Ancora Imparo
At the ripe old age of 87, Michelangelo is said to have uttered the words Ancora imparo, which translate as: I am still learning. This seems a remarkably humble sentiment coming from the painter of the Sistine Chapel, sculptor of the Pieta and creator of many other timeless works of art. It serves as a reminder that no matter how long I’ve been working at investments and financial planning, or how well we do for our clients at Warren Ward Associates, I will always be "still learning."
Following ten years of selling investments as a stock broker, I came to believe that being able to place my clients’ investments appropriately within the context of their entire lives was more important than just picking that day’s best stock or bond. That insight eventually led to the "client first" model under which WWA now practices. Clients pay our fees and we represent them exclusively, never receiving compensation from any brokerage firm, investment manager or insurance company that we might recommend.
As simple as that concept might sound, changing the way we did business required developing some new skills, so I earned my Certified Financial Planner certification in 2001. Becoming a CFP® requires completion of five Master’s level courses (Insurance, Investments, Taxes, Retirement Planning and Estate Planning) followed by a two day comprehensive exam. My associate, Jalene Hahn, had already earned her MBA but was not exempted from taking those same courses as she moves toward her own certification. She sat for the exam last November and we learned this week that she is among the 53% who passed. She will become fully "certified" once she has an additional year of planning experience but, in the meantime, she is adding her varied strengths and skills to the practice.
In addition to the process of earning the CFP® certification, WWA also became a Registered Investment Advisor. This means that our practice is now governed by a different set of regulations than brokers and insurance agents: we are obligated to exercise a fiduciary duty of care towards our clients, just as any physician, attorney or CPA must.
Even though Jalene has most recently been enrolled in coursework, I find that I am learning at the same time she is. In addition to keeping up with the bedrock fundamentals, I must also track the everchanging world of investment management and issues related to college funding, not to mention devising the new strategies which seem to be required following every update in laws and regulations. In addition to the books and magazines which have long been available and the conferences we attend to remain current, the internet now gives us access to a constant flow of data. At WWA, we subscribe to dozens of information sources, both printed and electronic. One positive outcome of this information explosion is that it provides us with numerous perspectives to consider as we try to help people with their financial planning needs. Tracking this volume of data is as challenging as it is necessary. At WWA, we strive to meet that challenge so we can provide relevant and up-to-date advice to our clients and friends.
Because things are always changing and there is so much information available, I am certain, at the ripe young age of 60, that I will never know everything and that I will always be "still learning."
Money Managers We Have Known
With the Grammys just completed and the Oscars right around the corner, I found myself thinking about awards. Every year, various publications weigh in with their honorees for best mutual funds (or money managers) of the year. I have written before that Warren Ward Associates rarely invests with those "best" managers because, over the years, we have found that their outstanding results are often the result of some unlikely-to-be-repeated event. While that philosophy certainly remains part of our investment strategy, I had to smile when I read about Morningstar’s 2005 domestic equity fund Managers of the Year, Christopher Davis & Kenneth Feinberg. Never say never . . .
Those of you who have been with us since 2001 may recognize their fund, Selected American Shares (SAS), as our year-in-year-out recommendation in the Large Cap Value area. The team of Davis & Feinberg has been co managers of that fund since 1999 and prior to that, Davis managed it alone.
Our process for selecting money managers is quite methodical and emphasizes consistency in investment strategy, manager tenure, reasonable costs and long-term thinking. It does not incorporate ratings given by any outside source. However, you may be interested to hear that Morningstar’s rating for SAS is their highest (5 star) and in naming Davis & Feinberg Managers of the Year, they have honored them even more highly. While WWA doesn’t claim to be able to identify the best manager in any asset category (or for that matter the best allocation among categories), it is reassuring when the acknowledged authorities in mutual funds confirm our assessment, as happened 2005 with Selected American Shares and its managers.
As investors have become more sophisticated, they have begun looking beyond investment results and have started asking questions about how funds are operated. Consequently, Morningstar (among others) is now rating funds from additional perspectives. Their Stewardship Grade is based on evaluation of various operational issues including compliance, the quality of independent board members, how the managers are paid and general corporate culture. Of the 1,243 funds Morningstar has rated so far, only 11 have received an "A", including our old friend, Selected American Shares.
