My Latest Thoughts on JM Smucker ("SJM")

It has been about a year since I initiated a purchase in JM Smucker (“SJM”) and, as such, wanted to do a quick health check-up on the position. At the time of writing SJM is the 10th largest position in the Satellite Portfolio at about 4.5%.

You can find my initial analysis here.

In a nutshell, the thesis goes that SJM is a historically well-run company that delivers consistent returns on capital and produces significant cash flow. The company is at an inflection point in which its top-line growth has decelerated, margins have compressed, and management has needed to reinvest in the company to restore growth by optimizing their product portfolio. My belief was that investors have been overly pessimistic about the stock and have projected negative trends to continue well into the future. Given the successful track record of the management team, I found this as an opportunity to add a quality compounder and dividend grower to the portfolio.

So where are we at a year later?

With a cost basis of about $105, the stock is now sitting at $108.50 at the time of writing. This is a dismal 3% return (6% including the dividend). However, as a long-term investor, I care more about the outlook over the next decade as opposed just one year. Has anything changed with the business?

Leadership Changes

On the Q2 2020 earnings call it was announced that after nearly 35 years at SJM and 15 years as the Chief Financial Officer, Mark Belgya, will retire on September 1st, 2020. He will be succeeded by Tucker Marshall, the current Vice President of Finance. Tucker has been with SJM for seven years and, in my opinion, this should be a natural succession for the position.

The other material announcement was the search for new leadership of the Pet Food business, which in the interim will be led by Rob Ferguson, an Officer of the Company with 14 years of management experience in the Pet category. He previously worked at Big Heart Pet Brands and has been instrumental “to the integration of both Pet business acquisitions and the delivery of over $250 million of synergies.” Jeff Watters, the former President and CEO of Ainsworth Pet Nutrition will serve as a strategic advisor. According to Mark Smucker, the idea here is to “ensure the alignment of a team that has a deep knowledge of the Smucker businesses and our industry.” This is important given the SJM acquisition of Ainsworth and the efforts to integrate the business into the product portfolio. The acquisition of Ainsworth was thought to be a natural fit with the current business that would provide both cost synergies and growth to the company. This will be important to monitor given the weakness in the financial results, specifically related to Pet Food. There’s always potential that this deal could be another classic case of value-destroying M&A, but the Pet Industry has been seeing decades worth of growth in household ownership of pets- providing a nice long-term tailwind to the product.

Business Update

When compared to the prior year, SJM was able to increase earnings by 4% to $2.26/share. This was mainly attributable to an increase in margins considering that sales growth was -3%. The increase in margins over the year is a good sign considering the prior trend had been in the opposite direction. The firm’s operating margin increased from 14.5% to about 17.0% last quarter. This is mostly due to the firm’s product portfolio consisting of higher margin products (i.e. pet food). Excluding the prior year’s sales related to the US baking business ($370MM), net sales were down about -1%. Here is a look at the YoY product sales as of the end of Q2 (October 31, 2019).

Category20192018Change
Coffee $    627.10 $    635.50-1.3%
Dog Food $    302.60 $    334.90-9.6%
Cat Food $    213.80 $    207.303.1%
Pet Snacks $    210.00 $    201.904.0%
Peanut Butter $    175.40 $    186.90-6.2%
Fruit Spreads $      86.50 $      83.004.2%
Frozen Handheld $      93.40 $      78.7018.7%
Shortening and Oils $      71.80 $      79.30-9.5%
Portion Control $      42.50 $      41.602.2%
Juices and Beverages $      32.40 $      33.90-4.4%
Baking Mixes and Ingredients* $      26.00 $      58.40-55.5%
Other $      76.30 $      80.10-4.7%
Total $ 1,957.80 $ 2,021.50-3.2%
* Divested Baking Business

Mark Smucker had this to say about the company’s results. “While pleased with our earnings results, our aggregate net sales performance does not reflect the potential of our brands or the progress we are making toward our strategic growth imperatives.” In the quarterly report, SJM attributed the declines to lower pricing in coffee and peanut butter, and higher-than-expected competition in Dog Food. Management stated that volume/mix had a neutral impact on net sales and that decreases in Dog Food and Shortening and Oils declines were mainly offset by an increase in Smucker’s Uncrustables (+25%).

As mentioned, I find it particularly worrisome is that the Dog Food segment is down -9.6%. Even though SJM’s revenue mix is very diversified, the poor results in this segment were not good considering its significantly increased position within the product portfolio. The Ainsworth acquisition was supposed to be a growth segment for the business moving forward. As the second largest product (Coffee #1), Dog Food generates about 16% of total revenues. This is likely why management is looking for new pet food leadership and why, in my opinion, that initiative will be important to monitor moving forward. Management did not anticipate the competition it was going to see in this segment and, as a result, continually revised estimates downward throughout 2019. The company originally said it expected sales growth of 1%-2% for the fiscal year. When it last reported in August, it revised this to a 0%-1% decline. Now Management expects sales to fall 3%. It also lowered guidance for earnings per share ($8.20) and free cash flow ($850M) in FY 2020.

Has my thesis changed or proved to be incorrect?

