If you haven’t noticed, the US stock indices have performed fairly well in aggregate over the past few months. Including several of my holdings.

What a bummer!

That’s probably not the reaction that you’d expect, but it’s rather common among long-term investors. When stock market prices go up, the paper value of a portfolio increases, but finding solid investments for currently invested capital becomes more difficult. My brother, an executive at one of the largest US defense contractors and a husband and father to a wife and three kids, is joyed to see his indexed portfolio replenished, and I can’t really blame him, but I’m disappointed to see some values lessen! I’m glad to see people get to work; I’m not disappointed about economic improvement. It’s strictly the stock valuations that can be suboptimal.

In a market with lower valuations, fresh capital can result in producing better returns, and reinvested dividends and company share repurchases result in better rates of return as well. Markets with higher valuations result in reinvested capital going to lower-return investments.

To illustrate this point, here’s an example. Company A has a P/E of 12, solid cash flow and a good balance sheet, pays out 75% of its EPS as regular growing dividends, and grows EPS by 6% per year. Company B is identical in every way, but has a P/E of 18. For simplicity, these valuations stay constant for 10 years, and dividends are pooled and reinvested once per year. I could have done this chart in multiple ways, such as making stock prices equal and having the two companies with different EPS (to reflect the differences in valuation), or I could have made EPS the same, and make the stock prices different. I choose the first approach so that we can start with the same amount of shares at the same price per share. This link shows a PDF of the charts and outcomes.

As can be seen, since both companies have the same payout ratio but company A is at a lower valuation (and therefore a larger dividend yield), investing in company A results in a larger initial amount of dividend income for the same invested value. In addition, over the next 10 years, since the valuation is lower and the yield is therefore higher, reinvesting the dividend purchases more shares, which grows the investment and the income at a quicker rate.

An investor in company A turned $12,000 into $39,403, which is an annualized return of 12.6% over this 10 year example. Meanwhile, an investor in company B turned $12,060 into $32,486, which is an annualized return of 10.4% over this 10 year example. The total dividend income growth rate matches the total return for each respective investment.

So, two identical companies had significantly different returns based simply on their valuation over that period. This is because dividends can buy more dividends when the valuation is lower (and this applies to share repurchases by the company as well). Of course, over any realistic time period, the valuation will rise and fall, but the point is, that at any given time, it’s preferable in the eyes of the long-term investor (net buyer) for the valuation to be low. Any time that’s spent with her stocks at higher valuation, is money lost. Now, there are some times of course when a spike in valuation could be profitable, such as if a stock goes up to an overvalued state and the investor sells, looking for a better stock, or if the valuation increases just when a person retires and cashes out part of her stock portfolio. But for most long-term investors, especially net buyers that aren’t retiring any time soon, it’s low-valued markets that provide the better long-term returns.

Now, one could point out that valuations are directly linked to growth expectations. In other words, when the stock market changes, it’s because investors are increasing or decreasing their expectations. The example chart that I provided only remains true if fundamental growth is unchanged by the changing valuation; it assumes the differences in valuation of those two identical companies are strictly irrational rather than due to legitimate differences in expectation. But one can look at any long term graph of stock price and annual EPS for a given set of blue-chip stocks, and see irrationality in the stock price.

Buy low, look for good combinations of dividend growth and dividend yield, solid balance sheets, strong cash flows, economic moats, and hope it stays low for a while to let those shares accumulate.

Abbott announced in mid October that the company will be splitting into two companies. It is expected to be completed at the end of next year.

I’m a shareholder of Abbott, and my 2011 analysis can be found here. It’s several months old, but it provides a solid overview of the company.

Split Facts

The company plans to split into two companies with a tax-free distribution. The sum of the dividends of the two companies is expected to equal the dividend of the combined company at the time of the split.

The first company, which will retain the Abbott name, will be a diversified medical products company with approximately $22 billion in annual sales. It will include the medical devices segment, diagnostics, nutritionals, and generic pharmaceuticals. Significantly more than half of the sales will be international, and the company will have strong emerging market exposure.

The second company, which is yet to be named, will be a researched-based pharmaceutical company with approximately $18 billion in sales. The business will invest in R&D to come up with new drugs. Abbott’s current blockbuster drug, Humira, will make up a considerable portion of the sales and will present much of the immediate growth, while other drugs will have to fill in for Humira’s success when it begins to go off patent in 5-6 years.

Advantages from Splitting

Splitting the company does offer some advantages.

-Smaller companies often have better growth opportunities. More opportunities are available to them that wouldn’t be large enough to matter for a larger company.

-Investors can invest in exactly what they want- diversified medical or pure pharma.

-The diversified medical company with the Abbott name should maintain very strong free cash flows since there will be no expenditure on leading edge pharmaceutical R&D. This should be good for dividends, and the risk overall may be reduced.

-The pharmaceutical company will be medium-sized. Although earnings will be more volatile than the diversified business over the long term, there is the opportunity for outsized returns if some of the pipeline drugs do well, and if Humira continues to grow as well as it has. Based on the medium size of the business, it’s not out of the question that this segment could be acquired by a larger rival, which would result in a premium for shareholders.

Why I don’t want to “Unlock Shareholder Value”

Apart from some downsides of the split, like the costs of duplicating operations and the cost of restructuring the debt, I believe a potential downside is what many are referring to as an upside.

One of the reasons given by investors for liking this spit is that it may unlock shareholder value. In other words, the combined stock valuation may increase due to the split. Segments can be more accurately valued for what they are, and many argue that Abbott is currently undervalued. Abbott’s flat stock price for more than a decade could see a boost.

As a long term investor, I’m not interested in an increased valuation, and in fact I’d rather it stay undervalued. An increased valuation may be beneficial to stock traders, but for long term dividend investors, it’s just an increase in paper value. Some of the best historical investments, such as Altria, were so great specifically because they remained undervalued. When a company trades for a low valuation, dividend payments can purchase a greater number of shares than if the valuation were higher, and this results in faster accumulation of dividend income and long-term total returns. On the other hand, increased paper valuation does noting for me if I were not intending to sell any time soon. It just lowers the dividend yield of fresh capital that I put into the company, and makes it so I can buy fewer shares and therefore smaller dividend payments.

Conclusion

While I can see some reasons for the split, as an intended long term shareholder, I’d rather hold the company as a unified whole. It’s too early to be sure, but my thoughts at this time is that I’ll likely keep my position in Abbott, and sell my position in the researched based pharmaceutical business. I’ll either reinvest that capital back into the Abbott half, or put it elsewhere. I’m not too interested in investing in pure pharma plays, and instead prefer diversified health care companies. This doesn’t necessarily mean I think the diversified medical company will have superior returns; it’s simply that I feel the diversified medical company more suitably fits my investor profile. I expect that the diversified company, Abbott, will continue to perform well, should stay at a reasonable valuation, and should have solid dividend growth prospects based on EPS growth and strong free cash flows.

