What makes a small business successful?

I had the opportunity to ask a man who owned an HVAC (heating, ventilation and air conditioning – you always wondered what the ‘V’ was for didn’t you … me too) business with a dozen or so employees, including his wife. His answer was ” That’s easy – great service and find your niche”.

I was reminded of my first foray into business. A neighbor was studying commerce at Western and had started a window-washing business. He knocked on my door and asked if I might be interested in washing storefront windows on the main street of Oakville. He would collect the money every couple of weeks from the stores and hopefully grow the business by going door to door and soliciting potential customers. I got paid by the window and made something like $50 for a Saturday, not bad for a teenager in those days. He made about the same and the relationship worked for a while.

Here’s the thing, I was the one washing the windows and I was the one that – in rain or shine, suffocating heat or freezing cold – was there. Shopkeepers saw that I was consistent and dependable and asked me to wash their windows. Part of the deal I had with my neighbor was that I could keep the proceeds of newly-generated business that I brought in myself. Soon it grew to exceed what my neighbor was paying me.

Naturally my neighbor discovered my success. He’d walk into a store to garner business and lo-and-behold I was already washing the windows. You see, when the weather was tough he was nowhere to be found, I was. He wasn’t providing the service, I was. I had the relationship.

He fired me. So I bought a bucket and squeegee and the next Saturday set out to start my own business. After a couple of months my neighbor was out of business. Over the next year I quadrupled my income. Over the next few years the business put me, and my brothers and sisters, through university.

The HVAC owner talked about his niche; water-based heating/cooling systems for condos. My niche was storefront windows. I’m always amazed when I pass a strip mall and see two dry-cleaners virtually side-by-side. Really? Two so close? What were they thinking? Then I see a sign in one that says ‘Alterations’ and in the other that says ‘2-for-1’ and realize that they too have a niche and provide unique services.

There’s a lot of niches and a lot of service out there. Small businesses – less than 100 employees – make up more than 98 percent of all firms in Canada. They created more than 3/4 of all private jobs from 2002 to 2012, a little over 100,000 jobs each year. Small wonder then that small business is the key driver of Canada’s economy. It’s not taught in school either, except the school of hard knocks.

Plan Your Business Exit

Do you have a plan in place to ensure you get a great price for your business should you become sick, disabled, die or when you decide to retire?

 

Why you need to plan ahead

If you own a business that’s growing or at least making you a decent living, chances are it may be worth a fair deal and quite possibly represents one of your most valuable assets.  So to ensure you get paid what it’s worth if you intend to sell it, or to minimize taxes on passing it to one or more of your children, you need to plan ahead for that day.

And since your ‘exit’ may not be at the time of your choosing – should you become sick, disabled or die, you need to plan now!

Without a succession plan secured with a Buy-Sell Agreement or a Shareholders’ Agreement, your business might:

  • not survive your death,
  • survive but be worth substantially less as your intended successor chooses not to pay a ‘high price’ for your business,
  • survive but materially hurt as customers are taken by competitors or ‘stolen’ by disenfranchised employees.

Your planning should consider the business acumen/capability and desires of your family members and employees in addition to your needs.  This can affect who you might sell to – be it family members, a partner, key employees, or even a supplier, customer or competitor.

You might even find that the most profitable solution might be to “grow” your own successor.  By hiring a younger person with the right skills, similar integrity as yours, and working closely with them for a few years, you’ll increase the odds that you can dictate a premium price.

The more time you have to plan, the greater the chances you’ll get more money after tax.  It takes time (read years) to find the best successor who is willing to pay the price you want, establish a Buy-Sell Agreement or Shareholders’ Agreement, fund the agreement to guarantee payment to your family should you die, get the successor up to speed with your business so that he or she has the skills needed, and ensure the structure will qualify for a tax effective transfer.

Selling assets or selling shares?

When you sell your incorporated business, you’ll have to decide between two general approaches.  Either you can have the corporation sell assets of the business, or you can sell shares of the corporation.

1. Taxation on the Sale of Shares to an Arm’s Length Party

If you sell the shares of the operating company, the disposition of shares results in a capital gain or loss.  The amount by which the proceeds of disposition exceed the Adjusted Cost Base of the shares is a capital gain; one-half of the capital gain is a Taxable Capital Gain (and this amount is taxed like investment income).

If your shares are held by you personally and are considered “Qualified Small Business Corporation Shares”, “Qualified Farm Property” or “Qualified Fishing Property”, up to $813,600 of your gain may be exempt from tax.  If your Family Trust holds these qualifying shares, it may be possible to multiply this exemption by allocating capital gain proceeds amongst beneficiaries such as you, your spouse, adult kids, and parents.

Your capital gains exemption is reduced, however, by investment losses.  The amount that your exemption is reduced by is the Cumulative Net Income Losses (CNIL) over all previous years.  The CNIL itself is increased by these amounts: interest costs on investment loans, carrying charges and interest on any business that you do not have direct control over, losses on partnerships or co-ownerships, rental or leasing losses and capital losses deducted versus capital gains that aren’t eligible for the exemption.  The CNIL balance is reduced by investment income you have received over the years including interest income and dividends.  So, you might plan to clean this up by taking relatively low cost dividends over a few years.  The exemption may also be restricted if you ever claimed an Allowable Business Investment Loss (ABIL) in which case you need some capital gains that are taxable.

