As I have mentioned in previous letters, prices in the capital markets are highly correlated with corporate earnings which are a function of economic strength. And while this didn’t change in the first quarter of 2017, there was another dominating influence – politics.
We know that investors began discounting the prospects for business friendlier policies and stimulus programs the day after the election. Naturally, this continued into and after the inauguration as excitement and optimism climbed higher. The expectations of reduced regulations, tax reform, and infrastructure spending powered stock prices and interest rates higher.
The stock market edged higher at the beginning of January and churned sideways until the inauguration. After the ceremony, the rally resumed and there was a steady climb throughout February. There was another surge higher to new record levels after President Trump’s State of the Union speech at the beginning March. In the final month of the quarter, stocks encountered a little turbulence after the failed attempt to repeal and replace the Affordable Care Act. However, stocks rallied into the end of
the month but remained below the records reached in early March.
Here are the returns for the major averages for 2017’s first quarter.
Dow Jones Industrial Average +4.6%
S&P 500 +5.5%
Nasdaq Composite +9.8%
Russell 2000 +2.1%
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividend.
Using a size weighted average, here is how the average Kildare Asset Management-Kerr Financial Group client’s account performed. This is calculated after all fees and expenses.
2016 Q1 +3.03%
Similar to markets having an oversized impact from politics, your account was influenced by one position – Fortress Investment Group. Fortress (symbol = FIG) is an investment management company that operate hedge funds, private equity funds, and credit funds. They manage over $70 billion of assets which makes them one of the largest publicly traded companies in this sector.
Fortress charges a fee for managing investments for their clients. In addition, they can earn incentives and bonuses if performance reaches certain thresholds. Their clients include institutions such as pension funds, endowments, and foundations, as well as high net worth individuals. FIG’s largest expense is compensation and benefits for their staff which includes executives, portfolio managers, analysts and traders.
I was first attracted to Fortress Investment Group because I believed it was an undervalued security that offered an attractive yield. The company has a very strong balance sheet as well as a history of consistent profitability. It has underappreciated assets and I thought that there was a
good chance that the business would continue to grow.
Concerning the dividend, the amount the company has paid varies based on its net income. Fortress often set a stable dividend payment for the year based on its projections and then paid a special dividend after they determined their actual results. The ‘normalized’ yield was approximately 6% with the ‘special’ dividend usually adding another 5% – 9%.
While this sounds like it was an easy and straightforward investment idea, there many legitimate reasons that Fortress was priced so cheaply. First, FIG is a limited partnership. Financial reporting for partnerships is different and, as a consequence, the analysis has some added steps as compared to the analysis of corporations. For example, in addition to net income, investors should consider such calculations as distributable earnings and net economic income. These metrics can be different from net earnings and may present a much different picture than typical analysis. These analytical complications can dampen investor interest.
Secondly, the alternative asset management industry (hedge fund, private equity, etc.) has been under intense pressure from clients. The appeal of these investment managers is the potential to outperform the benchmark averages while controlling risk. However, during the past several years, most hedge funds have underperformed the stock market averages and clients have become frustrated. Many have asked for their capital back including the high profiled decision by the California Public Employees Retirement System (CalPERS) to withdraw all money from hedge funds. As a result of this and similar institutional decisions, many hedge funds have closed.
Lastly, hedge funds and private equity funds are facing a potentially massive shift in the form of tax reform. As a limited partnership structure, these organizations enjoy some tax advantages. Specifically, some of the income from incentives and bonuses, which can be very material, are not taxable or, at worst, tax deferred. There have been efforts during the past several years to change the tax code and eliminate this benefit. So far, it remains in place. Eliminating this provision would significantly change the industry’s profitability and make these businesses less attractive. And with tax reform again in the news, the prospect of future scrutiny is a heavy weight on publicly traded investment partnerships.
Coming into 2017, Fortress had been in a narrow trading range for an extended period. It finally broke above the $5.50 level on high volume at the end of January. This price action was a strongly positive sign and, as a result, I added to the position. In the middle of February, Softbank Group offered to buy Fortress for $8.08 per share.
While there has been some minor debate whether this was the proper valuation (some have suggested that FIG is worth more than $8), the deal should close in the third quarter. While I think Fortress’s share price would have moved higher over time, this gives us the opportunity to stay in the same church but move to a different pew.
Blackstone Group and Ares Management are two investment management companies similar to Fortress and are being added to your account. Blackstone (symbol = BX) was a recent featured recommendation in Barron’s. Further this has been a position in long time clients’ account since the end of the financial crisis. BX’s dividend strategy is similar to Fortress’s as they pay a variable amount based on the quarterly bottom line. Blackstone’s current yield is 6.6% (based trailing twelve months). While they face the same challenges listed above, they are positioned to capitalize on opportunities throughout the financial markets.
Ares (symbol = ARES) is another investment management company that has good long term potential despite the industry challenges. They have numerous fee generating funds (a new one was added in the first quarter) as well as a pipeline of additional opportunities. The current dividend yield is 4.75%. I think the dividend payments have a good chance to grow over the next few years.
The capital markets had a busy first quarter. Things such as a Federal Reserve interest rate increase and the European political campaigns were overshadowed by a new administration in Washington. This brought both excitement and anxiety. Some were optimistic about the change of direction while others were despondent by the disrupted status quo.
While this divide could easily grow as the year continues, the markets have digested it so far. Of course, past reactions are not guaranteed to remain the same and the markets could change its sentiment if the craziness increases. It promises to be an interesting year.
Regardless how events development, I will continue to look for opportunities as well as monitor current positions. With the markets digesting the anticipated crosscurrents of 2017, there will surely be some favorable circumstances to take advantage of. Thank you for your continued support and please call with any questions.
Jeffrey J. Kerr, CFA
Kerr Financial Group
Kildare Asset Management
168 Water Street
Binghamton, NY 13905