Now that we are a couple weeks into the New Year, most economists, market strategists, bloggers and other prognosticators have already pushed the send buttons on their annual forecasts for stock market levels, interest rates, foreign exchange rates and the like. Most will be off the mark come year-end, but that never seems to stop them from gazing into their crystal balls and letting the world know what they see. Some have called for more aggressive Fed interest rate hikes, while others predict a “one and done,” on the view that a weakening economy plus an election year will minimize the likelihood of additional increases to official short-term interest rates. Many have made bold predictions for the dollar after two strong years of gains against other currencies (a major challenge for our global portfolios), and plenty have thrown out their guesses for stock market returns around the world.
Our investment team here at FIM Group is constantly asking hard questions about the future. After all, our jobs ultimately come down to making informed, thoughtful judgments about the magnitude and probability of the long-term future cash flows generated by every position we own (this is the essence of fundamental investment analysis). We structure portfolios with investments made as a result of these judgments, and constantly work to refine them as the future becomes “now” and our outlooks for the future evolve.
Rather than add to the pile of prognosticator outlooks for this Year of the Monkey (and let’s face it, many of these forecasts for 2016 stock, bond and currency returns will be no more accurate than those made by a room full of monkeys), We’ll share a few predictions that are effectively reflected in the way we are structuring client portfolios today. We don’t expect these to necessarily play out over the next 12 months (far too many factors, like government policies, interest rate changes, currency valuation, business cycles can have outsized influence over a short time period), but we do have high confidence that over our investment strategy-appropriate time horizons (ranging from three to five years at FIM Group), these predictions will play out in our client portfolios’ favor.
Prediction #1: Value Investing Will Once Again Come Back Into Style
In last month’s newsletter, we noted the underperformance of “value” investments versus “growth” investments globally these last few years. Most studies show that over longer time frames, investment strategies incorporating valuation criteria instead of just revenue and earnings growth have delivered superior performance. Data also shows that after extended periods of weak relative performance, subsequent recoveries for “value” strategies have been quite robust. In the chart below, the post-tech-bubble early 2000s perhaps best represent this phenomenon. While relative performance is not our primary concern here at FIM Group (we care most about generating absolute performance over strategy-appropriate time horizons), the outlook for a value “rebound” is as good as it’s been in years. As FIM Group portfolios are chock-full of these investments, we should benefit as this broad cycle comes back our way.
Prediction #2: Closed-End Fund Discounts Will “Revert” to More Normal Levels
Recall that a closed-end fund trades independent of the market value of its holdings (also known as net asset value or NAV). Because of this, there are periods, usually when investors are nervous about the future, where the funds can trade at 10%-20% below NAV (and in extreme cases even cheaper). This effectively allows us to buy $1 worth of assets for less than 80-90 cents and wait for the discounts to revert back to their average levels or even close back to NAV. This discount normalization acts as a return bonus to any income distributions and NAV improvements made during our holding period. In 2015, discounts across the closed-end fund world widened to levels not seen since the financial crisis. This widening comes, interestingly enough, during a period where the supply of closed-end funds is shrinking and as activist investors press fund boards of directors to take actions that can reduce such discounts.
For example, in 2011, there were almost 700 closed-end funds in existence, while at the mid-point of 2015 there were only 565. Meanwhile, fund boards are increasingly directing their funds to buy back stock, merge into open-end funds, and liquidate funds as proactive measures to reduce or eliminate discounts. In 2015, we saw several FIM Group holdings benefit from such action (including ACG, SGL and FTT), and we expect more of these actions in the years ahead. This, plus renewed investor demand as the historically large discounts attract value-oriented investors, is likely to pressure discounts back down and provide an additional return driver for our closed-end fund holdings.