The short answer is no. This is still a quality, shareholder-friendly company in a defensive, albeit sluggish consumer product sector. From a financial perspective, nothing material has changed that alters my thoughts on the business prospects moving forward. I don’t expect the negative trend in Dog Food to continue indefinitely and lack-luster performance from time-to-time can create a buying opportunity. The company’s quest to boost growth may take longer than investors are willing to wait. Investors are impatient, but I’m really looking for predictable cash flows and growing dividends with this investment. Long-term, I expect that to continue. However, at the end of the day, the most important thing is how much you pay for those future cash flows and dividends.

Free-Cash-Flow (“FCF”)

Over the past six months, SJM generated $309.1M in FCF.

Six months ending Q2 2020 (millions)
Cash From Operations (CFO) $  445.50
Capital Expenditures $ (136.40)
FCF $  309.10
Interest $  (98.50)
FCFE excl. debt borrow/repay $  210.60
Dividends $(196.60)

The firm’s FCF easily covers interest costs, the dividend is safe, and the remaining cash flow means that Management can continue invest in the company to fix the top line issues while simultaneously paying down debt. As the Ainsworth synergies are realized, integration costs are finalized, and interest costs decrease, the cash flow will be accretive to shareholders allowing plenty of run-way for future dividend increases.

FCF Valuation

My first stop in valuing shares is a FCF valuation. Given that the product portfolio is increasingly built on higher margin products, I have set my base case FCF assumptions slightly higher than top-line growth. This is a two-stage FCF model that also assumes the long-term, weighted average cost-of-capital (“WACC”) increases as management continues to pay down debt. I believe the assumptions are conservative, yet reasonable given the current business outlook and stress on the general retail environment.

Base Case Assumptions
ST FCF Growth3.0%
LT FCF Growth2.0%
ST WACC4.5%
LT WACC6.5%

I used management’s guidance to determine a starting point with 2020 FCF of $850M.

Year (10yr Period) FCF Discounted
2020 $          850.00 $          813.40
2021 $          875.50 $          837.80
2022 $          901.77 $          790.21
2023 $          928.82 $          778.87
2024 $          956.68 $          767.69
2025 $          985.38 $          756.67
2026 $       1,014.94 $          745.81
2027 $       1,045.39 $          735.10
2028 $       1,076.75 $          724.55
Terminal $     24,406.44 $     13,001.94
Firm Operating Value (Sum of discounted FCF above) $     19,952.05
Cash $            48.80
(Total Liabilities) $      (8,740.80)
Equity Value $     11,260.05
Shares O/S $          114.00
  Fair Value $            98.77

The results are a fair value per share of $98.77. Assuming I require a target margin of safety of 10%, this would result in a target price of $88.90 – about 18% below the current share price. Given that this is a defensive company with a predictable business, strong dividend and quality balance sheet, I don’t require a significant margin of safety. This is a good business that I am okay purchasing close to fair value.

The Dividend

SJM currently pays $0.88 quarterly dividend, or $3.52 per year. The 1yr, 3yr, and 5yr growth rates are 9%, 8%, and 8%, respectively. The current dividend yield is 3.4%. This is very close to the highest the dividend yield has been dating back to 1996. The yield has only reached these levels previously in 2000, 2009, and the end of 2018 (when I initiated a position). I really like the current dividend yield coupled with high single digit growth rates, however, the payout ratio is a bit high after the acquisition and, as a result, I expect dividend growth to slow in the near term.

Dividend Discount Model (“DDM”)

Again, I used a two-stage DDM model to determine fair value.  I assume a short-term growth rate of 7% (lower than the 1yr, 3yr, and 5yr growth rates) and assume a long-term growth rate of 4% given that there is plenty of room to payout free cash flow, especially as debt is paid down and interest costs decrease. The required return of 8% reflects the stable and predictable cash flows of the business and the defensive nature of the holding.

Base Case Assumptions  
Current Dividend

$3.52
ST Growth7.0%
LT Growth4.0%
Req. Return8.0%
YearDividendDiscounted
2020 $                3.77 $                3.49
2021 $                4.03 $                3.46
2022 $                4.31 $                3.42
2023 $                4.61 $                3.39
2024 $                4.94 $                3.36
(Terminal) $            128.36 $              87.36
Fair Value $            104.48

The result is a fair value of $104.48 – about 3.7% below the current stock price of $108.50. If we take the FCF assumptions from above, we end up with a FCF payout ratio of roughly 55% in year 5 assuming no share buy-backs.

Multiples Analysis

Lastly, I did a multiples analysis based on 10-year historical numbers to account for a full business cycle, as well as a comparison to four of SJM’s major competitors.

CompanyMarket Cap ($M)Forward PE RatioPS RatioPrice-to-Free-Cash-FlowPrice-to-Operating-Cash-FlowEV-to-EBITDA
JM Smucker$12,193.7713.21.614.610.613.1
10yr Hist. Avg20.91.819.413.312.5
Discount/ (Premium)58%15%33%25%(4%)
Target Price$171.38$125.19$144.65$136.14$103.77
CompanyMarket Cap ($M)Forward PE RatioPS RatioPrice-to-Free-Cash-FlowPrice-to-Operating-Cash-FlowEV-to-EBITDA
The Kraft Heinz$37,220.9811.71.513.010.10.0
General Mills$32,153.7515.81.914.211.714.0
Conagra Brands$14,103.2314.01.316.011.215.5
Campbell Soup$14,101.5518.71.713.910.121.4
Comp. Average15.11.614.310.812.7
Discount/ (Premium)13.8%2.2%(2.0%)1.4%(2.6%)
Target Price$123.49$110.93$106.31$110.04$105.68
       

The result is a wide range of stock prices from a low of $103.77 to a high of $171.38. Taking the average of the outputs I get a fair value of $123.76, or a 14% margin of safety at the stocks current price.

