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Why Am I Doing This?
About 10 years ago I took my entire portfolio private for a variety of personal reasons including my tendency to invest in start-up businesses which has been a true love of mine for many many years. Recently, liquidity events in my private portfolio and a lack of bandwidth to undertake new private projects have led me back to the public markets and it seems my timing could hardly be worse. I’ve got cash screaming at my brain “put me to work!” while I view the current market as fundamentally overvalued at the major index level.
I last ran a publicly-traded portfolio until the Fall of 2008. At that time, I had consistently beaten the market for 6 years. By sticking to the value investing principles my father and I have been talking about from the time I was a boy visiting his offices at Bear Stearns in the late 1960’s, I even posted a solid 2008 as I converted everything to private investments.
Buy Funds, Indices or Securities?
All through those conversations, my father repeatedly showed me how value investing in individual stocks consistently beat markets over time. His well documented decades of success has been proof enough for me; and I also have graduate level training from a top institution (Anderson School at UCLA) in portfolio math and derivatives.
So, instead of buying indices in a market I feel is overvalued because there is too much cash chasing a limited pool of qualified investment assets, I dare to tempt the Fates again – sailing by my training and experience onto the rough seas.
My goals for this new portfolio are:
- Capital preservation (I am willing to take equity level risk where I believe underlying cash flows support that equity value over a 5-year time horizon);
- Income through quarterly payments, or what I think of as “moments of truth” where cash flow performance meets the need to maintain or grow a dividend (where it’s an equity investment);
- Low capital and income upside over a 5 year period that started on August 14, 2020 (I’d be good with 2% a year with upside above that growth target); and
- Use traded funds where they meet my goals.
This portfolio is not a “set it and forget it” model I cooked up – I’ve done enough financial modeling over enough decades to know I need to review it often with skepticism because we live in a dynamic world not ruled by my analysis, hopes and predictions. Instead, each week I am looking to deploy more of my near cash equivalent pile in addition to another smaller liquidity event on the near horizon (selling a private loser to help tax timing on the private winners).
I hope to publish a weekly article looking at the pieces of this portfolio in far deeper ways while also tracking performance and updating the moves I am making to achieve my goals.
Here We Go!
So it’s the middle of August, 2020, a time when the general market appears overvalued to me, and I need to build an almost instant portfolio (took me about a week). To accomplish this in a short time frame, I simply flowed back to the basic idea that any company is still only worth the higher of its total net asset value (including intangibles) or it’s cash flow multiple (net of debt). For those cash flow multiples, there are some guideposts over the decades and through the various bubbles I and many others have used for publicly traded equity (for Seeking Alpha – I prefer the price/cash flow multiple rather than EV/EBITDA, and both are very useful):
- 4-6 times price/cash flow for a stable business in a steady state;
- 7-10 times price/cash flow for growth companies that maturing; and
- 11-15 times price/cash flow for companies in their high growth mode with an established business.
Given these guidelines, it’s a very, very tough market out there which has happened before. The market has always adjusted back to norms over time, so how to surf this environment without getting capsized when the market adjusts again toward more normal valuations over time?
I want my portfolio to act like a capable little sailboat that can handle most conditions as I sail forward in time around the globe (like the Robert Redford film, All is Lost). Because that sailboat exists in a largely hostile ocean, I need a plan, or investment thesis, by which to navigate, survive and hopefully prosper.
In this case, it’s what I think is going to happen within the economy over the next 3-5 years. As a long time CFO, I know I cannot predict this accurately, but maybe I can describe general directions as a sailor might look to the prevailing winds in adjusting his/her approach. I think the wind is blowing toward a slow recovery by 2023 because the pandemic will have some lasting effects until it is either eradicated or far better controlled in the US economy. Therefore, in what I believe is an overvalued market, the wind is against me for the next few years.
If the above is true, then I want to build a boat that does not track with the market because I expect negative conditions. There are several ways to do this and in this case I want lower volatility by looking for stocks that are either defensive in a difficult economy or have a cash flow story disconnected with the current market.
Rough Seas Ahead
I am facing an overall wind against me, so where can I use that wind to my advantage? In sailing, we would face the boat to cross the wind and set our sail so that we slowly sail left to right against the wind in what is called a tacking maneuver. It’s a way to grind forward slowly and probably my best bet in these conditions.
To create this, I need some reasonable level of diversification, both within sectors that I overweight and over the other sectors and capital structures that help me grind forward. I want to own equities, preferred stocks, fixed income and near cash equivalents (for flexibility). This is where I face my greatest risk versus simply buying a series of sector funds that give me an equivalent exposure at what would be a more diversified level. If I were a less active and able investor, I would give funds a closer look. After all, I am using two funds for my near cash equivalents.
