On Wall Street, the more popular something is, the more skeptical you should be.

Stock buybacks, in which companies take their own shares off the market by buying out the investing public, suddenly are sexy. But they don’t always pay off for shareholders.

How sexy are buybacks now? Even Berkshire Hathaway Chairman Warren Buffett, who has never done a share repurchase, is getting in on the act. This week, Berkshire announced it would buy back an unlimited number of its shares whenever, in Mr. Buffett’s eyes, they trade below their true value. All told, buybacks by companies in the Standard Poor’s 500-stock index jumped 22% in the second quarter to $109 billion, according to Standard Poor’s.

Companies must find ways to put their excess cash to use. When the market price of a company’s stock is lower than the “intrinsic value” of its business—the present worth of the cash it will generate in the future—then the company should buy back all the shares it can.

As Mr. Buffett wrote in his 1984 letter to shareholders, when the stock of a growing business with plenty of cash sells “far below” intrinsic value, then “no alternative action can benefit shareholders as surely as repurchases.”

But buybacks are far from an exact science. “You have to take a position on what the intrinsic value of the company is and buy stock only below that number,” says Richard Reese, chief executive of data-management company Iron Mountain, which has repurchased about $120 million worth of its shares since early 2010. Mr. Reese pauses, then adds, “I hope we get it correct.”

At their worst, buybacks can be a form of corporate cannibalism. Often the unspoken motive is to use extra cash to boost earnings per share by reducing the number of shares among which the company’s profits are divided. But that can be a slippery slope.

“If companies use buybacks to try to increase earnings per share, they can almost become trapped,” says Kevin Beech, an analyst at Behind the Numbers, an investment-research firm in Dallas. “If they don’t keep repurchasing stock, their earnings will take a hit. So it can turn into a sort of an addiction.”

Hewlett-Packard has spent $57.6 billion repurchasing its own stock since 2004, according to SP. The total value of H-P’s outstanding stock, after years of management turnover and strategic change, is only $47 billion.

According to H-P’s quarterly and annual reports, the company spent $7.6 billion to buy back nearly 200 million shares over the first seven months of 2011, at an average price of around $38. In 2010, H-P spent $11.3 billion to repurchase more than 250 million shares at an average price of more than $44. The shares traded this week around $24.

Declining to elaborate, an H-P spokesman cited a remark from incoming CEO Meg Whitman on a recent conference call: “In the near term, there is a need to moderate our share buybacks and investments so that we can rebuild the balance sheet.”

H-P isn’t alone. Yahoo also paid more for many of its shares than they are worth today. A spokeswoman says that as the company has repurchased 14% of its stock since 2009, its return on invested capital, a measure of profitability, has more than doubled. But are investors better off? Yahoo, which was above $33.50 in late 2008, traded below $13.50 this week after years of uncertainty about the company’s future wore on the share price.

Imagine two companies, each with $100 in cash and 10 shares of stock. The intrinsic value of each is $10 a share. But the stock market undervalues one company’s shares at $5 apiece and overvalues the other at $20. Each company decides to buy back $10 worth of stock.

The undervalued company gets to buy back two shares at $5 each, leaving $90 in assets spread across eight shares. That raises the intrinsic value of each share to $11.25.

The overvalued company uses $10 to buy back half a share, leaving the same $90 in assets spread across 9½ shares. That lowers the intrinsic value of each remaining share to $9.47.

With a buyback at a cheap company, “the continuing holders benefit to the detriment of the sellers,” says Michael Mauboussin, chief investment strategist at Legg Mason Capital Management, while in an overvalued repurchase “the sellers gain at the expense of the ongoing holders.”

So how can you spot a bad buyback? Here is a red flag: If cash is dwindling as buybacks are growing, the firm may be starving future growth to pay off present shareholders. That is fine if you sell into the buyback. But it is bad if you hang onto your shares. Owning a bigger piece of a corporate cannibal may leave you hungry in the long run.

—Follow Jason Zweig at twitter.com/jasonzweigwsj

Write to Jason Zweig at intelligentinvestor@wsj.com

Article source: Wall Street Journal

 

One of the ideas that has become quite pervasive within the minds of investors is the notion of a “good stock” or a “good property” to own.  This notion stems from a general desire on the part of most people to own things of quality.  In our personal life, this frequently manifests itself as a desire to own a comfortable home, and a reliable automobile.  Quality gives us a feeling of safety and security.  Thus, it seems completely natural to want our investments to be the stock of a high quality company, the bonds of a high quality corporation of government, or a property that is desirable in both its quality of construction and location.  The problem with this view is that it only provides one half of the information that you need to determine whether an investment is a good deal.

The second half of this investing puzzle is price.  Put bluntly, the quality of a stock, bond, or property investment only matters in relation to its price.  This means that a ram shackled, blighted property can be a phenomenal deal at a certain price.  The stock of media darling companies such as Apple, Google, and Amazon can all be terrible investments at a certain price.  It is certainly true that high-quality investments can frequently justify a higher price than lower quality investments.  However, it is equally true that any investment can be a spectacular deal if the price is right.

The key for investors is to determine when the price of a high-quality stock, bond, or property is over-valued, or conversely when the price of a lower quality stock, bond, or property is under-valued.  Any investment is a good deal at one price, and a poor deal at a different price.  Unfortunately, it is frequently very difficult to determine exactly where these two boundaries are drawn for any particular investment.

When estimating the appropriate price for a particular investment, there are two relevant factors that need to be considered.  The first is the expected future price, the second is expected future cash flow, and the third is taxes and inflation.  When combined, they will create a holistic picture of the value for any particular investment.

