What’s On Our Minds:
With the end of the year quickly approaching, portfolio managers are busy reviewing accounts and, if the opportunity presents itself, harvesting tax losses in accounts.
Aside from research roles, Tufton Capital’s portfolio managers are responsible for all aspects of portfolio construction and supervision, which includes the management of gains and losses that are realized in our clients’ taxable accounts. Of course, tax implications are not the paramount concern in the management of a portfolio, but trading responsibly with this in mind can make a big difference for investors come tax day in April.
Selling at a loss may seem to run counter to your investment goals, but because the IRS allows for investment losses to be used to offset capital gains, investors should look to make the best of an otherwise unprofitable investment. With that in mind, investors should consider selling poor performers in their taxable accounts by conducting tax loss sales. This strategy is especially good for investors in the 25-35% Federal tax brackets who must pay a long-term capital gains rate of 15%. The tax savings increase for the highest income earners in the 39.6% Federal tax bracket, who must pay 20% on long-term capital gains. Plus, depending on where you live, you may be subject to capital gains taxes at the state level. Our clients in Maryland know this all too well!
Of course, we don’t make trades just for tax purposes. If we think a stock is going to increase in value, we hold it. If we think it is going to go down, we sell it. But using a tax wash sale, in which a security is sold and then repurchased after 30 or more days, enable an investor to claim the tax loss but still hang on to an investment that he or she thinks has long-term potential.
Take for example a single person who has an annual income of $100,000. He would be in the 15% long-term capital gains bracket. In his brokerage account, he has a realized long-term capital gain of $50,000 in Investment A and an unrealized long-term capital loss of $30,000 in Investment B. If he sells his shares of the losing stock, he can offset the $50,000 gain against the $30,000 loss, resulting in $20,000 of net long-term gains. If he does not harvest the loss, the Federal tax on his $50,000 long-term gain would be $7,500. By partaking in this tax loss harvest, he will save himself $4,500, which would have otherwise been a piece of his Federal tax liability for the year (See Figure 1).
Portfolios with large unrealized gains will likely have some positions that have unrealized losses. Although a loss may be hard to look at, sometimes it’s best to bite the bullet and clean these losers out of a portfolio. This management strategy allows investors to free up cash in the portfolio, which can be deployed into other, more attractive investments.
While it’s important to avoid the tax tail wagging the investment dog in your overall investment strategy, a disciplined approach to managing tax liabilities is an important component of wealth management.
Last Week’s Highlights:
Stocks were lower for the second week in a row. After a calm summer and placid fall, we have seen a bit of volatility return over the past two weeks. Markets reacted to lower oil prices and worries surrounding the progress of Republican’s tax reform plan. Investors seem to be a bit doubtful that Republicans will be able to reconcile Congress’s plan and Senate’s tax reform plans in a timely fashion.
Existing homes sales will be reported on Tuesday and the Federal Reserve is releasing minutes from their meeting earlier this month on Wednesday. Markets will be closed Thursday and will close early on Friday.
The entire team at Tufton Capital Management hopes all of our friends and clients have a wonderful Thanksgiving holiday this week!
What’s On Our Minds:
This morning, Tufton Capital Associates Ted Hart, John Kernan, and Neill Peck taught a sixth-grade math class at Mid Town Academy in Bolton Hill. The purpose of the trip downtown was to teach the students about stocks and the stock market. The students participate in the Stocks in the Future program which is a 501C3 charitable organization that partners with schools in downtown Baltimore and provides a three-year financial literacy curriculum for middle school students in under-served communities.
The Stocks in the Future Program introduces students to business concepts, expansion possibilities, reasons for taking a company public, and ways to compare company performance. As students progress through the program, they earn money by attending school regularly and improving their grades. The students can earn up for $80 per year which enables them buy shares in a publicly traded company. When they graduate from high school, they get to keep the shares they have purchased. Today, our Associates explained how an investment advisory firm operates and we showed them how to analyze two companies; Facebook and Under Armor.
By the end of the class, the students remembered the 3 most important rules of investing.
1. Don’t Lose Money.
2. Don’t Lose Money.
3. Don’t Lose Money.
To learn more about Stocks In the Future’s Mission, follow the link below:
Last Week’s Highlights:
After 8 straight weeks of gains, U.S. large-cap stocks fell last week. Investors were focused on tax reform and the overall consensus is that the federal government is nowhere close to passing a bill. Congress and the Senate have both presented a plan and it will be in limbo until both houses compromise and present a mutually agreed upon plan.
On Thursday, the Dow was down over 200 points at its lows and the S&P 500 nearly broke its more than 40-day streak of no losses greater than 0.5% for a given session. Investors should see last week’s dip as a healthy retreat based on the rally we have seen in the last year. Remember, we have been experiencing one of the calmest markets in history this year and we remain close to all time highs.
Earnings season is coming to an end. 483 companies in the S&P 500 have already reported. Economic news and progress on tax reform will likely rule the headlines this week. On Wednesday, retail sales numbers will be released and on Friday, we will hear housing starts and building permit figures.