With large US deficits, trade deficits, the quantitative easing already performed by the Federal Reserve, easy money policies, and worldwide debt concerns, investors may rightly be cautious regarding the potential for inflation over upcoming years. Even optimistically, if economic growth picks up, that may allow inflation to finally take hold after it has been potentially building up due to these various policies.

There are several types of investments, however, that respond reasonably well to inflation. I don’t advocate market timing, or trying to tailor a portfolio to deal with very specific concerns, so here I present three investments that are useful in a variety of portfolios and that also respond well to inflation. It’s a fairly quick overview.

1) Stocks

Stocks, in general, are decent investments to hold over the long term during periods of substantial inflation. When prices are going up, it’s these businesses that are raising their prices. Periods of short-term major inflation can be bad for pretty much everything, including companies, but over the long-term, stocks hold up pretty well with regards to inflation. This applies to companies in general, but there are some specific types of companies that respond best to inflation.

-Companies with significant economic advantages, or moats, typically have good pricing power and can raise their prices accordingly.

-American companies that sell a significant portion of their products and services overseas in different currencies get “bonuses” when the US dollar falls. A company that has its expenses in a weakening currency, and revenues in strengthening currencies, reports growth that exceeds its “real” business growth due to positive currency effects.

-Foreign companies that primarily operate outside of the US are buffered against US dollar inflation.

-I don’t include commodities as a separate category in this article, but companies that deal with commodities and basic assets are sometimes suited for inflation.

2) Real Estate

Real estate, either in the form of personal or investment property holdings, or Real Estate Investment Trusts (REITs), is typically a good portfolio addition for inflation. The primary reasons are appreciation and leverage.

-When a property is located in a good area, it will hopefully appreciate over the long term, at a rate that either equals or preferably exceeds inflation. But considering that properties are typically purchased using debt, this effect is amplified. For example, if you put 30% down on property, and take out a mortgage for the rest, you control the whole property despite only having partial equity. This means that your gains on your equity are amplified when the property as a whole increases in value (or the opposite when the property decreases in value).

-If debt is fixed-rate, such as with a fixed rate mortgage or with a REIT that offers fixed rate notes, inflation is good for those that owe this debt. Inflation can help reduce the debt compared to asset value, meaning that debt as a percentage of assets will decrease because the asset side is partially indexed to inflation and the liability side is not. Real estate is typically more comfortably leveraged than many other things, so the effect of inflation on their debt is more noticeable.

3) Treasury Inflation Protected Securities

Most diversified portfolios include a bond segment, but a key risk for bonds is inflation. Treasury Inflation Protected Securities (TIPS) are bonds issued by the treasury that change with expected inflation. It’s perhaps not a bad idea to have a portion of your bond holdings in TIPS to protect that aspect of your portfolio from inflation. Compared to regular bonds, however, TIPS are a risk during rare periods of deflation.

Other Notes

-Having a ton of money in cash is not optimal in a period of inflation, and there’s almost always some level of inflation. Parking assets in an account that offers a yield lower than inflation means you’re specifically agreeing to a negative return on value in exchange for perceived safety. And you’re getting taxed on this negative return. It’s important to have a robust liquid emergency/savings fund, but apart from that, putting too much of a portfolio into cash equivalents can concentrate inflation risk.

-Precious metals like gold, or other commodities, typically respond well to inflation, but I believe that cash-flow-generating assets are better in general. I think there’s a lot more priced into gold than just inflation; there’s also a tremendous amount of fear and uncertainty regarding the global economy.

I figured this would be a good time to share a lecture I have enjoyed by David Swensen.

Swensen is the chief investment officer of the Yale Endowment, which has outperformed other large institutions over a long period of time. He helped pioneer the “Yale Model” which has been copied by other institutions. His full list of qualifications can be found on his wikipedia article.

To a certain extent, his Yale model was criticized when it experienced its first year of major loss in 2009, a year of systematic failure, but all things considered, his rather defensive position buffered Yale’s portfolio against what could have been an even worse impact (as measured by standard indexes). It was criticized because an institution like Yale needs to draw from its endowment annually to pay expenses. Yale’s long-term performance has outperformed the S&P 500 over the 25 years that Swensen has led it (since 1985), and has done so with less volatility (Yale only had 3 years of endowment reduction out of the 25, and two of them were very mild).
1900-2000
2001-2005
2006-2010

So what’s his secret for long-term risk-adjusted success? Asset allocation and attention to liquidity.

For those that don’t want to watch the hour-long lecture (I’d propose that a free lecture by Yale’s chief investment officer is worth an hour, but perhaps I’m unusual), or for those that wish to watch it but want some background, I’ll provide a quick summary of what his technique is and what his main arguments are.

I’ve mentioned it a few times here on Dividend Monk, but I suppose I don’t mention it enough considering I focus on a specific niche rather than portfolio theory in general: asset allocation is the most important decision for a portfolio. Choosing where to invest your money and what your broad strategy is, is far more important than which specific investments you pick. Everyone has their preferred investment class (some prefer indexes, some prefer dividend paying companies, some prefer other niches; I prefer both dividends and indexes), but what’s most important is how those investment types come together.

The main points from Swensen’s lecture are:
-Actively managed stock funds, in aggregate, underperform the market over the long term.
-Asset allocation is key, because it’s the closest thing to a “free lunch” around. With asset allocation, you can get better returns for the same level of total risk, or you can lower risk for the same level of portfolio returns. It’s an efficient way to maximize risk-adjusted returns, which modern portfolio theory assumes that any rational investor would want to do.
-There are some areas in which active management makes a difference, and it’s rather intuitive. The more efficient a market is, the less active management matters. In other words, the best bond traders are only slightly better than mediocre bond traders, but the best venture capitalists and leveraged buyout investors are significantly better than mediocre venture capitalists and leveraged buyout investors. The general progression of active management relevance is: bonds, stocks, real estate, buyouts, venture capital.
-Liquidity plays a big role in why some markets are more efficient than others. Less liquid investments, for the same level of risk, can often offer better returns. So, real estate and private equity, if invested in, can potentially provide outsize returns for a similar level of risk (assuming the fund is large enough to diversify even among these illiquid and large investments). If you want an example, look at a few of your favorite REITs, and imagine what your returns would be if you owned them personally at book value rather than paying a multiple of book value that the market has agreed is a good price to pay for what is on their part a passive and liquid real estate investment.

Obviously, some of this is more important for some managing an institution’s portfolio to know than for an individual investor to know. So what’s the takeaway for readers? The first takeaway is that, asset allocation really matters. The second is that, as an investor ascends in wealth, she may find it worthwhile to pursue some less liquid investments, including real estate and private equity (which to a certain degree are indeed accessible to individuals).

The third takeaway is, he also offers his portfolio advice for individual investors, which is not included in this lecture. The summary of his recommended asset allocation for a liquid individual portfolio is:

30% Domestic Equity
15% Foreign Equity
5% Emerging Markets
20% REITs
15% Bonds
15% TIPS

There are many similar portfolio allocations that will work approximately as well; the specifics are less important. There are ways to diversify effectively with only 3 asset classes rather than 6, and the various allocations could be either purely indexed (such as through Vanguard ETFs), or through individual stock selection. The benefits of this particular portfolio are that you get a ton of protection against inflation (REITs respond well to inflation, and TIPS (Treasury Inflation Protected Securities) are bonds that are indexed to inflation), and you get 70% of your portfolio allocated towards equity, which is typically the area that provides good returns.

