Happy 2018! We thought we’d kick off the new year with a FIM Group virtual roundtable discussion. On December 15, Paul Sutherland (PS), Jeff Lokken (JL), Barry Hyman (BH), Suzanne Stepan (SS), John Bresnahan (JB), and Zach Liggett (ZL) put together some thoughts on the year that was and the year ahead.
Q: Complete this sentence. For financial markets, 2017 was the Year of the…?
BH: New Stock Market Narrative. For the last few years, the U.S. stock market marched higher on the narrative that central banks were pumping money into markets. This extraordinary monetary policy put a lid on interest rates and pushed investors who wanted to beat inflation into higher stock allocations. This year, as the Fed signaled a reversal in its monetary policies, stock valuations ignored this significant reversal and latched onto a new narrative – anticipation of tax reform, which has fueled market valuations to ramp even higher.
One measure of these valuations, the Shiller PE of the S&P 500 (which smooths earnings over 10 years) started the year at an already high 28x (Figure 1). As we wrap up the year, this measure exceeds 32x. Another measure is the current price-to-sales ratio which is now back to Dot-com peak levels (Figure 2).
While it is true that the tax reform will likely benefit many businesses, the current prices of many stocks that make up the bulk of most major stock indexes have already priced in these factors, and more. That’s what is meant when economists refer to the stock market as a leading indicator – prices reflect future expectations of policy or actions. I think at their current valuations, prices of many of the stocks that make up the major indexes far exceed their intrinsic values. The goal of intelligent investing is to identify stocks throughout the world whose prices underestimate their future cash flows. Fortunately, we are still able to identify such opportunities, although many are not in the popular indexes.
SS: No Fizz Bond Market. Not only did volatility in the Treasury market hit new historic lows in 2017, the shape of the yield curve flattened significantly. While it was clear coming into the year, that the Federal Reserve would be hiking short-term rates, many prognosticators expect- ed long-term rates to follow. That proved wrong as longer-term interest rates dropped for the first eight months of the year, compressing the spread between short-term and long-term rates. Only in the last few months have longer-term rates started to rebound higher. This flattening trend turned out to be good for most investors and consumers. Interest rates on money markets and CDs began to creep higher, so savings accounts finally started earning something. Yet, the opportunity to finance longer-term assets, such as homes at low rates, remained very attractive. And broadly speaking, most risk assets benefitted as investors needing return on their long-term money had little opportunity cost to stick with stocks, high-yield bonds, and even precious metals like gold.
PS: Crypto Currency Mania! The rise of bitcoin and the whole crypto-currency space has simply been extraordinary. It will likely be the bubble of our lifetime. 2017 was a parabolic year for the price of bitcoin, and I have been wrong every time from $1,000 to $17,000 (and counting!) when telling friends to sell. The technology development with blockchain is fascinating and something our team will continue to research. But when it comes to bitcoin speculation, we’ll leave that to those who think they can ride the wave and can step off before it comes crashing down on them.
JB: This past year was a year of exceptional events, and what I like to call mere-exceptional events, or instances that might be deemed unremarkable in the future. Since I am a bottom-up investor foremost, intra-cycle gyrations (be they positive or negative) are just another data point for me to consider. While the aggregate numbers can be intriguing, the underlying bits that brought these end results to fruition are where I linger.
When I think about the global financial markets through the course of 2017, the word confluence comes to mind. In a world hypersensitized to all affairs, positive perception of the present (in aggregate) won the day. Companies that beat expectations on both top and bottom lines (revenues and earnings) while also forecasting confidence in their path forward were rewarded. Those entities with a mixed set of these three factors – or, worse yet all negatives (actual and/or perceived) – were punished. The dispersion of returns at the company, industry, and sector levels was wide.
While this sloshing around of capital can create inefficiencies, and thus opportunities, we are reminded that the velocity of this roiling is often a harbinger… of something. At the country level, geopolitics remained as noisy as ever; however, the global economy continues to endeavor forward. Market participants have been reminded time and again to put risk first. For me 2017’s lesson (as with 2013) was that of balance – that is, striving to be as cognizant of perceived threats as potential opportunities.
Q: Last year, several of you traveled to visit portfolio companies and attend conferences. If you could pick one highlight of these trips, what would it be?
ZL: In June, I did an Asia trip to Japan and Singapore with visits to a wide variety of companies. The Japan portion was probably the most productive for us investment-wise, and insights gained there helped strengthen our case to own several of the Japanese stocks in our portfolios today. We started a position for many clients – for example, in Ichigo Inc., not long after I returned stateside.
