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2014 August Newsletter

Paul Sutherland, CFP®
By: Paul Sutherland, CFP®

Discipline and Patience

I just read an article about how the younger generations, those just graduating from college and starting careers, are buying stocks, often with borrowed money or naïve understanding of what they are buying. They buy based on a Facebook friend’s Like post rather than on any meaningful research. Impatiently, they take risks to hopefully get ahead. They see little downside since they are already in debt, feel they have few job opportunities and, I will add, often are sleeping at Mom and Dad’s home anyway. So what’s to lose? 

Well, I would argue quite a lot. Let’s take the example of a typical 23-year-old, fresh out of college and living at home. If she could simply find a way to smartly invest $70/week (say by working 20 hours a week at $7/hour and putting half of this in an investment account), save at this same dollar amount until age 65, and let her returns compound at an average 6%, she would have a cool $692,000. At a 10% compound annual return, she could have an astounding $2.3 million! So like I tell my 23-year-old daughter Akasha and 19-year-old son Keeston, smart, patient, slow and steady wins the (investing) race. The long-term lucky save and invest

Where’s the Savings?

America, for the most part, has had a hard time distilling this message. In fact, as shown in this figure below from the National Institute on Retirement Security, we seem to be a country that treats saving and investing like it is some kind of plague! While Americans may have other assets to pull from in retirement beyond retirement accounts, the reality is that many are simply woefully underprepared to fund even a bare minimum retirement lifestyle.

Imagine if 42 years ago, every 23-year-old American got in the habit of saving just a fraction of their earnings and stuck with it throughout their lives. Wouldn’t we be in much different shape as a country now, and not looking to Washington to fix the economy and provide for all of our long-term health care and retirement income needs? I suppose that if every American living 504 months ago saved 5% to 10% of their income each year and invested it wisely, we would have so many millionaires that no one would be chatting about the 1% and such. Hopefully readers are not thinking I am making a moral, political or statement of judgment here. I am simply setting the stage to chat about discipline and patience. 

Median Retirement Account Balances

What Single Page Should You Read?

Ed Dowd, who will join our team in September, sent me an interesting article titled “What Single Page of an Investment Book Should You Read?” When I am asked the same question, the standard answer I usually give is the Table of Contents of The Book of Investing Wisdom (below). This is a very thick collection of 46 essays by some of the world’s greatest investors. Now I realize that in this day of ubiquitous ADHD and where plodding through Facebook posts serves as a robust intellectual workout, a book with 46 essays is probably a tough sell. However, as I like to quote to my kids, “tired don’t mean lazy” (Maya Angelou) and “laziness comes in many forms, all of which result in procrastination” (His Holiness the Dalai Lama). 

Price Matters

There are many lessons in The Book of Investing Wisdom that I’ve worked into our investment philosophies and processes here at FIM Group. Among these lessons, perhaps the most important and relevant to any saver/investor is the lesson that price matters. This is not groundbreaking stuff, yet it is probably the number-one screw-up that most investors make. What seems so easy in theory, “buy low, sell high ... buy cheap, sell dear ... buy fear, sell greed ...” remains a real trouble spot in practice. 

Avoid Manias

One “easy” way to successfully buy low and sell high is to avoid buying high. In other words, understand that an investment’s price and its intrinsic or fundamentals-based value can be two very different numbers. Price is set daily in markets by the whims of fellow individual investors, speculators, hedge fund managers and anyone else with money to invest/wager. These whims, which from time to time turn into full-blown manias, can send prices both well-above and well-below a reasonable assessment of an investment’s funda­mental value. Such fundamental value, on the other hand, tends to fluctuate with much less volatility based on conservative estimates of the magnitude and probability of the investment’s future cash flows. So be on the lookout for manias, and if something looks overvalued based on its fundamental intrinsic value, don’t buy it. Don’t pay 60x earnings for Coca-Cola shares like investors did in the late ’90s stock mania. And perhaps think twice about paying a zillion times potential touchdowns by San Francisco 49er tight end Vernon Davis as investors on the newest Wall Street “innovation” Fantex.com seem to be doing at the moment.

Buy Bargains

Another way to successfully buy low and sell high is to know what bargains look like and, importantly, to not be afraid of standing apart from the herd to buy such bargains. Many investors are not very patient and can’t stand to see their investment(s) go sideways or down in price (again, price can stretch far from fundamental value!). More than a few investors also get stuck obsessing over short-term variables rather than the long-term ones that account for nearly all the fundamental value of any stock or longer-term bond. 