The key to using a portfolio like this one is to realize the importance of rebalancing. The bond components aren’t necessarily a huge drag on returns; by rebalancing your portfolio with fresh capital or with annual selling/buying, you profit from both growth and volatility while being protected from some downside risk.

So, for those interested, here is his lecture, which I find to be worthwhile:

Warren Buffett recently published an opinion editorial in the New York Times called Stop Coddling the Super Rich. Buffett has been clear about his political views before, but due to the bluntness and timeliness of this article, it has received extremely widespread commentary and reaction, both positive and negative.

To summarize the article, Buffett argues that in this time of US deficits, debts, cuts, and unemployment, in addition to making spending cuts, the wealthy should pay higher taxes like they used to, and he defines wealthy as those making over $1 million, and especially those making over $10 million. To substantiate his point, he provides the information on how much he paid in taxes, and points out that he pays a lower percentage than anyone in his office, despite being the wealthiest by far. He claims he pays about 17% in taxes, while everyone else in his office pays between 33% and 41%.

I suppose I’ll get it out of the way and say I agree with him, but my main interest in this article is to analyze his claim, the claims of those who disagree with him, and to mostly stick to the facts about how this taxation works. This situation is relevant to dividend investing, because it is primarily about taxes on dividends.

Why Buffett’s Reported Tax Rate is So Low

The tax system in the US is complicated, just like most other countries. In theory, the more you make, the higher percentage you pay in taxes. In US history of the 1900s, the top tax rates were significantly higher than they were now, but a few presidents and Congresses, especially Reagan and Bush II, were responsible for reducing the top tax brackets significantly, for better or worse. In certain periods, dividends were taxed at the same rate as ordinary income, so people in the top tax brackets paid the top tax rate on their dividends. Under Bush II, the income tax brackets were mildly cut, and the dividend tax was substantially cut down from ordinary income tax to only 15% (or 0% for those in low tax brackets).

So, the most US citizens pay on qualified US dividends in taxes is 15% now. This was extended in 2010 until at least 2012, because President Obama and the Democrats made a deal with the Republicans in exchange for things they each wanted. I wrote an article before this occurred, about how tax changes may affect or not affect dividend investing, and a few months after that article, the tax cuts were extended, but the same article may be relevant as 2012 approaches.

So how does Buffett pay low taxes? It’s because most of his income that he fills out in taxes comes from dividends, and dividends are taxed at only 15%. Most of Buffett’s wealth is in the form of tens of billions of dollars worth Berkshire Hathaway stock, which he doesn’t sell (but sometimes gives away). Since Berkshire pays no dividends, he receives no personal income from his Berkshire stock, so he pays no taxes on it. If he were to sell Berkshire stock, he would have to pay capital gains taxes, which are fairly low, but would amount to billions of dollars on his position. He gets a relatively small (at least for him) six figure salary for his job as Chairman and CEO, which gets taxed as ordinary income. In addition to his Berkshire stock and his CEO salary, Buffett owns a personal portfolio of dividend stocks that is worth somewhere around $2 billion. Many of these companies are the typical dividend blue chips, including ones you’ll find in my portfolio like JNJ and PG, and from this portfolio, he makes somewhere around $60 million in dividends.

So his total taxable “income” is these tens of millions in dividends, his small six figure salary, and possibly a few other sources here and there, but mainly those two things. He gives a portion of this income away and gets to deduct it from taxes, so a smaller majority of the income is left, and is taxable. So, for most of his income, he is taxed at 15%, and for a small portion, he is taxed at a higher rate (ordinary income taxes plus payroll taxes), and for some of the money he gives away, he is not taxed. The result is that on his tens of millions of dollars of taxable income, he pays around 17.4% in taxes, which according to him is lower than anyone in his office.

The Counter Arguments

Although I agree with him, Buffett’s article is misleading. He’s not paying 17%.

I’m sure he’s completely aware of why it’s misleading, and he tends to write very simply to get his point across. (He once wrote a very good article to educate the population on the US trade deficit, and to present his solution to the US trade deficit, and told the story in the form of inhabitants of two islands: Thriftville and Squanderville.) But that doesn’t change the fact that it’s inaccurate, and here’s why.

Buffett’s real income is not that $60 million in dividends. His real income is his portion of the operating profit of every company he partially owns, including Berkshire Hathaway and his personal stock portfolio, (plus that small six figure salary which I’m going to ignore from now on since it’s smaller than a rounding error for him). Owning shares in a company represents owning that portion of profits, and the operating income is the pre-tax profit (in general; there is also interest expense). The profit is then taxed, and is represented as net income, of which a portion is paid out in dividends, and those dividends are taxed again at 15%.

Therefore, Buffett’s total “real” income is in the billions rather than the millions, and most of the taxes he’s really paying, are being paid by the corporations at the corporate level, rather than being paid by himself. Still, those corporate taxes are really his taxes, and it’s important to view business income like this. Businesses make money for individuals, so it’s indirectly but accurately a part of an individual’s tax. Now, to mitigate this, one could argue that these corporate taxes are not just on the owners, but also on the customers since it affects pricing, so to be fair, let’s say that these percentages are the upper limit.

So to calculate his approximate real tax rate, he would have to:
-find the weighted average of the federal tax rate on the operating income of the companies he holds stock in
-find the weighted average payout ratio of dividends to operating income
-Calculate that a rough estimate of his tax rate is:
Tax Rate = (1.00)(% Federal Tax Rate on Operating Income) + (Operating Income Dividend Payout Ratio)(15%)
-A translation of this equation is that 100% of the operating income is taxed at whatever the rate is, and then a portion of this equal to the payout ratio is double-taxed at another 15%.
-Plus, if he ever sold his stake, we’d have to add capital gains tax on top of this.

I’ve seen some articles argue that his tax rate is 50%, since the number given for corporate tax rates is 35%, and dividends are taxed again at 15%. One such article is this one that was published on Forbes. It claims Buffett’s numbers are misleading, but these numbers are farther off. Buffett’s tax rate would only be 50% if corporations actually paid 35% in federal taxes (usually untrue), and if they paid out 100% of their operating income as dividends resulting in 100% double taxation (usually untrue). To take an example, Procter and Gamble’s effective tax rate is reported to be 27% by Morningstar, and only a portion of that is federal tax. Let’s say the federal tax rate is 20% for simplicity. Then, Procter and Gamble paid out approximately 35% of its operating income as dividends, which were taxed again at 15%. So, this rough estimate of the tax rate for an owner of Procter and Gamble is 1.00*20% + 0.35*15% = about 25%. Now, if we were accountants, we’d have to get into deferred taxes and other items such as foreign income that remains overseas, and the true tax rate is a bit gray.

To continue, Buffett is not paying any double tax on his Berkshire Hathaway stock, since Berkshire Hathaway does not pay dividends.