Expected Future Price

• In the world of stock and real estate investing, this is referred to as appreciation.  Fundamentally, it represents the expectation that the future price of an investment will be higher than the price you paid to purchase it.  This is frequently referred to as the ‘buy low, sell high’ philosophy.  For most investors, this is the primary source of value that they see.  Stock market tickers report the price of securities, and the Multiple Listing Service reports the price of properties.
• However, the ubiquitous availability of price information frequently causes people to over-emphasize price appreciation as a source of value.  It is most certain that price appreciation is an important source of value for investments, but it is certainly not the only value vector.  The fact that so many people focus on market prices has made them become very volatile over the past few years.  Values for stocks, bonds, and real estate have all fluctuated significantly.  This has made future price appreciation very difficult to predict.
• In addition to all of this, there is one further characteristic of price that investors must take into consideration.  In order to capture the benefit of price appreciation, you must sell the investment.  This means that watching the value of your stocks or real estate skyrocket means absolutely nothing unless you sell and lock-in the gain.  Thus, in order to realize the full gains from future price appreciation, it means that you must sell at the right time.  In practice, this is very difficult to do and frequently results in selling while values are still going up.

Expected Future Cash Flow

• Another key characteristic of what makes a good vs. bad deal for investors is the cash flow that is produced.  In the case of stocks, this comes from dividends.  In the case of bonds, this comes from interest payments and the future return of the bond face amount.  In the case of real estate, this comes from rents that are paid by tenants for the use of your property.  The importance of cash flow to the value of an investment is that it represents a current, tangible return.  Typically, investments that produce the best cash flow don’t always have the best appreciation.  However, they also tend to be less volatile since the price tends to be more highly correlated with the rate of cash generation than the market expectations for future price increases.
• The way that most investors articulate the future cash flow of an investment is through its yield.  In simple terms, the yield of an investment represents its annual cash flow divided by the price paid for the asset.  In the case of stocks, the “dividend yield” is the annual dividends divided by the current market price.  In the case of rental real estate, the “capitalization rate” is calculated by dividing the annual net operating income of the property by the purchase price.  In the case of bonds, the discounted future value of all payments is compressed into an internal rate of return, which is articulated as the bond yield.
• In most cases, the rate of cash generation for an investment is much less volatile than the market price of that investment.  Stocks that pay dividends tend to adjust their dividend rate at a much slower rate than the market value gyrations of its price.  Rents from income properties tend to shift much more slowly than the value of the property.  Bonds typically feature a fixed interest and repayment price, with their market value being determined by the movement in yield rates for similar instruments.  When market yields increase, the price of bonds currently on the market go down.  When market yields decrease, the price of bonds currently on the market go up.

Taxes and Inflation

• The final key characteristic that differentiates good vs. bad investments is inflation and taxes.  Inflation represents the erosion of you investment’s purchasing power and taxes represent the amount of your gains that need to be paid to the government.  One of the oldest and most important concepts in finance is that “It’s not what you make, it’s what you keep” … fundamentally, this means that the “real” rate of return for your investments is much more important than the “nominal” performance.
• Starting with inflation, it is important to understand that when the amount of money in circulation expands more quickly than the amount of goods and services being traded, it creates upward pressure on prices.  For some asset classes, the effect of inflation is relatively benign, for others it is beneficial, and for some it is devastating.  By and large, property values tend to be lifted in proportion with inflation, while cash flows from dividends and rents are also increased by inflation.  Some stocks move up with inflation, but certainly not all.  On the other hand, bonds with a fixed interest rate are destroyed by inflation since it de-values the interest payments.  Conversely, fixed-rate debt that you owe is wiped away by inflation as the dollars you use to re-pay the loan become less valuable.
• Another key characteristic to understand is taxes.  Different types of income are subject to different rates of taxation.  Generally speaking, income that is earned from a job encounters the most taxes.  Income that is earned passively encounters less taxes, and income earned from capital investment encounters the least taxes.  Astute investors also understand the impact of legitimate business deductions, non-cash expenses such as depreciation, and deferring capital gains through a 1031 exchange to reduce their tax burden down to the legal minimum.  In many cases, it is tax advantages that turn a good investment into a great investment.

Ultimately, it is the responsibility of each person to determine what constitutes a superior investment deal.  Since people have different appetites for risk, there will always be a variety of investors bidding for a variety of assets.  What is most important for the individual investor to do is take an honest assessment of their personal investment tolerance and make decisions that incorporate all of the major value factors.  By balancing the future price, future cash flow, inflation risk, and tax characteristics, it will allow you to build a strong portfolio of optimized deals.

 

It can happen to the best of entrepreneurs. While a new business owner is putting in long hours to build a business, a marriage can fray. The next thing the owner knows, his or her spouse may be filing for divorce.

This scenario is all too common. Forty percent to 50 percent of all first marriages in the U.S. end in divorce, according to a 2010 report by the National Marriage Project at the University of Virginia. The divorce rate for second marriages is even higher.

For those whose marriage is in trouble or who are about to begin a divorce, a few strategies can help preserve a business. Once the divorce proceedings start, entrepreneurs won’t likely be able to implement some other legal maneuvers that, if accomplished in happier times, could keep their business from landing in a soon-to-be ex’s possession.

A typical scenario, according to family-law attorney Robert Kornitzer, at Pashman Stein, a commercial law firm in Hackensack, N.J., is: “You get married young with no prenup and you have a $100,000 business. . . not anticipating that, 20 years later, it’s a $5 million business, and now the spouse has some stake in the growth of the business.”

If you’re not careful in a divorce, you could find your ex is your business partner — or you could be fighting to keep your enterprise from being sold to raise cash.

Or you might lose the business to your ex. That’s what happened to Tereson Dupuy, founder of FuzziBunz, an online cloth-diaper business based in Lafayette, La.

Dupuy launched the company three years into her marriage after seeking better diapering options for her second child. But in 2005, close to the couple’s 10-year anniversary, the marriage unraveled. Dupuy discovered FuzziBunz would be considered a joint marital asset. Louisiana is one of a handful “community property” states, including California, which assume each divorcing spouse owns half the property accumulated during the marriage.

Dupuy says the stress of the divorce drove her into a nervous collapse and within 24 hours a judge put her husband in control of the company.

It took Dupuy a year and a large lump-sum payment to her ex — plus $15,000-a-month payments to her ex over many years — to regain ownership. The payments drained cash, and bankers considered her need to pay them outstanding debt, making it hard for her to borrow needed growth capital.

