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2017 May Newsletter

Zach Liggett, CFA®
By: Zach Liggett, CFA®

Spring Webinar Wrap

As we do at the end of each quarter, the FIM Group investment team holds a webinar for clients. Our latest took place on April 26, and a recorded version is archived on our website at http://fimg.net/media. Highlights this quarter include a general recap of market conditions and FIM Group investment performance, a discussion of recent portfolio actions, and a very-long-term look at global living conditions. 

Fading Trump Bump?

We started with a review of market conditions. Steady tailwinds supported many global stock, bond, and commodity markets during the first few months of 2017, although signs are emerging that the “Trump Bump” may be fading. Market participants most bullish on the prospects for domestic policy reform are beginning to hedge their bets. The failed repeal of the Affordable Care Act began a reset of Wall Street expectations. These expectations were based on the hope that corporate tax cuts were just around the corner, along with a sweeping, “shovel-ready,” domestic infrastructure program. Wall Street “old-timers” who recall the five years it took for Reagan to accomplish tax reform legislation starting in 1986 are no longer being ignored. 

Partisan Conflict Index

Gridlock in Washington is obviously nothing new, as our media dutifully remind us daily. On that point, look at the nifty chart below from the Philadelphia Federal Reserve. Dubbed the “Partisan Conflict Index,” it measures the frequency of newspaper articles reporting political disagreement among U.S. lawmakers each month. While an optimist might look at this hockey stick and conclude that we’ve reached “peak dysfunction” (and that the road from here can only get easier!), there certainly isn’t much evidence of that at the moment. 

Politics abroad have also been a dominant theme in financial markets so far this year. In the U.K., a surprise June 8 election adds a new wrinkle to upcoming BREXIT negotiations. Across the English Channel, federal French elections are raising fresh questions about the vulnerability of the Euro experiment. And as if that weren’t enough, there’s that pesky dictator on the Korean peninsula lobbing ballistic missiles and threatening thermonuclear war.

Unfazed by Political Uncertainty

Yet, when it comes to the market’s digestion of all this political noise, investors remain eerily complacent. For example, so far this year, the S&P 500 has closed up or down greater than 1% only two times. In the full years of 2015 (72 times) and 2016 (48 times), such moves were far more common (see figure above). Unfazed by the political uncertainty, market participants have generally been content to take their cue from global economic and corporate financial developments. 

S&P 500 more than 1 percent days

On that front, the news has generally been decent. Most major economic powers in the world are reporting relatively respectable growth and subdued inflation. This includes even Japan, where the economy showed growth in each respective calendar quarter of 2016 for the first time since 2005. (Kampai!) In terms of corporate earnings, results and outlooks have also been positive, in aggregate, through most parts of the world.

Along with the reasonably good economic and corporate financial fundamentals, market valuations have stayed fairly elevated for both global stocks and bonds. Measures like price/earnings ratios remain particularly high in the U.S. stock market, while bond prices globally continue to trade near all-time highs (yields near all-time lows). This backdrop supported solid global stock market returns, while bonds and precious metals have benefitted from “safe haven” demand amid the big geopolitical-question marks (see figure below). 

Major Stock Markets

FIM Group Performance and Positioning

Amid the market environment noted above, FIM Group-managed portfolios started the year off on a solid note. Our international stock exposures in high-quality conglomerates like FFP, Pargesa, Investor AB, Haw Par, and CK Hutchison were top performance contributors, along with niche growth companies like Gaia and Crius Energy, as well as precious metals royalty companies like Royal Gold and Silver Wheaton. Strength in these areas was partially offset by continued poor share-price performance at the Canadian investment company Dundee Corp, which remains in the early innings of a turnaround (and a position we are monitoring closely). U.K. maintenance services giant Interserve, a company coping with above-expected costs from an exited energy-from-waste business, was also a negative contributor. On the fixed income side, performance was influenced by benign bond market conditions and a heavy tilt to plain-vanilla, U.S. Treasury bonds. 