I’d estimate that his total real tax rate is somewhere between 20% and 30%, but it could be higher or lower depending on the precise federal corporate tax rates, precise payout ratios, and the gray answer to the philosophical economic question of which portion of corporate taxes are truly taxes on the owners, and which portion is a tax on the customers.

In addition, we could examine the reported 33% to 41% tax rate of his employees. Without details, we obviously can’t fact-check them, but I’d wager they are lower than these reported percentages. To get these figures, he’s taking into account income taxes and payroll taxes. But he’s focusing only on taxable income. These people likely have a lot of income that is not taxable, or is being taxed at a reduced and deferred rate, such as with an IRA, a 401(k), various government tax deductions and credits, and so forth.

Bringing it Together

Based on the arguments, the real situation is that he’s probably paying more than 17.4%, and his employees in his office are probably paying less than 33-41%. Still, I wouldn’t be surprised if he truly does pay a lower rate than some of them. The numbers seem to indicate that this is the case. Plus, his statement about wealthy fund managers holds true; they pay a very low tax rate. And, if Buffett wanted to legally minimize his taxes further, he could, by buying units of master limited partnerships (mostly deferred and somewhat reduced taxation), or by purchasing shares in companies that get huge government subsidies in the form of large tax breaks.

Although I disagree with his numbers, the basic concept holds fairly true. The poor pay little or nothing in taxes. The middle class and upper class pay a rather high rate of taxes, which comes in the form of income taxes and payroll taxes, and to some extent is mitigated with legal tax shelters (retirement plans), and tax credits and deductions. The rich can pay a huge variety in taxes depending on the source of their wealth, but it is likely lower than the upper middle class. Those who make money from work, get taxed pretty harshly. Those who make money with money, have far more options to reduce taxation. That’s the system he’s arguing against.

Buffet Interview

Recently, Buffett gave an interview where he talks about his opinion editorial. And for those who couldn’t care less about the politics of dividend taxation despite being dividend investors, he also talks about a lot of other topics, including his optimism on the US economy (and specifically why he is optimistic, and the two things stated by him that could potentially render his optimism incorrect). I highly recommend it:
Buffett Interview

Other Reading

Carnival of Personal Finance
I was included in a blog carnival.

5 Steps to Retire Early
Diviend Mantra wrote an article on how to retire early. And he’s not playing games; one can look at his income/expense statements to see that he’s walking the walk.

5 Things You Must Know Before You Invest
The Dividend Guy provides five warnings/encouragements.

Most investors are probably paying rather close attention to these charades in Washington. As the debt ceiling inches closer, Congress still hasn’t come to a deal. I do expect, however, that they will come up with a typical last minute solution. I usually keep politics out of this blog, but inevitably, sometimes politics and investing mix.

It’s important as investors and US citizens to remain calm and look at the facts about this. I’ve seen a ton of incorrect information out there. An overreaction to the debt, especially from Congress (or the voters that elect Congress), would be more economically problematic than the debt itself. For value investors, a depressed Mr. Market may be coming to your door daily to offer you some good bargains.

History of the Contemporary US Debt

Although the US has almost always had debt, our contemporary debt situation began seriously accumulating in 1981, towards the beginning of Ronald Reagan’s term as president. Before that, both Republican and Democrat controlled legislative and executive branches had steadily decreased debt as a percentage of GDP from World War II. But after 1981, starting with Reagan’s significant decrease in the top marginal tax rate and sustained or increased spending, debt as a percentage of GDP began quickly increasing. Both Republican and Democrat controlled executive and legislative branches led to an accumulation of debt over these last 30 years, beginning with Reagan’s first term. An exception is that at the end of Democrat Bill Clinton’s term as president when Congress was controlled by Republicans, the US had a budget surplus and had managed to decrease debt as a percentage of GDP. More recently, the debt is due to tax cuts, two wars, and an unfunded portion of Medicare under President Bush, and recession-reduced tax revenues and stimulus spending under President Obama. US leaders and voters need to understand that if you cut taxes, you need to proportionally cut spending, or if you increase spending, you need to proportionately increase taxes, at least over the long term. Short term variances are ok, but we can’t have it all.
National Debt by Presidential Terms, and Congress Majority- Wikipedia

Facts about the Current US Debt

-The US currently has about $14.3 trillion in debt. A significant percentage of this is owned by the government itself (such as the Social Security fund), another significant percentage of this is owned by US citizens and companies, and increasingly, a percentage of this is owned internationally.
Federal Debt Basics- US Government Accountability Office

-The US has the most debt out of any country. But when it comes to debt as a percentage of GDP, which is a much more important metric, the US is far from the highest. Many other developed countries have higher debt as a percentage of GDP than the US, but still, ours is higher than it should be.
List of Countries by Debt- CIA World Factbook

-The US is nowhere close to financially defaulting. We would only default if lawmakers decided to default. It would be like being completely in a position to pay your bills, but deciding to pay them late and incur the penalties.

-Overall, America has more than $50 trillion in private household net worth, and $14.3 trillion in public debt, so the public debt to private equity ratio is below 30%. If we exclude debt owned by the government, US corporations, and US citizens, that number drops further. If this were a business, it would be a good figure. The problem is, the US government doesn’t really have that equity unless it taxes for it. The interest coverage ratio (federal income divided by interest expense) can be estimated to be between 10 and 20, depending on what time period I use. Currently, interest rates are low, but as they rise, the interest coverage ratio will shrink. Overall, an interest coverage ratio of above 10 would be very solid for a company. But we want interest as close to zero as possible for the federal government, because any positive interest means that a portion of our taxes, perhaps 5-10%, go to interest payments, which is deeply unsatisfying. Essentially, the US has a reasonable balance sheet as long as problems are fixed fairly quickly. If the trillion dollar deficits or even “only” multi-hundred-billion dollar deficits continue, a larger and larger chunk of our spending will be on interest until the situation becomes unsustainable.
US Household Net Worth-Reuters
US Revenue and Expenditure- Wikipedia

-The US Debt situation is fundamentally different than the European Debt situation. The US currently has a perfect AAA credit rating because a) the balance sheet is worsening but still fair, b) it can print its own money, c) it can raise taxes as lawmakers see fit. This is why US debt is basically a proxy for “risk free”. In a worst case scenario, the US can slowly inflate its way out of the current debt (but would still have to fix its deficit, which is largely indexed to inflation), which would of course have disadvantages. To avoid bad inflation or hyperinflation, there needs to be confidence in the integrity of the currency, so it’s better to balance the budget and let slow GDP growth shrink debt as a percentage of GDP, which would naturally include moderate inflation. Many European countries, on the other hand, have joined their currencies in to the common Euro. This means that if any country grows its debt too high, it doesn’t have full control of the situation, and needs other European countries for help. Both areas have their balance sheet issues, but they are fundamentally different.

What Will Happen if the Debt Ceiling is Reached with No Solution?