Is your marriage headed toward a breakup? Here are seven strategies to consider if a divorce is threatened or already underway and your company is considered a joint asset.

1. Maintain good records, and keep the family’s finances separate from those of the business. “Don’t borrow out of the house [account] to buy company trucks,” Kornitzer says.

2. Pay yourself a good salary. If you starve the family’s cash flow to build the business, a lawyer might later make the case that your ex is entitled to more of the company’s assets, according to Jeffrey Landers, founder of Bedrock Divorce Advisors LLC, a divorce financial strategy firm based in New York City.

“If you paid yourself $80,000 a year instead of $300,000 and were hoping on retirement to sell the business and enjoy the proceeds together and now that’s not happening,” he says, “then your ex will want [his or her] share” of the company.

3. Fire your spouse. If your spouse is actively involved in your business, ease him or her out as soon as possible, says divorce lawyer Daniel Clement, principal of New York City family law firm Clement Law. The more prominent the ex’s role and the longer he or she worked in the business, the stronger the case a lawyer could make that this spouse helped build the enterprise and should profit from its growth.

4. Sacrifice other assets. In a divorce settlement, a couple’s total assets are added up and then divided. Try to retain 100 percent ownership of the business by forfeiting other assets instead, such as retirement accounts, the family’s home, vehicles or collectibles, Clement says.

5. Get a fair valuation. Use a neutral, court-appointed valuation professional and then arrange for another outside party to review the figure before you agree to it, Clement says. Dupuy wishes she had challenged FuzziBunz’s valuation, which was based on a projection of 10 years of future growth rather than current revenue, she says.

6. Arrange to make any payments over time. It’s common to pay an ex for a share of a business gradually, as Dupuy did. The monthly payments can come from the business’s cash flow or a bank loan.

7. Raise capital by selling a stake. You could sell a minority stake in your business to employees through an employee stock ownership plan, Landers says. Or find an angel investor or two who will pay cash in exchange for an ownership stake.

One bright spot for entrepreneurs: It’s rare that a business ends up being sold off to satisfy a divorce settlement, Clement reports. That’s because it would deprive the business owner of the future income needed to pay support payments.

Preventive Moves

Take action while your relationship is still rosy and you may greatly increase your odds of surviving a divorce with your business intact.

Here are five pre-emptive strategies from attorney Jeffrey Landers that can help protect you from losing your business in a divorce.

1. Sign a prenup. If your business existed before you wed, designate it as separate property owned by only you.

2. Secure an early postnup. This is much like a prenup, except the agreement is signed after the wedding. If a postnup is done long before the marriage disintegrates — ideally more than seven years before a breakup – it might be useful in defining a business as separate property. But judges often view postnups skeptically.

3. Place the business in a trust. This keeps the business from being counted as a marital asset as you no longer personally own it. The move also protects the value of the company’s growth.

4. Create a buy-sell agreement. It defines what happens to a business should any owner’s status change, as is the case in a divorce. The agreement might limit a spouse’s ability to acquire ownership, deprive a divorcing spouse of voting rights, or give you or other partners the right to buy at a low, preset price any interest awarded the ex.

5. Have insurance. A whole-life insurance policy that builds cash value can be liquidated to provide the funds to buy out a spouse’s share of the business, if need be.

Article source: Entrepreneur.com

 

Summer roller coasters are supposed to be fun.

But last week’s stomach-turning ride on the stock market — including the first time in the 115-year history of the Dow Jones Industrial Average that it moved more than 400 points for four consecutive days — was more like a terror ride on an out-of-control Big Dipper.

Still, despite all of the market’s Sturm und Drang, the Dow ended the whipsawed week off just 1.5% — only 175 points from where it began. The Standard Poor’s 500-stock index and the Nasdaq Composite took equally wild rides before ending down just 1.7% and 0.96%, respectively.

All three of the major indexes are down for the year: 2.7% for the Dow, 6.3% for the SP 500 and 5.5% for Nasdaq.

The market’s wild ride, which actually began two weeks ago, has left investors torn between worries of another recession and hope that stocks are at bargain-level prices.

The turbulence picked up late last month when European leaders unveiled their latest plan to bolster Greece and some investors began to worry about problems in Spain, Portugal, Italy and even France. By last week, concern focused on large European banks, many of which are holding the weakening debt of the continent’s various nations.

Much as U.S. subprime-mortgage problems bled into Europe and the rest of the world in 2008, Europe’s mounting troubles are affecting the U.S., which faces its own challenges. Among them: more than $14 trillion of debt, thanks, in part, to two wars and several years of muted or no growth — a burden underscored by the recent downgrade of the country’s credit rating by Standard Poor’s.

The ugly political sparring before Washington raised its debt ceiling and agreed to trim the nation’s debt raised questions about the nation’s leadership and convinced many investors that the government won’t take aggressive steps to bolster the U.S. economy. That’s troublesome because the economy hasn’t been able to grow at a pace of more than 2%. Some hope the Federal Reserve will again take aggressive steps, such as buy bonds, to spark the economy. The Fed last week promised to keep interest rates low until at least 2013, buoying markets. But it’s not clear how much the Fed can help spark growth.

So all is lost and investors should dump their holdings? Thankfully, no. As Treasury prices surge, as investors search for safe investments, that’s pushed mortgage rates lower, something that could give a shot in the arm to those looking for a home or to refinance existing mortgages. Gas prices also are dropping.

Meanwhile, corporate earnings have been strong lately, while retail sales have held up. Executives have been reasonably upbeat about the rest of the year. Unlike during the 2008 downturn, companies and consumers enjoy much stronger balance sheets. Non-financial companies in the SP 500 hold $1.12 trillion of cash and short-term investments, according to the most recent tallies, up 59% from the third quarter of 2008.

And U.S. stock prices now are at reasonable levels, some analysts say. That’s very different from 2007 when the housing market was in a bubble and stock prices very high.

