With many financial markets off to a volatile start in 2016, our team has been fielding an understandable increase in calls from concerned clients. We’ve aggregated some of the most frequent questions and our responses for this month’s investment strategy update. While generic discussion points like “everything is cyclical,” “investing is a marathon, not a sprint,” and “be fearful when others are greedy and greedy when others are fearful” generally describe the key tenets of our patient, opportunistic approach, we appreciate that many if not most of you already “get that.” So what follows are some additional perspectives on how we view the current investment landscape, and how we are managing through these headwinds. As always, we appreciate the opportunity to discuss your individual situation and encourage you to contact us with questions or concerns.
Q: 2016 seems to picking up where 2015 left off (i.e., not so great). Paul said at the end of 2015 that he was very optimistic about the outlook for 2016. Has FIM Group changed its tune given the rough first few weeks?
A: As this newsletter goes to the editors (1/20), most global stock markets have indeed had a tough start to the year. Many markets, including those in the U.S., have fallen 5%-15%, while parts of the corporate bond market (mainly the lower credit rating segments), have also performed poorly. FIM Group-managed portfolios have not been immune to this sentiment shift among market participants.
We came into the year close to fully invested in a diverse mix of stock and bond investments that are well-priced for good long-term total returns. Keeping relatively low cash balances and owning good quality holdings allows us to benefit from higher levels of dividends and interest and longterm price appreciation, just as owners of privately held businesses and real estate holdings do. But because we invest in public markets, the trade-off we accept for being nearly fully invested is more exposure to short-term downdrafts in portfolio market value when fear infiltrates market psychology.
Our focus remains largely on the fundamentals of our portfolio holdings (including things like their competitive position, cash flow generation outlook and balance sheet strength) and the market’s valuation of our positions. We see little evidence of any broad deterioration in our portfolio holding fundamentals, and in most cases the long-term outlook for increases in fundamental measures we monitor, like book value per share and dividends per share, remains intact. As long as this stays the case, slides in market value do not curb our optimism toward future returns. In fact, as the gap between market price and fundamentals widens, our optimism toward future total returns (dividends and interest + price appreciation) only grows.
Q: I’m still many years from retiring, and I’m saving responsibly. Why should I put more funds into FIM Group managed strategies after the subpar performance of the last 18 months?
A: Although we had a few dud investments in 2015 that were simply company-specific analytical misjudgments on our part, the lion’s share of the headwinds we faced came from areas that we deem cyclical rather than structural in nature. Namely, these headwinds included U.S. dollar strength relative to most other currencies and commodities, weak price action in areas perceived as sensitive to interest rate changes like real estate investment trusts and infrastructure stocks, and companies with high exposures to emerging market customers. While the jury remains out on the duration of the headwinds in these areas, we expect them to eventually cycle back to our favor. New money flows coming to FIM Group today (including cash that our team members are investing into FIM Group-managed strategies) are being put to work in a mix of holdings that includes good-quality holdings in these beaten-up areas where the forward return outlook is as compelling as it’s been in years. We are buying missioncritical infrastructure and service providers like hospital and senior living REITs, water utilities and alternative energy assets at exceptional prices. We are also using the strong dollar to buy international leaders in areas ranging from European public transport, to Asian healthcare and even (for Growth strategy accounts) Russian Internet search engines. In short, we are finding no shortage of good-quality, well-priced investments in a broad mix of areas, some of which are poised to benefit substantially as the dollar, interest rate sensitivity perceptions, and emerging market sentiment shifts back our way.
Q: I’m retired and depend on my FIM Group-managed portfolio to support my cash needs. Should I cash out and stay on the sidelines as this latest storm plays out?
