I regularly encourage team members, clients, family and fellow citizens to get out and see other parts of the world. For me, travel is not only something that I enjoy as a recreational pursuit, but it is also a great tool I utilize professionally to keep my mind sharp and my perspectives balanced.
My latest trip abroad took place in late December and early January when Amy, the kids and I traveled together to Buenos Aires, Argentina. Mixing in some work between family adventures proved to be quite seamless. Barring a few short power blackouts, the wonderful world of phone and Internet connectivity kept me plugged in with colleagues and global financial markets throughout the trip.
We were in Argentina primarily to visit my friend Chris, who I’ve known since we were teenagers. Chris moved there 15 years ago, married a local and has three delightful children. With his business background, Chris helps Argentineans understand American culture and also provides English training, interpreting, translating and consulting.
Argentina’s Roller Coaster Ride
Early in our trip, Chris briefed us on Argentina’s modern economic history, a pretty fascinating reminder of how severely things can change. In the first three decades of the 20th century, Argentina outgrew Canada and Australia in population, total income and per-capita income. By 1913, it was the world’s 10th richest nation per capita, seemingly stable, and conservatively run. But around 1930, a military junta took power, ending 80 years of constitution-based governance.
Under military rule, a variety of factors, including protectionism, extreme wealth concentration and wasteful spending on “military/police/defense” contributed to the country’s slow, steady economic decline. Argentina’s vast natural resources and agriculture became (and still are) controlled by the hands of a few. The nation’s ability to manufacture and add value to its bounty of commodities was stalled for many years. Only more recently has this begun to undergo a renaissance.
Today, Argentina is a very livable place, save for the occasional power shortage (which I learned can last for weeks), periodic runaway inflation (see chart at right) and fairly widespread corruption. There’s also still a sharp divide between rich and poor, although the country does have a growing middle class of highly educated and proud citizens.
Could the U.S. Become an Argentina?
Chris is closely tied to Argentina, and as an objective investor/businessperson, I found his observations about the global economy, the U.S., Europe and South America enlightening. He explained that when he first came to this country, one Argentinean peso equaled one U.S. dollar. Today, the ratio is around 10 pesos to the dollar. Chris makes a good living, but he said the average Argentinean’s wages have not gone up tenfold and have failed to keep pace with inflation. He added that prices of goods and services are so erratic that some stores do not price their items. For example, at Buenos Aires’ largest and most famous book store, you have to scan a book’s UPC code on one of the many scanners throughout the store to find its current price. I guess that’s one way to handle the currency weakness.
Chris’ dual perspective as an American who’s spent many years in Argentina gives compelling weight to his observations. One such observation is that regardless of current conditions, one should be very careful with assumptions about the future. Regarding the U.S., he was quite specific: “Egos get in the way. Don’t think for a minute that the U.S. could not become an Argentina. Argentina was once the seventh largest economy in the world. Now look at it!”
As investment managers, it is important to constantly probe and test our assumptions about existing paradigms. As I regularly tell our team, “things change” and “everything is cyclical.” History is chock-full of case studies where major paradigms get completely turned upside down. Dominant companies lose their way (remember Enron?) or become supplanted by trendier competitors (Myspace who?). Beaten-up companies regain their competitive mojo (Apple). Entire economies can face the same fates too.
When I was in school, Japan was envied for its hard work, manufacturing power and growth. Things have changed since then. In 1990, Japan had a government debt-to-GDP ratio of 30%. Today, it is 250% as the government turned to borrowing after a major private sector credit bubble popped. Japan, and many economies like it, is stuck between a rock and a hard place. The U.S. and Europe are not as bad (yet), but our policies are very similar and highly influenced by the idea that with simply the proper (government) policy mix, normal business cycles can be smoothed, volatility reduced, and the “business’ natural animal spirits” or market forces can be swept under the rug. You would think that by now we would have figured out that sustainable prosperity cannot be created with financial engineering, currency manipulation and increasing levels of debt. At some point we will realize that wealth is created by effort. People aren’t employed sustainably by creating debt or manipulating interest rates, and the paradigm will eventually shift back to one characterized by less policymaker intervention and more tolerance for natural market forces.
