Controversial Apollo Global Management Offers High Yield and Much More.

Apollo Global Management (APO) is one of the world’s largest alternative asset managers with a sizeable $160 billion of assets under management AUM.   The current distribution yield is 9.9%.

 However, it is not without controversy. 

 APO specializes in managing funds in the credit, private equity, and real estate strategies.  One of its biggest relationships is fixed-annuity issuer Athene with about $60 billion in AUM, or 37% of its AUM.  

 Morningstar’s description of APO’s attributes:

Apollo Global Management's specialization in illiquid credit instruments offers substantial potential in the coming years. Banks of all sizes, under tough regulatory scrutiny following the Great Recession, are shedding risky and complex credit assets to shore up their capital ratios. We see this as a secular trend, particularly as Basel III rules force banks to shed risk, and Apollo's relationships and deep expertise in the market position the firm to earn lucrative returns.

 APO’s niche is in illiquid asset management.  Of its AUM, $41 billion is in private equity, $108 billion in credit instruments, and $10 billion in real estate holdings. 

The type of assets held in each investment category is:

Private Equity:  Opportunistic buyouts;  Distressed buyouts and debt investments;  Corporate carve-outs

Credit:  U.S. Performing Credit; Opportunistic Credit; European Credit; Non-Performing Loans; Structure Credit

Athene:

Real Estate: Residential and commercial

Global private equity and distressed debt investments:

Performing fixed income.

The relationship with Athene is interesting, profitable and unique.  Several years ago, APO purchased the portfolio and developed the relationship to manage their assets.  Athene is one of the larger issuers/underwriters of annuities.  Unlike other types of customers who are looking for a return of their original capital contribution, the fixed-annuity profile of Athene is seeking return ON capital rather than return OF capital.  This allows APO to utilize its expertise – illiquid assets that provide better than market returns.   Most hedge funds and private equity firms have a 10 year life cycle for their customer’s assets, the Apollo – Athene relationship has no such constraints.  This gives APO a leg up to other alternative asset managers as a large portion of its AUM has a very long life cycle.

 Like most alternative asset managers, APO generates income from asset management fees and performance fees.  These vary based on asset categories:

Private Equity: 98pbs + 20% performance

Credit, ex Athene: 75 bps + 15% to 20% perform.

Athene:  40 bps + 0% performance

Real Estate:  77 bps + 10% to 15% performance

 APO is expected to earn $2.01 in 2015 and $2.25 in 2016. Long-term earnings growth is pegged at 10% a year.   As a LLP and similar to a MLP, APO pays out a large percentage of reported income as distributions.  This year, APO is expected to distribute $2.08 a share and $2.15 next.  

 In 2013, APO raised one of the largest private equity funds, Apollo Fund VIII, at $17 billion.  This capital is being put to work in the depressed oil and gas sector, which should provide a high return as energy returns to more “normal” valuations over the next few years.  The normalization of the energy sector could drive higher performance fees for private equity, and to a lesser degree credit assets. 

 Several of APO’s funds are traded on exchanges and are open for individual investors.  Below is a list of these funds and the current yield:

 AINV – Business Development Corp (11.0%)

AMTG – Residential Mortgage REIT (12.2%)

ARI – Commercial Mortgage REIT (10.3%)

AFT – Senior Floating Rate Fund (6.9%)

AIF – Tactical Income Fund (10.1%)

Apollo is not without controversy.  Earnings declined 58% in 2014, mainly from a large reduction in investments and their income.  Revenue declined from $3.7 billion in 2013 to $1.6 billion in 2014.    Since peaking in early 2014, APO share price has dropped 23% over the past 52-weeks while the S&P 500 is up 12% and a peer return of 7%.  

Brokerage firms either love’em or hate’em.  Morningstar has APO rated as 5-Star with a Fair Valuation target of $44 versus S&P Capital IQ rating at 1-Star and a price target of $19. 

According to benzinga.com, in March, JP Morgan reiterated its Overweight and a target of $25.  In Feb, JPM Securities maintained an Outperform with a target of $32; also in Feb, Keefer downgraded APO to Market Perform (neutral) with a target of $27.    In Dec’14 and Jan ’15, Citigroup upgraded its recommendation to Buy and Credit Suisse maintained its neutral rating

For a speculative, alternative asset selection in the diverse financial industry, APO could provide interesting total returns, supported by its high current income. APO is well worth additional research.

This article first appeared in the April 2015 issue of Guiding Mast Investments newsletter.  Thanks for reading,  George Fisher

Mercer In't: 2nd Largest Global Northern Bleach Softwood Producer Still Has Some Oomph In Its Tank

Mercer International (MERC) is a Canadian and European manufacturer of Northern Bleached Softwood Kraft pulp that is finally hitting on all cylinders.  While it is trading at multi-year highs, MERC offers interesting long-term exposure to a basic material in short supply in some markets, such as China.

 There are two types of Kraft pulp used to add strength to paper products such as tissue paper - softwood pulp and hardwood pulp. Softwood pulp is preferred as it adds more strength per ton of usage. Hardwood pulp is characterized as having shorter fibers and is less effective as a reinforcement agent. Mercer specializes in Softwood pulp.

 One of the advantages of this specialization is showing up in current and anticipated global capacity. While hardwood capacity is expected to continue its annual increase in capacity that started in 1990, softwood capacity is expected to remain flat. In 2006, both hardwood and softwood had about equal global capacity at 23 million metric tons. Capacity of hardwood pulp is expected to grow to about 34 million metric tons this year while softwood capacity is expected to remain flat at 23 metric tons. Between 2008 and 2014, hardwood capacity is expected to have expanded at a rate of 2.7% annually vs a decline of -0.5% annually for softwood.

 Mercer has an interesting history. Assembled in the early- and mid-1990s by acquiring various German paper facilities, the company grew as an affiliate of Hong Kong-based Mass Financial Corp, a network of businesses run or influenced by Michael Smith and Peter Kellogg. While Mercer separated from Smith in 1996, Kellogg still owns 8.4 million shares or about 18% of shares outstanding. Platinum Investment Group, a money manager from Sidney Australia, own 17%.

 Mercer is one of the first pulp manufacturers to expand into the bio-mass power generating business, and this gives it a huge leg up on its competitors.  A major cost in the manufacturing process pf pulp is the cost of electricity, and MERC not only generates enough electricity to be self-sufficient but to sell the excess power on the open market.  This gives the firm not only a cost advantage but also another revenue and income stream.  Operating costs decline by about $85 million a year from being energy self-sufficient and excess electricity/chemical sales adds about $100 million in additional revenues.  With annual sales in 2014 of $1 billion and EBITDA of $245 million, it is easy to see the importance of power generation and chemical sales is to the bottom line.

 Softwood pulp is used in high end paper products such as tissue, fine writing paper and absorbent materials.  As emerging markets such as China moves up the economic ladder, tissue usage also increases, creating an ever higher demand profile for the raw material.    

 MERC benefits from a strong US dollar as explained by the CEO during the most recent earnings release, “As our operating costs are primarily incurred in Euros and Canadian dollars and our principal product, NBSK pulp, is quoted in U.S. dollars, our business and operating margins materially benefit from the current strengthening of the U.S. dollar. Our energy and chemical sales are made in local currencies and as a result decline in U.S. dollar terms when the U.S. dollar strengthens. Going forward, while we will continue to benefit from a stronger U.S. dollar, it will be partially offset as in 2015 the rapid strengthening of the U.S. dollar has put downward pressure on pulp prices as a stronger U.S. dollar increases costs to our European and Asian customers."

 As a commodity driven business, profitability is directly impacted by the selling price of NBSK.  Below are multi-year graphs of the commodity pricing for Europe and the US.  It is safe to say that MERC needs strong NBSK pricing to thrive.  

The table below lists the annual operating profit margin per ton of production from 2006 to 2014.  As shown, profitability is very volatile.

With the stock price hitting 2-yr highs, having doubled from $7 to $14, and with earnings growth expected to soften this year, investors may want to nibble at the current levels.  The firm pays no dividend.  As a basic material firm with low cost manufacturing facilities and an excellent export profile, Mercer International has a bright future.  Buying on pullbacks is recommended, but MERC is worthy of being put on your radar screen.

 Latest investor presentation can be found here:

http://www.mercerint.com/i/pdf/presentations/2015-01-15-Mercer-Presentation-CIBC-Conference.pdf

This article first appeared in the March 2015 issue of Guiding Mast Investments newsletter.  Thanks for your interest,  George Fisshe

Revenue Shares Financial ETF Outperform S&P Financial ETF, But Both Hold The Same Stocks

Revenue Shares Financial Sector ETF (RWW) is a financial ETF that is weighted based on company revenues, not the usual market capitalization.  This subtle difference has created an ETF that has substantially outperformed the S&P Financial ETF (XLF) since its inception in Oct 2008 – Even though both hold the same stocks just different allocations. 

Revenue Shares Financial Sector favors financial stocks that represent the largest revenue generators in the sector, regardless of the sub-class or market capitalization.  This focus leads to an interesting portfolio of large financial stallwards.  The weighting concentrates the portfolio with 85 stocks, but the top six positions comprise 41% of assets and the top 11 comprise 60% of assets.  Below is the latest portfolio of the top six stocks:

Berkshire Hathaway               13.33%

JPMorgan Chase                     7.29%

Bank of America                     6.35%

Wells Fargo & Co                    6.16%

MetLife Inc                              4.87%

American Insurance Group     4.61%

Rounding out the top 11 positions, Prudential Financial, Goldman Sachs Group, Morgan Stanley, Allstate, and American Express each comprise between 2% and 3% of assets.

 According to Morningstar, a $10,000 investment in 2008 would be worth almost $27,000 today compared to $21,000 for a similar investment in S&P Financial ETF XLF.  

 Below is a price chart from Nov 1, 2008 to current showing RWW increased by 162% (blue line) vs a 132% increase for XLF (red line). 

Source: bigcharts.com

 Morningstar offers the following total return calculations.  While not seeming like much, the few percentage points outperformance of RWW has translated in to a meaningful difference since 2008.  Below are annual returns per M*. 

