My son William keeps bonking his head. He is seven months old and has yet to learn that there is a “causal relationship” between his movements toward something hard and a bonk. My wife Amy and I are veteran parents and know that it won’t be long before he figures this out, but in the meantime we try to soften the impact of these lessons with a “baby-proofed” home. So we climb over gates, rotate him in and out of his playpen safe zones and try to keep him away from the dangers he has not yet learned to avoid. All of this, of course, is normal stuff. Our other four kids know that electric outlets, Christmas tree lights, a steaming cup of hot chocolate, grabbing Dad’s Thanksgiving dinner plate, dogs, cars, water, heights, stoves and stairs all bring with them various risks. For now, William will have the ability to go where he wants in his constrained environment. Eventually he will have risks introduced as he is emotionally, mentally and physically ready for them. And before we know it, we’ll find ourselves missing the hurdle routine required to traverse from one room to the next.
Managing Risks as a Seven-Month-Old
As he gains life experience, William will learn that the world is full of risks. He will learn to manage these through acceptance (Earth gets hit by meteor), avoidance (get out of the road), minimization (wear a seat belt) and other means. When it comes to investing risks, he will, with any luck, buck the trend that continues to trip up many of his fellow humans who have trouble with the basic concept that uncertainty and risk exist. It seems that some very smart people still try to manage their investing affairs as if they are seven-month-olds. They park themselves in very constrained environments, hoping to avoid the risks they perceive as most threatening to their financial futures.
A zillion years ago when I started to study this investing stuff, one of the first concepts hammered into my investing soul was the simple premise that ALL INVESTMENTS HAVE RISKS. Sure, there’s the obvious risk that comes from a “hot” broker-touted biotech stock with no revenues or the newest social media darling IPO priced at absurd valuations. Most investors understand that these types of speculations will put their capital at serious risk of impairment. But what about the other end of the spectrum, like government bonds, FDIC-insured CDs, guaranteed annuities and the like? Think that these investments are risk-free? Think again. Here, the risks of capital loss are less obvious but nonetheless just as serious, especially in today’s zero-interest-rate environment. These investments, which promise fixed returns, do not promise to keep up with even the relatively low inflation levels we’ve averaged over the last two decades. Introduce a scenario of above-average inflation like we saw in the ‘70s and these investments will result in significant losses to what matters most for investors: their future purchasing power!
Then there’s the whole issue of lost opportunity cost. When you lock up your money in a 3%-pay annuity, not only do you face the prospect of watching your future purchasing power erode away to inflation, you also give up the potential to earn much better returns in other investments. Take some of the select real estate investment trusts (REIT) that our team has been buying in recent months, as just one example. Many offer at least double the 3% cash yield of the annuity AND real opportunity for long-term capital and income GROWTH.
The High Price of Low Volatility
Since I have been in this world, interest rates on one-year U.S. Treasury notes have been below 1% and above 16%. Inflation, stocks, bonds, real estate, gold, energy and pretty much everything else with a price has fluctuated. This is the reality of markets and need not be a bad thing. As I often repeat in my communications, everything is CYCLICAL. But to many investors, the changing prices that accompany the cyclical nature of economies and markets are painful (at least on the downside of the cycle, complaints are pretty rare on the upside). Often, volatility obsessed investors will behave in very self-defeating ways to avoid fluctuating assets.
Wall Street banks and insurance companies reinforce the volatility = pain meme and are happy to create products to soothe this volatility anxiety. They sell “low-vol” and guaranteed return products that are supposedly cycle-proof, but often fail to transparently explain their true costs. Under scrutiny, the costs of the volatility dampener, whether it be in the form of options, futures or synthetic insurance products all wrapped into a pretty package, usually far outweigh the benefit of the lower volatility.
So to sum up the first part of this note, risk is an investing problem. All investments have risks, cycles happen, trends happen, humans get greedy and fearful, and everything fluctuates. Wall Street knows all this, leverages its position with the financial media to amplify our anxieties further, and then sells worried investors volatility elixirs that rarely, if ever, deliver more than they cost.
Do You Wish to Know More About This Investing Problem or Solutions to This Problem?
Having sat on corporate and non-profit boards and spent time with academics and politicians, many “well-educated” folks seem inclined to concentrate on a given “problem” rather than the solution. We know that things fluctuate and that risks exist in investing. So spending oodles of time over-analyzing the problem seems silly. Gravity exists. William’s head gets drawn to our wood floors by gravity. Do we need a study to prove gravity exists?
