“Over the long run, the price of gold approximates the total amount of money in circulation divided by the size of the gold stock. If the market price of gold moves a long way from this level, it may indicate a buying or selling opportunity.”– Ray Dalio
During a recent investment committee meeting, I recalled a conversation I had back in the early ’80s with a fellow money manager who was much more experienced than me. I asked him
what he thought the ideal “paranoid-conservative, set-it-and-forget-it port-folio” would look like. His response: 10% gold for economic uncertainties like hyperinflation and geopolitical stress, and 90% U.S. Treasury bills for stability.
Needless to say, hanging on to this 10/90 portfolio would have required loads of patience and stubbornness over the last three decades. It would have performed quite poorly compared to most other investments during the lion’s share of this period, save for times like the early 2000s Tech Bust and the 2008-2009 Global Financial Crisis when it temporarily shined. Indeed, compared to the 2,000%+ return that the S&P had over this golden age for U.S. stocks, many would call this portfolio’s 200%+ return a real stinker. For the ability to reduce volatility and have less ups and downs, the paranoid investor would have given up a lot and have been financially damaged.
The 10/90 Portfolio Got Me Thinking
Since that conversation, I’ve been thinking about the 10/90 portfolio as a “conceptual” tool for risk and opportunity management. For most investors, parking 90% of a portfolio in T-bills is a strategy destined to fail over time, as taxes, inflation and insufficient income leads to woefully inadequate real returns. But the 10% portion devoted to protect against “what-if” scenarios has stuck with me. When financial markets are all rosy, such protection seems useless, a zero so to speak. But when economies and business climates turn stormy, hard assets, for example, used as portfolio protectors can play the role of hero. They can provide a volatility cushion when the investor herd panics during shock events like war, broad market bubble bursts, and major losses of confidence in prominent institutions (for example, central banks). And they can provide a source of capital for bargain hunting, assuming the owner of the heroes is willing to part with them when asset prices elsewhere are severely depressed.
What we’ve tended to do over the years, depending on market conditions, is allow a small part of our managed portfolios (not always 10%, but let’s call it in the 3%-15% range) to play the zero or hero part. Some might call these positions “black swan insurance” or “tail risk hedges,” but I just think of them as relatively low-cost-to-the-portfolio holdings that can provide real support against extreme market scenarios. Importantly, these holdings allow us to keep the remainder of the portfolio (the “90” conceptually) relatively fully invested in carefully picked holdings that do the lion’s share of our long-term return generation.
Golds and Govies
The two primary investment holdings that have played the hero/zero role over the years in FIM Group portfolios have been stocks of precious metals-related companies and government bonds of long-regarded safe haven countries like Switzerland. The nice thing about these, if chosen carefully, is that the risk of a true “zero” is very low. Other hero/zero candidates like index options see time value decay, which greatly increases the odds they expire worthless. This permanent destruction of capital is hard for a value investor to stomach. So we do not use speculative options or futures to hedge risks at FIM Group.
At present, throughout our managed strategies, most of our hero/zero holdings are comprised of a select group of individual stocks with precious metals exposure like Silver Wheaton, B2Gold Corp, New Gold, Dundee Precious Metals and U.S. Global Investors. All are well-managed and should be able to survive if markets stay free of “what-if” scenarios. In fact, our working thesis is that these stocks trade cheap relative to a positive, longer-term global economic scenario of limited new gold and silver supplies (harder and harder to find and mine the stuff) and growing demand as hundreds of millions of new middle classers emerge in precious metals-loving countries like China and India. Against any number of negative “what-if” scenarios, scenarios that envision a period of fear and panic in markets, these precious metals holdings look absurdly cheap.
As for safe haven government bonds as attractive hero/zero investments, they are much less compelling today than when their coupons were rich in yields. Due to central banker policies that have suppressed bond yields (raised bond prices) around the world, available yields for traditional safe havens are quite paltry. In recent weeks, for example, 10-year Swiss Government bonds were so coveted that they actually offered their owners negative yields (meaning their owners were effectively paying the Swiss government to hold them!). The Swiss franc has also been bid higher against the dollar and now trades not far from its long-term highs. So even though a “what-if” moment could push the franc higher and the yields of Switzerland’s bonds even further into negative territory, it seems like the zero outweighs the hero at this time for Swiss govies. Everything is cyclical, so right now we believe precious metal shares are a better way to go than the Swiss Governments.
