Respecting the Three C’s


Over my career, I’ve spoken and written quite a bit on the topics of complexity, connectedness, and change. Respect for these “three C’s” is something that our team at FIM Group regularly discusses as we analyze investments and manage portfolios. I recently circulated a report published by the World Economic Forum (WEF) in Davos, Switzerland, that includes Figure 1, showing major trends and five categories of risks (economic, environmental, societal, geopolitical, and technological) facing the global economy today. Our team does similar mind-mapping when analyzing how “big picture” developments might directly or indirectly affect the investments in our managed portfolios.

Our analysis of these and other trends and risks considers potential consequences to our investments in the two major spheres that influence an investment’s future value. The first is the sphere of investment “fundamentals,” while the second is the sphere of investment “price.” Fundamentals are the characteristics that ultimately determine an investment’s ability to generate the expected cash flow during our anticipated holding period. Price reflects the ability, willingness, and eagerness of market participants to pay for these fundamentals.

The coming energy revolution

For an example of these three C’s in practice, let’s take a look at one of the 12 key emerging technologies noted in that very WEF report (see Figure 2 on page 2 for all 12): energy capture, storage, and transmission. Fossil fuels such as coal and oil clearly remain deeply interwoven into the fabric of today’s economy. Through complex supply chains, they become parts of pretty much every product and service in the global economy today. Yet, innovation in the renewable energy area, which promises to disrupt legacy fossil fuel providers from both the supply and demand sides of the equation, can no longer be ignored. Legacy energy companies banking on their reserves of fossil fuel assets may find that these assets will become “stranded” underground should the world have less need for them. For companies that take on debt to finance their fossil fuel operations, like coal producer Peabody Energy did, changing industry conditions can prove fatal. Indeed, the share price chart of Peabody (ticker BTUUQ) is a figurative and literal “canary in the coal mine” for what others in the coal business may face ahead (see Figure 3). Not only have the fundamentals of the coal business faced rapid decline, but investor sentiment toward these fundamentals has slumped as well. Peabody, which filed Chapter 11 bankruptcy in early 2016, saw more than $15 billion in market value evaporate in less than five years. While the Trump administration may provide a temporary regulatory reprieve for coal producers, the technological threats ahead will continue to apply relentless pressure to companies in this space.


These same energy sector technology changes are opening broad new possibilities for nimble companies that can capitalize on them. Carmanah Technologies, for example, a Canada-based company that we hold for select accounts, is integrating the latest solar, LED, battery, communication, and sensor technologies across a wide portfolio of infrastructure illumination products. These products range from “smart” navigational buoys that can be monitored remotely to solar-powered, general illumination products (think parking lot or neighborhood lighting) that will soon become price competitive with grid-connected lighting. Other FIM Group portfolio holdings, including Sparx Group and Softbank in Japan, and Hannon Armstrong and Crius Energy in the U.S., are making significant, profitable investments in solar and other alternative energy projects.

Looking beyond these direct potential winners and losers, our team is also thinking intently about the broader complexity web effects that such an energy revolution may bring. If energy prices trend lower in the future, how will that affect the cost of living around the world, not to mention inflation, interest rates, corporate profits, and global productivity?

Take another look at the Trend Interconnection Map from the WEF (Figure 3) and imagine how many of the areas dominating risk management discussions today could be at least partially mitigated by a future world of cleaner, cheaper, and more accessible energy.


If you think this is far-away science fiction stuff, I would encourage you to think about how changes in energy technologies are already affecting your life in these very early innings. I remember hitting a deer a few years back as we were returning from a relative’s home on a snowy, northern Michigan night. The unfortunate critter ruined my hybrid car’s gas engine, and steam was billowing out from under my mangled hood. On my dashboard, a light came on telling me my battery would power the unharmed electric motor for 17 miles. We made it back without taking another sip of gas.

And here in our current Ugandan home, the public utility-provided electricity often goes out, but Amy and I can keep on emailing our friends and colleagues, reading the news, or enjoying Netflix due to cheap battery backups that can be recharged by a foldable portable solar panel that I keep in my office. Many homes here are going off the grid, or never even going on it – a disruptive force for utility companies watching their “franchise” and “moats” melt away as well as for millions of people whose lives will dramatically change when they can access a product (electricity) that so much of the world takes for granted.

