Marc Heilweil

Wednesday, 17 March 2004 11:43

Inflationary measures

An increase in the rate of inflation may be at hand. The past year has witnessed a rapid devaluation of the dollar, large budget deficits financed by running the government printing presses overtime and soaring metal and energy prices.

There's a common belief that equity holdings are a good hedge against an increase in the rate of inflation,

but that may not be true. Instead, consider other portfolio adjustments necessary to cope with higher rates of inflation.

 

Stock valuations

How should stocks be valued? A stock's price-to-earnings ratio indicates what investors are willing to pay for $1 of earnings for that company. While the market tends to award higher P/E multiples for stronger expected earnings growth, anticipated risk and market interest rates have the opposite impact.

Interest rates include an adjustment for inflation, so interest rates rise when the rate of inflation increases or is expected to increase. Therefore, holding all other factors constant, an increase in the expected (or actual) rate of inflation should result in lower stock prices.

Try to position your portfolio so that you are less vulnerable to an increase in the rate of inflation. Such actions are often subtle. For example, you could sell or hedge bank stocks which would be hurt by rising rates. Or, you can increase your exposure to foreign currencies and industries where pricing power may be restored by higher inflation.

Of course, buying resource-rich companies is a more obvious choice.

 

Fixed income holdings

Likewise, consider taking steps in your fixed income portfolios which will protect them against interest rate increases. Some actions to consider are:

 

1. Purchasing bonds at a premium, which are priced to a call that may not take place. The extension of

the call yields a higher rate than nonpremium bonds pay.

2. Buying mortgage-backed securities which will benefit from a slowdown in mortgage prepayments.

3. Buying TIPS, the inflation indexed bonds which the government has issued.

4. Shortening maturities in your existing portfolio.

5. Buying step-up securities often issued by federal agencies. These bonds must increase their interest rates at certain future dates.

 

For the last 22 years, stock prices have had a strong tailwind. The usual push from earnings growth has been magnified by the lower benchmark for returns that results in higher price earnings ratios. While a headwind from higher risk-free rate of return may retard stock prices, there are factors that lessen its impact.

Earnings growth will increase the "E" (earnings) in the P/E ratio. Higher inflation may allow some industries greater ability to raise prices. A rise in inflation could encourage consumer buying in order to beat higher prices in the future, and thus increase sales for corporations.

Although there are numerous elements that make one suspect higher inflation rates in the next several years, other economic forces could cancel these out. Indeed, there are some who believe that deflation may result from excess leverage and another economic downturn. We cannot be certain of increased inflation, but we do know that should we experience it, interest rates will rise and price earnings ratios will fall.

The benefits of lower inflation have helped financial assets for more than 20 years. We now face the likely prospect that this benefit has come to an end. The wise investor should make sure his or her assets are not ambushed by a renewal of inflation.

Marc Heilweil is president and CEO of Spectrum Advisory Services Inc. The firm manages approximately $282 million in assets, including the Marathon Value Portfolio mutual fund. Reach him at (770) 393-8725.

Thursday, 20 November 2003 09:34

Business savvy

Leaders of business are well-suited to select investment managers, far better suited than consultants, who often conceal their lack of insight behind a wall of concepts and data.

Excellent investment managers should have two basic business skills common to astute business leaders -- care in handling money and a sense of balancing opportunities and risk.

Why, then, are business leaders often dissatisfied with their choice of investment managers?

Too often, it's because convenience dictates the choice. Somebody has a locker near you at the club. Your neighbor handles people's money. Banks push existing clients to their investment departments.

But the easy choice has nothing to do with skill.

Many people don't realize it is illegal to tie loans to the use of other products. So don't think you're under any obligation to your bank or that your bank relationship will be helped by buying its investment products.

It makes no more sense to allow your banker to lead you to an investment product than it does to have your repair shop manager lead you to a heart surgeon. Commercial banking and investment management are no more related than are adjusting an engine valve and replacing a heart valve.

The cardinal requirements for choosing your investment manager must be an alignment of interest with you and superior judgment. In large financial services companies, that alignment of interest is very difficult. Corporate goals and management incentive often compete with the customer's interests -- witness the recent sales-motivated abuses in the mutual fund business.

