## The CAPM

Now that we’ve discussed beta and the Dividend Discount Model (DDM), I’d like to introduce you to one of my favorite equations, the CAPM (that’s pronounced cap-m, and it’s an acronym for “Capital Asset Pricing Model”). Right now, you’re probably asking yourself, “What sort of a person has a favorite equation?” As much as I hate to admit it, when I’m studying for the CFA exam and I come across the equation’s individual components in a practice question (Risk-free rate? Check. Beta? Check. Market risk premium? Check), I can hardly contain my excitement.

OK, so I’m slightly prone to hyperbole. But it is a very useful tool for asset valuation, and one of its merits is its simplicity. The equation is basically that of a simple linear regression, which you might remember as the equation of a line (y = mx + b). Here, “b” is the risk-free rate (the rate of return on a risk-free asset, like a Treasury bill), “m” is beta, which is a measurement of an asset’s systematic risk (see my earlier blog on beta for a more thorough explanation), and “x” is the market risk premium, or the difference between the market return and the risk-free rate of return. Plug in the variables, do a little calculation, and the result is an asset’s required rate of return, r.

So what does this tell you? Probably that you have long since forgotten the equation of a straight line. But other than that, you might notice that the CAPM required rate of return is dependent on the equation’s inputs. For example, holding everything else constant, a higher beta will result in a higher required rate of return. That makes sense, because a higher beta indicates a higher level of systematic risk, and you would expect to be compensated for taking on more risk by the possibility of earning a higher return. We can even go a step further and tie in to the DDM, because r (the required rate of return, which can be calculated via the CAPM) is part of the DDM equation. The DDM tells us that, all else equal, a higher r will result in a lower intrinsic value.  If the stock price is higher than its intrinsic value, you may deem that stock to be overvalued.

Of course, a model can’t be this gorgeous without making a LOT of simplifying assumptions. For example, the CAPM assumes that all investors have identical expectations, and that there are no taxes or transaction costs (what a wonderful world it would be, right?). Nevertheless, the CAPM has played an integral part in the development of modern portfolio theory since its introduction in the early 1960s. Plus, I just HAD to tell someone about my favorite equation. Of course, now that summer is here, I can put aside the study books and turn my attention to other matters of great importance. Now, where did I put that issue of Us Weekly?

Sarah DerGarabedian

## I Hear You, Stock Market Futures, but I am Not Listening

Every morning I come into work and set about reading the morning news. Whether it is the Wall Street Journal online, MarketWatch News, or Bloomberg.com, I peruse the stock market and business news to see what kind of rollercoaster the day will be. One thing that strikes me as ironic is how the daily stock market futures article gets my blood racing, at the same time that I write it off completely.

Speculators and hedgers enter into stock futures contracts in order to hedge against an existing asset or liability exposure, or often, to profit off of the direction of the stock market. To the parties of the futures contract there is either a payoff, or amount owed, depending on the subsequent direction of the stock market. Stock futures prices indicate if investors on the whole believe that the stock market will be higher or lower. What investors believe will happen changes by the second, as evidenced by the fluctuating stock market index futures.

Stock market futures indicate what direction stocks will go at the open of the market. But this is often then extrapolated into the general investing world as the tell-tale sign of what is to come for the remainder of the day and into the near future, many times turning out to be incorrect. If you come into the office every morning, every Monday through Friday of your life and read these articles, you can’t help but see the fickleness of the investors. One day the market is sure to drop into the abyss, other days it is off to the races. And no matter what is predicted, the journalist writing the article can always find some money manager somewhere to agree with what the stock futures may predict and give his or her reason for that.

Day after day the articles regarding stock futures are always the same, in that they always change. This is not to say that long-term, large macroeconomic forces do not affect the market, they most certainly do. But as a long-term investor it is my job to look beyond the day-to-day fluctuations, plan for broader market swings, and stay grounded, not letting emotions take over. However, the sentient being that I am makes this difficult, as I worry about my client’s money, emotions, and financial needs. So the article of the day, whether good or bad, gets my heart pounding a little, even though I realize its relevance is small in the big picture.

This represents to me perfectly what is so inherently frustrating about the stock market. Day to day the movement of stocks is uncertain, but you feel confident based on the news of the day of how stocks will move. You are sure you should be buying. But the next day the news leads you to be sure that you should be selling. Your emotions are high. Logically, academically, statistically, you know that the daily, weekly and monthly predictions are irrelevant and that the long-term outlook is what will have the greater impact on you financially if you are a well-diversified long-term investor. So if you feel unsettled or excited by the daily news, read for interest or understanding, then close the web browser and choose not to make sweeping changes to your portfolio that day.

