“The market will not go up unless it goes up, nor will it go down unless it goes down, and it will stay the same unless it does either.”
– Adam Smith
My friend Gevas, who teaches an evening class for MBA students on International Business, asked me to chat with his students a few weeks ago about global business, culture and investing. One task he assigns his students each session is to share a topic of global financial news for discussion. On the day I joined, one of his students announced, “The market was up today because people were optimistic about Greece.” The young student felt that was logical, and he might have been right. On the other hand, there could have been any number of reasons, many having nothing at all to do with Greece, behind the market ending a few points in the green that day. As I listened to the student and began preparing my complexity analysis spiel, I knew that there was a good chance I would lose the class’ attention.
So I started simply by discussing how our brains are wired to take shortcuts when presented with complex tasks. I explained that the brain is a big user of energy. In order to “conserve” energy, we develop habits so that we can move through any analysis more efficiently. This can be dangerous in life and in business, though, as such habits can lead to oversimplification and ultimately false conclusions. I then quoted a friend and author Don Beck who said, “Complex problems require complex solutions … and we make mistakes when we try to use simple solutions to complex problems.”
A young man in front of me was starting to doze off, so I asked him why he loved his wife. After a minute I said, “It seems insincere to try to explain why you love her, doesn’t it?” He nodded. I then said, “It’s complicated.”
We had a good discussion that day, and if nothing else, I hope the students left class a bit more critical of the financial news they read. Better yet, I hope that they come to realize that the action of complex systems, such as those seen in financial markets, rarely can be simplified down to easily digestible sound bites, even if that’s what the human brain craves.
“Left to its own devices, the brain will try to make almost any routine into a habit, because habits allow our minds to ramp down more often.” – Charles Duhigg,
>span class="s2">Short Cut Investing
Speaking of markets ending up in the green, the very same S&P 500 stock index we discussed in Gevas’ class has had quite a run over the past few years, especially relative to more diversified global stock indices. Valuations of many U.S. stocks are approaching nosebleed levels, which is one reason we currently don’t hold large weightings of S&P-type U.S. stocks in client portfolios.
The strong run of the overall U.S. stock market, since the trough hit during
the global financial crisis, has also influenced a clear shift in investor preferences. As the chart (on the next page) shows, investors, at least those investing in mutual funds, have defected from the active style we practice at FIM Group to the passive indexing style championed by the likes of Vanguard. Many investors have seemingly succumbed to a “just index” philosophy and have adopted an approach that “owns everything.” While appearing “simpler” and “cheaper,” the passive indexing approach forgoes making the two investment judgments (investment quality and investment price) that we believe play critical roles in successful LONG-TERM investing. The growing herd of passive indexers have seemingly accepted unusually high levels of risk to their wealth as the price required for the simplicity offered by these products. In my opinion, they’ve taken a shortcut that may well prove to have significant negative consequences.
“When You Know Better, You Do Better”
Poet Maya Angelou’s quote, “When you know better, you do better” sits in front of me as I type this. The quote reminds me of the importance of thoughtful analysis. Let’s face it, when an investment idea comes along, we should categorize it as a “theory” waiting to be proven as a good investment by a process. The process, hopefully honed by experience, training, education and reflection, leads to a result regarding the potential investment of BUY, or sets it aside until something happens. For example, the “something happens” might be the investment’s price gets better and/or positive developments increase the investment’s prospects. Eastern philosophies have a process – “Theory » Practice (analysis) » Realize (make real)” – that can be used to discover truth and avoid falsehood. This rigorous philosophical process of discovery also works with investing, although the ancients created it for questions like, “What is happiness?” “Why do we suffer?” and “What is our responsibility to the poor?”
Our process, in graphic form, is obviously a bit oversimplified, as there are immeasurable inputs to the investing, research and risk-management process.
Make the Decision
Still, the job of a money manager is developing a process that helps in his/her financial decision-making. It is complex and it is dynamic. Everything about investing is geared toward making a decision: Do I look at this [investment] idea? Do I buy? Do I sell? If I do not buy it, why not? Or when? The key to the investing process, ultimately, is not the process itself, but the ultimate decisions that are made on behalf of the portfolio. Unless the process leads to good decisions and thus good performance, it is just a process that “looks good on paper.” Because investing is difficult enough, being successful requires that the investment process be part of the cultural DNA of the firm, lived by its investment team, and manifested in its investment systems.
