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2018 April Newsletter

Paul Sutherland, CFP®
By: Paul Sutherland, CFP®

Keep It Simple

Bitcoin, index funds, leveraged mutual funds, inverse funds, ETFs, CMOs, and all the “Wall Street” fancy new products that these days make securities sound sexier did not exist, or were infants, when I started my career as a professional investor. Historically, you bought a stock (equity) or a bond (debt). You invested in equities, which are “ownership” assets, meaning that you got what was left after paying expenses and interest to the debt holders. If you owned debt, you knew two things – you would get interest, and the bonds’ maturity value was certain so long as the company or government was still around to pay you. Simple!

Options existed, but writing options to increase a portfolio’s cash returns was considered a far-out idea. I once met the guy who mainstreamed the use of options to increase income in trust portfolios. I remember him telling me it was hard to get trustees to adopt the use of option writing as an income vehicle. (Covered option writing was, and still can be, a low-risk way to increase income. Today, however, the “fun” or extra-risk premium has been sucked out of options so they’re no longer an attractive strategy. Everyone is doing it and competition has made option prices come down since I was a kid in this business.) 

What is sad today is that many “Wall Street” companies and salespeople are out there “selling” stuff that has not been tested, or is the equivalent of stock or bonds on Speed. I am amazed at how fast large brokerage firms got into Bitcoin, allowing their clients to buy something that was not even invented to be an investment but rather was meant to be a store of value – a currency, so to speak. It even had (or perhaps still has) the benefit, to some, of having no oversight and providing non-traceable transactions, which of course make it attractive to criminals and corrupt governments. Now, though, we are seeing Bitcoin implode, with Twitter and Google both banning the marketing on their platforms. 

My Three (Investment) Loves

I have tended to fall in love with three things in a company or investment: (1) nice big dividends, paid out in cash, and representing a part of the earnings of the company; (2) well-managed, quality companies that offer great products or services and have the ability to execute, develop the market, and grow the business; (3) complex businesses, holding companies, or closed-end funds whose constituent parts, when added up, are worth far more than the market is pricing the whole.

However, the underlying key ingredient is to always pay much less for an investment than you think it’s worth – in other words, to take advantage of what we call a risk-adjusted bargain. Thank­fully, investments tend to be cyclical, so they get both highly overvalued and highly undervalued, for various reasons. Some of these valuations are deserved, while others are just due to psychology. Sir John Templeton said that bargains tend to be found where “Reality is different than perception.” He also did not like labels, like growth, value, and such, as he said true investing is simply about making money over time (for the client). 

Our team at the FIM Group manages client portfolios that are full of solid, cash-generating businesses. Some of these businesses pay most of this cash in the form of dividends to their share­holders. Others reinvest most of this cash to further grow their companies. Our job, day in and day out, is to evaluate the future cash-generating potential of these businesses AND to make judgements related to the market’s pricing of this future cash-generating potential. In other words, we constantly assess investment quality and investment valuation, the two primary drivers of an investment’s success.

The super-simple grid below shows a matrix of basic scenarios to illustrate what happens when either investment quality or investment valuation changes during a holding period (or both!). Constant for all scenarios is a $100/share starting price and a 1-year holding period. The top section considers what happens when there is a “surprise” on the quality front. Let’s say that a company expected to generate a $4/year dividend actually delivers 10% more than that in a “good” scenario and 10% less in a “bad” scenario. You can see that, assuming the market’s required dividend yield is unchanged, the stock price will change in response to the quality change. This stock price change will also have a significant impact on total returns. In the middle section, the dividend (quality) is held constant, while the market’s required yield is altered down 10% in the “good” scenario and up 10% in the “bad” scenario. The dividend yields required by investors could change for a variety of reasons, including com-­ petition from other investments like CD’s or corporate bonds, but as you can see, shifts in required yields can also play havoc with stock prices and total returns. The lower section combines changes in both quality and valuation scenarios to illustrate the compound effect these factors can have on stock prices and total returns when changing in unison. 

Chart 1

Stock prices can be quite volatile as market participants make their judgments of investment quality and proper valuation. So far this year, a major driver of this volatility has been shifting views on the future trend of inflation, supply and demand of benchmark bonds and how these forces may change the yields investors demand from their stocks. Questions about the staying power of the current economic recovery, possible trade wars, and government policy changes in areas like regulation are further impacting investor assessments on the quality side of things. This is causing some fairly significant share price movements and opportunities for our team.

