Munis in Mind (Part 3)

What if munis are headed for a meltdown?

One of the principal tenets of disciplined investing is, what if you’re wrong. It’s all well and good to have a view of the world that allows you to avoid panicking and stuffing your cash in a mattress—or in T-Bills—but what if your investment outlook is mistaken?

With equities, we call it the margin of safety. How much is a business worth when broken up. If the economy tanks, what’s the minimum free cash-flow that the company would generate? Measure its present value, and you get the business’s intrinsic value. If you can buy a stock at or below its intrinsic value, you’re protected if things go wrong.

With bonds, we protect ourselves by focusing on well-managed issuers providing essential services. For example, many municipalities borrow against their water system or electrical system, and use the fees that system charges to pay the interest. The bondholder has a first lien on the revenue. Even if the city goes broke, the bondholders get paid.

Essential services bonds provide a significant level of security. There are services like water, electricity, and education that all communities need. There are other services like sports stadiums and monorails that are optional. Bonds from growing regions of the country—like Texas—or from low-tax states like Florida or New Hampshire are also safer than bonds from low-growth high-tax regions like Ohio or Wisconsin

We look after our equity investments by focusing on price. We look after our bonds by analyzing quality. In either case, we’re protected if things go wrong. Because eventually, they will.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Munis in Mind (Part 2)

Munis are not headed for a meltdown.

There are many reasons to be concerned about the muni market. Fraudulent disclosure on the part of the issuers, fraudulent bid-rigging on the part of correspondent banks, fraudulent off-balance sheet transactions on the part of municipal employees—you get the picture. But the criminal actions of a few public officials do not taint the entire $2.3 trillion dollar market.

Credit is a multifaceted thing. Rigorous analysis evaluates the borrower’s liquidity, solvency, efficiency, credibility, and growth. In plain language: how much cash do you have, how much have you borrowed, how much can you save, how much do people trust you, and how fast can you grow.

As an example, when Lehman failed, declines in bond prices wiped out their capital. They were insolvent. They weren’t efficient enough to grow their capital back, and when lenders realized the extent of the problem, they pulled their liquidity facilities. By September of ’08, poor management decisions had cost Lehman the credibility it needed to put a deal together. Failure was the result.

When we evaluate cities and states via the same matrix, we see a mixed picture. But we don’t see a meltdown happening. As an example, most municipalities have committed only about 10% of their budgets to paying principal and interest. By contrast, in 2007 67% of Lehman’s revenues were devoted to paying just interest. When times got tough, they couldn’t raise cash internally. Munis aren’t in that same boat.

It’s not easy to evaluate thousands of different issuers across the country. But when you run the numbers, munis seem pretty safe.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Muddle in the Middle Kingdom

Where is China going?

The conventional wisdom seems to be, anywhere it wants. China is now the world’s second largest economy, and if it continues to grow 6% faster than the US, it will be bigger than the US economy in 15 years. But the past isn’t prologue. While many expect China to run everything, in China they’re running scared. They’ve had an investment led economy ever since Deng Xiaoping broke with Mao’s orthodoxy in 1978. Investment-led economies can and do grow at elevated rates for a while. But all good things must come to an end, and the investment boom will surely follow this dictum.

Look at it this way: China is building its industrial base. It’s building factories to produce the materials to build more factories. This kind of bootstrapping can provide rapidly expanding growth, but eventually it overshoots. In the Southwest of the US homes were built to house all the people moving into the area to work in homebuilding. The world can’t afford for China to become an immense housing bubble.

But there are examples of economies that successfully transitioned from an investment economy to a consumer economy: postwar Germany industrialized intensively during the Marshall Plan era, and then moved to a consumption-led economy in the ‘70s, as did Korea in the ‘90s. But success isn’t guaranteed. For every Korea, there’s a Japan. What’s the difference?

Ironically, it seems to be openness to imports. Countries that let their consumers buy what they want from where they want seem to transition more easily to consumer-led societies. Will China follow this model? I’ll quote Confucious: “The middle way is best.”

Douglas R. Tengdin, CFA
Chief Investment Officer
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Munis in Mind (Part 1)

Are we headed for a municipal meltdown?

That’s what Meredith Whitney thinks. The former Oppenheimer analyst who correctly predicted Citibank’s demise has released a 600-page report in which she claims that municipal finance is the next sub-prime bubble. In the report she evaluates the finances of the fifteen largest states—representing two-thirds of the US economy—and finds them wanting.

