The Role of Equities in a Portfolio

by Rick Rubin

At Tufton Capital, we allocate portfolios based on our clients’ financial objectives, risk tolerance and time horizon, and we factor in our expectations for long-term investment returns.  For most clients, we manage balanced accounts that consist of diversified portfolios of stocks, bonds and cash.  Occasionally, a client asks us whether all their investments should be fully invested in stocks, because stocks have higher returns over time.  Our answer is usually … NO! A key reason to diversify your assets is related to a concept known as “correlation.”


How do we apply this concept to managing money?  Correlation quantifies the strength of the association between two variables.  Correlation is expressed as a value between -1 and 1, with 1 indicating perfect positive correlation and -1 indicating perfect negative correlation.  Our ultimate goal is to identify a portfolio of securities with high return expectations and with high negative correlation to each other (-1 or slightly under).  Said differently, we want to own securities that perform well in the long run and whose price changes do not track each other closely.


For example, we invest in stocks across a wide range of economic industries such as technology companies, utilities, financials, etc.  We like the long-term value characteristics of many technology companies (Microsoft, Oracle, Qualcomm), and yet we continue to have sizable investments in slower-growth utility and telecommunications sectors.  In part, we can justify these seemingly differing investment positions because of the “correlation” benefits.  That is, the technology sector’s stock prices behave quite differently than stocks in the other two sectors in the short term.


As compared to stocks, we view bonds and cash as “defensive” investments.  Typically, bonds we purchase tend to perform well when the stock market is weak.  In particular, U.S. Treasury bonds are viewed as a safe haven by investors, and these bond prices rise sharply during times of stock market turmoil (think 2008-2009 financial crisis).  Thus, we invest a portion of our clients’ money in U.S. Treasuries because these bonds have high negative correlation to the stock market.


We use stocks as the primary vehicle of producing capital appreciation, income and dividend growth for clients.  Stocks prices are volatile, and they can add stress to investors’ lives as they watch their investments fluctuate.  As your portfolio manager, we work to lower your portfolios’ volatility by using a balanced allocation and purchasing value-oriented stocks that offer a margin of safety.  It’s important to remember that even though stocks can be volatile in the short term, historically, stock returns far exceed the returns of bonds and cash.  Also, stocks protect a portfolio’s purchasing power against the negative impacts of inflation.


We believe above-average dividend yields of high-quality companies provide huge benefits to a portfolio.  One of the biggest advantages of reinvesting dividends is a compounding wealth effect.  Albert Einstein realized this concept when he said “compound interest is the eighth wonder of the world. He who understands it, earns it … He who doesn’t … pays it.”  Although slowly compounding dividends may not be as exciting as your friend’s hot stock tip, this strategy helps build and preserve your wealth over time.  We believe in owning shares of well established companies that consistently pay and grow their dividends!

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Charitable Giving Vehicles

Learn how to use charitable giving tools to grow a donation through investment, possibly allowing you to donate more than by gifting directly.


When making a sizable donation as a direct gift, you know exactly how much you can afford to give and how it will affect your overall finances, but you may wish you could do more. If so, charitable trusts and annuities provide ways for you to make a major charitable donation while simultaneously receiving reimbursements that can help provide financial security.


Charitable Gift Annuities (CGAs)

With a normal annuity, donors fund the annuity with an initial payment, this payment receives gains from investment and then the donor is paid a fixed income throughout the year using this money. With a CGA, the charity, rather than an investment firm, serves as the management company, and any profits the investment earns go to the charity rather than the donor.


Essentially, CGAs allow a charity to borrow the money put into the annuity for investment growth before returning the majority of it back to the holder through annuity payments. CGAs usually have lower return rates than other annuities, but can compensate for these low returns through the tax benefits that they offer. The charitable donation deduction amount is equal to the present value of the charity’s “remainder interest” of the donation, or the excess of the fair market value of the donation over the present value of the annuity. This allows the donor to receive an income tax deduction as well as a portion of the donation back through annuity payments.


As with any investment, CGAs do have some downsides. They can tie up a large portion of your retirement funds and are costly to terminate outside of their set term. Before you enter into a CGA, you should be completely sure that you will not need the funds you are contributing in the immediate future. CGAs can also be risky because they will terminate if the charity you donate to goes bankrupt. In order to avoid this, it’s crucial to research the charity you will donate to and make sure that it is financially stable.


Charitable Remainder Trusts (CRTs)

CRTs provide a different way to grow charitable donations through investment. The donor makes an initial donation to the trust, which is then invested and makes annual distributions to a beneficiary (usually the grantor), giving the remainder to the chosen charity. CRTs offer more security than CGAs because they don’t make the donation until the end of their term, so donors can give to smaller and potentially less stable charities without putting their income at risk.


CRTs offer many tax benefits, including an income tax deduction and the fact that the trust itself is not taxed for income. However, the beneficiary is taxed on any income distributed to him or her.


