What is the Real Cost of the Gulf Oil Spill?

Many years ago, and on a regular basis ever since then, we reviewed BP and decided to rate the stock a “buy” and purchase it for many of our clients. We bought Transocean stock for many clients as well. When it became clear that the Gulf oil spill was a devastating disaster, we decided to sell BP and keep Transocean. The reason for this apparent contradiction is that as it stands now, BP, who operated the oil rig, is responsible for the spill and will be financially liable for the majority of the clean-up. Currently Transocean, who owns the rig and leased it to BP, has limited liability for the clean-up. In light of this, and a significant back-log of revenue for their 140+ rigs, we see Transocean as over-sold and have decided not to sell the security at its current depressed price.

What is the Cost?

Financial analysis involves valuing a company based on estimated variables. One way we value a company is to discount future dividends using estimated growth rates. We also take the consensus earnings growth rate and estimate how that translates into a future stock price. We look at many other factors, such as the market value of the company’s debt and equity, or the present value of future earnings.

All of these factors are estimates and variable but they are known. By known, I mean they are conceivable factors. We could not have conceived of an oil spill this large, that would happen at this time, and that would be attributable to BP with any reasonable certainty. And because the estimated probability of something like that would have been so small, it would not have affected any analyst’s valuation metrics. This makes the case for portfolio diversification. In order to protect against company-specific and industry-specific risks, we put 40-50 company stocks in a portfolio, at about a 2% weighting.

Our sell/hold decision on BP/Transocean was based on the spill’s potential impact on the companies’ earnings, and thus the value of the companies. But what if we had made our decision based on the true economic impact of the spill? What if we could quantify the entire economic impact of the spill and attribute that to the companies’ earnings and value? Once we considered the injury to the livelihood of the shrimp fishers, the effect on the Gulf States’ tourism, and the government expense to clean the wetlands and beaches, would there be any earnings left at all? But this is not the charge of our Investment Policy Committee and of course, the impact could never truly be quantified.

What is the Solution?

Some of our clients have requested that we make investments for them in clean energy stocks. It seems like a simple proposition – these emerging technologies are on the cutting edge and will surely be profitable. However, that is often not the case. New industries and technologies face high costs, high barriers to entry, tough competition, and the simple risk that their technology may not be the technology that prevails in the end (think Betamax versus the VCR). For these reasons emerging industries are considerably more difficult to evaluate than established industries, and thus we have opted to buy an index of clean energy companies for those clients who have requested it, rather than invest in a single company.

There is considerable technological ability, capital, expertise and intelligence among those developing technology in the oil industry. They have developed a way to locate the presence of pockets of oil that reside miles under water and thousands of feet further underground, get major machinery down to that spot and drill down to access this reservoir, then pump the oil back up through miles of water and into vessels above the surface. With this type of might and capability, theses companies could put substantially more focus on developing alternate energy technologies. The economics of that development may show it as not yet profitable enough at first glance. But if we calculated the real costs and risks of energy production, perhaps they would see the benefit. I hope that out of this terrible environmental disaster we see an improvement in the collective understanding of the importance of clean energy.

Harli L. Palme, CFP®
Financial Advisor

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The Market

Obviously, we are going through a difficult time – again – in the market and investors fear there will be another drop similar to the last one. I read the following in an AP article on the web this morning: “Don’t panic. Think long-term. Corrections are normal.”

The idea to get out of the market when it starts to go down and get back in when it goes up just does not work. The reason it doesn’t work is that despite all the predictions you read and hear out there, no one knows when the market hits the bottom or when it will turn around. Long term investors should not be concerned about short term volatility. You should always keep enough cash for emergencies and have the proper allocation for your situation. You need a long-term plan and you also need to resist the temptation to succumb to the fear that the media generates.

I received a newsletter this week where the title concerned another bubble that is about to explode. They predict that the average $100,000 portfolio will be worth $48,000 at the end. However, if you would only take the bold steps outlined in the report you could turn that $100,000 into $2.4 million. The report is 20 pages long and outlines some compelling evidence and I can see why people would be influenced by reports such as this. If it was so easy to make so much money why is the author writing a newsletter? There are also books – that are best sellers – that are predicting dire things for the economy. There are also books that give a more balanced historical perspective, such as “Manias, Panics, and Crashes” (fifth edition) by Charles Kindleberger and Robert Aliber. While we usually hear “this time is different” the truth is that every time is different, yet surprisingly the same.

Barbara Gray, CFP®
Partner

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Alpha

Question: what does alpha have to do with an ox? Answer: as far as investing goes, nothing. But I did find an interesting nugget on Wikipedia when I Googled “alpha” this morning. In Moralia, Plutarch discussed why alpha should be the first letter of the Greek alphabet. The story goes that Cadmus, a Phoenician, put alpha at the beginning because it was the Phoenician word for ox, and the Phoenicians considered oxen a primary necessity. Plutarch, who was not a Phoenician, tended to side with his grandfather, who noted that the “a” sound is the easiest sound to make, and thus the first sound children make when learning to talk.

