TFA – Quarter End Report, Sept. 30, 2015

Since “going independent”, that is, changing my relationship with clients from that of “broker” to that of a fee-only investment adviser, in January 2001, the stated objective for Balanced/Value accounts has been to “capture” most of the total returns available from U.S. stocks and with less risk. As shown below, this has been fully achieved for most clients over a period spanning over 14 years.

Source: Thomson-Reuters and Trusted Financial Advisors using Portfolio Center™ software

Of note, the S&P Case-Schiller residential real estate index of 20 cities has grown at an average rate of 3.64% during the 14½ year period referred to in the table above.

To put the above figures in perspective, consider that the only major index that approaches Trusted Financial’s performance over this long span of time is a pure stock investment in the major U.S. index. Happily our clients bested the S&P 500 with 1/3 less volatility than a stocks-only portfolio. Bonds gave a quieter ride but earned substantially less than our clients’ composite return. International investing, all the rage for much of the past 14 years has proven unrewarding and dangerous. This bears mention because I did use some foreign stocks and stock funds along the way, but fortunately knew when to move away from this sector.

Seen another way, consider the “Rule of 72”. This is a curious and useful financial measure you may want to keep in your back pocket for future use. To compare investments, consider how long an investment would take to double. To do so, you simply divide the annual rate of return (actual or projected) into the number 72. This tells you how many years it will take to double your investment.

From the above table you can make your own calculations, but in case you’re feeling lazy the answers can be found in the footnote below.¹

Let me hasten to remind you that our composite performance includes all client accounts ever managed, whether extant or closed as of September 30, 2015. It is also weighted so that larger accounts carry greater influence.² To achieve these objectives, the equities chosen have usually been those with a track record of paying increasing dividends. Studies have shown that dividends represent at least half of positive investor returns, and that dividend paying equities are less volatile than those that do not pay investors with cash. High technology, biotech, start-ups and one hit wonder companies can be exciting, but they are often companies with a lot of debt, a limited variety of products and/or a “hipness” factor³ that attracts neophyte investors who can be fickle. Such equities are known to turn on a dime and surrender gains in short order. By contrast, owning good, established companies with good dividends has become ever more important as we plod through an era of low single digit bond and CD yields. Despite their generally lower long term rate of return than stocks, bonds have usually been the way in which this portfolio manager dampens portfolio variance, since bond prices usually do not fluctuate as much as stocks. But, to provide an attractive, higher-than-inflation source of income, it’s currently close to impossible to find a good quality bond or CD that meets this need. Nearly every client who enjoyed the juicy bond yields we were able to find in 2007, 2008, 2009 and 2010 are seeing their bonds spirited away by early redemption. As a result, I have tried to replace these called bonds with equities that could generate relatively high dividends.

Preferred stocks have nicely filled this requirement. Over the past 12 months I’ve continued to add these to many portfolios. However, there is a dilemma with preferreds: they could become volatile if long term interest rates rise sharply, and more importantly, it is unwise to place too much of any one preferred issue into any one portfolio, because selling these instruments could be difficult under certain circumstances.. They often trade with volumes under 100,000 shares a day (worth about $2.5 million, a tiny volume when compared to large capitalization common stocks). So, in addition to preferred stocks I seek to own common stocks that do and will continue to pay good dividends. Like good tenants in an apartment complex they can be counted upon to pay their rent on time. Not all holdings pay high dividends. As a rule, those holdings with lower dividends that we own are companies from which I anticipate significant dividend increases in coming years.

Even great stocks can get battered, as this year and especially the recent quarter reminded us. Benjamin Graham, father of value investing famously said: “in the short run the stock market is a voting machine. In the long run, it is a weighing machine.” What Graham meant is that with stocks, as in politics, emotions and impulses can run high. Great businesses, the solid ones, will emerge as winners, but this may require investor patience to be realized. It is with this philosophy in mind that our clients’ portfolios have been constructed. Most companies held provide essential products and services, and most clients do business with these companies in some way ( do you have a Mastercard in your wallet? Do you own an iPhone? Do you heat your home with natural gas? Put tires on your car?).

Savvy investors understand that success in achieving this rather challenging objective is to be measured over a market cycle: bull and bear. Performance for one quarter or even one year is simply too brief to offer perspective. After a period of tepid or disappointing performance, second guessing is the natural reaction. For any given quarter or year, hindsight usually makes clear that the “smart money” would have been placed primarily in…technology stocks…er….biotech stocks…or maybe residential real estate….er…gold…er… shale oil drillers…you get the picture.

As always doom sayers become more vocal as stocks struggle. There is some merit to their worry: stocks in general have not been particularly cheap, bond yields are generally unattractive, and real estate prices may be getting frothy. I’ve been raising cash as under- priced equities or bonds have been more difficult to identity. However if there is further erosion in the price of perfectly good stocks, this could give us an opportunity to put some of that cash to work, picking up bargains.

There are two questions for investors to ask: does a weak quarter and uninspired 12 months for equities signal the onslaught of a massive bear market, the kind of thing experienced between 2001 and 2002 or between late 2007 and early 2009?

As indicated, I maintain that this is a correction in a secular bull market. Many, if not most of the financial excesses that almost led to a depression and became apparent in 2007 and 2008 have been cured. Households have greatly reduced debt, corporations have plenty of cash and “free cash flow” is the mantra of corporate management. Best of all, most of the vexing economic challenges of the past fifty years are dormant. North America, an area where the rule of law and an independent judiciary prevail is also producing surplus energy for the first time since the 1950’s. Unemployment is near an all-time low. Inflation is tame. Finally, by any historical measure, equities are not overvalued. Real estate, the cause of periodic recession/depressions since Europeans began settling North America, does not appear to be in a bubble, as lenders are more selective and must now retain a portion of each loan. On October 15, it was reported that the Federal budget deficit is likely to fall to its lowest level since 2007 by the end of this year.

A look at the top three companies traded by Fidelity account investors (generally retail investors) on the last day of the quarter indicated that Apple, Netflix, Tesla were of high interest. These are all “New Economy” firms. Middle class Americans and those in other nations are enjoying the instant gratification and high efficiency that technology, has bestowed upon us. From where did most of these companies originate? The United States. Despite all the hand wringing that we hear as we approach a presidential election year, the United States remains the principal place where innovators and risk takers create the marvels of tomorrow. These enterprises create jobs and keep the pulse of the stock market beating. No, I do not see this as an imploding economy. Rather it is one that is going through one of its periodic adjustments.

The apparent source of current stock market indigestion is a dramatic slowdown in Chinese growth. China has been the great sponge, absorbing raw materials from developing countries. As Chinese demand slows, commodity prices tumble. Is the Chinese growth recession going to infect the entire planet? I doubt it. Even if we go into a slowdown, indications are that most U.S. based companies are relatively insulated from China, other than commodity producers, notably energy. Meanwhile, continued weakness in commodity prices means inflation will remain tame, a good thing.

There is also the unending chatter about an interest rate rise by the Federal Reserve Open Market Committee. As I said in a communication last month to our clients, this is the most over hyped non-event in my 40 years in finance. The markets have essentially adjusted to a small increase in rates, so that when it happens, there should be little disturbance.

It’s been reported that hedge funds, managed for the very wealthy by Masters of the Universe like David Einhorn and Bill Ackman have suffered double digit losses this year, most of it in the recent quarter. Even Warren Buffet’s Berkshire Hathaway is down 11% this year. By contrast, our client accounts, while down a bit, have held up pretty well.

I believe our 14½ year track record is safe.

Gary Miller