Everything is cyclical – spring/summer/fall/winter … recession/recovery/boom periods … deflation/inflation. An experienced farmer knows full well that weather directly affects the harvest, so he is prepared for both good and bad years. His success lies in the patient preparation and planting of the soil. Today, it seems that investors are obsessed with short-term performance (three years or fewer).Impatient investors jump from one strategy to another without any long-term plan, or end, in mind. Market cycles are three to 10 years in length, so timing (i.e., buying solid opportunities at the right price and time) and patience are paramount. Leo Tolstoy wrote in his epic novel War and Peace that “The two most powerful warriors are patience and time.” It seems today that investors are forgetting that success is measured in decades – like the ability to “stay” retired.
To every thing there is a season, and a time to every purpose under the heaven:
A time to be born, and a time to die; a time to plant, and a time to pluck up that which is planted.
– Ecclesiastes 3, King James Version (KJV)
In July, billionaire investor Carl Icahn criticized Laurence Fink, CEO of BlackRock, at a CNBC conference, for selling exchange-traded funds (ETFs) that own “extremely illiquid” securities like high yield bonds. Icahn singled out BlackRock’s iShares high yield ETF, saying it held bonds that were “extremely dangerous.” Fink shot back saying that “ETFs create more price transparency than anything that is in the bond market today.” Adding power (I assume) to his remark, Fink added, “To trade ETFs at every minute [emphasis added] of every day, you have to have a valuation of every bond at every minute.”
I do not wish to give a discourse about the specifics of high-yield bonds or ETFs. What struck me was the idea that if an ETF trades every minute, then the underlying securities also trade every minute. Who needs to trade bonds every minute anyway – except perhaps specu-lators trying to pick up nickels? For fun, I tested the “every minute of every day” liquidity that Fink mentioned against a holding in his $13 billion high yield fund, HYG. It seemed fitting to select the Wynn Resorts and Casino 5-3/8%bonds of 3/15/22 for this exercise. On July 16, 2015, these bonds traded only 16 times in a range of 104.79 to 101.76, a far cry from trading “every minute of every day.” To ensure I didn’t research an “off” day, I looked at the previous Friday’s performance and saw there were eleven trades – still a far cry from the 390 minutes each day that Fink’s high-yield fund trades each day in New York (not to mention other exchanges).
A so-called liquid investment comprised of illiquid, not easily traded securities is a recipe for failure. I will side with Carl Icahn’s thoughtful approach on this matter. Like me, he is not selling anything – he manages portfolios as a professional investor.
ETFs are fairly new and amazingly popular because they allow investors to “speculate” (or invest) in another “hot” area of investing: indexing. They are designed to simply reflect the day-to-day performance of whatever index they are tracking (e.g., S&P 500, emerging markets, junk bonds, etc.). Index investing started out innocently to help investors save costs, diversify and invest long-term, but it has morphed into a “product” that allows investors to speculate “by the minute.” The cham-pion and “father” (to some) of indexing (and long-term investing), Vanguard founder John Bogle, said recently, “In my experience – almost 64 years – I have learned to beware of investment ‘products,’ especially when they are ‘new’ and even more when they are ‘hot.’”
Bogle started his index funds to help investors, especially smaller investors, lower costs. He emphasized patience, advising investors to not get rattled by day-to-day fluctuations. Bogle has written extensively on investing, and his book The Clash of Cultures: Investment vs. Speculation ends with 10 lessons for investors. While my own “10 lessons” would differ slightly from Bogle’s, there are four that stand out: 1) Time is your friend, impulse your enemy (Be patient); 2) Remember reversion to the mean (What’s “hot” today isn’t likely to be hot tomorrow, and what’s “cold” today is likely to again have its day in the sun – everything is cyclical); 3) There is no escaping risk (Volatility is a side effect to good long-term performance no matter what the insurance, annuity or limited partnership salesperson tells you); and 4) Stay the course (Be disciplined, patient and don’t be rattled by the ups and downs).
So … Where Have All the Long-Term Investors Gone?
