Spanish novelist, playwright and poet Miguel de Cervantes Saavedra would have celebrated his 467th birthday this year. He lived 200 years before America’s founding and is most famous for writing Don Quixote, which is considered the first modern European novel. The phrase “the proof is in the pudding” comes from his book, but it has been oversimplified in translation. Correctly translated, “por la muestra se conoce el paño” says, “the proof of the pudding is in the eating.”
Marketing is taking over our world. We have been trained, it seems, to let oversimplified slogans rule our life. We all are busy, and our brain uses a lot of energy, so it is just simpler to adopt phrases, sound bytes and quotes to run our life. The proof is in the pudding – but only if you eat the pudding.
Making Retirement “Pudding” at FIM Group
Companies have three things that they can do with a dollar of income: 1) Reinvest it in the business for organic growth projects or acquisitions; 2) Return profits to investors through dividends or share buybacks; or 3) Some combination of reinvesting in the business and returning capital to shareholders. At FIM Group, we are very keen to own investments in companies that pay great cash dividends, and we are equally keen to own companies that actually earn those dividends and even have some extra cash around to reinvest in “rainy-day” opportunities like acquisitions or savings. We also like to own companies in industries that we feel will grow over time so that their dividends, profits, net worth and cash increase and compound over time.
If I compile a list of FIM Group’s holdings (i.e., our “pudding”), the key characteristics would be: large and small U.S. and foreign companies that produce high cash flow, profits and income that can be used as dividends or reinvested. Generally, we look to have a 10% or better expected “return” from our clients’ stock investments. That return can come from dividends, income/free cash flow, increase in the company’s asset value and such. As long-term investors, presuming a company’s stock will go up “just because we believe stocks will trend up” is silly and speculative. It is, however, rational to think that stocks and most investments will fluctuate over time based on how well they produce income, dividends and growing asset values for their shareholders. Short-term fluctuations are caused mainly by irrational, moody markets that are influenced by sentiment and emotion rather than the specifics of the investment. Rest assured that FIM Group makes investment decisions not on what the market might think of them (like a beauty contest), but rather on what they are made of. This, eventually, leads to profits and income.
American Realty Capital Properties
So let’s take a look FIM Group’s third largest individual stockholding, American Realty Capital Properties (ARCP), and determine why it is a favorite. First, the company owns real assets (single-tenant real estate properties) and pursues a strategy of seeking high current income and growth. At today’s price of ~US$12.30, ARCP has a cash dividend representing an 8.15% current yield, which it earns.
American Realty Capital Properties (NASDAQ: ARCP) is the world’s largest net lease real estate investment trust (“REIT”) that acquires, owns and operates single-tenant and multi-tenant commercial real estate properties. ARCP’s high-quality property portfolio is leased to corporate tenants that are primarily investment grade-rated occupying properties located at the corner of “Main & Main” and in other well-trafficked, strategic locations. Unlike other net lease REITs, ARCP focuses on acquiring both mid-term and long-term leases, which provide for both monthly income generation and “outsized” growth potential over the longer term. (SOURCE ARCP website)
PRICE Matters and Strength in Numbers
FIM Group’s portfolios are designed specifically to meet each client’s goals, whether it’s saving for retirement, serving as a source of income or ensuring their children’s/grandchildren’s education. We strive to build portfolios that are chock-full of investments that we expect to perform well in the future that are purchased at the right price. ARCP is bargained priced at ~US$12.00, giving yield around our ~10% minimum goal. If the share price of ARCP were US$24.00 (roughly double the price today) its dividend yield would drop from 8% to 4%. Most investors lose sight of the fact that the price you pay for an investment is a key component to investing and the key to its future performance. They will look at past performance or past price action and fail to realize that those are born out of speculation and not based on any rational “price maters” criteria. Sadly, Wall Street is always glad to sell whatever investors are willing buy, adding the proviso, “Past performance does not guarantee … etc.” and letting the customer do as he or she wishes.
