Top

2016 April Newsletter

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

Finding Niches, Avoiding Valeants

FIM Group has long taken pride in our independent views. While we don’t necessarily set out to be contrarian, the nature of our value-focused investing often leaves us standing apart from the herd. This month we’d like to share some perspective about why we aim to avoid the herding instinct and how we go about keeping our thinking sharp and unbiased.

Danger in Numbers

Our team has long recognized the dangers of “groupthink” or “herding” when it comes to structuring and managing portfolios. Time and time again, investors seeking comfort in numbers flock to the trend of the day. This happens on upswings when greed rules the day and on downswings when fear sets in. The resulting crowding effects drive asset price volatility in markets that far exceeds changes in underlying fundamentals. Inevitably, many pile on during the later stages of the trend or are foolish enough to bring borrowed money to the table. These folks learn the hard way that the safety of the herd has little application in the investing world.

In 1989, Kevin Kallaugher captured these emotional swings and herding instincts with the cartoon below.

In the nearly three decades that have passed since then, Kallaugher’s image remains just as relevant. Today, investors equipped with hyper-connected iGad-gets and a smorgasbord of easily traded financial products can get whipped into a frenzy more quickly than ever. Recent herding examples from 2015 alone include the Chinese stock bubble and bust, the FANG (Facebook, Amazon, Netflix, Google) stock boom, the stratospheric rise of Vancouver home prices, and the rout of oil-related stocks. Our job as your investment managers is to be very wary of herd behavior and to stay disciplined with our independent investment decisions. On the latter point, this discipline applies to both mania avoidance when the herd gets greedy and bargain hunting when it turns despondent.

Discovering Niche Opportunities

A commitment to independent invest-ment thinking offers benefits beyond opportunities for risk and return manage-ment at market extremes. It also allows us to search for and invest in the more attractive niche areas that exist outside of the mainstream. The flexibil-ity to invest in non-traditional niche areas is vitally important today. This is because the prolonged period of ultra-low global interest rates (including the many countries now with negative rates!) has pushed the prices of more traditional investments, like many blue-chip dividend-paying stocks, to unattractively expensive levels.

One example of such a niche area where we’ve made investments throughout our history is the closed-end fund (CEF) space. CEFs are investment structures about which we’ve communicated quite a bit in these pages, webinars and client meetings over the last year. Unlike traditional open-end funds, CEFs trade on stock exchanges throughout the day at prices independent of the value of their underlying holdings. They are a statistical blip in the grand scheme of “pooled” financial products available to investors today. For example, the entire universe of CEF assets totals only $300 billion or so. This compares to more than $16 trillion in the open-end funds that most investors associate with mutual funds. We like this relatively unknown area for several reasons, but in today’s markets there is one feature we really like. This is the additional return potential available when CEFs are bought at unusually high discounts to their reported net asset values (NAVs). When such discounts “normalize” back toward average levels, or even back to or above NAV in some instances, investor returns benefit as the CEFs’ prices move more than that of their underlying fund holdings.

Recently, our portfolio performance was helped by this discount normalization phenomenon. Discounts across many of the fixed-income funds we own in client accounts (primarily in our Balanced, Balanced Conservative and Yield Income strategies) narrowed significantly from the abnormally high levels of late 2015 and early this year. If you closely monitor the trade confirmations in your account, you’ve likely noticed some heightened trading activity with these CEFs. We have been selling funds that witnessed sharp price jumps in recent weeks, primarily due to discount normalization. An example of one of these holdings, the DWS Strategic Income Trust (ticker: KST), is shown in the Figure 1. While the chart breaks out the NAV and share price in the upper portion, the lower portion illustrates this discount normalization. KST’s 17% discount in late 2015 compressed to 8% by mid-March, which added nearly nine percentage points of return during this period relative to similar mainstream open-end mutual fund alternatives.