A: This is a question that should be discussed directly with a FIM Group team member, as each client situation is different. Generally, though, the strategies we typically manage for clients taking modest distributions (for example, 4%-6% of the portfolio value in “normal” times) from their portfolios each year (namely Balanced, Balanced Conservative and Yield Income) are structured to allow such distributions during even the most challenging of market conditions (like those in 2008- 2009). We structure these portfolios to generate solid, recurring dividend and interest yields throughout the year. Many of these dividend and interest streams derive from long-term contracts with diverse groups of financially sound counterparties (such as is the case with our REITs, infrastructure and corporate bond fund investments). We also normally have allocations to “safe haven” U.S. government bonds or notes that tend to hold their value or appreciate in times of market stress. These recurring dividend and income streams and safe haven assets allow us to fund distribution needs as other parts of the portfolio recover from sentiment-driven sell-offs. The benefits from such an approach are chiefly twofold: 1) We can avoid selling assets at fire-sale prices to meet distribution needs (i.e., avoid permanent loss); and 2) We can avoid having to “time the market,” making massive portfolio shifts out of investments and into cash (and then back), which history shows is the numberone way to transfer wealth to other investors who can stay patient through stressful market conditions.
Q: Should I change investment strategies to something with less drawdown risk?
A: Each of FIM Group’s four core strategies (Growth, Balanced, Balanced Conservative and Yield Income) is designed to accept varying degrees of drawdown risk (temporary drops in portfolio value). These are not guaranteed loss limits, but rather are parameters by which we structure the mix of investments in each strategy. These volatility thresholds are 45% for Growth, 30% for Balanced, 25% for Balanced Conservative, and 20% for Yield Income. While it is not ideal to shift strategies during panicky financial markets, it is important that we manage a strategy suitable to your tolerance for these drawdowns. The main reason for this is that we want to avoid situations where the volatility becomes too much to bear and drives a decision to turn temporary losses to permanent ones. Like the question above, each client situation is different, so please call a FIM Group team member if you would like to discuss a possible strategy change for your accounts.
Q: We continue to hold considerable allocations to international holdings. Yet everything I read points to a good chance for further dollar strength against most foreign currencies and headwinds for my portfolio. What am I missing here?
A: The dollar has been in a very sharp upward trend since mid- 2014, appreciating more than 20% against a broad group of other major currencies. As our international holding allocations generally range from 20%- 60% in our core strategies, this dollar surge has led to a currency translation effect that has temporarily impacted portfolio returns. A generally stronger U.S. economy compared to other major economies like Europe and Japan, along with anticipation of diverging monetary policies (tightening in the U.S. vs. loosening in Europe and Japan), have been key factors behind the dollar surge. As Figure 1 shows, the dollar is now above its 40-year average levels. It has rallied 40% off its 2008 lows. The previous cycle higher in the dollar was a six-year affair from 1995-2001 that saw the dollar strengthen by 45%. Could this cycle prove longer and of greater magnitude than the last? Sure it could. The four-year dollar bull from 1980-1984 saw a 77% move higher. But generally speaking, with the dollar now above its long-term averages, we are more likely to see less of a medium-term headwind effect from foreign currency translation. And with valuations in other parts of the world in many cases providing significant discounts to U.S. holdings, we will continue to keep high-quality international holdings in our mix.
Q: Financial media continues to report on an economic implosion in China. What is FIM Group’s view on this, and what is my portfolio exposure?
A: China’s economic transition from a capital investment and export-dominated model to a domestic consumption-driven one is having major implications for markets around the world. The primary impact has been to commodity producers as demand has ebbed for the raw materials that were needed to support the capital buildout and export machine. No country that has grown to China’s scale can sustain double-digit economic growth forever, so we should not really be surprised at China’s now sub-7% growth rate. But what many of the sensational headlines miss is that China has been rebalancing for some time into a more sustainable economic model and that consumption across many categories is thriving there (see Figure 2 and Figure 3).
Our managed portfolios have little direct exposure to China, ranging from less than 1% in Yield Income to just over 5% in Growth. The exposure we have in China is generally via U.S., Singapore and Hong Kong-listed companies with leading niche positions in areas like e-commerce (Vipshop), wellness goods (Eu Yan Sang and OSIM), household paints (Yip’s) and mixed-use development (CapitaLand). We have confidence that as the negative headlines around China become less dramatic, investors will return and market values will better reflect the solid long-term outlooks for each of these holdings.
