Tuesday, 23 October 2012 13:34

Fundamentals falter ... But fears fade

Every quarter, FirstMerit sends a newsletter to all its wealth management clients. In the Fall 2012 edition, Bob Leggett, CFA, Senior Investment Strategist, FirstMerit Wealth Management Services, discusses the year-long battle between fears and fundamentals.

Here's an excerpt from the newsletter:

For the past year, we have been harping on the need to downplay fears and focus on fundamentals. Our point was that fundamentals were at least okay and might actually surprise the consensus to the upside. The fears were not unreasonable, but appeared to us to have low probabilities of occurring within our tactical time horizon. Thus, a total focus on the downside risks of fearsome outcomes (such as a U.S. recession, the Fiscal Cliff, the European crisis, or a China hard landing) could — and did — cause many investors to miss the opportunity to participate in a bull market.

Market returns were very good through Q3 and the S&P 500 led the way with a 16.4 percent total return. Midsized and smaller stocks were up about 14 percent and despite U.S. Dollar strength and European leadership's determination to shoot themselves in the foot, EAFE was +10 percent and Emerging Markets +12 percent. Fixed Income returns weren't bad either (although Treasury returns were only low single-digits), as "spread product" such as Corporates (+7.1 percent) and High Yield (+12.1 percent) continued to do well. Somewhat ominously, TIPS did much better than non-inflation protected Treasuries.

Read the entire newsletter here: 10629_Fall2012_MM_r4

Bob Leggett, CFA, is the Senior Investment Strategist at FirstMerit Wealth Management Services. Reach him at robert.leggett@firstmerit.com or follow him on Twitter @firstmerit_mkt.

Published in Chicago

Is there a pipeline in your investment future? Master limited partnerships (MLPs) are a type of publicly traded holding structure employed widely in the natural resources energy infrastructure space, which includes pipelines, storage facilities and anything in the transportation chain, from the wellhead to the market consumer.

“Yield-starved investors are dying for ideas, so here’s an idea of a niche asset class that has high current income, growth potential and some tax-deferred characteristics,” says John Micklitsch, CFA, director of wealth management with Ancora Advisors LLC. “They bring some diversification to a portfolio because they have a low correlation with stocks and bonds, and they have the potential to hold up well in an inflationary environment because they are a hard asset and their distributions are growing.”

Smart Business spoke with Micklitsch about the advantages of MLPs and why this might be a smart investment for you.

How do MLPs work?

MLPs trade on major stock exchanges such as the New York Stock Exchange or NASDAQ like any corporate stock, but instead of being a common shareholder of a corporation, you are a unitholder in a limited partnership. Like stocks, there are no liquidity or minimum purchase requirements. Some MLP examples include Kinder Morgan Energy Partners (KMP) and Energy Transfer Partners (ETP).

Ninety percent of a MLP’s income must derive from natural resources production, transportation or storage, real estate, dividends or interest income. As it turns out, the majority of publicly traded MLPs are in the natural resources production, transportation and storage sectors. Basically, the government decided in order to have a strong energy infrastructure in this country, it would give companies participating in that infrastructure a subsidy by not taxing them, provided they distribute their income out to unitholders.

Why are they potentially attractive investments?

MLPs have the highly sought after characteristics of strong current income and future growth potential. The business model is very predictable and simple to follow, as MLPs are paid fees, based on long-term contracts, for the natural resources that go through their pipelines or storage facilities. Generally, midstream MLPs take no ownership of the underlying commodity and therefore have little or no exposure to commodity price volatility. This fee-based, steady income stream allows them to pay out high distributions.

The Alerian MLP Index, which represents the universe of publicly traded MLPs, showed yields above 6 percent as of June 30. Comparatively, utilities were around 4.1 percent, real estate investment trusts near 3.9 percent, the Dow Jones Industrial Average was 2.7 percent and the S&P 500 was 2.2 percent.

In addition, MLPs are predicted to grow because energy production is transforming due to the technological breakthroughs associated with horizontal drilling and the exploration and production of the country’s shale resources, known as fracking. Whether the newfound natural gas and oil is consumed in this country, as is likely, or exported, those resources are too valuable to sit in the ground and will find their way to market to the benefit of these volume-based infrastructure providers.

