2015 Second Quarter Report1

I am playing with the format of this report to hopefully make it more accessible. MCS clients’ interest in financial markets varies considerably. Finance is fascinating for some and a difficult, boring language for others. If you have comments or suggestions to improve this or other communication, please let Jeff or me know!

Executive Summary

  • Performance
    MCS client performance was up just .5% for the first 6 months of 2015. Bonds returns for the same period were down very slightly -0.1% and stock returns were up slightly 1.2%.
  • Auxier Stock Portfolio Update
    MCS directs Auxier to implement tighter risk controls – sell losers sooner.
  • Economic Overview
    In the first half of 2015, US stock and bond markets could be described as a whole lot of noise (Greece, China, interest rates, commodities, economic growth worries) and little progress. The trend continues.
  • Investment Opportunities
    Bad news on Puerto Rico and a melt down of energy stocks and bonds means bargains for our clients as other investors toss out money babies along with dirty bath water.
  • What MCS is Doing
    Finally some attractive investments appear! MCS has been buying investment grade bonds with over 6% yield to maturity for our clients. Clients with highest cash allocations get first dibs.

  • Performance

    If MCS clients’ investments were treated as one large portfolio including their cash, the first half 2015 return was 0.5% Individual client returns ranged between 1.5% and -0.9%. The client with the lowest return was negatively impacted by exposure to a large inherited position in oil giant Exxon with very low cost basis. The client with the highest returns had 10% in cash, 85% in bonds and 5% in stocks. Auxier sub-portfolios, on average, lost -0.3%. The Auxier results are included in the total client results above. For comparison purposes, the S&P 500 Total Return Stock index gained 1.2% and the Barclays Aggregate Bond Index lost -0.1% for the period.

    Auxier Stock Portfolio Update

    Jeff Auxier is a value investor. He likes to buy companies with a problem, a beaten down or underperforming stock price, and low expectations. If these companies can just get back to normal, a nice profit can typically be made on the stock. But buying a problem company has its risks. The problems could get worse and the price could decline further. Jeff tries to reduce this risk by making multiple buys over time to dollar cost average into the position.

    I see my role as an active effort to improve my clients’ results. In mid-June I called Jeff Auxier to discuss the portfolio. It takes time (years) to evaluate a strategy, but there was one aspect of Jeff’s strategy that was sticking out, and I wanted to change it. After reviewing the portfolio, I asked him to sell all the losers along with some of the winners. I asked Jeff to sell any stock that declined by 20% after purchase. When we talked there were eight stocks up over 100%. Unfortunately, a couple stocks had lost more than 50%, negating some of those great
    gains. We both know the math. If you lose 20%, you need a 25% gain on t he remaining capital to break even. However, if you lose 50% or 75% you need a 100% or 200% gain respectively to breakeven!

    I believe that tighter loss control will improve Auxier performance, Now that I have 3 years of data and some new software tools, I will be doing a more in depth analysis of Auxier performance over the summer.

    Economic Overview

    Greece will remain a source of market volatility. The odds of a win/win outcome between Greece and lenders are nil. The Greek situation matters because it will set expectations about what happens when a dysfunctional economy enabled by outside lenders hits the wall. Greece isn’t the only economy that’s promised more than it can deliver, borrowed to deliver on its promises and can’t grow its way out of the debt. The Greek effect on financial markets will wax and wane as implications of events are projected on to Eurozone economies, especially Italy and Spain.

    China’s slowing economic growth has reinforced a vicious downturn in commodity metals prices. The trend is further exacerbated by a glut of oil and gas. Financial markets are concerned that the downturn in commodities is signaling weaker global growth ahead. I’m not convinced it’s as bad as it seems. I believe that speculation and securitization (creating securities that enable investors to speculate on commodities) artificially boosted past demand and prices. It’s hard to separate the true industrial demand from speculators’ buying /selling. The good news: lower energy and raw materials prices help consumers and reduce costs for manufacturers.

    The US economy will muddle through and the economic expansion will continue. Expect more volatility (price fluctuations) in stock and bond markets. A .25% Fed funds interest rate hike is likely this year to be a source of that volatility.

    Bad News Creates Investment Opportunities

    Puerto Rico was back in the news in June after governor Alejandro Garcia Padilla, declared the island’s debt ‘not payable’. This was no surprise to anyone who had been following the situation. Bond prices already anticipated a default. Nevertheless, municipal bond fund outflows spiked after the announcement. Investors are reacting by selling any bond with the name Puerto Rico in it, even insured bonds that would not be affected by the default.

