May 2019 Client Letter

Would You Rather Have $1 Million or a Penny That Doubles Daily for 30 Days?

Long-time client Tom recently emailed me the following question and answer. I have seen various versions of this in the past, and I always enjoy rereading it. This piece appears to have been from the company Grow, www.grow.acorns.com, which has partnered with CNBC to deliver educational features on developing successful money habits.

At first glance, it’s an easy choice: $1 million is a lot of money, and pennies aren’t even worth the copper they’re minted from. But if you pick the million dollar payout, you’d regret it.

Why?

On day 1, things are bleak: You’ve got one cent, and you’re down $999,999.99. It’s not even until day eight that you break $1. Half a month in, and you’re still only in the $100 range. Now you’re sweating, and if someone offered you $500,000 in exchange for your doubling penny, you might be tempted to take it.

But hold on, and the real magic happens in the last week of the month, when you go from a little more than $80,000 to $5 million.

In a world without magic pennies, who cares?

While the odds of getting 100-percent returns on anything are pretty slim (at least in the short term), there is a very real force at play that got that penny to more than $5.3 million in a month: compounding.

That’s when the interest or returns on your money start earning interest or returns of their own, and so on. In other words, anything you earn on top of the original amount of money is added to the base and reflected in all future returns. Let’s say you earn 10 percent on $100; that becomes $110. If you earn another 10 percent, your compounded return is $121, instead of just $120. Over time, those extra earnings add up.

We see compounding at work in both good and bad ways: It’s the reason why interest adds up so quickly on our credit card balances and how we can grow our money significantly through investing.

How can I get some of that?

By giving it time. If you’d cut and run and traded your magic penny for $500,000 in the middle of the month—or even sometime in the final week—you would have missed out on the majority of gains you’d eventually have.

The same goes for investing in stocks. Though you are very unlikely to double your money overnight, and there may be times when you’re down, the S&P 500-stock index has averaged nearly 10 percent annual returns over the past 90 years. That means money invested in a fund tracking the 500 index would have doubled in value about every 7.5 years. No magic required.

Three Takeaways from the $1 Million vs. 1 Penny Story

The first and most obvious takeaway is the success that can be had when you compound money. I wrote last month how the act of continually reinvesting dividends creates a snowball effect in which your initial investment grows exponentially. The hypothetical scenario above is compound interest on steroids. Obviously no investment can double daily for a month, but the example demonstrates the impressive power of compounding.

One of the main contributors to successful compounding is time. Early on, the results are not as robust. But over the years, things really kick in. In the example above, look at the massive gains made in the last several days.

The Double-Edged Sword of Compounding

Another takeaway is how compounding can be your enemy. Think of this as reverse compounding. Carrying a credit card balance guarantees a reverse compounding effect. I suspect not many of you carry a balance, but perhaps your kids or grandkids do. There may be times when carrying a balance is necessary, but it’s no way to build wealth and should be avoided whenever possible. Inflation is another example of reverse compounding.  Annual price increases of goods and services slowly but surely make the grocery bill or nights out at your favorite restaurant much more expensive in future years. As time passes, the purchasing power of your savings begins to erode. This is one of the primary reasons we all invest—to keep pace with inflation. The negative impact of inflation is also why we focus so hard on buying stocks that raise their dividends annually. Those annual increases help us keep pace with rising costs.

Do You Have the Right Return Expectations?

The third takeaway has to do with return expectations. Keep your return expectations for stocks on the more modest side. Although the S&P 500-stock index has averaged nearly 10 percent annual returns over the last 90 years, not many of us have that much time. We have much shorter horizons with periods of market chaos and ongoing liquidity needs.

Would You Trade a 50% Loss for a 10% Return?

Over shorter time horizons, investors have to deal with significant market declines. According to a recent article at Marketwatch, stock market investors can expect to lose half or more of their money about every 18 years. Over the last two decades, there have been two 50%-plus loss episodes.

Losses of 20% or more (the accepted definition of a bear market) happen even more frequently. According to Marketwatch, a correction of at least 20% has occurred 15 times over the last 126 years—about once every eight and a half years. 

A decision to go all-in on stocks in hopes of earning double-digit long-term returns presents significant risks to those looking to draw on their portfolio in the near term (retired and soon-to-be-retired investors). The following hypothetical example can illustrate this.

Too Much Risk Can Ruin a Retirement Plan

Assume an investor with a $1,000,000 portfolio retires today and plans to withdraw $40,000 per year from his portfolio during retirement. Sounds reasonable. But observing the historical 10% returns on stocks vs. the 2.5% return available in Treasury securities today, this investor reasons, the stock market is a better opportunity—so he goes all in.

Unfortunately for our hypothetical investor, in the first year of his retirement, the stock market plunges 50%. At the beginning of year two, he would be left with $460,000 ($500,000 loss plus the $40,000 distribution). Would he stick with this all-stock portfolio or liquidate in a panic?

Even if he stayed the course, the probability of his money lasting the balance of his retirement drops significantly. A $40,000 annual draw in year two of retirement would be equal to 8.7% of his $460,000 portfolio—more than double the initial 4% draw.

Even for those investors with time horizons of 20, 30, or 40 years, the prospect of earning a 10% average annual return is more difficult to achieve in practice than in theory. Studies by Dalbar and others have shown the tendency of many investors to make emotionally charged investment decisions that lead to poor outcomes. Last month my letter included a chart that showed how missing the best 10 months in the stock market over a 50-year period wreaked havoc on wealth accumulation.

The Worst Week of 2019

Until recently, 2019 has witnessed a serene market. Volatility was mild and returns were impressive. A breakdown in trade-talks between the U.S. and China has changed that dynamic. Stocks had their worst week of the year last week.

As the business and financial cycles mature, volatility may increase. It is during these periods that dividend stocks such as those included in our Retirement Compounders portfolios tend to become more desirable. The WSJ recently ran a piece highlighting the benefits of a dividend-focused investment approach.

While most investors buy dividend stocks for the steady income stream, that isn’t the only benefit these investments offer, financial experts say. Indeed, research shows that dividend stocks often outperform their non-dividend-paying counterparts over longer periods.

From 1958 through 2018, a portfolio with the top 20% of S&P 500 companies ranked by dividend yield and weighted by market capitalization outperformed the overall S&P 500 by 2.13 percentage points annually, according to Chicago-based Greenrock Research.

That’s partly because dividend payments account for a substantial portion of the stock market’s total return….

Dividends are inherently a relatively stable and important part of total return,” says Chris Litchfield, a retired hedge-fund manager who is now a private investor in Greenwich, Conn.

The S&P 500 currently yields 1.92%, and Mr. Carter says Lenox has been purchasing stocks with yields of about 4%. He and others stress that investors shouldn’t seek yields much higher than that. Extremely high yields often signal a company in trouble. Yield is calculated by dividing the annual dividend by the current stock price, so a very high yield could simply be a sign that the company’s share price has dropped sharply due to, say, weak earnings.

“High dividend yields often reflect that the dividend is uncertain and may be cut,” Mr. Litchfield says. “More money has been lost chasing yield than any other investment strategy.” A 6% yield or higher should give investors pause about pursuing a stock, he says.

Investors also want to make sure a company isn’t devoting too much capital to its dividends, because it might not be able to afford it without borrowing….

What investors should look for is stocks with a history of dividend increases, as this is generally a sign of financial strength. Research shows that companies that initiate or increase their dividend historically outperform other stocks, including other dividend stocks, and have done it with lower volatility than the other stocks, according to Michael Sheldon, chief investment officer at RDM Financial Group – HighTower, in Westport, Conn.

There is sound advice in the WSJ article. We also favor dividend-paying companies that regularly hike their dividend and eschew the highest yielders prone to dividend cuts in the portfolios we manage.

Hershey: Dividends Today and More Tomorrow

Hershey is a modest yielder, offering investors 2.26% today; but the dividend has compounded at 8.5% over the last five years, and we project mid-single-digit dividend growth over coming years. Hershey is ubiquitous in the U.S. Nearly everyone has eaten a Hershey’s bar or Kiss or a Reese’s Peanut Butter Cup. Founded by the famous Milton Hershey 125 years ago, Hershey today employs 18,000 people around the world. The company maintains over 80 brands, including Hershey’s, Reese’s, Hershey’s Kisses, Jolly Rancher, Almond Joy, Brookside, , Kit Kat®, Lancaster, Twizzlers, Whoppers and York . Hershey’s has moved beyond confectionary snacks with brands like SkinnyPop, Krave, and Popwell. Hershey’s brands are sold through a diverse variety of store channels including mass merchandisers, convenience stores, grocery stores, and others, with no channel representing more than 31% of its mix.

Union Pacific a Dividend Growth Stalwart

Union Pacific is another dividend growth stalwart. UNP has increased its dividend for 12 consecutive years at a compounded annual rate of over 20%. Union Pacific offers its customers “the most efficient, environmentally friendly transportation solutions available today.” The railroad’s network covers 23 states stretching along the entire West Coast, and heading eastward through America’s heartland, ultimately stretching alongside the Mississippi River from New Orleans northward, on into the Great Lakes region and Chicago. Union Pacific employs nearly 42,000 full-time employees on its trains and in its vast network of distribution centers, intermodal terminals, ports and border crossings. The employees navigate over 8,000 locomotives pulling 62,200 freight cars across more than 32,200 miles of track.

A 56-Year Record of Dividend Success

On Dutch Street, in the bustling New York City of 1806, William Colgate opened a soap and candle “manufactory.” Soon the factory would be joined by a starch factory in Jersey City. After Colgate’s death, his son Samuel kept the business going. He expanded the business into new areas, including toothpaste in 1896. Today, after many mergers and much innovation, the Colgate-Palmolive company is celebrating over 200 years of history and its success in over 200 countries. The company sells its products to hundreds of millions of customers worldwide. Colgate shares yield 2.42%. Colgate has increased its dividend for 56 consecutive years.

Have a good month. As always, please call us at (888) 456-5444 if your financial situation has changed or if you have questions about your investment portfolio.

Warm regards,

Matthew A. Young
President and Chief Executive Officer

P.S. “The gift that keeps on giving to low-tax states.” That’s how The Wall Street Journal’s editorial board described Connecticut in a May 7 piece titled “Connecticut’s Tax Roulette.” Politicians in the state want to add a 2% surcharge to capital gains earned by those residents with the highest incomes. For years Connecticut attracted hedge fund managers and bankers from New York looking for lower taxes. They were a major benefit to the Nutmeg State’s economy, and now Hartford is turning them into an ATM from which to fund poorly managed policies. In CNBC’s annual state business rankings, Connecticut ranked 47^th for infrastructure, 46^th for cost of doing business, and 45^th for economy.

P.P.S. Connecticut isn’t the only place capital gains are being targeted. Senator Ron Wyden (D-OR) is using his perch as the ranking member on the Senate’s Committee on Finance to propose taxing unrealized gains in investment assets every year at income tax rates. In other words, if Wyden’s proposal is passed, and you own a stock which had its price increase, even if you don’t sell it, you’ll need to pay taxes on that gain. As Richard and Gabriel Rubin write, implementing such a plan would necessitate the “need to figure out how to value complex assets, handle declines in value, deal with people without enough cash to pay the tax and address illiquid investments such as closely held businesses and real estate.” Wyden’s proposal isn’t going anywhere in the Senate soon, but it opens the door for similar proposals in the future.

P.P.P.S. Recently, the Defense Department released a threat assessment of China’s economic and military capabilities. Front and center in the report is the $50 billion of damage China does to America’s economy each year. Andrew Erickson reports for The National Interest , “In keeping with the Trump Administration’s outlook and priorities, there is greater emphasis on economic issues than in earlier years of the report. This year’s iteration highlights the U.S. Trade Representative’s conclusion that PRC government policies cause ‘harm to the U.S. economy of at least $50 billion per year.’”

P.P.P.P.S. We recently updated both Part 2A and Part 2B of our Form ADV as part of our annual filing with the SEC. This document provides information about the qualifications and business practices of Richard C. Young & Co., Ltd. If you would like a free copy of the updated document, please contact us at (401) 849-2137 or email cstack@younginvestments.com. Since the document was last updated in March 2018 there have been no material changes.

April 2019 Client Letter

As you know, we are fans of the simple but effective strategy of compound interest. Compounding is the process of using your dividends to buy more shares of the company that just paid them to you. Over time, the act of continually reinvesting dividends creates a snowball effect in which your initial investment grows exponentially. The exponential growth of one’s savings is why Albert Einstein described compound interest as the greatest discovery of all time.

Looking back at the fourth quarter of 2018, compounding enthusiasts can see the bonus received even though the stock market was behaving terribly. As the stock market fell, most companies continued to pay dividends. For companies whose share price declined, those dividends were reinvested at not only a lower share price, but with a higher yield.

The P&G Example

Procter & Gamble shares didn’t sell off nearly as much as the broader market last quarter, but in early 2018, they were down 23% from a prior high. The first quarter 2018 sell-off in P&G shares provided investors with an opportunity to buy more shares at a lower price and a higher dividend yield.

The table below shows the quarterly dividend pay dates for Procter & Gamble, along with the dividend amount, closing share price on that date, the number of shares purchased with dividend payments, and the indicated dividend yield based on the closing share price. 

In November 2016, P&G was trading at $83 per share and offered a yield of 3.2%. P&G shares were range-bound for the ensuing 18 months until they fell to a low of about $70 in early 2018. Up until the second quarter of 2018, P&G’s quarterly dividend provided enough cash flow to purchase about eight more shares of the stock at an indicated yield of 2.9% to 3.2%.

With the May 2018 dividend payment, the dividend generated enough cash flow to buy an additional 10.3 shares at an indicated yield of 3.9%—a 25% increase in the yield earned on reinvested shares only two quarters prior.

P&G is one example of a broader trend that occurs when you invest and reinvest in dividend-paying shares during market downturns.   

Opportunities for 4% Yields

The December volatility also pushed the yields on some of our other favored names above 4%.

IBM

Most Americans are familiar with IBM, the storied technology industry giant. The Computing-Tabulating-Recording Company (CTRC), which would later become IBM, was founded in 1911. CTRC built scales, clocks, and other devices for keeping track of information. The business would continue to grow and change, staying on the cutting edge of technological demand. More recently, IBM has been a pioneer of artificial intelligence (AI), with its Watson AI system that has become a household name and indispensable to some businesses. Alongside its AI, IBM is a major supplier of cloud and security services. The cloud-computing market is expected to grow by 18% per year until 2023 to $623.3 billion. IBM shares yield 4.5% today.