“U.S. banks don’t have toxic mortgages, and there’s less leverage in the financial system,” notes Stephen Roseman, who runs the Thesis Flexible Fund. “Companies are still reporting good numbers.”

One thing seems clear: The U.S. and global economies will grow at a slow pace during the rest of the year, and maybe longer, especially as consumers begin to digest their reduced 401(k) accounts. A U.S. recession may not result but it likely will feel like a recession for many businesses and consumers. At the same time, Europe’s debt troubles likely will hound it for the foreseeable future.

Given that discouraging backdrop, it’s best to keep ample cash on hand, hold investments that could do well if things deteriorate, and focus on companies and investments that can prosper in a weak environment.

“You want to be less aggressive, which means hold more cash, shorter maturity and higher-grade bonds and large-capitalization stocks,” says John Brynjolfsson, who runs hedge fund Armored Wolf. He discourages investors from shorting stocks or using leverage.

Mr. Roseman, who says he has reduced his exposure to companies reliant on the debt markets and on selling to consumers, is a fan of master limited partnerships, which mostly are companies that own and operate pipelines, primarily for natural gas and oil. They usually pay out cash to investors at rates much higher than yields on bonds and have stable cash flows. Teekay LNG Partners LP (TGP), for example, has a yield of nearly 8% and has long-term contracts, Mr. Roseman says.

KKR Financial Holdings (KFN), a specialty finance company that owns various debt and has a yield of 9.5%, is another pick of some investors.

Dan Rice, manager of the BlackRock Energy Resources Fund (SSGRX), one of the top-performing energy-focused funds over the past decade, is a fan of Range Resources (RRC) and EQT Corp. (EQT), energy companies with holdings in the Marcellus Shale, a rock formation underlying several states in the Northeast that has become one of the most prolific sources of natural gas in the U.S. (For more stock picks, see this week’s Barron’s Insight column by Andrew Bary.)

Robert Wiedemer, co-author of the book “Aftershock,” and managing director of Absolute Investment Management, says investors should have ample amounts of gold-related investments in their portfolios, such as the exchange-traded fund SPDR Gold Trust (GLD). Gold could do well even if central banks become more aggressive because such actions could lead to higher inflation.

“Newmont Mining [NEM] offers something gold itself does not — a dividend of more than 2%,” says Darren C. Pollock, portfolio manager at Cheviot Value Management. “And the company has enough ounces of gold in the ground, and a low enough cost of extracting that gold, to make a case for the shares to easily be worth 50% more than the current market price.”

Write to Gregory Zuckerman at gregory.zuckerman@wsj.com

Article source: Wall Street Journal

 

Cash-strapped Americans are bracing for a further squeeze following last week’s downgrade of U.S. government debt, as interest rates on deposits continue to fall and some borrowing costs edge higher.

Priscila Kubota sought to modify her mortgage last week at Bank of America in Los Angeles. Mortgage rates fell Monday as U.S. Treasurys rallied.

Consumers have already been struggling with high unemployment and elevated levels of personal debt incurred during a pre-recession spending binge. Now they are grappling with shrinking retirement accounts, as major stock indexes nose-dive and yields on U.S Treasurys touch new lows amid the market turmoil.

“People are going to feel less rich and that will make them hold back on spending, which would be a further blow to the economy,” said Beth Ann Bovino, a senior U.S. economist at Standard Poor’s. On Friday, the firm lowered its rating of government debt one notch to AA-plus, the first time the U.S. has lost its top-ranked standing.

Consumers are already earning less on the money in their checking, savings and money-market funds as well as on certificates of deposit, because banks, flooded with cash in the market upheaval, continue to reduce rates as they have trouble finding profitable ways of investing the cash and are faced with higher regulatory costs.

Some consumers said they were already changing their spending and investing habits as a result of the debt downgrade and the continued uncertainty over the economy.

“My wife and I decided over the weekend that we’ve got to go on another high-alert spending freeze, because we don’t know what the future holds,” said Warren Hershkowitz, 39 years old, who owns a real-estate consulting firm in Manhattan.

Ryan Zagata, a 37-year-old software sales executive who lives in Brooklyn, N.Y., said he was reconsidering the amount of money he invests in mutual funds. “My wife and I talked about moving more of our money to cash. We are not there yet, but we will definitely slow down the amount we are investing each month.”

Bank of America Corp., the nation’s largest bank as measured by assets, lowered rates on four-year CDs by as much as 0.45 percentage point in certain states. J.P. Morgan Chase Co. cut its long-term rates by a quarter percentage point earlier in the week.

The average deposit rate is 0.79%, compared with a high of 4.53% last seen in September 2006, Market Rates Insight said. Deposit rates are expected to fall further as the flight to the safety of federally insured bank accounts continues.

Since December 2007, domestic deposits have increased by $1.1 trillion and now total about $8.1 trillion. The larger a bank’s deposits, the larger the total amount of interest it has to pay out and the greater the payments it has to make to regulators in order to insure those funds.

Bank of New York Mellon Corp. became the first financial firm last week to charge corporate clients a fee for holding large amounts of cash. Analysts said they didn’t expect it to be the last.

“It’s only a matter of time before banks lower rates even further or start charging to hold deposits,” said Dan Geller, executive vice president of Market Rates Insight.

The higher deposit costs are especially painful to banks, because they are unable to offset them by making more loans. Both the volume of lending and the rates that banks charge borrowers have remained anemic since the recession, curtailing a major source of revenue.

Mr. Geller said the combination of higher deposit costs and lower loan revenue was unsustainable for banks and could lead to increased borrowing costs for consumers as financial firms try to boost revenue.

Auto-loan rates, which had been falling since the beginning of the year, have started to edge up in recent weeks, according to Bankrate.com. The average five-year loan for a new car now carries a rate of 5.6%, up from 5.43% in June.

Credit-card rates have largely remained unchanged since new rules took effect last year that restrict the fees and interest rates issuers can charge. The rules require issuers to give customers 45 days’ notice of any rate increase and only apply the increase to future purchases.

