2014 – 1st Quarter Letter – The Value of Volatility
April 15, 2014
Greetings Bulls and Bears,
In our last letter we reduced our equity affection from “Really Like” to “Like.” Since the first of the year the Dow is down 0.11% while the S&P has gained 1.84%….not much confirmation from either source. The P&A Blend is up 1.03%. We didn’t predict an equity return for 2014 in our January letter but should have. I have been using “something in the 7.00 – 9.00% range” during conversations with clients this year and my co-workers seem to agree with that target, let’s use 7.00 – 9.00% as the P&A prediction. Not as awe-inspiring as the returns enjoyed in 2013 but still significantly higher than money market and fixed income returns.
The Value of Volatility…
Last year was extremely volatile. Most of you didn’t notice because it was “upside” volatility instead of “downside volatility.” We didn’t receive one volatility complaint, but it was a very volatile year. The S&P delivered a positive 32.44% return, almost three times its five year standard deviation of 11.68%. I can hear the nattering nabobs of negativity (thank you Spiro Agnew) disagreeing with our definition of volatility as I write this paragraph….claiming ”upside” doesn’t count as volatility. Everyone needs to be honest with themselves when discussing this issue, volatility is measured when the market rises as well as when it falls. Standard deviation is a +/- calculation, it cuts both ways. In 2008, the S&P fell 37.03%. There never seems to be an argument when the arrow points down…. that’s volatility in everyone’s book. As you might imagine, we held quite a few hands during 2008.
So how smooth was the 32.44% return delivered by the S&P in 2013? Which members of the index were outliers and which delivered a return fairly close to the average?
I’ll save you the trouble of checking your accounts; none of our clients owned any of the five winners, none of our clients owned any of the five losers. We did, however, have client positions in all five of the middlers. Our Custom Equity composite (100% equities) generated a 27.38% return during 2013…..trailing the 32.44% S&P but doing a good job of matching the 28.83% P&A Blended Index. We have done an even better job of matching the Dow, S&P, and P&A Blended over longer periods of time
When all of you signed on with us we told you that one of our goals was to minimize the taxes you pay. Working towards that end, we have owned some great stocks for our clients over the last 20 years. Names like Apple, Celgene, Cerner, Seagate, Tractor Supply, Ross Stores, Visa, Fossil, all the different railroads and lots of successful oil companies. Very few were purchased at their lows and probably fewer were sold at their highs (for some reason selling is harder than buying). In order to find these stocks we ran down our own share of dead ends…. we bought some losers.
Most of our equity accounts hold 30-35 equally weighted positions, think 3.0 – 3.5% of the equity portfolio per position. Our threshold of downside pain is negative 20%. Really doesn’t matter if it is a retail stock, a bank or techie…. Down 20% and we want out. That figures to ~0.70% of the entire equity portfolio (3.50% x 20% = 0.70%).
Selling a loser provides a cleansing feeling equaled only by confession and prayer. It often feels like taking a shower. This process usually gives us a new lease on life. We still have 80% of our original capital and the opportunity to make a better decision. It’s probably unfair to describe these holdings as losers or dead ends, some of them haunt our rearview mirrors. Wall Street is a rough and tumble place and it’s easy to buy the right stock at the wrong time. Nonetheless our down 20% rule has paid good dividends over time.
Since we don’t like to be uninvested, it is very common to see us execute these trades as tax swaps. Selling and buying stocks that are not substantially identical (avoiding the wash sale rule). Lots of examples here: Verizon for AT&T, 3M for Honeywell, Apache for Anadarko, Wells Fargo for US Bank, etc. Think of these “paired transactions” as tax swaps. They keep our clients’ monies fully invested while moving unrealized losses from the portfolio to the tax return. We are aggressive about doing trades like this and they have produced some interesting reactions from clients. Rarely a complaint about the activity, instead some pained expressions when the client runs out of loss carryforward and has to pay tax. No one likes to pay tax.
Meanwhile, Back to the Subject of Volatility….
