Individual 401k Potentially Superior to SEP IRA for Self Employed Individuals

The following is a discussion of the merits of the Individual 401k plan as a retirement savings alternative for self-employed individuals such as independent contractors, sole proprietors, and single employee C and S corporations. The sources for this discussion are materials that originally appeared in the Journal of Accountancy in 2003, as well as material from the IRS Website (IRS Retirement Plans Navigator), IRS Publication 560 and Charles Schwab.

Background:

Beginning with the Economic Growth and Tax Reconciliation Act of 2001 (EGTRA), self employed individuals obtained a strong incentive to establish individual 401k plans as opposed to the more common SEP IRA. The SEP IRAs had been the vehicle of choice prior to EGTRA because they are easy to set up, and because employers had been required to deduct employee salary deferrals from the maximum tax-deductible retirment plan contribution (1). After EGTRA the advantage shifted to the Individual 401k. Employers were no longer required to deduct the Employee salary deferral from their calculation of the maximum retirement plan contribution. Hence, self employed individuals were entitled to take their maximum salary deferal and have their business make its maximum annual contribution to their retirement plan.

Quantifying the Advantage of the Individual 401k:

Let's put some numbers on this. For 2009/10 the maximum annual employee contribution to a 401k is $16,500. Employees above the age of 50 may be eligible to make a catch up contribution of $5500. The maximum total contribution from Employer and the Employee is 20% of eligible compensation or $49,000 (or $55,000 if over 50). Self employed individuals can contribute this amount to their Individual 401k plans.

Self employed individuals using a SEP IRA in 2009 are entitled to contribute the lesser of $49,000 or 20% of eligible compensation.

For 2009, $245,000 is the maximum allowable compensation that may be used to calculate the amount of benefits. This applies to both Individual 401k and SEP IRA. It is only at this $245,000 level that the SEP IRA provides an equal maximum contribution to the Individual 401k. For all lower levels, the Individual 401k allows a greater maximum contribution (2).

Individual 401k vs. SEP IRA Breakeven Analysis

Individual 401k Candidates (3)

An individual 401k is designed for self-employed individuals, and owner-only businesses with no employees, other than a spouse (includes corporations, partnerships and sole proprietorships).

Target profile

1. Wants to make larger contributions than are typically allowed by SEP IRA or QRP.

2. Needs flexibility on annual contributions

3. Wants an easy to administer, low-cost plan

Eligibility

1. Must have no employees other than a spouse

2. A partnership is eligible only if each partner owns 5% of the business

3. A corporation is eligible only if it has no employees other than a sole shareholder and his or her spouse

Disclaimer: This report was produced by South Shore Capital Advisors LLC for information purposes only. It is not intended that this serve as tax advice. Individuals should consult with their tax advisors prior to making any tax-related decisions regarding their retirement savings. South Shore Capital Advisors is a Massachusetts and Rhode Island Registered Investment Advisor.

(1) “The Single Participant 401K”, Journal of Accountancy, March 2003.
(2) IRS Publication 560 p. 1, p. 24.
(3) Charles Schwab

Copyright 2009, South Shore Capital Advisors, LLC, 16 North Street Hingham, MA 02043

This Holiday Season, Pour Your Guests the Wines the Four Seasons Pours at a Fraction of the Cost

If you want to pour the same wine for your holiday guests that the Four Seasons pours its clientele, it doesn't have to cost you an arm and a leg.

In the spirit of the Holiday Season, this commentary provides an assessment of value in one corner of the wine world and shows how readers can "get in on some of the action," at prices that are well within reach.

Here in Boston, the Bristol Lounge at the Four Seasons Hotel is a wonderful place to relax, meet some acquaintances for a glass of wine and possibly have a bite to eat. Albeit at prices that reflect its status as a "home away from home" for celebrities and international business elite. Those who have been there, or to any other Four Seasons, recognize that the wonderful atmosphere, service, food and drink all come at Four Seasons prices. So when paying the bill, it is helpful to remember that - in the words of Warren Buffett - Price is what you pay but Value is what you receive. How much value you place on the ability to sit, on any given night, near members of the E Street Band or the back court of the Chicago Bulls, determines how much sticker shock you feel when the bill comes at the Bristol Lounge.