What’s On Our Minds:
House Republicans released their long-awaited tax reform bill last week. They are calling the bill the Tax Cuts and Jobs Act and are looking to have it passed by the end of the year. The bill aims to permanently lower the corporate tax rate from 35% to 20% and to reduce the number of individual tax brackets. The plan eliminates the alternative minimum tax and it doubles the standard deduction for individuals and couples. The plan limits the home interest deduction to loans up to $500,000, increases the child tax credit to $1,600, and doubles the estate tax exemption immediately and then will eliminate it by 2024.
Under the Republican plan, people will still be able to deduct up to $10,000 on the property taxes they pay locally, but they will no longer be able to deduct the other taxes they pay to state and local governments from their federal tax payments. This compromise appears to cater to a Republican’s base living in states where local taxes are relatively low and has drawn criticism from GOP representatives from New York, New Jersey, and Pennsylvania.
The tax plan does not make direct changes to how income on your investment portfolio is taxed. While the new plan doesn’t directly address capital gains and investment income taxes, setting new income tax rates means many investors will pay less in taxes on short term capital gains and dividends because their ordinary income tax rate will effectively be lower.
Though cutting benefits for 401k contributions was allegedly on the table at first, the official plan makes no changes to retirement savings tax breaks provided by contributing to 401k and IRA accounts. That is good news for investors saving for retirement.
Last Week’s Highlights:
Stocks has a strong week and were in the green for the eighth week in a row.
President Trump nominated Jerome Powell to replace Janet Yellen as the 16th chairman of the Federal Reserve board early next year. Powell is a lawyer by training who served as a top Treasury Department official under H.W. Bush and then joined the Carlyle Group (a private equity firm), where he remained from 1997 to 2005. President Obama nominated him for a spot on the Federal Board of Governors in 2012. Powell has always been supportive of Yellen’s moves, which suggests a continuation of slowly raising rates and easing regulations.
October’s Jobs Report was released on Friday. Nonfarm payrolls rose by 261,000 and the unemployment rate dropped to 4.1%.
Earnings season continued. Facebook and Apple reported strong numbers. Baltimore’s Under Armour reported poor performance and shares took a beating.
We are getting close to the end of earnings season but hundreds of companies are set to report third-quarter results this week. 48 companies in the S&P 500 report earnings will share their results this week. President Trump will spend the week touring Asia. University of Michigan’s Consumer Sentiment report is set to be released on Friday.
What’s On Our Minds:
The Tufton Investment Committee meets weekly to discuss our current holdings and examines our entire universe of companies that we would like to own at the right price. Managing all assets in house and conducting independent research is a timely process but the strategy is designed to pay off over the long term. We believe that it is our responsibility to manage a portfolio of individual securities, rather than merely play “quarterback” by redirecting funds to outside managers.
The Tufton Investment Committee is very conscious of price and we shy away from overpaying for shares in a company. While this may hurt us when the rest of the street is chasing momentum stocks higher, we believe that by purchasing undervalued securities our clients are provided a “margin of safety”. We believe that our independence is an advantage.
Tufton Capital seeks to build our equity portfolios of 40-50 stocks. Of these companies, 50-60% equities we hold are what we consider to be “trophy companies”. These companies are industry leaders based on profitability measures and market share. These companies have proven and stable management teams, consumable products or services, operate in a relatively mature industry, pay a dividend, and their share price is typically stable. We look to buy and hold these stocks for the long haul.
30-40% of a Tufton’s equity portfolios are made up of what we consider to be “economically sensitive companies”. These companies we purchase with no specific time horizon, but we set very specific price targets. These companies are significantly influenced by the stages of the economic cycle and can be more volatile than our trophy companies.
The remaining 0-10% of an equity portfolio is what we consider to be “special opportunities”. These companies are typically have smaller market capitalization, operate in an emerging industry, have some sort of leading edge product with above average growth potential. These companies’ share prices can be volatile but we recognize the value in buying shares in these types of companies at a reasonable price.
Last Week’s Highlights:
For the seventh week in a row, domestic equities were positive and reached record levels. It was the busiest week of third quarter earnings season and investor optimism was confirmed by strong numbers. The technology sector had a particularly strong week. The NASDAQ was up 2.2% on Friday. While single stock volatility can be increased during earnings season, overall, equity markets continue to be strong.
It’s a busy week with 135 of the S&P 500’s companies reporting third quarter earnings. The Federal Reserve will issue its decision on interest rates on Wednesday. October’s jobs report will come across the wire on Friday morning.
From the Baltimore Business Journal:
Randy McMenamin went into work on Oct. 19, 1987, ready to buy stocks. By the end of the day, he was telling himself, “Holy you know what.”
Thirty years later, Black Monday still remains the biggest single-day stock market collapse in history, partially the result of computer programs automatically selling index futures amid a drop in the markets. The Dow Jones Industrial Average fell more than 500 points, or 23 percent. McMenamin was working on the investment side of Baltimore’s Mercantile-Safe Deposit & Trust Co. at the time. Now a managing director at Hunt Valley-based Tufton Capital Management, McMenamin and other local money managers say they have not forgotten about the infamous day, and they think a big collapse will inevitably occur again one day.
