The Style Box Paradox

Zeno’s dichotomy paradox refers to a philosophical conundrum where someone wishing to get from point A to point B must first move halfway before completing the journey. However, since they always have to complete half the journey first, and the half-journeys can go on ad infinitum, the Greek philosopher was forced to conclude that they would never arrive at the destination but would forever be stuck at various halfway points. It’s a great theory, but it just doesn’t make sense in the real world. People get to their intended destination all the time.

In investing, the theoreticians often study portfolios in the context of investment style boxes. Some portfolios are characterized as small cap value while others are classified as large cap growth. Classifying portfolios in this way is helpful in understanding fund performance looking backward over a discreet time period. However, classifying portfolios by style box classification is not particularly helpful while building portfolios. In the real world, bottom up investors shouldn’t care that much what style box the stock falls in. A more helpful way to classify stocks when constructing the portfolio is by industry and sector. At May-Investments, our portfolio building process has always emphasized sector rather than style box classification. We might look for a consumer stock with good earnings growth prospects that sells for a reasonable valuation, but we really don’t care how the stock is classified by the style box methodology.

A recent Fidelity Investments study explains that, “beyond company-specific factors, sector exposure has been the most influential driver of equity market returns.” While passive indexers mimic their marketing masters who repeat ad nauseam the myth that stock selection doesn’t matter and that a static asset allocation makes up 85% of investor return, in reality the studies showed that asset allocation is so important that it shouldn’t be held static, and that stock picking and sector selection actually matter a lot. While these facts inconvenience the passive indexing crowd, that doesn’t change them.

Style box investing, while great for performance attribution, helps little during the portfolio construction process. It’s a great theory, but it just doesn’t make sense in the real world. The Fidelity study notes that managing sector exposure is key because, “of the distinct risk and performance characteristics of the 10 major sectors.” While a specific stock’s style box attributes fluctuate constantly as ever-changing financial characteristics evolve, companies’ sector and industry attributes remain fairly constant. Moreover, these consistent performance drivers have a wider dispersion between the best and worst performing categories. “Equity sectors tend to have significant performance dispersion relative to each other, which is a key attribute for any alpha-seeking equity allocation strategy,” Fidelity observes. In other words, for investors trying to focus their portfolio on the best performing investments, more can be gained by focusing on sectors where the difference between the best and the worst is significantly wider than is the case with styles.

Another key difference is that different sectors have lower correlations to one another. This makes it easier to diversify risk than can be done using a style box orientation. “During the 2000s, the average correlation of sectors versus one another was 0.52, while the same average correlation among style box benchmarks over the same period was 0.76.” The higher the correlation, the higher the risk that all types of styles will rise and (more importantly) fall at the same time. Fidelity goes on to note that portfolios created with equity sectors “are more efficient – providing higher return and lower risk – than those created using style box components.”

Vanguard Fund founder, John Bogle, has made quite a stir lately criticizing the exchange traded fund industry for creating industry specific ETFs and branding the investors who use them as some form of wild speculator. Bogle, of course, made his fame and living off of passive investing. To his credit, he developed a firm based on low-cost investing strategies. To maintain that his approach is the only legitimate strategy is a bit arrogant, however. The lowest price car in the U.S. is the Nissan Versa S Sedan, priced at $12,780. The car comes with a manual transmission, a less fuel efficient engine, 2 wheel drive, bad ground clearance, a hardtop and very few bells and whistles. Are we all fools for not buying the lowest priced car, as Bogleheads suggest? Or are there other reasons to prefer a different way of viewing the world?

Anyone interested in getting a copy of the Fidelity Investment Insights white paper (Equity Sectors: Essential Building Blocks for Portfolio Construction) can e-mail us and we will be glad to forward a copy of the study.

Douglas B. May is President of May-Investments, LLC and author of Investment Heresies.

Japan ETF Trade

The Japanese stock market has been on a tear since Prime Minister Shinzo Abe initiated his own version of Quantitative Easing (printing money) which appears to be QE100X (quantitative easing “on steroids”).  Money has to flow somewhere, it seems, and these days the money seems to flow directly into the stock market.  In response to the rapid printing press strategy, the value of the yen promptly and materially declined in value.  Japan’s twenty-year bear market seemed finally to come to an end, and it did (for a few months).

As we mentioned in our Tuesday Noon Classes in April, our strategy calls for moving money toward asset classes that are working.  The strong and seemingly sustained strength in the Japanese market led to our initiating positions at the beginning of May.

The Japanese market kept rallying into mid-May, and then the short-lived rally came to an end.  The Nikkei 225 turned down and never really looked back, entering bear market territory this week.  At the moment, to generalize, we have small losses in our positions and are frankly not in the mood to take a big loss. 

The Japanese market ran up fast in furious in 2013.  The iShares Japanese Index ETF (ticker symbol EWJ) is still up about 11% year-to-date, in spite of the market currently being in “bear” territory.  The Japanese market is another QE-driven asset class with an ETF that is quickly attracting widespread hedge fund interest, somewhat reminiscent of gold in 2011.  The main difference is that gold wasn’t just coming out of a 20-year doldrum when it ramped up.

For the most part, I have viewed the recent sell-off as somewhat appropriate given how fast the Japanese stocks moved up earlier in the year.  Some “consolidation” would actually be a good thing.  Stocks don’t go “straight up,” typically.  Those that do go parabolic usually do so just before crashing back down again.  A little correction would have been welcomed.  At the beginning of the week, it seemed more like a time to add to positions, rather than a time to bail out.

Then came Wednesday night.

On Wednesday night, the Japanese market fell about -6.5%, overnight.  As you can imagine, this created a bit of consternation as I watched the sell-off unfold that night.  Moreover, the yen (currency) was also moving a lot.

When we bought the iShare (EWJ), we chose the exchange traded fund security that demonstrated the best liquidity characteristics.  There are other ETFs available that try to eliminate the impact of currency adjustments by hedging away currency moves.  We weren’t buying EWJ in order to speculate on the yen, one way or the other.  We have, however, seen futures-based ETFs disappoint investors as the constant and costly futures trading result in those securities underperforming our expectations.  We chose EWJ in order to avoid the currency issue, prioritizing liquidity and low expense ratios over currency strategies.

Instead, this week it became clear that one way or another, currency is going to be part of the equation.  To be honest, not understanding the currency impact as well as I should have, when I saw the dollar/yen relationship moving –1.5% on Wednesday night, the pessimist in me pretty much assumed that the currency was moving against us as well.  On Thursday morning, I came in to the office expecting to see EWJ moving down –8% (just days after doubling up on some of those holdings).

So, imagine my surprise when EWJ closed UP over 2% that day.

This caused me to do a couple of things.  First, I jumped for joy.  The security we owned performed 10% better (in a day) than I had expected.  Luck was on my side.

However, it also meant that I really didn’t understand how this ETF was working, not nearly as well as I needed to.  If it meant that I could be 10% lucky on one day, I could just as easily get a 10% disappointment on (literally) the next day.  That was unacceptable.  So the first thing I did was cut our position in half until I could get a better understanding of what was driving the performance of this security.  In theory, it’s really not that tough.  ETFs are usually pretty straightforward instruments.  The Nikkei 225 Index goes up or down, and this ETF should follow.  But at the end of Thursday, I had all sorts of questions.

