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2013 July Newsletter

Paul Sutherland, CFP®
By: Paul Sutherland, CFP®

Active Long-Term Investing

We are long-term investors. We are not investors that “time” the market or guess the psychology of the fickle investors that think the Wall Street Journal, golf buddies, CPAs, lawyers, and Money Magazine give solid investment advice. We also realize that most “investment advisers” are not advisers at all, but rather are general order takers that manage their portfolios in accordance with their clients’ whims and biases, ending up with similar (poor) performance.

FIM Group’s history of solid, profitable long-term performance is attributable to our core tenet, namely, that we are the ones who (right or wrong) should use our expertise, training, experience and talent to make the decisions regarding our clients’ portfolio construction – not our clients, their fathers, mothers, lawyer or brother-in-law. Naturally, there is a “trust walk” our clients must make when allowing a leadership-oriented adviser like FIM Group to assist clients - fears or reservations can be allayed by looking at our track record, chatting with our clients and reviewing our performance history. Unlike many other advisers, our history is based on actual outcomes – not hypothetical “if-then” scenarios. Many other advisers have recently jumped on the “ETF bandwagon” as the way to manage their clients’ assets. ETFs are a recent phenomenon. The first ETF was launched in 1993, and now ETFs make up a $1.5 trillion industry. Fads usually appear to be great when initially proposed, because they are usually built on logic. ETFs certainly have a place in investing, but they are not “the way” to invest. Still many advisers and investors choose ETFs as their guide.

Growing and Preserving Wealth

At its core, investing is about purpose. And investment management, i.e., the process of investing, must also have a purpose. For most it is about wisely and prudently growing wealth and/or creating a reliable current or future income stream. Most investors manage their investing affairs based upon what they think is a long-term strategy, but often that seems to change when prices go down on their investments.

The DALBAR chart at right illustrates the disconnect between what investors “want” and what they “get” quite remarkably. As you can see, the average “do-it-yourself” investors that DALBAR identifies use an Asset Allocation strategy (a mix of stocks and bonds) does not even keep up with inflation. Some advisers champion the “set it and forget it” Asset Allocation models, but the fees they layer on top of those passive indexing strategies obliterate the gains they are trying to create by being supposedly more efficient and cost-effective. It also appears based on the DALBAR study that emotion and fads take over and set them off course. These strategies are simple, but in the complex world of investing, simple is simply a way to ignore the reality of markets, economics and common sense.

Math, Common Sense and Judgment

It is really quite boring looking at the growth charts of a country’s economic activity, for example, its GDP (see graph to the right). Consider the GDP of the United States (green), with the iShares MSCI Emerging Markets Stock Index (orange = EEM iShares) and the U.S. S&P 500 Stock Index, as represented by the SPY fund, superimposed over it. As you can see, the stock market indexes went down significantly in 2009, while the GDP (U.S. total goods and services) barely moved. Also interesting to note is how dramatically the MSCI EEM ETF went up following the crash only to fall to a more ”normalized” level.

What does this tell us? Simply that price fluctuates more than value. Large baskets of stocks as represented by the EEM and SPY should move in tandem with GDP and the general growth of the overall economy. Some stocks within those baskets will grow much more dramatically than others, which, of course, represents opportunity. Microsoft, one of the world’s largest companies, saw its sales drop from approximately $60 billion in 2008 to $58 billion in 2009, nearly a 2% drop in sales. Microsoft’s share price high in 2008 was $35.99 and its low on 3/06/2009 was $14.87, nearly a 60% drop. Microsoft’s sales were slightly lower, but its earnings per share dropped from $1.94 in 2008 to $1.70 in 2009. Not much change. Microsoft’s earning this past year were $2.73. What’s the point of all this? To illustrate the point that PRICES FLUCTUATE MORE THAN THE VALUE OF COMPANIES.

Active Long-Term Investing/Be Early

In last month’s newsletter we included a psychology chart. Today we are also including it, but with a bit of a twist. We like to buy companies with stable and growing incomes. We also like to invest in companies at the right price.

The chart at left (Investor Psychology 101) illustrates how to use the normal cyclical nature of markets to earn profit and to preserve wealth. Obviously, you will never buy at the point of maximum pessimism or lowest price or sell at the top. Putting perfection aside, however, allows us to embrace the idea of being early by realizing markets are cyclical. Price earnings, price-to-sales and historic measures allow us to know when a company is either a bargain or too expensive. Legendary investor of the Magellan Fund’s, Peter Lynch, once said (I’m paraphrasing here), “The average stock fluctuates [in a range of] around 40% in a year – a lot of money can be made in that 40%.” So over time, a portfolio needs to be managed to hold assets that are priced right. In other newsletters we have chatted about the industries we like, how management is important and how we pursue companies with solid balance sheets and quality products. In other words, how we look for great companies. The key is to buy those companies when they’re bargains and, more important, be disciplined enough to take the profit when they are no longer bargained priced.