Harli L. Palme, CFP®

I was reading The Wall Street Journal the other day, and an article caught my eye (“More Investors Say Bye-Bye to Buy and Hold,” April 8, 2009).  The premise was that some investors are beginning to trade more frequently for a variety of reasons, from attempting to recoup losses to trying to profit from short-term price movements in individual issues.

This reminds me of the infamous Business Week cover story “The Death of Equities,” which ran in 1979.  Over the next 20 years, the stock market had a total return of +17.9% annually, the highest in modern history.  People who changed their approach out of frustration or panic, or after reading that article, missed out on substantial gains over the following years.

In down markets, people are understandably worried, and all sorts of investment strategies appear out of the woodwork.  As of the end of 2008, large company stocks had the worst 10 year returns since 1926, when the Ibbotson data series begins.  This includes the Great Depression.  In such an environment, some people are tempted to abandon long-term investing in favor of some different, often self-destructive, approach.

At Parsec, we do not engage in market timing, or dramatic shifts in our clients’ asset allocation based on the mood of the day.  We do believe in a low-turnover approach, but our portfolio strategy is more sophisticated than a pure buy and hold.  A buy and hold strategy does not answer the important question, “When do I sell?”  There are two primary types of trades that we make in client accounts:  trades at the block level and trades at the individual client level.

In a block trade, we are selling a particular security across all client accounts.  Our conviction regarding that security’s merit as a long-term investment has changed.  The trade may be at a profit or at a loss, but our Investment Policy Committee has determined that there are better opportunities elsewhere.

The second type of trade we make is at the individual client level.  When we review client portfolios, we ask ourselves “How can I make this portfolio better?” This may encompass reducing an individual stock position that is overweight, or correcting an overweighting or underweighting in a particular economic sector.  When an individual stock exceeds 5% of a client’s portfolio, it is our policy to reduce the position unless there is a client-specific reason not to do so.  There may be an opportunity to improve diversification, to add a new investment idea, or to increase portfolio income.  If there is no trade that we find compelling, then we take no action.  Although it can be difficult, oftentimes the right thing to do is to do nothing at all.

We believe that a buy and hold strategy combined with a sell discipline, broad diversification and avoiding market timing will allow our clients to prosper over the years ahead.

Bill Hansen, CFA

May 15, 2009

## Our Investment Process – A Behind the Scenes Look

As a Parsec client, you receive quarterly statements from us which list your individual holdings – stocks, bonds, mutual funds, exchange traded funds, and other securities, combined in a way that is appropriate for your individual situation. But how did we select those particular securities, and what is our ongoing review process? You may be surprised to find out that Parsec has a dedicated team of people who are involved in the day-to-day process of identifying, reviewing, and selecting the securities that you see on your statements. In this article, we will focus on individual stocks, as they constitute the majority of our clients’ assets.

Our process is heavily rooted in fundamental analysis, which means that we look at an individual company’s earnings, cash flow, debt, and profitability measures, compared to similar companies operating in the same industry. These data come directly from the company’s financial statements, and are combined to form various ratios such as price to earnings (P/E), price to free cash flow (P/FCF), debt to equity (D/E), and return on equity (net income/equity). We also use consensus estimates (for measures such as 5-year earnings growth rate forecasts), third party research (Value Line, Standard and Poor’s, Argus, Credit Suisse), recent news, and regulatory filings to flesh out the quantitative data.

In general, we look for financially strong companies that are market leaders, with high-quality balance sheets, stable earnings growth, above-average profitability, and sound management. We compare each company to others in the same industry, as well as to an industry average, so that the fundamentals can be evaluated in the context of that particular type of business.

Based on our research and analysis, we have compiled a list of securities from which an advisor builds your portfolio. We monitor the prices of the securities on this list throughout the day, as well as any news regarding these holdings. In addition, every security in our coverage universe is formally reviewed at least 3 to 4 times a year, and more often if circumstances dictate. Each week, Mark Lewis and I (collectively known as the Research and Trading department) gather information for a group of companies in a particular sector. We analyze the data and submit it to the other members of the Investment Policy Committee (IPC) for review.

Over the past year, as the credit crisis has unfolded, the economy has worsened, and markets have exhibited abnormal volatility, you may have noticed more trading activity in your portfolio as we seek to implement our convictions in response to rapidly-changing conditions. However, of the approximately 80 buy-rated securities that we cover, there are many companies that have been rated a ‘buy’ for a long time and are considered core holdings. You are undoubtedly quite familiar with their names, as you see them on your statements quarter after quarter, and you may have wondered what we do in the way of ongoing research and due diligence. Hopefully, this glimpse into our investment process assures you that we are reviewing those companies as well as the ones garnering more media attention, and will continue to do so, day in and day out.