Fresh thinking is stifled by rigid policies and approved lists.

You could spend hours discussing what constitutes superior judgment, so we'll save that for another day. Instead, here are a few observations on the current financial climate:

* All the dials on instruments of stimulus are turned up to their maximum.

* The dollar weakness will, in the short term, provide additional stimulus.

* Consumers, and to a lesser extent businesses, are joining government spending in an acceleration of economic growth.

* The balance sheet of the American consumer has deteriorated badly, buoyed only by strong housing prices.

* Debt relative to disposable income remains at unprecedented levels.

* Changes in the pricing and availability of home mortgages may be afoot. Should these take place, the repercussions in housing will threaten the recovery.

As of late October, stock market valuations were high. Analysts and investors like the improvements in corporate earnings. If the focus is limited to the next 12 months, the current optimism may be warranted.

Nevertheless, the value of any business, public or private, should be measured over a longer period. In this respect, caution is warranted, since today's extraordinary resuscitation efforts on a leveraged economy will cause undesirable side effects.

Marc Heilweil ( mheilweil@spectrumadvisory.com) is president and CEO of Spectrum Advisory Services Inc. The firm manages approximately $260 million in assets, including the Marathon Value Portfolio mutual fund. Reach him at (770) 393-8725.

Friday, 16 July 2004 09:14

Wise options

Whenever constituents suffer losses or are unhappy, they ask the government, "What are you going to do about it?"

Eager to please, the government tries to fix things. In the case of the Sarbanes-Oxley Act, I have argued elsewhere that the solution penalizes American business by putting it more in the hands of the large accounting and law firms that sanctioned the abuses in the first place. In the case of mutual funds, reforms are, once again, based on legal reasoning rather than practical notions.

So let's examine mutual fund management, especially in the 401(k) world.

Some younger readers may not realize the change in landscape between the world of today and that of a generation ago, when most employees had their retirement taken care of by their employer. Today, at least in the private sector, it is in employees' own hands through mutual funds. Individuals must make their own choices in a 401(k) plan.

The old system had two elements that allowed it to work. First, the company officers responsible could meet directly with the managers of the investments, and second, the company could adopt an appropriately long horizon for making the investments.

While one would expect to find these elements in mutual funds as well, many of the trends head in the opposite direction. For example, shareholder letters should allow the money manager to speak openly and directly to funds investors.

Myriad regulations make this communication more and more the domain of lawyers and compliance officers. As a result, some funds have retreated from offering these letters. The thought process of the manager writing the letter is subverted by regulatory demands. By restricting honest communication, the investor's education and ability to make informed evaluation is limited.

More important is the ability to make wise long-term choices. There are two factors at play. The most familiar is the need to think beyond the short term. The more subtle issue is the need to make decisions from a bewildering array of choices.

Employees are confronted with choices that baffle the most able and experienced of investors. They must choose between "growth" and "value," and among large, mid-cap and small capitalization funds. Additionally, they are asked to choose between domestic and international equities and an array of fixed income opportunities.

We all know how the fund industry has adopted the familiar consumer strategy of segmenting. Funds distinguish themselves by standing out in a category, not by offering the investor a broad exposure to the equity market. In fact, a broader-based fund that takes such an approach is guaranteed to lag in the category into which it is placed.

Employers would be wise to look for the company's 40l(k) solutions -- funds that incorporate the elements that will help their employees succeed. They should see to it that honest and wise communication is available to their employees. They should winnow their employees' choices to funds that allow proven managers to make more of the investment decisions for long-term retirement security.

Funds that buy from all segments and are not restricted from holding cash will keep their employees headed in the right direction. Marc Heilweil (mheilweil@spectrumadvisory.com) is president and CEO of Spectrum Advisory Services Inc. The firm manages approximately $282 million in assets, including the Marathon Value Portfolio mutual fund. Reach him at (770) 393-8725.

Tuesday, 25 May 2004 07:35

Value proposition

In order to make wise stock market investments, it is necessary to understand what is meant by "value" investing and "growth" investing. These terms can be complex, but by better understanding them, you'll have a better feel for the correct way to analyze a common stock.

