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Financial Planning

Market Corrections – here we go again

Market Corrections – here we go again

We're not minimizing the concerns around market corrections. We've seen the market drop by around 6% in recent days although we’ve had a bounce and they’re now down 3.3% from record highs at the end of July.

We think this is all down to the trade, slowing economy and not-so-great news coming from overseas. One thing we do know is that small corrections are frequent and part of the pattern of stock market investing. We've also seen this before.

Take a quick look at the table below. In all the corrections going back to 1970, most market dips have seen quick recoveries.

So the message is, whatever today’s cause for stock market weakness, dips happen and happen often. You just don't need to react to them all.

  --Christian Thwaites, Brouwer & Janachowski, LLC

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

18 Lessons from 40 years of investing

When markets correct, it’s worth revisiting why we like stocks.

When you buy an equity, whether a single stock or basket of index stocks, you become an owner in the company. As a shareholder, you receive what’s left after the company pays its employees, suppliers, overhead, debts and loans. These costs tend to stay fixed. Revenues, however, fluctuate.

If revenues go down, because of a recession, competition or less demand, the amount left for shareholders will fall.

If revenues increase, because of higher prices, new products or general growth, the amount left for shareholders will rise.

It’s what makes equities potentially rewarding but frustrating in the short term. Stocks try to anticipate the changes to revenue and earnings. Because these are difficult to forecast, equities tend to overshoot in both directions. Sometimes they rise too fast too quickly. Sometimes the gloom is overdone.

Here’s a long view of the annual returns of the S&P 500 since 1929. These numbers do not include dividends which add somewhere between 1.5% to 2.5% a year.

The average return is 7.1% a year. The average up year is 17.6% and the average down year -14.4%.

Note that real rates of interest don’t seem to correlate well with stocks. Sometimes stocks do well in low real rates (early 1950s) and in high real rates (1980s). And sometimes the other way around as in 1945 and early 1930. It’s the rate of change that probably matters more.

Here are some of our lessons from decades of investing. We don't claim them as all original. Better and smarter men and women have come before us and will follow us. Nor is this list complete but generally we think about these things when markets start to move.

  1. Markets tend to return to the mean over time.

  2. Markets go up by the stairs and come down in the elevators.

  3. Markets do not correct by going sideways.

  4. Every market has excesses.

  5. There are no new eras, so excesses are never permanent.

  6. Everyone buys the most at the top and the least at the bottom.

  7. Fear is stronger than long-term resolve.

  8. Markets are dangerous when they trade on a handful of can't lose names.

  9. Bear markets have three stages: sharp down, a rebound and a drawn-out downtrend.

  10. When all the experts and forecasts agree, something else will happen.

  11. Bull markets are more fun than bear markets.

  12. Never trade on headlines.

  13. Being early and right is the same as being wrong.

  14. Prices change more often than the facts. Don’t confuse the two. (h/t David Ader).

  15. You are either an owner (equity) or a lender (a bond).

  16. There’s no such thing as an alternative investment. Just variations of #15.

  17. It is very rare that drastic market events require immediate action (See#12).

  18. Intelligent people do stupid things, especially if it’s easy to do those things.

Please check out our 119 Years of the Dow chart  

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 --Christian Thwaites, Brouwer & Janachowski, LLC

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

 

 

100 Year of Inflation and Real Rates - Updated May, 2019

We looked at 100 years of inflation. This chart shows: 

1. The annual change in US inflation

2. The real rate of 10-Year Treasury bonds

3. The names and start dates of the Fed chairs

4. Highlights from each year that influenced inflation

Our takeaway is that inflation remains low by historical standards and that it has not been much of a problem for nearly 30 years. The level of real rates looks very low and suggests more deflationary than inflationary forces.  

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice. We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security. The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended. Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data. Past performance is no indication of future results.

Why we’re not fans of Floating Rate Note funds.

Floating Rate Notes are back in the news. Here's our take. 

Original post August 2017. Updated April 2019

1.     What are they? Floating Rate Note (FRN) funds come out to play whenever there’s a whiff of interest rate hikes in the air. They are bonds that reset their coupon as rates move. So, if the initial coupon is 4%, they may move to 5% if rates rise or 3% if rates fall. The price of the FRN (or floaters) will, therefore, be less volatile than a normal bond because the reset reflects current conditions. Nice. The price should stay around par value. What could possibly go wrong?

2.     Who issues them? Typically governments, financial companies and industrial companies. For governments, it's  a cheaper way to borrow for short periods and for financials, the liability of the coupon payment (i.e. it goes up and down) is very similar to the income of their assets (i.e. bank deposits). That’s not always the case for a manufacturing company.

 3.     How often do rates reset? First, understand that the reset period and the coupon period are independent. Coupon payments may be quarterly, semi-annual or annual. Reset periods are mostly quarterly but can be daily or annually and pretty much everything in between.

4.     What determines the reset? For U.S. Treasury FRNs it's relatively easy. The rate calculates as a spread from recent T-Bill rate auctions. Recent spreads have been in the range of 4bps to 7bps. As of writing a U.S. FRN maturing in October 2018 yields around 1.36% and a three-month T-Bill yields 1.25%.

For corporate bonds it’s more complicated and many FRNs are tied to a LIBOR (London Interbank Offered Rate and see below) spread and is often called “the index.”

5.     What are some examples of FRN? Let’s look at three examples. Some are quite straightforward. So first up, the Goldman Sachs FRN November 2018, which is a large component of the Bloomberg Barclays FRN  <5 Years Index. It has a BBB rating and pays a coupon of three months LIBOR plus 1.1% and has a yield to maturity of 2.19%. It’s a senior note and non-callable. For the last twelve months, the price has been between $100 and $101.

6.     Got it! And another? But to provide investors with a higher yield, things become more complicated. So for number two, let’s look at a major FRN fund’s largest holding, which is First Data Corporate New Dollar Term Loan, 3.00%, 7/08/22. There are several things to note here:

  • It's a term loan, which means it’s a loan originated by a bank and then sold to investors.