When Paradigm Change Meets Leveraged Currency Speculators
Financial markets recently featured a small dose of what such a paradigm change can mean for the ill-prepared. While en route to the “Chinatown” of Buenos Aires, I read that the Swiss National Bank (SNB), run by stoic, conservative bankers, had scrapped its three-year policy of capping its currency against the euro. Action in currency, stock and bond markets was swift, with massive single-day moves. The Swiss franc (aka the “Swissie”) rose more than 10%, and the Swiss stock market plunged 9%. Swatch, the largest exporter of Swiss watches, dropped a whopping 16%. History shows that when you suppress normal cycles, pressures still build and the consequences are often more severe than just letting nature run its course. Things were working well in Switzerland for those three years, but like the man who fell off the Empire State Building who said “so far so good” as he flew past the 17th floor, gravity exists, and suppressing and manipulating the market only kicks the issue into the future.
The SNB’s president, Thomas Jordan, told Zurich reporters, “We came to the conclusion that [capping the franc against the euro] is not a sustainable policy.” Interestingly, not one of the 22 economists surveyed by Bloomberg News between January 9 and 14 expected the SNB to abandon its cap. Apparently neither did more than a few hedge funds, which after making “easy” money month after month front-running the SNB’s currency interventions with leveraged bets, lost everything on the surprise announcement.
While I imagine most readers will have little sympathy for leveraged hedge funds taking concentrated bets on a continuation of central bank policy status quo, there are lessons to be distilled here. Obviously as investors, smart diversification (company, sector and currency for starters) is rational. Taking a very cautious eye toward leverage is also good common sense. And betting the farm on central bank promises? Well, by now we should know that if a given policy position is unsustainable (like the SNB’s), you’d better be really careful making bets on such policies continuing forever. Indexers and those betting their futures on the easy policies of the feds of the world should be especially cautious. Herbert Stein’s famous dictum, “Unsustainable trends are unsustainable,” seems more true today than at any time in history.
Managing Finances for Resilience
Our team diversifies the portfolios we manage for resilience to future unknowns. We are wary toward stocks and bonds of companies that are seemingly priced for “perfection,” and we are attracted to those where expectations are more muted. Leverage is something we examine very carefully in any investment we make.
Volatility-proofing the portfolios we manage is not our goal. Doing so (for example, by sitting in large levels of cash or CDs for long periods of time, or putting on “hedge” positions) is generally expensive in both explicit terms (hedging costs) and in terms of purchasing power losses. With meager returns available on low-volatility investments, inflation can grind away at the real wealth we strive to protect and grow.
We don’t attempt to forecast central bank behavior or try to time cyclical fluctuations in major currency pairs. Instead, we look at portfolio positions one at a time and continually test our investment theses against a range of possible internal (e.g., management execution) and external (e.g., exchange rates) factors. If we feel that a given position no longer provides sufficient risk-adjusted return potential, we sell and move on to something else. For example, in recent months we’ve been trimming or selling some of our strongest-performing long-term European holdings given insufficient compensation (expected return) for the embedded currency risk these positions contain. Thinking long-term, and investing in strong businesses managed by good people and purchased at great prices are other ways we strive to reduce risks and increase long-term performance.
Outside of investment portfolios, too, there are numerous steps we encourage clients to consider that can boost family financial resilience ahead of unknown future economic and life changes. For example, one area that often comes up is the proper level of housing expense (including mortgage debt) a family should take on. In Argentina, as Chris explained to me, strong family ties serve as a buffer to economic risk with children often living with parents until they are married (and even longer in some cases). Mortgages for home purchases are effectively non-existent in Argentina, so one must pay cash for real estate. Housing costs are significantly lower in Argentina due to this “cash for a home” paradigm, creating financial flexibility where families can spend their income on basic needs like food, clothing and such.
In the U.S., Canada and Australia, where home loans are common, many people have been stuck with big mortgage payments, ultimately hurting their finances and family stability. Thinking critically about choices surrounding levels of housing expense, including mortgage debt, can make a real long-term difference in building one’s long-term nest egg, providing financial resilience and peace of mind.
