• Financial & Investment Management Group
  • Tuesday, January 06, 2009

2008 Roundtable with the FIM Group Investment Team

by Portfolio Team
Posted February 10, 2008
FIM Group
PDF Version

Q. Market volatility increased significantly during 2007 as the U.S. housing mess drove concerns of a broader economic slowdown. FIM Group portfolios were performing well during this volatile year until the fourth quarter. What drove the short-term weakness towards the end of 2007?

A. Although our portfolios are broadly diversified, a perfect storm of sorts impacted several core areas in which the investment team chose to stay invested during the fourth quarter. Our investments in Asia (and Japan more specifically), natural gas (especially Canadian trusts and U.S. exploration and production companies), smaller cap U.S. companies, and beaten up ?deep value? U.S. stocks (newspapers, community banks) fell during the fourth quarter as investors shifted to large cap U.S. stocks (mainly non-financials), continued to sell Japan, and trimmed exposure from strong-performing markets. We were negatively impacted in the short-term by these developments as well as by a rebound in the U.S. dollar. Our hedge positions (for example, the inverse funds) partially mitigated these developments, but not to the extent required to prevent the temporary performance slide. We view this last quarter as a normal part of investing for the long term. In fact, it is times like these, when markets become increasingly volatile, that we are often able to find and buy bargain-priced investments that will help drive solid long-term future returns.

Q. Does the investment team believe it's active risk management processes are still effective?

A. Absolutely. Our active risk management processes focus primarily on protecting against the risk of permanent capital loss. In other words, we strive to minimize the amount of realized losses in our portfolios. Short-term market fluctuations are impossible to precisely predict, but are a necessary evil when positioning a portfolio for long-term positive returns. We address our highest priority risk of permanent capital loss in several ways. First and foremost, we pay very close attention to valuation and do our best to avoid speculatively-priced investments. We also strive to avoid investments in companies with lousy business models, weak balance sheets, or inept management. As these fundamental factors are often inherently subjective and prone to miscalculation, we control position sizes (keeping investments in each individual company small relative to the overall portfolio) to minimize any negative impact. Supplementing these processes, we will selectively use investments like inverse funds and other defensive investments to protect our portfolios when shorter-term market risk is judged to be unacceptable for a given client?s comfort level. These supplemental positions help us reduce our exposure to market risk, without creating unnecessary taxable gains and transaction costs.

Q. What else is the investment team doing in response to the fourth quarter?

A. While we were disappointed in the portfolios? fourth quarter performance, it was not out-of-line with what happens from time to time during a normal market cycle. We remain focused on our long-term objective of sustainable positive returns. Our team continues to revisit each company we own to gauge if the fundamentals have deteriorated. When the answer is no, we have added to these positions. In some cases, we believe that we are buying at fire-sale prices. We place stocks or bonds with fundamental ?issues? (like deteriorating earnings, cash flow, or balance sheets) on a negative watch list. If operating improvements fail to materialize, we sell our position. These negative watch stocks also become sells if we find better opportunities (including opportunities to limit tax losses). We are also continuing to stay partially hedged via inverse funds given our unease with broad global stock market valuations, which in our view do not sufficiently reflect the chance for a further deterioration in U.S. economic fundamentals.

Q. So does that mean that FIM Group has a bearish outlook for 2008?

A. Despite the growing chance of a U.S. recession in ?08 (as seemingly indicated by strength in the bond market, the inversion of the yield curve, and weakness in stock sectors like U.S. financials, housing, and discretionary consumer goods), we believe that certain parts of both the U.S. and international markets offer excellent value. We believe that 2008 will be an individual stock and bond-picker?s market and that passive, index-tracking, investment strategies may face headwinds.

Q. Given this general outlook for global stocks and bonds, how will you protect the portfolios you manage and where do believe your investment team can find ?excellent value??

A.There are three broad categories of investments, discussed in more detail below, that our investment team is currently targeting:

  • Deep Value/Out of Favor investments
  • Global Secular Tailwind investments
  • Short-Term Opportunity investments

Supplementing these positions are defensive positions designed to mitigate the impact of a renewed market flight to safety.