As much as I’d like to continue in this random vein, I’m afraid I must come back to investing, since this is the Parsec blog. Fortunately for me, alpha does have meaning in our world, too. Most often, it is used as a way to measure a portfolio manager’s skill – you may have heard it mentioned in conjunction with mutual fund performance. Well, here’s the Morningstar definition: “Alpha is a measure of the difference between a portfolio’s actual returns and its expected performance, given its level of risk as measured by beta.”

Crystal clear now, isn’t it? As Inigo says in The Princess Bride, let me ‘splain…no, there is too much – let me sum up. Let’s say you have a large cap mutual fund, and you want to know how it performed compared to the S&P 500 index. First, you look at the fund’s beta relative to the benchmark (the S&P, in this example). I’ve discussed beta before, so I won’t revisit the topic here, but basically if the beta is over 1 (let’s say it’s 1.10) you would expect the fund to return 10% over the S&P. If it does as expected, then the fund manager didn’t add any value – the fund performed as expected given its level of risk and its alpha is 0. However, if the fund returned 12% over the S&P, the fund’s alpha is 2%, meaning that it performed better than expected given its level of risk – the manager added value. Of course, this is assuming that the only risk is market risk (beta), and that the chosen benchmark is an accurate comparison for the fund in question.

Enough tedious financial arcana – get outside and enjoy the beautiful spring weather. Seriously, what are you doing reading this? Begone!

Sarah DerGarabedian
Research and Trading Associate

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To Convert or Not to Convert?

I hate paying taxes. I know, I know. The government needs money to provide services and secure the national defense. I just hate paying taxes. You probably share my sentiments.

You will be surprised to know I am actually considering an option that would require me to pay more taxes over the next two years. For 2010, the IRS has changed the rules for conversions of traditional IRAs to Roth IRAs.

In the past, if you converted, you must pay taxes on the value of the distribution when you prepared your tax return the following year. However, for conversions processed in 2010, you can spread the tax liability over two years.

So, why would anyone want to do this? Distributions from traditional IRA accounts are taken at ordinary income tax rates. If you think you will be in a higher tax bracket in retirement, it might make sense to pay taxes now.

Presumably, you would pay less tax now than at retirement, when your IRA account has (hopefully) appreciated in value, and tax rates may be higher. Keep in mind that Roth distributions are tax free if you have had the Roth for at least five years and are over 59 ½.

There are other reasons to consider a conversion:

• Individuals who were previously ineligible to convert to a Roth because of income limits can now take advantage of the conversion option.
• You are not required to take minimum distributions from a Roth account.
• Distributions will be made income tax free to your heirs over their lifetimes.

Still, it may not be the right decision. If you think your tax bracket will be lower in retirement, then why pay more taxes now? If you have a short time horizon to retirement, it might not be worth the tax liability. Do you have cash available to pay the taxes? Using funds from the IRA you are converting or selling taxable assets to raise funds might be defeating the purpose.

Confused?  Your financial advisor would be glad to review your situation and determine if a Roth conversion is the right step for you.  Please give him or her a call.

Cristy Freeman, AAMS
Senior Operations Associate

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Do December Job Losses Mean “Double Dip”?

This morning we received a disappointing jobs report from the Department of Labor indicating that U.S. employers cut 85,000 jobs during the month of December. Since the consensus of analysts was expecting a loss of only 10,000 jobs, one can only wonder if this disappointing news means the end of positive jobs data.

As we move into this economic recovery we must remember that one piece of data does not a trend make. In fact, we have seen most indicators (leading, coincidental and lagging) improve over the last 6-9 months. When reviewing economic data, it is very difficult to make any conclusion from a single piece of data. Instead, it can be more important to follow the trend of data to get a sense of whether the economy is improving or weakening. During 2009, monthly job losses moderated substantially. Employment losses in the first quarter of 2009 averaged 691,000 per month, compared with an average loss of 69,000 per month in the fourth quarter. In following the recent trend, it is clear that the economy is strengthening.

We must remember that it is the job of the news people to shock us in order to ensure that we “tune in” tomorrow. Buried in today’s headlines, we learned that the US Labor market actually added 4,000 jobs in November rather than losing 11,000 as initially reported. This marked the first job growth in two years. This is excellent news that, along with the current trend, should indicate job growth for quarters to come.