Sarah DerGarabedian

## Dividend Discount Model

Part of my job here at Parsec is to perform due diligence on the securities we cover, and I was just in the middle of reading up on Colgate when I thought to myself, “How can I possibly put this off for a little while longer? I know! I’ll write something for the blog.” I think I’ll talk about a little term people in the investment biz love to throw around – “undervalued” (and its sinister twin, “overvalued”).

I’m currently in the midst of studying for Level II of the CFA exam (I believe Dante includes this in the ninth circle of hell) which focuses heavily on security valuation. I’ve noticed that the answer to just about every question is, “discount the future cash flows.” The basic premise is that a security (or a company, or a capital project) should be worth the present value of its future cash flows. Present value means that, thanks to inflation, a dollar ten years from now will be worth a lot less than a dollar today. I guess that’s why my mom could ride a bus, see a movie, eat a hot dog, and buy her first house for just a nickel way back when. Therefore, a security (let’s take a dividend-paying stock, for example) should be worth something equivalent to all of its future cash flows (i.e., dividends) adjusted to today’s value.

How in the world do you calculate this, you wonder? Until recently, I thought it was a matter of going to the Bloomberg terminal and typing in a few commands. Thanks to my exam prep, I have learned that it can actually be calculated with something called a “pencil.” There are many ways to calculate fair value, one of which involves the dividend discount model, or DDM. The DDM requires several inputs, among them our good friend beta, swirls them all around and spits out a price. If the price (also called intrinsic value or fair value) is higher than the security’s current market price, the stock is undervalued. That means that the value of its future dividends in today’s world is higher than what you’d pay for it in the market. It’s like finding a pair of Manolos on Ebay for \$100 when you know they retail for a good \$400 more (I am still kicking myself with my cheap Payless shoes for letting those slip away). Conversely, if the DDM gives you an intrinsic value lower than the current market price, the security is overvalued. As with any mathematical model, the output is only as good as the input, and the resulting value estimation is sensitive to changes in any of several assumptions (EPS and dividend growth rates, beta, the market risk premium, etc.).

Well, I better get back to my Colgate research. I think it looks undervalued, but I need to do some more analysis. If anyone needs me, I’ll be under my desk discounting future cash flows.

Sarah DerGarabedian

## Article from Associated Press, Feb 24, 2009

I read this article the other day and thought it relative to the current market situation so I am passing it on in this blog. Hope you find it interesting.
Q: How does this drop compare with others?
A: At its low on Monday, the Standard & Poor’s 500 index was down 52.5 percent from its October 2007 peak. That makes it the third worst bear market since 1929. But the speed of the fall is the real story. In the past, it’s taken 21 months for stocks to fall this far. This time it only took 13 months.
The drop in stocks has also been playing out all around the world.
“The swiftness and the severity of this bear market I think were unprecedented — partly the global nature of it,” said Sam Stovall, chief investment strategist at Standard & Poor’s.
Q: The drop was fast but it still feels like stocks just can’t pull higher. Is this downturn longer than normal?
A: Since 1932, this is the longest time stocks have spent near a market bottom, according to Marc Reinganum, director of quantitative research and senior portfolio manager for Oppenheimer Funds.
Q: What has needed to happen in the past to turn a slumping stock market around?
A: Wall Streets need some source of hope. It could be as simple as one bit of news that acts as a catalyst for a rally. Investors will pounce once they believe the economy is poised to turn higher. But first, pessimism has to be running so high that many investors simply want to walk away.
Because many investors are laying bets for the months ahead they often look beyond the news of the day. So the market can recover well before the economy as a whole.
In the past 60 years, the S&P 500 has hit its low a median five months before the recession has ended and nine months before either corporate earnings have hit bottom or unemployment has peaked, according to S&P.
Q: What are the signs of a bottom?
A: A market bottom can bring punishing drops in prices, heavy trading volume and a large number of stocks that hit new lows. The cathartic sell-off is like a brush fire that drives many investors from the market but clears room for a recovery.
“Bear markets don’t end in whimper. They usually end with a crash,” Stovall said.
Q: What might a recovery look like?
A: That’s the good part. History shows that the rallies coming out of a bear market are far stronger than most advances.
Curtis Teberg, portfolio manager at the Teberg Fund, likens the market’s fall and recovery to a basketball thrown hard at the ground: The ball’s ascent is fastest right after it begins its bounce and its climb slows as it gets higher.
“The biggest bounce will come immediately and whoever is there will get to participate,” he said.
In bear markets since 1932, the S&P has gained an average of 46 percent in the 12 months after stocks hit bottom. The gains range from 21 percent to an incredible 121 percent.
Q: The slide has been so unnerving. Should I even bother to wait for a rebound?
A: Sticking around can pay off for those with the time. In the first year of a recovery investors have recouped an average of 82 percent of what they lost in the entire prior bear market, according to Stovall.
“Unless you believe that the world economy will stop and that all stocks will go to zero, one of these days this bear market will end,” he said.
Nervous investors should decide how soon they need the money. Stocks are for long-term investing. For those who can wait, cashing out at the market’s lows will only lock in the losses.
“It certainly is not the time to say ‘OK, I’m going to put everything in today,'” said Teberg. Instead, he recommends investors put one foot in the market at a time with money they won’t need right away. That way they can take advantage of deals on beaten-down stocks without risking too much at once.
Teberg is less nervous about the market at these levels than when stocks were at their peak in late 2007.
“At some point in time we will again see the market at those levels, which means there is a 100 percent gain for those who are willing to get into the market.” Investors just have to be willing to wait, he said.
“This market has never gone straight up or straight down forever.”

