Altus Insight February, 2018

~~The Altus Insight
Market news, commentary and relevant topics for today’s alternative asset investor

Date: February 28, 2018
FR: Forrest Jinks
RE: Around the Horn

Spring isn’t quite in the air yet, but baseball is back.  At least the spring training portion of baseball.  While some consider baseball to be slow and boring, I love the intricacies and strategy of the game.  Pitchers and catchers spend considerable time and effort learning the strength and weaknesses of themselves, their teammates, and their opponents – and hitters are doing the same from the opposite angle. This continual learning effort is ongoing, not just throughout the course of a game, but even within each series as it evolves over a stretch of games against the same opponent, each season as it progresses, and even over the course of players’ careers.  This mental side to the game is critical to success, to support your teammates with your strengths and to aid their weaknesses against the common opponent, as the team strives to meet its goals.

Our approach to our business has some distinct similarities to America’s pastime – the greatest of which is our team-wide dedication to learning and improvement.  Our ongoing development of our knowledge base and skillset, to aid our growth and reach our goals, is much the same as those ballplayers striving for their own success and that of their team.  However, there is one primary difference between that of a pitcher/hitter and our own experience:  Baseball is a zero sum game – 1 winner and 1 loser.  In our world, we seek to learn all we can about our teammates, our environment, and those outside our company that we interact with as we seek our goals; it is with a desire to find the solution that works best for each opportunity.  Will everyone always leave each transaction and each interaction thrilled with how it unfolded?  Of course not.  Thoroughly unexpected events can unfold in an instant, both in baseball and in life, both good and bad, and it’s our job to manage those events as best we can with the knowledge we’ve acquired.  But if we are approaching each situation from a collaborative point of view, it is our belief that we will reap the rewards of better relationships and better profits over the course of our careers.

Now, let’s throw that ball ‘Around the Horn’.  The title of this article has two different meanings in baseball. One is a double or triple play where the ball is hit to the third baseman who then throws to the second baseman covering second base, who in turns throws to the first baseman. A snappy 5 – 4 – 3 double play is one of the prettiest things in baseball. The second use of the term is when, after a strikeout with no one on base, the catcher throws it to the third baseman who then throws it to another infielder who then throws it on, etc.. While a weird relic of baseball tradition, it keeps the infielders’ heads in the game. Done correctly, the ball being thrown around the horn is a clean and quick process, all occurring before the next hitter can walk to the batter’s box. I am going to try my own version of an economic and investing “around the horn”; four bases, hopefully covered quickly and cleanly:

HOME: After the stock market excitement early in the month, I had several people email me to ask about my VIX position. As a reminder, I purchased far out of the money call options on the VIX index. At the time of purchase the VIX was around 10, and the strike price on my options was around 50. When the stock market got a little sideways early in the month, the value of my position was up over 100% and in just a few months, a great percentage return. However, because the purchase price was so cheap, the absolute return on my position wasn’t going to be enough to change anyone’s life. The purpose of buying the options wasn’t to make some money on the price of the option increasing. It was as a very cheap “lottery ticket”, in case things really got crazy. And they got very close to being crazy with the index reaching the high 40s. If it had continued higher and crested above my strike price, and assuming I had the time to then exercise the option and sell the underlying securities, I would have made $1000 on each $1 invested for each $1 above the strike price the index rose.  Knowing that I may end up with a total loss, I held on to my position. If the index falls backs to previous levels, I will buy more options. I don’t know if it will rise past my strike price during the option term, but I know that it will again at some point in the future, and I would love to own the options when it happens.

To THIRD: The President and Congress (finally) came to an agreement on a budget for the fiscal year ending September 30th of this year. Never mind that the year is already 40% complete. As a fiscal conservative, I am not at all impressed with the budget, which is set to increase the deficit (and therefore the debt). I am also not impressed with the Republicans in Congress that got elected on a platform of reducing the deficit, nor the Democrats who are now complaining about the deficit after having no trouble running massive budget deficits under the previous administration. Everyone has their pet projects that need money, and losing their own funding is far worse to them than government working itself towards insolvency. It turns out that complaining about the deficit is just a convenient talking point for whichever party isn’t the one racking up the bills. But in real life, government debt matters. Many a study has shown that government debt levels over ~100% of GDP has a direct correlation to reduced economic growth rates. Reduced growth rates also reduce future tax receipts and directly impacts the participants within that economy. For reference, the US debt to GDP ratio is ~105%, which doesn’t include off balance sheet liabilities like upcoming Social Security and Medicare entitlements. The deficit is anticipated to add another ~$1 Trillion to the national debt this year, pushing the debt to GDP ratio close to 110%. Additionally, increased debt requires increased buyers of debt. The bid-to-cover ratio at the most recent 4 week, and 3 and 6 month, T-Bill auction was the lowest in 10 years. Ten-year auctions also showed a heightened lack of interest. This reduced demand can lead to higher interest rates but even more importantly, the money invested in T-Bills is also not invested elsewhere, robbing the economy of an engine of growth.