In the early 1980’s we experienced what some call a “double dip” recession. This double dip recession was actually two recessions (Jan. 1980-July 1980 & July 1981-November 1982) separated by a period of rapid economic growth. In fact, the economy recovered so strongly from the 1980 recession that inflation forced the Fed Reserve to increase interest rates to a point that forced the economy into the second recession of 1981-1982. Let’s not forget that the economic period after the recession of 1981-1982 was arguably the strongest period of sustained economic growth in history.

This lesson in history teaches us that a slow and steady recovery may be more sustainable than a quick, inflation driven recovery. Although the trend to economic growth remains intact, the reasonable rate of change may allow the Fed to remain accommodative. This freedom could allow the Fed to raise rates when it feels the economy is stable enough to handle a tighter money supply.

Each and every one of us has either been directly affected or had a friend or family member who has been affected by the worst recession since the 1930’s. Their pain and suffering make us wish for a sharp economic recovery and strong job growth. However, we must not forget that before you can run you must first learn to walk. As long as the trends remain positive we will be running in no time.

Michael J. Ziemer
Partner

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When Mutual Funds Make Sense

The best thing about mutual funds is that they are an easy way to hold a diversified investment.  The difficult thing about mutual funds is that many mutual funds underperform the broader market, they can be expensive, and there are so many options available that picking among them can be daunting.  But it is possible to pick high quality, low expense mutual funds that are suited to you, and it is important to determine when a portfolio calls for them.

It is our philosophy that in large portfolios, mutual funds are best used to get exposure to international, small-cap, and some mid-cap companies.  This is because the universe of international and small companies is so large, it is best to rely on an active manager who specializes in those areas.  Also, research and financial data is not as readily available on international and small-cap stocks, making active managers all the more important. 

We do believe, however, that we can create a well-diversified portfolio of large-cap, domestic (S&P 500) companies by buying individual stocks.  There is a plethora of research available on these companies, making financial data transparent and easy to obtain.  The trading costs on individual stocks is low enough that this is a more cost effective way to get exposure to this area if your portfolio is large enough to fit 30-50 individual positions of a reasonable size.

In smaller portfolios it becomes less cost effective to buy individual stocks.  To get 40 individual stocks in a portfolio that already encompasses bonds, international and small-cap funds, we would need to resort to very small position sizes.  The smaller the position size, the larger the transaction cost as a percentage of the holding.  Therefore, we believe that depending on the size and the number of accounts within a portfolio, mutual funds may be the best option.

When we choose mutual funds we look for those of the highest quality.  We focus on long-term performance track records, various risk measures associated with the funds, and low-cost investments.  We routinely assess the quality of the funds we hold, and screen for new additions to our fund buy list.  If a fund no longer meets our criteria, we will replace it with a fund we view as better.

To what extent a client has mutual funds in their portfolio is determined on a case-by-case basis.  Sometimes this comes down to client comfort level and perspective.  Other times it is a function of the type and size of accounts in a portfolio.  We work with clients to determine what makes the most sense for their particular situation.

Harli L. Palme, CFP®

Financial Advisor

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Inflation Ahead?

With the extraordinary amount of fiscal and monetary stimulus pumped into the financial system over the last 12-18 months, many investors are concerned with the prospect of future inflation. The large U.S. budget deficit is another potential inflationary factor if it is financed by the government expanding the money supply.

Despite these factors, inflationary expectations in the bond market are quite low. There is even a small but vocal minority of market participants that believe that deflation remains a significant risk. One way to determine the markets’ expectation for inflation over the next ten years is to compare the yields of U.S. Treasury Notes against those of Treasury Inflation Protected Securities (TIPS) of similar maturity. The current yield on the 10-year U.S. Treasury Note is 3.33% as of this writing, while the 10-year TIPS yield is 1.5%. The difference of these two numbers is the implied inflation rate over the next 10 years of 1.83%. If inflation over the next 10 years turns out to be higher than 1.83%, then you would be better off buying the inflation-protected security. Since 1926, inflation has averaged about 3% annually. While we do not believe that there will be a sharp increase in inflation over the next 1-2 years, it certainly is a possibility over the longer term. Therefore, within the fixed income allocations of our client portfolios, we have been avoiding purchases of traditional Treasury securities in favor of TIPS.

 What asset classes would perform better in an inflationary environment? Among fixed income investments, we would expect inflation-protected bonds and high-yield bonds to perform better. Although the short-run impact of inflation on stocks has historically been mixed, stocks typically act as a hedge against inflation over longer time periods. This is particularly true of companies and industries that have the ability to pass along price increases to consumers, or those that have comparatively low levels of fixed assets. Our core strategy of broad diversification and no market timing would remain unchanged, whether the environment is inflationary or deflationary. The main determinant of a portfolio’s return is the asset allocation. Having the discipline to stick with your chosen allocation is more important than the specific allocation that you choose.