The Friday before Black Monday, the stock market fell 200 points, setting the stage for what was to come. At the time though, McMenamin said he had his team ready to buy stocks on Monday. He had his team compile a list of the 10 or 15 stocks to give to the trader. Later that day, McMenamin asked the head equity trader how things were going, and found out the computer system was clogged because of the selloff. McMenamin canceled the trades.
“I was scared,” McMenamin said. “I was frightened. I came home and my wife and daughters met me outside and were clapping cheering, ‘Daddy’s home.'”
When he turned on the television, he thought the world was coming to an end. The next day, McMenamin said a mentor called him to ask how he was doing. The mentor asked if anyone had died. When McMenamin said no one had died, he realized that the crisis at the time was not permanent and the market would eventually recover.
“We didn’t know when, but you have to be patient,” McMenamin said. “We decided don’t sell. We may not buy anything, but don’t sell. Quality always recovers. It was scary, but we reached back and said quality always prevails.”
The stock market didn’t recover overnight, but McMenamin said he “started nibbling” by buying stocks on a selective basis.
David Berman, co-founder and CEO of Timonium firm Berman McAleer, had just begun his career in 1988, in the aftermath of the crash. He said he was scrambling to attract clients at a time when people wanted little to do with the stock market.
“It colored every prospecting call for a couple of years,” Berman said.
When the latest recession happened, McMenamin and Berman both used their experience to weather the storm. McMenamin recalled buying General Electric Co. at $9.50 per share and Harley-Davidson Inc. for $10 per share. Now, General Electric (NYSE: GE) trades around $23 and Harley-Davidson (NYSE: HOG) trades around $48.
For Berman, he said saw how those who didn’t panic in 1987 turned out. So when the Great Recession happened, his firm did not sell off anything. Instead, the firm used the recession as an opportunity to “rebalance” its funds by buying certain stocks in different asset classes.
“We were fully invested in the recovery from the recession,” Berman said. “We took the full brunt of the pain but got the full experience of the recovery.”
While McMenamin learned from his experience, he said he thinks another big stock market fall will happen again for several reasons. For one, he said there are new people coming into the business who do not have a lot of experience and have not been through a panic. He also said crashes are somewhat cyclical, with the “nasty ones” occurring about every 15 years.
Niall O’Malley, the founder and managing director of Blue Point Investment Management LLC in Towson, was still in college at the time of Black Monday. He recalled being involved in a stock club and “just seeing these huge numbers.” Like McMenamin, he thinks there will be another crash one day because “human nature has a repeatable pattern.”
The current market, in the midst of an 8-year run, has a lot of “valuation risk,” O’Malley said.
Trading has become “crowded” and the market has become inflated, O’Malley said, because everyone is investing in Apple, Facebook, Amazon, Netflix and Google. More money has also been invested in passive strategies, like exchange-traded funds and passive index funds, which are weighted toward the same big technology companies.
If something were to happen to any of the companies, O’Malley said, it could create a crash. He also that a change in leadership at the Federal Reserve could also have a massive impact on the markets.
“The Federal Reserve has played a role in the financial market valuation more than any other factor,” O’Malley said.
To protect against a potential future crash, McMenamin said his funds are balanced between common stocks and bonds, since they tend to trade at the inverse of each other. O’Malley said he has decreased his holding in Amazon from 10 percent down to 3 percent. He also uses cash as an asset class and maintains a 14 percent cash level, higher than the typical 5 percent of most mutual funds.
Like McMenamin and O’Malley, Berman said he fully expects to see another crash.
“It’s highly likely it will happen again, and happen multiple times again during my career,” Berman said.
When a crash does happen, investors should not sell off because then they will lose out in the long run during the recovery.
The equity market is still the best way to create wealth, Berman added, and people should not be scared of investing just because there could be another Black Monday.
“You don’t not get into a car because you never want to get into a traffic jam or an accident,” Berman said.
What’s On Our Minds:
Equity markets have been on a roll lately, but don’t forget about interest rates!
Interest rates are, to put it mildly, a complex beast. There are a few mechanisms by which rates affect the economy and the stock market, not all of which are obvious, but which have large effects. We’ve tried to break down these levers without getting too granular or using financial jargon.
The first is the most obvious: a lower interest rate means it’s cheaper to borrow. Consumers borrow more money to buy houses or cars, businesses borrow money to expand production. And thus, we get economic growth. Everybody’s happy. Except, maybe, the people who get less money in interest for loaning out their hard-earned cash.
An interest rate raise, like the one that seems imminent, is a signal that rates are moving higher, might cause both consumers and Chief Financial Officers to cut back on spending. So businesses earn less, and earnings fall.
Another very important but more abstract concept is the valuing of stocks via a discount rate. If I think a company is going to earn $10 million in ten years, the interest rate would have to be 0 for me to want to buy its stock now for a $10 million valuation. But if interest rates are higher, I’d be better off just putting the money in the bank for ten years and earning some interest in those ten years. In this way, investors compare interest rates with their expectations for the earnings of companies. If interest rates are low, companies’ stocks are more attractive, and therefore worth more in today’s dollars.
