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CASHING OUT
OR CASHING IN
By Donald Pearson
December, 2002
Today, more than ever before, we are faced with difficult choices for our savings and investments. In the last three years many of us have lost a great deal of our retirement dollars and must reassess what we thought was an “etched in stone” strategy. For the last three weeks I have tried to research the newest, the oldest, and the safest opportunities for amassing wealth, and then come to a conclusion as to which would give me the best return versus risk results. To do this I researched annuities, bonds, money market funds, and individual stocks.
A skittish investor looking for something safe to fit his need might consider an annuity. An annuity is a non-FDIC insured tax-deferred investment, underwritten by an insurance company, providing payments for life or a specified period. It can be purchased through insurance companies, banks, or brokers. Annuities are subject to investment risk including loss of principal. You will find many from which to select and many are tax deferred. The first thing to remember is the GUARANTEE by the company is only as good as its financial strength. To begin with, you should first investigate the annuity or the life insurance vehicle. With Moody or Standard & Poor AAA is their highest rating. It is also important to remember annuities generally come with sales commissions and early distribution penalties. The lower capital gains tax has diminished the attractiveness of variable annuities because money that builds up inside the vehicle will be subject to higher income taxes when it is distributed than it would have incurred had the money been invested in individual stocks outside the variable annuity.
One thing to consider before surrendering your principal is anyone guaranteeing a 4% return over the life of a contract must be putting it where he strongly believes he will receive 5% or more. Is this same option not available to me? Do I really want to give up control of my principal for 5-7 years, or longer? What if I need or want the money in the future?
Another option I found that sounded promising was a “principal-protection” fund. This is offered as a vehicle that GUARANTEES the principal too. The supplier offering this uses a combination of bonds, equities, and insurance combined over a fixed period, usually 5-7 years. A major downside to these funds is the cost of the insurance which is built into them because of the money back GUARANTEE. Costs for this type of a vehicle usually run from 2-3%. The fund must remain ultra conservative, and the potential gain is minimal. If the insurance company providing the guarantee thinks the fund manager is taking too much risk, it can take over the asset-allocation duties. In managing risk, investment performance often drops out of the equation.
No matter which of these investment vehicles is considered, it is imperative to read the small print and be very clear on the total costs, expense ratios, and redemption fees. I know that with inflation eating away at my principal, I should target at least a 6% return annually. So I ask myself, can I live without any capital growth, as all of the above are far below the 6% I am seeking?
I considered a money fund as another possibility. Money funds are mutual funds that can invest in commercial paper, bankers-acceptances, repurchase agreements, time deposits, Treasury bills, and a few other arcane, relatively safe, investments that mature in an average of 90 days or fewer. Prior to the last Fed rate move, according to moneynet.com, the average money market mutual fund was earning 1.21%. In the first week after the rate cut, money fund yields dropped to an average of 1.05%. By the end of the next week, the average money market fund will be earning in the neighborhood of 0.75%. I think it’s safe to say this cannot get the job done either.
For those who believe bonds are the answer for diminishing risk, you must also be prepared to accept a below par return. A government bond held to maturity will GUARANTEE the principal plus some return. Municipal bonds are currently averaging 4%. The same cannot be said about a corporate bond, which runs a higher risk of default. If you are like many individual investors, your exposure to bonds comes through mutual funds, which can lose money since they typically trade bond issues and don’t hold them to maturity. They are therefore subject to price and interest rate volatility, as well as credit risk. What’s more your return always will be reduced somewhat by the annual fund expenses you pay. With today’s interest rates at a near all time low, bonds become considerably less attractive. Historically, bond prices move in the opposite direction of interest rates. As the interest rate begins to rise, prices will fall, and that should reduce a bond fund’s return.
After reviewing all of these options, I came to the conclusion that the strategy we have maintained for pursuing the 6% plus return is the better choice. You should first decide how much cash you might need in the next few years, and be certain this is protected in cash, bonds, or a money market. Next you should determine how much you would like to invest in a 6% plus account. We have an example of this on our website. Click on CD Buster and view the model portfolio. It is currently up 4% year to date without yields and fees built in. It would net at approximately 7.5% after all costs and yields have been included. Although this cannot be guaranteed, it does give an investor a tremendous amount of flexibility. Money can be added and removed as desired, and monthly withdrawals can be set up the same way as an annuity. There are no pre-withdrawal penalties, and your money remains your money and callable at any time.
