Mexican Standoff

A confrontation in which no strategy exists that allows any party to achieve victory. As a result, all participants need to maintain the strategic tension, which remains unresolved until some outside event makes it possible to resolve it.

https://en.wikipedia.org/wiki/Mexican_standoff

On May 30th, the Trump administration announced stepped tariffs on Mexican imports under cover of the International Emergency Economic Powers Act. Once again it appears to have been a bargaining ploy using the American consumer and farmers as pawns in a game of Chicken as these were “indefinitely suspended” on June 7th – perhaps realizing the signature USMTA was now at risk by this action or the push back by the business community or the fact that Republican Senators realized they did indeed have a backbone (albeit, small).

While I’ve never been a huge fan of ETFs as my view is that an investor is consigning themselves to the average, my preference being to develop a thesis and buy individual companies in support of the idea – with the expectation being the return will be outside the norm (hopefully in a positive manner). That said, I realize ETFs can – and do – serve a purpose and as such I have five in my portfolio, one being iShares MSCI Mexico Capped ETF (EWW). This issue peaked at $44.54 on May 30th before bottoming at $42.64 on June 3rd which is precisely where my order to add executed. Yes, it was luck calling a bottom but it was also a validation of the Headline Risk concept.

One of the first analyses published was that of a short-seller, BOOX research. He does present a decent argument on all counts, save one. This was followed by Liumin Chen’s analysis which missed the same issue. To be fair, I’m now operating in hindsight – post Trump’s reversal, but I did spend most of last weekend forming my conclusion which was the negative tariff impact to EWW was overblown due to one factor. One where you can’t just look at the forest without reviewing the respective trees.

One uncertainty I have with BOOX is his view of a pending peso devaluation as that would likely torpedo any trade agreement and give rise to currency manipulator status. More important is the view that the Consumer Staples exposure is a negative. While it is true that this sector comprises 30.5% of the ETF, only one of the top ten (Walmart de Mexico) has significant Mexican domestic consumer exposure where US imports (tariffs) could be in play. The other two Staples either don’t interact with the US (Fomento Economico Mexicano) or has significant US operations in their own right (Grupo Bimbo with 22,000 US employees). My take is tariffs would slow – but not cripple – the Mexican economy.

Indeed there could be a silver lining for Mexican multinationals that do not import US products. Some brands at the forefront are Tracfone (America Movil), Groupo Mexico (Southern Copper) and the aforementioned Bimbo (Thomas, Entenmann’s, Mrs. Baird’s). Basically these entities could be repatriating US gained profits in inflated USD to Mexico as artificially depressed MXN. A possible spread play that is typically the province of banks and insurers – and an untended consequence that probably escaped the purview of the experts running this show. The icing on the cake? Cemex with 11 plants and 50 quarries in the US. What’s a good border wall without cement and concrete from a Mexican owned company paid for by US taxpayers?

So this is a contrarian play which – so far – is in the money. I believe the real pain would have been felt in the auto and produce industries which do have significant numbers of US workers. Hopefully this is a fire drill that won’t be reenacted any time soon.

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Trump-Tied Banks

Headline Risk

the possibility that a news story will adversely affect a stock’s price

https://www.investopedia.com/terms/h/headline-risk.asp

As my readers are aware, for a variety of reasons I’ve had an affinity for the banking sector following the financial crisis. Outside the rants of a few of the current presidential contenders highlighting abuses against the ‘normal people’, this sector has been relatively subdued albeit with a major storm cloud brewing on the horizon. This formation hit my radar with the August 19th, 2018 article in the American Banker. Since then, I’ve been tracking the progress of this storm to either identify a manner to profit from the event, to see if it dissipates or if it evolves into a black swan.

This week, the storm finally arrived although I have yet to batten down the hatches. My sense of urgency to publish my findings only increased when I ran across a piece by one of our own, All About Interest, in determining a possible investment in Citizens Financial Group (CFG). My response was: Tending to err with an abundance of caution, I would dig much deeper on CFG. Their former parent had financial issues (hence the spinoff) and most recently has been the associated with Manafort loans (speculation is they are ‘Lender B’ in the Mueller report). Another bank with Manafort ties (BANC) last week cut their dividend by 53.8% – although this could be unrelated and pure coincidence. Basically pointing out a basic flaw in pure DGI screening methodology – Headline Risk.