At FIM Group, we know what a bargain looks like, and we know that many bargains become bargains because of overreaction to the news flow of the moment. Last year’s panic selling in closed-end bond funds, this year’s panic-selling of anything with even a trace of Russia exposure, and the current sell-off of companies going through a price war in the U.K. supermarket sector (see this month’s Investment Team Spotlight) are just three recent examples of bargain opportunities that emerge because other investors are simply impatient or over-focused on short-term news flow.

Could bargains like these become even more bargain-priced in the future? Of course they could! Do most investors react to stock and bond bargains becoming even bigger bargains like they do when anything else they are ready to buy goes on sale (think cars, homes, clothes, steaks)? Usually not. And that’s where standing apart from the herd and investing with conviction when prices are dirt cheap can make a real difference to long-term success.

Below is my favorite “avoid manias, buy bargains” chart that we’ve shown in other newsletters before. It basically illustrates the fact that the real money is made by being invested when invest­ments are priced at bargain levels. With tens of thousands of investments in the universe today, there are always some that are significantly overvalued and should be avoided. There are also always investments coming out of a bear market or just simply priced significantly below their fundamental intrinsic values that are bargain-buy candidates. 

Discipline and Patience

The real “secret” to long-term, “buy low and sell high” investing success is discipline and patience – the discipline to keep from being pulled into the manias of the day and the patience that goes with hunting for bargains wherever they may be. Today, exchange-traded funds (ETFs) and stock market index strategies seem to be the mania of the moment. Tomorrow, perhaps Fantex will grow to be all the rage. 

What we know is that someday in the future the investors buying overvalued ETFs and market indexes will be quite frustrated by their lack of discipline. They will discover the hard way that buying into “what’s hot” and at prices far removed from fundamental value is a recipe for losses. They will wish that maybe they had invested more time learning some of the cardinal laws of investing like those spelled out in The Book of Investing Wisdom or in hiring a manager like FIM Group that incor­porates such wisdom into the investment processes executed on behalf of clients. They will eventually sell in panic and disgust, taking permanent losses and creating bargains for those more patient and with investment processes grounded in fundamental analysis. 

And, let’s face it, if the masses fail to break their habits of poor investing discipline, impatience and simply saving far too little in the first place, can we really expect our country’s “retirement readiness” stats to look any better? My guess is probably not. And so rather than a country where household financial security is the norm and not the exception, we will continue to be a nation where savers procrastinate and look for easy riches. This won’t be all bad: after all, lottery commissioners, ETF product designers and finger-pointing political talk radio show hosts need to eat too. 

The Book of Investing Wisdom Edited by Pter Krass
Table of Contents
THE NUTS AND BOLTS OF ANALYSIS
Warren E. Buffett: Track Record Is Everything
Philip Fisher: The People Factor
Henry Clews: The Study of the Stock Market
Arnold Bernhard: The Valuation of Listed Stocks
Paul F. Miller, Jr.: The Dangers of Retrospective Myopia
Jim Rogers: Get Smart...and Make a Fortune
Peter Lynch: Stalking the Tenbagger
ATTITUDE AND PHILOSOPHY
Adam Smith: Can Ink Blots Tell You...
Ellen Douglas Williamson: Do-It-Yourself Investing
John Moody: Investment versus Speculation
John C. Bogle: A Mandate for Fund Shareholders
B. C. Forbes: Wall Street Millionaires
Fred Schwed, Jr.: The Wall Street Dream Market
STRATEGY
Edward C. Johnson, II: Contrary Opinion in Stock Market Techniques
Peter L. Bernstein: Is Investing for the Long Term Theory or Just Mumbo-Jumbo?
Sir John Templeton: The Time-Tested Maxims of the Templeton Touch
Mario Gabelli: Grand Slam Hitting
Gerald M. Loeb: Importance of Correct Timing
Philip Carret: When Speculation Becomes Investment
MARKET CYCLES
Charles H. Dow: Booms and Busts
William Peter Hamilton: The Dow Theory
Roger W. Babson: Three Different Stock Market Movements
Bernard M. Baruch: Does a Stock Market Slump Mean a Business Slide-Off?
Abby Joseph Cohen: A Fundamental Strength
Joseph E. Granville: Market Movements
Arthur Crump: The Importance of Special Knowledge
Robert R. Prechter: Elvis, Frankenstein and Andy Warhol
VIEWS FROM THE INSIDE
W. W. Fowler: The Stock Exchange
Edward H. H. Simmons: The Stock Exchange as a Stabilizing
  actor in American Business
Otto Kahn: The New York Stock Exchange and Public Opinion
Charles E. Merrill and E. A. Pierce: A Declaration of Policy
Michael H. Steinhardt: Investing, Hedge-Fund Style
Laura Pedersen: The Last Frontier
LESSONS FROM NOTORIOUS CHARACTERS
Bouck White: Daniel Drew on Wall Street
Richard Whitney: In Defense of the Stock Exchange
T. Boone Pickens, Jr.: Professions of a Short-Termer
James Grant: Michael Milken, Meet Sewell Avery
CRASH AND LEARN
Frank A. Vanderlip:  (1907)
Edwin Lefèvre:>span class="s4"> Vanished Billions
 (1929)
J. Paul Getty:  (1962)
George Soros: >span class="s4">After Black Monday
 (1987)
BEYOND YOUR AVERAGE BLUE CHIP
Leo Melamed: The Art of Futures Trading
Stanley Kroll: How to Win Big and Lose Small
Benjamin Graham: The Art of Hedging
Martin E. Zweig: Selling Short-Itís Not Un-American
Donald J. Trump: Trump Cards: The Elements of the Deal
Zach Liggett, CFA®
By: Zach Liggett, CFA®