Source: Morningstar

 The sub-industry breakdown of the top 20 positions of RWW and XLF reveals the difference in asset allocation.  The top 20 for RWW comprises 72% of assets while the top 20 for XLF is a smaller 62% of assets.  RWW has a higher allocation to insurance companies while XLF has more allocated to banks, credit card companies and REITs.  Below is a breakdown of the major sub-industry allocations of the top 20 positions of each ETF:

                                    RWW               XLF

Insurance                    38.2%              13.5%

Banks                           27.4%              34.5%

Investment Banks          5.8%                6.9%

Credit Card, REITs         1.6%                7.3%                         

Below is a list of the top 20 positions of each ETF:

Source: Morningstar, My Investment Navigator

Expense ratios are a bit higher with RWW at 0.46% vs a fee of 0.15% for XLF.

 In addition, RWW rebalances its portfolio quarterly while XLF alters only when the underlying index changes.  As specific companies increase their revenues faster than their respective competitors do, it is reflected as a higher allocation in the ETF.

 The underlying ETF index is managed by VTL Associates LLC, who has introduced several revenue-weighted ETFs.  From a 2013 article in Financial Advisor magazine concerning revenue-weighted ETFs:

“We concluded that whatever the S&P is doing, it’s doing it well,” founder Vince Lowry says. “And we further concluded that the only way to beat the market is to beat the index that is the market.”

 Lowry wanted to avoid the perceived shortcoming of cap-weighted indexes, and he zeroed in on revenue as a true measure of a company’s economic value. “A revenue- weighted strategy forces investors to purchase more shares of stocks with low price-to-sales ratios and fewer shares of stocks with high price-to-sales ratios than other strategies,” he says. “Over time, this strategy results in outperformance.”

 With its higher allocation to insurance and specifically overweighed in Berkshire Hathaway, it is surprising the ETF has not caught on.  With assets of just $32 million, RWW is a small fish in the financial ETF pond.  Nevertheless, a fish that is ripe for investors.   

This article first appeared in the March 2015 issue of Guiding Mast Investments.  Thank you for fyour time and interest,  George Fisher

FPA New Income Fund: "We Don't Like to Lose Money"

For conservative investors seeking protection of principal, FPA New Income Fund (FPNIX) should be on the top of the list.   Think back to the dark days of the last financial crisis.  Some bond and fixed income prices were being hammered along with equity prices.  FPA New Income, on the other hand, was doing its job of principal protection.   The following pie chart outlines their holdings:

Morningstar offers the following chart of the value of $10,000 invested in FPNIX and in nontraditional bond index, the classification for FPNIX.  FPNIX did not experience a loss nor cut its distribution when it was common for peers to do so.  The graph covers the period from Nov. 30, 2007 to Jan. 4, 2013. FPNIX is in blue and the index is in orange.

The fund’s website offers an interest recap of their investment approach:

Objective:  The primary investment objective of FPA New Income, Inc. (FPNIX) is current income and long-term total return. Capital preservation is also a consideration.

FPA New Income, Inc. seeks to generate a positive absolute return through a combination of income and capital appreciation. To achieve this goal, we employ a total return strategy using investments in fixed income securities that focus on income, appreciation and capital preservation. Market opportunity will dictate emphasis across these three areas.

Philosophy:  We do not like to lose money!

In order to do this we adhere to the following principles:  Absolute value investors. We seek genuine bargains rather than relatively attractive securities.

From a Morningstar review: 

This fund is very well-suited for investors seeking a safe haven, but investors looking to participate in bond-market rallies should look elsewhere.

FPA New Income’s absolute returns have lagged most of its peers, but the fund’s Morningstar Analyst Rating of Silver is based on the fund’s low volatility and strong risk-adjusted returns.

The fund isn’t necessarily designed to best its category though, as its ultra-conservative positioning is better suited for investors looking for a safe haven against bond-market sell-offs, rather than those looking for upside during fixed-income rallies. For example, the fund’s short duration helped shield it from losses during 2013’s taper tantrum and contributed to its 4.3% return in 2008 while many nontraditional bond funds posted losses that year. Low volatility is also a hallmark of the fund and its Positive performance rating is based on long-term Sharpe ratios that top not only its nontraditional bond category but also the intermediate- and short-term bond categories.

Despite a conservative bias, the fund finds opportunities in areas with unique risks. Recent examples include loans to mortgage servicers who are purchasing and working out distressed mortgage pools; and interest-only bonds structured from pools of GNMA project loan IOs. High-yield corporate bonds also make up 10% of assets. 

The goal of safe-haven positions in a portfolio is to generate the maximum protection against loss of principal.  Since its founding in 1984, FPNIX has historically accomplished this important goal.

FPNIX offers a current yield of 2.8%, in line with 30-yr bond yields of 2.69%.  FPNIX offers long treasury yields with less than 1/10th of the interest rate risk of long bond funds and 1/3 of the interest rate risk of the Barclay’s US Aggregate Bond Index, based on a current duration of 1.36.   

This article first appeared in the Jan 2015 issue of Guiding Mast Investments  Thank you for reading.  George Fisher

Glencore - Contrarian Industrial Metals Trader and Miner Is Best for patient investors

Swiss-based and London-listed Glencore (GLCNF)  is one of the world’s largest industrial miners and commodity traders adversely affected by the current decline in commodity pricing.  Glencore is one of the ten biggest companies within the London FTSE 100 Index. The firm’s industrial and marketing activities are supported by a global network of more than 90 offices located in over 50 countries.

For patient and contrarian investors looking for a pick-up in Chinese industrial demand and a stable/declining US Dollar, Glencore could a top choice.  However, over the past few years as commodity prices fell, GLNCF has greatly underperformed the S&P.  It should be noted GLNCF has outperformed its peers with a -7.6% one-year decline vs the industry at -27.1% and an average -6.6% annual 3-yr decline vs its peers at -10.6%.   

Glencore has significantly expanded its production base and marketing capabilities following the acquisitions of Xstrata and Canadian-based agricultural trading firm Viterra.

GLCNF has one of the most appealing commodity exposures. Among the diversified miners, Glencore has the highest exposure to base industrial metals and especially copper, zinc, and nickel which many believe have a positive medium- to long-term outlook. In addition, Glencore has limited exposure to recently downgraded iron ore.  GLCNF generates 55% of EBITDA from mining activities, 40% from commodities trading, and 5% from oil and agricultural. 

Glencore has the potential for strong free cash flow generation and modest debt levels.  Given the lack of iron ore exposure, the more resilient marketing business, as well as the pullback in capex, GLCNF should remain free cash flow positive from 2015 onwards even at current spot commodity prices. Below is a table outlining 2014 to 2017 proposed capital expenditures, separated between funds needed to sustain current production and anticipated growth initiatives, along with 2014 trailing current twelve month operating cash flow, in billions.

As shown, even with the current depressed commodities market, management believes in its ability to grow the underlying business.    

Concerning growth plans, Chief Executive Ivan Glasenberg recently said, "Our focus is on expansion that can generate profit, on a tidy, neat balance sheet and any excess cash we will give back to shareholders."  The firm has been keeping its promise of returning excess cash to shareholders.  The recent semi-annual dividend was increased 11%, long-term debt is being reduced, and the company has embarked on a $1 billion share buyback program. 

In its most recent Investor’s day presentation, management offers its forecast for commodity pricing going out to 2018.  As shown in the graphic below, all commodities, except oil and iron ore are expected to be higher in 2018 than 2014.  A rebound as indicated below should greatly improve shareholder returns.

Commodity prices have fallen back to their lows of 2009, which of course was at the height of the financial crisis. While global economic growth will be muted in 2015, the decline in commodity prices to panic levels of 2009 seems overdone.  Any rebound will greatly enhance Glencore’s operating cash flow and shareholder returns. 

Morningstar offers its insightful research with this recap:

Bulls say: Glencore's globe-spanning network of traders and logistics assets generates significant economies of scope.  Full access to Xstrata's mine production allows the combined enterprise to extract greater value from those volumes.  Glencore is more diversified than other large mining companies are.

Bears say: Glencore's mining portfolio is decidedly "overweight" higher-risk countries with relatively underdeveloped institutions and limited legal safeguards for foreign investors.    Despite disclosures afforded by the initial public offering and subsequent filings, the marketing business remains incredibly opaque to outsiders.  While marketing activities are less sensitive to the general direction of commodity prices than its industrial activities, the best-laid plans of traders can go awry when prices rise or fall faster than anticipated or historical correlations break down.

Investors should appreciate the market in 2015 markets will favor companies with higher revenue exposure to the US.  In addition, a strong US Dollar hurts Glencore earnings by negatively influencing commodity prices. By the conversion of earnings to USD, GLCNF could be a candidate for contrarian thinking for patient investors.

Current yield is 3.8% with a strong likelihood of a dividend increase with the May payment. EPS in 2015 are expected to be $0.43 and in 2016 $0.54 per share.    

CEO Glassenburg is actively seeking to expands its mining interest and made an offer to purchase Rio Tinto (RIO), which was rebuffed.  By British securities law, GLCNF cannot make another offer  for Rio Tinto for 6 months but Glassenburg is still on the hunt for bolt-on acquisitions.  With low oil prices, it would seem natural for Glassenburg to pick up some longer-term energy assets on the cheap.      

While it may take a while for shareholders to reap the benefits of an anticipated commodity price turnaround, new purchases or position additions at the current depressed market prices should amply reward long-term investors. 

Author's Note: This article was first published in the Jan 2015 issue of Guiding Mast Investments Newsletter  Thanks for reading.  George Fisher

Morningstar Wide Moat Total Return ETF Offers an Interesting Conglomeration of Stocks

Morningstar Wide Moat Total Return ETF (MOAT) offers an interesting conglomeration of stocks.   All the companies have one common attribute – a high barrier to entry for competitors and an undervalued stock price. MOAT offers exposure to the top 20 companies identified by Morningstar as having a “wide moat”. Below is the current list of stocks:

80% of assets are large cap stocks and 20% are mid-caps.  40% are considered Value, 49% considered Growth and the balance 11% a Blend.  Sector allocations of these holdings are:

MOAT offers a 1.2% yield and charges a 0.45% fee. 

While the underlying Index has been around since 2007, the ETF was established in early 2012 and MOAT has about mirrored the S&P 500 return. Van Gleck ETF database offers this review: 

Moat = Sustainable Competitive Advantage

Morningstar equity analysts use a time-tested proprietary process to determine if a company has an economic moat.  The Index Favors Undervalued Stocks.  Of the broad equity universe analyzed by Morningstar, currently about 10% receive a wide moat categorization; the 20 stocks with the most attractive valuations are selected for its Index.  Proven Index Track Record.  Index has generated significant excess returns relative to the overall market since inception in 2/07. 