My key reason for not using sector funds is easily illustrated when I look at the consumer goods sector. I want to overweight breakfast because in a recession, inexpensive nutritious meals like cereal do better. I also want to load up on diapers because in the past, when populations have been scared and sheltered, nine months later a baby boom tends to appear. It’s been 6 months and I’m doing the math. I cannot very easily tailor my bets in a fund without also having to rip through the derivatives market, killing me in frictional costs. While not using a fund makes more sense for me in these situations, funds are a good alternative if you do not want to undertake the specific moves I have made.
I also want to execute certain special situations that cannot be replicated in a fund, so I’m building most of this one security at a time.
Building A Tough Little Boat
In building my vessel, each investment area I think gives me an advantage going forward represents a part of that boat. I’ve used 7 different pieces in differing proportions representing both investment classes and economic sectors to initiate this new portfolio:
- 10% – Corrugated Boxes and Paper. Increased demand for shipping boxes and an eventual return of printer paper demand as business comes back to offices (less than 100% return to pre-pandemic paper demand).
- 24% – Consumer Staples (particularly breakfast). Breakfast is the least expensive nutritious meal and great for a recession. Cereal is king and category leader consumer staples are defensive in a recession.
- 6% – Technology. Internet infrastructure is an evergreen sector that continues to grow despite commodification and increased competition in services (I am CFO of a private SAAS email security company and helped create that industry in the late 1990’s with FrontBridge)
- 4% – Base Materials/Mining. I look for strong reserves in the ground – it’s mostly about the extraction and the prevailing market prices a the base of our economy.
- 16% – REIT and REIT-like structures. I like having a layer of insulation between my capital and the operating business for added protection in tough times in areas I believe will be good over time.
- 8% – Preferred Stock. In this case, it’s a REIT preferred where the preferred is outperforming and part of a special situation.
- 32% – Near Cash Equivalents. I’m using short duration (less than 6 months), high quality paper through a couple of funds. Gives me flexibility (no friction costs to exit) and/or a hedge against equities going further negative.
In every case, I expect a dividend “moment of truth” every 3 months with a current 4.16% yield. I also have expected dividend growth upside based on track record and a recovering economy to support underlying cash flows.
Here are the specific securities I’ve used to build the boat:
- Boston Properties (NYSE:BXP)
- Cisco Systems (NASDAQ:CSCO)
- Deutsche Telekom (OTCQX:DTEGY)
- Eaton Vance Short Duration Gov’t Income Fund Claas AA (EALDX)
- Farmland Partners 6% Participating Preferred B (FPI.PB)
- General Mills (GIS)
- International Paper (IP)
- Kellogg (K)
- Kimberly-Clark (KMB)
- iShares Short Maturity Bond ETF (NEAR)
- National Retail Properties (NNN)
- Realty Income (O)
- PepsiCo (PEP)
- Rio Tinto Group (RIO)
- SFL Corp (SFL)
- The J.M. Smucker Co (SJM)
- Unilever (UN)
Is This The Right Boat To Sail Today?
There are many economic sectors and sub-sectors out there. I am even sure one could use substitute sectors to achieve similar results to what I have built. The difference is that I have either direct operating experience or have been tracking some situations far more closely for far longer than others. In the end, I always prefer to invest in what I know combined with what believe is happening. My somewhat diverse background helps me know enough about enough sectors to do this without taking what I would consider overly speculative risk today.
Corrugated & Paper
When I left Wall St., I ran a turnaround in the logistics and corrugated business for a number of years. Almost every shipment of goods uses some form of corrugated, whether as the container or as a protective lining. If I want to play on the trend toward shopping online and I do not see great value in stocks like UPS and Amazon, then looking at the corrugated manufacturers makes sense as an alternative. I bought International Paper (IP) as an in-sector overweight to capture the dividend payable next month. I will be looking to diversify further within the sector if I find a compelling reason. I realize I am taking an overweight risk here and that buying cohorts like Weyerhauser (also a REIT) may make more sense over time. We will explore it.
I feel comfortable in consumer goods from my days as an M&A associate on Wall St. where I covered this sector along with wine and financial institutions for the largest French merchant bank. I have already elaborated on my desire to increase my exposure to breakfasts and diapers, above.
I know tech fairly well. I was the CFO of the first data center in Los Angeles which we sold to Digital Island while co-founding one of the early cloud-computing pioneers in email protection which we sold to Microsoft. Since then, I have continued to invest and work in tech start-ups. In my experience, owning internet infrastructure is the safer play than owning websites. Both Cisco and Deutsche Telekom represent bets ranging from 5G cellular through Deutsche’s Telekom’s T-Mobile subsidiary or Cisco position in network infrastructure at a much lower cash flow multiple than I would have to pay for any FAANG stock.
