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The 12b-1 fee was a bad idea from the start, and has had 24 years to prove it. There may never be a better time than now to put it to rest. - Chet Currier, Bloomberg 2-13
But every rules change brings unintended consequences, and mandatory redemption fees are no exception. In this case, the problems could snare a lot of ordinary investors. The problem occurs because people who invest through large firms get folded into an "omnibus account." In this fashion, all customers of, say, Charles Schwab, get lumped into one account. In an overly simple example, a fund is not told that "Schwab customer Joe Smith bought 100 shares and John Doe sold 50." It is only told that Schwab's customers combined to buy 50 shares. If both individuals reverse those trades two days later, the fund only knows that a total of 50 shares was sold by Schwab investors, and it does not know that the two individuals have been in and out quick. You can hide a lot of trading activity that way, which is why redemption fees to date have only slightly reduced the problems associated with rapid-fire trading. By making the redemption fee mandatory, you force those intermediaries to identify each individual account. That stops investors from gaming the system by market timing in 401(k) accounts, brokerage accounts or other places where this kind of activity has not been ferreted out. Getting that kind of information on all accounts won't be cheap, and you can bet that fund companies will pass the cost along in the form of higher expense ratios. What's more, if you rebalance your 401(k) account every six months and just happen to be in a fund that has a six-month redemption fee, the fund will now be identifying your trading activity and dinging your account. Smooth your portfolio too often, and your fund might kick you out altogether because you make too many trades. Rebalancing and tactical asset allocation moves are not problems the SEC wants to stamp out. When all is said and done, the redemption fee may not be enough to stamp out abusive trading, but the SEC won't make the fee more punishing. Expect traders to price the fee into their models and keep going.
Can a portfolio be too large? Yes. According to academics, a portfolio becomes too large when the risk-reduction benefits of adding an additional stock are outweighed by the additional transaction costs associated with buying that stock. So optimal portfolio size is a trade-off between additional risk reduction and higher transaction costs. Several factors have caused the equilibrium in this trade-off to increase markedly over the years. One is a dramatic reduction in transaction costs. When the original research into optimal portfolio size was conducted in the 1960s, brokerage commissions were higher. Recommended portfolio size therefore came in at a relatively low level, at around 20 stocks. Today, in contrast, transaction costs are much lower. So the equilibrium comes in at a many more than just 20 stocks. Another factor causing this equilibrium to be reached at a much bigger portfolio size is individual stocks' increasing volatility. The average stock today is more than twice as volatile as it was in the 1960s. Interestingly enough, the professors who conducted this research also found that the overall market is not any more volatile today than it was 40 years ago. It appears to me that the decreasing correlation between randomly selected stock A and randomly selected stock B is the stronger reason that portfolio size needs to be increased. [See paragraph three in the posting below for the stats on that finding.] Hulbert may have confused the 'decreasing correlation' with what he labels 'volatility'. If not, then he missed the stronger argument for increased portfolio size. The text of the study is not layman friendly. So there is some chance that the confusion rests with me. 'Have Individual Stocks Become More Volatile' Cambell, Lettau, Malkeil & Xu - 2000 Over the period of 1962-97 there has been a noticeable increase in firm-level volatility relative to market volatility. We first confirm and update Schwert's finding (1989) that market volatility has no significant trend using monthly data from 1926 to 1997. There have been episodes of increase volatility, but they have not persisted. We find that market and industry variances have been fairly stable in CRSP data ranging from 1962-1997. However, firm-level variance display a large and significant positive trend, more that doubling between 1962 and 1997. Telecommunications, computer and retail sectors exhibited a particularly large upward trend in firm-specific volatility. We document the evolution of correlations among individual stocks by calculating all pairwise correlations among stocks traded on the NYSE, AMEX and NASDAQ. There is a clear tendency for correlations among individual stock returns to decline over time. Correlations based on five years of monthly data decline from 0.28 in the early 1960's to 0.08 in 1997, while correlations based on one year of daily data decline from 0.12 in the early 1960's to between 0.02 and 0.04 in the 1990's. William Schwert ('Why Does Stock Market Volatility Change Over Time' 1989) presents an extensive analysis of the relation of market volatility with economic activity confirming R.R. Officer's ('The Variability of the Market Factor of the NYSE' 1973) earlier results that market volatility is higher in economic downturns. Cambell, Lettau, Malkeil & Xu find that volatility is three times higher during recessions and that the volatility is even stronger for smaller portfolios. In response to Officer, Andrew Christie ('The Stochastic Behavior of Common Stock Variances: Value, Leverage, and Interest Rate Effects' 1982) argues that this effect is due to increased financial leverage in recessions. However, Schwert shows that leverage by itself cannot account for the strong negative correlation of market volatility with economic activity. More recently, James Hamilton and G. Lin ('Stock Market Volatility and the Business Cycle' 1996) find that economic recessions are the single most important factor explaining market volatility, account for about 60% of its variation. Reasons for Increased Volatility There are several reasons why the variance of idiosyncratic shocks to cash flows might have increased over the past several decades. In corporate governance; there has been a strong tendency to break up conglomerates and replace them with more focused companies specializing in a single industry or economic activity. Companies have begun to issue stock earlier in their life cycle, often at a stage where profitability is not yet clearly established and there is considerable uncertainty about long-run prospects. Increased leverage would explain some of the volatility, but the bull market of the 1990's decrease US corporate leverage. It is tempting to argue that idiosyncratic volatility might have increased because information about these cash flows is now disseminated far more rapidly. But Kenneth West ('Dividend Innovations and Stock Price Volatility' 1998), Robert Shiller ('Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?' 1981) and Stephen LeRoy and Richard Porter ('The Present-Value Relation: Tests Based on Implied Variance Bounds' 1981) show that improved information actually decreases volatility. The improved information increases the volatility of the stock price, but it reduces the volatility of the stock return because new arrives earlier, at a time when the cash flows in question are more heavily discounted. One of the most noticeable recent changes in the stock market is the increased share of institutional ownership, particularly in large stocks. Inquisitional investors - notably pension funds and mutual funds - form a small, relatively homogeneous group whose sentiment may be influenced by a few common factors. this suggests that shocks to institutional sentiment might be important in explaining the increased idiosyncratic volatility of stock returns. Malkiel and Xu ('The Structure of Stock Market Volatility' 1999) find that the proportion of institutional ownership is correlated with volatility. This could be due to reverse causality, since institutions prefer more liquid, heavily traded stocks which may tend to be more volatile (Paul Gompers and Andred Metrick - 'Institutional Investors and Equity Prices' 1999). While gathering studies by the above authors, I ran across 'Efficient Tests of Stock Return Predictability' by John Campbell and Motohiro Yogo, where they found evidence for stock return predictability with the short rate and the long-short yield spread. It surprised me that the 'random walk' theory could be replaced. Other studies in that vein that could be of interest: (1) Andrew Ang, and Geert Bekaert, 'Stock return predictability: Is it there?' 2001 (2) Eugene Fama and Kenneth French 'Dividend yields and expected stock returns' 1988 (3) S.P. Kothari and Jay Shanken 'Book-to-market, dividend yield, and expected market returns' 1997
Federal regulations require that a majority of fund directors be outsiders - people not affiliated with the funds or the advisory firms - and the SEC has proposed raising this to 75%. "It's hard to imagine why requiring the board to choose its chairman from that group is an unreasonable restriction," argues John Bogle, founder and former CEO of the Vanguard Group. Edward Johnson, chairman and CEO of Fidelity Investments, argues that numerous academic studies have shown that public companies chaired by outsiders don't enjoy better stock gains than ones chaired by insiders. There are two flaws to this view. First, it fails to recognize that fund companies are very different from ordinary corporations. With a fund, the customers and shareholders are the same people, so the fund's board is expected to do what's best for the customers. But with a car manufacturer or other typical "public" company, the shareholders and customers are different groups. The board, working on behalf of an ordinary corporation's shareholders, has every right to act against the customers' interests - by raising prices, for instance. For a more apt analogy from the world of ordinary corporations, consider the carmaker that has as its chairman the person who runs the company's steel supplier. The steelmaker wants to charge more for its product; the carmaker wants to pay less. If the same person chairs both, whose interests does he favor? That's the problem when fund boards are chaired by their investment advisers. The second flaw in Johnson's case is its assumption that ordinary corporations set a standard that fund companies should emulate. In fact, shareholder democracy at corporations, as well as fund companies, is like democracy in the old Soviet Union: You get to vote, but there's only one candidate. Johnson would have a stronger case if he had pushed for real democracy in funds - annual votes for directors and a streamlined way for unhappy shareholders to nominate candidates to compete with those picked by the directors themselves. In fact, the SEC's chief failing in the current round of fund-management proposals is that it hasn't gone this far. But in proposing independent chairmen, it is at least moving in the right direction.