  • It's not tied to LIBOR but to ABR (Alternative Base Rate), which is a mix of LIBOR, Fed Funds and the prime inter-bank rate.

  • It’s not rated. This doesn't mean it's a bad credit just that given the amount of the loan, at $725m, a credit rating was probably too expensive.

  • It comes with covenants, which lower the payment to investors if the company’s EBITDA falls below a certain ratio.

  • It's thinly traded and is a Level 3 asset. This means there is no observable price (like a trade) so values can only be calculated using estimates or risk-adjusted value ranges

7.     Are there mortgage or asset backed FRNs? Indeed there are, which brings us to our third example. One high quality FRN fund that holds Federal Home Loan Mortgage Corporate FRN of 25 Feb 2046 looks like this:

  • It’s backed by individual Adjustable Rate Mortgages or ARMs and by FNMA

  • It has a floor rate of 0% and is based off LIBOR 1-month. They can change the index any time

  • It's subject to the normal pre-payment risk and the experience of the underlying mortgages.

8.     LIBOR is going away, so what happens to FRNs? The end is coming for LIBOR after banks manipulated the rate. It used to be that banks would report the demand for inter-bank funds, in any currency, take a daily average and publish the LIBOR rate. But with LIBOR going away in 2021, it looks like each country will take its own approach. Meanwhile, there is confusion all round. In the U.S., the Fed thinks there is no trading in about half of the standard LIBOR notes. This is why funds have to use Level 3 pricing. The Fed has yet to come up with a solution.

Bondholders could be at risk because if there is no LIBOR rate, issuers will use a “fall back rate” which will be the last, and increasingly stale, LIBOR rate. So if rates increase, investors could be left with low paying bonds and prices will adjust down.

9.     What has been the experience of FRN funds? Funds holding high quality rated floaters pay a little more than money market funds and should have a stable NAV. The trouble begins when funds chase yield and buy lower quality assets. Here’s a chart:

FRNs 2_BFRIX-USA.jpg

One of the promoted benefits of FRNs is low correlation to other fixed income assets and low volatility of principal. As you can see in 2008, rates fell and the recession began to bite. The problem with the FRNs was that credit fears took over, default fear rose and the price of the two FRN funds shown fell some 20%.

The next problem was in early 2016 when rates began to rise but the FRNs rate reset was slow to follow. So fund investors were left holding a lower rate bond at a time when rates were increasing. This time the price decrease was around 5% to 10% depending on the fund. Meanwhile benchmark long bond (the blue line) increased in price.

10.     And performance? Here’s a quick recap through November 16th 2017:

frns table.jpg

So what can we conclude?

  • FRNs should have a stable price but many don't especially if the credit cycle is deteriorating or rates are rising fast

  • Stretching for yield often means credit quality declines.

  • Many of the securities are illiquid or use Level 3 pricing.

  • The higher the quality of the FRN fund, the more it's likely to concentrate on financial stocks. The Bloomberg Barclays FRN <5 Year index has 65% invested in financials.

  • FRN funds seem not to have performed better than high quality bond funds in both rising and declining rate environments despite taking i) more concentration and ii) credit risk and iii) less interest rate risk.

Give us a call if you’d like more information.

Other information:

Fannie Mae on floaters

Quick definitions

How it's taught at business school

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Take me to Attorney Briefs

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Take me to Attorney Briefs

 

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted. 

10 Items to check on your Statement

10 Items to check on your Financial Statement

 Brokerage and investment statements can be tricky to read. This is a quick read. The mantra is check, check, check and ask. It's your money. Here are 10 things to look for:

1.     Mutual Fund Share Classes: There are many! Check the five letter ticker. The last letter is always an "X". What you don't want to see are any “B” or “C” or “R” class shares. They're expensive and probably pay the broker a trail or 12b-1 fee. How can you tell? Well, one clue is that a B, C or R will be the penultimate letter in the ticker just before the “X.” What you do want to see is “A” or “I” in the ticker and, preferably, with “LW” or Load-Waived at the end (e.g. AGTHX.LW). (Note 1) 

If in doubt call and ask “Am I invested in the cheapest available share class?”

2.     ETFs: Most tickers will be three or four letters. There are some with clever ticker names, which are marketing driven and possibly geared more towards traders. So EEM is iShares $32bn Emerging Markets Fund. It carries an expense ratio of 0.7% and has underperformed its index. IEMG is another Emerging Markets ETF from iShares but it costs 0.14% and has outperformed its index. If you have an ETF with a cute name (AMPS, MOO, BLNG, CAFE) just, you know, double-check it.

Some ETFs are ETNs. This means that they invest in derivatives and they will probably incur roll costs. Some ETNs and ETFs will also have “ultra” or “2x” or 3x” which means they're leveraged. We won't touch these and you shouldn't either. Look in your statement under the ETPs (Exchange Traded Products) section.

3.     Tickers: U.S. listed ETF and stock tickers are straightforward. They're usually two to three letters. A lucky few have one. If they have “ADR” after them, they're foreign stocks listed in the USA and will usually end in "F" or "Y", so NSRGY for Nestle in the US. If the ticker has three or less letters, it means the stock is listed on the NYSE. If it has four, it’s listed on NASDAQ. (Note 2). If the ticker ends in a “Q” it means the company is bankrupt so, unless you’re into protracted legal dealings, don’t buy it.

Some tickers have cute names too but they don’t carry the same concerns that we have for ETFs. So, SAM is Boston Beer (from Sam Adams beer), TAP is Coors, Mammoth Energy is TUSK and Nordstrom is JWN, the initials of the founder John W Nordstrom. FIZZ is the National Beverage Corp. The list goes on.