Today, the general stock market is selling at an earnings yield of between 5% for the NASDAQ and 6% for the Dow or S&P 500 (definitely not “bargain prices”), and many investors in index funds and funds aggressively benchmarked to indexes will find their returns quite disappointing going forward. Some international markets have much better prospects based on the price you pay for earnings or dividend income than the U.S. For example, the average dividend yield of the U.S. S&P 500 is 1.95%, while the yield on every Europe index is higher – in some cases more than double our current dividend yield. With thousands of available stock investments, there are many to invest in globally that look attractive. FIM Group recently added the three largest U.K. food retailers to our portfolios. Tesco, WS Sainsbury and WM Morrison have average cash dividend yields of in excess of 5%, even after a recent dividend cut at Tesco, and their current earnings yield are all average around 10%. The stocks are down between 33% and 45% in the past year due to intense competition in their markets. Darlings of investors can often be abandoned, and dividends and earnings could continue to erode for these three retailers as they adjust to a brave new retail environment. “Ya gotta eat” regardless of the economic reality, so food companies historically have been favored by investors – especially those wishing stability and safety. Food companies tend to have much more stable income, prices and sales; however, after a few misses by the three, investors have dumped the shares to prices that are significantly lower than their U.S. and foreign counterparts based on earnings, sales and dividend yields. We have seen this swoon as a buying opportunity and have bought and added to these positions over the past few months.
When to Invest
Lately the markets have been volatile. Markets are cyclical and many investors try to “time” markets by jumping in and out based on everything from guidance from charts to gut feel to astrology. With the actions globally and in our own economy, many investors are feeling panicky and ill at ease. Historically, when markets are swooning, savvy investors are investing. The chart on page 2 illustrates the importance of staying the course and being invested properly going into a market’s rough patch.
When an investment is bargained-priced, being patient is the way to win long-term as an investor. Zach Liggett’s is a case in point. Most investors do not call us when their portfolios are performing well – calls come in when our portfolios are trickling down on a short-term basis. Human nature seems especially prone to point out the (short-term) negatives and forgets that long-term success is predicated on some volatility – no one is going to consistently buy at the exact bottom of a price decline. The quote attributed to Warren Buffett – “Better to be generally right …” – comes to mind. When our team wins, no one seems to spend a lot of time chatting about the missed goals, baskets or touchdowns … which makes sense. There is no finish line or “game over” for most investors (although death might be if there are no heirs). Retirement funds must be managed for income and to preserve capital and purchasing power now and into the future. Discipline, talent and patience tend to cause investment success. How do we know this? The proof is in the pudding.
September served as a reminder that FIM Group-managed portfolios are not designed to be volatility-proof. Our team plans for and accepts temporary dips in portfolio value along the way as a natural part of investing in publicly listed securities to achieve long-term goals. Having taken some calls on this topic of late, I thought I would share a few related points.
1) IM Group-managed portfolio returns tend to be lumpy and typically will not track closely with common “market” indices. This holds especially true over short-term time periods. We take a long-term view and focus our risk management on minimizing permanent losses. This is starkly different than obsessing over temporary fluctuations in market value or trying to stay within a narrow range of an arbitrary “benchmark” index. We do not expect our returns to come in a nice, linear fashion. With most of the stocks and bonds that we buy in each of our core investment strategies, we plan on a three-year time horizon for expected total return targets to be achieved. Sometimes when we get lucky, the returns are much quicker, and some-times when we make mistakes, the expected returns on an investment idea never hit our bogey. The important point though is that the flexibility afforded by a long-term view allows us to buy on the cheap when others are more focused on short-term issues.
Additional Comment: We began buying WM Morrison, one of the major U.K. supermarket chains, in July at the equivalent of $3/share. As I write, shares now trade at $2.75. Our base case investment thesis is that on a three-year view, shares should be worth at least $4. This thesis is built on the appraised value of Morrison’s real estate portfolio and a very conservative forecast for cash flow generation in the years ahead. Do we expect the share price to immediately rocket 45% to our fair value bogey? Of course not. In fact, it would be quite normal to see a total return path that is low or even negative in the first year of our holding. This is the lumpy nature of our investing style. Although we expect to receive a 7.5% annual dividend yield while our thesis plays out, we can’t predict when the share price will come around to reflect the fundamental value we see within this holding.