Many people nearing or at retirement age choose to donate through a CRT because it can provide them with an annuity for a number of years. For those donors who have estate planning concerns, CRTs may be especially attractive, as they offer a full estate tax deduction if created at the grantor’s death. When considering CRTs, grantors should keep in mind that they are required to distribute between 5 and 50 percent annually to the beneficiary of the trust.


Charitable Lead Trusts (CLTs)

CLTs are similar to CRTs, except that they make their annual distributions to the charity and hold the remainder for the grantor or beneficiary instead of the other way around. If the grantor receives the remainder, it is referred to as a “grantor trust,” while if a beneficiary or third party receives the remainder, it is referred to as a “non-grantor trust.”


Grantor trusts offer an income tax deduction, while non-grantor trusts provide an estate tax deduction. Additionally, with a grantor trust, the grantor is taxed for income not given to the charity. With a non-grantor trust, the trust itself is taxed for this income. Grantor trusts are usually used if an individual wants to donate during his or her lifetime, while non-grantor trusts are used to provide a gift to an individual’s family after his or her death while still providing money to charity.


Annuities versus Unitrusts

CRTs and CLTs both come in two different forms, annuity and unitrust. The only difference between the two is how annual payments are calculated. With CRATs (charitable remainder annuity trusts) and CLATs (charitable lead annuity trusts), the beneficiary receives annual payments of fixed dollar amounts. With CRUTs (charitable remainder unitrusts) and CLUTs (charitable lead unitrusts), the beneficiary receives annual payments at a fixed percentage of the trust’s value for that year. CRATs and CLATs offer more consistency, while CRUTs and CLATs give the beneficiary the opportunity to potentially receive larger (or smaller) payments depending on the trust’s value that year.

Choosing a Giving Method

Charitable trusts and annuities can allow you to make a larger contribution to charity than a simple gift, because they allow your money to grow over the trust’s term. However, these options can be expensive and difficult to manage. They also create an extended timeline, which delays the full benefit of your donation from reaching the charity until a number of years have passed. Yet, for donors that would otherwise have to sacrifice their charitable goals to protect their own finances, trusts and annuities may be a more appealing option.


Before deciding to integrate these types of giving vehicles into your charitable strategy, interested donors should seek financial and legal advice to avoid any potential complications.   n


This article was written by Advicent Solutions, an entity unrelated to Tufton Capital Management.  The information contained in this article is not intended for the purposes of avoiding any tax penalties. Tufton Capital Management does not provide tax or legal advice. You are encouraged by your tax advisor or attorney regarding any specific tax issues. Copyright 2013 Advicent Solutions. All rights reserved.

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Tufton Capital rolls out Viewpoint quarterly newsletter

There’s nothing quite like springtime in Maryland. As the temperature slowly rises, our community returns to the pursuits that we hold dear. Gardening plans are launched into action, outdoor grilling resumes, and, in keeping with local fashion etiquette, wardrobes that for months relied on royal purple abruptly shift in favor of orange and black.

Of course, we aren’t the only ones sporting a new outfit: Mother Nature, after a few weeks of chilly indecision, has at last decided to put on her Spring dress. Nowhere is that more apparent than from our office’s vantage over the Tufton Valley, which is becoming greener by the day.

As you may have heard, the view isn’t the only thing that has changed around here. On February 23rd, after months of careful deliberation, we officially changed our firm’s name to Tufton Capital Management. And as we settle into our new look, I want to assure you that while the lettering on the door may have changed, the values that define us have not. We remain, as a team, deeply committed to protecting your today, growing your tomorrow, and honoring the trust you have placed in us—and we believe our new name more accurately reflects the strength of that shared commitment.

With our new firm name comes the inaugural issue of Tufton Viewpoint, which begins with our outlook for the economy and financial markets. In this article, we remind our readers that equity investing is a long-term proposition, as evidenced by the recently completed first quarter. Timing the market earlier this year could have led to big losses (through early February) while missing the market’s impressive recovery through March.

Also included in Viewpoint is a timely discussion regarding active versus passive investing and the rise in popularity (and pitfalls!) of ETFs. As active investors, the financial professionals at Tufton Capital believe that “being average” is not enough. We seek to provide our clients with returns higher than the relevant benchmarks over a full market cycle without taking any undue risk.

This quarter’s Tufton Viewpoint analyzes one of our favorite stock ideas: onshore oil rig driller Helmerich & Payne (HP). Finally, Trusts as a Planning Strategy, discusses how a properly structured trust can help you transfer wealth in the most efficient way possible.

As we enter our third decade in business, we’re as optimistic and excited as ever about the outlook for our firm and our clients. We wish all of you a very happy spring, and thank you again for your continued support!

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The First Quarter of 2016: Lessons in Investing

The first quarter started with a bang as the stock market began a precipitous decline. By the end of the fifth trading day of the year, the Dow Jones Industrial Average and Standard & Poor’s 500 indexes had recorded losses of 6.2% and 6.0%, respectively. The losses are both records for the time period. The selling persisted and the market continued to head lower. The trough was reached in mid-February, but not before the major averages gave back over 11%. As stomach churning as the first six weeks were, the markets bounced back very strongly. After all the gyrations, we closed the quarter almost exactly where we started.

