By: Paul Sutherland, CFP ®
As disciplined and patient, fundamental value-focused investors, we are trained to watch for fire sales. These are highly discounted investment opportunities that come about when others find themselves forced to sell. Reasons for forced selling of investments are varied, although the culprits often boil down to a handful of interrelated causes:
- Use of leverage (borrowing)
- Poor provisioning for liquidity needs
- Loss of conviction in a company’s fundamentals
- Investing with a strategy poorly suited to one’s tolerance for volatility
- Giving in to speculative impulses
On point #5, let me share a quick story. At a Rotary Club meeting just this month, I had a man say he bought Facebook at the IPO (initial public offering). He bought it because he thought it was cool, and he admitted that he later sold it for half of what he paid. I asked him what compelled him to buy a company that was priced at $100 billion and then sell it when it was 50% off. He shrugged his shoulders and made an unpleasant comment about Mark Zuckerberg, Facebook’s founder.
As Warren Buffet says, “Investing is simple, but it is not easy.” This “investor” did not look at Facebook’s earnings and cash flow numbers, comparative advantage, capital structure or perhaps most importantly the PRICE he paid for his shares. He was speculating not investing. I think that our team at FIM Group would take a serious look at Facebook should its stock price drop to $10 a share, which is 1/4th of his price. Those who buy investments because they sound cool or are familiar, use significant leverage, have insufficient liquidity or have a weak stomach for volatility are likely to become sellers-atany- price. And who will they be selling to? Disciplined, patient investors like FIM Group who are happy to provide a “bid” to these forced sellers.
Fire Sale in the F.I.R.E. Economy
Somewhat ironically, it was the F.I.R.E. sectors of the economy (Finance, Insurance, and Real Estate) that have been subject to an ongoing fire sale in investment markets over the past few years. Between AIG’s forays into exotic derivatives, ridiculous levels of leverage at the “too big to fail banks,” and nearly an entire nation sucked into the home mortgage debt bubble, the recent “F.I.R.E. economy” gave way to a stock, corporate bond, and real estate fire sale of epic proportions. For those who could hold their noses and buy assets in 2009 and 2010 during the first stage of this fire sale, the resulting gains have been outstanding. But even now, five years post the “Lehman Shock,” there remains a recency effect* keeping many investors far away from anything to do with the F.I.R.E. economy. The result: plenty of stocks offering considerable value and the potential for significant total returns.
Our team remains cautious towards the too big to fails (think Goldman, JP Morgan, Citi). These companies have 2 complex, opaque financial statements full of accounting shenanigans and future prospects tainted by lawsuits and lawmakers eager to look like they are doing SOMETHING to “fix” the financial system (i.e., via re-regulation and forced deleveraging). We are also quite aware that the runway for a nationwide recovery in real estate values could well be a long one. One only need look at Japan real estate prices since their late 80’s bubble to see a precedent for recovery measured in decades rather than years (figure 1).
That said, we are finding a wide range of F.I.R.E. sector “special situations” at compelling values, six of which are noted here. Although recency effects may take a while to fade, we are confident that others will eventually see what we see: fundamentally sound companies shunned by forced sellers that still trade incredibly cheap. For many of these, we collect nice cash dividends each year as we wait patiently for price appreciation.
Finance: Two Industrial Holding Company Transformations
Power Corporation of Canada (www. powercorporation.com) began its life back in the 1920’s when a pair of Canadian stockbrokers formed an investment vehicle to buy up Canadian power utilities. In the late 1960’s, famed Canadian financier Paul Desmarais took control and made the company into a diversified, financial-services giant, similar in many ways to Warren Buffett’s Berkshire Hathaway. Today, Power Corp owns a 66.1% position in another listed holding company, Power Financial Corporation, and is the sole owner of Square Victoria Communications Group. The former holds stakes in two leading financial firms, Great West Lifeco (insurance) and IGM Financial (wealth management) as well as a position in Belgium-based conglomerate Groupe Bruxelle (a significant FIM Group holding). Square Victoria operates in Canadian digital and print media and includes French language, national newspaper La Presse. Due in part to its complex organizational structure, Power Corp trades at a significant discount to the value of its parts (we estimate a 40% discount to conservative net asset value). In addition, the company has been a consistent dividend payer with recent yields near 5%. RHJ International (www.rhji.com) is also an industrial-to-financial services transition story, although one still in the very early stages of its makeover. It owns a EUR60M book value “legacy” portfolio of industrial assets (consisting of a Japanese health products company and a Japanese business consulting services firm), a EUR347M book value portfolio of financial services investments (primarily Kleinwort Benson Group), and a whopping EUR269M in net cash. KBG integrates private banking with corporate advisory work focused on U.K. entrepreneurs and international clients. The bank has a liquid balance sheet with no reliance on wholesale funding and a strong capital position. Management is working to reduce its EUR26.3M in fixed holding company costs to EUR15M by 2013. Other initiatives include selling off its remaining industrial assets and buying the BHG Bank from Deutsche Bank. Given the early stage of the transformation, we have been able to buy shares at a market capitalization of EUR 333M, or less than 50% of our sum-of-parts estimated value.