Implementing the Independent Investor Mindset

Shifting gears from why we feel investing independently of the herd is important to how we go about doing that, let’s review a few of our key processes. For starters, we train ourselves to be skeptical toward the sizzle sold by much of Wall Street and corporate America. Our investment team members prefer to read company filings (for example, annual reports) footnotes first (where most of the important stuff is buried), while saving the usually sweeter smelling press release bullet points for last. We focus more on balance sheets and cash flow statements and less on income statements. It is the latter where many companies report “funny” numbers like adjusted EPS (earnings per share) and adjusted EBITDA (earnings before interest, taxes, depreciation and amortization). Such figures conveniently omit expenses that, on an unadjusted basis, could make a company’s profitability look far less flattering. 

Our team also takes a cautious stance toward the stock ratings reported by Wall Street analysts. These analysts, while in most cases are well-informed with the companies and sectors they cover, are often put in a difficult position. The hedge fund clients who effectively pay much of their salaries (by trading through the analysts’ firms) often rank analysts’ access to senior management higher than their ultimate investment ratings. This can lead to stock rating and target price “inflation” as analysts who put a negative rating on a stock may be less likely to gain the future C-suite access that their paying clients covet.

Confirmation Bias

Another step we take when scrutinizing our holdings is to be aware of the confirmation bias that can creep into our own internal research process. Confirmation bias is the behavioral trap where one seeks supporting evidence of a given idea and ignores or downplays conflicting data. For example, after spending countless hours getting to know an investment and then recommending to the team that we purchase it, our brains can naturally seek out collaborating evidence that the idea is a good one while treating less flattering data or viewpoints as immaterial or “already baked in” to the current market price of the security.

Our investment staff meets formally twice a week as a team, and one of the things we try to do at these meetings is to challenge any potential confirmation bias that has crept into our portfolios. We ask each other critical questions about the assumptions we’ve made on a given investment thesis and whether or not these are still valid. Acknowledging changes to these assumptions or the significance of adverse developments is not always easy, especially if doing so means ultimately deciding to take a loss. Last year, when we bought Kinder Morgan (KMI) for select accounts, it wasn’t long before we began to see evidence that stress was mounting throughout the energy sector. Team members raised concerns that this stress could significantly impact KMI’s growth outlook and put its dividend at risk. We ended up selling the holding at a modest loss not long after adding it to portfolios, which never feels good. But by countering potential confirmation bias with open team discussion, we prevented a much steeper loss.

ESG Integration

A third aspect of our independent investment process is the integration of environmental, social and governance (ESG) factors into our analysis. While many investors view these issues as those that only “tree huggers” or “bleeding hearts” should care about, we beg to differ. Indeed, we believe that the standards and actions of a company in these ESG areas are mission-critical to the corporate resilience that ultimately supports a company’s ability to deliver long-term value to its shareholders. For example, how will companies that treat their employees poorly retain and attract the talent needed to sustain their future long-term performance? And how long can a company abuse the environment or even its customers in the name of short-term profitability before brand damage, regulation and/or litigation drowns out any future profit potential? While companies showing little concern toward major ESG “defects” can still capture the attention of momentum of chasing speculators, we generally try our best to keep them out of our managed portfolios. The risks that lie underneath the surface of these single-bottom-line focused companies are often woefully underestimated by the investing public.

Oh (no) Canada!

If there’s a current poster child for groupthink gone awry and the importance of independent analysis, Canada’s leading Big Pharma company, Valeant Pharmaceuticals International, seems to fit the bill. Valeant’s stock soared five-fold from 2013-2015 as analysts and big-time money managers alike fell in love with its unique approach to the drug biz. At its peak last year, it was Canada’s largest listed company by market value. Valeant’s business model centered on borrowing money to acquire companies with approved drugs in areas with little competition. It would then typically fire most of the R&D staff of the acquired companies to cut costs and raise drug prices as high as they could get away with. This strategy worked for years, at least as measured by the “adjusted” financial metrics that management touted and analysts regurgitated in report after report. The herd kept piling in and Valeant’s share price chugged higher and higher. As Figure 2 shows, as of 7/31/15, when the stock traded at around $250/share, most of the analysts following it expected the good times to just keep on rollin’.