Q: Why do I keep seeing increasing trading activity in my account, including simultaneous buys and sells on the same day?
A: When other investors get panicky and when market prices move significantly below our assessments of fair value, we seek to be opportunistic. This generally means we like to bargain hunt and buy when “blood is in the streets.” In some cases, to take advantage of great prices, we will rotate from holdings with less risk-adjusted return potential to make room for those with superior potential. That is why you may see us sell and buy on the same day and even sell certain holdings at a loss as we look to refine your portfolio and improve its outlook for future returns.
Q: You keep telling us there is “underappreciated” value in my portfolio. Can you elaborate with an example or two?
A: We regularly profile investments each month in our newsletter’s Investment Team Spotlight section. John Bresnahan writes about one such investment this month in France-listed FFP Holdings. During our autumn webinar in October (archived on our website), we also discussed holdings where value “surfaced” via corporate actions like the announced deals with Cable and Wireless (to be bought by Liberty Global), Saizen REIT (taken private) and Strategic Global Income Fund (proposal to liquidate at NAV). And today (1/20), another holding, Capstone Infrastructure, which we first bought last July, announced that it would be taken private at more than a 40% premium to its recent market price. In each case, our holdings were trading like a coiled spring at market prices wellbelow our estimates of fair value before they “released” to reflect a value more in-line with their fundamentals. And while we surely can’t bank on corporate actions to be the only catalyst for “surfacing” the value in our portfolio, such transactions do often act as a wake-up call for other investors looking at similar names. We are happy to discuss our analysis of the unrecognized value of any holding in your portfolio, whether it be mission-critical infrastructure like hospital REIT Medical Properties Trust, the deeply discounted natural resources turnaround situation at Dundee Corp, niche industry leaders like Cott Corp (private-label beverages) and SunOpta (organic food ingredients), and unusually highly discounted closed-end funds like Western Asset Inflation- Linked Opportunities (WIW).
The recent excitement over the $1.5-billion-dollar Powerball jackpot led me to think about windfalls. The 293,000,000-to-one odds against winning the Powerball means that none of us will ever win such a huge lottery payout (though that won’t stop us from playing). Some of us, however, may still come into significant financial windfalls in our lives. An inheritance, lawsuit payout, insurance distribution or any other unexpected payout can reshape financial circumstances and open great new financial opportunities. They can also bring a host of unfamiliar, unseemly and unanticipated challenges. Stories of lottery winners going bust within a few years aren’t unusual. The same outcomes can accompany other windfalls as well. A few guidelines, fortunately, can help prevent such a blessing from becoming a curse.
Don’t do anything. If a windfall comes your way, the best first step is, essentially, to do nothing. Make no immediate life changes: Don’t quit your job; don’t buy a swank new car; don’t buy a nicer house; don’t make any significant financial commitments. At least not yet. Safeguard the funds in a savings account, money market or CDs for at least a few months to allow time for thinking and planning.
Understand and plan. Taking a step back to catch your breath will not only help prevent the expenses and impulsive spending that could cause the funds to fade away, it will also give you time to develop an overarching, long-term plan and to understand the true value of funds, which may be subject to taxes and other expenses. Indeed, don’t ignore taxes! Inherited retirement accounts, for example, require special treatment for tax purposes. Failing to adhere to IRS requirements will result in significant additional expense. For anyone unaccustomed to dealing with large sums of money, it makes good sense to assemble a team of advisers for legal, accounting and financial planning help. Your team can be invaluable for establishing appropriate trusts for tax planning, for long-term investment and spending plans, and for effective charitable giving.
Plan for the worst. If you don’t already have an emergency fund, establish one for quick and easy liquidity. Six months’ living expenses is a typical rule of thumb, providing living expenses should you lose a job and liquidity for other unforeseeable but significant expenses. Review insurance coverage for newly established liability gaps. Greater financial assets can also mean higher liability risk. A big enough windfall may also put a target on your back for opportunists, making risk management and proper insurance coverage even more important.
