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2014 December Newsletter

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

Idiosyncratic

id-i-õ-sıng´krat´ik/
adjective
adjective: idiosyncratic
relating to idiosyncrasy; peculiar or individual.
“she emerged as one of the great, idiosyncratic talents of the nineties”

synonyms: distinctive, individual, characteristic, distinct, distinguishing, peculiar, individualistic, different, typical, special, specific, representative, unique, personal, private, essential 

NOTE: FIM Group’s goal is to have 100% of our client portfolios made up of investments whose success is not dependent on external factors like the direction of the economy, stock market performance, interest rates, politics, etc. We want our investments to stand on their own merits and perform well. 

Now don’t get me wrong – we are all about a rational investing policy based on consistent, rewarding long-term performance. I’m talking about those short-term fluctuations in portfolio values resulting from people acting out of fear, greed or other emotions exaggerated by an abusive Munchausen-esque press that fabricates the harshness of events, and distorts the reality and impact potential of those events just to sell their papers or to keep us tuned in to their network. I can with great confidence tell you that regardless of who wins an election or whether or not Russia melts down, that people will continue to eat, barbers will cut hair, people will watch TV and text their loved ones. Life will go on. Perhaps we will buy a smaller car, eat down the food chain or forgo the fancy shampoo the barber suggests, but we will still engage in economic activity.

Idiosyncratic Investments

My definition of an “idiosyncratic” investment is one that we make that is not dependent on a certain degree of economic growth, interest rate movement, inflation, bullish or bearish market sentiment, deflation, government intervention or other significant external economic events to perform reasonably well. All of those factors are part of the investing landscape and must be considered. But it seems irrational to invest where you’re dependent on the economy doing well to make money. I would rather own investments that will perform well no matter what. So in that light, let’s get specific and discuss some of our actual investments, and why we feel they will perform well over time despite external factors that their management teams have little to no control over. 

Cable and Wireless (Schwab Ticker: CWIXF): The potential returns from this Caribbean-based communications business are more heavily weighted toward its management’s action than the vagaries of the markets they are in. The new management team has shed unprofitable businesses and moved its headquarters closer to its field of operations. It also has a keen eye on reducing corporate overhead while investing in the business to improve customer service. The balance sheet carries far less debt than its peers, which gives the company considerable flexibility to pursue an acquisition strategy or weather an economic storm. Most important, the company is valued at only 5.5x EBITDA and pays a 5.5% dividend. Basically, the stock is paying
us to wait while management executes its low-risk plan.

Life Time Fitness (Schwab Ticker: LTM):
As a sports, fitness and recreation center owner/operator, Life Time Fitness has multiple ways to win that are independent of the broader economic environment. The company is in a growing and long-term trend of people wanting to remain fit and healthy. Obesity is becoming a national problem, and Life Time Fitness is in the nexus of solving that problem. Its store base is small enough at 112 centers, so it can continue to grow for years. Additionally, the company owns most of its own real estate, which is an undervalued asset on its balance sheet. Management has entertained the idea of unlocking that value in the form of an income REIT vehicle. 

Quest for Growth (Schwab Ticker: QGPLF): This is a Belgian closed-end fund that specializes in public and private technology and healthcare firms. The fund trades at a 37% discount to NAV, which gives us a large margin of safety. Additionally, the fund pays a dividend with an expected 2014 yield of 7%. Technology and healthcare are inherently volatile spaces due to the rapid change that occurs. Quest’s team, however, has a proven track record of picking long-term winners. Due to its tax structure, the company is able to pay a healthy cash dividend to holders, which is not usually found in these types of growth industries.

American Realty Capital Properties, Inc. (Schwab Ticker: ARCP): ARCP is the classic case of idiosyncratic risk. It is an income-generating real estate portfolio that now trades at 75% of book value. ARCP’s portfolio is “Main Street”-oriented, with leases to quality tenants like Red Lobster, CVS and others. The opportunity to purchase this stock at such a significant discount to book value has arisen due to accounting errors and the subsequent resignation of the company’s CFO. We have determined that these errors, while concerning, do not impair the assets or the cash flows of the company. Price has decreased due to the uncertainty surrounding the CFO’s departure and the company’s controversial Chairman. It is our belief that this uncertainty will lift, and the stock will trade closer to its value. The dividend yield is providing us with good income while we wait for the resolution of the uncertainty. 

