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2014 February Newsletter

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

A Principled Approach

A friend of mine is running for Congress as an independent. She says she’s compelled to run in order to “stop the erosion of our liberties, freedoms and what America stands for” by what she refers to as “death by 1,000 cuts.” She believes that, as a country, we have lost our way, and that most people have defaulted to anger and blame rather than maintaining a can-do attitude and seeking viable solutions. I respect her for her stance, but I am sure she’ll face constant ridicule, criticism and a barrage of name-calling, like “heartless,” “commie” or “fascist” before she is done with her campaign. 

What’s interesting is that her supporters sit on both sides of the political fence: liberal and conservative. It seems, though, that regardless of one’s political view, we all want the same things: safety, democracy, food, good schools, a fair justice system, equality and for things to work. It’s just that the path to these things is a bit jumbled by our life experience. We tend to want it simple – as human beings, we want to put our facts, friends, enemies, teachers and politicians in simple little boxes and “forgetaboutit.” But life doesn’t work that way. Still, my friend believes that there are rights and wrongs: Killing is wrong. Racism is wrong. Exploitation is wrong. Lying is wrong. Yes … lying is wrong.

JPMorgan and Moral Capitalism 

JPMorgan just paid out more than $20 billion in fines, penalties and such for criminal and civil charges. Some were related to its role in the Madoff scandal, while others were related to mortgage loans and such. Amidst all this, their stock hit a new high on January 6, 2014. 

I could list numerous other companies that have been hit with criminal prosecution, but the story’s always the same – nobody goes to jail, the company pays a fine, the customers are numb to its wrongdoing and Wall Street rewards it with higher stock prices. Of course the company promises to try harder, put ethics as its core principal and implement systems to control the problem.

At its core, “ethics” means “to act with virtue.” If a society acts ethically, it should help everyone. Aristotle said that ethics is about moderation – the middle – avoiding the extremes. Ethics should guide us to do what is right, and embrace the reasons behind the regulations, laws and social norms of our society. Fences don’t make good neighbors, and laws don’t make a good society. Good people, living principled lives, make a society where we can have life, liberty and the ability to pursue happiness.

On December 1, 1862, President Lincoln said to Congress. “In times like the present, men should utter nothing for which they would not willingly be responsible through time and eternity.” We at FIM Group believe principles matter. That is one reason you don’t see certain investments in your portfolio. We are not perfect and we have to be pragmatic – but it is easy to identify lying or extreme self-dealing. Looking the other way to things like the Madoff scandal, so fees can be collected and reputations maintained, seems like an extreme case of self-dealing. One of these days, I believe that investors, customers and service providers will just say “no” to the companies that take the easy, the less ethical way, and that will make a difference. Imagine working at a company that created the poison milk that killed more than one baby and put 50,000 infants in the hospital. Did employees look the other way when they watched the melamine added to the formula, or when reports came in about all the hospitalizations? How did investors feel about it? Did they just hope that their investment would hold up, not feeling any responsibility for the actions of those using their capital?

Thousands of banking lobbyists influenced banks to relax their regulations, allowing for the crazy excesses that helped support and cause America’s financial crisis. And the profits banks make off our deposits go to pay those lobbyists. So I am to blame too, and I think that is the “rub,” so to speak. We are part of the system, so we are part of the problem. We are helping create some of the 1,000 cuts.

So Do We Do Nothing?

As a society, when we are merely measuring profits, we seem to forget our purpose. One of our economic mistakes that chronically misguides us and our leaders is what I term the lottery winner paradox. Consider, for example, a town of 500 people who are dirt poor. The total GDP of this town is $5,000,000. If you take the 500 families and divide it into that $5,000,000, you get $10,000 per family … not even enough for health insurance. Say now that one of the townspeople wins the $100 million lottery. Now the GDP per family goes up twentyfold to $210,000 per family. The winner then flies to New York, Toronto, Paris and Tokyo and buys homes, jewelry, art and cars with his $100 million. An economist will say that everyone is richer. But unless that money went toward the town’s education system, or created new jobs, it did no one any good. In some ways, arguably, the winner’s actions hurt his community because his winning communicated to the townspeople that the way to get ahead is by gambling and getting lucky rather than by education and working hard. 