Forward-looking solutions are where the big payoffs are, not only in investing, but also in life, business and relationships. While we must learn from the past, we must not stare at it to the point of paralysis. Now in full disclosure, as most readers are aware, I am a member of the World Futurist Society and used to speak at their conferences earlier in my career. Five kids later, my speaking schedule has slowed down quite a bit, but I remain as focused as ever on finding solutions in a world that is constantly changing.
Werner Heisenberg had a thing or two to say about uncertainty, motion and change. I infer from Heisenberg’s reflections that the more you think you know about where things are, the less you know about where they are going. Heisenberg studied nature, particles and such and realized that you must study moving things while they are in motion rather than in an isolated, stationary state. A falling rock needs to be studied as a falling rock, not just as a rock. Baby William needs to be studied as a seven-month-old in motion, not while stuck in Mom’s arms, his car seat or crib.
Perhaps Heisenberg studied Zen stories, as one of my favorites is about a monk who asks his young student to study the river. The student went down to the river with a pail and grabbed a bit of the river and brought it back to his hut. He then stared in the pail to learn about the river.
Not Just the Facts Ma’am
I’ve had some similar experiences to this monk over the years with young aspiring investors who proudly stated that they have read The Wall Street Journal cover to cover for years. I ask if they have ever read any books on investing by real professional investors, interviewed any professional investors, attended any seminars by investing pros. or invested their own money. Most have not, which means they might have a good grasp of current facts, but very little context for these facts and even less of a clue on what kinds of investing decisions might be warranted by these facts. The Wall Street Journal does a credible job of telling us what is happening in the world of business and markets, but these facts are just a snapshot in time of a variety of fluid, ever-evolving situations. In isolation, such facts are of little use if we have no context or experience by which to digest them and take ACTION. I will not recast “facts” or “what is” in this note. We are all familiar now with the incredible levels of central bank liquidity sloshing around global financial markets, the complacency building among average investors, high valuation levels of many assets and the exuberance sprouting in certain areas like social media IPOs. Instead, I will conclude by discussing some of the actions we are taking as the year-end approaches. Thoughtful investment actions, after all, are partly the solutions to the problem of ever-present investment risk.
Year-End Clearance Sales
FIM Group portfolios are invested in good quality investments, some of which are currently out of favor and facing selling pressure as we end the year. Looking at this as a problem, three common traits stand out as reasons for this selling pressure: taxes, window dressing and investor psychology.
As for taxes, it is a typical fourth quarter seasonal phenomenon to see investors sell securities that are down in price for the year in order to lock in realized losses for tax purposes. This is especially so in years like this year, where U.S. equity markets’ performance has been strong and investors seek to offset gains elsewhere in their portfolios. As the year winds down, the balance between sellers and buyers leans heavily toward sellers as they scramble against the year-end clock. This puts pressure on prices until the New Year begins when the balance reverses, tax-loss sellers are nowhere to be seen and buyers bid prices up again.
Window dressing refers to the common practice among investment managers at year-end to “pretty up” their portfolios by selling under-performing positions. Some investors only look at their professionally managed portfolio once a year so the manager will sell the losers at year-end so he/she doesn’t have to explain why they bought a stock like Blackrock Real Asset Equity Trust at more than $18 (June 2008 high) that is now under $9. This puts further pressure on out-of-favor stocks into the year-end.
In terms of investor psychology, we have chatted often in the pages of our newsletters about the recency effect. This is the predisposition to take current information and give it substantially more decision-making weight than history or facts would support. So if something is going up, people pile on, usually after its price hits levels far beyond what the fundamentals would justify. When prices are falling, the recency effect can kick into gear and go the other direction, causing prices of underperforming securities to fall well below their fundamental values.
All three of these things: tax-loss selling, window dressing and, of course, the always present investor psychology are taking place right now. This creates a significant low-risk opportunity to boost long-term portfolio returns by buying year-end, clearance sale-priced securities. At FIM Group, we are patient, opportunistic investors. I suspect that our willingness to be a buyer of out-of-favor securities during a time when seasonal pressures are often the highest will benefit our client portfolios longer term.