While the Value of a glass of wine poured and consumed at the Bristol Lounge is unique to the person enjoying it, the Price is the same for everyone. In a word, expensive.

Various restaurant folks will quote different ratios for an establishment's wine price per glass to the cost of the bottle. In some cases the first glass poured will pay for the entire bottle and in others it may only pay for half. My research indicates that this holds true at the BL.

On a recent field trip to the Bristol Lounge in what Wall Street analysts might refer to as a "store check," I observed the following per glass prices:

Chardonnay: Laetitia Estate 2006, $15/glass
Sauvignon Blanc: Russian Jack New Zealand 2008, $12/glass
Riesling: Dr. Loosen L Mosel 2008, $9/glass
Pinot Noir: 12 Clones Santa Lucia 2007, $18/glass
Malbec: Catena Vista Flores Mendoza 2006, $10/glass
Merlot: Souverain Alexander Valley 2006, $14/glass
Cabernet: Flora Springs Napa 2005, $22/glass
Cabernet Blend: Chappelet Mountain Cuvee Napa 2006, $18/glass

In checking with my local wine merchant, Taylor Tibbetts of Harborside Wine & Spirits in Scituate, MA I was able to find the following wines available on order by the case:

Sauvignon Blanc: Russian Jack New Zealand 2008, $163.10/case = $13.59/bottle
Riesling: Dr. Loosen L Mosel 2008, $122.30/case = $10.19/bottle
Merlot: Souverain Alexander Valley 2006, $193.70/case = $16.14/bottle
Cabernet: Flora Springs Napa 2005, $336.50/case = $28.04/bottle
Cabernet Blend: Chappelet Mountain Cuvee Napa 2006, $336.50/case = $28.04/bottle

and rounding out the investigation with a trip to a few of the producer websites

Chardonnay: Laetitia Estate Chardonnay 2008, $194.40/case = $16.20/bottle (not the same year as at the BL)

The only wines that did not seem to be available were the Malbec and the Pinot Noir.

For the holidays, treat your company to the same wines the Four Seasons pours without the sticker shock. The Price should be right for everyone, but since they are at your home it is up to you to supply the Value.

Don’t Be Afraid to Rebalance Your Portfolio

With the S&P 500 having advanced 20.4% year to date as of 10/16/2009, and the MSCI EAFE index up 28.2% over the same period, it is legitimate and prudent to question the sustainability of this advance. The equity markets have been fueled by liquidity, a steady diet of improving news flow about the economy, and bona fide improvements in corporate performance. Nevertheless, after such a torrid advance from the lows of March, there is scope for a pullback, suggesting that investors should practice prudent portfolio rebalancing in order to keep portfolio risk aligned with their tolerance and capacity for volatility.

A few notable observations have crossed my desk in the last few days:

S&P 500 Fair Value

According to Bank of America Weekly Strategy Insights dated 10/19/2009, Bank of America strategists believe the fair PE multiple for the S&P 500 is 16.5x (this is based on 6% real cost of equity capital). According to this multiple, at 1097.25 the market is implying $66.00 in normalized earnings, in line with the current quarter’s annualized EPS. However, Bank of America believes that the current quarter’s earnings are still cyclically depressed, and they expect that the S&P 500 will grind higher as investors raise their expectations for the S&P’s normalized earnings power.

Visitors to the Standard & Poor’s website will see that S&P’s estimate for 2010 S&P 500 operating earnings is $73.55 (as of 10/19/2009). Using the Bank of America Fair PE Multiple of 16.5x on this earnings estimate would imply a fair valuation of 1214 at some point over the next six to nine months.

I have often used the “Rule of 20” to calculate a fair value multiple for the S&P 500. The crude assumption behind this rule is that 20 minus the rate of inflation represents a fair value multiple for the S&P 500. Using the yield of the 10 Year Treasury minus the real yield on the 10 year Treasury Inflation Protected Securities (TIPS) one can derive today's market expectation for inflation of 2.05%. (10 year treasury yield 3.37% - 10 year TIPS yield 1.32%). This yields a fair value multiple of 17.95x using the Rule of 20. While this is somewhat higher than the Bank of America Fair PE it is within the same ballpark.

Regardless of which method one uses to calculate a fair value multiple, the market appears to offer upside from here if earnings do not disappoint versus current expectations.