Tesco Corporation (Schwab Ticker: TSCDF): This company has stumbled of late and trades at a substantial discount to its history and current market share. Though it is affected by the economy and the new intense competition within its category, we believe that these factors have been more than priced in at this point. The real opportunity lies in the fact that it has a new management team that will undo much of the damage of the old management team and steer this company down the right path. Accounting errors and fumbled strategies have provided us with a substantial cushion in price to allow for a fix. The dividend yield, while modest, also provides investors with cash dividend income while waiting for the new management team to turn the boat. They are one of the largest retailers and grocers in the United Kingdom with significant global assets and choice locations, so with patience we believe a return to growth in profits and revenue growth can be achieved. 

LeapFrog Enterprises Inc. (Schwab Ticker: LF): LeapFrog creates, designs, develops and markets technology-based educational products for children. The stock trades below book value and has priced in a lot of bad news. One-third of the company’s value is cash, and it has no debt. This valuation is at historical, extreme lows. The opportunity lies in the fact that LeapFrog has an exciting, new product cycle in LeapTV, which will solve the lack of appropriate video games for the “8 and under” crowd. Additionally, LeapFrog has a new CFO who can fix the system’s problems that has caused inventory angst for the company and bad stumbles from last year. The stock is bargained-priced to such an extent that the economy will have little effect as investors don’t really expect much at this price. The returns rest squarely in the hands of management’s new product execution and the value of the 1,200-title children’s education library which has tremendous value if they or a buyer could monetize. LeapFrog pays no annual cash dividends, is mainly a growth investment and thus is not owned in all FIM Group portfolios.

Western Asset/Claymore Inflation-Linked Opportunities & Income Fund (Schwab Ticker: WIW): WIW is the largest single holding in FIM Group’s Balanced Conservative and Yield Income income-oriented accounts. WIW seeks attractive current income with capital appreciation as a secondary objective. To achieve its goals, WIW invests primarily in U.S. Treasury inflation-protected securities (or TIPS). Approximately 80% of the portfolio is invested in AAA U.S. government TIPS that have their income tied to inflation. TIPS pay a certain percentage income over inflation (U.S. CPI), have guaranteed value at maturity, and provide an element of predictability to portfolios. WIW should provide reasonable returns in a deflationary economy/low-inflation environment and higher nominal returns if inflation accelerates. WIW also invests approximately 30% of its portfolio in other income-oriented domestic and global investments, which boosts current yield, adds some protection if the USD declines in value, and provides some added growth potential. WIW is a closed-end investment that is priced at approximately 87% of its Net Asset Value, which offers a margin of safety and allows us to purchase a solid portfolio of investments at a great price. 

We have not listed all the investments that exist in our clients’ portfolios; however, each has a similar theme to those highlighted above – the ability to grow and prosper regardless of the economic landscape. We believe that price matters, so to add a margin of safety, our portfolios are full of risk-adjusted bargains. While we may feel that an investment may have great merit as an investment, we still wish to buy it at a bargain price. For example, we avoid paying $2 for an investment that merits a $1 price based on its intrinsic value. At FIM Group, we favor doing the hard work, and spending time and resources to discover investments that can be purchased at a price that provides an excellent opportunity for good income and profit regardless of economic factors, politics, interest rates and such. 

Zach Liggett, CFA®
By: Zach Liggett, CFA®

Notes from the Field

It’s been 20 years since I first traveled to Asia. In the summer of 1994, I embarked on a year abroad to Osaka, Japan. There I studied Japanese, took some courses in Asian economics and politics, and traveled a bit around the region. I got hooked, went back to teach English in the small town of Takamatsu for a year after college, and then returned to Japan as part of a graduate business program. Upon completing that, I landed my first job in the investment industry researching video game and toy company stocks for a German bank in Tokyo. 

These years working as an analyst provided the opportunity to meet and interview a wide range of Japanese management teams. I also made occasional trips to see our fund manager clients throughout Asia and discuss with them my buy-and-sell recommendations. At the time, Japan was 10 years into what has become a two-decade-plus battle with slumping real estate and stock market prices after its extraordinary financial bubble burst in 1990. Neighboring China was embarking on a massive growth spurt that would rapidly make it an economic force to be reck-oned with, and many other parts of Southeast Asia were recovering from the near-death Asia financial crises of the late ’90s.

After three years with the German bank in Tokyo, I returned to Michigan newly married. I joined FIM Group in 2003, and since then have gotten back to Asia every year and a half or so. These trips are a great chance to connect face-to-face with the management teams of our investment holdings as well as some of my former colleagues and friends that still live in the region. They also provide a chance for the Liggett family (which has grown over the last decade to include a daughter and a son) to visit with many of our relatives who reside in Western Japan. 