Complacency Is the Biggest Risk
When a company believes that it has “figured it out” and then rests back on its lazy brain habits, it is taking a significant investing risk. Research charts and written processes must be continually challenged, questioned and critiqued to protect a firm from the lazy brain complacency that can set in. At FIM Group, when we look at equity investments we always try to ascertain if management is forward-looking, growth-oriented, or resting on a few good past years or a few good products. Today, many larger companies are growing their share price by borrowing to buy their own stock – this is a near zero-sum game and artificially makes a company look successful in the short-term. It is one reason we believe that indexing is a flawed strategy today. The indexing investors are most likely in the dark about the way their companies are managed – just buying with no ongoing analysis and forgetting about it. While buying one’s own stock works in the short-term, a company’s long-term objectives should be about creating solid products, implementing great product development strategies, performing stellar research and creating value for its customers – that’s what make a company sustainable and successful. Borrowing to prop up a share price is not sustainable.
Upon analysis, the young men and women in Gevas’ MBA class, would easily be able to see the flawed strategy of borrowing to buy and prop up a company’s share price. However, unless they look, they will not know. And if they don’t know, they can make flawed decisions. It’s complicated.
Over the last few years, my family’s been on a bit of a quest to better connect our financial life with our social and environmental values. I’m finding that an increasing number of FIM Group clients are doing the same. Some wish to know more about the impact their FIM Group-managed portfolio companies have on the world. Others are looking for ideas that might help them make everyday financial decisions more meaningful. While I have the opportunity to regularly chat with colleagues and clients about such things in meetings, I thought that the broader FIM Group readership might enjoy a taste of these discussions. So here is Impactapalooza, an alternative mishmash of impact investing highlights from FIM Group portfolio holdings, my personal financial experiments and other random snippets of loosely related happenings in the quest for triple bottom-line returns. Have an idea for Impactapalooza or a desire to further the discussion? Please don’t hesitate to be in touch (firstname.lastname@example.org or 231.929.4500).
“Electricity is really just organized lightning.” – George Carlin
Welcome to the first edition of Impactapalooza! For this maiden voyage, we’ll set the table with a definition of impact investing and then charge (pun intended) through an electrification-themed variety pack of stuff that will hopefully spark your interest. We’ll review a few recent alternative energy developments across FIM Group portfolio holdings, look at some shocking digits from the solar and EV worlds and explore the current pulsing through a local Northern Michigan investing group. If you find yourself nodding off and a need a musical selection to multitask to, I would think that any of the AC/DC standards, sufficiently amplified, should pair quite well.
Q: So Zach, what the heck is impact investing anyway?
A: The Global Impact Investing Network (GIIN) defines impact investing as “investments made into companies, organizations and funds with the intention to generate a meaningful, beneficial social or environmental impact alongside a financial return.”
>span class="s2">Portfolio Notes
(Companies in bold are FIM Group-managed holdings in appropriate accounts at the time of writing.)
Freezing my butt off here in Northern Michigan’s winter wonderland, I thought it fitting to start these portfolio notes with Finnish snow tire producer Nokian Renkaat OYJ (Ticker: NKRKF). Nokian launched a new tire that claims to be the most energy-efficient winter tire on the market.1 The Hakkapeliitta R2 tire, designed for BMW’s i3 electric car, offers 30% lower rolling resistance compared to other winter tires without sacrificing safety performance. The lower rolling resistance helps the i3 save energy and maximize its electric range. Nokian also announced that its Nokianvirran Energia joint venture is building a new 62 MW combined heat and steam power plant fueled by forest residue and wood chips. The plant will produce district heating for the town of Nokia, Finland, and process steam for an adjacent Nokian tire factory.
In other news on the alternative energy front, Google (Ticker: GOOG) announced that by 2016 the search giant will power 100% of its Googleplex campus in Mountain View, California, with power generated by NextEra Energy’s Altamont Pass wind farm.2 A unique feature of this project is that NextEra will replace 370 old turbines installed in the 1980s with 24 new, state-of-the-art machines. These machines are designed to generate twice the energy of the old array, while reducing the negative impact on local bat and bird populations.
Some of the surplus Altamont Pass wind power may eventually fuel bus rides in North America. Toronto-listed New Flyer Industries (Ticker: NFYEF) has already entered a half dozen of its XE40, zero-emission buses into service with lithium-ion battery packs that allow for partial recharges using regenerative braking systems. The company also recently announced that it is developing 3 The combination of batteries, a fuel cell and hydrogen storage allows the fuel cell to operate at a relatively steady state, while the batteries provide power for acceleration.