She doesn’t expect the states to default, but she does think that they will reduce their transfer payments to cities and towns. Since those governments are indebted, they’ll default. And while the states may get Federal help, smaller governments won’t. She claims that a wave of defaults may be just around the corner.

There are a number of significant problems that I have with this analysis, but I’ll focus on just two. First, what makes Meredith Whitney qualified to evaluate public finance? Yes, she can read an income statement and a balance sheet, but she seems shocked, shocked that municipal accounting occasionally gets creative. Hello—have you heard of New Jersey or San Diego? They got seriously spanked by the SEC for playing fast and loose with their pension numbers.

Which is another issue: Ms. Meredith is all het up over retirement costs. She doesn’t think that the states will be able to pay them. That’s a reasonable concern, but the governments have a remedy. It’s called legislation. Retirement formulas can be altered, or the whole mess can even be outsourced to Social Security. That’s what Maine just did.

There are plenty of other questions the report raises: why is real-estate a factor when it’s a minor item in most state budgets; or what about the thorny constitutional issues involved in Chapter 9? But my biggest concern is this: is Meredith Whitney just pumping up Meredith Whitney, Inc. Who benefits from all this publicity?

Douglas R. Tengdin, CFA
Chief Investment Officer
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Present at the Creation

Welcome to the tablet wars.

New products come and go. Some seem destined for the trash bin within hours. Remember “Tickle-Me Elmo?” But some are truly game-changers, and alter our lives in a fundamental way.

Such has been the case with the tablet computer. While “Tablet” may be the category, the iPad is the product everybody knows. And when it comes to tablets, there’s the iPad and there’s everyone else.

Yes, it’s grating to have to go through the iStore for every file you want to transfer; and it’s galling to have to confirm your credit card number every time you download an upgrade to a free app, and sending comments and complaints to Apple’s customer service area is like putting letters into a bottle from a desert island in the Pacific. But for all that, the iPad is the “it” hardware. It defines the tablet.

Tablet computing is all about software—an integrated operating system with apps that use the potential of the 7 inch screen, so you look through the device to get to the content, whether it’s text-and-graphics, photos, video, or some combination. Throwing Windows into a tablet won’t work any better than throwing Windows into a smartphone platform did. Anyone remember the “Glisten?” Thought not.

But lots of companies will try. So as the Samsung Galaxy, the BlackPad, HP’s Slate, and a host of Android devices rush to the market for the holidays, look for Apple to cash in. Because imitation is the sincerest form of flattery. And sometimes your competitor’s ads are your best marketing.

Douglas R. Tengdin, CFA
Chief Investment Officer
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A Sad End

A specialist is said to be someone who knows more and more about less and less until he knows everything about nothing.

That’s the way it is with some Exchange Traded Funds. By constructing ever-more-specialized indices, these investment vehicles become so focused and targeted as to lose sight of the original premise of a mutual fund—diversification. The point of any fund is to pool your money with other investors so you can efficiently buy a group of stocks rather than just one or two.

But the makers of some ETFs didn’t get that memo when they started to elaborate their business model. The first ETFs were indeed based on broad market aggregates like the S&P 500. Then they expanded into foreign markets, and then sectors of the market, like small-caps or financial stocks.

The motive for all of this is fees, of course. Smaller funds attract a dedicated audience who will supposedly be willing to pay higher fees. If the ETF attracts enough interest, those fees can become substantial. But if the funds just languish, or if the fund company just doesn’t find them profitable, the ETF will be liquidated and investors will find themselves either with a lot of small holdings or get saddled with closing costs.

Such was the case recently with the Luxury Retail ETF, ROB. It was focused on the high-end retail brands like Hermes and Wynn Resorts. But the fund only grew to $17 million, and the fees it generated weren’t enough for it to pay its way. So its sponsor, Claymore Funds, shut it down. Now investors have to figure out what to do.

That’s a little-known risk of ETF investing. Because the fund’s parents matter. It’s not just what you make. It’s what they keep.

Douglas R. Tengdin, CFA
Chief Investment Officer
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After Taxes

There’s one other factor in the mutual fund discussion: taxes.