Our team continues to stay patient on both the stock and the bond front. We are largely avoiding the heavily index-owned U.S. blue chip stocks, on valuation concerns. The same goes for most fixed income closed-end funds, where attractive value has been difficult to find. We continue to emphasize smart diversification, balancing investment xposure to underlying cash flows that are more cyclical in nature with those that are more defensive. An example of the former is our holding in Symphony International, which, among other assets, owns Asian restaurants and hotels. Phoenix-area water utility Global Water Resources, with a very stable cash flow profile, is an example of the latter.

Currencies and Commodities

Major Bond Markets

Tip-Toeing into U.S. Retail-Related Stocks

One of the specific investment areas we began targeting over the last few months, albeit with modest exposures at this point, are beaten-up U.S. retail-exposed companies. For example, we’ve started small positions in Vitamin Shoppe (sports nutrition, health and wellness products), and Sequential Brands Group (which licenses brands including Martha Stewart, Emeril Lagasse, Heelys, and Gaiam). Each of these investments has its own dynamics, although a common theme shared by all is subdued investor sentiment. A main source of this negative sentiment is the perceived business risk coming from e-commerce giants like Amazon. While we believe that these risks are real, we also believe that the management teams of these companies are adapting. Poor investor sentiment has pushed valuations to levels (mostly mid-single-digit price/cash flow multiples) that we believe significantly undervalue their long-term prospects.

Spirit Realty Capital

Another stock we’ve added amid these same “brick and mortar” retail concerns is Spirit Realty Capital. Spirit is a U.S. real estate investment trust that owns over 2,600 retail properties. These are not traditional department store-anchored shopping malls, but rather standalone buildings in high-demand areas. Tenants include the likes of Wal­greens, Church’s Chicken, Advanced Auto Parts, and The Home Depot. Most of Spirit’s leases are structured with built-in inflation escala­tors on a long-term “triple net” structure. Tenants are responsible for property improvements, operational expenses, and taxes. 

We believe that the market is under-appreciating major changes that Spirit manage­ment has made over the last four years to de-risk its business (see figure above). These include significantly reducing levels of both tenant concentration risk and debt. The result is a portfolio and balance sheet that measures up well to listed peers on most fundamental metrics, yet a stock that trades on far cheaper valuations. For example, Spirit trades at 12x funds from operations (a common cash flow metric for REITs) compared to a 16x average for its peer group, while offering a 7% dividend yield (5% peer average). We expect this valuation gap to close with time as management continues to execute on its portfolio restructuring and growth initiatives while paying close attention to cost control.

Keeping a Long-Term Perspective

Before fielding questions, we wrapped up the webinar with a few comments on the importance of taking a longer-term view. As investors, one of the biggest potential pitfalls we face is getting sucked into the “short-termism” that so dominates society today. Keeping a long-term perspective when distilling data and information is critical to making sound investment decisions. Our featured chart related to this point was the one below, sourced from the University of Oxford’s Our World in Data (OWID) online publication, which can be found here: https://ourworldindata.org. The visual takes a 200-year look at the history of global living conditions across six basic categories. I found it an interesting contrast to surveys that often conclude “things are getting worse,” as well as a good reminder that despite the world’s near-term challenges, we still have much to celebrate. 

The World as 100 People

Lucas Schwaller, CES®
By: Lucas Schwaller, CES®

We'll See, Says the Zen Master

One word above all others seems to describe the first 100 days of the new administration, and that word is unpredictability. This is not to say that unpredictability is a bad thing … or a good thing, for that matter. No, this article is independent of political leanings and ideology. Donald Trump wasn’t a traditional candidate, so it’s no surprise that we’re getting something new from him. There’s new rhetoric to decipher, a myriad of things said on the campaign trail or tweeted late at night that the 24-hour news wendigo churns into content or that the Internet ghouls – on both sides – craft into #MAGA or the latest call for impeachment. But how much of it actually lends itself to substantive, lasting change? And how much of that change is actionable for our everyday lives (that is, affecting some law or policy that requires a decision to be made as a direct consequence)? It seems that somewhere in all this rhetoric and unrest we’ve gotten lost in the headline, the meme, the tweet.