Winning an award like Manager of the Year has a way of attracting attention. It tends to draw money into a fund, sometimes more than the managers can effectively put to use. Our process requires periodic review of even the best managers so you may be sure that we’ll watch for any signs that SAS might be getting into trouble. For now, though, it is a pleasure to see the research and analysis that is an integral part of our recommendations to our clients affirmed by others. We hope to be able to continue recommending Selected American Shares in the future as we have in the past but, if we do, that recommendation will be based on our process, not the fund’s past performance or even receipt of prestigious awards.
The World is Flat
"Capital goes where it is welcome and stays where it is well treated"
- retired Citibank Chairman Walter Wriston
In his fascinating book The World is Flat, Thomas Friedman says that in spite of all the upheavals related to manufacturing jobs, one of the continuing virtues of the US is the strength and openness of our capital markets. I agree – there is not another country whose markets have the combination of depth, openness and active regulation that ours do.
One of the fundamental truths of investing is that no one knows which way the markets will move other than "up" over long periods of time. That’s why Warren Ward Associates believes in the allocation of assets, taking care to have investments spread through multiple sectors of the markets. From the first dollars WWA managed for clients, we have suggested that some be invested outside the US, as those foreign markets tend not to move in synch with ours.
As Friedman’s book so clearly points out, the world has a way of changing and we must all do our best to keep up. He discusses how the US economy has been altered by outsourcing. Businesses have been forced to move jobs to lower cost areas of the world in order to remain competitive. Our Federal Reserve Chairman, Ben Bernanke, recently shared some concerns about our economy, especially related to our less well-educated citizens. He quoted reports stating that, in 2005, the median weekly income for a US citizen with a high school diploma was just over half (57%) of that of someone with a bachelor’s degree. Surely that observation reinforces the idea that our job market is not what it once was.
In some ways, it might be nice to return to simpler days when education was not as important and when access to lower-wage workers in other countries was not simply a mouse click away. On the other hand, the shift has helped keep US inflation under control and brought people from distant lands into contact with us as they manufacture more (or in some cases, all) of our TVs, furniture, cell phones and clothing.
For various technical reasons, including fluctuations in the value of currencies, WWA is now re-directing some additional capital towards overseas investments, including what are known as developing markets. These include such countries as Russia, China, Indonesia and Brazil. All of them are experiencing exceptional growth rates but none of them have the level of regulation and government-enforced business practices that the United States does. Enron notwithstanding, in the US, we have a pretty clear idea what the word "profit" actually means. Our markets are liquid and transparent enough to allow millions of shares to change hands every day. In some developing areas of the world, Generally Accepted Accounting Principles are not quite as clear and the additional requirements of Sarbanes-Oxley are completely unknown.
In increasing our clients’ exposure to these markets, we have sought out managers who study the world’s markets carefully, who have solid track records of making good stock selections and who focus on only the largest – hopefully, the most fully disclosed – of the available investments. At WWA, we are interested in having our clients participate in the additional growth which may be available elsewhere in our increasingly "flat" world but not at the expense of significantly increased volatility.
Silly Season Suggestions
Following last week’s tax-related investment cautions, I thought I’d share a few last minute tax-related suggestions for people to consider.
If you are not ready to file by the 17th, an easy-to-file extension is available. Either you or your tax preparer can file it and it is automatic, i.e. it does not require approval. This six month extension is from having to file your taxes, not pay them. If taxes are owed, interest (and probably penalties) will accrue from the 17th. If a refund is due, the IRS will pay you interest.
The IRS has tightened-up a couple of categories of deductions. Donated items must now be in "good" condition, although "good" is not defined. I think that asking for a receipt which includes a description of the item’s condition might be a prudent step. In prior years, cash contributions of up to $250 did not require documentation but for 2006 and going forward, proof must be provided.
Tax-efficient investing can be accomplished in a number of ways beyond IRAs and other tax-deferred strategies. No load variable annuities make sense in some cases, as do mutual funds which are managed with tax efficiency in mind. We have begun using a "buy and hold" strategy with individual dividend-paying stocks, an approach that is showing promise.
If you are thinking about retiring and are covered by a retirement plan, be careful how you go about taking a rollover. It is important to follow the correct procedure so taxes are avoided. As I mentioned last week, we see a lot of people roll 401(k) plans over into annuities. These insurance-based products include significant "overhead" which must be covered before positive investment results begin to make money for you. We are aware of no advantage in selecting an annuity over a roll-over IRA.
If a significant portion of your retirement nest-egg is in a company’s stock, give careful consideration to diversifying. Even the best companies can suffer difficult periods and, as we learned from the Enron fiasco, in the case of fraud, literally everything can be lost. It is sometimes possible to diversify in ways which allow tax savings, so be sure to ask for advice if this is an issue.