  • CFG has had a troubled history probably due to its’ former parent, Royal Bank of Scotland (RBS) (IPO’d in 2014, fully divested in 2015)
  • CFG was apparently “Lender B” in the Mueller Report with questionable loans to Manafort (perhaps a coincidence, they issued $300m in stock as Series D preferred in January)
  • Another bank involved in Manafort loans, BANC, announced a dividend cut of 53.8% effective July (I can’t say if there is a correlation)
  • An indictment against another Manafort lender, Federal Savings Bank (pvt) CEO Stephen Calk, was unsealed after I posted my comment (alleging his personal actions to bypass standard loan processes resulted in a $16m loss to the institution)

Certainly enough thunder to keep me away from an investment in any of these. My count indicates the Trump 8 identified by the American Banker has more than doubled and now stands at 15 – some of which I’m invested in. I’ve basically categorized them into Questionable, Cooperator, Cautionary, Litigant in addition to the three Culpables addressed previously. This is not to imply any wrongdoing – only one of the barometers I use to assess relative safety and mitigate Headline Risk.

QUESTIONABLEhave issues that are unsettling to my investment philosophy

  • Sterling National Bank (SNL) – provided financing for Cohen’s taxi-medallion business
  • Signature Bank (SBNY) – allegedly lent money to real estate developers, (including Kushner’s family) that used improper tactics to push out low rent tenants. Ivanka served on the board between 2011 and 2013.

CAUTIONARYhave potential exposure but appear to be on the right track

  • First Republic Bank (FRC) – filed a Suspicious Activity Report (SAR) on flow through money related to the Stormy Daniels payment and a Columbus Nova payment (Russian Billionaire company)
  • Royal Bank of Canada (RY) – McDougal and Daniels payments were allegedly made through a City National account (now RY). It appears the SARS report was filed late probably found by RY through a merger related audit. They are also cooperating on Congressional subpoenas, although a deadline was missed. (own RY)

COOPERATORbased on the Bank Secrecy Act, which allows Congress access to financial information to search for money laundering (all owned except MS)

  • Toronto-Dominion (TD) – provided documents
  • Wells Fargo (WFC) – provided documents
  • Citigroup (C) – missed subpoena deadline
  • Morgan Stanley (MS) – missed subpoena deadline
  • JPMorgan Chase (JPM) – missed subpoena deadline
  • Bank of America (BAC) – missed subpoena deadline

LITIGATORSTrump (Pres., family, companies, foundation) suing to block release of information (lost the first round this past week) (none owned)

  • Deutsche Bank (DB) – Lawsuit under appeal by Trump
  • Capital One (COF) – Lawsuit under appeal by Trump

I can kind of understand the appeals related to his personal financials except where inter-related with SARS filings. In hindsight, this is perhaps a textbook case for use of a blind trust – which as we all know was not done.

In this group, TD has about 1.48% of my portfolio and RY about 0.58%. The others I own are about 0.25% each – therefore my exposure to possible downside risk is minimal. Of the ones not owned, the only one I would currently consider is FRC on weakness. The common thread being compliance to current laws.

Do you account for Headline Risk? Hope you all have a wonderful holiday weekend!

Tax Efficiency

I figured a little reflection was the order of the day as we recently completed tax season in the US, and yes, I had to pay for the first time in years. My initial take was Trump’s tax law did no favors to those of us on fixed incomes – rather tilting the scales to benefit the wealthy and to a lesser degree the working class – though there were winners and losers across the board. In preparation for next year’s fiasco, I’ve been attempting to ascertain some of the intricacies of the changes. Previously, I opined on the foreign tax credit remaining in place. Today’s revelation potentially turns conventional wisdom on REITs on its’ head.

Sage advice has typically been – with a few exceptions – REITs are best held in tax advantaged accounts, like IRAs. The new tax law adds a few wrinkles to this concept, which Justin Law outlines nicely. The essence of his piece is that Section 199A distributions now have a 20% deduction which may warrant a review how tax advantageous REITs are in ones tax deferred versus taxable portfolio. DGI darling Realty Income (O), recently reviewed by Tom at Dividends Diversify, could well be a poster child for this type of analysis as last year’s payouts were 77.1% Section 199A and the remainder Return of Capital. The delay in this week’s post was due to some difficulty in completing a review of the fourteen REITs in my portfolio.

Two of my REITs were excluded from this analysis as I have them classified as probable sales, Uniti as their dividend cut was likely a debt covenant issue and Lamar as their IRS reporting is not straightforward (the corporate filings differ from the filings on the shareholders’ behalf). As all of my REITs are in taxable accounts, using Justin’s generic template, they were first ranked by the new Section 199A exclusion.