Q. What is a Deep Value/ Out of Favor investment?

A. These are essentially companies that the market has completely given up on and are trading accordingly at deep discounts compared to estimates of fair value. U.S. newspaper companies, for example, have been in a multi-year funk as the market fears their businesses will disappear with the growing popularity of internet-based ?new mediA.? We certainly acknowledge that the way people receive and interact with news is evolving rapidly, but we also believe that newspaper companies are adapting to this reality. Newspaper companies like Gannett (USA Today) and New York Times are broadly diversified companies with operations in television, radio, and internet-related mediA. As plenty of readers continue to buy newspapers, these companies generate significant cash flow. This cash is being deployed into ?new media? investments and back to shareholders in the form of healthy dividends and stock buybacks. Gannett and New York Times trade at only six times their operating cash flow with dividend yields in the 4-5% range. We consider these levels inexpensive given the power of their brands and the strength of their management teams.

Q. Any other Deep Value/Out of Favor investment areas targeted by FIM Group?

A. We continue to own Japanese stocks which are now the cheapest they have been in a long time on measures like price-to-earnings, price-to-book and dividend yield. This is a market with enormous pent-up consumer buying power (in the form of massive household savings) that remains on the sidelines as Japan?s government leadership continues to do all the wrong things (the latest being a draconian re-regulation of building permit rules that paralyzed the home building market). We admit that one reason many Japanese stocks are inexpensive is the lack of near-term catalysts, but we also feel that over time a normalization of these Deep Value/Out of Favor conditions could result in strong stock price gains. A third area of Deep Value/Out of Favor investments that we see emerging is that of U.S. regional and community banks. This is certainly an area that may go from cheap to cheaper should banks be forced to take additional hits on their exposures to the structured credit area that has been shaken with the imploding housing market. But in many cases, it looks like the proverbial baby has been thrown out with the bathwater. Our approach is to look for well-managed banks with strong credit risk management that trade at discounts to book value with sustainable healthy dividend yields. We began making select investments at the end of 2007 in common and preferred stocks of banks that we feel have been carelessly sold. Admittedly we could be early, but we believe that we can achieve full positions at great risk-adjusted prices and hold these for solid total returns over the next few years.

Q. What is the Global Secular Tailwind concept?

A. We follow several long-term investment themes that should provide tremendous earnings tailwinds over the next 5-7 years (and in some cases beyond!). Because of these tailwinds, when we can find reasonable valuations we feel confident investing in these ideas regardless of the near-term outlook for the U.S. economy. Examples of themes include clean water, alternative energy, Asian infrastructure, and healthcare information technology.

Q. How about an example in the water theme?

A. We believe that water could be to this century what oil was to the last century. The statistics and challenges of global clean water are striking. For example, 4,000 children die daily from water borne diseases and 2.5 billion people worldwide lack adequate sanitation. We currently invest in a Chinese company, Singapore-listed Sinomem Technologies whose membrane filtration technology is one small part of the global solution. Sinomem trades at around 12x next year?s earnings and has a solid, cash-rich balance sheet. We are also researching several other companies in the global water filtration, infrastructure and treatment areas that we may add to our portfolios in 2008.

Q. And alternative energy? Isn?t this sector already over-bought?

A. There are certainly areas within alternative energy that warrant caution. In some cases solar energy stocks are looking like the telecommunication and internet stocks of the late 90?s. Yet, we believe that the fundamental outlook for alternative energy industries remains strong. Even if oil prices fall with a slowing global economy in 2008, government and corporate mandates for cleaner energy should support the future earnings for ?green? energy companies. It is important for us to avoid mania-like valuations and find under-valued stocks of well-run companies that will benefit from this theme. We like energy efficiency ideas including Centrotec Sustainable (www.centrotec.de), a leading European heating/ventilation company that we recently added to the portfolios. Centrotec trades at only 10x expected 2008 earnings. This compares to Trane in the United States which recently agreed to be bought by Ingersoll-Rand for 18x 2008 earnings.

Q. You also mentioned that you look at shorter-term opportunities. Can you expand on that? A. Certain events often trigger short-term trading opportunities. For example, the year-end practice of some portfolio managers? window-dressing and tax-loss harvesting, especially in the small cap and closed-end fund space, often create opportunities for us. We can buy stocks depressed by this short-term activity and then sell them at gains as investors pour back in during the new calendar year. Clumsy political moves (for example, Thailand?s attempt to control capital flows last year) can also generate knee-jerk reactions in the stock market. We keep watch lists of quality companies that under normal conditions trade too expensively for us. When short-term events trigger opportunities to buy these companies at compelling prices, we will look to take advantage of the circumstances.