Barbara Gray, CFP®
Partner

## The Story of Beta

You may be familiar with the term beta as it’s used in valuing investments. At the very least, if you’re at all comfortable with the Internet (and I assume you are, as you’re reading this blog) you can look it up and find out that it’s a measure of systematic risk. Great! That’s like my husband telling me that bike part over there is a derailleur. Now I know what it is, but I have no idea what it does or how it works with the rest of the bike (though I do know how to spell it, which is no small accomplishment). You may have even been at a party talking investments with someone (whose returns are “fabulous”) when they start tossing out terms like beta. You find yourself nodding along, silently wishing you could clock the guy with your derailleur.

So, what is beta? Well, it’s the Greek letter “b”, which you may remember from college. Not because you took Greek in college, but because your school had a “Greek system” (which is how institutes of higher learning keep you from graduating on time and therefore make more money). As I mentioned earlier, in the context of valuing investments, beta measures systematic risk. Unsystematic risk refers to risk that you can diversify away – industry risk, for example. If you had all your money invested in bank stocks last year, please accept my condolences and go fix yourself a nice, strong drink. If, however, you had a diversified portfolio of financials, consumer goods and services, healthcare, energy, industrials, etc., the returns in sectors such as healthcare and consumer goods would have mitigated (to some degree) the losses in the financial sector. The other type of risk is systematic, or market risk, which cannot be diversified away. Recessions (as we are painfully aware) affect the entire market regardless of business type, industry, and country, and even a properly diversified portfolio cannot escape all risk.

Beta is a number that measures market risk for a particular security. As a baseline, the market has a beta of 1. If a security has a beta of 1, its price is expected to move with the market. If it is less than 1, the price is expected to move less than the market. If it is greater than 1, the price is expected to move more than the market (for example, a beta of 2 indicates a security should move about twice as much as the market).

So now you know what it is and what it measures. The insatiably curious may also want to know how these numbers are derived. For all two of you out there, I will try to make the explanation as short and sweet as possible. Basically, it’s calculated using something called linear regression, which is nothing more than trying to make a straight line out of a bunch of data points that look like buckshot. If you regress the returns of a security against the returns of the overall market, you will get an equation for a line that represents the “best-fit” line through the data points. Beta is the coefficient in the equation that makes it all work.

I hope that was illuminating, and that you haven’t fallen asleep on your keyboard. If you have any questions involving derailleurs, please contact my husband.

Sarah DerGarabedian

## Tax Loss Selling

We will be busy between now and the end of the year doing tax loss harvesting in our client’s taxable accounts.    With such a broad market decline this past year it isn’t hard to find some losses – in some cases, many losses.   There are a few tactics that can be used in tax loss selling.  A security can be sold for the loss and then bought back in 30 days.    If you want to take the loss, but think the market might have a rally in the next 30 days, you can double up on the stock and then sell the original lot in 30 days.   That way you get the loss and you don’t miss out on the gain.    However, there are many securities trading below what we believe to be their fair value, so reinvesting the proceeds immediately in something else is also prudent.

Mutual funds typically pass on capital gains to their shareholders in December.  You may have a large loss in a mutual fund and also be burdened with capital gains.   Since so many mutual funds have also had losses (almost all of them) we will be reviewing them for tax loss selling as well.