An inheritance can provide a welcome cushion to a nest-egg but care should be used in deciding how to "take" it. Inherited IRAs can be rolled over and, although distributions are then required, taxes are deferred. If a larger estate is involved, be sure to take advantage of potential deductions based on estate taxes already paid.
If you expect to leave a large estate, look carefully at how your life insurance policies are titled (especially if there is a trust involved). Also, review the named beneficiaries of both insurance policies and IRAs. Those are among the categories of assets which pass "by operation of law" before the terms of a will come into effect. That means that the provisions of your will not be considered as far as those assets are concerned.
If you have a second home, you will have do choose between making it your first home so you can take advantage of the capital gains exclusion or use the 1031 exchange method to swap it for another investment property. Neither of these strategies is particularly difficult to execute but each must be done carefully so that tax advantages are not lost.
If you own other investment property, using a 1031 exchange to "get out of the property management business" can be an appealing strategy. It is entirely possible to "swap" into a professionally managed investment and realize regular income from it. There are strict time limits on identifying and purchasing the replacement property and the services of a Qualified Intermediary are required. Again, ask for advice if you are in this situation. If you own a business and plan to sell it to help finance your retirement, be sure to obtain competent tax advice. There may be alternative methods of sale that can reduce your tax burden.
Although Warren Ward Associates does not prepare tax returns for our clients, we do keep up with changes in tax law. If you are doing your own taxes and are considering bringing in a professional, we’ll be glad to make a recommendation based on your specific situation.
The Silly Season
As the weather turns warmer, people’s minds just naturally turn to thoughts of . . . well, in many cases, taxes. As April 15th approaches (actually it’s the 17th this year), people become more susceptible to making an investment decision based on tax issues instead of common sense. At this time of year, products containing a tax "hook" are brought up by salespeople and sometimes even the most prudent investors find themselves considering an investment they wouldn’t look at otherwise.
In approximate order of popularity, here’s a roundup of the usual suspects:
Variable Annuities (VAs) – These are basically mutual funds held within an insurance policy. Since they are insurance products, they receive the traditional benefit of tax-deferred growth. However, we often see them recommended for IRA rollovers which are already tax-deferred, making the added annuity costs a drag on investment performance. VAs do provide insurance in the amount of the original investment, even if the value of the mutual fund investments drop. On the other hand, accounts continue to be charged for insurance costs even when the investment value rises, providing something for nothing to the company and nothing for something to the investor. Typically, an investor will be penalized for withdrawal within the first five years, so these contracts should not be entered into lightly. We have researched "no load" VA’s and do recommend them when we believe they provide the best solution for a specific situation.
Equity Indexed Annuities – These are similar to the VAs above but are not considered "investment products" by regulators, so they are available through thousands of additional insurance agents who are not licensed to sell securities. Instead of having a mutual fund inside an insurance policy, these are [effectively] a stock index option inside a policy. Again, these commonly include layers of cost which are charged to the buyer and they often have even longer surrender penalty periods than VAs. We recently reviewed one with a 12 year penalty period which had been sold to a 62-year-old. We are not saying that an EIA is never the proper solution and we do not hesitate to suggest them, depending on specific circumstances. However, they are often presented as a "blanket" solution, appropriate for almost everyone, and we do not believe that to be the case.
1031 Property Exchanges – Like so many things in the financial planning world, the 1031 is named for a section of the tax code. It allows the owner of an appreciated investment asset (other than a business) to exchange it for another. These can be a very effective tool in a number of situations but are governed by a strict timeframe and should not be attempted without strategic consideration. Do not allow yourself to be rushed into a significant property investment because you have just sold another. Carefully review your overall investment objectives to be sure you are making a good long term decision.
Annuity Trusts – These have garnered significant interest following a 1969 IRS ruling. They have been used to attempt to avoid, or at least defer, taxes on appreciated property. The IRS came up with new rules in October 2006 and cited taxpayer abuses of the strategy as the reason for their clarification. If someone suggests one of these to you, I would be very careful, as I believe the new rules are sending the message that all such trusts are liable to be challenged.
It is our belief that a good investment must first make economic sense, then tax issues should be considered. It is an unusual situation indeed, when allowing the tax "tail" to wag the investment "dog" proves to be the most appropriate strategy.
A-Maize-ing Grace?