Our latest trip to Asia took place during three weeks in late October and early November. I spent a week each in Hong Kong and Singapore before heading to Tokyo for a couple of days. From there, I took the bullet train to Osaka, where I reunited with family for a long weekend of R&R before heading back to Michigan. These trips are usually pretty packed full of meetings, and this one was no different. In addition to attending a climate business conference, I visited nearly two dozen management teams. Below are some notes from the trip that I hope you’ll find interesting.

Strolling Through a Protest

When I planned on adding Hong Kong to the trip earlier this spring, there was no Occupy Central protest movement. But about two weeks before departing, the protesters spawned their movement of civil disobedience across several Hong Kong financial and government districts. This created an additional variable to my trip, but one that ultimately proved benign.

Fortunately, the protests have remained largely peaceful to date. I even walked through one of the protest zones between two of my company visits. It felt a bit strange and almost like I was a character in a post-apocalypse Hollywood movie walking in my suit through an elevated expressway completely transformed into a temporary tent city. Temperatures were in the low 90s, and from what I could tell most of the protestors were elsewhere, waiting for cooler nighttime temperatures to arrive before taking to the streets again. 

The purpose of their civil disobedience is to bring universal suffrage to the election of Hong Kong’s Chief Executive in 2017, which is on a present course to be heavily influenced by a mainland-dominated nominating committee of some 1,200 people. In my unscientific poll of the Hong Kong business leaders I met with on the trip, the consensus seems to be that the Chinese government will keep a peaceful approach and let the movement burn itself out. The theory seems to be that the “practical” business side of Hong Kong will ultimately overwhelm the momentum of the protestors, a group largely comprised of students.

While only a few weeks young, several of the companies I met with had already felt mixed impacts from the protests. Management at Traditional Chinese Medicine retailer Eu Yan Sang, for example, noted a meaningful slowdown in its Hong Kong operations during the month of October. Several of its stores near the main protest zones, which sell “unique” wellness products (at least to my American eyes) like bird nest soup and worm fungus pills (you read that right), had to be temporarily closed. Its other Hong Kong stores saw a drop in sales as the inflow of Chinese tourists slowed thanks to “soft sanctions” from the central Chinese government encouraging mainland travelers to go elsewhere. 

MTR Corp, on the other hand, probably wouldn’t mind if the protests lasted for quite some time. The company runs Hong Kong’s public train system and has seen a significant jump in its ridership since the beginning of the Occupy Central movement. MTR’s clean and efficient subway network provides a very easy alternative to a congested road system made considerably worse by the protests.

Green Economy Opportunities

Hong Kong would likely benefit from more train ridership as its environmental quality has definitely gotten worse since I first visited in 1994. I joined a two-day Climate Business Forum during my Hong Kong stay that brought together institutional investors, clean-tech business executives and members of global development institutions like the World Bank to discuss Asia’s mounting environmental challenges. While those seeking change at the government level lamented the slow pace of progress, business leaders and investors were clearly much more bullish on private sector developments underway in areas like water and wastewater management, alternative energy, clean transport
and green buildings. 

In the days surrounding the conference, I met with management teams of Chinese companies, including Yip’s Chemicals and Xinyi Glass. Yip’s is finding great market opportunities in China for its more environmentally friendly solvents and paints. Xinyi is riding the wave in green building and alternative energy with its strong positions in glass used in solar energy applications as well as low-emissivity glass used in energy-efficient building windows. These companies should benefit from solid “green economy” tailwinds even as China’s economy slows to a more sustainable pace.

Singapore’s Property Obsession

After Hong Kong, I hopped on a plane to Singapore for the weekend and three days of company visits. Property remains a large investor focus there, and local newspapers were loaded with full-page ads for residential condos starting in the $1M range and seminars on how to invest in property abroad. One of the companies I visited, Gallant Venture, is seeking to tap into this property lust with its resort develop-ment in neighboring Bintan, Indonesia. I took a 45-minute boat ride with a Gallant executive to tour its Lagoi Bay project on Bintan where off-water villas start at $500K and beachfront homes at $1M. The development was halted during the global financial crisis but is now underway again. Sales of building parcels are picking up as is construction activity, although much of the development areas I toured remained largely vacant. 

Gallant’s business shifted dramatically last year when it bought a majority stake in Indomobil, one of Indonesia’s top automobile companies. Indomobil assembles, sells and services Nissan, Volkswagen and Audi vehicles among other brands and has launched a new “low-cost green car” offering under Nissan’s Datsun brand (yes, that brand lives on). The car, with price points under $10K, is designed as an entry-level vehicle that taps into Indonesia’s massive emerging middle class.

