South Shore Capital Advisors Insights

Mid Quarter Update from South Shore Capital Advisors Newport

2011-09-14T06:24:00.000-07:00

September 1, 2011

Given the volatility and related uncertainty in the market I felt it might be worthwhile to provide an update. I send out quarterly letters to this end, but with the recent turmoil in the markets a mid-quarter update seems appropriate.

Recession in the US The global economy is clearly slowing down. Worried about inflation, China in particular has stated a desire to put a brake on growth, and that seems to be working. Governments in the US and Europe would like to speed things up but have few tools at their disposal. France reported zero GDP growth for the second quarter, and the slowdown in China has been noted by exporters in Germany. Closer to home, estimates for US year over year GDP growth have been reduced to around 2% for 2011. Economists are now saying there is a 30% or 50% chance of a recession. That seems a bit too exact for a profession that got the last recession exactly wrong and brings to mind John Kenneth Galbraith’s comment that “the function of economic forecasting is to make astrology look respectable”, but let’s just assumes there is a chance of a recession. Accepting the probabilities above we can then assume there is also a 50% to 70% chance that we avoid a recession. In the summer economic activity slows and it may be that is all that we are experiencing right now. We could see a reacceleration come September, helped by lower interest rates and oil prices, especially if China backs off some of its recent tightening moves.

Financial Crisis in Europe
Concern about where the US economy is headed is clearly influencing stocks prices. However, the 4% and 5% swings in the market witnessed over the last few weeks suggest that something more is at play than the risk we slip from low growth into recession. And these swings have little to do with the S&P downgrade of the US, Treasury bonds actually rallied on the downgrade news. It appears to me that the bigger issue is fear that the world is headed for another financial crisis, one similar to what we saw in 2008, but this time sourced out of Europe. As discussed extensively during the last recession, and best described in the book “It’s Different this Time”, recessions caused by the failure of the financial system are much deeper than ones caused by other forces, say the Fed tightening (1991) to slow inflation, or a period of overinvestment (2001) that needs to be digested. A financial crisis is when banks stop doing business with each other, and because of the interlinked nature of the global financial system, a financial meltdown in Europe would be felt elsewhere. Just two examples, US money market funds are major lenders to European banks, and Deutsche Bank and Soceite Generale of France are two of the biggest counterparties behind the derivatives contracts found in many ETF’s.

Europe’s banks face a situation that is similar to what the US banks experienced three years ago. Too much money has been lent to too many people who can’t possibly pay it back. In this case the loans went to subprime countries and not subprime homebuyers. At some point this debt will have to be written down to reflect reality, or assumed by some other entity. Financial Crisis II begins if the banks can’t offload their sovereign debt or have to write it down without an injection of capital. Pressure is building on the banks, today’s newspapers carried the story that authorities are questioning why some banks value their Greek debt at 85 cents to the dollar while that same debt trades in the market at 50 cents. The International Monetary Fund estimates that marking European sovereign debt to market would put a $287 bn hole in Europeans banks’ balance sheets.

After Sixty-Five Years Germany Wins by Default
Europe as a whole has the resources to deal with the crisis. The problem is they do not have a central government, or a powerful central bank that can step into the breach in the same way the Fed and the US Treasury did. All the Europeans have right now is the Germans – with an economy one-third bigger than the next largest economy in Europe and possessing the largest pool of savings. Europe will avoid crisis if the government in Berlin decides to end it, a fact that has created political paralysis across Europe. Of course the US suffers from political paralysis too, but perhaps only from the waist down relative to the full body paralysis of the Europeans. There is at least vigorous debate in this country, and TARP and the auto bailouts got done despite distaste for both from all involved. In Europe there is denial and silence. No one wants to see German Finance Ministry officials arriving in the capitals of southern Europe with detailed plans about how these countries will pay them back.

However, something not too far from the scenario above might happen. Consensus seems to forming around the idea that to prevent a financial crisis and to keep the euro as the common currency for all 17 countries that currently use it, requires the creation of “Eurobonds”. Bonds that would not be guaranteed by the individual countries that issues them, but instead jointly guaranteed by all euro-zone members. No fools, the German tax payers know this means the burden of the guarantee falls on them. Without a Eurobond some unknown number of countries will default. More than likely Greece and Portugal would be the first to go. When they need to refinance maturing debt they will find no buyers for their bonds. In fact there haven’t been buyers for their bonds since the start of the year. To date the European Central Bank has filled the void, but at some point they will run out of capacity. Default would ultimately lead to a country abandoning the euro. Newly printed drachmas, escudos, and punts would be issued and would devalue instantaneously against the euro, allowing these countries to become more competitive again. This is how it used to work pre the 1993 introduction of the euro when the drachma, lira, peseta, escudo and punt devalued annually vs. the Deutsche mark.

