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2018 February Newsletter

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

Fear of Missing Out (FOMO)

This month I’d like to share some thoughts on 2017 performance, investment transparency, a mentor from my past, and our more conservative positioning as we begin 2018. Let’s start with performance, which we also discussed on our recent investment team webinar (a replay of which can be found at www.fimg.net). In simple terms, our managed strategies posted respectable total returns in 2017. While our returns lagged the smokin’ hot U.S. and global stock markets, the combined price appreciation and income generation in our portfolios exceeded the long-term, inflation-adjusted bogeys we target in each of our four core strategies. Perhaps as importantly, we achieved our returns taking far less risk than I believe was embedded in financial markets during the year.

As 2017 progressed, we sold and trimmed stocks and closed-end bond funds that reached our fair value targets faster than we could replace them. This led to higher cash and U.S. government bond holdings which remains a characteristic of accounts today. We also avoided most of the high-flying, household name growth stocks like Amazon, Facebook, and Netflix which traded at valuations we just couldn’t get comfortable with. These actions ultimately served as drags on relative performance, but in my view they are acceptable given our ultimate objective of protecting and growing the long-term, after-inflation value of your hard earned funds.

The year wasn’t without a few duds, and one stock in particular, Dundee Corp, continued to frustrate our team (and I know many of you). In 35 years of professional investing, Dundee is my single biggest loser. Every client who has looked at their portfolio appraisal, investment by investment, is well aware of the loss. We still own Dundee for most of our clients, and whether 2018 is the year things turn around for Dundee’s share price or the year we decide enough is enough and throw in the towel, is yet to be seen. For now, we believe there remains significant unrecognized value in this Canadian conglomerate and that the fundamentals there are slowly turning around. But we also thought that at the end of last year, and the market has yet to share our view on the stock.

Transparency

Many clients do not drill down on their portfolio holdings and only look at the aggregate results. In fact, I would say that most of our clients look strictly at the aggregate. Since I started FIM Group more than thirty years ago, I felt clients should be able to drill down and see exactly what we paid and how a holding is priced. While not the best analogy for a long-time vegetarian, I wanted you to see how the (portfolio) sausage is made. That is, however, not an industry-standard attitude. And with many investors today using funds rather than individual stocks and bonds, the full glory of a Dundee screw-up would never be seen. 

But we at FIM Group believe in honest, straightforward transparency. So, Dundee’s blunder will exist, and such “failures” will teach us better than success does. They keep us humble. Disclosing the “mistake and loser” investments is only honest, and keeps us on our toes. Success can breed overconfidence, which in turn can produce risky behavior. I see this in all walks of life, but especially with young athletes who, given their raging hormones, healthy bodies, and success on the pitch, field, or court, feel – well, a bit invincible and often get involved in risky behaviors. Driving too fast, consuming drugs or alcohol, hanging out with the wrong crowd, and such can all lead to disaster before they know it. The world of investing is no different, and part of our job is to be hyper-vigilant towards signs of overconfidence in markets and the risky investment behavior that often follows. 


Sir John Templeton

When I look through the haze of experience, training, and education over the 45 years I have been investing personally and professionally, I feel most grateful that Sir John Templeton was alive and well and writing a great deal when I was developing my skills as a professional investor. I read his every word, and admired his no-nonsense, commonsense approach. Back then, it seems he often claimed that investing was about making money, about total returns, and not about slicing and dicing growth or income, whether international or domestic. It was simply about making money and preserving wealth. I now look back on my early years and feel thankful that I was attracted to his global, value matters/price matters approach, rather than to some of the other investment philosophies prevalent during that time.

For example, as I was just beginning my career in the 1970’s, an often-touted strategy, especially from the trust companies and blue-blood investment manager herd was to “just buy the Nifty-Fifty and then head off to the golf course.” The Nifty-Fifty were the fifty most popular “blue chips” of the New York Stock Exchange, including stocks like IBM, GE, Coca-Cola and Johnson & Johnson. These stocks were described as “one-decision” choices, as they were “expected” to be stable growers over time. As this philosophy took hold, the valuations of the Nifty-Fifty hit 50 times earnings, which by any standard was completely crazy. Of course, all good things end, and the bloodbath left by that “craze” scarred the psychology of the average investor. Wikipedia summarizes that era well (the 1970s through 1982): “Because of the under-performance of most of the Nifty Fifty list, it is often cited as an example of unrealistic investors’ expectations for growth stocks.” Also, “The American Nifty Fifty is now defunct, as it was subsequently replaced by the S&P 500.” I used to wonder when I saw massive losses from those who built portfolios based on the Nifty Fifty if I would have survived this business had I taken that approach, or if I would have gone on to another career. I felt lucky to have been figuratively “mentored” by a great man such as Templeton. 