    Figure 1
    Flows Seesaw

    MCS | Second Quarter Report | July 2015 | Figure 2

    Increased expectations of a Fed interest rate hike, bad news in May regarding Chicago, and June’s Puerto Rico news combine to spur municipal bond fund outflows.

    My third quarter 2014 report discussed the performance of energy related stocks. Stocks were hard hit late last year and then prices rebounded somewhat. I continued to research energy MLP’s stocks and bonds but held off investing believing that the bounce in oil wasn’t sustainable. I eliminated energy related MLP bonds as a possible investment due to the potential for those bonds to be subordinated to new financing (subordinated bonds are less secure and would likely drop in price if the company had to borrow more money).

    Here is an update of the ‘example’ chart presented in my third quarter report:

    Figure 2
    Legacy Reserves LP (LGCY)

    MCS | Second Quarter Report | July 2015 | Figure 1

    Legacy Reserves LP declined 17% from December 31, 2013 to October 21, 2014. As of July 28, 2015 it is now down 67%. Legacy is an exploration and production company; the energy sector hardest hit by the oil price declines. In contrast, pipeline and storage index declined about 14%.

    The most attractive part of the energy sector is midstream; pipeline and storage facilities. These are a toll road; charging to store and transport gas and oil from producers to users. Pipeline profitability is not very sensitive to oil and gas prices. On the other hand, pipeline stock prices are sensitive to investor sentiment, so these money babies (yielding over 7%) are being dumped with rest of the energy investments. Demand for gas transportation is set to grow as cleaner, low cost gas displaces coal in power plants – an environmental plus.

    What MCS is Doing

    Bargains have emerged again; For example, insured Puerto Rico bonds are state and federally tax free and yield over 5.5% (a 9.17% taxable equivalent in a 40% tax bracket). I bought these on the last dip and will be selectively adding to positions. Note: there is more than one insurer and some insurers are stronger than others.

    AA rated Insured bonds with BBB or lower underlying ratings also look attractive compared to non-insured A and AA rated bonds. The insurance significantly raises the credit rating and security of the bond.

    In March, MCS started dollar cost averaging into a fund that specializes in midstream oil & gas investments. The initial purchase was 1.5% of client portfolios. A subsequent 1.5% purchase was made in June. The goal is a 6% position. The fund yields over 7%, projects growing distributions and is trading at the historic lows.

    How Bond Insurance Works

    A municipality with a less-than-top-tier investment grade rating (BBB or A) may elect to purchase insurance to improve its rating to AA. Insurance works like this: even if something unexpected happens and the municipality cannot pay its debt obligations, the bond’s insurer makes the debt payments on the original terms. Insurance makes the bonds a safer investment for purchasers, who are therefore willing to buy bonds at a lower interest cost to the municipality. At the end, the municipality saves money by paying less interest, and bond purchasers have a loan guarantor if the municipality gets in trouble.

    1 MCS Family Wealth Advisors (MCS) consolidated client returns are dollar-weighted, net of investment management fees unless stated otherwise, include reinvestment of dividends and capital gains and represent all clients with fully discretionary accounts under management for at least one full month in 2015. Individual client returns represent client discretionary accounts under management for the entire period – starting on 12/31/2014 and ending on 06/30/2015. These accounts represent 100% of MCS’s assets under management as of 06/30/2015 and were invested primarily in US stocks and bonds (18% of client assets on 06/30/2015 were invested in tax-exempt municipal bonds). The Auxier sub-portfolio returns are dollar-weighted, net of investment management fees unless stated otherwise, include reinvestment of dividends and capital gains and represent all clients with fully discretionary accounts under management for at least one full month in 2015. These accounts represented 10% of MCS’s assets under management as of 06/30/2015 and were invested primarily in US and foreign stocks. The Stock Index values are based on the S&P 500 Total Return Index, which measures the large-capitalization US equity market. The Bond Index values are based on the Barclays Capital US Aggregate Bond Index, which measures the US investment-grade bond market. Index values are for comparison purposes only. The report is for information purposes only and does not consider the specific investment objective, financial situation, or particular needs of any recipient, nor is it to be construed as an offer to sell or solicit investment management or any other services. Past performance is not indicative of future results.