Verizon

Verizon is the descendant of some of America’s oldest telephone companies, but today it is on the cutting edge of wireless technology. Verizon is pioneering 5G ultra-wideband networks, which will be significantly faster than 4G and capable of carrying massive amounts of data. All that data capacity will be necessary to operate the coming “Internet of Things.” High data speeds and bandwidth will be necessary when nearly every device people use is hooked up to the Internet. Today, Verizon operates a 4G LTE network covering 2.5 million square miles and 98% of the American population. The company also runs a fiber-optic network providing high-speed Internet to six million customers, and a media company that includes major brands like Yahoo, Engadget, and TechCrunch. Verizon shares are yielding 4% today.

ExxonMobil

Another 4% yielder is ExxonMobil. This giant business is one of the world’s largest publicly traded energy and chemical companies. In 2018, ExxonMobil produced 3.8 million barrels of oil equivalent per day and sold 5.5 million barrels of petroleum products per day while selling 26.9 million tons of chemical prime product each day. In 2018, ExxonMobil recorded $36 billion in cash flow from operating activities, its highest since 2014. Exxon returns loads of that cash to shareholders and uses much of the rest to invest for the future. Last year Exxon spent nearly $26 billion on capital and exploration expenditures.

In addition to high yielding stocks like these, we incorporate more modest yielders that offer dividend growth potential into our investment portfolios. One such company is Air Products.

Air Products

One company that exemplifies my dad’s motto of “dividends today and more dividends tomorrow” is Air Products (APD). APD is a world-leading industrial gases company that sells products like bottled oxygen and acetylene to businesses. Air Products was founded by Leonard Parker Pool in 1940 to provide onsite production of industrial gases. Today the company has 16,000 employees and operations in 50 countries. Air Products’ board of directors has increased its dividend every year for the last 35 years. And for the last 10 years, the board has raised the company’s dividend at an average rate of 9.63% per year.  

Patience is a Winning Approach

We advise regularly that patience often leads to long-term investment success. A patient approach has been a winning approach over the last six months. Investors who panicked and tried to engage in market timing by “getting out” during the December sell-off may have missed much of the subsequent rebound.

The Dangers of Market Timing

The chart below highlights the dangers of market timing.

If a buy-and-hold investor put $1 in the S&P 500 at the end of January 1970, he would have $141 today. If that same investor tried to time the market but missed the best 10 months, he would have $44 today. If he missed the best 20 months, that $1 would be worth a mere $19 today. Market timing not only risks losing out on significant gains, but it also risks missing vital dividend payments.  

What’s Your Investment Plan?

One of the keys to successful investing is having a plan in place and a portfolio suitable for your individual financial needs and risk tolerance. You do not want to be in a position of panicking and realizing too late that your nest egg’s strategy does not sync up with your personality or financial goals.

As my dad reminded his readers in 2013, having patience and a plan is essential to long-term investment success.

Your goal should never be what to sell next; rather, it should be [about] what stocks you can hold through thick and thin. It is true that portfolio activity, for most investors, runs inversely to consistent long-term performance. How should you measure performance and how should you construct an all-weather portfolio? First, “all-weather” means you do not want to be jumping in and out of the market attempting to predict bull and bear markets. For five decades, I have been investing my own money as well as advising conservative investors saving for retirement. As such, I have invested through many gut-wrenching bear markets and disastrous single years like 2008, which ended with the speculative non-dividend-paying NASDAQ down a frightening 40% for the year. Through all the years of turbulence, I have remained fully invested in a balanced, widely diversified securities portfolio featuring a counter-balanced approach.

I have firsthand experience of what happens when counterbalancing is not in force. The Harleys I rode back in the old days had engines bolted straight to the frame. Talk about vibration and calamity. The constant vibration caused nuts and bolts to loosen and fall off. When you’re on a long-distance road trip, a breakdown in the middle of nowhere is cause for concern. I have found myself in just such a situation and it’s no fun. Today’s Harleys feature counterbalanced engines offering both a smooth ride and a minimum of road trip calamities.

A 2008 Test Kitchen

Counterbalancing simply makes common sense. Let’s look at 2008 as a test kitchen. All the broad averages got hit. High ground, so to say, was achieved by owning positions that got hit least. Consumer staples worked well; no matter how bad the times, investors are not going to forsake toilet paper, toothpaste, or their prescription drugs from Walgreens or CVS.

Counterbalancing a Core Strategy at Richard C. Young & Co., Ltd.

Counterbalancing is at the heart of how we manage portfolios for you. A mix of stocks and bonds helps reduce volatility.

As many of you are aware, the bond market has been challenging over the last decade. The Fed’s ultra-low interest rate policy and quantitative easing have made it difficult to generate interest income. That difficulty was reinforced following the Federal Reserve’s March FOMC meeting.  

What Did the Fed Decide in March?

The Fed announced an even more dovish decision than Chairman Powell had hinted at in January. Powell took any additional rate increases in 2019 off the table and announced a much faster-than-expected end to the roll-off of the Fed’s balance sheet.

Bonds will stop rolling off the balance sheet in September, with a reduction in the pace of roll-off starting in May—that’s next month. During the crisis and in its aftermath, the Fed increased the size of its balance sheet by $3.6 trillion, but it is only taking back about $750 billion of that amount.

Inflation is the Patsy

The Fed justified this pivot to an easy money stance by claiming it hasn’t credibly achieved its symmetrical inflation target of 2%. In other words, Powell & Co. want to see inflation above 2% before they consider raising rates.

Core inflation was running at 1.94% at the time the Fed announced that decision. So, if Chairman Powell is to be taken at his word, getting an indicator that measures inflation in a $21-trillion economy up a few basis points is vital.

We’re suspect.

The real motive here looks to be putting a floor under the level of asset prices. There’s really no other credible way to explain the Fed’s behavior, in our opinion. Despite evidence that suggests monetary policy managed for the level of asset prices is at the heart of the boom-and-bust cycles of the last two decades, the Fed appears unphased.

How Are We Investing Under the Fed’s New Interest Rate Regime?

With the Fed’s decision in March, the odds we are at the top of the interest-rate cycle have increased meaningfully, in our view. It is not a foregone conclusion, but the bar appears to have been raised significantly for further interest-rate hikes.

That doesn’t necessarily mean a recession is right around the corner, but it is a recognition this expansion is 10 years old, U.S. growth has slowed some, global growth is soft, and the yield curve is inverted.

Looking to next year, we can envision a further step down in U.S. growth. The cyclical effects of the tax cuts are likely to fully wear off by next year. There will be positive supply-side effects from the tax cuts, but we don’t expect those to kick in during an election year that is likely to bring greater uncertainty over the future path of fiscal policy. Polls are likely to be close next year, and some of the politicians’ proposals may dent confidence for businesses and high-income households.

Unconventional Monetary Policy Will Make a Comeback

Contemplating the end of the economic cycle (call it the medium term), we anticipate the Fed will quickly take rates down to zero and bring back unconventional monetary policy. It’s possible the Fed tries to move rates into negative territory or caps long-term interest rates. QE will likely be ramped back up and we would expect it to be much greater in magnitude than prior versions. We’ve seen commentary from some Fed board members about announcing QE that doesn’t stop until economic expansion is sustained.

Fixed-Income Positioning for the Late Cycle

To better position fixed-income portfolios for the road we see ahead, we are gradually moving toward a barbell approach. A barbell approach invests in long-term bonds and short-term bonds. Initially, we will look to target about 20% of fixed-income portfolios in long-term bonds with the remaining 80% in shorter-term maturities. 

A barbell approach should provide a greater hedge to portfolios in the event of a downturn in equity markets. This strategy will also incrementally add yield on both the Treasury and corporate side. In Treasury portfolios, longer maturity issues offer higher yields than short-to-intermediate term notes. On the corporate side, spreads on longer-term bonds tend to be wider than they are for short-term bonds. For example, looking at the A-rated Merrill Lynch corporate bond indices, the 1- to 5-year index offers a yield advantage above Treasuries of 0.57% compared to 1.27% for the 10- to 15-year index. Both indices have similar credit quality and duration risk.

As the economic and interest-rate cycles continue to evolve, so too will our fixed-income strategy.

Have a good month. As always, please call us at (888) 456-5444 if your financial situation has changed or if you have questions about your investment portfolio.

Warm regards,

Matthew A. Young
President and Chief Executive Officer

P.S. By this point, people are accustomed to every new product from Apple being described as the “next iPhone.” But with demand for the iPhone seeming to ebb, Apple is making a pivot to build its services business, announcing at a recent event new streaming TV, gaming, magazines, and credit card products. Can services ever be the “next iPhone?” Tripp Mickle reports on Apple’s new strategy for The Wall Street Journal:

In January, Apple reported its first decline in revenue and profit for a holiday quarter in over a decade. By contrast, revenue from the services business grew 33% last year, to nearly $40 billion—accounting for about 15% of the company’s total of $265.6 billion. The company’s ambition in video is to become an alternative to cable, combining original series with shows from other networks to create a new entertainment service that can reach more than 100 markets world-wide. It is the tech giant’s latest attempt to reinvent television, something it has tried to do for about a decade with limited success.

P.P.S. In February, sales of existing homes in the U.S. increased by 11.8%. Laura Kusisto of The Wall Street Journal explains that the market appears to be driven by the strong labor market and rising wages:

Sales of previously owned homes posted their largest monthly gain since 2015 in February, a sign that lower mortgage rates and more attractive prices are helping to lure buyers back to the market just in time for the critical spring selling season. Existing home sales rose 11.8% in February from the prior month to a seasonally adjusted annual rate of 5.51 million, the National Association of Realtors said Friday. That was the second-strongest monthly gain in home sales ever.

P.P.P.S. In a recent op-ed in The Wall Street Journal, Senator Rick Scott of Florida, the state’s former governor, discussed the flight of wealthy Northeasterners, especially New Yorkers, to Florida and other low-income-tax states. The cap on the deduction for state and local taxes has hit the wealthy especially hard in high-income-tax states. Now, wealthy New Yorkers, New Jerseyites, and others are following the fixed-income crowd to places like Florida, Texas, and South Carolina for low taxes and better weather. Scott writes that politicians from high-tax states should “commission a study of Florida to see what happens when conservative ideas are put into practice. The luxury real-estate market in Manhattan may be sagging, but Florida’s economy is thriving, expanding at a record pace.” It sounds like a good idea.

March 2019 Client Letter

For over 30 years, investors subscribed to Richard C. Young’s monthly investment strategy report, The Intelligence Report (IR), for advice on how to become more comfortable and consistent long-term investors. When paging through earlier issues of IR, it’s not difficult to find examples of the newsletter’s consistency. Text from early issues of IR could easily be inserted into the last report in 2017 and still have relevance. By example, here is text from February 1986: “My basic financial armadillo concept is built around safety of principal value, and the merits of compound interest. Trading is not a part of this program. If your investment portfolio does not include gold insurance, now’s a good time to add some gold.”

While the overriding strategies of IR remained consistent, the advice evolved over the years to reflect the ever-changing and cyclical nature of markets and the economy. U.S. Treasury zero-coupon bonds were emphasized in the early 90s as interest rates declined, but once rates bottomed out, the zeros strategy had less appeal and was gradually replaced, in part, with preferred stocks.

Actively managed, no-load, equity mutual funds formed the foundation of both the IR strategy and our equity component in the early days. However, as time passed, funds became less of a focus and were replaced by individual equity shares.

Why Our Focus Has Shifted to Individual Stocks

Our focus shifted toward individual stocks for several reasons. First, some of our favored mutual funds became so large as to limit the flexibility of their investment approach. Take the Vanguard Wellington Fund, for example. The fund was once a staple holding at our firm, but now has over $100 billion in assets. Taking a position in a stock equal to 2% of the Wellington Fund’s assets would require a $2 billion investment. In order to stay under the U.S. Securities and Exchange Commission’s 5% ownership rule requiring additional filings and disclosures, a fund of Wellington’s size would be limited to investing in about 2% of all U.S. publicly traded companies. Large funds have many benefits for mutual fund companies, but almost none for mutual fund investors.

Individual Stock Portfolios Are More Easily
Customized Than Mutual Fund Portfolios

Mutual funds also limit customization. We have clients who don’t want to hold a specific security because they have a legacy holding outside of our management, or they want to avoid certain stocks that are out of line with their personal beliefs. With a mutual fund or ETF, such an approach is not possible. With a managed portfolio of individual stocks, portfolios can be easily customized.

Tax Efficiency of Individual Stocks vs. Mutual Funds

Tax efficiency is another big advantage of investing in individual stocks as opposed to mutual funds. Mutual fund investors must pay taxes annually on distributed capital gains and again at the time of sale. The former is true even if your mutual fund has lost money. Consider, for example, the Vanguard Explorer Fund. Investors who purchased the Explorer Fund in the fourth quarter of last year got a nasty capital gains surprise. Those who bought the fund on September 28 of last year were down 19.5% on December 31. But even though the fund lost 20%, investors who held for the entire quarter would have received taxable capital gains distributions of $8.87 for each share owned, or about $4,400 on a 500-share position.

Mutual funds also limit the ability to harvest tax losses. While it is true the fund manager can harvest losses within the fund, mutual fund owners can only harvest a loss when the overall fund position is down. That opportunity tends to fade soon after purchasing a mutual fund or ETF when the broader stock market is rising.

Alternatively, in a portfolio of, say, 40 individual stocks, at least a couple of positions are likely to be held at a loss, even when the overall portfolio is at a gain. And capital gains distributions aren’t a problem with individual stocks. Capital gains taxes are only due when a position is sold at a gain. With individual stocks, investors have more control over when to recognize their gains.

It is also important to remember the tax liabilities generated by mutual funds depend partly on your fellow shareholders. Let’s say you own a mutual fund with a tax-sensitive portfolio manager who has held onto positions with big unrealized capital gains. If investors in the fund panic during a period of elevated market volatility, the fund manager may have no other choice but to liquidate positions held at a big gain in order to satisfy redemptions. The sentiments of other investors never create a tax problem when investing in individual stocks.