But as summer yielded to fall, cracks began to appear. In October, independent research firm Citron Research published a report that accelerated a flurry of regulatory scrutiny over Valeant’s drug distribution and pricing practices. Citron’s report had a sensational flare, comparing the company to Enron, but it ultimately exposed major flaws in the Valeant business model and its financial reporting. If that weren’t enough, Hillary Clinton recently called out the company on her campaign trail as a symbol of all that’s wrong with the pharmaceutical industry (if you watch any TV, you’ve likely seen her political ads centered on this). Then, in mid-March, Valeant management had to admit that its financials needed more scrubbing. This, among other things, may even lead them to default on their debt. Needless to say, the share price
had cratered, and big-time investors like Pershing Square, T. Rowe Price and ValueAct Holdings are stinging from billions in lost market value on their Valeant stock holdings.

Staying Fiercely Independent

Valeant was never a stock we considered for investment at FIM, but it’s become a great example to learn from and a reminder of how important independent thinking is to investing success. Thankfully, our team has never taken much comfort in investments (either owned or under consideration) that happen to come highly recommended or highly owned by some of Wall Street’s smartest analysts and fund managers. If anything, such conditions, when they exist, tend to make us more critical toward our own assumptions. We also strive to be ever-vigilant toward herding tendencies, skeptical of adjusted financials, alert to confirmation bias and demanding of high ESG standards with every investment we make in managed accounts.

Alice McDermott, CFP®
By: Alice McDermott, CFP®

Teaching Your Child About Money

“There are two gifts we should give our children; one is roots, and the other is wings.” 
– Author Unknown

Ask your five-year-old where money comes from, and the answer you’ll probably get is, “From a machine!” Even though children don’t always understand where money really comes from, they realize at a young age that they can use it to buy the things they want. So as soon as your child becomes interested in money, start teaching him or her how to handle it wisely. The simple lessons you teach today will give your child a solid foundation for making a lifetime of financial decisions.

Lesson 1: Learning to handle an allowance

Giving children an allowance is a good way to begin teaching them how to save money and budget for the things they want. How much you give them depends in part on what you expect them to buy with it and how much you want them to save.

Some parents expect children to earn their allowance by doing household chores, while others attach no strings to the purse and expect children to pitch in simply because they live in the household. A compromise might be to give children small allowances coupled with opportunities to earn extra money by doing chores that fall outside their normal household responsibilities.

When it comes to giving children allowances:

  • Set parameters. Discuss with your children what they may use the money for and how much should be saved.
  • Make allowance day a routine, like payday. Give the same amount on the same day each week.
  • Consider “raises” for children who manage money well.

Lesson 2: Opening a bank account

Piggy banks are a great way to start teaching children to save money, but opening a savings account in a “real” bank introduces them to the concepts of earning interest and the power of compounding.

Many banks and credit unions have programs that provide activities and incentives designed to help children learn financial basics. Here are some other ways you can help your child develop good savings habits:

Help your child understand how interest compounds by showing him or her how much “free money” has been earned on deposits.

Offer to match whatever your child saves toward a long-term goal.

Let your child take a few dollars out of the account occasionally. Young children who see money going into the account but never coming out may quickly lose interest in saving.

Lesson 3: Setting and saving for financial goals

When your children receive gifts of money, you may want them to save it for college or other long-term goals, but they’d rather spend it now. Let’s face it: children don’t always see the value of putting money away for the future. So how can you get your child excited about setting and saving for financial goals? Here are a few ideas:

  • Let your child set his or her own goals (within reason). This will give your child some incentive to save. 
  • Encourage your child to divide his or her money up. For instance, your child might want to save some of it toward a long-term goal, share some of it with a charity and spend some of it right away.
  • Write down each goal, and the amount that must be saved each day, week or month to reach it. This will help your child learn the difference between short-term and long-term goals.
  • Attach a picture of the item your child wants to a goal chart, bank or jar. This helps a young child make the connection between setting a goal and saving for it.

Finally, don’t expect a young child to set long-term goals. Young children may lose interest in goals that take longer than a week or two to reach. And if your child fails to reach a goal, chalk it up to experience. Over time, your child will learn to become a more disciplined saver.