Whenever you hear about Janet Yellen attending a big Federal Reserve meeting, they have to think about all of this, with the added complexity of inflation. The inflation target is 2-3%: at this level, prices are stable, but there is incentive to spend, rather than save, money, and to push the economy along. With inflation at zero, you know that the car you want to buy will cost about the same in year, so you might just think about it for a while, dampening economic activity.
Deflation, when inflation falls below zero, is a major problem: here, you might wait to buy that car, since it will be cheaper next year. And the year after that. And… This gives rise to the “pushing on a string” phenomenon that was one of our investment committee’s favorite metaphors. You can’t entice people to spend money by cutting rates indefinitely, since rates below zero (usually) are avoided by simply keeping the cash. This illustrates, in part, one of the major limitations of monetary policy (setting interest rate, money supply, etc.) vs. fiscal policy (where and how the government spends their money). But fiscal policy is a topic for another post.
Last Week’s Highlights:
Equity markets enjoyed their 6th consecutive week in the green. The Dow Jones and S&P 500 recorded record highs on Thursday on the 30th anniversary of Black Monday. The Dow Jones had a great week and was up 2%. So far, we have seen strong third quarter earnings reports that has investors pushing equity market ever higher. General Electric was an exception to the news of strong earnings figures. GE’s CEO opened earnings remarked by saying, “The results I’m about to share with you are completely unacceptable.” He telegraphed big changes ahead for the company. According to the numbers, American companies appear strong and the economy continues to improve. Investors were also supportive of the news that Jerome Powell could be nominated to replace Janet Yellen.
Can stocks continue steaming upward? That’s the question on everybodys’ minds.
Politicians in Washington seem to be getting closer to proposing a tax reform plan. Equity analyst will be busy listening to earnings calls this week. CNBC provided the chart below highlighting key earnings releases coming from blue chip companies this week.
What’s On Our Minds:
This Thursday marks the thirty year anniversary of “Black Monday”. On that day, the Dow Jones tanked nearly 23% in a chaotic selling spree. For the most part, the one day crash was caused by growing complexity in the market. Computerized trading platforms were new at the time and complicated hedging strategies that used equity index futures contracts were just being introduced. Today, on a percentage basis, that correction would knock over 5,200 points off the DJIA. As a former stock broker told us this morning, “that was a tough day in the trenches”. On the bright side, the S&P 500 has returned nearly 900% since.
Tufton Capital Portfolio Managers, Randy McMenamin, saved the Wall Street Journal from that day. This paper, along with other “fateful” days in the markets are kept it in our firm’s library as a reminder that corrections can and do happen.
Last Week’s Highlights:
Third quarter earnings season kicked off and investors were optimistic.
Going into the week, investors were expecting solid performance in the big bank’s earnings reports. On Friday, Bank of America’s report was met with happy investors and the company’s share price increased by 1.5%. JPMorgan and Citi sold off as they failed to meet some important metrics. Particularly, both banks failed to deliver strong loan growth and loan quality metrics.
Investors will have a keen eye on earnings reports coming across the wire this week. Many believe that in order to sustain the rally we have seen in equity markets, investors will need to see strong earnings growth over the next few week.
On Monday we will hear from highflier, NetFlix. On Tuesday we will see earnings from Goldman Sachs and Harley Davidson. On Wednesday, Abbot Labs reports their results. Phillip Morris, Berkshire Hathaway and Taiwan Semiconductor report on Thursday. On Friday, we will wrap up the week with reports from General Electric and Proctor & Gamble.
by Chad Meyer
As the temperature finally drops, the landscape subtly shifts, and children everywhere resignedly dig out their real shoes and dust off their school uniforms, it’s difficult not to take pleasure in the perennial change that autumn brings. As anyone who has watched more seasons pass than they care to admit knows, this brand of change—the predictable kind—doesn’t really count as change at all. Instead, it represents a keeping of plans, and all the comforts that come with knowing the world is still spinning right on schedule.
Of course, in an autumn like this one, even the most optimistic among us could be forgiven for suspecting that there may be a different sort of change afoot—and that whatever “schedule” once reigned is now subject to revision with a few hours’ notice. As a glance at the evening news suggests, our country is plainly on the brink of a dramatic and unpredictable change on multiple fronts. From the hurricanes rocking our nation’s shores, to the political debates rocking our national dialogue, to the looming prospect of war with North Korea, stability appears to be a commodity that grows scarcer in America by the day.
Nor, it would seem, is the the financial sector bucking the trend. As hordes of market commentators (and, perhaps, your local cabbie) will eagerly attest, Bitcoin, Ethereum, and various other “crypto-currencies” may well be on the verge of sending dollar bills the way of the dodo bird. But even as the market’s enthusiasm for digital currency renders it the hottest asset class of the year, all the fervor has some experts crying foul. Bitcoin “is a fraud,” declared JPMorgan Chase CEO Jamie Dimon at a recent investor conference. “It’s just not a real thing.”
Finally, and perhaps most perplexingly, there’s the stock market itself, humming along nicely as the world around it rattles and shakes. In the third quarter of 2017, the Dow Jones, S&P500, and NASDAQ all rose by roughly 4% or more, with the latter index posting gains of nearly 6%. That level of performance and the low volatility that attended to it have, in some circles, given rise to the anxiety that the market is “ignoring” broader macroeconomic trends. Doesn’t the market see (so this brand of hand-wringing goes) all the change that’s lurking about?