Why is the Nikkei suddenly so volatile?  Moving –6.5% in a day is not the norm for a healthy market.  How could the U.S. market response to the previous night’s plunge be so different?  EWJ opened up, and just kept getting stronger.  It never reflected the sell-off at all.

There are four fundamental factors that I needed to monitor in order to come up with the answer.  First, the action on the Nikkei stock exchange is the primary influence on returns.  Second, the movement of the currency is significant – more significant than I had originally wanted to believe.  Moreover, in my shock at the –6.5% decline in the market, I had assumed that the currency was also moving against me.  In fact, the yen was increasing in value on Wednesday night, which reduced the dollar-denominated loss to a –5% market move.

Third, ETFs trade at a premium or discount to their net asset value and this, too, was having a bigger impact than I had expected.  ETFs normally trade pretty close to net asset value, by design.  If the computer-generated valuation of the stocks in the index is $10, then the ETF might trade at a discount of $9.98 or a premium of $10.02, but in general discounts and premiums aren’t material.  One of the reasons that we prefer exchange traded funds (ETFs) to closed-end funds, which also trade at discounts and premiums to net asset value, is that market makers can generally keep the gap to a minimum.

On Wednesday night, before the Japanese market opened, EWJ was trading at a pretty hefty 2.5% discount to net asset value.  As a result, the first –2.5% decline in the value of the Nikkei 225 was already “baked in” to the price of EWJ.  Now, instead of having to explain a 5% variance, I’m down to only a 2.5% variance in what happened to EWJ as compared to my expectations.

Finally, at the end of the day on Thursday, EWJ was trading at a 4% PREMIUM to the Nikkei 225.  As the trading day continued, it is quite possible that money was flowing INTO the EWJ exchange traded fund.  As buyers came in to “buy the dip” in the Japanese market, the demand for EWJ shares was so strong that they actually began to trade up versus the security’s intrinsic value (the “net asset value”).  Also, the U.S. market was trading up during Thursday, and certain large Japanese stocks like Honda and Toyota trade on the American exchanges, so the intrinsic value of the Japanese market was moving up even though the Japanese market wasn’t open at the time.

The bottom line is that our positions in EWJ are still slightly below cost.  If EWJ goes down much more, we will cut our losses and sell out.

Second, the volatility the yen is having an enormous impact on the valuation of our EWJ investment.  We really wanted to ignore the currency impact on this investment.  That was naïve.  Just because we don’t want to be currency speculators, and use a security that doesn’t focus on currency hedging, doesn’t mean that we will be able to.  Once again, the political ramifications of easy money policies are creating enormous uncertainty in the markets.  There’s just no way around it, these days.

Third, the market makers aren’t doing a particularly good job of closing the gap between the price of EWJ and its net asset value.  This is a pretty new problem.  Normally, gap issues only impact investors during times of crisis.  In normal trading times, the gap is relatively immaterial.  Right now, that’s not the case.  Hopefully it’s just an unusual time for this particular ETF, rather than a sign of big underlying liquidity issues across all of the international markets.  Still, we’re going to have to treat EWJ almost like a closed-end fund, limiting buying opportunities to times when there is a significant discount, and taking advantage by selling into premiums, as we did on Thursday.

Lastly, I have a sense that the underlying fundamentals in Japan are not what’s driving the market.  The Nikkei was said to dive because U.S. quantitative easing policies are about to “taper” off.  Why would U.S. monetary policy cause a –6.5% mini-crash in Japan?  That doesn’t make much sense.  Unless, of course, what’s driving the Japanese markets higher are U.S.-based investors, using EWJ as the preferred speculative tool.

In watching markets, this week, it did not appear that EWJ (the U.S. trading tool) was following the Japanese market.  It appeared the EWJ was LEADING the Japanese markets.  It seemed, at times, like the entire Japanese market was responding to what EWJ was doing over here.  The tail seemed to be wagging the dog.

If that’s true (and I’m not at all sure that it is), then it would appear to be somewhat like when all of those U.S. investors bought gold ETFs in 2011, which drove the real markets higher as the financial demand for gold overwhelmed the actual supply in the physical markets.  Could it be that financial demand for the Japanese market, through hedge funds buying ETFs, is the source of Japan’s rally?  If the fundamentals in Japan aren’t improving, and the source of the Nikkei rally, then that’s a big deal and makes me much less willing to own shares of EWJ in the portfolio.

In any case, this week’s buy-then-subsequent-sale of EWJ shares is not something that I ever want to do again.  Because the Japanese market mini-crash wasn’t being reflected in the U.S. traded shares of EWJ, mostly because the ETF swung overnight from a 2.5% discount to a 4% premium, we took advantage of the gift and reduced the size of our exposure.

Soon we’ll have to decide if we’re going to completely eliminate it, or not.  If Abenomics works and this finally helps Japan begin to climb out of its twenty year recession, then we’ll get back in and just pay more attention to the yen and the gap between the ETF and its net asset value.

On the other hand, if we decide that the fundamentals in Japan aren’t driving the Japanese market, but rather it’s just U.S. speculators pushing that market around, then I’m not as inclined to stick around.  If trading in U.S. markets determines what the Japanese market does the next day, then something’s wrong.  If Japanese news causes its market to rise and fall, on its own, and then the U.S. ETF simply reflects these changes, then that’s an asset class in which I will consider investing.

Right now, it’s not clear what’s the driving force with this investment.  If trading activity doesn’t start making sense, and I mean soon, then we’ll just exit the rest of our position.

You know what they say about markets and poker.  If you don’t know who the patsy sitting at the table is, then it’s time to fold your cards and go home.

Douglas B. May is President of May-Investments, LLC and author of Investment Heresies.

ETF Swap in Mutual Fund Accounts

The portfolios recently sold shares in the iShares MSCI EAFE Index fund (EFA), which invests in companies in the Morgan Stanley Capital International Europe, Australasia, and Far East markets.  With the proceeds, we purchased the iShares Dow Jones International Select Dividend fund (IDV).

Swapping from EFA to IDV is a bit more arcane than our normal portfolio move and we wanted to explain the (very simple) rationale behind the switch.

Fidelity Investments has had a small number of exchange traded funds which trade no-commission, much like the no-transaction-fee mutual funds which we typically use.  EFA has been on that list, but very few other ETFs (including IDV) were included as NTF exchange traded funds.

About a month ago, Fidelity inked an agreement with Blackrock, the company that sponsors iShares, to broaden the number of exchange traded funds that trade without commission on the Fidelity platform.  Importantly for us, there were several ETFs which we do normally use to track alternative asset classes that are now included.

We are believers in actively managed mutual funds, but at times the advantages of ETFs are large enough that they make sense instead.  One of the disadvantages, particularly with the international mutual funds, is that we are locked in for a minimum 90-day holding period.  If clients need those funds for any reason, or if the market starts breaking down and we would like to get out, which definitely happened in the 2008 crash, the ETFs have the advantage of less onerous minimum period holding fees.  Instead of charging 2% of principal for selling a mutual fund early, as is the case with our Matthews Tiger Fund (MAPTX), with the ETF selling before 30 days costs us, at most, $17.95 per trade.  If the markets are indeed starting to crash, $17.95 is nothing.

So, as a result of the new deal between Blackrock and Fidelity, the EFA iShare was being removed from the No-Transaction Fee platform (I have no idea why), and IDV is being added to the NTF platform.  We had until April 30 to get out of EFA, commission-free.  I’ve been holding on, trying to determine whether the international fund can hold its position in the portfolio, but thus far it has been doing fairly well and we simply are running out of time to make the swap on a transaction-fee basis.

