| Quarterly Newsletter - 3rd Quarter, 2013 | ||||||||||||||||||||||||||||||||||||
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The big surprise of the last quarter of 2014 was not that our first market correction in three years was only 5% instead of the 10% predicted by most market pundits, but that the price of oil fell a whopping 50% to $53/barrel at quarter end. We addressed the causes and the supply/demand outlook for oil in our mid-quarter email blast and client letters, but suffice it to say that Saudi Arabia started this slide by letting the free market work for the first time in decades. This leading producer was tired of losing market share within OPEC’s disparate and fractious membership. The Saudis, along with Kuwait and the Emirates, have the most cash in the bank ($2 trillion) so it is doubtful that they will “blink” first, and free oil market economics might be the order of the day for several months or quarters. Countries such as Libya, Iran, Algeria, Nigeria, Venezuela, Iraq and Russia are more likely to argue for higher prices because their governments depend on $90 to $110 per barrel pricing to balance their budgets. These countries are already running serious deficits. The selling in the energy sector over the last three weeks of 2014 has positioned the market for several very attractive investment opportunities with potentially large returns over the next two to three years. It is worth noting that there have been six similar drops in the price of oil since 1960, and in each instance the S&P rallied an average of 10% over the following twelve months after the price decline.
FMR taxable accounts have had a multi-year benefit from the ownership of MLPs. However, the FMR large weighting in energy sector MLPs for taxable accounts (roughly 30% comprised of seven to eight securities) was largely responsible for the FMR taxable accounts’ 4Q decline. Most energy MLPs in FMR portfolios corrected between 5% and 10% in 4Q before counting their dividend distributions. Kinder Morgan Energy Partners (KMP) was the exception since it was +20% in 4Q before dividends. It should be noted that during 4Q virtually all energy stocks corrected with declines of 15% to 30%. This across-the-board selling of all energy stocks caused the price weakness among FMR’s energy MLPs. We anticipate that this short-term weakness will be reversed as investors are comforted by continued strong financial results for energy MLPs such as those owned in FMR portfolios. Importantly, the fundamentals of FMR’s energy MLPs are protected from energy price volatility because they have long-term product contracts which are volume-based, not commodity price-based. Because FMR qualified accounts cannot hold MLPs, these accounts performed positively in 4Q.
Five Mile River’s performance results for 2014 matched or exceeded our expected full-year performance estimate of +8% to +9%. The S&P 500 was +13.69% (with dividends). FMR 2014 performance for taxable accounts averaged +9% to +12% depending mainly on the portfolio weightings of the energy master limited partnerships (weightings depend on client objectives since FMR taxable accounts are tilted toward one of three strategies: “income,” “growth” or “balanced”). FMR performance for qualified accounts was on average +8% to +11% for 2014. The 4Q performance was -2.59% for FMR taxable accounts and +1.01% for FMR qualified accounts vs. +4.93% in 4Q for the S&P 500.
Both taxable and qualified accounts benefited significantly from the purchase of KMP by Kinder Morgan, Inc (KMI) on November 26, 2014. KMP stock was up approximately 25% from the date of this announcement in August. KMI stock, held in many qualified and taxable accounts, moved up approximately 30% from the announcement date. FMR portfolios continue to hold a 5% weighting of KMI in most FMR accounts (both taxable and qualified) and we expect the stock price to move toward $50 over the next two years (+20%), in addition to a 4% dividend growing at 10% per year. KMI has delivered a 13% average annual return to shareholders since its public offering in 2011. KMP has delivered an average annual return of 24% since 1997. With more than 80,000 miles of pipelines and 180 storage terminals, Kinder Morgan is the largest midstream company (“midstream” referring to the transportation and storage of petroleum products) and is the third largest energy company in North America.
The best performing sectors in 2014 included utilities, Real Estate Investment Trusts (REITs), technology, defense and healthcare stocks and these sectors are well represented throughout FMR portfolios. In this letter we will discuss one of FMR’s attractive REITs – a stock that owns several different kinds of healthcare facilities.
After a six year bull market, what is next for 2015?
The S&P 500 made its Great Recession low almost six years ago at 666 on March 9, 2009, and the 2014 closing price for this benchmark index was 2059. It has been three years since we had one 10% correction. Our “Camelot” scenario for 2014 in our January 17, 2014 letter was +15% or at 2125 for the year. That was not our most probable forecast because it seemed unlikely that we would have both meaningful fiscal policy reform and normalization of monetary policy in the same year. As you know we had neither, however the Federal Reserve has indicated that the normalization of interest rates will begin possibly by June 2015. Also, there is some hope for very narrow and targeted productive fiscal policy initiatives as a result of the mid-term election. Modest earnings growth (5% to 7%) in 2015, but no further price earnings (PE) multiple expansion, are central to our market forecast. The long-term 10-year U.S. Treasury Note reached an improbable low yield of 1.9% at year-end due to a strong dollar, the drop in oil prices to $53/barrel and a flood of overseas cash seeking shelter in the safety of the U.S. markets. Our 2014 mid-year caution that stocks are no longer undervalued continues for 2015, and we expect more frequent market volatility will provide attractive risk/reward entry points for new cash.