I’m not talking about the debate in Washington over top marginal tax rates. I’ll leave that to the politicians. What investors need to worry about is capital gains. Active mutual funds buy and sell shares as they manage their holdings. This activity generates gains and losses, and our tax code requires that any realized gains need to be taxed. In order to avoid paying the taxes themselves, the mutual fund companies pass through the gains to their holders.

Funds held in a 401(k) or IRA aren’t affected. Any taxes are paid when the money is withdrawn. But funds not sheltered from taxes are likely to experience “tax inefficiency.” That’s where taxes have to be paid today even if the fund is never sold. It has the effect of raising the cost basis at the expense of negative cash flow. It’s a side effect of high turnover. Many index funds whose constituents tend not to change have less of a problem.

So many folks are drawn to index-based Exchange Traded Funds as their investment vehicle of choice. We use them too. They allow us to manage our taxes, manage our holdings, and own over 3000 stocks around the world in a tax-efficient manner.

Because when it comes to investments, taxes matter. It’s not what you make, it’s what you keep.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Choices, Choices (Part 4)

So how do you find a winning fund?

Active managers often underperform the market in the long run after fees. This happens for lots of reasons. Hot returns are self-defeating.

Economic laws work against active management on many levels. But there are ways for average investors to use them to their advantage. For example, the law of risk and uncertainty—sometimes called the black swan effect—means that you don’t know what you don’t know. This doesn’t just mean bad news: there are “white swans” out there: a cure for cancer or a 100 mpg car.

The most efficient way to profit from these undiscovered inventions is to own the total market. That way, you’re guaranteed be invested in the latest advance. So is indexing the best approach? After all, that’s the cheapest way to invest in everything.

Yes, and no. You want to have the total market. But market weighting means buying more of expensive companies and less of cheap ones. If you can invest in everything but manage your holdings so you own a little less of what’s hot, you can use the law of mean-reversion as well: hot sectors eventually blow up. When they do, you want to be under-weighted.

By investing in a portfolio of global index funds that hold most of everything but that let you assign ideal weights to different sectors, you can often do better than the market even after fees. It’s like running downhill. When the law of gravity is on your side, you just move a little faster.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Choices, Choices (Part 3)

Picking a mutual fund is a loser’s game.

I’m not saying that funds are for losers, or that only losers manage them. A loser’s game is a game that you win by not losing. Call it sports for the rest of us. Not many can drive 300 yards or serve at 130 miles per hour. We do well to keep the ball in play. It’s the same with investments. The way to win is not to lose.

There are some obvious things to look at: fees, turnover, and performance. Fees, because every dollar the manager makes is one less dollar for you to take home. Find out what the fund’s all-in fees are. Disqualify any funds that charge a front-end, back-end, or ongoing marketing charge.

Look at expenses. They shouldn’t be more than 1.5% for the most personal service. For an off-the-shelf fund, it should be less than 0.75%. Turnover measures how long the fund holds its investments. A long-term investor shoots for 20% turnover, or less. Excessive turnover creates a cost headwind. The only thing it assures are steady brokerage fees: fees that you’ll be paying.

Surprisingly, performance isn’t that important. Short-term scores are rightly dismissed, but even awesome 10-year records almost always mean-revert and underperform in the next decade. The best thing to look for is consistency.

By focusing on these factors, you should be able to avoid the worst funds. But there is a better way.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Choices, Choices (Part 2)

So how do you pick a mutual fund?

The mutual fund industry has made a business out of selling this diversification and manager expertise. There are now almost 90 million investors in funds worth over $10 trillion in the market. What are some of the most common pitfalls of using mutual funds?

We saw last week why picking a hot fund is self-defeating: hot funds attract hot money that overheats their sectors and leads to a boom/bust cycle. But investing in an un-hot sector has its problems as well. Often those turn out to be specialized niches of the investment landscape—such as emerging market funds, junk bond funds, or mico-cap stocks. Prudent investors are wise to limit how much they put into any one of these areas.

Eventually, however, by putting a little money into lots of different funds, you end up owning the whole market. That’s okay, but active managers are going to charge active management fees, so after fees you’re probably not going to do as well as the market. You’d be better off in a total market index fund.

So hot funds and the grab bag approach are out. But what does work? An old Russian proverb: trust, but verify.

Douglas R. Tengdin, CFA
Chief Investment Officer
Hit reply if you have any questions—I read them all!

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