Our income strategies are oriented around maximizing your income distributions within the context of your risk capacity and risk tolerance. The basis is the risk free rate of return, typically U.S. Treasury investments, with a tilt toward higher yielding investments to meet your monthly income goal. For example, you may have a large portfolio and modest needs for monthly income and you could be invested 100% in a laddered portfolio of U.S. Treasury securities. In this case we would analyze all of your sources of income outside of your investment portfolio, including Social Security and any annuity or pension income, investing just enough funds in U.S. Treasuries to satisfy your monthly income goal. We could then invest the balance of the portfolio in any number of higher yielding or growth alternatives. As another example, you may have a smaller portfolio but a greater monthly income need. Again, we look at Social Security and any other sources of income outside your portfolio and then construct an income producing portfolio to reach your monthly income need. In this example it may be necessary to invest in higher yielding investments such as high grade and non-investment grade corporate bond ETFs, Master Limited Partnership ETFs, REITs and closed end bond funds, just to name a few alternatives.
We monitor your portfolio for opportunities to either increase income or decrease risk as markets change. For example, your portfolio may begin with a 50% allocation to U.S. Treasury Bills and U.S. Treasury Notes with higher yielding investments for the other 50% as depicted below in "Initial Allocation". Markets will change over time with yield spreads narrowing or widening between riskier asset classes and risk free U.S. Treasuries. When narrowing spreads occur, riskier asset classes can represent a larger proportion of your portfolio. At this point, we can reallocate out of higher yielding asset classes back into U.S. Treasuries without sacrificing much income. The opposite is true when yield spreads widen, presenting an opportunity to allocate out of U.S. Treasuries and into higher yielding asset classes.
Your investments are held at Charles Schwab as a client in our income strategies. We utilize exchange traded funds (ETFs) to a large extent when allocating our client's capital to income strategies. In our opinion, Charles Schwab has the best platform for managing portfolios of ETFs with its Schwab ETF OneSource™. With Schwab ETF OneSource™ we can access more than 500 equity and fixed income ETFs spanning more than 79 Morningstar categories on a commission-free basis from industry-leading fund companies.
I would like to discuss a strategy for maximizing my monthly income
Low Cost Passive Equity
Low cost is not open to interpretation. In the context of investing, "passive" is often misunderstood. In professional asset management, passive generally connotes a non-discretionary approach to portfolio construction and management, usually index investing, whereas "active" management is discretionary with respect to individual stock selection in portfolio construction. Over the past decade there has been a powerful trend of investor funds flowing into passive equity vehicles and out of actively managed mutual funds and separately managed accounts (SMAs). The investment vehicles receiving these flows are passive index funds, the most popular of which is the Standard & Poor's 500 (S&P 500) index containing the largest publicly traded U.S. companies. When you invest in an S&P 500 index fund you are gaining exposure to the U.S. stock market in general and there are other low cost passive indexes containing medium and small sized companies in which you can invest. You can also invest in foreign markets through low cost index funds.
Below are graphs, courtesy of Morningstar, depicting the share of investment flows from active into passive investment vehicles over the ten years from 2009 through 2018. As shown in the first graph, passive share has increased from approximately 20% to roughly 40% over this period. The first graph depicts global market share. The U.S. share of passive has increased to an even greater extent representing approximately 50% of domestic equity allocation as shown in the second graph.
When investing in index funds you are capturing equity market investment returns at a very low cost. You will, however, under perform whatever index you are investing in to the extent of administrative fees and any other costs associated with running the index fund. However, these costs tend to be very low in comparison to the typical actively managed mutual fund, hedge funds and SMAs with high wrap fees. For example, the all-in administrative costs for the Vanguard S&P 500 Index Fund is approximately 3 basis points or 0.03% of funds invested and is considered a very low cost. So, if the S&P 500 index returns 10% in one year, an investor in the Vanguard S&P 500 Index Fund will generate a return of approximately 9.97%.
It is extremely difficult for active managers of mutual funds, hedge fund managers or wealth managers running SMAs to match, let alone beat, the passive indexes over long periods of time. There are several reasons for this near impossibility, chief among them being the fees associated with managing the funds. When you consider that most active mutual funds charge between 0.80% and 1.20% on funds invested, it's a high hurdle to leap over just to break even with the Index performance which charges only 0.03% for index fund administration costs. The outperformance impossibility increases when you consider that most actively managed mutual funds are "diversified", meaning they hold many individual stocks in the fund. Statistically, as the number of individual stocks from different sectors surpasses 20-30 in a mutual fund or SMA, the gross (before management fee) performance of the fund approaches that of the passive index fund, particularly when the sector weighting is similar to the index. This is referred to as "closet indexing" in the world of money management. It is even worse with hedge funds because the managers of hedge funds typically charge "two and twenty", or 2% of funds invested plus 20% of out performance over a fixed hurdle rate.