To SECOND: Before we sling the ball to second, a quick sidebar: I am not sure if I was appropriately straight forward in communicating the impact of rising interest rates on the market values of yield producing assets. IF the Federal Reserve follows through on their planned interest rate hikes, and IF the market interest rates follow, as it currently appears they are, the market price of income producing asset prices will get hammered. If you are in it for the cash flow, as we are in most of our investments, no harm no foul. However, it seems to us that right now is a time for caution and keeping powder (cash) dry for the better opportunities that will be arising in the next couple years. This isn’t to say that great opportunities won’t come up more immediately, and it certainly doesn’t mean that we have stopped looking, but we are being a lot more conservative in the way we underwrite and make offers on opportunities.

I am completely sure that I missed mentioning one potential upcoming opportunity in the list in last month’s article: I grew up on a farm and though I have been largely out of agriculture for the past couple decades, I continue to keep my finger on the pulse of a few different commodities and certain ag land prices in some areas. Most loans for agricultural property are fully adjusting, so lower interest rates means lower payments, which means more cash flow. This not only means more money being produced on existing land, it also means that each dollar of NOI can cover a larger amount of total debt on additional land or equipment purchases. Additionally, since a large portion of ag production is shipped outside the US, the strength of the dollar greatly impacts the profitability of ag production. The weaker the dollar, the greater the international demand, the higher the price of the product in dollars. Quantitative easing was a double win for agriculture. Not only did the cost of debt plummet (and cash flow therefore dramatically increase), QE weakened the dollar dramatically, therefore increasing the price of the commodity. This combination was a huge win for farmers. The farmers, making more money and as any good business person would, wanted to increase production, so more land was purchased, which pushed land costs up.

So long as interest rates were low and commodity prices high, this wasn’t a problem. But now, interest rates are increasing, and the adjustable ag loans with it. At the same time, the combination of rising interest rates and quantitative tightening (the Federal Reserve reducing the amount of money in the economy) should (SHOULD) lead to a stronger dollar, which in turn will hurt exports and commodity pricing. Suddenly, after years of favorable tail winds, Agriculture is now looking at the probability of increasing costs (interest rates) and decreasing revenue (strong dollar). Something has to give. I believe this damage will be manifest in the price of land. It isn’t going to happen immediately because there is still tons of cash floating around within the industry, but when it does happen, it could be stark.

To FIRST: As written in previous Insight’s, I am not a huge fan of the new tax plan (though I don’t think it is nearly as bad as some have claimed). However, after meeting with our tax accountants to strategize our own business moves in response to the tax plan, there is one component of the plan of which I now have a much greater respect. I have been critical of the so called “wealth effect” or “trickle down effect” that was the goal of the Federal Reserve in boosting asset prices. Their claim was that people would feel richer if their asset prices increased, and if they felt richer they would spend more, which in turn would help grow the economy (never mind that consumer debt levels are now higher than in 2008). My big issue with that theory is that it benefitted those with the majority of assets (the rich – exacerbating the rich/poor gap), and that an increase in market price didn’t have the impact on the economy as hoped because those owners of the higher priced assets knew that if they sold those assets they would pay a lot of taxes on the gains. While the stock market (and bond market, and real estate market, and art market, etc..) was going up, there was very little reinvestment into the economy.

Now contrast that to our own business. We are currently structured as a limited partnership, which is a passthrough entity. At the end of each year we distributed 50% of our income for the year to cover tax payments of the partners (since the business income is marginal to the partners, it is taxed at the marginal tax rate - ~50% in CA). This reduced our company’s ability to invest in growth by 50%. In our case, that has directly impacted hiring. And yet, due to the high corporate rates and the double taxation of dividends, we were still better off with the flexibility afforded using a pass-through entity versus a corporation.

Now, back to the new tax plan. By aggressively reducing Federal corporate tax rates (35% to 21%), the corporation as an entity has become much more attractive. In our case, it means that under a corporate structure we can maintain 39% more of our income in the entity versus our current pass through structure (prior to CA state taxes). Not only CAN we do it, we are INCENTIVIZED to do it. This doesn’t just hold true for our business, it holds true for millions of small and medium size businesses across the country. We are now incentivized to leave funds within the corporation, which can be reinvested with less friction. Not reinvested into financial instruments, but into PPP&E – People, Property, Plant, and Equipment. For larger corporations, the reduction of taxes means more cash at the end of the year, and just like those of us in the smaller companies, cash inside the company makes sense to invest directly back into the business.

As a related aside, corporate taxes are a relatively minor part of federal tax receipts, even before this tax cut. To me, this is an area of small investment by the government (investment via a reduction of tax receipts) that can lead to economic growth, both through the aforementioned incentive for intercompany reinvestment, but also by making the US more competitive for business internationally.

 

Happy Investing.

Forrest Jinks
Altus Equity Group, LP
off: 707/932-5887
fax: 707/544-2972
www.altusequity.com

About the Author: Forrest Jinks is a managing director of Altus Equity Group, LP and licensed real estate broker. Forrest has many years of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start up (online marketing and site retail). He can be reached at fjinks@altusequity.com.