Small changes in trading fees don’t often trigger portfolio changes, but it did in this case.  Every $17.95 helps. 

Douglas B. May is President of May-Investments, LLC and author of Investment Heresies.

Six Steps To Prevent Identity Theft

Joe Garagiola tells the story of a baseball star who wouldn’t report the theft of his credit cards because the thief spent less than his wife.  In today’s world, identity theft of my medical identity could mean that I end up with someone else’s medical records.  What happens if the thief is in better condition than me?  Would my insurance rates improve? 

In reality, of course, identity theft is no laughing matter where the average “simple” case costs victims 81 to 600 hours, $2,000 to $15,000 in lost wages, and $850 to $1,400 in out of pocket expenses.  Indirectly, identity theft can cost victims by driving up insurance rates and credit card fees, result in being denied loan approval, housing, employment opportunities and even travel privileges.  In a worst case scenario, it can lead to victims being arrested.

Phishing occurs when thieves impersonate someone you know and request private information that they will later use to assume your identity.  The safest rule, of course, is to not provide personal information unless you initiated the correspondence.  Sometimes that is easy to forget, however, especially in the form of e-mails that appear to come from a vendor you use.  When I receive an e-mail from KeyBank, it’s easy to know they’re fishing because I’ve never had an account there.  When it comes from my own bank, it is easier to set my phishing concerns aside, but don’t!  That’s how they get their victims.

I looked at the web traffic on my blog, last night.  Fully a third of the traffic going to my site comes from European and Russian IP addresses.  I’m not too proud to admit it that I know they are not visiting my site to read my investment opinion.  We are up against a worldwide organized crime effort with computer skills that vastly exceed our own.  Fortunately, they tend to write in broken English.  But you can’t guarantee that will always be the case!

Another popular scam is to impersonate a relative in distress.  Using information gathered from Facebook, they can impersonate a grandson who needs bail money (please don’t mention it to his parents because he might get in trouble), or a granddaughter on the side of the road needing car repair money.  Double check all family distress tales before sending any financial help.  These scams are more prevalent than any of us want to imagine.  Of course, these days, the financial distress might come as a result of having bought Facebook shares when the stock came public!

ABM News just released a story about phantom debt collectors from India that harass Americans, demanding money.  Hundreds of thousands of cash-strapped Americans have been targeted by abusive debt collectors in a phantom debt collection scam. 

Retirement Outfitters recently invited an investigator with the Colorado Bureau of Investigation to the Tuesday Noon Lunch series and attendees received a rapid fire list of steps that can be taken to reduce the risk and impact of identity theft.  Here’s an abridged list of suggestions from that workshop.

1. Opt out of receiving junk mail so no one can steal a pre-approved application from your mailbox.
2. To protect against electronic “skimmers” that steal your card information when it is swiped, cover the keypad and pretend to type some extra numbers so that no one can learn your PIN code by watching.
3. Use a separate credit card for travel, or to carry with you, from what is used for monthly utility payments.  If the travel card is compromised, you don’t have to change payment instructions on all of the other accounts.
4. Monitor bank and credit card spending, online or through household spending software (like Quicken), or consider using a credit monitoring service.  The quicker the ID theft is discovered, the less you’ll have to unravel, later.
5. Rotate among the three major credit report services and use www.annualcreditreport.com to check for unusual activity every four months.  You get one free report per year from each service, so rotating among them allows you to check more frequently.
6. Determine if your credit card company offers a smart card, chip card, or integrated circuit card (ICC).  These cards can’t be effectively skimmed because authenticating data changes after each transaction.  However, some of these “contactless” cards emit a wireless signal that can be read by a nearby reader, so customers should also consider buying a credit card RFID blocking sleeve as well.

Retirees are targeted by identity thieves because they don’t use credit as often and are less likely to immediately notice when their card or medical identity has been compromised.  For this reason, retirees who aren’t borrowing money very often ought to consider putting a freeze on their credit record by contacting the three major vendors (Experian, Trans Union, and Equifax).  This can prevent fraudulent applications from being processed in the first place.

Children, newborns even, are also targets.  The beautiful part of stealing the identity of a baby is that it could be 18 years before they grow up, apply for credit, and discover that they already owe thousands of dollars in debt against their social security number.  The Social Security Administration, realizing that its formulaic way of determining social security numbers was part of the problem, is taking steps to make this more difficult.  For years, however, thieves could easily “guess” a new baby’s social security number and they would have an 18-year free pass to spend before they would be noticed.  Children would reach the age of 18 and immediately be faced with paying tens of thousands of dollars in debt.  This doesn’t happen as often as it used to, unless you want to include Congress among the list of criminals.

The Colorado Bureau of Investigation has a small Identity Theft unit, including a Victims Advocate.  The cases they work on usually span multiple jurisdictions, making enforcement action more complex.  The statewide hotline to report identity theft activity is 1-855-443-3489. 

Barbara Traylor Smith, Retirement Outfitters President, also received a stack of materials at the workshop to help educate Coloradans about identity theft prevention.  Email info@GJretire if you want to stop by Barbara’s office to pick up a packet.
 
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Get Out The (Proxy) Vote

Citigroup made headlines in April when its shareholders rejected the company’s “say on pay” proxy initiative in response to C.E.O. Vikram Pandit’s $14 million pay package.  Only 45% of the proxies voted to “approve” the TARP-recipient’s compensation practices.  In addition to the shocking pay package for a company that requires ongoing government support just to stay in business, both of the major institutional proxy consultants recommended shareholders vote against the proposal.  Proxy voters are speaking their minds, so to speak, and companies are beginning to take notice.

The culture of capitalism fits well with the spirit of democracy where, in both systems, people and ideas compete for the approval of those governed.  Shareholder elections take place each year when companies send out proxies soliciting votes from individual shareholder/owners.  In fact, capitalism would probably work better if more investors took these referendums seriously, as May-Investments does on clients’ behalf.

May-Investments may be in the minority of investment advisor firms that vote proxies on behalf of clients.  Key proxy issues include approving executive compensation and authorizing future incentive plans, whether the company should require an independent Chairman of the Board, and electing directors for the upcoming year.

May-Investments reviews each company election independently to determine how we will vote client shares.  Given the outsized compensation packages that most boards approve for their executives, May-Investments believes that most boards are abdicating their fiduciary responsibility to shareholders, and that most executive teams are more skilled at absconding with company assets than they are at managing the enterprise.  In our view, C.E.O.’s  that have failed to grow earnings for a period of years, and whose company stock price has failed to rise along with earnings power, do not deserve the multi-year multi-million dollar pay packages which are the industry norm.  To generalize, we tend to vote against approval for overly generous pay packages and we typically vote against the directors that have approved such corporate largess after confirming that these board members are often paid in excess of a quarter-million dollars in exchange, it seems, for playing the part of C.E.O. sycophant.

While the Occupy Wall Street movement might delight in our voting “against” the 1%, we would prefer to think that our clients are more Ayn Randian in our demands that owner representatives be more parsimonious with shareholder resources.  Ayn Rand likes to see success rewarded.  But first, there must be success.  We vote not the politics of envy, but we do desire accountability.

