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

Research and Trading Associate

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Watch Out For That Tree!

Recently, I took a week off for a stay-at-home vacation. The Friday before the beginning of my vacation, I was in a big hurry to get to work. As I eased my car down my driveway, my mind was focused more on work than on the tree at the bottom of my driveway. The loud bang when my car hit the tree certainly redirected my attention.

I exited the car and was stunned at the damage caused by a small tree. Back in the old days, if your car hit a tree, you might knock off the dust on your car. You certainly would not cause major damage.

I was even more shocked when I learned how much the repair will cost. In a flash, I realized how important it is to have an emergency fund.

We have all read that you should have enough money to cover six months of expenses. Saving such a large sum can be a daunting task. You can understand why some people never bother, choosing instead to rely on retirement funds or credit cards for emergency expenses. It costs more in lost savings in a retirement account for an early withdrawal or exorbitant interest rates and fees from charges to your credit card, depending upon your emergency source.

I started small as I began building my emergency fund. As do most brokers and banks, Charles Schwab, Fidelity, and T.D. Ameritrade offer automatic debit programs. I have a fixed sum withdrawn from my checking account every pay period. I found that I would never “pay myself first” if I had to manually sweep the funds.

You can start an emergency fund too. Just call your Parsec investment advisor and ask about setting up an automatic debit program. The service is free and requires minimal paperwork. Even if you set aside just $10 per week, at year’s end you will have $520 that would have otherwise disappeared in your budget. It is a start!

Now, if you will excuse me, I need to surf eBay’s site. Perhaps a vintage Caddy could survive an attack from a malevolent maple.

Cristy Freeman, AAMS®
Senior Operations Associate

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Roth Conversions

Currently, you can convert your traditional IRA to a Roth IRA if your adjusted gross income is less than $100,000.  In 2010 the income limitation is being lifted for one year only, so now is the time to start thinking if a conversion is right for you. 

 

When you reach age 70 ½ you can no longer contribute to a traditional IRA.  In fact, you must start required minimum distributions at that time.   There are no required minimum distributions with a Roth account and you can continue to contribute as long as you have earned income.   A contribution to a traditional IRA is tax deductible if you meet the eligibility rules on income; a contribution to a Roth is not tax deductible.  However, all withdrawals from a traditional IRA are taxed like ordinary income; Roth withdrawals are not taxed. 

 

The downside for the conversion is that you must pay taxes on the amount you convert, but taxes on 2010 conversions can be spread out over 2010 and 2011.  Of course, we don’t know what the future will bring but I’m fairly sure it will still include taxes.  In retirement it would be a benefit to have several sources of income — taxable accounts billed at the capital gains rate, retirement money taxed at your ordinary income tax rate, and Roth money that is tax free.   Or, you could leave the Roth account to your children and they could enjoy tax free withdrawals for their lifetime. 

 

Please contact your advisor if you are interested in the Roth conversion.

 

 

Barbara Gray, CFP®

Partner

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Budgeting and Saving in Uncertain Times

The lower real estate and stock prices brought on by the economic recession has all Americans re-examining their spending priorities. The increased savings rate comes on the back of a long-period of over spending by most households in America. Everyone should have a basic household budget or cash flow statement. Keeping track of all inflows and outflows is useful exercise. Budgeting creates awareness about spending and forces consumers to prioritize the importance behind their consumption. Identifying a shortfall in inflows early on is imperative to then take corrective actions to get back on a sustainable budget.

There are many account strategies to consider when saving money. After establishing a comfortable emergency reserve, an obvious choice is to increase your savings rate to work sponsored retirement plans (401k and 403b), IRAs and Roth IRAs. Using a taxable securities portfolio should be considered once tax advantaged accounts have been maxed out. Section 529 education accounts and Roth conversion strategies are a little less known. Your advisor at Parsec Financial can guide you through the many account strategies to determine which makes the most sense, taking into consideration your unique goals and objectives.

Rick Manske, CFP
Managing Partner

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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®
Financial Advisor

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Is Buy and Hold Dead?

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

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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.

Parsec’s IPC consists of eleven members, nine advisors and two research and trading associates (the latter are non-voting). Committee terms are for one year at a time, but advisors may remain on the committee for longer if they wish (the two research and trading associates are permanent members, as are the CEO and one of the managing partners). Every Tuesday morning, the committee meets to discuss each company and vote on a recommendation: buy, sell, or neutral. If the committee votes to sell a stock, the Research and Trading department initiates a block trade across all discretionary client accounts so that the committee’s convictions are effected on a firm-wide basis in an orderly and timely fashion. When the trade is executed, all accounts participating in the trade receive the same price.

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

Research and Trading Associate

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Living Trusts

You’ve heard you might need a Living Trust and have no idea what it is or how it could be of benefit. Relax; you are not alone.

The trust world can be very intimidating and complex with its own confusing acronyms. So instead of delving deep into that world, I’ll speak to three benefits of a Living Trust. Please know that your advisor can work individually with you to help determine if you and your family can benefit from one.

First, it provides continuity. Initially, you control and manage the assets in your trust. Should you become incompetent, incapacitated or die, your Successor Trustee can step in immediately to manage the assets as you have instructed. This prevents unnecessary court involvement, saving time and expense. And, it allows for quick intervention, minimizing interruption of asset management for you or your heirs.

Second, it provides privacy. At the time of your death the assets will be managed or distributed as you have directed and are shielded from public view. This is different from a will which at death is probated and becomes a public document. Therefore, anyone can go to the courthouse, pay a fee and get a copy of a probated will. A Living Trust will never become a public document.

Third, it avoids probate. This saves time, court expense and involvement, and shields it from public view as discussed. Since a trust never “dies,” it isn’t subject to probate and the associated time consuming court involvement and expense.

Although these are not the only reasons to utilize a Living Trust, they are important ones. Please call us if you would like more information.

Michael E. Bruder, CFP®, CTFA
Senior Financial Advisor
Senior Trust Advisor

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E-Mail Security

We have all read countless stories about the ever-present threat of identity theft. We all know by now that we should shred confidential documents instead of tossing them, intact, into the recycling bin. We dutifully avoid releasing personal information to strange people. We guard our social security numbers. What about e-mail communications, though?

It is easy to forget that e-mail is rarely a secure communications medium. A few moments of your time can save you hours and hours of frustration later if your identity is stolen. Here are a few tips:

• Never open unsolicited e-mails.
• Never use links in e-mails to go to other sites. Instead, use the web address you know to access the vendor’s site.
• Use anti-virus and firewall software. Regularly run virus scans on your computer.
• Never send confidential information via e-mail.

The last bullet point is very important. We have received e-mails from clients that contained account numbers, dates of birth, and social security numbers. While we may ask you in an e-mail to send the information, we also ask that you call us with it. Please do not hit “reply.”

In turn, we will not e-mail similar information to you. We will call you with the information. For your convenience, we sometimes e-mail account documents to you. We will remove account numbers and other confidential information from the document before sending the information to you. We take the security of your information very seriously.

Cristy Freeman, AAMS®
Senior Operations Associate

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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
Research and Trading Associate

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