 According to Morningstar,

“only companies with an economic moat — a structural competitive advantage that allows a firm to earn above-average returns on capital over a long period of time — are able to hold competitors at bay.” 

In addition to offering a wide moat, the Index identifies the most undervalued of these companies and incorporated the top 20 most undervalued stocks. 

An informative SeekingAlpha article written by Morningstar concerning their Wide Moat Index can be found here:

http://seekingalpha.com/article/1954541-best-ideas-a-look-at-market-vectors-wide-moat-etf

Morningstar adjusts the Index portfolio once a quarter to reflect new names that are upgraded and deletions to Wide Moat Index status.  Most of the deletions are triggered by better value elsewhere.    The latest adjustments are below:

 From its founding in 2007 to the bottom of the market crash in 2009, the Index mirrored the S&P 500 return.  However, since 2009, the Index has substantially outperformed the S&P, as shown in the graph below:

Source: marketwatch.com

The blue line is the performance of the Wide Moat Index and the red line is the SPX. 

From the graph, long-term investors in the Index have generated more than 50% greater returns than the market. 

MOAT is an easy method of gaining portfolio exposure to both the specific companies and to the investing philosophy of Morningstar.  Long-term investors should review MOAT as a core holding.    

Disclosure: Long MOAT.  Thanks for reading.  This  article first appeared in the December 2014 issue of Guiding Mast Investments newsletter.  George Fisher

BlackRock - Neutral Rated but Long-Term Core Financial Holding

BlackRock (BLK) is the largest asset manager in the world, with $4.525 trillion in total assets under management AUM and clients in more than 100 countries.  The AUM generates Fee Revenues of around $5.5 billion a year.   Product diversity and a heavier concentration in the institutional channel have traditionally provided BlackRock with a much “stickier” set of assets, or a propensity not to migrate to competitors, than its peers.  BlackRock's well diversified product mix makes it neutral to shifts among asset classes and investment strategies, limiting the impact that market swings and/or withdrawals from individual asset classes or investment styles can have on its AUM.  For example, BLK offers the iShare brand ETFs in Equity, Fixed Income, International and Multi-Asset allocations. 

Many think BLK is mainly a retail-focused firm, but they offer specialized services for the following categories of customers:

•  Investment Professionals Advisors and RIAs
• Asset Managers
• Fixed Income Professionals
• Broker Dealers
• ETF Investment Strategists
• Institutional Consultants
• Insurance
• Pensions, Foundations and Endowments

In its most recent investor’s presentation, the company offers an interesting breakdown of its client base:

Source: blackrock.com

The company outlines its philosophy on its website:

“BlackRock is the world’s largest asset manager, and our business is investing on behalf of our clients, from large institutions to the parents and grandparents, the doctors and teachers who entrust their savings to us.

We work only for our clients—period. Our promise is to offer them the clearest thinking about what to do with their money and the products and services they need to secure a better financial future.

That is why investors of all kinds entrust us with trillions of dollars, and it is why companies, institutions and global governments come to us for help meeting their biggest financial challenges.”     

Retail investors represent only about 12% of assets but generate 35% of base fee revenues.  iShares represent 23% of assets and also 35% of revenue,  The bulk of assets and fees are generated in the instructional sector with 65% of assets and 30% of fees. As shown, growth in the retail segment will drive earnings higher over time.   Management believes overall AUM can organically grow by 5% a year, driven by retail growth in the high single digits.

 Retail asset expansion is slowing from its 5-yr average growth of 11%.  iShares assets are expected to maintain its 5-yr average of 16% with mid-double digits growth projections.  Institutional assets are expected to maintain its 5-yr average growth in the low single digits. The firm also sees growth potential in its BlackRock Solutions, which is a complete risk assessment and portfolio management service for institutional investors.

Earnings per share have been growing at a 15% annual rate since 2010 and have driven dividend growth of 19% over the same timeframe.  Consensus EPS is for $18.50 in 2014, $20.60 in 2015 and $23.60 in 2016. At a PE of 15, or its EPS growth rate, share prices could reach $430. 

At a constant 44% payout ratio, the dividend could grow to $10.50 from its current $7.72.   However, if global markets do not return 6% to 7% annually and AUM growth falls below 5%, these estimates will be reduced.

Morningstar analysis offers the following observations:

Bulls Say: BlackRock is the largest asset manager in the world, with $4.525 trillion in total AUM and clients in more than 100 countries.  Product diversity and a heavier concentration in the institutional channel have traditionally provided BlackRock with a much stickier set of assets than its peers.  BlackRock's well diversified product mix makes it agnostic to shifts among asset classes and investment strategies, limiting the impact that market swings and/or withdrawals from individual asset classes or investment styles can have on its AUM.

Bears Say:  The sheer size and scale of BlackRock's operations could end up being the biggest impediment to the firm's AUM growth longer term.  Despite accounting for two thirds of total long-term AUM, institutional clients generate less than one third of BlackRock's long-term base fees given the lower fee structure attached to these large investment mandates.  While actively managed funds account for just over one third of total long-term AUM, they account for more than half of long-term base fees, increasing the pressure on BlackRock to fix its active equity and fixed-income offerings.

In addition, Morningstar offers this recent opinion:

BlackRock's $15.2B purchase of iShares from Barclays at the depths of the financial crisis could go down as the financial services equivalent of the Yankees' purchase of Babe Ruth from the Red Sox, says ETF Trends, noting iShares now offers more than 700 ETFs and is closing in on $200B in AUM.  The top three ETF providers (iShares, Vanguard, State Street) "have effectively maintained a triumvirate," says Morningstar, with 82% of the U.S. market and 70% of the global market - figures that aren't likely to change a lot in the near-to-medium term. "We expect iShares to continue to be the biggest growth driver for BlackRock in the near-to-medium term," says Morningstar, noting the unit in 2014 is expected to surpass last year's $62.2B in inflows (accounting for 56% of BlackRock's long-term flows).

Over the past 15 years, BLK has generated a 17.5% total annual return compared to the S&P 500 of a mere 4.3% return.  Going forward, BLK has a realistic potential to generate 10% annual total return for long-term investors. 

Although BLK has seen a huge run from its low of $308 just a few months ago to its current $356, the future looks bright for the firm.  Investors seeking a top-quality financial firm should consider making an initial position here and add on weakness over the next few months.

BlackRock is followed by Guiding Mast Investments newsletter.  Thanks for reading, George Fisher

Fluor: Industrial Construction Firm Getting Rave Reviews

Fluor (FLR) is an engineering and construction company focused on power plants, chemical and drug factories, bridges and other big structures.  Their boilerplate description is a great recap of FLR :

Fluor Corporation (NYSE: FLR) is a global engineering and construction firm that designs and builds some of the world's most complex projects. The company creates and delivers innovative solutions for its clients in engineering, procurement, fabrication, construction, maintenance and project management on a global basis. For more than a century, Fluor has served clients in the energy, chemicals, government, industrial, infrastructure, mining and power market sectors. Headquartered in Irving, Texas, Fluor ranks 109 on the FORTUNE 500 list. With more than 40,000 employees worldwide, the company's revenue for 2013 was $27.4 billion

 Like many large project construction companies, such as Netherland-based Chicago Bridge and Iron (CBI) and London-based AMEC (AMCBF), FLR has a substantial backlog of work.  With a backlog of over $40 billion, the company has about two years of work under contract.  Below is a recap of the backlog by operating segment:

Government                $5.2 billion 13% of backlog

Power                          $1.7 billion 4%

Industrial and Infrastructure   $9.2 billion 23%

Oil and Gas                 $24.4 billion 60%

The company’s recent awards include a multi-year contract to decommission a nuclear power plant in the UK and a gas pipeline in Mexico.  One of FLR-designed and constructed complex medical projects was named the International Society for Pharmaceutical Engineering 2014 Facility of the Year for Project Execution.   As the conversion from coal-fired power generation to natural gas marches on, the construction budgets of power companies globally will continue to be strong.  However, two sectors are dragging down investor’s interest – mining and energy. 

Investors should continue to watch the spread between new awards and revenues on a quarterly basis.  For example, during the second quarter, the company booked $5.9 billion in new business while billing $5.3 in revenue, increasing the backlog by $600 million – a positive sign for future revenues.

Morningstar offers an interesting recap of FLR’s strengths and weaknesses:

Bulls Say: Much of the world's easily accessible natural resources have already been harvested, meaning future mining and extraction projects will increasingly take place in remote areas. Fewer companies can service these types of projects, which should benefit Fluor. Fluor has a solid balance sheet with plenty of cash to spare for buybacks and making strategic bolt-on acquisitions where necessary.  Major multiyear project awards will provide top-line stability over a number of years.

Bears Say:  Fixed-price contracts will become more common in the coming years. Though they can carry higher margins than cost-plus contracts, fixed-price contracts are also riskier as they put more of the burden on the contractor to control costs and manage unforeseen circumstances like poor weather.  With more than 40,000 employees around the world, rising labor costs in emerging markets could keep pressure on Fluor's margins.  Working on large projects in remote areas of the world may create a greater chance of cost overruns and geopolitical risks. 

 With the current decline in most energy related stocks, Fluor offers interesting opportunities at its current price.  Shares have dropped about 15% since the market high in Sept and are 23% below its 52-week high of last spring.  There is concern the current drop in oil prices will curtail oil and gas infrastructure projects, negatively affecting FLR and other oil and gas E&C firms.  However, with only 60% of its business in the oil and gas business, the slide in share prices has eliminated the company’s well-deserved valuation premium. 

One consideration is management’s negative Net Return on Invested Capital.  Below is the Weighted Average Cost of Capital WACC as offered by ThatsWACC.com and the three-year average Return on Invested Capital, as offered by Morningstar.  The list includes FLR, CBI and competitor Jacobs Engineering (JEC):

As shown, FLR capital costs seem to be in line with its competitors.  With the decline of CBI’s returns post-Shaw merger, the trailing twelve months ROIC for FLR and CBI are neck-in-neck at 14.2% for FLR and 13.8% for CBI.  

With a 2015 forward PE of 13 and a growth rate of 13%, the PEG ratio is 1.00, or fairly valued.  Earnings should grow from $4.02 in 2013 to $5.62 in 2016.  With a yield of 1.2%, the anticipated total annual return of 18.7% over the next 24 months will come from its share prices moving back over its previous high of $87.