What is particularly concerning about one country leaving the euro is that you do not know what will follow. If Greece and Portugal go are they followed by Ireland? Can it stop there, or do big countries like Spain and Italy go? Will we see the return of the lira and peseta? Together Spain and Italy are the same size as Germany in terms of GDP, and their combined debt is much higher. There are no good options. No one wants the Germans to bail out the rest of Europe, especially the Germans, and no one wants to see the end of the euro. Expect inaction for some time.

Conclusion – Defending the Indefensible before giving up to the Inevitable
Because of the uncertainty of what would happen if the Euro zone crumbled, I place a higher probability that the Germans will step up than on the return of the drachma. The Germans also understand that they have been beneficiaries of the Euro. Many more BMWs were sold in Greece, Italy and Spain after the introduction of the Euro than before it. But it could take a long time for German politicians to lead their country in that direction. In the meantime I expect financial markets will remain volatile.

At SSCA Newport cash levels right now are high, and bonds are 15% to 25% of portfolios. I have incorrectly been negative on bonds, particularly US Treasuries, but believe it is important to have some exposure, and that exposure has been beneficial. Stocks still look like very good value.

As noted in my last letter, there are companies that have better balance sheets and growth outlooks than most western governments. They also pay you in dividends more than what the US, German, British or Japanese governments are willing to pay you to buy their debt. I would use rallies to lower bank stock positions, and selloffs to buy high quality global consumer brand companies. These are companies that can maintain/ grow earnings in a low growth environment and maybe through a recession. Non-life insurance stocks which have their own cycle look attractive. Some healthcare stocks offer good earnings growth in a slowing economy. Investing in pipelines that bring newly discovered shale gas to market also seems like a winner.

As always, if you have any questions please call or email.

Lowell Thomas

Second Quarter 2011 Investment Commentary from South Shore Capital Advisors Cohasset

2011-09-08T13:58:00.000-07:00

Investment Outlook

After a very strong Q1 for financial markets, second quarter returns were more subdued. It was a quarter marked by more cross currents than any other in recent memory. The generally favorable news on corporate performance that was delivered in the form of strong First Quarter financial results was offset by headline data about slowing economic growth in the U.S. and fears about the impact that a Greek default would have on the global financial system.

More than the economic data, what troubled markets in my opinion was the relentless stream of headlines relating to government and central bank intervention in global economies.

Eurozone President Jean Claude Juncker (also President of Luxembourg) may have delivered the single statement that best captured the essence of what investors faced during the past quarter and that remains a challenge today. The Wall Street Journal reported that in April Juncker had said in addressing a gathering on the topic of financial crises “When it becomes serious, you have to lie.” This statement attracted not very much attention until early May when Juncker proved to be a man of his word. His office issued first a denial, and then a confirmation that a meeting of key European finance ministers had occurred to discuss the Greek situation on May 6^th. Certainly misinformation has been passed along in many instances over the years, but for someone of Juncker’s stature to so boldly admit it seems particularly in keeping with the times.

David Viniar, Goldman Sachs Chief Financial Officer captured well the sentiment of many market participants in his comments on the firm’s 2nd quarter earnings conference call. He said “a lot of what is happening in the markets, at least it felt that way to us, were [sic] not driven by the underlying economic issues but by political issues. Markets were moving based on statements. That’s very hard for us to analyze and we found it hard to take advantage of.

The good news is that corporate performance remains strong. According to Standard & Poor’s, of S&P 500 index companies reporting their 2^nd quarters so far, 74% have surpassed expectations. Further, after declining to 14.1% growth from 16.6% in the 1^st quarter, year on year earnings growth is expected to reaccelerate in the second half to 16.4% in the 3^rd quarter and 19.8% growth in the 4^th. In another healthy sign, capital expenditures by companies in the S&P 500 grew 46% in the first quarter versus the first quarter of 2010.

A few changes to client portfolios that were made in a broad fashion during the second quarter were as follows:

1. The sale of the closed end funds John Hancock Bank & Thrift Opportunity Fund (BTO) and the Hambrecht & Quist Healthcare Investors (HQH). Both had seen their discounts to Net Asset Value decline (a good thing) since they were initially included in client portfolios over a year ago.

2. Purchase of Teva Pharmaceuticals (TEVA). This Israeli based company is the world’s largest producer of generic drugs. Its management has a long track record of successfully consolidating acquisitions, and they are in the midst of two significant such consolidations right now. These will offer them plenty of opportunities to grow earnings through cost cutting. Also, the generic drug industry is poised for significant growth over the next several years as certain major drugs lose their patent protection and government involvement in health care spending increases.

3. Purchase of Royal Bank of Canada (RY). This Canadian bank is extremely well capitalized and its loan book is solid. They never cut their dividend during the financial crisis and they recently raised it for the first time in several years. The current dividend yield is a well covered 4.06%.