Apple's board of directors approved a pay package for new C.E.O., Tim Cook, of $900,000 cash and a $378 million stock grant, just for taking the job.  Seriously?  They tried to give him a sufficiently large equity position to persuade him to focus on the task at hand.  In reality, even if Apple's stock plummets 75 percent, they will have paid him nearly $100 million to preside over the Titanic.  Not a bad gig, if you can get it, but what was the Apple board thinking?

In the relatively few instances where corporations have delivered on promises of earnings growth and shares have appreciated to reflect that performance, we will give managers and boards the benefit of the doubt and approve very generous pay packages.  In most cases, however, managements are being paid too much and our vote reflects our displeasure with how salaried employees are raiding the nesteggs of passive retiree-shareholders.

Increasingly, shareholders are proposing their own election items.  Frequently, shareholders will propose an independent Chairman, forcing management to relinquish key responsibilities to someone better able to represent outside shareholders.  Despite management’s recommendation that shareholders reject these proposals, we typically concur that anything to give shareholders better representation is an idea worthy of support.  Shareholder proposals to install better controls on executive compensation are also likely to receive support, unless the company has been able to grow earnings and shareholder value materially during previous years.

While not everyone will agree with our willingness to vote against management on these issues, we think it is necessary to look out for clients’ best interest.  I can think of very few clients who would disagree with my view that most managements are drastically overpaid.  As a fiduciary, voting client shares on their behalf, I believe that our vote should reflect this point of view.  Further, for capitalism to reach its potential, boards should be holding managements accountable.

During proxy season, many magazines publish articles ranking the most- and least-overpaid corporate chieftans.  We hope that you’ll appreciate that you are not sitting out this election.  Hopefully the directors at Citigroup and other companies will accept the responsibility with which they’ve been blessed.  We are looking to invest in profitable companies at attractive prices.  It is also important to send the message to boards that compensation packages should enrich managers for achieving success instead of enriching every Tim, Vik & Mary who manages to land the job.  After all, as Apple's board may yet learn, past performance may not necessarily be an indication of future success.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Predicting Community Banks Failure

Community Banks of Colorado was taken over by the FDIC and remaining assets were given to Bank Midwest, out of Kansas City, MO, itself owned by National Bank Holdings Corporation, chaired by Timothy Laney, an alumnus of Bank of America and, more recently, Regions Bank. Taxpayers will protect most depositors. Only shareholders and savers with money in excess of the current $250,000 FDIC limit could face losses. A review of Community Banks’ declining financials shows that the takeover was entirely predictable.

The lack of research about local banking institutions leaves many large depositors worried about whether their bank will be the next to fail. Regulators don’t like to make rankings public so that they don’t cause a run on a troubled institution.

As a result, savers may be overly anxious about keeping their savings in a local bank, depriving local lenders of resources that could be invested in the community to create jobs. Instead, money flows toward “too big to fail” institutions who are increasingly investing in government bonds – funding the big government juggernaut – but leaving local job creators without sufficient expansion capital. While big banks increase fees to make up for their lack of interest income with a host of new fees, including the appropriately-named new Durbin fee on debit card transactions, smaller institutions are prevented by the regulators from making loans in the areas they know best, to local investors who are best suited to take over management of the millions of homes across the country that sit in foreclosure portfolios.

Finding objective information is difficult, but relying on rumors just increases the level of anxiety. Several local banks have been the subject of rumors in the past year, including Community Banks.

Large depositors with concerns about their deposit institution should do the research for themselves on the Federal Financial Institutions Examination Council web site. (https://cdr.ffiec.gov/public/) The site makes it easy to view or download data for individual institutions.

In our research for a local foundation client, we focus on a few key statistics to keep the analysis manageable. The first ratio we review is the Tier One Leverage Capitalization which measures the amount of investor money at risk before losses would impact depositors with savings above the FDIC guarantee levels. Most of the local institutions have nearly 10% in tier one capital. As of June 30, Community Banks of Colorado’s capital ratio had declined to only 1.66%, meaning another 2% in bad loans was all it took to wipe out the equity.

We also look at the total past due loans and leases. At Community Banks of Colorado, there was another 11.31% in past due loans as of mid-summer, so it shouldn’t have been a big shock when the equity was wiped out. In our review, we concluded that only one of the remaining twelve institutions is “under water” in the sense that its past due loan percentage is greater than its current tier one capitalization. In all of the other banks, even if every past due loan went bad, there would still be equity left to protect depositors from future losses.

In our review of thirteen local institutions, Community Banks was far and away the most likely institution to fail. Unfortunately, as tight regulatory policies force banks to walk away from more and more borrowers, forcing additional foreclosures, these numbers do change over time so you need to perform the analysis on an ongoing basis.

The benefit of performing this research, which only takes about an hour to complete, is that depositors can make an informed decision before allowing a local bank to keep deposits in excess of the FDIC lending limits. The data is reliable, compiled by the bank regulators who are paid to look over the shoulder of the industry. And while it isn’t exactly kept in an easily understood format, analysts who identify a few key ratios can make sense of the mountain of data that is available.

 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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RIP eMag; Long Live the Blog!

We recently decided to return to a more traditional blog posting process with "new post" e-mails issued whenever new articles are posted. Returning to a traditional blog posting process allows for more timley posts, albeit at the loss of some local content.

We want to thank Bob Kretschman, in particular, for helping us create content and develop article ideas over the past several months. It could not have been possible without the help of his Kretcom Communications. Many readers have spoken with Bob in interviews and I have personally come to appreciate his sense of humor and business perspective, in addition to his ability to put May-Investments “on the map” in the local media community.

The eMag was designed to be a ten-article monthly publication incorporating timely and interesting articles of local interest to our target audience, folks enjoying and beginning to plan for their retirement. Our strongest readership, however, has always been the articles that detail what is happening in portfolios. What I hadn’t anticipated, however, was that by tying ourselves to a monthly publication schedule, the timeliness of what we write would be impacted as well. In the past, we’ve been free to write about portfolio changes shortly after they occur, and market events as they unfold.

Just as you read a newspaper for one purpose, and a monthly magazine for something else, our most widely read articles were about time-sensitive issues more appropriate to a blog or newspaper, than to a monthly reader.

Another goal of the eMag was to incorporate information about broader financial planning topics, taking advantage of the expertise that Barbara Traylor Smith (President of Retirement Outfitters) has in Income Planning and insurance, and the experience that Kim Last (Kimberley A. Last Financial Services, Inc.) has in Long-term Care planning and many other topics. Unfortunately, because they own their own companies and have their own compliance people to satisfy, it was never really possible to integrate our information dissemination and education efforts.

While it’s easy for us to “play in the same sandbox” in order to provide clients with better and more comprehensive financial services, we were never able to convince the bureaucrats that “doing a better job for clients” was, in fact, an industry “best practice.” Too bad.

Fortunately, the short experiment with our eMag did teach us a lot about formatting and publishing, in addition to what we learned about misguided and inflexible regulatory insanity. We can continue to use parts of the eMag format to get the message out about upcoming workshops and seminars, and we will continue to include links to outside articles of interest, as well as our own internally generated posts.

Most importantly, our keys goals of being cooperative with clients’ full team of advisors, and fully transparent about the portfolio management process, still rule the day.  Let us know your thoughts so we can continue to improve the May-Investments communications strategies. 
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Model RFP can help you ask the right investment questions

You’re an investor, you want help managing your funds, and you’re trying to figure out which investment manager to choose. How do you avoid casting your lot with the next Bernie Madoff?