The Rush to Buy Bonds

In this weekend’s Barron’s, Michael Santoli pointed out that there have been $11 dollars in net inflows to bond mutual funds for every net dollar into equity funds over the past three months.

Bonds are an important part of most investor portfolios. Treasury bonds because they offer tremendous liquidity and are backed by the full faith and credit of the U.S. Government, and other types of bonds (Investment Grade Corporate, Municipal, Mortgage, Senior Secured Loans) because they can offer income and portfolio diversification benefits alongside cash and stocks. Amidst the recent market turmoil, many investors have reintroduced themselves to this asset class in search of the previously mentioned benefits. We have supported this notion. However, we cannot overlook the current love affair that investors of all stripes are showing toward this asset class and not point out that this supports the overall attractiveness of equities.

Equities remain an asset class that is vitally important for many investors who possess the goal of growing the value of their principal and preserving its purchasing power versus inflation. With a nod to the above data point from Barron’s, it is fair to say that investors have not been rushing to buy stocks despite the significant advances year to date, and particularly from the lows. This, combined with valuations that certainly appear reasonable, continues to support the case for owning equities, as well as bonds, and not being afraid to rebalance in the direction of equities for investors who possess the capacity for the potential volatility.

Important Legal Information:

Past performance is no guarantee of future results. Investing involves the risk of loss. This material should not be used as the basis for investment decisions on its own. Prior to investing, an investor should assess the specific risks of given instruments and determine (with his or her professional advisors) if the investment is suitable for his or her circumstances.

Taylor Thomas

10/20/2009

Are we faced with another bubble in risky assets?

With the recent sharp rallies in virtually all risky asset classes the question has come up several times about whether or not we are now in overvalued territory or on the cusp of another financial markets bubble.

One needs look no further than the U.S. market that has seen the S&P 500 advance 51.68% from its March 9th trough as of 8/21/09. The more volatile BRIC markets (Brazil, Russia, India and China) have advanced by an average of 59.83% during the same period.

In recognition that markets are subject to short term fluctuations based on technical patterns such as overbought and oversold levels, and also with regard to the fact that September is historically the poorest performing month in the U.S. stock market, how “safe is the water” for taking advantage of a potential pullback to put additional cash to work? (According to Bespoke Investment Group data, September and February are the only two months that have seen a negative average monthly return for the Dow Jones Industrial Average over the past 100 years.)

In trying to answer this question, Standard Chartered Bank U.S. Economist John Calverly's “Checklist of Bubble Characteristics” is a useful tool. This was published in his 2004 book Bubbles and How to Survive Them when the author was Chief Economist at American Express Bank.

Checklist: Typical characteristics of a bubble (assessment by the author of this comment in italics)

1. Rapidly rising prices » stocks yes, housing no, commodities no
2. High expectations for continuing rapid rises » no
3. Overvaluation compared to historic averages » no
4. Overvaluation compared to reasonable levels » no
5. Several years into an economic upswing » no
6. Some underlying reason or reasons for higher prices » prices still below highs
7. A new element, e.g., technology for stocks or immigration for housing » no
8. Subjective “paradigm shift” » no
9. New investors drawn in » no
10. New entrepreneurs in the area » no
11. Considerable popular and media interest » no, still fear and doubt
12. Major rise in lending » no
13. Increase in indebtedness » no, savings are rising
14. New lenders or lending policies » perhaps central banks
15. Consumer price inflation often subdued (so central banks relaxed) » yes
16. Relaxed monetary policy » yes
17. Falling household savings rate » no
18. A strong exchange rate » no
Source: John P. Calverly, Bubbles and How to Survive Them, p.13.

No apparent bubble in Emerging Markets:

As of August 18th Global Emerging Markets (GEM) had rallied 56% since OECD lead economic indicators troughed in December 2008, making the current rally about twice the average seen after previous episodes when OECD lead indicators troughed. However, the trough valuation for GEM in December 2008 was 1/3 lower than in previous cycles, and GEM valuations are only now at just 5% above their average when lead indicators bottom.

GEM Historical P/E – now versus previous cycles when OECD leading indicators troughed

Source: Datastream, OECD, Credit Suisse Estimates published in Credit Suisse Asia Daily 8/18/2009

No apparent bubble in U.S. Equities:

In the U.S., stocks have advanced by 51.68% from their March 9th closing low as of 8/21/2009 according to Bespoke Investment Group. This naturally causes worries about a bubble. However it appears far premature to give this label to the present market.