Conclusion

After the Q2 earnings release I expected shares to fall, instead they rose about 4%. This was likely due to the increase in margins. At this point, I think SJM’s stock is slightly overvalued. Perhaps Investors are assigning the stock a small premium given that it is a defensive holding with consistent FCF and dividends. Historically, the company has traded at a premium to the market. I don’t view the stock as overvalued to the point where I want to cash-in my shares, but I will not be adding to my position at these levels. The price of the stock has been pretty range bound between $103-$109 over the past year. I will let the Ainsworth acquisition play-out and continue to hold. If the stock drops to about $95 I will re-assess my valuation and see if adding to my position makes sense. On the contrary, I will do the same if we see the stock moves significantly to the upside without significant improvements in fundamentals.

-Pennybags


 

Q3 2019 Quarterly Portfolio Update

(July – September)

Q3 2019 was a fairly quiet quarter for investment activity. As I have been mentioning recently, a focal point of mine at this stage in the business cycle is to raise cash. I would like to have a nice stockpile of ammo to take advantage of any major market downturn when that happens. I don’t know when it will happen, but it will, and I intend to be ready to buy stocks “hand-over-fist.” I don’t consider myself skilled in being able to time the market and, as such, will stay invested through the cycle. This is merely tactical positioning as dividends roll in and I add new capital to the portfolio. As such, I am compiling a list of quality companies that I want to own but the market hasn’t given me attractive enough pricing yet.

In addition to raising cash I have been thinking a lot about what some of the major threats facing my portfolio are today. After investing through the latter half of a decade-plus long bull market, capital preservation is key. I believe the biggest risk that could create permanent impairment to my portfolio is inflation. As a hedge to macroeconomic and geopolitical risks, I added gold exposure to my portfolio during Q3 2019. My thoughts on this addition can be found here.

General Portfolio Updates

CVS       Pharmacy Benefit Managers (PBMs) and other healthcare players jumped in mid-July in reaction to the Trump administration’s reversal on its proposed overhaul of rebates collected by the drug middlemen. I am still down roughly 5% on my CVS holding but like the prices I have been to accumulate shares at and the dividend that I receive. The stock has bounced back as I was down over 20% at one point. I continue to think this is a solid long-term holding and I like the strategy the management team is taking to set the firm on the right track for the future. Eventually, I expect the company to start raising the dividend again. As mentioned previously I will likely be revisiting my valuation in the near future.

BAC       Buffet increased stake in BAC to 10%+. This has been a popular holding (along with some other banks) for The Oracle of Omaha. Buffet received a sweet deal on warrants back in 2011 and has profited significantly from this position. The idea that he is confident on the future prospects of this banking giant help provide me with some confidence in my holding. The firm is well-run and has provided significant shareholder returns since the financial crisis. They continue to buy-back shares, raise the dividend, and are well-capitalized. I am also a Bank of America client. Just like Peter Lynch, I am a fan of investing in what I know.

SBUX     Starbucks exceeded expectations and showed strong comparable same store sales growth in the US and continues its expansion in China/Asia Pacific. The stock essentially doubled since I initiated a position but has since pulled back a bit to the mid-$80’s. I won’t be adding at these levels since you’d really be paying up for future growth. However, I continue to like this company as a long-term hold. There is plenty of runway for dividend growth as well. Part of me wishes the price hovered around my purchase price for a bit longer so I could scoop more shares.

Q3 Buys/Sells

  • Buy – JNJ           
    • I first purchased Johnson and Johnson back in 2015. This holding is a cornerstone to the satellite portfolio and a position that I will look to continually add to when the market gives me a discount. The company is known for being a leader in the healthcare market and has been rewarding shareholders for years. Investors know this is a great company and, as such, it can be difficult to establish a position at discounted or even fair prices. Fortunately, during Q3, I was able to scoop up shares when the price dipped in July. This was likely a result of risks surrounding opioid lawsuits, trace amounts of talcum found in baby powder, and uncertainty facing drug pricing in Washington. JnJ is one of two corporates rated AAA by S&P (Microsoft being the other). I am happy to pick up AAA risk with a dividend yield of ~3%, a payout ratio of 60% and 1,3,5 year div. growth rates of roughly 6.5%. This is a best-in-class firm that produces a FCF margin of over 20%. I consider the price to be about fair-value and by no means think I’m getting a steal. But this is a stable and predictable business that should be around for a long time and providing its investors with consistent dividend growth. Since I like to focus on risk management as opposed to chasing returns, my thoughts on JnJ can be summed up with the following quote:

“My largest positions aren’t the ones I think I’m going to make the most money from. My largest positions are the ones where I don’t think I’m going to lose money.” — Joel Greenblatt

  • Buy – GLD (See above)
  • Sell – BBL (Reduced Position)
    • I mentioned in my Q2 quarterly that I was thinking about reducing my position in BHP Billiton. Given where we are in the economic cycle, the cyclicality of the company’s cash flows, and the firm’s reliance on commodity prices to create profits, I decided to reduce exposure by trimming my position by half. This slightly damages my dividend income as the stock yields close to 6% and my yield-on-cost was over 8%. However, I don’t like having one stock constitute such a large percentage of overall dividend income, especially when its cash flows are reliant on commodity prices. I thought it would be prudent to harvest some capital gains here.