Matthew Orsagh, CFA, CIPM, senior policy analyst with the Capital Markets Policy Group for the CFA Institute Centre for Financial Market Integrity, says in CFA Magazine that the Model Request for Proposal (Model RFP) developed by the CFA Institute Centre can give investors some questions to ask prospective managers.

Although the Model RFP is intended for use by institutional investors, individuals can use it to develop their own questions to ask potential investment managers. Using the tool to ask the right questions can help investors see red flags that indicate possible problems with an investment manager. Conversely, answers to the questions also can help confirm investors’ faith in their investment managers.

Orsagh contends that many red flags were missed by victims of the Madoff scandal, and if some of the investors had asked the right questions before investing with Madoff, they might have used a more cautious approach. The Model RFP can help investors formulate the right questions.

The Model RFP consists of three parts: Equity, Fixed Income, and Real Estate. All three parts are available free in PDF form from the CFA Institute’s website.

The Model RFP – Equity can be found at http://www.cfapubs.org/toc/ccb/2008/2008/6.

The Model RFP – Fixed Income can be found at http://www.cfapubs.org/toc/ccb/2008/2008/5.

The Model RFP – Real Estate can be found at http://www.cfapubs.org/toc/ccb/2008/2008/4.

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Self-funded reverse mortgages can work in the right circumstances

Reverse mortgages, in which retirees borrow against their homes to create an income stream during retirement, typically are funded through brokers and financial institutions.

However, under the right circumstances, a wealthy family member can take the place of the brokers and institutions and finance a reverse mortgage for close family members. For lack of a better term, call it a privately financed reverse mortgage, or perhaps a do-it-yourself reverse mortgage.

Travis Perry, a Grand Junction attorney, assisted some clients who wished to set up such a private arrangement between an individual and his retired parents.

“This circumstance worked out well because there was a family member who had done well (financially) and had significant cash savings,” Perry says. With that savings, a loan for the parents was created and structured as a reverse mortgage on their home. In a reverse mortgage, the borrowers receive regular payments from a loan on their home, and the lender receives repayment when the home eventually is sold.

Perry says the arrangement in this particular case utilized a deed of trust on the real estate and a promissory note. A loan agreement spelled out details of the deal. The loan carried the going rate of interest on mortgages at the time the deal was closed, and Escrow Specialists of Grand Junction handled the financial arrangements.

“What we avoided were the majority of closing costs,” Perry says. Among the costs of the transaction were attorney’s fees and escrow costs, but most other typical closing costs were avoided, which resulted in a “significant savings,” he says.

“It’s kind of a win-win,” Perry says, pointing out that the borrowers received a low-cost loan at a competitive rate, and the lender received a competitive rate of return on his money.

Perry cautions, however, that such an arrangement for a reverse mortgage is rare and works only when a good relationship exists between the borrower and lender. “The perfect elements to come together haven’t appeared too often,” he says. “But this is a good alternative in the right circumstances.”

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You’ve Got Mail: Pros and Cons of Going ‘Paperless’ with Fidelity

On June 7th, Fidelity will send an e-mail notice to each of our clients who have an e-mail address on file with them. This notice will ask for your consent to enroll in the electronic delivery (eDelivery) of trade confirmations and legal documents, including shareholder material and revised account profiles. The express purpose of these e-mails is to make it easier for you to enroll in eDelivery of documents, and at the end of the message, you will be given a choice to agree with or ignore the e-mail. Agreeing will result in electronic delivery of the said documents, while ignoring it will allow you to continue to receive paper docs. Please note that while we are not necessarily advocating that you switch to electronic delivery of your documents, we do want to explore the issue as an option.

What exactly are the pros and cons of going paperless? In addition to reducing ‘clutter’, there can be some monetary advantages for certain clients – namely, those with less than $1,000,000 in cumulative balances at Fidelity. Fidelity offers a significant discount on trades for clients who go completely paperless – from $17.95 per trade for shares up to 1,000 and a penny and a half for each share over 1000, to $7.95 per trade for shares up to 10,000 and a penny per share over 10,000. On a $500,000 account where Doug is trading a block of 10,000 ETF shares valued at $5.00 each, that would mean a cost of $7.95 for the ‘paperless’ client versus $138.95 for the ‘papered’- a significant savings on an example that Doug describes as ‘very reasonable’. Please note, for this discount to apply, a client would need to be entirely paperless, meaning that they receive their statements electronically too. The message you are receiving on June 7th will strictly be to opt in or out of electronic trade confirms and legal documents - opting for electronic statements can easily be done with a call to our office. Also note that clients with cumulative balances of $1,000,000 or more at Fidelity already receive the discounted fees, so there would be no additional monetary advantage for them.

In the past, the per trade discounts have not really mattered much for clients under $1,000,000, since most tend to be invested in the Fund Scout strategy, which employs the use of mutual funds rather than individual stocks; however, Doug does expect to begin using ETF’s in these portfolios, and these are subject to the same fees as stocks. For that reason, switching to the electronic receipt of documents might make sense going forward.

In order to 'go electronic’, you must be prepared to organize the files on your computer and back-up your files regularly. This can be one significant disadvantage (though you can always print a copy of the documents you receive electronically if you feel you can’t get away from storing the paper copies).

As stated above, we do not necessarily advocate going paperless; in fact, our past recommendation has been against it since we didn’t feel that most of our clients were adequately prepared to organize, store, and back-up their electronic files. This is an issue that is going to continue to come up, however, as businesses continue to strive for more digital and less paper. The paperless movement is not likely to go away, and we are at a point where the cost savings might begin making sense for some clients. If you would like to talk to someone about your specific situation and whether or not it would make sense for you to transition into paperless, please feel free to give us a call at the office – we are always glad to help.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Mutual funds and ETFs: What’s the difference?

Since 2007, May-Investments has pursued an investment strategy that is primarily focused on mutual funds. However, as markets become more volatile, the firm expects to reintroduce exchange-traded funds (ETFs) to the portfolio.

Doug May, owner and managing member of May-Investments, says ETFs were once part of the portfolio but were phased out about four years ago. Today, ETFs represent a way for the firm to gain an investment foothold in certain niche industries.

“As we contemplate future market volatility, I would think that ETFs would find their way back into the portfolio,” May says.

So what’s the difference between a mutual fund and an ETF?

Both are legally pooled funds that own investment assets for their shareholders, May says. Mutual funds are designed so that at the end of the trading day, assets in the fund are valued, and the fund trades at net asset value. Basically, you know at the end of the day what the fund’s price is.

In contrast, ETFs are investment pools whose shares trade over the course of the day, rather than at the close of the trading day. As a result, a significant difference can exist between the ETF’s net asset value and the price at which its stock trades. That difference, whether it is a premium or a discount, can create uncertainty that causes investors to shy away from ETF investments.

ETF are designed to track certain indexes, and when they don’t hit their target, investors can become nervous about ETFs.

ETFs exist in specialized industries – for example, utilities – which makes them attractive vehicles for investors looking to move into certain industries.

“We want to control our portfolio, so we’re more interested in the niche ETFs than in broad-market ETFs,” May says.

Many mutual funds are actively managed by professional managers who buy the best stocks of the class in which the fund specializes. In contrast, ETFs tend to buy the biggest stocks in the class without much regard for quality factors. Such a strategy can result in more volatility than typically happens in a mutual fund, May says.