There are many excellent long-term investors in the business, but today there’s an epidemic of short-termism. I see it in the way politicians speak (sound bites without depth) and the news is reported (few photos, short video or a small quote or two … and on to next “story”), but as professional investors serving clients, we see it every day in the questions our clients ask.
Years ago, I asked a fellow investment manager, Harvey Eisen, to tell me the best way to improve his performance. Without hesitation he said, “If my clients only looked at their portfolios once every five years.” I didn’t necessarily agree with his five-year theory, but we both agreed that as a matter of practicality, clients need to understand and pay attention to their portfolios, without ever becoming too obsessed over short-term exposure.
Based on my experience, I find most investors would rather follow the crowd and be wrong in company than take the risk of being successful but shunned by the crowd. Today’s “crowd” is embracing indexing and ETFs, but these are mere tools used in investing, not the means of successful investing. Success involves numerous factors – value, paying the right price, present value of future cash flows, patience, experience and discipline.
Let’s Look at Cycles
First, positive performance tends to be compressed. As we all know, investments go down and up and interest rates rise and fall. Success happens when we embrace these facts and use them to our advantage. One key is to be early. The chart “Be Early and Bear Markets” (page 3) uses the U.S. stock market to illustrate the importance of 1) being invested before things turn around; and 2) being well-compensated while accepting the volatility of being early. As you can see, sitting in cash for the six months after a bear market ends cuts performance in half for the ensuing three years. Most investors reading this experienced firsthand the crash of 2008/2009, and the real losers, as we know, were those who went to cash and “sat it out” only to see markets come back up quite quickly.
One certainty is that investors that tend to have poor performance generally sell or switch strategies when things are performing poorly because they don’t understand that “everything is cyclical.” They need to re-evaluate whether or not they own “good” investments and take a longer-term view (e.g., five years) on the investments they currently hold.
Let’s examine simple currencies. One reason that FIM Group portfolios are facing some headwinds these last few quarters is our exposure to the Canadian dollar, euro, Australian dollar and Swiss franc. The U.S. dollar as a currency is strong, which means it is also strong against other currencies. The table “Foreign Currencies Significantly Below 10-Year Highs” (below) illustrates that foreign currencies have had a rough go. Specifically, factors like Greece’s economic woes, recession and such have caused the euro to go down 31% from its high, which means that the euro would need to go up approximately 45% against the dollar to get back to its all-time high. Is that likely to happen? Who knows? The chart merely illustrates that because markets are cyclical, investments can go from being too expensive to too cheap. It’s hard to say, “Let’s sell our inter-national investments and wait for quiescence,” which we know does not happen. Everything moves.
Let’s look at some of FIM Group’s largest holdings in local currencies and in U.S. dollar terms. Keep in mind if we were reporting our performance in euros, our portfolio returns would be 10% higher this year. As you can see in the table “Select FIM Group Holding Share Prices,” the securities are not near their 10-year highs in either their local currency or the U.S. dollar. While a security valued at a price much lower than its former high is not a statement of value, as sometimes companies
destroy value and their securities should go down, often it is just investors’ psychology that causes the investment to be shunned. Let’s look closer at the four holdings in the table.
While Pargesa’s earnings are down less than 10% from its all-time high, it seems that the stock being cut in half is going a bit too far relative to the company’s fundamentals. Pargesa, a holding company with a long-term focus on creating value, sells at a significant discount to its breakup or intrinsic value, pays a cash dividend and has a rock solid management that owns more than 50% of its shares. Pargesa’s management’s interests are aligned with ours.
Canadian holding company Dundee, which has investments that include energy, mining, real estate, agriculture and investment management, is down 49% in Canadian dollars and 61% in U.S. dollars from its high in August of 2013. What is interesting about Dundee is that its book value is only 15% less today than it was in 2013. Dundee was selling near its book value in 2013, but today it sells at less than half its book value. Warren Buffett advises us to invest with a margin of safety (which comes from buying at good prices). Certainly he would agree that buying Dundee at less than half of book and Pargesa at around 75% of book gives us a nice margin of safety. The two other holdings, Quest for Growth and Atrium Real Estate, are both currently priced at less than their book (intrinsic) value. Atrium paid a 6% dividend and Quest for Growth a 7% dividend this year based on current share prices. Atrium has seen its dividend rise by 18% per year over the past three years.