Innovation in technology applied to finance has brought us to a point where we can now construct investment funds based on rules that have, from an historical perspective, produced returns in excess of broad market indexes such as the S&P 500. There are certain factors (stock characteristics) that have historically beaten the performance of the broad market as a whole, and these factors can be bought and sold quantitatively in low cost exchange traded funds (ETFs). There is great academic debate as to why these factors have worked well historically, and the debate tends to orient around volatility and risk. Regardless of the reason for the excess historical performance, these factors include: small company size, low valuation, quality (or profitability) and low reinvestment (low capex reinvested in the businesses). It is now possible to capture long-term broad market-beating returns (historically speaking) with low cost passive ETFs that are managed using quantitative rules-based algorithms capturing these factors. The trade-off for this out performance is the management fees and costs of running the factor ETFs vs. the passive index cost of 0.03% at its lowest.
It is our view that any portfolio allocation tilting away from market capitalization indexing should produce superior investment returns over the very long-term. Market capitalization weighted indexes rank stock allocation based on company size (number of shares multiplied by stock price) from highest to lowest. For example, if Apple is the largest company in the S&P 500, Apple will represent the largest proportional holding in the S&P 500 index fund based on its size as measured by market capitalization. Similarly, the smallest company in the S&P 500 will represent the smallest proportion of the index. This weighting methodology perpetuates itself when money flows into index funds en mass, creating higher and higher valuations for the largest companies in the indexes because the capitalization weighted index funds must buy each company in proportion to its size. There is a German proverb stating "Trees don't grow to the sky" meaning there are natural limits to how high growth will occur, and this also applies to economics and market prices. In fact, there has been a strong statistical law of "reversion to the mean" in markets and market prices. Market capitalization indexing is a de facto momentum investment strategy whereas a simple equally weighted indexing strategy is a de facto valuation tilt.
Tilting away from market capitalization indexing, which is the most prevalent methodology used in indexing today because of its low administrative costs, can be accomplished by equally weighting or fundamentally weighting the index constituents. There are now many investment alternatives for investors to accomplish fundamental or equally weighting, while at a very low cost. Below is a graph depicting returns on the S&P 500 market capitalization weighted index (dark blue line) vs. the S&P 500 equally weighted index (light blue line) from 2003 through year-to-date June 2019. As can be seen, the equally weighted index has beaten "the Market" as measured by the S&P 500 market capitalization index by approximately 91% over this 16 year period. $300K invested in a simple market capitalization weighted index in January 2003 would have grown to approximately $767K by mid year 2019. The same $300K invested in the equally weighted S&P 500 index would have grown to approximately $1.04 million over the same period of time, $274K more than the capitalization weighted index.
There is no guarantee that this equally weighted index outperformance in the past will persist into the future, nor are there any guarantees that small company size, low valuation, quality or low reinvestment will outperform into the future. In fact, as of this writing, statistical low valuation as a factor has under performed "the Market" over the past decade. But these considerations are important for investors over the long-term or for families which are invested for the goal of inter-generational wealth accumulation. A small 2% annual outperformance of the broad market return results in immense dollar amounts compounded over many years. When you include additional benefits from the savings accomplished by lowering management and administrative fees on actively managed "closet indexing" funds or eliminating high wrap fees on SMAs, the difference in performance is staggering over long periods of time.
Our low cost passive equity strategies incorporate this type of analysis and we implement strategies based on your risk capacity and risk tolerance while at very low costs. And we monitor your portfolio as markets change over time, rebalancing among investments based on relative valuations and changing risks/return expectations for different global asset classes. For example, if large cap has had a very good run relative to small and mid cap, as evidenced by higher relative market multiples on trailing earnings, we will remove money out of large cap funds (i.e. a fund such as the S&P 500 equally weighted index as described above) and allocate more to mid and small cap low cost index funds. Remember, trees don't grow to the sky and there are strong mean reversion tendencies in markets. The impossible thing to do is time reversions perfectly so we periodically tilt toward value instead.