Put simply, it does, but it also recalls that it has seen all this before. For the last two hundred years, while America has faced conflicts and crises of every ilk, at home and abroad, the U.S. stock market has quietly chugged along as one of the most reliable wealth creation vehicles in the history of mankind. And at the risk of seeming old-fashioned, we here at Tufton Capital tend to believe it’s going to keep chugging, no matter how the wind howls outside our door.
In a world that changes by the minute, we thank you for the opportunity to protect and grow your capital, and we remain honored by the trust you’ve placed in us.
by Eric Schopf
The third quarter gave us yet another solid advance in the stock market. The Standard & Poor’s 500 delivered a total return of 4.5%, and for the year in full, the broad-market benchmark has delivered 14.3%. Also keeping in line with the first half, the S&P saw little volatility in the quarter. Wanting to give us at least a little excitement, the bond market gyrated throughout the past three months. However, by September 29, intermediate- and long-term interest rates closed essentially unchanged from June 30. Short-term interest rates continued to move higher in reaction to Federal Reserve policy. And so, we march steadily upward.
The stock market’s lack of volatility is truly remarkable given the wide range of social, geopolitical, and meteorological events that punctuated the quarter. The largest setbacks in the markets occurred in mid-August, when tensions with North Korea rose. Reports from the self-isolated nation revealed that it was examining an operational plan to strike areas around the United States’ territory of Guam with medium-to-long range strategic ballistic missiles, enough to rattle any market participant. Then, a week later, it was rumored that Gary Kohn, the Director of the National Economic Council and a chief economic advisor to President Trump, was considering resignation after the President failed to blame neo-Nazis for the Charlottesville, VA violence. The resultant selloff was short-lived, though, and the stock market was within a few points of its all-time high by the end of the month. The Category 5 forces of Harvey, Irma, Jose, and Maria only fueled the market’s advance. Investors looked past the short-term effects and saw that building reconstruction and automobile replacement will more than offset the temporary slowdown in economic activity.
Falling in line with the squadron of ho-hum, the interest rate backdrop changed little during the quarter. Rates remain at historically low levels. The Federal Reserve did announce plans to begin winding down their $4.3 trillion bond portfolio by letting bonds mature without reinvestment. This development didn’t raise rates, though, as the pace of contraction will initially be so slow as to be almost undetectable. Inflation is also keeping rates down below the Fed’s 2% target, despite a low unemployment rate of 4.3%. Low unemployment rates belie the true state of the labor market, which is likely looser than we’d prefer, given the labor force participation rate.
Labor force participation, the ratio of payrolls to the working age population, is a clear indication that there is still slack in the work force (see chart). The broader deflationary themes of an aging population (and thus, work force), globalization, and technological innovation continue to play a significant role in the disinflationary environment. Low inflation undermines the Fed’s case for interest rate hikes. Low interest rates in turn support higher stock valuations. Thus, we seem to be stuck with low inflation, low interest rates, and a richly-valued market.
We turn now from the “boring” market to the piece of modern America that seems more turbulent than it has ever been – politics. Washington’s focus has now shifted from the Affordable Care Act to tax reform. Potential changes in the tax code have replaced the Fed as the primary influence on interest rates for the balance of the year. If these reforms were both successfully passed and meaningful, they would be a major catalyst for the equity and credit markets. The ultimate scope of reform will depend on Congress’ ability to compromise on change, something that has been rare of late to say the least. The very idea of implementing a complex reform versus a simple tax cut gives some uncertainty to any such proposal. The more variables that are added to any plan, the less certain economic growth becomes. A tax reform cannot avoid adding many unknowns.
The current tax thinking goes like this. Seeking to reshape both tax structure and the U.S.’ prosperity, the heart of reform lies in reducing corporate tax rates. Our statutory rate of 35% puts America at a competitive disadvantage with nearly all global peers. So, the plan is to reduce corporate rates to a level that makes it economically feasible to keep jobs at home. These additional jobs would lead to a greater collection of personal income taxes. If the Administration’s math is to be believed, the larger take on personal income taxes will largely offset the loss of corporate taxes. Thus, a balance is achieved, and everyone is happy.
However, there is also discussion of lowering taxes on individuals. Lowering personal taxes strains the Administration’s math, which to begin with is somewhat tenuous. Many experts do not think that the taxes from the higher spending that are supposed to come on the back of greater growth will compensate for the proposed cuts in tax rates. To help bring taxation and spending more into line, the elimination or reduction of tax deductions will be required. This is the part that requires compromise and is so difficult, since no taxpayers want to give up their deductions. Furthermore, reductions in Federal spending have been absent from the conversation.
We have no doubt that the economy could benefit, at least in some small measure, from changes in the tax code or a tax cut. There is little room for error though. Should tax reform not generate the desired growth, the national debt will balloon (see chart). A greater national debt at a time when the Federal Reserve is reducing their net holdings of Treasury securities will most likely push interest rates higher. The Fed could always modify their strategy and slow the pace of balance sheet reduction. Low rates have been the catalyst for the stock market for a long time. The question is whether the economy and the stock market can support higher rates.