Interest rates were a sharp contrast to the stock market during the quarter. The 10-year U.S. Treasury bond started the year at 2.3%. As the stock market was reaching a low in mid-February, interest rates were also falling with the 10-year reaching 1.66%. As interest rates fall, the price of bonds rise. Bond prices have remained strong, and we closed the quarter with a 10-year treasury yield of 1.81%.

If we view the first quarter as a voting booth for the Federal Reserve’s decision to raise interest rates last December, we find that investors voted “nay.” The Fed has gotten the message and has turned more dovish with regards to monetary policy. The new stance was punctuated during a speech that Fed Chair Janet Yellen delivered to the Economic Club of New York on March 30, where she articulated that only gradual increases in the federal funds rate are likely to be warranted in coming years.

Chicago Purchasing Manager Index

The first quarter reinforces some valuable lessons in investing. First, equity investing is a long-term proposition. Timing the market in January and February may have led to big losses while missing the market’s recovery. Second, fixed income securities, whether they are Treasury bonds, corporate bonds or certificates of deposit, provide valuable diversification that helps reduce an investment portfolio’s volatility.

The economic environment continues to improve slowly. Employment numbers remain at impressive levels, and housing starts and housing permits are trending higher. More importantly, manufacturing, which has been volatile and generally weak over the past year, demonstrated strong growth in March. The combination of moderate economic growth with little inflation continues to be a winning combination for the stock market. Although inflation is low today, we closely monitor the situation for change. The Fed’s accommodative policy has provided a strong tailwind for nine years. An unanticipated increase in inflation could lead to a shift in Fed policy, resulting in headwinds. The dramatic collapse in the price of West Texas Intermediate crude oil from about $140/barrel in 2008 to $33/barrel earlier this year is clearly disinflationary. The price of energy percolates through many goods and services. However, the lowest prices are most likely behind us as supply and demand have worked towards equilibrium. A rise in energy prices will be inflationary to some degree. The response of supply and demand to higher prices will dictate pricing levels and the impact on future inflation.

Inflation - Core CPI % Year-Over-Year Change

The stock market gets more attractive as prices continue to languish. Obstacles to profit growth like a strong U.S. dollar and weak international markets are now being lapped, making year-over-year earnings comparisons easier. Valuations remain reasonable and are supported by the low interest rate environment. Bonds, on the other hand, are less attractive given the big drop in interest rates over the past three months. We are more selective in maturity patterns given the higher prices.

The lessons learned in the first quarter may continue to serve investors well over the balance of the year. Risks and volatility are ever-present. The terrorist attacks in Belgium are a reminder of the geopolitical tensions around the world. The political landscape at home remains unsettled. The presidential election includes a cast of characters with political views that run the gambit and party infighting is headline news. The uneven economic recovery has left many citizens angry and ready for radical change. The uncertainty of the outcome may weigh on the markets as we get closer to the election. As always, we will use the volatility to uncover opportunities as we seek to add value to your portfolio.

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Passive Investing… The Good, The Bad, and The Future??

Over our twenty year history, Tufton Capital Management has followed a disciplined investment process where we focus on taking advantage of investors’ emotions and identify mispriced securities. As long-term value investors, we are happy to move against the herd and purchase securities when the market has given up on them, and later sell them when sentiment has improved. While we are fully committed to sticking with our strategy, we pay close attention to trends emerging in the money management business. One such trend is the popularity of passive investments including index funds and exchange-traded funds (ETFs), which investors have piled into since the bull market began in March 2009. While indexing may be an appropriate, low-cost option for retail investors, we believe a portfolio constructed entirely of these products is suboptimal for investors with sizable assets. Quite simply, these passive products in and of themselves are not tailored to meet a client’s specific financial objectives or risk parameters.

So why have investors (and financial advisors) moved towards passive indexing? First off, indexing is easy. You can purchase a few products and get a broadly diversified portfolio. Secondly, you don’t need to spend a lot of time or have expertise researching or monitoring the funds, as compared to the fundamental research we perform on our individual securities. Finally, most index funds and ETFs have lower management fees when compared to their actively managed counterparts. It’s no secret that only one out of five actively managed mutual funds typically beats its respective benchmark in a given year. Considering the poor performance and high fees of active funds, we consider the move towards indexing to be a logical one for small investors, but it has its drawbacks.

Net New Cash Flow

A fundamental flaw with passive indexing is that, by nature, the funds often buy high and sell low to mirror the performance of a specific index. For example, when a company has done well and is added to an index, typically its business has been thriving, which would likely have already propelled shares higher. On the flip side, when a company’s business has underperformed and it is removed from an index, an index fund is forced to sell and their investors have no opportunity to profit once a company’s prospects start to improve. Furthermore, because indexes like the S&P 500 are market capitalization weighted, as the price of a stock increases, the stock receives a greater weighting in the index. This conflicts with what we focus on as value investors – buying securities as they fall in price.