4. Purchase of Anglo American (AAUKY). In addition to iron ore and copper mining, this South African mining company owns 45% of diamond producer DeBeers, and accounts for 40% of global platinum production. Diamond prices have recovered well since the recession and platinum possesses attractive leverage to automotive demand. Auto sales are expected to continue to grow thanks to the rising middle class in emerging markets and ongoing economic recovery in the U.S. The business generates enormous free cash flow, and thanks to that the company will most likely be debt free and positioned to expand its dividend payments and share repurchase by year end.

Thank you for your continued support. Our business grows by referrals and has expanded from $5 million in assets under management in 2007 to almost $29 million as of today for an annual growth rate of over 50%. We continue to believe that globally diversified balanced portfolios are appropriate for most individuals. We carefully research the securities in our clients’ accounts, and the clients enjoy the benefits of liquidity and transparency of their holdings.

Sincerely,

Taylor Thomas

Principal

As of 9/8/2011 South Shore Capital Advisors clients and its employees are holders of all of the above mentioned stocks. This content is provided for information purposes only and is not intended as research. Investing involves the risk of loss. South Shore Capital Advisors is a boutique registered investment advisory firm with offices in Cohasset MA, and Newport, R.I. For more information about South Shore Capital Advisors go to the link "About South Shore Capital Advisors" at the top of this page.

First Quarter 2011 Investment Commentary from South Shore Capital Advisors Cohasset

2011-05-19T07:46:00.000-07:00

Provided below is the first quarter 2011 quartlerly investment comments from the South Shore Capital Advisors Cohasset Office. Since this piece was written in early April, there have been more positive data released relative to corporate performance in the U.S. Standard & Poor's pointed out recently that q1 2011 was the first quarter since q1 2006 where S&P 500 companies reported sales growth greather than +10% versus the prior year. The percentage of companies delivering positive surprise relative to expectations for earnings and sales growth also remains very favorable.

Investing Climate

Had I known in advance that the 1st quarter of 2011 would see the price of oil rise 17%, the price of gasoline at the pump rise from $2.82 to $3.85,[1] and the 10 Year Treasury bond yield rise from 3.30% to 3.47%, I would have reduced stock holdings and prepared for a pullback in the market. Had someone told me that there would be a major earthquake in Japan that would cut 0.5%[2] from Japanese GDP forecasts, and major political and social turmoil in northern Africa; I might have sold even more stock. Lacking such “good” information we purchased more stock for clients early in the quarter, and raised equity weightings, a move that turned out just fine given the S&P 500’s 5.42% advance.

Last quarter reminded us that it is hard to make accurate predictions, and harder still to make winning investment decisions based on such predictions. That is why we focus on fundamentals. We like stocks of companies with strong balance sheets and attractive levels of free cash flow. In the realm of bonds we look for individual issues or funds that offer an attractive real return and acceptable risk.

At the end of last quarter, I pointed out that stocks were still a good deal, particularly in relation to bonds, and were likely to be the better bet for price appreciation. I still feel that way. With Standard & Poor’s estimating 2011 earnings of $96.64[3], and an index close of 1324 on 4/11/11, the valuation of the S&P 500 remains reasonable at 13.7x earnings particularly given low inflation and interest rates.

Corporate performance remains strong as companies continue to beat earnings expectations amidst this unprecedented earnings recovery. According to Bloomberg, by mid summer 2011, profits will have recovered their entire 92% decline in 50 months. This compares to the 19 years it took for profits to recover from their 67% drop during the Great Depression.[4]

Extremely low real interest rates are a notable aspect of the current environment. Central banks have engineered this by keeping their policy rates low to stimulate economic activity. Just how low are they?

Right now there are only 5 countries in the G20 where a holder of the currency can make a cash return greater than the level of inflation. This was a key factor in our decision to purchase one year Australian Government bonds in mid February funding that with a sale of US Treasury Inflation Protected Securities that offer near record low real yields of -0.1% for a 5 year bond.[5] Those one year Aussie Bonds give us an almost 2% premium versus Australian inflation and very limited risk of principal loss from rising interest rates

Another purchase last quarter was the stock of Renaissance RE (RNR). A Bermuda based reinsurance company that is a traditionally profitable underwriter with a stock that was trading near book value. The company is engaged in a large effort to return capital to its shareholders through stock repurchases. From a starting point of January 1, 2010, it is likely that shareholders will see them return over 20% of their current $4.5 billion market capitalization through stock purchases. At the beginning of the year, the underwriting environment for property and catastrophe reinsurance was uncertain, but we bought the stock based on its valuation and the fact that the business generates a lot of cash that they are returning to shareholders. Since then, the market for P&C reinsurance has tightened because of the losses from the earthquake and tsunami in Japan. RNR will likely experience manageable losses from this, but will be able to charge higher premiums on new business as industry capital conditions tighten. In future quarters investment income RNR earns on its substantial cash balances should increase as real interest rates rise.

