Investing in the Age of the Frugal American

The February 13 issue of Barron’s made a statement that caught my eye:  Americans are paying down their mortgages.  (See “Paying Down the Mortgage.”)

50% of all refinancings now result in smaller loans that the previous mortgage.  Rather than using their homes as a virtual ATM machine, extracting equity (if you have any) to meet current expenses, Americans are actually retiring their mortgage debt early.  It’s a remarkable change in behavior for a nation of consumers who, just a few short years ago, had a well-deserved reputation for wanton frivolity in their personal finances.

As Barron’s pointed out, paying down your mortgage at, say, 4% can be considered an “investment” when bonds yield barely 2%.  But more than this, it is a change in sentiment brought about by changing demographics.  America’s Baby Boomers, the largest and richest generation in history, are entering a new phase of their lives.  With retirement approaching fast, the Boomers are adopting the fiscal habits their parents were known for.  (We all eventually become our parents; it just took the Boomers a little longer than past generations.)

A role model for the parsimonious

The Boomers are the engine that has made the U.S. economy (and by proxy world economy) go over the past 30 years, and their reticence to spend will have a real impact on economic growth.

What does this mean for investors?  Surprisingly, the news isn’t all bad.

True enough, top-line revenue growth for companies that depend heavily on the American market will almost certainly be modest in the decade ahead.  Earnings per share growth, where it happens, will have to come from share count reductions through stock buybacks and from revenue growth in emerging markets.

The good news is that investors can still make a decent profit under these conditions, assuming they choose their investments wisely and pay a reasonable price.  With less need to expand their businesses, many American companies are finding themselves with unprecedented levels of cash on hand. Some—such as notorious tightwad Apple ($AAPL)—are simply stockpiling the cash (Apple’s cash balance is estimated to be an astonishing $100 billion).

But others, including Apple’s rival Microsoft ($MSFT), are using their excess cash to reward their shareholders with share buybacks and, even better, dividends.  Microsoft raised its dividend by a full 25% last year, and more increases are expected in 2012.

A better example might be that of tobacco “sin stocks.”  Unlike Apple and Microsoft, which still have robust and growing demand for their products, American tobacco firms have faced slowing demand for their products for decades.  But with no need to spend cash on investment and no need to advertise, tobacco stocks have still proven to be fantastic investments, with total returns beating the sox off the S&P 500 over the past decade.  And nearly all of this is due to their rock-solid dividends.

I consider dividends to be the key to profitable investing in the years ahead.  There will be periods when speculative growth stocks are more attractive, and we happen to be one this quarter (seeSin Stocks Trail Their More Virtuous Peers as an example).  But for the core of your portfolio, stable, dividend-paying stocks are an attractive option in a world of slow growth and bond yields of just 2%.

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Risk Aversion Ad Absurdum

Barron’s ran a featured story by Kopin Tam in last weekend’s edition titled “Just Don’t Lose It” that was telling.  Tam pointed out that, even after the best January in well over a decade, investors weren’t embracing equities, and neither were their financial advisors.  Only 44 percent of financial advisors planned to increase their clients’ exposure to stocks in 2012 compared to 63 percent this time last year.

I wasn’t particularly surprised to read these statistics.  After all, the financial wealth of this country is dominated by the Baby Boomers, the largest and richest generation in history.  The Boomers lived through the biggest bull market in history (1982-2000), but they also saw a decade’s worth of returns go up in smoke in 2008.  At this stage of their lives, they don’t feel like they can afford the risk of another meltdown.  I get that.  Even while I myself am bullish, I understand Boomer risk aversion.

This is where it gets weird: it’s not the Boomers that are skittish. It’s their children.

As Tam writes, “Risk aversion is particularly acute among ‘Generation Y’ investors born after 1980, who have decades to go before they retire but are especially reluctant to invest… As a result, this cohort allocates roughly 30% of their money on average to cash, more than any other age group.”

Far from being the reckless risk takers that youth are wont to be, this generation is showing a level of risk aversion I might have expected from an elderly retiree that lived through the Great Depression.   Fully 40 percent of the Gen Y investors said they would “never feel comfortable investing in the stock market.”

I can’t say that I don’t understand the general squeamishness with equities these days.  The same Barron’s article noted that the average daily move in the S&P 500 was 1.44 percent in the second half of 2011.  That’s nearly double the 0.75 percent average that has prevailed since 1928.