Sometimes there are plentiful opportunities for unusual return[s] with less-than-commensurate risk, and sometimes chances are few and risky. It’s important to wait patiently for the former. When there’s nothing clever to do, it’s a mistake to try t o be smart. – Howard Marks


Nifty-500?

In some ways, today’s S&P 500 index of U.S. stocks reminds me of the Nifty-50 from my past. Many investors and advisors today seem to believe that products based on this index or a sampling of stocks from this index make for simple “one decision” investing. Many investment sellers or product providers like Vanguard, Fidelity, brokers and trust officers will tell you, “indexing with blue chips works,” and that any “rational” investment program should start with a solid chunk of S&P 500 stocks.

Those advising that approach no doubt have recent history on their side. From the end of 2008 to the end of 2017, the S&P 500 has compounded at 15%+ annually with very few hiccups along the way. In retrospect, investors who bought the S&P 500 and headed to the golf course, would have far outperformed just about anything else including strategies like ours that thoughtfully diversify with cash, bonds, international stocks and yes, non-S&P 500 securities. During this period, our efforts to add value through traveling to visit various countries, holding conference calls with management, spending late nights doing research, assessing our own internal arguments, engaging in vigorous debates about how a portfolio should look, and positioning to limit downside volatility in each of our four core strategies, have proven to be largely unnecessary.

The stock market is a device for transferring money from the impatient to the patient. - Warren Buffett


So, should we change course and become a Nifty-500 shop? If we did that, would we feel confident at a time of historically high stock and bond valuations, that our clients could get to retirement and live the retirement lifestyle they aspire to? In short, I believe the answer to these questions is a resolute “No.”

As I write this, I think of the crashes I have lived through (sometimes barely) in my professional life—big ones and little ones. I think of the Internet craze, Black Monday, 9-11, October 2007 to March 2009, and a number of others. I was at my desk working all of those times. Happily, I was not alive in the big crash during the Depression, but of course I studied it. And I believe that now is the time to be patient, not the time to be “clever” and to go along with the crowd. Now is the time to be as vigilant as ever towards risk and to manage it thoughtfully. As Warren Buffet says, “To buy when others are despondently selling and sell when others are greedily buying requires the greatest fortitude and pays the greatest reward.”

As noted above, markets today are giving us more opportunities to sell then they are to buy. We maintain well diversified portfolios with a broad mix of very compelling holdings that, combined, position us well to weather whatever comes next. Although we would love to own many of the companies in the S&P 500 today, the prices (valuations) for most of these stocks are just too rich. Instead we are finding niches here and there, that offer much more compelling value. This month’s spotlight holding, Kennedy Wilson, is just one such example, and we are always happy to discuss any of the holdings in your portfolios (even Dundee!). 

The world can seem like a crazy place right now. But it has always been so. We humans can be a bit silly. Thankfully, life goes on; things change, we change with them, we help improve them and move toward a better life. Sadly, though, most systems tend to be reactive, so we often need to have some volatility, events, or traumas to get us on the right course – back to rationality. Whether or not 2018 turns out to be a “rationality-check” year remains to be seen, but I’m confident that we will be prepared either way. We will continue knowing that buying $1 for 50 cents has less risk than paying $3 for the dollar. And that paying $10 for one dollar’s worth of earnings is less risky than paying $30 for that same dollar of earnings. While markets may “melt up” to the point where the going rate for a buck of earnings is $50, as they did for many stocks in my formative “Nifty-Fifty” years, we won’t get sucked into the FOMO (fear of missing out) trap. Instead, we will continue to do what has worked over the decades at FIM: manage with transparency, learn from our mistakes, apply the lessons of investment legends like Sir John Templeton, and manage with patience, discipline, and unwavering focus on the things that matter. 

Matthew J. Desmond CFA®
By: Matthew J. Desmond CFA®

Tax Cuts and Jobs Act: Impact on Individuals

On December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act, a sweeping $1.5 trillion tax-cut package that fundamentally changes the individual and business tax landscape. While many of the provisions in the new legislation are permanent, others (including most of the tax cuts that apply to individuals) will expire in eight years. Some of the major changes included in the legislation that affect individuals are summarized below; unless otherwise noted, the provisions are effective for tax years 2018 through 2025.