Mutual fund tickers can be tougher. They will have five letters and an “X” at the end (e.g. POAGX). If they're a money market fund, they will have two Xs (e.g. AJLXX). The first letter usually shares the first letter of the fund company’s name. So, Vanguard funds start with a V, Fidelity funds with a F, and so on.

Option tickers are a different animal. The company ticker may not be the same as the regular ticker. Additional letters indicate the strike price and the month of the option. 

4.     And what if it's a bond? Then it won't have a ticker but a CUSIP (pronounced Q-SIP), which is a string of nine numbers and letters. The first four or six numbers identify the bond issuer, so 9128 means it's a U.S. Treasury, 13062 means it's the State of California, 037833 means it’s Apple and so on. The next two identify the actual bond and the last one is an accuracy check system.

5.     Cost Basis: Not all statements have these but you should know where to get them. The cost basis on mutual funds, ETFs and even stocks will change constantly if you have elected to have dividends or capital gains reinvested. You should also ask your broker or financial institution what basis calculation they use. They should ask you at the time of any sale of securities.

6.     Yield: For equities this is simply the latest quarterly dividend multiplied by four, divided by the share price. It’s a current yield and probably won't be the same as you have actually received in the prior twelve months.

For bonds, it’s more complicated. The yield is the annual coupon on the bond but if it’s a premium bond things can get tricky. First check if the price you paid for the bond was more than $100. If it is, you have a “premium” bond. Now you have a choice. For example, a bond that you paid $11,000 for will redeem in 10 years at par so you can either amortize the premium of $100 a year or you can pay income tax along the way and take a capital loss. (Note 3) 

7.     Transactions: In the back of the statement you will find a list of transactions. Some will reflect reinvestment of dividends and capital gains. We're not concerned with those. But look at other transactions for stocks, bonds, ETFs and funds. Transactions are not free. Many brokerage firms charge for a purchase or redemption of a security and even if they don't, you will still incur the cost of a bid/ask spread. Add up all the transactions on your statement and divide it by the market value. If the transactions amount to more than 30% of the market value, you may want to find out why.

 8.     Fees: If you use a broker or adviser, the statement should show the management fees. If it’s a quarterly statement, multiply the amount by four to get an annual rate and divide that by the total market value. Anything over 1% is high.  

 9.     Income: Every line item on your statement should have an income number. Even if it's a stock that pays no dividend, there will typically be a dash (“-“). Income should also be consolidated with your account summary. Check it. It's one of the most important numbers of your investments. Review the maturity dates of your bonds. The capital will usually be reinvested but, again, check. Don't confuse 1) yields with total investment returns or 2) estimated annual income (EAI) or estimated yield (EY). These are only an estimate and will change.

10.     Current Price: All investments should have a current price as of the date of the statement. Some illiquid stocks may have an old price from a prior date and some (and this is bad) will have a n/a, which means it's no longer traded. Also, check the prices of a security you don't recognize against an older statement. If the price hasn't changed much, it may indicate it doesn't trade. (See Note 4) 

Useful websites

Everything you need to know about CUSIPs

Investopedia: Wikipedia for investing. Generally (but not always) good.

Understand option tickers

Notes

1. Also look to see if you are invested in more than one share class of the same fund. This can happen if you have a consolidated or household statement, which combines multiple accounts (e.g. IRA, Roth, Trust, taxable). You want the one with the highest price because that will be the cheapest.

2. If you see something like LON, SWX, MEX, WBO or BATS after the ticker, it means the stock is listed overseas (so London, Switzerland, Mexico or Austria) or on multiple exchanges (BATS is an electronic exchange).

3. Here's where your CPA and the 1099-INT IRS form comes into play. Worst case is that you end up paying full income tax on the fixed income yield and end up with an undeclared capital loss. So, pay attention to those bond prices.

4. A good rule of thumb is that the longer the company name (e.g. Vantage Drilling UTS, INTL STPLD C/O Ord SH & 1%/11/2% Step up SR SECD), the more likely it's an illiquid stock.

10 Financial mistakes people make in a divorce

It’s the most stressful of times. People experience loss of self-esteem, weight loss , and anxiety going through a divorce. It's not the best time to be making life changing financial decisions. Divorce attorneys are experts on the legal side but not always on financial issues. Too often, settlements end up with a straight division of assets and that’s when problems begin.

 Here are the 10 most common mistakes people make:

1. 401(k) and IRA beneficiaries. The legally required default beneficiary designation is for the spouse to receive the assets. That means that if you or your spouse never named someone, it defaults to the spouse. That’s what your 401(k) provider, broker or mutual fund company will have on record. Make sure you change these.

 2. Insurance beneficiaries. There is typically not a default life insurance beneficiary. But make sure these are changed or updated, especially the group life insurance policies offered by many employers.

 3. All about the house. It’s tempting to take possession of the marital home especially if you're the one with most custody. But wait. Take a simple division of $500,000 in investments and $500,000 in a house.  

  1. Selling a house will cost at least around 5% of the value, so the realizable value is really more like $475,000 and probably less. The investments, meanwhile, have little or no transaction cost.

  2. Investments, especially stocks, will likely grow more than housing especially over the long term. There are a few exceptions in some tight housing markets but it’s rare for property to rise faster than stocks.

  3. Houses are expensive. Upkeep of a house, taxes, depreciation, insurance, repair and utilities can cost anywhere from 3% to 5% of the value of the house. And that excludes mortgage payments. Don't have too much emotional value tied up in the house. And make sure you don't underestimate upkeep costs.

4. Some investments have more growth potential. Or, put another way, not all investments and assets are equal. A $100,000 investment in Apple is not the same as $100,000 Tesla Model X. Don't confuse the two and don’t be tempted to take what looks easier. Investments held in tax-deferred accounts like 401(k), IRAs, and deferred compensation are generally more tax efficient than those held in taxable accounts. But there are tax consequences when you withdraw, and penalties if you’re under aged 60. So, check with a CPA or Financial Adviser.

