Herbert Stein, Chairman of the Council of Economic Advisers under the Nixon and Ford administrations, came up with a principle many years ago that has guided me over several decades of professional investing. Stein’s Law, as it is now known, is simply this: “If something cannot go on forever, it will stop.” In other words, unsustainable trends are unsustainable.
Let it (the Investing Herd) Go
It never ceases to amaze me how time and time again so many investors fail to heed this basic rule of the universe. Respect for the cyclical nature of just about everything gets chucked out the window as trends of the day gather more and more followers (and investment dollars). I’m not complaining, because this works to our advantage. Let me explain.
I believe that one reason FIM Group has succeeded over the years is this: We’ve refused to follow the herd during times when it throws Stein’s Law to the wind. For example, during the late ’90s Internet boom, we generally said “no thank you” to the highly popular and ridiculously expensive dot-com stocks. Many felt that these stocks were on a straight-line path to the moon, but our rational analysis suggested otherwise. And in the ’08-’09 Global Financial Crisis, when the crowd panicked and priced even the highest-quality companies as if they would go “poof,” what did we do? We held our ground and stayed invested as others chose to cash out at incredibly (and temporarily) depressed prices.
2015: The Year of Cyclical Forgetfulness?
Last year was interesting for many reasons, but a standout for me was the “cyclical forgetfulness” that plagued investors in two very different areas of the market. On one hand, we witnessed a late-’90s-like wave of investor euphoria for “new economy” stocks. Think Amazon, which posted a 117% total return for the year, and Netflix up even more at 134%. Yes, these companies are seeing significant business success at the moment, but will they continue to grow at a pace that justifies market valuations of more than 400 times last year’s earnings? Maybe. But so far this year (as of February 12), both stocks have lost a quarter of their value. Those who loaded up on shares after last year’s stellar results are discovering Stein’s Law the hard way.
On the other hand, 2015 saw a second year of massive declines in the price of oil. After dropping 45% in 2014, West Texas Intermediate Crude Oil (WTI) dumped another 30% in 2015. And just five weeks into 2016, WTI plunged another 25%. Putting this extraordinary move in dollar terms, WTI went from $107/barrel in the summer of 2014 to sub-$30 today. Will this trend continue right on down to zero?
Stein’s Law, and common sense, would suggest not. Are oil markets temporarily oversupplied? Absolutely. Will oil prices below the cost of production persist forever? No way. Yet segments of global financial markets today are reacting as if the new normal will be one where oil companies can somehow figure out a way to sell their product below cost forever.
As our team highlighted during our February Investment Team Webinar (posted at www.fimg.net), we have identified several investments offering compelling value that are currently being impacted by the “oil price heading to zero” mentality in markets today. I’ll add a few comments to one specific example here, with Immofinanz. Suzanne writes about another area of markets where prices seem to reflect too much Oilmaggedon thinking: senior loan funds.
Half-Off European Real Estate Sale
Immofinanz (Schwab ticker: IMMZF) is a leading Austria-based property company that combines property rental (roughly 80% of earnings) with property development (20%) across 391 European office and retail properties. Its net asset value per share (assets minus liabilities) is around EUR4.10 and its share price (February 12) is EUR1.72.
So why so cheap and what does European property have to do with the oil price slump? One answer to both questions can be found in the fact that about 25% of the Immofinanz property portfolio is located in Russia. The company’s five standing investments there are all large retail properties like the one pictured, and these are feeling the brunt of Russia’s current recession. Oil is a huge part of the Russian economy, and its price slump has coincided with a big drop in the ruble, double-digit inflation for con-sumers and slumping wages (see Wages Contract chart below).
For Immofinanz, the Russian economic funk has several temporary ramifica-tions. First, it has been offering short-term rent reductions to keep its tenants in place (these properties are now around 85% occupied). Second, it has written off some rent receivables for tenants who went belly up. Third, it has marked down its property values to reflect the current weakness in rents.