Holistic Risk Management
As value and growth investors focused on holistic risk management, we look at the downside first with any current or prospective investment holding. We use conservative assumptions of future competitive advantages, asset values and free cash flows when making estimates of an investment’s intrinsic value, and look at various “fire sale” scenarios to gauge each holding’s exposures to “what-ifs.” This analysis is used to determine the price we are willing to pay. We require more margin of safety than less as the range of potential risks widens.
Additionally, we construct portfolios of these holdings in a diversified way that limits concentrations to specific companies, industries, currencies, interest rate scenarios, tax schemes and other variables. And yes, in certain periods (like the current one), we add some “what-if” protection via positions like those mentioned above. At the moment, given scarcity of value in safe haven bond-land and surplus value in precious metal-land, our “10” portion in the portfolios is largely comprised of gold- and silver-related companies. While these holdings may appear to play the role of zeros in this current period of investor complacency, we expect them to emerge as heroes should any number of “what-ifs” shake things up.
Over the past half decade, anyone who banked on rising interest rates knows this has not been an accurate expectation. Throughout the past five years, the media has speculated that interest rates have “nowhere to go but up.” The prospect of interest rates potentially rising has been dripping on us for a while. Yet, as we have seen, interest rates can remain static or even decline while the hunt for precious yield remains a priority.
Back in mid-December 2014, the Federal Reserve decided it was going to take its sweet time raising interest rates. Central bank language pointed toward “patience in beginning to normalize the stance of monetary policy,” and there was a plan to keep interest rates low for a “considerable time.” This “considerable time” phrase provided an indication to investors that the Fed would likely keep interest rates static until mid-2015 or beyond. Due in part to this indication, the FIM Group investment team began to take note of an ideal investment candidate.
Floating-Rate Fund Characteristics
Floating-rate closed-end bond funds had market prices that were between 12%-13% below their stated net asset values (NAVs) this past December. The investment team began to add this asset class to our fixed-income allocation in some of our lower-risk tolerance portfolios. These closed-end funds invest in a diversified grouping of bank loans that are made to corporations. The commercial loans are senior to other debt obligations within a company’s capital structure and are patterned with a variable interest rate that is tied to a benchmark such as the U.S Treasury bill rate, LIBOR, the Fed funds or the prime rate. The loans tend to adjust their rates every 30 to 90 days.
While the debt of these corporations is usually not on the higher end in terms of quality, they are secured by the company’s physical assets. In the event of a bankruptcy, these loans come as a first lien, or as senior debt. These types of provisions take precedence over all other claims, giving investors first priority of claims on the company. The historically low default rates of bank loans and their potential to produce increased income in the event of rising interest rates means they should perform well in our base-case scenario of a slow-growth, but gradually improving, domestic economy.
Total Return Drivers
An improving economy should give the Fed room to begin normalizing short-term interest rates, which have been stuck at the “emergency” zero level ever since the global financial crisis (see Figure 1). Higher rates should eventually lead to higher income distributions from our floating-rate closed-end funds as their underlying bank loan rates adjust to the increase in rates. Most of the floating-rate funds that we’ve been buying pay us income yields of 5.5%-6% in the current zero-interest-rate environment. As short-term rates begin to increase, we would expect to see upside to these income streams.
In addition to the higher income potential, our selective purchase of these funds for less than 90 cents on the dollar to their stated NAVs presents an opportunity for price appreciation. The widely discounted prices were especially appealing at our entry point back in mid-December 2014. Historically, many of these floating-rate funds have traded at premiums to NAV given the relatively limited supply of fixed-income product in the market that provides investor protection against rising rates. While we do not model a return to NAV premiums with our floating-rate bond fund holdings, we do believe that there is ample room for discounts to return to the low single-digit average levels where they have traded historically. This “discount compression” could add several percentage points of price appreciation to the mid-single-digit income returns we expect from these funds. In fact, in some cases, we’ve already traded out of certain floating-rate funds where the discount has compressed and prices have rebounded to levels we consider fairly valued.