Seeking a margin of safety amid the three C’s

Getting back to investing in this Brave New World of ever-increasing complexity, connectedness, and change, a basic principle that our team applies to any investment we make is the “margin of safety.” Essentially, we aim to leave an ample margin for analytical error in both of the spheres noted above (investment fundamentals and investment price), especially when considering the unknowns that loom ahead from so many emerging new technologies. For example, we prefer investments that demonstrate attributes of fundamental resilience (such as strong, “ triplebottom- line-minded” management teams, flexible balance sheets, and defendable competitive advantages), and we aim to own them at prices that allow for bumps in the road ahead (such as investments that are not “priced for perfection”). In the current environment, these are getting harder to find, which is one reason you have probably noticed we are carrying higher levels of cash and temporary “parking place” investments like U.S. Treasury notes and bonds.

Paltry earnings yields in most of the U.S. blue chips

While we’ve discussed this in previous newsletters and webinars, one investing reality we face today is that many stock and bond markets in the world (especially those in the U.S.A.) are, in our view, expensive. At today’s prices, they simply offer an insufficient margin of safety for the “less than perfect” scenarios that may await us down the road. The web of factors that have led to today’s relatively high valuation of the S&P 500, a proxy for the U.S. stock market, is perhaps a topic for another day. Yet the end reality is one in which this collection of blue chip stocks will likely offer investors unsatisfactory future returns at these prices.

For example, the S&P 500 currently offers an earnings yield to investors of roughly 4.6%. This means that in exchange for a $100 investment in the stock market, an investor requires $4.60 in earnings from her portfolio. When we plot the data over the last six decades (Figure 4), we can see how much this earnings yield requirement has changed over time. For example, over my investing career, which began in the 1970s, the earnings yield has fluctuated from a high of 14% (investors requiring $14 in earnings for every $100 they invest) to a low of 3.5%. Today, we are clearly at the low end of this historical range, which has averaged 6.6% over the last 60 years and 5.5% over the last 30.


To merely get back to that 30-year average, we would have to see some pretty significant earnings growth across the entire market, or a meaningful stock market correction, or some combination of the two. For example, if S&P 500 earnings (now around $108) grew 20% this year and the stock market price stayed flat (2,359 at this writing), we would be back at a 5.5% earnings yield. A 43% growth would then be required to return to the 6.6% average earnings yield of the past 60 years. These growth rates seem pretty ambitious, even if President Trump is able to push some of his reform agenda through. An alternative route to the 5.5%, 30-year average earnings yield would be one in which S&P 500 earnings stayed flat and the stock market corrected 16% or so. A flat earnings scenario accompanied by a return to the 60-year average earnings yield would require a 30% correction from current market levels.

If it was only about yields, we’d be backing up the truck in my current backyard

After this long­winded way of communicating (again!) that we are not super-­thrilled with the return proposition provided by the S&P 500, it is important that I mention that higher yields alone are not a sufficient condition for investment elsewhere. For example, the largest remaining U.S. coal stock by market capitalization (Arch Coal) offers a 12% earnings yield, and here in Uganda, two-­year government bonds offer an annual yield of 15%. But you won’t see FIM Group make an investment in either, despite yields that are two to three times greater than those available in the S&P 500. We already covered the threats to the coal business above, which don’t seem worth taking even with a 12% yield. And here in Uganda, I’ll just paraphrase a statement from the recently elected head of state, who said he’s “a servant to no one but himself and his family,” as representative of the governance risks one must take on in return for those 15% yields.

Fortunately, we continue to find places to invest both in America and abroad that provide us with a sufficient margin of safety. Most of these investments fall somewhere in between an S&P 500 priced for near­-perfection and high yielders like Arch and Ugandan govies with funda­mentals (looking forward) that are way too fragile. We own well-­managed, mission-­critical infrastructure providers like hospital REITs (real estate investment trusts), water utilities, and communica­tion equipment companies. Also in our portfolios are companies innovating on the cutting edge of the emerging trends noted by the WEF report, including those involved with alternative energy, new computing technology, and biotech. We also hold companies that provide goods and services to developing countries in Asia, Eastern Europe, and Africa that will grow with the rise of their middle classes.


As your wealth managers, we consider two of our jobs to be embracing the reality of complexity, connectedness, and change and successfully navigating your investment portfolio to support your financial goals. Energy is only one area that will be transformed by tremendous global innovation now under way, with spillover effects that will reach all parts of the global economy. Major advancements in healthcare, robotics, and machine-­to­-machine communications also lurk just around the corner. While I am optimistic that these trends will bring net benefits to society, there will clearly be disruption along the way. I am confident that our team has the training and temperament to assess the risk and return opportuni­ties amid these three C’s – and to structure and manage well­-balanced, high­-margin­-of-­safety portfolios that can thrive in the years ahead.