Prediction #3: Demand for Life’s “Basics” Will Stay Resilient Through the Uncertainty Ahead
Could we have a recession in the next few years? If history is any guide, that seems likely. Will consumers cut back in certain areas during such an economic downturn? That seems likely too. But as we all know, there are certain bills that must get paid first. It seems reasonable that even in a future recession, consumers will stay current on their water bills, hospitals will pay their rents, and well-financed utilities will honor their power purchase agreements with those producing the power they distribute to their customers. FIM Group portfolios include a healthy allocation to companies exposed to these essential services like Global Water Resources (Phoenix-based water utility), Capstone Infrastructure (solar and wind power production and water distribution), and Medical Properties Trust (world-class hospital owner throughout the U.S. and Europe and featured in this month’s Portfolio Team Spotlight).
Prediction #4: Global Demand for Health and Wellness Products and Services Will Remain Robust
It’s no secret that consumers around the world are increasingly demanding products and services that improve their health and wellness. In developed countries, some of this demand comes from the dual demographic wave of Boomers who desire to stay active in their retirement years and Millennials adopting healthier pathways earlier in life. Across emerging economies, billions of newly minted middle classers are also spending discretionary income on wellness-improving things. FIM Group portfolio holdings stand to benefit from these trends across a wide spectrum. Gaiam, for example, is bringing yoga goods to the masses via stores like Target and Kohl’s. Singapore-listed OSIM International is selling massage chairs, nutritional supplements (as a GNC franchisee) and high-end tea throughout Asia. Ten Peaks (a chemical-free decaffeinated coffee producer) and Sunopta (one of the largest sourcers, processors
and packagers of non-GMO and organic foods) are both bringing healthier food options to North American consumers. And IHH Healthcare, a major hospital group held by Symphony Holdings, is filling healthcare gaps throughout Asia and the Middle East. The list goes on, but needless to say, we expect our portfolios to benefit from this bullish long-term trend.
Prediction #5: Skilled Management Teams Will Continue to Positively Transform Companies
Part of our investment strategy at FIM Group is to allocate funds to corporate turnarounds and other situations where a successful investment result is much more dependent on company-specific actions than on broader economic or sector growth tailwinds. Cott Corp, for example, is developing a leading North American home and office beverage delivery business that will transform the company away from reliance on its slowly declining private label carbonated soft drink manufacturing business. FirstGroup PLC, a U.K.-based public transportation company with U.S. and U.K. bus and train operations, is in the early stages of a company-wide cost savings initiative that offers a good chance of boosting profitability even without robust top-line growth. Immofinanz, an Austrian commercial real estate company, is rationalizing its valuable Eastern European real estate portfolio by selling its non-core logistics and residential properties to focus ahead on its under-appreciated retail and office assets. We believe that actions like these can boost a company’s future cash flow generation and therefore boost the return profile of our portfolios through a wide range of global economic scenarios.
Prediction #6: Currencies Will Remain a Performance Swing Factor
FIM Group has always been a global investor. We believe that historically our willingness to invest abroad has benefitted clients. Including international stocks and bonds into the portfolio mix offers diversification benefits and opens up return opportunities not available to U.S.-only portfolios. It does, though, create several additional elements for us to contend with, and one of these elements is foreign currency movements.
2015 was the year of the greenback, as the dollar appreciated strongly against just about every other currency we invest in. The Singapore Dollar, for example, dropped about 6% against the dollar, the Euro 10%, and the Canadian dollar more than 15%. Emerging market currencies like the Russian Ruble (-20%) and the South African Rand (-25%) fared even worse. These currency movements negatively impacted our performance in 2015 and will remain a swing factor in the years ahead, adding or subtracting to the interest, dividends and price appreciation we earn from our foreign investments. We view most of the foreign currencies that we invest in as undervalued relative to the dollar. As such, we expect that even though we’ll have years like 2015 where the dollar spikes higher, the longer-term impact from currency exposures in our portfolio will predominantly be a positive one.