-Nobody can really be sure, because this is unprecedented and rather silly. The August 2nd date may not be the exact date the problem occurs. In reality, the US reached its debt ceiling a few months ago, but has been able to juggle its books to make a bit of room. This room is expected to run out sometime in early to mid August, and the conservative figure is August 2. The US is still bringing in revenue, but not enough to cover its obligations, so some things will go unpaid, whether it’s treasuries, social security, nonessential government options (government shutdown), armed forces, etc, until the debt ceiling is increased.

-If the US credit rating is downgraded, either because it defaults, or because it cuts services to pay the debt, or because it doesn’t extend the debt ceiling far enough, or because the budget remains grossly imbalanced, it will mean the US will have to pay a higher interest rate on its debt. This essentially means higher taxes or lower spending for citizens. Various private interest rates could increase as well. In addition, this would sadly mean that the bonds of four non-financial US corporations that currently are rated “AAA” (Johnson and Johnson, Microsoft, Exxon Mobil, and Automatic Data Processing), would be considered “less risky” than US treasuries. (Disclosure, I own JNJ and XOM stock.)

-Individuals, governments, or companies that rely on the integrity of US treasuries could be greatly affected. This is perhaps the most problematic, and least understood, area of this situation.

-There are already problems. The Federal Aviation Administration has already partially shut down without notice for nearly a week now. Congress wouldn’t agree on tiny details of the FAA reauthorization (they concern unions and a few subsidies to small airports; partisan issues), so all research, development, and construction of the FAA is currently shut down without notice. The House of Representatives slipped in some new things into the bill, which includes a union-weakening measure and an elimination of subsidies, and the Senate rejected it. 4000 federal engineers, scientists, programmers, and managers are out of work with no pay and with virtually no warning. In addition, thousands of private contractors that provide engineering services and work along with those federal employees, or that provide construction services on airports around the country, are immediately halted. There are over $2 billion of contracts affected, and there are literally empty construction sites on airports right now, and empty offices with expensive equipment sitting there. This wasn’t specifically due to the debt ceiling (instead it was due to irresponsible partisan politics), but it’s a smaller taste of what can happen. 4,000 federal workers and 70,000 contractors/construction workers are affected.
The Airport Jobs We Desperately Need: Congress’ Failure has Consequences
We Need an FAA Bill Exension
4,000 feds and 70,000 construction workers

How Do We Fix the US Debt Situation?

I’m certainly no wiz, and there are many potential paths to take, but there are some things worth considering.

-The debt problem cannot be fixed simply by refusing to increase the debt ceiling. Without raising the debt ceiling, the US would literally have to balance its budget over a matter of days or weeks, which would mean increasing taxes or decreasing spending by over a trillion dollars per year. The current debt represents our previous promises, not our future ones. Spending would have to align with the volatility of US revenue. This would mean either enormous and abrupt tax increases, or enormous and abrupt cuts to social security, medicare, defense, and various domestic spending.

-The debt problem, however, can be fixed over time. If the budget is balanced over the next few years, then debt as a percentage of GDP will decrease as the GDP increases. The largest spending areas right now are Social Security, Defense, Welfare, and Medicare and Medicaid.

-Social Security currently has a trust fund of over $2 trillion due to surpluses, at least on paper. Receipts have exceeded expenditure. The problem, however, is that when social security was started, the date of retirement was approximately the same as the average life expectancy. The number of people paying into the system was much larger than the number of people withdrawing. As people live longer (into their 80s rather than 60s), and as a large generation retires, the ratio of payers to withdraws will continue to decrease. To keep social security sustainable, there are numerous options. People can pay more into it, the income cap can be increased, cost of living increases can be reduced, and/or the retirement age can be increased. The other problem is that other areas of the government have “borrowed” from social security to pay for other unfunded things, so although social security is not entirely broken, it is rather broke.

-Welfare has spiked recently with the recession. It used to be in the ~$300 billion range but now it is in the ~$500 billion range. This can decrease if the economy improves. It can also be decreased by making it harder to receive benefits to try to keep out people who don’t really need them.

-The US spends around $700 billion per year on the armed forces. This is a huge chunk of our total spending, and a huge chunk of the total worldwide defense spending. The US has less than 5% of the world population, but spends somewhere around 40% of the total world’s annual military expenditure. In addition, defense spending as a percentage of GPD is larger than almost all large and developed countries.
Military Spending by Country- Global Security

-Corporate tax accounts for a fairly small percentage of US revenue, while individual taxes are a major component. We have a trade deficit, meaning we import more products than we export. This trade deficit mainly became a problem during President Clinton’s term (the timeline is rather correlated to the signing of the North American Free Trade Agreement), and continued under President Bush and President Obama. Corporations have benefited, because they can get cheaper labor and fewer restrictions on environmental damage elsewhere. But, if inflation-adjusted labor rates decrease domestically, that increases the divide between socio-economic classes and reduces the tax base. Government regulation and/or consumer decisions to spend more consciously, can potentially help address this issue.

-Medicare and Medicaid currently are causing part of the deficit. It’s the same fundamental problem as social security- an aging population. Worse yet, the life expectancy is lower than many other highly developed countries, and the infant morality rate is higher than many other highly developed countries, and yet we pay more per capita, and as a percentage of GDP on healthcare, than most all other countries. There is a ton of improvement potential here.
Health Care Spending by Country
Infant Morality Rate- CIA World Factbook
Life Expectancy- CIA World Factbook

-The US has maintained rather consistent taxation as a percentage of its GDP over contemporary history, but has significantly lower taxation than other developed countries. Taxation has become less progressive, as the top marginal rate has significantly decreased, and dividend and partnership taxation has decreased. This how someone like Warren Buffett can pay a lower tax percentage than his secretary. Nonetheless, the upper middle and upper classes have most of the tax burden, mainly because they have most of the wealth. When discussing taxation, it’s important to compare the situation to the past, and to compare it internationally, to see what’s working and what is not. The United States currently attempts to provide services to its citizens that roughly correspond to the low end of other developed countries (social security, medicare, disability, high standards for medicine and food, but no universal health care, and rather low subsidy for higher education), yet taxes at levels that correspond to the upper end of developing countries. There needs to be a decision- either tax and provide the services of a developed nation, or tax and provide services at the high end of a developing nation. We can’t provide the services of one, and pay for it with the taxes of another.
15 Charts about Wealth and Inequality in America- Business Insider
Worldwide Tax as Percentage of GDP- World Bank
Tax Revenues Fall in OECD Countries

-Discretionary domestic spending is actually a fairly small part of the US budget, and so is foreign aid. These areas can be looked at and streamlined.

Summary

There are a variety of ways to fix the deficit, and it will require compromise, moderation, and reason. As previously mentioned, if the budget can be balanced, then debt as a percentage of GDP will decrease over time. I do not think the government will default, and in the off chance that it does, it would be due to leadership failure rather than due to necessity.

As for dealing with the current situation, the same answer pretty much always applies. Make sure you are diversified in terms of number of companies, number of sectors, and asset class (stocks, bonds, etc). Look for opportunities to buy on weakness; companies that may lose value if the markets react poorly to US silliness, but that you believe are good long term investments. Remain focus and fact-driven, and allow any potential market irrationality to help you rather than hurt you over the long term. Portfolio values may temporarily fall, but remember, for net buyers of stock, markets with low value are better than overvalued markets. As always, buy quality companies at reasonable prices.