Worth mentioning here is AT&T, a stock that has been in portfolios for a long time. What drew us to AT&T was its dominant industry position in telecom, accompanied by a strong free cash flow yield of 10%, and a consistently growing wireless business. It has been a cheap stock for a long time because its wireline telephone business is in perpetual decline. What made it attractive were a growing wireless business and an affluent subscriber base who love their Iphones. In March, AT&T announced the purchase of T Mobile from Deutsche Telecom – the deal will transform the company from a 50/50 wireless/wireline TelCo to a truly wireless-first carrier that receives 80% of its revenue from wireless and wireless data. Spectrum acquired from T-Mobile will position the company for long term revenue growth and cost savings from the deal will fund faster future earnings growth.[6]

Looking ahead, many folks are inclined to worry about what impact the end of the Federal Reserve Quantitative Easing 2 program will have. I am among this group. But as pointed out earlier in the letter, departing from a focus on fundamentals may not be productive. Therefore, over the coming months I expect to continue to monitor the business performance of our current holdings while watching for new opportunities and keeping duration short in the bond portfolio because I do want to be prepared for rising interest rates.

Please feel free call me if you have any questions.

Sincerely,

Taylor Thomas
Principal

[1] Federal Reserve Bank of Dallas, Quarterly Energy Update, 1Q 2011
[2] Credit Suisse Japanese GDP Growth Forecast, 4/7/2011
[3] Standard and Poor’s Estimate
[4] Bloomberg, Rita Nazareth and Michael Patterson, April 4th, 2011
[5] Us Treasury.Gov Daily Treasury Real Yield Curve Rates for 4/12/11
[6] Sanford Bernstein Research

As of 5/19/2011 South Shore Capital Advisors clients and its employees are holders of Rennaissance Reinsurance and AT&T. This content is provided for information purposes only and is not intended as research. Investing involves the risk of loss. South Shore Capital Advisors is a boutique registered investment advisory firm with offices in Cohasset MA, and Newport, R.I. For more information about South Shore Capital Advisors go to the link "About South Shore Capital Advisors" at the top of this page.

4th Quarter 2010 Quarterly Letter to Clients of South Shore Capital Advisors Cohasset

2011-01-25T08:19:00.001-08:00

Provided below is the main body of the 4th Quarter 2010 Quarterly Letter recently mailed to clients of South Shore Capital Advisors' Cohasset office.

Investing Climate:

A generally improving business environment, and growth-friendly news out of Washington during the 4th quarter allowed investors to feel more comfortable putting money to work in the stock market, and less willing to accept the “return free risk” of sub 3% bond yields. Throughout the quarter with each passing week, buying stocks was rewarded with more good news about economic growth here at home.

The big developments in Washington during the 4th quarter were:

1. Quantitative Easing II: The renewed and expanded initiatives undertaken by the Federal Reserve to purchase government bonds that will see them purchase $600 billion in treasury bonds in the open market between November, 2010 and June, 2011.

2. Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010: The aggressive fiscal stimulus measures passed by Congress through its extension of the Bush Era tax cuts for two more years, the extension of unemployment benefits, and the reduction in payroll taxes from 6.2% to 4.2% for 2011.

The move to cut payroll taxes by 2% was unexpected, and it will be a shot in the arm for the 2011 economy. The Congressional Joint Committee on Taxation estimates that this will save Americans $111.7 billion for the year - roughly $370 for each of our 300 million people. The employed will experience the direct benefit of this. For that 90% of the 154 million U.S. workforce, the benefit will be about $800 apiece.

Human nature is such that when a stock or bond goes up in price people want to own more of it even though it is now more expensive. Nowhere during the past few years has this been more on display than the bond market. According to a recent article in Fortune, since the depth of the 2008 financial crisis in September 2008, a total of $937 billion has poured into bond funds – increasing the total investment in those funds by 55% and dwarfing the $195 billion that has flowed into stock funds over the same period. (“The Danger In Bonds”, Fortune, Dec. 27, 2010 p. 108) In my view bonds have become less attractive investments over this time, particularly bonds with longer durations that have prices more sensitive to changes in interest rates. I have reduced the duration of client bond portfolios and I am proceeding cautiously with allocations to that asset class.

When I look at client portfolios, I am heartened by the fact that stocks, which are the majority of most of our client assets, are still a good deal. Even after the market rise of over 80% from the lows in March 2009, there are still high quality companies with strong balance sheets, excellent free cash flow, and rising dividends that can be purchased at attractive prices. On current 2011 earnings projections of $94.80, the S&P 500 is trading at a 13.5 multiple. This equates to an earnings yield (earnings/price) of 7.4% versus a 10 year U.S. treasury yield that is right now around 3.4%. As a broad statement, this gap between the earnings yield and the bond yield makes stocks the better bet for price appreciation during 2011.