5. Valuing public and private stock. Some employers offer stock in retirement plans or as part of a compensation plan. Make sure you receive an independent present and future value of the stock if you give up some of your ownership rights.

6. Ensuring continuation of child support and alimony. The requirement to pay either is only as good as the spouse’s ability to pay. So, take out a life or disability insurance policy on your ex-spouse to maintain payments in case something happens. You may have to pay the premiums to ensure the policy does not lapse.

7. Understanding your debt. Any unsecured debt incurred in a marriage is a shared liability regardless of who holds the debt. So, student debt incurred when single but refinanced when married, becomes a joint debt. Same goes with credit cards. It's best to settle all these before finalization of divorce.

8. Valuing Defined Benefit Plans. These typically pay an employee a guaranteed lifetime income at retirement. They're often offered by state or local governments, union or educational employers but there are plenty of companies that still offer them. You’ll need to calculate the present value of a defined benefit plan. This can be tricky and will depend on when it starts, interest rates, income and age. But, roughly, a plan that pays $2,000 a month in retirement is valued from $200,000, if it starts in 10 years, to $480,000 if it starts immediately. Do not underestimate the value of these plans just because they start in the future.  

 9. Have your QDROs in place. A Qualified Domestic Relations Order or QDRO is a legal document attached to a 401(k), 403(b), 457 or any qualified plan. It orders the plan administrator to pay the non-employee spouse their agreed share of the qualified plan. The payments may not be due for many years so it’s important the new beneficiaries are in place at the time of the divorce. Trying to do them later can be a major headache.

 10. All in the details. Ok, this is a catch all. But remember to update the will, any Power of Attorney documents, Advanced Healthcare Directives, investment accounts, credits cards, bank and mortgage accounts, utilities and phones. Anything where there’s a joint name or ownership. And if you haven’t understood or kept track of all the investments and assets when married, now is the time to start. Don't delay. You are now fully responsible.

 And a final thought. You’ll need a Financial Recovery Plan after a divorce. Your life style will probably need to change. Check your expenses and budget. And start a savings plan. Even if it's  $50 a month. It’s a start and will help you feel in control and that you're building some financial independence.

 Some sites

 Running costs of a home

Finding a financial advisor

Check your Social Security status

Spending habits after divorce

Brouwer & Janachowski, LLC

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

Don't forget Dividends

Dividends are a very important part of successful investing. The chart shows the S&P 500 price return and the S&P 500 total since 1988. Starting with $100 in 1988, the investor carefully reinvesting dividends would now have $2,107, a 10.7% compound return. The investor in the price only S&P 500 would have $1,046 or 8.1%.

The difference of 2.6% a year meant the dividend investor retired with almost double the amount.

 --Christian Thwaites, Brouwer & Janachowski, LLC

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

10 Questions You Must Ask Any Financial Advisor

1. Are you a fiduciary?
A fiduciary must put the client’s interest first. And is legally liable if they fail to do so. So they can't act for their firm, their personal income nor for any product they may represent. An advisor as fiduciary cannot have any conflict of interest and must state all fees clearly and in advance. It is a binding legal relationship.

If you get no further on this page, ask this first!

A fiduciary has a higher degree of accountability than “suitability.” For example, it may be “suitable” for a client to invest in high-commission, high-cost mutual funds simply because it meets a client’s growth objective. But a fiduciary must take the next step and show that a fund is as low cost as possible, with no hidden fees and disclose what, if any, fees or rewards they may receive from any third party.

 The answer you should look for: "Yes, I am a fiduciary under the requirements of the Department of Labor Fiduciary Rule (more here)"

2. What investments do you use and do you recommend proprietary products?
Some advisors use only non-affiliated investments, some use their own in-house funds and some do both. There’s nothing inherently wrong with any of them. Vanguard, a very reputable firm, may only recommend Vanguard funds on the basis that they have many funds and they're among the cheapest in the business. However, there are plenty of times when the in-house funds are neither the best nor the cheapest option. Either way, you need to know if your advisor can use any fund to meet your needs. And that the investments are tailored for you.

The answer you should look for: "Yes, we can provide funds from multiple investment firms."

3. How are you compensated?
An advisor may receive fees from you, the client, and commissions from selling you a mutual fund, annuity or insurance product. They may also participate in sales competitions or other awards. A fiduciary advisor receives only the management fees paid by the client. And these fees are agreed on and disclosed up-front. They should be in the range of 0.5% to 1.2% depending on the assets.

The answer you should look for: "Yes, we only receive management advisory fees from you the client. We receive no other incentives, commissions, cash or non-cash compensation, soft dollars or inducements."

4. How much turnover in my portfolio should I expect?
There are three expenses you must know:

  1. Your fees (see #5)

  2. Fund expenses (see #6) and

  3. Turnover expenses

The third is a function of the trading costs (see #5) times the number of trades. Generally, the higher the turnover, the higher your expenses. Any number above 50% should ring alarm bells.

The answer you should look for: "On average, our turnover is between 5% and 15%. It can depend on market conditions but we aim to keep turnover low."

5. What are my fees, trading costs and any other expenses? Investment expenses can be one of your highest household bills. You will want to know what you pay in management fees, trading and any other account maintenance expenses. You should know what these will be every year, although some, like trading costs, will depend on the amount of turnover in your portfolio. If you're paying more than 1% in management fees, well, you shouldn't be.

The answer you should look for:  "We charge x%, depending on the size of your account, and around $5.00 for ETFs and $20 for mutual funds. And that’s per trade not per share."

6. What are the average total expense ratios of the funds you might recommend? In today’s world of lower expenses, you should not pay high expenses for your investments. If it’s a mutual fund, you should be invested in Class I or “A shares at NAV”. Not Class B or Class C. Expect to pay less for an index fund. A reasonable average would be 0.5% for equity funds and ETFs and 0.4% for fixed income funds. If they’re index funds, cut another 0.2% to 0.3% from those numbers. There’s plenty of information on the importance of low cost funds.