In the mining area I have no expertise, but I have been following Rio Tinto (RIO) since I was in high school. In my first job after college in London, RIO was a client to the stock-broking firm where I worked in corporate finance (early 1980’s). I read filing after filing as a proof reader marking up documents for submission to the London Stock Exchange and I kept following them. I feel I’ve known them over the years and their overall track record remains stellar. The company boasts rich reserves and often finds the right economic conditions under which to extract these resources. I am taking more risk here because the sector is not only notoriously volatile, I have also bet it all on RIO for a little excitement to goose my upside if the economy recovers faster. Are there better mining plays? We’ll also look at that more closely as we sail along.
I feel pretty good in REIT-land. I worked in a lot of brick and mortar retail before moving to the Internet (Virgin, Craig Corp and Landmark Theatres). The underlying real estate issues and financings have been a big part of my past. REITs also made up a big portion of my last publicly-traded portfolio. I am adding some new ones here while leaving behind my all time favorite, Entertainment Properties Trust – a movie theatre REIT where I knew almost every lease. That company has changed and Covid-19 has savaged its portfolio for now.
I’ve followed and owned Realty Income in the past. They have stellar management. I also believe, having worked remotely in one of my businesses the last 8 years, that the move to remote work will not be as significant as forecast several months ago (we are already seeing some of these effects). If you want to manage a steady state business, remote works pretty well. If you need to collaborate, share energy and excitement – remote sucks. Departments like accounting and finance can do pretty well remotely while marketing and sales need more shared energy in my humble experience. Remote doesn’t get you there today.
REIT-like Structures – Special Situation 1
Shipping as a REIT-like structure is a sub-specialty of mine and a special situation. SFL is no longer covered by Wall St. which is a shame because owning and leasing boats is similar to airlines with even better downside protection in the current pandemic because these boats carry goods instead of passengers. I have been following SFL for 15 years as it transitioned from the primary lessor of oil tankers to Frontline to primarily a container ship lessor with Maersk as its largest customer. For me, this is a REIT-like structure for two reasons:
- A boat is also similar to an office building on average land where the building is the primary value. Leasing out that space to quality tenants drives the cash flow. Unlike a boat, however, land provides an appreciating asset over time. There’s no underlying land with a boat, so I need a much higher return than a REIT; and
- Both pay me pre-tax distributions (because SFL is headquartered in the Carribbean).
I like the direction SFL has taken in diversifying away from oil and I believe in recovering international trade. With a 10%+ current dividend yield and a solid book of long term charters (as opposed to day-rate risk), the secret here is understanding how capital leases hit the reported financial results and why there is both dividend growth and stock appreciation upside here. That makes this more a special situation than a sector play.
Preferred Stock – Special Situation 2
I first uncovered this here: Farmland Partners Participating Series B Preferred Stock (FPI.PB). If you look at the preferred and the common stock, they have about the same yield. That’s where the similarities end and the subject of my next article. The FPI.PB not only trades below its par redemption value, it also:
- Pays a 6% dividend;
- Can be called at par plus an “FVA” upward adjustment from September 2021 to September 2024;
- Will have to pay a 10% dividend plus any “FVA” upward adjustment upon final redemption starting in 2024 if the stock is not early redeemed; and
- Is most likely going to be called by 2024 unless the economy crashes.
In my next article, I will show you how the 6.23% Yield you see on your Seeking Alpha screen actually understates the actual yield-to-call this security will likely receive in this market environment. Participating Preferreds are fascinating beasts and we will explore this one further next week.
Finally, I chose two short duration (average time to maturity or call) fixed income funds where I can move in and out without any penalty while achieving an average 2% yield. I have chosen exposure to high quality corporate debt (NEAR) and short dated agency mortgages with tons more underlying equity than 15 years ago (EALDX), which has a minimum to trade in and out freely. What I want is a bit of a fixed income hedge along with flexibility to hit new opportunities when I want more equity than I have today. The balance feels right now. I don’t know about next quarter.
So How’s It Going?
I entered the market on 8/14/20 when the Dow was at 28,653 and the S&P was at 3,508. At market close on, 9/8/2020, the Dow is at 27,501 and the S&P 500 is at 3,332, representing declines of 4.02% and 5.02%, respectively. Meanwhile, my little boat is down 0.67% plus accrued dividends payable next month (I captured IP a day before it went ex-div). I am not reinvesting the dividends.
As I track performance, I am not correlating strongly to any major index at the moment and the boat is sailing as I had hoped over this very, very small timeline sample size.
I will continue to update as well as elaborate on these various investments and why they deserve a place in my vessel. Will I sink, capsize, flounder or make it through these most interesting times and I hope to help others who face a “what do I do now?” decision.
Disclosure: I am/we are long BXP CSCO DTEGY EALDX FPI.PB GIS IP K KMB NEAR NNN O PEP RIO SFL SJM UN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.