To minimize the risk while placing the focus on growth, the portfolio is built using the following guidelines:
• Any stock selected should have a minimum of three years of solid sales growth, positive earnings growth, and price appreciation.
• The stock selected is paying above average dividend yields, while at the same time increasing their annual dividend.
• Any stock failing to meet the performance requirements for two quarters of reporting is replaced immediately.
The S&P has 24 companies that currently meet this criteria.
We also use different Real Estate Investment Trusts to bring additional diversification to the portfolio. The estimated annualized return (yield) for REITs through 2008 is 11.4%. Although REITs have had a terrific run for the past two years, they are still undervalued compared with the S&P 500, and their dividend yield is higher (7.5% vs. 2%). The yields are also inflation-protected because the price of commercial real estate usually rises with consumer prices.
With this type of an account the focus is protecting the assets with a properly diversified portfolio. We will not be reaching for high, unrealistic returns, and we will be sticking with a long-term financial game plan. I believe this portfolio can and will meet the performance objective. We have built and are currently maintaining many of these accounts for others. Might we build one for you too? Please call us for details.
THE FACTS AS I SEE THEM
By Donald Pearson
10/04/02
With obvious uncertainty in our immediate future, today’s stock market has reached a six-year low. More than $7 trillion—equal to $25,000 for every man, woman, and child in America—has been lost. A dollar invested in the Standard & Poor’s 500 stock index fund in March 2000, is now worth 55 cents. Labor department statistics show the number of workers staying on the job age 55 or older increased 1.2 million for the year ending in June. This is a much larger number than we have seen in prior years. CEO’s in many companies are being brought up for stealing, being indicted on fraud charges, and in some cases being put in jail. We cannot even believe the earnings numbers and the analyst recommendations about which we hear and read.
What’s the answer you ask? Is there a solution to this problem, or do I take my money and put it in my mattress? I believe, if you know the facts and invest the time needed, you can still be successful in this very difficult period. An article published in the October Money Magazine regarding the top Salomon Smith Barney telecom analyst references his letter of resignation sent to the firm on August 15 of this year. He is currently earning $20 million a year for his services. Money’s article laid out his potential conflict of interest and lousy stock picking record. Of his “top ten” selections for his State of the Union address in March 2001, six have filed for bankruptcy, and only one now trades above a penny stock level. He is currently under investigation for his selections and has decided to walk away and take his $32 million in severance.
The lesson here is simple: Do not rely on any one person for recommendations. We purchase analyst
data and other research information from various
sources as well as do our own. Even with this you’d be amazed at how many times a company that looks like a can’t miss doesn’t perform as expected because of built-in variables. A competitor may have invented a better product, or can do something faster, or for less cost; the reasons for underachieving are endless. As far as the crooks running these companies today, it is important that we not lose focus on the fact that a few bad apples do not make a stock market. You have around 10,000 stocks from which to choose and only a handful of these bad apples are making the news. Do your homework as we do, and set higher standards for your selections. Past performance is not enough; raise the bar.
Are you also aware of the fact that when you read about a company’s earnings, the bottom line of an income statement is actually a product of enormously complicated rules called Generally Accepted Accounting Principles (GAAP)? These rules have so much subjective judgment they can be easily manipulated. A company can estimate the fair value of its securities, certain contracts, and other assets, at the end of each quarter, and count any increase in value as earnings. Accounting rules allow tremendous flexibility in deciding those valuations. Half of Enron’s pretax profits are thought to have been accounted for by this method.
The answer to this problem is simply to dig deeper when doing your research. Don’t settle for the obvious. As the SEC puts new and tougher accounting standards in place, don’t rely on them to do the job for you. Dig, dig, and dig deeper for more information before selecting. We have many ways we can help ourselves today if we do our homework and know the facts. Look over your entire portfolio and see if there are any other
opportunities.
Here’s a great example of many missing out on an investment opportunity. Today Americans have lost $2 billion in potential interest since 1990 by failing to cash in matured savings bonds and reinvesting the money elsewhere. Currently more than $7.9 billion worth of U.S. savings bonds have reached maturity and therefore are no longer earning interest. If you are one of these people currently in this situation, you can call the Bureau of Public Debt at 304-480-6112 for alternatives. Our clients with managed accounts can contact us, and we can transfer them to their accounts at TD Waterhouse.