The answer you should look for: "We offer low cost, no commission index funds and ETFs. The weighted average expenses of our portfolios do not exceed 0.6% (and lower is better)."

7. Who custodies my assets? A custodian (usually a bank) holds title to your assets. It will ensure your assets are not commingled with other clients (which was one of the problems at Madoff). You want to make sure that a reputable U.S. domiciled custodian holds your assets. You should also have a choice of custodians, for example, Schwab, Vanguard, Fidelity, TD America, NATC.

The answer should you look for: "Your assets are custodied at [this should be a company you know] and independent of our [the advisor’s] operations. It is your account, not ours. You can instruct the custodian to change or fire your advisor at any time."

8. How are investment decisions made? You will want to understand how investment decisions are made and how they take your personal circumstances into account. Some investment processes are quantitative, some value based. Some are committee based and modular. Others are more fluid. But everyone should have a thorough systematic method that you understand. Your advisor should be part of the decisions and must take into account your needs, taxes, objectives and risk tolerance.

 The answer you should look for: There are many choices. Just make sure you understand them and listen for the phrase “…depending on your needs and goals”.  

9. Are my investments in public, tradable securities?
Most advisors use public stocks, mutual funds, ETFs and bonds. These are all traded daily on national exchanges and platforms. Some advisors offer non-public investments. These may include venture, real estate, private equity and hedge funds. These will be i) expensive and ii) illiquid. You need to know if your assets will be invested in non-public funds.

The answer you should look for: "We use public securities. If we propose any non-public funds or pooled investments, we will explain all costs and liquidity limits clearly before we invest on your behalf."

10. How much experience do you have, who will look after my account and what succession plans do you have?
OK, we know these are three separate questions. But they’re all to do with the personal side. Look for a minimum of 10 years investment experience. You don't want an advisor learning the job on your time. Check for designations like Certified Public Accountant (CPA), CERTIFIED FINANCIAL PLANNER™ (CFP®) (1), Chartered Financial Analyst® (CFA) or Juris Doctor (JD).

Find out who actually manages your account. It’s common for firms to have one person “pitch” the account and another manage it. And ask for references.

Finally, the advisor should have a detailed succession plan in case something unexpected happens. Your high level of service should not change and the same group of experts should continue to provide your wealth management and financial planning needs.

Check the experience and background of your advisor on the FINRA website or the firm on the SEC website. If they're not on these sites, leave immediately.

The answer you should look for: Your primary advisor and team has 10 years of investment experience through all market cycles. Your management team includes [get introductions to at least three people] and the firm’s succession plan ensures full continuity.

Selecting a financial advisor is a very important step. If they do their job right, you will be working with them for many years. Take your time. Make comparisons. And use these questions.

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Some useful web sites

DOL Fiduciary Rule explained

Why low expenses matter

Video on fiduciary and brokers (it's fun and informative)

New York Times: 21 Questions you should ask your broker

Mutual funds share classes explained

Financial regulators

SEC search on your advisor’s firm

FINRA search on your advisor or broker 

Everything a custodian does

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice. We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security. The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended. Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data. Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

1. the Certified Financial Planner people insist on caps!

Retirement Checklist - Are you on track?

Your Retirement Checklist

Saving and investing enough for retirement is daunting. Here’s a Checklist to help you stay on track. Don't worry if you can't do all of these. These are all good habits but none of us are perfect. 


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Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice. We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security. The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended. Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data. Past performance is no indication of future results.

Stocks staying ahead despite trade

The Days Ahead: More corporate earnings. Industrial production.

One-Minute Summary: We’re in earnings season and it’s going to be a cracker. In most earnings seasons, companies “beat” expectations because that is how the game works. Analysts put out an estimate early in the season, the CEO (well actually normally the IR guy) sucks their teeth and says, “dunno about that…”, the analyst revises down (this can repeat a few times with knowing winks), and then the company comes in and beats. Everyone happy. That’s why 70% of companies beat every quarter. It’s not that CEOs are great or analysts incompetent. It's just how it’s played.

Anyway, if you're a CEO of an S&P 500, 400 or 600 company, you didn’t even have to show up in the first and second quarter and you would have a 10% to 15% gain in earnings just from the lower corporate taxes. But if you did show up and threw in some growth and buy-backs, then your earnings will be up 22% YOY this quarter.

So, we’re celebrating a great earnings season. But most of that was in the price of the S&P 500 seven months ago, which is why stocks haven’t moved much so far this year (although up 7% from the February mini-crash). Yes, small company stocks and growth had another good week.

There were good economic numbers as well. Job openings were strong, inflation moderate, producer inflation in control but the headlines were dominated by the latest round of tariffs, which now includes onions, buffalos and maleic acid (no idea, sorry) but not cell phones or computers. And of course NATO and BREXIT. Normally, when these stories dominate the fireworks are in FX markets and that was somewhat true last week. It seems as if markets are “What’d he jus’ say? He can't mean it. We hope he doesn't mean it. He doesn't mean it.” That cycle takes about two hours these days. Tailor made for neurotics.

Stocks were broadly higher here and in Europe but on summer trading, which always has a torpid feel. The 10-Year Treasury was flat but 30-Year Treasuries strong.

1.     The next recession. One of our favorite commentators over at Financial Intelligence asked this question recently.  One lore is that recessions do not die of old age; the Fed murders them.  Which is nonsense. Recessions are normally preceded by over leverage, inflation and crisis of confidence. The Fed is merely the instrument that starts the rate cycle.

 The Fed started hiking rates in 1972, 1976, 1986, 1993 and 2004, all without triggering a recession. And in some cases, as in 1973, 1984 and 1994 they started to lower rates some two years before a recession. And that points to another problem: insufficient data. Whenever you hear someone say “a recession always come when…” you can quietly muse that there have been eight recessions in the last 64 years (so 12% of the time) and 18 in the last 103 years. If a researcher from one of the hard sciences showed up with a theory based on 18 data points, you might politely sigh.