Barron’s recently published an article on FLR titled “Oil Slump Makes Fluor Stock a Potential Double.  Sliding crude prices have put shares of the biggest U.S. engineer in the bargain bin.”  From their article:

Long-term Fluor shareholders have made out handsomely, with a yearly total return of 12.7% over the past decade, versus 8% for the Standard & Poor’s 500 index. However, year-to-date, Fluor has flopped, selling off 19% while the S&P 500 has gained 4%.

Earnings estimates have moved lower, but not nearly as fast as the share price. For example, back in July analysts predicted Fluor would earn $5.15 a share next year. Now they say $4.97, or 3% less. One reason forecasts have held up better than the shares is that Fluor has a $40 billion backlog of upcoming projects, enough to supply it with 21 quarters worth of revenue.

About 80% of the backlog consists of “cost-plus” jobs, where visibility on profits is high, according to investment bank D.A. Davidson. It initiated coverage of Fluor shares at the beginning of this month with a Buy recommendation and price targets of $85 over the next 12 to 18 months, and $150 over five years. The nearer-term target is about 30% above Fluor’s recent price of just below $65. The longer-term one is 130% higher.

The article can be found here:

http://online.barrons.com/articles/oil-slump-makes-fluor-stock-a-potential-double-1414146666

Investors looking for a large-cap growth company with exposure to expanding oil and gas infrastructure should review Fluor as a core holding in the energy sector.  The current market weakness should provide a good entry point for new positions. 

Disclosure: Long FLR.  FLR is  followed by Guiding Mast Investments newsletter.  Thanks for reading, George Fisher

Johnson Controls: Auto Batteries and HVAC Make Strange Bedfellows

Johnson Controls is an industrial company with diverse interests in automotive, heating and air conditioning. Johnson Controls is really three companies in one. Already one of the leading automotive seating and interiors suppliers, Johnson Controls continues to diversify. Growth in its building efficiency and power solutions group helps offset vicious cyclical declines in the automotive experience group.

The automotive segment contributed 51% of fiscal 2013 sales, down from 69% in fiscal 2005, which shows the company's increasing diversification.

Building efficiency in fiscal 2013 was a $14.6 billion business, contributing 34% of sales compared with 21% in fiscal 2005. The 2006 acquisition of York, manufacturers of heating and air conditioning equipment, made Johnson Controls a much larger player in HVAC equipment and service. This depth allows the company to market itself as a one-stop shop for service, controls, and equipment, which differentiates JCI from other large providers. Eighty-three percent of segment sales come from repeat business, but the company seeks to increase its exposure to more profitable HVAC product sales for a 50/50 product and service segment mix.

Power solutions is highly profitable, with 15% of fiscal 2013 sales and an operating margin over 15% in fiscal 2013. The segment has 36% share in the lead acid automotive battery market. This business is also a good diversifier because 80% of segment sales are to the replacement market, which makes battery demand more inelastic and gives the company strong pricing power. Johnson is the dominant player in start-stop vehicle technology thanks to its leading position in absorbent glass mat AGM batteries. Power solutions should benefit from automakers needing more fuel-efficient vehicles to meet environmental regulations.

There is tremendous growth and profit potential in AGMs because the batteries sell for twice the price of a normal lead acid battery. AGMs also generate 50% better profit margin. European auto production is forecast to increase the use of advanced lead acid batteries, such as AGMs, to 75% by 2015 from 40% in 2011. North American auto production is forecast to increase advanced lead acid use to 59% by 2015 from nearly zero in 2011. Globally, management expects start-stop to be 50%-60% of powertrains in new vehicles by 2020, up from 14% in 2012.

At the current price and a 15% anticipated EPS growth rate, JCI is trading below its earnings growth rate with a 2014 PE of 13.  JCI has been paying a dividend for decades and the current price offers a dividend yield of 2.0%.  JCI has a 5-yr dividend growth rate 7.9% and a 3-yr growth rate of 13.5%.  Management recently announced a dividend increase of 16.1%.  However, reported EPS over the same timeframe have been rather flat, mainly due to restructuring charges. 

JCI has a price target of $56, about 35% above its current price of $41.  While EPS have been stagnant over the past few years due to restructuring and charges, management should be about complete with its realignment of their businesses.  The underlying strength in the automotive and construction industries should help turn earnings around.   After being negative in 2010 and 2012, Free Cash Flow (operating cash flow minus capital expenditures) turned positive in 2013 to the tune of over $1.3 billion, and continues positive YTD.  Management believes free cash flow could top $2.0 billion by the end of 2016.

From Morningstar’s JCI report:

Johnson Controls has 15,000 HVAC service providers, making it 3 times the size of the second-largest player.

More governments wanting green buildings and the company's unique ability as a one-stop shop will keep the building segment growing and profitable, especially in emerging markets.

Increases in lead prices are mitigated by the fact that 100% of the lead price pass-through has been standard contracting with battery retailers for more than 70 years.

The company still gets about half of its sales from the very cyclical auto industry, and the market perceives it as an auto-parts supplier.

Commercial property servicing is very fragmented, and it could take time to capture significant share in the middle-market segment.

About 20% of battery sales are to automakers, which further exposes Johnson Controls to declines in auto production.

Investors looking for a high quality industrial company for the long term should review JCI.  Stock valuations have been consistently near the top of our universe.  More information can be found in JCI’s most recent investor’s presentation:

http://www.johnsoncontrols.com/content/dam/WWW/jci/corporate/investors/2014/JPMorganAugust2014.pdf

First appeared in the Oct 2014 issue of Guiding Mast Investments newsletter.  Thanks for reading,  George Fisher

Lockheed Martin's Growth Fueled by Net ROIC of 30%

The world’s largest defense contractor offers dividend growth above inflation expectations and a yield higher than the current 30-yr Treasury.    Lockheed Martin (LMT), with $45.4 billion in revenues, has a 5-yr average dividend growth of 21% and a current yield of 3.5%.

A good description of the company is from their website:

LMT is a global security and aerospace company principally engaged in the research, design, development, manufacture, integration, and sustainment of technology systems and products. The Company also provides a range of management, engineering, technical, scientific, logistic, and information services. It serves both domestic and international customers with products and services that have defense, civil, and commercial applications, with its principal customers being agencies of the United States Government. It operates in five business segments: aeronautics (31% of 2013 sales), missiles and fire control (17%), mission systems and training (16%), information systems and global services (18%), and space systems (18%).

 LMT manufactures the newest jet fighters, F-35, and its fortunes will pivot on this important defense business, both in the US and abroad. 

 Dividend increases have been fueled by an 8% earnings growth and a payout ratio that has expanded from 30% of earnings to 53%.  While unsustainable at this growth rate, a long-term dividend growth matching its earnings growth of 8% would remain a respectable combination. 

 LMT should not be considered a value selection as it is trading at a PE of 18 with an underlying growth rate of 8%.  Share prices are up 12% from early August, and up 50% over the past year, substantially outperforming the market.  However, LMT has been a solid dividend payer with a lower-than-market beta of 0.72.    

 Helping long-term eps growth has been a reduction in shares outstanding.  Over the past 10 years, LMT has reduced share count by 28% - from 443 million shares outstanding in 2004 to 319 million currently.  This has help drive both eps and share prices higher. The combination of dividend growth and share reductions is a double positive for long-term shareholders.  It should be anticipated LMT will continue this trend.

 Management has one of the highest and most consistent returns on invested capital (ROIC) at a whopping 34% to 43%, with a 6-yr average of 37%.  Based on a cost of capital of 7.3%, management generates an eye-popping 30% net ROIC annual return.       

Analysts at Stifel upgraded shares of LMT to Buy from Hold and raised the stock's price target to $220. Joseph DeNardi stated,

“We believe the cash flow generation outlook for Lockheed’s core business, combined with the expected cash recovery from its pension over the next several years, should support continued growth in the company’s dividend and share repurchase activity to a degree that will differentiate it from its peers.”

Other highlights include: Defense spending bottoming in fiscal year 2015.  Analysts anticipate growth in F-35 sales as production rates increase.  DeNardi believes Lockheed is the best way to play what it see as a challenging but stable outlook for defense budgets.

Equity income investors looking for strong dividend growth with current yields competitive with long treasuries should review LMT.  However, share prices are currently overvalued and capital gains may be hard to come by from here.  Waiting a bit for a pullback, and buying the dip, should be the most prudent approach to this dividend growth machine.

 First appeared in the Oct 2014 issue of Guiding Mast Investments newsletter.  Thanks for reading,   George Fisher

Which Equities Should Perform Better in Times of Higher Inflation and Why Should I Care?

One aspect of rising interest rates is the fight to control inflation.  As history demonstrates, loose monetary policy leads to too many dollars chasing too few goods, creating upward pressure on inflation.  In the previous piece, Atlanta Federal Reserve Bank’s Mr. Dennis Lockhart stated that a prominent risk of low interest rates is an uptick in inflation.   As the chart at the end shows, interest rates are set to rise in 2015 and continue into 2016, but if the Feds are already behind the curve and if rates do not rise sufficiently to curb inflation, it will once again creep back into our everyday lexicon.

There are sectors of the economy that historically do better with a touch of inflation and positive real interest rates.  While the list is not meant to be exhaustive, we hope to touch on a few sectors and which stocks in our universe may be poised to benefit from this environment.

Commodities and basic materials usually react favorable with a touch of inflation and usually rise with it over time.  Glencore (GLNCF) is a trader and miner of industrial chemicals.  BHP Billiton (BHP) is a global miner of industrial commodities as well. Southern Copper (SCCO) is a major global miner of copper.  

Financial firms with fixed income investments, especially international finance and insurance, should experience an uptick in investment income as rates improve.  Berkshire Hathaway (BRK-B) has less of its investment portfolio invested in bond than its peers do.  Buffet prefers equities and entire businesses than purchased a portfolio of fixed income investment.  While this has worked to its favor as equity markets have outpaced the bond markets over time, other insurance companies may see a bigger boast in their investment income.  Power Corp of Canada (POW.TO, PWCDF) owns a majority percent of Power Financial/Sun Life of Canada.  Although a substantial chunk of fixed assets held by AFLAC (AFL) are in Japanese and European fixed income markets, higher income from its US bond portfolio should boost earnings.   Lincoln National (LNC) should benefit as well.

Real Estate usually increases with rising inflation. Both rents and home/commercial prices trend higher with the inflation rate.   Many REITs should perform adequately, however rising interest rates may pressure competitive yield offered by REITs.  Established triple-net REITs, such as National Retail Properties (NNN) or Reality Income (O), are structured to pass along increases in operating costs to their tenants. 