Mortgage rates, which tend to trade in tandem with yields on 10-year government bonds, declined slightly on Monday as prices of U.S. Treasuries rallied, and remain near all-time lows.

But analysts said they expected financial firms to review their borrowing terms and potentially raise rates for the least credit-worthy borrowers in coming months.

Mike Moebs, who provides consulting services to banks, said he expected consumer borrowing costs to increase by a quarter to a half percentage point over the next six months.

“If Uncle Sam is riskier, so is everyone else,” Greg McBride, a senior analyst with Bankrate.com, said.

By SUZANNE KAPNER, ROBIN SIDEL and DAN FITZPATRICK

Article source: Wall Street Journal

 

By JEFF D. OPDYKE

Generating the most income in the safest fashion from a nest egg is the holy grail of retirement income planning. You obviously want your dollars to stretch as far as possible without taking on much risk.

The proper mix of stocks and bonds and cash is the mix that allows you and your parents to sleep at night. That may sound trite, but it is the only true gauge that works. Mom and Dad can look at all the charts and all the probabilities, but if at the end of the day the mix of assets has them paranoid that a market correction will wipe them out or leave them unable to afford their cost of living, then it is clearly the wrong mix. Thus, telling you what an appropriate mix might be for your parent is largely impossible. But there are a couple of generalities and rules of thumb around which you should begin helping your parent structure a nest egg.

Do not put all the money into CDs, savings accounts and bonds. Inflation will decimate those assets over time and that will not help a parent maintain financial security later in life.

Depending on a parent’s age, put between 20% and 60% of the nest egg into high-quality, dividend-paying U.S. and global stocks to provide the necessary growth as well as income. Where your parent should be on that spectrum between 20% and 60% largely depends on age.

And remember: While we’re focusing on managing the finances of elderly parents, many of the issues apply to your own retirement planning as well.

U.S. Stocks

Too many retirees tend to shy away from stocks for fear of losing their principal. Better to be ultrasafe than devastated by a dramatic downturn in the financial markets. However, given the potential length of time a retiree will spend in retirement these days, a nest egg really demands some exposure to stocks in order to survive for as long as a retiree does.

This is not an argument for investing in high-growth Internet stocks or biotechnology companies with unproven medications. No retiree needs exposure to the market’s riskiest stocks.

Adapted from “Protecting Your Parents’ Money: The Essential Guide to Helping Momand Dad Navigate the Finances of Retirement” by Jeff D. Opdyke. Copyright 2011 by Jeff D. Opdyke. Published by Harper Business, an imprint of HarperCollins Publishers. Used by permission.

However, it is an argument for owning stable, blue-chip companies, particularly those that pay dividends. These are big, brand-name firms that have a long history of growing their business year after year and that in many cases have an equally long history of spinning out a healthy stream of dividends — companies like Pfizer, McDonald’s, Wal-Mart Stores, Johnson Johnson, Exxon Mobil and Coca-Cola. Mind you, those aren’t recommendations of stocks you should go buy for your parent’s portfolio. Rather, they’re examples of the kinds of companies that make for relatively stable, dividend-earning investments.

Indeed, the best advice for the bulk of retirees is to own blue-chip stocks through a mutual fund, where the portfolio manager’s aim isn’t to shoot out the lights in the quest for capital appreciation but, rather, to own investments that along with modest growth prospects pay out a stream of dividends or other forms of income.

Foreign Stocks

A retirement portfolio should have a small exposure to overseas stock markets, particularly for retirees early into their retirement. While foreign stocks are often considered riskier assets than U.S. stocks, when you narrow your focus to developed markets like Japan, Australia and Western Europe, those shares are, statistically speaking, no more risky than what you find in America.

But they offer retirees some advantages. First, they typically pay meatier dividends (as a percentage of the stock’s price). And they offer exposure to the growth happening in other economies, which can offset weakness in the U.S. economy. And potentially more important, putting some money to work in foreign markets exposes a portfolio to other currencies — especially important when the U.S. dollar is weakening against other currencies.

Bonds

Even more than with stocks, you’ll largely want your parent’s bond portfolio in a mutual fund; bonds can be much more challenging to research individually because there are just so many of them. In general, stick to a broad-based, intermediate-term bond index fund (intermediate-term because bonds of between five and 10 years in maturity tend to deliver decent rates with only moderate risk).

You also should give some consideration to municipal bonds sold by the various counties, cities and agencies within your parent’s home state. Most of these are tax-free at all levels, meaning parents owe no income taxes at a city, state or federal level on the interest income received.

One caveat you should understand about bonds and bond funds is that, generally speaking, owning individual bonds tailored to a parent’s specific situation is preferable to owning a bond mutual fund.

But building a portfolio of individual bonds typically requires at least $100,000 in cash to adequately diversify across at least 20 different bonds in various sectors of the economy. Such a sum implies a much larger overall portfolio when you consider that your parent still needs exposure to stocks and cash. As such, individual bonds are out of the question for most retirees.

Certificates of Deposit

A CD ladder is essentially a series of certificates of deposit, each maturing at a different point in time. CDs are standard fare for retirees, and with good reason. The cash is in a rock-solid institution and will never accrue losses.

You don’t need a specific amount of money to ladder CDs. You could, for instance, put $100 in three CDs, maturing respectively in one, three and five years. In practical terms, however, laddered CDs tend to make the most sense when a parent has several thousand dollars to spread out. That’s where you’ll see the biggest impact in terms of income.

With a $50,000 lump sum of cash, a parent has the option to put all of it in a one-year CD so that the money is available fairly readily, or the cash can go into five $10,000 CDs laddered across one-, two-, three-, four- and five-year periods, with some of the cash fairly readily available, and some of the cash locked up for a number of years.

—Email: forum.sunday03@wsj.com.

