- A Closer Look at Europe
- The Cost of Cash
- How Do I Plan with the Expiration of Tax Cuts?
- Investment Spotlight
By: Paul Sutherland, CFP ®
Let's go on a journey and pretend that you are fresh out of school, full of enthusiasm and ready to start a career in investment management. You have studied the classic writings of heavyweight investors like Benjamin Graham, David Dodd, John Templeton, Warren Buffett and Peter Lynch. From these legends, you've learned that the way to consistently make money is to buy good businesses at great prices and be patient. So you look at the world today and you see that in Europe you can buy companies for half to two-thirds the price of some comparative companies in the U.S.A. and Asia.
You go out and tell your story to everyone who will listen. EUROPE IS ON SALE! IT'S TIME TO BUY! The response from potential clients is largely along the lines of, "Don't you read the news? Europe is a socialist experiment run amuck. The region's economies are in a death spiral, the workers are lazy and the Euro is toast! Thanks but no thanks Junior, I'll keep all my money right here in the good ol' U.S.A., where we still have at least a resemblance of capitalism."
Despite your persistent efforts, you fail to attract much interest in your investment ideas. One day, you hear that a friend of a friend is "making lots of money" as a "financial adviser" selling a wide range of "five-star" funds and "guaranteed" products. You buy this woman (also fresh out of school) a drink, and she tells you that her company's lineup of funds and annuities aim right at the sweet spot of human greed and fear. Got a client who likes to chase winners? Presto, here's last year's big winning fund. The client will melt like butter when he hears the words "income for life." Ta-da, how about a nice income annuity? Forget about fundamentals and helping clients avoid the mistakes that can lead to financial ruin, she says. Just give them what they want. If things go bad, you can always blame the "market" or "government" and switch them to the next hot product.
Enticed by her pitch and with a family to feed, you trade in your value investing classics for a copy of How to Make a Killing in Annuities and Financial Products. Shortly thereafter, you find a firm, get your license to sell, and BINGO! the commissions start rolling in. Your new found friend was right. Selling past performance and guaranteed income is so much easier than fundamental analysis and critical (often contrarian) thinking. Heck, if the next few months go like the first few, you'll soon be making plans for 2 pm tee times and that red Ferrari that you thought only the bigwigs on Wall Street could afford.
The Risk that Plagues the Investment Industry
The decision of our young pretend manager to take the path of least resistance is all too common these days. Legendary investor Jeremy Grantham of Grantham Mayo Van Otterloo, succinctly summarizes the tendency of advisers to herd around popular investment products in his highly recommended April 2012 newsletter:
The central truth of the investment business is that investment behavior is driven by career risk. In the professional investment business we are all agents, managing other peoples’ money. The prime directive, as Keynes knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority “go with the flow,” either completely or partially. This creates herding, or momentum, which drives prices far above or far below fair price. There are many other inefficiencies in market pricing, but this is by far the largest. Source: http://www.gmo.com/ websitecontent/JGLetter_ALL_4-12.pdf
As I’ve discussed recently, investing in Europe during this period of intense uncertainty and fear requires a fairly high tolerance for going against the flow.
Market-level valuations across Europe reveal broad investor distaste for European stocks. For example, Figure 1, shows that relative to U.S. stocks on a normalized price-earnings basis, European stocks are the cheapest they’ve been in over 30 years. In other measures, Europe also looks increasingly compelling. The average dividend yield of 4.4% is back above its long-term average and as a percent of world market capitalization, Europe is returning back to levels of two decades ago (See figures 2 and 3).
These valuation levels seem to be pricing in a prolonged period of depressed economic conditions, depressed corporate profits and depressed investor sentiment. But could this time be different than the past history of market fluctuations? Cycles governing economic growth, profits and investor sentiment that have been with us for hundreds of years could be broken, and we may resign ourselves to a forever-funk of economic and market malaise. As investors, this is not realistic.
Europe has problems (as does most of the economic world), and the process of overcoming the debt roadblock (through default, inflation or economic growth) will take time. There will be plenty of political and economic pain to go around with more guaranteed market volatility. But like most of the developed world, Europe has sufficient wealth, democracy, entrepreneurism, infrastructure, education, social safety nets and rules of law to get through this period. During this time, there will be tremendous opportunities for savvy, well-managed and well-financed companies to gain share from weaker rivals and emerge stronger.
Adding to Select European Holdings
Our team continues to add to select European holdings, several examples of which follow in the pages ahead. Overall, our exposures to this region are in our comfort zone. We are prepared to increase these exposures should sentiment diminish even further. On the first page of this newsletter is a quote from friend and fellow investment manager Peter Kinney of Acacia Capital whom I respect greatly for his honesty, integrity and ability to call it like it is. We are in the investment business to grow and preserve wealth for our clients and we take our duty seriously. We do not take the majority approach of “selling what is hot” or feeding into fear. Instead, we ground ourselves in broadbased, long-term, critical analysis of each client’s situation, investment quality and investment price. Through this process, we remain confident that we can find great areas of long-term investment return potential. In our view Europe, is one of those areas. It offers considerable value to those willing to see beyond the fear and uncertainty keeping most careerrisk- minimizing advisers far away.