Insurance: Ireland’s Share-Taker and a U.K. Restructuring Story
Ireland’s economy has been in a multi-year slump and its stock market remains more than 60% off its 2007 highs. These are not exactly helpful conditions for insurance companies as lower economic activity and faltering investment markets negatively impact earned premiums and investment income. FBD Holdings (www.fbdgroup. com), one of Ireland’s top-3 property and casualty insurers, has not been immune to these economic forces. That said, management has done an admiral job managing through the challenges, and it continues to underwrite profitably despite rough market conditions. FBD is also taking share from competitors (figure 2), and has steadily grown its net asset value since bottoming in 2010. With a strong core franchise, growth opportunities in farm and business lines, a debtfree balance sheet, and a low-risk investment strategy, we believe there is significant total return potential in FBD. The company remains on
track to grow earnings, dividends, and book value, despite Ireland’s sluggish economic recovery. In time, we expect suppressed valuations (now trading around 1.1x net asset value) to expand. While we wait, we will collect a 4% (and growing) dividend. Across the pond in London, FBD rival Aviva PLC (www.aviva.com) presents interesting value as well. New management is quickly moving to derisk the company’s forward outlook by disposing of non-core businesses and ceasing new underwriting in areas where economic returns are insufficient. It is also reducing the company’s exposure to peripheral European bank debt. Recent reports suggest that the company may be close to selling its US life insurance operation, which could fetch up to GBP1B and help management’s objective of bolstering the company’s balance sheet. The market remains fearful of anything having to do with Europe and Financials and has seemingly ignored this restructuring story. Therefore we have been able to buy shares at .75x book value, 6x expected earnings and with a nearly 9% dividend yield.
Real Estate: Two Resilient Dividend Payers
Like most stocks related to North American real estate, Brookfield Real Estate Services (www.brookfieldresiinc. com) shares took a beating in 2008, dropping 50%. Yet, its operating profits were scarcely impacted during the financial crisis thanks to a unique, fixed royalty fee-heavy business model (figure 3). Brookfield franchises the Royal LePage name to real estate offices across Canada, the country’s largest network of agents with 22% share based on transactional volume. With 68% of revenues from fixed royalty fees and a variable cost structure, the company’s business model has proven remarkably resilient and supportive of steady dividend payouts. We were able to buy shares with an expected 9% dividend yield and for only 6.5x operating cash flow.
As noted above, for sheer duration, it is hard to find a developed country real estate market that has gone through as much pain as Japan’s two decade and counting real estate funk. Saizen REIT (www.saizenreit.com. sg), a Singapore-headquartered real estate investment trust that invests exclusively in mass market Japanese residential real estate, operates in just such a distressed space. Saizen owns a 36.4B Japanese yen residential real estate portfolio with steady occupancy above 90% and stable rent trends. Geographically, its portfolio is spread across the country with the largest exposure (26%) in Sapporo (a major city in Japan’s northern most island of Hokkaido). After subtracting liabilities, Saizen’s net assets are valued at 30 Singapore cents/share. We believe that our average purchase price in the 15 cents range give us significant margin of safety. While we wait for investors to get just a little less pessimistic about Japan, we expect to collect an 8 percent (and growing) dividend.
*Recency effect: Rather than the always rational beings assumed by modern investment theory, humans are emotional creatures who tend to weigh recent events more heavily in our thinking. In investment markets, this phenomenon tends to see rising markets trigger a greedy response and falling markets a fearful one.
