Underlying energy ETF in Wells Fargo’s leveraged notes may not offer best value, adviser says

By Emma Trincal

New York, Aug. 16 – Wells Fargo Finance LLC’s plans to price 0% market-linked notes with leveraged upside participation to a cap and fixed percentage buffered downside due March 9, 2023 linked to the Energy Select Sector SPDR exchange-traded fund could have benefited from the choice of another underlying fund among many that offer better value, a contrarian adviser said.

The payout at maturity will be par plus 150% of any ETF gain, capped at par plus 44% to 49%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the ETF falls by up to 15% and will lose 1% for each 1% decline beyond 15%.

For Steven Jon Kaplan, founder and portfolio manager of TrueContrarian Investments, the deal would have been much more appealing if the issuer had used another underlying ETF.

Exxon, Chevron

“It’s my least favored energy fund because it tracks the S&P too closely. This fund is highly concentrated. Its top names are very large-cap energy stocks, which are going to move with the S&P. It doesn’t capture other segments of the energy market, which are ideal for bargain-hunters,” he said.

The two top holdings of the ETF are Exxon Mobil Corp. and Chevron Corp., which represent a combined 45% of the fund’s portfolio.

“With the XLE, you’re more skewed toward the U.S. very large-cap indices than you are toward the small-cap and mid-cap spectrum when you want exposure to domestic energy stocks,” he said.

The acronym “XLE” is the underlying’s ticker symbol on the NYSE Arca.

Bargain hunting

In contrast, Kaplan prefers to get exposure to smaller-cap energy funds, for instance the VanEck Vectors Oil Services ETF, which is listed on the NYSE Arca under the ticker “OIH.”

Alternatively, he uses equally weighted funds to diversify across large, mid and small cap stocks. His favorite ETFs in this group are the Invesco S&P 500 Equal Weight Energy ETF (ticker: RYE) and the SPDR S&P Oil & Gas Equipment & Services (ticker: XES).

Kaplan also likes funds that have relatively large-cap stocks as long as they are not too heavily concentrated on mega-cap stocks like Exxon. An example is the iShares U.S. Oil Equipment & Services ETF (ticker: IEZ).

Hit the hardest

“I’m looking at exposure to funds that tend to correlate to the energy sector rather than to the S&P. That’s why I think XLE is probably not the best choice.

“Your returns are very likely to be influenced by the S&P, an index that’s highly overpriced.

“Smaller energy stocks are out of favor, and by ignoring them you’re not taking advantage of the bargains they offer,” he said.

For instance, the SPDR S&P Oil & Gas Equipment & Services was down more than 62% from its most recent high in January 2018 during midday trading session on Friday, he noted.

The share price of the iShares U.S. Oil Equipment & Services ETF has dropped 57.5% from its peak in May of last year.

In comparison, the Energy Select Sector SPDR fund of the notes has also dropped since its peak 15 months ago but by a lesser percentage of 25%.

“It seems like a big drop. But compared to the others, it’s not,” he said.

As a contrarian investor seeking stocks with lower price-per-earnings ratio, Kaplan said that most of the components of the energy funds he is bullish on and has previously mentioned have a P/E between 7 to 9.

“You would have to go back to 1974 to see prices that depressed,” he said.

The P/E of the Energy Select Sector SPDR fund on the other hand is 15.

Insiders have not missed the buy signal, said Kaplan, who monitors their buy and sell activity.

One of the reasons he likes the four oil funds he mentioned is because of the heavy insiders’ activity around their top stock components.

“I expect the energy sector in the medium to small-size space to be very strong because of all the insiders’ buying I see right now. There is an all-time record for those names, a lot of heavy buying. Meanwhile, insiders are selling Exxon,” he said.

Herd mentality

“All the fund bogleheads are massively buying large-caps. Their philosophy is: keep on piling on your savings in equity indices. Long-term you’ll come ahead. It’s not exactly that simple.”