Another issue with index investing comes when indexes and ETFs are forced to trade securities only after an index’s plan to add a new stock is announced to the market. Traders can “front-run” these additions and buy shares beforehand, as they know the index funds will be buying the shares when the company is officially added to the index. An example of this occurred last year on Monday, March 16th when it was announced that American Airlines would be joining the S&P 500 that Friday. Come Friday, the stock had risen 11%. Index funds were thus forced to buy the stock at a higher price. Similar to the way high-frequency traders are able game the market, this is an example of smart money taking advantage of an index fund. Over time these events may erode the returns of investing in these low-cost products.

While riding the momentum in index funds feels great during a bull market, index investors may be left exposed from a risk perspective when the market inevitably heads south. This is because an index fund may have larger positions in companies with high valuations, and smaller positions in lowly valued companies. Thus, even though index investors are able to manage risk relative to their benchmark, they may struggle managing risk on an absolute basis. One of our goals is to provide our clients a higher return on their equities than the S&P 500 over a full market cycle, without taking any undue risk. Hence, we will stick to our guns and continue seeking to buy a dollar’s worth of assets for fifty cents.

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Company Spotlight: Helmerich & Payne (Ticker: HP)

Helmerich & Payne (Ticker: HP) is a contract driller that provides well-drilling services for oil and gas exploration and production, specializing in meeting the unconventional needs of the Shale Boom. Counting some of the best oil and gas companies among its clients, HP leads the market in unconventional onshore drilling rig services, having developed a rig uniquely suited to drill horizontal shale wells with outstanding efficiency. The company primarily operates through its 343 US-based onshore rigs, though it also operates offshore and internationally in Latin America.

Since the 1990s, the rig specialist has secured a position at the forefront of the Shale Revolution through a history of principled innovation, anticipating the demands of the market to make drilling faster, safer, more adaptable, more mobile, and exploit any opportunity to increase the output on a drilling site. The company first introduced its FlexRig technology in the late 1990s to provide the market with a rig that has increased mobility and an ability to drill at a range of depths. The first two models of the FlexRig line, FlexRig1 and the FlexRig2, were designed to drill at depths between 8,000 feet and 18,000 feet. In 2001, HP introduced the FlexRig3 with enhanced safety features and an even wider range of depth capability – from 8,000 to 22,000 feet. The company next focused on increasing the efficiency of the drill site as a whole. The FlexRig4 in 2006 introduced a “skidding” feature that gave improved mobility, allowing up to 22 wells to be drilled on a single pad space. In 2011, the FlexRig5 continued this trend and facilitated long lateral drilling of multiple wells in a single location. But the most important contribution of recent years has been the FlexRig’s ability to adapt to unconventional horizontal shale wells with staggering efficiency. The rigs, in fact, are capable of fetching daily rates nearly 50% higher than their peers.

Helmerich & Payne (Ticker: HP) Stock Chart

Despite uncertainty in the energy markets, Helmerich & Payne is trading at an attractive valuation. Though forecasting the sales and earnings may prove to be difficult, conventional valuations of onshore drilling companies can be calculated on the basis of the value per rig and per unit of horsepower. Given the company’s market share and the exceptional efficiency delivered by their rigs relative to competitors’, Helmerich & Payne is more than likely to command a premium rate on either basis. Previously, acquirers have paid as much as $24 million per rig in precedent transactions, according to investment bank Johnson Rice. At a valuation of $24 million per rig, Helmerich & Payne is worth $87 per share. On a basis of horsepower, acquirers have paid as much as $17,500 per unit. Based on this valuation, the company is worth nearly $97 per share.

More than likely, Helmerich & Payne will not be acquired, but their market position and current valuation provide a solid margin of safety for investors. Its management has proven to be prudent and conservative with their capital, distinguishing the company as one of the few in the energy universe that entered the downturn without any debt. Further, Helmerich & Payne has paid a dividend every year since 1977, and the stock is currently yielding about 5%. In a no-to-low growth world, we would be happy to be “paid to wait.”

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Trusts as a Planning Strategy

Find your plan of attack. Read on to decode the acronyms of wealth transfer and clear the mystery.

Trust Options

There are many different types of trusts that can help alleviate the effects of gift and estate tax and direct the flow of your wealth transfer. By designing a wellplanned trust strategy, you can transfer your wealth in the most efficient way possible.

Grantor retained annuity trusts (GRATs)

A GRAT is a type of trust that makes annuity payments back to its grantor over a number of years and then transfers any remaining value to a beneficiary. When a GRAT is created, the IRS uses a set growth rate (called the 7520 rate) to estimate the trust’s future value. It then subtracts the annuity payments from the future value to determine the remainder—the only portion taxed as a gift. Because GRATs are taxed upfront, any excess growth (growth above the 7520 rate) will be not be subject to gift taxes. Therefore, grantors often select annuity payments that equal the IRS’s expected future value, creating a GRAT that incurs no gift tax and leaves all excess growth as the remainder.