There are some mixed signals on the economy. One one hand, jobless claims were reduced. But, if the research, development, management, and construction of the FAA federal employees and contractors remains shut down, and if other government agencies have to shut down, this will undo itself. In addition, Emerson Electric warned about a slowing economy in the US and Europe. Being a cyclical business, Emerson tends to have a pretty strong understanding of economic conditions. Emerson reported that orders are still growing, but that they “moderated”, and the stock price fell 7%. (Disclosure, long EMR). Housing is still not showing strong signs of improvement.

I’m interested in reader opinions- what do you think of the deficit, the debt, the current debt ceiling debate, the partial FAA shut down, the investing opportunities, and the current state of the world economy?

Other Weekend Reading

Carnival of Personal Finance 319
I was included in a blog carnival this week.

Master Limited Partnerships: The Perfect Dividend Stocks
The Dividend Growth Investor presents some dividend ideas.

Ensure your Dividends with Insurance Stocks
Dividend Mantra presents some insurance companies.

Should you Fear US Treasury Bonds?
Andrew Hallam presents some facts about America’s situation, from a non-American perspective.

I recently published an article on Seeking Alpha called Exxon Mobil Returning Cash to Shareholders that takes a look at Exxon Mobil’s 10 year history of dividends and share repurchases in order to quantify how much the company has given back to shareholders, and more particularly, to show how the share repurchases have affected EPS growth and dividend growth over the period. It’s currently one of the highest page-view articles on Seeking Alpha for today, mainly because people tend to have pretty strong opinions about share repurchases and like to debate it in the comment section, which is healthy.

It’s interesting seeing a mix of both investors presenting correct statements regarding the downside (or upside) of share repurchases, as well as the investors with a misunderstanding of the topic. Either way, I think it’s a useful article for anyone interested in Exxon Mobil as a company, to get a quantitative look at a long history of dividends and repurchases. As a disclosure, Exxon Mobil is a holding of mine.

Investing research can be overwhelming. This is especially true for novice investors; there are just so many metrics to consider, and they all relate to each other in a large and complex whole, so how can one make sense of a set of investments and compare them?

This article is meant to provide a quick organization viewpoint in regards to scanning companies for investments. It’s not meant to be an all-inclusive guide on how to select a company, but it provides what I consider to be among the most important investing criteria, and how they relate to each other. Some businesses, such as financial companies and partnerships will require a different set of metrics, but these work well for a large collection of dividend stocks out there.

I have broken the metrics down into a few categories: Growth, Financial Strength, Dividend, Subjective Information, and Valuation. Growth metrics are a few ways of analyzing how quickly a company is growing. Financial Strength metrics show how strong a company’s balance sheet is. Dividend metrics are obviously important for those seeking dividends, but also important to gauge overall shareholder friendliness of the company and long-term stability. Subjective Information allows one to take into account non-quantitative aspects of the company, like strength of the moat and quality of the management. Lastly, Valuation metrics are a tool to understand how much investors are currently willing to pay for the company, and this will generally depend on the other metric categories like growth, financial strength, and subjective information.

Generally, things like solid growth prospects, strong balance sheets, and positive subjective information will lead to higher reasonable valuations for a company. So when analyzing a company, I look to find a company with decent growth prospects, a strong financial position, positive subjective information, and shareholder friendly management, and then I look to see if the valuation is reasonable given this total information.

Growth:
Net Income Growth
Revenue Growth
EPS Growth
FCF compared to Net Income
Return on Equity

Financial Strength:
Debt/Equity
Interest Coverage Ratio
Goodwill/Equity
Current Ratio

Dividend Information:
Dividend Yield
Dividend Payout Ratio
Dividend Growth
Share Repurchases

Subjective Information:
Business and Industry Prospects
Economic Advantage
Management Quality

Valuation:
Price-to-Earnings (P/E) Ratio
Price-to-Free-Cash-Flow (P/FCF) Ratio
Price-to-Book Value
Market Capitalization

Growth

A company can grow in many ways, so looking at a variety of growth metrics is important.

Net Income Growth
Income is the bottom line that business owners are after. Companies operate to bring in profits, and profits ideally grow over time. It’s useful to look at net income growth over 3-year, 5-year, and 10-year periods to get an idea of what kind of long-term growth prospects this company may have, and how the trends are changing (is growth slowing or accelerating, or neither?)

Revenue Growth
In many cases, it’s important to look for revenue growth as well. If a company is growing net income but not revenue, it means they are becoming more efficient and therefore increasing their profit margins, but this can only go so far. For sustained growth of net income, sustained revenue growth is required.

EPS Growth
To investors, growth of earnings-per-share is typically even more important than net income growth. If a company grows its net income, while using some of its money to repurchase its own shares, then EPS will grow faster than net income. If, on the other hand, a company is diluting its shares by issuing more shares than it is repurchasing, EPS will grow more slowly than net income. In addition, EPS may be growing even if net income is flat or decreasing, so it’s important to look at both per-share metrics and total company metrics.

FCF compared to Net Income
A company that maintains solid free cash flow numbers is a sign of health and economic advantage. If a company can maintain profitability and growth with minimal capital expenditure, then it’s likely performing quite well. I look for operational cash flow to be substantially higher than net income, and for free cash flow to be either higher than net income, or at least comparable to it, in most investments. It depends to a certain extent on the industry.

Return on Equity (ROE)
When you divide net income of a company by their total shareholder equity, you get return on equity. Typically, higher returns on equity are a sign of competent management and a profitable business, because they are bringing in a lot of income for each dollar that is on the balance sheet. One must be careful, though, because a bad balance sheet can sometimes boost returns on equity. If a company has a large amount of liabilities compared to assets (and therefore a small amount of shareholder equity), then ROE will seem quite high. So it’s important to look at the whole picture, and compare ROE to financial strength metrics.

Financial Strength

A company that is in good financial shape reduces risk, provides opportunity, and shows management responsibility. All else being equal, a company with a strong balance sheet is worth more than a company with a weak one.

Debt/Equity
Debt/Equity is an important metric. Long-term Debt/Equity is calculated by taking the total amount of long-term debt and dividing it by the amount of shareholder equity. The lower the number, the less debt the company has compared to equity. I prefer companies with less than 0.5 debt/equity ratios, or at least less than 1.0 debt/equity ratios, but it will vary to a certain extent in some industries. Companies that necessarily have large amounts of capital expenditure will usually have substantial debt levels.

Interest Coverage Ratio
If a company holds debt, it’s paying interest on that debt. A company with a lot of debt will be paying a lot of interest, but other factors matter too. A company with a strong balance sheet and a good credit rating generally pays lower interest rates than a weaker company, and so a metric is needed to sort out different situations. If you take income before taxes and divide it by the amount the company pays in interest over that time period, you’ll get the interest coverage ratio. I typically look for companies with an interest coverage ratio of at least 3, but prefer to see it over 8 or more.