By combining mutual funds and ETFs in a portfolio, investors can gain the advantage of actively managed mutual funds with the potential gains of ETFs that specialize in niche industries, May says. The combination also means that the relative stability of mutual funds can help temper the potential volatility of ETFs.

When ETFs join the portfolio, what will May-Investments clients notice that’s different? Because of the way ETFs operate, clients could see trading costs and commissions in their portfolios for the first time, May says. However, May says the benefits of combining ETFs and mutual funds in the portfolio can be worth the cost.

“I think clients are looking to us to make the right choice between the two,” May says. “Our clients trust us to make the right decision.”

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Reverse mortgages are worth a look for retirees with home equity

Retired people who have equity in their homes and need extra income might find that a reverse mortgage gives them more options.

Reverse mortgages are loans against the property that do not have to be paid back as long as the homeowner lives in the home. Many reverse mortgage programs and payment plans exist. The homeowner may choose a monthly payment, a line of credit, a lump-sum cash advance, or a combination of any of these. There are no monthly payments. The loan is paid back in one payment when the home is sold.

“Reverse mortgages are a way for older adults to receive money out of their home and be able to live in their home as long as they choose to,” says Valerie Begalle, a reverse mortgage specialist with MetLife Home Loans. “The FHA requirements to receive a reverse mortgage are that the homeowners be 62 or older and have equity in the home, and live in the home as a primary residence.”

The funds received in a reverse mortgage are considered proceeds of a loan; consequently, the funds are received tax-free. Reverse mortgages have no income qualifications, the borrowers retain title to the property, there are no restrictions on the use of the money received, and because reverse mortgages are federally insured, no debt will be left to the homeowners’ heirs or estate.

The responsibilities of the homeowners are to live in the home as their primary residence, keep the property in good repair, and remain current on real estate taxes and homeowners insurance.

“Many people have been told that a reverse mortgage is too expensive, but there are so many new programs with lower origination fees, no service fees, and even a purchase product, that folks can downsize from a larger home into a smaller more manageable home with no payment,” Begalle says.

Reverse mortgages are not for people whose priority is to leave their property to their children free and clear. The mortgages can affect the inheritance that children get from their parents, particularly if the children planned to inherit their parents’ home. Begalle says that if a reverse mortgage exists on a house, then upon the last parent’s death, the house would be sold, the reverse mortgage would be paid back to the lender, and any extra proceeds from the sale would be distributed to the heirs. The possibility of such a circumstance occurring should be discussed among family members before a decision is made about a reverse mortgage, Begalle says.

“On the flip side of that coin, reverse mortgages are all non-recourse loans – you or your heirs are guaranteed never to owe more than the value of the home,” Begalle says. “They are federally insured loans, which means if when the home is sold the homeowners owe more than what the house is worth, the insurance picks up the difference, and there is never any debt left to the heirs.”

“Also, if the children would like to obtain a mortgage to keep their parents’ home, they can do that,” Begalle says. “They simply get a loan for what is owed on the reverse mortgage and the home is theirs.”

Because some reverse mortgages are more expensive than other sources of financing, borrowers have to clearly understand the expected costs.  However, under the right circumstances, Begalle says, reverse mortgages can be an excellent way for older adults with equity in their home to tap that equity and remain living independently.

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Start Right | Finish Well

A recent New York Times article showed that a little known secret of investing is that historical returns can vary dramatically depending on starting and finishing times for the period of time in question.  Pick the wrong year, or decade, or even twenty year period, and you can fail to keep up with inflation.  But if you start right and finish well, selecting an opportune point of entry and have an optimum exit strategy, the market can be a wonderful place to invest.  The NYT chart shows clearly that the long-term assumption that "stocks earn 10%" is a dangerous presumption.  Investors who buy and hold are often frustrated if they think that "time in the market," alone, is a sufficient buffer against disappointment.

The stock market matrix chart was prepared by Crestmont Research and is a wealth of information, albeit in the form that only a chart geek (like me!) could love.  Take a look for yourself.  It's a work of art, in my opionion.

What investors should take away from viewing the chart is the question of what is a realistic return expectation?  One obvious point is that the chart has a lot of red color, and red represents time periods when stocks fail to keep up with inflation - and deep red probably means they failed to keep "up" at all!  There's a reason why we call it "red money" in our practice.  It requires active management, to coax more green into the mix, and those periods where anybody can make money in the stock market don't happen as often as we would like.

Ed Easterling, a Corvallis, Oregon-based investment advisor, observes in the article that, "market returns are more volatile than most people realize....even over periods as long as twenty years."  This is particularly true for investors who adhere strictly to a buy-and-hold strategy, whether - as we are known to observe - they are passive "by choice" or "due to inattention."

The 20-year median real return (the return above the level of inflation) is 4.1%.  If inflation increases at a 3% rate, which might be a reasonable long-long-term assumption, then a passively managed stock portfolio might be expected to return 7.1%.  That's not quite the 10% that many planners assume, and well under the presumed 20% rates of return that investors held during the technology bubble, when unrealistic thinking and irrational exuberance were the norm for investors and investment bankers, alike.

I'm not writing this to discourage investors from buying stocks.  Given the negative real rate of return facing bond and money market fund investors, stocks might be one of the best games in town - particularly if the companies in question can maintain pricing power.  However, stock investors need to go in with their eyes wide open.  Financial advisors who spout platitudes about how a long-term time horizon erases the risk, or how "time in the market" turns this risk profile upside down, are doing a disservice to their clients.

The best thing that can be said about stocks, in light of this chart, is that as bad as it looks, the bond chart probably looks worse!

 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Almost Finished

To save about $2 on the software, I converted from TurboTax to H&R Block for my 2010 tax return. Some people go to Las Vegas to gamble. I go shopping. My CPA does the business taxes, but for my personal taxes I use software because I figure they’ll have to throw about 20 million people in jail if it makes a mistake, and there just isn’t enough room in the slammer for all of us.

The I.R.S. has estimated that I can do my taxes in about 3 ½ hours, which is crazy. It took me longer than that just to buy the alcohol I needed to get me through the data entry process. It’s the same as when I used to have my CPA do my personal taxes, except that now there’s no issue when I search through the stack of receipts at midnight, in my underwear, which is something that used to drive my CPA nuts. No wonder he stopped working out of his house. In the movie version of my life, these forms are kept hermetically sealed in neat files, locked for security and ordered chronologically. In real life, I use a garbage sack with a twist tie.

The I.R.S. assigns letters and numbers to different tax forms. I graduated from the 1040EZ many years ago – about the time my braces came off, as I recall. Like many others, I use the schedule A because the government subsidizes the huge mortgage payment we took on when we bought a new house last year. Schedule A is also used to deduct charitable contributions, such as tithing. I find it somewhat humorous that the Administration is trying to reduce the tax break for donating to charity, but lawmakers of all persuasions are digging in to protect the right of Americans to buy more house than they need, which I consider to be more of a privilege and less of a “right.”

My tax return is a four letter form. Schedule D, for realized gains, is next. Isn’t it irritating that the government feels entitled to gain from our investment prowess, but that’s just the cost of living and investing in America. And, to be honest, since some of those gains are merely the result of inflation, and since the rate of inflation is likely to skyrocket as a result of current government policies, I guess maybe they do have a right to claim some of those gains as their own after all.