Management must also keep focusing on the other 75% of its business outside of Russia and continue to build long-term shareholder value. We think it’s doing a pretty good job of that despite these tough conditions and that several initiatives underway this year will bring the company back onto the radar of oil-spooked investors. These initiatives include disposing of its legacy holdings in logistics and residential properties and re-establishing a sustainable dividend policy.
In short, we believe that Immofinanz trades at a market price far disconnected from the underlying value of its income-producing properties. The negative stigma currently attached to its Russian assets seems to be the primary culprit for this disconnect. Simply trading back to levels in line with the average Austrian property company (10% discount to NAV), would provide us significant upside given Immofinanz’s more than 50% discount today. Add the resumption of a 3%+ dividend stream this year and the potential for longer-term normal-ization of operating conditions in Russia, and you can see why we remain excited about this holding.
There is no doubt that today’s global economy gives us plenty to worry about as your investment managers. Trillions of dollars of negative interest rate government bonds outstanding, relentless terrorism, refugee crises, potential currency wars, a sure-to-be divisive U.S. election season and the list goes on. What I know is that Stein’s Law is pretty darn robust and that we will continue to let it guide our broad thinking. This will help keep us level-headed when the herd gets overly exuberant about trends of the day and well-prepared to seize opportunities when this exuberance shifts to panic and drives bargains our way.
Critical to successful investing is having a disciplined investment process. Part of such a process during volatile times is keeping our emotions at bay and honing in on the fundamental, long-term value that can emerge as others get panicky. As Paul mentions in his article, minding Stein’s Law (unsustainable trends are unsustainable) can help us take positions in areas where investor sentiment is temporarily depressed. In today’s invest-ment landscape, we believe that one such area is in senior floating rate loans.
What Are Senior Floating Rate Loans?
Senior floating rate loans (sometimes referred to as leveraged loans) are variable-rate debt instruments created by banks and other financial institutions that are extended to large corporations. Borrowers apply for these types of loans to restructure their existing debt and equity mix to stabilize their capital structure, refinance higher-priced debt, finance possible acquisitions and expand their businesses. The floating interest rate adjusts periodically, typically every 30, 60 or 90 days, based on a predeter-mined credit spread above the LIBOR (London Interbank Offered Rate). LIBOR is a key lending benchmark rate for short-term loans between the highest creditworthy international banks. This rate essentially reflects the market pulse of systematic risk within the financial system.
In general, senior loans mature in seven years. They are referred to as “senior loans” because they are collateralized by specific company assets, such as the borrower’s inventory, property or receivables. These assets are senior and first in priority when servicing debts. The fixed credit spread is negotiated at the time the loan is extended and is tied to the credit quality of the borrower. The borrower’s credit is based on the market value of the collateral used when the loan was created and any covenants that restrict the borrower’s actions when other conditions are met.
Plain Vanilla Bonds vs. Senior Floating Rate Loans
Both plain vanilla bonds and senior floating rate loans are debt issued by companies. The main difference is that the interest rate for the plain vanilla bonds is fixed for the life of the bond with no direct ties to the borrower’s assets, whereas the interest rate for senior floating rate loans resets at regular intervals and has a secured claim on the indebted company’s assets. Should general market interest rates go up, then the price on the vanilla bonds would fall. The opposite occurs if prevailing interest rates drop, and the price of the bonds will increase. Thus, there is an inverse relationship between the movement of market interest rates and the price of plain vanilla bonds.
On the contrary, since the interest rate floats with a senior floating rate loan, the market value of these loans is far less volatile to variations in market interest rates. Another advantage of senior floating rate loans is that on average, a plain vanilla bond that files for bankruptcy will recover approximately 40% of its face value, while a senior floating rate loan recuperates about 80% (see Figure 1).
Senior Loans Less Exposed to Energy
As Paul also mentions in his article, Oilmageddon has created a ruckus across a wide range of asset classes. Global credit markets have not been immune. We believe that concern with upcoming defaults in the energy patch is one reason we’ve seen recent weakness in the senior loan space. What’s interesting about this though, is that unlike the high yield, plain vanilla bonds sector in which energy plays a fairly large role (around 15%), the energy sector exposure within the senior loan universe is far less (around 4%) as seen in Figure 2. While prolonged stress for the energy sector could certainly have a contagion effect on other sectors, investors seem to be painting too broad of a negative brush over senior loans, and we believe that creates an opportunity for us.