One other fact about the stock market worth noting is that nine other times since World War II the market has been taken down in this fashion, and it has recovered every single time. As strange as it might appear, there are times something unpleasant such as the stock market continuing to decline can have some long-range upside to it. As one’s wealth is deteriorating, I realize it is very difficult to have any type of immediate optimistic outlook. I only want to make you aware of the fact that the lower the market retreats, the better the buying opportunities. The lower the price of the stock, the lower the price earning ratios become, and, as such, the safer the stock market becomes.
WHERE ARE WE GOING FROM HERE!
By Don Pearson
March 2002
PearsonCapital close on the first quarter of 2002 and begin the second quarter with more optimism than any time in the last two years. Although you will still receive a mixed message, no matter which day or hour you are tuned in to, from one of the supposed “experts” delivering his or her report, it would appear we have a glimmer of light at the end of the tunnel. The bullish prognosticators will tell you we may be poised for a healthier advance than we’ve seen in a while, but more bearish folks say investors should remain cautious, because there is still a lot to fret about.
A good example of this took place in the last week. Federal Reserve Chairman Alan Greenspan stood in front of Congress and gave an update on the economy that really lacked any clear direction. One week later, after reviewing a productivity report that showed higher than expected growth, he was suggesting the economic expansion is already under way.
As we continue to read more of the favorable data being published, I believe it is safe to say: maybe! Orders to U.S. factories for large ticket items rose for the third straight month, and consumer confidence surged to its highest level in seven months.
Two additional indicators that we at PCI watch very closely are trending favorably at this time also. The first is the unemployment numbers that are now on the decrease. After their peak in late September, they have been decreasing regularly and are currently down 30 percent from that period. Unemployment claims tend to peak as business cycles bottom. Secondly, analysts are falling over each other revising up their 2002 outlooks.
So what does all of this mean to us you ask? It means we can begin to plan to whittle away at the losses many of us have endured throughout the last two years. We may not see a period like the boom times of the 1990s, but that doesn’t mean we cannot do very well for ourselves. We must remember now not to abandon our strategies and turn aggressive when things are beginning to look better. Remember this lesson well: If you invested $1,000 at the start of 2001 and lost 33% (the loss of the NASDAQ for the year), you would need a 50% gain this year to be even again. For those of you who chose to move your money out of stocks or mutual funds and into some type of money market or CD opportunity, it is important that you be aware of the following: Money funds still offer safety and liquidity, but yields are at their 30-year lows. Average yields today are 1.35%-1.76% for U.S. money market mutual funds. The average simple and compound yields on tax-free funds are currently at 0.81%. Interest on CDs for one year is barely over 2%.
It is sometimes hard for people to understand that those of you who chose to be in a money vehicle for the last two years have also lost considerably too. Let’s just think for a minute that it is twenty years ago, and we are sitting around my house together. I’ve got a One Dollar bill in my pocket and I’m on my way to the store. I will be purchasing a pen to write a letter, and I will also pick up a postage stamp to mail the letter that I write. On my way home from the store I am going to stop and have a hamburger for lunch and follow this up with an ice cream cone. If you tried
to tell me that in twenty years (today) I couldn’t even buy a hamburger to eat with my dollar, let alone have desert and run my errands, I’d think you were crazy. Get the picture?
Our money must grow faster than inflation. Consider individual stocks as a part of your portfolio. You do not have to be a wild risk-taker to have some. Did you know that within the S&P 500 there are twenty companies that have reported higher earnings in every quarter for at least twelve years and at the same time have increased its dividend every year over the same period too? Although there are no guarantees that all, or many, of these companies purchased together in a portfolio for you may outperform your current and future CDs, it is an assumption one could make. It is definitely an alternative worth considering.
We have dedicated a section of our investment letter for those that wish to focus on growth stocks with above average yields. Here you will find stocks that afford the safety one pursues while minimizing exposure to risk. As an example, we have built a small portfolio from the selections made in our January and February Investment Letters. We will publish these and their annualized returns as a comparison to the CD quarterly.
CAN I REALLY HAVE INCOME & GROWTH TOGETHER?