Funds Are Less Liquid and More Expensive Than Stocks

We favor individual shares instead of mutual funds because open-end mutual funds can only be purchased and sold once per day. ETFs can be purchased throughout the day, but, during periods of heightened volatility, there is no guarantee your shares will be redeemed at net asset value. Mutual funds can also be expensive, adding an unnecessary second level of fees. An advisory firm charging a 1% management fee and investing in a portfolio of mutual funds with an average expense ratio of 1%, costs the end investor 2% per year.

Expanded Research Capabilities

Finally, our preference for individual stock portfolios has increased over the years as we have added research staff and invested in technology, allowing us to craft globally diversified and customized dividend-stock portfolios more efficiently.

Our dividend-stock portfolios are focused not only on yield, but also on dividend growth. Yield is important when investing in dividend stocks, but it isn’t the only variable to consider. Historically, investing solely on the basis of yield has been a losing strategy. Investing in companies with steadily rising payouts tends to be a more reliable method for finding quality dividend-payers that can withstand the economy’s ups and downs.

Our equity component today is primarily comprised of individual dividend-paying stocks of companies that look to raise their dividend yearly. Many of the companies we buy are familiar stodgy types, including Kimberly-Clark and Johnson & Johnson, or those from the widow-and-orphan sector, such as Wisconsin regulated utility WEC. Others, however, may not be as familiar.

The Business Strategy That Delivered 54 Years of Dividend Growth

You may never mention Illinois Tool Works around your kitchen table, but its products power your car, build your home, keep your food safe, and affect your life in hundreds more ways. ITW is a holding company that manufactures parts for cars, construction materials, food equipment, polymers and fluids, welding tools and supplies, electronic testing and measurement equipment, and more. ITW’s brands include Miller and Hobart welding products, RainX, Vulcan Equipment, Paslode, and Deltar.

ITW was founded in 1912 and has grown to include 85 divisions in 56 countries. To manage the many pieces of its diverse business, ITW has developed and refined what has become known as the 80/20 front-to-back process. This is a proprietary set of business practices structured to satisfy the needs of ITW’s largest and most profitable customers. The process seeks to minimize the cost, complexity, and distraction associated with serving small customers while giving the 20% of customers who generate 80% of the revenue the most attention.

In addition to its 80/20 process, ITW has a renowned innovation program, which has fueled over 17,000 granted and pending patents. The company’s decentralized management style empowers teams closest to products and end markets to innovate without moving every decision through layers of bureaucratic overhead.

The 80/20 process has helped ITW become a dividend powerhouse. The company has paid a dividend every year since 1933. And, without fail, ITW has increased its dividend in each of the last 54 years—that’s more than half a century of annual dividend growth. ITW’s long record of dividend success has earned it a place in the coveted Dividend Aristocrats Index, an elite group of companies with at least 25 consecutive years of dividend growth.

A New Powerhouse in Streaming

Among the more familiar names, we are buying is Disney. Disney is a global media conglomerate and owner of what is likely the world’s most valuable media library. Disney not only owns rights to Mickey Mouse and Donald Duck, but they also own rights to everything Marvel (X-Men and Captain America), LucasFilms (StarWars), and Pixar (Cars and Toy Story) have created.

Disney also owns a portfolio of media networks including ESPN, ABC, the Disney Channel, and Fox’s cable networks. The recent acquisition of 21st Century Fox will provide Disney with a majority stake in the Hulu streaming service.

In addition to Disney and Fox’s offerings on Hulu, Disney is set to launch a new streaming service called Disney+ later this year. With an unrivaled portfolio of content, Disney is well positioned to compete with existing streaming services, including Netflix and Amazon Prime.

While Netflix may have pioneered the direct-to-consumer model for media consumption, the firm relied heavily on licensed content and is now scrambling to catch up to Disney and others in original programming. As any long-time observer of the media industry will likely tell you, creating content consumers desire is easier said than done. Netflix is doing its best to catch up, but they are spending billions creating new content that may prove worthless.

And to make Netflix’s challenge more daunting, before the Disney+ service launches later this year, Disney will pull all its existing movies and shows from Netflix and other streaming services.

What Exactly is Disney+?

Disney+ will include all Disney, Pixar, Marvel, and Star Wars video, including existing movies and shows, along with four to five exclusive movies and TV shows at launch. Disney plans to make Disney+ the sole outlet for the company’s family-friendly content. The edgier, adult-oriented content, including programming from the Fox acquisition, will be delivered via Hulu.

We view Disney’s value as attractive, and the upside opportunity across the business as compelling. Disney’s dividend yield is a modest 1.55%, but it is well covered and likely to increase at a mid-to-high single-digit rate over the medium term. Disney is also a regular buyer of its own shares. Buybacks have exceeded dividends by a wide margin for eight consecutive years. We would prefer to see the firm pay bigger dividends as opposed to buying back shares, but buybacks are a net benefit to shareholders nonetheless.

Not Your Father’s AT&T

Like Disney, AT&T is a familiar name and one that often comes to mind when thinking about consistent dividend payouts. Like electric utilities, telecom companies have historically been dividend champions. Commonly viewed by investors as a provider of cellphone and related services, AT&T is a massive multinational conglomerate whose businesses include technology, mass media, and entertainment.

AT&T’s business segments include wireless, consumer fixed-line and DirecTV, the recently acquired WarnerMedia, fixed-line business, and Latin America. The wireless-business and WarnerMedia assets are where we see AT&T’s opportunity. The emergence of 5G wireless technology has the potential to be a game changer. 5G speeds are competitive with fixed-line high-speed Internet, and they will be needed for the emerging Internet of Things.

The eyesore in AT&T’s business lineup is the consumer fixed-line and DirecTV business. DirecTV was purchased in 2015 and increasingly looks like a mistake. While the business generates cash for AT&T, company management overpaid for what is now a declining business. Our preference would be a sale of DirecTV with the proceeds used to reduce debt.

AT&T’s Beefy Dividend

While we aren’t fans of AT&T’s DirecTV business, we do favor the company’s attractive dividend. AT&T shares yield 6.5% today. AT&T has increased its dividend for 34 consecutive years. We anticipate continued modest increases over coming years. With a yield of more than 3X that on the S&P 500, some investors are concerned AT&T’s dividend may not be rock-solid given the increased debt load used to purchase DirecTV and Time-Warner. We wouldn’t necessarily disagree that AT&T went heavy on the debt, but the dividend appears secure at current levels. We expect AT&T’s free cash flow to be $26 billion this year. The dividend should come in at about $13.5 billion, which leaves a more than ample $12.5-billion cushion that can be used to pay down debt. There is, of course, no guarantee the dividend won’t be reduced, but the risk-reward is appealing in our view.

Disney and AT&T in New Communications Services Sector

You will note on your quarterly holdings report that both Disney and AT&T are listed in the communications services sector. Standard & Poor’s and MSCI (the creators of the GICS sector hierarchy) decided to replace telecommunications with the expanded communications services sector last September. This sector includes telecom companies as well as media, entertainment, and interactive media firms. The largest companies in the sector are Facebook and Google, neither of which pay a dividend.

Have a good month. As always, please call us at (888) 456-5444 if your financial situation has changed or if you have questions about your investment portfolio.

Warm regards,

Matthew A. Young
President and Chief Executive Officer

P.S. The retail business has been tough lately, with many storied businesses, including Sears, Toys R Us, and others going bankrupt. Walmart, though, seems to be showing brick-and-mortar retailers the pathway toward competing in today’s e-commerce focused world. In the fourth quarter of 2018, Walmart had its best holiday season in at least a decade. Comparable sales rose 4.2% in the quarter. Part of what made the season such a success was Walmart’s drive to soak up as much of Toys R Us’s market share as possible. The company pushed hard, using in-store experiences online retailers couldn’t replicate to get children and their parents through the doors. While e-commerce will surely continue to grow, Walmart’s adaptation is a survival blueprint for other retailers.

P.P.S. While it appears that no one in Washington, D.C., is worried about growing deficits, we are. Deficits are blowing out, and the U.S. will likely spend about $900 billion it doesn’t have this year. America’s accumulated debt is over $22 trillion. Republicans don’t want to talk about the debt because they’re afraid it will encourage talk of raising taxes, and Democrats don’t want to talk about the debt because they’re afraid it will encourage talk about cutting spending. The problem is soon the cost of the debt service itself will increase to a size that will hurt America’s economy. By next year America will spend more on interest than on Medicaid. And by 2024, America will spend more on interest than on the military. While politicos like former Treasury secretary Larry Summers are suggesting America doesn’t need to worry about the debt, it is hard to ignore the possible effects all that debt could have on the economy.

P.P.P.S. In January, America’s economy enjoyed its 100^th straight month of higher employment, with the number of payrolls rising by 304,000. Wages also rose by 3%, and the unemployment rate remained low at 4%. Even Americans who have been out of the workforce are returning to look for jobs. Participation of women in the workforce aged 25 to 54 is at its all-time high of 76%.

January 2019 Client Letter

Last year ended on a sour note for stock-only investors, with the S&P 500 losing more than 9% in December and more than 13% for the quarter. December’s performance was the second-worst December on record for the index. While we weren’t surprised by the correction, the magnitude of the decline looked excessive given the lack of any meaningful negative surprises. Fed policy and trade rhetoric took the brunt of the initial blame for the sell-off; but Wall Street quickly decided the sell-off was a warning sign of recession. Demands for the Fed to back off its interest-rate-hiking cycle soon followed.

After initially resisting the Street’s appeals for support, steeper losses caused the Fed to capitulate. Just six weeks prior the Fed indicated interest rates would continue to increase in 2019 and there were no planned changes in the balance sheet unwind. Then, in its first meeting of 2019, the central bankers did a complete 180 on their policy outlook. As of now, no further interest rate increases are penciled in for 2019, and the balance sheet unwinding is likely to end sooner than originally anticipated. The selling pressure in the stock market seems to have subsided since.

Is the Stock-Market Correction a Signal of Recession?

Recessions are often accompanied by falling stock prices, but falling prices don’t guarantee economic contraction. There have been plenty of false positives throughout history. While the Fed made the predictable decision to cave to Wall Street’s demands to halt interest-rate increases, there aren’t yet many signs a recession is on the way.

The coincident economic data points toward continued economic strength. GDP is growing close to 3%, according to the Atlanta Fed GDPNow forecast; industrial production is up close to 4% over the last year despite trade skirmishes; the unemployment rate is under 4%; consumers appear to be in good financial shape.

The leading indicators look less solid, with two out of the last three months down; but financial markets have played a big role in those downticks. We are also encouraged that the railroad sector, a good leading economic indicator, continues to show signs of strength.

As the WSJ reported recently, the CEOs of two of the biggest rail firms in the U.S. are signaling that the U.S. economy remains on solid footing:

CSX CEO Jim Foote said customers plan to ship more goods and are also moving ahead on long-term capital projects, including expanding facilities. “When you talk to the business people, they’ve always indicated that the economy was still in good shape,” Mr. Foote said in an interview last week…

“There are a number of overhangs that you could point to and worry about whether that could trigger a slowdown,” including trade effects and consumer sentiment shifting due to the government shutdown, Union Pacific CEO Lance Fritz said last week. But the railroad’s customers expect strong demand and shipments across a number of sectors, including construction materials, steel, and plastics.

A Key Takeaway from Last Quarter’s Volatility

A key takeaway from the fourth-quarter volatility is how quickly things can unravel. Investors have apparently grown so accustomed to a decade of easy money and low interest rates that small changes in the amount of stimulus and in interest rates can have a large impact.

A phrase on Wall Street says that old age does not kill a bull market. While true, we are many years into the current cycle. The economy and stock market are cyclical beasts, and eventually, this cycle will end. Some believe the end of the current stock-market cycle is already here.

Are We at the End of the Cycle?

Jeremy Grantham’s firm, GMO, says the bubble in U.S. stocks is busting. Grantham is an expert in financial bubbles and widely known for identifying in advance the dangers of the dotcom and housing bubbles. Grantham’s associate, Martin Tarlie, wrote recently that a new model of bubbles suggests we may be at the beginning of the end of inflated U.S. stock valuations.

Tarlie suggests the size and duration of the move0 in stock prices in the last quarter of 2018 is similar to the moves that preceded the tech bubble burst and the crash of 1929. Tarlie and his fellow analysts found five major bubbles over the last 200-plus years, including the 1910s, 1929, the early 1980s, the tech boom, and today. Grantham wrote this in a more recent letter to investors:

As a historian of the great equity bubbles, I also recognize that we are currently showing signs of entering the blow-off or melt-up phase of this very long bull market…. When most have talking heads yammering about Amazon, Tencent and bitcoin and not Patriot replays—just as late 1999 featured the latest in Pets.com—we are probably down to the last few months.

If Grantham and Tarlie are correct, what should you do with your portfolio? Risk assessment is always paramount, but it is especially important toward the end of a growth cycle. Through the years, my dad has been relentless in his efforts to alert investors of the dangers of taking on too much risk. In August 2014, he explained a strategy for risk avoidance:

One of the most important investment steps you can take is to look at the big picture—that is, get high above street level so you can actually see the parade. Big risks are always big ideas, loaded with complexity and controversy. In most cases, the media is geared to work against you, and it’s difficult to break through and get at the truth. To frame risk parameters, I use inference reading—what I call outcome analysis—and on-the-ground anecdotal evidence. Whether you are currently in retirement or saving for a secure retirement within the next decade or so, retirement investing leads directly to risk analysis. I exert minimal effort worrying about what I am going to make on my investments. I concentrate on interest, dividends, portfolio balance, diversification, and compound interest. I know what I am being paid up front. And I know that a well-diversified portfolio of equities, fixed income, precious metals, and foreign currencies has historically provided consistent, positive, prudent returns.”

We pursue the same approach at Richard C. Young & Co., Ltd. We concentrate on diversification, income, compound interest, portfolio balance, and dividends.

The Humble Dividend

Dividends are central to our equity investment strategy. If a company doesn’t pay a dividend, we don’t invest. Over the last few years, dividend investing has fallen out of favor with many in the investing public. High-growth sectors where dividends are scant have captured investor attention and dollars.