Gold is usually mentioned as benefiting from inflation.  The S&P Gold ETF (GLD) and various gold miners should rise as gold’s price tracks inflation numbers.  Gold mining mutual fund Tocqueville Gold (TGLDX) should benefit from inflation.   Gold mining and energy income fund Gabelli Global Natural Resources (GGN) offers a 10% distribution (mainly categorized as return of capital) and should benefit as well.     

Oil and natural gas prices will move higher along with inflation.  Suncor (SU), Dorchester Minerals (DMLP), and Total (TOT) should respond favorably.

Floating rate bank loan mutual funds will increase their income as higher interest rates and inflation take hold.   Fidelity Floating Rate High Yield Income (FFRHX) and Oppenheimer Senior Floating Rate (OOSYX) are two examples of funds that hold variable rate bank loans. 

Investors should care because inflation will become a headline event not too far into the future, and when it happens, it could be too late to move into these inflation-sensitive investments. Do not be like the Feds and become behind the inflation-curve. 

First appeared in the Sept 2014 issue Guiding Mast Investments newsletter.  Thanks for reading and your interest,  George Fisher

FS Investments Went From Privately-Held to 4th Largest Public-Traded Firm in its Industry - Overnight

FS Investment Co (FSIC) went from being privately held to the fourth largest publicly traded company in its industry – overnight. FSIC was spun off from Franklin Square Holdings, a private investment company.  FSIC is a Business Development Company BDC and supplies capital for smaller companies looking to raise equity and debt.  By market capitalization, FSIC is the 4th largest BDC out an industry consider to total 41. 

Before the Great Recession, BDCs were very popular with investors due to their high yields and unique expose to growing companies.  However, as many businesses began to fail, BDCs ran into severe trouble and were unable to collect on their debts. Most lost money, experienced rapid declining book values, and failed to make money for longer-term investors.  A good example is American Capital LTD (ACAS).  A $10,000 investment in 2004 would have been worth $416 or less during much of 2009.  Currently, the $10,000 would be worth $15,000 vs. $22,000 if invested in the S&P 500.     

A business description is found on their website:

FS Investment Corporation is a publicly traded business development company (BDC) focused on providing customized credit solutions to private middle market U.S. companies. We seek to invest primarily in the senior secured debt and, to a lesser extent, the subordinated debt of private middle market U.S. companies to achieve the best risk-adjusted returns for our investors. In connection with our debt investments, we may receive equity interests such as warrants or options.

FSIC is advised by FB Income Advisor, LLC, an affiliate of Franklin Square Capital Partners, a leading manager of debt-focused alternative investment funds, and sub-advised by GSO/Blackstone Debt Funds Management LLC, an affiliate of GSO Capital Partners, the credit platform of Blackstone. 

 Of interest to investors is the connection between FSIC and Blackstone (BX), one of the largest investment, hedge fund and private-equity managers.  The majority of FSIC loans (76%) are variable rate with an average maturity of 2020 and the average credit rating of its 125 portfolio companies is B3.  

FSIC could be substantially overpriced if the 9.3% current yield is unsustainable.  The monthly dividend is $0.88 annualized, and a $0.10 special dividend was recently announced.  The dividend is supported by the company’s portfolio of loans with an average interest rate of 9.9%.

As the overall interest rate environment remains low, these loans are at risk of being refinanced at lower rates, reducing income for FSIC.  In addition, the advisory fees charged by Franklin Square and BX are around 2.0%, expensive for the assets managed - $4.2 billion.   

 BDCs with longer operating histories include Triangle Capital (TCAP) with an 8.1% yield and PennantPark Investments (PNNT) with an 11% yield.  While their industry was collapsing around them during the financial crisis, these two companies did not cut their dividends.  All BDC investors should appreciate this important trait. 

The bottom line for FSIC is that there may be better avenues for generating above average income and the risks associated with FSIC are not necessarily fully compensated by a 9.3% yield.

More information on FSIC can be found in their investors presentations:

http://www.fsinvestmentcorp.com/investor-relations/presentations-and-reports

First published in the Sept 2014 issue of Guiding Mast Investments newsletter, Thanks for reading, George Fisher

Suncor Energy: If It's Good Enough for Warren Buffett, It Should be Good Enough for You

Suncor (SU) is the largest Canadian oil company, but not quite large enough to be included with the Big Seven Sisters.  (The phrase was coined in the 1950s, referring to the largest seven global oil companies of the time.  The original group comprised Anglo-Persian Oil Company (now BP); Gulf Oil, Standard Oil of California (SoCal), Texaco (now Chevron); Royal Dutch Shell;  Standard Oil of New Jersey (Esso) and Standard Oil Company of New York (Socony) (now ExxonMobil)). 

During the obligatory disclosure period at the end of each quarter, Berkshire Hathaway (BRK.B) revealed it initialed a position in SU by purchasing 17.7 million shares.  While still rather minor at just 1.2% of SU shares outstanding, the investment of $500 million is no small potatoes, even for Mr. Buffet.  Shares are up nicely to $41 from a purchase price of between $27 and $32. 

Suncor is an investment that is depended on its 100-yr potential of oil reserves locked in the Oil Sands.  While the firm also produces oil from conventional offshore drilling along the Canadian East Coast and in the North Sea, the majority of its production will come from oil sands.   

SU had a rough 2nd quarter 2014 with write-downs of some of its projects.  The company wrote down $223 million in Oil Sands projects following a review of certain assets that no longer fit Suncor’s revised growth strategies. SU also incurred $297 million charge against the company’s Libyan assets due to continued political unrest.

The company said production volumes from the Oil Sands operations increased to an average of 378,800 barrels per day in 2Q14—compared to 276,600 bpd in the same quarter last year.

Quarterly production volumes for the Exploration and Production segment decreased to 115,300 barrels of oil equivalent per day (or boe/d).  Production volumes were 190,700 boe/d in the same quarter last year, but included conventional natural gas assets recently sold. 

Suncor’s cash cost of production is around $12 per boe offshore in the Maritimes, $6 in the North Sea, and $32 in the oil sands.   While operating costs are higher, the future of the company is based on achieving higher production volumes from their sands projects.  

The investment trade off with Suncor is accepting higher operating costs in exchange for higher production reserves. SU owns 37 yr. Proven and Probable Reserves compared to 19.7 yrs. for Apache (APA) and 13.5 yrs. for Total (TOT).  The amount of estimated recoverable oil in the area of SU’s assets could contain as much as 22.5 billion barrels, which could sustain 500,000-boe production for over 100 years.  Below are two graphs from Suncor’s investor presentation outlining planned production growth and historic operating costs from their oil sand projects:

Since 2011, SU has generated $8.3 billion in free cash flow, or operating cash flow less capital expenditures.  An important consideration in the oil business is the high cost of capital expenditures needed to offset production declines.  Apache generated $0.5 billion in free cash flow and Total $4.1 billion during the same period.

Management has earned a 12-month return on invested capital of 7.75%, and is about the industry average of 8.76%.  Operating margins of 16.1% are above industry average of 10.2%. 

Suncor pays a dividend of $1.03 a share and offers a 2.5% yield. The dividend was recently raised by 22% and marks the 12 straight year of dividend increases.  With a payout ratio of 30%, future dividend increases should track long-term earnings growth rate of 8%.

More information can be found in the most recent Suncor investor presentation: 

http://www.suncor.com/pdf/SU_IR_Q2_2014.pdf

First published in the Sept 2014 issue Guiding Mast Investments newsletter,  Thanks for reading,   George C. Fisher

ITC Holdings: An Unconventional Utility with Oversized Growth Prospects

ITC Holdings (ITC) is a mid-cap regulated electric utility with substantial growth prospects not seen elsewhere in the sector. ITC is expected to grow earnings by 13% a year, more than double the utility sector’s 4% to 6% growth rate. ITC focuses solely on federally regulated (Federally Energy Regulatory Commission FERC) transmission assets where allowed return on investment is higher than the typical state-regulated assets. The difference is federally regulated usually allows for about 12% to 13% return on equity vs. the most recent quarter’s rate case average for state regulated allowed return on equity of 10.5%.

Translating this into potential profits – for every dollar ITC invests in transmission assets, the allowed return is between 14% and 23% higher than the average utility investment whose rates are regulated by state agencies. The company just announced a $4.5 billion capital expenditure budget for the next 5 years. This should drive earnings higher by 11% to 13% annually as these assets become included in its rate base calculations. Net Property, Plant and Equipment should double in size from $4.8 billion to over $9.3 billion by 2018.

The stock has had an impressive run over the past year, rising from $30 to $37. ITC is up 23% over the previous 12 months while the S&P Utility ETF (XLU) is up 5%. Price targets range from $41 to $48, leaving plenty of room for future shareholder returns. There are currently 156 million shares outstanding, which is low for the sector, even after a 3-1 stock split (remember those?).

Over the past few years, the stock has had several uninterrupted moves higher. After collapsing in the 2009 market meltdown from $17 to $7, the stock rose nonstop back to $17 in 2010, paused a bit to $15, then rose to $26 in 2011. The stock paused again between $25 and $22, and then ran up to $32, paused again, then climbed to $35 in 2012/2013. Recently, the stock fell back to $31, and then charged up to its current $37 as the stock split was announced. Share prices would have to drop below $34 to signal a break in the most recent up trend.

The dividend yield is quite low for a utility, as ITC has been plowing investable cash back into its cap ex program. The current yield is only 1.5%, but dividends are expected to grow by 10% annually over the next few years. Dividend growth investors should be savoring this growth rate.

ITC may be considered to be fully valued and future capital gains will come from higher earnings and dividends. ITC is trading at a PE of 25, vs its previous 5-yr high of 23 and price to cash flow ratio is double industry valuations. With a low payout ratio of 36%, higher earnings and an expansion of the payout ratio will support higher dividends over the long-term.

Starting a beginning position in ITC, with the concept of adding to shares over time, would make a timely addition to the utility allocation of your portfolio.

Disclosure: Long ITC and ITC is followed by Guiding Mast Investments.  First published in the May 2014 issue of Guiding Mast Investments newsletter.

Update:  The FERC recently reduced the allowed ROE for electric transmission assets.  With incentives for being an independent company, ITC should earn 11.47% ROE, down for a range of 12.16% to 13.88%.  ITC should be eligible for the highest allowed ROE of its peers. 

Thanks for your time and interest in Guiding Mast Investments,  George C. Fisher, Founder and Publisher

Are Bond Fund Exit Fees in Your Future?