Goodwill/Equity
Some assets are called “goodwill”, which is an accounting asset rather than a real one. When a company pays more for a company than its book value, they put the remainder on their balance sheet as goodwill, and management is responsible for deducting from it as appropriate. If a company has a lot of goodwill, it can artificially lower metrics like debt/equity. On the other hand, goodwill isn’t necessarily a bad thing if it is accurate. Some companies, especially those prone to making acquisitions, will naturally hold more goodwill than others. Dividing the total goodwill by the total equity shows what percentage of equity consists of goodwill. All else being equal, it’s optimal to look for fairly low or moderate levels of goodwill.

Current Ratio
The current ratio is calculated by taking total current assets (cash, short-term investments, receivables, etc) and dividing by total current liabilities (payables, short-term debt, etc). This should typically be above 1, and I prefer to see a higher number in smaller companies.

Dividend Information

To dividend investors, researching the dividend is obviously of immense importance. One wants a significant dividend yield, a growing dividend, but a payout ratio that is low enough to increase the likelihood that the dividend remains safe and growing.

Dividend Yield
To calculate the dividend yield, take the amount that the company pays in dividends per share each year and divide that amount by the share price. Typical dividend investments typically pay 2.5% to perhaps 7%, with 3-5% being a pretty good area. Yields under that are pretty low, and yields above that may be value traps.

Dividend Payout Ratio
An unsustainable dividend is not a very useful dividend. Divide the total yearly dividend by the EPS to get the earnings payout ratio. This represents the percentage of earnings that the company is paying to shareholders as dividends. It’s also worthwhile to divide the total yearly dividend by the per-share free cash flow to get the FCF payout ratio. Ultimately, it’s cash that determines dividend sustainability.

Dividend Growth
Some companies pay the same dividend each year, some companies grow or reduce their dividends erratically, while others successful grow their dividend year after year. Seeing dividend growth trends can help determine future growth of your passive income and your yield on cost.

Share Repurchases
Some companies repurchase their own shares, which means the existing shares that a shareholder owns are worth a greater percentage of the company (or the company can eventually issue the shares again for an acquisition). Companies typically also issue shares to executives for compensation. Looking at the net share repurchases of a company (repurchases minus issues), shows how much money the company is spending on share repurchases. It’s sometimes useful to compare this amount to how much they are paying in dividends. Share repurchases will boost EPS and fuel dividend growth, but can sometimes be used irresponsibly.

Subjective Information

This is what separates humans from machines. Anyone can plug in the above numbers (and they should), but it takes someone with insight to figure out the rest. This is what separates good investors from mediocre ones, along with discipline and patience. This part of the investment process takes the most work.

Business and Industry Prospects
For long-term investments, it usually makes sense to pick a business that is in an industry that is not going to go away any time soon. A healthy and growing industry makes it easier for a company in that industry to grow and increase profitability. Likewise, even a great company in a struggling industry may find itself in trouble. Even the world’s best horse-and-buggy company will run into trouble if everyone starts driving cars. Sometimes an industry may seem to be in bad shape, but the long term is what’s important. Sometimes great values can be found in industries that are currently out of favor but that have great long-term potential.

Economic Advantage
Some companies have advantages over others that separate them and allows them to achieve and maintain impressive levels of profitability. If companies compete against each other without economic advantages, they are essentially offering commodity products and services, and it often leads to the result that they will not be quite as profitable or have as much staying-power, as those that do have strong advantages. The popular explanation is that an economic advantage is a company’s moat, keeping competitors away with little work.

Examples of Economic Advantages include:
Scale: If a company is larger than others, it likely has more purchasing power, a more effective and efficient distribution network, and the ability to buy-out or out-spend competitors. Companies have trouble competing against scale because they lack scale themselves, and they cannot achieve scale unless they compete well, so it’s a vicious cycle.

Switching Costs:
When it is difficult for a customer to switch to competitor’s product or service, they likely will not. It’s a hassle to change banks, to change infrastructure, and to change computer systems.

Regulation:
Some companies operate in such a way that they essentially have a regulated monopoly. Their risks and rewards are reduced and investments can potentially be more predictable.

Intangible Property: People are willing to pay a little more money for the same product or service when they feel trust towards a brand. In addition, when a person is selecting a product or service seemingly at random, they are likely to pick one they are familiar with. Brand strength is an intangible benefit to many companies. Patent shields are also powerful defenses. When a company can patent its product or service, it keeps competitors away temporarily and allows high levels of profitability.

Management Quality
Lastly, it’s worthwhile to look at management quality. How long has the current CEO been running the company? How have they performed? How much of the company do the executives own? What is the company culture like? Having an outstanding group of individuals running a high-quality business can do wonders for your portfolio.

Valuation

The valuation of a company is the snapshot of what investors are willing to pay for this business at the current time. Fair valuation depends to a large extent on other metrics, and must be considered alongside them.

Price-to-Earnings (P/E) Ratio
The P/E ratio is the price of a share divided by the earnings-per-share. Because price is measured in dollars, and earnings are measured in dollars per year, the units for P/E are measured in years. A higher P/E ratio means that investors are currently paying more per unit of earnings, while a lower P/E means investors aren’t willing to pay very much per unit of earnings. Typically, my investment purchases have a P/E of between 10 and 20 with a few exceptions, and it varies based on a number of factors.

Price-to-Free-Cash-Flow (P/FCF) Ratio
P/FCF is similar to P/E, except free cash flow per share is substituted for earnings. Free cash flow is the total amount of cash brought in by operations minus the amount of cash that was used for capital expenditure. It can sometimes be more truthful than earnings, but tends to be more volatile because management may spend more in capital expenditure in some years than others. Monitoring both income and cash flow is important to get a good grasp on how the company is really performing.

Price-to-Book Value
When you take a company’s total assets and subtract their total liabilities, you get the total shareholder equity, or book value. Book value per share is the total equity divided by the total number of shares. Tangible book value is the same, except it excludes intangible assets such as goodwill. If the company were to go out of business, the tangible book value is the theoretical amount each share would be worth. Different industries have different reasonable book values, because some types of businesses require more assets than others (think manufacturers vs. software).

Market Capitalization
Market capitalization is the total number of shares multiplied by how much each share is currently worth. Theoretically, this is how much the market has decided the entire company is worth. It’s worth looking at, because investors often look to have a mix of big companies and smaller ones.

Conclusion

In conclusion, it takes a lot of work to thoroughly analyze a company. These metrics are a good start, and one will also need to delve into their annual reports, compare the company with competitors, research investing and public commentary on the company, and assess risk and potential growth catalysts.

When looking for a company to invest in, I look for a strong balance sheet, decent growth prospects, competitive advantages, a positive industry, shareholder friendly and competent management, and solid dividend information. I focus on long-term potential and total shareholder return.

Asset allocation, the practice of deliberately using several distinct forms of investments to accumulate or preserve wealth, has both obvious and subtle advantages. Various forms of investment include, but are not limited to, stocks, bonds, real estate, options, commodities, insurance, and currencies.