Still, when I see this kind of pervasive fear in the market, particularly among those who should normally be aggressive, I can’t help but be bullish.  Bearishness has reached the level of the absurd.

For the past two years, I’ve advocated investing in high-quality, dividend-paying stocks, and I continue to recommend these as the bedrock of a portfolio.   The alternatives for most conservative investors are sparse.  Cash pays nothing in interest, and most bonds pay only slightly more.  Meanwhile, the cash levels of U.S. companies are at an all-time high, and dividend payouts are hovering near all-time lows.  Conservative investors can assemble a portfolio of stocks that will out-yield a bond portfolio today and that will almost certainly benefit from rising dividends in the years to come.

For more aggressive investors, the time has come to “risk up” by buying the sectors that took the biggest beating in 2011.  I am bullish on Europe (see “Going Long on Two Euro Stocks”) and emerging markets (see “Emerging Markets Will Make a Comeback in 2012”).  And while I don’t make a habit of recommending commodities, I would have to add commodities to my list of cyclical sectors likely to do well in 2012.

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Jackass Investing: Don’t Do It. Profit From It

“This book should not be controversial, but it will be,” writes Michael Dever in the introduction to Jackass Investing. “That is because investing, which should be a rational pursuit, is not… [M]ost people’s investment decisions are not based on rational facts. They’re based on myths and emotions.”

Regrettably, Mr. Dever is correct in his assessment. The belief in rational, efficient markets has been a core tenet of the investment faith since the 1950s. Only recently has the investment community begun to reach the conclusion that every successful practitioner already knew by instinct or learned through experience: humans are not always rational, and humans acting as a group are often even less rational than humans acting as individuals. And, again contrary to efficient market dogma, rather than avoid unnecessary, uncompensated risk, investors often engage in risk-seeking behavior (i.e. taking more risk than is necessary)—which is Dever’s definition of Jackass Investing.

Michael Dever is the founder of Brandywine Asset Management and a long-time technology entrepreneur. He is also a “macro,” top-down investor with a unique approach to allocation. Rather than look at asset classes (i.e. large cap stocks, emerging market bonds, etc.) Dever looks at return drivers, or the underlying fundamentals that drive the investment performance of a given asset. “Diversification” is not simply shifting money between asset classes—which, as 2008 demostrated with brutal efficiency, all tend to fall in lockstep during a crisis—but allocating your precious funds across different investing and trading strategies that exploit different return drivers.

Dever’s thought processes are not altogether different than those we apply in the Sizemore Investment Letter. We diversify based on durable macro themes—such as the rise of the Emerging Market Consumer or the coming of age of the American Echo Boomers—and not based on arbitrary asset class distinctions. Dever dedicates his book into exploding a series of myths that “permeate common financial wisdom”:

    1. Stocks Provide an Intrinsic Return
    2. Buy and Hold Works Well for Long Term Investors
    3. You Can’t Time the Markets
    4. Passive” Investing Beats “Active” Investing
    5. Stay Invested So You Don’t Miss the Best Days
    6. Buy Low, Sell High
    7. It’s Bad to Chase Performance
    8. Trading is Gambling—Investing is Safer
    9. Risk Can Be Measured Statistically
    10. Short Selling is Destabilizing and Risky
    11. Commodity Trading is Risky
    12. Futures Trading is Risky
    13. It’s Best to Follow Expert Advice
    14. Government Regulations Protect Investors
    15. The Largest Investors Hold All the Cards
    16. Allocate a Small Amount to Foreign Stocks
    17. Lower Risk by Diversifying Across Asset Classes
    18. Diversification Failed in the ’08 Financial Crisis
    19. Too Much Diversification Lowers Returns
    20. There is No Free Lunch

I initially took issue with Dever’s claim that stocks provide no intrinsic return. After all, stocks represent ownership shares of businesses and those businesses earn profits and (ideally) pay dividends.

But while this may be true, Dever correctly points out that the stock market returns realized by investors are driven by two (and in the end, only two) return drivers—the earnings generated by the companies comprising the market and the multiple that investors are willing to pay for those earnings. And except over the very long term, it is primarily investor psychology—the multiple investors are willing to pay—that determines stock returns. On that count, there are not guarantees. Your returns are at the mercy of the fickle and emotional whims of other investors.