Pay down debt. Take advantage of the new liquidity to clean up your personal balance sheet. Pay off credit cards and other short-term loans. Some debt, such as a mortgage, may justify itself as good tax planning thanks to the interest deduction from income. But sometimes it may not. Living mortgage-free has its advantages!
Think about yourself in the medium- and long-term. Is there training or education, for example, that will help advance your career but has been out of reach due to cost?
Think of the future. What are your long-term financial goals? To meet those goals, establish investment funds for significant foreseeable expenses down the road. Retirement, of course, is the big one most of us share. Responsibly establish what this windfall may mean in terms of income replacement in the medium- or long-term. Be sure to max out any retirement plans or accounts. College tuition for children or grandchildren is another common financial goal.
Give. One good turn deserves another, right? There may never be a better time to create a really effective charitable giving program than when you come into a sum of unexpected funds. Consider issues that are important to you and seek out the efforts or organizations addressing those issues. Decide whether a one-time gift or recurring contributions are most suitable for you, and what you want to achieve with your donations. Discuss with your advisers the most effective and tax-efficient ways to fund your charitable gifts.
Spend a little on yourself. Be sure to enjoy good fortune and reward yourself for your sensible and long-term oriented approach to shepherding your funds. Depending on the situation, you may be able to take that vacation you’ve always dreamed of, acquire that car you’ve desired, or buy that bike, skis or computer you’ve had your eye on. Be sure this nonrecurring expense still fits within the capacity of your overall financial plan. If not, scale back to something that does.
No one solution or plan fits every windfall situation. Yet every successful windfall plan and spending decision shares foundational underpinnings of being intentional and long-term oriented.
Share Price | Market Capitalization (01/20/2016): €55.25/€1.39B
Company Description: FFP was founded in 1929 and is the listed holding company of the Peugeot family, which currently controls 87% of the voting rights. Since 1997, FFP has actively worked to diversify its portfolio. Today, PSA Peugeot Citroen remains its largest investment at roughly half of FFP’s net asset value. PSA Peugeot Citroen is the second largest automobile manufacturer in Europe, with manufacturing in Western Europe, Latin America and China. PSA Peugeot Citroen owns a majority stake in Faurecia, a leading global automotive supplier. FFP’s second largest holding, at roughly 10% of its net asset value, is Zodiac Aerospace, maker of aircraft evacuation slides, passenger seats, oxygen systems, interiors and galley equipment. The remainder of FFP’s portfolio includes: SEB (small appliances – e.g., All-Clad, Tefal, Krups, etc.), Lisi (fasteners for aerospace and autos), Orpea (long-term care/postacute care facilities in Europe), DKSH (market expansion services), Ipsos (market research), Immobilière Dassault (real estate), IDI (investment company), Ciel (diversified holding company in Mauritius with investments across Africa), and private investments such as a partnership with Louis Dreyfus Armateurs in shipping and Château Guiraud winery (we estimate the private investments to be roughly 13% of FFP’s net asset value).
Investment Thesis: FFP is an entity that we anticipate to be a prudent steward of capital through all phases of the market cycle, employing a strategy that will preserve and grow capital for decades. We estimate that FFP is trading at roughly half its net asset value (liquidation value); this discount widens further when we analyze the underlying assets. Put another way, if we believe that PSA Peugeot Citroen is fairly valued today – then we are getting all other investments for free. Another angle is that the rest of the portfolio is fairly valued and we are getting PSA Peugeot Citroen for free. Our take is that the case is somewhere in-between; however, a discount this wide is not justified when we look into the brands (and their performance) that are owned within the portfolio.
As we see it, there are two key elements to FFP: the people (and who they are beholden to) and the portfolio itself. Understanding the values of FFP’s management team is as important as the portfolio they have built, regardless of the discount that the market has placed on them. With this belief, we have taken the efforts to meet with management at FFP, PSA Peugeot Citroen, and done channel checks for Zodiac within management meetings at Air New Zealand and Finnair (in addition to discussions with analysts). It is important to note that we have not ignored their other investments; instead it is our belief that, at this time, having a deep understanding of PSA Peugeot Citroen and Zodiac is integral, as one could categorize both entities as portraying value characteristics currently (i.e., the other investments are currently more stable – ceteris paribus).
