Minding our P’s and Q’s
FIM Group’s Traverse City, Michigan, office has a new intern in town – William Zank, who will be helping our team with investment research this summer. We sat down for lunch together on his first day and discussed the importance of minding our P’s and Q’s while reviewing current investment holdings and working on new ideas.
At first glance, you might think our investment team found a compelling link between investor manners and investment returns. But no, that’s not the case. Instead, the P’s and Q’s we discussed relate to how an investment’s Price and its fundamental Quality play such an instrumental role in determining its future returns.
Meet the Q-factor…
So that we’re all on the same page, allow me a moment to explain what I mean by an investment’s fundamental quality. I’ll use a made-up term, the Q-factor, to hopefully keep this readable. Financially speaking, the Q-factor of an investment can be thought of as the mix of characteristics that drive the magnitude (how much), the probability (how likely), and the timing of its future cash flows. These characteristics include a company’s business model, its competitive position, its stakeholder relationships, its management team’s ability to lead and adapt, and its financial strength, among other things. Better scores across these areas, or a higher Q-factor, generally correlate with higher levels of expected future cash flow. Rational investors, in turn, focus on this expected cash flow when estimating the fair value of an invest-ment. So, all things being equal, higher Q-factor = higher expected cash flow generation = higher investment fair value.
…and its sometimes irrational friend, the P-factor
Now, as we all know, investment markets are full of human participants (and, increasingly, of machines programmed by humans), which means that rational investment behavior isn’t always a safe assumption. And that’s where an investment’s price, which I’ll call the P-factor, can play such a heavy role in determining future returns. In a “pretend world” without greed and fear, market prices for stocks and bonds would closely track the quality of their fundamentals, or Q-factor. Correctly assess an investment’s quality and set your sails for a nice, smooth financial journey. In the real world of markets, however, emotions often hijack rational thinking. And when this emotional interference reaches severe levels, the P-factor can really tip you into the water with regard to the future return profile of an investment.
Good companies aren’t necessarily good investments
For a closer look at how these P-factors and Q-factors can influence real investment returns, let’s take a page out of the ol’ B-school playbook and create
a quick case study. Procter & Gamble (P&G) is a company most of us know for its iconic household good brands, like Pampers, Tide, Gillette, and Crest. When it comes to the Q-factor, P&G has been a pretty consistent performer. Its earnings per share (shown in Figure 1), for example, have generally trended steadily higher for most of the past two decades. P&G is a company with strong brand power in categories that consumers need, regardless of economic conditions. When it comes to its P-factor though, as reflected by the price/earnings ratio line, take a look at that volatility!
The blue ovals in the figure mark two extremes in the level of investor eagerness to own P&G stock. Investors were willing to pay 38 times earnings during the height of the late ’90s stock bubble but only 12 times at the trough of the global financial crisis in 2009.
The figure also illustrates how much the subsequent shareholder returns varied from investments made at each extreme. Investors who focused only on PG’s high Q-factor in late 1999 suffered negative total returns over the next three years (even though earnings per share rose over that period). Those who pounced on the bargain prices available in early 2009, in contrast, did exceptionally well (despite a decline in earnings). The key point to bang home here is this: Even if you mind your Q’s and you get the quality right, if you should ignore your P’s and overpay, your subsequent investment returns will likely suffer! In other words, good companies don’t necessarily make good investments.
Over the years, our investment team at FIM Group has generally had little trouble with the P-factor. We have not been afraid to pounce on bargains when sentiment is sour, and we have largely avoided high-valuation multiple stocks where far too much growth is already priced in. Like most value-oriented investors, our occasional missteps tend to be with the Q-factor, where our analysis of a company’s resilience proves to be overly rosy.
Companies hit bumps all the time, but most of them are not fatal to stock and bond holders. Marketing campaigns that miss the mark can be reformulated, new product development delays can get back on track, and loss-making divisions can be revitalized, closed, or sold. In fact, more often than not, these temporary, fixable issues create great opportunities for patient and opportunistic investors like us to obtain the purchase prices we desire as others lose their nerve.
Some quality issues, though, turn out to be far less benign. Overly aggressive financial management (causing high debt), dramatic shifts in the competitive landscape, and surprise regulatory changes can upend business models and force management teams and boards of directors into desperate measures.