2) eptember performance, while not typical for us, is also not all that unusual. During the month, investors began to take a harder look at the different monetary policy outlooks across the major economic regions of the world. The U.S. seems to be moving to a modestly tighter monetary policy with the end of Quantitative Easing and will likely move away from its zero-interest rate policy. Europe, Japan and China, on the other hand seem content to stay put with their hyper-loose approaches. The perceived change in this relative policy positioning helped push the dollar sharply higher against other currencies and also had a negative impact on certain sectors perceived to have benefited from years of extreme U.S. monetary policy. This had a negative translation effect on many of our foreign stock holdings (primarily those in Europe and some emerging market countries like South Africa) as well as some of our real estate-related holdings world-wide. The strong dollar also added to the weaker trend in gold and silver prices, negatively impacting our small basket of precious metals miners.
Additional Comment: I dug into our monthly data from 2000 to see how our performance in September lines up with FIM Group’s historical experience. Looking back at even our most conservative core investment strategy, Yield Income, I found that in 10 of the last 15 years we had at least one monthly drop of more than 3%. So yes, this type of performance month is not something new for us and is something we usually see in more years than not.
3) olatility insurance can really add up over time. One way to “self-insure” against temporary drops in portfolio value is simply to hold large allocations of cash in the portfolio. The risk here of course is that doing so means the lost opportunity to be earning dividends, interest and capital gains from owner-ship of high-quality, attractively priced stocks and bonds. Over long periods of time, this “cash drag” can be a real lost opportunity. As an alternative, the investment industry is happy to provide products that aim to deliver the holy grail of volatility-light or volatility-free investment returns. Structured products, annuities, derivatives and funds designed to go up when the market goes down are great money-makers for those who sell them. For patient investors, they just tend to be unnecessary and very expensive insurance that often doesn’t even work as advertised.
Additional Comment: I recently had a meeting with a partner of a newer real estate-focused mutual fund company. The fund charges its shareholders 2.3% annually and aims to reduce price volatility by investing the lion’s share of its assets in real estate private equity managers. In the company presentation, the partner showed me a slide depicting the average historical returns for the types of private real estate the fund invests in. Over the past 30 years, these returns have been about two-thirds the levels of publicly listed real estate (8% average annual returns v. 11%) with only about one-third of the annual volatility.
I understand how this product could be wildly popular with those who see volatility as public enemy number one. But at a 2.3% annual cost to share-holders and a 3% overall average annual historical performance lag to the public real estate space, it sure seems like this volatility insurance comes at a steep price.
4) IM Group portfolios are designed to meet portfolio income needs through a wide range of financial market environments. In particular, our portfolio strategies designed and managed for retired clients (Balanced Conservative and Yield Income) are structured to deliver portfolio income without having to sell positions at distressed prices during adverse conditions.
Additional Comment: We design and manage our Balanced Conservative and Yield Income strategies to generate dividends and interest income through even the harshest market environments. Well-financed real estate investment trusts with high-quality tenants, food distributers, and energy and communications utilities are just a few examples of the areas we invest in where cash generation is quite stable through entire economic cycles. This cash generation, now running around 4%-5% annually, meets the lion’s share of most client portfolio income needs. Additionally, we proactively diversify across geographies, asset classes, sectors and companies so that even during times when the overall portfolio value is down, we would expect certain portions to hold their value or even increase in value. For example, in a “flight to safety” scenario where the prices of our stocks and high-yield bonds come under temporary pressure, we would expect that our holdings in shorter-term U.S. Treasury bonds and bond funds could provide additional client liquidity while we wait for other parts of the portfolio to recover.
5) here is a bright side to taking on the “risk” of the short-term volatility in publicly traded stocks and bonds. Namely, we can take advantage of the lower prices that emerge when volatility causes others to trade on emotion.
Additional Comment: As value-oriented and opportunistic investment managers, one of the keys to our success is staying emotionally neutral to the noise of the day, having conviction on a given investment’s fundamental value, and taking the other side of trade when others are forced to sell at low prices. Because we invest “without borders,” opportunities to do just this regularly come our way. Last year, when certain fixed-income closed-end fund investors sold indiscriminately on a perceived change in Federal Reserve monetary policy, we were able to find great deals on funds yielding 7%-8% and trading at 85 cents on the dollar. With the current sharp move higher in the dollar, you can bet we will be taking advantage of discounts on both existing and new holdings in markets where our greenbacks now have considerably higher purchasing power.