The S&P 500 valuation now resides at 18.89x 2009 using Standard & Poor’s current $54.40 bottoms up S&P 500 operating earnings forecast. For perspective, the same multiple of operating earnings was consistently in the high 20’s during 1999 through the first half of 2000 as the S&P 500 was topping out at the peak of the last bull market. For even further perspective, a look back to the Nifty 50 era of 1972 shows that the original Nifty 50 traded for between 46 and 92 times earnings according to Forbes magazine. Therefore it seems that there is plenty of scope for stock valuations to move higher before we can be considered to be in a bubble; particularly if there is a steady diet of positive news flow.

No apparent bubble in Investment Grade Corporate Bonds:

As highlighted by Argus Research on August 24th, as of July 31st the average yield spread between a AAA-rated corporate bond and the U.S. Government long bond was 185 basis points. Over the past 55 years this spread has averaged 80 basis points. For BBB rated bonds, the average spread was 353 basis points as of July 31st, versus a historic average of 178 basis points (as published in Argus Market Watch 8/24/2009).

Conclusion:

With few conditions for a bubble present, and financial markets exhibiting inexpensive to normal valuations, there are no signs of a bubble in any of the aforementioned risky assets – U.S. stocks, emerging markets stocks or corporate bonds.


Absent an external shock such as a terrorist attack, or significant problems with a major trading partner, and assuming continued improving economic news, stock and corporate bond markets offer scope for solid returns from these levels despite the healthy advances of the recent past.


Important Legal Information:

Past performance is no guarantee of future results. Investing involves the risk of loss. This material should not be used as the basis for investment decisions on its own. Prior to investing, an investor should assess the specific risks of given instruments and determine (with his or her professional advisors) if the investment is suitable for his or her circumstances.

Taylor Thomas 8/30/2009

Enter Goldilocks?

A recent conference call by the Fixed Income strategists at a major NY investment bank set forth the following forecasts for interest rates and inflation:

• CPI inflation is likely to return to positive by year end 2009. However, slack labor markets and low capacity utilization at factories will cause core CPI (ex food and energy) to remain negative through 2010.
  
• The U.S. Federal Reserve is likely to engineer a gradual increase in the Fed Funds rate, but this firm did not expect the Fed Funds rate to reach greater than 1.25% by year end 2010.
  
• Because inflation expectations will remain anchored with the aid of a negative core CPI, 10-year treasury rates are not expected to surpass 4% between now and year end 2010. In fact, they may fall from current 3.5% to 3.00% within 12 months. (They are already down from 3.80% at the time of the call earlier this month.)
  
• The flattening of the yield curve is expected to lead the way higher for risky asset (stocks).

All of the above makes sense in my opinion, yet it is critically dependent on the ability to keep inflation expectations firmly anchored. The extremely high levels of liquidity that have been injected into the system by the Federal Reserve and other central banks will need to be artfully removed. We heard the first on this from the Fed in their statement following their meeting last week. In addition to making generally positive comments about the decline in the rate of deterioration in the overall economy, they also did not expand their program to purchase treasuries, mortgage backed securities, and U.S. Government Agency Debt. Not expanding this program was viewed favorably by the markets that have been looking for a carefully crafted exit to these potentially inflationary programs.

For those looking for a guidepost, the spread between the 2-year treasury and the 10-year treasury's interest rates is a usesful place to start. This has contracted since early June when the 10-year yield was 3.71% and the 2-year yield was 0.97% for a spread of 274 basis points. As of June 26th that spread stood at 242 basis points with the 10-year yielding 3.52% and the 2-year treasury yielding 1.10%.

Firmly anchored inflation expectations accompanied by economic data that is neither "too hot" nor "too cold," may well usher a new Goldilocks era.

Gold and Economic Freedom

A friend recently reminded me of an article written by former Federal Reserve Chairman Alan Greenspan in 1966 titled "Gold and Economic Freedom" It makes the case for gold as a store of value and a protector of purchasing power.