Article source: Wall Street Journal

 

The financial planning profession has a long history of demonstrating the power of compounded growth to clients who are looking to invest for the future.  Typically, a chart will be shown that shows the difference between investing $100 per month at 1%, 5%, 8%, and 10% rates of return for 20, 30, and 40 years.  As expected, the results are typically astounding.  The extended impact of compounding for a longer period of time at a higher rate of return creates a tremendous difference in the amount of compounded returns after a long period of time.  Thus, the fundamental assumption behind all contemporary financial planning models is to invest money into financial products that have historically produced a high rate of return so that you will be able to enjoy a happy and comfortable retirement from your compounded returns.

Unfortunately, there is one question that never seems to enter into the conversation.  This question is whether the historic rates of compounded growth for the stock market will continue into the future?  If the returns produced by the stock market in the past do not extend out into the future, there will be many hundreds of millions of people who have their entire financial lives decimated.  And the shock will be even more severe, as many people have not even considered that it could happen.  For many years, it has been assumed that the stock market can continue to grow faster than Gross Domestic Product (GDP) indefinitely.  However, that assumption may be faulty.

Currently, the ratio of total US Stock Market Capitalization compared against GDP stands at approximately 95%.  This means that the total value of all US stocks adds up to 95% of total US economic output for one year.  This ratio is consistent with the 10-year average from 2000 through 2010, but is higher than the 20-year or 30-year average for the stock market to GDP ratio.  This disconnect raises an interesting question.  How much longer can the stock market continue to grow faster than the economy?

It is important to consider that the overall stock market can only grow if new capital is invested.  Individual stocks will go up or down in value as people switch from holding one company to holding another, but there is only one thing that can propel the entire market upward, and that factor is additional investment.  However, that additional investment must come from economic activity.  What happens if the level of investment required to continue driving the stock market upward at historic rates is larger than the amount of economic growth?  The answer should not come as a surprise … if the money to invest isn’t being generated by the economy, it won’t be invested, and the stock market won’t grow at it’s historic rate of appreciation.

To illustrate this point, both total stock market capitalization and GDP have been projected out at historic growth rates over the next 15 years, starting with actual data from 2010.  Over the last 30 years, the total stock market capitalization has grown at approximately 9% per year, while GDP has grown at approximately 5% per year.  When these assumptions are extended out to 2025, the infinite compounding fallacy becomes quite clear.  in order to maintain the historical rates of appreciation that are used in almost every financial planning model, the stock market will need to be $17.4 Trillion dollars larger than US Gross Domestic Product by the year 2025.

When one considers that this gap represents approximately 57% of Gross Domestic Product, it becomes increasingly evident that the total stock market capitalization simply cannot continue to grow at its past rates because there is not enough additional output being generated to fund the incremental investments that would be necessary to continue driving market values upward.  Thus, the answer to the question of what will happen to stock market capitalization is very apparent.  Unless the economy grows dramatically faster than it has in the past, there will be insufficient capital to propel the stock market values upward at previously experienced rates of appreciation.

Upon further analysis, the problem grows even more complicated.  Since the ratio of total stock market capitalization to GDP is currently equal to the 10-year average from 2000 through 2010, and is higher than both the 20 and 30 year averages.  This means that if the ratio between stock market capitalization and GDP regresses back to historical levels, the growth in stock market valuation will not only be constrained by GDP, but may actually grow slower than overall economic output.

Over time, it is not possible for the stock market to grow nearly twice as fast as the economy.  Eventually the capital required to drive further value growth equal to past rates of appreciation will not be available.  In this way, the fallacy of infinite compounding becomes strikingly apparent.  Financial planning models have been built on the assumption that one can passively generate a rate of return significantly higher than the growth rate of the overall economy.  Over time, this assumption will prove to be faulty, and spell ruin for the traditional models of investment planning.

So what can a person do?  It’s one thing to point out the problems with compounded appreciation assumptions built into financial planning models, but it’s another thing entirely to plot out a new course that overcomes these challenges.  The truth is that this course will be different for every person.  However, there are a few guiding principals that will make finding this course much easier.  These considerations are that cash is king, and leverage amplifies results.

Cash is King

This is the oldest and most hallowed of financial axioms.  Cash stands and the fundamental basis of investment value.  The ‘real’ value of an investment is the cumulative discounted value of all future cash flows it produces.  This can come in the form of dividends from a stock or rent revenue from an income property.  When evaluating an investment based on the cash it produces, the value is easy to see.  However, if the value of an investment depends solely on selling it to somebody else for a higher price in the future, it can result in tremendous volatility and risk … especially if the investment does not produce any cash flow.  Thus, the paradigm of the future for investors should be to seek cash flows.

Leverage Amplifies Results

Another fundamental consideration for astute investors is the power of leverage.  This can take the form of both financial leverage and organizational leverage.  In either case, the leverage will allow you to amplify the results produced by your efforts.  In the case of financial investments, borrowing at a low rate of interest and investing at a higher rate of return will allow you to amplify your returns much higher than could be earned with cash alone.  Similarly, leverage will amplify any losses that are incurred from your investments.  This is equally true with organizational leverage for business owners.  Amplifying your time through the efforts of others will allow you to generate better results if you are highly effective, or will create chaos if you are disorganized.

In the end, future investors will need to rely on their ability to create value.  The days of infinite compounding from perpetually escalating market values are reaching an end.  The people who survive and thrive in this environment will be the ones who focus on fundamentals and create value.  It is important to understand that every difficulty carries an opportunity, and that each person is responsible for capturing that opportunity to create the best future that they can.

 

There is a cash crisis in corporate America—although it comes not from a shortage of the stuff, but from a surplus.

In the first quarter, the five companies with the greatest cash hoards—Microsoft, Cisco Systems, Google, Apple and Johnson Johnson—added $15 billion in cash and marketable securities to their balance sheets. Microsoft alone packed away roughly $9 billion, or $100 million a day. All told, the companies in the Standard Poor’s 500-stock index are sitting on more than $960 billion in cash, a record.

To be sure, at many companies the cash piling up is at global operations that generate “undistributed foreign earnings” that can’t be brought home, under U.S. law, without incurring taxes of up to 35%. But hundreds of billions in cash remain available—and idle.