Your account(s) are held at Charles Schwab as a client in our low cost passive equity strategies. We utilize exchange traded funds (ETFs) almost exclusively when allocating our client's capital to passive equity strategies. In our opinion, Charles Schwab has the best platform for managing portfolios of ETFs with its Schwab ETF OneSource™. With Schwab ETF OneSource™ we can access more than 500 equity and fixed income ETFs spanning more than 79 Morningstar categories on a commission-free basis from industry-leading fund companies.
I would like to discuss your low cost passive strategies for investing
Our active value strategy is a concentrated portfolio of stocks that are either: 1) priced at what we believe to be a significant discount from intrinsic business value or 2) have exceptional business, industry or economic characteristics which have historically produced substantial long-term compound returns over time. Because this active value strategy is concentrated and could encounter high volatility, we offer it to only those clients who are "accredited investors" defined by the U.S. Securities & Exchange Commission as having either: 1) annual income exceeding $200,000 over the past two years and one year prospectively or 2) have a net worth exceeding $1 million. Furthermore, we restrict this service to only those investors having a good understanding of the stock market, who have a very long-term investment horizon and who also have the temperament to avoid making irrational investment decisions when markets become erratic or when stock prices drop precipitously. This strategy is also not offered in retirement accounts such as IRAs.
We deem intrinsic value to be the inherent value of a business stemming from its future free cash flows discounted to the present at a risk free rate of return. We use the risk free rate rather than a cost of capital or hurdle rate because we believe the latter is far too arbitrary in its formulation, instead preferring a wide margin of safety in price from intrinsic value. The prospective cash flow determination of a business is subject to many unknown variables, making predictions of intrinsic business value prone to error. Because of this difficulty in predicting future free cash flows and therefore, the difficulty in determining intrinsic business value, the stock price of a company must be low enough relative to intrinsic value as to offer a substantial margin of safety should our estimates be way off.
If we can find an average business selling for far less than what we determine to be its intrinsic business value...that's great! If we can find an exceptional business with superior economics, with top rate management, producing very high returns on invested capital and which is fairly priced...then even better! At this point some real life illustrations should be in order for both subsets of opportunities, that is, average businesses at significant discounts and exceptional businesses at smaller discounts.
It is no secret to most experienced investors that banking is an average business at best. It is competitive, it is low-to-no growth, it is subject to changing technology and potential technological disruptions, bank capital structures are leveraged just to provide an adequate return to equity holders, and banks are also highly regulated. The banking industry is full of value traps; banks that have no competitive edge from one-another and having no real cost advantage other than scale which helps to absorb centralized overhead and technology cost burdens. The only positive attribute that banking has going for it is the relationships it has with its customers tends to be "sticky". It is a pain to move accounts between institutions; think of all the direct deposits and automatic bill paying transactions that would be interrupted! But from time-to-time the market psychology of investors is often stuck in the past and fighting the last war. Many of the larger national banks were tossed expensive lifelines during the financial crisis in 2008 when they were underwriting risky business with highly leveraged balance sheets. Fast forward eight years and the industry and regulatory environment had completely changed with banks having thicker capital cushions doing much more conservative business. This combination of higher equity capital and more conservative business in 2016 resulted in lower returns on equity, capping potential upside and causing investors to virtually ignore bank stocks. What happened next? A change in administration with promises of greater fiscal stimulus and higher interest rates resulting in wider net interest margins. The banks rallied through a continuation of slow but growing retention of earnings and a higher re-rating of earnings multiples. It was quite obvious in 2016 that the whole banking sector was cheap, but investors were too impatient in a low growth economic environment to venture in. This is an example of average businesses in an average industry selling at significant discounts from intrinsic business value re-rating closer to fair value. We will sell these types of investments out of our active value portfolios as the margin of safety between price and intrinsic value narrows.