Only a few years after Greenspan wrote this piece, the U.S. abolished the gold standard that had preserved the convertability of the U.S. dollar into gold at $35/ounce. Over the ensuing years, salaries, property values, stocks and the price of many commodities have advanced dramatically, but the purchasing power of the dollar has eroded greatly. Here are several charts that illustrate how much less gold and oil a dollar buys today than it did in 1969.

At present, the economy appears to be working through a period of near deflation, but the expansion of the monetary base that is being engineered by the U.S. Federal Reserve (see chart), and other central banks, is likely to lead to inflation. Should this occur, holdings with cash flows that are leveraged to inflation, be they commodities, natural resources, real estate, or timber should protect purchasing power better than cash.

Parting Wisdom from a 20 year veteran of Merrill Lynch - Investment Strategist Rich Bernstein

Parting wisdom can sometimes be insightful. I found Rich Bernstein's parting words well worth the read. Enjoy.


*************************************************************************************
Tomorrow will be my last day at Merrill Lynch. I want to sincerely thank my colleagues and clients for the opportunity to work with them. It is because of them that my 20 years at the firm have been so rewarding.
As a last report, here are what I view as 10 of the most important investment guidelines I've learned in my time at the firm:

1. Income is as important as are capital gains. Because most investors ignore income opportunities, income may be more important than are capital gains.
2. Most stock market indicators have never actually been tested. Most don't work.
3. Most investors' time horizons are much too short. Statistics indicate that day trading is largely based on luck.
4. Bull markets are made of risk aversion and undervalued assets. They are not made of cheering and a rush to buy.
5. Diversification doesn't depend on the number of asset classes in a portfolio. Rather, it depends on the correlations between the asset classes in a portfolio.
6. Balance sheets are generally more important than are income or cash flow statements..
7. Investors should focus strongly on GAAP accounting, and should pay little attention to "pro forma" or "unaudited" financial statements.
8. Investors should be providers of scarce capital. Return on capital is typically highest where capital is scarce.
9. Investors should research financial history as much as possible.
10. Leverage gives the illusion of wealth. Saving is wealth.

A Different Way to Look at Portfolio Risk

Recent data from the Federal Reserve highlights that the U.S. saw a 12.5% increase in the population aged 55 to 64 between 2004 and 2007. Near retirement, and typically beyond their largest earning years, this group faces tough decisions about their investing and spending even in good times. Today, because of large declines in the value of the stock market and residential real estate, those decisions are harder than ever. Traditional assessments of portfolio risk have been inadequate for a long time, but for this group it is even more relevant to discuss the importance of relating the assets to the liabilities of the investor.

I recently came across a compilation of articles from the Journal of Portfolio Management that were published in a 1998 compendium called Streetwise (Princeton University Press). A 1984 article, "A New Paradigm for Portfolio Risk," by Robert Jeffrey, caught my eye.

In "A New Paradigm..." Jeffrey argues against using only portfolio volatility as the measure of portfolio risk. His underlying assertion is that risk is a function of a portfolio's liabilities as well as its assets, and in particular of the cash flow relationship between the two over time.

The new paradigm that Jeffrey argued for in his 1984 article never occurred. For the past 25 years it has been standard for individuals to construct portfolios that offer the promise of the greatest return for the maximum tolerable amount of risk, defined as portfolio volatility.

For the most part, individuals have not been encouraged by mutual fund companies and large brokerage firms to think about their portfolio risk in terms of their liabilities. The business models of these firms can be called "manufacture and distribute." What they manufacture are the mutual funds and other products that they market to individual and institutional investors. Most likely, the asset based approach to risk management, generally advocated by these firms, is a product of the fact that portfolio assets are what they manufacture. Yes large brokerage houses do offer mortgages, but in my experience this is a discreet function, perhaps facilitated by the client's sales rep, but not incorporated into the portfolio risk discussion.

The problem with volatility based risk measures, as Jeffrey points out, is that they say nothing about what is being risked as a result of the volatility. Said another way in the same article, "the determining question in structuring a portfolio is the consequence of loss; this is far more important than the chance of loss."

The 50 or 60 Something investor, who faces tough decisions about investing and spending, needs to be considering the consequence of loss as highlighted above. This is a very personal exercise that requires a thoughtful breakdown of the timing, magnitude and predictability of future cash requirements. A competent advisor who works with the proper incentives can be an invaluable resource in this process by asking the right questions and highlighting opportunities for savings or realignment of assets. An objective, knowledgeable advisor is in a position to show investors the best of what is out there to meet their needs.

