Sunday, November 30, 2008

An Attitude of Gratitude

During the Thanksgiving period and similar Harvest festivals in other countries and cultures we become more mindful to be thankful for what we have. This week, Thomas Dolan in a Barron’s editorial comment, noted he was grateful for our market system. I agree. Dolan feels the price discovery aspects of a free market are beneficial for the financial community and others. As we have been taught, if the markets are sufficiently informed, prices eventually reach an equilibrium point where both buyers and sellers find value. (Whether the interventions of various governments around the world will aid in this discovery of equilibrium is an interesting and worthwhile discussion for another time.)

As part of our Thanksgiving weekend tradition, my wife Ruth and I conduct informal market research at the nearby high-end Mall and in local stores in our small town. At 8:30 AM on “Black Friday” I arrived at the Mall with a family member. This was after the early morning openings of department and promotional stores, but prior to the mandatory opening of all stores. We were able to park closer to the entrance than on a normal week-end. Not a good sign for the merchants.

Walking through the Mall we saw many people carrying store-labeled shopping bags, but appearing only to have a single, relatively light weight box or bag. Many people must have entered the Mall through the “anchor” department store, but walked through without buying anything. The exception was the one department store which was heavily advertising promotional prices. Their shopping bags were being carried by perhaps half the shoppers we saw. Three stores did have good crowds. The first was a department store renowned for good service and quality, as well knowledgeable sales people. The Apple store also drew a good crowd of mostly, but not all, young people. However, Apple did not need the entrance line it had set up, Finally, one of the two mobile phone stores had somewhat more shoppers than its normal crowd. At the other cell phone store the handful of clerks outnumbered the potential buyers. My initial conclusion is that shoppers were being highly selective in their purchases.

Later that morning I went to the downtown retail section of our community and found plenty of parking available. I noticed that traffic was lighter than normal on our Interstate highways. Obviously there were fewer shoppers involved with competitive shopping. Perhaps the arena for finding the best prices has been captured by the Internet. Current gas prices are no longer a plausible excuse for weak retail sales. The dampening factor could be that we live in an area which is a financial services “ghetto”, Many of our neighbors work in or around Wall Street, and others have sizeable portfolios which have taken a steep hit.

On Saturday, Ruth returned to the Mall initially to pick up some clothes being altered to fit a more slender frame. The magic of a good merchant persuaded her to consider unintended purchases. She found great bargains seriously marked down, and not advertised. Discussing her Saturday experience, Ruth commented that buyers were not only being more skillful buying at perceived great price, but in many cases upgrading quality from the their everyday purchases. Our Thanksgiving research demonstrated that the market system is working and that determined shoppers were finding their equilibrium points. This is good news.

Analysts seek to extrapolate investment conclusions through small, hopefully representative samples. The skilled retail shopper and the relatively low purchase price of individual stocks and domestic stock funds suggest that both shoppers and investors are waiting. What are they waiting for?

Lower prices are not necessarily the answer, as demonstrated by shoppers’ willingness to step up to higher price goods if they truly represent a bargain in price and quality. My guess is that retail investors and a substantial number of institutional investors will become buyers in earnest when their confidence returns, even if that means cheap prices are not at hand.

The lack of confidence is one of the reasons for currently lackluster retail sales. Many families, including our own, are cutting back on the quantity of planned Christmas presents. In doing so, we hope to avoid embarrassing family members and friends who are experiencing difficult times.

Substituting a large amount of gifts by a smaller number of high quality items is a good example of the market system working selectively. As we get closer to Christmas, a sudden surge in the retail trade or in participation in the market, may signal the early stages of a return of some confidence.

I am extremely appreciative that we live in a culture where the market systems often direct our economic moves.

Sunday, November 23, 2008

Will 401(k) Miracle Help All Investors?

Those who were in school in the 1940s and 1950s had teachers who lived through “The Great Depression.” They focused their lectures on various government programs for unemployment insurance, the willingness to run a peacetime deficit, and a more enlightened tariff policy that would prevent another Depression. Why then on November 20th, 2008 did stock market measures set the record for the largest annual decline (50%) since the beginning of recorded market history in the 1870’s?