Lesson 4: Becoming a smart consumer

Commercials. Peer pressure. The mall. Children are constantly tempted to spend money but aren’t born with the ability to spend it wisely. Your child needs guidance from you to make good buying decisions. Here are a few things you can do to help your child become a smart consumer:

  • Set aside one day a month to take your child shopping. This will encourage your child to save up for something he or she really wants rather than buying something on impulse.
  • Just say no. You can teach your child to think carefully about purchases by explaining that you will not buy him or her something every time you go shopping. Instead, suggest that your child try items out in the store, then put them on a birthday or holiday wish list.
  • Show your child how to compare items based on price and quality. For instance, when you go grocery shopping, teach him or her to find the prices on the items or on the shelves and explain why you’re choosing to buy one brand rather than another.
  • Let your child make mistakes. If the toy your child insists on buying breaks, or turns out to be less fun than it looked on the commercials, eventually your child will learn to make good choices even when you’re not there to give them advice.

Lesson 5: Earning and handling income

Older children may earn income from part-time jobs after school or on weekends. Particularly if this money supplements any allowance you give them, wages enable children to get a greater taste of financial independence.

Earned income from part-time jobs might be subject to withholdings for FICA and federal and/or state income taxes. Show your children how this takes a bite out of their paychecks and reduces the amount they have left over for their own use.

Lesson 6: Creating a balanced budget

With greater financial independence should come greater fiscal responsibility. Older children may have more expenses, and their extra income can be used to cover at least some of those expenses. To ensure that they’ll have enough to make ends meet, help them prepare a budget.

To develop a balanced budget, children should first list all their income. Next, they should list routine expenses, such as pizza with friends, money for movies and gas for the car. (Don’t include things you will pay for.) Finally, subtract the expenses from their income. If they’ll be in the black, you can encourage further savings or contributions to their favorite charity. If the results show that your children will be in the red, however, you’ll need to come up with a plan to address the shortfall.

To help children learn about budgeting: 

  • Devise a system for keeping track of what’s spent.
  • Categorize expenses as needs (unavoidable) and wants (can be cut).
  • Suggest ways to increase income and/or reduce expenses.

Lesson 7: The future is now

Teenagers should be ready to focus on savings for larger goals (e.g., a new computer or a car) and longer-term goals (e.g., college, an apartment). And while bank accounts may still be the primary savings vehicles for them, you might also want to consider introducing your teenagers to the principles of investing.

To do this, open investment accounts for them. (If they’re minors, these must be custodial accounts.) Helping older children learn about topics such as risk tolerance, time horizons, market volatility and asset diversification may predispose them to take charge of their financial future.

Your child can greatly benefit from opening a Roth IRA as soon as he or she has earned income. Show your child this powerful illustration below: Time Value of Money.

Should you give your child credit?

If older children (especially those about to go off to college) are respon-sible, you may be thinking about getting them a credit card. However, credit card companies cannot issue cards to anyone under 21 unless they can show proof they can repay the debt themselves, or unless an adult cosigns the credit card agreement. If you decide to cosign, keep in mind that you’re taking on legal liability for the debt, and the debt will appear on
your credit report.

Also:

  • Set limits on the card’s use.
  • Ask the credit card company for a low credit limit (e.g., $300) or a secured card to help children learn to manage credit without getting into serious debt.
  • Make sure children understand the grace period, fee structure and how interest accrues on the unpaid balance.
  • Agree on how the bill will be paid, and what will happen if the bill goes unpaid.
  • Make sure children understand how long it takes to pay off a credit card balance if they only make minimum payments.

If putting a credit card in your child’s hands is a scary thought, you may want to start off with a prepaid spending card. A prepaid spending card looks like a credit card, but functions more like a prepaid phone card. The card can be loaded with a predetermined amount that you can specify, and generally may be used anywhere credit cards are accepted. Purchases are deducted from the card’s balance, and you can transfer more money to the card’s balance whenever necessary. Although there may be some fees associated with the card, no debt or interest charges accrue; children can only spend what’s loaded onto the card.

One thing you might especially like about the prepaid spending cards is that they allow children to gradually get the hang of using credit responsibly. Because you can access the account information online or over the phone, you can monitor the spending habits of your children. If need be, you can then sit down with them and discuss their spending behavior and money management skills.