Within the equity portion of client portfolios, we may overweight certain sectors or industries that we believe would fare better in a particular inflationary environment. However, since the future is uncertain, our main goal remains to create client portfolios that will perform well in a variety of economic scenarios.

 Bill Hansen, CFA

October 9, 2009

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Risky Business

The wild 700-point, daily market swings certainly gave us all a nasty lesson in market risk. Let’s take a closer look at risk because market risk is not the only risk involved in investing.

There are two main categories of risk: systematic and unsystematic. Think of systematic risk as non diversifiable or risk that is inherent in the system. Investors cannot control which direction interest rates will go. The value of the dollar will most likely be different ten years from now, but who knows what that value will be? Systematic risk encompasses market fluctuations from all the unknowns in the system as a whole.

Unsystematic risk, however, is unique to a particular investment. For example, the future of the company who makes the hottest trendy item might be more uncertain than the company who makes peanut butter. You can reduce this type of risk by having a well-diversified portfolio.

Keep in mind that there are risks in not being invested, such as opportunity cost and purchasing power risk. Opportunity cost is the cost of missing a positive return because a person was not invested in a rising market. Purchasing power risk occurs when an investor’s lower-returning asset class does not keep pace with inflation. For example, money market interest rates are now near zero, yet the price of everything else continues to rise.

Each of us has a different risk tolerance. As you evaluate yours, please consider your financial goals. Do you plan to retire soon? Are you already retired? Do you have children who will be entering college soon? Do you want to start your own business?

If your risk tolerance and financial goals have changed, please talk with your advisor.

Cristy Freeman, AAMS
Senior Operations Associate

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Gold as an Investment

We are frequently asked about gold as an investment. Sir Isaac Newton set the gold price in 1717 and it remained the same for two hundred years. The gold standard was lifted in the 1970’s and the price has fluctuated since then. The price was $40.62 in 1971 and it rose to $615 in 1980. The return from 1980 to 1990 was -4.6% (1990 price was $383.51). The return from 1990 to 2000 was -3.12% ($383.51 to $279.11). The period from 2000 – 2008 was good for gold with a return of 15.2% ($279.11 – $871.96).

Large company stocks (from Ibbotson) had a return of 9.62% from 1926 – 2008; small company stocks returned 11.67%; and long term government bonds returned 5.7%. Gold returns for the same time period returned 4.67%. Don’t forget those returns do not factor in the average inflation rate of 3%. If you bought gold in 2000, you would have out-performed stocks as the last decade has been dismal for stocks. Gold is currently at a very high price of $1,006 today, so if you are thinking of buying gold, you just might be buying high. Another drawback to investing in gold is that it is considered a collectible and is not granted favorable capital gains treatment.

Barbara Gray, CFP®
Partner

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This Time, It’s Personal

Not too long ago, we were reviewing the retail segment of the Consumer Services sector (which happens to be one of my favorite sectors to research – so much more interesting than Industrial Materials. Ball bearings? Kill me now.) We were discussing the relative merits of Target versus Wal-Mart, always a lively debate. After a careful dissection of each company’s fundamentals, financial strength, and growth prospects, the committee voted to sell Target and move the proceeds into Wal-Mart, as the latter looks like the better investment. And I, in my role as impartial provider of research, wholeheartedly agree with that decision.

However, as a consumer and Target devotee I find it difficult to reconcile this with my personal feelings. I avoid Wal-Mart like the plague. To be fair, Wal-Mart does provide a plethora of goods and services for a low price, something that everyone needs when times are tough (and even when they aren’t). I just don’t like the idea of buying tires and grapes at the same store.

My point (and I do have one) is that it can sometimes be difficult to put personal ideas/prejudices/feelings aside when evaluating investments. At what point do you let those biases influence your portfolio? It all depends on how strongly you feel about them, in my opinion. Take the Target/Wal-Mart example. As an investor, do I really feel so strongly about my shopping experience that I would eschew buying WMT stock in favor of TGT, regardless of the fact that WMT clearly looks more attractive? Definitely not. I have no problem (in my mind) being a shareholder of one and a customer of another, hypocritical as that might seem. I might draw the line at buying the stock of a tobacco company, though, even though the fundamentals look fabulous. Of course, I am invested in several different mutual funds, any of which may own stock in tobacco companies, and I have to admit I have not checked into that, nor do I care to as long as the funds are performing well. I realize that’s completely illogical, but as I am a human and not a Vulcan, I’m allowed to be illogical.

Some investors, on the other hand, feel more strongly than I do about their individual stocks AND their mutual fund holdings, which leads us into the realm of Socially Responsible Investing, a topic to be more fully addressed in a future blog (I can’t use up all my topics at once, you know). At the moment, I’ve got to run to Target to buy 3 things I need and about 20 that I don’t.

 

Sarah DerGarabedian

Research and Trading Associate

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