While Washington squabbles, the economy continues to churn upward in unimpressive but steady fashion. Annual gross domestic product growth in the range of 1.5% – 3%, par for the course since the end of the Great Recession, appears to be the new normal. However, accommodative monetary policy, gridlock in Washington, falling unemployment, and this slow but steady economic growth have provided a powerful foundation for stocks and bonds. The trends are still in place but the sands are beginning to shift.
We are at an inflection point with Fed policy. If the Fed raises interest rates, they would eventually become an economic headwind. But higher rates could also impact corporate profits in the near term, because higher rates would likely mean a stronger U.S. dollar. A stronger dollar makes corporations’ exports more expensive to foreign buyers, and thus less competitive.
Corporate profits have been aided by a dollar weakened by the Fed’s pivot to a slower monetary policy pace in 2017. Also menacing are the classic late-cycle signs throughout the markets. Stock valuations are elevated, the yield curve has flattened, and balance sheets are more levered. We remain cautiously optimistic but mindful of the environment as we work hard to grow and preserve your capital.
by Neill Peck
You may have heard this old Wall Street maxim that warns against greed and impatience, but have you followed it? Without a doubt, the stock market can be an exciting place, and it’s easy to get roped into the allure of finding the next home run or timing a trade just right. For instance, a friend at a cocktail party may tell you about the killing he made off that ABC trade, and you may think, heck, why can’t I do that? Then there’s your inner trader who may get the best of you and get you thinking that you too can perfectly time your entry and exit points. If you have ever found yourself directing trades based on your emotions or you have attempted to time the market, are you really investing for the long haul? Or are you looking to make a quick buck? At Tufton, we may even suggest that you are gambling (not investing) with your retirement savings.
Research has shown that investors are significantly better off by following the approach of “time in the market” rather than timing the market. From 1998 until 2012, CXO Advisory Group ran a study to attempt to see if 28 self-described market timers could successfully time the market. The overall results were not good. They found that market experts accurately predicted the direction of the market only 48% of the time. Only 10 of the 28 experts could accurately forecast equity returns more than 50% of the time, and not even one could outperform the S&P 500. The evidence was so conclusive that CXO decided to stop tracking the statistics entirely! Unfortunately, sales skills triumph over investment skills on Wall Street from time to time, and often the loudest pundits get most of the attention. If an investment strategy sounds too good to be true, it is.
Another caveat to deter you from timing the market is that, over time, it’s possible to underperform significantly by sitting on the sidelines. Yes, it can be very costly to sit in cash. For instance, if you examine the chart below, you see that if you missed the top 12 months in the past 5, 10, 25, and 50 years, you would have underperformed the S&P 500 significantly in each scenario.
Even though a disciplined investment approach may sound like it’s old advice straight from your grandfather’s roll top desk, it’s an idea that has stood the test of time. By staying the course and grinding it out over a long period, investors avoid the worst of which can happen and will happen over the years. A disciplined approach to portfolio management keeps average investors from overreacting and hurting their long term positive return that we all need to retire well. It’s almost impossible to avoid the allure of “knocking it out of the park” with your investments. Just remember, as history has shown us, if you’re not careful, you may end up “getting slaughtered.”
by Scott Murphy
While the overall stock market has been rewarding for most investors in 2017, the same cannot be said for the retail sector. Amazon has become a “legendary and mythical beast” of sorts and has become the biggest competitive threat for every retailer, placing the stocks of traditional brick-and-mortar retailers on the sale rack. As value investors, we readily acknowledge the magnitude of change in retail but still believe there is a place in our portfolios for a traditional retailer like TJX Companies, Inc. (TJX).
TJX has a leading market position in the off-price retail market. They control 45% of the discount retail market and operate 3,800 stores under the brands TJ Maxx, Marshalls, HomeGoods, and HomeSense. In a tough and changing retail environment, TJX has been able to grow its same store sales for twenty one consecutive years. Simply put, they have proven they can grow sales and earnings through good and bad economic times. Many attribute this resilience to their customers’ “treasure hunting” experience. At TJ Maxx, customers can arrive at the store not knowing exactly what they are looking for, and end up finding something they like at an irresistible price – a “treasure.” This customer experience and incredibly low prices have largely allowed TJX to defend itself from the industry disruption caused by Amazon.
Therefore, we have begun to initiate positions in this well managed, industry leading discount retailer that has underperformed the market for two straight years. Our expectation is the market will realize they have misjudged the power of this off-price traditional retailer and will become buyers again, boosting the stock price in the process.
by Ted Hart
As mentioned in our lead article, the S&P 500 is up 14.3% this year through the third quarter. With that gain, the market has witnessed the second-longest period without a 3% pullback since 1928. If this streak continues through October, the S&P 500 will set the record for longest such period. On top of that, the average range between daily highs and lows on the index is also hitting historical bottoms. Investors are attributing this low volatility to a number of factors, some of which include passive and quantitative investing strategies. In fact, many of these approaches might be providing investors competitive returns. However, all of them ignore company fundamentals and can often push stocks higher without any regard for how a company or an industry is performing. Money has poured into these strategies in the past few years. As volatility inevitably rises, these trades should begin to unwind.