A growth approach will usually emphasize enterprises that are expected to show above-average rates of growth in earnings or sales. Since growth companies tend to reinvest a greater portion of their earnings back in their businesses, for purposes such as R&D or expansion, these stocks often pay out lower dividends. Such companies often have price-to-earnings ratios higher than those of other competitors because investors are willing to pay more for a growing stream of earnings than a steady stream of earnings.

A value approach is thought to pay more attention to the intrinsic value of the assets and seeks a below-average price-to-earnings or price-to-book value ratio. While money managers and stocks often are characterized as one or the other, neither term, as commonly used, identifies the correct approach to stock investing.

The best approach is value investing that goes beyond the conventional definition. We begin with the notion that the initial price is crucial in determining the ultimate rate of return. Imagine a building that produces $100,000 of profit for its owner. It is clear that the return to the buyer who pays $800,000 is 12.5 percent, but the buyer who pays $1 million only receives a 10 percent return.

It is the same with stock. The value of a company is measured by the amount of cash that will be available to its owners over a 10-year period. Of course, at the end of the period, the company's capacity must be the same; that is, paid-out cash is not at the expense of replacing equipment or otherwise partially liquidating the company. To the extent that the company retains its earnings, we need to know the rate of return it is earning on its cash reinvested in the business.

We have now arrived at the juncture between value and growth investing. A company is more valuable if its reinvested earnings will produce a higher return than its existing business. If reinvested earnings cannot earn at least equal to what the company is earning now, the business is worth less, and the company should consider paying dividends rather than reinvesting its earnings.

Attempts to characterize style often lead to confusion. Morningstar, for example, has an arbitrary nine-box style system for dividing common stock mutual funds. We have already seen how arbitrary growth and value distinctions are. Another defect is grouping funds in a category based on the market capitalization of the average holding. (Market capitalization equals the price of a share multiplied by the number of shares outstanding.)

The mutual fund which I manage, Marathon Value Portfolio (MVPFX), has about 20 percent of its holdings in medium capitalization companies, yet is called a mid-cap blend fund because Morningstar combines the large and small capitalization stocks to get an average.

Many funds in that category, however, are focused on the medium-capitalization sector. The other mutual fund service, Lipper, does a far better job by distinguishing between a multi-cap fund and a fund that invests strictly in medium-capitalization companies.

After we have shunned labels, we arrive at the following conclusions:

 

* The price paid is important because it establishes the initial return.

 

* The value of a company is determined by its ability to return cash to its owners.

 

* For a company that is not returning all its unneeded cash, a judgment is needed about the rate of return at which it can reinvest its cash. It is here that the growth and value investments distinction has to be abandoned. Marc Heilweil (mheilweil@spectrumadvisory.com) is president and CEO of Spectrum Advisory Services Inc. The firm manages approximately $282 million in assets, including the Marathon Value Portfolio mutual fund. Reach him at (770) 393-8725.

Wednesday, 20 October 2004 18:17

Investing for the future

In past editions of this series, I have discussed:
  • Solutions to protect against inflation, even in bond portfolios
  • The use of investment vehicles other than stocks and bonds as part of any substantial portfolio
  • How to bridge the difference between value investing and growth investing
  • Why 40l(k) plans can benefit from having mutual funds which invest in all capitalizations and that do not readily fall into the value and growth styles
  • That in selecting an investment counselor, one should emphasize proven judgment and a person who will be responsible to you.

The reader has also received a timely warning that the measures used to stimulate the economy posed a threat to the length of the economic upturn, and that the risk of rising interest rates had to change fixed income strategy. In this, the final article of the series, I will revisit these issues.

So how do I see the next five years?

The current economic upturn should prove more short-lived than normal. Domestic consumption will likely suffer much more in the next downturn than it did in the last recession. Lower consumer spending is both necessary and helpful.

The U.S. trade deficit now exceeds 5 percent of gross domestic product, and no country has ever reached that level without a significant adjustment taking place. If we are to avoid the financial crisis and devaluation that often results from this, our consumption must decline or the government deficit must be rapidly closed. I am confident that in the next five years, we will see a major reaction to the ever-widening trade deficit.