Disrupters

We all know that disruptions are a normal part of life. Kids wake up parents in the middle of the night, bosses throw last-minute projects at staffers hoping to get a head start on the weekend, and space storms force airlines to reroute dozens of flights a year. Space storms? Yes, according to Stephanie Stoughton at Bloomberg Businessweek (“Who Turned Out the Lights?” July 7-13, 2014), airline companies around the world deal with not only rain, snow, flocks of migratory birds and inebriated passengers but they must also contend with super­heated, electrically charged gas clouds spat out randomly by the sun. And when these gas clouds hit the Earth’s magnetic field and generate geomag­netic storms … look out below! Stoughton reports that with an extreme space storm scenario theorized in a 2008 National Academy of Sciences report, the U.S. could see hundreds of high-voltage transformers severely damaged, leaving more than 130 million people without power for months. Checked your battery supply lately? 

On the Lookout for Disrupters

At FIM Group, we are constantly on the lookout for disruptive forces that can break an investment thesis. These disrupters come in many forms, including new technologies and business models that threaten the competitive position of existing companies. Disrupters can also take the guise of broader shifts in consumer culture that leave the value proposition of an existing company much less attractive.

O Canada!

As an example of a new technology-driven disrupter, I recently sat on a conference call with the management of a Canadian company called Radient Technologies. Radient has developed a patented, Microwave-Assisted Processing technology that could really shake
up the natural ingredients world. Compared to the conventional solvent extraction process used by most ingredient makers, Radient’s technology reduces extraction times from hours to minutes, improves compound purity by 50%-300%, increases yields by 2x, and reduces energy and solvent use by 50%-75%. While the company won’t be profitable for at least another year and is not a likely investment candidate just yet for FIM Group portfolios, it is a great example of a technology-driven disruptor that could ultimately threaten the existence of conventional natural ingredients producers.

The German Discounters

Over the last few weeks, I have also been following a pair of business model-driven disrupters quite closely as part of an investigation into the United Kingdom supermarket sector. Aldi and Lidl are both privately held German discount supermarket chains that have taken the U.K. by storm. These disrupters bring a no-frills, low-cost approach to retailing that appeals to Britain’s struggling lower and middle classes. As a result, investors in Britain’s incumbent “Big 4” super­markets now worry about the impact Aldi and Lidl will have on their market shares and bottom lines. Indeed, the share price of one of these incumbent chains, Wm Morrison Supermarkets plc, has been nearly cut in half from 2013 levels. As we note in this month’s Investment Team Spotlight, we have started nibbling on Wm Morrison shares where we believe the price now gives zero value to what is still a highly cash-generative grocery business. 

Taking Share in the Sharing Economy

Then there’s a group of disrupters that are shaking things up by identifying the cultural shift toward both more of a “sharing economy” and one that has little use for traditional intermediaries. These “Direct-Connect” disrupters are licking their chops at some of the largest sectors in the economy, including hospitality, transportation and finance. Transpor­tation network companies like Uber and Lyft use online platforms to connect passengers with drivers using personal, non-commercial vehicles. Airbnb does the same by connecting those seeking lodging with those who might have a spare room (or unused home) to offer. In the financial sector, there are establish­ed peer-to-peer lending platforms like Prosper.com and emerging investment crowdfunding platforms like Localstake. These firms essentially aim to cut out financial intermediaries and directly connect those seeking capital with those who have it.

Direct Connect Disrupters

Capitalism Still Alive and Kicking

Such disrupters of the status quo are
a sign that capitalism is still alive and kicking despite what can feel like policymaker attempts to bury it six feet under. They force businesses that desire to stay relevant (and solvent) to keep their ears tuned to customer needs and to innovate continually. Additionally, they call out cozy regulator/business/union relationships that tend to stifle consumer choice. And for investors, these disrupters can create significant opportunities.