Anyway, here’s what we think might cause some problems:

  1. Politics and trade
  2. The fiscal stimulus from the 2017 tax changes running out sooner than expected
  3. High federal debt
  4. Corporate leverage

We don't really think the consumer is a problem this time round. Yes, things like student debt are off the charts and consumer and mortgage debt are at all-time highs in absolute terms. But so is GDP and we’re fine with personal debt growing in line with nominal income. Consumer and mortgage debt is now around 70% of GDP from a 2009 peak of over 90%. Also, we’ll stick to our belief that the forces causing the recession last time don't get to do it again. So, the consumer gets a pass this time round.

Corporate debt is a different story. Here it is:

This shows corporate bonds owed by non-financial companies (blue bars) doubling from 2008. But they've also increased cash so the net borrowing is around $4.5 trillion. That reached a record level of over 20% of GDP two years ago and has since plateaued (bottom graph).

We've excluded other corporate debt, like bank loans and payables. We'd add that not all these companies are financially stretched. Still, it’s a high number and at some point, rising rates, if only at the short end, are going to make life difficult for companies. That’s why we've been lightening up on corporate credit for the last few months.

2.     What's inflation up to? Not much. Last week’s report showed headline inflation at 2.8% and core (so knock out food and energy) at 2.2%. This is above the Fed’s goal but i) the Fed uses the broader PCE measure of inflation and that’s at 1.9% and ii) there are some important base effects going on, that we've written about. The main one is cell phone rates, which fell sharply last year when Verizon cut prices, and used cars, but both are pretty much done. The Fed’s, rather difficult, job is to differentiate between temporary and entrenched inflation.

The Atlanta Fed tries to do this with its Sticky and Flexible measures of inflation. Sticky prices are ones that don't change too much. The classic example is coin-operated laundries, which change their prices once every six years. The list also includes fees, rent and medical costs. Flexible prices are those that change a lot. So things like vegetables, gas and clothes change prices every few weeks. This is what’s going on with the two:

As you would expect, Flexible prices are volatile with prices swinging from -3.0% to 3.5% in the last year. Sticky prices are moving much more slowly and haven’t changed their rate of growth much in the last four years. We think it's likely to stay that way. And as for wages?

They're not keeping up with inflation (black line). To some, this is a puzzle. Low unemployment, low participation and a tax change trumpeted as good for workers and their wages should lead to wage increases. But, no. There has been some increase in hours worked, so take-home pay is up. But it's by a very small amount. For us, real wages have to increase to push inflation up meaningfully and, so far, ‘aint ‘appening.

Bottom Line: More good earnings numbers coming up. Stocks are within a whisper of all time highs but, if companies report concerns about tariffs, expect some weakness. We still favor small company stocks

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SEC drops whistleblower prog

Young billionaires

 --Christian Thwaites, Brouwer & Janachowski, LLC

 Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.
All charts from Factset unless otherwise noted.

Detectorists

The Value of Advice

The Value of Advice

We’re not suggesting a bubble… but maybe now is a good time to talk to an advisor? 

 

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Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted. 

What Tax Diversification Means To Your Retirement

No doubt many of us have encountered the familiar dilemma of navigating the pros and cons between tax-deferred or Roth accounts when saving for retirement. While discussion of the topic is pervasive, much of the information out there fails to explicitly explain why the choice is an important one. Further, many oversimplify the decision along the narrow lines of whether or not one believes he/she will be in a higher or lower tax bracket in retirement than he/she is now.

This framing inherently fails to acknowledge the complexities and the planning that a successful draw-down strategy should incorporate, as well as the small fact that it is (currently) impossible to predict the future. Behind all the talk of Roth vs. tax-deferred is the fundamental concept of tax diversification—a broad term that is central to positioning one’s wealth in order to most tax efficiently tap assets in retirement.

When we think about the most likely (and widely used) sources of retirement income, it is useful to understand their differences along the lines of tax treatment in order to grasp the importance of tax diversification. Here’s a chart summarizing this information.

tax-chart

Keeping the above basic assumptions in mind, let’s look at three different draw-down/distribution strategies to demonstrate why tax diversification is important.

Let’s consider a married retiree at the age of 65, with both a tax-deferred IRA containing $1 million and a Roth IRA with $1 million. She has decided that she will need to draw approximately $80k per year from her retirement accounts, and she and her partner have no other income at this time.  For simplicity’s sake, let’s also imagine that she’ll be taking the standard deduction on her tax return.

Scenario 1: Take the annual required $80kfrom her tax-deferred IRA.

Scenario1_Tax-Diversification.png

She would withdraw $80,000, as well as an additional $7,968 to service her income tax obligation, for a total withdrawal of $87,968. Her effective tax rate would approximately be 10% ($7968/$87,968), and her marginal tax rate would be 15%.

Scenario 2: Take the annual required $80k from her Roth IRA

Scenario-2_Tax-Diversification.png

Because all the funds in the Roth account are after-tax assets, our retiree would pay no taxes on her distribution, with her effective tax rates being 0%.

Scenario 3: Take a portion of the required annual income from both the tax-deferred and the Roth IRAs.

Scenario-3_Tax-Diversification.png

The retiree would take $20,500 from her tax-deferred IRA, and the additional $59,500 from her Roth IRA. She would pay $0 in taxes with an effective tax rate of 0%.

While scenarios 2 and 3 have equal tax consequences, scenario 3 may be more advantageous because it not only eliminates a tax bill, but also preserves more funds in the Roth account by drawing a portion from the tax-deferred account, thereby lowering future Required Minimum Distributions.

RMD-Graphic-300x225.png

These are fairly simplified examples, but they do serve a purpose in demonstrating why tax diversification is important and why the same amount of annual retirement income can have quite different tax consequences depending on which type of account we draw from. When we add required minimum distributions, social security, and taxable investment accounts to the mix, an extra level of complexity is added.