Dividends

Q3 delivered the highest ever income received by the portfolio. Q3 2019 income was 51% higher YoY. I am very happy with the passive income growth realized by the portfolio and hope I can continue building income at a high growth rate.

The portfolio’s dividend yield is 3%. This is down slightly due to the elevated cash position and the dividend cut by Tailored Brands. (More on TLRD below)

Dividend Increases:

BAC +20% to .18 quarterly

UNP +10.2% to .97 quarterly

SJM +2.5% to .85 quarterly (Not great, SJM had a lax-luster performance this year/past quarter) The share price has been trading sideways.

WPC +.2% to $1.036 quarterly (This stock increases the dividend quarterly)

ORI – Paid a special dividend of $1.00/share (has done this annually since I’ve held it)

Tailored Brands

What a volatile month is was for TLRD! This stock demonstrates how emotional investors can be. The stock price dipped as low as $3.70 in early October and has since steadily climbed back up to the mid- $5’s. I am still holding on to a loss but the story continues to play out as expected. I believe that the turnaround is in progress and the excessive pessimism in the stock has created an opportunity. Given the riskiness of this play the position is a smallish percent of my satellite portfolio (approx. 3%) (See applicable Greenblatt quote above) but I may look to accumulate more shares if this continues to play out as expected. Here are some of the major highlights from the last quarter:

  • Michael Burry (Scion Capital) wrote a couple of letters to the management team telling them that their best use of capital was likely not to continue to pay out a dividend, but rather use FCF to pay down debt or buy-back shares. I mentioned in my initial thesis that the dividend I was receiving (12%+ yield) was nice, but I did not expect that to continue indefinitely. Management has since cut the dividend to focus on debt repayment and share buybacks. I am not certain if share repurchases have taken place yet, but we’ll likely find out on the next quarterly. I believe this was a good capital allocation decision.
  • More insider purchasing. EVP and General Counsel Alexander Rhodes bought 13,369 shares of TLRD stock in October (Q4. I know, I was late with this post) at an average price of $3.87. Director Theo Killion bought 15,000 shares of TLRD stock in September at the average price of $4.64. President and CEO Dinesh Lathi bought 44,000 shares of TLRD throughout September and October at an average price of about $4.50. Together, the executive team spent roughly $325,000 on TLRD stock.
  • Short interest still sits around 20%. Good news could set in motion a ‘short-squeeze’ that causes the price to jump.

Other

I continue to look for new investments to add to the satellite portfolio. With about 20 holdings across many different sectors I believe the portfolio is sufficiently diversified and I am not looking to make the portfolio much bigger in terms of the number of overall positions. Any new additions may result in me selling a current holding. This forces me to really evaluate the moves that I make.

There aren’t many positions currently held in my portfolio that I would add to at this point given their current valuations or relative size. I am mainly looking outside of the portfolio for opportunities. However, that is not to say that I find any of the stocks in my portfolio overvalued to a point that I’m willing to sell out. There is two or three positions that I would take profits in if I could substitute for a more attractive investment.

I continue to look for stable and predictable business models that hold a competitive edge and provide significant FCF that support an attractive dividend growth story. I also continually monitor the spin-off universe, tender offers, going-private transactions, and any other special situation opportunities that could present indiscriminate selling and/or attractive risk/reward profiles. Patience is key. If I can find 2-3 profitable opportunities each year while the portfolio continues to distribute a healthy income stream, then I am well on my way to financial independence.

-Pennybags

FAIRLY VALUED: Kontoor Brands, Inc.

Kontoor Brands, Inc.

Ticker: KTB

Price: $38.50

Shares Outstanding: 56.9 million

Market Cap: $2.1 billion

Cash: $76.7 million

Interest Bearing Debt: $990 million

Enterprise Value: $3.1 billion

Kontoor Brands (KTB) has run up rather quickly since our initial post on June 18th, 2019. The dynamics of forced selling from large cap mutual funds were clearly in play within the first few weeks of trading, sending the share price from $40.50 on May 9th on the when-issued market, to a low of $25.78 on June 25th. We believe that the stock is fairly valued from an absolute and relative valuation basis and are therefore selling the majority of our position, as we view the margin of safety to be minimal, which increases the risk of the stock.

KTB has reached what we think is fair value at $38.50 today based on the FCFF analysis performed at the time of the initial write-up. Not much has changed within the business since then and management has executed as expected. Additionally, KTB currently trades at 11.30x EV/TTM EBITDA. LEVI currently trades at 11x EV / TTM EBITDA. As we mentioned in the initial write-up, we believe that LEVI should trade at a premium multiple to KTB due to its past growth story. Therefore, we believe that KTB is fairly valued on an absolute basis and relative basis (the LEVI growth story has certainly slowed, as they’re facing some challenges within their U.S. wholesale division).