Management at FFP has been conservative, and after meeting with them we are inclined to believe that this isn’t going to change anytime soon. They are active investors that like to build long-term, significant stakes in companies, often taking board seats. FFP’s portfolio is agnostic, in that they are interested in making the best investments possible, period. A benefit of their shareholder structure is the time horizon they are allotted; they are managing the portfolio for perpetuity. FFP devises a hypothesis and invests accordingly; near-term noise is monitored but doesn’t dictate change.
This is evinced by the fact that FFP has never disposed of a position at a loss. Per the Peugeot family, they want their capital protected first with growth as a secondary objective; in addition, there is a desire for a stable and sustainably grown dividend stream.
Chances are that if you have recently flown somewhere and were surprised to find the seats comfortable, you were likely sitting in a seat manufactured by Zodiac Aerospace. Zodiac Aerospace (€5.23B market cap.) is the company that the airlines love to hate. Its product is considered far superior to the competition, but there is a caveat ... demand has far outstripped supply and there have been growing pains. Most airlines have been understanding with the exception of American Airlines and their pending litigation (which we do not deem material). In speaking with the CFO of Air New Zealand ($3.41B NZD market cap.), while they are displeased with the delays, eventually the seats themselves are so well received that they are willing to deal with the near-term inconveniences. The CFO of Finnair (€666.31M market cap.) relayed the same sentiments; of note, neither planned to switch vendors. Ultimately we agree with FFP that the issues at Zodiac Aerospace, while not trivial, are fixable and hence transitory; we are reassured as FFP is taking a hands-on role – recently increasing its stake. In Zodiac Aerospace we see value and a company that is aligned with a shrinking planet (you can get anywhere in 24 hours). PSA Peugeot Citroen (€10.66B market cap.) is trading at a substantial discount to peers nearly any way you slice it.
PSA Peugeot Citroen is just now implementing things that other automakers have been doing for years (e.g., shared platforms and parts). Its plan to get “back in the race” is more than half a decade ahead of schedule; we are apt to believe it will continue on this track. The company has net cash (ostensibly the best balance sheet in the industry), is showing pricing power and has strong free-cash-flow generation. If we put an industry multiple on PSA Peugeot Citroen, which seems fair given how much better it is performing than its peers (and considering that the company isn’t in all markets – e.g., U.S.), Peugeot could be seen as trading at 50% of its fair value (in addition to FFP’s discount). PSA Peugeot Citroen has levers to pull and is seeing results: France’s footprint in Africa (e.g., Moroccan expansion), its financing arm’s joint venture with Santander is going well (i.e., margins are increasing), its research and development spending is more targeted than competition (i.e., it doesn’t want to spend excessively trying to be the first to market with something – efficient and effective), it has a hands-on, “fiery” CEO in Carlos Tavares, workforce efficiencies are happening faster than anticipated, and its working capital has improved dramatically. At some point, we anticipate Peugeot to divest its majority stake in automotive parts supplier Faurecia (€4.33B market cap). In addition, while Peugeot has exposure to China, it is not nearly as large as peers – and it is exposed primarily in the small SUV segment, which continues to do well. At some point, Brazil and Russia will see brighter times, and that will be yet one more tailwind for Peugeot, which should get a modest boost from the recent lifting of Iranian sanctions. We have spoken to management at PSA Peugeot Citroen and FFP regarding the Volkswagen (and now Renault) scandal, and have been assured that its testing standards have been of the highest in the industry and that it has been actively lobbying for tighter standards.
While PSA Peugeot Citroen isn’t currently paying a dividend, FFP is paying roughly 2% of its net asset value, which has an upward trajectory as Peugeot wanted to get its house in order before returning capital to shareholders. Going forward, we expect the assets within FFP’s portfolio to grow, the discount that that market has placed on FFP to narrow and the dividend to grow sustainably. Solid characteristics for what we would deem a core holding.
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