Right now, due to significant volatility in the market, we at FIM Group are able to buy companies at great prices that have good, solid dividends and that we also expect to grow. The chart below lists only a few of these. We show the dividend yield and the internal EBITDA yield, a measure of valuation based on Earnings Before Interest, Taxes, Depreciation and Amortization. We expect that our companies as well as our other investments will do well over time, regardless of the direction of the general stock market. Let’s take a look at VEREIT, a real estate investment trust that invests in triple net-leased real estate. Its cash dividend, which is paid out quarterly, is 8.2% based on today’s price. We expect that dividend to stay steady and perhaps even to rise. We also expect the company will grow it’s earnings as well as the value of its real estate properties over time. The market has, over the last year, priced this investment at a high of $8.92; it is currently at $6.75.

Chart 2

Be Rational – Don’t Overpay

A chief rule in investing is to not be dumb and to avoid buying irrational investments that have little economic benefit in terms of value-adding properties or societal benefits. Also, it’s critically important to “buy right” and to avoid buying something that is worth $20 for $50. 

A recipe for disaster occurs when simple stocks and bonds are marketed in ways designed to make potential buyers believe that they can get more than they should expect to get from an investment, based on its intrinsic worth. A 3% U.S. Treasury bond, for example, is guar­anteed to give 3% yields over its lifetime and to return its maturity value when it matures. Putting a simple bond or stock in an ETF, a mutual fund, an annuity, an LLC, a hedge fund, or a trust shell will not increase its “value.” A bond is a bond and a stock is a stock – that’s all! The returns come from the performance of the security, whereas the “shell” is merely a kind of wrapping paper. Today, more than ever, the exotic, the flashy, the “new thing” seems to be attracting investors. We at FIM Group are pitched these investments daily, but we know that what’s key is to evaluate the quality and valuation of the securities sitting inside the shell. When I see billions of dollars going into Bitcoin, and trillions going into enhanced ETFs and mutual funds, I wonder if the people buying those investments have really looked under the hood to assess the actual intrinsic value of the investments. 

Stock Sale Cartoon
Alice McDermott, CFP®
By: Alice McDermott, CFP®

Social Security Benefits – file or delay?

The question “at what age should I file for social security benefits?” is definitely in the top five asked during a typical retirement planning meeting. 

Before you file, there are options and strategies to be considered. After filing, circumstances change and some people will wish they had delayed. This article will address a number of the nuances, benefits, and options for soon-to-be-retirees reaching that minimum age of 62.

There are three primary reasons to delay taking social security benefits between age 62 and full retirement age (FRA):

You are still working because you either want to or have to. Regardless, by taking your benefit “early” (below the FRA), not only will you receive a lower amount, but this amount may also be reduced based on the amount of other earnings such as wages and self-employment income you receive during a given tax year. In addition, your benefits may be taxed at a higher rate based on your combined Adjusted Gross Income, which includes income from other sources such as investments, rental income, pension payments, and the like. 

By delaying, you receive a bigger check for life. Starting at 62 means an immediate 25%–30% reduction of what you would receive had you waited to collect between ages 66 and 67. By delaying beyond your FRA, you receive an 8% bump for every year you delay. For example, if at age 67 you decide to delay to age 70, you will receive 24% more in your monthly check. If at age 67 you would have received $2,000, this equates to an additional $480 more per month, or $5,760 per year, which is significant over many years. Assuming you outlive the mortality average, and well into your mid to late 80s, this will have been a wise financial decision.

According to the Social Security Administration, “If you live to the average life expectancy for someone your age (and with average health), you will receive about the same amount in lifetime benefits no matter whether you choose benefits at age 62, FRA, age 70, or somewhere in between.” The reason is that, although the initial checks you receive will be smaller, there could be many more of them, so for those who believe they will not outlive their average life expectancy (typically between 79 and 83, with females living on the longer end), it’s basically a wash, and they would be a good candidate for collecting “early.” However, if you have good genes and historical longevity, imagine the financial reward of living into your late 80s or even 90s! Due to healthier lifestyles, as well as advancements in medicine and technology, I see many clients living much longer than they expected.

Strategize with a spouse, and your options increase. Delaying social security benefits can be a good thing if coordinated with a spousal benefit strategy. Although these have recently changed, married couples still have more options when it comes to collecting than a single person does (with the exception of divorced individuals and widows or widowers). This may be especially valuable if there is great disparity in the earnings history and benefit amounts. Another important factor to consider is that if both spouses are collecting a benefit and one dies, the survivor receives only the higher of the two benefits. For this reason, it is wise for the spouse with the higher earnings record to delay beginning benefits as long as possible so that a surviving spouse may then collect that higher benefit for life. Finally, when one spouse collects a lower, spousal benefit, this may allow the other spouse to receive the highest income allowed.