Ichigo is an opportunistic, integrated commercial real estate and infrastructure company. Management there looks for unique situations, whether these be in middle-tier office buildings, boutique hotels, or solar farms, and invests where they believe they can add meaningful value. Ichigo earns rental income while holding and updating their properties. It then looks to make further profit by selling to buyers at prices reflecting the value created during the holding period.In addition to investing their own balance sheet, Ichigo also raises and manages property as well as solar funds for other investors. These produce attractive, recurring fees on top of the rent and profits they earn from their real estate holdings. While in Tokyo, I met with Ichigo’s corporate executives, saw examples of their property investments, and chatted with key managers of the funds they manage.
JB: When I think about the 75 extraordinary interactions I’ve had with management teams across the globe in 2017, three words come to mind: unique insights/ perspectives.
If you’re on the edge of the Australian outback touring an almond plantation (speaking with management, board members, and other investors) the lessons aren’t exclusive to those conditions. Select Harvest is planting trees that, literally, won’t bear fruit for years; yet they need to keep markets and investors up-to-date of the business every few months. Yes, that is a simplification, but if you spend a single day there you start to gain a better awareness of all that the business entails. At some point, you must start to trust that there is an understanding of the underlying business by the board and management, use longer periods to judge performance, and eventually make your tacks.
It is worth a midnight call from Finland to New Zealand to speak with an activist investor in a mutual holding. Instances such as this help you to understand the true lay of the land. In the case of NZX (the New Zealand Stock Exchange), I gained a clearer impression of what frustrations local investors have felt and ultimately what might prove to be opportunities for those patient enough.
Speaking with a company about their day to day business, while also engaging their controlling shareholders (for example our holding companies) can really round out a picture. Understanding how FFP approaches investing and its business strategy beliefs can inform one as to where PSA (aka Peugeot/Citroen/Opel) is headed in the long term versus the often-fretted-over short/intermediate term.
Every situation and resultant decision is a learning opportunity. I’ve found that I do best when I grade myself, revisiting assumptions and beliefs at later dates. These direct engagements with management, board members, and other investors can help to refine my expectations in advance.
Q: As far as client questions over the last twelve months are concerned, did you find any recurring themes?
SS: Our holding in the Canadian conglomerate Dundee came up often with clients, as it continued to trade well below our average cost. Despite the disappointing share price development, the fundamental news at Dundee was generally positive in 2017. Management completed a major deal to sell a cash-burning energy development in the Republic of Chad, and they opened a long-awaited urban hospitality project in Vancouver. They also paid off corporate level debt and now have a much more resilient financial footing. Unfortunately, these fundamental improvements have yet to be embraced by investors. As we speak [December 13], Dundee trades for around C$2.60/share against our “fire sale” estimated valuation of C$3.95/share and a reported book value of over C$11. We remain of the view that Dundee management has taken measures that add significant runway for an eventual turnaround. That said, we are also realistic that the pace of travel down this runway has been frustratingly slow. We continue to closely monitor progress at Dundee and carefully weigh the option of staying patient with our holding, as opposed to moving on to other ideas.
BH: Relative investment performance seems to be a regular discussion topic. I understand the temptation to compare how we are doing to what CNBC or the nightly news says “the market” did for the day/month/year, but I really try my best to discourage it. I believe intelligent investing should be a research-driven, long-term process that requires complete market cycles for hypotheses to play out. The movement of market indexes over several months or even a few years can distract and derail investors from achieving their objectives. We design and manage each of our core investment strategies with the objective of generating inflation-beating absolute returns over multi-year market cycles. In plain English, we manage to protect and grow our clients’ funds to meet their present and future financial needs. This is clearly a different objective than trying to beat an arbitrary measure of the overall market....
JL: Political risk came up a lot. Will Trump be impeached? Will the North Korea situation escalate from words to war? I’ll admit surprise to the way global markets handled these headlines. Just when I’d expect emotions to overtake the moment and bring fear back into markets, calm would prevail. It certainly invites the question, “If threats of nuclear war won’t knock this bull market off track, what will?”
ZL: The number of questions around our portfolio alignment with client interests in “good for society” investments seemed to trend higher. I think that’s part of the national trend where “impact” or “responsible” investing has really hit the mainstream. Our portfolios have ample exposure to companies innovating in alternative energy, water infrastructure management, green building, healthy living, and environmental services. We also continue to invest with a broad “triple-bottom-line” approach. We feel that companies that manage for far more than just short-term financial gain and embrace longer-term financial, environmental, and social considerations are likely to prove more resilient to future unknowns. This improved corporate resilience, in turn, should make their stocks and bonds more attractive to investors.