Common recommendations include keeping the term length of a GRAT relatively short, depending on the time horizon, or creating several short-term GRATs rather than one long-term GRAT. The reason for this is that if the grantor dies prior to the expiration of the GRAT term, the GRAT will fail in its purpose and all assets will remain subject to estate tax. For this reason, many opt for a “rolling GRAT;” which is a series of consecutive short-term GRATs. This technique also helps to hedge some of the risk of market fluctuations. However, short-term and rolling GRATs require larger annuity payments, so if there isn’t a large amount of liquid assets available, a long-term GRAT may be more effective.

Things to keep in mind when considering GRATs:

  • GRATs are still subject to income taxes.
  • GRATs are irrevocable—they cannot be changed or terminated.
  • GRATs are legally required to pay annuities, regardless of growth.

Grantor retained unitrusts (GRUTs)

GRUTs are almost identical to GRATs, with the only difference being in how annual payments are determined. Instead of returning a fixed amount, GRUT annuities are a percentage of the trust’s value that year. That means that the income distributions will be less stable and may be higher one year, but lower the next.

Irrevocable life insurance trusts (ILITs)

ILITs are trusts designed to hold the life insurance policy of their creator. An ILIT essentially removes your life insurance policy from your official property, thereby protecting it from estate taxes. This type of trust also provides the surviving beneficiaries with funds while not passing into their estates, which helps avoid estate taxes as well. ILITs can help grantors feel secure because they guarantee that no matter how much a grantor spends in their lifetime, their beneficiaries will still receive an income after their death from their life insurance policy.

When considering ILITs, keep in mind the following:

  • It takes three years after the ILIT is created for the IRS to consider the trust as outside the grantor’s estate.
  • A provision known as Crummey powers allows beneficiaries to take small gifts annually from the trust for a brief period of time (usually 30 days). This allows beneficiaries to avoid gift taxes by taking the funds out in small amounts rather than receiving the total value of contributions as a large gift once the grantor dies.

Intentionally defective grantor trusts (IDGTs)

IDGTs are trusts that make the grantor the owner of the trust for income tax purposes but not for estate tax purposes. Using a trust with the word “defective” in its name may seem counterintuitive, but this simply refers to the fact that the grantor is taxed on the income the trust receives. The “intentional” part of the trust hints at the fact that this type of taxation allows the trust itself to remain untouched, leaving more money for the grantor’s future heirs. This “defect” in the trust is what makes it such a useful tool for generational wealth transfer.

This type of trust essentially freezes assets for estate tax purposes by allowing them to grow outside of their estate without income tax reductions, as the trust income tax is applied to the grantor instead of the trust itself. Since the tax rates escalate much more quickly for trusts than for individuals, this type of trust helps to save on overall income tax by putting the taxes in a lower bracket. As of 2016, trusts that earn over $12,400 will be taxed at a 39.6 percent rate—an individual would have to make over $415,051 before he or she was subject to those same rates.

Choosing a trust to aid your wealth transfer plan can be tricky, so it’s important to work with legal and financial professionals to do so. You should consider the unique aspects of each trust and whether or not they fit with your wealth transfer plan and your family’s needs. Whether you choose one type of trust or a combination of trusts, the most important thing is that you pass on your money in a way that makes you feel secure about the future of your legacy.

This article was written by Advicent Solutions, an entity unrelated to Tufton Capital Management. The information contained in this article is not intended for the purposes of avoiding any tax penalties. Tufton Capital Management does not provide tax or legal advice. You are encouraged by your tax advisor or attorney regarding any specific tax issues. Copyright 2013 Advicent Solutions. All rights reserved.

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Stay the Course

As we look back at last year’s financial market results, it appears at first blush that we had a very quiet, uneventful twelve months in the investment world. The Dow Jones Industrial Average (DJIA) increased a mere 0.2% (including dividends), while the S&P 500 eked out a 1.4% total return. But like the proverbial duck, calm on the surface but paddling like crazy underneath, there were indeed extensive market-driving global events throughout 2015 and the volatility that ensued.

Last year’s activity began with quantitative easing (QE) from the European Central Bank, followed by a spike in bond yields. As the year continued, we experienced the Greek drama, a stronger U.S. Dollar, a continued slide in commodity (namely oil) prices, and ongoing concerns over growth in China and other emerging markets. The terrible events in Paris in November and the increased threats of global terrorism continued to dominate headlines. And let’s not forget the Fed! After months of “will they or won’t they”, Federal Reserve Chair Janet Yellen and her Committee presented us in December with the first shortterm interest rate increase in almost ten years.

What do these events mean for investors as we look into the future? The volatility we are experiencing serves as a reminder: markets “climb a wall of worry” in the long term. That is, while things can and do get very choppy, investors need to hold on and stick to their long-term goals. Part of our job at Hardesty Capital Management is to guide our clients through these turbulent times, helping them to focus and not react emotionally. Back to the proverbial duck, our role is to analyze and manage the “craziness” that exists beneath the surface. Our goal is that this allows our clients to live calmer lives and focus on other, more important things.

We begin this quarter’s Hardesty Horizons with our firm’s outlook for the economy and financial markets beginning on Page 2. As you’ll read in our investment analyses throughout Hardesty Horizons, we continue to be cautious but still positive on the equity market and are forecasting a low single-digit percentage gain for stocks this year. While we anticipate a slightly positive year for equities, we foresee another year of significant volatility in getting there.