Prediction #7: Governments Will Continue to Interfere (and Create Great Investment Opportunities)
The notion of “market economies” is largely a relative one. Governments around the world manage their economies to various degrees with the goal of benefitting their citizens (or at least themselves) via all sorts of interventions. These include things like trade, regulatory, fiscal and monetary policies which frequently send waves through our globally connected financial markets. With 196 countries in the world engaging in a complex dance of maximizing the benefits to their own populations without causing too much pain abroad, the results are often less than pretty. At times (some would argue most of the time), these interventions end up backfiring and/or causing dislocations that patient investors like FIM Group can benefit from.
One example of this is the current disruption in energy markets, in part the result of aggressive Saudi government policies. This disruption has led to fire sales across a wide range of stocks and bonds in regions and sectors perceived to be permanently impacted by the lower oil price (real estate companies with modest Russian exposure like Atrium Real Estate is just one example of this). For our team, we expect such government interference in economies to provide continued investment opportunities. The fact remains that such interference often leads to unintended consequences, investor over-reaction and significant value for those like us who can take a more patient, longer-term view.
Anticipating a Year of Noise, Volatility and Compelling Investment Opportunity
2016 will surely give our team plenty of “noise” and associated market volatility to sort through. We have little skill in forecasting election outcomes, short-term movements in interest rates or currencies, or the more-often-than-not irrational behavior of our fellow market participants, so our confidence in predicting 2016 developments along these lines is quite low. It is hopefully clear that we won’t be betting the portfolio “farm” on guesses related to these areas. Instead, we will stick with our beliefs in the areas mentioned above. We will stay value-oriented in our investing and search out high-conviction ideas in areas like closed-end funds, “mission critical” products and services, bullish secular themes like health and wellness, and companies with value-adding management teams.
This month’s newsletter focus is about forecasting and the future. The following article illustrates how data, history and analytics (fundamental analysis), overlaid with “common sense,” can uncover investments to avoid while creating opportunities in its wake. Every trend has multiple countertrends. We expect that those who believe brick-and-mortar retailers like Kohl’s, Target or a Meijer are becoming antiques will be surprised as their management’s mesh the best online practices with the ability to see, feel, experience and touch the product, often with the aid of a “expert.” When I need to fix something, I go to Ace Hardware and ask the “how-to” questions. My wife Amy loves the people at The Home Depot and Lowe’s. Online retailers have changed the face of retailing, though it is not new as “delivered to your door” has existed since the invention of postal services. Competition happens and things change – that has always been the reality. This essay takes a deeper look at retailing from the vantage point of Amazon.
– Paul Sutherland
Over the last couple of months there has been an impression that Amazon is the cause of the current woes of the retail market. Companies like Walmart, Target, Kohl’s, Macy’s and Nordstrom have reported bad results and have seen their stocks move down a considerable amount. I received a call from a port-folio manager friend of mine bemoaning his lack of ownership of Amazon and that it is “killing everyone else.” The folks on CNBC and Fox Business News are saying the same thing, so it must be true ... right? A logical person would therefore assume that you should sell the other stocks and buy Amazon. Doing that, however, would be a very costly mistake.
Amazon has been a fantastic stock that is up 700% since the Great Recession. When I was at BlackRock, we owned the stock and I loved the story and the growth potential. Today, I would not own the stock as perception is very different from reality. We are in the final stages of a parabolic move with the stock up 100% this year. When the company began its online growth phase, it had a number of tailwinds at its back, including:
As time went on, the company took advantage of these strengths and took revenues from $24 billion in 2009 to $107 billion this year – a stunning 28% compound annual growth rate over those six years. However, since 2011,
the revenue growth and returns on capital have decelerated because of
the following reasons:
The stock peaked in 2013 and struggled through most of 2014 as cash flow quality was poor and revenue deceleration and expenses were very high. Essentially, its early protective moat had disappeared. The stock then accelerated dramatically in 2015 because it cut expenses temporarily and revealed its Amazon Web Services business as growing very fast and supposedly profitable when it finally broke it out on its Q1 earnings release. The stock then took on a dreamlike multiple as perception became greater than reality.