Remaining an Optimist
While I feel very good about the positioning of FIM Group-managed investment portfolios and the financial planning steps our clients have taken to boost their family financial resilience, like many of you, I do worry about our country as a whole. As Chris warned, egos seem to be getting in the way at our highest levels of leadership. While change can certainly “trickle up” from the community level (and in many cases, thank goodness it is!), egos, conflicts of interest and just plain lack of boldness at the top seem to be adding to the fragility to our society at a time when more resilience and common sense are urgently needed. I also worry about long-simmering religious, ideological, social and environmental tensions that seem to erupt with greater frequency and magnitude these days – Charlie Hebdo being just the latest example.
Nonetheless, I remain an optimist. Despite these concerns and the unknowns ahead, I remain firm in the belief that I have shared on many occasions – that being guided by fear is neither logical nor a reasonable strategy to pursue in investments or life. I have had few times in my career where I have felt like opportunities are as significant as they seem to be for 2015. Yes, risks are there, but every investment (regardless of whether an investment of time, money, emotion, etc.) has risks.
We are finding many fine investments that have cash dividend and interest yields of 3% to 8% and that we feel can grow in addition to paying their dividends over time. Will they fluctuate in value? Yes. Will we be happy five years from now that we “put up” with the volatility? In my opinion, absolutely!
Chris isn’t leaving Argentina. He puts up with the risks and volatility he’s learned to cope with every day. He sees them as inconvenient but worth taking to live a life he loves. I admire that attitude and concur with his view that we should constantly test the beliefs we hold most dear. This is especially true when it comes to managing finances, whether at the personal level or the professional one.
Approaching every day with a “things change” mindset is an important piece to the financial resilience puzzle. Such a mindset comes naturally in many parts of the world, as travel abroad often reminds me. Yet, long runs of relative stability have a way of wiping out this mentality. And for those caught unaware, like the many leveraged currency speculators caught short by the Swissie, it has a way of wiping out capital too. As investors we must be cautious of getting lulled into thinking “so far so good” when short-term trends favor our positioning. We must not be guided by fear. Life is full of natural tensions and is complex, and our behavior and response to those competing tensions will be the main influencers of the results. Humility, patience, courage and objectivity/open-mindedness are the virtues that we will strive to exemplify as we manage portfolios in our world. Certainly it is not a time to be fearful; things change, life goes on, and opportunities abound because of these changes.
A friend told me a joke this week:
Q: What does an optimist call a glass that is filled 50% with water?
A: Half full.
Q: What does a pessimist call a glass that is filled 50% with water?
A: Half empty.
Q: What does an engineer call a glass that is filled 50% with water?
A: Too big.
Being a former engineer, I chuckled at first. Then as I thought about my ex-colleagues who were the best engineers, such an answer is exactly the kind of response they would have given. Good engineers don’t jump to judgmental or biased conclusions. Instead they consider all the factors they can think of and focus on solving the matter at hand.
Good investment management is similar. But a good investment manager might have yet a different answer: “The glass is completely full – half with water and half with air.”
For every headwind, there is a benefic-iary. For every loser there is often a winner. For every dour economic factor there is a counterbalancing factor. Considering all factors and responding in a measured manner helps mitigate extreme outcomes and generates steadier results.
More than a few clients have asked of late why their portfolios own foreign holdings while the dollar is rising. We addressed this a bit in our latest webinar, but I think it is worth discussing some more. The question is understandable. U.S. stocks have been the star of global markets, with indices like the S&P 500 tripling over the last six years from the trough levels hit during the global financial crisis.
Reasons for not owning foreign holdings go something like this: The dollar is rising and foreign currencies are correspond-ingly falling because the U.S. economy is the strongest horse in the race; interest rates, while low here are lower abroad, are attracting investment to the U.S. dollar; unemployment is worse abroad; growth is weaker abroad; and so on.
But if you look past the headlines and you look forward instead of backward, there are a multitude of factors supporting many international economies and markets. Take Europe, for example. GDP growth in the Eurozone is projected to grow from 1.5% at the end of 2014 to 2.5% by the end of 2015. While 2.5% growth pales compared to the estimated 4% GDP growth for 2015 in the U.S., it is an improvement of 40%. By comparison, U.S. GDP growth in the final three quarters of 2014 was north of 4%, so growth here is expected to flatten while Europe’s is expect to rise.