In addition to good value, business performance supports the case for owning stocks, as many companies continue to deliver earnings that are better than forecast, and estimates for next year’s earnings continue to rise. According to Standard & Poor’s, for the 3rd quarter 2010, 326 of the 500 companies in the index delivered stronger than expected earnings and analysts continue to raise their earnings forecasts for 2011.

Portfolio Comments:

Recently, two companies were added to your portfolio - Becton Dickinson and Canadian Oil Sands Limited.

Becton Dickinson (BDX) is a maker of hypodermic needles, syringes and test equipment for doctors. Over the past several years Becton had paid down its debt to a point where it was virtually debt free. It is a dominant player in its business and its products are non-discretionary purchases. In October, they decided to take advantage of low interest rates by borrowing $1 billion that they will use to repurchase their own inexpensive stock. They borrowed this money for 30 years at 5%. Over the next 12 months I expect them to buy $1.5 billion dollars worth of their own shares. If the company purchased all the stock at today’s $83 price, we shareholders would get an 8% raise even if their earnings do not grow at all. If next year is like any of the last 10 years, they will grow their operating income too, so earnings per share should grow more than 10%.

Canadian Oil Sands Limited (COSWF) is an energy company that generates substantial and growing cash flow as long as the price of oil remains high. The business’s asset is a 37% ownership of the Canadian Oil Sands joint venture known as Syncrude. Through this ownership, Canadian Oil Sands Limited controls between 40 and 80 years of crude oil reserves. It is costly to produce oil from oil sands, but becomes rapidly more profitable as the price of oil rises. At $80 oil, management has said that they expect to generate $2.35 per share in cash flow this year. At today’s $90 oil they will earn closer to $3.00 per share in cash flow. Its cash flows will be more volatile than those of Becton Dickinson, but an investment in oil is an investment in long term global growth. Global energy demand is expected to increase by 30% between now and 2020 with the lion’s share coming from faster growing developing economies. With a $13 billion enterprise value, the company trades at a substantial discount to what the Chinese entity Sinopec paid for Conoco Philips’ stake in Syncrude this past summer. A buyer paying Sinopec’s price of $515 million for each 1% of Syncrude would need to pay approximately $18 billion for Canadian Oil Sands shares or about 50% more than where the stock trades today. Speculating on a sale of the business is all “pie in the sky,” but since Canadian Oil Sands Limited is no longer a Canadian Income Trust as of December 31st, foreign holders can own more than 50% of the business leaving the door open for this.

Between now end the end of the 1st quarter, you will most likely receive another mailing from South Shore Capital Advisors that contains our revised SEC Form ADV Part II. The new financial regulations require us to revise these documents so that they are written in “plain English.” Our lawyers wrote the last ADV part II before that law was in place, and it could use a little editing in my opinion.

Please give me a call if you have any questions about your portfolio or if there have been any changes to your circumstances that warrant a fresh look at your investment strategy.

Sincerely,

Taylor Thomas

As of 1/25/2011 South Shore Capital Advisors clients and its employees are holders of Becton Dickinson and Canadian Oil Sands Limited. This content is provided for information purposes only and is not intended as research. Investing involves the risk of loss. South Shore Capital Advisors is a boutique registered investment advisory firm with offices in Cohasset MA, and Newport, R.I. For more information about South Shore Capital Advisors go to the link "About South Shore Capital Advisors" at the top of this page.

Emotional Intelligence Helps Make a Good Investor

2010-08-03T10:21:00.000-07:00

Robert Shiller is the Arthur M. Okun professor of economics at Yale University and author of the books Irrational Exuberance (2000) and Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism (co-author 2009). He is generally regarded as having predicted the Tech Bubble and the Housing Crisis.

In a recent interview that appeared in the May/June issue of REIT Magazine he made the following observation:

It is certainly plausible that the best investors have always succeeded because they excel in emotional intelligence.

They listen better, so they understand motivations better. They form relationships better, so they learn things about the world that other's don't and also who to trust. They're a better judge of genuineness and can see through the artifice in investment presentations that may draw others into poor propositions. In that sense, emotional intelligence is highly relevant to sound investment strategy.

Secret Millionaires

2010-07-28T08:27:00.000-07:00

In an environment like Today’s where the stock market has virtually treaded water for the past 10 years, we do not hear the stories about Secret Millionaires the way we did in the Nineties.

Secret Millionaires are those people that amass fortunes well beyond what might have been expected based on their incomes, and keep it quiet. Because they keep it quiet, few people know about their riches until after they pass. Even then publicity generally comes when they leave the money to charitable institutions that share the good news of the gift with the public. The following are four stories about secret millionaires.