Our short-term catalyst of the declaration of the dividend held true. Management indicated in the form 10 that they planned on paying out a dividend, but hadn’t officially declared it, so the information was not listed in any financial database. On July 23rd, they declared a $.56 dividend after the market closed. The stock closed at $31.00 on July 23rd and has since risen to $38.50 even after going ex on September 9th.

If you had purchased shares the morning after our write-up was posted and sold at our fair value of $38.50, you would have made a total return of ~41.5% within four months.

We are going to continue to hold a small position in KTB, as it is a very resilient business and the long-term catalysts have yet to play out. Cash paid for interest should decrease within the next four to six years as they pay down their large debt load that was initially taken on to pay VF Corp for the spinoff. This cash flow paid to the financiers of the company should eventually transfer to equity holders if they continue to maintain their 60% target payout ratio. Our current dividend yield on cost is ~7.6%. If we are correct about their future dividend after they pay off their debt, the yield on cost should be ~12%.

We would be very pleased if we can bring three to four of these types of ideas to the table every year. We are constantly on the lookout for opportunities such as this one. We believe that markets are efficient most of the time, yet acknowledge the existence of market anomalies with the expectation that our analysis will be eventually be rewarded.

  • Porcupine

Portfolio Insurance [GLD]

Portfolio Impairment

The risk that a loss would hurt my portfolio’s ability to recover said losses in a reasonable time frame is, in my opinion, the biggest threat that must be managed closely. What I mean by this is that I don’t want to make a mistake that I can’t come back from without having to make a significant change in my portfolio strategy or lifestyle. Examples of lifestyle changes are having to find ways to increase my income or further cut out expenses in order to reach my goals. A large drawdown in an investor’s portfolio that leads to permanent portfolio impairment can be extremely difficult to recover from. The easiest and most common way for an investor to manage this risk is through asset class diversification.

Obviously, we know that there are benefits to spreading your bets around to allocate risk to different investments and/or different asset classes. The old adage, “don’t put all your eggs in one basket” that we’ve all heard since we were kids. However, it is not diversification for diversification’s sake that is beneficial. This can lead to “Diworseification.” Diworseification (as coined by Peter Lynch) is the process of adding investments to one’s portfolio in such a way that the risk/reward trade-off is worsened. This occurs from investing in too many assets with similar correlations, leaving you susceptible to diversification across assets that could be simultaneously dropping in price. That’s a rather unfortunate situation to be in.

General Thoughts on Asset Allocation

In 1986, Gary P. Brinson, CFA, Randolph Hood, and Gilbert L. Beebower attempted to explain the effects of asset allocation policy on pension plan returns. In their study, “Determinants of Portfolio Performance“, published in the Financial Analysts Journal, the researchers asserted that asset allocation is the primary determinant of a portfolio’s return variability, with active management playing a lesser role. According to the Financial Analysts Journal, the study examined the quarterly returns of 91 funds over the 1974 to 1983 period and benchmarked the returns to those of a hypothetical fund holding the same average asset allocation in indexed investments. They concluded that asset allocation explained 93.6% of the variation in a portfolio’s quarterly returns.

In 1997 William Jahnke published a follow-up to their study arguing that “The fundamental problem with their analysis is its focus on explaining return volatility rather than portfolio returns. In fact, investors should be more concerned with the range of likely outcomes over their investment planning horizon than the volatility of returns.” In other words, the study ignored a forward-thinking analytical approach that factors in the idea that as an investor’s circumstances (market opportunities) change, so also should the investor’s asset allocation to align with new outcome probabilities.

The studies gave way to further research from known academics of the financial world, Roger G. Ibbotson and Paul D. Kaplan. They found that only about 40% of the return variation between funds is due to asset allocation, with the balance due to other factors, including asset-class timing, style within asset classes, security selection, and fees.

There have been many additional studies, but I cherry picked those because they are rather well-known and serve to get my point across. The point? Strategic asset allocation matters. One can argue over the level of importance, but to ignore it altogether could be detrimental to successful portfolio management. As a result, I consistently analyze my strategic asset allocation and look for ways to improve it.

Interesting Piece that Caught My Attention

On July 17th, Ray Dalio (Co-Chairman of Bridgewater Associates, L.P.) published a great piece on LinkedIn titled “Paradigm Shifts.” In this article, he explores the many different “Paradigms”, or economic environments that persisted throughout the past 100 years. Dalio conveniently breaks these paradigms into decades (i.e., the 60s, 70s, 80s, etc.) and discusses how one market environment gives rise to the next. In doing so, we can observe that each decade was extremely dissimilar to the preceding decade, yet oftentimes quite similar to other periods in history. Dalio discusses the current themes that describe the “paradigm” that the U.S. is in, and then attempts to deduce what the next “paradigm” might look like. It is a great read that I highly suggest and it can be found here.

Reading Dalio’s piece gave me a few insights as to what themes he believes will define the coming “paradigm.” After reading Dalio’s work I decided to revisit my current asset allocation to determine if any shifts were necessary to prepare for the next paradigm. To draw on William Jahnke’s point, what I really wanted to know is whether my portfolio was constructed in a way that would maximize performance given a potential shift in the macroeconomic environment.