Individual income tax rates

The legislation replaces most of the seven current marginal income tax brackets (10%, 15%, 25%, 28%, 33%, 35%, and 39.6%) with corresponding lower rates: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. The legislation also establishes new marginal income tax brackets for estates and trusts, and replaces existing “kiddie tax” provisions (under which a child’s unearned income is taxed at his or her parents’ tax rate) by effectively taxing a child’s unearned income using the estate and trust rates. (see chart below)

Single

If taxable income is:

Then income tax equals:

Not over $9,525

10% of the taxable income

Over $9,525 but not over $38,700

$952.50 plus 12% of the excess over $9,525

Over $38,700 but not over $82,500

$4,453.50 plus 22% of the excess over $38,700

Over $82,500 but not over $157,500

$14,089.50 plus 24% of the excess over $82,500

Over $157,500 but not over $200,000

$32,089.50 plus 32% of the excess over $157,500

Over $200,000 but not over $500,000

$45,689.50 plus 35% of the excess over $200,000

Over $500,000

$150,689.50 plus 37% of the excess over $500,000

Head of Household

If taxable income is:

Then income tax equals:

Not over $13,600

10% of the taxable income

Over $13,600 but not over $51,800

$1,360 plus 12% of the excess over $13,600

Over $51,800 but not over $82,500

$5,944 plus 22% of the excess over $51,800

Over $82,500 but not over $157,500

$12,698 plus 24% of the excess over $82,500

Over $157,500 but not over $200,000

$30,698 plus 32% of the excess over $157,500

Over $200,000 but not over $500,000

$44,298 plus 35% of the excess over $200,000

Over $500,000

$149,298 plus 37% of the excess over $500,000

Married Individuals Filing Joint Returns

If taxable income is:

Then income tax equals:

Not over $19,050

10% of the taxable income

Over $19,050 but not over $77,400

$1,905 plus 12% of the excess over $19,050

Over $77,400 but not over $165,000

$8,907 plus 22% of the excess over $77,400

Over $165,000 but not over $315,000

$28,179 plus 24% of the excess over $165,000

Over $315,000 but not over $400,000

$64,179 plus 32% of the excess over $315,000

Over $400,000 but not over $600,000

$91,379 plus 35% of the excess over $400,000

Over $600,000

$161,379 plus 37% of the excess over $600,000

Married Individuals Filing Separate Returns

If taxable income is:

Then income tax equals:

Not over $9,525

10% of the taxable income

Over $9,525 but not over $38,700

$952.50 plus 12% of the excess over $9,525

Over $38,700 but not over $82,500

$4,453.50 plus 22% of the excess over $38,700

Over $82,500 but not over $157,500

$14,089.50 plus 24% of the excess over $82,500

Over $157,500 but not over $200,000

$32,089.50 plus 32% of the excess over $157,500

Over $200,000 but not over $300,000

$45,689.50 plus 35% of the excess over $200,000

Over $300,000

$80,689.50 plus 37% of the excess over $300,000

Standard deduction and personal exemptions

The legislation roughly doubles existing standard deduction amounts, but repeals the deduction for personal exemptions. Additional standard deduction amounts allowed for the elderly and the blind are not affected by the legislation and will remain available for those who qualify. Higher standard deduction amounts will generally mean that fewer taxpayers will itemize deductions going forward.

2018 Standard Deduction Amounts

Filing Status

Before Tax Cuts and Jobs Act

After Tax Cuts and Jobs Act

Single or Married Filing Separately

$6,500

$12,000

Head of Household

$9,550

$18,000

Married Filing Jointly

$13,000

$24,000

Itemized deductions

The overall limit on itemized deductions that applied to higher-income taxpayers (commonly known as the “Pease limitation”) is repealed, and the following changes are made to individual deductions:

State and local taxes – Individuals are only able to claim an itemized deduction of up to $10,000 ($5,000 if married filing a separate return) for state and local property taxes and for state and local income taxes (or sales taxes in lieu of income).

Home mortgage interest deduction – Individuals can deduct mortgage interest on no more than $750,000 ($375,000 for married individuals filing separately) of qualifying mortgage debt. For mortgage debt incurred before December 16, 2017, the prior $1 million limit will continue to apply. No deduction is allowed for interest on home equity indebtedness.

Medical expenses ­– The adjusted gross income (AGI) threshold for deducting unreimbursed medical expenses is retroactively reduced from 10% to 7.5% for tax years 2017 and 2018, after which it returns to 10%. The 7.5% AGI threshold applies for purposes of calculating the alternative minimum tax (AMT) for the two years, as well.

Charitable contributions – The top adjusted gross income (AGI) limitation percentage that applies to deducting certain cash gifts is increased from 50% to 60%.

Casualty and theft losses – The deduction for personal casualty and theft losses is eliminated, except for casualty losses suffered in a federal disaster area.

Miscellaneous itemized deductions – Miscellaneous itemized deductions that would be subject to the 2% AGI threshold, including tax-preparation expenses and unreimbursed employee business expenses, are no longer deductible.