That’s why, to borrow the Ford slogan, we believe that quality is job 1 when it comes to analyzing and taking actions with the investments in our portfolios. We put significant efforts into this Q-factor analysis, but we also know that we’ll have our share of “value trap” investments that don’t go our way.
These are investments in which the bargain price offered to us proves to be an accurate signal of a fundamental decline ahead.
For example, the educational toy-maker Leapfrog, which we bought for less than the net cash on its balance sheet, proved to be a real dud investment. Long story short, its management team failed to evolve its business model to meet rapidly changing consumer preferences. Within a matter of several quarters, its big cash pile eroded significantly, and the company ultimately sold itself to a Hong Kong competitor for a fraction of the value that we believed was embedded in the brand.
Two investments with great P’s and Q’s
In this month’s Investment Team Spotlight, we highlight CK Hutchison (CK Hutch), a core holding with P’s and Q’s that appear quite attractive. This Hong Kong–based, multi-billion-dollar global conglomerate trades at more than a 30% discount to our assessment of fair value. It has exceptionally high-quality management and competitive positions across mission-critical areas, including personal health, infrastructure, and telecommunications.
I’ll conclude with another FIM Group portfolio holding, Cott Corp (COT), where the P’s and Q’s have played out quite nicely for managed accounts that held it over the last two years. COT is one of the world’s largest producers of private label juice and carbonated soft drinks. Since acquiring DS Services in 2014, it also runs one of the most extensive home and office bottled water and beverage service networks in North America. We noted COT as an Investment Team Spotlight in our July 2014 newsletter, shortly after our initial purchase.
When we first bought COT shares, we knew that there were some Q-factor concerns in the market related to shifts in consumer preferences. The carbonated soft drinks (CSDs) segment that made up a large portion of the company’s sales (35%+) was facing an inevitable industry decline as healthier beverage alternatives grow more popular. COT management had a plan to diversify the business away from its CSD concentration via acquisitions in other beverage categories, but investors seemed ho-hum. We took a more constructive view on COT’s fundamentals, as we felt that it had a very strong competitive position (and could gain share in a declining market), as well as a healthy balance sheet and a management team determined to reposition the company. In terms of the P-factor, shares were trading at only around 7 times free cash flow back in 2014, which seemed like a price that gave zero probability for the success of management’s repositioning plan. (See Figure 2.)
Fast forward to today, and COT management has “walked the talk,” making a series of acquisitions that dramatically changed the company’s business model and future outlook. The most significant of these moves was its 2014 DS Services acquisition. This deal brought a dominant and growing home and office beverage delivery business into COT’s business model and drastically reduced its CSD exposure (now less than 15% of cash flow). The traditional beverage manufacturing segment has gained market share and remains a solid cash generator, while the recent acquisitions provide a new platform for both growth and operating synergies that should continue to benefit COT’s cash flow generation capability. In recent weeks, we’ve trimmed back our COT position (and sold our position in some strategies entirely) to free up funds for other investments. Overall, though, we remain confident that COT has a bright future ahead.
And on the topic of bright futures, I expect that William Zank, our new intern, will make meaningful contri-butions to our investment team this summer. We have plenty of projects in the pipeline, and he seems eager to jump right in. With any luck, he will learn a thing or two, including the point I’ve tried to make right here – that minding one’s P’s and Q’s has applications beyond just the manners department.
With increases in the upper-end marginal tax rates, the addition of Medicare-related surtaxes on investment income, deduction limits, and the like, most of the tax code changes in recent years have made long-term tax planning even more important and impactful. One of the great tax-planning tools that can enhance long-term income tax efficiency is the Roth conversion.
Retirement savers and retirees tend to have a much higher portion of retirement funds in traditional, pretax IRAs or retirement plans than in after-tax Roths. Because of the tax considerations, however, Roths can add significantly to the tax optimization in retirement. Traditional IRAs consist of pretax earned income, taxes on which are deferred until distributions during, typically, retirement. Distributions are recognized as income in the year taken and are subject to taxes at the account owners’ marginal rate in that year. With Roths, by contrast, contributors pay income tax up front – Roth contributions are not deductible from income taxes – instead of down the road on distribution. One of the critical components of the decision to fund a Roth or a traditional IRA in any given year hinges on current applicable income tax rates and those expected in retirement: The lower the current tax bracket and the higher the expected retirement tax bracket, the more appealing a Roth contribution becomes. The inverse – the higher the current tax bracket and the lower the expected tax bracket in retirement – favors traditional IRA contributions.