Inflation Risk

I consistently ask myself the following question:

What is the biggest risk to my portfolio that could lead to portfolio impairment and do I have some type of protection in place?

Lately it seems that I keep coming to the same conclusion.

Inflation.

This is a huge risk because it could be detrimental to every asset currently in my portfolio.

Inflation is the decrease in the purchasing power of the dollar (i.e. increase in prices of goods) and it would erode the value of my portfolio in multiple ways. Not only would it diminish the importance of my cash buffer, it would eat into my fixed income allocation and destroy the value of earnings underlying my equity holdings.

What happens to my portfolio when it is not just a single asset that loses 50% of its value, but rather the US dollar?

Bad things.

It doesn’t seem like the threat of inflation, or even hyper-inflation, has picked up steam in the mainstream media. It gets mentioned in passing but I believe it is a big threat to the bull market we’re in. The largest losses always seem to come from unforeseen events and unexpected threats. The media is focused on the Fed and the trade war with China. The Fed is talking about cutting rates further after a 25bps move to 2% in early August, there is still no trade deal on the table, and we are coming up on an election year. No one seems to be talking about what could be potentially bubbling under the surface.

Previous High Inflation Periods

We have not seen high inflation in the U.S. since I have been actively investing (about 4 years). You can see how subdued it has been over the past decade in the below chart.

Inflation has been virtually non-existent since 2000, coming in below the Federal Reserve target of 2% over the past year. However, this clearly has not always been the case as inflation was significant and increasing in the late 40’s and the late 70’s.

In the 1970’s the United States was suffering from a period of “Stagflation”, which was low growth coupled with high inflation. The gold standard was abandoned in 1971 and the dollar was devalued to ease government deficits that had ballooned at the end of the previous decade. Significant money printing ensued, resulting in high inflation.

3 Main Reasons Why I Care About Inflation Today

The following reasons are the main points as to why I believe the current market environment may at some point give way to higher-than-expected inflation.

  1. After the financial crisis (‘08/’09) central banks around the world, including the Federal Reserve here in the United States, embarked on a lengthy period of easy money policies known as Quantitative Easing (“QE”) that poured money into the economy.
  2. The level of fiscal debt and growth of the Budget Deficit undertaken by the federal government is unsustainable and will need to be monetized.
  3. Low Unemployment could overheat the economy.

Let’s start with the first reason.

#1: Quantitative Easing

After the Great Financial Crisis, the Federal Reserve stepped in to put out the fire and help fuel an economic recovery. The Federal Reserve helps to steer the economy by manipulating interest rates. The Fed has the power to directly impact the short end of the yield curve by adjusting the fed funds rate. This is the primary tool used by central banks to stimulate economic growth and create price stability. Lowering the rate encourages lending and spending in the economy allowing business’ and consumers to borrow money to conduct business as usual. The graph below shows the level of the fed funds rate and you can see that after both the tech bubble in ‘00/’01 and the financial crisis in ‘08/’09 the fed cut rates significantly.

In addition, the Fed attempted to impact the long end of the yield curve as well. They did this through open market asset purchases, essentially creating artificial demand for assets and pushing prices up (and long-term rates down). From the end of 2008 through October 2014, the Federal Reserve greatly expanded its holding of longer-term securities through open market purchases with the goal of making financial conditions more accommodative. The spread on the 10yr – 1yr has steadily fallen from a previous high of 3.43% in March of 2010 and is currently inverted.

Below is a look at the total assets held by the Fed.

Ultimately, the point is that the actions by the Federal Reserve resulted in more money circulating in the economy.

#2: Budget Deficit

The rock bottom interest rate environment across the entire yield curve has led to a significant increase in the use of debt. Corporations have used cheap money to expand their enterprises and return capital to shareholders through dividends and share buybacks, helping to prop up the equity markets. Also, the US Government has expanded their debt burden to point where it is now greater than US GDP at over $20 Trillion.

The annual US Federal Budget Deficit for Fiscal Year 2020 is $1.10 Trillion and growing.

Some argue that a budget deficit is not all bad as it increases economic growth. (See: Forbes) Fiscal spending puts money in the pockets of businesses and families and their spending creates a stronger economy. That makes other countries happy to lend to the U.S. government, which has never defaulted and has always fulfilled its obligations. However, when the debt becomes excessive, owners of the debt become concerned that they won’t be paid back. If this results in investor’s demanding higher interest rates this can serve to exasperate the issue, potentially causing a currency crisis. Think Argentina in the early 2000’s. When debt is growing faster than GDP- it is unsustainable. Whether we are at the tipping point remains to be seen and I’m not claiming to know. In a strained economic situation, I doubt the U.S. government would even consider defaulting and, as a result, they would likely monetize the debt. This means the U.S. Treasury Dept. would ask the Federal Reserve to step in and buy the debt by printing money.

More money printing and more inflationary pressure.

Below is a look at the explosive growth in the monetary bases since the fed began its “easy money” policies after the financial crisis. The monetary base is the total amount of currency that is in general circulation in the hands of the public or in the commercial bank deposits held in the central bank’s reserves. Inflationary Monetarist theory suggests that inflation will occur at some point if the supply of money is increased and it has increased dramatically since the financial crisis.