Also included in this Horizons issue is a timely discussion starting on Page 4 of the benefits of value investing over the long term. The investment professionals at Hardesty Capital Management have long subscribed to the value philosophy, seeking to purchase a dollar’s worth of assets for fifty cents. We continue to be confident that value investing will outperform growth investing over a full market cycle.

This quarter’s Hardesty Horizons analyzes one of our favorite stock ideas for the New Year: Qualcomm (QCOM). While QCOM’s business of making semiconductors might not be overly exciting to some, the company’s prospects and stock’s valuation excite us! Finally, our article on Pages 7-8 discusses the complications of transferring wealth to the next generation and how to avoid possible pitfalls.

As we enter our third decade in business, we’re as optimistic and excited as ever about the outlook for our clients and our firm. We wish all of you a very Happy New Year, and thank you again for your continued support!

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2016: Cautiously Optimistic on Equities, Concerns About Credit Risk

A surge in the stock market over the closing two weeks of the year allowed the S&P 500 to post a positive total return of 1.4% for 2015. This meager return is more than welcome given the market’s mid-summer swoon of 10% and an increase in volatility prior to the Federal Reserve’s decision to increase short-term interest rates in December.

Although we flip the calendar to a new year, many of the headwinds buffeting the stock market persist. The U.S. Dollar remains strong, in part because Europe, China and Japan are stimulating their economies while the Fed is taking steps to limit future inflation. In turn, the strong Dollar has a pronounced negative impact on reported revenue and earnings by those U.S. companies with extensive international exposure. Further, the highly valued Dollar keeps a lid on energy and other commodity prices. Lower energy prices will reduce output in America, leading to slower economic growth in the short term. The impact of a strong Dollar and weak overseas markets can be seen in returns from the different major stock market indexes. The industrial-rich Dow Jones Industrial Average has now underperformed the S&P 500 and the NASDAQ for the fourth consecutive year.

The economic windfall provided to consumers from lower energy prices has not fully percolated through the economy. Instead, savings rates have increased. Expectations were for savings at the pump to be spent in other areas. Higher savings rates may portend a lack of confidence in our economy – a troubling development. Similarly, the popularity of Donald Trump may be a reflection of a loss in confidence and the dissatisfaction with the status quo.

Federal Reserve actions will also continue to impact the markets. We continue to believe the Fed will move slowly and deliberately. William McChesney Martin, Jr., the Chairman of the Federal Reserve from 1951 to 1970, once said that the Fed’s job is to take the punch bowl away just as the party gets going. From the depths of the recession in 2009 through the first half of 2015, average annual real gross domestic product growth in the U.S. has been just over 2%. This doesn’t exactly constitute a party. Although the first few rate hikes may remove a few hors d’oeuvres, the punch is still flowing.

Treasury Yield Curve

A few additional areas of concern have emerged during the course of the year. The value of merger and acquisition activity involving U.S. companies has reached $3 trillion. Prior peaks of $2.25 trillion in 2007 and $1.75 trillion in 1999 preceded recessions. The lack of organic growth has companies turning to M&A to provide the growth that investors expect.

The compression of interest spreads in U.S. Treasury yields has also entered our radar screen. The Fed’s decision to begin raising short-term rates has had little impact on the 10-year Treasury. While the Fed has great sway over short-term rates, longer-term rates are controlled by the market and expectations for growth. A critical level for the spread is at the point of inversion, which occurs when the short-term rate actually exceeds the longerterm rate. The scenario is a good indication of a looming recession. We are not close to inversion yet, but the spread contraction is something we monitor very closely.

The upcoming presidential election will certainly begin to shape the investment landscape. It is difficult to handicap the race, especially for the Republican Party. However, with the left and the right pulling further apart, gridlock may be the end result. In any case, we continue to monitor the candidates and their platforms to determine the impact on your portfolios.

Not to be completely overshadowed, the economy continues to expand and the employment ranks grow. A late-year budget deal included increased government spending without raising taxes, which should boost our GDP by as much as 0.5% next year. Equity valuations are not cheap, but at the same time they are not excessively high. We anticipate below-average equity returns for 2016 with the S&P 500 delivering a total return of around 3%. We remain cautious but opportunistic in our equity investments.

The bond market has also experienced gyrations this year. Most of the action has been in the high-yield area. Many energy companies, having incurred high amounts of debt to build infrastructure to capture abundant deposits, have fallen on hard times as both oil and natural gas prices have collapsed. Bond prices have fallen and liquidity is now a concern. Investors who entered the space in a hunt for yield may precipitate further weakness as they head for the exit. Our investment-grade strategy has held up well. We own bonds for their stability and steady income. Equities are the asset class for risk-taking.