Of course, no investment is without risk, and there are several attributes of these floating-rate funds that we monitor closely. First, as noted above, the underlying bank loans held by the funds do carry credit risk. In fact, one of the reasons the floating-rate funds fell out of favor last year was their perceived exposure to the oil patch. Generally speaking, the funds we own have only limited exposure to energy companies and are broadly diversified across a wide range of sectors.
The limited trading liquidity of floating-rate loans is also a risk factor that we accept when owning these funds. Should credit market conditions turn volatile, there is a risk that these loans will trade poorly and be temporarily priced accordingly in the NAVs of our holdings. Given the permanent nature of the closed-end fund structure, we do not expect such pricing to force the managers of these funds to sell their holdings at disadvantageous prices. Instead, they should be able to ride out any market disruptions and continue passing on the income their loans earn to us through any such periods.
In summary, we believe that our select group of floating-rate closed-end fund holdings makes for a nice addition to our diverse portfolios. While not without risks, these funds offer a solid income yield component that should grow over time in a world where interest rates begin to normalize. They also offer a price appreciation opportunity as unusually high discounts to NAV compress back toward normal levels.
Tax-Wise Charitable Giving
Charitable giving can be personally rewarding and helpful to a nonprofit as well as tax-wise. Should you be charitably inclined, there are many options to make tax-wise gifts both while living and at death. This month I would like to briefly describe three different tax-wise methods of making charitable gifts. As in all income tax planning, it is important that you consult your tax adviser before implementing any of these strategies.
Charitable Donations of Appreciated Stock
If you are planning to make a relatively substantial contribution to a charity, college, etc., you should consider donating appreciated stock from your investment portfolio instead of cash. Your tax benefits from the donation can be increased, and the organization will be just as happy to receive the stock.
This tax-planning tool is derived from the general rule that the deduction for a donation of property to charity is equal to the fair market value of the donated property. Where the donated property is “gain” property, the donor does not have to recognize the gain on the donated property. These rules allow for the “doubling up,” so to speak, of tax benefits: a charitable deduction, plus avoiding tax on the appreciation in value of the donated property.
Example: Tim and Tina are twins, each of whom attended XYZ University. Each plans to donate $10,000 to the school. Each also owns $10,000 worth of stock in ABC, Inc., which he and she bought for just $2,000 several years ago.
Tim sells his stock and donates the $10,000 cash. He gets a $10,000 charitable deduction, but must report his $8,000 capital gain on the stock.
Tina donates the stock directly to the school. She gets the same $10,000 charitable deduction and avoids any tax on the capital gain. The school is just as happy to receive the stock, which it can immediately sell for its $10,000 value in any case.
Caution: While this plan works for Tina in the above example, it will not work if the stock has not been held for more than a year. It would be treated as “ordinary income property” for these purposes, and the charitable deduction would be limited to the stock’s $2,000 cost.
If the property is other ordinary income property, e.g., inventory, similar limitations apply. Limitations may also apply to donations of long-term capital gain property that is tangible (not stock) and personal.
Depending on the amounts involved and the rest of your tax picture for the year, taking advantage of these tax benefits may trigger alternative minimum tax concerns.
Charitable Remainder Trusts
There is a very powerful estate-planning tool that may enable you to reduce your liability for income and estate taxes and diversify your assets in a tax-advantaged manner. It’s called a charitable remainder trust (CRT), and here’s how it works.
A CRT is an irrevocable trust that makes annual or more frequent payments to you, typically until you die. What remains in the trust then passes to a qualified charity of your choice.
A number of advantages may flow from the CRT.
First, you will obtain a current income tax charitable contribution deduction for the value of the charity’s interest in the trust. The deduction is permitted when the trust is created even
though the charity has to wait to receive anything.
Second, the CRT is a vehicle that can enhance your investment return. Because the CRT pays no income taxes, it can generally sell an appreciated asset without recognizing any gain. This enables the trustee to reinvest the full amount of the proceeds and thus generate larger payments to you for your life.
The trust will be eligible for the estate tax charitable deduction if it passes to one or more qualified charities at your death. If you wish to replace the value of the contributed property for heirs who might otherwise have received it, you could use some of your cash savings from the charitable income tax deduction to purchase a life insurance policy on your life for the benefit to your heirs. Often, through the leveraging effect of life insurance, it is possible to pass on assets of greater value than those contributed to the CRT. In this way, your heirs are not deprived of property they had expected to inherit.