The reality is that its market share growth has been slowing due to the above advantages going away, and that 50% of its growth in Amazon Web Services has come from tech startups. The problem with that is venture capital technology startups are cyclical, and growth will go to zero as funding dries up, so the growth is unsustainable. It reminds me of the telecom boom in 1999 when Lucent and Nortel were growing very fast as they sold equipment to telecom startups, but most of these startups went to zero. The markets were not kind to those stocks as growth decelerated.
If retailers have caught up to Amazon from an online and pricing presence plus a cessation of Amazon’s sales tax advantage, why is it doing so poorly?
The answer is simply that the economy is slowing and that the 25%-50% premium increase from Obamacare due next year is causing a pause in the consumer spending. I would expect the consumer weakness to show up in Amazon’s results soon enough and, coupled with the unsustainably high Amazon Web Services growth, we will find that the projected growth rates for next year are way too high. Given that the current price-to-sales ratio is 3 and the current Enterprise Value to EBITDA ratio is 40, the forward return for investors is quite low here. In fact, I could argue it is extremely negative.
At FIM Group we are positive that as investors sell their brick-and-mortar stocks to buy Amazon, opportunities over the next 12 months will present themselves to our clients. To put things in perspective, retail sales in the U.S. total about $4.5 trillion, while Amazon will do about $107 billion in sales. The law of large numbers is catching up to Amazon, and its growth will slow and the incremental sales will be less profitable as it expands its categories away from its original advantage in books and media.
Much in the way that December is a time for reflection, January is when we make plans and set new goals, seizing the opportunity for a fresh start. In keeping with that spirit, I’m writing to share the following Financial Planning Resolutions for 2016. These resolutions are intended to serve as guidelines for helping you achieve your financial goals. As always, if there’s anything your FIM Group advisers and financial planners can assist with, please reach out at any time.
1 Rebalance Your 401(k) and Other Investments Not Managed by FIM Group
Rebalancing is the process of selling and buying assets so that your allocations are in accordance with your investment plan, such as 60% stock and 40% bonds. Changes in performance of the assets in your retirement account might require rebalancing, as they can throw off the allocations you’ve determined based on goals and risk tolerance. Rebalancing is most effective at reducing volatility and can lead to improved risk-adjusted returns. Consider annual rebalancing, at a minimum, and anytime your horizon, goals or risk tolerance change.
2 Review Your Beneficiary Designations
Remember to review your bene-ficiary designations on all accounts no less than annually and always following a major life event for you and any of your beneficiaries. Major life events include marriage, divorce, birth, death, etc., and it’s prudent to think of them as triggering events for adjustment considerations to your financial and estate planning.
3 Check Your Income Tax Projections
Tax planning is something that should be done throughout the year, not just during the usual “tax time” period of January 1 through April 15. By projecting your income tax liability for next year, you’ll be better equipped to make adequate withholdings and avoid unexpected tax consequences. In addition, knowing your tax bracket will help determine if you want to declare or defer income for the upcoming year.
4 Review Your Employer Benefits
A flexible spending account, health savings account, qualified retirement plan, etc. are all excellent, low-cost mechanisms for saving money. Review your existing plans to maximize their benefit in your unique situation and make sure they are taken into account when examining your broader financial plan.
5 Conduct an Insurance Review
An annual review of your insurance can help eliminate gaps in coverage, in addition to identifying any available credits or opportunities to reduce premiums. Checking the policy summary of your plans for property and casualty, life, disability, etc. at least annually is recommended.
6 Review Your Estate Plan Documents
Priorities and wishes change and evolve, and it’s important to remember that your estate plan should not be standardized, but individualized. Review your estate plan documents and confirm they will accomplish your objectives and unique goals. Critical estate plan documents – such as those for durable powers of attorney, trusts, wills and your advance medical directives – should be reviewed annually and following any of the major life events mentioned above in #2.