Vacations Can Wait
These year-end investment clearance sales can be so attractive that I tend to never schedule a vacation over the Christmas holidays. People often procrastinate and wait until the last minute to “give up” and sell the securities they once “loved.” Most investors, even professionals on holiday, prefer not to slog into the office to watch for investment opportunities created in the last weeks of December. I suspect that this year may have very pronounced year-end distortions, so we will be ready.
Life Is Good
I am writing this early in the morning as my family sleeps. Often William is awake at 4 a.m., thankfully, he usually falls back to sleep after a bottle. My office is “bonk-proof” so no worries for now. Before long, he will be able to reach my computer keyboard, and then I’ll have to shift some things around to manage that risk. Yes, life has risks. And investing has risks. We can manage these risks by being forward-thinking, applying our experience to the facts of the day, and concentrating our efforts on solutions. FIM Group celebrates 30 years of looking at solutions next year. Life is good. Happy holidays and blessings to all.
While chatting about waste and displaced effort of governments, businesses and individuals, a friend mentioned she had just read or heard a commentary on “precycling.” Although my spell checker says precycle or precycling aren’t recognized words, Wikipedia defines precycling as “the practice of reducing waste by attempting to avoid bringing items which will generate waste into the home or business.” The basic idea is that by making additional upfront effort you can avoid unnecessary waste, reduce costs and improve efficiency.
What a great concept. It resonated with me in terms of all endeavors, including investment management. Precycling is about making a pre-emptive strike, investing time, thought and effort at the front end of an action to achieve a better outcome, including reducing waste that needs to be recycled. By exercising significant care up front, costs and other undesired consequences can be reduced.
This concept is very much at the core of FIM Group’s investment process. Our primary goals are to grow our clients’ wealth over time, increase their portfolio income especially near and during retirement, and avoid permanent loss. One of the most important processes we deploy to attain these objectives is precisely this concept of precycling.
Before making an investment or constructing a portfolio of investments we:
From the client end there are pre-emptive actions clients can help with to improve their results:
Before we make an investment we research and examine its quality and financial health. We look at factors including debt, cash-flow, credit-worthiness, earnings power and other measures of financial strength. We also look at the competitive, economic and regulatory forces and try to ascertain whether the business model is optimal given those factors. We explore and talk to management of most companies we own as well as to other analysts and industry experts to flush out our suppositions.
Price Discipline/Margin of Safety
Once we determine a potential investment meets our fundamental criteria, we estimate the rational or intrinsic value of the investment. We also quantify what we believe is the potential downside for each investment and determine a sufficient “margin of safety” (the target “discount” or amount below the “fair value” of the investment) to determine the maximum price we are willing to pay for it. Once the price of such an investment is below this buy limit, we compare that investment to all other potential investments available at that point in time to determine if it is a superior opportunity.
In our November webinar we talked about doing “market shock dress rehearsals.” Here, we regularly analyze how our managed strategies might react to a significant market shock or a “bear market” correction. Our investment team applies conservative assumptions to estimate how asset prices might react in the short-term under such negative market conditions. We then quantify what such a move could mean for the values of our managed portfolios and consider adjustments to our positioning to manage our estimated maximum downside volatility within targeted ranges.
In order to help us achieve your objectives, it is incumbent on you to engage in the process. The surest way to erode income generation and create permanent losses is to be in a position where we are forced to sell investments at inopportune times. At all times, investors should have sufficient liquidity to meet cash needs. This is precycling at its core. Please continuously monitor your liquidity and cash needs. In addition to the normal cash your adviser recommends you keep liquid, usually a function of your living expenses and income reliability, you should also keep liquid the right amount of additional cash for other anticipated expenses. FIM Group advisers are always available to help you determine the minimum amount you should keep liquid.
It is imperative that your portfolio volatility does not exceed your volatility limit, and that you are willing to accept volatility up to that limit. Volatility is not the enemy. The enemy is permanent loss. Selling because you are uncomfortable with volatility turns price fluctuations into permanent losses. In addition to communicating closely with your adviser to keep your portfolio within your threshold, it is equally important that you understand the difference between price and value.
Price, Value and Opportunity
The price of an investment is the midpoint at which other investors are willing to buy or sell it at each point in time. Investors are emotional beings acting frequently on emotion, news flow and ignorance. In doing so they move prices of investments to levels well above and well below their actual values. Price is typically determined by emotion. Value can be rationally appraised. One common measure of value is the present cumulative amount of future cash flows that an investment will generate. As long as an investment is able to continue to generate a certain level of cash flow, its value remains stable even though its price can fluctuate wildly.