Q. FIM Group-managed portfolios continue to hold a significant level of non-U.S. stocks and bonds. Are your strategies at risk if the U.S. dollar rebounds in 2008?

A. As we mentioned in the December newsletter, we would not be surprised to see a rally in the U.S. dollar, at least against certain currencies in 2008. Our investment team is most cautious with the Euro and the commodity currencies (Canadian, Australian and New Zealand dollars). We incorporate this caution into the prices we are willing to pay for stocks and bonds denominated in these currencies. Our outlook is more bullish on most of the Asian currencies. We believe that these currencies will be supported by relatively strong economies and continued undervaluation on long-term measures of relative value like purchasing power parity.

Q. FIM Group-managed portfolios have relatively little exposure to large-capitalization U.S. stocks, but this is an area that many CNBC and Money Magazine ?pundits? and ?gurus? believe will do well in 2008. Why not ride this trend?

A. FIM Group has never subscribed to a crowd-following investment strategy. That said, when we feel that we are compensated by owning large-cap US stocks, we will back up the truck! At this point, we see better opportunities for total return elsewhere and are investing accordingly.

Q. I see in the newsletters and other correspondence that Paul, Zach, and Suzanne travel quite a bit. Do you actually work on these trips?

A. While these trips may sound exotic, in actuality they can be quite grueling. As an example, during Zach?s last trip to Thailand, he squeezed in over thirty company visits and management meetings into a single week. We enjoy these brutal schedules as we get to really ?kick the tires? of the companies in which we invest. So while we sometimes find time to squeeze in some ?fun? while traveling, the primary purpose of our trips is research.

Q. Many FIM Group-managed portfolios have significant allocations to the Utopia Funds. Please explain what these are and how they are used in FIM Group-managed portfolios.

A. The Utopia Funds are four mutual funds that we launched at the end of 2005 as a tool to improve our management of separate accounts. The same investment team that manages FIM Group separate accounts manages the Utopia Funds. In some cases, with smaller tax-advantaged accounts, we will allocate up to 100% of an account to one Utopia Fund. In other situations, we will use a smaller allocation to the Utopia Funds. It can not be emphasized enough that each Utopia Fund, like our separate accounts, is a fully-diversified portfolio! In fact, our own team holds concentrated Utopia Funds positions as significant portions of their own personal investment accounts. While the advantages to the mutual fund structure are many, the Utopia Funds give us greater flexibility (for example access to markets like Taiwan not accessible to a separate account), trading efficiencies (given larger pools of money), and much more efficient response to client liquidity needs.

Q. Why wouldn?t even a larger client want 100% of their money in the Utopia Funds? What?s the downside?

A. In many cases, a 100% allocation to the appropriate Utopia Fund is the optimal allocation. However, the Utopia Funds in their present form are not strictly managed for tax-efficiency. Therefore, in some cases we may be able to generate better after-tax returns employing Utopia Funds in conjunction with individual positions. Also, a mutual fund is subject to the purchase and redemption requests of all shareholders. Our team has tools at our disposal to mitigate this effect, but there is a risk that a large group of shareholders may attempt to exit at the same time and force fund repositioning that otherwise would not be necessary. Our team carefully monitors these issues when deciding how much of an account is to be invested in a Utopia Fund and always makes decisions based on the optimal risk-adjusted return potential for each client.

Q. Any final thoughts for the year ahead?

A. While we believe the markets will face a broad range of challenges this year, we remain very optimistic that our investment philosophy and processes are the right ones to meet our clients? long-term objectives. Our investment team is very excited about the prospects for our current portfolio holdings and we continue to identify new investments that we will add to the portfolios when the price is right. As always, we strive to generate favorable returns over three to five-year rolling periods, irrespective of how the ?market? performs during those periods. We also strive to generate the greatest client experience possible and we will continue to do our best to exceed your expectations. Should you ever have questions about your portfolio or our investment strategies, please never hesitate to contact us.

 
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