#3: Low Unemployment

As of writing, the unemployment rate sits at 3.7%. The lowest rate since Nov. of 1986

The relationship between inflation and unemployment has traditionally been inverse, however, it should be mentioned that the relationship has broken down on several occasions. Theory goes that in times of low unemployment, the demand for labor exceeds the supply of it. As a result, workers are competitive over wages because they can go down the street and get another job. This leads to wage inflation, which ultimately puts more money in the hands of consumers, who then go out and spend it. Consumers are willing to spend more on products creating demand and corporations will need to raise prices to make up for the higher wages they are now paying their employees, as well as the higher prices for raw materials. This phenomenon is known as cost-push inflation.

But Where is Inflation?

I can’t claim to know for sure. But I find it interesting that we could be exiting a “Paradigm” that was defined by QE, a ballooning national debt, and an all-time low unemployment, yet there has been no inflation. There are multiple theories as to why we don’t see rising inflation given the onslaught of inflationary pressures. One popular one I’ll mention is the slowdown of the “velocity of money”, or in other words, how quickly money circulates throughout the economy. The formula is simple:

V = PQ/M

  • V = Velocity of money
  • PQ = Nominal GDP, which measures the goods and services purchased 
  • M = Total, average amount of money in circulation in the economy

The argument is that in the short term, the velocity of money is highly variable, and prices are resistant to change, resulting in a weak link between money supply and inflation. Perhaps this holds true in the short-term, but ultimately, I believe the evidence suggests that money printing and debt financing will eventually lead to inflation.

To quote Ray Dalio one last time, he concluded in his paper that, “it would be both risk-reducing and return-enhancing to consider adding gold to one’s portfolio.”

As such, on August 5th I bought shares of the SPDR Gold Trust ETF (GLD).

Why GOLD?

I find the argument compelling. Given that gold is a reasonably strong inflation hedge and has a low correlation with the equity market, I have added it to my portfolio as a form of insurance.

My intention was to pay mind to the aforementioned studies by respecting the importance of asset allocation while doing so in the context of the current macroeconomic landscape.

All over the world, throughout history, and today, gold is viewed as money. It is considered a global store of value and has maintained its value since ancient times. Societies have been experimenting with what they use as money for decades. Gold became the victor through centuries of trial and error.

You can see in the chart below that historically, and over the long-term, there has been a negative correlation between stocks and gold. This was evident after the 2008 crisis when the Fed conducted a series of rate cuts and Fed Fund rates moved towards zero. Gold prices performed exceptionally well during that period and reached an all-time high of around $1900/oz. Another previous example includes the 1970’s (high inflation prevailed).

Position Sizing

The current purchase makes GLD roughly 2.0% of my portfolio. I expect this position to increase during periods of stress on the portfolio or periods of inflation. I have given it a max allocation of 5% and will trim and reallocate to other asset classes (preferably equities) that would, in theory, become cheaper during these times. I do not intend on letting Macroeconomic and Geopolitical forces derail my investing progress though permanent portfolio impairment. I view my gold position as a hedge to these forces and will continue to grow its allocation as the portfolio grows.

Questions? Comments? Do you own Gold?

-Pennybags

CLOSED: Twin River Worldwide Holdings, Inc. Modified Dutch Auction Tender Offer

Twin River (TRWH) announced the final results of their tender offer this week. As expected, holders of 100 shares or more were significantly pro-rated (6.309%) due to the market price moving below that of the lower bound of the modified Dutch auction. Naturally, the purchase price ended up being the lower bound of $29.50.

We initially wrote about this modified Dutch auction on June 18th, when the price was trading around $30.48. We did not purchase TRWH at this time due to the fact that the price was above the lower bound. On July 11th, we purchased 99 shares of TRWH in order to participate in the tender offer. If you had purchased after the publication, you would have realized a 7.55% on your investment, or roughly $200.00 within a month. While this is insignificant for larger portfolios, it can have an impact on smaller portfolios.

We will continue to monitor and write about odd lot tenders of this size, but will only do so via private email rather than in this public forum going forward so we do not spoil the opportunity (see Blue Bird Corporation removing their odd lot priority provision due to a seeking alpha posting). There are risks inherent in these special situations, as we saw with BLBD last year. 

Be sure to follow the blog via email to receive updates on these special situations that may be beneficial for smaller portfolios. 

Quarterly Portfolio Update – Q2 2019

(4/1/2019 – 6/30/2019)