Meanwhile, the payout ratio—the proportion of earnings paid out as dividend income to shareholders—fell to 28.9% for the past four quarters. That, says SP senior index analyst Howard Silverblatt, is the lowest level since 1936. Dividends are going up—Intel, UnitedHealth Group and WellPoint have recently raised them—but cash is still piling up far faster than most industrial giants can possibly find a prudent use for it. Of course, investors themselves might have a better use for the cash, if they could get at it.

As Daniel Peris, co-manager of the Federated Strategic Value Dividend fund, says, “The likelihood of spending money poorly is increased by having a surplus of it.”

Christophe Vorlet

Microsoft’s purchase price for the online telecommunications firm Skype, widely criticized as too rich at $8.5 billion, almost precisely matches the amount of cash that Microsoft raked in last quarter. Was that torrent of cash burning a hole in Microsoft’s pocket?

“No way,” says Bill Koefoed, general manager of investor relations at Microsoft. “We see this as being a very strategic acquisition.”

The heart of the problem, as the great investor Benjamin Graham pointed out decades ago, is that the best interests of corporate management and outside investors are at odds. That is especially true for giant companies whose growth has been slowing. “The more dubious the company’s prospects…the more anxious management is to retain all the cash it can in the business,” Graham wrote. “But the stockholders would be well advised to take out all the capital that can be safely spared, because these funds are much more valuable to them if in their own pockets, or invested elsewhere.”

Amnesia is another culprit. In the past, companies paid out vastly more of their profits as dividends, and they should again. “If there were a greater historical sensibility among investors and managers,” Mr. Peris says, today’s low payouts “would be called out as an abnormal situation that’s likely to lead to that money being less well-spent than it otherwise might be.”

Dividends have gotten short shrift in recent years as investors have come to favor companies that instead use cash surpluses to buy back their shares. Meanwhile, with the economic recovery barely out of the sickbed, many companies are reluctant to invest heavily in expansion. Others want to keep cash handy for potential acquisitions. So cash sits idle—even as interest rates, after inflation, are so low that cash often produces negative real returns.

Benjamin Graham made three simple proposals in 1951 that deserve to be revived.

First, investors need to realize that a company’s cash is a valuable asset, even when interest rates are low; if management won’t put it to good use, investors must speak up. As Graham wrote: “When the results on capital are unsatisfactory, it is appropriate for stockholders to…insist that it be returned to stockholders on an equitable basis.”

Second, companies should set formal dividend policies. Rather than paying or raising dividends out of the blue, they should state in advance what proportion of earnings they expect to pay out as cash dividends. If, instead, they plan to use excess cash to buy back shares, they should offer hard evidence that the stock is undervalued.

Finally, Graham advocated that leading companies should pay out two-thirds of their earnings as dividends. That rate isn’t as radical as it might sound, even though it would amount to more than a doubling from today’s levels. The dividend payout, as a percentage of total profits, has averaged 52.3% since 1936 and 46% over the past two decades, according to Standard Poor’s.

If the companies in the SP 500 raised their payout ratio to 50%, Mr. Silverblatt estimates, that would put an extra $207 billion into investors’ pockets—at a time when shareholders’ dividend income is taxed at historically low rates.

“Companies are basically earning more than they’ve ever made before, but their payouts are nowhere near that high,” says Mr. Silverblatt. “They’re holding their cash really tight. You can call them Scrooges if you want.”

Article source: Wall Street Journal

 

Silicon Valley has a new case of “sudden wealth syndrome.”

Bloomberg

This week’s stratospheric public offering of LinkedIn Corp., the social-networking company whose shares more than doubled on Thursday, turned company founder Reid Hoffman into the nation’s latest tech billionaire, with a stake valued at more than $1.7 billion. CEO Jeffrey Weiner, who joined the company in 2009, is now worth more than $200 million.

With more IPOs in the offing, from Zynga Inc. to Groupon Inc. to Facebook, the social-media craze has become America’s latest supernova of wealth creation, launching a new generation of millionaires and recalling the instant riches of the 1990s dot-com explosion. Terms like sudden wealth syndrome and “affluenza,” which had largely vanished from the offices of Palo Alto, Calif., and the cocktail parties of nearby Atherton, are back.

Yet when it comes to investing and spending their newfound fortunes, Silicon Valley’s newly rich are likely chart a different course from their predecessors. In the wake of the dot-com bust in 2001, which left many dot-com millionaires with massive mortgages and worthless stock, the new tech magnates are likely to take a more cautious approach to their money. Advisers say the new class of dot-commers is likely to sell as much of their holdings as possible and protect their cash.

“We’ve been through such a number of watershed events over the past decade, and those lessons are writ so large,” says Chris Sheldon, director of investment strategies at BNY Mellon Wealth Management, which has a number of wealthy tech clients. ” I think people seem to have a better chance this time around of starting out the right way.”

Of course, some of the suddenly wealthy of 2011 may end up making the same mistakes as the last group. Tech entrepreneurs often pursue their corporate visions with missionary zeal and are loath to sell company shares, even if it is financially prudent. And loading up on social-media stocks has proved highly lucractive for investors like Russian billionaire Uri Milner, who invested with Facebook, Groupon and Zynga, and recently bought a $100 million house in Los Altos Hills, Calif.

Yet Silicon Valley’s top wealth managers are telling their newly rich clients to cash out as much as possible. If the old message was “risk and returns,” the new message is “protect and preserve.”

“The folks today don’t have the sense that the world will keep getting better and everyone will keep getting richer,” says Keith Whitaker, a wealth counselor and president of Wise Counsel Research in Boston, which studies wealth. “There’s a desire to be liquid, and less trust in financial markets and less of an appetite for risk.”

Here are a few of the tips advisers are giving to the Valley’s freshly minted millionaires and billionaires.

• If it’s not cash, don’t spend it. Mr. Hoffman may be a paper billionaire, but he sold only about $5 million of stock in the IPO. He is still rich, of course. But advisers are telling the instantly wealthy to limit their lifestyles to their cash rather than their paper wealth, which can vanish overnight.