Passive investing is the most basic form of this investment trend and simply involves investing money in a stock market index, such as the S&P 500. This strategy has rewarded investors over the course of the bull market, but despite having low fees, it still has a few flaws. To maintain the proportional stock weightings of a given index, the fund or ETF provider must buy shares in stocks that have increased, and sell shares in stocks that have decreased. This can lead to overvaluation of the companies that are consistently bought (think Netflix). In addition, because of the flows to passive investment vehicles, Goldman Sachs estimates that the average stock in the S&P 500 trades on fundamental news only 77% of the time, down from 95% ten years ago. When the markets eventually turn south and investors pull their money from these indexed products, the forced selling will likely create a cascade effect as index fund suppliers are forced to sell securities to meet investor redemptions.
Risk parity is another investment strategy that often ignores company fundamentals and feeds off low volatility. Risk parity investors make investments in a company, index, or asset class based on volatility. The strategy targets a specific volatility measure and will typically be buying securities as the volatility is declining and selling securities when volatility rises above the target. Recently, risk parity strategies have pointed to holding more stocks than bonds as the volatility of stocks has significantly declined. As volatility increases, the recent trends should flip as risk parity strategies begin selling stocks and proceed to buy bonds to “pare the risk.” Many investors believe that because risk parity strategies have grown, the forced selling could create a sharp selloff in stocks – possibly creating an opportunity for the patient investor.
While these strategies continue to push stocks higher and investors likely buy every dip in the market, market liquidity is also plentiful. As a result, buyers of stocks and ETFs are not having difficulty finding sellers and vice versa – sellers of stocks and ETFs are easily finding buyers. In fact, since the Federal Reserve started tracking the data, the M2 money supply (which includes checking accounts and mutual funds) as a percentage of nominal GDP has never been higher. The elevated levels of liquidity in the markets can be the result of many factors, including the Federal Reserve’s Quantitative Easing policy and low interest rates. QE, as it is known, took the Fed’s balance sheet from just under $1 trillion in 2009 to over $4 trillion today. Also adding to liquidity are additional flows into ETFs, particularly from the retail investor.
No matter what the cause of low volatility and rising markets, we at Tufton continue to search for new investment ideas and monitor our buy prices. As one investor said, “Investments are the only business where when things go on sale, everyone runs out of the store.” Whenever that happens, we will be right at the front door.
What’s On Our Minds:
Donating Appreciated Securities
This time of year, charities may begin hounding you to make your annual donations. Have you ever considered donating appreciated securities? It’s a tax efficient way to support charities. Read on to learn how you might be able to “kill two birds with one stone” utilizing this strategy.
Charitable giving provides donors with tax relief every tax season in the form of deductions. In an effort to encourage positive social action, the IRS provides incentives for all kinds of charitable contributions, from monetary donations to used cars. You can even donate your appreciated securities (stocks, bonds, mutual funds, etc. that have risen in value) to the charity of your choice. Long-term appreciated securities are the most common non-cash donations, and they can be the best way for donors to give more to their chosen charities. The tax advantages to donating stocks are such that both the donor and the charity benefit.
What are the benefits?
Donating appreciated securities yields two tax benefits for the donor. The first tax benefit is the elimination of capital gains tax. Normally when you sell an appreciated stock, you pay capital gains tax on the amount your securities have increased in value since being purchased. For example, if you bought stocks for a total of $1,000 and then sold them years later for $5,000, you would owe capital gains tax on $4,000 of income from the sale. This tax can add up significantly depending on what tax bracket you fall under, how many stocks you sell and how much they’ve appreciated over time. When you donate appreciated securities, however, you don’t owe any capital gains tax, no matter how much they’ve increased in value. The charity receiving your donation is free from capital gains tax on your contribution as well.
The second tax benefit is writing off the donation on your tax return. As long as you itemize, you can deduct charitable contributions on your return, and the more you donate, the more you can deduct. In this case, you’ll be donating more since you can donate the entire value of the asset, not the value minus taxes. Thus, your tax write-off will be greater. In other words, you can take a charitable deduction on money that hasn’t been taxed. This also benefits the charity, because they’ll get a larger donation than they’d otherwise receive.
There is a limit to how much you can deduct for charitable contributions, which varies depending on what you’re giving and what organization you’re donating to. Most organizations are subject to a 50 percent limit, meaning your charitable tax deduction cannot exceed 50 percent of your adjusted gross income. Other organizations have a 30 percent limit. You can check with the IRS or ask the organization themselves to be sure. These limits apply to monetary charitable donations. If you’re donating appreciated securities, the limits change; a 50 percent organization’s limit becomes 30 percent for appreciated securities, and a 30 percent organization’s limit moves to 20 percent.
Another benefit to donating your appreciated securities is reducing risk in your portfolio. If too much of your portfolio is dedicated to a certain kind of investment, your risk increases because your portfolio is less diversified, so your assets are all relying on that one kind of investment to succeed. To decrease that risk, you’d normally have to sell the stocks and pay capital gains taxes. Donating them, on the other hand, is a tax-free way to rebalance your portfolio.