The distributions a given MLP would be able to pay are expected to grow 5 to 7 percent over the next several years. When added to current yields, you could be talking about potential low double-digit returns.

What else might impact MLP performance?

Many people are currently worried about inflation, but MLPs are hard assets. In addition, their distributions, which are not fixed and are expected to grow, stand a better chance of preserving people’s living standards in an inflationary environment.

When purchased directly, there are some potential tax-deferral benefits for investors, making MLPs and the income they produce potentially a tax-advantaged asset. However, it is important to work with an adviser to find the best ownership fit for you, direct or through a fund, as both have certain considerations.

One other advantage the MLP universe has exhibited in the past is a relatively low correlation with both the stock and bond markets, making them a good diversification tool. For example, in 2008 and 2009, MLP prices fell, but importantly, MLPs not only met their distributions but many of them continued to increase those distributions. MLP business models are very resilient to economic and commodity volatility.

What does the future look like for these investment vehicles?

The future is extremely bright for MLPs based on domestic energy production, led by this horizontal drill, shale/fracking revolution and simple demographics. The aging population will be starved for yield; interest rates are at an all-time low. MLPs’ combinations of high current yield plus distributions that should keep pace with inflation put them in a very attractive position for the key baby boomer demographic over the next five to 15 years.

In addition to yield-starved individual investors, institutions — endowments, foundations, defined benefit plans — are becoming more aware of MLPs and their benefits. Institutions could increasingly become involved in the MLP space over the next decade as they search for sources of return that allow them to hit their long-term actuarially driven targets. Even though they face the hurdle of unrelated business taxable income, it can be solved by a variety of ownership structures.

What should investors remember about MLPs?

MLPs are a very interesting asset class that’s growing in stature and awareness, due to the attractive combination of high current yields and growth potential of distributions, but MLPs do have several nuances that make their incorporation into your overall portfolio best accomplished with the help of an experienced adviser well versed in the space.


John Micklitsch, CFA, is the director of wealth management with Ancora Advisors LLC. Reach him at (216) 593-5074 or johnmick@ancora.net.

Insights Wealth Management & Investments is brought to you by Ancora

Published in Cleveland

The investment market has been rocky the past few years, and there is no indication that volatility is going to change any time soon.

But current market conditions make it an excellent time to invest in dividend-paying stocks, says Sonia Mintun, CFA, vice president with Ancora Advisors LLC.

“Given the historically low bond yield environment, dividend-paying stocks are an attractive alternative,” says Mintun. “Right now, you can assemble a portfolio of quality stocks with a yield of 3 to 3.5 percent, in comparison to the 10-year Treasury yield of approximately 2 percent. Dividend-paying stocks also offer downside protection, providing a cushion during negative equity markets, while also allowing for the capture of upside potential.”

Smart Business spoke with Mintun about why dividend-paying stocks are a smart investment in today’s economy.

Why does dividend-oriented investing make sense in today’s markets?

There are several reasons: Dividend-paying stocks are less volatile than non-payers and they have been proven to have a lower standard deviation, which is a measure of risk. Dividends have accounted for 40 percent of total returns in the market since 1940, and dividend-paying stocks have outperformed non-dividend-paying stocks over the last 80 years. These stocks tend to be relatively stable over time because dividends are a component of earnings that are less subject to speculation. In addition, dividends are sticky, and tend not to fall, as companies are reluctant to cut them. Dividends allow investors to collect some income while they’re waiting for the fundamentals of the company to improve.

Furthermore, payout ratios are hovering at extremely low levels historically. They tend to revert to the mean over periods of two to three years. The current payout ratio is 30 percent, compared to a historical rate of 52 percent. With increased confidence and economic stabilization, we will likely see deployment of large cash balances on companies’ balance sheets toward higher payouts.

Dividend yields are also below long-term averages of 2.8 percent. Currently, yields are about 2 percent, despite cash balances being at record highs. Moreover, earnings are recovering from the financial crisis and balance sheets are healthy, so there is good potential over the next year or two that yields will rise due to increased payout ratios.