In our view, it’s folly to eschew dividends today for the promise of capital appreciation from speculative sectors tomorrow. Dividends have always formed an essential part of the stock investing equation. In fact, over the last three decades, dividends and the reinvestment of dividends have generated over half of the stock market’s total return.

So why don’t more investors demand dividends? A hang-up for many is that dividend-paying companies are often boring businesses. They make things like soap and bleach, or they transmit electricity. The growth opportunities of many dividend payers pale in comparison to those available to firms in emerging industries. Nobody is getting rich quickly by investing in dividend-paying stocks. Creating wealth through the power of compounding is a slow and predictable process. But slow and predictable still beats speculative, unlikely, and uncertain as a strategy for building wealth.  

Dividends a Soothing Tonic

What else is there to like about dividends? When markets fluctuate violently, as they did in December, the knowledge you are investing in businesses paying reliable dividends today with the promise of higher dividends tomorrow can act as a soothing tonic during uncertain times.

The Secular Health Care Wave

Our affinity for dividends is why we recently decided to close our positions in the Fidelity and Vanguard Health Care funds and to instead purchase individual health care stocks. We continue to favor the long-term outlook for the health care sector. By purchasing individual stocks, we have been able to nearly double the dividend yield of the health care ETFs while maintaining exposure to the sector’s powerful secular tailwind.

By the year 2030, the Baby Boomers will all be 65 or older. The Boomer generation represents such a large part of America’s population that one of every five American residents will be at retirement age. Reaching 65 and retiring creates obvious demands on your portfolio, but there are also major health impacts. Americans 65 and older use twice the number of prescription drugs compared to the under-65 population. Increased utilization, combined with growth in specialty medications, is expected to fuel a 6% rise in annual prescription spending over the next decade.

In 2010, Americans over 65 spent three times more than the average working-age person on health care and, even though they represented 13% of the population, America’s elderly citizens generated 34% of all health care spending. As Americans age beyond 65, the costs accelerate, with health expenses doubling between ages 70 and 90.

More Than Half of Americans Are on Two Prescription Drugs

In 2008, 88.4% of Americans over age 60 were using prescription drugs, and 36.7% of Americans 60 and over were regularly using five or more prescription drugs. Another 27.3% were using three or four drugs regularly. A 2013 Mayo Clinic study found that “nearly 70 percent of Americans are on at least one prescription drug, and more than half take two.” What does this all mean for the future? Health care spending is projected to increase to $5 trillion by 2022.

The stocks we are purchasing today to participate in the health care sector include Johnson & Johnson, CVS, Pfizer, Merck, Medtronic, Novartis, Novo Nordisk, and Sanofi Aventis. Most of you are familiar with JNJ and CVS, as both are long-time holdings. New names you may not be as familiar with are profiled below.

Pfizer

Pfizer is a global pharmaceutical company with strong portfolios of branded consumer drugs and prescription medications. Among Pfizer’s best-known consumer health care products are Advil, Robitussin, Centrum, and Nexium. The drug maker’s prescription portfolio is headlined by well-known names like Celebrex, Chantix, Enbrel, EpiPen, Lipitor, Prevnar, Viagra, Xanax, and Zoloft. Pfizer has been paying a dividend since 1901.

Merck

Merck is another major pharmaceutical producer. Merck spends billions on R&D each year to produce a pipeline of innovative and proprietary drugs. Merck’s portfolio of drugs includes well-known names like Clarinex, Fosamax, Gardasil (a vaccine for the human papillomavirus), Keytruda, the MMR II vaccine, Propecia, Singulair, and Zocor. Merck has been working on ways to treat and prevent illness since 1891 and has paid a dividend to shareholders since 1935.

Medtronic

In 1949, Earl Bakken and Palmer Hermundslie founded a medical equipment repair shop called Medtronic. The two men were asked to modify and create custom medical equipment solutions for their customers, and they became known for their ability to get the job done. When a blackout hit the Minneapolis area where Medtronic was based, Dr. C. Walton Lillehei, who often came to Bakken and Hermundslie for help with medical devices, asked the men to invent a battery-operated pacemaker. The invention would put Medtronic on the map. Today Medtronic operates from over 370 locations in 160 countries. The company now employs over 9,600 scientists and engineers and has amassed a portfolio of over 46,000 patents.

Novartis

Novartis is made up of three main segments. The first is innovative medicines, which is again broken into two pieces: Novartis Oncology and Novartis Pharmaceuticals. The Oncology division focuses on treatments for cancer and rare diseases. Pharmaceuticals focus on a wider range of treatment and research areas, including ophthalmology, immunology, hepatology and dermatology, neuroscience, respiratory, and cardio-metabolic. Novartis’s portfolio of drugs includes well-known names like Cipro, Cosentyx, Ilaris, Lamisil, and Ritalin, among others. Novartis’s other businesses are Sandoz, which produces generic and biosimilar drugs, and Alcon, which produces the world’s widest selection of eye care devices.

Novo Nordisk

In Denmark in the mid-1920s, two separate companies were founded to produce and sell insulin, which had recently been discovered. The companies, Nordisk Insulin Laboratorium and Novo Terapeutisk Laboratorium founded in 1923 and 1925, respectively, would later merge, becoming Novo Nordisk. Since that time, the company’s focus has been on care for diabetes. Today 81% of Novo Nordisk’s sales are related to diabetes care, for which it supplies nearly half the world’s insulin. Novo Nordisk does have smaller divisions focused on treatments for hemophilia, growth disorders, obesity, and other serious chronic diseases.

Sanofi

Sanofi is a global healthcare leader focused on human vaccines, rare diseases, multiple sclerosis, oncology, immunology, infectious diseases, diabetes and cardiovascular solutions, consumer healthcare, established prescription products and generics. Sanofi’s consumer healthcare portfolio is loaded with brand name over the counter drugs and products including Allegra, Gold Bond, Nasacort, Unisom and many more. The company’s prescription portfolio is also full of strong brands, including Ambien, Flomax, Plavix, and more.

Have a good month. As always, please call us at (888) 456-5444 if your financial situation has changed or if you have questions about your investment portfolio.

Warm regards,

Matthew A. Young
President and Chief Executive Officer

P.S. We view gold as an insurance policy for your portfolio. Gold tends to perform well during periods of uncertainty and stress. In the fourth quarter, gold performed as one would expect. The SPDR GoldShares ETF was up 7.5% compared to a 13.5% loss in the S&P 500.

P.P.S. One of the more disappointing developments beginning in the fourth quarter was the decline of the bellwether 10-year treasury yield. After climbing to a near-seven-year high, the yield declined back down to 2.75% in late January. As the yield environment in general improved for much of 2018, we saw a significant increase in the yield on new purchases for corporate bonds. For new individual corporate bond purchases, we still anticipate being able to tie down yields north of 3%.

P.P.S. Several clients have rightfully expressed concern to me about the amount of debt owed by the U.S. federal government. While certainly a concern, the more pressing risk could be the debt and budgetary issues facing many states in the U.S., especially during the next recession. Many states have cash reserves of only 1% to 2% of their budgets. Many are also funded almost entirely by their income taxes. Income taxes take a major hit during recessions, and the states most reliant on them will be hit hard. Perhaps what’s worst about state finances are the many underfunded pension programs across the country. States have been underfunding their pensions for years, robbing Peter to pay Paul. At some point, perhaps during the next recession, those states will be forced to choose between keeping the promises they have made to their retired employees and maintaining their current spending. The extra taxation and debt necessary to deal with any shortfalls could negatively impact economic growth and soak up financing, leaving businesses paying higher rates, eroding earnings and ultimately costing shareholders.

December 2018 Client Letter

The New York Times ran a piece in December titled “Investors Have Nowhere to Hide as Stocks, Bonds, and Commodities All Tumble.” The article highlighted the difficulty investors faced in 2018. Most major asset classes fell last year or edged out minimal gains in the final few days of the year.

For the first time in decades, every major type of investment has fared poorly, as the outlook for economic growth and corporate profits is dampened by rising trade tensions and interest rates. Stocks around the world are getting pummeled, while commodities and bonds are tumbling—all of which have left investors with few places to put their money.

If this persists or grows worse, it could create a damaging feedback loop, with doubts about the economy hurting the markets, and trouble in the markets undermining growth.

Pessimism emanating from the stock market could leave consumers and businesses scared to spend. The rout in junk bonds makes it more expensive for financially fragile businesses to borrow. The collapse in crude oil prices discourages new investment and hiring in the oil patch, which has been a source of job growth.

In that sense, the markets are both a gauge of what investors expect to happen in the economy, and a potential catalyst for their decisions. The mood in the financial markets ultimately feeds into spending by companies and consumers, and if they pull back, based on panicky ups and downs, growth could suffer.

Ned Davis Research explains in the Times article that in every year since 1972 at least one of the major asset class categories the firm looked at generated a return of 5% or more. 2018 has been a different story with losses (or minimal gains) in almost every asset class and style.

With unemployment at some of the lowest levels on record, third-quarter economic growth coming in above 3%, profit growth getting a boost from the corporate tax cut, and interest rates still at historically low levels, what is causing the widespread decline in financial asset prices?

The Monetary Policy Headwind

There are plenty of explanations to go around and no single cause, but a reversal in the monetary policy that helped levitate asset prices for much of the last decade may now be contributing to their decline.

We have written often in these monthly strategy updates about the distortive impact global central banks have had on financial asset prices of all kinds. Years of zero and even negative interest rates, along with trillions of dollars of liquidity injections from the world’s biggest central banks, unduly elevated stocks, bonds, real estate, commodities, private-equity, and almost any other asset you can think of.

Markets have been under the influence of quantitative easing for so long it has become background noise, but during the fourth quarter of 2018, global central banks transitioned from being a major tailwind to a headwind.

It is true the Fed stopped expanding its balance sheet through asset purchases in October of 2014, but almost as soon as the Fed stopped buying, the Bank of Japan and the European Central Bank stepped up their purchases, offsetting any reduction on a net basis.

The Fed started to unwind its balance sheet late last year, but the early reductions were modest and entirely offset by ongoing purchases from the ECB and BOJ.

It wasn’t until October of 2018—when the Fed increased the rate of monthly balance sheet reductions to $50 billion per month and the ECB reduced its monthly purchases to €15 billion per month—that a true unwinding of global central bank support began.

Where to Hide in an Investment Environment like This

When almost all asset classes are down on the year, you shouldn’t expect to make money hand over fist, but a defensive allocation that includes Treasury bonds can help limit losses.

You can’t just buy any Treasury bond and expect to profit, though. Proper positioning within the Treasury market is important to limit your losses. Until mid-November of 2018, long-term Treasury bonds were down more than 8%, trailing stocks by as much as 16 percentage points. Alternatively, as the chart below shows, an investment in the Bloomberg Barclay’s 1-3 Year Treasury Index was in the black for most of the year, despite a better than 50% increase in the 2-year Treasury rate.

The bond portfolios we manage for you have been focused on shorter maturities, and over recent years we have upgraded the credit quality of the portfolio. We increased the amount we invested in Treasuries and focused more on higher-rated bonds. Both moves benefited the bond side of our clients’ portfolios in 2018. Short-term bonds outperformed long-term bonds. Treasuries and short-term investment-grade bonds outperformed high-yield bonds after a dismal fourth quarter for the latter.

While we remain hopeful the 3.2%+ 10-year Treasury rates we saw early last fall will return, based on the much less inspiring 2.66% 10-year Treasury yield we see today, we will continue to favor shorter-term maturities in bond portfolios.

Two Big Challenges Investors Face Today

During bull markets, many investors have an easy time riding though the minor ups and downs; but when bear markets begin, investing becomes much more difficult. Bear markets can be scary. For starters, the losses can come with a staggering amount of velocity. Historically, bear markets move from peak to trough more than twice as fast as bull markets move from trough to peak. The rapidity of the losses has been on display in recent weeks and months. From its September 20th high, the S&P 500 lost 19.8% through its December 24th low. That three-month loss wiped out all the capital appreciation in the index over the prior 20 months. The speed of the losses seems to have become even more exaggerated in recent years as high-frequency trading has proliferated.

Like you, we would prefer markets to have waved a yellow caution flag and allowed ample time to reduce equity allocations before losses ensued, but that’s not the world we live in. Unanticipated and high-velocity bear markets are likely here to stay. The solution in our view is to prepare for them by crafting a portfolio that will prevent panic even in a worst-case scenario.

Battling the Barrage of Negative Headlines

A declining portfolio value isn’t the only struggle investors face in a bear market. Another challenge is the 24-hour news cycle and access to up-to-the-minute headlines and alerts. Frightening headlines that used to be read with fresh eyes and a hot cup of coffee first thing in the morning are now blared over Twitter, Facebook, CNBC, and via text message the moment they happen. Some investors feel compelled to make snap decisions based on such headlines.

When you combine periods of high volatility with relentless negative headlines, it is easy to see how investors are put in a state of anxiety. This can lead to emotionally driven investment decisions that can adversely affect one’s long-term investment plan. We have long counseled investors that a cold, calculating approach is necessary to achieve long-term investment success. CNBC and Twitter don’t factor into that equation, but the Bureau of Economic Analysis, the Conference Board’s Index of Leading Economic Indicators, and the Bureau of Labor Statistics certainly do.

While the price action in the stock and bond markets sends a signal of caution on the economy and should not be ignored, as outlined earlier the correction in markets may have more to do with the withdrawal of global central bank stimulus than economic growth.

Some of the economy’s interest-sensitive sectors do look soft, but there are also still positive factors to point to. Employment is still strong, wages are up, the tracking estimate for fourth-quarter GDP growth is still closer to 3% than 2%, and consumer spending over the holiday season was the best in six years according to Mastercard SpendingPulse. That is not to say things can’t change; but based on the current rate of economic momentum, one might expect another decent year for the economy in 2019.

Have a good month. As always, please call us at (888) 456-5444 if your financial situation has changed or if you have questions about your investment portfolio.

Warm regards,

Matthew A. Young
President and Chief Executive Officer

P.S. Apple is having a hard time selling phones in India, the largest untapped market for smart phones in the world. There are 1.3 billion consumers in India, and only 24% of them own an iPhone. Apple’s market share in the country is a whopping 1%, down about 50% over the last year.

What is Apple doing wrong? Price is a major problem. Apple raised the price of its newest phone, the iPhone XS with 256Gb of storage, to $1,149. With 95% of smart phones costing less than $500 in India, there is almost no value to be found in the iPhone at $1,149.