If the Fed Model held true, earnings growth should be slower when Treasury note rates are high and faster when those rates are low. Historically that has not been the case, according to the new study, "Inflation Illusion and Stock Prices," by the Harvard finance professors John Y. Campbell and Tuomo Vuolteenaho. The study has circulated this month as a National Bureau of Economic Research working paper and is at www.nber.org/papers/w10263. A similar conclusion was reached in a study by the finance professors Jay R. Ritter of the University of Florida and Richard S. Warr, now at North Carolina State. That study, published in 2002, covered 1978 to 1999, but the new one covered a much longer period: 1927 through 2002. According to the professors, interest and inflation rates are highly correlated. And over those 75 years, earnings growth has tended to be higher during periods of high inflation and lower when inflation is low. They found that the growth rate of real [inflation-adjusted] earnings is relatively constant when measured over several-year periods. That means the growth rate of nominal earnings tends to rise and fall with inflation. Professors Campbell and Vuolteenaho found that the stock market has tended to become significantly undervalued in times of high inflation and overvalued in times of low inflation. Consider equity valuations during the late 1970's and early 1980's, when interest rates and inflation were high. Investors used the equivalent of the Fed Model to justify a low P/E ratio for the overall market. That caused stocks to become significantly undervalued - and a reason for the strong bull market in the 1980's and 90's. The situation today is the mirror opposite of what prevailed in the late 1970's, suggesting that stocks may be as overvalued today as they were undervalued then. My first impression is that there are not enough periods of high inflation during these time periods to make a statistically significant finding. It is equally likely that the findings are a product of coincidence without causation. I think that productivity also grows profits, and productivty would be dis-inflationary. But I am trying to overcome that first impression. The finding starts to make sense once I stop believing that 'this time is different' and productivty - which has a history of being sporadic - will this time be a continuing force. Also, I have a natural investor's prejudice against any arguement that says the market is over-valued. It is also natural to believe that investors prefer a sure thing. As bond rates rise, more investors would be drawn to bonds. Thus stocks, due to the lack of fund flows, would become relatively under-valued. And as bond rates drops, more funds flow to stocks and they become over-valued. The Campbell and Vuolteenaho research is basically saying the same thing. More information on the 'Inflation Illusion' From 'The Decline of Inflation & the Bull Market of 1982-1999' by Jay Ritter and Richard Warr Inflation erodes the real value of the bondholder's asset. Inflation results in a wealth transfer from bondholders to the equity holders of levered firms. Debt, being a nominal or fixed dollar contract, is reduced in real value terms by inflation, but bondholders are compensated for this by an inflation premium in the nominal interest rate they charge the firm. This nominal borrowing cost results in lower net income for the firm. The decline in net income, however, is offset by the decrease in the real value of nominal liabilities. Generally accepted accounting principles do not recognize this gain. But it is a true economic gain to equity holders, whether or not accountants recognize it. Any valuation approach that relies on earnings will be biased downward for levered firms in the presence of inflation unless explicit correction are made. This misvaluation is not due to an inflation surprise, or a change in unanticipated inflation; rather, this error can occur even if investors have perfect foresight about future inflation.
Investors ought to know better than to chase hot funds, but it seems they don't. Consider the flow of money into stock funds in January for proof. Americans poured a near record of $40.8 billion into funds last month, according to AMG Data Services, with much of that cash going into last year's hot asset groups like foreign and small-cap stocks. It was the third best month since 1992. One more reason to fear that investors are chasing performance: The last time this much money was gushing into funds was the first two months of 2000. You know what happened next. Before the bear market, many funds were too new to have experienced a significant downturn. So specialists suggested investors turn the performance ads upside-down, and ask themselves, "If a fund can go up 75% in a year, it can lose that much, too. Would I be able to stomach that ride?" Here's a suggestion: Any fund that is willing to show off its most recent year of performance should also have to show its worst 12-month run ever. That decline should not be based on annual numbers. If a fund peaked on March 10, 2000, and had its worst year immediately thereafter, it would have to show the loss from March 10, 2000, through March 9, 2001. Fund executives will have a cow over that suggestion. And that's precisely why it is worth requesting. "You'd get a good flavor for volatility looking at that kind of number, a real-live worst potential downside," says Ruben Brewer, director of mutual fund resources at Value Line. "It's something that might stop some people from chasing the performance they see . . in the ads." "If recent performance attracts you, look at the worst performance. If it looks too scary, you'll forget about what you saw in the performance ad. And that might be the best thing that fund investors can do" says financial adviser Mark Balasa of Balasa, Dinverno & Foltz.
2. Why are people who are appalled by insider trading so quick to trade on inside information when it comes their way? 3. If foreign markets are so risky, why do citizens of those countries invest so much of their own money at home? 4. Why will we spend 20 years in a job we hate so we can get a traditional company pension and yet, when we retire, we wouldn't dream of using our own money to buy an immediate annuity, thus purchasing a similar stream of income? 5. When we decide we have too much in stocks, why do we sell in dribs and drabs when, in fact, the quickest way to reduce risk is to sell everything right away? 6. Why do life-insurance agents seem to be the only people who think cash-value life insurance is a great investment? 7. When the stock market plunges and pundits declare that investors are panicking and selling, why don't we ever hear about the buyers? 8. If a young company's outlook is so bright, why are the founders so anxious to sell shares through an initial public stock offering? 9. When we buy a mutual fund through our individual retirement account, why do we shrug off the fund's high annual expenses, but get really steamed when the fund company duns our account for the $10 IRA fee? 10. Why do investors with terrible results nonetheless brag about their one investment that went up? 11. Why do people who had the foresight to start saving at age nine continue to save when they are age 90? 12. If stocks are a long-term investment, why is there so much buying and selling? 13. Why do the most glamorous companies often turn out to be the worst investments? 14. If we are investing for the next 20 or 30 years, why do we get rattled when the market has a bad day? 15. When we buy a stock, why are we so confident we know better than the folks who are happily selling us their shares? 16. Why do people buy like crazy when the local department store holds a sale, but rush to sell when share prices get marked down? 17. Why do stock-market forecasters take credit when the market goes their way, while decrying the stupidity of others when it doesn't? 18. Why do mutual-fund companies constantly remind shareholders to act like long-term investors, even as they advertise those funds with the best short-run performance? 19. If saving money is the key to amassing wealth, why are we so convinced that the neighbors are rich when all we ever hear about are their new cars and their lavish vacations? 20. Why do we hold onto investments that, given the choice, we would never buy again today? 21. Why do folks, who proclaim that the stock-market averages can't be beaten, never seem content simply to buy and hold market-tracking index funds? 22. Why do we sell winning stocks and hang onto losers, even though selling the losers and hanging onto the winners would be the smarter tax strategy? 23. Why do fund companies and brokerage houses continue to mistreat investors, when these firms would likely make far more money over the long haul if they helped customers to prosper? 24. Why do ultraconservative investors, who are so afraid of losing money that they keep everything in certificates of deposit, also buy lottery tickets, where losing money is all but guaranteed? 25 Why do people scramble to buy investments after they have performed well, even though that good performance means future returns are likely to be lower? 26. Why do we insist that the new kitchen cabinets are an investment, even as we concede that the new bedroom chest of drawers is just another purchase? 27. Why will we raise our bid for a house by $10,000 without blinking, but we kick ourselves when we forget to take the coupons to the grocery store? 28. If the salesman is so sure the stereo is well made, why is he also trying to sell us an extended warranty? 29. Why do people spend countless hours planning their one-week summer vacation, and yet they never give a moment's thought to how they will pay for their 20-year retirement?