Roller Coaster to Nowhere

It is logical to assume that the markets will muddle along for quite some time as the economies of the world heal from the excesses of the past. Liquidity will be abundant, psychology will go from greed to fear, and this will cause markets to fluctuate dramatically. This we believe is going to create a market and period like the ’70s early ’80s, in which you sell when a company is no longer a bargain and buy when it’s priced right again. That takes discipline. We believe over time the earnings of our companies will grow, but we are not going to get greedy and try to stick around for the last bit of performance. In roller-coaster markets, sell discipline reduces risks of substantial losses, and buying right gives a margin of safety to help us preserve wealth. The real risks will be to those investors that try to “set it, and forget it” or just passively let their money roll in an index fund or ETF asset allocation model, neither of which, we believe is logical, in the near to mid future. I can say that I think that a lot of money will be made by savvy investors in the years to come. Of course, I believe we will be on the right side of those years.

History, Safety, Income and Cash Dividends

We do believe that a large portion of returns will come from dividends and interest from our dividend-paying common and preferred stocks and bonds. Buying good companies at bargain prices and collecting dividends and income while patiently allowing the market to realize the fair value of our investments currently guides our base case scenario. In this complex world, money has a purpose, and its owners need to manage it. Common sense – not emotion – therefore, should guide the construction of portfolios. As I mentioned earlier, if you use history as your guide it’s irrational to invest in the “hot” new strategies that are pushed by the media, which is always looking for a new/novel story. It is equally silly to buy the story crafted by investment marketers selling the next “cool” thing to unsuspecting investors. We only work for you, our clients. We are not investment sellers. In the markets ahead we believe this philosophy will benefit our clients more than any time in our history. 

Barry Hyman, MBA
By: Barry Hyman, MBA

Summer Has Finally Arrived

Several days after this article was written, 19 members of the “Granite Mountain Hotshots,” Arizona’s elite firefighting force, lost their lives while battling this wildfire.

In support of the families affected by this tragic event, FIM Group is making a donation to the Prescott Firefighter’s Charities (www.prescottffcharities.org) in memory of these brave souls.

We are deeply saddened by this incident, and our thoughts and prayers are with the families, friends and communities affected by the devastation.

In the case of the forest that abuts my house in Prescott, Arizona, it has arrived in the form of an 8,000-plus-acre-and-counting fire (named the “Doce Fire”). My tenants and my entire subdivision were mandatorily evacuated before the flames reached within feet of the homes yesterday. Thank goodness no people, and so far no homes, were damaged, in part, due to the cool-headed actions of the skilled professionals and residents alike.

I briefly mention this because as I write, the global financial markets, both equity (stock) and fixed-income (bond) markets are experiencing some flames and melting of their own. I can’t help but make shameless analogies between the two events. For one, I can picture panicked “investors” fleeing what they fear to be an investment fire, selling investments which just weeks ago they believed were sound, thinking they can time these events and “get back in” later at a lower price. Countless studies that are published cycle after cycle indicate that investors who try to time the behavior of other investors invariably get back in too late, missing the best opportunities created by volatility, and achieve sub-par long-term returns. Every sale has a buyer on the other end of the transaction. By contrast to the panicked sellers, “cool-headed” investors, with the experience and foresight to see across the chasm of volatility, buy, taking advantage of volatility to lock in long-term income and generate favorable long-term returns.

An analogy that applies to how FIM Group is responding to the current volatility came in an interview with one of the firefighters in Prescott who said, “This ‘thinning’ of the forest reduces the chances for future massive fires, but residents should use this close call as an action call to cut a ‘fire perimeter clearing’ around their properties.”

Forest Thinning: Our team constantly assesses FIM Group portfolios for “thinning” candidates – in other words, stocks or bonds that no longer present sufficient risk-adjusted return potential. Our Growth-Oriented clients have seen the cash level in their portfolios increase steadily throughout 2013 as we have sold positions that have become fully valued. We have strategically held much of the proceeds in cash, waiting for the price of replacement investments to reach favorable levels. In our Balanced and Income-Oriented portfolios, we sold several income investments, increasing cash to peak levels by the end of the first quarter. Recently bonds have fallen, causing yields to rise. Raising some cash in the first quarter created some “dry powder” in the form of cash that we have recently been deploying at these higher yield levels, locking in favorable long-term income for our retirement and pre-retirement phase clients.