While Apple’s $330-billion market value collapse over the last quarter may be overdone in the short run, as we see it, the long-term risk to the business remains unfavorable.

P.P.S. Here come the tax refunds. Many Americans haven’t really seen what the Trump tax reform will do for their returns. With big checks possibly coming back to many families, the retail sector could be buoyed for longer than anticipated. Bloomberg’s Matthew Townsend reports:

The law cut tax rates for some individuals, but lots of Americans haven’t seen all those savings flow through to their paychecks, according to Wells Fargo & Co. That will be made up during a “historic” refund season early next year, with, for example, a household earning $45,000 a year realizing 70 percent of its tax benefit, the bank said Friday in a research note.

Oftentimes, retailers struggle to draw shoppers in February and March. But bigger-than-expected refunds could help maintain the momentum this year from what is shaping up to be one of the best holiday shopping seasons in recent memory.

P.P.S. State budgets across the country are being massacred by spending requirements. Medicaid programs are especially to blame, according to a report released by the GAO on December 13. Johnny Kampis writes in The American Spectator that:

The main culprit is health-care spending, namely Medicaid expenses and spending on the health benefits of government employees and retirees. Fiscal hawks across the U.S. have warned that government debt is growing across the country not only because of underfunded pensions, but also due to the increased cost to provide these medical benefits to retired government workers.

The GAO noted that there are “long-term fiscal pressures” faced by the government sector. That’s likely an understatement; but most worrisome is how government actions to balance its budgets could affect retirees and savers. Higher tax rates are the most obvious bad solution to filling the budget gaps.

P.P.P.S. For years my father has extolled what he calls The Swiss Way. Switzerland’s low tax rates, neutral foreign policy, and locally focused governance combine to create one of the world’s highest standards of living. In a recent issue of his magazine, Steve Forbes took time to question why the IMF ignores the lessons of Switzerland’s success when giving recommendations to troubled nations. He writes on taxes:

Understanding investment’s basic importance to progress, this Alpine nation imposes no capital gains tax. That’s right: zero. Its value-added tax (VAT)—7.7%—is paltry by European standards, where punishing double-digit levies are the norm. The corporate tax rate averages 17.7%, better than the rates of most of its peers (the rate varies depending on which canton—the equivalent of a state or province—the company is located in; the lowest is a mere 11.5%). The highest personal income tax rate (federal and local) ranges from 22% to 45%. The comparative range in the U.S. is 37% to over 50%.

Naturally, the IMF and too many economists recommend burdening taxpayers even more.

November 2018 Client Letter

Here is something I’ve been reviewing with clients that is helping with their unsettledness over the past three months. Most of you have a balanced portfolio, which includes a mix of cash, bonds, precious metals, and stocks. When you hear and read about the market’s decline and the uncertain period ahead, it is wise to remember these nasty headlines are not affecting your entire portfolio. Most of you have approximately 50% invested in equities and the other 50% invested in securities which tend to hold their value or decline less compared to stocks.

As for the stocks in your portfolio, we look to invest in blue chip, industry-dominating, financially stable companies. Sure, the share price of these companies will have periods of decline. But we expect most of the companies we own to weather market corrections and continue to generate sales, market their products or services and pay you a dividend each year.

None of us likes to see our portfolio lose value, but that is the nature of investing. Markets go both ways over time. But the more time passes, the greater the odds of success—especially when owning a group of solid businesses.

The following diagram shows that, over a one-year time horizon, investors should expect to lose money in stocks about 25% of the time, or once every four years. Extend the time horizon to five years and the risk of loss falls to 11%. For long-term investors, the news gets even better. Over the 132 fifteen-year periods since 1871, U.S. stocks have never lost money. That includes during the Great Depression and the more recent financial crisis. Successful investing has lots to do with quality and time. If we are invested in quality businesses and have time on our side, the chances of winning are pretty good.

Quality and time may not work for you when your time frame is short, you are not properly diversified, or you are over-concentrated in a limited number of securities. On occasion, even the bluest of blue-chip companies runs into trouble.

Blue-Chip Stocks That Ran into Trouble

The Dow Jones index is considered a blue-chip benchmark. In theory, one could buy stocks from the Dow and never need to sell. But the index changes because companies do not always last. At year-end 1999, the once-venerable General Electric, Hewlett Packard, General Motors, Eastman Kodak, Citigroup, and old AT&T were members of the Dow.
For decades, General Electric was considered the best-managed company in the world. GE’s management training program was second to none, with many former executives going on to lead large publicly traded companies. In 1998 Business Week ran a cover story on how well GE was managed, calling Jack Welch “America’s #1 Manager.” Today, General Electric is no longer a member of the Dow and appears to be struggling to survive.

Hewlett Packard was a pioneer in the technology industry and once considered one of the most innovative companies in America. It too was dumped from the Dow. HP has been sliced and diced and is now a shadow of its former self.

General Motors has long been America’s biggest car company, but that didn’t prevent GM from filing for bankruptcy following the 2008/2009 financial crisis.

Ditto for Eastman Kodak. Eastman was a former Dow member and the dominant provider of film in America, but the firm failed to adapt to the digital world and went bankrupt.

Citigroup, once the biggest banking enterprise in America, almost failed during the financial crisis, and AT&T, a longtime member of the Dow, was swallowed up by SBC Communications, one of the Baby Bells. SBC of course took AT&T’s name.

At year-end 1999, a portfolio invested in General Electric, General Motors, Citigroup, Hewlett Packard, the old-AT&T, and Eastman Kodak would have likely been considered a blue-chip portfolio. Admittedly, a poorly diversified portfolio with only six names, but blue-chip nonetheless.

How did this hypothetical blue-chip portfolio perform over the subsequent 19 years? The following chart tracks the performance of an equal investment in each of the above-named six stocks since year-end 1999. This portfolio would have lost about two-thirds of its value over a 19-year period.

I am of course cherry-picking a portfolio of blue-chip losers to illustrate a point, but even the blue-chip stocks that have survived and performed well can suffer from poor stock-market performance. Microsoft’s stock comes to mind in this category.

Microsoft

Microsoft is on the verge of becoming the world’s most valuable company, but at times its stock performance was not great. If you retired at the beginning of this century and owned a significant holding in Microsoft, you may have regretted your decision. Yes, things have worked out as of today; but, for the first 15 years of this century, the shares were underwater.

Today, we own Microsoft stock in some client portfolios. In addition to an impressive dividend-growth record, Microsoft’s position in the technology industry appears to be well entrenched. The Windows operating system and Office productivity suite still have the leading market share among consumers and businesses. Microsoft is also a strong number two in the public cloud, where growth has been robust. Unlike some technology businesses that have few barriers to entry and almost no competitive advantage, we believe Microsoft possesses both.

Pacific Gas & Electric

Investors who believe diversification doesn’t have to be one of their primary concerns because they invest in regulated utilities and other “widow and orphan” stocks should think again. The recent share price collapse of Pacific Gas & Electric is instructive. PG&E is a large California-based gas and electric utility. Because of potentially bankrupting liability related to fires this year and last, PG&E has eliminated its dividend, and its share price is down over 60% from September of 2017.

Diversification a Cornerstone Principal at Richard C. Young & Co., Ltd.

At Richard C. Young & Co., Ltd., diversification is a cornerstone principle of our strategy. We seek to own a group of names diversified geographically and across industries. We will inevitably hold a stock like PG&E at an inopportune time or be invested in a blue-chip firm that fails to adapt to the ever-changing economic landscape. That is the nature of investing. But because we craft diversified portfolios, the risk of such an event having a devastating and lasting impact on your portfolio is remote, in our view.

Unlike many of the market-cap-weighted index ETFs favored today, we favor what is essentially an equally weighted allocation strategy to common stocks. We believe a capitalization-weighted allocation strategy creates an overconcentration in the biggest firms. An ETF that tracks the S&P 500, by example, may own 500 names, but the top 10 account for an outsize share of the portfolio.

We own both Exxon Mobil and WEC Energy (a utility) in some client portfolios. Both stocks receive the same allocation in our clients’ portfolios, but if we pursued a market-cap-weighted approach, we would own about 14 times more Exxon than WEC Energy.

How Is the Economy Doing?

Third-quarter GDP growth came in at an impressive 3.5%, but some indicators now point to a potential slowing in economic momentum. The slowing is not yet broad-based enough to become overly concerning, but it is meaningful enough to make us perk up and pay attention.

The interest rate-sensitive sectors appear to be the most impacted. Auto sales have plateaued over the last year or two, and now the housing sector is looking top-heavy.

My chart below on new and existing home sales shows signs of a slowdown in housing. The nearly one-percentage-point rise in mortgage rates since the start of the year has likely dampened demand. With consumers still in good shape, the question for investors is whether the slowdown in home sales is a temporary reaction to the “sticker shock” of higher interest rates or something more lasting.

In the coming months, we will look to the Conference Board’s Index of Leading Indicators to assess the prospects for the economy. Last month the leaders registered their lowest monthly rate of increase since May of this year.

The slowing in select sectors of the economy appears to have caught the attention of the Federal Reserve. Some members of the policy-setting FOMC committee have started to call for a pause in interest rate increases. We continue to anticipate one more interest rate hike in 2018, but the number of hikes in 2019 is now less certain.

Have a good month. As always, please call us at (888) 456-5444 if your financial situation has changed or if you have questions about your investment portfolio.

Warm regards,

Matthew A. Young
President and Chief Executive Officer

P.S. Last year at this time you would have been forgiven for thinking Bitcoin was taking over the financial universe. Today, things have changed dramatically. Prices for Bitcoin are down 79% in less than a year. There may be value in the innovative technologies that drive Bitcoin; but, as a currency, Bitcoin remains speculative and best avoided by retired and soon-to-be-retired investors.

P.P.S. The China Household Finance Survey run by Gan Li at Chengdu’s Southwestern University of Finance and Economics recently found that one fifth—that’s 20%—of Chinese homes do not have occupants. Instead, these homes are owned as investments in what could be one of the world’s most distorted markets ever.

Keeping in mind Chinese shares are already down over 20% (in yuan terms) in 2018, the country has had rocky trade relations with the U.S. That and the disturbing real estate statistics above makes it appear China has some problems. In 2012 my dad explained his bearish outlook on China:

I have long advised against direct investment in China. Among the many reasons I am bearish on China is the country’s vastly distorted economy. China is a command style economy run by an unelected political party—the Communist Party of China (CPC). The CPC’s policies have resulted in a grand misallocation of capital. A mercantilist currency policy, perverse incentives for provincial government officials, and crude monetary policy tools have helped inflate a fixed asset and real estate bubble that puts the U.S. real estate bubble to shame.

In our view, until and unless there is meaningful reform in China, direct investment in the country should be avoided.

P.P.P.S. According to the WSJ, some 15,000 financial advisors at Merrill have complained to management about a pay structure that encourages customers to take on more debt. This is possible because brokerages like Merrill are held to the low-bar “suitability” standard of client service. Boutique fee-only investment counsel firms like Richard C. Young & Co., Ltd. are held to the higher fiduciary standard. Fiduciaries must put clients first, and we always do.
Read this from Lisa Beilfuss in the WSJ about how Merrill advisers are pressured to push their clients to take on debt to maximize company profits:

Adding to tension within the Merrill ranks: Some brokers say they feel pressure to push Bank of America products, such as checking accounts, to wealthy investor clients. Merrill is the brokerage arm of Bank of America.

Advisers can make up lost compensation by acquiring new clients and doing more for existing clients. The catch, some brokers say, is that growing portfolios by pushing clients to take on debt can be easier than finding new assets.

Loans that are backed by a client’s investment portfolio are a particular favorite of brokerage firms, said Jeffrey Harte, a brokerage analyst at Sandler O’Neill + Partners. “It’s taking money that’s already there and making more money on it, versus the much harder job of going out and growing assets,” he added.

October 2018 Client Letter

When stock market volatility escalates, clients may ask what needs to be done with their portfolio. I explain that often minimal, if any, trading is required. Certainly, heading to the exits is not a strategy we favor. We did not overreact to the 2008 financial crisis, nor will we today. A knee-jerk reaction to movements in the market is most often the play of the amateur investor or the investor with no thoughtful guidance. Few things can be more stressful than fretting over your hard-earned savings amid a market correction.

Preferably, investment portfolios are crafted to reflect personal financial situations and tolerance for risk. Investing is both about making money and limiting your downside. Younger, working folk can naturally assume more risk. But as you get older, you need to look in the mirror and determine a strategy that is most appropriate.

The Right Strategy for Many Investors Who Are in or Nearing Retirement

For many, that strategy is a high-quality, balanced portfolio with the ability to endure a lifetime. High-quality means investing in businesses that can be expected to persevere through various business and economic cycles. Balanced refers to the inclusion of both stocks and bonds in the portfolio.

Yes, bonds appear boring, and yields have been low, but their counterbalancing characteristics can be critical. We all caught a bit of a break during the 2008 financial crisis. As ugly as it was, stocks rebounded quickly. I caution any investor assuming quick rebounds from a crash are the norm. Remember the dotcom crash? Particularly concerning about the era was how long it took for some stocks to recover. It took 13 years for the S&P 500 to fully put the damage of the dotcom bust behind it, and the Nasdaq didn’t reach a new high for 15 years.

Imagine if a similar correction and lengthy recovery period occurred today. How comfortable would you be waiting 15 years to get back to even while getting ready to retire, or while in retirement and drawing money each year to live? A bond component is one way to potentially mitigate significant losses during more unpleasant environments. When stocks go down, bonds will most likely hold their value, making them look a lot less boring.

You can also take comfort knowing that while the market may be down, you are still making money from your stocks by way of a healthy dividend yield. As you are probably aware, stocks pay a dividend based on the number of shares owned, not based on the share price.

Dividends are not like the interest earned on a bond or in a savings account. The interest from these is fixed; in other words, if you receive 3.5% on your bond this year, you will receive the same interest next year. Dividends from stocks, however, are not fixed. And while dividends can be cut, we focus on those with a history of being increased annually, ideally in all types of economic environments.

Stock markets are volatile, and volatility is typically one of the first things investors consider before investing. But perhaps equally or more damaging to investors is the threat of inflation. Annual dividend increases help offset the nasty effects of inflation.