Gaining Senior Loan Exposure Through Closed-End Funds
Senior loans tend to be traded by large institutions and are hard for us to cost-efficiently buy and place into individual accounts. Fortunately, there are a variety of closed-end funds that provide an effective vehicle for us to gain exposure to these investments. Closed-end funds also feature additional advantages and return opportunities as I’ll note with
an example below.
Nuveen Credit Strategies Income Fund (NYSE: JQC) is one of the closed-end funds focused on senior loans that we’ve been buying for our Balanced, Balanced Conservative and Yield Income client portfolios. One advantage for us with JQC is its specialized management team, which has a long track record managing in the senior loan market. This team is not just buying the whole index, they are performing deep analysis, one loan at a time, and structuring the fund for superior returns. A second advantage with JQC’s closed-end fund structure is that it is “permanent capital.” This means that, unlike a regular mutual fund structure, JQC’s managers do
not have to deal with the constant subscription and redemption demands of its shareholder base, which usually occur at just the wrong time. In other words, shareholders wanting to add money to the fund after a period of strong performance when loans are more expensive and those wanting to take their money out during more fearful times when the loan market, is full of bargains. A third advantage with JQC is that we are afforded cost-effective diversification.
As of 12/31/15, JQC had 254 holdings, of which the large majority were senior loans. JQC diversifies quite heavily across companies and sectors with its top sector concentrations in Software (9.3%), Media (8.3%), Hospitality (5.7%), Telecommunications (5.4%) and Real Estate Investment Trusts (4.3%). Like the broader senior loan universe and as explained above, JQC’s exposure to energy is very low.
A fourth advantage to accessing senior loans with closed-end funds is the fact that the funds themselves trade independently of their underlying portfolio net asset values. Because of this, during times of fear, which we seem to be in today, investor demand for these funds can falter and cause their prices to trade at extraordinarily large discounts. With JQC, you can see in the orange shaded portion of Figure 3 that its discount to net asset value has widened to 16%. This presents an additional return opportunity not available to those owning the senior loans directly or through a mutual fund or exchange-traded fund. We would anticipate that as sentiment normalizes, this discount will narrow back toward historical averages and provide additional returns to those we expect from: 1) annual distribution yields of roughly 8% today; and 2) net asset value appreciation as the senior loan sector comes back into investor favor.
Senior loans are surely not devoid of risk. Recessions can lead to an up-cycle in defaults just as it can for other areas of high yield credit. That said, we believe that today’s senior loan prices sufficiently reflect a much darker default situation and therefore provide us with a healthy margin of safety. This margin of safety is further enlarged via the closed-end funds we own as discounts have widened to unusually high levels. While we should anticipate that these closed-end funds will trade with more day-to-day volatility than their underlying loans, we believe this is a small price to pay for their above-average expected returns. And as part of our overall portfolio strategies, we think an allocation to these funds makes great sense. Someday, the market will worry again about inflation and higher rates and get re-excited about owning secured loans with income that increases as
rates increase. When it does, we’ll be rewarded for buying when deflation was the dominant theme of the day and prices for these investments were so attractive.
A favorite saying of mine: “Don’t let the short-term ‘stuff’ blur your long-term vision ... and there will always be short-term ‘stuff’!”
In turbulent times and market volatility, investors get nervous and the focus shifts from a long-term mindset to what I consider an instinctive desire to “jump off the cliff.” This is a natural response, yet one that may lead to financial devastation. The primary role of a financial adviser is to educate clients that market fluctuations are just a part of the cycle, and they should not allow short-term fluctuations lead to “bad behavior.” Volatility may occur due to a change in leadership, a drop in oil prices, a poor jobs market report, or a less than desirable outlook in the global markets. These short-term “catastrophes” are typically short-lived, lasting anywhere from a few weeks to a few years (2007-2009). But what does this really represent over a span of 25-30 years?