But the issue is not just whether the investment qualifies, but whether the investor has done the right thing to earn the tax break, too. Without getting too bogged down in specifics, investors don't qualify for the reduced tax rate if they don't own the issue for more than half the 120 days around which the dividend was paid. That's where the confusion really starts when it comes to the new tax rules and mutual funds. The rules are much more complicated with stock ownership, margin accounts and more, but this discussion is limited to funds. That's where the confusion really starts when it comes to the new tax rules and mutual funds. The rules are much more complicated with stock ownership, margin accounts and more, but this discussion is limited to funds. Say, for example, you invested in Fund X on Dec. 1, 2003, and the fund distributed dividends and capital gains on Dec. 9. Let's say your stake in the fund generated $500 in dividends, of which $250 were qualified. The fund by now would have sent paperwork showing you that $250 qualifies for the lower rate. But the fund company has no way of knowing if YOU qualify. If you dumped the fund on Jan. 30, 2004 - even though the sale occurred in a different tax year - you weren't in it long enough to earn the better tax rate. The firms sending you 1099s don't police the rules and they are counting on individuals knowing what to do. What makes this issue so tricky is that qualifying dividends are handled differently than most fund tax issues. When a fund distributes capital gains, for example, it is the trading activity of the fund alone that determines how those gains are taxed. So if you buy Fund X eight days before it distributes a long-term capital gain and dump the fund a month later, the fund's payout remains a long-term gain even though you held the fund a short time. The good news here is that buy-and-hold investors don't have this problem, meaning the tax confusion should be limited in scope.
Last year - when the small-caps of the Russell 2000 index returned 47% and the large-caps of the S&P500 returned 29% (both figures include dividends) - was the fifth in a row in which small-caps beat large-caps. Similar streaks have occurred between 1938 and 1945, between 1963 and 1968, between 1974 and 1983, and between 1991 and 1994. Yes, the small-cap cycle is getting a little long in the tooth. Byron Wien of Morgan Stanley reminded clients recently that "the current cycle . . . has already lasted about as long as the average run for these stocks," which is about five years, and that "the best time to buy small-cap stocks is at the bottom of a bear cycle or the trough in an economic recession." Right now, we're in the third year of an expansion. Also, the valuations of small-caps - for example, their price-to-earnings (P/E) ratios - were low in the late 1990s compared with high-flying large-caps. Now, they're almost back to normal. Still, it's not wise to fight momentum, and small-caps are on a roll that could match that glorious 1974-83 period, when they rose 867%, compared with 175% for large-caps. Third, small-caps are benefiting from market inefficiencies. According to efficient market theory, at any moment all publicly available information is reflected in a stock's price. It's the "right" price and, from today's perspective, the price will move in the future in a "random walk," a journey you can't predict. But, as Warren Buffett has written, "Observing that the market was frequently efficient, [the theorists] went on to conclude incorrectly that the market was always efficient. The difference between the propositions is night and day." In other words, a smart investor can often find inefficiencies - or bargains - in mispriced stocks. Moe believes that small-caps are far less efficient than large-caps because investors and analysts pay far less attention to them - so all possible information doesn't get built into the price. The efficiency disparity between small- and large-caps has always existed, but Moe argues that it has gotten wider. One reason is that money has poured into index funds, which are mainly based on the large-caps of the S&P 500. Those bigger companies, more than ever, are the focus of attention, so they are less likely to carry "incorrect" prices. The other reason is that major investment firms have cut back on research after the recent corporate scandals, which forced reforms that separate investment bankers from analysts. Perhaps those reforms will make research more accurate (I have my doubts), but they have certainly made it less plentiful. "Currently," writes Moe, "90% of the Nasdaq companies and 60% of the NYSE companies that are below $1 billion in market cap . . . have zero research coverage." For investors looking for bargains among small-caps, that's very good news. In the end, the appeal of small-caps is this: They return more than large-caps (by about 2 full percentage points annually, on average, since the 1920s). But higher returns always come with higher risk. You need small-caps in your portfolio, but don't go overboard. Between 10 and 20 percent of your equity assets will do. More on Small-Caps AP via Boston Globe 2-18 Even if you missed out on last year's gains, there's still plenty of reason to put money in this asset class. The smaller firms that survived the downturn have emerged leaner than before, and in some cases with stronger management, benefiting from an influx of senior staff laid off by larger organizations. Now, with a robust economy predicted for this year and many smaller companies consistently reporting earnings above expectations, small-caps are poised for continued success, said Mary Lisanti, president of New York-based investment adviser AH Lisanti Capital Growth. "A lot of intellectual property resides with small companies," Ms. Lisanti said. "There's usually some theme that gives them a nice wind at their back. You add that to an economic expansion and it becomes a nice, stiff breeze." If you were among the investors who raised their small-cap exposure to more aggressive levels last year, it may be time to count your winnings and trim back, said Laura Pavlenko Lutton, a mutual fund analyst at Morningstar. Broadly speaking, she said, small-caps have had a strong run and are probably due for a breather. "But you don't want to abandon this group," Ms. Lutton said. "That was a great lesson of the bear market. Small-caps were chugging along when many of the diversified funds were crashing and burning. You always want to have a small portion of your portfolio dedicated to small-caps, so you won't miss it when they go up again." There are 5,500 public companies with market caps below $2 billion. Related: Time for Big Caps? Odette Galli, SmartMoney
Many economists increasingly are asking whether there's something about this recovery that is substantially different from past ones: Are companies more cautious than they've ever been before? Given the relentless pace of globalization, it may be that many executives have greater competitive concerns than has been true at this stage of previous recoveries. And that may be translating into a stronger reluctance to spend, or at least a sharper focus on spending as little as possible. A fourth-quarter survey of U.S. chief executives by PricewaterhouseCoopers found that 68% believe that the current business environment is making companies risk-averse, the accounting and consulting firm said last week. Just 5% of the CEOs in the survey said they were taking "significantly" more risks in their business than a year ago - even though 85% said they were confident they would meet or exceed profit targets this year. Some Wall Street pros say it would be more surprising if executives weren't cautious, given what they've been through in the last few years. The recession of 2001 wasn't severe in terms of consumer spending, but it was horrendous for corporate finances: The operating earnings of the blue-chip S&P 500 index companies suffered their deepest plunge in more than 50 years. Mindful of that slump, and of the resulting surge in business bankruptcies, many companies feel continuing heavy pressure to bolster their finances, said Gail Fosler, chief economist at the New York-based Conference Board. Something else may be weighing on corporate spending: Some say the scandal wave that began with Enron Corp.'s collapse in 2001 has fostered a climate of fear in the executive suite - including fear of making an otherwise honest misstep. "We see more and more evidence that 'reputation risk' is a huge issue with CEOs," said Daniel DiFilippo, head of the U.S. governance, risk and compliance practice for PricewaterhouseCoopers. If executives truly are worried about making strategic mistakes with shareholders' money, they have another option: send more of the cash directly to shareholders, via dividends. If corporate caution remains at high levels, fatter dividend payments could be the best hope for new job creation in the economy. By reinvesting the money, or by spending it, investors might well contribute more to economic growth than if the cash just sits in corporate checking accounts.