Higher Dividend-Yields Not Always Better

The mistake many novice investors make when choosing dividend stocks is to focus on the highest-yielding companies. Yield is, of course, an important factor in dividend investing, but a high yield may indicate the dividend is not sustainable at current levels.

The last nine decades of stock market history show that, when you sort stocks into five groups based on yield, higher-yielding stocks outperform lower-yielding stocks. However, when you sort stocks into 10 groups based on yield to ferret out the highest yielders, you find that bucket ten, the highest-yielding 10% of stocks lags the performance of buckets eight and nine, the next two highest yielders.

Dividend Growth a Necessary Ingredient

Dividend growth is an important factor when selecting dividend stocks. At Richard C. Young & Co., Ltd. we craft global dividend portfolios focused on companies offering above-average dividend yields which also have records of making regular, annual dividend increases.

With Dividend Stocks, Stock Market Volatility is Less Worrisome

When you invest in companies that pay dividends and increase those dividends consistently, share price fluctuations become less worrisome and capital appreciation tends to take care of itself.

Consider the hypothetical example of a company offering a 3% yield today that is able to increase its dividend at 7% annually over the next decade. Assume an initial dividend of $3 today would imply a purchase price of $100. After 10 years of 7% growth, the dividend will have increased to $5.90 per share. What would investors be willing to pay for $5.90 of dividends from our hypothetical firm? All else equal, probably something close to $196 per share, which equates to a 3% yield on the $5.90 dividend.

Now, of course, everything else is not always equal. Ten years from now, the economic environment could change, or the company could run into trouble. But when you put together a portfolio of firms offering solid dividend yields and solid dividend-growth prospects, you stack the odds of success in your favor.

That’s the strategy we pursue for you at Richard C. Young & Co., Ltd. The dividend yields of the firms we purchase vary, and the growth rates are merely projections, but the concept is the same: Buy dividend-payers that make regular dividend increases, remain patient, and allow capital appreciation to take care of itself.

Solid Dividend-Payers

Johnson & Johnson:

For 130 years, Johnson & Johnson has been innovating solutions to health care problems. Robert Wood Johnson began tackling medical problems as a pharmacist’s apprentice during the Civil War. With breakthroughs from Louis Pasteur, Joseph Lister, and Robert Koch in medicine coming shortly thereafter, Johnson was in the midst of a revolutionary time. In 1873, Johnson and his partner, George Seabury, founded a medicated plasters company, which grew quickly. After achieving success with Seabury, in 1886 Johnson began a new business with his two brothers, Johnson & Johnson. From there the company went on to achieve success in innovation and production of medical supplies, equipment, technology, and pharmaceuticals that would power an unbroken 74-year streak of dividend payments, which includes the 15^th-longest record of consecutive annual dividend increases: 53 years counting. JNJ yields 2.55% today with strong, dependable cash-flow streams.

ExxonMobil:

Colonel Edwin Drake and Uncle Billy Smith sound like two characters from an episode of Green Acres; but those are the real men who drilled the first successful oil well in Titusville, Pennsylvania, in 1859. The result was an “oil rush,” leading to the 1870 creation of the oil market giant Standard Oil by John D. Rockefeller. In 1911, the U.S. Supreme Court broke Standard Oil into 34 pieces, including Jersey Standard, which would become Exxon in 1972, and Vacuum Oil, which became Mobil Oil in 1966. In 1999, Exxon and Mobil merged, forming Exxon Mobil Corp., reuniting two of the original pieces of Standard Oil. In its lineage formats, ExxonMobil has been paying a dividend each year since 1882, with an unbroken record of annual dividend increases dating back 35 years. Shares of XOM yield over 4% today.

Lowe’s:

This home improvement giant is a Mergent Top 10 dividend-increasing powerhouse, with the ninth-longest record of consecutive, annual dividend increases, stretching for 56 years straight. After being founded in 1946 as a small hardware store in North Carolina, the retailer has paid a dividend since it first went public in 1961. Lowe’s growth can be credited to Carl Buchan, brother-in-law and partner of Lowe’s founder, James Lowe. Early on, Buchan bought out Lowe and implemented his vision of a hardware store chain capable of feeding America’s post–World War II building boom. The company has grown from offering tiny neighborhood hardware stores to 103,000-square-foot stores in larger markets. Over the last 10 years, Lowe’s has increased its dividend at an average annual rate of 19.31%.

Cracker Barrel Old Country Store:

In 1969, Dan Evins opened the first Cracker Barrel Old Country Store in Lebanon, Tennessee. With cornbread made from scratch, the company worked hard to create an atmosphere of warm hospitality and homestyle cooking. Despite Cracker Barrel’s focus on the little things, Evins began expanding in 1977, with 13 stores across the South. It turned out people across the country liked the way Cracker Barrel is run, and the restaurant chain now has 656 locations across 45 states. Cracker Barrel has paid dividends since 1972 and has increased dividends over the last 10 years at an average rate of 22.86%. Shares of CBRL yield over 3% today.

Visa:

In 1958, Bank of America created a credit card for the masses. It had a $300 limit and was made of paper. In 1973, what had become National BankAmericard launched the first electronic authorization system, along with an electronic clearing and settlement system. This would be the basis for a payment revolution. By 1976, Visa was born, and by 2001 had one billion cards held by consumers. In 2008, Visa began trading on the New York Stock Exchange. Today the company has 3.3 billion cards in use and processes over 173 billion transactions in a year through VisaNet. Visa has paid a dividend every year since it went public. That dividend has compounded at a rate of over 20% over the last five years.

The Bond Environment

Markets are volatile. We all know this. What tends to be more troubling these days are the wild fluctuations. We went from no volatility in 2017 to some whipsawing in the first quarter of 2018 to a relatively good summer and early fall to a turbulent October.

The main market-related headlines we read today include the trade war with China, the Fed, and the election cycle. What tends to receive some attention but hardly falls into the camp of being over-reported is the rise in longer-term rates.

The rise in longer-term rates is a significant development. In October, we woke up in the morning and had the benefit of reading the following headline in the WSJ: U.S. Government 10-Year Note Yields Climb to Seven-Year High. Now, granted, the use of the word “high” in the headline is a description to be viewed loosely, as the yield climbed up to 3.22%. Nonetheless, progress is being made. It’s beneficial to us all if we can see the yield on full-faith-and-credit-pledge Treasuries get back to more normalized levels.

Jamie Dimon, CEO of the world’s largest bank, thinks 10-year Treasury yields could reach 5%. A 5% 10-year yield could do wonders for retired investors and those nearing retirement. In corporate bonds, we are finding some attractive bonds with yields of over 4%. A 5% yield on at least a portion of your fixed-income portfolio may soon be within reach.

Have a good month. As always, please call us at (888) 456-5444 if your financial situation has changed or if you have questions about your investment portfolio.

Warm regards,

Matthew A. Young
President and Chief Executive Officer

P.S. Brazil has a new president. Jair Bolsonaro won Brazil’s run-off election 55% to 45%. Bolsonaro is a hard shift to the right for Brazil. The Brazilian real has rallied sharply on the news. Interest rates are down and the stock market is up. It remains to be seen how much Bolsonaro can get done, but we are encouraged by the news. Brazil is the second-biggest economy in the Americas.

P.P.S. Counterbalancing. Gold is still down year to date, which is not surprising given the strong economy, a strong dollar, and rising interest rates. But did you notice what happened to your gold position in the past month? As most stocks were declining, GLD actually rose almost 3.5%.

P.P.P.S. This has been one of the longest economic expansions on record. At some point, the cycle will end. Recent price action in the stock market—including weakness in interest-sensitive sectors, transportation stocks, industrial shares, and weakness in foreign markets—sends signals of caution. On the flip side, the economic data remains strong, sentiment is hitting record highs, and wages are beginning to rise. We are watching carefully for signs of weakening in the data.

P.P.P.P.S. While P&G is down on the year, it was nice to see its share price rise 7.5% during the month of October when the S&P 500 fell 6.84%. Procter & Gamble has increased its dividend every year since 1955. Over the last decade, the dividend has compounded at 7.25%. Investors buying shares today are earning a yield of 3.25%.

P.P.P.P.P.S. Each year, Barron’s ranks the nation’s top independent advisors. Richard C. Young & Co., Ltd. was again recognized on this list, appearing for the seventh consecutive year.

September 2018 Client Letter

The 2008/2009 global financial crisis destroyed almost $12 trillion of America’s net wealth. Measured globally, the figure was much larger. Many households and businesses saw their net worth cut in half, or worse. Wealth that had been accumulated over years of diligent saving and investment was annihilated in a matter of months.

The S&P 500 fell over 56% from its high in October 2007 to its low in March 2009, but most of those losses came in the final six months of the crash. At its March 2009 low, the S&P 500 had wiped out its gains of the prior 13 years.

What followed was the deepest economic recession since the Great Depression. Unemployment soared, residential and commercial real estate prices collapsed, bankruptcies rose, and home foreclosures shot through the roof. Most Americans had never experienced such a scary environment.

Recessions that stem from financial crises tend to be the deepest and last the longest. The Great Depression lasted for over a decade, Japan is still feeling the effects of its real-estate and stock-market collapse almost three decades later, and it took years for the U.S. economy to recover from the ‘08/’09 market crash.

Financial crises aren’t the only events that can destroy wealth. The dotcom bust, which was associated with a mild recession, devastated the savings of many investors who were hypnotized by the drum beat of positive media over new economy stocks. The relatively benign impact of the dotcom bust on the economy was partly due to the fact technology shares were not owned as widely as homes, and there was much less leverage associated with tech stocks.

It is also true that, while the tech-heavy Nasdaq plummeted 78% in the dotcom bust, not all stocks fared so poorly. The Russell 2000 Value index of small companies was up 20% in 2000 and 11% in 2001, while the Nasdaq was down 39% and 21% in those years.

The biggest losers of the dotcom bust were investors who allowed their portfolios to become overly concentrated in Nasdaq-type stocks. Little thought was given to diversification and portfolio construction by this crowd. While few escaped unscathed from the dotcom bust, investors who properly diversified their portfolios across sectors and styles, and included bonds, fared much better.

Risk Management is Paramount

In investing, diversification is a central tenet of risk management. Over the years, my dad has written often about risk management. In 1997, he explained the importance of risk management to readers:

When the difference between life and death can be counted in milliseconds, you need every advantage you can get. Which is why SureFire developed its Special Operations series [flash light] to be the best extreme-duty tactical illumination tool in the world.

Risk Management Defined

When SureFire asked operators what they wanted, the company was told a light that could survive a halo insertion or a midnight raid on a crack house. Operators wanted SureFire to deliver a light bright enough to find and blind suspected adversaries. SureFire handhelds can be used as non-lethal “force options.” As the company likes to say, “Shine a SureFire in a suspect’s eyes, and he’s out of the fight.” The company understands that you might not be a Special Forces operator hunting for terrorists in an Afghanistan cave to benefit from the retina-searing white light produced by the 500-lumen M6 Millennium. And you may not need a SureFire weapon light for your Heckler & Koch, Colt, or SIG submachine gun, but, then again, you may. But Special Forces operators around the world take dead aim with SureFire illumination tools as the ultimate in risk-management tools.

Invest for Consistency

Every Special Ops fighter knows that on any mission risk management is the first order of duty. It’s a basic military tenet that also works as a basic financial tenet. Why then do so few investors seem to know anything or care about risk management? Usually because of (1) greed, (2) lack of training, and (3) pressure from salesmen, who account for most of the assets held by individual investors. I’m often shocked when I hear what an investor owns in his or her retirement portfolio. For the most part, investors own portfolios of securities that have been sold to them. It’s true. There’s no way to sugarcoat the deal: Most investors simply own a pile of rubbish.

For four decades, I have been a consistently successful investor, practicing my basic investment tenet of diversification and patience built on a foundation of value and compound interest. I’m sure you can dig up folk who will at least tell you that they make more money than does Dick Young. Perhaps this is the case, but my conservative, balanced approach is suitable for investors who want to avoid debacles and emerge from the investment wars with a comfortable nest egg in retirement.

Unmanaged Risks Lurking in Some Portfolios

Two potential big risks we see lurking in the portfolios of some investors today are too much exposure to stocks and an overconcentration in certain segments of the stock market. Years of zero interest rates have no doubt caused some investors to reach for return by over-allocating to equities. But stocks aren’t a one-way bet. Should the stock market experience another 50% plus drop, as it did twice in the last 20 years, over-allocated equity investors will suffer.

Concentration risk is also becoming an issue. The high-flying FAANGs are a contributor, but so are the proliferation of market-cap-weighted index ETFs and mutual funds in retail investor accounts. An Index500-stock portfolio, by example, may give the impression of diversification, but only a handful of names and one or two sectors drive most of the performance in the market-cap-weighted S&P 500.

In our January 2000 client letter, we wrote about the concentration risk of the S&P 500.

The S&P 500 was up 19.5% for the year [1999], but just seven names—Microsoft, Cisco, GE, Wal-Mart, Nortel Networks, Oracle, and AOL—accounted for 50% of the S&P’s total gain. In fact, the S&P 500 had more losers than winners last year: 54% of the 500 stocks were down. And, on the NYSE, only 38% of stocks listed had gains for the year.

Nortel and AOL are long gone, and Microsoft and Wal-Mart took more than a decade to regain their dotcom-era highs.

You have read similar statements from me over the last year on how the performance of just a handful of big, and in some cases speculative, names are driving the performance of the S&P 500. I’m not forecasting a similar fate for the handful of stocks driving the S&P 500 today, but the possibility of such a scenario should not be ruled out.

How We Manage Risk for You

How do we look to maintain the proper asset allocation and manage overconcentration risk in your portfolio?

We craft globally diversified balanced portfolios of individual securities (almost entirely) for our clients and monitor the allocations of those portfolios continually. The ongoing monitoring is vital to risk management. Allocations can shift widely over time as stock and bond markets fluctuate. As a basic example, consider a 50/50 portfolio comprised of the S&P 500 and the Bloomberg Barclay’s Aggregate Bond Index. If you purchased that portfolio at year-end 2009 and never rebalanced, you would now have a portfolio that is 70% stocks and 30% bonds. You would also be nine years older today, which might demand an even more conservative asset allocation than your starting 50/50 portfolio, yet the risk profile of your portfolio has increased.