For any democracy or healthy social system to work, citizens must balance their freedoms with responsibilities. Luke 12:48 states, “For everyone who has been given much, much is expected [demanded]; and from one who has been entrusted with much, much more will be asked.” As someone who has traveled to many parts of the world, I feel pretty confident in the statement that as Americans, we have been endowed and entrusted with an immense wealth of freedom and opportunity, not to mention a general standard of living that ranks high relative to both our own history and most other countries around the world. Treating this endowment with the respect that it deserves and ensuring its legacy for generations to come is something that seems to me to be an absolute responsibility of citizenship.

Where to start? How about by taking actions in our own lives first? Here’s a few that I continue attempting to implement in my own life:

Investing back into our personal health. Better health, whether it be physical, mental or spiritual, brings with it the ultimate “trickle-down” effect. For starters, investments in personal/family health lower our own lifetime healthcare expenses, which are increasingly becoming one of the largest items in family budgets. Better health also sets the stage for more energy and clearer thinking in our daily lives, compounding the impact we can bring to our families, workplaces and communities. And ultimately, when improved across the country (and the world for that matter), investments in “health responsibility” allow our incredibly innovative and talented life sciences and medical industries to redirect billions now spent researching treatments for lifestyle diseases (e.g., diabetes, heart disease, various forms of cancer) toward genetic conditions like cerebral palsy.

Teaching our kids and grandkids the invaluable lessons of personal responsibility. This should be incredibly obvious, but so many families these days seem to prefer outsourcing such responsibilities to our already-stressed school systems. What a terrible cop-out. We can all find more time to engage with the future of America, starting with our own children and then making time to help the plethora of youth-focused organizations that are perpetually looking for volunteers.

Thinking and acting more critically toward the monetary decisions in our lives. It is so easy to get stuck in old habits, but there are plenty of new habits that we can create. Over time and when compounded by others, these can have very meaningful impact. Shifting savings to local banks and credit unions, investing for “triple bottom line” returns in responsible companies both locally and globally, carefully considering the products and services we buy for variables beyond just price (for starters, product quality, the values of the company behind the products, the social and environ-mental costs of the product to be born long into the future), and investigating the effectiveness of the charities we donate to are just a few broad areas worthy of much closer attention.

I am convinced that if every American gave up an hour a week of American Idol or scrolling for gossip on Facebook and re-engaged on just the three areas above, my friend would probably have little reason to seek office and attempt to influence change from the top. Let’s face it, our nation’s challenges are in many ways self-inflicted, and there are two sides to every “trade.” JPMorgan doesn’t have a market if buyers of its products and investors in its bonds and shares require a higher level of corporate responsibility. In a similar fashion, BIG GOVERNMENT has few customers if we as citizens take better care of ourselves, our neighborhoods and our communities. As consumers, investors, employees and employers, we have significant power from the “bottom up.” There are many things we can do, none of which involve blame or anger.

Barry Hyman, MBA
By: Barry Hyman, MBA

Finding Value in a High Priced World

The son asks the Rabbi in Fiddler on the Roof, “Is there a proper blessing for the Czar?” The rabbi responds, “A blessing for the Czar? Of course.” He continues, “May God bless and keep the Czar …” then he pauses, thinks and finishes with, “… far away from us!” I recall this line as a local performing arts group is rehearsing for a production of this play. It resonates for me when I have been answering seemingly impossible questions recently about investing. My overriding response is, not unlike the rabbi’s, that there are always answers, solutions and compromises rather than putting one’s head in the sand and taking the fetal position when conditions present challenges. Here’s two of the more common I’ve been fielding of late:

Q: With the broad U.S. stock indexes up on the order of 30% or more in 2013 and the S&P 500 at an all-time high, aren’t stocks awfully expensive, and should we be “getting out”?