The economy is in a period of contraction and official unemployment is in the mid single digit range. (The most credible pessimistic estimate for the future is in the high single digit range.) Perhaps, a more important statistic is the under-employment total, which measures those who want to work full time for an employer other than themselves, and is now just shy of 12%. I have not seen any under-employment estimates of the future over 15%. In the Depression, excluding farmers, the low point was calculated to be 28%. If the market is tied to the perception of the future economy, the current market decline is overdone by perhaps 50%. But as traders know and investors too often forget, the only real indication of value is the current price.

I believe the current price is more a measure of how bad we feel than an estimate of what the future will provide. There is a good reason for this pessimism, but not about the economy itself. The reason for the pessimism is that having surpassed record declines, we have lost all of our historical yardsticks.

In the US Marine Corps, we were trained the best defense was an offense. In a similar manner at the race track one learns that the percentage of winning favorites multiplied by their odds, most often produce a loss if one bets an equal amount on each race every day. This suggests that it pays to bet selectively against the crowd. With the perspective of these two schools of great learning, I have a positive outlook for the market long term.

One of the many reasons to bet against the pessimistic crowd is the miracle of the 401(k), 403(b), and 457 plans that allow and often encourage employees to defer a small part of their current wages into a tax deferred savings plan. These plans did not exist in 1929 and in the 1930s. As of 2007 there were $4.5 trillion in defined contribution plans and another $4.7 trillion in Individual Retirement Accounts (IRA), with over half invested in equities. The Total Retirement Capital last year stood at $17.6 trillion, again with a significant portion invested in equities.

Why do these figures make me optimistic? With US Treasuries’ yields below the actuarial requirement for Defined Payment plans, with endowments’ planned spending rates above these miniscule yields, and with the expected investment income of many 401(k) plans, the current income generation of bonds will not help enough, therefore they will buy equities not bonds.

In addition, with Defined Contribution plans needing to invest hundreds of billions of dollars, I foresee steady buyers of equities each and every year. With the sellers currently capitulating and the buyers waiting, the mid-term the outlook is good for the stock market. Therefore, my answer to the question, “Will 401(k) help all investors?” is YES.

In the near future I will use this forum to discuss whether 401(k) and similar plans should be investing for capital preservation (after inflation) or for capital appreciation. As the answer to this question is largely a function of individual facts and circumstances, I appeal to our readers to pose specific questions (no names of funds, please) that focus on investment strategy for them.

Sunday, November 16, 2008

Reserve the Reserves

When examining the financial condition of wealthy people, I find it useful to them to determine the sources of their money. This is especially true when dealing with reserves of short term cash. There is a separate value attached to money from various sources, even though in truth, money is fungible. The difference of cash generated from the sale of non operating investments such as stocks and bonds is very different from cash that is left over from spending.

One could say that only those who are generating more cash than the amounts that they are spending are truly wealthy. The others are just rearranging their poker chips. Thus a family of limited means spending less than they are earning is on the way to becoming wealthy, in contrast to the family which is spending a couple of million dollars a year more than all of their income. Supporting their costly “life style” could result in becoming poorer either by intention or not. The mechanics of dealing with ultra high net worth investors (UHNW) is easier than the family on the upward trajectory, but the psychological factors are much more difficult and intense.

I find that excess cash generated has a very different psychological meaning than an equal or greater amount generated by the sale of securities. The excess cash generates a feeling of upward progress and can be utilized in any fashion desired without damage to the fortress of wealth. The cash generated from the sale of securities is either to fund spending, or in these trying days, to alter the asset allocation in one or more portfolios. (I advocate multiple mini-portfolios in my book MONEY WISE.)

My advice to all those who are fortunate enough to have cash is to drop your expenditure rate on your personal needs, and increase your support of charities. Remember that charity begins at home (or with your family - particularly a relative currently having an extraordinarily difficult time). To those holding cash/short term instruments, I recommend more than ever to be prudent, particularly if you are acting as a named or un-named fiduciary.

Recently I spoke to an executive MBA program who visits New York to be lectured by various “experts.” I was horrified to learn that a number of these so-called experts stated that they were all in cash and have been for two years. While one might congratulate them on their trading skills (if true), the advice was far from prudent. Limiting your investment to one type of asset not only requires the extreme confidence of being right, but also the vision to predict important trends and the discipline to get on before the train leaves the station. The long term penalty for being wrong can undermine the future of a family or a charity.