Turning to the investment world, I am more tentative. While the U.S. stock market will continue to be the home of many of the largest, most profitable companies in the world, its return may lag behind those of many countries when measured in U.S. dollar terms. The Japanese and British markets may rank among the best in the industrialized world.

For those managing their own portfolio, it will be important to ignore the zigs and zags of the market and remain with those companies that can maintain their profitability. For those who let others manage their money, stick with proven, dedicated investment people. The firms that cover a wide spectrum and are exclusively focused on money management will do best.

The first generation of a firm is often the best.

Test the business knowledge of the person managing your money. Stay away from those who claim they have discovered a short-cut formula. And avoid those who charge more than they are worth -- especially when considering hedge fund managers.

As I write in late August, the median return for hedge funds so far this year is about zero. Yet the hedge fund industry, now widely promoted, has seen record inflows, which have lifted its size to $870 billion. The hedge fund manager still charges a normal fee and gets expenses paid. When they do better than break even, the hedge fund manager typically gets 20 percent of the profits. No wonder the number of hedge funds is soaring. There are quite a few hedge fund managers among the lists of the very wealthy, but I know of no wealthy person who attributes his wealth to an investment in a hedge fund.

The challenge of managing funds for others is a great privilege. It requires a strong sense of responsibility and depends on your ability to learn constantly about the world. In the end, investing is a field that requires an ability to understand our environment. For that reason, it is a wonderful occupation.

Marc Heilweil (mheilweil@spectrumadvisory.com) is president and CEO of Spectrum Advisory Services Inc. The firm manages approximately $282 million in assets, including the Marathon Value Portfolio mutual fund. Reach him at (770) 393-8725.

Monday, 02 February 2004 06:17

Wise investing

It is not so difficult to make money. It is easy to lose money. It is very hard to hold on to accumulated wealth over time.

Making money in one's own business and losing it in someone else's is too often the case for successful businesspeople. To help you avoid this misfortune, this article will address common misconceptions.

In managing business, we are used to looking at measurements over defined, relatively short periods. We ask what the profits were last quarter, how much did a salesperson sell last month or other such questions. Measurement of investment results is a trickier matter.

For example, we may put money in a company that is in an industry that is consolidating. The investment may produce meager results for several years until the company is acquired at a premium, which results in a very satisfactory rate of return for the entire period. Real estate investors in raw land will recognize the investment strategy.

Similarly, an investment in a company whose industry is out of favor may not produce a satisfactory result until its industry returns to favor even though the company was doing well. Remember that even sound thrift institutions were out of favor until the savings and loan crisis was resolved.

My point about the fickleness of measurement intervals is well illustrated by this year's extraordinary returns. Clearly, a percentage of this year's returns is making up for the excess in last year's decline. In effect, last year's returns were too low and this year's are too high. Expand the time period and you have a better measure of investment performance.

Looking forward to the next few years, it is apparent to me that success will require diversification, and I mean diversification for the purpose of improving returns, not just lowering risks.

At current levels, U.S. stock markets challenge us to make heroic estimates about revenue growth and profitability enhancement. If the U.S. stock market promises subpar returns, higher returns must come from other avenues. Our firm is constantly searching for the investment area where returns are superior on a risk-adjusted basis, and we then place some of our money in that area.

A few years ago, real estate had better returns than common stock, and we bought REITs and real estate operating companies. More recently, foreign stock markets promised better risk-adjusted returns, and therefore received more allocation.

Two other categories to place funds are in arbitrage and distressed securities. Arbitrage takes advantage of price discrepancies between related securities. Investing in distressed securities requires careful research to find opportunities, usually in the bonds of companies that have encountered severe problems.

Managers of a business usually should stay focused on their markets. In portfolio investing, it is wiser to scan the investment horizon and diversify into different areas.

Marc Heilweil is president and CEO of Spectrum Advisory Services Inc. The firm manages approximately $260 million in assets, including the Marathon Value Portfolio mutual fund. Reach him at (770) 393-8725.