In the absence of perfect risk gauges, investors turn to imperfect ones, such as the P/E ratio. From 1935 through 2003, the P/E for the Standard & Poor's 500 index, the most widely used market gauge, averaged 15.5, based on earnings reported in quarterly reports, according to Standard & Poor's. But the figure has averaged 23.6 since 1988 and 29.5 since 1996. Most experts seem to agree that the "normal" P/E is now higher than the long-term figure of 15.5, since conditions have changed over the years. At the same time, many agree that the 1996-2003 P/E of 29.5 was too risky, since the late '90s bubble and subsequent crash were the result. So where does that leave us? Lots of pros think "normal" is around 20 - maybe. At the end of last week, the S&P 500 had a P/E of 23.4, indicating stocks are still somewhat risky. Unless earnings grow, share prices would have to fall about 15% to get the P/E to a norm of 20. There's another problem: Which earnings figure should we use? The long-term averages are based on "reported" earnings, but different accounting produces "operating" earnings, "pro-forma" earnings, "core" earnings and "forecasted" or "estimated" earnings. Using a "forecasted operating" earnings figure for 2004 put the P/E at only 17.7. That's low if the norm is 20; stocks don't look risky. Cliff Asness, founder of AQR Capital Management, argues that comparing forecasted earnings to a norm based on reported earnings is apples to oranges. Instead, he says, forecasted earnings from the past should be used to figure the norm. The data, which go back to 1976, show that this produced an average P/E of 12.1. Today's level of 17.7 means stocks are "a lot more expensive than the norm for the last 28 years," he concludes. If earnings don't rise, stock prices would have to fall by more than 30 percent to get back to the norm. Next, he takes on another of today's rationalizations - that it's OK for P/Es to be high when interest rates are low. This view involves flipping P/E over and dividing earnings by price, producing a figure called earnings yield. If so, today's P/E of 23.4 looks all right. But there's a problem, says Asness: In the real world, low interest rates come in times of low inflation, which means companies cannot raise prices on the goods and services they produce. That hurts profits enough to offset the benefits of low interest rates. Even when interest rates are low, high P/Es mean high risk, he says. This doesn't mean today's P/E ratios spell imminent disaster. Even if companies cannot raise prices, they can increase earnings by cutting costs and selling more goods and services. Stock-market investors can hope that not many people see things as clearly as Asness does. So long as investors think share prices should rise, they will. That's called a bubble - and we know what happens to them. Reasonable Valuations Valuations overall are reasonable but not cheap. The S&P trades at 18 times 2004 earnings, up only slightly from a forward P/E of 17 at this time last year, despite a 26% gain in price since then. If the market only rises in line with expected earnings progress, that still would represent a healthy double-digit return. . . . With corporate profits seemingly well on the mend and the economy picking up steam, the major impediment to the market's continued gains is potentially rising interest rates. Given that the Fed is for the first time since the 1930s actually hoping for slightly higher inflation (to eliminate the risk of an economy-stopping deflation) and that 2004 is an election year, it is unlikely the Fed will take drastic action this year (absent an exogenous financial shock). (Edwin Everett, The Babson Staff Letter, via Washington Post 2-01) Low Rates Boost S&P Income Jesse Eisinger, WSJ 2-09 Investors need to know what portion of profits is at risk if rates rise, as is widely anticipated. In 2003, the financials sector, as defined by the Global Industry Classification Standard that S&P uses, accounted for 27.1% of earnings before extraordinary items and 31% of operating earnings (adjusted for market capitalization). Many companies outside the financial sector have finance activities so those figures underestimate actual financial earnings. The CSFB quantitative equity derivatives strategy group added up all the nonfinancial companies' financial earnings. It turns out that financial profits before special items as a portion of overall S&P 500 earnings rises to 33.4% from 27.1%. It rises to 37.4% of operating earnings from 31%. That means that fully 10.3% of the operating earnings of nonfinancial companies comes from finance activity, a significant portion to be at risk in a new rate climate. So which companies? About half of GE's earnings, according to Barra calculations, come from finance earnings from the GE Capital unit. Ford gets 15% of earnings come from financing and GM a third. Many industrials, have finance arms. About 12% of Deere's earnings come from finance. As Mika Toikka, the head of the CSFB group, points out, while expectations for stock volatility are quite low now, in the longer term, "Once rates start increasing, we may see more earnings volatility because S&P 500 earnings have such a high sensitivity to financial earnings. That could play out in equity-market volatility." And that means at some point, things will get bumpy again.
Unlike retail investors, who can buy or sell these shares only from other retail investors, these institutional investors conduct their transactions with the fund itself. According to Roger Edelen, who published four research studies on fund liquidity and pricing while he was a finance professor at the Wharton School of the University of Pennsylvania, these investors quickly trade an ETF's shares whenever the spread widens between its market price and per-share value. This has the effect of largely eliminating the difference. Doesn't this institutional market require an ETF to continuously calculate its per-share value? Mr. Edelen says no, because these transactions are conducted in kind, not in cash. When an institutional investor sells ETF shares, it receives shares of the stocks that the fund shares represent. For the process to work, institutional investors must know in advance which stocks an ETF holds and the precise portfolio weights of each. This need for disclosure would create a huge problem for an actively managed fund, because it would require managers to divulge not only the exact composition of their portfolios, but also every transaction they intend to make. This would allow speculators to trade ahead of the fund, which would likely hurt its performance. Mr. Edelen suspects that the ETF model will never catch on among actively managed funds. And Gus Sauter, the chief investment officer of Vanguard, said late last month that it was difficult to imagine how "the integrity of the fund could be protected." Related: ETF's vs Mutual Funds - Jonathan Clements, WSJ Michael Brush, MSN Money 2-04-04 Investors are looking for alternatives to the measly returns of money market funds or short-term bonds, for that matter. Where can they turn to find a substitute? One great option is a little-known but high-yielding corner of the investment world known as master limited partnerships (MLPs). In a nutshell, these are relatively safe investment vehicles - usually in the energy sector - that throw off 6% to 8% a year in the form of quarterly cash payments. Often, those payments grow as much as 7% a year. And they do all this in a way the lets you defer taxes, which is always a nice thing. If you've never heard of MLPs, join the club. This little cash cow that could gets lost in the shuffle for three reasons: [1] They are a little tricky to understand at first, so people tend to skip over them. When you read "Tax Treatment" in a following section, you will see the 'tricky' part. [2] Mutual funds can't own them, for the most part. So that parade of money managers on TV never touts them. (The Bush energy bill would change that.) Mutual funds (regulated investment companies) are required to obtain 90% of their income from specific qualifying sources identified in the tax code. No more than 10% of their income can come from other sources, or they will lose their 'regulated investment company' status. Largely because publicly traded partnerships (PTPs) / master limited partnerships (MLPs) did not exist when the mutual fund rules were written, PTP/MLP income is not on the list of qualifying sources. { source: National Propane Gas Association web site } [3] The term 'limited partnerships' dredges up bad memories of a series of devastating investment scams in the 1980s where investors lost billions investing in partnerships that never made a dime. The ABCs of MLPs First, by law, they mainly operate in the energy and natural resources fields. To qualify as an MLP, a partnership must receive at least 90% of its income from qualifying sources such as natural resource activities, interest, dividends, real estate rents, income from sale of real property, gain on sale of assets, and income and gain from commodities or commodity futures. Natural resource activities include income exploration, development, mining or production, processing, refining, transportation, storage and marketing of any mineral or natural resource. { source: Wachovia Securities } Like stocks, MLPs are traded publicly. Most are listed on the New York Stock Exchange. But when you buy one through your broker, you are buying a 'unit' (not a stock) that in essence makes you a limited partner in the MLP. It's that easy. In exchange, you get all the benefits of belonging to a partnership - which include the following: (1) You are getting income AND growth. MLPs have to give investors most of their cash flow in quarterly distributions. Those distributions are typically big enough to produce an annual yield of around 6% to 7% on your initial investment. And it's easy to find MLPs that are increasing their distributions enough so that if you hold one of them for a few years, you'll be enjoying an annual yield of 15% or more. During the past one and five years (as of 11-7-03), our MLP composite has delivered total returns of 45.6% and 17.6%, respectively, versus the S&P 500 Index total returns of 18.8% and negative 0.2%. For the first eleven months of 2003, our MLP composite has appreciated by 28.6%. { source: Wachovia Securities } (2) You get piece of the action in a relatively safe business. Many of the better MLPs are growing by purchasing oil and gas pipelines. TheyÌre on the market because the big oil and gas companies want to raise capital to develop promising fields. So they are selling off some of their slower-growth operations and pipelines in the United States. The pipeline business is relatively safe for two