While I don’t know when a bottom price will occur, if it hasn’t already, I am confident that there is a bottom price for all surviving investments. History suggests that after a bottom, prices will irregularly move higher until the next top is achieved to be followed again by a decline of some magnitude.

In looking back from the next peak, a favorite technique of historians and analysts, one would find that there was a period of time to buy very inexpensive assets. However, the “cheap” period is relatively short in duration. Our increasingly efficient market perceives unusual value before prices move up to fair value on their way to fully priced value and beyond. Not participating in the ‘cheap’ period will produce mush lower returns for long term investors.

There are many reasons to adopt my mini-portfolio approach to investing toward specific long term goals and obligations, but one of the best is that one can set different reserve amounts for each goal. For example, one would have a different reserve level for next year’s college tuition than for a newborn’s senior year. When setting reserve levels for oneself and for your spouse/companion, actuarial assumptions adjusted for current health conditions are a good starting point for retirement planning.

Returning to the subject of cash reserves, I do not view reserves as an important part of income generation as the yields are currently too low. Unfortunately for prudent investors, top quality yields will have to rise to the high single digit levels before they become a major income generator. While there are intriguing fixed income credits in the marketplace today, they are not without risk and belong in the risk assumption portion of a portfolio. Some of these credits could be appropriate for one mini-portfolio but not others. For example the tenth year slice for retirement might be appropriate, but not for next year’s tuition.

In summary, one should analyze the amount and quality of reserves one has. Over-reserving for some of the portfolios can be as dangerous long term as under- reserving. Reserves are an important ingredient to the overall structure for each of your portfolios.

Sunday, November 9, 2008

Augmented Unemployment Report Leads to Augmented Balance Sheets

The world being circular, when you begin going in one direction you eventually come back to where you started. This circumnavigation also applies to words. Recently on Bloomberg radio I heard a cogent discussion of the impact of unemployment statistics on the domestic economy. The speakers very quickly blew past the Department of Labor’s official unemployment number of 6%+, focusing instead on what the department calls “an alternative measure of total unemployment.” This “augmented unemployment” statistic takes into consideration part time workers who want to work full time, those who have dropped out of looking for employment, and a portion of the “self employed” who would prefer to be on someone else’s payroll. This augmented number is over 11%, possibly 11.8% for November.

From the standpoint of an analyst or policy-maker, the difference between 6% and 11% is huge. Basing decisions upon misleading data can have serious consequences to a national economy or to an individual’s wealth.

In the investment world, we see something of a contrary relationship. Simplistic “value” investors often feel a stock is “cheap” relative to its book value as presented in balance sheets. A careful analysis of what makes up book value, particularly for a company that has grown by acquisitions, include a number of items generated by acquisitions such as the value of customer lists, an updated value of real estate (useful for an acquisition, but not for an acquirer) plus the remaining net difference between the price paid and all other assets which is labeled “goodwill.” This is not the first time that accounting rules and investment usage differs.

The accounting book value is measured against price to determine whether a stock or a market is currently attractive. On this basis, many investors believe much of today’s stock prices are attractive compared to history. Those of us who have grown up in the financial community prefer to rely on “tangible book value” which is lower than reported book. I often advocate reconstructing a balance sheet to determine true value under varying assumptions. Many accountants and investors have accepted that an augmented book value is more useful than a book value generated by hard assets.

Then why is it so difficult for wealthy individuals, particularly ultra high net worth (UHNW), to develop their own augmented personal balance sheet?

One of the elements of an augmented personal balance sheet would be what someone would pay for his/her home less the expenses of the sale, including taxes, less the cost of replacement living accommodations. This figure should be modified by the difference between the mortgage on the old dwelling and the new. Another example of an asset to be added to your balance sheet is the value of your business-related mailing lists. (If you do any significant amount of fund raising for any non-profit or political organization your personal mailing list could be quite valuable to another fund-raiser.) There are other assets that could and perhaps should be added, such as a portfolio of unexploited patents, sale of a brand name, current ownership of debt selling well below maturity value, etc. The augmented personal balance sheet should a complete list of actual and potential liabilities or commitments.