So, what are the options for those who truly want to retire at age 62 or 63, but also wish to delay their benefit to FRA or even age 70? In this circumstance, we look at which sources of income might be available to cover the annual need, and for how many years. These sources may be cash savings, a pension, investment/dividend income or funds taken from a retirement account to supplement income (remember, there is no 10% penalty for those over 59½ ). By drawing funds “early” from an IRA, or before age 70½, you are reducing the size of that account, at which time you will be forced to take out a Required Minimum Distribution, which (if you’re lucky) may be more than you need. In addition, if you are already collecting social security, depending on the amount you need, this higher RMD might kick your social security benefit into a higher tax bracket. How best to strategize will therefore depend on your current savings, your investments, how your investments are invested, and any restrictions on accessing them (that is, potentially with annuities), and is based on your personal financial situation. All these factors should be discussed with your financial advisor.

Earlier, I mentioned the possibility that some people who file early may later regret that decision. For those who begin benefits before their actual FRA, they have only one choice: withdraw the benefits and pay everything back. You must do this within one year of filing and you may only do this one time. You must also consider family members who may also be collecting benefits under your record, as they, too, will lose their benefit and need to repay all benefits received (with the exception of divorced or widows and widowers). But let’s say you decided to apply at age 64 and your FRA is 66. If you are still collecting social security at 65½ , you are no longer eligible to withdraw (over one year), yet once you hit age 66 you may “suspend” your benefit and apply down the road, up to age 70. In other words, you are not eligible to suspend your benefit until your FRA or later. This would make sense for someone who began working again, perhaps received an inheritance, or realized they don’t need the money and would prefer getting the higher benefit for their life or their spouse’s life.

Clearly, social security – when to apply, spousal benefits, divorced and widow/widower options – can be complex and confusing to many. Feel free to contact any one of our Certified Financial Planners or the planner you work with, and we’d be happy to discuss and review your options. It’s always best to plan early, to prepare for a sound financial roadway ahead

FIM Group Staff
By: FIM Group Staff

Investment Team Spotlight: Hanesbrands, Inc.

Summary Snapshot

Ticker: HBI

Website: www.hanes.com

Share Price/Market Capitalization: $19.70/US$7.1b

Hanes Champion

Investment thesis: Hanesbrands, Inc. (HBI) is an apparel company focused on the basics with dominant North American category shares. The company has opportunities to drive long-term free cash flow growth via acquisitions, international expansion, and cost optimization programs. While exposed to a shifting retail landscape, HBI has established brands and a low-cost global supply chain providing sustainable competitive advantage. We are buying shares with an expected dividend yield of 3%, mid-single-digit base case earn­ings growth with upside, and valuation multiple expansion potential back to historical and peer group averages.

HBI is the largest basic apparel company in the world with leading share in “essentials” categories like T-shirts, bras, underwear, socks, hosiery, and activewear. Founded in 1901, it established such brands as Hanes, Champion, Bali, Maidenform, Playtex, and Leggs. More than 70% of the company’s unit sales are manufactured in company-owned facilities or by dedicated contractors throughout the world. Its finished goods are sold across a wide range of channels, including mass merchant stores like Target, department stores like Macy’s, club stores like Costco, and e-commerce companies like Amazon.

Although HBI operates in a highly competitive industry, it holds #1 or #2 market share in most of its categories. Key competitors are Fruit of the Loom (Berkshire Hathaway), Russell Corp., and Jockey International. Industry demand growth for general inner-ware products is replenishment driven and steady at 2–3%/year with higher growth rates (10–12%/year) for activewear products. While price is a factor, consumer preference is more often driven by comfort, fit, and product consistency.

HBI business strategy is centered on three main elements: growing the brand further globally, innovating and building product platforms focused on 5–10 year megatrends (like Tagless), and maintaining one of the lowest-cost global supply chains in the industry. We expect that the combination of steady internal growth, accretive acquisitions, and relentless cost control can deliver consistent low to mid-single-digit sales growth as well as higher profit growth in the years ahead.

The share price of HBI has fallen some 40% from its 2015 peak as investors reacted to below-expectation earnings results in 2016 and 2017. We believe that these “misses” primarily reflected changes to the inventory stocking policies of its key customers and also “door closures” as retailers adjusted to the threat from e-commerce. Our analysis shows that HBI management has already made course changes that are underrecognized in the market and that the company is back on a growth trajectory. By 2020, we believe that HBI will generate cash flow north of $1b/year versus about $700m this year. As it executes to this level, we expect its market valuation to normalize higher to peer group and historic levels and to reward us with solid price appreciation on top of it’s 3% annual dividend yield.

Hawaii

444 Hana Hwy,
Suite D
Kahului, HI 96732
p: 808.871.1006
f: 808.871.1433

Michigan

111 Cass Street
Traverse City, MI 49684
p: 231.929.4500
f: 231.995.7999

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1837 E. Main Street
Onalaska, WI 54650
p: 608.779.0300
f: 608.779.0304

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