FIM Group strives to find companies where we expect dividends to rise over time to help offset inflation and provide compound growth in portfolio values.
Five Years Out
Taking a long view is important as a manager. Our job is to keep our retired clients retired, and to help grow wealth to be used in the future for retirement, kids’ education, a legacy for family or charity, or a new organ for a church whose money we manage. When I look at our portfolio holdings in five years under any scenario – recession, inflation, boom times, a currency collapse or even hyper-inflation – I am confident we will be able to keep our mandate to our clients. This is so because the companies and investments we own are creating real value and are making earnings and cash flows that they can either pay out as dividends or use to build share price. If you compound the value of the earnings and cash these companies generate, and add that we have bought the securities at great prices – maybe a bit early of course, but better early than late as illustrated so well in the “Be Early and Bear Markets” chart – it is very easy to be optimistic.
Last month, Ed Dowd wrote about his experience as a portfolio manager at one of the world’s largest mutual fund companies, BlackRock. He explained that risk in the mutual fund world is often measured relative to benchmark indexes rather than in a way that’s meaningful to real investor goals like protecting and growing wealth. His article reminded me of famed investor Jeremy Grantham’s, who also wrote along a similar theme. Grantham observed:
The central truth of the investment business is that investment behavior is driven by career risk ... The prime directive, as Keynes knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority “go with the flow,” either completely or partially. This creates herding, or momentum, which drives prices far above or far below fair price.
Over the years, the mantra of meeting or beating an index (the difference only really a function of whether you sit in the “passive” investing camp or the “active” one), has trickled down from Wall Street to Main Street and has come to dominate the mindset of many if not most investors.
And while FIM Group clients generally “get” the idea that we operate differ-ently, it is still fairly common to field questions along the lines of “How did I/we/you do against the S&P 500 (or Dow, EAFE Global Index, Barclays Aggregate, etc.) this year?” Or even more basic inquiries like, What is index investing? My friends tell me (or I have heard) I should be invested in index funds because they cost less and active managers can’t beat the indexes. Lately, these inquiries seem to be ticking up. So this month, I thought I would explore this index investing topic a bit further. We’ll take a look at what investment indexes are, how they were transformed into investment products and why they can lead to poor investing outcomes.
What’s an Index?
First, let’s start with a basic definition. Investment indexes are passive groups of securities, grouped to measure specific areas of the market. The most famous, the Dow Jones Industrial Average (the “Dow” or the “DJIA” or “The Market” as it is often referred to) is an index of 30 large U.S. companies. It was created in 1896 by a financial company to measure the pulse of the economy by looking at the prices of a broad basket of U.S. stocks. The S&P 500 is a newer, larger index that consists of 500, large, mostly U.S. companies. The MSCI EAFE Index (which stands for Europe, Australia and Far East) is a similar index containing large international stocks. The Barclays Aggregate Index is a U.S. bond index. And I could go on and on and on as there are literally thousands of other indexes that measure various groups of securities.
Within an index there are securities with good future prospects, poor prospects, some that are expensive and some that are bargain-priced, some that are doing great things and some that are doing risky, irresponsible or foolish things, and everything in between. In other words, most investment indexes have been built with no judgment whatsoever on the critical factors of investment quality and investment valuation. I believe that the founders of the original indexes would be turning in their graves at the concept of blindly investing in all of the securities in an index regardless of each one’s individual merit.
From Measuring Tool to Investment Product
In our world of “think it and it will be so, ”a group of financial experts (i.e., academics) surmised that investing in such blind passive indexes could be an investment strategy. They built a theory around it, called the Efficient Market Hypothesis, and then Wall Street built a money-making industry around it, first via passive mutual funds, then index funds and most recently ETFs, or exchange-traded funds. Once they (Wall Street firms) built it, they marketed it. Then the people came. And over the last few decades, passive index fund strategies have seen a strong and steady flow of new investor dollars, a trend that has really gained traction over the last few years, please reference the graph above.