As for the materials holding the charge in New Flyer’s XE40? Perhaps someday they will be sourced from >span class="s3">Umicore (Ticker: UMICF). The Belgium-based industrial recycler and materials technology group announced a new effort with phosphate producer Prayon.4 The joint venture, named beLife, will focus on developing advanced, cost-competitive products and processes used in lithium-ion rechargeable batteries for hybrid and electric vehicles.
Digits on the Radar: A Pair of 40s
Looking at the level of cost deflation Deutsche Bank analyst Vishal Shah projects for solar power systems in the years ahead, you might think Belichick and Brady were running the industry. Shah forecasts a 40>#/b### drop in the cost to produce solar energy by 2017 after looking across the solar supply chain and finding scale and efficiency potential pretty much across board.5 For those looking to go off-grid, waiting a couple of years might not be a bad bet. By then, if Shah is correct, you might be able to run your home on the sun and have enough dough left over to bury a few more ounces of gold in the backyard.
Meanwhile in Japan, Bloomberg News reports that there are more than 40,000 electric car charging points in operation.6 Interestingly, the number of charge points, which includes those in both public and private garages, has eclipsed the number of gas stations in sushi land (34,000). Companies there, like Nissan, are working on one of the key concerns holding back electric car ownership – namely range anxiety –by building out a national network of charging stations. Here in the States, where gas is half the price consumers pay at the pump in Japan, the number of charging stations is only around 20,000. But that looks like it will change soon as trailblazers like Tesla build out their proprietary supercharger stations and utilities like Great Plains Energy seek new growth projects. Great Plains, based in Kansas City, Missouri, plans to have 1,000 charging stations ready later this year, with free charging for all during their first two years of operation.
A Community Investing Experiment
While Northern Michigan-based investment networking group As Local As Possible (ALAP) hasn’t reviewed any local business projects involving energy-efficient snow tires, modernized wind farms, electric buses or state-of-the-art battery materials, it does include alternative energy as a sector of focus. ALAP is an informal, kinder, gentler Shark Tank (more like Koi Pond) of sorts that welcomes local businesses seeking local capital to share their visions at a monthly potluck meeting.
It is one of a growing number of grassroots, do-it-together networking groups and investment clubs sprouting up across the country whose members seek to invest a portion of their portfolios with local businesses. ALAP presenters have represented a wide range of high-impact businesses, including several small-scale organic farmers, a sustainable biofuel producer, a used building materials company, an alternative healthcare provider, a nontoxic detergent producer and an online portal for local food producers, just to name a few. Some have been upstarts, but most are established businesses looking to diversify their own sources of funding and/or leverage the advantages that come from having customer-investor-evangelists.
The ALAP investing group is one I’ve been involved with since its beginning several years ago. It has been the source of several small, direct community investments my wife and I have made, and we hope to make more in the future. To date, that’s the way ALAP has worked. Local businesses are introduced to local investors at the potluck gatherings, and if an interest is sparked, “deals” are pursued independently. A number of ALAPers are also going through the process of setting up a more formal “investment club,” where we will pool some funds via an LLC and target investments collectively. For those interested in learning more, check out www.aslocalaspossible.com for additional information and meeting dates, or let me know and I’d be happy to chat with you about the group.
Closing Humor (Family-Friendly)
What did the baby light bulb say to the mommy light bulb?
I love you watts and watts.
Why is wind power so popular?
Because it has a lot of fans!
References and Links:
Charitable giving is too often the ignored afterthought of an otherwise comprehensive financial plan. That’s not due to greed or lack of well-meaning intent. It probably stems from most financial plans’ laser focus on meeting retirement asset and spending goals. Charitable giving often falls in the category of things to do with extra money after taking care of higher-priority spending needs. Many people, if not most, however, aspire to increase their charitable giving, whether that be through annual giving, through more significant gifts following periods of wealth accumulation, at the end of life or a combination thereof. No matter the pattern, an intentional, forward-looking charitable giving effort can help maximize gifts and even potentially help reach other planning goals while enhancing tax efficiency.