  1. American Tower (AMT) 99.68%
  2. EPR Properties (EPR) 95.94%
  3. Washington RE (WRE) 91.89%
  4. Outfront Media (OUT) 86.10%
  5. Iron Mountain (IRM) 83.04%

The next tier combined Qualified dividends and Cap Gains as their tax treatment is similar (and not onerous):

  1. Duke Realty (DRE) 22.59%
  2. Kimco Realty (KIM) 18.29%
  3. Prologis (PLD) 17.33%

The one tier I need to keep an eye on is the Return on Capital with Vereit (VER) 86.17% and Crown Castle (CCI) 34.39%. This part of their distribution is tax deferred until sold or the cost basis reaches 0.

The ugly tier is the Section 1250 gains with a 25% tax rate.

  1. Spirit Realty (SRC) 49.2%
  2. Spirit MTA REIT (SMTA) 21.2%

I consider this to be a one-off due to the spin of SMTA from SRC. Kimco (26.94%) could fit in this category as well although my sense is that their portfolio repositioning is the culprit, but there are opposing views to mine.

Bottom line, I’m willing – even eager – to pay taxes. Yet the rules of the game reward those able to minimize the government’s share. While the key resides in understanding the nuances of the rules, I say, “Seek the rewards and let the games begin!”

My World of Banking

A comment thread on a recent post cornered part of my thought process recently.  I realized that I was assuming a baseline of knowledge of the audience.  For newer readers and newer investors, my apologies.  To that end, the questions raised by doptionsseller are worthy of greater elaboration.  I won’t dive into the history as the basics are generally known to all – The Financial Crisis decimating the industry from which new regulations were formed.  Regardless of your personal view on regulation, I’ve found over the years that with an understanding of the rules the game can be played more advantageously.  The following details a portion of my thought processes and the evolution my strategy has experienced.

THE TARP YEARS

In 2009, the FASB changed the rule on mark-to-market accounting with the result being renewed investment in financial institutions.  In 2013, I started reinvesting in the sector with banks that refused TARP – taking security over uncertainty.  All the while I kept my eye on the TARP recipients and in 2015 began investing in some that had repaid the government.  I also looked at some that were unable to repay but shied away as the bulk of the paper was auctioned by the government to hedge funds, one being Hildene’s Opportunities Growth Fund II.  

Some, like Blue Valley Ban Corp (BVBC), bought out the hedge funds preferred stock due to relatively onerous terms (5% rising to 9%).  In recent news coverage, they’re laying claim to victory.  While I concur great strides have been made, they still don’t pay a dividend and have a looming balloon payment due in 2020 (on a current 5.25% variable rate note).  In my opinion this is a company limping along the right path but looking over their shoulder for the next economic downturn.  Others have yet to repay the respective funds.  Either way, this space carries more risk than I’m willing to bear. 

Dodd-Frank Stress Tests (DFAST)

With the advent of DFAST, I realigned my methodology to conform with these standards with conventional wisdom being consolidation was a foregone conclusion.  The ranges being assets < $10B, $10-50B, $50-250B and $250B and over.  In 2014  most of my investments were in the $10 – $50 range.  As I realized banks had real costs associated with breaking the $10B barrier, in 2015 I migrated more into smaller asset sized banks.  The one rule I have (which I’ve broken a few times) is that a dividend is paid to compensate my patience.  This bucket is the majority of my bank holdings.

Mutual Conversions

In late 2015 I found another investing angle.  Similar to an IPO, thrifts converting to stock companies are called 2-step conversions.  The first being the sale of stock to their depositors and the second a conversion to a full stock company.  Flush with cash, I’ve seen minimal downside.  Patience is required as there is a three year wait (by law) before they can be acquired.

Courtney over at Your Average Dough invests in some conversions but takes it a step further by becoming an account holder first.  Trickier but more lucrative if you guess right.

Arbitrage

Another opportunity is subsequent with an merger announcement.  There are times when analysts waffle on their decision to recommend – or not.  BOKF’s recent acquisition of CoBiz is one example.  It was two days before analysts determined it was a good deal.  Meanwhile I picked some up before the price went up.  Cautionary note: The reverse can be true as well.


As you can see, there are multiple ways to play the game and my approach has changed with the times and as my knowledge/experience increased.    This type of investing is not for everyone either.  Only a portion of my portfolio is handled in this manner.  But if success arrives the gains can be stellar!

 

Uh-Oh …

In last weeks’ post I shared that effective January, my portfolio will experience two dividend cuts.  Based on how my holdings are structured, the overall impact will be a but a blip.  The greater hit is to my pride.  Other than M&A or spinoff activity, never have I experienced more than one cut in a year.  This, my friends, is with forty years of investing under my belt.  And now we have two announcements in the span of one week.  Also (and perhaps warranted), The Dividend Guy published a piece that essentially says that, “hey, I might have screwed up on OZK but at least I never invested in these dogs”.  Like yours truly.  Happy fifth year to you bud and let’s see if that record holds for another thirty.