The necessity of having a portfolio rebalancing strategy should now be established wisdom. Rebalancing cuts risk and may even boost return. But for many, rebalancing is the chore that never gets done. What to sell, when to sell, how many positions to sell, which accounts to sell in, and tax considerations, are all questions that must be answered.

We, of course, take the hassle of rebalancing away from you. We don’t employ the set-in-stone monthly/quarterly rebalancing strategies that so many in the industry seem to favor. Nor do we bother with minor deviations in portfolio allocation. Stocks and bonds need room to breathe. Our approach seeks to reduce risk while integrating our investment strategy and minimizing taxes and transaction costs.

The Health-Care Tailwind

Last month I profiled the defensive nature of the consumer-stock sector. The health-care sector shares some defensive traits with the consumer staples sector. In addition, the aging of America’s population is a powerful secular growth tailwind for the health-care sector. It’s no secret that as people get older they demand more health-care products and services, and America’s population is aging rapidly. Census Bureau data shows that in 2020 nearly 55 million Americans will be aged 65 and over. By 2030 that number will jump to over 72 million, a 30% increase in just 10 years. Americans over 65 will represent 19.3% of the country’s total population, a record high.

Many of America’s elderly are already on medications, and the numbers will likely increase as the country’s cohort of elderly citizens grows. In a 2015 study, the CDC reported that 40% of Americans 65 years and over were on five or more prescription drugs. About 65% were on three or more. And 91% were on at least one.

This striking reality appears to bolster the case for investing in the health-care industry. We target health-care companies with strong records of regular dividend payments and attractive yields. Merck is a company on our current buy list and one held in many portfolios via the Fidelity and Vanguard Healthcare ETFs. Merck has paid a dividend since 1935, and its yield of 2.7% today is more than twice the yield of the broader health-care index.

Making Merck

In 1668, Jacob Friedrick Merck acquired Angel Pharmacy in Darmstadt, Germany, and began the Merck family pharmaceutical business. In 1853, the business, known as E. Merck, made one of its first forays into America at the World Exhibition in New York City. In 1887 the company opened its own New York City branch. In 1891, George Merck traveled from Germany to New York to oversee the newly formed Merck & Co., a standalone firm built from E. Merck’s American operations. In subsequent years, Merck produced groundbreaking medicines, including the first diphtheria antitoxin, a smallpox vaccine, a bubonic plague vaccine, and more.

Merck was a large supplier of medicines and vaccines to the military during both World Wars, alongside Sharp & Dohme, another major pharmaceutical company with which Merck merged in 1953. In the same era, Merck began producing medicines for animals, opening up its business to the large market for agricultural health-care products.

Modern-Day Medicine

Later, Merck would begin producing consumer products, and they continued to roll out drugs such as Sinemet and Pneumovax and vaccines like MR-II and Deptavac-HVT. In more recent years, Merck has developed breakthrough medications and vaccines like Gardasil and Keytruda.

Today, Merck operates in over 140 countries, with approximately 69,000 employees. In 2017, Merck spent $7.3 billion on research and development and generated over $40 billion in revenue. The company’s core areas of focus today include diabetes, infectious diseases, oncology, and vaccines. Merck is also innovating in animal health, with efforts aimed at livestock, companion animals, and aquaculture.

Have a good month. As always, please call us at (888) 456-5444 if your financial situation has changed or if you have questions about your investment portfolio.

Warm regards,

Matthew A. Young
President and Chief Executive Officer

P.S. Pipeline shares have made a comeback over the last six months. Since March 31st, the Alerian MLP index has gained 18.7%, including dividends. Year-to-date, the Alerian MLP index is up 5.34%. Higher oil prices, more clarity on a FERC ruling that hurt the stock price of many pipelines earlier in the year, more favorable sentiment, and less new-equity supply have helped the sector. With yields approaching 7%, we continue to favor MLP pipelines.

P.P.S. Chinese real estate remains a looming risk to the global economy. Marketwatch recently reported Chinese real estate sells for $202 per square foot—a 38% premium to the median price per square foot in the U.S. despite the fact the U.S. has income per head that is more than 700% higher than in China. Rental yields of 1.5% aren’t supportive of Chinese real estate prices, nor are the vast number of vacant apartments. Prices are being supported by the greater-fool theory of investing. Sooner or later, that will end. And when it does, the mop-up will likely be unpleasant.

P.P.P.S. Residents of high-tax states are preparing to face a reckoning in 2019. Changes made to the tax code last year capped their ability to deduct state and local taxation from federal tax returns. That means high-income earners in high-tax states could now pay much more each year.
High-income earners have been fleeing high-tax states for years, but Chris Edwards of the Cato Institute explains the trend could continue given the new tax burden placed on those filers. He writes:

High earners are the hardest hit by the new tax cap, and the IRS data show that they were already moving to low-tax states. For the 25 highest-tax states, the average migration ratio for those earning more than $200,000 was 0.84, meaning large net out-migration. For the 25 lowest-tax states, the average ratio was 1.37, meaning large net in-migration.
New York had the lowest ratio for high earners at 0.49, while Florida had the highest at 2.62. High earners love Florida’s lack of income and estate taxes, and there has been a steady stream of high-paying financial firms moving to Florida from the Northeast for that reason.

August 2018 Client Letter

Not long ago, Wall Street’s favorite acronym was BRICs (Brazil, Russia, India, and China). The BRIC countries were hyped by many of the big brokerage firms as an investment opportunity with profound promise. As a group, the BRICs were believed to have attractive natural resources, a young overall population, and years of robust growth ahead.

Did the BRICs live up to the hype?

The following chart shows the performance of the MSCI BRIC Index. The BRICs have suffered a lost decade. The MSCI index peaked in 2007 and remains more than 30% below its high. My second chart shows the Google Trends chart for the search terms “BRICS Countries” and “FAANG stocks”. FAANG is the favorite acronym of many investors today—it refers to Facebook, Amazon, Apple, Netflix, and Google.

Google Trends chart for “BRICS Countries” (blue) and “FAANG stocks” (red)

The FAANGs have had an impressive run; but, if popularity was predictive of future performance, The New York Times would have a best-sellers list for stocks. Investing is rarely intuitive. Great companies and great growth stories don’t always make great investments. More often than not, we find the most compelling opportunities in companies and sectors that are unloved, out of favor, and underappreciated.

Cycles are Part of the Territory

Savvy investors recognize stocks, bonds, foreign economies, and even currencies go through cycles. Cycles vary in duration and magnitude. Some end quickly, while others extend far beyond their natural expiration date.

We craft portfolios with the understanding cycles are part of the territory. Some assets in a given portfolio are likely to be in an up cycle, while others are in a down cycle. Year-to-date, the S&P 500 health-care sector is up double digits, while the S&P 500 consumer staples sector (even after a solid three-month rally) remains in the red.

In relative terms, consumer staples stocks are in a down cycle, while health-care shares are in an up cycle. But just because an asset is in a down cycle doesn’t mean it should be sold. On the contrary, down cycles often sow the seeds of future opportunities.

Consumer staples shares have long been among our most favored areas of the stock market. The defensive nature of their businesses helps staples stocks hold up better during recessions than more cyclical businesses. Toilet paper, toothpaste, breakfast cereal, and groceries aren’t the most glamorous products, but they are purchased in good times and bad. The reliable nature of demand for toilet paper and toothpaste, by example, allows staples companies to offer investors consistent dividend growth regardless of the current position of the economic cycle. In fact, more than a dozen consumer staples companies are members of the Dividend Aristocrats club, which is comprised of companies that have increased their dividends for at least 25 consecutive years.

What companies do we favor in consumer staples today? We recently added Kroger to some portfolios, and Walgreens remains one of our favored consumer staples stocks.

Walgreens Opportunity

Amazon’s recent acquisition of PillPack sent a chill down the spine of some Walgreens investors; but, while Amazon is likely to take some market share in the retail pharmacy space, the threat may be overblown. A recent Marketwatch article put numbers to the story.

Americans currently spend $450 billion a year on drugs. Walmart is the fourth-largest pharmacy in the U.S., with sales of $21 billion, or 4.6% of the company’s total sales. Let’s say that over the next five years Amazon gets to Walmart’s sales level of $21 billion. If the U.S. pharmaceutical industry grows 2% a year over that time, total drug sales will have increased by $45 billion, or the equivalent of two Walmarts (we are ignoring compounding here), to $495 billion. Walgreens, with its pharmacy selling about $70 billion a year, would barely notice Amazon’s presence.

Walgreens’ U.S. business, which is about 75% of its total sales, is impressive. A single stand-alone store produces revenues of about $10 million a year—$7 million in the pharmacy and $3 million in front-end sales (milk, candy bars, T-shirts, etc.) A single store fills about 121,000 scripts a year (up from 97,000 four years ago). Walgreens has one of the highest sales-per-square-foot numbers in the retail industry, at around $1,000 per-square-foot.

Investors can purchase shares of Walgreens today for 11.6X next year’s estimated earnings. Walgreens offers a dividend yield of 2.54%. The dividend is up 10% over the last year, and we expect a similar size increase next year. Walgreens also returns billions to shareholders via buybacks. Over the last 12 months, Walgreens repurchased $6.1 billion in shares, reducing the number of outstanding shares by more than 7%. In June the company authorized an additional $10-billion-share-buyback plan, so investors should anticipate continued share buybacks.

Kroger

Kroger is a grocery company founded in Cincinnati in 1883. Kroger grew quickly, opening over 100 locations in its first 25 years. The business also innovated, becoming the first grocer to put a butcher shop inside the store for convenience. Today Kroger is America’s largest grocery company and operates nearly 2,800 supermarkets in 35 states, 269 fine jewelry stores, 38 food manufacturing facilities, 1,522 supermarket fuel stations, and 2,274 instore pharmacies. Now Kroger is taking its strategy overseas by partnering with China’s largest online retailer, Alibaba. With the new deal, the grocer will gain access to over 500 million consumers for its private-label brands. Kroger has proven its commitment to shareholders by increasing dividends in each of the last 11 years.

5% Treasury Yields

Jamie Dimon, the CEO of America’s biggest bank, recently warned about 5% Treasury yields. While “warned” may be strong, Mr. Dimon believes the possibility of 5% Treasury yields is greater than many assume.

We would welcome a 5% Treasury yield. In fact, while many investors are focused on new highs in the stock market, we continue to cheer on rising interest rates. Short-term Treasury rates are now over 2.5%, and short-term corporate bond rates are over 3%. Long-term Treasury rates are also up over the last year, but not nearly as much as we would like to see.

The following table puts some context around the rise in interest rates across the yield curve. If short- and long-term rates increase by similar percentage amounts over the coming 12 months, income investors will be back in business in a major way. An almost 4% 10-year Treasury rate could mean 5% plus yields on comparable-maturity corporate bonds. And, if Jamie Dimon is right and we see a 5% 10-year Treasury rate, 6% plus corporate bond yields may be in your future.

What’s Going on with Gold?

After posting double-digit gains in 2017, gold has retreated this year. This should come as no surprise. In fact, the surprise should have been last year as gold did so well given the relatively poor environment. Gold does best in periods of fear, panic, unrest, or inflation. Last year was a rather calm year, which should not have favored the metal. This year, economic growth remains strong, interest rates are rising, and the dollar is strengthening. Not the best mix for gold. Gold is a counterbalancing asset. We own gold in client portfolios because gold may rise when stocks fall, or bonds fall, or stocks and bonds fall. Counterbalancing is, of course, the basis of crafting a diversified portfolio.

In the August 2013 issue of The Intelligence Report, my dad had this to say about counterbalancing.

Managing a common stock portfolio takes—above all else—patience. Your goal should never be what to sell next; rather, it should be what stocks you can hold through thick and thin. It is true that portfolio activity, for most investors, runs inversely to consistent long-term performance. How should you measure performance and how should you construct an all-weather portfolio?

First, “all-weather” means you do not want to be jumping in and out of the market attempting to predict bull and bear markets. For five decades, I have been investing my own money as well as advising conservative investors saving for retirement. As such, I have invested through many gut-wrenching bear markets and disastrous single years like 2008, which ended with the speculative non-dividend-paying NASDAQ down a frightening 40% for the year. Through all the years of turbulence, I have remained fully invested in a balanced, widely diversified securities portfolio featuring a counterbalanced approach.

I have firsthand experience of what happens when counterbalancing is not in force. The Harleys I rode back in the old days had engines bolted straight to the frame. Talk about vibration and calamity. The constant vibration caused nuts and bolts to loosen and fall off. When you’re on a long-distance road trip, a breakdown in the middle of nowhere is cause for concern. I have found myself in just such a situation and it’s no fun. Today’s Harleys feature counterbalanced engines offering both a smooth ride and a minimum of road trip calamities.

Counterbalancing simply makes common sense. Let’s look at 2008 as a test kitchen. All the broad averages got hit. High ground, so to say, was achieved by owning positions that got hit least. Consumer staples worked well; no matter how bad the times, investors are not going to forsake toilet paper, toothpaste, or their prescription drugs from Walgreens or CVS. Intuitive common sense, is it not? Well, in ’08, Vanguard Consumer Staples Index (VDC) fell by 16.6%, versus a 37% clipping for the S&P 500. You won big by going with the common-sense approach that was Vanguard Consumer Staples. So, what else worked in the 2008 debacle? The 60/40 balanced Wellesley Income Fund declined by only 9.8% before quickly rebounding, gaining over 16% in 2009 to wipe out all the 2008 bad memories in one fell swoop.

For various reasons, we have moved on from most ETFs and open-end mutual funds (a few exceptions remain), but the concepts my dad outlined above still apply. Instead of relying on the fund approach, we invest in a diversified portfolio of individual bonds and individual stocks. Our portfolios have similar characteristics to Wellesley, given our focus on blue-chip bonds and large-cap, dividend-paying, blue-chip stocks.

Have a good month. As always, please call us at (888) 456-5444 if your financial situation has changed or if you have questions about your investment portfolio.

Warm regards,

Matthew A. Young
President and Chief Executive Officer

P.S. Even for a government program, Social Security is complex. Many soon-to-be-retired Americans have misconceptions about what Social Security will and won’t do for them. In a recent post on its website, https://www.fidelity.com/viewpoints/retirement/social-security-myths, Fidelity debunked five common Social Security myths. Here is a much-abridged version of a few of my favorites from the post.