As for Myth #2 on long-term, buy-and-hold investing, Dever points out that “All of the real stock market returns earned over the past 111 years can be attributed to a just an 18 year period—the great bull market that began in August 1982 and ended in August 2000. Without those years, the real, inflation-adjusted returns of stocks, without reinvesting dividends, was negative.” Investors today would no doubt nod their heads in understanding. Excluding the modest returns earned from dividends, investors have seen virtually no returns in over a decade. After adjusting for inflation, the returns are well into negative territory. Dever also correctly points out that for much of the period of time covered in long-term stock market studies, the United States was an “emerging market,” with the higher rates of growth that this implies.

Furthermore, studies that demonstrate “market” returns are meaningless because until recent decades, no one bought “the market.” Index funds didn’t exist, and stock market investing was a hobby primarily of the wealthy, not the middle class. And returns came primarily from dividends. “Just because something happened in the past does not mean it will reoccur in the future,” writes Dever. “We must first understand all of the return drivers, and then determine whether those return drivers are still valid.”

Well said.

Lest this review turn into book by itself, I’ll spare readers a review of the remaining 18 myths. I will, however, share one of Dever’s more amusing market analogies—the George Costanza trader.

Dever recounts the Seinfeld episode in which Costanza realizes that “every decision I’ve ever made, in my entire life, has been wrong. My life is the opposite of everything I want it to be. Every instinct I have, in every aspect of life… It’s all wrong.”

Costanza then decides to do the opposite of what his instincts tell him to do, and his life turns around. He gets a gorgeous girlfriend and the job of his dreams. This is the essence of contrarian investing; doing precisely the opposite of what our emotions—and the actions of other investors—tell us to do. Or, as Warren Buffett succinctly puts it, “being greedy when others are fearful and fearful when others are greedy.”

Overall, Jackass Investing is an entertaining and informative read. Consider adding it to your 2012 reading list.

Book Review: The Big Retirement Risk


The financial planning industry has no shortage of voices offering advice.  Unfortunately, they all tend to say the same thing, and it’s not what most investors need or want.  In fact, it’s often the exact opposite.

Above all, most investors want security.  They want to know that the nest egg they’ve spent a lifetime building will be there when they need it.  Somewhere along the way, the financial planning industry lost sight of this and turned the profession into something resembling a Las Vegas casino.  The retirement hopes of millions of Americans depend on the stock market rising ever higher.  Yes, the same stock market that lost half of its value during the 2007-2009 meltdown and had negative returns after inflation over the past decade.

Erin Botsford is a refreshing voice of prudent common sense, and her new book The Big Retirement Risk should be required reading for every financial planner in America.  Clients would be well served if their planner used it as an instruction manual.  Individual investors—particularly the 77 million American Baby  Boomers fast approaching retirement—will also find its insights valuable.

If there is one dominating focus in Erin Botsford’s financial practice, it is risk.  The identification and elimination of risk is something of an obsession for Botsford, and this is not merely an academic exercise for her.  As a woman whose early life was marked by tragedy, she has the instincts of a survivor and does a fine job of translating those instincts into actionable financial advice.

The “big retirement risk” that Botsford warns against is running out of money before you run out of time, and Botsford’s perspective here is unique.  As a young girl, she witnessed it happen to her own family.  With the death of her father at the age of 50, Botsford’s family saw her family’s comfortable middle-class lifestyle reduced to one of poverty and constant worry. Tragedy struck a second time when, as a teenager, Botsford was in an automobile accident in which another motorist died.  Faced with mounting legal bills, her family nearly lost their home.

As if these setbacks were not enough, in her early 20s Botsford got firsthand experience with investment risk.  After winning a modest windfall as a contestant on Wheel of Fortune, she trusted her newfound wealth to a stockbroker.  In short order, the broker lost it all by taking risks that were woefully inappropriate.

Suffice it to say, The Big Retirement Risk is written by an author who knows a thing or two about risk and about the disastrous effects that a lack of planning can have on a family.  Proper planning can never totally eliminate risk, but it can give you the means to manage it.