Financial learning apps for children:

  • PiggyBot
  • Allowance & Chores Bot
  • Savings Spree
  • Kids Money
  • Bankaroo
  • FamZoo

Books to help teach children about money:
The Opposite of Spoiled, by Ron Lieber
The Teen Money Manual, by Kara McGuire
A Random Walk Down Wall Street, by Burton G. Malkiel
Grande Expectations, by Karen Blumenthal

NZX Ltd.

NZX Ltd. (New Zealand Exchange)

(Ticker: NZSTF, http://www.nzxgroup.com

Share Price | Market Capitalization
(03/18/2016): NZD $1.02 | NZD $273.5mm

Company Description: With roots dating to the 19th century, Wellington, New Zealand-based NZX Limited (NZX) is the only licensed operator of a registered securities/derivatives (stock) exchange in New Zealand; operator of the designated settlement system; publisher of agriculture sector news/data in New Zealand and Australia; operator of the only electronic grain-trading platform in Australia; provider of superannuation/Kiwi Saver-managed investment products and exchange-traded funds; provider of wealth management services for advisers in New Zealand; and market operator for New Zealand’s electricity and dairy markets. 

Investment Thesis: New Zealand is aligned with global mega-trends (e.g., sustainability, population growth, and need for food sources, global “connectiveness” –
aka globalization – and mindful external policies that attract migrants). NZX is an entity set to benefit from New Zealand’s parallel first/early mover status with regards to these trends.

New Zealand exports goods/services the world over, but it’s primarily known for its dairy industry – yes, there are far more sheep than people, but don’t confuse their people for sheep. You need to look beyond the patures to companies like Vista Group International (which dominates software for the global film industry), SaaS leader Xero (provider of online accounting systems), and Auckland Int’l Airport, the $5.2B USD entity helping to ferry millions of tourists into/out/around New Zealand each year (tourism accounts for around 12% of New Zealand’s GDP), you need to look beyond the pastures. 

More than 75% of New Zealand’s electricity is produced via renewable sources (hydroelectric, wind, geothermal, solar and bioenergy). In 2012, the country’s military expenditures as a percentage of GDP were a mere 1.13%, ranking them 87th in a year where the U.S. was 9th at 4.35%. 

New Zealand is ostensibly exporting renewable energy. A single aluminum smelter in the south is responsible for ~14% of electricity demand, and the dairy industry is a large energy consumer (water pumps for irrigation require a lot of electricity). All the while peacefully advocating in the global forum, New Zealand is quite vociferous in its anti-nuclear stance. Moreover, we are heartened by efforts to rectify long-standing strains with aboriginal peoples (the Maori); though the statistics aren’t pretty, they are getting better. 

Just what makes New Zealanders (or “Kiwis,” as they are known colloquially) such enthusiastic and successful entrepreneurs? We suspect it has to do with their roots and geographic location – when you are isolated you must take action, when you are a smaller nation you mustn’t rock the boat, and when you are on an island you best take care of what little you’ve got.

>span class="s1"

>span class="s1">New Zealand comprises 103,364 square miles (about the size of Colorado), and roughly 43.2% of its land is considered suitable for agriculture (95% of which is pasture land). With an estimated population of 4,649,700 (as of 12/31/2015) New Zealand ranks 127th globally. Auckland is the most populace city with ~ 1,415,550 inhabitants (2013 census) while Wellington (the capital) has a population of ~471,315 (2013 census). New Zealand’s urban population is estimated to be ~86.3%. 

New Zealand’s economy (ranked 3rd for Economic Freedom by the Heritage Foundation) has changed dramatically over the past few decades, with greater industrialization and a foremost free market economy being responsible for significant income growth. While its economy began to contract before the global financial crisis, it had come out stronger than many nations. Still yet, weak commodity prices and the Canterbury earthquakes have seen the government employ stimulative efforts over the last few years.