5 Key Take-Aways/Strategies

  1. Roth funds can give you an enormous amount of flexibility in your drawdown strategy.

  2. RMDs can inadvertently keep you in a high tax bracket if you have high balances in your Traditional IRAs.

  3. Consider easing into retirement through a year or two of part-time/declining workload, as well as deferring Social Security to give you some lower earning years in which to convert tax-deferred assets into Roth funds (Roth conversions).

  4. Use proper (coordinated) asset allocation to optimize the value of retirement accounts for tax efficiency and tax diversification strategy.

  5. Taxable assets have a purpose in funding retirement-- like helping to keep you in a lower income tax bracket (capital gains vs. earned income), but should generally be funded after tax-sheltered accounts when saving for retirement.

 

-Emily Taken-Vertz

Have Questions? E-mail me: etakenvertz@bandjadvisors.com

 

For general information purposes only and should not be considered an individualized recommendation or personalized investment advice.  This information does not constitute and is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Brouwer & Janachowski recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager.  All expressions of opinion are subject to change without notice.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

Hog Wash

The Days Ahead: Employment report and probably some trade talk. Shorter week.

One-Minute Summary: Markets lost their patience with the trade issues. Ye gods, on Friday the rumor was that the U.S. will withdraw from the WTO. That actually require an act of Congress so no immediate threat. The market recovered from its lows but there was a general risk-off theme.

The 30-Year Treasury had a good week, with yields falling from 3.08% to 2.96%. Why? Well, we’re in the middle of a great quarter for growth. We know this because 1) first quarter GDP was revised down to 2% 2) since the crisis, there are some very weird seasonals not captured in Q1 that flow through to Q2 and 3) with things like a lower trade deficit, the GDP now model is flashing around 4% growth.  There have been some quarters of 4% growth since 2009 but they have very quickly rolled over to the lower average growth of 2.0% to 2.5%. We think that’s going to happen again. The decline in the 30-Year Treasury yield tells us the market is not convinced growth will last.

A rough week for Emerging Markets, which are dominated by the dollar, interest rate and trade issues. We're watching to see how China reacts. They may impose more tariffs. But they could just 1) weaken the Renminbi 2) sell U.S. Treasuries or 3) go after U.S. companies doing business in China from China. Apple has 18% of its sale in China and another 18% in Asia Pacific. Any iPhones sold there are made there. If China was to start making life difficult for firms selling in China, then goodbye Queensberry and hello cage fighting.   

1.     Markets are jumpy – maybe because there are fewer defensive stocks around. Stocks feel like they're volatile but the standard deviation and VIX numbers are pretty much in line with levels from two years ago. It’s only against the unusually low 2017 levels that it feels more risky.

 But in some ways the market as a whole is a more risky animal than in past years.

 We looked at the classic defensive sectors of the S&P 500. So, that’s utilities (e.g. DUK, SO) telecommunications (T, VZ) and consumer staples (PG, WMT, KO, MO). We took their combined market capitalization as a percent of the S&P 500 market capitalization. Here it is:

Defensive stocks have indeed fallen to a near all-time low of 12% of the market from 21% in the pre-crisis era. Some of that is because these companies face more competition and they’re just not great businesses. But some is because big companies keep getting bigger because, well, they are good businesses and there has been little to no anti-trust enforcement.

So, Amazon is 25% of the Consumer Discretionary sector and accounts for 35% of the gain in the S&P 500 this year. The top 10 growth companies account for 100% of the gain. And the top four tech companies (AAPL, GOOG, FB, MSFT) are 42% of the tech sector.

It’s going to get worse too. In the fall, S&P will create a new sector called “Communication Services” by taking some stocks away from tech and consumer sectors. When that's done, the top five stocks of each of those three sectors will account for 50% to 70% of those sectors.

So, yes, the market has become less defensive which means the market is more vulnerable to any correction in non-dividend paying, momentum stocks (h/t David Ader).

2.     Bought a washing machine lately?  So how much will the tariffs cost us in the end? We're more concerned about the on/off mixed messages of the tariffs. If we take a more or less worst case scenario and all imports from China are taxed at 25%, we would see a about a $125bn cost to the U.S. economy. Sometime in the second quarter of this year, the U.S. economy passed $20 trillion. So that’s a 0.6% hit to GDP. The economy will grow around 3% this year. A drop from 3% to 2.4% does not remotely qualify as a recession. Of course, we can play with even bigger numbers. How about 25% on all auto imports? That’s 0.2% of GDP. Or the EU throws a 20% tariff on all U.S. exports? That’s 0.3%.

But of course, it’s much more than keeping score on who can raise the most or who blinks. The real problem is in the complex global supply chains of modern companies and flow of intellectual property. So, if Harley Davidson, which was in Twitter’s sights last week, faces a 20% increase in its prices in the EU and higher steel prices in the U.S., it must divert production to its existing overseas plants. To do otherwise would surely be a breach of its responsibilities. The stock (HOG) is down 25%.

We don't really know yet what the impact of the trade disputes will be. We do know that tariffs are a tax. Someone has to pay the tax. If companies pay the tax, margins are squeezed. If consumers pay the tax, prices go up. Back in January, the administration imposed a 50% tariff on washing machines and 25% on solar panels. Consumers ended up paying for this one. This is how washing machine prices have changed:

That top green line shows prices accelerating by 83% in the last few months. That's after many years of price declines. This tariff was targeted at LG Electronics and Samsung. Both companies’ share prices fell 13% to 25% this year and showed up in South Korea’s exports to the U.S. (in the blue bars).  

So, all together, tariffs hurt consumers. The question now is how will consumers, businesses and politicians respond to the trade talks? If there’s enough of a blow-back, we might get less bluster and more thought. But it will take at least six months to show up in the data. (h/t Ian Shepherdson at Pantheon Economics)

Bottom Line: Large cap will probably remain in a trading range. The S&P 500 should remain above its 2700 support level but expect some rapid moves.  Emerging Markets remain the weak point.