Capital gains can be offset by capital losses.  If you do not have any capital gains a couple can deduct \$3,000 of losses on Schedule D of their tax return, a single person can deduct \$1,500.  You can carry forward an unlimited amount of losses for use in later years.   If there is an upside to a down market it’s that most of us should not be paying capital gains for 2008.

Barbara Gray, CFP

Partner

## November Pain

Recently we have experienced one of the most severe market sell offs in history.  The S&P 500 is now down over 22% since the start of November.  This sell-off would be clearer if there was a specific tangible event that we could grasp onto to justify this market move.  Instead, this market is being driven down by investor panic, a lack of buyers and huge redemptions at hedge funds and mutual funds.

Our economy and stock market has survived a number of stock market crises and panics.  First, take the crash of 1962.  In this panic, the stock ticker ran four hours late.  Then in the 1973-1974 bear market, the S&P 500 fell 48% and the average stock fell 70%.  In October of 1987 the market fell over 20% in a single session, more than twice as much as the largest daily decline during October 2008.  Then, of course, there was the 2002 “tech bubble” with the S&P 500 down 49% and tech stocks down over 75%.

As I write this email, the S&P 500 is down over 48% in the 2008 calendar year.  If we finish the year at these levels, 2008 will go down as being the worst performing stock market since 1926 (with the prior worst being 1931 with a return of -43.3%).  As of October 27 the Emerging Countries were down an average of 66% (China down 75%).  Like the previous bear markets cited above, now is absolutely the wrong time to bail out of the market.  Emotion is an investor’s greatest enemy, be it greed, or in this case fear.

Consider the following:  The global liquidity crisis, the probable cause of the last half of the current decline, has peaked and is now easing thanks to the concerted efforts of governments around the world, including new support from China, Russia and the Middle East.  Economies in the U.S., Europe and Japan are now in recessions with the U.S. recession getting under way about a year ago (in hindsight).  The stock market, being a leading economic indicator, typically turns positive about midway into a recession.  If the U.S. recession lasts 20 months (which would make it the longest since WWII – with the average being approximately 12 months), one would predict that the stock market could begin to rebound in December of 2008.

Although it seems extremely difficult to believe that the market could rebound under the current dreary economic cloud, markets typically begin advance while economic news is getting worse.  In our view, this is a terrible time to reduce or liquidate stock market holdings.  Since 1900, the market rebounded an average of 47% in the 12 months following a bear market bottom and 60% over the next two years.  Although this constant drumming we are taking in the market on a daily basis is hard to bear, we must visualize how difficult it will be if we sell at these levels and watch the market advance to levels much higher.

What can we do?  We can all revisit our budget and look for ways to reduce spending during these difficult times.  We can harvest tax losses in order to make sure we do not pay any more taxes (this year and in the future) than necessary.  We can reallocate our portfolio into higher dividend yielding stocks (which there are currently many) in order to maximize portfolio returns (or minimize losses) while we wait for market and economic conditions to improve.  We can stay strong and not allow the daily panic to lessen our confidence in the fact that ownership in companies and real estate are the only proven way to build long-term wealth.

Michael J. Ziemer, CFP®
Partner

## Here We Go Again

Here we go again.  After having the biggest ever advance on an election day, the S&P 500 experienced another gut wrenching sell off with the biggest two day decline since 1987 – Wednesday and Thursday of this week.  Clearly the market is still digesting the bout of bad economic reports, including payrolls which indicate the highest jobless rate since 1994 at 6.5% and a 4.6% decline in the sales of existing homes.  Both reports were worse than expectations.  The news out of Detroit is particularly bleak, with the big three burning cash at an astonishingly high rate, as vehicle sales cratered in the last two months.

With such horrendous news in the economy one would be led to believe that the stock market would be teetering on the edge of another precipitous decline.  This is not necessarily true.  As we have said, the stock market is a leading economic indicator.  The market is down tremendously over the last year, during a period of economic growth.  As the economic clouds darken, the stock market is forward looking towards the horizon for the slightest sign of a break in the clouds, at which time we could experience a sizable and unexpected rally in the midst of the storm.

Take this time to focus on the things you control.  Review your family cash flow statement with an eye towards reducing discretionary expenditures.  If you are in an accumulation phase, increase your savings rate, and buy stocks when they are cheap.  If you are in the distribution phase, rebalance your portfolio by increasing your dividend income and improving diversification.  Most of all keep a clear head and don’t let the emotions overwhelm your decision making.

Rick Manske, CFP

Managing Partner