Botsford uses the opening chapters to explode a number of popular myths that dominate the investment profession (the stock market always goes up over time, diversification and asset allocation reduce risk, your net worth determines your lifestyle, etc.) and instead takes an approach that is a little reminiscent of Rich Dad, Poor Dad author Robert Kiyosaki.  She focuses on the generation of income, correctly pointing out that “Your net worth has no relevance to your lifestyle if it isn’t in a form that can quickly be converted to cash to provide for your everyday living expenses.”

Well said, Erin.

In later chapters, Botsford outlines the investments and strategies employed in her financial practice, including bonds, real estate, options strategies, and investment products that offer guaranteed returns and focuses on her trademarked Lifestyle-Driven Investing.  Her focus throughout is not on “beating the market” or on generating some arbitrary annual return.  Instead, her focus is on the preservation of her clients’ lifestyles by guaranteeing sufficient and diverse income streams.

The Big Retirement Risk is a welcome addition to the existing literature on investing and financial planning, and fills in several gaps that sorely needed to be filled.  Our compliments to Erin Botsford on a job well done.

Japan’s Endgame Nears

I read a fact this week that I never expected to read in my lifetime: “The Japanese government is expected to announce Wednesday that the country recorded its first annual trade deficit since 1980″ (see ” End of Era for Japan’s Exports “).

Trade deficit? Japan?

Japan’s economy has been a slow-motion train wreck for the past 20 years. The bursting of the country’s 1980s credit, stock market and real estate bubble would have wreaked more than enough havoc on any economy. But on top of the normal debt deflation that would follow the bursting of a financial bubble, Japan adds the worst demographics of any developed country. Japan is aging rapidly, and its population is shrinking.

Most of the research on the effects of Japan’s demographics have focused on skilled labor shortages and pension funding. These are legitimate concerns, to be sure. But you don’t have to be an Ivy League economist to see that there is a much larger problem. The only business not affected by this downfall is the Japan’s オンラインカジノのおすすめランキング online casino which continues to provide players with the best casino experience.

If you own a business—anything from a world-class automaker like Toyota (NYSE: $TM) to a neighborhood corner café—you have a smaller pool of potential customers every year, and within that smaller pool a larger percentage are elderly consumers who buy less. Some companies grow at the expense of others, but it becomes a zero-sum game. Growth in the aggregate becomes impossible. The math simply doesn’t add up.

Unless, of course, you export. And this is what Japan has been quite adept at doing for the past 20 years. Until now.

In his 2011 book Endgame , New York Times best-selling author John Mauldin calls Japan a “bug in search of a windshield,” and it’s a great metaphor. Like a bug buzzing along a highway, Japan’s economy has bumbled along for the past two decades, not really growing but not imploding either. In the not-too-distant future, Japan may be in for a good “splat.”

Two things have kept Japan’s economy afloat all these years: its healthy trade surpluses and its government’s ability to borrow large sums of money at ridiculously low interest rates to fund enormous budget deficits. The high price of the yen and prolonged weakness in the United States and Europe are doing a fine job of denting exports. And soon, the low interest rates may be under attack.

Anyone reading this article is well aware of Europe’s debt woes. But Japan’s debts make Europe’s look like pocket change. Italy, the most indebted of the major Eurozone countries, started to see its market bond yields reach punitive levels when its debt-to-GDP ratio reached 120 . As a comparison, Japan’s debt-to-GDP ratio is an almost unbelievable 220 percent (IMF).

The only reason that Japan hasn’t had a run on its bonds is that they are all by and large purchased by domestic buyers. As Mauldin explains it in Endgame, “94 percent of all JGBs have been bought by the Japanese.” But demographically, Japan is fast shifting from a nation of middle-aged workers saving for retirement to a nation of elderly retirees liquidating their savings to pay their bills. The savings rate has been in stark decline.

The domestic demand for Japanese bonds cannot last forever, and when it dries up, Japan will find itself at the mercy of international banks and investors. Ask Greece and Italy how that worked out for them.

Japan can look forward to a currency and debt crisis that makes Europe’s look mild by comparison. Yet betting on Japan’s collapse is a little like fraternity hazing for macro hedge fund managers. It’s just a rite of passage that they have to go through. They short Japan’s bonds, lose a fortune, and learn a few painful lessons.

Knowing this, I’m not going to recommend you short the yen or Japanese stocks or bonds — yet. Wait until you see Japanese yields starting to creep up. And when they do, position your portfolio for the potential short of a lifetime.