Perimeter Clearing: FIM Group selects investments with valuations that are akin to a fire perimeter. Rather than choosing investments that are “hot,” i.e., have price momentum, are “overly loved” by other investors and whose prices have reached inflated levels, we invest in securities whose prices have typically not risen and often have recently fallen to levels below which financial analysis says is rational. At such prices, investments offer a long-term “margin of safety.” Requiring sufficient margin of safety when investing is akin to the perimeter clearing call to action from the Prescott firefighters.

Successful “margin of safety” investing is all about creating room for variables, many of which can be tricky to predict, that can impact an investment portfolio’s value over time. These variables include things like future changes to corporate competitiveness, financial management, regulatory conditions, inflation and client sensitivity to short-term portfolio volatility. Our team, whether managing a Growth strategy for a client early in her saving cycle or a Yield Income strategy for a client who is taking regular draws from his portfolio, emphasizes a margin of safety in every investment we make.

With our more volatility-sensitive strategies (Balanced Conservative and Yield Income), the current era of ultra-low interest rates requires a particularly opportunistic approach. We know that simply owning a portfolio consisting entirely of traditional safe havens like U.S. Treasury bonds or CDs, even with the recent bump up in yields, will provide little margin of safety against the potentially vicious variable of future inflation. Although inflation is currently low, a return to long-term average levels would virtually guarantee that many of these investments lose purchasing power over time AND experience more volatility than desired. Fortunately, the bump higher in yields has also spooked holders of several closed-end bond funds that invest in government bonds. We have been buying a select number of these government bond-oriented closed-end funds, where the 10%-15% discount to net asset value provides a sufficient margin of safety that direct investment at current market prices simply does not.

We are also finding investments in other parts of both the global fixed-income and equity universe that have durable business models and strong cash flow characteristics. Although most of these investments introduce new variables like credit risk or corporate competitiveness to the equation, we feel that we can proactively assess and manage these variables in such a way that protects and grows client wealth.

Examples of recent investments in these strategies include:

  • Several portfolios of quality fixed-income (corporate and government agency bonds, preferred stocks) selling at 10%-15% discounts (i.e., built-in appreciation potential) with yields of 5%-8>#/p###

  • Various individual Preferred stocks with yields-to-call in the 7%-8% range

  • A basket of Utility common stocks selling at a 12% discount yielding 8>#/p###

  • A high-quality REIT (Real Estate Investment Trust) with an 8.4% yield

  • A basket of IT, Health Care and Clean Technology industry stocks at a 30% discount to the combined net asset value of the holdings

  • An Asian infrastructure-oriented investment company going through a wind-down process selling at a 20% discount to conservative net asset value

Over time, it is very possible, actually probable, that the market prices of these investments could fluctuate significantly, as they have in the past few weeks. But based on history and prudent analysis, it is likely that, unlike the fixed (i.e., stagnant) interest that Treasuries, CDs, fixed annuities and most bonds pay, the income these investments pay as a group will likely increase. It is also likely that over time, their earnings and financial condition will continue to improve. A higher and likely increasing income stream provides superior long-term retirement income, helping our retired clients remain retired, as long as they can remain patient and focus on the income their investments generate and not their short-term market values.

Guidelines for Planned Giving

Charitable giving is an important though all too often overlooked component of a personal financial plan. The following guidance for planning charitable giving comes from the article “Making Charitable Giving Part of Your Financial Plan, A Five-Step Guide,” originally published by Minnesota Public Radio. The full article can be viewed at http://access.minnesota.publicradio.org/civic_j/giving/fivestepguide/ind....

Set Your Own Standard

Only you can decide what your personal giving standard should be. The amount you donate should be something you can really afford financially and psychologically after you have budgeted for your living expenses, insurance, retirement savings and other goals you may have. However, it is important to budget contributions just as you budget other expenses. If contributions are not planned into your budget, they are likely to fall short of your own expectations. Or, if you tend to be a very generous person, your contributions could get out of control.

Build a Budget

Like the electric bill, planned giving is part of your budget. It gives you guidelines for how much you can afford to give and provides a plan to be executed. When a request for giving falls outside your giving plan, it is easier to say no. Also, as you construct a budget, you might ask yourself whether you view giving as a mandate or an elective expense. And, from a financial perspective, keep the benefits of planned giving in mind.