Seriously though, the GE and OMI situations can’t be any more different.  The only commonality is the cut.  The Dividend Guy mentions a couple of others as well – which I don’t own.  I continue to be suspicious of the real strength of the overall economy as MAIN also announced a revision to their dividend policy (though not directly a cut).  As an investor looking toward dividends, if this is the beginning of a trend it may be time to pare some of the speculation and migrate towards a more conservative posture.

Meanwhile, in these types of circumstances I feel compelled to share my reasoning and anticipated reactions.

Owens & Minor (OMI)

I have to concur with Dividend Guy’s observation earlier this year that this was “dead money”.  I pretty much reached the same conclusion when I reduced my holdings by about 20% in 2015.  I was content with the minimal dividend growth due to their stellar track record.  The sea of change began in earnest in 2017 with fears of the Amazon effect.  Then a couple of losses to competitors (one being CAH).  Current pressure is hitting them on at least two fronts: the trend for hospitals to in-source and the ability to pass on increasing costs.

Being a patient investor I could accept all of the above and even a frozen dividend as they sort out the issues.  But an unexpected cut of this magnitude leads me to believe there is another shoe to drop.  Obviously I’m not alone in this concern on the earnings call, an analyst from Robert W. Baird & Co. asked the operative question, ” … And how comfortable are you with the covenants at this point on the debt position?”  Last time I saw this question was when Orchids Paper (TIS), another former DGI darling, was in their free fall.  I still like OMI’s logistics but they failed to capitalize on the head start they enjoyed prior to this advantage becoming a commodity. 

OMI accounted for 3.46% of my 2017 dividends received and through 3Q 2018 had been reduced further to 1.89%.  As this is an IRA holding I’m limited in the loss realization but intend to sell after ex-dividend and replace with a Canadian stock (with no tax withheld in IRAs).  I suspect my Q1 2019 numbers will see minor impact in the Y/Y growth.


General Electric (GE)

On GE, Dividend Guy’s analysis matches mine, hands down, purely from a DGI perspective.  GE, however (in my view) never regained their prior glory when the financial crisis exposed their warts.  There is but one reason to have GE in a portfolio and it’s not the dividend, it’s corporate actions – which include things like spinoffs (which were the subject of one of my muses).

As this type of approach is speculative in nature, it pays to be mindful of the weightings.  In my case, GE has ranged from 0.05% – 0.07% of total dividends for the past two years.  My self-imposed maximum for speculation is 1% per issue.  Therefore, I’m well within my targets.

So I consider this similarly to a currency trade where GE stock is the fiat.  The wild card is the exchange rate when the spins are finalized.  Best case is that GE is now fairly or under valued, in which case pending actions will be in my favor.  Worst case I get a unfavorable cost basis that reduces (under current law) my tax basis.  Therefore with minimal downside (unless GE goes belly-up) I intend to increase my GE holdings (once the price settles) to the nearest round lot and await the spins.


Therein lies my strategy for dealing with these events.  I’ll attempt to follow the adage: When life gives you lemons, make lemonade!

Work Freedom Day

Once per year – assuming a static or growing portfolio – the day arrives where current year dividends paid exceed the prior years’ total dividends.  For me, yesterday (October 19th) was the day.  Now the term, coined by Dividend Life in 2014, is a little bit of a misnomer as I don’t work but the concept is applicable.  This compares favorably with last year (October 25th) but still shy of my all time best (in retirement) of October 4th in 2016.  The improvement this year is largely attributable to Tax Cuts and Jobs Act which resulted in increased regular and special dividends.  Whether this is a one-off or sustainable remains to be seen but as my mother was fond of saying, “Don’t look a gift-horse in the mouth.”


I’ve been noodling over an article for awhile – one of those that need to be absorbed in doses.  I see bits and pieces of me across all levels, but probably a three – maybe a four.  The relevance?  In a recent post (9 Sep) I stated:

Bank OZK (OZK) has had some curious moves of late with a costly name change and repositioning from federal to state oversight. These, along with their increasing exposure to high value CRE gives me pause.

Obviously the esteemed Jason Fieber is not among my handful of readers as he initiated a position on 1 October citing:

There are some concerns over its loan portfolio (when are there not concerns about a business?), especially seeing as how the bank has aggressively moved into construction lending in recent years. This tiny bank is behind some of the biggest projects in some of the biggest markets in the US.