Value of Mergers and Acquisitions

Given our outlook for modest interest rate increases, our primary concern is credit risk, not interest rate risk. Credit risk reflects the issuer’s ability to make interest and principal payments. Interest rate risk reflects price changes due to movements in interest rates. As interest rates move higher, the price of a bond with a fixed rate of return will move lower. Although interest rates are still at very low levels, we have started to extend maturities as rates have crept higher from the depths reached in 2012.

Each new year presents uncertainty and unique challenges, and 2016 will be no different. We appreciate your support and confidence as we work hard to add prosperity to your New Year.

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Benefits of Value Investing Over the Long Term

Generally speaking, there are two schools of investing: growth and value. Growth investors look to invest in companies that are normally growing their sales, earnings, and perhaps customers at a rate well above the typical company. A successful growth company firing on all cylinders and achieving the above factors often leads to the company’s stock outperforming the broader market. However, when the markets start to decline and overall growth is anticipated to slow, growth stocks frequently decline more than the market. On the other side of the spectrum lies value investing. Often, value investors are more risk-averse and first look for the downside scenario that might face a company. With the downside determined, value investors attempt to buy the company’s stock at a discount to the estimated intrinsic value. While the company’s earnings may not grow at a rate faster than or even matching the broader market, the expected downside in the company’s stock price is limited during periods of stock market volatility. As a result, value investing has proven to outperform growth investing over the long term.

The investing styles move in and out of favor depending on what investments are perceived to deliver the best returns. Since the beginning of this bull market in 2009, growth investing has been en vogue as investors have sought companies that are actually growing in a no-to-slow-growth economic environment. 2015 was no exception as Facebook,, Netflix, and Google were among the S&P 500’s best performers. Often known by the acronym FANG, these four companies held up the S&P 500 from further declines during the year, while the average stock in the index was down 18% from its 52-week high.

Value vs. Growth

A handful of stocks leading the market is nothing new to Wall Street. In the late 1960s and early 1970s, investors were enamored with “the Nifty Fifty” which included companies such as IBM, Walt Disney, Coca-Cola & McDonalds. All came crashing down when the bear market arrived in 1974. A similar craze occurred in the late 1990s and early 2000s with several technology stocks, such as Microsoft and Intel, leading the market. Once the “tech bubble” burst, some overvalued technology stocks lost more than 80% of their value. A share purchased in Microsoft or Intel early in the 2000s would, even today, not have made an investor a single dollar.

At Tufton Capital, we practice the value investing philosophy, looking to outperform in bear markets while performing adequately in bull markets. There is no telling when the next bear market will arrive, but one thing is definite – we are currently in the second longest bull market of all time. Our style will come back into favor. Until then, we will maintain our discipline, be patient, and continue to focus on finding a dollar’s worth of assets trading for fifty cents.

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Employee Spotlight: LaShawn Jenkins, Account Administrator

LaShawn JenkinsWe recently welcomed LaShawn Jenkins back to the Hardesty Capital team as an Account Administrator.

LaShawn has over 20 years of experience working as an administrative and customer service professional. She began her career as a receptionist at Prudential Securities, followed by positions at A.G. Edwards & Sons and M&T Bank. LaShawn worked at Hardesty Capital Management from 1996 through 2001 and returned to the firm in 2015. Just prior to rejoining Hardesty, she worked as a Gift Entry Coordinator at Kennedy Krieger Institute.

LaShawn is involved in fundraising and raising awareness for the Cystic Fibrosis Foundation. She is also actively involved in fundraising efforts for the Kennedy Krieger Institute. LaShawn lives in Parkville with her daughter, Amaya.

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How to Avoid the Complications of Wealth Transfer

Help your descendants help themselves by learning about these common wealth transfer problems.

Money can make even the closest family relationships turn ugly. Anticipating the emotional issues attached to wealth transfer can help you avoid them altogether or deal with them more efficiently if they do arise.

Sudden wealth syndrome

Coming into a large amount of money unexpectedly seems great from an outside perspective. However, if an heir receives this money without being adequately prepared for the responsibilities that come with it, he or she can experience something similar to what lottery winners often feel. This instant gratification is often called “sudden wealth syndrome.” Because the heir did not have to work to gain the money and/or may not have talked with his or her predecessor about the work that went into earning the money, it may result in a lack of motivation. The person may find it hard to develop skills like delayed gratification and thrift. Therefore, an heir is more likely to spend the windfall and blow through most of the inheritance. Heirs in this situation often experience frustration, feelings of failure or a false sense of entitlement. They may avoid accountability or withdraw from others, sometimes even developing serious social disorders.

How to fix it

The most important thing to remember to avoid giving your children sudden wealth syndrome is to take the time to communicate to your family the values that allowed you to accumulate your wealth. Children who understand and empathize with the struggle that their parents may have gone through to attain their wealth will feel more of an emotional attachment to this money and will be less likely to spend it all at once. If you feel that your children are not emotionally ready to handle this wealth, consider setting up trusts or placing an age restriction on when your future heirs can inherit their money. This sets up a longer time line and gives the next generation time to mature.

Leadership voids

A leadership void can occur when a family business owner dies suddenly before training the next generation. If it’s not clear who should step up to take responsibility of the business, power struggles can occur among the remaining heirs. Even if financial wealth or the entire business isn’t lost, the vision for the business often is.