The Benefits of Planned Giving

Personal Benefits

Planning your giving and using a budget help you determine how much you can afford to give and when you should give it. When a request for giving falls outside your giving plan, it is easier to say no

  • Planning saves you time in the long run

  • It can help focus your giving and make it more effective

  • Your financial resources are more likely to align with your personal values

Tax Benefits

  • Planning maximizes the tax benefits available to charitable givers, who can deduct qualified donations that total up to 50% of their adjusted gross income

  • The tax benefit received reduces the cost of a donation. A $100 donation from someone in the 30% tax bracket really costs the donor only $70

  • Stocks that have appreciated in value can be donated to charity, avoiding capital gains taxes for the donor and providing a tax deduction as well. Donors can deduct the fair-market value of their gift stock, enabling them to give a larger charitable gift than they could give if they simply sold the stock, paid capital gains taxes and donated the net proceeds. The nonprofit organization pays no taxes on the stock.

Types of Gifts

The instruments available for making charitable contributions continue to multiply – here are a few of the most common:

Cash: A direct gift of cash or a check is the simplest giving option. It is also tax-deductible up to the 50% of adjusted gross income limit. But remember, you should have a receipt.

Appreciated stocks: When you donate stock the IRS allows you to take a tax deduction on the fair-market value of your gift, providing you have held the stock for more than 12 months. Mutual funds may also be donated and are subject to the same rules.

Other assets: Real estate, artwork, insurance policies, automobiles, boats, time share units, clothing and other tangible goods can qualify as donations.

Pro-bono services: Time is not tax-deductible, but expenses, including mileage allowances, are deductible.

Leveraging Your Giving

The following tools enable you to leverage your giving to increase its value to you or to a nonprofit organization:

Matching funds: Many companies will match charitable contributions made by their employees, a practice that magnifies the value of individual contributions.

Charitable remainder trusts: Stock or any other assets held in this account earn annual income, which the donor or the donor’s heirs may enjoy for their lifetimes. When they die, the charity receives the remaining assets. The donor also receives a partial tax deduction at the time the trust is established.

Charitable gift funds: Sometimes called donor-advised funds, charitable gift funds are mutual funds that allow donors to receive immediate tax deductions while their money grows, potentially enabling larger amounts to be contributed to charity at some date in the future. Donors have a say in who receives contributions and when they receive them.

Insurance: Charities may be named as sole or partial beneficiaries on life insurance policies. They may also be named as owners of a policy, which allows the person buying the policy to deduct premiums. Potentially, this tool could cost little to give a charity a lot when you die.

Endowments: Endowments are meant to sustain an organization for the future, not provide operating funds for the present. The principal of an endowment remains intact and is invested to earn interest for the endowed organization. You can contribute to an organization’s endowment or set up your own endowment – typically with a large gift.

Foundations: There are more than 44,000 foundations in America – many of them family foundations and two-thirds of them with assets of less than $1 million. Foundations have legal costs associated with setting them up as well as ongoing administrative expenses, so establishing a foundation is practical only for people who have a half-million dollars or more to give away.

Investments” in philanthropy: The venture-capital model is becoming popular in philanthropy circles. More and more givers see themselves as investors in new ideas for nonprofit action. Two vehicles suitable to this philanthropic style are social venture funds and giving circles.

Social Venture Funds: These support projects that may not be supported by traditional grant makers. Like venture capitalists, investors in social venture funds often offer management expertise and other practical assistance as well as money. They are willing to take a certain amount of risk on new ideas, and they closely monitoring the results.

Giving Circles: In the giving circle a small number of members meet regularly to make joint decisions to invest their charitable contributions. As in investment clubs, participants share responsibility for proposing, investigating, and monitoring organizations in which they invest.

Leaving a Legacy

Giving generously and focusing your giving on a special cause throughout your life and through your will may enable you to leave a legacy that continues well beyond your lifetime. Endowments and foundations are tools that help donors leave legacies. Through their will or through beneficiary designations, donors also may leave sizeable assets to charities, including such assets as real estate, retirement accounts and insurance benefits.

With good planning you can minimize inheritance taxes on your estate and also leave a greater legacy. Estate taxes currently are 40% for amounts exceeding $5.25 million for an individual (edited for current exclusions and rates). In your will, charitable bequests are not taxed if they name the recipient and the amount of your gift. That is not the case if you merely leave verbal instructions.

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