It was five years ago that the current equities bull market began, although you’d have had to search far and wide to find any investor, professional or layman, who properly called that bottom at that time.  At Trusted Financial, we strongly suspected we were in a bottoming pattern and were continuing our program of selective buying of stocks and bonds, at what I felt were bargain prices. For a journey back to that worrisome time, please take a few minutes to read the words written for our Trusted Advisor client newsletter by following this link: Client Newsletter, April 2009.

Report for Quarter ending March 31, 2014
Client accounts saw a modest gain of about 2% to 3% in first quarter 2014. This topped most domestic stock indexes. New price highs were experienced in cyclical holdings such as PPG (coatings) and US Bank (banking), Cummins (truck power plants), and in non-cyclicals such as Dominion Resources (electric and gas utility) and Enterprise Product Partners (energy pipelines and storage. In other words, it was a pretty satisfying quarter.

Based on a recent presentation at Enterprise’s “Analysts Day”, I would not be surprised to see their dividend increased substantially this year. By contrast, the Kinder Morgan complex of competing energy pipelines and storage was weak throughout the quarter. Kinder is going through a massive capital spending boom, seeking to expand its already enormous network of energy transportation and storage facilities to take advantage of shale gas and oil production which is exploding in various parts of our lucky continent. An often overlooked phenomenon sometimes appears in a rapidly expanding industry: in order to take advantage of a long term profit opportunity, businesses may have to borrow and invest today in order to create an infrastructure that will generate profits for many years to come. This was seen during the build out of the electric utility industry at the turn of the 19th century and for cable television companies in the 1980’s. To finance this capital expansion, Kinder has issued additional shares, lowering book value per share in the past year or so. I believe this represents “stepping back to leap forward”, but not all investors agree. Further, many more Master Limited Partnerships (MLP’s) have been created in the energy space, offering an alternative to KMP and this likely has drawn off some investment capital. Having owned Kinder Morgan for about 11 years, I feel this stock weakness is worth tolerating for a time, due to the strong track record of the company’s management team still headed by Rich Kinder. If Mr. Kinder’s vision is realized, the company will be generating a cascade of additional revenue and the share price should recover and go on to new heights.

Fixed Income Strategy
I share a widely held belief that we are in the trough of interest rates and that the next move will be higher. However, this trend change appears likely to manifest itself only gradually. I’m not one who believes that massive money creation will lead to runaway inflation with interest rates rocketing upward to contain it. That was the scenario between 1972 and 1981, but that was forty years ago and something has changed: productivity. We are still in the early to mid – innings of a silicon based productivity revolution.  Fewer employees can accomplish more tasks per dollar of capital investment. Further, the North American energy bonanza will, for decades, dampen the cost of energy, a key input to inflation.

If I’m correct, this implies low inflation and relatively high unemployment, which means that monetary authorities will not need to goose interest rates higher, but may in fact continue with measures that keep rates near historic lows. New Fed Chairperson Janet Yellen recently said as much. In fact, technical behavior of bonds right now suggests rates could again drop.  This presents a dilemma for those depending on income from their investments and those of us who seek to satisfy this need. If Certificates of Deposit can only offer yields of .75% to maybe 2.00% over the next decade or so, and quality bonds and preferred stocks remain in the 3%-5% range, from whence will the income be derived?  My answer:  Dividends on quality wide-moat stocks. Right now, I’m reluctant to hold more than about 15%-25% of client portfolios in the fixed income sector (which includes preferred stock). In fact, most of our current holdings are legacy positions from the days when we could obtain fat, safe yields. (Again, see link to my April 2009 newsletter.) Today there is little juice in this sector, little chance of earning more than the rate of inflation. Bond funds, if well managed, can play the yield curve game, borrowing at short term interest costs and buying long term bonds, but this is potentially risky. As last year’s rout of many bond funds demonstrated, bond mutual funds are not a risk free investment.

So should you worry about over-allocation to equities? Please consider that there are a wide range of risk profiles for investments known as “equities”.  Clients hold many excellent quality stocks that pay good dividends, often in defensive industries. With few exceptions, (Kinder Morgan was discussed above), they have bulletproof balance sheets with low debt-to-equity ratios. “But isn’t the stock market volatile?” might be the concerned response. To which I would reply, “yes it can be volatile, but we do not own ‘the Market”. Rather, client portfolios are a collection of businesses purchased for their individual, unique characteristics. High on the list of investment criteria is finding companies with relatively low volatility. For example, an established utility like Southern Company (SO) is nearly always less volatile than a currently popular over-the-counter darling like Tesla, Facebook or Netflix. Volatility becomes worrisome when a company is highly dependent on borrowing. Volatility is a risk when a company depends on a narrow list of products or a narrow geographic or demographic distribution of its product: would you want to depend on “gamers” by owning a stock like Electronic Arts (EA) which in the past three years has fallen from about $24 per share to about $11 per share then rebounded to $30? None of our clients hold Electronic Arts, Tesla, Netflix or the like! Volatility is a risk when a company’s profit margins are narrow, leaving little room for error by management. Airlines are typical offenders in this department, and we own none of them. With the exception of a few clients, Trusted Financial portfolios have few or no holdings that carry the risk of high volatility.

True, if the stock market melts down with little warning, even defensive equities will likely suffer some price erosion. But you pay Trusted Financial to manage risk in the markets, something we have accomplished through two big bear markets in the past thirteen years, I feel confident in sharing my belief that even our most cautious clients among you are unlikely to be seriously injured, even in an outsized bear market.

Still, you may want to quantify your risk tolerance in your own mind by taking a quick test:

A deep market correction is often defined as a loss of 10% to 15% of stock index value. A bear market is anything 20% and over to the downside. Since your portfolio has a volatility level that is less than half that of the U.S. Stock markets, you can do the math and derive a dollar loss figure that is highly possible while under our management.

A 15% correction would likely see the nominal value of your portfolio decline about 6%; a 20% drop in a bear market could well cause 8-10% erosion. Multiply 10% times the value of your assets under management with Trusted, and that is how low your accounts would most likely sink if a bear market takes hold. If this causes sleepless nights for you right now, then we certainly need to talk and re-orient your situation to get you back to your comfort level. This may mean holding larger amounts in money market or certificates of deposit, however.

Position changes in the Quarter
Notable changes in positions included the addition of Apple Computer (AAPL) to many portfolios. Apple has only been in portfolios for less than two months, but so far we have a healthy unrealized profit of about 6%.  We also sold AIG, the insurance giant, having held it for a little over a year closing the position with a significant profit for those involved, taxed as long term capital gains rates for those who owned the stock outside of a retirement account. For more risk-averse clients, we reduced or closed a position in Lazard International Equity mutual fund. I began the year feeling optimistic that the European economy had bottomed, which is why we assumed this position in January.  However, the land grab by Russian dictator Putin is of great concern to me. At worst, Russia may continue to advance into Ukraine, provoking a military response from NATO. At best, sanctions by the United States and Europe are likely to result in a hit to European GDP.  Neither scenario is salutary for European stocks, which feature prominently in the Lazard fund.  We have held on to this for clients that can accept a greater level of risk, but it remains a candidate for full liquidation.

While remaining optimistic, I note that we are headed into a seasonally weak period for stocks (although last year was a pleasant exception). This may present some bargain buying opportunities.

As always, please feel free to contact me to personally discuss your situation!

Gary Miller