The Obvious Advantage

Most people readily grasp the obvious advantages of asset allocation. By spreading one’s wealth among a variety of investment types, one avoids “putting all of their eggs in one basket” and therefore reduces risk by reducing concentration. Sometimes stocks have bull runs and sometimes they have bear runs, sometimes bonds have solid returns, and other times they have low returns, and so diversifying between asset classes can reduce volatility and exposure to any particular risk. Fixed income investments have inflation risk, while equities are fairly resistant to inflation over the long-term. Equities are more volatile and have a more complex risk/reward profile.

The Subtle Advantage

Asset allocation is a bit more powerful than simply the obvious advantage. It allows one to, either actively or passively, take advantage of upturns and downturns in various asset classes.

Consider the simplified example of a portfolio perpetually consisting of 60% stocks and 40% bonds. Stocks and bonds tend to have imperfect inverse periods of highs and lows. In other words, when stock indices are going up, bond indices are often going down, and vice versa.

If one keeps their portfolio consistently allocated according to the 60/40 distribution, then they will be buying and selling stocks and bonds as the markets go up and down. When stock indices go up, the stock part of the portfolio will increase, and that would lead to the portfolio no longer being balanced with a 60/40 distribution. So, to counter that, some stock would have to be sold, and bonds purchased, in order to bring the distribution back to 60/40. Then, at a later time, when stocks have a considerable drop, the stock part of the portfolio will decrease, and that again would lead to the portfolio no longer being balanced with the 60/40 distribution. So, to counter that, some bonds would have to be sold, and stock purchased, in order to bring the distribution back to 60/40. A similar effect can be done by choosing to put regular contributions into whichever side is under-balanced.

If one keeps this up, they are essentially forcing their self to buy low and sell high. When stock indices are high, they are selling stock and buying bonds in order to get back to the 60/40 distribution. When stock indices are low, they are selling bonds and buying stock in order to get back to the 60/40 distribution. This approach, almost robotic-like in nature, allows one to buy low and sell high without attempting to predict market movements or time the perfect highs and lows.

This example can be expanded to include multiple asset classes. For instance, the “stock” category can be divided between domestic large caps, domestic small caps, and foreign stocks, and as their various indices go up and down, the wealth will be continually distributed among them.

Asset Allocation Doesn’t Necessitate Passivity

Many forms of asset allocation involve passive investments, but asset allocation should not be understood to necessarily mean a strictly passive investment strategy, although that’s one possibility. In fact, while I do not argue with the usefulness of index funds, I promote individual active investing in addition to them.

Why? In this particular article, I’m not going to get into the debate about whether passive or active investment is more likely to produce better returns for a given individual investor. Passive investing is an excellent financial strategy in many cases, and active investing may or may not produce better returns than this low-maintenance, high-reward strategy. Instead, the reasons I encourage individual stock selection are:

-The ramifications of citizens not having control of their country’s corporations are unfortunate in my view. With so much index investing and mutual fund investing, where people are invested in the economy as a whole with little concern for individual investments or shareholder voting rights, corporations are in a position to operate in a way that does a disservice to society. When the masses give up their voting rights into the hands of a few, rather than take active interest in the economy of their society, I find the situation to be problematic. What more could a board ask for than for shareholders to indirectly provide capital while willingly giving up their voting rights and attention?

-Some people panic or get confused when their passive retirement accounts decrease. There’s a sense of lack of control when people don’t understand their investments. Some people view the stock market as a casino, and some people take money out during market bottoms out of fear. When you’ve thoroughly analyzed a company, and can observe the specific results of their operations, the strength of their balance sheet, and their continued ability to pay and increase their dividend, then one becomes virtually immune to worry about stock price movements. One begins to only care about company performance. Disciplined passive investors can, however, achieve similarly powerful mindsets.

-Many people are unfortunately financially illiterate. I encourage people to be well-rounded: literate in science, history, business, culture, and so forth. Although not everyone is suited for active investing, the excuse that people are too busy doesn’t hold much water in my opinion.

-Although some forms of passive investing allow one to be a dividend investor, many of them do not. I feel that acquiring robust streams of passive income from investments that one understands is an important aspect of wealth, and many forms of passive investment don’t focus on it.

Conclusion

Regardless of whether you’re a passive or active investor, realize the obvious and subtle advantages of asset allocation, and use them to your advantage by understanding that asset allocation is more than just the sum of the parts. Keep your wealth growing and safe, and utilize approaches to buy at good prices without trying to predict market highs and lows.

What is Ethical Investing?

“Ethical Investing” or “Socially Responsible Investing” is a form of investing where you don’t invest in companies that you find to be against your own personal morals. Classic “sin stocks” are tobacco, alcohol, casinos, military, and sometimes big oil and other polluters.

There has been a lot of debate about ethical investing over the years. Some people are inclined to invest only in companies that they like, while others invest in whatever companies they think will provide them with great returns regardless of what that company actually does. There are arguments for both sides, and I won’t get into them. I’m simply going to offer my view and in return ask readers for their view.

My reasons

I like an uncluttered mind. I believe in aligning all activities and thoughts as much as possible, and so I personally will not invest in a company whose fundamental product or service is something that I truly disagree with. Unfortunately, just about every large corporation does things I am not fond of, and there’s really no escaping that, but I’m willing to invest in a company as long as the heart of what they do does not completely conflict with my values (especially since shareholders have the power to align the company with their values). The reason is that I don’t want to have the mental inconsistency of cheering for a company to grow (so that my wealth grows) while simultaneously hoping that fewer people use their product (for ethical reasons/a better world). What does this mean? Well, it can be gray for sure, but I do have a list.

My ethical investing list

I don’t invest in:
-tobacco companies
-slaughter houses/ meat companies
-companies largely owned by countries that don’t support adequate human rights

I don’t necessarily mind investing in:
-alcohol producers
-tasty but unhealthy food companies
-companies that sell meat as a part of their business but not as a centerpiece
-oil companies
-defense companies (although by an agreement, I cannot invest in most aerospace companies)
-companies known for unethical practices but for which the fundamental product or service is not against my principles (ie Walmart)
-Health care companies that face a wide range of litigation
-anything else (a given company with no notable ethical issues)

As admitted, it’s pretty gray, and I’m not going to defend against claims that there is certainly some inconsistency in there, despite my love for consistency. If I could find a company that does no wrong, well, I’ll look for some flying pigs. My overall guideline is basically that I have to be able to sleep at night with my investments.

I also promote shareholder advocacy. For companies that have a core product or service that aligns with your principles, but whose changeable business practices do not, shareholders have the power to change the values and the culture of their company, but only if enough of them decide to do so. This is also a reason why I promote individual stock ownership: I favor voting wealth to be in the hands of individuals rather than financial institutions.

This can be a pretty intense issue for some people. I would love to hear people’s thoughts in the comment section. What won’t you invest in? What’s the most evil company out there? Inversely, what’s the most ethical company out there? Will you invest in a company that does not align with your set of values?