Last Week’s Highlights:
Equity markets hit record highs again last week. Stocks continue to “climb a wall of worry” but investors got some encouraging economic data releases last week. Reports showed stronger than expected trends in the automotive, manufacturing, and service sectors. Friday’s job report was weaker than expected but that was attributed to the effects of the recent hurricanes in the southeast.
Earning season is upon us! We will kick things off with Delta and BlackRock on Wednesday. Thursday we will see earnings from JPMorgan and Citigroup and then Bank of America and Well Fargo on Friday. Also on Friday, the U.S. Census Bureau will announce retail sales numbers for September. August’s figures showed a 0.2% dip from July to August, but an increase of 3.2% from August 2016. We will also see how the American consumer is feeling with the University of Michigan’s consumer sentiment figure for October. Their survey found a 1.7% dip in confidence from August to September so it will be interesting if things change course.
What’s On Our Minds:
“A year from now, it’s not going to be Tech.”
Such was the general consensus at last week’s investment meeting at Tufton Capital. While the Tech sector analyst is characteristically overenthusiastic about the forward march of technology, we are reminded by history that the high flyers are rarely up for very long, and when they are, the crash is ever the more painful.
As we look at this year’s winners, the Tufton approach gets pooh-poohed as more exciting names are gobbled up and soar ever higher. “Why isn’t half your portfolio cryptocurrencies?” is not quite the question we are always getting, but it seems that way. We are confident, however, that a disciplined approach will win out over time. But in the mean time, the temptation remains strong to jump into these names that just seem to keep going up in price. Why shouldn’t you?
Another joke around the Tufton offices when we have another big up day is to say, “Wow, stocks just always go up!” Of course, the joke is that they don’t, and to be careful of another fall. The tech stocks at the head of the run-up have amazing possibility in them: self-driving cars, artificial intelligence, interconnected everything, a new kind of currency that will reshape accounting and the financial world. Even if all these things come to fruition, there is a price for everything, and an overvaluation for everything. How does one determine the correct valuation for Bitcoin? We’re afraid no one will know for sure until after the climb comes to a screeching halt. Similarly, Amazon and Facebook are valued like they will rule their respective worlds someday very soon. Perhaps they will, but betting on the next world-changing trend has been nothing but a loser’s game in the past.
Amazon has had Price/Earnings ratios in the triple digits for years.
What’s a value investor to do?
Last Week’s Highlights:
Stocks were again higher last week and hit record levels. High hopes for the Republicans’ tax plan pushed stocks ever upward. Stocks are looking at moving into mid-teen growth for the year, a solid performance to be sure. The 10-year Treasury continued to rise. While resulting in lower bond prices, increased rates are signs of a solid recovery, and gives the Fed more breathing room.
Plenty of economic data this week, including manufacturing PMI on Monday, vehicles sales Tuesday, and the September jobs report on Friday.
What’s On Our Minds:
Tune your TV to CNBC on any given day and more and more attention is given to activist investors and the companies they target. As activists, investors look to maximize shareholder value by often taking large enough positions to influence management decisions- they are looking to shake things up at the company. Activists may decide to move in on a company if they believe management has stumbled, it would be better off as a private company, it has excessive costs, or if the activist think they have a better capital allocation strategy, such as buying back stock or raising the dividend.
Often activists are targeted by the media and politicians for being “hit and run” investors, but activists will argue that they are genuinely concerned about companies and the U.S. economy. The issues surrounding activism are not clear cut; some activist may just be greedy, while others actually want to maximize shareholder value over the long-term.
Over the summer, Nelson Peltz’s $12.7 billion hedge fund, Trian Partners, took aim at household product conglomerate Proctor and Gamble. His fund currently owns $3.3 billion worth of P&G shares. Peltz thinks P&G is not structured properly and believes that the company in resistant to change. He is currently in a proxy fight for a seat on the company’s board. The company says they have been actively working with Trian but is against adding him to the board. In dollar terms, P&G is the largest company to ever face a proxy fight of this nature.
Activists take positions in all different types of companies, across many different industries and of various market caps, but more often than not, activist target companies that have been beaten up and are considered value stocks. At Tufton Capital, we are not activist investors but we do look for undervalued stocks so it’s not uncommon for companies in our equity portfolio to have activist involvement. Thus, we do have to pay attention to the hype created by these market players.
While activist investors grab plenty of headlines, it’s tough to determine the actual impact activism is having on the overall market. According to a study conducted by the Wall Street Journal last year, of the largest 71 activist campaigns between 2009 and 2014, only about 50% of targeted companies outperformed their peers.
Last Week’s Highlights:
Stocks were marginally higher last week and hit record highs. The highlight of the week was the Federal Reserve’s announcement that it would begin normalizing its balance sheet in October. The Fed also stated that it would keep its federal funds rate between 1 and 1.25 percent. The announcement caused 2 and 10 year Treasury yields to increase along with the the value of the dollar.
Investors will see how the housing market is doing this week when the Case-Shiller Index of home prices and new home sales figures are released on Tuesday. We will also get a report on consumer confidence on Tuesday and Janet Yellen is scheduled to deliver a speech. Investors are expecting her elaborate on the Fed’s plans to unwind the huge balance sheet it has amassed since the financial crisis.