Last, given today’s bond yields, the S&P earnings yield — which is the inverse of the price/earnings ratio — is pretty attractive relative to the 10-year Treasury on a historical basis.

How does inflation impact dividend-paying stocks?

Historically, dividends have grown faster than the rate of inflation in the U.S. With 3 percent inflation now, short-term, high-quality, fixed-income instruments are losing purchasing power. You can get a 3 or 3.5 percent dividend yield on a diversified portfolio of good quality stocks, and have potential for income growth relative to the fixed coupon on bonds.

The average dividend income from a portfolio of S&P indexed stocks has grown at a rate of 5 percent per year since inception in 1957, which is one full percentage point over the rate of inflation in the same time period. As a result, dividend stocks offer both the potential for capital appreciation and income growth. Dividends increased more than 10 percent in 2011, on top of a 10 percent gain in 2010. Also, dividend-paying stocks have outperformed more often in higher inflationary times.

What vehicles can be used to implement a dividend-paying strategy?

Investors can buy individual equities in portfolios that are sizable enough to diversify the risk of one particular issue or sector. While dividend-paying stocks tend to be less volatile, it’s prudent to make sure your portfolio is not too concentrated in one sector or company.

Investors can also buy exchange traded funds, or ETFs, that concentrate on dividend-paying stocks. ETFs are a cost-effective way to invest in dividend payers while achieving diversification in smaller accounts. There are also mutual funds that focus on dividend-paying companies. These typically have higher expense ratios than exchange traded funds, but the fund manager can trade them more tactically than ETFs, which are passively managed and based on an index.

Are all dividend-paying stocks the same?

All dividend-paying stocks are not the same. It’s very important to do your homework on the company when you are buying individual stocks. Higher yield stocks are associated with better subsequent performance, but only to a degree. Those in the 3 to 6 percent dividend yield bucket have outperformed their peers, both those with higher dividend yields and those with lower yields.

Stocks with yields in the 6 to 9 percent range and above tend to have a higher standard deviation, or risk. Sometimes investors fall into the yield trap, buying troubled companies that cannot sustain high payouts, leading to cuts in their dividends.

Investors should seek stocks in which the dividend can be sustained, potentially evidenced by a low payout ratio and ample net cash or share buybacks. Look for companies that have consistent cash flow, a healthy balance sheet for their industry and that increase their dividends consistently.

Given today’s historically low bond yields, the potential for inflation down the road, as well as the other reasons I detailed, investing in dividend-paying stocks makes sense. With the expectation that volatility is going to continue due to our upcoming election and events in Europe, investing in less volatile stocks paying dividends is a sound strategy. Furthermore, based on price/earnings ratios and the potential for improving earnings, the disparity between the earnings yield on the S&P relative to 10-year Treasury bonds make dividend stocks an attractive investment.

Sonia Mintun, CFA, is a vice president as well as an Investment Advisor Representative of Ancora Advisors LLC (an SEC Registered Investment Advisor). In addition, she is also a Registered Representative of Ancora Securities, Inc. (Member FINRA/SIPC). Reach her at (216) 593-5066 or sonia@ancora.net.

Published in Cleveland

If your key executives left, could your business continue to function, or would the loss cripple your company?

If the thought of losing your key people —whether to another employer or because of death or disability — keeps you up at night, a Supplemental Executive Retirement Plan (SERP) may be the answer, says Mark J. Dorman, president of Dorman Farrell, LLC.

“Finding and keeping talented difference-makers in an organization is tough,” says Dorman. “But, if your 401(k) or other retirement plans aren’t meeting the retirement income needs of your key people, SERPs can help you reward and retain those individuals.”

Smart Business spoke with Dorman about how SERPs can be a big win for both key employees and the company.

What is a SERP?

A SERP is a non-qualified plan, which means it is not subject to the same restrictive federal regulations and tax laws that govern qualified retirement plans, like 401(k), profit sharing and pension plans. SERPs work essentially like a private pension plan for each key employee for whom the employer wants to offer it. The employer makes a legally-binding agreement to pay additional compensation to the employee at some point in the future — usually retirement.