While not getting much mainstream press, the Fed may be thinking about what will occur as interest rates increase and its effect on the value of bond mutual fund prices.  From a Barron’s article, June 21 Up and Down Wall Street:: 

“The Federal Reserve is floating a trial balloon, or at a minimum give bond investors a “heads up”.  It might be well that the Federal Reserve appears to be thinking about the consequences of the end -- and eventual reversal -- of its massive experiment in monetary stimulation. Last week, the Financial Times reported that the central bank is mulling exit fees on bond mutual funds to prevent a potential run when interest rates rise, which, given the ineluctable mathematics of bond investing, means prices fall. Quoting "people familiar with the matter," the FT said that senior-level discussions had taken place, but no formal policy had been developed.

Those senior folks apparently did not include Fed Chair Janet Yellen. Asked about it at her news conference on Wednesday, she professed to be unaware of any discussion of bond-fund exit fees, adding that it was her understanding that the matter "is under the purview" of the Securities and Exchange Commission.

That nondenial denial leaves open the possibility that some entity in the U.S. financial regulatory apparatus is indeed mulling bond-fund exit fees. The Financial Stability Oversight Council established by the Dodd-Frank legislation oversees so-called systemically important financial institutions, or SIFIs, which include nonbank entities. And, indeed, the FSOC has considered designating asset managers as SIFIs, as Barron's has noted previously.”

http://online.barrons.com/news/articles/SB50001424053111903927604579628353649352222

Remember that in the jaws of the last financial crisis, a run on money market accounts during the fall of 2008 caused the Feds to alter money market fund status by temporarily guaranteeing them, equaling the protection of FDIC-insured bank savings accounts.  This temporary guarantee expired in Sept 2009. 

An exit fee for bond fund sales might be an attempt to stem potential fund outflows as rates increase.  While most commentators do not believe this will actually happen, it is important for investors to take notice of the Fed’s worry.   

Most of us have some bond funds and it essential for investors to understand the “interest rate risk” and its potential impact on that specific fund.  While seemingly a complex calculation, it is actually quite easy.  Most of the complicated math has been done for you and is reflected in two important bond fund fundamentals.   These are “Average Maturity” and “Average Duration”.

The important takeaway is the topic of interest rate hikes is starting to gain traction, even within the inner circle of the Fed.  How are you preparing for the next move up in the interest rate cycle and how will it affect your finances?

First published June 2014 issue of Guiding Mast Investments newsletter.  I appreciate your time and interest in Guiding Mast Investments, George Fisher, Founder and Publisher

Goldman Sachs Moves Up the Date for he Demise of the Bond Market - The Modified Taaylor Rule and EuroDollar Futures Agree

From a Marketwatch news article published July 6, 2014:

“LONDON (MarketWatch) -- Goldman Sachs now believes the first hike in the U.S. federal funds rate will come in the third quarter of 2015, rather than in the first quarter of 2016. The changed forecast comes in response to "the cumulative changes in the job market, inflation, and financial conditions over the past few months," chief economist at Goldman Sachs, Jan Hatzius, said in the note from Sunday. The revised forecast is close to current market expectations, but Hatzius said the change is important because it is the first time since the crisis that Goldman Sachs has moved forward its rate-hike expectations. "We view this as an illustration of the substantial progress that the U.S. economy has made in overcoming the fallout from the housing and credit bubble," he said. Goldman Sachs now expects the funds rate to rise gradually back to 4% by 2018.”

http://www.marketwatch.com/story/goldman-sachs-brings-forward-forecast-for-first-us-rate-hike-2014-07-07?siteid=yhoof2

Seeking Alpha’s reading of the Eurodollar futures seems to agree with the Goldman Sachs’ belief and offered the following news headlines on July 7, 2014:

“Checking Eurodollar futures for expectations of tighter monetary policy, they've backed off a bit from rate hikes as well, the June 2016 contract ahead by four basis points, but still pricing in a Fed Funds rate about 130 basis points higher in two years then it is now.”

http://seekingalpha.com/news/1833425-treasury-yields-reverse-post-employment-report-surge

The current yield curve for US treasury notes/bonds is below.  Based on the curve, the 10-yr is yielding 2.65%, 20-year is yielding 3.21%, and the 30-year is yielding 3.47%

Yield Curve July 5, 2014, www.treasury.gov

If 10-yr rates are expected to increase to 4.0% and based on the same yield curve slope, one should expect yields to increase to 4.56% on 20-yr and 4.82% on 30-yr, for a net increase of 1.35% across the board.  

Below is a graph of historic 2-yr and 10-yr rates going back to 2004.  As shown, before the 2008 financial debacle, both 2-yr and 10-yr rates were in the 4.0% range, and it was not until the easy money of the past few years that rates dramatically declined.

www.treasury.com

http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/Historic-Yield-Data-Visualization.aspx

In addition, the Modified Taylor Rule adds another layer of agreement with rates climbing dramatically after 2015, as shown below.  The chart outlines how the Modified Taylor Rule has mirrored the Fed Funds rate from 1985 to the current crisis’ beginning in 2008. 

Modified Taylor Rule and Fed Funds Rate.  www.brookings.edu

“A simple, but highly effective way of transforming output gap estimates into monetary policy comes from the Taylor Rule, which is based on John Taylor’s 1993 paper Discretion Versus Policy Rules in Practice. It calculates a recommended federal funds rate based on only three variables: the amount of slack in the economy; the deviation of inflation from its target; and the neutral interest rate described above. While there is much disagreement about the exact definition of these variables and the appropriate weights on them, the modified Taylor Rule depicted in Figure 3 seems to do a very good job at modeling Fed behavior.

The modified Taylor Rule suggests that the fed funds rate should’ve been cut well below zero during 2008 and should remain negative today. Since it is very difficult to charge negative interest rates, the Fed came up with alternate policies, such as expansion of its balance sheet to initially ease up frozen credit markets in 2008-09, then to lower longer-term interest rates as well as encourage credit creation and risk taking today. Though the latest jobs report of weak payrolls but a lower unemployment rate present a confusing picture of the economy, the modified Taylor Rule currently recommends that since the economy is recovering and starting to eat into the spare capacity - as evident by the declining unemployment rate - interest rates should not be as negative as before.

Using the latest FOMC Economic Projections (Table 1) in combination with the CBO’s estimate of potential, we can attempt to forecast monetary policy going forward (see the right hand side of Figure 3). The modified Taylor Rule forecasts that the Fed will start raising interest rates at the end of 2014, and the funds rate should be above 3% by the end of 2016.”

More information on the Modified Taylor Rule can be found here:

http://www.brookings.edu/blogs/up-front/posts/2014/02/07-strong-correlation-cbo-projections-fed-actions-coheng

http://en.wikipedia.org/wiki/Taylor_rule

http://web.stanford.edu/~johntayl/Papers/Discretion.PDF

A inescapable fact is that bond prices in the secondary market react inversely to interest rate movements.  As interest rates go up, bond prices go down; as rates go down, bond prices go up.   So what does this mean for bond investors?  In a short sentence – it means a massacre of long bond prices is in the offing.  IF  the yield curve does not steepen and IF  long rates are held to only a 1.35% increase, the following ETF/bond funds will decline by the following percentages: 

ZROZ PIMCO 25 Year+ Zero Coupon Treasury Bond will decline by 37.15%

EDV Vanguard Extended Duration Treasury Bonds will decline by 33.75%

TLT iShares 20 Year+ Treasury Bond will decline by 22.1%

TLH iShares 10-20 Year Treasury Bond will decline by 13.1%

IEF iShares 7-10 Year Treasury Bond will decline by 10.2%

Below is a Morningstar graph of the cumulative inflows and redemptions of bond vs. stock funds for the 5-years from 2008 to 2013.  As shown, the inflow for bond funds is about five times the outflow of stock funds. 

Bond Fund Inflow vs Equity Fund Outflows 2008 to 2013 www.morningstar.com

What to do?

The first step is to determine your personal interest rate risk by fund or ETF.  Morningstar.com on its quote offers the average duration, or the ratio of rate sensitivity, for almost all bond funds and ETFs.  To calculate a specific bond fund’s interest rate exposure, multiply the anticipated rate movement by the duration.  For example, ZROZ has duration of 27.5 and the example above is a 1.35% rise in rates.  Multiply 27.5 x 1.35 = 33.75, or a decline of 33.75%.

While floating rate ETFs and funds have no duration as they reflect the current rate environment, duration of 4.0 or less would be considered low. The easiest means of lowering duration would be to shorten maturity exposure.  

Bond investors are facing a difficult choice – reduce short-term income by moving out of higher yielding, longer term and higher duration investments.  Which is better for you 1) reduce your income over the next few years or 2) experience a considerable loss of principal?  It is like the deciding the better of two evils.

I appreciate your time and interest in Guiding Mast Investments, George Fisher

What is Under that FIG Leaf? Distributions and More Distributions

Fortress Investment Group (FIG) is a controversial hedge fund manager that either analysts love or they hate.  A share price at $7.50 and a dividend yield of 4.5% would seem to reward shareholders with a longer-term horizon.  However, FIG is not without issues.

A good two sentence overview from their press release:

Fortress Investment Group LLC is a leading, highly diversified global investment firm with approximately $62.5 billion in assets under management as of March 31, 2014. Founded in 1998, Fortress manages assets on behalf of over 1,500 institutional clients and private investors worldwide across a range of private equity, credit, liquid hedge funds and traditional asset management strategies.

Like many of its peers in the alternative investment field, Fortress Investment Group is structured as a LLC, much like a MLP, where unit holders receive a K-1 tax form. 

FIG generates revenue based on fees charged for their investment services.  As shown below, the bulk of AUM, along with revenue growth is in its fixed income programs. Going forward, this segment should continue to be the driver for growth in AUM to over $115 billion by 2017. 

The following chart taken from its 1st qtr. 2014 press release outlines the major business sectors by Assets Under Management (AUM). 

The latest investor presentation dated 2013 can be found in the link below:

http://shareholders.fortress.com/Cache/1001183295.PDF?Y=&O=PDF&D=&fid=1001183295&T=&iid=4147324

Earnings per share are expected to increase from $0.80 per unit in 2013 to between $0.94 and $1.28 by 2017.  Distributions are expected to grow from $0.30 per unit, for a 37% payout ratio, to a minimum of $0.55, for a 58% payout ratio, in that timeframe as well.  Consensus price targets range from $10.50 to $11.50, but FIG has a high beta at 2.5, so investors could expect a volatile ride up.