No one enjoys having to pay more for something than is absolutely necessary but knowing what’s necessary can sometimes be a challenge. Courtesy of the laws of supply and demand, most markets tend to remain pretty much in balance. Grocery stores don’t stock extra milk during the summer in case of a snow storm. Yet, we would be surprised if stores did not do so during the winter – especially if bad weather is forecast. The supply and demand equation is more complicated with power generation than with milk. All of us want enough electricity available so that our air conditioning can run during the hottest part of the summer but no one wants to have to pay to keep an extra power plant standing by year round, just in case.
The same balance holds true for the oil-based fuels we count on to run our vehicles, heat our homes and, sometimes, provide our electricity. The past few years have exposed us to another round of high gasoline prices. These have been brought on by a combination of reduction in supply and hedge fund speculation in the markets. These price spikes have raised questions about replacing some of our [mostly] imported oil with some [possibly] home-grown ethanol. In fact, in his 2007 State of the Union address, President Bush proposed a ten-fold increase in ethanol usage from around 3.5 to 35 billion gallons per year by 2017.
If my initial contention re supply and demand holds true, the current supply of corn should be fairly close to the demand for it. What might be the result of a significant increase in demand for corn? We found out last year when the rise in oil prices led to increased demand for ethanol which, in turn, sent corn prices up. In Mexico, where corn is used to make the staple food tortillas, those rising corn costs drove tortilla prices up 70% between Sept 2006 and January 2007. President Felipe Calderón had to cap the price of tortillas in response to protesters in the streets. Is it possible that producing ethanol isn’t the most important use of corn?
Developing a biofuel strategy may be a politically popular answer to controlling gasoline prices but there are significant issues beyond rising corn prices which must also be dealt with. Since ethanol and gasoline cannot be transported through the same pipelines, either a huge increase in tanker truck capacity or numerous "hometown" processing plants will be required. According to the US Department of Agriculture, ethanol currently costs more to produce than gasoline and would not be at all cost-competitive without the 51¢ per gallon tax subsidy that the federal government provides.
Several other biofuel concepts are being tested around the world including utilizing trees to replace corn as the basic feedstock. When I read about that in "The Economist" recently, I found myself wondering about the potential for conflict when one green concept like reducing fossil fuel use must compete with another, i.e. preserving our forests.
Whether our dependence on oil, imported or not, can be resolved through replacing some of it with ethanol is a complicated question. In my mind, it goes beyond sound bites delivered on the evening news. If our country does proceed down this road, it will not be without substantial costs. As things stand, corn crops are subsidized by the government, ethanol plants receive tax relief and ethanol fuel offers consumers fewer miles per gallon. The question which must be considered is this: How much will each of us be willing to pay, not for energy independence, but simply for reduced reliance on imported fuels?
The Physics of Investing
I was talking with a friend the other day. He is in his early 50s and has not yet begun saving toward retirement. He had asked whether it would make sense to start after waiting so long. After I assured him that it is never too late to begin, he mentioned the difficulty of implementing a saving/investing plan after many years of not having done so.
As we talked, we shared the observation that the "inertia" of his habit of spending pretty much all he earns might be keeping him from moving forward. I wondered if this might be the financial version of Sir Isaac Newton’s First Law of Motion. Could it be that since objects at rest tend to remain at rest, people who don’t save tend to continue not saving?
My friend said he had always heard that you should "pay yourself first" but found that easier said than done. I agreed and so, as we talked, I tried to offer some suggestions to help him. Since he thinks adjusting his budget to earmark money for investing would be difficult, I proposed that he begin by taking all, or at least part, of his next raise and contribute it to his 401(k) plan. Assuming the increase has not already been "mentally spent", that would allow him to begin investing without having to adjust his budget.
Quite sensibly, he followed up by asking if that would prove to be "enough" savings. My answer - probably not. However, I went on to say that I almost always see reluctant investors become more enthusiastic as their account balance starts to grow. That may be where Sir Isaac’s second law comes into play: an object in motion tends to stay in motion. That is, once people begin investing and see the results, they usually become heartened by the increasing account values, find more money to invest and, eventually, those investments do become "enough".
The question of where to begin, beyond utilizing the next raise, can be a difficult one. Basically, I think the marketing folks at Nike have probably provided the best answer: Just Do It. The hard part is getting started. If you start by contributing 1% to your retirement plan, your budget will adjust to the relatively small impact and next year you can raise the percentage. It doesn’t matter if you start with just a little: in order to reach your financial goals, you must get started.
Overcoming "I never seem to get around to saving", inertia is not easy. However, I believe that most people find regular investing, once begun, is like any other habit. The results become self-reinforcing, leading to a successfully funded retirement or whatever goals are most important to you.