While LinkedIn, Groupon and the other companies have enjoyed steadily higher valuations in the private market, they are likely to endure a more volatile ride in the public markets.

“There’s a temptation to start spending the money right away,” Mr. Sheldon says. “But the lesson from recent history is that your stock doesn’t always have the same value in six months that it does today.”

• Hedge, pledge and sell. Advisers recommend that founders and executives sell large chunks of their stock so they don’t have so much of their wealth tied up in one investment—especially one as volatile as a tech stock. Katherine Ellis Nixon, a regional chief investment officer at Northern Trust Corp., says she advises clients to create a “barbell,” with their company stock on one end and ultrasafe investments (like short-term Treasurys) on the other.

Many times company chiefs are subject to lockups that prevent them from bailing out of all their shares. Mr. Hoffman, for instance, has a six-month lockup. Advisers are telling those clients to create “stock collars,” which are options trades that limit the downside and upside of a stock movement.

They also are recommending hedges using options that would involve, for instance, betting on a decline in broader tech stocks to offset an executive’s ownership in his own company.

The goal, Ms. Nixon says, is to “offset the high volatility and concentration of their company” shares.

• Give it away. The government is offering attractive terms for gifts, raising the lifetime gift-tax exemption to $10 million from $5 million for married couples. Advisers also say today’s newly rich—often in their 20s and 30s—are highly philanthropic. Many of them (like Facebook’s Mark Zuckerberg) are giving away millions already.

• Stop and listen. Wealth psychologists say instant wealth can be highly disorienting.

“When you suddenly cross that boundary like these guys just did, it’s like going to another country,” says Lee Hausner, a psychologist who works with many wealthy families and entrepreneurs in California. “It’s like getting dropped in a rural village somewhere. You have to stop and do nothing. Just get the lay of the land and try to learn.”

She tells clients to initially avoid wealth managers and park their money in cash until they can get educated in the peculiar customs and rules of investing, spending and giving away large wealth.

“You need to start with the big questions, like what are your life goals and family goals before you start picking an investment strategy,” Ms. Hausner says. “You can’t just run to someone with a vested interest in selling you something.”

By ROBERT FRANK

Article source: Wall Street Journal

 

It hurts to lose your own money in the market, but losing the money you have set aside for your children is agonizing. Just look at what has happened to “529″ plans.

At their best, 529s are a safe and sensible way to save, tax free, for your children’s college expenses. At their worst, they offer irresponsibly risky exposure to stocks and appallingly bad investments that can blow parents’ money and students’ dreams to smithereens.

All too many families have gotten the worst. Of the 3,506 options (including funds with different sales charges) in college plans tracked by Morningstar, 93% fell in value over the past year, and 1,098 lost at least 40%.

Of course, the stock market was down 43% over the same period. But the popular “age-based option” for 529s is supposed to protect investors. It should work like this: A young child’s account starts out primarily in stocks; with each passing year, more money moves into bonds and cash. By the time the student hits college, less than 20% of the money should be at risk in stocks — limiting the potential damage from even an epic bear market to 10% or so.

That is vital. Students typically have a finite period, often only four years, during which they spend their 529 savings. They don’t have the luxury of waiting for stocks to recover.

Nevertheless, some states pushed students into stocks or out of cash. Last April, Oregon doubled the stock exposure in its “1-3 Years to College” portfolio to 40%. In 2004, an in-college student in Rhode Island’s aggressive age-based portfolio would have had 40% stocks, 31% bonds and 29% cash. By 2008, the equivalent was 40% stocks (including real estate), 55% bonds and a measly 5% cash.

Other plans took too much risk all along. In Utah, college enrollees could have 65% in stocks. Several states, including Maine and New Mexico, offered 529 portfolios with no allocation to cash for students over the age of 18. Even after North Carolina finally scaled back its risk earlier this month, a college sophomore can still have 43% in stocks, real estate and junk bonds.

Says Mercer Bullard, a securities-law professor at the University of Mississippi: “In some states, the asset allocation for the 16- to 18-year-olds looks as if it was designed by the 5-year-olds.”

Unfortunately, the states compounded their bad strategic decisions with even worse tactical choices. One of Maine’s portfolios for students 18 or older consisted of the following Oppenheimer funds: 60% Limited-Term Government, 20% Core Bond, 10% Champion Income and 10% International Bond. Gorging on mortgage-backed securities, the first three funds lost 6.3%, 36% and 78%, respectively, in 2008. That portfolio fell 22% over the past 12 months (not including sales charges).

The “Ultra Conservative” portfolio in New Mexico had 0% cash, 20% stocks and 80% in two Oppenheimer bond funds; it fell 23% last year. Some of the same funds blew up 529s in Illinois, Oregon and Texas. “The performance of the OppenheimerFunds 529-plan portfolios,” says a spokeswoman for the fund company, “is not much different than what others have experienced as a result of [the] unprecedented market events [of 2008].”

Assets in 529s, which peaked at $112 billion at year-end 2007, totaled $88.5 billion as of this December. Sadly, the public’s faith in 529s appears to be based partly on a false premise: that state bureaucrats are good at managing other people’s money.

Officials in several states, including Maine, New Mexico and North Carolina, declined or didn’t respond to requests for comment; nor did J.W. Seligman Co., which ran the riskiest portion of the North Carolina plan.

Contributing to a 529 is still worth it for the tax benefits alone. Visit savingforcollege.com and the plan’s own Web site to make sure your teenager is not up to her armpits in the stock market. If she is, transfer to a less-risky option within the same plan. If you can’t tell, call the fund company that runs the 529 and demand details on how the money is allocated.

For young children, consider the remarkable deal offered by Ohio’s 529: federally insured certificates of deposit from Fifth Third Bancorp with maturities of up to 12 years at yields as high as 5%. But it is tough to beat a risk-free 5% return exempt from federal income tax. What a tragedy that more states didn’t offer similar options before it was too late.

Write to Jason Zweig at intelligentinvestor@wsj.com

Article source: Wall Street Journal