As always, investors should "consider the source" when receiving investment advice. In addition to educational background and years of experience, some key questions are; How much time does the person that I am working with spend trying to understand my whole financial picture? How is the advisor compensated? Does the advisor offer an "open architecture," or are the recommendations constrained by his or her firm's product line? Does my advisor receive commissions when I purchase something that may color his or her incentives? Is he charged with acting as a fiduciary?

Individual client risk management is improved by considering assets and liabilities together. Advisors who practice this approach can be invaluable in helping their clients with this.

U.S. Royalty Trusts for Income-Oriented Investors

There are several publicly traded U.S. Royalty Trusts with interests in the oil and natural gas sector that are worth a look for investors seeking high current income. Their projected next twelve month yields are in the range of 8-10%. They also hold appeal for investors who would like to own assets whose performance is linked to the change in oil and natural gas prices without exposure to a leveraged corporate balance sheet, or the potential for poor corporate management.

San Juan Basin Royalty Trust (NYSE: SJT), and Permian Basin Royalty Trust (NYSE: PBT) are the two U.S. Royalty Trusts that this article will focus on, though there are a number of others. There are detailed descriptions of the trusts available on the trust websites and in documents available at the SEC website (http://www.sec.gov/). The goal of this piece is to provide a concise description of each, and a summary of why it might be an attractive investment.

San Juan Basin Royalty Trust:

Principal Asset:

This trust owns a 75% net overriding royalty interest in certain properties located in Northwestern New Mexico. These properties are virtually 100% natural gas producing.

Unit Information:

Recent Price $14.99 as of 3/17/2009

Number of Units Outstanding 46,608,796

Market Value $698,665,852

2008 Distributions $3.069833

Most Recent Monthly Distribution $0.09889 per unit paid 3/13/2009

History of the Trust

The trust was formed by Southland Corporation in November 1980 to contain the royalty interests on the above mentioned properties. The income producing properties are operated by Burlington Resources Oil and Gas (BROG), a division of Conoco Phillips. BROG retains a 25% interest in the properties.

Production outlook

The actual production of the properties linked to the trust has exceeded the trust’s published production outlook since its inception in 1980. Current estimated future net revenue per unit is $15.83 (2008 10-K).

Going back 10 years to 1998, the estimated future net revenue per unit was $5.18 yet actual distributions per unit have totaled $20.40 during the intervening period. (Based on SEC filings) This means that someone who purchased a unit of SJT at its 1998 high price of $9.37, and still held it today would have received $20.40 in distributions and would own a unit with a market price of $14.99. Today the estimated future net revenue per unit is $15.83 and the current unit market price is $14.99, so the units are available at a multiple of estimated future net revenue of 0.95x. This compares with a multiple of estimated future revenue of 1.8x in 1998, so on this basis the units are cheap relative to that time.

Income Potential in the near term

Borrowing from the work of well-regarded energy analyst Kurt Wolff, he estimates that distributions per unit over the next 12 months will be $1.25 (http://www.mcdep.com/). Should he prove correct then the yield for the next 12 months is a potentially tax advantaged 8.33%. While only an estimated income based on estimated monthly distributions, this is an appealing yield relative to many other income-related alternatives, particularly since this comes with no balance sheet leverage.

Tax Benefits

There is favorable tax treatment of the distributions for individuals who hold the units in taxable accounts. Depletion allowances provide an opportunity for taxable investors to shield close to 100% of the unit distributions from income taxes in the early years of ownership. Investors should consult with an accountant to obtain a better understanding of these.

Permian Basin Royalty Trust:

Principal Asset:

The trust’s principal assets are a 75% net overriding royalty interest in oil and gas producing properties in Crane County Texas and a 95% net overriding royalty interest in other oil and gas producing properties carved out by Southland Royalty Company from its properties in Texas. The production from these properties is approximately 2/3 oil and 1/3 natural gas.