How to fix it

If a business is among your assets, one of the first things your wealth transfer plan should establish is how that business will function after you are gone. Will your family continue to run the business, or will it pass through sale to a third party? If you choose to keep it within the family, you will want to set specific role designations for your future heirs. It’s important to remember that “fair” is not always “equal.” For example, if you have two children, one who has worked alongside you in the business for years and understands your business plan and ethics, and one who has shown no interest in the business and knows little about your business practices, you may not want to split the business equally between these children. When making these choices, it’s important to discuss your rationale with your family ahead of time so that your future heirs understand why they are placed in their roles and what is expected of them in those roles.

Trustee-beneficiary relationships

Difficult trustee-beneficiary relationships can occur when families adhere to the “nothing revealed until death” principle of estate planning. If trustees and beneficiaries are not kept in the loop during the planning process, the beneficiaries suddenly find themselves inheriting an unexpected amount of wealth at an already emotional time in their lives. If they haven’t talked to the grantor about the idea of a trust before the grantor’s death, they can feel as though the trustee is standing between them and what they are “rightfully entitled” to.

How to fix it

It’s important to consider who you name as trustee and why. For example, it can be common practice to name a child as a trustee. However, what if you die before your spouse and your spouse then has to ask your son or daughter for principal distributions from a trust? This can create an uncomfortable family situation. It’s important to consider the possible ramifications of who you name as trustee and whether or not they will be able to handle the difficult decisions left to them. Depending on your family situation, it may be best to name a trustee who is impartial to family dynamics.

Property squabbles

Depending on how specific you are in your wealth transfer, there may be certain items that are “up for grabs” in your estate. These items may have emotional value to one of your descendants, or may be culturally significant, such as prominent works of art. This can lead to arguments among family members over who gets to keep what, especially amongst siblings or descendants who may already be prone to fighting.

How to fix it

Depending on the personalities within your family, it might be wise to avoid leaving property division decisions to your descendants. You have the option to try to be as specific as possible in your estate planning documents, or you can name an impartial executor to divvy up your property. If you do choose to leave property division to yourself, make sure you are open and honest with your future heirs about how and why you chose to leave certain things to certain people. Also, you should avoid promising the same piece to more than one person—a tactic that some people use to try to avoid conflict in the moment. Unfortunately, this usually leads to enlarged conflict later on.

Communication is key

Even if you set up a beautifully planned wealth transfer with a variety of financial strategies and your financial planner executes it perfectly , it still has the potential to fail if you don’t have your future heirs on board. Beyond preserving your wealth, communicating money values and generational wealth transfer plans in the most open way possible can also help your children to become more knowledgeable and responsible with their finances.

This article was written by Advicent Solutions, an entity unrelated to HardestyCapital Management. The information contained in this article is not intended to be tax, investment, or legal advice, and it may not be relied on for the purpose of avoiding any tax penalties. Hardesty Capital Management does not provide tax or legal advice. You are encouraged by your tax advisor or attorney regarding specific tax issues. Copyright 2013 Advicent Solutions. All rights reserved.

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Looking Over the Horizon

Chad MeyerThe volatility that we’ve experienced in the global markets in recent months serves as a great reminder: although markets generally “climb a wall of worry” over the long run, they don’t do so in a straight line. While the first half of 2015 resulted in a flat S&P 500, this year’s third quarter brought the much-anticipated correction that we (and much of Wall Street) had been patiently awaiting.

But while corrections are no fun for investors, they are a normal and necessary component of the long-term market cycle. Moreover, market pullbacks give value investors like us opportunities to put our expertise to work. Our firm has been finding value in stocks such as Emerson Electric (EMR), which now trades at 12 times next year’s earnings while offering a 4.4% yield (please see our EMR analysis on Page 7). And with companies such as Procter & Gamble (PG) and Chevron (CVX) yielding 3.7% and 5.5%, respectively, good investments become even better ones in down markets. So while corrections (more…)

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Investing Through Volatility

Ted HartThe month of August showed the return of volatility in the financial markets. The S&P 500 dropped 11% in the span of seven days and the VIX, widely known as “the Fear Index,” hit an intraday high of 53 – a level not seen since the financial crisis. In one day of trading, the Dow Jones Industrial Average opened down more than 1,000 points within the first hour, causing a “Flash Crash” as many ETF investors attempted to run for the exits. All of this chaos resulted in the >10% correction we had been long awaiting.

Throughout this volatile time, I received texts and calls from relatives asking if they should sell or trim their portfolios. My response often was “What? Why would you? I’m buying!” As we have mentioned in previous articles, >10% corrections are common and have occurred about every two years since 1957. Selling or trimming your portfolio during these corrections is one of the (more…)

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Tax Loss Harvesting

W. Neill PeckHardesty Capital Management spends a considerable amount of time searching the universe of publicly traded companies for undervalued stocks to purchase in our clients’ accounts. Aside from research roles, our 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, and with the end of the year quickly approaching, 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 (more…)

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