reasons. First, energy-price fluctuations are irrelevant, since these pipeline MLPs are paid for moving oil and gas around. Second, most of the fees they charge are set by regulators, which makes them very predictable. (3) You get protection against dumb management moves. Like it or not, many managers do a pretty lousy job of reinvesting cash from their businesses. But with an MLP, you are buying into a structure that forces management to give you the cash. To make an acquisition, the partnershipÌs management must have to ask your permission to issue new equity. (4) You can defer taxes. Essentially you can put off paying most of the taxes for as long as you want. Most of the dividend - typically between 80% and 90% according to Wachovia - gets treated as 'return of capital', which causes a downward adjustment to your cost basis. It is not taxable in the year it is recieved, but increases your capital gains taxes in the year you sell the MLP. Wachovia also notes that you will pay "ordinary income tax on deferred income" when you sell. See "Tax Treatment" in the Wachovia section below.. What to look for in an MLP First, you want to go for those that already pay a big distribution. Since MLPs often issue debt to expand, you want to see a debt-to-capital ratio below 55% as a rule of thumb. You want to look for signs of strategic thinking by management. It's better to shy away from MLPs that are exposed to the unpredictable movement of commodity prices (like propane and coal. We do include safer propane and coal MLPs in our seven picks, one each, because you want some diversification across a few sectors.) You should also know what percentage of income goes the general partner. As a unit holder, you are a part of the limited partners. The general partner 'runs' the company and gets a non-proportionate amount of the cash flows for the effort. Sometimes non-proportionate is disproportionate. Some risks and concerns Those cash distributions, of course, are not guaranteed. So for safety look for a "distribution coverage" ratio of more than 1. Distribution coverage is basically cash flow before accounting adjustments divided by the amount distributed. A ratio of 1 makes it sound like they are just squeaking by. But in reality, all of our seven picks { listed below } have cash reserves on hand as an extra cushion. And all but one - Teppco - have two classes of shares, a dual structure that puts public investors ahead of another share class in case cash is short. So the coverage ratio is really higher than it appears. Next, MLPs aren't suitable for IRA accounts because earnings above $1,000 will be considered unrelated business taxable income by the IRS. And as income-producing investments, MLPs could get whacked if interest rates and inflation go up too much. But, unlike bonds, they have some powerful, built-in safeguards. For starters, most of the energy-related MLPs on our list are in regulated industries where the tariffs rise in line with inflation. TheyÌre also increasing their distributions a lot, which helps offset any damage from fears that interest rates are going up. Finally, many investors in MLPs would face large tax bills on huge amounts of deferred taxes if they sold their units. That is taxed as ordinary income. So, the investors are often reluctant to dump the units just because interest rates are going up. A short list of good MLPs Seven attractive MLPs, according to buy-side analysts and A.G. Edwards' Ronald Londe, include: energy pipeline companies Teppco (TPP), Crosstex Energy (XTEX), Plains All American Pipeline (PAA) and Valero (VLI); gas processor MarkWest Energy (MWE); propane distributor Inergy (NRGY); and coal distributor Alliance Resource (ARLP). Londe says you should own at least five of these to get good diversification. A short list of good MLPs II From John Tysseland of Raymon James on 8-23-2002: Our favorite names in this sector are Enterprise Products Partners, El Paso Energy Partners, Inergy, Kinder Morgan Energy Partners, TEPPCO Partners, and Williams Energy Partners. We think these partnerships have some of the best growth opportunities and are the most likely to increase distributions to unitholders going forward. More MLP Information from Wachovia Securities Average Yields From 1998-2002, our MLP universe has had an average yield of 8.7%, ranging from a high of 12.1% to a low of 6.9%. The disparity in yield among MLPs can be explained by several factors including risk profile (financial and operational), growth prospects, and interest rate environment. Interest Rates & MLPs According to our analysis, the movement in interest rate can explain roughly 25-30% of MLP price movements, over the past ten years. Over that time period, the spread between the yield for the ten-year treasury (a proxy for interest rates) and MLP yields has averaged roughly 213 basis points. Thus, in periods of rising interest rates (i.e., when "risk free" money is available at higher rates), MLP yields have tended to increase, in kind. An increase in yield for MLPs implies a decrease in the price of MLPs. Tax Treatment Net income from the partnership is allocated each year to unitholders, who are then required to pay tax on his/her share of allocated net income regardless of whether they receive distributions. In general, distributions are well in excess of any tax liability. However, the unitholder is also allocated a share of the MLP's deductions (such as depreciation and amortization), losses, and tax credits. These deductions often offset a majority of the allocated income, thereby reducing the amount of current taxable income. Taxes are not paid on the portion of allocated income that is shielded by deductions until the investor sells the security. This is the tax-deferral benefit of owning an MLP. When the investor sells the security, there is a recapture of the deductions (depreciation, etc.), meaning the income that was deferred by the deductions becomes taxable income and is taxed as ordinary income. An investor's tax basis is adjusted downward by distribution and allocation of deductions (such as depreciation) and losses, and upward by the allocation of income. The net effect (the difference between cash distributions and allocated taxable income) creates a tax deferral for the investor. When the units are sold, a portion of the gain is paid at the capital gains rate and a portion of the gain (resulting from the tax shield created by allocated deductions) is taxed at the ordinary income tax rate. What Are I-Units? In order to expand the universe of potential investors in MLPs to institutional investors and tax-deferred accounts such as IRAs, an investment vehicle similar to LP units was created known as i-units (the i stands for institutional). Kinder Morgan was the first to offer i-units with the creation and issuance of Kinder Morgan Management, LLC (KMR), a limited liability company, in May 2001. Currently, the only other i-unit security is Enbridge Energy Partners, L.P. (EEQ). More MLP Information Lauren Rudd, Pittsburg Post-Gazette 10-23-03 MLP History Federal legislation in 1986 gave energy companies the right to spin off their capital-intensive production and transportation assets into separately traded master limited partnerships or MLPs. Congress enacted the legislation in an effort to stimulate what was, back in the 1980s, a moribund gas and oil industry. Taxes & MLPs When you buy an MLP, you are buying units of a partnership, not shares of a corporation. While operationally the differences are minimal, they do become obvious when you prepare your taxes. Instead of receiving a 1099 form detailing the dividends received during the year, you will get a K-1, which details partnership distributions. Note to self: Verify that your tax software can handle K-1's. The Biggest MLP Kinder Morgan LP (KMP) is the largest publicly traded pipeline limited partnership in the United States in terms of market capitalization and volume of product delivered. It also controls the largest independent refined petroleum products pipeline system in the country. The partnership owns or operates more than 25,000 miles of pipeline and approximately 80 terminals, which transport more than two million barrels per day of gasoline and other petroleum products and up to 7.8 billion cubic feet per day of natural gas. MLPs vs Royalty Trusts Dorothy Hinchcliff, Financial Advisor Magazine Oct 2003 Master limited partnerships and royalty trusts have similarities, but also major differences. One difference between the two investments is that cash flowing into royalty trusts primarily comes from oil and gas exploration, while cash going into energy-related MLPs usually comes from energy processing and distribution. In most cases, royalty trusts aren't partnerships and all units are equal. MLPs have a general partner that operates the partnership. As an MLP increases its distributions to common unitholders { the limited partners }, the general partner usually gets a disproportionately higher amount of total distributions as an incentive. Rising interest rates generally have more impact on the unit prices of MLPs, whose fees, based on contracts, won't necessarily be rising at the same time. Royalty trust units often are less affected because inflation generally accompanies interest-rate hikes, and that means the prices they get for their oil and gas will rise, too. But MLP's cash flow comes from fee-based businesses, such as the delivery of oil and natural gas through pipelines. Because they are delivering products rather than exploring for them, their distributions tend to be more stable than those of royalty trusts and aren't affected much by fluctuations in energy prices. A second advantage: The short reserve life of the oil and gas fields that generate cash for a royalty trust often means distributions wonÌt last very long. Widely respected independent energy analyst Kurt Wulff takes a dim view of many MLPs. "Their stability is partly offset by greater leverage and further by the free ride the general partners gets. They are not a particularly safe investment," he comments. Wulff says many MLPs are now overvalued and are paying distributions in excess of their sustainable capacity. Most general partners are getting 50% of incremental cash flow from their properties, he says. "They are diluting ownership because they are buying properties that offer a competitive economic value at eight times cash flow, and it will pay enough of a return to get the principal back and make 6% to 8%. The limited partners are responsible for the debt. The general partner is taking an equal amount but puts up no money. In the end, the properties aren't good enough to pay both," Wulff maintains. He adds general partnership interests often are not fully reported. Although he thinks many MLPs should be avoided, Wulff says one oil and gas MLP, Dorchester Minerals, may be worth a look. "It has no debt and owns royalty interests in some properties. It also isn't paying out any high general partnership compensation". He notes Enterprise Products Partners recently cut its GP compensation to 25%, but other MLPs have yet to follow suit. A long list of MLPs After looking at the dividend history of the AG Edward lists, I decided to do a bit more looking. VLI only started paying dividends in 2001, and XTEX in 2003. I wanted a longer history of dividend payments so that I could see dividend growth. I also knew that if I had used my brokerage in search for REITs, I would have had a smaller and less profitable group of REITs in which to choose. So I wanted a larger universe of menu choices than AG Edwards had provided. This data came from Yahoo. I sorted the sectors by dividend yield, then cross checked the high yielder's with a list of MLPs from "The Coalition of Publicly Traded Partnerships". The last 2 columns in the table - 'Revenue Growth' and 'EPS Growth', are for the most recent quarter compared to the same quarter of the previous year. the 'Coalition' web site listed more than twice this amount of MLPs, but this is the whole group from which I could retrieve Yahoo data. KMP and NBP were added to this list later, which is the reason that some of their columns are missing data. The Raymond James list was added 3-25-03.