A company can do many things with the cash or profits it generates. It can retain it (to reduce debt or increase the cash a company holds), it can use it to invest in its future growth, and it can pay some of it out to shareholders in the form of dividends. FIM Group favors companies that pay out significant dividends to shareholders. The level of a company’s dividends and its ability to continue to pay out and increase those dividends over time determines the intrinsic value of such investments.
One misconception that is critical to understand is that an investment’s income is dependent on its price. That is not correct. Dividends on stocks and interest on bonds are not dependent on the market price of those investments, and their incomes do not drop because the market prices of the investments fall. In fact, in the case of stocks, sometimes a company will actually increase its dividend payout when the stock price is falling to help increase the demand for the stock.
Let’s look at a couple widely held long-term FIM Group investments to explore this concept. Group Bruxelles Lambert (Symbol: GBLB:BB) is a Belgian-based holding company that holds shares of some of Europe’s strongest “blue chip” companies. FIM Group has held this investment, or its nearly identical cousin, Pargesa Holdings, in many client portfolios at various times over the past decade. The graph of GBLB shows two lines that extend back to before we began investing in the shares in 2010. The green line is the price of the company’s stock (right-hand scale) and the brown line is the dividends the company paid to shareholders (left-hand scale). Notice that while the price has risen, fallen, risen and fallen over the past 20 years, the company has continually paid steady or rising dividends. While fear drove some investors to sell the stock both during the dot-com crash of 2000-2 and the global economic recession in 2007-9, long-term investors who understood the value of GBLB’s portfolio companies held on, and while doing so the dividends each share pays them has more than doubled since 2000. Investors who owned this stock in 2000 would have obviously been well-served if they embraced volatility and took advantage of those price drops adding to their positions each time the market drove the price down. You will frequently see FIM Group adding to positions whose prices fall more than their cash flow.
A second example is Total Produce (Symbol: TOT:ID), an Irish-based European fresh fruit and vegetable distributor. Despite the global recession and the resulting reduction in Total Produce’s revenues, the company had the cashflow and assets to pay out and eventually increase their dividends. While its price cratered from a high of 0.80 euros in 2007 to 0.20 in 2009, investors were still paid a steady or rising income from this stock.
Investors who precycle, who are prepared in advance fiscally and mentally by having sufficient liquidity to withstand volatility, such as the stock market crashes in 2000-2 and 2008-9, and the mindset to seize the opportunities created by them, are able to benefit in two ways. First, if they own solid, income-producing investments, they will generally continue to be paid relatively steady income despite seeing the value of their portfolios temporarily decline. Those who have foresight to see that many investments get unduly punished by other panicked investors are also able to capture some of the opportunities created by rotating out of investments that hold more of their value than others. They then benefit as investments like Total Produce handily outperform broader global stock markets. By maintaining sufficient liquidity, accepting volatility and keeping a clear focus on value versus price, investors are positioned to grow wealth and retirement income over time, even through periods of extra downside volatility.
Giddyup. 2014 is the Year of the Horse according to the Chinese zodiac, and soon Wall Street’s finest economists and strategists will be racing down the stretch to publish their forecasts for what the New Year will bring. Will global economic growth rebound or fade? Interest rates surge or slump? Stock markets rally further, pause, fizzle or collapse? Wall Street’s prognosticators will have the answers and, conveniently, a full lineup of related investment ideas and products at-the-ready for its minions to sell to the masses.
I’ll admit that the annual prediction game ritual still finds a way to pull at me. During my first years in the biz analyzing toy company stocks in Tokyo, our research team would hustle into the wee hours of the night to crank out year-end strategy reports. Most of our predictions ended up well off the mark, but that didn’t stop us from trying, and the reports would give us at least a month’s worth of discussion fodder for our fund manager clients (after which we would then start working on our 2nd Quarter forecast reports…).
So for this month’s newsletter, I decided to dust off my crystal ball and see what it has to say about the year to come. I’ve asked it to produce some predictions that we can “take to the bank,” so there won’t be any forecasts of stock market levels or interest rates to share. Instead, it cranked out four high-probability predictions worthy of our consideration.
1) The crowd finally gets its chance to sample a piece of the banker pie.
