shares. The majority of options bought end up expiring worthless (for a variety of reasons).

Hedging with options

As Icahn discussed in this week's episode, there are many ways investors hedge long-term portfolios using options. Long-term investors who (wisely) do not wish to actively trade may, on an ongoing basis or at discretionary points in time, choose to buy put options on individual stocks or index fund ETFs as a cost-efficient way to offset potential losses in their portfolio. As a straight-forward example, if an investor believes the stock market to be overvalued and fears a looming crash, he or she may choose to buy puts on the S&P 500 Index ETF (SPY), giving them the option to be short the market from a specified price. While the options could expire worthless, if the market does go down sharply, their put options would likely spike in value and offset losses in their portfolio.
 
The Greeks
 
The Greeks are the mathematical pricing and risk guidelines for options. Trading options without at least basic understanding of the Greeks is akin to participating in a triathlon without knowing how to swim or ride a bike. The most important Greeks to understand are: 
  • Delta: sensitivity to underlying asset's price
  • Gamma: sensitivity of delta in response to price changes in underlying asset. Delta:Speed::Gamma:Acceleration. 
  • Theta: time decay, or rate of decline in value, of the option as it approaches expiration. Time decay is the worst enemy of an option buyer. 
  • Vega: sensitivity to underlying asset's volatility
Options are highly mathematical in nature, and we'll save a deeper dive into the Greeks and options strategies for another day.

Have more questions about options? Email us at prosper@wallstreetweek.com
Week Links
China Coaster, Greece Gloom, FIFA Farce 
US

Economy in U.S. Shrinks for Third Time Since Expansion Began (Bloomberg, Sho Chandra)

Shrinking Economy? No, but It's Not Surging Either (NYT The Upshot, Justin Wolfers)

New Home Sales Rise 6.8% In April, Jumping 26% Year-Over-Year (Forbes, Maggie McGrath)

What the Supreme Court’s fixes for retirement savings may do to your 401(k) (MarketWatch, Chuck Jaffe)

Stock-Market Traders Pile In at the Close (WSJ, Dan Strumpf)

Top Managers Monopolize HF Assets, Preqin Finds (AI-CIO, Sage Um)


Analysis

Stocks Still Have Room to Grow (Alliance Bernstein Blog, Vadim Zlotnikov)

Market Crashes Haunt Investors for Decades (BloombergView, Barry Ritholtz)

What Chicago’s Fiscal Emergency says about the Quality of Credit Analysis in the Municipal Bond Market (Medium, Kristi Culpepper)

Smart beta strategies risk becoming crowded (FT, John Authers)

Can your portfolio survive rising interest rates? (Fortune, Joshua Brown)

Robo Advisors Take on Wall Street (Barron's, Alexander Eule)

John Nash’s Game Theory and Greece (BloombergView, Mohammed A. El Erian)

The Importance of Liquidity (Blackstone Market Commentary, Byron Wien)


Asia

Stocks in China: Still Too Hot to Handle? (WSJ MoneyBeat, Jason Zweig)

China's yuan 'no longer undervalued': IMF (CNN Money, Sophia Yan)

Share prices in China: Flying too high (The Economist)

Japan Limps Into 2nd Quarter as Inflation Stops, Spending Falls (Bloomberg, Toru Fujioka)


Europe

U.S. warns G7 of global economy ‘accident’ without Greece deal (Reuters, David Ljunggren and Paul Carrel)

With Money Drying Up, Greece is All But Bankrupt (NYT Dealbook, Landon Thomas Jr.)

Jury Is Still Out on European Central Bank’s Stimulus Program (The New York Times, Jack Ewing)


Tech

Avago to Buy Broadcom for $37 Billion in Biggest Tech Deal Ever (Bloomberg, Jeffrey McCracken, Alex Sherman, and Ian King)

Charter's $56 billion Time Warner Cable deal to face U.S. scrutiny (Reuters, Malathi Nayak and Diane Bartz)

The Google-Apple connected car battle has begun (Fortune, Kirsten Korosec)

Internet Trends (KPCB, Marry Meeker)

Google’s Nuttiest Project is Making Big Progress (Time, Victor Luckerson)

Vox Media Adds ReCode to Its Stable of Websites (New York Times, Syndney Ember)

Technology, Inflation and the Federal Reserve (FT, Gavyn Davies)

 
Potpourri

Let’s count all the ways FIFA is corrupt (Vox, Libby Nelson)

The $6.5 Billion, 20-Year Plan To Transform an American City (Fast Company, Neal Ungerleider)

Americans gave their lives to defeat the Nazis. The Dutch have never forgotten. (Washington Post, Ian Shapira)

More than ever, advisers make a splash with social media (InvestmentNews, Alessandra Malito)

10 Non-Investing Quotes with Great Investing Lessons (Clear Eyes Investing, Todd Wenning)

Why Do Former High-School Athletes Make More Money? (The Atlantic, Joe Pinsker)
 
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