Raymond Fay

Raymond Fay lived a modest life in Philadelphia. He died at the age of 92 in December, 1995. Never earning more than $11,400 a year, he retired as a high school chemistry teacher in 1969. He spent the next 26 years reading books -- nearly 16,000 of them, and catalogued them neatly on 3x5 cards he kept in shoe boxes. At his death he left the Free Library of Philadelphia $1.5 million which he had accumulated in municipal bonds.[1]

Donald and Mildred Othmer

Donald Othmer was a picture of industry, frugality, intellect and charity. Othmer was a professor of chemical engineering at Polytechnic University in Brooklyn, NY. Donald died in 1995 and his wife Mildred passed away in 1997. They left hundreds of millions to their favorite charities. How did they do it?

Don’t be disappointed to learn that they invested with Warren Buffett. Frugality and industry played a big part as well.

Othmer was born and raised in Omaha, NE. According to stories, in his youth he earned money picking dandelions from neighbors’ yards, delivering newspapers and telegrams, and walking a farmer’s cow to and from pasture. He graduated from University of Nebraska and received a Ph.D. from University of Michigan in 1927 after which he went to work for Eastman Kodak in Rochester, NY. His research resulted in 40 patents for Kodak, but he grew unhappy earning only a $10 bonus for each patent so he left in 1931 to become a professor at Polytechnic in Brooklyn where he could keep his patent earnings and have the use of graduate assistants for his research and consulting. He often worked six days a week. Othmer achieved commercial and academic success as the co-editor of the Kirk-Othmer Encyclopedia of Chemical Technology which became an industry bible.

His first marriage fizzled but in 1950 he married Mildred Topp, a former high school teacher who had received a master’s degree from Columbia Teacher’s College in 1945. Their wedding was held at the Plaza Hotel in New York City, a sign that they had achieved some significant means at that time. They then settled in a townhouse in Brooklyn Heights. They lived on two floors, and rented out the other three. They never had children.

Warren Buffett recalls that Mr. Othmer’s mother first approached him in 1958 when he was 27 years old about managing some money for the family. At this time Buffett was managing less than $1 million. Other Othmer family members withdrew money, but Donald and Mildred were patient investors. When Buffett dissolved the Buffett Partnership in 1969, the Othmers took shares in Berkshire Hathaway. Donald’s investment had grown to $770,000 and Mildred’s to $817,000.

The couple’s initial Buffett Partnership investment had been $25,000 each. The Berkshire Hathaway that they received in 1970 was valued at $42 per share. That would equate to 18,333 shares for Donald and 19,452 for Mildred. Along the way they must have sold or bequeathed some, because at the time of his death in 1995, Donald’s estate contained about 7000 shares of Berkshire that were sold after his death for just under $30,000 per share. Mildred’s estate at the time of her death in 1998 held 7500 shares valued at approximately $75,000 each.[2]

Florence Ballenger

It was a surprise to many in 1999 that Florence Ballenger, a retired junior college English teacher, was a wealthy woman when she died at the age of 92. Her personal estate totaled $3.6 million and her late husband’s trust totaled about $3 million, having grown from $387,000 in 1985 at the time of his passing.

She did it by saving her pennies and investing in common stocks. Most of her wealth had been accumulated in General Electric that her husband bought in the sixties when he started work there as an engineer.

However, she was also known as a saver who spent little on herself except for her one indulgence of an efficiency apartment in London that she would rent in the summer to escape the Florida heat. She also kept herself busy, volunteering at St. Petersburg Junior College as an English tutor five days a week from the time of her retirement from the school in 1976.

She never had children, and when she died her money went to educational institutions. $1.2 million to St. Petersburg Junior College, her former employer, $1.2 million to her Alma Mater Eastern Illinois University, and $1.2 million to Kennedy-King College in Chicago where she had also taught. Her husband’s trust, which she never took a withdrawal from, left its $3 million to Clemson University in S.C. She was very modest and very particular about trying to live on her social security and teacher’s pension according to a long-time friend.[3] [4] [5]

Theodore and Harvey Baker

Nothing in the history of Ted and Harvey Baker of Chilton, WI spoke of great wealth. Their parents removed them from school in the eighth grade to work on the family farm. Harvey, the older brother, took care of Ted who was mentally disabled. In the late 1950s they sold their family farm for perhaps $50,000 and moved into town to take unskilled factory jobs. How did Ted and Harvey amass $2 million and $4 million estates by their respective deaths in 1989 and 1994?

According to their lawyer they did it through frugality, and by investing in blue chip stocks. The Baker brothers did not turn on lights at night. They cooked in bacon grease, and for years they had no car. According to their long time stock broker, Harvey Baker knew the closing stock prices every day.[6]

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Most if not all of the people described above would be considered eccentric; their frugality something that most readers would find unappealing. However, in addition to frugality, they all seemed to show some form of industriousness, and most were well educated and studious.

While in each of the cases above the players did not have children, which no doubt helped with their saving, the lack of children is more likely the reason why the money was left principally to the charities that spread the word about the gifts, rather than to family.