While these estimates vary widely, it is important for investors to understand the structure and use of units as a management compensation vehicle.  FIG has two classes of units, Class A and Class B.  Class A is publically traded while Class B, also known as Operating Group Units, is not. Class B units are owned by management and are a used as an important compensation tool.  Not only do they receive equal distributions, but B units are sometimes bought back by the firm, or are swapped, directly or indirectly, for publically traded A units.   For example, in March 2014, FIG announced that it will sell 23.2 million newly issued Class A units in a secondary offering, with proceeds used to buy Fortress Operating Group Units from management. At $7.50 a share, the value of the purchase of Class B units would be around $175 million.  As of the end of the 1st qtr, there were 229 million Class A and 226 million Class B shares outstanding.  As shown, management owns a substantial percentage of total units outstanding  and this ownership provides them with a valuation of $1.7 billion of units and an annual income flow of $67 million.

Management is definitely on the same page as us lowly Class A unit holders.

Credit Suisse offers an interesting thesis:

Our Outperform Thesis: We remain Outperform on the FIG stock given that (1) FIG has almost $3 per share in net cash/investments. We think FIG will look to return capital to shareholders as their illiquid PE and credit fund investments on B/S return capital to LPs (which includes FIG). This will be source 1 of dividends going forward. (2) We estimate FIG will earn between $0.50 and $1.40 per share over the next five years and will target a dividend payout of earnings (source 2) around 50-80% (with a larger dividend payout occurring in 4Q – starting in 4Q14). So after adding dividend source 1 and 2 – we think FIG may be returning a very large amount of cash to shareholders over the next five years ($2.50 to $4.00 range or ~45% of current share price). (3) We think the core FIG business (x-the large excess capital balance) is worth about ~$11-12 - supported by $8-9 in value from mgmt. fee-based revenues (~$0.40 in normal year x 20x multiple – these fees are growing quickly and generally have very high persistency) and $3 in value for performance-fee-based EPS (~$0.50 in norm year x 6 multiple).

On the other side of the fence, Morningstar offers a down-in-the-mouth assessment of FIG in their most recent review.

The aftermath of the 2008-09 financial crises has changed Fortress Investment Group permanently, and we don't think for the better. We believe Fortress' reputation was severely damaged as the firm used side pockets to prevent redemptions on its most illiquid investments and suspended redemptions at its major Drawbridge Global fund at the height of the crisis. These actions as well as poor returns angered investors, who pulled out billions in capital over the next few years.

Fortress' struggles mean that its outlook is very different from many of its peers. The company raised only about $9 billion in new capital for its alternative funds over 2011-13. This level of fundraising is far lower than peers that raised several times more in new capital and consequently have stronger growth prospects. Believing that the firm will continue to face challenges with client inflows, we anticipate that Fortress will struggle to raise enough capital to offset our forecast level of redemptions and realizations as its funds age. As a result, we expect alternative assets to reach just $43 billion in 2017 from $40 billion in 2014, leaving the majority of Fortress' most valuable assets under management and earnings power to be largely stagnant in the near future.

Instead, we think the bulk of Fortress' growth over the next few years will come from its traditional fixed-income business, Logan Circle, which was acquired in 2009. We expect AUM for the segment to reach about $36 billion in 2014 and $70 billion in 2017, which will be roughly 60% of Fortress' total AUM and far greater than 2009's $11.5 billion. Inflows will be driven by fund performance, which is in the industry's top quartile, but Fortress earns only about 14 basis points (versus 150-200 basis points plus performance fees at its alternative funds) on the capital. Separately, the company recently hired a group of managers who have experience managing $20 billion of equities, believing it can charge investors 60 basis points to participate in the new strategy. However, given the significant difference in fees, we still expect the contributions of this segment to be around 10% of distributable earnings in 2017.

I fall on the side of Credit Suisse and think the current price offers adequate future total returns. With a payout ratio in the 50% range and high-end earnings estimate of $1.28, the distribution could grow to $0.64 a unit.  With a payout ratio of 80% and low-end earnings estimate of $0.95, the distribution could be $0.76 a unit.  Either way, the yield on cost could explode from a current 4.5% to between 7.5% and 10.0%.  

Oh, by the way, the firm has $2.2 billion in cash and investments and $1.2 billion in liabilities.  This equates to net cash and investment assets of $2.83 per unit, or about 37% of the current share price. Looking for a future high-yielder with additional capital gains potential?  FIG may fit the bill.

Disclosure: I am long FIG and the company is followed by Guiding Mast Investments monthly newsletter. 

I appreciate your time and interest in Guiding Mast Investments, George Fisher

Man-o-Man, Based On These Guy's Advice, I Would Never Take My Advice

There are a growing number of websites that offer to rate specific analyst's and blogger's stock picks. One such site is tipranks.com.  A detailed description of their service is available on their website.  So, I did what any self-respecting financial writer would do – I looked up my performance on TipRanks.com

I have the unique situation of writing for Seeking Alpha from Feb 2010 to Feb 2012 using my given name.  Due to compliance issues, during the later days of being a RIA from Sept 2012 to March 2014, I wrote using the pen name Jon Parepoynt.  Therefore, I looked up both authors.

The various options for searching performance on TipRanks.com are “stock ratings automatically closed at “1 qtr., 1-yr., or 2-yr.”  Comparisons are available using “S&P 500, Sector, or None” . 

When selecting “2-yr timeframe” and “None”, George Fisher generated a 16.3% average return per recommendation with a 31 out of 44-success ratio, or 70%.  However, when compared to the S&P 500, the results plummeted to -4.1% average return above the S&P and a 20 out of 44-success ratio or 45%.

When selecting “2-yr timeframe” and “None”, Jon Parepoynt generated a 12.2% average return per recommendation with a 40 out of 48-success ratio, or 83%.  However, when compared to the S&P 500, the results plummeted to -2.3% average return above the S&P and a 28 out of 48-success ratio or 58%.

I reviewed my own rating and found it obviously quite disappointing.  As author George Fisher, I was rated #2019 and as author Jon Parepoynt I was rated #2469 out of 3233 bloggers tracked compared to the S&P.    Man-o-man, I would never take my own advice.

TipRanks.com website has been discussed on the contributor forums of Seeking Alpha.  One contributor contacted TipRanks.com to clarify their measuring methodology and below is the reply, as posted on the forum:

I understand there is a thread on SeekingAlpha regarding TipRanks and I would like to explain a bit how experts performance are measured. I would appreciate it if you could publish this on the thread so all the dear contributors will get answers to their questions.

Before I dive deep into the calculations, I would like to point out that TipRanks is here to let laymen investors know who they can trust there are 3100 sell side analysts 3200 bloggers (out of which 800 are from SA) and it is amazing to see that average bloggers performs so much better than an average sell side from Goldman Sachs.  And our users love the fact that they can easily find rock stars from blogs and see what they have to say as experts.

Our measurement system was developed by a leading professor of Finance from Cornell University called Roni Michaeli who is an industry leader in performance research and published hundreds of academic articles in the field of analyst performance.

When our machine detects a recommendation to Buy a stock, we "virtually" buy it, but we also buy relevant benchmarks, the SPY and an ETF of the sector of the stock recommended….When a blogger recommends a stock we will close his position either after the time defined or if he writes another article about the stock (if it is a buy and then a buy we will close first position and open a new one, and the performance of both "buy" calls will be added to his portfolio).

We also measure success rate which is the number of stocks who had positive return in case of no benchmark or outperformed the benchmark if a benchmark is chosen.

We then run a Z test on the success rate meaning that the more the data is significant the more weight the expert is getting (e.g. if someone has 10 out of 10, he is not as good as someone who has 75 out of a 100 even though the first one has 100% success rate and the second has only 75%)

These 2 factors are combined into a single ranking which is displayed by the amount of stars.  Our platform was awarded twice as the best of show on Finovate for its power and innovation and there are many thousands of happy users using it on a daily basis.  It is a powerful tool to research stock and filter out underperforming analysts when using analyst consensuses, which institutional investors use as a benchmark. bWe were also offered many times to close the platform for individuals and provide it only to professional money managers and refused to do so, arguing that our vision is to empower the main street.

I would be happy if you could publish this on the thread to clarify the questions some contributors might have.  Sincerely,  Uri.

So, I dug a little deeper and decided to upload my own portfolio based on the specific advice as offered by tipsrating.com.  The site does allow for review of each data point they analyze with the date and share price.  I use the premium service at Morningstar.com to track my personal portfolio and to evaluate portfolio construction.   

 I uploaded into the M* portfolio tracker the same buys as listed on TipRanks.com, using a cumulative $2,000 per recommendation.  If there were three recommendations offered, the portfolio would be credited with three $2,000 purchases on the day each recommendation was made. The difference between TipRanks and M* was most interesting.  Needless to say, there is some stark and distinctive variances.

Using the M* portfolio analysis tools, each position as described by TipRanks was added.  There were two companies that were bought out: Thomas and Betts was bought by ABB for a substantial gain of 200% and CHG was purchased by Fortis at a 30% profit.  Both of these were stock mergers and the site had difficulty correctly accounting for the shares.    Three positions were closed.  There were some discrepancies in prices quoted in the linked article and on the site, such as DMLP was quoted as $15.16 when the actual market price for the day was $20.50. 

First off, according to M*, the performance of the 44 Jon Parepoynt selections were “1-yr” 16.6% total returns, and a “Since Purchased Annualized” total return of 17.1%.  M* also offers a “Personal Total Return” calculation that incorporates the timing within the month of deposits/buys into the portfolio, and is a bit higher at 18.4% and 21.6% respectively.  According to M*and using the M* US Market Index as a benchmark, the index returned 16.2% and 18.9% respectively. Below is their return performance graph.

Jon Parepoynt Performance Sept 2012 to May 2014

Combining the 44 recommendations of Jon Parepoynt and the 48 recommendations of George Fisher brought the number to 92 specific recommendations in 59 different companies.  Adding these specific recommendations together would produce the following M* performance chart:

Combined George Fisher and Jon Parepoynt Performance Feb 2010 to May 2014

There are two very important differences with these comparisons. The first is the concept of price-returns as offered by TipRanks.com and the total returns offered by M*.  The second is the asset allocation.  M* offers their calculation combining both capital gains and income while tipranks.com offers price-based capital gains only.  The portfolio income is $6,600 annually, for a current yield 2.8%.

The second major difference is asset allocation.  The 59 companies with 92 transactions nowhere near duplicated the sector represented in the index.  Below is a sector breakdown of the final portfolio as offered by M*. 