The next set of data is from Multex via WSJ. It shows the median analyst rating and the dividend history since 1998. It is a concern to me that many of the companies do not have that long of a history. Those companies that I would consider as passing the dividend history test: BPL, PAA, TPP, EPD, GTM, KMP, and NBP in Oil, ARLP in Coal and HPG, SPH and possibly NRGY in Propane.
Altered Minutes One reason it has been so difficult to determine what top management and directors knew about - and did to cause - the business disasters of the late 1990s is the distortion of corporate-board minutes. All too often, these critical records are altered or left incomplete. When fraud comes to light, investigators struggle to assign blame, making it harder for investors to recoup losses and less likely that misbehavior will be deterred in the future. "The attitude is that it's OK to lie by omission in board minutes," says Charles Niemeier, a member of the Public Company Accounting Oversight Board. "It's the way it gets done, and the problem is that we have become accepting of this." The oversight board was set up under the Sarbanes-Oxley Act, legislation Congress passed in 2002 to improve corporate accountability. While the act addressed financial statements and public filings, lawmakers didn't look closely at problems concerning internal corporate documents. Name a corporate blowup, and there is usually an example of board minutes being altered or left incomplete. At Enron, investigators traced the board's knowledge of one dubious off-balance-sheet vehicle only through handwritten notes taken by the corporate secretary during a board meeting in May 2000. The information from the scribbled notes suggested that at least some Enron directors knew the arrangement was an accounting maneuver, rather than something aimed at substantive economic activity. But the formal board minutes from that meeting contained no reference to the directors' knowledge on this point. There aren't hard rules on how thorough board minutes should be. As a result, some corporate lawyers routinely use bare-bones minutes as a shield to protect companies from liability. The more words you put down, the greater exposure you have. But after the recent wave of scandals, many corporate attorneys are re-evaluating whether they need to include more detail in minutes to be able to show that directors have acted with due care and in good faith. In the WorldCom fiasco, a court-appointed bankruptcy examiner has found that the company created "fictionalized" board minutes in connection with its announcement in November 2000 of plans to create a so-called tracking stock that would correspond to the performance of its consumer business. WorldCom said at the time that the board had approved this move. In fact, the board hadn't given its approval, the bankruptcy examiner concluded. The board had held only a "minimal" discussion of the idea during a brief "informational" meeting. WorldCom management decided to transform records from the October meeting into minutes of a formal board meeting, complete with references to a discussion about the tracking stock that hadn't really taken place. The examiner faulted former senior WorldCom executives for the decision, although board members and WorldCom lawyers also bear responsibility. Unpaid Judgments Arbitration awards to investors who have been cheated often go unpaid. Sometimes suspect brokerage firms simply shut down. Wall Street has opposed certain changes that would ease the problem, such as requiring brokerage firms to have increased capital and more liability insurance. In the first quarter of 2003, the NASD imposed $99 million in damage awards against brokerage firms and brokers nationwide. What the NASD doesn't trumpet is that investors haven't been able to collect $30 million -- or almost one-third -- of that amount during that period, the most recent for which numbers are available. For 2001, the most recent full year for which figures are available, 55% of the $100 million in arbitration awards went uncollected. The NASD can suspend the license of a broker or securities firm that refuses to pay up. But many firms and brokers just walk away rather than pay. In 2000, the GAO issued a report calling for improvements in arbitration-award payouts. The NASD has responded by installing a system that tracks unpaid awards and requiring firms to certify they have paid, among other steps. But securities firms have successfully lobbied against two other potentially effective reforms. One would increase capital requirements, so that firms would have cash on hand to pay awards. The other would require firms to carry more liability insurance to cover awards. The Securities and Exchange Commission, which oversees the NASD and has jurisdiction on these issues, has reinforced this resistance in its own comments to the GAO. In reports released in 2000 and last year, the GAO recounted arguments made by the SEC that increasing capital requirements could force many brokerage firms out of business and potentially penalize responsible firms. The SEC also has argued that stiffer insurance requirements could raise investor costs. Murky Municipals Munis trade on an open market, but there isn't a place small investors can go to figure out whether they are getting a fair price. Bond dealers, with their superior knowledge of the market, can make a legitimate profit on the difference between what they buy bonds for and their sales prices. But dealers have gone a step further: opposing full online dissemination of real-time muni-bond prices that would help small investors. The dealers say that because many munis trade infrequently, it's difficult to determine precise prices. Immediate disclosure of some prices, they add, might increase volatility in the market and cause some dealers to stop trading certain bonds. Without fresh data on bond trading, individuals can fall prey to brokers who tack on excessive "markups." An example: Last May, the NASD alleged that Lee Murphy, a former broker at Morgan Keegan, charged too much in 35 bond sales. Murphy obtained markups from investors ranging from 4.07% to 7.18%. There aren't specific limits on markups, but the industry rule of thumb is that margins should be well below 5%, unless there are exceptional circumstances, such as the strong possibility that a municipality will default. Murphy settled the administrative charges without admitting or denying wrongdoing. He was suspended for 15 days and fined $6,000. Individual investors - who directly own an estimated $670 billion of the $1.9 trillion in outstanding munis - are better off than they were just a year ago. That's when the Municipal Securities Rulemaking Board expanded the amount of muni-bond data available on a Web site called Investinginbonds.com. The MSRB, a congressionally created self-regulatory body, provides the price, size and time of each trade - but typically with a delay of up to 24 hours. The board plans to report same-day trade data for many bonds beginning next year. But Wall Street is resisting. Brokers are lobbying the MSRB to delay the release of real-time data for some larger trades and lower-quality bonds so that the impact of the disclosures can be examined. And the list could have gone on. No one has touched on the subject that P/E ratios are sometimes so full of stale information as to be meaningless. The staleness of short ratios has been reported - infrequently. Trading/exchanging a mutual fund for a stock should NOT take separate business days. And given that some fund families will do exchanges with some other fund families without a commission, [see How to Dump a Fund Without Getting Clipped - Jonathan Clements, WSJ] this should be public knowledge. Muni Pricing Joe Mysak, Bloomberg 2-13 If you are an individual investor in the municipal bond market, you pay too much in fees for your bonds. You pay about double what the institutional investors do, about 2% of the value of the securities you buy. This is the conclusion of a report on `Municipal Bond Liquidity' by Lawrence Harris, chief economist of the SEC, and Michael Piwowar, a visiting scholar in the SEC's Office of Economic Analysis, published this week. The report was based on an analysis of 167,000 trades reported to the Municipal Securities Rulemaking Board from November 1999 through October of 2000. Consider some bonds sold by the Port Authority of New York and New Jersey that traded recently. These are the consolidated revenue bonds the Port sells regularly, backed by the fees it collects at New York area airports and tunnels, among other things. In other words, these are very solid bonds. As if that were not enough, these bonds are also insured, and so rated triple-A as to payment of principal and interest: the gold standard. The bonds were sold in 1998, and carry a 4.25% coupon due in 2026. They were originally priced at 92.16 to yield 4.76%, and are callable at 101 in 2005, and at par in 2007. On three days last week, the bonds were worth 92.5, 95, 95.5, 96, 96.5, and 98, depending on where you sat in the transaction and how many bonds you were buying or selling. This week, the bonds were worth 91.765, 92.856 and 96.5. Over the two weeks, the yields ranged from 4.38% to 4.79%. That seems to be a pretty big gap for some very secure and generic securities.