Myth #1: You must claim your Social Security benefit at age 62: Many people are adamant that Social Security benefits must begin at age 62. This is a myth: 62 is the earliest age you can claim your benefit, but it’s not the only age.

Myth #2: You can claim early, then get a “bump up” once you reach full retirement age: Many believe there is a “bump up” or “added income” once they reach their full retirement age. They’ve heard they can claim early at 62, then when they reach 66 or older, their checks will increase to the amount that corresponds to their full retirement age benefit. That’s a big misperception.

Myth #4: Your benefits are only based on wages that you’ve earned before age 65: Your benefit is calculated based on your highest 35 years of earnings; they do not have to be consecutive years or before age 65.

P.P.S. Last month I told you that perhaps the greatest risk-factor facing investors today is the outcome of the elections in November. That still holds true. Constant negative media stories regarding the president are adding uncertainty to the process of predicting an outcome in November. The number of Americans who feel that the country is headed in the right direction continues to trend upward, but polls also show Americans harboring a deep dissatisfaction with Congress. The president’s personal approval ratings have been stable over the last month, but during that time polls asking Americans whether they would vote for a hypothetical Republican or Democrat in November have been volatile, though they trend in Democrats’ favor.

In the close-to-home proxy race I’m watching in Florida, Governor Rick Scott has managed to slightly outpace Senator Bill Nelson in polls. Florida’s diverse population and multiple big-media markets make it a nice bellwether for American elections. If the race for Senate in Florida is any indication, this election season will come right down to the wire.

P.P.P.S. The physical benefits of regular exercise have been known since even before the codification of the principles of yoga in 600 BC. It is also commonly thought that physical activity helps clear the mind. Now researchers have performed a survey that gives some scientific weight to that idea. Sumathi Reddy reported on the research in The Wall Street Journal:

Researchers rated mental health based on a survey. It asked respondents how many days in the previous month their mental health was “not good” due to stress, depression or problems with emotions.

People who played team sports like soccer and basketball reported 22.3% fewer poor mental-health days than those who didn’t exercise. Those who ran or jogged fared 19% better, while those who did household chores 11.8% better.

In a secondary analysis, the researchers found that yoga and tai chi—grouped into a category called recreational sports in the original analysis—had a 22.9% reduction in poor mental-health days. (Recreational sports included everything from yoga to golf to horseback riding.)

P.P.P.P.S. The WSJ recently penned a downbeat article on Exxon. We own Exxon in many portfolios and continue to purchase it. We believe Exxon’s dividend is the most secure of all the major oil companies, and the company has a good record of dividend growth. Exxon also has a strong balance sheet—a necessity in a cyclical, capital-intensive business. We view Exxon as the most conservative of the major oil producers, and it generates the highest average return on capital. While Exxon may lag when oil prices are on the rise, it tends to fall less when oil prices drop. Today Exxon shares yield 4.1%.

July 2018 Client Letter

Federal deficits and debt are a perennial worry for many investors, but while a burgeoning U.S. government is a long-term problem, public finance at the state level may be the more immediate concern. The Wall Street Journal recently ran a feature highlighting the troubling condition of state budgets.

Even nine years after the last recession, many state budgets still haven’t fully recovered. Soft revenue growth (partly due to the Amazon effect) and heavy pension and Medicaid costs have weighed on state finances. The WSJ reports 21 states had a rainy day fund last year that was smaller as a share of spending than it was in 2008. Because most states don’t run deficits, rainy day funds are necessary to fill the void during economic downturns. New Jersey emptied its rainy day fund in 2009 and hasn’t refilled it. Oklahoma’s rainy day fund is 1.6% of spending today, compared to 9.3% in 2008.

New York is another state unprepared for a downturn. The WSJ reported “The New York State Comptroller Thomas DiNapoli warned that the state badly needed to replenish its reserves. New York will face budget shortfalls, reduced borrowing capacity and possible cuts to federal aid, he said in a report. ‘Yet, there are no plans to add to our reserves, leaving the state with little cushion in the event of an economic downturn,’ he said.”

In 2009, total revenue at the state level fell 11%. States that haven’t prepared for the next downturn by replenishing their reserves are likely to face ugly choices in the future.

Preparation is Key

Whether dealing with public or personal finances, preparation is vital to make it through volatile periods. Unfortunately, when analyzing the state of the investment industry today, it appears many individuals are not prepared for the next crisis.

As a share of their liquid assets, households have only had this much invested in equities twice before—once during the tail-end of the dotcom bubble and again just before the financial crisis. Neither instance turned out well for investors.

But the allocation to stocks isn’t the only indication of a poorly prepared investing public. Index-based ETFs have become the preferred investment choice for many retail investors and even financial advisors. There was a time when index-based products comprised a meaningful share of our clients’ assets, but that is no longer the case. The environment has changed and so has the S&P 500—the most widely tracked stock market index.

Is the S&P 500 Diversified?

The S&P 500 is invested across 500 different companies, but a handful of the biggest ones dominate the index. Apple, the largest stock in the index, matters more to the S&P 500 than the aggregate of the bottom 100 stocks. And the top five stocks have a combined weighting in the index well over the total of the bottom 250 names. Sound like diversification to you? There are only a handful of companies steering the ship. You can see it in the YTD performance of the S&P 500. The FAANGs plus Microsoft account for 99% of the index’s YTD return.

The makeup of the S&P 500 has also changed over recent decades. In the early 1990s, defensive sectors accounted for 35%–40% of the S&P 500. That figure drifted lower during the 1990s, but over the last two years the decline has accelerated sharply and sits at a mere 16% today.

If the S&P 500 was able to fall more than 50% during the last two big bear markets when defensive stocks were a greater share of the index, what happens during the next big bear market?

The biggest sector in the S&P 500 today is technology. During the dotcom bust, the S&P 500 technology index plunged 83%, eviscerating the savings of millions of investors loaded to the gills with technology shares.

According to the most recent Bank of America Merrill Lynch Fund Managers Survey, the most crowded trade on Wall Street today is big technology stocks.

Unsuspecting index-based ETF investors may have an unpleasant surprise in store during the next market downturn. That seems to be the opinion of Jim Rogers. Rogers was the co-founder of the Quantum Fund, one of the most profitable hedge funds on record. Rogers expects the next bear market to be “horrendous”—maybe even the “worst”—and he thinks ETFs could collapse more than anything else because that’s what everybody owns. ETFs are of course supposed to trade near the underlying value of their assets, but during sharp market moves we have seen prices diverge widely from the underlying value of those assets.

How is Your Portfolio Prepared for the Next Downturn?

As you are of course aware, we don’t invest in mutual funds or ETFs based on the S&P 500 index. We craft conservative portfolios comprised of companies that pay and increase their dividends. Our approach is defensive and global in nature. We are focused on meeting your goals and objectives, not on the performance of a tech-heavy index we view as inappropriate for retired investors and those approaching retirement. As a result, the portfolios we manage for our clients have as much as 40% invested in defensive sectors of the market. But even in the less-defensive sectors, our dividend-focused approach favors the more defensive end of the spectrum.

Take Lowe’s, by example. Lowe’s is in the consumer discretionary sector. Most discretionary stocks are sensitive to the business cycle. When the economy enters recession, consumers tend to delay big purchases and stick with the necessities. Remodeling activity undoubtedly slows during recession, and Lowe’s revenue and profits tend to fall as well. But compare Lowe’s, with its history of paying and regularly increasing its dividend, to something like a mall-based fashion retailer. Recession can mean ruin for some of the fly-by-night mall-based retailers.

Choose Your Investments Wisely

For most Americans, retirement is a giant and often scary leap into the unknown. In your working years, the occasional investment mistake can be taken in stride. There is time to get back on track or add to your savings to make up for misguided investment decisions. In retirement, the margin of error is smaller. You no longer have a steady stream of income to rebuild your savings. If you make a major mistake in retirement, you may not have a chance to recover. Retired investors often need their nest egg to last for the rest of their life, and their spouse’s. For a 65-year-old couple retiring today, the probability of at least one partner living to 90 years old is 49%, and the probability of one partner living to 95 is 23%.

A lot can happen over three decades. For starters, you can count on living through multiple recessions and bear markets. And if you are unlucky, you may retire at the start of a period of accelerating inflation. Investors who retired at year-end 1965 had to deal with a three-decade period that slashed the purchasing power of their dollars by 80%.

Investors who don’t prepare their portfolios properly may face the nightmare scenario of running out of money in retirement. The task is doubly difficult in today’s low-interest-rate environment. We help our clients craft portfolios designed to provide a reliable retirement income for decades, through bull markets, bear markets, low-interest rate environments, high-interest rate environments, economic expansions, and even recessions.

Fear of the FAANGs

The market’s obsession with Amazon and other FAANG stocks is telling: The mere rumor of a FAANG entering a new industry can shave 10% off the price of a company in that industry. The most recent victims of Amazon’s gaze appearing on our radar were the pharmacy stocks.

Amazon recently acquired a company called Pillpack, an innovative little firm that prepackages medicines for consumers who take multiple drugs regularly. The big pharmacy stocks sold off on the news that “big-bad” Amazon is entering their business, but in our view, there is much less to be concerned about than meets the eye.

Selling prescription drugs is very different from selling Amazon Kindles. A quick review of the Pillpack website shows just that. It takes 10 to 15 minutes to simply sign up. There is insurance that needs to be dealt with, regulation, pharmacy benefits managers, and back and forth between doctors and pharmacies when drugs are prescribed.

Is Cellophane a Competitive Advantage?

There will also be a competitive response to Amazon’s acquisition. PillPack’s idea to package multiple medicines together was a good one, but is cellophane really a sustainable competitive advantage? How long do you think it will take CVS and Walgreens to offer the same service? CVS is also in the process of merging with health insurer Aetna. Guess which insurer probably won’t include PillPack in their pharmacy network.

The share-price performance of the two big pharmacies is unfortunate if you are a value-conscious investor. The pharmacy stocks are among the most attractively priced in the market today. But overreaction to Amazon and other FAANGs isn’t an unfamiliar story.

Take retail shares, for example. The performance of the SPDR retail ETF over the last 12 months is instructive. The SPDR Retail ETF was down as much as 25% from its 2015 high (with many individual retailers down much more) on concern Amazon would bankrupt every brick and mortar business in America. Sentiment on the sector was rotten last summer and fall, but from its lows of last year the SPDR Retail ETF is up 30%, and many individual retailers are up much more.

Or take W.W. Grainger. Grainger is in the industrial supply business. They have a big online presence, and Amazon is gunning for them. Grainger even had to cut prices to stay competitive. The stock was down as much as 33% last year during the height of the concern, but the share price has more than doubled since then and now trades at a new high. Amazon is a much more serious competitor to Grainger than it is to the big pharmacies.

We anticipate a similar sentiment reversal in shares of CVS and Walgreens and continue to pursue other opportunities where investors overreact to FAANG news.

Have a good month. As always, please call us at (888) 456-5444 if your financial situation has changed or if you have questions about your investment portfolio.

Warm regards,

Matthew A. Young
President and Chief Executive Officer

P.S. The promise of lifetime income associated with annuities may sound tempting to retired investors and those approaching retirement, but if you bother to read the details of an annuity contract, the appeal can wear off quickly. I often hear about annuities that offer 6% or 7% returns. A “guaranteed” 6%-plus return in an environment where Treasuries offer 3% sounds too good to be true, and it is. 6%-plus income streams from annuities are not uncommon for retired investors, but an income stream is not a return. Let’s look at an example:

A 70-year-old couple who invests $100,000 in an annuity-guaranteeing income for life can expect to receive $6,310 per year, or about 6.3%, in income. The problem is that a large portion of the $6,310 annual check is simply the insurance company returning principal to the couple. And 30 years down the road, even with modest inflation your $6,310 would only buy about half of what it buys today. If our couple stuffed that same $100,000 under their mattress and withdrew $6,310 every year, their money would last until they were 86. They would pay no fees, no surrender charges, and no taxes, and they would have no insurance company default risk or lockups to worry about. In our view, it would make a lot more sense for this couple to invest in a diversified portfolio of stocks and bonds, take a 4% draw, adjust that draw for inflation so they don’t end up destitute, and still have the flexibility and potential to meet unexpected spending needs and have money to pass to their heirs.

P.P.S. Perhaps the biggest risk factor facing investors today is the unknown outcome of the November mid-term elections. Currently, oddsmakers suggest the GOP will retain control of the Senate but lose the House of Representatives to Democrats. If that happens, the progress of the tax and regulatory reforms currently underway could be threatened, leading businesses to pull back their investments. Polls tracking congressional and presidential approval, along with Americans’ feelings about the direction of the country, have been oscillating wildly, with changes in direction coming at every storyline covered by the media. A good proxy for what will happen all around the country will be a race right here in Florida between Governor Rick Scott (R) and Senator Bill Nelson (D). Scott is running to replace Nelson in the Senate, and the two well-established candidates will battle it out in what will likely be one of the most-expensive and most-watched races of the election cycle. Scott has the lead in the RealClearPolitics average of polls, but that lead has been shrinking and the race is close. We’ll be watching the race for clues to the mood of voters and how they feel about both parties leading up to the election.

P.P.P.S. Invest in your health. On Mercola.com, Dr. Joseph Mercola tells his readers about research showing that the more vegetables you eat, the lower your risk of heart disease. Read these key points and heed Dr. Mercola’s message. He writes:

• The more vegetables you eat, the lower your risk of heart disease, with different types of vegetables protecting your heart through different mechanisms
• Leafy greens have high amounts of nitrates that naturally boost your nitric oxide level. L-citrulline in watermelon also boosts nitric oxide
• Cruciferous veggies lower your risk of stroke and heart attack by promoting more supple neck arteries and preventing the buildup of arterial plaque
• Probiotic-rich sauerkraut has been shown to reduce inflammation, improve high blood pressure, reduce triglyceride levels and maintain healthy cholesterol levels, all of which benefit your cardiovascular and heart health
• The best way to maximize your benefits is to eat a wide variety of vegetables on a daily basis, making sure to include nitrate-rich leafy greens, cruciferous vegetables, magnesium- and quercetin-rich varieties, plus onions and some homemade sauerkraut