Managing for the Total Return

It seems hard to believe that we are only a few months away from the fifth anniversary of the market collapse that marked the beginning of the economic malaise we still find ourselves in today.  The stock market as measured by the Dow Jones Industrial Average reached its peak of 14,165 back in early October 2007.  The following year and a half saw that average fall more than half and bottom out just above 6,500.  Since then, stocks have thankfully recovered much of those losses but are still roughly down 11% from the 2007 levels. 

It’s anyone’s guess when the stock market will have fully recovered, but we think that will likely happen sometime next year.  That implies that stock investors will have seen zero price appreciation in over five years.  That’s a long time.  It’s especially a long time if you’re retired and depending on some amount of appreciation to supplement your income.  In addition, this will have been the second time in less than a decade that stocks have experienced a 50% decline. 

When the tech bubble burst in 2000, stocks sold off for the following three years and then fully recovered (except the NASDAQ index) over the next two.  This means that any of the cumulative gains over the past dozen years have occurred in barely two years.  This has been a real problem for savers and has discouraged many people from investing in stocks at all.  This is understandable because if you spread those couple of years’ gains over twelve years, the per-year return doesn’t look so good.  In fact, it’s pretty lousy. 

Modern portfolio theory has constantly preached that the best real returns are to be had in the stock market over the long term.  The problem is that there isn’t a definition as to how long the long-term is.  Here lies the problem for anyone making regular withdrawals from their savings. 

As many of you have heard me say, the only time you care about what something is worth is the day you bought it and the day you sold it.  From this perspective, cash flow planning is where investment management and financial planning come together.  Successfully done, a good retirement plan will: 1. Provide a relatively steady income stream independent of the market 2. Allow you to adjust your income for inflation (maintain your purchasing power) 3. Do this for a lifetime.  These goals can only be achieved through a total return perspective - i.e. a combination of cash income and share price appreciation.  

In today’s interest rate environment, this is becoming increasingly difficult to achieve because of the Federal Reserve’s monetary policy.  The Federal Reserve has pushed down short-term rates to all-time lows in response to the financial crisis and ensuing recession.  Even before the crisis, the Fed had set rates extremely low.  Many believe (us included) that the years of easy money policy have been a big contributor to the debt meltdown in the housing market and on Wall Street.  Now, in addition to holding down short-term rates, the Fed has embarked on “Operation Twist” which is a program to manipulate the long end for the interest rate curve too.  These policy goals are achieved through the Fed’s open market activities.  This is where the Fed actively buys and sells its own bonds and a select few other issues to influence the process in the secondary market.  Price changes in turn affect the yield. 

In the Fed’s defense, their actions are largely driven by the federal government’s atrocious fiscal policies and global economic condition.  The huge annual deficits and a lack of any long term tax policy has put the Federal Reserve in a difficult predicament of having to print money via quantitative easing and eroding the value of the dollar.  All the while they are risking the inflationary impact which undermines their price stability mandate.  Inflation has thus far been tame but only because of the crisis in Europe.  It’s only a matter of time before expanding the money supply will lead to higher prices.

Investors have now been put into a position where their traditional reinvestment opportunities are yielding less and less.  Every time a bond matures or a security gets called, investors are faced with lower and lower income prospects.  These policies have created a perverse situation where the most financially responsible individuals in the economy (savers) are being punished to benefit (bailout) the least financially responsible (debtors).  It’s a bad deal all the way around, but one we’re going to be faced with for a while.

As investment managers, we’re often asked by our clients what can be done about this.  It’s challenging to say the least.  The lack of stock market returns and increased volatility has led us to focus on current income over the last few years.  We’ve had a lot of success as evidenced by that fact that most of our client accounts have moved past their 2007 values.  We have accomplished this by focusing on mortgage related investments and bank preferred stocks.  However, as the mortgages continue to payoff and the preferred stocks are getting called, we have had to expand our universe of what we consider fixed income investments.