Sector allocation of the 56 companies in the combined portfolio

As shown, there are large gaps of underweighted sectors and substantial overweighting of others.  Specific stock recommendations are not necessarily made to conform to asset allocation parameters and focusing on certain sectors, such as utilities, will skew both investor expectations and performance. 

Probably the most interesting aspect with tracking of my recommendations is the omission of about 2/3 of the articles published on Seeking Alpha.  I have a combined total of almost 300 articles published since 2010 and TipRanks.com offers a link to 92 articles While not all 300 are specific stock recommendations, there are more offerings than listed on TipRanks.com

On second thought, I guess I would take my own advice – and do.  However, I will not publish a continuum of all 300+ articles, as these 92 should suffice.

Below are the positions in the combined portfolio, from M*:

Performance by position and purchase date for Combined portfolio

Disclosure: I am long CBI, NFG, ITC, RICK, DMLP, RYN, UTX, BGCP, SO, ETP, SE.  All long positions are followed by MyInvestmentNavigator.com monthly newsletter.

Update June 1:  I received the following email from TipRanks:

"Hi George,

My name is Gilad Gat and I’m the CTO of TipRanks.  I read with great interest your  article on MyInvestmentNavigor.com.  I wanted to make a few clarifications as to our performance measurements.

My goal is to clarify and to get your perspective so we can fine-tune and perfect our methodology.

·        To measure stock ratings we use the EOD price on the day of the recommendation. We have started an internal committee on this and are considering using the opening price of the day following the recommendation. Would be interested to get your thoughts on this.

·        For S&P-500 we use SPDR S&P 500 (ticker SPY) which also incorporates the dividends of the S&P-500 companies.

·        Stock prices used by our engine are taken from Xignite, a leading financial provider recommended by Nasdaq.

·        For sector benchmarking we use the sectors from Yahoo! Finance, we will likely switch to sectors definitions by Xignite during the month of June.

·        Performance is measured on a per-rating basis, not as a portfolio (i.e., no rebalancing and re-investment of dividends).

·        My team will evaluate the two companies that have been bought-out to verify we deal with such cases correctly.

Please feel free to contact me directly with any question, comment or concern."

 

 

I appreciate your time and interest in Guiding Mast Investments, George Fisher, 

3 Income Ideas from Mario Gabelli

Mario Gabelli manages several different investment platforms with a few focused on being income investments.  Over time, the main attraction of these is a steady cash flow into your account.  For some, the steady flow takes precedents over variations of market value of the underlying security.  Income funds may be suitable, for instance, to a retired individual who is looking to improve their income.

Gabelli Utility Fund (GABUX) is an income fund focused on utility stocks. The strategy is to specialize in stocks with the potential of being purchased by larger utilities as the multi-decade sector consolidation marshes along. However, these stocks must also pass Gabelli’s value criteria and should be worthy of ownership on its own merits. From their 2013 Annual Report:

“For several decades, utility companies have acquired other utilities and utility assets for the sake of gaining economies of scale and efficiency. The same forces that resulted in more than one hundred utility takeover announcements over the past two decades remain in place, and new forces have come into play that continue to drive this long term trend. Climate change and environmental policy have pressured marginal players. The pickup in merger activity reinforces the long-term bias of utilities to increase scale or gain a strategic benefit. Small companies are selling out at premium prices as the cost of staying in the game rises.

The historically lengthy merger review and approval process appears to have eased, as policy makers come to understand the new economic dynamics. Despite over ninety completed utility mergers/acquisitions since 1993, the electric and gas utility sector remains fragmented, with over sixty electric utilities and thirty gas utilities. This is fifty more than we need, from the standpoint of economic efficiency.

Our investments in regulated companies have primarily, though not exclusively, focused on fundamentally sound, reasonably priced, mid-cap and small-cap utilities that are likely acquisition targets for large utilities seeking increased bulk. We prefer utilities that operate in more constructive regulatory environments, possess lower carbon footprints, and/or have access to strategic geographies. We favor utilities with pending transmission line developments, and we focus on natural gas pipelines and storage operators as a way to take advantage of the growing demand for natural gas in the U.S.”

Annual Report: http://www.gabelli.com/Gab_pdf/annual/470.pdf

GABUX distributes $0.07 a month, or $0.84 annually on a share price of $5.60, for a distribution yield of 15%.  However, the majority of the distribution is termed Return of Capital.  As such, the ROC is deducted from share cost basis, reducing overall accounting cost of the position.  Taxes are due when the position is sold rather than upon receipt of distribution.  As the cost of shares continually declines until the cost is recorded as $0.00, any distributions after the cost is zero will be taxed as income. 

Gabelli Global Gold and Natural Resources Income Fund (GGN) is a closed-end fund with monthly distributions of $0.09 a share and yielding about 10.2% based on a price of $10.59.  The strategy is to buy mining and energy stocks and  to increase income from writing covered calls on these positions.  While this strategy will generate about a 10% income stream from the option contract proceeds, it also limited potential upside if the underlying stocks are called away during a market sector rally. From the 2013 fund annual report : 

“GAMCO Global Gold Natural Resources & Income Trust is a non-diversified, closed-end management investment company. The Fund's primary investment objective is to provide a level of current income. The Fund invests primarily in equity securities of gold and natural resources companies and focuses to earn income primarily through a strategy of writing (selling) primarily covered call options on equity securities in its portfolio. Because of its primary strategy, the Fund forgoes the opportunity to participate fully in the appreciation of the underlying equity security above the exercise price of the option.

At the end of the fourth quarter of 2013, implied volatility levels contracted to 46% for gold equities, 32% for mining companies, and 30% for energy companies. The volatility in the gold mining sector continues at an above average level due to continued uncertainty about the pace of the economic recovery and inflation expectations. The energy sector continued to perform well, especially at the exploration, production, and U.S. refiner’s levels. The metal mining sector extended its recovery at the same pace. The overall maturity of the option portfolio was approximately 2, 2, and 1.8 months for gold, mining, and energy holdings, respectively. The participation of the Fund to the upside was close to 88% for gold, 60% for mining, and 56% for energy.”

Annual Report: http://www.gabelli.com/Gab_pdf/annual/-116.pdf

Of the $1.44 distributed in 2013, 4% was from investment income, 52% from short- and long-term gains, and 44% from return of capital.  Corresponding distributions for 2012 were 2%, 84% and 15% respectively. In Jan 2014, the monthly distribution was reduced to $1.09 a yea r($0.09 a month), from $1.44 ($0.12 a month) in 2013 and $1.66 ($0.138 a month) prior. The reason for the decline is an overall deterioration in gold and silver mining stocks, and these comprise about 40% of fund assets.  However, the fund has done better than the Philadelphia Gold and Silver Index of mining stocks.   Comparing GGN to Morningstar Natural Resources Index, total return on a 1-yr basis for GGN is 11.7% vs. 5.4% for the index; -4.9% vs. -3.8% on a 3-yr basis; and 5.7% vs. 8.6% on a 5-yr basis.   The fund has about 40% in gold and silver mining stocks, 44% in oil and gas companies, and 16% in US Treasury Notes.       The current price is a 3.6% premium to the NAV of $10.22.

Investors looking for increased allocation exposure to gold and energy, along with desiring monthly income should review GGN.

An alternative to these two funds is the Preferred Stock Series B for GGN, ticker GGN.PB or GGN.PrB.  Trading at $21.75 and paying a quarterly dividend totally $1.25 a year, GGN.PrB offers a 5.7% yield and 15% discount to the par value of $25.

All three of these should be well suited for most investors seeking steady income over capital appreciation, and are very worthwhile for further due diligence.

Disclosure: I am long GABUX, GGN.  GABUX is followed by Guiding Mast Investments newsletter.

I appreciate your time and interest in Guiding Mast Investments, George Fisher 

Pope Resources' Loss is Rayoneir's Gain

Pope Resources’ (POPE) loss is Rayonier’s (RYN) gain.  David Nunes is moving from the Washington-based POPE timber REIT to the Jacksonville-based RYN REIT.  RYN has announced it will split its timber assets from the performance fiber business in an attempt to unlock the valuations of its timber holdings. 

From the press release: “David Nunes brings three decades of timber and real estate industry leadership to his new role, including more than 15 years as a senior executive. He joins Rayonier Inc. from Pope Resources where he has served as president and CEO since 2002. Appointed president and CEO in 2002, Nunes launched the company’s private equity timber fund business, which now manages timberlands in three funds. Pope Resources also manages development acreage in the Seattle metropolitan area. In his tenure as CEO, Nunes has consistently delivered value to Popes unit holders.

Rayonier is a leading international forest products company with three core businesses: Forest Resources, Real Estate and Performance Fibers. The company owns, leases or manages 2.6 million acres of timber and land in the United States and New Zealand. The company's holdings include approximately 200,000 acres with residential and commercial development potential along the Interstate 95 corridor between Savannah, Ga., and Daytona Beach, Fla. Its Performance Fibers business is one of the world's leading producers of high-value specialty cellulose fibers, which are used in products such as filters, pharmaceuticals and LCD screens. Approximately 50 percent of the company's sales are outside the U.S. to customers in approximately 20 countries. Rayonier is structured as a real estate investment trust.”

Nunes has been a driving force in expanding POPE’s timber assets through the development of private equity funds.  POPE invests alongside outside investors, providing a cost effective platform for expanding its Northwest asset base.  Over the past few years, POPE has been trading timberland closer to Seattle/Tacoma for assets in Southern Washington/Northern Oregon. 

While POPE is fully valued at its current price, the breakup of RYN may provide some interesting gains.  The combination of the performance fibers with the timber business gave shareholders two distinct exposures – specialty fibers and commodity timber.  RYN has substantial land holdings along the I-95 corridor in the Southeast that has the potential of offering a steady stream of higher and better use sales revenues.   

As timber is a very cyclical commodity, buying into these timber REITs needs to be timed very carefully.  There are a few strong outside forces that will benefit the long-term pricing model of NW timber, such as the mountain pine beetle and growing exports to China.  However, housing has the biggest impact on the long-term pricing of timber.  With housing on the rebound, timber REITs are no longer the bargains they were a few years ago and investors should tread lightly.   The exception could be RYN, especially with the appointment of David Nunes.

Disclosure: I am long POPE, RYN.  POPE and RYN are followed by Guiding Mast Investments monthly newsletter

I appreciate your time and interest in Guiding Mast Investments, George Fisher