Unit Information:

Recent Price $9.94 as of 3/17/2009

Number of Units Outstanding 46,608,796

Market Value $463,291,432

2008 Distributions $2.39136

Most Recent Monthly Distribution $0.04356 per unit paid 3/13/2009


History of the Trust

The trust was formed by Southland Corporation in November 1980 to contain the royalty interests on the above mentioned properties. Burlington Resources Oil and Gas is the operator of record for the properties in Crane County, Texas. The Texas Royalty Properties consist of royalty interests in mature producing oil fields. They contain approximately 303,000 gross and approximately 51,000 net producing acres. Riverhill Energy performs all accounting operations related to these properties and Schlumberger Technology Corp. performs summary reporting of monthly results.

Production outlook

The actual production of the properties linked to the trust has exceeded the trust’s published production outlook since its inception in 1980. Current estimated future net revenue per unit is $6.906 (2008 10-K).

Going back 10 years to 1998, the estimated future net revenue per unit was $2.01 at that time yet actual distributions per unit have totaled $10.96 during the intervening period. (Based on SEC filings) This means that someone who purchased a unit of PBT at its 1998 high price of $5.19, and still held it today would have received $10.96 in distributions and would own a unit with a market price of $9.94. Today the estimated future net revenue per unit is $6.906 and the current unit price is $9.94 so the units are available at a multiple of estimated future net revenue of 1.44x. This compares with a multiple of estimated future revenue of 2.6x in 1998, so on this basis the units are cheap relative to their valuation in 1998.

Income Potential

Borrowing from the work of well-regarded energy analyst Kurt Wolff, he estimates that distributions per unit over the next 12 months will be $0.97 (http://www.mcdep.com). Should he prove correct then the yield for the next 12 months is a potentially tax advantaged 9.8%. Given that this comes with no balance sheet leverage, this is appealing relative to many alternatives in the market place. Of course, the risk cuts both ways in that if commodity prices fall further then the yield will not be earned as expected.

Tax Benefits

There is favorable tax treatment of the distributions for individuals who hold the units in taxable accounts. Depletion allowances provide an opportunity for taxable investors to shield close to 100% of the unit distributions from income taxes in the early years of ownership. Investors should consult with an accountant to obtain a better understanding of these.

Note: As of 3/23/2009 clients and principals of South Shore Capital Advisors are now holders of San Juan Trust (SJT)

Municipal Bonds relative safety highlighted in WSJ "Heard on the Street"

How Safe are Municipal Bonds?

As highlighted in the WSJ "Heard on the Street" column above, a Moody's study found muni credit loss rates across 1970 - 2000 were lower than for triple A rated corporate bonds. Among general obligation and essential-service bonds - 60% of issuers surveyed - the default rate was exactly zero.

However, we should go back to the Great Depression to obtain a deeper perspective. When we do that the data still look very good.

The above WSJ piece highlights a study by Professor George Hempel who found that the default rate on municipal bonds across the period from 1929-37 was 16.2% of outstanding debt, but the estimated loss rate was just 0.5%. Further, using a recent example in Orange County, CA from 1994, bond holders recovered 100% of principal and interest.

There are counterpoints to this arguement. In a recent Forbes article the same issue was handled somewhat less optimistically. The article notes that creditors who hung in there during the Great Depression by and large received their principal and interest. However, the legal rights of municipal bond investors are not entirely clear according to Georgetown Law Professor, noted bankruptcy expert, and Dartmouth College Trustee Todd Zywicki. In one specific example, however, it is noted that the General Obligation bonds of the State of California enjoy a lien on state revenue second only to education spending.

Where is the investment opportunity? If the favorable risk profile, and attractive relative valuation creates increased demand for munis, there is room for the relative outperformance versus treasury bonds. In 1988 munis peaked at 4.5% of household and non profit organization assets while today they are just 2%. According to the WSJ, if they were to grow to 4.5% of holdings again, that would imply an extra $1.15 trillion of demand, equivalent to 43% of the total amount of muni debt outstanding and well over double the likely issuance this year.

Treasury Bonds May be in a Bubble, but Most Investors Will Want to Think Twice Before Shorting Them

There has been a lot of discussion in the media about a "bubble" in the price of treasury bonds - i.e. the yields on treasury bonds are at unsustainably low levels. This has increased the focus on opportunities available to the individual investor who wants to try to make money from shorting treasury bonds. There are a number of vehicles available to individual investors who would like to do this. Here is a link to my analysis of the potential payoff. It illustrates why someone might want to think twice before making this trade.