By: Jeff Lokken, CFP®, ChFC
Cash is piling up on the balance sheets of corporations and the consumer. This is happening at a time when interest rates are at all-time lows, resulting in unfavorable investment returns on this “safe” asset class. The current yield on a 10-year treasury bond is under 1.5%, a one-year certificate of deposit at your local bank pays less than one-half of one percent, and interest rates on money market and savings accounts are basically zero. The current reality is that the asset class of “safe” investments pays very little return.
In 2006, the interest rate on a one-year certificate of deposit was more than 5%. An investor with $100,000 could purchase a one-year certificate of deposit and receive $5,000 of annual interest income. That same investor today would receive less than $500. In simple terms, this is a loss of 90% of annual interest income in six years. Income investors who wish no risk of principal loss have lost most of their income and are being forced to reduce their standard of living, take on more risk or spend down their principal to make ends meet. To the safe investor, none of these options is very comfortable.
The reality of this dilemma is that, regardless of interest rates, safe investing has never generated real long-term positive returns by growing wealth and increasing income. Real return is best defined as the return an investor receives after inflation and taxation. The real return on cash investments has never been good. Consider the safe investor I mentioned above with a $100,000 one-year certificate of deposit. What is the current real return on the $100,000 certificate of deposit? In 2011, inflation was about 3% and assuming this investor paid an average of 25% federal and state income taxes on interest income the real return is a -2.625%. $3,000 (3% of $100,000) was lost to inflation and taxes totaled $125. Even when interest rates were extraordinarily high, like in 1981, the safe investor had poor real returns. In 1981, interest rates were almost 14% but inflation was more than 10% and income tax rates were higher. The combination resulted in no real return or wealth creation.
Pessimism is causing investors to be wary of investing in stocks and stockpile cash. Justifiable concerns about Europe’s financial health, the slowing growth in China, the November election in the United States, the residual effects of the U.S. mortgage crisis and the unsustainable level of sovereign debt in many countries, amongst other problems, are certainly issues to be concerned about. However, big problems are not new to the world and its investors. Stocks and their associated dividends have grown over the years, creating wealth and growing income despite enormous obstacles like world wars, genocide, currency collapses and revolutions. Economic activity has increased, the world’s standard of living has improved, life expectancies have increased and wealth has grown. Over the long term, cash investments have had negative real returns losing ground to inflation and taxation.
My hero John Templeton is no longer with us, but I am confident that in his quiet and humble way he would be encouraging us to be kind, diversify globally and invest in stocks because of the prevalence of pessimism in today’s world. When I close my eyes I can almost hear his southern gentleman voice say, “Buy stocks, collect dividends and be patient.”
By: Alice McDermott, CFP®
This seems to be the question around the water cooler these days. How does one plan given the possibility of tax cuts expiring?
Tax Hikes Loom in 2013
Tax cuts more than a decade old are set to expire by the end of the year, creating a challenge for advisers and their clients. The expiration of the Bush tax cuts (signed into law in 2001 and 2003) on wages, capital gains and qualified dividends will go back to the pre-2001 levels. The biggest challenge is the uncertainty – sometimes it’s better to know the rules even if we don’t like them! All we do know is that if Congress does not act by the end of 2012, approximately 50 items in the tax code will expire, which will mean more taxes for the majority of Americans.
“All tax rates for every taxpayer will go up,” said George Yin, former chief of staff at Congress’ Joint Committee on Taxation. “In terms of planning and thinking about their lives next year, all of these items will potentially have an impact.”
So just what are these tax burdens, and what do they mean for most of us?
Capital gains rate: If the tax code expires, the rate will increase to 20% and qualified dividends will be taxed as ordinary income – as high as 39% for those in the highest tax bracket. This increase is significant because the current rate on qualified dividends is a fixed 15%. In terms of planning, if you have an asset you intend to sell in the near future, you may consider selling in 2012 rather than waiting.
Charitable contributions: The opposite is true for charitable giving. Because income tax rates may increase, the benefit of a charitable contribution will be greater.
Income tax: It’s estimated that about 60% of tax filers will see rates increase about 3% to 5%. For example, a couple earning $90,000 would pay an additional $2,700 (or $225/month), which is a substantial increase for that tax bracket.* Also, parents of children under age 17 would lose $500 of the now $1,000 tax credit per child, and as we all know tax credits are a dollar-fordollar reduction of their tax liability.
Fortunately, both parties have said they want to extend part of the Bush tax credits, with Republicans aiming for a full extension and President Obama (and most Democrats) aiming for those earning less than $250,000 (which would affect the majority – roughly 98% – of the population). From what I’ve heard and read, the overall sentiment is that Congress will take action and prevent the credits from expiring, but how much will be extended and for how long will depend on who wins the election and current budgeting legislation. More likely than not, the decision will come down to the wire, given the election is not until November.
I believe there is one thing we can all agree on – predicting the outcome of taxes is as reliable as predicting a presidential election. As always, if you have any questions regarding your personal investment portfolio and would like to project a few whatif scenarios, please give one of our Certified Financial Planners – Paul Sutherland, Kevin Russell, Suzanne Stepan, Jeff Lokken, Jason Sobolik, or me – a call. A Hui Ho! (“Until next time!”)
There is no Spotlight for this issue.