Over the past couple years, the U.S. has continued to prime the pump through quantitative easing expanding our government debt. Over that same period, the European Central Bank has tightened policy reducing ECB assets from more than 3 trillion euro to just over 2 trillion. So again looking forward, while the U.S. is about to embark on the process of tightening and taking away the punchbowl, the ECB position to, and will likely begin, pumping money into the economies there. At the same time, the improvement in GDP combined with the beneficial effects of lower oil prices is likely to drive unemployment rates in Europe lower.
The result of these combined forces, plus others, could drive Europe’s economies out of their double-dip recession to levels the markets are underestimating. At the same time, it is feasible that the clock for the U.S. party could be approaching midnight. Where the rubber hits the road for investors is where there is a perception-reality disconnect. When investors overreact to negative headwinds, opportunity for long-term benefits abound. If the scenario described above unfolds, prices of some international investments could spring to life.
Over a full market cycle, headwinds create vacuums and enable tailwinds. Looking out two to three years, currency dislocations create opportunity. As the local currency of a company falls, its stock price falls accordingly in dollar terms in the short term. But as that company’s domestic currency falls, its products become more price competitive on a global basis. If the company can capitalize on this improved competitive position, it can take market share and increase revenues. As those revenues and earnings are translated back into the currency of the company, earnings can subsequently rise. The question becomes whether that improvement in earnings outstrips the decrease in the currency. All things being equal, in the end it could be a zero sum gain. But if the company actively improves its position by taking advantage of the opportunity it is given by its weaker currency, it should be able to yield a net positive gain. And, eventually, if the currency benefits from some amount of mean reversion, this improvement gets leveraged for dollar-based investors.
There are opportunities outside the U.S. There are also opportunities inside the U.S. The case can be made that the U.S. is overvalued. The case can also be made that the U.S. is the best and safest place to invest U.S. clients’ assets. But opportunity comes from every place, in every form. Keeping in mind that more than two-thirds of the global investment opportunities exist outside the U.S., it would be nearsighted to ignore international investments. We scour the world to find the best-priced risk-adjusted investments we can find. Our investment committee investigates dozens of ideas for each one that warrants our deeper analysis. And even then we often have widely disparate opinions after making our case.
We build portfolios from the bottom up, favoring businesses that have an edge. We construct portfolios that ultimately own U.S. and international companies. We certainly take into consideration
all potential risks, including currency effects. At times, like we have done recently, we will reduce our exposure to global investments as the risk/return profile of foreign currency-denominated investments we own degrade. Nonetheless, when we are confident the longer-term opportunity outweighs the short-term volatility risks, opportunities at the individual investment level pull
us into foreign investments. In the end, we resist the temptation to predict the future or overreact to the short-term present. Instead we handicap multiple possible outcomes and assemble portfolios built for all potential outcomes rather than optimize them for a single scenario.
New IRA Rollover Limitation Beginning 2015: Internal Revenue Code Section 408(d)(3)(B)
Financial planning is dictated by the Internal Revenue Service (IRS). A vast amount of individual wealth resides within retirement plans. While the IRS does allow for tax-favored Individual Retirement Account (IRA) distributions, strategies for tailoring distributions have been reduced over the years and have become more complex.
A 2014 Tax Court ruling has dictated the IRS to tighten Individual Retirement Account (IRA) rollover rules. This announcement stems from clever tax-payers who effectively created interest-free loans from their IRA accounts.
In 2008, an esteemed New York attorney specializing in tax law, Alvan Bobrow, and his wife, Elisa Bobrow, requested a series of distributions from multiple contributory IRAs, rollover IRAs and non-IRA investment accounts (Court, 2014). The withdrawals and transfers were completed in a manner that the Bobrows assumed to be permissible under the 60-day rule* for tax-free IRA rollovers. The IRS felt differently.
*Typically, an individual must make the contribution of a received distribution from an IRA or employer plan by the 60th day to be considered tax-free.