Given this trend, I suppose that I should not be surprised by the increase in questions around index investing and relative performance of late. I’ve seen such upticks before. In the late 1990s and again during the housing bubble of 2006-2007, the number of these relative performance questions increased. The clamoring for indexing and relative performance comparisons seems to peak along with the indexes … after they have already enjoyed sharp advances.
Investors’ Returns vs. Investment Returns
Most of us know that over long stretches of time U.S. stock markets have shown pretty compelling returns. Since 1900, for example, the Dow has averaged total returns of roughly 10% per year. With this data, it’s understandable that some folks assume they can blindly “buy the market,” sit tight and make similar returns going forward. Yet most investors have not achieved the long-term performance of those benchmarks. Why not? My theory is that most just can’t stomach the downside that comes when blindly investing in “the market” during its transitions from bubbly valuations to distressed valuations. They bail when they can’t stand the paper losses any further and they miss the inevitable market recoveries that follow, diluting their performance
versus the long-run averages.
Relative or Absolute
At FIM Group, we believe that building an investment portfolio around relative performance objectives, whether in the form of passive strategies that track an index or active ones that strive to beat one, is unnecessarily risky. We don‘t tie our portfolios to arbitrary relative benchmarks like indexes to help clients achieve their life goals. Instead, as the commercial goes, we answer to a higher authority: each client’s financial objectives. We work closely with our clients to determine how much income they need in retirement, what they will need to pay for education, healthcare, housing, lifestyle, etc. Then, we build and manage portfolios aligned with their specific needs, exposing their life savings to the least chance of permanent impairment of capital necessary to provide their objectives over full market cycles. As we make investment decisions, we pay very close attention to the quality and valuation considerations that indexers ignore.
In doing so, we accept periods, like the past year, during which our portfolios underperform common benchmarks. Experience tells us to keep our minds on the task at hand and avoid meandering down the path of relative return-think. While that may elevate our “career risk” per Grantham’s observations, we believe that being willing to be “wrong on our own” from time to time will ultimately help us deliver the real client outcomes that matter.
Despite the consistent denigration Social Security suffers at the hands of politicians and media commentators, it will continue to remain a key pillar of retirement income for all but the wealthiest of Americans. Few of us will have any other lifetime source of reliable, inflation-adjusted income that is immune to market volatility. For those reasons, understanding Social Security benefits and optimizing your claiming strategy for your unique circumstances are critical to effective retirement planning.
First, here are a few terms key for any discussion about Social Security: Full Retirement Age (FRA) – the age at which a person can first claim full benefits through the Social Security Program. Primary Insurance Amount (PIA) – the amount paid to a beneficiary at FRA. Cost of Living Adjustment (COLA) – the annual increase in Social Security benefits to offset increases in the cost of living (inflation). Spousal Benefit – the claim for Social Security benefits that a husband or wife can make based on his or her spouse’s earnings record. Delayed Retirement Credit (DRC) – the amount a benefit increases for each year a claim is delayed beyond FRA. FRA is 65 for anybody born before 1943 and 66 for those born between 1943 and 1954, with an increase of two months for every birth year between 1954 and 1959. Those born in 1955, for example, have an FRA of 66 and two months. A 1958 birth year has an FRA of 66 and eight months. All those born in 1960 and later have an FRA of 67.
The most significant decision people often face regarding Social Security is when to start claiming benefits. The earliest choice is age 62. While some may simply need the money, others are in a position to hold off on claiming the benefits, so sooner may not be necessarily better. In fact, sooner can often be a mistake. Claiming benefits before your FRA comes with a penalty that can drastically and permanently reduce your monthly payments. Waiting until FRA to claim means receiving the full PIA, or the full benefit. Furthermore, each one year delay beyond FRA until age 70 increases one’s benefit by approximately 8%, plus the annual COLA. With compounding and typical inflation, delaying can almost double a monthly payment compared
to the early claim benefit that would be received at age 62. Because income, health, desired retirement age and personal circumstances differ for everyone, the best time to claim Social Security differs as well.