Figure 1

A: Neither the absolute price level nor the amount it has risen are indicators of whether an investment is expensive. Take, for example, investment real estate, or a small business you might be contemplating buying. If that investment’s price had risen 30% in the past year and was now priced at all-time highs, does that make it expensive? The answer is that you cannot tell without knowing more information. If that investment is generating returns equivalent to 3% of the price of the investment (and therefore priced at a high “multiple” of these returns), then yes, I would say that it is likely overpriced. But if that investment generated 15% annually, for example, if the rent of the real estate in question were 15% of the new “higher” price, or a business that is selling for $1 million generates $150,000 in net profits, it may very well still be bargain-priced, based solely on the return on investment. Of course there are additional factors one must ascertain. But the point is, one must look at the expected cash flow, income, earnings and outlook, in addition to the business model, competition, management, etc., and compare these factors to the price to see if an investment makes financial sense.

In the case of the S&P 500 (a proxy for the larger companies of the U.S. stock market), current valuations suggest that the aggregate “market” is indeed starting to look “awfully expensive,” at least on some measures. The Economist, for example (see Figure 1), recently highlighted two measures that suggest significant downside possibilities for the S&P 500 should prices revert back toward long-term historic multiples of cyclically adjusted earnings and the replacement cost of companies’ net assets (Q Ratio). While there is certainly the chance that the companies in the S&P 500 can grow their earnings and replacement values to “catch up” with such lofty multiples, our investment team is not holding our breath. Instead, we believe that those invested in S&P 500 index funds (or other strategies that believe there is safety in a broad mix of U.S. “blue chips” ) face very poor return prospects ahead given high valuation multiples today.

Figure 2

Our Investing Without Borders approach allows us to eschew investments that are expensive (as many but not all U.S. stocks are) and to find good-quality holdings that are priced to provide acceptable returns. We continue to find such holdings across a variety of geographies, sectors and asset classes and will only “get out” of such positions when we feel they no longer meet our strict parameters for quality and valuation. 

Q: Why have some stock markets risen so much?

A: The gain (or loss) of any stock (or market) can be broken down into component parts of: 1) dividends; 2) earnings growth; and 3) the multiples of earnings investors are willing to pay. Figure 2 highlights these components for some of the major global stock markets in 2013. In the case of the U.S., more than 20 percentage points of the 30% or so in total returns came from an expanded price/earnings multiple. In other words, sentiment improved to the point where investors were willing to pay 17x the earnings of the S&P 500 constituents at the end of 2013 versus only 14x at the beginning. Only about 6 percentage points came from earnings growth and 3% or so from reinvested dividends. Europe and Japan also benefited from higher multiples (increased investor sentiment), although in the case of Japan, whose exporters took advantage of a Bank of Japan-engineered depreciation of the yen, earnings growth drove the lion’s share of market gains. 

As noted above, with valuation multiples in the U.S. quite extended relative to historic averages, it is hard to make the case for a repeat performance of 2013’s large U.S. stock market gains. Market-level dividend yields are low and expected earnings growth remains modest. In fact, with the Federal Reserve now in “tapering” mode (reducing the level of Treasury Bond purchases in an effort to stoke financial markets and the economy), one can make the case that the risk ahead for the U.S. market is that any growth from earnings and dividends is offset by valuation multiple contraction. In that sense, the relatively weak performance of emerging markets last year (where valuation multiples contracted) may foreshadow what’s in store for its more developed cousins in 2014.

As opportunistic value investors, our team takes an ever-vigilant stance toward both the fundamental quality of what we own and the valuation multiples our positions command in the market. When it looks like a given holding is exposed to valuation multiples contraction (like many of the large U.S. blue chips today), we sell and find other positions where valuations are at levels more likely to help returns than hurt them. This price discipline does not provide complete volatility immunity from a market-wide slump in investor sentiment, but it does reduce our risk of permanent loss. Our portfolios today are full of stocks offering solid dividend yields and earnings growth potential with valuation multiples at or below levels we consider appropriate. This keeps us optimistic toward the future and thankful for our unconstrained approach that does not limit us to an unappetizing menu of expensive U.S. blue chips.

Matthew J. Desmond CFA®
By: Matthew J. Desmond CFA®

Demystifying Medicare

Life is complicated. Medicare makes sure of that. While a lot of Medicare questions and concerns quickly reach a complexity that requires a specialist for reliable answers and comprehension, this simple overview will hopefully help demystify the basics.