When it's Time To Cash in that Variable Annuity -

Abstract:

Today, with the stock market at levels not seen in 12 years, many equity-oriented variable annuities have passed their surrender penalty periods and have no earnings to be taxed. Now may be the time to get out from under those fees and look for better options.

Not long ago I spent a number of hours helping a client in her sixties review her holdings in order to develop a strategy for generating income and assets to fund her retirement. One of her holdings was a variable annuity from an insurance company called Allmerica, the Allmerica Advantage. I studied this annuity in detail, and for the life of me I couldn't see the "advantage" for her (sorry for the bad joke).

This annuity had been purchased by her husband many years before as a savings vehicle. The logic seemed straight forward. The owner earns tax free returns on the appreciation of a basket of mutual funds chosen from a predetermined group of options. Also, there is a death benefit feature that would pay out to his beneficiaries at least as much as the owner put into the annuity . In exchange for this death benefit, the owner pays fees and accepts a "surrender period" - in this instance 9 years, during which he will be penalized for withdrawing his assets.

In this situation the annuity transferred to the wife upon the death of her husband. It had passed the surrender period. Further, due to the poor performance of the stock market during the past 12 years, it had no earnings since its value was less than the amount invested in the various mutual funds. Therefore the cost to redeem was zero from a tax perspective and zero from a surrender charge perspective. The one catch was that it was below its death benefit.

This particular annuity had a series of fees that were as follows:

Mortality and Expense: 1.25%
Administrative Charge: 0.20%
Fund Mgmt Expenses: 1.01%

Total Expenses 2.46%

Recognizing that there was a death benefit, but given the above fee structure, and the recognition that her goals were retirement income-oriented, my advice was the following:

If your primary concern is not the size of the inheritance you are going to leave, but how you are going to enjoy the next twenty or thirty years, cash it in and have it managed by a fiduciary (Registered Investment Advisor) who will charge you much lower fees and give you advice in the process.

Also, I see shedding the high fees of the annuity as a "life benefit." A savings of 1-1.25% per year for many people is enough to pay for a few nice weekend getaways or an emergency car repair if needed.

Aren't we missing the option to annuitize? Yes, a single premium annuity is an attracitve option to some, and in her case. If we were to visit the Website of Bekshire Hathaway Direct, we would learn that for her life she could lock in a yield of 3.65% and that it would be tax advantaged for the first 18.5 years because during that period the IRS will consider 75.7% of each monthly payment a return of principal.

A key catch is inflation.

Assuming 3% inflation - one's purchasing power will go down by 50% over the next 12 years, so the $1639 monthly payment will only seem like $819.50 in today's dollars when this annuitant is 79 years old. Further, once the money is in the annuity, the annuitant must prove financial hardship to access the principal, and if she passes away in two years, the insurance company "wins the bet."

An alternative would be to purchase a U.S. Treasury 20 year inflation protected security. According to Bloomberg, the 20 Year TIP currently offers a real yield of 2.4%. Combine that with a 3% inflation rate and the holder receives 5.4% for holding the bond. Additionally, as a Treasury bond it offers the backing of the U.S. government, combined with this built-in hedge against inflation. Not bad right! Further, should one want to be more aggressive and maintain some investments in the stock market, a portfolio of blue chip stocks would offer a growing (one hopes) 2.5-3.0% dividend yield. If these dividends grow at a 3% rate of inflation, then the payout will feel like 3.75 - 4.5% in 12 years time.

Amidst the market turmoil, this is one opportunity to look at a widely held instrument (the variable annuity) in a new light.

Insurance Company Solvency is being called increasingly into question

This Economist Article from last October may seem dated, but the issue is more relevant than ever.

Last week's capital conversion at Citigroup, and the downgrades of a number of insurance companies by A.M. Best and Standard & Poors place a new spotlight on this topic. Transparency at insurance companies is typically weak and their balance sheets possess exposure to a range of financial assets that have suffered greatly amidst this market decline: financial institution debt and preferred stocks, and commercial real estate. In most states, a guaranty association handles insurance bankruptcies, but the maximum aggregate benefit for all claims from an individual is often $300,000.

UNDER THE COVERS
Oct 30th 2008

See this article with graphics and related items at http://www.economist.com/finance/displaystory.cfm?story_id=12516997&mode=comment&intent=postTop