If the goal is to achieve (and/or preserve) financial wealth, one must remain disciplined and not allow market volatility to lead to poor decisions and a permanent loss of principal. A loss of value does not equate to a loss of principal, nor does it mean it’s a bad investment. A loss of principal comes from selling an asset for less than what you paid for it. If an investor has done his/her due diligence, has completed a thorough and fundamental analysis, and comes to the conclusion that the loss in value is from “bad news” or the herd selling in fear, this creates an opportunity to buy more at a discounted price. This is what FIM Group does for client portfolios – i.e., looks for well-managed companies, paying decent in-comes, with a potential for capital appre-ciation over the long run.
So what can investors/clients do during market corrections? Well, the first and most important step is to NOT panic, take a deep breath and reassess their personal financial situation. This is best accomplished by sitting down with their financial adviser for a review.
The following are topics to consider:
Whether you are the faintest of heart or have nerves of steel, remember to focus on the long term and don’t allow short-term chaos to effect the long-term goal. Again, there will always be short-term chaos attempting to defeat your financial goals. If you find yourself standing on the edge looking into the abyss, it’s probably a very good time to connect with a Certified Financial Planner for a review.
Silver Wheaton is a precious metals streaming company with revenues split roughly 60-40 (shifting to more than 70% silver in the coming years – silver has more industrial demand than gold) between silver and gold. Typically Silver Wheaton makes an upfront payment to a miner for some percentage of future mining production. As production occurs and the precious metals are delivered to Silver Wheaton, a delivery payment is then made to the miner (usually quite far below the spot price of the metal).
Silver Wheaton has 22 operating mines and seven projects in development.
Partners: Vale, Glencore, Goldcorp, Barrick, Lundin, Eldorado, Hudbay, Pan American, Primero, Capstone, Alexco and Sandspring
Not ones to speculate on the near-term movement in commodities prices, we have decided to take a different tack with Silver Wheaton. Three factors should be understood foremost: SLW’s debt, cash and cash flows. Rough math:
– If silver and gold prices stay where they are today, then SLW should be in a net cash position circa mid-2019 (barring any additional acquisitions). If silver and gold prices drop 10% immediately (and stay there), then SLW should be at a net cash position circa the end of 2019. Should silver and gold prices drop 25% immediately (and stay there), then we would expect SLW to be in a net cash position circa mid-2020. [If we add in SLW’s potential tax liabilities in Canada, net cash estimates get pushed out roughly six months.]
– If precious metals prices are down 25% from here, the sector will likely be in great turmoil; while SLW would be okay on paper, we would be closely watching its counterparties/partners (as we already are).
Now, obviously, this is an overly simplistic way of looking at SLW – if we were only to look at these metrics. So how is this useful? All things being equal, we can discern from the above information that SLW has modeled its agreements around lower precious metals prices for longer. Even its most recent deal, which looks expensive at first blush, when scrutinized appears to be at a ~18% discount to spot silver prices.
Okay, so we know that SLW’s operations don’t entail much overhead, its deals seem good on paper, and its proven and probable reserves look decent. What about its counterparties? While the entire sector looks stressed, there is a silver lining; increased activity between the streaming/royalty companies and traditional miners has been improving balance sheets – while also providing cash to the miners, keeping mines operating and streams/royalties flowing. We like the idea of being in the same camp as the “lenders of last resort.” SLW management has also done, what appears to be, a decent job diversifying its partners and assets.
With cash from operations expected to grow significantly (high double digits) and a dividend policy set at ~20% of cash from operations, we believe we have found an operator in the precious metals space that will not exhibit the traditional risks of the sector, specifically: massive leverage, a business model predicated on ever-increasing metals prices, and (unbeknownst to many) base metals prices – often the key determinant in whether miners are able to generate positive cash from their operations. We expect SLW to pay a ~2.3% dividend in 2016, growing in line with its operating cash flows, which should increase even if precious metals prices drift moderately lower.
Data Sources: Management Meetings,
Company Filings, Bloomberg,
25 January, 2016
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