So to wrap this up, our team views volatility as much more of a blessing than a curse. This allows us to invest with a long-term view and take months like September in stride. Our risk management process prioritizes the minimization of permanent portfolio losses over temporary ones. Because of this, we can reduce allocations to cost-generating volatility insurance and raise allocations to solid, positive return-generating investments. While we won’t be volatility-proof with this approach, we can be resilient to temporary dips. We can also benefit over the long run from the return opportunities that present themselves when others view volatility as a much more malignant force.
Optimizing assets in retirement gives rise to several questions. In addition to the questions of when it’s best to start collecting Social Security and what investment strategy best fits retirement years, retirees must also devise a withdrawal strategy from their financial accounts. Knowing which account to use and when to make the proper withdrawal makes a significant difference.
Retirees often have several types accounts from which they can take the distributions that fund their lives: IRAs, Roth IRAs, defined benefit retirement plans (such as a 401(k)) and taxable accounts. Because each type of account has different tax ramifications, the order in which accounts are depleted will have an impact on the longevity of the overall portfolio and the ultimate legacy that remains for heirs. Maximizing longevity and potential requires understanding the long-term impact of each account type’s taxation. Every retirement situation is unique and requires individual review, but a “typical” case can be constructed with a few simple assumptions. First, the retiree’s overall portfolio consists of a diversified basket of stocks and bonds. Second, the retiree receives, or will receive, at least one fixed-income stream outside of the investment accounts (Social Security for most people, pensions for some and annuities for others). Third, the retiree’s taxable investment account does not have a high potential capital gains tax from a very low-cost basis.
The key distinction to draw is between assets that are taxable and those that are tax-deferred. Taxable assets generate taxable income through interest income and realized price appreciation. Tax-deferred assets include those held in traditional IRAs, SIMPLE IRAs/SEP IRAs, and retirement plans such as 401(k)s, 403(b)s and Keoghs, in which taxes are paid only upon non-rollover withdrawals. Roths, whether in the form of an IRA or 401(k), make up a second tax-deferred group. They differ from traditional IRAs in that distributions, as long as they adhere to the rules, are not taxed.
Retirees should first turn to the taxable accounts for withdrawals. Mathematically, extending the benefit from deferring capital gains taxes and taxes on interest and dividends on tax-deferred assets increases a portfolio’s overall longevity. The Roth would be next in line, also in order to continue deferring taxes on the traditional IRA/401(k). Because of the income tax paid on IRA withdrawals, a higher gross amount must be withdrawn from that account to equal the net amount withdrawn from a Roth. Those higher withdrawals would lead to faster depletion of the traditional IRA, while utilizing the Roth would keep a higher overall amount of funds to grow over time. If, however, maximizing benefits to heirs is a priority over higher lifetime accumulation, it may make sense to preserve the Roth IRA for distribution to beneficiaries without any income tax. Beneficiaries of traditional IRAs are subject to income tax upon withdrawals. It’s also important to note that the advantages of delaying use of tax-deferred assets increase with higher tax rates and better investment returns.
A couple of issues that accompany real-life scenarios make the taxable account first strategy a rule of thumb rather than a strict rule. One is the required minimum distributions (RMD) that start at age 70½ for most non-Roth tax-deferred accounts (IRAs, 401(k)s, etc.). Penalties associated with failure to take the RMD far offset any benefit to preserving the funds in the IRA in order to favor withdrawals from a taxable and put the IRA first in line for withdrawals up to the amount of the RMD. Individual tax rates also have an impact. Higher income tax rates and capital gains rates paid by an individual will increase the longevity impact of taking distributions from a taxable account, then Roth, and then traditional IRA. Conversely, lower rates diminish the impact. Tax rates of beneficiaries can also have an impact on the decision
of whether to first deplete a Roth or a traditional IRA. Because no situation is truly typical, these guidelines are to be taken as that – guidelines. Each situation deserves a unique assessment for the optimal strategy.
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