Gifts of cash, most often conferred at year-end, are the most frequent giving strategy, though referring to it as a strategy would usually be an overstate-ment. Many of us write checks to favored charities or in response to a solicitation with little forethought beyond what’s available in the checking account. But not always: Thanks to deductions to income provided by qualified donations (the charity simply has to be a registered 501(c)(3) not-for-profit organization), well-planned donations can be an important part of an overall tax strategy. Just a little more forethought can enhance the positive tax implication even further. A donation of shares of a highly appreciated, publicly traded stock instead of straight-up cash will eliminate the capital gains and resulting taxes associated with those shares. Let’s say a hypothetical client would like to make a $5,000 donation to a nonprofit. This client, as many FIM clients, owns Lifetime Fitness (LTM) in her portfolio and has a substantial gain in it that represents significant capital gains tax exposure. Instead of sending a $5,000 check, she could contribute $5,000 worth of LTM shares to the charity. If the cost basis (think purchase price) of LTM was $3,000, the capital gain of $2,000 ($5,000 minus $3,000) and resulting capital gains tax transfers away with the shares. If those shares were instead sold, the client would have to pay a capital gains tax based on the $2,000. The client can still claim the full $5,000 income deduction for the donation. The beneficiary organization doesn’t have to absorb the gains tax either, that include desired donation amount and the destination organization. Our portfolio managers will determine the best portfolio holdings to use and then execute the transfer.
Charitable gift annuities represent another vehicle that can provide valuable funds to a charity as well as significant benefits to the donor. A charitable gift annuity is simply a contract between a donor and a charity that provides a guaranteed stream of >span class="s1">lifetime income to the donor in exchange for a lump sum of cash to the charity.
In many ways, the charitable gift annuity is an estate gift made prior to death that comes with the added income benefit. Organizations typically will adhere to payment rates published by the American Council on Gift Annuities and based on life expectancies. Unlike the estate gift made following a donor’s death, the donor of a charitable gift annuity is able to enjoy the gratification of making the contribution, yet she doesn’t sacrifice the income-generating potential of the cash. Gift annuities also have two tax advantages: The donor can claim an immediate tax deduction for the gift. Also, a portion of each payment, considered a return of principal, is tax free until the donor reaches her statistical life expectancy. Finally and importantly, the payment is only as secure as the charity and its own financial strength. If a charity goes out of business, the payments will stop. Consequently, the charity must demonstrate clear long-term financial viability.
Shares of stock transfers and charitable gift annuities are just two strategies for maximizing the mutual benefits that can come with the altruistic act of charitable giving. They certainly aren’t the only ones. Stay tuned for future articles that will delve further into the many different ways to include gifting in your financial plan.
Select Income REIT
(Ticker: SIR, www.sirreit.com)
Share Price/Market Capitalization (02/25/15): US$24.67/ US$2.2B
Company Description: Select Income REIT is a U.S.-focused single-tenant, net lease office and industrial real estate investment trust.
Investment Thesis: SIR offers compelling value at a time when many U.S. REITs are looking fully priced, primarily due to legitimate concerns with the firm’s historical corporate governance record. We believe that pressures are building, which will strengthen this governance and gradually improve investor sentiment. In the meantime, we expect to collect an 8% and modestly growing dividend.
SIR recently completed a large acquisition that has made it one of the largest U.S. single-tenant commercial REITs. The portfolio now spans 115 properties across 35 states with 97.7% occupancy. Remaining lease terms average 10.8 years, and tenants are broadly diversified. Debt maturities are well-distributed with less than 3% of outstanding debt due in the next three years.
Approximately 20% of SIR’s annualized rental income is generated from a portfolio of prime Oahu industrial real estate situated between the airport and Honolulu’s central business district. Most of these Hawaiian leases have market rent resets every five to 10 years. These resets have averaged more than 35% in the last 10 years, providing a solid source of future income growth. The organic growth within SIR’s mainland portfolio is likely to be much more in line with general economic growth, supported by a diverse mix of high-quality buildings and tenants.
Compared to other net-lease peers, SIR trades at a significant discount. For example, while its peer group trades on a roughly 5%-6% dividend yield, we have purchased SIR on yields of around 8%. We believe that SIR’s discount is attributed to several factors, including investor dislike for its aggressive acquisition pace, potential overhang from the most recent acquisition of a non-traded REIT (where shareholders received SIR shares and may wish to sell them to
buy other non-traded vehicles), and an external management structure many investors feel is outdated and poorly aligned with shareholder interests.
These “warts” as we call them represent legitimate concerns, although we believe they are already sufficiently discounted in the current share price. Since peaking in April 2014, SIR shares have returned -16% while the Dow Jones Equity Index has returned +15%. Our base case scenario sees us earning an 8% dividend yield that grows modestly over time and provides good income in a low-rate, deflation-biased world. Should SIR’s board begin to address investor concerns, we envision a much more attractive return profile with the 8% yield plus significant share price appreciation potential.
Data Source: Company Filings, Bloomberg
444 Hana Hwy,
Kahului, HI 96732
111 Cass Street
Traverse City, MI 49684
1837 E. Main Street
Onalaska, WI 54650