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.
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.
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.
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?
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
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.
The level of fiscal debt and growth of the Budget Deficit undertaken by the federal government is unsustainable and will need to be monetized.
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
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
As such, on August 5th I bought shares of the SPDR
Gold Trust ETF (GLD).
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).
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.
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.
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
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
56% of my investments are considered “Passive”,
33% are “active”, and the remaining 11% are held in cash.
Q2 Dividend Increases
AAPL + 5.6%
CAH + 1.1%
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.
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.
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
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.
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.
A June addition to the Satellite portfolio resides in a part of the equity markets that investors are very fearful of these days. The retail sector. Typically, I navigate away from retail in my investment process because consumer trends can change very rapidly. In addition, I usually avoid turnarounds with high debt loads. However, value cannot be ignored, and I purchased shares in Tailored Brands (“TLRD”) in early June. The idea came courtesy of Michael Burry, who’s firm, Scion Capital Management, disclosed a stake back in March.
TLRD is a beaten down, small cap retailer in a niche corner of the retail clothing market. The company is the largest men’s formal wear provider in the U.S. and Canada. The business has struggled lately but I believe that the current valuation has priced in an unwarranted amount of negativity that has produced an asymmetrical risk/reward opportunity that, with a little patience, investors can exploit.
I have sized the position relative to the higher risk of this investment. My position in TLRD is ~3% of my active portfolio. This will be reflected in in the Author’s section with the next portfolio update. Questions/Comments? What do you think about the investment?
Twin River Worldwide Holdings, Inc. (TRWH) merged with Dover
Downs Gaming & Entertainment, Inc. on March 26th, 2019. Dover
Downs shareholders received ~.08 shares in the combined company for every share
held of Dover. Twin River operates casinos and racetracks in Rhode Island, Colorado,
and Mississippi. Dover Downs, a wholly owned subsidiary of Twin River, owns a casino,
hotel & conference center, and a raceway in Dover, DE.
On June 25th, Twin River announced a proposed modified
Dutch auction tender offer for their shares with an odd lot priority provision.
They plan on using $75 million to purchase shares at a price no less than
$29.50, but no greater than $33.00 per share. The offer is set to expire at 5:00
P.M. on July 24th, unless the offer is extended or terminated.
In a modified Dutch auction, investors elect a price at
which they will tender their shares within the range given by the company. From
these prices, the company determines the tender purchase price and tenders those
shares that were tendered at or below this price. The risk here is that if you
offer too high a price, your shares will not be tendered. This is also true for
the odd lot priority provision. Holders of 99 shares and less will
automatically be tendered if they elect to tender their shares at or below the
purchase price, or if they elect to tender shares without specifying a purchase
Executive officers and directors do not plan on tendering
their shares. They hold ~2.8% of shares. Standard General, an event-driven
limited partnership, owns ~31.8% of total shares outstanding. They have not
stated whether or not they plan on tendering shares. However, they plan on informing
shareholders about their decision no later than 6 business days prior to the expiration
of the offer (July 18th).
It is worth noting that two other large holders of the
company have been selling their shares. This can give us some insight as to
what price they may elect to tender their shares at. Chatham Asset management
holds 13.4% (5,496,003 shares) of the company. They have sold 438,085 since June
20th at an average price of $30.55. Their lowest sale price was
$30.25. They also sold 50,000 shares in April at $33.00. Solus Ltd. Holds 7.50%
(3,118,225) of the company. They sold 144,183 shares in early April at an
average price of $31.01. Their lowest sale price was $31.00.
Of course, due to the nature of a modified Dutch auction,
the purchase price isn’t determined by the largest shareholders, but rather
those shareholders who offer the lowest price to the company. If the minimum
price of $29.50 is determined to be the purchase price, they will purchase 6.2%
of total shares outstanding. If the maximum price of $33.00 is determined to be
the purchase price, they will purchase 5.5% shares outstanding. Had this been a
larger tender, then the large holders of the stock would surely have more power.
Regardless, it is still useful to see the price where certain large holders
value the company at.
TRWH currently trades at $30.48. Given the small size of the
tender relative to the total amount of shares outstanding (5.5 – 6.2%), it is
likely that the share price won’t be pegged to the tender range. As a smaller
shareholder, this is a good thing, as your shares will not be prorated if you
own less than 100. Unfortunately, there are no options on TRWH to use as
reference for implied volatility up to the expiration date. The implied forward
volatility would be useful in determining the probability of getting in at a
It’s hard to say what the purchase price will be, so I am therefore keeping this on my watch list. This tender offer is also risky in that it can be terminated at any time before expiration if certain circumstances occur (e.g., a 10% drop in market averages, suspension of trading… etc.), so it is probably most prudent to just sit and watch to see if Mr. Market gives you a fat pitch.
Disclosure: No position in any of the securities mentioned in the above article.