But these concerns seem to be more than priced in. It’s almost as if the last four years of growth are worth nothing. Of course, growth could, and likely will, slow in the new construction market. And sticking to strict lending standards means opportunities might dry up.

The market’s (and my) concerns were that “strict lending standards” weren’t consistently followed.  Fast forward to Thursday’s earnings report:

On July 16, 2018, the Bank changed its name to Bank OZK, changed its ticker symbol to “OZK,” and adopted a new logo and signage, all as part of a strategic rebranding. As a result of this name change and strategic rebranding, the Bank incurred pretax expenses of $10.8 million during the third quarter and $11.4 million for the first nine months of 2018.

During the third quarter of 2018, the Bank incurred combined charge-offs of $45.5 million on two Real Estate Specialties Group (“RESG”) credits. These two unrelated projects are in South Carolina and North Carolina, have been in the Bank’s portfolio since 2007 and 2008, and were previously classified as substandard. The combined balance of these credits, after the charge-offs, is $20.6 million.

The CRE issues are centered on two projects in the Carolinas, one a mall with Sears exposure.  I have no conviction that these are one-time issues.  Much depends on the economy and the hurricane related recovery in this area.  Yet I couldn’t resist the the opportunity to average down yesterday on the 26% price drop.  So yes my crystal ball worked this time, but no I didn’t sell in September, nor did I short.  Which is why I may not be a Level 4.


Inspired by Catfish Wizard and Jim Cramer’s Power Rankings, this weekend I’ll add the 2019 DGI Picks by Sector as a Menu Item (fun and games only!).  If you’d like to be included, submit your top pick for each sector.  I’ll probably recalibrate the results around Thanksgiving to provide a level playing field.  🙂

Bank Strategy – 2017/2018 Review

During the 2007/2008 financial crisis, bank stocks were one place many investors fled from – like herds of lemmings.  I can’t say this was unreasonable as these companies sustained blow after blow – some deserved and some not.  When a company such as Lehman collapses,  mortgage  GSEs are federalized and mortgage lending comes to a grinding halt one has to consider the Chicken Little scenario – is the sky really falling?  From this systemic failure emerged a new dawn on the heels of legislation, notably Dodd-Frank.  Though far from perfect, this bill in 2010 established a floor from which the system could be rebuilt.

To paraphrase Warren Buffett, my view was this fear and dysfunction presented an opportunity.  With the dust beginning to settle, in early 2013 I dipped my toes back into Financials.  With the exception of Prosperity Bank (PB), which I classified as a Core position at that time along with a few others, these holdings – peaking at about 32% of the total portfolio in aggregate – didn’t exceed the 1% threshold individually.  Financials currently hold 29.9% and are trending down.  Truth be told, this group did provide the octane enabling my portfolio to consistently exceed the benchmark.

The Dividend Diplomats employ a similar small bank strategy but our approaches differ.  Whereas their baseline is the dividend screen process, I rely more on size and geography.  This is due primarily to embedded distortions in a TARP (and post-TARP) world as well as historical factors regarding bank failures.  For example, Lanny’s Isabella Bank purchase wouldn’t make it onto my list as I consider Michigan banks inherently risky due to the number of failures within the state during the last crisis.  You could posit a macro versus micro view in our perspectives.

Since I began this strategy I’ve periodically reported my results with my 2015 and 2016 reviews.  I was remiss earlier this year as the pace of significant mergers decreased in the post-Trump world.  This activity is now accelerating due to two factors, I think.  The first being the Dodd-Frank modifications enacted in May making it less onerous for banks of a certain size to combine.  The second being rising interest rates.  This one is less obvious as rising rates should be a boon to banks.  However, the spread between long and short rates is compressing (perhaps inverting soon?) which is where much of the profit is derived.  So the results, please?

Bank Strategy
YEAR TTL FULL PREM REVERSE % NOTES
2014 6 1 2 21.9% 41 positions
2015 16 3 0 38.7% 49 positions
2016 8 2 0 13.8% 58 positions
2017 16 1 0 25.8% 62 positions
2018 15 5 1 19.23% 78 positions

Note: through 7 Oct 2018

Of interest is that the majority of 2017 was mostly a year of consolidation with smaller banks (usually thinly traded or private) being acquired by one of my holdings.  2018 is interesting in that a number of mergers have a cash component which adds to the complexity of determining the ‘real’ valuation resulting in some initial pricing or recommendation assessments by firms on Wall Street.  I bought into two of these before the assessment changed in my favor (resulting in an unanticipated unrealized gain).

Now that this sector is pretty much fairly valued unless some compelling opportunity presents itself I’ll hope for some of the remaining 73 to be acquired and place my cash elsewhere. 🙂