Q: Looking ahead to 2018, what is a key theme you are thinking about?
PS: I’m thinking about preparation for a return to a more normal volatility environment. It has not been easy, these last six months to find places to put money to work in a risk-controlled way. Each of our team members is doing a great job researching ideas which gives us confidence in our current holdings and a good “shopping list” on both the stock and bond sides. We’re staying disciplined on price, which requires patience, but I believe that our patience will be rewarded and that we’ll be ready to pounce on opportunities that come our way.
I feel that, more than ever, we need to stay vigilant toward various feedback loops. Since the crisis, markets have gotten used to a big flow of funds from central banks, passive indexers (those who invest with zero consideration of an investment’s price or quality), and trend-following strategies. These flows have arguably created positive feedback loops for stock and bond prices. Investors treat central bank interventions and continued market volatility as the “new normal,” so they “sell” volatility and “buy” the market via the cheapest strategies available (low-fee index strategies). Markets go up and trend followers jump on the train and add further fuel to the bull run. Active investors, who care about price and quality when making investment decisions and historically act as a governor to overall market valuations, see their influence wane. The result, after years of this positive feedback loop could be an unstable equilibrium of sorts where balance in the market just gets out of whack until something (even a small disturbance) leads to a large change. I may be way off base, but I’m glad we invest the way we do. We’re aware of potential market distortions, and we invest where we see good value rather than to keep up with a given index. When we can’t find sufficient value, we’re content to step aside.
JL: I ‘ve been thinking quite a bit about potential impacts not only to financial markets but also to clients from the large-scale tax changes now under debate. Love it or hate it, this new law will likely be the biggest set of changes since 1986. Once we sift through the final law, there will potentially be opportunities to revisit existing financial plans and make proactive strategy pivots. I’m sure that we’ll be communicating these opportunities in client meetings, calls, webinars, and newsletters throughout the new year.
SS: Having just finished a year with relatively low interest-rate volatility, and entering 2018 with a new Fed chair and the tax law reform just mentioned by Jeff, the outlook for interest rates remains a key theme for me. Will the Fed remain steady with its normalization of short-term rates even if an inflation pick-up fails to materialize? Might longer-term rates finally break higher if tax reform is deemed to pressure deficits higher? And, if they do, will they soon roll back over if higher rates halt the growth of a still-debt-laden economy?
JB: When I think about tomorrow, I try to step out and view things from a future historical perspective. In 20/40/80+ years, what events will be taught? We live in a novel time where everything is recorded…. We need to ask ourselves, beyond the data: What knowledge must be passed on? Where might wisdom be gleaned, in hindsight?
While it may seem like the trope of the day, “global-mega-trends” come to mind. I believe at least some of those that have been identified will live on. More important, I would surmise that these survivors can date their roots back well beyond 2017.
A good place to start is by comparing Johan Norberg’s Progress (2016) to Dr. A.H. Maslow’s Theory of Human Motivation (1943), colloquially called “Maslow’s Hierarchy of Needs.” Norberg highlights humanity’s advancements in these same base areas that Dr. Maslow identified and stratified.
For me the key for 2018, and beyond, is to identify entities whose business models are built on satiating these needs, while discerning the defensibility of their niche against commoditization, and quantifying the most probable result of their vision and strategy.
Examples of companies in FIM Group portfolios positively exhibiting these attributes include:
Put simply, success at entities such as these means success for humankind; that is what gets me excited for 2018 and beyond!
ZL: The broad world of alternative energy remains a key investment theme for me. In our portfolios, 2018 will be an important year for Carmanah Technologies as it rolls out arguably the industry’s leading solar-powered outdoor lighting products. Waste-to-energy leader Covanta should see some nice earnings benefit this year from the start of its new, state-of-the-art facility in Dublin, Ireland. I also expect conditions to remain solid for the solar businesses within our Japanese holdings. Commercial real estate owner/operator Ichigo, which I mentioned before, and investment management firm Sparx Group are leading investor/developers in Japan’s solar power markets. I expect both to continue benefitting as investors are attracted to highly desirable project returns there.
Q: Paul, is there anything else you’d care to share as we wrap this up?
PS: While this likely won’t surprise most of our readers, I’m quite optimistic about the year ahead. We have a strong team, good processes, and a sound investment philosophy to guide us through whatever financial markets throw our way. I continue to have high expectations for the investments we hold today, and we will maintain sufficient “dry powder” to deploy should market volatility return. We wish all of you a prosperous year ahead and remain grateful for your trust.
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