Kaplan seeks undervalued, out-of-favor sectors or asset classes. Small-cap energy stocks are one of them. But he also likes emerging markets, steel manufacturing, even sea shipping.

Structured notes can be interesting for the types of payoff they provide, he said.

“You get buffers. You get leverage on the upside and not on the downside.

“But one of the issues I have is you don’t easily get access to those niche sectors that have tremendous value. There is an awful amount of deals on the S&P when the S&P is near its all-time high.

“And yet, investors are still crowding in the S&P. Everybody has Amazon and Apple in their 401K. They really are missing the bargains. Insiders understand that. They’re selling what’s overpriced and buying what’s undervalued.

“When you buy an asset whether in the equity market or indirectly as a note, you want to get in early, not when prices are high,” he said.

Top energy underliers

The Energy Select Sector SPDR fund, which is used in the notes, is the second most common underlying for equity-linked deals in the energy sector. So far this year, $47 million linked to this fund in nine offerings have been issued, according to data compiled by Prospect News.

But the biggest “seller” is the S&P Oil & Gas Exploration & Production ETF, which is listed on the NYSE Arca under the “XOP” symbol. So far, $143 million have been priced on it in 54 deals.

“XOP is more in the mid-range. You don’t find the mega-cap companies that you get in the XLE. But it’s still not the smaller spectrum where you can tap into real value,” he said.

Ignored gems

Conversely only one of the energy funds Kaplan said he liked the most has been used so far this year. It’s the VanEck Vectors Oil Services ETF, spotted in nine deals totaling $14 million, the data showed.

None of the three other funds he keeps on his buy list or holds as a position has been used so far.

These include: the Invesco S&P 500 Equal Weight Energy ETF; the SPDR S&P Oil & Gas Equipment & Services; and the iShares U.S. Oil Equipment & Services ETF.

Kaplan said he was not surprised: the same lack of appetite for deeply depressed assets can also be seen in the overall stock market.

“These ETFs are unusually cheap and yet not every investor is taking advantage of this segment of the energy sector,” he said.

“Either it’s not covered by the media. Or maybe there’s no hype around energy. Energy is a very important sector in our economy. But you’ll see more headlines on marijuana stocks than on oil stocks. Part of it is also fear. But I think it’s also the herd mentality: everyone is fixated on the S&P.”

Tenor and 2024

The duration of the notes could have also been better, said Kaplan.

“It’s going to mature in March 2023 just a year prior to the 2024 Presidential Elections. Not so good if you take into account a pattern that has been verified going back 100 years. Historically, the strongest years for the stock market are between the mid-terms and the Elections,” he said.

“By getting out in March 2023, you’re missing almost half of this potential rally.

“I’d rather have a five-year than a three or three-and-a-half year.”

Longer term, no cap

But the structure offered several advantages.

“First, having a true buffer is always good. I like the 15% in hard protection,” he said.

“The leverage is also good to have.”

The 1.5x factor given the 44%-49% cap range would give investors an annualized compounded return of 11% to 12%.

“It’s not a bad cap. But you could be missing a very important rally.”

One classic solution to eliminate the cap is to extend the maturity.

Kaplan wouldn’t mind doing that.

“It would work better for me actually. I’d rather have a longer maturity anyway so if I can do that and get rid of the cap, that’s a good thing,” he said.

The cap is more appropriate for investors who are less bullish than Kaplan.

“It’s fine if you don’t expect a huge recovery in this sector. But I do.

“To me, picking a less expensive underlying, extending the maturity and getting rid of the cap would be the three things I’d do if I had to reconfigure the notes.

“I’d want to keep the buffer as it is. And if the condition to have no cap was to eliminate the leverage, I would be willing to take that trade-off.”

The notes are guaranteed by Wells Fargo & Co.

Wells Fargo Securities LLC is the agent.

The notes will price on Aug. 30.

The Cusip number is 95001H7F2.

© 2015 Prospect News.
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