For now, that means taking on more risk in the effort to replace this income.   We accomplish this is by looking to use a greater amount of alternative investments such as master limited partnerships (MLP), real estate investment trusts, bank loan funds, high yield bonds, corporate bonds, and dividend stocks.  While each of these have their own set of nuances and challenges, they share the ability to potentially generate better levels of cash flow than can be produced by more mainstream bond-like investments.  Here’s an example of two of these:

Master Limited Partnerships (MLPs) - An example would be the ALPS Alerian MLP.  This exchange traded fund is the largest MLP ETF in the market with assets of $3.2 billion.  MLPs are a type of publicly traded limited partnership.  As a limited partner, a person provides capital, and in return, receives a periodic pay out from the company’s revenue.  These MLP ETFs typically track the performance of natural gas and crude oil pipeline operators.   We have chosen to begin adding this asset class because while the yield is excellent (currently 6.25%), it also offers us diversification in properties that tend to move independently of other asset classes such as stocks, bonds and commodities.

Bank Loan funds - An example of one we own is PPR (ING prime rate trust).  This exchange traded fund invests in senior loans that are typically issued by lower investment grade companies.  We typically own this asset class because it pays a healthy dividend (currently paying + 7%) and offers a floating interest rate.  This helps us two ways:  we make income now and have the potential to make more once interest rise in the future.

The only downside to these alternative investments is that they come with more short-term share price volatility than the traditional bond portfolio.  But we’re comfortable with this as long as we’re afforded the time to ride out those price fluctuations.  This is a similar strategy that we’ve used with several of the equity positions that we hold.  The international sector, for example, has been quite volatile in the past twelve months. It would have been nice to have avoided those price swings, but doing so would have meant guessing on timing those trades and giving up on an almost 4% income stream. 

We believe a total return perspective pays off.  A portfolio’s total return is the combination of both income and capital appreciation.  The two work together but in very different ways and over very different time horizons.  Don’t focus on one or the other but instead look at the cash flows over the short-term and the capital appreciation over the long-term. 

Obamacare Lives Another Day

Unless you spent the day adrift at sea, I'm sure you have heard that the Supreme Court upheld President Obama's health care reform bill. Even though the day was filled with plenty of news and analysis about this decision, we thought we'd chime in with ours too.

While there were several parts of the law that were under review by the Supreme Court, the most controversial part surrounded the individual mandate. Just to refresh your memory, here's a quick recap on the individual mandate. The Patient Protection and Affordable Care Act was signed in 2010 and imposes a health insurance mandate set to take effect in 2014. This mandate requires all individuals who can afford health insurance to purchase a comprehensive policy that meets minimum coverage requirements. Traditionally, many healthy (and usually young) Americans have opted to carry no insurance or high deductible insurance (catastrophic policies) in the past. This was obviously a financial decision because those people felt they could pay out of pocket for the minor things and either didn't think something bad would happen or had insurance to cover the really expensive healthcare. Those choices are no longer legal. The law states that individuals who can afford health insurance (defined as those above the poverty line for whom the minimum policy will not cost more than 8% of their monthly income) must purchase minimum coverage. Those who can't afford it will be provided that insurance, paid in part or entirely by the Federal government.

From day one, this act has been very controversial with the biggest question being whether or not the act violates the Constitution by requiring everyone to purchase something in the private sector. The authors of this law depended on the Commerce Clause in the Constitution to legitimize this requirement. The clause states that the U.S. Congress has the power "To regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes." Opponents of the mandate claim that the decision not to do something (i.e. not buy health insurance) is economic inactivity and therefore not a behavior the federal government can regulate. Supporters of the mandate argue that the decision not to purchase health insurance has an economic impact and therefore can be regulated.

While yesterday a divided Supreme Court did uphold the constitutionality of the individual mandate, they also made a very important clarification. The court concluded the "penalty" for not purchasing insurance is in fact a tax. As a tax, the mandate is allowable under Congress' taxing authority. This is something that supporters had blatantly refused to admit. In an interview with George Stephanopoulos back in 2009, when asked if he rejects that the individual mandate is a tax increase, President Obama's response was "I absolutely reject that notion." Never mind the fact that the penalty is based on your taxable income and collected by the IRS.   As the saying goes, if it looks like a duck, swims like a duck and quacks like a duck, it's probably a duck.