The Roth conversion, a completely different matter than a contribution, allows IRA holders to move funds from a traditional IRA account to a Roth IRA. The amount moved to the Roth is subject to income taxes that year and thereby removes the tax liability on distributions down the road. That increase in the conversion year’s taxable income is the downside of the conversion. The benefit, of course, is the elimination of any future tax liability on the converted funds. That tax year tradeoff is where opportunity often resides. For current workers, years of a lower-than-normal top marginal tax bracket can be a great time for Roth conversions. To determine how much, the typical approach is to convert as much of the IRA as there is room left in that lower marginal tax bracket. For certain retirees, Roth conversions may also be particularly attractive. The years of retirement before age 70½ and the imposition of required minimum distributions (RMDs) often have lower tax rates for those who are able to avoid tapping a traditional IRA or retirement plan. Once RMDs start, however, the resulting income tax can push top marginal rates to higher brackets. Shifting funds from traditional IRAs to Roths during those low-tax bracket years will reduce the RMDs subject to higher top marginal rates in future years. Care needs to be taken, of course, to ensure that conversion amounts do not push the year’s income into the higher tax brackets.
Some situations might make a Roth conversion seem like a mistake after the fact. Because conversions must be completed by the end of the tax year for the year to which they are to be attributed, income projections dictate how much to convert. For many, it’s difficult to accurately project income before year end. Investment perfor-mance may also take a steep dive in the months following a Roth conversion, leaving the account owner paying taxes on the full conversion amount for an asset that is no longer worth as much. For example, let’s say you converted $50,000 from a traditional IRA to a Roth, increasing your taxable income for that year by $50,000. In the first six months or so of the next year, if poor investment performance caused a 15% decline in value, that $50,000 will have shrunk to $42,500, but you’ll still have paid taxes on the full $50,000.
Fortunately, a Roth conversion gone bad can revert back to the traditional IRA. Called a recharacterization, the convert-ed funds can be reversed back to the traditional IRA as late as October 15, eliminating the near-term tax liability as if the conversion had never happened.
It’s important to be aware of some additional considerations when evaluating a Roth conversion. Longevity risk is one. Normally, longevity risk refers to the financial challenges that might come from a long lifespan. Because a Roth conversion shifts tax payments forward, however, longevity increases the appeal of such a conversion. The more time, the more likely it is that the portfolio can overcome that income tax brought forward. Conversely, an early death could result in not realizing the intended benefits of a conversion.
Many factors determine whether or not a Roth conversion is beneficial, so a thorough examination of each situation is important. In the right circumstances, however, Roth conversions can greatly increase the long-term tax efficiency of a retirement plan.
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CK Hutchison Holdings Limited (Tickers: 1 HK Hong Kong Exchange; CKHUY US Over the Counter, website: www.chk.com.hk)
Share Price/Market Capitalization: US$11.45/US$44.2billion
Company Description: CK Hutchison (CKH) is a Hong Kong–based global conglomerate with operations in Energy & Infrastructure (37% of net asset value), Telecommunications (22%), Retail (22%), and Shipping Ports (18%). Revenue sources are Europe (46%), Hong Kong (16%), Australasia (13%), China (10%), Canada (9%), and other parts of the world (6%).
Investment Thesis: CKH is a high-quality company trading at compelling valuations. Based on 2016 estimates, CKH offers a 2.9% dividend yield and trades at 6 times cash flow and more than 30% below our estimate of fair value. We expect future dividend hikes both because we believe the company has room to increase its payout ratio (now only 30% of earnings) and because we expect high single-digit earnings growth for years to come. We also expect investor sentiment to recover as a recently blocked merger deal fades from memory.
CKH is Hong Kong’s largest listed company by market capitalization. It was formed by the 2015 merger of Cheung Kong Holdings and Hutchison
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