I’m fortunate that the letters in my return stop at “K.” The K-1 is used to report income, or lack thereof, from my business. Currently, I get to choose whether my lack of income is taken personally, flowing directly onto my personal income tax, or whether it is taxed corporately, in which case it will once again be taxed to me personally, as a dividend, should I ever decide that I need the money more than my corporation does. Thus, I get to choose whether the money is taxed once, or twice. Naturally, I choose the alternative which costs me the least amount of money. This freedom to choose between being taxed once or twice is receiving the scrutiny of Tim Geithner, my public servant who heads up the U.S. Treasury’s efforts to debase the dollar. To Geithner’s way of thinking, I should always have to pay taxes twice, although personally I would much rather just eliminate his salary, once and for all.

Then there is the “kiddie tax.” That will be the real test for my new software. Can it handle calculating taxes on the kids’ accounts? The examples given by the tax guides generally use the example of a single tax return, for a single child. It never occurred to the writers that some of us are slow learners and have more than one deduction.

I don’t know when I reached the stage in life where completing my tax return revolves around whether my K-1’s come in on time. It came on slowly. And each year it seems like I have more of them. It’s like a frog in the frying pan and this was my year to get boiled.

So I won’t be filing on time. I’ll file my extension, buy another six-pack, and revisit my taxes again in October. When I file, the IRS wants me to e-file. Filing electronically probably saves them data input time, and they don’t have to scan the document before they lose it. I figure that they ought to share some of the pain that I experience each year, so I fill each form out by hand, after the software has determined the correct dollar amounts. Then I crinkle the paper up so it won’t go through a scanner, and mix up the pages so that some agent in Utah has to sort out the 90+ pages that I send them before they can begin entering the data.

They estimated that it will take me 3 ½ hours to complete my return. I’m hoping that it will take them at least that long to sort out and type in my return. Maybe in 2012 they’ll send me a nice letter, asking me not to file at all. 
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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New Adviser Disclosure Brochure Coming Your Way

With the recent passage of the Dodd-Frank Wall Street Reform Bill (long name, even longer bill), it has become necessary for May-Investments to update and change our Adviser Disclosure – commonly known in the industry as an ADV.

For those of you not familiar with the ADV, the purpose of the form is to provide information about how we perform our business: who we serve, our fees, how we manage our accounts, invest money, and so on. The ADV is given at the time a client comes on board, and is made available and offered to clients on an annual basis.

Diane Gigliotti, May-Investments Office Manager, has been hard at work revising our current ADV (alongside Doug) so that it is compliant with the new law. She explained some of the changes. “The new law states that the ADV should be clearly written and current, with a meaningful disclosure of our business practices. Plainly put, the new form should be more user-friendly.” And while the form will maintain much of the same information, it will add more extensive data about the background of the firm’s adviser and advisory personnel.

For those of you who are scratching your heads at this point trying to remember what your ADV said, don’t fret, you will soon have the chance to find out! Where the old law required that we offer the ADV on an annual basis, the new law requires that we provide the ADV on an annual basis – so all clients will receive a copy of the new ADV in the near future. In the meantime, we still have the old ADV available for anyone looking for late-night reading material. We’ll provide the ADV, but you have to provide the cookies and milk!

Should you have any additional questions concerning the new ADV, please don’t hesitate to call the office at 263-5126 – we are always happy to help.

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"Relative P/E Investing" April 5 Educational Workshop

Can I teach readers how to buy a stock, in eight paragraphs, really? No. But I can briefly describe what I look for in selecting stocks for our portfolios. It’s not the only way to buy stocks, but it’s what we do.

We are looking for “undervalued” stocks – but who isn’t? For us, a stock’s intrinsic value is based on its demonstrated earnings power. We are likely to miss high potential companies that aren’t projected to make money anytime soon, but have the potential to be great. My boys and I stopped by the Tesla Motors gallery in Boulder when it opened in 2009. Tesla makes beautiful cars with exciting technology. It might be a wonderful investment. However, to pick a stock, first I want to be able to put a number on its intrinsic value. Without current earnings, it is tough for this analyst to place a value on the business. To me, current earnings power is one thing that separates the speculative bets from more conservative investments.

Contrarian investors tend to buy stocks with low absolute Price/Earning ratios. I cut my teeth in a contrarian shop. In today’s market, for example, Merck sells at about 8-times its projected earnings power. The inverse of the P/E ratio is the Earnings Yield. For Merck, it’s nearly 12.5%, quite a bit higher than what banks are paying depositors. Merck only pays out a portion of its earnings to stockholders in a dividend. The annual dividend yield is 4.7%, still better than a bank account, but well below the company’s earnings yield.

In the late-1990’s I converted from a deep value contratian to “Relative P/E” investing. Instead of being limited only to stocks with the absolute lowest P/E ratios, relative P/E investors value a stock relative to where it normally trades. This takes a bit of research to determine what the normal P/E ratio is for a particular stock or industry, but it opens the portfolio up to faster growing stocks. A technology company that normally sells at 20-times earnings but is now selling at only 10-times earnings might be a much better bargain than a slow-growing utility company that is currently priced at a lower absolute P/E ratio of 9, but has a normal P/E ratio of 10-times.

A return to a normal P/E ratio takes time, of course. How long it takes is a key variable. An untimely stock might take five years to right itself and return to a more normal valuation. Stocks that are more timely might already be in the process of being revalued back to a more normal level. The quicker the stocks return to normal, the higher the investors’ rate of return. So after comparing the intrinsic value of a company (based on its normal P/E ratio) to the current price in order to estimate appreciation potential, investors should estimate how quickly stocks can reach target in order to calculate the annualized estimated rate of appreciation on each potential investment.

Finally, dividend yields do matter. Merck pays investors waiting for the stock to go up 4.7% per year. Tesla owners earn nothing. For each of the stocks in our portfolio, and for a set of potential purchase candidates that sit on our “watch list,” we have calculated the total expected return, which is the estimated annual capital appreciation plus the current dividend yield.

After that, portfolio construction takes on much more of a macroeconomic feel. Which industries have strong economic fundamentals and are likely to be timely investments? How much diversification outside of the U.S. stock market makes sense. Should investors reduce portfolio risk by putting bonds or cash into what is normally an all-stock portfolio? These asset allocation decisions are crucial, but once the macro characteristics of the portfolio have been determined, stock selection mostly boils down to picking the stocks in each sector that have the highest expected return.
 
The best thing about having a discipline (almost any discipline!) is that it reduces the impact that emotions play in investing. Interviewing management creates emotional bonds. Falling in love with cool products can lead to disaster. I love Boston Market restaurants, and have ever since I started taking my fiancé to them for a cheap date in the early -1990’s. My devoted patronage didn’t stop the company from going bankrupt, however. But having a quantitative basis for buying a company, establishing a target price, calculating expected return, determining timeliness, and buying, selling or holding an investment takes out some of the emotion and can lead to better portfolio performance. 
 
On April 5, May-Investments will host a workshop on "Relative P/E Investing" at our offices.  Starting at noon, lunch will be served and Doug will spend the next 60 minutes talking about the stocks in the Timely & Undervalued individual stock portfolio, and how they were identified by the relative P/E methodology for inclusion in the portfolio.  Workshop attendees might want to bring a company of their own if they want to see the method applied to a stock of particular interest. 
 
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Estate planning remains important despite benefits of estate-tax law

The estate-tax law that Congress passed at the end of 2010 has many benefits for taxpayers, not the least of which is an exemption of $5 million per person. It also contains a “portability” provision that lets a surviving spouse claim the unused portion of the deceased spouse’s exemption, which creates a potential exemption of as much as $10 million for a couple.