Last year we probably did a better job of finding middlers than big winners. When the middlers are 30%+ gainers we take no shame in that. As luck would have it, we missed the big losers as well. In other words, we missed most of the volatility. A scenario like this is pretty rare. Think of it as an 18 hole round of golf without any birdies or bogies… all pars…. just doesn’t happen very often. We did a lot of tax swaps in 2010 – 2012 while averaging an 8.40% equity return. That compares favorably with our 8.33% P&A benchmark during the same period. So what would you rather have, an 8.33% return with no deferred taxes or 8.40% with some of your gains deferred into future tax years? Even better yet would be an 8.40% return that included some tax deferral and generated a loss carryforward.
Unfortunately, Global Investment Performance Standards (GIPS) do not embrace the economic benefits generated by tax swaps. That’s why you get longwinded letters like this explaining them. GIPS also comes up short in describing the virtues of dividend growth, spin-offs and the philanthropic gifting of appreciated assets. Guess one size rarely fits all. As mentioned earlier, we told all of you we would do our best to minimize taxes when you signed on. Consider this letter to be a reiteration of that promise.
The sad truth is that most of our clients exhausted their loss carryforwards in 2013…. 30%+ markets will do that. It should also be noted that the loss carryforwards we generate are available first come, first served on your tax return. If you have a profitable real estate sale, liquidate a business at a gain or experience any kind of recapture, your accountant will use your loss carryforward before we get to it. That’s ok. Tax savings are tax savings and we are happy to share the benefits. Don’t miss the takeaway here! Without volatility we have a much harder time managing these advantages out of your after-tax accounts. Your before-tax accounts (IRAs, 401ks, Roth IRAs, etc.) cannot be used to generate similar tax losses. However, remember how hard it is to card 18 pars during a round of golf. Volatility creates opportunity, even in retirement accounts. It might upset your stomach for a while but in the long run it is grease for your wheels.
What Price Smooth Returns?
When the next 2008 arrives, the financial press and lots of our competitors will try and turn your heads with products that reduce volatility. The list will include municipal bonds, annuities, and alternative investments. The alternatives will include “long/short” strategies, hedge funds and private equity deals. A well-organized portfolio that includes these asset classes has a decent chance of outperforming when markets decline but are generally hard-pressed to keep pace during the good times. Since 1900, large cap stocks have posted positive annual performance 65% of the time. That’s a pretty compelling number. The case for alternative investments is strongest when equity markets are performing the worst. However, all portfolio managers know that regardless of the asset class, they always need to “lead the duck.” That means owning alternatives well before market corrections and maintaining their equity allocations when the horizon is cloudy.
We have done extensive research and trial by error in a host of alternative investments. Those efforts will continue. For the most part we are put off by the high fees and the lack of liquidity indigenous to these products. During our brokerage years we were licensed to sell insurance products, managed commodity accounts, options, private equity deals and hedge funds. We relinquished those licenses gladly when P&A was organized. We found that our brokerage clients who claimed satisfaction with single digit returns during the tough times, fired us when our competitors promised them double digit returns during the good times. We didn’t like that. Our efforts and those of our clients are much better spent accurately profiling risk tolerance and understanding how a portfolio works. We consider tax swaps to be a low fee alternative strategy….the same kind often found inside hedge funds. We also use REITs, MLPs and natural resource investments as alternatives. In all of those endeavors we consider volatility to be our friend.
The World According Pitt and Dan….
As mentioned earlier, we like equities but do not think that this year will be a repeat of last year. However, it still looks much preferable to the alternatives. Our bogie is 7.00-9.00%, which will probably figure to slightly less than the average real return delivered by the S&P. Investors should also remember that it is a tax advantaged return (dividends and capital gains are taxed at 20% by the Feds), and greatly exceeds money market rates.
The Consumer Price Index grew at an average rate of 3.25% between 1913 -2013.