By Donald Pearson
02/02/2002
Last month on page three of our letter I wrote an article ("FALLING RATES HURT RETIREES") outlining a strategy to overcome fallen money market and CD rates. It generated many phone calls asking numerous questions. I wanted to write more about this subject hoping to clear up a great deal about actual portfolio growth, along with real rates of return. Besides telling you why I believe we should all be pursuing income and growth together, I will explain how to do it. When I watch NFL playoffs each Sunday, I hear the announcers say the team that was smart enough to take what the other team gave them was the winner. I believe this is also true with investing today.
Let's begin by first placing a real number on inflation and how much money I would lose by not doing anything. I'm not so much interested in the number I read in the paper every day by the politicians seeking reelection. I want the number that affects me realistically and will use 6% for an annual average. That is the growth I must receive just to remain even.
I learned as I wrote last month that the average CD for one year was returning only 2.21% nationwide, so I searched throughout the country to find the best "traditional" CD rate available. Banks are rated on a 1-5 star safety system with five stars indicating the most desirable performance. I wanted to deal with 4 or 5 star rated banks only. I found I could get a CD for one year with a rate of 3.3% annually at Providian Bank of Tilton, NH. (4 star rating), or I could get one for 2.5 years at a rate of 4.27% at Capital One of Falls Church, VA. (4 star rating). These were the highest I could find anywhere. As we can see, both CDs will have a negative affect upon my cash holding after I factor in the 6% inflation rate that I am held hostage too. (Note: When purchasing a CD you must remember to verify before signing that you are getting a traditional CD and not a callable CD. You do not get a certificate with a callable; that's the alert. You are given a statement instead because you've really purchased a "Book Entry." I point this out only because brokers offer higher rates with these because they are very difficult for you to turn in when you decide you've had it long enough.)
I also know I can choose from a long list of mutual funds, but in all honesty I believe this is a more difficult choice because of the downside exposure risk. There are so many to select from, and naturally they all have a different agenda. I know the fund manager must make decisions on what is best for the fund, and perhaps his year-end incentive bonus, rather than what's best for me personally. And, my personal capital gains liability will never be considered. I have read the results for 2001 and they are not a whole lot better than 2000. Technology sector funds year-end loss @ 38.3%. Communications sector funds year-end loss @ 34.6%. The utility sector funds, once thought of as an investing haven for widows and orphans, tumbled 21.2% in 2001, thanks, in part, to the hard-hit telecom stocks many of them hold. Growth funds, those buying stocks of large companies, lost 23.6% last year and that's after losing 14.5% in 2000. Morningstar has stated the few big fund winners that did do well were mostly off the beaten path. On average,
diversified U.S. stock funds lost another 10.3% last year.
Another problem I have with this selection process is the advertising I read or see on TV stating funds results. Be careful not to read the funds "annual return" when trying to decide its value. You must have them give you their average compounded results! Here's the difference: Put $10,000 into a mutual fund, and the first year the fund grows by 100% doubling to $20,000. The second year it falls dramatically by 50% back to $10,000. The third year it climbs 19.1% up to $11,910. The "average, or the average annual return" for this fund for three years is an impressive 23%. (100 minus 50 plus 19.1 divided by 3) But the average annual compounded rate of return for this mutual fund is really only 6%. If the fund performs and compounds 6% annually, it would grow to $10,600 after one year, $11,236 after two, and $11,910 after three. Some advertisements for fixed annuities stress that you will double your money in 12 years. Although this appears to be an attractive 8.33% a year, in reality it's less than 6% when compounded annually.
So how do I see the best opportunity today for us? Just like the Sunday football team that wins, I want to take what they give me. In every issue of our investment letter we offer at least one and many times two stocks that have great earnings growth potential along with a yield that outperforms the CD rates of the day. Many times we offer outstanding REITs too.
I believe the smart investor today, looking to remain ahead of inflation while taking risk to the smallest denominator possible, must pursue companies that are continuing to grow while at the same time their stocks have an income yield included. Every month we recommend companies we believe meet this criteria. We have a large portfolio of these that we select from, but space will allow me to only reference a few.
On the front page of this month's issue you'll see two that should outperform a CD all this year and next. Washington Mutual (WM) is one of my personal favorites for growth with minimal risk, (p/e under 10) and a yield of 2.8%. Phillip Morris (MO), owners of Kraft Foods and Miller brewery is a diversified holding within itself. With a price earnings ratio of 13 and a yield of 4.6% this company also looks exceptionally attractive. The third choice of today is Fannie Mae (FNM). This stock has a p/e of 13.6 with a yield of 1.6%. The last quarter was its most impressive yet. Earnings soared 22% at the nation's largest buyer of home mortgages. This company has had 15% a year earnings growth for the past three decades.