Most banks continue to coast on cruise control. They pay zero on the money we deposit with them and earn a comfy spread on the loans they make. But a new wave of platforms will emerge next year that allow individual borrowers and lenders an alternative route.
Peer-to-peer lending platforms like Prosper.com and LendingClub.com already allow individual borrowers and lenders to transact directly with each other online. In 2014, it looks like the SEC will finally get around to setting some rules for true crowdfunding. With this, we should see the launch of new platforms and the evolution of existing crowdfunding “donation” sites like Kickstarter and Indiegogo to sites that provide financial return opportunities for individual investors. While these certainly won’t put much of a dent in the traditional banking model for now, they will open up new ways for investors to shift some of their savings to non-bank and non-Wall Street alternatives. They will also introduce a new source of capital for small business owners looking for options beyond their local bank loan committee.
2) The synchronous bull markets in whining and neglect will continue to make new highs.
Complaints about the ineptitude and recklessness of Washington policymakers will reach new peaks. A new round of debt ceiling debates and upcoming Fed policy decisions will make easy scapegoats for the many in the middle class struggling with diminished financial prospects. At the same time, the endangered species known as personal financial responsibility will take one more step toward going the way of the dinosaur. Rather than examine financial factors that we can personally influence, such as savings and spending rates, the financial footprints of the homes we live in and cars we drive, and the skill-sets and networks we build to cope with a changing economy, many Americans will instead continue to take solace in blaming things they have little influence over. The result will be a new round of “eye-opening” statistics like those in the adjacent table and further success for today’s megaphones of discontent (think Facebook, the local coffeeshop, etc.).
3) The forces of greed and fear will continue to separate the investing herd from its money.
Stock and bond prices will reflect the ebb and flow of these emotions, and the investing herd will react, predictably, by buying high and selling low. What it will be buying and selling is whatever the Wall Street marketing machine feels will best appeal to the emotions of the day. Boomers will be especially vulnerable, especially those who find themselves ill-prepared to finance their dream retirements. Those prone to gamble a bit will bite on specialty exchange-traded funds and other products that promise sexy returns to boost that nest egg. Others, fearful of what the next correction means for their savings, will succumb to those pitching “risk-free” annuities without even attempting to understand the costs of these guarantees buried in the all-important fine print.
As a side note, our team is well-prepared to capitalize on whichever emotion the herd chooses to follow. If greed drives market prices higher in 2014, we will be happy to be sellers. Holdings that appreciate above our judgments of fundamental value will be traded away and proceeds will be recycled into better-priced alternative positions. Should fear force a herd stampede to the exits, we will stand ready to buy (at depressed prices of course) the companies in our portfolio or on our watch lists that exhibit resilient fundamentals and exceptional long-term outlooks. Which takes us to the fourth and final prediction for 2014.
4) Investors that can focus on what matters will thrive regardless of what 2014 brings.
It is not unusual for investors to focus on portfolio market value rather than the fundamental factors that drive this value over the long-term. After all, we can review our account balances 24/7 and in a split-second see how other market participants feel about our holdings at any given time. Never mind that these other participants may have very different objectives and motivations than ours and that their actions can distort market prices in the short-term.
Should 2014 bring periods of lower investment prices, investors obsessed with the market value of their portfolios will be vulnerable to the emotional tug of fear. They may sell holdings in a bid to protect their portfolio value, and in the process transfer their wealth to those buying these holdings at temporarily distorted, bargain prices. Successful investors will expect short-term volatility with any stock, bond or real estate asset they own and will focus instead on the factors influencing the cash flows these investments produce. These factors include things like a company’s competitive position, business model resiliency and balance sheet strength. It is the durability of these cash flow drivers that ultimately anchors the fundamental value of any investment. Investors that can focus on these factors will be well-positioned to seize “wealth transfer opportunities” from those whose investment decisions are corrupted by an over-obsession with day-to-day market value.
So there you have it, four bankable predictions for the New Year. Crowd-funding platforms will surge forward as will the ongoing bull markets in whining and personal financial neglect. Greed and fear will work their powerful magic to separate the investing herd from its money, especially as vulnerable Boomers become easy targets for the Wall Street marketing machine. And finally, regardless of how market prices behave in 2014, investors who focus less on day-to-day market value and more on the fundamental, long-term drivers of that value will thrive.
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