Large cap stock returns averaged 10.60% since 1900….. minus 3.25% = 7.35%
The S&P 500 returns averaged 12.60% since the end of WWII…. minus 3.25% = 9.35%
The S&P 500 returns averaged 11.37% over the last 50 years…. minus 3.25% = 8.12%
Last year the CPI was 1.60%, much lower than its historic average. That allowed the S&P to produce a generous 30.84% real return….truly an outlier. If the CPI rises to 2.00% this year and the S&P hits the midpoint of our estimate (8.00-2.00=6.00%), equity returns would trail the historic averages and still beat money market rates significantly. Put your liquidity in your P&A account and post us on your short term cash needs. You will be rewarded.
Errant K-1 reports….
January 31st is the date that the IRS requires all corporations to report the distribution of certain payments made during the preceding year. This rule applies to the dividends and interest payments you receive on form 1099-D, as well as your earned income reported on form W-2. Forms 1099-B, 1099-S and 1099-Misc (whatever they are) need to be reported to you by February 15th. If you own or receive income from an LLC, S-corp, Master Limited Partnership (MLP), trust or estate, you will receive a K-1 instead of a 1099. K-1s are “supposed” to be issued by March 15th.
The market dropped precipitously in 2008 (I’m sure you heard about that). It has been recovering steadily since….different rates for different asset classes. We found value in and started buying MLPs in 2009, concentrating on pipeline companies. In 2012 we added financial MLPs to our mix. Both of these investments generate K-1s, and have been successful. MLPs are considered messy by accountants since they sometimes return capital and require a little more reporting than traditional common stocks. To that end, most of our MLPs have been purchased in retirement accounts, eliminating the messy reporting requirements present in before-tax accounts. We have used Kohlberg Kravis and Roberts (KKR) in a few after-tax accounts in an effort to capture the firm’s private equity expertise. This was an investment decision, accepting the baggage created by an MLP organization.
In early 2014 we were informed by Charles Schwab that our clients holding MLPs in retirement accounts had to review those K-1s for Unrelated Business Income (UBI). In order to maintain its tax posture, an MLP must generate 90% of its income from their core business enterprise. Any retirement account generating more than $1,000 per year in UBI is required to pay income tax on the marginal amount. As luck would have it, none of the MLPs we use generated any UBI. However, a few generated an Unrelated Business Loss (UBL), which becomes an asset…offsetting UBI in the current or future reporting periods. If this isn’t complicated enough, your custodian Charles Schwab, not your accountant, is charged with the responsibility of reporting UBI (or UBL) to the IRS and deducting the tax from your IRA. This is not part of the tax return you file by April 15th.
We caught this nuance and wrote a letter of instruction to all of our clients who held MLPs in retirement accounts. At about the same time we received notice from KKR that their K-1s would not be sent to clients until late March (it turned out to be more like April 11th). In hindsight, we should have written a letter to all of the after-tax holders of this security as well, advising them that the K-1 would be late. We didn’t…sorry about that. How to deal with this late K-1 will be your accountant’s decision, follow their lead. If the results become onerous let us know and we will put salve on the wound.
Retirement Plan Contributions…
Making a deductible contribution to a retirement account should be a simple transaction….not always. You make money all year and then try and shelter as much of those earnings as possible….the American way. When it comes to a non-employer retirement plan contribution, most of you rely on your accountant to make the calculation. If you wait until April 10th or later, it is very difficult for us to help. Typically, the contribution must be in the hands of your custodian (Charles Schwab) or postmarked by April 15th. January 31st through April 15th is a very crowded period. If this event is going to go down to the wire for you, give us a call and we will help you devise a stress reducing plan that will fulfill the transaction.
We love investing money and treasure being able to put smiles on faces. Resolving all these other issues reminds us of life in a cartoon…the roadrunner and the coyote passing a lit stick of dynamite back and forth. How about Ralph E. Wolf and Sam Sheepdog clocking in, chasing each other around for the length of the story and then clocking out again at quitting time? Alphonse and Gaston both insisting the other act first…“after you…oh no, after you…I wouldn’t think of going first…after you!” None of this will ever change. It will continue to be same song, different verse until the end of time. In the end we love the chaos too. Dan and I have both decided not to retire…. more vacations, but here for the long haul.
James S. Pittenger, Jr,