When in Doubt, Throw it Out

As a general rule, our team does not short stocks (the practice of borrowing shares, selling them in the market and returning the shares later at hopefully a lower price, pocketing the difference as a gain). So shorting the stocks of “disruptees” whose businesses look to be at risk from a disrupter is not really an option for us. However, we can look to mitigate potential losses when disrupters threaten FIM Group portfolio positions. When we: 1) see disruptive forces that threaten the long-term cash flows of a portfolio investment; and 2) feel that these forces are not properly reflected in the current stock or bond price, we sell the position. 

A recent example of this was our decision to sell Hawaiian Electric (HE) from client accounts. With solar adoption accelerating in Hawaii, we believe that the company, which has been slow to come up with a tactical response, will soon begin to face increased pressure on its profitability (see a concurring note from Barclays in the sidebar). With our contention that HE’s share price was not fully reflecting this threat, we sold.

Free Options

While global markets are chock-full of visible disrupters that capture media headlines and speculator interest (think Amazon.com, the zillions of revenue-less biotech firms and the high-flying social media sector), most disrupter stocks, including those like Radient mentioned above, do not meet our team’s strict investment criteria. We tend to favor more seasoned companies with solid histories of strong returns on capital and solid cash flow generation. And we like to buy these companies only when they are trading at significant discounts to private market values. That said, we do own several conglomerates and investment holding companies where we essentially own free options on high-growth-potential companies that aim to bring significant disruption to their respective industries. 

One of our largest holdings, Quest for Growth, for example, is a Belgium-listed holding company that owns a portfolio of both listed and privately held European companies. We bought shares at a price that essentially gave zero value to Quest’s ownership in privately held disruptors like Kiadis Pharma and Prosonix. Kiadis is a clinical stage biopharmaceutical company focused on life-saving therapies for patients with late-stage blood cancers. Prosonix is developing an innovative portfolio of inhaled respiratory medicines for diseases like asthma and COPD. Both have multi-billion-dollar market opportunities ahead of them.

FIM Group portfolio holding Dundee Corp, a Canadian conglomerate focused on the resource, real estate and infrastructure sectors, provides a similar “free option” situation. We bought Dundee shares at an approximate 45% discount to break-up value. Buying so cheap essentially gave us, among other things, Dundee’s controlling stake in Dundee Sustainable Technologies (DST) for free. DST is developing disruptive technologies for the extraction of gold from ore in a cyanide-free and mercury-free manner. The company has also developed non-chloride fertilizer products that could disrupt the massive potash industry, where repeated use of chloride salts is sterilizing the world’s agricultural soils.

Adapt and Thrive

Disruption is a part of life to which we all find ways to adapt. Parents of young children give up the dream of a good night’s sleep, workers bite their tongues and grind through last-minute job tasks, and airlines reroute planes. As an investment team, we are no different. We aim to avoid the devastating impacts disruption can have on slow-to-react companies just as the staffers at the National Oceanic and Atmospheric Administration’s Space Weather Prediction Center aspire to do with their monitoring of space storms. 

Where we differ from the sun-watchers at NOAA is that we have the ability to benefit from disrupters in the market. Our team can buy deeply discounted “disruptees” like Wm Morrison, and we can gain exposure to the free options of dynamic disruptors buried in conglomerate holdings like Kiadis, Prosonix and Dundee Sustainable. The NOAA crew, on the other hand, would likely benefit from its space storm analysis in only a very limited way: beating the rest of us to the battery
aisle of the closest supermarket before the lights go out.

Electric Utilities at Risk
(Source: Barclays Credit Strategy Team, May 2014): 
Electric utilities … are seen by many investors as a sturdy and defensive subset of the investment grade universe. Over the next few years, however, we believe that a confluence of declining cost trends in distributed solar photovoltaic (PV) power generation and residential-scale power storage is likely to disrupt the status quo. Based on our analysis, the cost
of solar + storage for residential consumers of electricity is already competitive with the price of utility grid power in Hawaii. Of the other major markets, California could follow in 2017, New York and Arizona in 2018, and many other states soon after.
In the 100+ year history of the electric utility industry, there has never before been a truly cost-competitive substitute available for grid power.
We believe that solar + storage could reconfigure the organization and regulation of the electric power business over the coming decade.
We see near-term risks to credit from regulators and utilities falling behind the solar + storage adoption curve and long-term risks from a comprehensive re-imagining of the role utilities play in providing electric power.
Hawaii

444 Hana Hwy,
Suite D
Kahului, HI 96732
p: 808.871.1006
f: 808.871.1433

Michigan

111 Cass Street
Traverse City, MI 49684
p: 231.929.4500
f: 231.995.7999

Wisconsin

1837 E. Main Street
Onalaska, WI 54650
p: 608.779.0300
f: 608.779.0304

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