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NIMBYism San Francisco style

Rodents in ATM

 --Christian Thwaites, Brouwer & Janachowski, LLC

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice. We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security. The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended. Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data. Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

Dreams

A look at some bubbles

The Days Ahead: More earnings and jobs numbers.  

One Minute Summary: A lot more economic news to feed off this week but not a lot of action. GDP numbers were soft with consumer expenditures and almost every category weaker than the last quarter of 2017. The high point was a build-up in inventories, which makes sense because consumers went on a mini spending binge last year and companies then had to build inventories back up. Anyway, the market yawned as they did with disappointing factory orders and lower home sales.

The S&P 500 was flat. Some oversold sectors like staples and telecomm did well. Europe was mostly flat but we think they're likely to outperform this year. Emerging Markets were flat but off 2% in dollar terms as the dollar rallied, particularly against the Euro. The 10-Year Treasury hitting 3% was not unexpected and soon retraced.

What we’re seeing with earnings is a pattern of selling on the news. Some of the biggest moves this week were companies that reported perfectly fine numbers but gave weak outlooks. Caterpillar (CAT) was a good example…down 9% on multiyear margins and net income. 3M (MMM), Teradyne (TER) and Freeport McMoRan (FCX) were the same. What’s going on? A lack of the next big thing. Earnings are good, economy okay, inflation ticking up gradually. These are all fine but there’s no big catalyst in the wings so stocks are taking a breather. No reason for any portfolio changes

1.     Bubbles: The problem with bubbles is that they're difficult to spot when you're in them (post hoc is a piece of cake). Having gone through two out of the three worst market corrections in the last 80 years, let's just say we’re on the lookout for any signs of exuberance, rational or not.

Two areas that have given us some concern are commercial real estate and (some) tech and we’ve written about both at length. The two came together spectacularly in a bond offering from WeWork, a company that creates a world where people work to make a life, not just a living. It’s basically shared office space for the tech firms, the gig economy with a lifestyle twist (like free beer and foozball) and has raised plenty of equity money to value it at $20 billion, which would make it the 150th most valuable company in the S&P 500, if it were listed. But to get into the S&P 500 you kinda have to make money, which WeWork does not. The 342 offices are all over the world and in some pretty nice locations too.

They came to market with a 7.85% seven-year $500m bond, with a rating B+, which is pure junk or as S&P put it, has:

“Adverse business, financial, or economic conditions will likely impair the obligor's capacity or willingness to meet its financial commitments.”

No kidding. You’d think with all those offices, it would be an asset intensive business. But WeWork doesn't own the properties, it leases them. So it’s more of an operating real estate company and should be asset light.

Why, then, does it need the money? Because it's tearing through cash. In 2017, it had revenues of $822m and lost $883m. At that rate, it will eat up its cash assets in two years. It has no equity cushion, unless SoftBank chips in another $4bn. Its EBITDA is so awful that the company has to adjust it like crazy:

Source: WeWork Prospectus via FT Alphaville

GAAP says you must produce a real, accountant certified earnings number. That’s around $771m in the above. But GAAP also says you can restate EBITDA if there are one-off expenses (like stock options you grant once), or you expect some earnings to come through for a full year (instead of a partial year). You don't have to disclose exactly how you got there but, from the above, all that gets WeWork to a $193m loss.

They then put in a “Community Adjusted EBITDA” to get it to a $233m profit (the bit in yellow). How did they get there? By adding back in all the sales and marketing expenses saying, in effect, they won't happen again. No investor has ever heard the phrase “Community Adjusted EBTDA” before or quite so aggressive an income restatement. Neat trick: turning a $933m loss into a $233m profit. 

Enough on accounting. But suffice to say it’s a very dodgy way to report your expenses but because it’s a private company, you have to go with it. So how did steely-eyed irascible bond investors take it? They over-subscribed and the company looks set to raise $702m.

So why are we concerned? Mainly because it's:

  1. A hunt for yield
  2. A basic business model (it's a landlord) masquerading as something new age
  3. A ton of debt sitting on a ton of debt because the properties they lease don't belong to them but leveraged real estate companies.
  4. An eye watering valuation

So, leverage on leverage, novel accounting and demand at-any-price is not a great combination. Add in that seven of the world largest tech companies are tech and that never before has one sector dominated the large cap universe, that tech is now 27% of the index (it was 33% at its peak) and, you know, the general euphoria around tech, and well, color us skeptical.

It's another reason why we focus on quality, dividends and companies with management discipline.

2.     ETF Screens: We attended a meeting with a major index provider and asset manager the other day, somewhat under Chatham House rules. The topic was social investing and index managers. Blackrock has made a big splash about corporate responsibility asking that companies account for their societal impact or risk the ire of the world’s largest asset manager. But Blackrock is the largest shareholder in multiple firearm manufacturers and doesn't have much of a choice except to invest in them as long as they are listed companies.

On the firearms side, we ran the performance of the four listed manufacturers (there are others but they're mostly private or foreign) against the Russell 2000 small cap index. They're terrible investments but that’s not really the point.

Most of them are small market capitalizations and together they're only 3 basis points (so, $15 for every $50,000) of the index. The lower line shows the performance of the four companies and, clearly, they have not performed well at all.

What we wanted to explore was whether we could use an ETF that excluded either i) firearm manufacturers ii) retailers of firearms or iii) some broader definition of societal good and responsibility. We'd like your thoughts and please let us know either here and jump to the comments section or here.

Bottom Line: We're in a range bound market for bonds and equities. We expect it to stay that way. We'll be looking for wage and hourly earnings increases in the job numbers. We don't expect to find any.

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Stuffed anteater disqualified

--Christian Thwaites, Brouwer & Janachowski, LLC

 

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.
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