By: Suzanne Stepan, CFA®, CFP ®
Not long ago I was with my family playing a friendly yet competitive game of Scrabble. For much of the game I was perturbed that my innate ability to tile pick just about everything opposite a vowel had failed me. While I sat staring at the nonperforming consonants sitting in their cradle, no valid word entered my brain. Soon it would be my turn, but my brother seemed to be having a difficult time as well. To my excitement he laid down something relatively lame, but it set me up for a boatload of points. Lo and behold, I had the right tiles and board positioning to place the word “yielding.” After that special gift I was compelled to write this newsletter article on yields.
Every so often a client will inquire as to why bank savings account yields are so low and then ask my suggestions for higheryielding – yet just as safe – alternatives. It is true that savings account interest rates are at an all-time low. According to the Federal Deposit Insurance Corporation (www.fdic.gov), the national average on savings accounts under $100,000 is at 0.09%. At that rate you may just as well put your Benjamins, moolah, double sawbucks, clams, greenbacks, cabbage, potatoes (pronounced puh-tay-tuhs), fins and cheese underneath the old mattress – of course, all you’ll get in return is flattened cash.
You may have heard a news story or two about the Federal Reserve lowering the Federal Funds Rate and the LIBOR rate. Whatever the Fed decides will directly affect your bank’s savings account rates. The Federal Reserve sets a target interest rate called the Federal Funds Rate – the rate it charges another depository institution to borrow money overnight. The Fed also sets the LIBOR rate – the rate that banks charge each other for loans.
These two federally controlled rates are the main influences on bank interest rates and are directly related to consumer interest rates currently being at historical lows.
Keeping short-term interest rates so low for so long, however, negatively impacts the purchasing power of any savings kept in a bank or money market account. When you factor taxes and inflation into the yield earned on your savings, purchasing power is lost, even though you have done your best to protect the principal balance.
As passbook savings account yields have dwindled to almost nothing, dividends paid on stocks have become a hot topic in the investment arena. During periods of volatility, the assurance of a strong dividend payout and stable interest income has captivated investors.
Do you know the interest rate paid on your savings accounts? According to the Consumer Federation of America, 57% of savers have no idea what the interest rate is. Did you also know that just a few more percentage points could brighten your financial future? For example, a $100 monthly deposit earning 1% compounded monthly for 30 years would yield $41,963. The total out-of-pocket investment would be $36,000.
But as you can see from the table below, interest, compounding and the time horizon are critical factors in making your savings grow for future wealth. As more investors try to cope with yields that have sunk below the rate of inflation in today’s market, dividends are playing a more important role in rounding out the total return expected by an investor than in the past. Data captured from the early 1900s tells us that dividends have historically contributed about 45% of the overall total return for stocks. During periods of slow economic growth, it is important to pay close attention to individual equity dividend payouts. With current economic growth still sluggish, the Federal Reserve intends to keep interest rates low until sometime in 2014. This means that savings interest may not be increasing anytime soon.
The answer to seeking out better yields does not lie in merely buying highdividend- yielding stocks. Rather, the solution is finding a well-diversified mix of securities that provide strong dividends and help create an overall positive total return. Many companies currently have excess cash on their balance sheets that can support and even increase their dividends. It is important when investing to understand the philosophy that a company’s management team has on the dividend payout ratio. It is also necessary to understand a company’s financial statements and how it generates cash to declare its dividends. Your best bet is to always exercise caution and manage risk versus potential reward when evaluating a dividend-yielding stock.
Our goal at FIM Group is to seek out stocks with current dividend payout ratios that are fully supported by a company’s net earnings, liquidity, future prospects, cash and management philosophy. The yield generated in our portfolios comes from diversified holdings in both equities and fixed income. A client’s individual risk tolerance is used to measure the allocation made to dividend-paying stocks. We keep a close eye on the companies generating sufficient earnings. In today’s “next to nothing” yield earned in savings accounts, it is highly advantageous to have a portion of your savings in a well-diversified portfolio consisting of a group of strong dividend-paying stocks. My brother ended up winning our family Scrabble game primarily due to hitting a few key triple word scores. While I may not have had the most points, I felt I was the real winner by having Alfred Butts (who is credited as the inventor of the first Scrabble-type board game) telepathically request the topic of my next newsletter. Thank you Mr. Butts!
There is no Spotlight for this issue.