Anyone with a CD coming due of $10,000 to $100,000, I would strongly consider having us build one of these accounts for you. For those of you who are somewhat sceptic, why not have both? As an example, a $25,000 Personal Wealth Account would have approximately 40 individual stocks in it with the objective of outperforming the CD while at the same time minimizing down side risk. The best part of this portfolio is your knowing that we have a research department monitoring the holdings every day for you. We also oversee your capital gains liabilities at the same time, and this will considerably minimize your exposure.
ALL ABOARD
By Donald Pearson
01/04/2002
We are now faced with one of the hardest decisions we will make in 2002. How do we manage our assets? In what direction will the stock market and our economy head in the upcoming year? No one knows for sure, nor could anyone guarantee that their opinion is the right one, but I can guarantee you this: I have read all the data I could find and then read many of the so-called experts' opinions before forming my own.
First let's begin by analyzing where we are today. I will try to briefly explain some of the events from last year that have placed us where we currently are, as well as some of the activities that are now occurring that are setting our course for this year. Obviously, the many hidden variables such as Sept. 11 can change all of this overnight, but sitting around to wait and see will probably mean we'll miss the train as it leaves the station. My recommendation is: Get on board and enjoy the ride!
Last year was a dismal year again for the stock market. Corporate earnings were not what were expected or forecasted, and the Sept. 11 terrorist attack brought the market to its lowest level in three years. For the year the Dow dropped 7%, the NASDAQ lost 21% and the S&P fell 13%. The last time all three indexes fell for two consecutive years was in 1973 and 1974. Looking back on 2001 it will be remembered as not just a negative, but a truly dismal year.
Many investors thought getting in early in 2001 would catch the "Bull Market" at the very beginning following the dot-com and high-tech meltdown of 2000, as few envisioned that earnings or the economy would deteriorate much more. The Federal Reserve also made its first of eleven interest rate cuts, leading many to predict a soft landing. Many believed profit losses and layoffs would be confined to technology and manufacturing and be short lived.
In March, Proctor and Gamble was warning of weak profits and by the middle of the spring stocks were officially in "Bear Market" territory, the term used to describe a drop of 20% or more from the market's peak. Goldman Sachs and many other investment firms saw hope through the summer period and predicted the market would finish the year higher. The market began to climb again but this was unsustainable as more earnings warnings were coming in, particularly in the tech sector.
Then came the event of Sept. 11 that caused many jittery investors to panic. In the fourth quarter we were informed our economy is in a recession, yet the market was beginning to rebound somewhat. The indexes had returned to pre-Sept. 11 levels. Is this momentum to build on? Lets examine some of the facts we have available to us and try to make important decisions based upon what we know rather than what we hope for. We all want peace and prosperity without risk, but this will never be available. The question to be asking is; is this the time to begin investing, or reinvesting, or is it to soon?
The upcoming year, as every other year, will present risk for sure. Yet managed properly, the rewards could far outweigh the risks. The recession has been targeted to end in Feb-May of 2002. The war against terrorism appears to be going well, and this will build consumer confidence. Consumers who control about two-thirds of the US economy will probably begin spending again. Lower interest rates, tax cuts, and the drop in energy costs will support this. Improving profits will encourage companies to resume investments in technology and other projects that will boost productivity.
All of this information leads me to believe the economy and the stock market will move ahead in 2002. I don't believe the engine will be firing on all cylinders in the first half. The second half of the year should be when the real growth takes place. I believe we will probably have a few false starts as the stock market tries to anticipate the beginning, thus causing above-average volatility to test the investor's tolerances. This makes asset allocation even more important for each investor. It is important to note that short-term economic, political, and social events should not be cause for entirely changing people's investment strategy, even if the portfolio is adversely affected as a result. People should not loose focus of their long-term perspective. After two consecutive years of watching the stock market contract, it is difficult to convince others we should be investing and that growth and prosperity can be had here. For new startup investors it is especially difficult, yet they may be at the opportunity of a lifetime. As we look back in time, we can see over and over again the question is not if the market will regain its positive performance again, it is simply when.
As the conductor of the 2002 train, I simply say "All aboard"!
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