Whenever I hear or read some piece of news, some development that’s so packed with hyperbole that the context points to either the end of the world or the dawn of a new golden age, I’m reminded of the parable of the Zen master from the underrated movie Charlie Wilson’s War:

There’s a little boy and on his 14th birthday he gets a horse, and everybody in the village says, “How wonderful. The boy got a horse.” And the Zen master says, “We’ll see.” Two years later, the boy falls off the horse, breaks his leg, and everybody in the village says, “How terrible.” And the Zen master says, “We’ll see.” Then, a war breaks out and all the young men have to go off and fight... except the boy can’t cause his leg is all messed up. And everybody in the village says, “How wonderful.” And the Zen master says, “We’ll see.”

In this new norm of unpredictability, then, what am I to say to a client who asks me for my views about the estate planning landscape, specifically with regard to tax policy and the potential for a repeal of the estate tax? “We’ll see” may provide a healthier philosophical outlook for the larger pieces that are out of our control, but it has no place in estate planning. Estate planning is intimate, often delicate, having tangible, real consequences and benefits – not to mention pitfalls for those we care about most. So, I tell clients to worry about the things within their control and to…

There’s no justifiable reason to wait until there is a more definitive tax policy to discuss estate planning with your adviser.

Plan Today, Not Tomorrow

There’s no justifiable reason to wait to discuss estate planning with your adviser until there is a more definitive tax policy. For one thing, a significant aspect of estate planning involves transferring assets to irrevocable trusts, which offer a number of benefits that have nothing to do with taxes (asset protection, divorce protection, business continuity in the event of a disability, and so on). In addition, it may actually be better to go forward with tax planning before drastic changes are made in the policy, because many professionals do not believe an estate tax repeal would come without a sunset provision (e.g., in ten years the taxes will come back into force). Not to mention the fact that future administra­tions may reinstate whatever estate taxes this administration repeals. We’ll see.

Perform Routine Maintenance 

While it’s natural and even deserved to feel a sense of accomplishment or relief when the components of an estate plan are put into place, know that an estate plan is not the sort of thing that’s ever completed, at least not until one passes away. An estate plan is a living thing, and it must be updated and tweaked to reflect the changes that occur naturally in our lives. The general rule of thumb is that you should review your estate planning documents at least every five years or after a major life event – for instance, the birth of a child/when children are no longer minors, relocation to another state or country, the death of a spouse/family member, a medical emergency, care required for special-needs dependents or a family member, a major purchase or sale (homes, property, business), a falling out with a family member, to give only a few examples. 

The primary components of an estate plan where this maintenance should be focused are the will, advance directives, trusts, power of attorney documents, and life insurance. Each of these should be analyzed critically to determine whether you’re still pleased with your choices and understand them fully. This is your life and legacy, and you likely didn’t pay an attorney to draft all those documents out of the kindness of your heart. Confirm that everything still meets your wishes and that you’ve done everything you can with the information you and your adviser have available.

Mandalay Resources Corp

Mandalay Resources Corp 
(Ticker: MND CN/MNDJF)
Share Price: $0.58/$0.43 CAD/USD
Market Capitalization: $261.7mm/$194.1 mm CAD/USD

Mandalay Resources is a Canadian precious metals mining company (gold, silver, and antimony) with producing sites in Australia, Chile, and Sweden. 

Born out of the Global Financial Crisis, Mandalay Resources employs a strategy uncommon in the precious metals mining industry. If not for its industry, we might call it conservative; at any rate, it surely is prudent. In 2009, the current management team/board came in and took over the company, investing sizable amounts of their own wealth.

Bradford Mills, formerly CEO of Lonmin PLC and a past president at BHP Billiton (with three decades of experience), joined with Dr. Mark Sander, a PhD in Ore Deposits and Exploration from Stanford University (with two and a half decades of experience), to create a unique entity in the mining sector. Together with their investment vehicle, Mr. Mills and Dr. Sander own roughly 7% of the company.