In each community, while rare, there are likely a few Harvey Bakers, and Florence Ballengers.

How one chooses to spend money is a very personal decision. This is not intended be a lecture on the virtues of frugality since some people would happily spend every penny. What it is intended to highlight is the power of compounding which worked particular wonders during the Nineties when stock market returns averaged 15.9% annually, a rate at which a portfolio’s value will double in only 5 years.

The Eighties, which saw the Dow deliver a 12.9% average annual return, and the Nineties with their 15.9% average annual return produced a lot of stock market believers, and consequently not so many savers. The first decade of the 21st Century has shaken the faith of many in the market.

The 2000s is not the first dark age for stock market returns, nor will it be the last, but in time, handsome returns will come again.

Perhaps what sets these Secret Millionaires from the Nineties apart is that in order to achieve the gains that they did, they had to invest while others shrank from the risk.

These are stories about people who lived through the Great Depression which saw the Dow Jones Industrials lose 89% of its value. They lived through the Thirties when the Dow returned an average of 1.7% per year, and they lived through the Forties when the Dow returned only 3.69% per year. Additionally, they lived, and stayed invested through the period from 1966 when the Dow hit a high of 1001.11 through 1982 when it finally crossed that level for good – a 16 year lost era (save for dividends which can be meaningful) for many buy and hold stock market investors.[7] Yet buy and hold they did, and by investing a little more each year they achieved remarkable compounding.

[1] USA Today, March 13, 1997, pg. 13A.
[2] New York Times, July 13, 1998, section A, pg. 1
[3] The Tampa Tribune, August 18, 1999, pg. 1
[4] St. Petersburg Times, August 18, 1999, pg 1
[5] Chronicle of Higher Education, September 24, 1999, pg. A51
[6] New York Times, July 14, 1996, section 3, pg. 5
[7] Econostats.com

Are Your 401K Costs Too High?

2010-04-13T15:05:00.000-07:00

While mutual fund expenses and brokerage commissions receive plenty of attention in the financial press, 401k plan fees are a much less frequently discussed topic. However, both the employers who sponsor 401ks and plan participants can benefit from a review of the topic. This note presents some key information, and then an example of how one firm with a $2.5 million plan could save $16,650 per year, and at the same time add potentailly valuable advice from a fiduciary for the plan participants.

The Department of Labor Weighs In

The United State Department of Labor offers a booklet that provides a detailed look at the fees and expenses paid by 401k plans. This booklet is a worthwhile read for 401k plan sponsors, and may also be of interest to plan participants who would like to better understand various details of their company’s program. Fees and expenses are a particularly relevant topic for plan sponsors since they hold a fiduciary duty to the plans. For plan participants, fees and expenses are one of the factors that will affect their investment performance and impact their retirement income.

As the Department of Labor website points out, fees should not be the only consideration in choosing a plan provider, though they can provide a meaningful drag on investment performance. Employers who are the plan sponsors should recognize this.

The Reality

Particularly at businesses where 401k plan assets are less than $10 million, one finds expensive programs. Employers who sponsor these smaller plans often elect an off-the-shelf, bundled solution where the 401k provider is either a mutual fund or insurance company. These “closed” or “semi-closed architecture” offerings provide one stop shopping for plan design, custody, and investment choices. However, this typically comes at the cost of higher fees and more limited investment options than would be available to participants in a well-designed “open architecture” 401k plan. Such a plan would feature a separate plan administrator, custodian, and mutual fund managers.

The Data Supports the Value of Advice

There is often very little advice provided to 401k plan participants about their investment options and appropriate asset allocation. This is unfortunate because there can be significant improvements to investment performance when employees receive investment advice.

Consultants at Hewitt Associates Inc., Lincolnshire, Illinois, and Financial Engines Inc., Palo Alto, Calif., have published data supporting that conclusion in an analysis of data on 400,000 401(k) plan participants.

The consultants at Hewitt and Financial Engines, both active players in the 401(k) plan services market, found that, on average, the median annual return for participants using investment help was 1.86 percentage points higher, net of fees, than the median annual return for participants who did not use professional help (Life and Health National Underwriter, 1/28/10).

The Numbers Can Be Compelling

An industry record keeper recently provided the following numbers. They illustrate how 401k fees might differ between a broker provided 401k program and one structured in an open architecture with advice provided by a fee-based RIA firm. These numbers are for a 40 participant plan with $2.5 million in plan assets.