Investors who sign up for financial plans believe they are getting independent advice tailored to their own needs. But in one of several "open secrets" that have been hazards for investors in this era, these plans often are little more than sales tools that stand a better chance of making money for advisers and their firm than their clients. Critics say advisers rarely disclose that they get big bucks for directing investors to insurance products and mutual funds that provide the highest payouts, rather than offering investments that may pay the adviser less but are better-suited to the client's needs. Any information about potential conflicts is often vague at best and tucked into documents provided to investors when they are already well into the planning process. John Haritos was looking to cut his tax bills and save for retirement when he agreed to a free financial consultation with American Express Financial Advisors. Told his finances wouldn't allow him to meet his retirement goals, Haritos paid $500 in July 2000 for a financial plan. Haritos thought he "was paying for ... unbiased advice." He now says he figured wrong. What did Mr. Haritos get? A laundry list of American Express products he should buy. So he moved $26,000 from a money-market fund into a brokerage account that charged a flat 1.5% a year and invested largely in high-fee mutual funds. He also transferred his $4,000 individual retirement account to American Express and rolled a life-insurance policy into an annuity run by IDS, also a unit of American Express Co. Nearly all of the investments, which generated high fees for AmEx and its advisers, fared poorly. Haritos soon cashed out and sued the firm. He lost roughly $14,000, or about 35% of his total investment. American Express is contesting the charges. A good financial plan can be useful to chart an investor's future, of course. But "for a number of advisers it is a marketing hook," says Matthew McGinness, an associate director with Cerulli Associates, a market-research firm. Many financial firms that provide such plans also offer proprietary, or in-house, financial products. The potential for conflicts at American Express is intense because of its large stable of in-house mutual funds and insurance products. Proprietary products account for roughly 65% of adviser sales at AmEx, a regulatory filing says. Many AmEx funds have been poor performers. Over the past three and five years, AmEx funds have, on average, ranked in the bottom third of all fund families, according to Morningstar. American Express Financial Advisors carries a lower profile than the firm's credit-card business, yet it accounted for roughly 24% of American Express's $26 billion in revenue and 22% of its net income last year. Fees from financial plans and other advice services accounted for just $121 million of the unit's $6.2 billion in revenue last year, according to regulatory filings. But the importance of planning to AmEx and the firm's more than 12,000 advisers is far greater: Three-quarters of total sales were generated by financial plans and advice services. Financial advisers use the planning process to draw clients in, but they depend on product sales for their livelihood, current and former advisers say. Other former AmEx advisers say that when they presented a financial plan, they dubbed it "The Close," because of its usefulness in selling high-fee products, including proprietary funds and insurance that paid more to the salesmen - and to the firm.
David Bianco, accounting analyst at UBS, has a message for the doubters out there: It still pays, big time. In an analysis of earnings quality among companies in the Standard & Poor's 500-stock index, Mr. Bianco found that since 1998, stocks of the highest-ranking companies outperformed the index by a considerable margin. While the index returned 3.3%, annualized, during that period, the 50 companies with the best-quality earnings generated average annual returns of 12.3%, including dividends. Conversely, shares of the bottom 50 companies showed zero return, on average, over the same time. Mr. Bianco's measure of earnings quality takes into account one-time or special charges that companies often take to reflect what they consider unusual events, like major restructurings or widespread layoffs. But many companies take such charges all too regularly. And they often do not reflect them in their so-called pro forma earnings, the results they want investors to focus on. So, Mr. Bianco's view is that the more significant the charges over time at a company, the more questionable its quality of earnings.
About 70% of companies in the Deloitte survey made contributions to employees' accounts. Some match employees' contributions dollar for dollar, others pay in some percentage of what workers put in. Historically, many publicly traded firms have made their matching contributions in the form of company stock rather than cash. But more companies have given employees the right to immediately sell company shares in their 401(k) plans and shift the money to other options, the Deloitte study found. More than 80% of companies in the Deloitte survey said they had formal procedures for reviewing the performance of mutual funds in their plan. Fifty-five percent said they benchmarked their fund options quarterly, up from 47% the previous year. The Deloitte survey found that 36% of companies offer all employees customized investment advice.