7 Consider a Roth Conversion
A Roth IRA differs from a traditional IRA in that contributions are not tax-deductible, but the earnings can be withdrawn free of income tax if you’re at least 59½ and have had the Roth at least five years. In addition, required minimum distributions (RMDs) aren’t required at age 70½. If your IRA account has dropped in value and/or your tax rate is lower now than what it might be down the road, it might be the opportune time to convert a portion of your IRA to a Roth IRA. This move is especially useful if it can be performed while remaining under the top of the 15% federal income tax bracket.
8 Maximize Retirement Plan Contributions
Contributions to your qualified retirement account are made on a before-tax basis, which reduces your current taxable income for the year. In addition, the contributions grow tax-deferred.
For those of you over the age of 50, don’t forget about catch-up contributions. Catch-up contributions, which are made in addition to your current limits, are permitted in IRA, 401(k), 403(b), SARSEP and 407(b) plans for anyone age 50 or over by the end of the calendar year. It’s important to remember that the rules and limits differ among plans, and you’ll need to check with your benefits department for clarification.
Medical Properties Trust
(Ticker: MPW, www.medicalpropertiestrust.com)
Share Price/Market Capitalization (12/30/15): US$11.65/$2.8b
Company Description: Medical Properties Trust is a real estate investment trust (REIT) that acquires and develops net-leased hospitals, including those specialized in acute care, ambulatory surgery and inpatient rehabilitation.
Investment Thesis: MPW gives us exposure to mission-critical real estate, leased to industry-leading operators, at a great price. Annualized total returns are expected to be in the high single-digit to low double-digit range, comprised of a nearly 8% yearly dividend yield and price appreciation driven by organic and acquired property income growth and valuation multiple expansion.
MPW is a pure-play hospital REIT with 187 properties in the U.S., Germany, the U.K. and Spain, leased or loaned to 30 operators. Revenues generated from its $5.6B asset base break down as follows: General acute care hospitals (55%), rehabilitation hospitals (34%) and long-term acute care hospitals (11%).
The geographical breakdown of MPW’s revenues is around 80% U.S., 18% Germany and 2% U.K./Spain. Properties are leased on long-term arrangements to top-class hospital operators, including Prime Healthcare, MEDIAN and Ernest Health. In fact, more than 70% of MPW’s leases are contracted beyond 2025.
Although industry concerns around hospital revenue trends under the Affordable Care Act have pressured investor sentiment, MPW’s leases are covered nearly 4x by its tenant-operator cash flow. 98% of these leases have annual rent escalators, and more than half adjust fully with changes in consumer price inflation. Rent for MPW’s operators is mission-critical, and management is very selective toward its property locations and tenant relation-ships. We view the risk of MPW’s tenants defaulting on their lease obligations
as very low.
MPW runs a conservative payout policy with its shareholder distributions. On current cash flow projections, our expected dividend this year implies only a 70% payout ratio, which is lower than most peers. Although balance sheet debt is running on the high side of target ranges, management has committed to dispose of non-core properties in the quarters ahead. There are no major maturities until 2018. We believe the risk of management issuing new stock at current undervalued levels is nearly zero.
During its recent analyst day, MPW management showcased its high-quality operators and reiterated its confidence in the REIT’s solid growth platform. Demographics in MPW geographies are great for the healthcare industry, and MPW has a strong portfolio of assets to benefit from this. We expect that the next few quarters will be more focused on internal development rather than large acquisitions, which should ease investor worries around the risk of dilutive capital raises.
MPW trades around 8.5x its normalized cash flow. This seems far too cheap given the strength of its business model, which at minimum should generate low-to-mid single-digit cash flow growth for many years to come. Other REITs with hospital assets currently trade in the 11x-12x range. If valuations persist at these levels much longer, we would not be surprised to see interest from larger players. In the meantime, we will collect a nearly 8% annual dividend.
Data Sources: Company Filings, Bloomberg
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