One approach to the timing decision focuses on the “break-even” age, the age at which the higher monthly amounts from waiting would catch up to the amount received by claiming early. That approach seeks to ensure the highest cumulative payout from Social Security and puts an emphasis on not “leaving any money on the table” due to death prior to the break-even age. Another approach emphasizes Social Security’s role as insurance against longevity risk, the risk of outliving your assets. Maximizing the monthly benefit by delaying your claim and thereby avoiding early claim penalties and/or accumulating DRCs plus compounding the annual COLA provides the highest monthly Social Security income stream, one that increases annually to help offset inflation and lasts until death.
Thanks to the often overlooked spousal benefit, married couples have options that make the claiming decision more complicated and, potentially, much more beneficial. The spousal benefit allows an individual to make a Social Security claim based on his or her spouse’s work record. That can boost a husband or wife’s Social Security income to up to half of the spouse’s full PIA. It can also, to a degree, allow a couple to have its cake and eat it, too, by providing a couple some Social Security income without sacrificing the benefits from delaying the claim beyond FRA.
One additional consideration for married couples is the survivor benefit. It essentially guarantees that, following a death, the surviving spouse will continue to receive the higher of the couple’s two Social Security benefits, complete with its early claiming penalties or DRCs. Couples should consider, then, how their claiming strategy will affect the survivor’s benefit. Claiming one benefit early in order to delay and thereby maximize the other, for example, can make a significant difference to the surviving spouse’s income.
While the claiming options and consequences for unmarried individuals are relatively straightforward, married couples have options and permutations that allow for fairly high level of optimi-zation and customization. Rules abound, of course, so these already complex strategies get even more complex very quickly. Navigation becomes confusing and even risky. Your FIM Group adviser can certainly provide much-needed guidance as can your local Social Security Administration office.
Finally, if you need some advice about where to start when thinking about Social Security, go to www.socialsecurity.gov, register on the site and access your Social Security statement. You can view your earnings history and projected PIA in addition to what your early claim benefit with reductions at age 62 would be as well as your delayed benefit with increases at age 70.
New Senior Investment Group (Ticker: SNR, www.newseniorinv.com)
Share Price/Market Capitalization (07/17/15): US$13.40/ US$1.1B
Company Description: New Senior Investment Group is a U.S. real estate investment trust (REIT) that specializes in senior housing properties.
Investment Thesis: New Senior will benefit from a structural demographic tailwind as the 65-80 population is set to grow five times faster than the overall population in the next decade. The company has a high-quality property portfolio and a deep pipeline of acquisition prospects. Shares offer a nearly 8% dividend yield today, and we expect this dividend to grow long-term.
New Senior was recently spun-out from Newcastle Investment and owns a $2.4B portfolio of 124 senior housing properties across 32 states. Within senior housing, New Senior specializes in independent living and assisted-living properties and holds a mix of properties that are managed (approximately 41% of net operating income) and those that are triple-net-leased (59%).
The business model at New Senior is one that blends both organic and acquisition-driven growth. Organically, on the triple-net-leased side, leases are structured with automatic annual increases in the low single-digit range. On the managed side, the company is pursuing slightly higher same-property income growth (mid-single-digit) by bringing undermanaged properties up to market rates and profitability. In terms of acquisitions, management has identified a $3B pipeline of target deals in its specialty areas where ownership is still highly fragmented.
Although New Senior is externally managed by affiliate Fortress Management Group, we believe that the fee structure is reasonable with incentives in place to grow shareholder equity rather than assets (and thus not encouraging reckless, debt-driven growth). This investment (like any) is not without risks, and the most obvious one at the moment is the relatively higher gearing (leverage) that the company carries on its balance sheet (around 60% total debt/enterprise value). We believe this risk, along with its relatively short operating history as a stand-alone entity, is sufficiently reflected in its belowaverage market valuation. We estimate that by 2016, New Senior will be delivering annual dividends of $1.19/share, which represents a nearly 9% yield on current prices and a very compelling value given New Senior’s solid long-term prospects.
Data Source: Company Filings, Bloomberg
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