On a purchasing power parity basis, New Zealand’s GDP was estimated to be $166B USD, for a real growth rate of 2.2% in 2015; with per-capita GDP estimated at $36,400 USD (ranking 47th globally). Public debt as a percentage of GDP is estimated at 33.5% for 2015, ranking New Zealand 131st globally (by comparison, the U.S. is 39th at 73.60%). As of December 31, 2015, the Kiwis had an unemployment rate of 5.3%, consumer price inflation of 0.7% and a central bank discount rate of 2.5%. 

As of 2014, China was New Zealand’s number-one trade partner (20% of exports), followed by Australia (17.5%), the U.S. (9.3%) and Japan (5.9%). In 2015, New Zealand exported $34.33B USD worth of goods/services vs. $41.96B USD in 2014; importing some $35.34B USD of goods/services in 2015 vs. $41B USD in 2014; for a 3% trade deficit in 2015 vs. a 2% surplus in 2014. Recently, numbers suggest an inflection upward though only time will tell. Taking a longer view, we are confident
New Zealand’s story is a robust one.

{Currently, $1.00 New Zealand dollar (NZD) will buy $0.6767 U.S. dollars (USD) | As recently as July 10, 2014, that same NZD could buy $0.8821 USD | A decline of 23.285% in a mere 21 months.}

NZX has multiple channels for growth, foremost an increase in trading volumes. This can be achieved through larger capitalization (the assets on the exchange attaining a higher intrinsic value and hence market value, also an increase in the numeric amount of assets also helps – think IPOs and secondary offerings) and for the time being a relatively weak currency, which has the benefit of attracting foreign investors. 

>span class="s1"entities that otherwise might have been relegated to a relatively small market opportunity are now able to leverage an economic moat globally. No matter the field, nor the company – if they are Kiwi-based, NZX stands to gain. From energy futures (which help to hedge out the effects of weather anomalies such as El Niño) to dairy derivatives (which help farmers to smooth out cash flows), to stocks and bonds … NZX stands to benefit. 

>span class="s1">New Zealand has a large privatized pension system, Kiwi Saver (Australia has something similar you’ve likely heard of – the Superannuation Fund), which is still in the early innings. Simply, NZX benefits through increased investment in publicly listed securities; traditionally, Kiwis have been savers through bank accounts. NZX also has active and passive investment channels. Of note, there were no entities stepping up to fill the demand for passive investments, so NZX teamed up with U.S.-based Vanguard Group to offer exchange-traded funds. NZX also has a premier wealth management platform, whose moat is born in NZX’s regulatory expertise and control of systems. While that is on the personal advisory side, they’ve also got a robo-advisory service in place. 

NZX’s current management team is entrepreneurial and straightforward, often seizing an opportunity when presented, and have thoughtfully transformed the company left by previous management. The management team has done an excellent job shifting the business, making it less cyclical. By cleaning up the agricultural data management side (i.e., farmer periodicals and data), selling non-core businesses, and their electronic grain exchange in Australia (where we believe lingering litigation is pertinent though manageable). The management team has done an excellent job shifting the business, making it less cyclical. As foreign investors, it is nice to know that management is thinking of us, offering foreign investors a supplemental dividend to ensure its dividends are free of New Zealand taxes. 

From NZX we anticipate a healthy dividend (currently mid-high single digits) to be supplemented by moderate growth that is driven by initiatives at company and country levels. When we compare NZX to its peers, we find that NZX is trading at discounts through many lenses (e.g., net cash on their balance sheet and a peer leading dividend). Ultimately, in NZX, we see long-term value, aligned with momentous global trends, and a company that’s run by prudent and opportunistic stewards of shareholder capital. 

Data Sources:
management meetings, company filings, Bloomberg, 
www.pbs.org/wayfinders/index.html
https://www.cia.gov/library/publications/the-world-factbook/geos/nz.html
Essentials of Oceanography, by Tom Garrison
Web.stanford.edu/~scheidel/acme.htm
www.teara.govt.nz/en/1966/aotearoa
stats.govt.nz
Environment Aotearoa 2015 – Ministry for the Environment & Statistics New Zealand
State of the World’s Indigenous Peoples, United Nations – Economic & Social Affairs www.heritage.org/index/country/newzealand

Hawaii

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

Michigan

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

Wisconsin

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

Request Info