In almost all cases, the letters that shareholders are receiving - and this activity has been spotty rather than universal across the industry - suggest that one of the key issues is whether investors hold the funds involved in multiple accounts. But getting an invitation to file a claim is a long way from actually receiving a rebate, and it can be a long process for little or nothing. If you get a letter suggesting you might be due a refund, check it out carefully. Call the firm before you file. Get specific instructions as to what kind of activity they are reviewing; insiders at several large firms have suggested they will process specific types of claims now, and may make a second round of letters for a different type of accounting discrepancy. Consider your eligibility. Breakpoints - where you get a break on sales charges - are enjoyed by folks with a lot of money at stake. Don't be shy about calling the fund families involved to find out what their breakpoint policy is, so that you know whether you would qualify. Find out whether their breakpoints are for monies within one fund or those spread out over the entire fund family. Once you know how the rules work, you may have an idea that you deserve a break. At that point, you'll be able to go through the paperwork with an expectation of a result besides disappointment and frustration. Read the fine print carefully. Make sure you are not waiving your right to pursue other remedies with the firm. Also look to make sure you give the information being requested. That includes not only account information in the time range being reviewed, but information from other accounts you hold. Without knowledge of your other accounts, the firm will go based entirely on information it has, and if that wasn't enough to get you a break the first time around, don't expect things to be better now. Keep your expectations reasonable. The more money you have invested, the more you save in breakpoints. But if you barely qualify - with, say, $50,000 in one fund, spread between a few accounts - your discount will be much smaller, most likely no bigger than 0.5 percentage point of the amount you invested. So let's say you had $25,000 in a retirement account and put another $25,000 into the fund through the brokerage firm. If that second deposit should have been charged the reduced rate, you'd be owed a refund of $125, or 0.005 times the amount invested. Just the Facts Senators Outperform Market US senators' personal stock portfolios outperformed the market by an average of 12% a year in the five years to 1998, according to a new study by Alan Ziobrowski of the Robinson College of Business at Georgia State University. The finding was based on 6,000 financial disclosure filings. There was no difference in performance between Democrats and Republicans. A separate study in 2000, covering 66,465 US households from 1991 to 1996 showed that the average household's portfolio underperformed the market by 1.44% a year, on average. And Dalbar stats would tell you the underperformance would be far greater. Corporate insiders (defined as senior executives) usually outperform by about 5%. (Financial Times 2-24) Seniors Underperform Market According to a new AARP study, in a survey of 900 Americans 50 and older - 60% of the respondents said they owned stocks in 2003, and half of those reported losses. Although 30% of older investors reported losses in 2003, 77% said they lost money on investments the previous year. The study did not explore why older Americans suffered stock losses in 2003, a year in which the S&P 500 rose 26%. I found the stats hard to believe. Another study released last week found that seniors who use credit cards are taking on more debt. For example, the average monthly credit-card balance of people between 65 and 69 tripled from $1,842 in 1992 to $5,844 in 2001, according to the "Retiring in the Red" report by Demos, a nonpartisan research group. (Chris Baker, Washington Times 2-24) Treasury Ending Bond Roll-Over At the end of August, the Treasury Department announced last week that it is taking away a very nice tax benefit allowed to holders of Series E and EE U.S. Savings Bonds - the ability to roll them over at maturity into Series HH bonds and defer taxes on the interest built up in the E/EE bonds. The department will cease issuing new HH bonds. Current holders of E and EE bonds will have until then to convert them; after that, E/EE bond holders will have to cash them in when they mature or sit on them and earn no additional interest. To make an exchange, E/EE bond holders need to file form PD F 3253, "Exchange Application for U.S. Savings Bonds of Series HH." To beat the deadline, this must be completed, properly signed and certified by a qualified savings bond agent -- typically a bank - for forwarding to a savings bond processing site by close of business on Aug. 31. (Albert Crenshaw, Washington Post 2-22) The 'Dirty Dozen' Red Flags in Financial Statements Barrons 1 Heavy reliance on nonoperating income or repeated 'nonrecurring' gains; 2 Using acquisitions rather than internal growth to boost earnings; 3 Creating reserves that can then be released into income; 4 Booking sales aggressively, esp. at the end of a reporting period; 5 Repeatedly taking write-offs or restructuring charges; 6 'Capitalizing' (putting on the balance sheet) development costs or anything that would normally be an expense 7 Changing accounting principles - or accounting firms; 8 Significant related-party transactions, insider stock sales or off-balance-sheet liabilities; 9 SG&A, receivables and/or inventories are growing faster than revenues; 10 Interest payments absorb a larger and larger portion of operating earnings; 11 The company pays a much higher dividend yield than its peers; 12 Cash flow is negative or the companyÌs cash position is steadily declining. Key Ratios to Gauge a Company's Health Operating Ratios: 1 Gross Margin = (Sales-COGS)/ Sales; 2 Operating Margin= Oper. Profit/Sales; 3 Net Margin= Net Income/Sales; 4 Return on Assets= Net Income/Assets; 5 Return on Equity= Net Income/ShareholdersÌ Equity Financial Ratios: Coverage Ratio = EBIT/Interest Quick Facts, Stats & Opinions In December, investors poured $12.6 billion of new money into exchange-traded funds, according to the ICI, pushing the funds' total assets to more than $150 billion for the first time. The December ETF inflows were nearly on par with investments in traditional stock funds. (Paul Lim, NY Times 2-29) Seventy-five percent of young women, according to an Oppenheimer Funds study, suffer from "Sex In The City" syndrome, where they believe they should look wealthy even if they're not. (Thomas Kostigen, CBS.MarketWatch 2-23) Good news for fundamentally inclined stock investors: Morningstar recently upgraded its free stock financial reports. Morningstar's financial reports now show each stock's fiscal year data going back 10 years. Morningstar also computes all the essential analysis ratios for us. (Harry Domash, San Francisco Chronicle 2-22) The Social Security cost-of-living adjustment is only 2.1% this year, based on the consumer price index. But much of the inflation protection the adjustment is supposed to provide will be eroded by Medicare's Part B premium increase of 13.5% for 2004. The monthly premium was $45.50 as recently as 2000 and is $66.60 a month now. The payment rising is also consuming a larger part of the average retiree's benefit. In 2000, it represented 5.7% of a typical monthly Social Security benefit payment, but it is rising to 7.2% this year. (Stephen Dunphy, Seattle Times 2-22) Automakers installed large V-8 engines in 29.1% of all passenger vehicles built in North America for the U.S. market last year, the highest rate since 1985, according to Ward's Automotive Reports. The rate has risen every year since 2000, when V-8s went into 25.3% of North American-built cars and trucks for American drivers, Ward's statistics show. In the same four-year stretch, smaller 4-cylinder installations fell from nearly 27% to 25.3%. The popular Hemi engines, which dates to the 1950s, gets its name from the hemispherical shape of its combustion chamber, which Chrysler executives say allows it to produce more power and achieve greater fuel economy. (John Porretto, AP 2-18) Focused on growing deposits, increasing loan quality and minimizing financial liabilities, good smaller banks have steered clear of scandals and consistently boast strong results in good times and bad. . . . We profile six regional banks that are buys now: [Arrow Financial (AROW), First Tennessee (FTN), Hibernia Corp. (HIB), NBC Capital (NBY), Union Planters (UPC) and United Bankshares (UBSI)]. (Roger Conrad, Personal Finance via Washington Post 2-15) Reducing mutual fund advisory fees could hurt smaller investors, according to a soon-to-be-released study by Strategic Insight. By forcing firms to lower their advisory fees, many fund companies may have to increase their minimums--making their funds inaccessible to many investors. According to the study, only 138 funds, or 2% of the 7,000 open-end funds available, filed for a change in advisory fees in 2002 and 2003. Five times as many funds requested to reduce their fees as those seeking a fee increase, the study cites. (Fund Marketing Alert 2-12) Perhaps 85% of stocks today are purchased on momentum. That's especially true of Nasdaq, where some of the wildest movers had no earnings. Such a market virtually guarantees a sickening decline next time around, and particularly so with the widely accepted strategy of remaining fully invested at all times. (Charles Allmon, Growth Stock Outlook via Washington Post 2-08) Landmark 1986 research in the Financial Analysts' Journal by Gary Brinson, L. Randolph Hood, and Gilbert L. Beebower shows that 90% of your investment return is determined by the asset class or type of investments. (Alan Levine, Boston Herald 2-01) It has been illegal to die of old age since 1951, when the federal government deleted it from the official list of causes of death. (Kelly Greene, WSJ 2-01) Our sense is that earnings, which rose by an estimated 10 percent to 15 percent in 2003, will rise at a similarly strong pace in 2004. The stock market is celebrating these prospects already. . . Unfortunately, this sharp rise in prices has increased price-earnings ratios rather sharply and lifted the overall risk of the market. With these favored prospects being partially offset by high P/E ratios, we are essentially neutral on the stock market. (Selection & Opinion, The Value Line Investment Survey via Washington Post 2-01) We remain bullish on the market overall and in particular for small- and mid-cap growth companies. The economy is accelerating, earnings growth is strong, valuations remain attractive vis-…-vis interest rates, there is a demand imbalance for stocks, and inflation is muted. The beat goes on. . . ." (Michael Moe, ThinkThoughts, ThinkEquity Partners via Washington Post 2-01) Home Page Previous Factoid Top Sites
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