$100K Minivans

As I chatted about the Datsun offering with the Gallant executive, I thought about how stark the difference in car prices is between Singapore and neighboring Indonesia. Indeed, most Singaporeans must laugh at the concept of a $10K car. There, the government restricts the number of cars on the road through a certificate of entitlement scheme where 10-year licenses to own a car cost more than $60K. Add in the actual cost of a car and you’ll find that the entry price for a basic grocery-getter minivan runs well north of $100K! That’s certainly one way to keep the traffic (and related air quality) in check.

Test Drives and Tea Time

Traffic was anything but light at the Singapore malls I traversed between company visits (taking advantage of the free air conditioning). I checked in on several Singapore mall-based stores of the above-mentioned Eu Yan Sang, where business was faring much better than in Hong Kong, and also took some time to “test drive” the high-end massage chairs at healthy lifestyle retailer OSIM. Singapore-listed OSIM has built quite a loyal following for its chairs, which retail for $2K+, although sales of its latest luxury model missed expectations, leading to its first quarterly profit drop in 23 quarters. I was also able to see OSIM’s other business units at these malls, including GNC (nutritional supplements) and TWG Tea, a luxury tea retailer that the company positions as the “Chanel of Tea.”

OSIM’s uInfinity Massage Chair Starting at US$5,999

While not nearly as diverse as the 800+ tea varieties sold by OSIM’s TWG, the companies I met with in Singapore do represent a fairly broad array of sectors and business models. In addition to wellness (Eu Yan Sang, OSIM), I met with Singapore-listed companies involved in ports (Hutchison Ports), online travel (Asiatravel.com), container shipping (Rickmers Maritime Trust), property and hospitality (Straits Trading Co.), Indonesia shopping centers (Lippo Malls – see this month’s Investment Team Spotlight) and even Japanese apartments (Saizen REIT). 

A Halloween Treat for Financial Markets

Which brings me to my final stop for the business part of this trip: Tokyo. While still in Singapore, Japan announced a double Halloween treat for global financial markets. The first came from the world’s largest pension fund, Japan’s Government Pension Investment Fund, which declared on the last day of October that it would shift its target asset allocation away from domestic bonds to greater weights for domestic and international stocks. Hours later, the Bank of Japan’s (BOJ) Haruhiko Kuroda brought out his bazooka once again with the announcement that the BOJ would increase its annual purchase of Japanese government bonds from JPY60 trillion to JPY80 trillion. These purchases would continue until inflation in Japan hit the BOJ’s 2% bogey. 

Japan and global stock markets jumped on the news and the yen dropped sharply against most currencies. This felt like a bit of déjà vu for me as the last time I was in Japan (about a year and a half ago), Kuroda unleashed the initial round of unprecedented monetary easing. This was part of Japan’s “three arrow” strategy of fiscal easing (higher deficits), monetary easing and structural reform to revive its economy.

I discussed the latest policy announcements with executives at Sparx Group (a listed investment manager in Tokyo), portfolio managers of two closed-end funds we have invested in historically (Aberdeen and Schroders), a top-level manager at Coca-Cola East Japan (one of Coke’s largest bottlers globally), and a mix of friends, in-laws and taxi drivers. Most felt that the policies were a temporary positive for Japan as they would push profits up at exporters (thanks to a cheaper yen) and perhaps even lead to greater consumption and positive inflation (wealth effect from higher stock prices and higher wages). Some, though, shared my concerns that these policies did little to address core structural issues (massive public debt, a rapidly aging workforce and a shrinking population) that remain longer-term headwinds for Japan. These skeptics also view the policy thrust as one that will ultimately prove counterproductive as it brings an additional tax on Japan’s aging population (with the cheaper yen leading to higher food and energy costs for seniors pulling from savings that continues to earn nothing at the bank). My mother-in-law seemed to share these sentiments, deeming Kuroda’s latest announcement more of a trick than a treat.

Corporate Conditions the Best in Years

For the moment though, corporate conditions in Japan seem to be the best they’ve been in years. Balance sheets have improved significantly (net cash in aggregate) and revenues are benefiting from the weaker yen and a rising middle class in emerging Asia (buying everything from Shiseido cosmetics, to Shimano bicycle components, to Toyota sedans). These new middle-classers were evident throughout my travels and were definitely noticeable in Tokyo and Osaka. There, retailers are increasingly catering to the hordes of tourists coming in from China with specialty signage and Chinese-speaking staff.