A CRT is a very complex arrangement, but it is also an invaluable planning tool in the right circumstances.
Charitable Planning for Retirement Benefits
When funds are drawn out of retirement plans and IRAs by noncharitable beneficiaries, Federal income tax of up to 39.6% will have to be paid, and state income taxes also may be owed. Furthermore, retirement funds possessed at death may be subject to substantial Federal estate tax and state death tax.
Retirement benefits are to be contrasted with other assets that can be passed to noncharitable beneficiaries free of income tax. For example, an individual inheriting stock worth $300,000 from his parent (that was purchased by the parent for $100,000) won’t have to pay income tax on the $200,000 appreciation. That’s not the case for retirement benefits. They are subject to both income tax and estate tax. A special income tax deduction for the estate tax helps noncharitable beneficiaries, but the combined income and estate tax can still be quite substantial. Because of this double tax bite, someone who plans to make charitable gifts should consider naming a charity as beneficiary of his/her IRA or retirement plan to gain these advantages:
For one who is not in a position to leave his entire retirement benefits to a charity, there are these options:
Another popular way to transfer IRA assets to charity is via a tax provision that allows IRA owners who are 70-1/2 or older to direct up to $100,000 of their IRA distributions to charity. Congress typically approves this provision annually and often late in the year, so should this be a strategy you wish to pursue you may have to delay your required minimum distribution decision till late in the tax year. The money given to the charity counts toward the donor’s required minimum distribution, but doesn’t increase the donor’s adjusted gross income or generate a tax bill.
Keeping the donation out of the donor’s AGI is important, because doing so: 1) Helps the donor qualify for other tax breaks (e.g., having a lower AGI can reduce the threshold for deducting medical expenses, which are only deductible to the extent they exceed 7.5% of AGI [10% of AGI for people under age 65 and for everyone after 2016]); 2) Reduces taxes on the donor’s Social Security benefits; and 3) Helps the donor avoid a high-income surcharge for Medicare Part B and Part D premiums (which kick in if AGI is over certain levels).
Citation: 2015 Thomson Reuters/Tax & Accounting.
Life Time Fitness (Ticker: LTM, www.lifetimefitness.com)
Share Price/Market Capitalization (03/20/15): US$70.77/ US$2.7B
Company Description: Life Time Fitness is a U.S.-based health club operator with more than 100 fitness centers across North America.
Investment Thesis: Life Time Fitness offers both a strong position in the growing health and wellness space and an underappreciated portfolio of real estate. The company has a variety of options at its disposable to improve shareholder value and a board that seems willing to pursue these strategic alternatives.
Life Time Fitness opened its first gym in 1992 and now operates 114 large-format sports centers under the LIFE TIME FITNESS and LIFE TIME ATHLETICA brands. The centers span 25 states and one Canadian province in 32 different markets. Many of the centers feature a wide range of premium amenities, including pools, basketball and racquet courts, personal training, child care centers, cafés and spas. As of the end of 2014, Life Time served more than 1.4 million members via a variety of membership options with monthly fees in the $50-$160 range. These members generated 2014 revenues of more than $1.3 billion and net income of $115 million.
Life Time has benefited from the solid secular tailwind of growing U.S. expenditures on health and wellness services. Revenues and profits have more than tripled over the last decade on both organic growth and new center development. Beyond just growing its membership ranks, the company has also grown its revenues per member by offering a wider menu of products and services within the center (like personal training and spa services).
We initiated a position in Life Time last August after the company announced it was exploring the possibility of converting its real estate assets into a Real Estate Investment Trust. Over the years, the company came to own 42 of its centers outright with another 32 centers mortgaged. The value of these assets did not seem to be reflected in Life Time’s share price. We began buying shares in the $45-$50 range, which came out to about 14x expected earnings for 2015. Our conservative base case for fair value was $65, which valued the company at around 20x earnings.
Recently (March 16), Life Time announced that it would be taken private by a consortium of investors, including the Chairman and CEO of the company for $72.10/share or 22x earnings. The deal is expected to close later this year, and we have begun taking profits in select (predominantly tax-deferred) accounts at share prices north of $70.
Data Source: Company Filings, Bloomberg
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