Medicare’s mission is straightforward: to provide health insurance to individuals age 65 and older and those under 65 with permanent disabilities. Its implementation, on the other hand, has lots of moving parts. I mean that literally: Part A, Part B, Part C and Part D. 

Part A: Known also as the Hospital Insurance program, Part A covers inpatient hospital services, skilled nursing facilities, home health services and hospice care. The payroll tax of 2.9%, typically split evenly between employers and employees, provides funding for Part A, so just about anybody who paid Medicare taxes for 10 years, or whose spouse paid those taxes, receives Part A for free. Coverage of specific services can vary from state to state.

Part B: The Supplementary Medical Insurance (SMI) program, Part B, helps cover physician, outpatient, home health and preventive services. Part B enrollment is voluntary, though the vast majority of those in Part A also participate in Part B. In fact, for most, enrollment in Part B is automatic upon Part A enrollment, with a voluntary opt-out option available. While general tax revenues help to fund Part B, beneficiaries also pay a premium based on income. Coverage for Part B can also vary from state to state.

Part C: More commonly referred to as Medicare Advantage, Part C allows beneficiaries to enroll in an HMO, a PPO (preferred provider organization) or private fee-for-service plan. The private company contracts with Medicare to provide Part A and Part B services. Some Medicare Advantage plans have prescription coverage (Medicare Part D), others don’t. Medicare Advantage enrollees still have Medicare, but coverage comes from the private company instead of from “Original Medicare.” Medicare pays a set, monthly amount to the Advantage provider. The provider follows the rules set by Medicare. Each Advantage plan, however, can charge different out-of-pocket costs and have different procedures governing access to care. Premiums, deductibles, and copay or coinsurance also vary among plans. Differences can be significant, so it is important to understand the details of individual Medicare Advantage plans. 

Part D: Medicare’s prescription drug coverage, Part D, relies entirely on private prescription drug plans (PDPs) or Medicare Advantage prescription drug (MA-PD) plans. Most Part D enrollees pay a monthly, income-related premium, similar to Part B’s. Before joining a PDP, Medicare Advantage enrollees must be sure that their Advantage plan does not include prescription drug coverage. If it does, joining a PDP will cause automatic disenrollment from the Medicare Advantage plan and enrollment into Original Medicare. 

Medicare Supplement: Frequently called Medigap insurance, supplemental Medicare insurance helps cover cost-sharing requirements (copays, coinsurance and deductibles). Some policies will also provide coverage lacking in Original Medicare. Medigap is not Medicare Advantage. Medigap simply helps fill in some of the “gaps” in Original Medicare. Medicare Advantage negates the need for Medigap; only those enrolled in Parts A and B purchase Medigap. Ten different Medicare Supplement plan designs (labeled Plan A, B, C, etc.) are available and are standardized across all insurance companies. Benefits, consequently, do not vary from company to company, though they do from plan to plan. Price and service, on the other hand, will vary from company to company.

Enrollment is another significant factor of Medicare. Those who already receive Social Security automatically enroll in Parts A and B and will receive their red, white and blue Medicare card in the mail three months before turning 65 (or on the 25th month of receiving disability). Those who do not elect for Social Security before turning 65 have a seven-month sign-up period starting three months before and four months after their 65th birthday. Those who miss that initial enrollment period can still enroll during the General Enrollment Period from January 1 to March 31 of each year. Late enrollment, however, may result in higher premiums. There is a big exception for those covered under a group health plan from a current employer. As long as they or their spouse is working, they can sign up for Medicare at any time. They also have an eight-month Special Enrollment Period for Part A and/or Part B that starts the month following termination of employment (or, if it comes first, termination of the group insurance).

One final thing to look out for: As anybody who has turned 65 knows, Medicare-related mail and offers pour in as age 65 approaches. Many of these offers are for Medicare Advantage plans and supplemental coverage. And many of these offers add to the confusion because they are intentionally misleading. Be a conscientious shopper: Do the research, compare policies and ask for details before making any purchase. Also rely on the local Social Security offices for help. They typically have volunteers or staffers who can provide excellent guidance. And feel free to call us. We often may not know the answers directly, but we can either find the answers or point you to another resource that will have an answer. 

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