Child tax credit

The child tax credit is doubled from $1,000 to $2,000 for each qualifying child under the age of 17. The maximum amount of the credit that may be refunded is $1,400 per qualifying child, and the earned income threshold for refundability falls from $3,000 to $2,500 (allowing those with lower earned incomes to receive more of the refundable credit). The income level at which the credit begins to phase out is significantly increased to $400,000 for married couples filing jointly and $200,000 for all other filers. The credit will not be allowed unless a Social Security number is provided for each qualifying child.

A new $500 nonrefundable credit is available for qualifying dependents who are not qualifying children under age 17.

Alternative minimum tax (AMT)

The AMT is essentially a separate, parallel federal income tax system with its own rates and rules – for example, the AMT effectively disallows a number of itemized deductions, as well as the standard deduction. The legislation significantly narrows the application of the AMT by increasing AMT exemption amounts and dramatically increasing the income threshold at which the exemptions begin to phase out. (see charts below)

Other noteworthy changes

The Affordable Care Act individual responsibility payment (the penalty for failing to have adequate health insurance coverage) is permanently repealed starting in 2019.

Application of the federal estate and gift tax is narrowed by doubling the estate and gift tax exemption amount to about $11.2 million in 2018, with inflation adjustments in following years.

In a permanent change that starts in 2018, Roth conversions cannot be reversed by recharacterizing the conversion as a traditional IRA contribution by the return due date.

For divorce or separation agreements executed after December 31, 2018 (or modified after that date to specifically apply this provision), alimony and separate maintenance payments are not deductible by the paying spouse, and are not included in the income of the recipient. This is also a permanent change.

SOURCE: Broadridge Investor Communication Solutions, Inc.

2018 AMT Exemption Amounts

Filing Status

Before Tax Cuts and Jobs Act

After Tax Cuts and Jobs Act

Single or Head of Household

$55,400

$70,300

Married Filing Jointly

$86,200

$109,400

Married Filing Separately

$43,100

$54,700

2018 AMT Exemption Phaseout Thresholds

Filing Status

Before Tax Cuts and Jobs Act

After Tax Cuts and Jobs Act

Single or Head of Household

$123,100

$500,000

Married Filing Jointly

$164,100

$1,000,000

Married Filing Separately

$82,050

$500,000

Other noteworthy changes

The Affordable Care Act individual responsibility payment (the penalty for failing to have adequate health insurance coverage) is permanently repealed starting in 2019.

Application of the federal estate and gift tax is narrowed by doubling the estate and gift tax exemption amount to about $11.2 million in 2018, with inflation adjustments in following years.

In a permanent change that starts in 2018, Roth conversions cannot be reversed by recharacterizing the conversion as a traditional IRA contribution by the return due date.

For divorce or separation agreements executed after December 31, 2018 (or modified after that date to specifically apply this provision), alimony and separate maintenance payments are not deductible by the paying spouse, and are not included in the income of the recipient. This is also a permanent change.

SOURCE: Broadridge Investor Communication Solutions, Inc.

FIM Group Staff
By: FIM Group Staff

Kennedy Wilson

Ticker: KW
Website: www.kennedywilson.com
Share Price/Market Capitalization: $17.20/US$2.6b

Investment thesis: Kennedy Wilson (KW) is a global company that owns, operates, and invests in commercial real estate. We bought this high-quality portfolio of property and a growing asset management platform for 30% below our estimate of net asset value (NAV). The stock’s 4.5% dividend yield is well covered by cash flow, and we expect mid-high single-digit annual dividend growth in the years ahead.

KW is an opportunistic global property investor that owns over $7b in commercial real estate. The company recently completed a merger with its subsidiary Kennedy Wilson Europe and is currently focused on multifamily and commercial properties in the Western U.S., the U.K., and Ireland. Its portfolio spans 389 assets and includes over 26,000 apartment units and 19.8m square feet of commercial floor space. 

The company has amassed a 30-year track record and has built a network of long-term relationships with major institutions and local service teams that gives it competitive advantage. Management is executing a multi­pronged strategy that includes growing its apartment portfolio, converting projects now under construction into cash-producing investments, and recycling lower-yielding assets into higher-yielding ones. It is also leveraging its decades of know-how to raise and manage third-party capital (real estate funds) in the U.S. and Europe. With these funds, it earns recurring management fees, as well as a share of profits.

We believe that insiders, who own 15% of the company, are well-aligned with us and that the company has substantial liquidity (over $700m) that it can deploy in new growth opportunities. Shares trade at a significant discount to our estimated sum-of-parts. We believe this is, in some aspects, due to a “complexity discount,” because KW doesn’t fit into the narrowly focused style and geographical box that some investors prefer. We believe this flexibility to invest where and when it sees fit is an advantage. As management continues to grow net asset value and dividends, we expect to earn meaningful total returns.

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

Wisconsin

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

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