However, despite the law’s benefits, people still need to consider creating a strategy for preserving and passing along wealth, says William H.T. Frey, a Grand Junction estate attorney and partner in the firm Dufford, Waldeck, Milburn & Krohn. Even if assets total less than $5 million, people need to think about setting up trusts and not relying on the portability provision.

Frey says portability can be a “trap” for tax purposes, and he suggests using a family trust rather than relying solely on estate-tax laws that can change at the whim of lawmakers.

A trust is preferable to the exclusion amount for several reasons. The first, Frey says, is that if the combined estates of the husband and wife exceed $10 million, use of the portable exclusion instead of a family trust exposes asset growth to estate taxes. The second reason is that the estate-tax law after 2012 (when the current law is set to expire) might not contain a portability provision, and consequently, the surviving spouse may not be able to utilize it. Third, if the surviving spouse remarries, and the new spouse dies, the exclusion that passed to the surviving spouse from the first spouse could be reduced.

The new law holds some benefit for business owners who want to pass their businesses to their children, Frey says.

“For business owners, I think it’s a golden opportunity to shift that business into the next generation with minimal transfer tax,” he says. Several types of trusts and other arrangements, such as gifting, can help minimize estate and transfer taxes, and Frey says this year is a good time for people with questions to confer with financial advisers about such arrangements, especially since the exclusion amount might be reduced in future versions of the estate-tax law.

“It’s probably worth spending the money to do estate planning now, even though the law might change in two years,” Frey says.

Frey also pointed out in a recent Estate Planning Council meeting that anyone wanting to use the portability of the exclusion on the death of the first spouse must file a 706 (estate return tax form) even though the new law does not require a filing if the deceased spouse's estate is under $5 million. If the laws do go back to the old levels, it may be important that the exclusion of the first spouse has been transferred to the surviving spouse to cover any assets allowed to roll over to the surviving spouse that become of their estate. Filing a 706 may be an expensive hassle, but for many affluent folks it will remain a necessary evil. So while the new law seems like reason for celebration, it is more important than ever to be certain your estate plan is up to date, now that we have a new set of temporary rules.
 
The discussion of tax issues and strategies in this article is not intended to be legal advice and is not intended by the presenter to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer. A taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax adviser. 

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Is Your Opinion Worth $25?

Retirement Outfitters, LLC (Barbara Traylor Smith's company) conducts a variety of different educational workshops about investment and financial topics in the local community. With the recent changes in the economy, we want to keep these workshops current and useful for our potential clients.

In doing so, we are looking to conduct focus groups to gather feedback from people who are planning for retirement, or are already enjoying that season of life. We ask for an hour of time and will be offering a $25 gift card for the hour and feedback. We even provide a light lunch!

The focus groups help us understand what consumers perceptions are of different financial products, current understanding and beliefs about the products, and if their understanding or beliefs change after a short presentation. We ask for written and verbal feedback during the hour. All of this allows us to focus our time and resources in the areas that are relevant to our clients.

If you would like to see if you qualify for our focus group, feel free to call Donnie Alexander at 256-1748 for information. Focus Groups are held at Retirement Outfitters (and May-Investments) office and space is limited to 10 participants so we can get input from everyone.  The next event is February 24 at 12:00 p.m. 

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Dodging The Estate Tax - For Now

At the end of 2010, when Congress rushed to make sure that the tax cuts of 2002 didn’t expire, the legislation contained good news and bad news , particularly regarding the estate tax.

The good news regarding estate taxes? There’s now a $5 million exclusion for individuals, which means that if you die, your estate won’t owe any estate taxes if it is worth less than $5 million.

The bad news? The new rules are in effect for only two years. After that, anything can happen.

“By putting the exemption at $5 million, they’ve done a lot of people favors by taking them out of the equation,” says Michael Lammers, Senior Vice President and Chief Trust Officer for Investors Independent Trust Co. in Boulder. “But there’s still a great need for people to do estate planning.”

Regardless of the amount of assets in a person’s estate, a plan for distributing those assets must be in place. Otherwise, courts decide how to handle the estate.

Surviving family members can find themselves in a difficult position when someone dies without leaving current estate-planning documents or a will.

“Dying without a will is not a good thing,” Lammers says. “It’s not that expensive to have a simple will in place.”

Lammers suggests that people consult a good estate-planning attorney to examine their options, even though the estate tax isn’t an immediate problem for most families. A good estate plan can make the distribution of assets run more smoothly.

Because the estate tax exclusion amount and other rules seem to change every few years, it is important for people to think about the structure of their estate, says Billie Castle, a trust and estate planning attorney in Grand Junction. Even families who did their estate planning years ago should revisit and update their plan.

“People did their estate planning with the idea that they would never have to touch it again,” Castle says.

However, certain arrangements involving marital and family trusts that once were effective now might be leaving people open to high capital-gains taxes, Castle says. Revising old estate plans and restructuring financial arrangements potentially can save significant money. Revisions also can introduce some flexibility into the plans to deal with changes that might come along after the current estate-tax laws expire in 2012.

“The old estate plans are more likely to bite somebody than the estate tax ever would,” Castle says.
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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Real Estate Investing: 'Not for the faint of heart'

Traditional investors hunting for better returns on their money should be cautious about venturing into income-producing properties, says an experienced real-estate investor.

Real-estate investing can have a strong upside. Buying a house or other income-producing property can produce a steady stream of rental income and result in financial-leverage advantages and tax shelters. Buyers of such properties can manage their risk more effectively if they are aware of the potential problems and pitfalls that come with such investments, says Ed Hokanson, a professional real-estate investor in the Grand Junction area with more than 30 years of experience.

“It’s a fairly sophisticated thing for somebody without experience in real estate,” Hokanson says. “It’s not for the faint of heart.”

Hokanson says investors shouldn’t buy real-estate with the expectation that the property will take care of itself. On the contrary, owning rental real estate can be a time-consuming job that requires strong management skills and even a little handyman knowledge. Those might be obvious requirements for investors who manage properties themselves, but investors who hire property management companies to run their rentals must know how to “manage the manager,” Hokanson says.

In fact, he suggests that investors manage properties themselves for two years before hiring a property manager so that they become familiar with the issues they will face as owners of income-producing property. In addition, the more you know about the property you own, the more efficiently you can manage that property and maximize your returns.

Another suggestion from Hokanson: “Don’t buy junk.”

Although foreclosed properties can seem like great bargains, many of them have sustained a significant amount of damage, courtesy of the former owners who defaulted and either neglected or trashed the property before leaving. Such properties can cost investors large sums of money to repair, and there’s no guarantee that more problems won’t appear.

The better investment properties tend to be existing homes or multi-unit complexes that have been kept in good shape and have stable tenants, or new properties that have warranties. Hokanson compares the process to buying a used vehicle: Most people would rather buy a high-quality used car or a new car, rather than a damaged car that requires continuous repair, and the same concept applies to the purchase of investment properties.

Hokanson says real estate can be an effective way to diversify an existing investment portfolio, but he suggests that investors make sure they are comfortable in the role of landlord before they put money into income-producing properties. That means they should be willing to take phone calls from tenants and should be prepared to handle the problems that can arise with buildings, from sewers to roofs and everything in between.

“People still need to know something about real estate before getting into it,” he says. 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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