The augmented personal balance sheet can make the difference between an estate that accomplishes the grantor’s desires and one that produces just the opposite. In one specific example, a rather extensive list of specific dollar commitments to personal or charitable beneficiaries was designed both to meet those obligations and to reduce the residual estate so that a bunch of spoiled trust fund babies were not created. But, in this case, because little or no value was placed on various intellectual properties-patents, brand names or badly out dated valuations of real property, the residual estate was many times the expected amount, creating just the situation and resulting behavior pattern the grantor wanted to avoid.

The same result might occur if the grantor, while alive, used too small a valuation on his/her assets relative to liabilities and thus had reserves too large for future payments. This type of discussion and analysis should be done privately and often with other professional advisers present.

Traditionally when the Marines have landed their basic units; platoons, companies, battalions, regiments and divisions, are augmented with additional specialists and firepower. Thus, I am quite comfortable with the process of augmentation as it is often needed to accomplish the mission.

I discuss these principles in my book, Money Wise, and in my recent interview with Steve Forbes on's Intelligent Investing site. I hope you find it as interesting an experience as I did.

Sunday, November 2, 2008

Ultra High Net Worth Grantors & Charities: Plans “B”, “C” and “D”

If the wealthy really believe in the good works of specific charities, they need to step up their investment of time and money to prevent charities from having to play the alphabet soup game.

‘Tis the season for charities to push for collections through cookie sales, luncheons and galas to meet the fund raising goals set in the “Affluent Times” of a year ago. This could be described as executing Plan “A.” Judging by last minute invitations to fill a table at prestigious events and low returns from auctions silent and live, Plan “A” is coming up discouraging short.

Depending on which non-essential, pricey consumer item one focuses on, sales fell off a cliff in August, September, and October. Confirming this trend is the decline in discretionary spending for ball gowns and high-end vacation homes. Unfortunately, gifts to charities are also way below budget - in many cases below levels of sustainability.

This is the budget season for charities, be it your Alma Mater, hospital, social services organization, or cultural institution. In each of the board meetings of the organizations that my wife and I sit on, expenses are being scaled back almost to the point of endangering the mission. Existing fund raising efforts are being pushed to be more effective. Thus, we are in Plan “B,” which is to continue the existing mission(s) using diminished, available resources. This is the plan which most military leaders are eventually graded, however some of us conservative investors fear that Plan “B” won’t work.

So far there is little talk about Plan “C” where “C” stands for cutbacks. Due to funding short falls, organizations may be forced to cease funding major commitments which could amount to 10-25% of Plan “A” expenditures.

A difficult by-product of Plan “C” is the compensation review of hard-working, effective senior level staff who are generally paid only a percentage of what similar work would command in business. In a Plan “A” World, this works well, however when commercial wages are being cut back, (which can happen soon), the ratio of high paid non-profit staff rises to perhaps an unsustainable level in the eyes of major contributors. As most non-profits are thinly staffed in senior positions by very hard working people, a reduction of their pay can lead to them being forced to leave. This would affect many donors at all levels who identify with staff leadership almost as much as with the charity’s mission. Staff departures at this level make necessary the consideration of Plan “D.”

Plan “D” is based on the belief there will not be a quick, cyclical recovery, placing into question the sustainability of a charitable unit. Plan “D” would merge the unit into a larger, perhaps umbrella organization. As an investor, a buyer and a seller of companies, I have a high level of skepticism that mergers work. Most that fail presume that revenues (in the case of charities, grants) will grow by just expanding the product line without significantly expanding the number of sales people. The flawed strategy also holds that a larger group might generate more favorable purchase discounts on products and services that can be essential e.g. advertising, cars, etc. For Plan “D” to work, a crisp execution is necessary.

The wealthy, that is anyone that has funds in excess of current needs, should be changing their priorities, moving grants/gifts to charities from a discretionary expense to an obligation level. This is the time when both present and future programmed dollars can mean the survival for many purveyors of good works. What is also extremely important is to make available one’s skills in sales, administration as well as the mergers & acquisitions of good people and organizations.

An important part of my approach to building a personal augmented balance sheet is the segregation of different demands on one’s wealth. Ideally, each charitable obligation should have its own portfolio of assets to meet the charity’s immediate and long term needs. The squeeze on today’s gift dollars should motivate people to create specific asset bases to support specific charities. There is no better time than now to start this process.