The Court reviewed Section 408(d)(3)(B) of The Code that limits a taxpayer from executing more than one nontaxable rollover in any given one-year period – rolling 365 days, not a calendar year, with respect to IRAs and individual retirement annuities. This ruling contradicts the familiar IRS Publication 590 that states the Section 408(d)(3)(B) rule to apply to each IRA separately (Slott, 2014). So, the change in application by the IRS will reflect the interpretation by the U.S. Tax Court judgment of the Bobrow case.
The IRS rule change does not impact all IRA transfers. Ruling 78-406, 1978-2 C.B. 157, states a trustee-to-trustee transfer between IRAs, or direct transfers, and conversions from traditional to Roth IRAs are unlimited (Internal Revenue Service, 2014). This year, the limit of one rollover per year applies by aggregating all individual IRAs, to include SIMPLE IRAs, SEP, traditional and Roth IRAs. Hence, the indirect method, or where the individual receives a check, is limited to one aggregated rollover across all IRA accounts per 365-day period that must be deposited within 60 days to avoid taxation and possible 10% penalty if under age 59½. For additional relief, the IRS won’t apply the new limitation for distributions prior to January 1, 2015.
Our financial planning team keeps abreast of IRS changes in order to better serve our clients. Based on the IRS tightening of rollover rules, there’s an even more compelling argument that transfers between retirement plans be accomplished through direct transfers, or trustee-to-trustee, to avoid the rollover complications. If you have any questions regarding the mentioned material, we encourage you to contact our financial planning team.
Alvan L. Bobrow and Elisa S. Bobrow v. Commissioner of Internal Revenue, 7022-11 (United States Tax Court January 28, 2014).
Internal Revenue Service (2014, Novem-ber 17). IRA One-Rollover-Per-Year Rule. Retrieved January 14, 2015, from Internal Revenue Service: www.irs.gov/Retirement-Plans/IRA-One-Rollover-Per-Year-Rule.
Slott, E. (2014, May 16). A warning on multiple IRA rollovers. Retrieved January 14, 2015, from Investment News: www.investmentnews.com/article/20140316/REG/303169996/a-warning-on-multiple-ira-rollovers.
Cable & Wireless Communications
(Ticker: CWIXF, www.cwc.com)
Share Price/Market Capitalization (01/16/15): US$.74/ US$2B
Company Description: Cable & Wireless (CWC) is a full-service telecommunications company with primary operations in the Caribbean and Latin America.
Investment Thesis: CWC is a clear market leader offering attractive total return potential. This return is expected to consist of a 5.5% annual dividend yield and long-term price appreciation from acquisitions and “self-help” initiatives that improve free cash flow generation.
CWC’s history in the Caribbean and Latin America dates back to the 1870s when it introduced telegraph services to the region. Today, it offers a full range of mobile, fixed, broadband and TV services to household, business and government customers in Panama, the Caribbean (more than a dozen countries) and the Seychelles. CWC is the leader in the majority of its markets and generates nearly $1.7B in annual revenues with operating cash flow margins north of 18%.
Management is pursuing multiple strategies to improve its long-term value proposition to both customers and shareholders. On the customer front, the company is implementing Project Marlin, a multi-year capital investment program that will upgrade its fixed, mobile and TV networks throughout its service areas. These upgrades will improve network speed and reliability, the two factors customers demand most from their telco service providers.
Simultaneously with the capital investment program, CWC has also been busy reshaping the company to focus on Pan-America. In recent years, it sold its Macau division and the majority of its Monaco business. It is currently in the process of completing a $1.8B acquisition of Columbus International, a leading Caribbean, Central America and Andean region telecommunications provider that will add more than $500M to group revenues and generate significant cost and capital expenditure synergies. CWC is also currently in the midst of a company-wide costreduction program expected to bring $100M in annual savings. This program includes facility rationalization, headcount reduction and network efficiency improvement.
We expect 2015 to be a year characterized by the acquisition completion and integration of Columbus and accelerated capital expenditures on CWC’s network. Free cash flow generation should begin ramping from 2016 to levels that ultimately produce free cash flow yields of more than 10%. As management executes, we would expect increased interest from investors and possibly even strategic acquirers. In the meantime, we expect to collect a 5%+ annual dividend.
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