Broker Sponsored 401k Sample Cost Breakdown

Administration/Compliance…………………………8.6 bps
Custodian Contract Fee…………………….…….…50.0 bps
Broker Fee – current advisor…………………………………Paid via 12b-1 fees
Net Mutual Fund Expense Ratio…..........…....149.0 bps avg.
Net Cost to Client…………………………..…...…..207.6 bps

Open Architecture 401k with RIA Co-Fiduciary Sample Cost Breakdown

Administration/Compliance………………......……3.0 bps
Custodian Contract Fee………………………..……..0.0 bps
RIA/Co-Fiduciary………………………………....….50.0 bps
Net Mutual Fund Expense Ratio……..…………..58.0 bps avg.
Net Cost to Client…………………………….........…141.0 bps

Savings to Client = 207.6 bps – 141.0 bps = 66.6 bps x $2.5 million = $16,650/yr.

In this instance the plan would save $16,650/year and plan participants would obtain advice from an independent RIA that is a co-fiduciary to the plan along with the plan sponsor.

Conclusion

At a minimum this data about plan costs and the potential benefit that advice can provide should make plan sponsors take a look at their plan expenses relative to the alternatives. Independent fee-based Registered Investment Advisors can play an instrumental role in helping small and medium sized businesses improve their 401k offering; assistance with the creation of a cost effective, open architecture 401k plan and the provision of investment advice being the two most obvious areas.

Calpers Looks at Cutting its Return Assumption

2010-03-01T11:44:00.000-08:00

The Wall Street Journal reported this morning that CALPERS, the California Public Employees' Retirment System, is considering lowering its return assumption for its portfolio. Apparently the discussion has focused on lowering the assumption from 7.75% to 6%, though nothing is final.

For some time clients of South Shore Capital Advisors have been hearing that appropriate targets are in the range of 6%. After all, one must consider the impact of fees and transactions costs when contemplating this, and for taxable investors, there is also the bill due to Uncle Sam for income and capital gains.

In addition to the three P's that institutional investors often consider - Philosophy, Process, and People, an important fourth consideration that investors should consider is Price, or the fees that one pays for the service received. While this is not new news it never hurts to be reminded of it, particularly because if the lower return world is in fact the new reality, the fee as a percentage of total return on the portfolio increases. Particular bugaboos of mine are potentially expensive savings vehicles such as variable annuities, and also wrap accounts from brokerage firms that posess high fees in order to cover the expense of a.) the management of the assets, b.) the compensation to the broker/advisor, and c.) the take for the brokerage firm itself.

Taylor Thomas

External Debt To GDP For PIIGS, BRICs and a Few Others

2010-02-18T13:36:00.000-08:00

The CIA and World Bank websites offer current data on External Debt to GDP. I recently gathered this data and created a table of these statistics for a select group of countries that have been in the news lately - Portugal, Greece, Italy, Ireland and Spain - the PIIGS. While I was at it, I also pulled data for other key countries in order to use it as a basis for comparison.

External Debt is the total public and private debt owed to non-residents, repayable in foreign currency, goods and services.

The goal here is to merely shine a light on the topic and to offer what I believe are a few simple truths:

First, the world is a very interconnected place! Countries and their banks own a lot of each others' assets. Given the leverage this table illustrates, the problems of one country's government or its largest financial institutions can quickly spread to others if a cross border contagion develops.

Second, there are a number of countries that would be hard pressed to bail out their own banks. Think Ireland, and the United Kingdom.

Third, this is yet another measure where Brazil, Russia, India and China - the BRICs - look to be in good shape.

Lastly, all this debt underscores why deflation is potentially a greater threat than inflation. Banks want the value of the assets they lend against to rise not fall, and governments need the value of their tax revenues to increase not decrease. Deflation means shrinking asset values, fewer capital gains and smaller incomes.

2010-01-11T14:08:00.000-08:00

Here is a link to a recent upgrade of San Juan Basin Royalty Trust (SJT) by well respected energy stock analyst Kurt Wulff of McDep LLC an independent research firm.

http://www.mcdep.com/rtweek91211.pdf

SJT was presented in this forum last spring under the heading "US Royalty Trusts for Income - Oriented Investors." In his note published mid December Wulff points out that holders of SJT benefit from its 100% natural gas focus with no leverage and no hedging. He forecasts an 8% distribution yield for the security over the next 12 months - which by the way is a tax advantage yield.

A Principal of South Shore Capital Advisors, and certain South Shore Capital Advisors clients are holders of San Juan Trust.

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

2009-12-22T08:55:00.000-08:00

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

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

2009-11-03T11:41:00.000-08:00

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

2009-10-19T14:08:00.000-07:00

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?

2009-08-30T13:25:00.000-07:00

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?

2009-06-29T12:26:00.000-07:00

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

2009-05-18T11:19:00.000-07:00

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

2009-04-14T09:27:00.000-07:00

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

2009-03-23T12:11:00.000-07:00

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

2009-03-18T12:13:00.000-07:00

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"

2009-03-12T07:09:00.000-07:00

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

2009-03-05T12:03:00.000-08:00

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 -

2009-03-03T13:42:00.001-08:00

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

2009-02-28T12:05:00.001-08:00

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