Strategic Asset Allocation

  • YTD my investment portfolio IRR is approximately 14.1%, lagging the S&P 500 which has exploded on the year, increasing by 18.5%. I am confident the portfolio is well positioned to outperform in the long-run and in down markets. I don’t pay much attention to benchmark returns, especially over the short-term, but I think it can useful to check in periodically.
  • With elevated equity markets I continue to try to keep over 10% of my portfolio in cash that I can put to work during the next market downturn.
  • Given historically low interest rates resulting in historically rich corporate debt markets and my current age (younger than 30) I continue to keep a very small position in fixed income. About 6% of my investment portfolio is allocated to domestic (U.S.) fixed income. I gain this exposure through index funds in my retirement accounts and slightly increased my monthly allocation as I would like to get this to about 8% by the end of 2019. I continue to monitor this asset class as economic stress tends to hit the corporate debt markets first and is often a leading indicator for equities.
  • I have a roughly 24% allocation to emerging market and international equities combined. This is on the high end of my Strategic Asset Allocation range. I’m typically comfortable at about 20% in foreign equity exposure. I won’t be making any changes here unless the allocation breaches 25% for an extended period (1-2 Quarters) given the level of US equities. Since I’m allocating new funds elsewhere, this allocation should tick down over the coming quarters.
    • I continue to like a slightly higher exposure to emerging markets equities as they have been hammered pretty good over the past couple of years. Since January 2018 the iShares MSCI Emerging Markets ETF (EEM) is down 18%. This is likely due to being on the receiving end of a trade war with the U.S. According to Lazard Asset Management, emerging markets continue to trade at discounts of about 23% compared to developed markets from a P/E standpoint (as represented by the MSCI World Index).
  • 67% of my investments are held in a tax-advantage retirement account, the remaining 33% are held in a taxable brokerage account.
  • 56% of my investments are considered “Passive”, 33% are “active”, and the remaining 11% are held in cash.

Satellite Portfolio

Q2 Dividend Increases

  • AAPL + 5.6%
  • BAC +20.0%
  • CAH + 1.1%
  • CLX +10.4%
  • KR +14.0%
  • WPC +0.2% (Quarterly increases)

* 2019 total dividend income has increased 17% over the 1st half of 2018. The portfolio dividend yield and yield-on-cost are 3.1% and 4.2%, respectively.

Q2 Buy/Sells

  • Sell – SOUHY
    • My position in South 32 LTD was established when BHP Billiton decided to divest some of its non-core assets in May 2015. The company focused on the production of Alumina, Aluminum, Manganese, Silver, Zinc, Lead and Nickel. I sold the position in April for a 26% gain. The position was an extremely small percent of my portfolio (<1%) and after the run up in price I thought I could better allocate the funds elsewhere.

Noteworthy Q2 Position Updates

  • BAC – The Federal Reserve gave Bank of America the go-ahead with their intended capital plan following the completion of the 2019 Comprehensive Capital Analysis and Review (CCAR). The dividend was increased by 20% to $0.18 per share and the Board of Directors has approved $30.9 billion in share buybacks over the next year ($0.9 billion in repurchases would offset shares awarded under the company’s stock program).
  • BNS – Scotiabank received approval to repurchase up to $24 million of its common shares (~2% of outstanding shares) over the next year.
  • BBL – BHP Billiton has been riding the iron ore rally in 2019 and is up roughly 20% YTD (Iron Ore prices have jumped about 65% YTD). It is now the 7th largest position in the Satellite Portfolio at 6.5% and represents about 10% of my annual dividend income. This is a bit higher than I like for a very cyclical company that is highly correlated to commodity prices. I may harvest some profits and look to trim this position over the next few months.
  • WPC – W.P. Carey is up 30% YTD and has now become my largest position at roughly 7% of the Satellite Portfolio and producing 7.4% of the portfolio’s annual income. W.P. Carey’s real estate portfolio is primarily comprised of single-tenant office, industrial, warehouse, and retail facilities located around the world. They are highly diversified and are run by a superior management team that has repeatedly demonstrated the ability to generate strong returns on capital. I have no intentions of trimming this position but will not be adding for the time being. WPC hit their all-time high in mid-June at a price of $65.54.

Credit Ratings

Moody’s %
Aaa 6.56%
Aa1 6.88%
Aa2 0.00%
Aa3 2.05%
A1 4.39%
A2 0.00%
A3 10.50%
Baa1 30.27%
Baa2 26.07%
Baa3 3.16%
N/A 10.12%
100.00%


Odd Lot Tender

  • Interesting Odd-Lot Tender with Twin River Holdings, Inc. (TRWH). The tender is a Modified Dutch auction with a minimum tender price of $29.50. The current market price ($27.35 at time of writing) is not attractive enough for me to purchase shares, however, I will be monitoring this over the coming weeks to see if Mr. Market provides me an opportunity to enter the trade and make a nice return in a short period of time. I will entertain the idea of purchasing shares (99 shares or less) if the price drops below $27.00. The offer expires July 25th. More details can be found here: TRWH Odd-Lot Tender

Other

CAH and CVS continue to be laggards in the portfolio (-39% and -29%, respectively) due to uncertainty around government intervention in the healthcare industry and the impact that may have on future earnings potential. However, these stocks are very cheap on a historical basis and the best prices are usually offered when investors are fearful about the future. I will be re-visiting my valuations to see if they potentially warrant some averaging-down over the next few quarters.

There is an updated portfolio overview in the Author’s section as of June 30th, 2019.

Questions/comments?

-Pennybags

UPDATE: Twin River Worldwide Holdings, Inc. Modified Dutch Auction Tender Offer

Twin River (TRWH) announced that they were purchasing two casinos from El Dorado Resorts (ERI) today. The stock is currently trading at $27.25 and is down 5.05% on the day. According to their IR department, the tender is still on track to close on the 24th. We have yet to hear what Standard General plans on doing, but at an 8.25% spread between the market price and worst-case tender price, I believe that there is some value here. I have established a position in my portfolio.

– Porcupine