It is also no secret to most experienced investors that credit card, debit card and e-commerce payment providers are fantastic businesses with exceptional industry and economic characteristics. These businesses enjoy very high returns on invested capital, are asset-lite and benefit from what is referred to as "network effects" in which the more ubiquitous the use and acceptance, the more valuable the product or service becomes. Also, the piece of each transaction taken up by the payment processor is very small in comparison to the average dollar value of the transaction, resulting in very low "frictional costs". And the more cards using Visa or MasterCard or more e-commerce transactions using PayPal, the lower the marginal cost to the processors as the incremental cost of clearing the next transaction is close to zero, allowing almost all incremental revenue to flow through to the bottom line. This becomes somewhat of a virtuous circle. These attributes create a wide "moat" around these businesses which protect these companies from competitive intrusions (i.e. there are likely to be no new payment providers competing with Visa or MasterCard in the near future, in our opinion). You could say that looking out into the future, the only possible danger to the payments business is a disruptive technology displacing the need for their payment technology. Block chain technology or something similar may someday dislodge these payment providers, but it is nice to earn 20%-30% annual returns on invested capital until disruption may, or may not happen in the near future. The caveat with these types of exceptional investment opportunities is that they always seem to trade at high multiples of earnings and free cash flows. The advantageous opportunities to invest in these types of companies are often rare and fleeting because, although there are worse mistakes one can make, its not good to overpay for an exceptional business. Again, we go back to "Mr. Market" with his manic depressive mood swings. The short-term and temporary dislocation in the market during December 2018 cratered even exceptional businesses such as payment processors, opening a narrow window to accumulate shares at more reasonable prices. This is an example of exceptional businesses in an attractive and highly profitable industry going on sale for a brief period of time. We like to hold these types of businesses forever as long as all the positive attributes remain intact, allowing these companies to compound high returns on their invested capital into the future.
What do we look for in an average business presenting a cheap investment opportunity?
- The business or industry should not be in a significant long-term secular decline
- The company should not be experiencing an illiquidity event
- Management should not be selling large amounts of personal stock holdings
- There should be little-to-no past history of dilution or a large current dilution overhang
- The company's shares should be selling at a significant discount from intrinsic business value (preferably > 40%)
- A reasonable opportunity in the near future for the company to either: 1) re-rate (P/E) or 2) an actual earnings rebound
We look to have most, if not all of the above criteria satisfied before we consider further research and consideration of a cheap investment name. Once added to portfolios following a thorough due diligence process, these cheap investment opportunities are monitored and held until either; 1) the business begins to deteriorate substantially prompting us to sell out of the position at a loss or 2) the discount from intrinsic business value narrows either through a descending or ascending price trend (of course we prefer the latter).
What do we look for in an exceptional company?
- The company's product(s) or service(s) must be satisfying an enduring economic need
- The company must have a strong competitive position as evidenced by a wide economic moat
- The company must have the capacity to generate substantial free cash flow through all phases of the business cycle
- Management should have a significant stake in the company
- Management's compensation should be aligned with long-term outside shareholders
- A management that has exhibited very good capital allocation over time (capex, buybacks, dividends, acquisitions)
- Any incremental growth should be profitable
- Opportunistic stock buybacks are desirable whereas constant buybacks at high prices are questionable
- The Company must have a strong balance sheet as evidenced by low debt to equity or low debt to EBIT
- The business should have a long runway for future capital reinvestment at similarly high historical ROIC rates
- The stock must be priced at a reasonable discount from intrinsic business value (preferably > 15%)
The more that a company meets the criteria outlined above, the stronger is our conviction regarding its stock for further due diligence and investment. The inclusion and sizing in the portfolios is a function of the level and strength of the first 10 criteria (the first 10 combined because it is extremely rare to get all 10 in one company) as well as the size of the discount in the 11th criteria. The size of the discount from intrinsic business value is often captured opportunistically as market prices fall or sector dislocations occur. Positions in these exceptional companies are often built up over time as the market offers us opportunities to accumulate shares at attractive prices. We prefer to hold on to these investments indefinitely but will sell out if key fundamentals deteriorate.
Your account(s) are held at Interactive Brokers as a client in our active value strategy. In our opinion, Interactive Brokers provides a low cost trade execution and custodial service for separately managed accounts holding individual stocks and options contracts.
I'm interested in your Active Value investment strategy
SNE Investment Advisers, LLC
70 Perry Hill Road
Acushnet, MA 02743
The information contained in Southern New England Investment Advisers, LLCs (SNE's) website are of a general nature and is for informational purposes only and does not constitute financial, investment, tax or legal advice. These materials reflect the opinion of SNE's Management on the date of production and are subject to change at any time without notice due to various factors, including changing market conditions, regulations or tax laws. Where data is presented that is prepared by third parties, such information will be cited and said sources have been deemed reliable. Any links to third party websites are offered only for use at the site visitor's own discretion. SNE's Management is separate and unaffiliated from any third parties listed herein and is not responsible for third party product, services, policies or the content of third party websites. All investments are subject to varying levels of risk, and there can be no assurance that the future performance of any specific investment or product referenced directly or indirectly in this website will be profitable, perform equally to any corresponding indicated historical performance levels or be suitable for the individual reader's investment needs. Past performance is not indicative of future results.
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