What attracted us foremost is their value proposition. And we aren’t talking about the speculative play you often hear discussed when people speak of mining gold and silver. 

Their strategy is straightforward:

  1. Acquire “unloved”/undervalued assets at a deep discount
    • Target 3-5x value creation in 3-5 years 
    • Base case: a 2x return on investment
  2.  Improve through value-additive exploration
  3.  Improve mining and processing methods
    • Safer, leveraged technological improvements (e.g., mechanization)
  4. Assets must be near to/already producing (i.e., cash generative)
    • Target cash costs to be 50% of realistic metal price expectations (i.e., mean reversion)
  5. Flat management structure
    • Keeps costs low and gives local teams the flexibility to adapt and improve
  6. Keep leverage low; currently they are in a net-cash position
  7. Return capital to shareholders
    • 6% of trailing gross revenue

Bjorkdal

Bjorkdal

Costerfield, purchased in 2009, is in Australia and, by our math, accounts for roughly 10–15% of the net present value of the company. This was a neglected asset held by a coal mining company. When purchased, the mine held “zero” reserves; but to date they have been mining for seven years and there are at least four years of proven and probable reserves in the ground. 

Cerro Bayo, in Chile (2010, from Coeur d’Alene Mining), makes up roughly 35–40% of the net present value of the company. When purchased, the mine held three years of reserves. Mandalay has been continuously mining there for six years and believes there are at least four years of reserves left. 

Björkdal, in Sweden, was acquired in 2014 (via the takeover of Elgin Mining), and makes up the remainder of Mandalay’s net present value. Since 1988 over one million ounces of gold have been mined, and the resource life has continued to grow, with over 200,000 ounces recently added to the reserves – driven by a greater understanding of the minerology there. 

Challacollo and La Quebrada, both in Chile, are exploration assets that the market is valuing at a virtual donut but that could be worth some 15-20% to net present value of the company. At Challacollo the company set out to find a new water source so as not to negatively affect agriculture in the region (even though it already had permits); these delays are nearly behind them and we expect more news on the asset shortly. La Quebrada is a smaller asset and we would expect to see it divested in the near future. 

“Our strategy is repeatable and sustainable,” says CEO Dr. Mark Sander. “Costerfield & Cerro Bayo have already delivered our target returns, and Björkdal is well on its way…. We are determined to deliver similar or better performance as we develop our next acquisition targets.”

While there are natural ebbs and flows to its industry (precious metals prices aside), through cycles we expect a team such as Mandalay’s to be able to work through rough patches. Currently Cerro Bayo is going through one of those patches, yet it is believed (and we are inclined to trust management) that capital expenditures today will pay off in 12-18 months’ time. 

As for precious metals prices, we are aware of their volatile nature and feel emboldened, because Mandalay is a proven, low-cost producer. Add in a discount to the resources that they present­ly own (FIM Group’s net present value calculation) and we are confident that we can realize solid returns through a market cycle. At today’s valuations, we are getting a dividend in the 6% range. This dividend will grow as assets produce more, as additional assets are acquired, or if precious metals prices increase. 

We like that two of these drivers are controlled by a proven, prudent management team that is invested alongside us. Also, receiving 6% of gross revenues via dividend is a setup we don’t often come across, providing a more-direct return for investors. 

Chile

Management has been proactive on other fronts, employing hydroelectric power in Sweden; as well as wind power, solar evaporators, and reverse osmosis in Chile. On the reclamation front, Mandalay Resources appears to be a no-corners-cut entity. Coupled with improving safety rates and community outreach, we believe Mandalay has been and will continue to be a solid corporate citizen. We see a good balance between shareholders and stakeholders at Mandalay.

We look forward to hearing about a new acquisition in the next 12-18 months that will solidly underpin Mandalay’s growth story. In the interim we will stay tuned in, remain in close in contact with management, and perform a site visit or two should the opportunity arise. 

Sources: Company, Bloomberg

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