How does a SERP benefit both the employer and the key employee?

The key benefit for the employer is the ability to offer a really attractive future benefit to the employee — a benefit that makes the employee want to stay with the company. For example, if a business owner said to a key executive ‘I need you to stay with the company until age 60 to get the business where it needs to be,’ the executive may be reluctant to make that commitment. However, if the owner said ‘If you stay until age 60, I will pay you $X in annual retirement income between the ages of 61 and 70,’ suddenly the idea of staying becomes a lot more attractive. This incentive to stay with the company is often referred to as ‘golden handcuffs.’

Now is a good time to focus on executives’ retirement benefits. While government regulations have always restricted the deferrals highly compensated employees (annual incomes greater than $110,000 per year) can make to traditional 401(k) plans, what little they have been able to defer has likely taken a hit with the economic downturn and lackluster stock market performance. Executives are likely to have concerns about their retirement income and will find a SERP an appealing option.

SERPs also offer the employer a great deal of flexibility in designing the plan. Because they are not subject to the same regulations as qualified plans, the employer can pick and choose which employees are offered a SERP and design specific provisions. For example, the employer may choose to include a vesting schedule that vests the key employee over several years or, alternatively, requires the employee to stay for the entire term of the agreement to receive any benefit at all.

How do employers fund these plans?

SERPs don’t necessarily have to be funded at the time of the agreement. But if you don’t fund it, you create an unfunded liability on your books that you will have to pay out of future cash flow.

The vast majority of SERPs, particularly in private companies, are informally funded using either taxable investments, such as mutual funds, or tax-favored investments in the form of corporate-owned life insurance (COLI). The company owns, pays for, and is the beneficiary of the life insurance policy. The growth on the cash value accumulation is tax-deferred and used to the pay the SERP benefit, while the death benefit provides corporate cost recovery to the plan sponsor.

Here is an example of how a corporate-owned life insurance policy can be structured to fully fund a SERP: Assume an employer has agreed to pay a SERP participant $50,000 a year for 10 years between the ages of 61 and 70. The employer purchases a corporate-owned life insurance policy and uses the cash value accumulation to pay that benefit during those years, and takes a tax-deduction for the benefit during each year it is paid. Once the SERP benefits are fully paid, enough cash value remains in the policy that it stays in effect throughout the employee’s lifetime (even after leaving the company). When that person dies, the company receives the life insurance benefit tax-free, recovering the cost of the years of employer-paid premiums.

Are there any other considerations?

Yes. It is important for the employer and the employee to understand that one of the key requirements for non-qualified plans, including SERPs, is that there must be a substantial risk of forfeiture to the plan participant. If this requirement is not met, the IRS will deem the benefit to be ‘funded’ and immediately taxable to the participant. The primary risk to the participant is that the funds are subject to claims of the company’s creditors.  Additional planning is needed to protect the participants from a change in control and other factors that may threaten the security of their benefit payments.

What should an employer do to get started?

Companies should first enlist the help of experienced professionals. An experienced executive benefit consultant, along with the company’s accountant or attorney, can help you design a SERP agreement, determine appropriate financing and communicate with the key employee. The initial process usually takes between nine and 12 months. Once the plan is up and running, the administration is really quite simple.

Mark J. Dorman, CFBS, is president of Dorman Farrell, a member of the Skylight Financial Group . He has nearly 25 years of experience in the financial services and executive benefits arena. Mr. Dorman assists middle market privately held Northeast Ohio employers with their executive and employee benefit needs. He also works with business owners on the creation of business exit planning strategies. Reach him at (330)725-0501 or mdorman@dormanfarrell.com. Dorman is a Registered Representative of and offers securities, investment advisory and financial planning services through MML Investors Services, LLC. Member SIPC. Supervisory Office: 1660 West 2nd Street, Suite 850, Cleveland, Ohio 44113-1454, Phone: (216) 621-5680. Dorman Farrell is not a subsidiary or affiliate of MML Investors Services, LLC or its affiliated companies.   CRN201307-150122

Published in Cleveland