Japan, Inc., is also displaying a pronounced shift in focus toward profitability and shareholder returns. When I walked through Japan bookstores, ROE (return on equity) was a common theme on local business magazine and book covers. I also learned that the Japanese government had even spawned a new stock index (the JPX-Nikkei 400), which includes only companies that hit certain ROE and operating profit targets. This index was referred to as a “shame index” of sorts designed to spur companies not included in the index to become more profitable. 

From the Tropics to the Winter Wonderland

As I return back to Michigan and deal with the inevitable case of jet lag (and temperature lag), I’ll look forward to sharing these and other thoughts with colleagues on our investment team and clients who own many of the companies I visited in their portfolios. Much in Asia has changed since I first visited in 1994. Among these changes, the rise of the region’s middle and upper classes and the accompanying degradation of the environment are two that really stand out. Whether buying their first McDonald’s “Ebi Sensation” or a beach home in Bintan, consumerism in Asia is alive and kicking, although on any given day you might have to squint through the smog to see it. 

If continued unchecked, this consumption growth in the East will leave a trail of mounting environmental liabilities for future generations to inherit. There seems to be a growing acknowledgement of these risks in the public sector around the region, although I’m more impressed with the response from the wide array of innovative business leaders working
to address these challenges. I am convinced more than ever that there will be investment opportunities galore within the general theme of a “more sustainable Asia” for many years to come. Trips like these, affording the chance to see and discuss such investment opportunities firsthand, are one means to help uncover them. 

Matthew J. Desmond CFA®
By: Matthew J. Desmond CFA®

The New Year Brings Financial Planning Challenges

Like every New Year, the flip of the calendar to 2015 brings changes that taxpayers, savers, retirement plan participants and IRA owners need to know. There are no new game-changing programs or regulatory requirements that pose potential pitfalls. Even so, over time, the modifications for 2015 can make a significant difference for many investors.

Good news for defined contribution retirement plan participants (including 401(k), 403(b) and 457 plans): The IRS has increased the maximum annual amounts that participants can defer from their paychecks to $18,000, up from $17,500. The additional “catch-up” contribution available to 50 and older has increased to $6,000 from $5,500. If you’re over 50, then, you can contribute a total of up to $24,000 in 2015. That’s $1,000 more than in 2014.

IRA contributors, however, won’t have the opportunity to increase additions to their tax-advantage accounts in 2015. Roth and Traditional IRA contribution limits remain at $5,500. The catch-up for those over 50 is also unchanged at $1,000. These accounts won’t start the New Year with nothing to show for it, though. If you file taxes as single or head of household, the adjusted gross income (AGI) maximum for making full Roth IRA contributions increased $2,000 to $116,000. You can still contribute an amount less than the full $5,500 up to $131,000 AGI. This so-called “phase-out range” for Roth IRAs for those that are married filing jointly is $183,000 to $193,000.

Traditional IRAs, likewise, have their own phase-out ranges. They apply, in this case, to the deductibility of traditional IRA contributions for taxpayers that are also participants in a workplace retirement plan. For heads of household and those filing single, traditional IRA contributions are fully tax-deductible up to an AGI of $61,000, a $1,000 increase over 2014. After that, contributions are partially deductible up to $71,000, above which contributions cannot be deducted from income calculations. For those married couples filing jointly in which the contributing spouse is also covered by a workplace retirement plan, the new phase-out of $98,000 to $118,000 increased by $2,000 on each end. An IRA contributor that is married to someone covered by a workplace plan but not covered by one himself/herself, has a more generous traditional IRA phase-out range of $183,000 to $193,000 for deductible contributions. Traditional IRA owners with AGIs above the phase-out range and earned income can still make contributions, but they cannot be deducted from income tax.

One final statement about traditional and Roth IRAs: Contributions can be made for 2014 until the tax filing deadline of April 15, 2015. 2014 contributions are subject, of course, to the 2014 limits and not the increased limits discussed above.

  • >span class="s1">Social Security payments will have a cost-of-living adjustment of 1.7% to account for inflation
  • AGI subject to Social Security taxes (Social Security wage base) will increase to $118,500, up from $117,000
  • Federal Estate Tax Exemption will increase to $5.43 million, up from $5.34 million

In addition to the IRA contribution maximums, one thing that remains unchanged is the gift tax exclusion amount: The first $14,000 of gifts to any person during the year are exempt from the gift tax.

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