Because this debate has centered on the healthcare law, most of the news and analysis has been focused on upholding the individual mandate. However, I think the real story here is that this is the first time that the court has established a boundary to the Commerce Clause which has been one of the most congressionally abused sections of the Constitution. For decades, Congress has used the Commerce Clause to justify all means of regulation. They have said that their power to regulate is given due to the fact that whatever they were trying to regulate had an economic impact and thus fell under the Commerce Clause. Economic impacts are unavoidable. Every day that you get out of bed you create some economic impact, no matter how small. When you turn on a light switch, you've just purchased electricity. When you brush your teeth, you've just purchased water and toothpaste. You have to eat and so on. So you can see that taken to the extreme, there is no end. This decision has at least recognized a limit. Chief Justice Roberts writes that construing the Commerce Clause as the Obama Administration argued "would open a new and potentially vast domain to congressional authority. . . . The Framers gave Congress the power to regulate commerce, not to compel it, and for over 200 years both our decisions and Congress's actions have reflected this understanding."

Taxing people for not doing something is an interesting concept, however, and I think this is going to open up a whole other can of worms. According to Chief Justice Roberts, the penalty is merely a tax on not owning health insurance, no different from "buying gasoline or earning income," and it thus complies with the Constitution. This is a large loophole though. The result is that Washington has unlimited power to impose new purchase mandates and the courts will find them constitutional if Congress calls them taxes, or even if it calls them something else and judges call them taxes.

The more immediate impact of the Supreme Court decision is that, barring a political party change, the Affordable Care Act will continue to move forward. This, honestly, worries us. Anyone who has read what we've written in the past couple of years knows that we view the explosion in deficit spending and borrowing as the single biggest threat to this country's prosperity and our client's long-term retirement. The ironically named Affordable Care Act will do nothing to make healthcare more affordable. More specifically, it won't bring down the cost of healthcare. It will make it more affordable to those who will receive free or subsidized insurance, but the rest of us will continue to see our premiums rise. Those changes will occur at the payer level (insurance companies) but not at the provider level (doctors and hospitals).

I'm certain that the real goal of this whole process was to expand healthcare services to as many people as possible and had little or nothing to do with controlling the cost. There's probably no better evidence than the fact that the law will impose a new 2.3% sales tax on medical equipment. Why would you raise the price of something that you're trying to control the cost of? Obviously this is to help pay for the real goal of expanding coverage.

The government is now going to start picking up the tab in part or in total for approximately an additional 16 million people. This is going to be very expensive. While all the additional taxes (everything from medical devices to tanning salons) will help offset some of these costs, they will in no way come close to covering them. There is no way of estimating the cost of this new entitlement or how much those costs will change over time, but there are a couple examples - Medicaid and Medicare. These two examples are not pretty. Both are the single biggest budget busters at the state and federal level. Many of the new insurance recipients will be placed into the Medicaid program which means the government will be directly paying for their healthcare. The others will have most or some of their premiums paid by the government. Very few of the current uninsured will pay their entire premiums.

The total amount spent in the U.S. on health care as a percent of GDP is 17.4%, which is higher than any other nation. Medicare spending accounts for 3.7% of GDP and this number is increasing at an alarming rate. A recent CBO study estimated that Medicare will cost $1 trillion annually and be bankrupt by 2022. Meanwhile states are desperate to get their budgets in balance but Medicaid spending has nearly doubled over the last decade. On top of already skyrocketing costs, the Affordable Care Act seeks to expand Medicaid eligibility from those with income up to 100% of the poverty level to those with income up to 133% of the poverty level. However the Supreme Court just ruled that participation in the expanded Medicaid program must be voluntary and several state governments have declared they will not participate. The bottom line is without drastic changes in healthcare costs, both Medicare and Medicaid are simply unsustainable and will cripple our economic growth. For a country that is running 1.2 trillion dollar deficits and borrows 40 cents of every dollar it currently spends, this does not portend well.

In conclusion, I think most would agree that providing healthcare access to as many as possible is an admirable goal. There are aspects of this law which many will benefit from. My personal belief is that because, as a society, we won't let people just die on the street but instead will take care of them, as a member of that society everyone should be required to contribute towards that care in the form of carrying insurance. Bankrupting the country in pursuit of this is not going to help anybody.