We continue to play offense by selecting companies that pay significant dividends whose yields are larger than the average stock market yield, and whose managements keep growing those dividends year after year without dividend cuts. As you have heard from us many times, the companies that are the dividend growers possess significant competitive advantages. Such companies are resilient and moated (protected) and thus able to generate substantial free cash flow, make strategic acquisitions and not only pay dividends but also engage in stock buybacks. FMR portfolio companies consistently follow this playbook.
Remember that approximately 45% of the total stock market return comes from dividends and 90% of the companies in FMR portfolios are growing their dividends annually by anywhere from 5% to 15%. The power of compound interest and the reinvestment of those dividends is a proven wealth building strategy for long-term investors. That stream of income is growing above the rate of inflation and certainly exceeds the fixed returns available from comparable risk bonds. The volatility of these stocks in market corrections is typically less as the dividend supports the stock price more than non-dividend paying stocks. Why? Cash matters. Dividends represent management confidence in current, as well as future operations, and demonstrate Board and CEO commitment to shareholders. Tenure of management that cuts dividends is typically similar to a losing NFL coach who stays in his job an average of only 2.9 years.
2015 Forecast:
A PE of 17x to 18x S&P 500 earnings of $123 to $125 plus a dividend yield of 2% equates to a +4% to +11% total return for 2015. Our median forecast for the S&P 500 of +7.5% in 2015 assumes no spike in inflation or interest rates, no meaningful fiscal reconciliation between the political parties and no significant “black swan” geopolitical events. We should note that the very definition of a black swan is that it is unexpected, and the 2014 black swan of 50% oil price decline seemingly came out of nowhere.
At the September Fed meeting, Chairman Yellen reported that a poll of 17 officials showed a median forecast of 1.75% for the overnight federal funds rate by the end of 2015 vs. the current funds rate of 0% to 0.25%. The forward futures market looks for only 0.45% by December 2015 and 1.33% by December 2016 – a big gap between what the Fed “gurus” say and what the market thinks they will do. Because economies in Europe, Japan, South America and China are either weak or stagnant, a smaller increase of long-term interest rates appears now to be the better forecast. Real economic growth should continue to grind along at no more than 2% to 3% and corporate profits at 5% to 7%, supporting our 2015 single digit market forecast.
We know what we own in FMR portfolios and why we own it. However, we maintain strict selling disciplines, when the price/value ratio gets too high, management changes for the worse or there is a shift in corporate fundamentals. We then exit or reduce the position in portfolios and look for better opportunities. As one of the leading characters in The Godfather, Tom Hagen (played by the great actor, Robert Duvall) said to Sonny Corleone (played by another fine actor, James Caan), “This is business, not personal.” We work very hard at trying to avoid the cognitive dissonance that can come from believing we can time the trade out and back in successfully when the market corrects. Computer-generated program trading and less committed investors exacerbate corrections because they get nervous and do not trust or possess their own fundamental judgment. Corrections and a few special situations, such as corporate restructurings, should provide attractive buying opportunities in 2015.
A FMR Portfolio Holding: Health Care REIT, Inc.
Health Care REIT, Inc. (HCN) is a Real Estate Investment Trust that focuses on senior housing and healthcare real estate, skilled nursing facilities, medical office buildings, in-patient and out-patient medical centers and life sciences facilities. Stock price: $75.67 (as of December 31, 2014); dividend: $3.18; yield: 4%; dividend growth: 8%; market capitalization: $19 billion. HCN stock price was +44% in 2014.
Real estate in the healthcare space is resilient because the demand for healthcare is need-based and the growth is forecast to be strong with 70 million retiring baby boomers. The last of the baby boomers turned 50 in 2014. The projected growth of the over 75 age group for the next 20 years in the U.S., U.K. and Canada is 88%. The rapid growth of new therapies, new biotech drugs and personalized medicine from the sequencing of the human genome all contribute to a massive and growing $1 trillion total healthcare market. Healthcare expenditures in the U.S. are currently about 18% of GDP and are projected to rise significantly faster than the economy. HCN has access to capital and a strong experienced management team. Annual growth prospects are 7% to 8%. FMR portfolios own HCN for most qualified accounts (IRA’s, 401k’s, corporate pension plans) and some taxable accounts where appropriate.
We wish you and your family a healthy and happy New Year. Please do not hesitate to bring us your questions and comments.
Sincerely,
Lee Todd Martha
The performance information above * is not audited and has not been otherwise reviewed or verified by any outside party. While Five Mile River Investment Management, LLC endeavors to furnish accurate information, investors should not rely upon the accuracy or completeness of this information.
This letter is not meant as a general guide to investing, or as a source of any specific investment recommendation, and makes no implied or express recommendation concerning the manner in which any client's accounts should or would be handled as appropriate investment decisions depend upon the client's investment objectives. Any offer to sell or the solicitation of an offer to buy any interests in any securities may be made only by means of delivery of a Five Mile River Investment Management Agreement and or other similar materials which contain a description of the material terms and various considerations and risk factors relating to such securities or fund. Different types of investments and/or investment strategies involve varying levels of risk, and there can be no assurance that any specific investment or investment strategy will be either suitable or profitable for a client's or prospective client's portfolio, and there can be no assurance that investors will not incur losses.
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