 2. Taxation on the Sale of Assets to an Arm’s Length Party

No capital gains exemption is available if you sell business assets.  So from your point of view, it’s better to sell company shares.  If you sell the assets from your company, the proceeds from the sale are taxed inside a company.  You’ll also have GST/HST sales tax on asset sales.  You then have to pay tax a second time on withdrawals from the company.

How the proceeds are taxed depends on the type of assets sold and the income generated.  If you are selling depreciable assets, such as equipment, this results in recaptured depreciation if the sale proceeds exceed the Undepreciated Capital Cost (“UCC”) up to the original purchase price, thereafter you’ll have a capital gain.  Recaptured depreciation is included in income and taxed as active business income.  If sold for less than UCC, one has a deductible terminal loss.

The sale of non-depreciable non-inventory assets, such as land and building or shares of an operating company, result in a capital gain equal to the sale proceeds less Adjusted Cost Base.  One-half of capital gains is included in income and taxed as investment income (assuming it is on account of capital and not as an inventory item being sold).  The non-taxed half is added to the Capital Dividend Account where one might elect to pay out a non-taxed capital dividend.  The sale of land may result in land transfer tax.

Gains on the sale of intangibles and goodwill are also included in taxable income at a 50% inclusion rate; the taxable portion is taxed as active business income as opposed to investment income.

The type of income (i.e. active business income versus investment income) and type of corporation (for example, a Canadian controlled private corporation (“CCPC”) versus a non-CCPC) determine the corporate tax rate.

If you are trying to sell your business, the buyer may prefer to purchase assets which is usually much cheaper.  The buyer gets a higher cost on depreciable assets which will help generate more Capital Cost Allowance (CCA) or tax depreciation to offset future income.  Buying assets and not the shares is less risky to buyer as it doesn’t include your business liabilities or tax risk of potential future reassessments.

Preparing your business for sale

Having your accountant structure your ownership and cleaning up the company for sale at least 24 months in advance so it qualifies for the qualified small business capital gains exemption is just one aspect of preparing your business for sale.

You might also take steps to prepare your business so it’ll command a higher price.  For example, all of your client knowledge and details in running the business smoothly needs to get put on paper (or even better into a computer database).  If your business can be run with little or no involvement by you, then the business is worth more as there’s less key person risk.

You might also be able to increase your sales price if you strengthen its competitive position (or competitive advantage) – like operating profitable business niches with little to no competition or developing the business so that it is the lowest cost competitor.  In addition to the niche business potentially being very profitable, it might also have higher odds of transition success – where customers have little other choice to buy products or services from your business.

If your family business has more than one range of business operations, you might find that splitting it into logical focused businesses and selling each piece to the highest bidder might be more profitable than selling the whole pie to just one buyer.

When to sell?

Deciding on the best time to sell your business can be difficult.  But generally you should be able to command a significantly better price if you sell when business prospects are good and you’ve got a few years of great historical financial results.

For example, if you forecast growth of 20% and can show for the last three years 20% year over year growth, you have a good case for a premium price that reflects the prospect of future growth.

Another option might simply be for you to hold onto your business as long as you can manage especially if multiples for your industry are low.  But if this means the business isn’t well looked after and customer service deteriorates, your selling price could be accordingly affected.  So, you might end up working a few extra years and not be ahead financially.

The price

One common problem small business owners have is that of not being able to objectively arrive at a fair price.  That’s because there may not be a “stock market” or commonly known industry rules of thumb to tell them the value of their business.  So any offer that isn’t a premium offer for their baby may seem too low.

Rules of thumb used in your industry, if available, may be a helpful starting point to get some ballpark basis of worth.

A business valuator might be able to improve on this rule of thumb estimate or might possibly help bring the buyer and seller together to agree on valuation principles.  Four common valuation techniques used are:

  • Comparable Company Analysis – this is an attempt to measure value by employing the market values of public companies possessing similar attributes to your business;
  • Comparable Transaction Analysis – this is similar to the previous technique except companies used as models are those that have been recently bought or sold;
  • Discounted Cashflow – here the worth of the company is based on the total amount of after-tax cash it can generate (usually the most expensive price); and
  • Liquidation Analysis – here the worth is derived through selling off assets less the cost of satisfying debts (usually the most cheapest price).

From the amount determined based on one or a combination of the above techniques, there may be one or more valuation discounts applied such as:

  • Lack of marketability discount – this applies to closely held businesses where there is virtually no market;
  • Minority interest discount – this applies to where a buyer purchases a minority interest (less than 50% interest) in the business and doesn’t end up with control;
  • Key-person discount – this applies where the company’s success is dependent on a key person and the loss of the key person would result in adverse consequences.

With a valuation, the assumptions used can have a drastic impact in the resulting estimate of value.  So it’s important that both the buyer and seller are in agreement with the assumptions or you might end up wasting your money on the valuation.

Earn-out Arrangements

Carefully structured, an earn-out arrangement can be a win/win in that the seller likely receives a higher value for the business while the buyer minimizes the risk of goodwill impairment and obtains favourable internal financing.

And if you don’t offer an earn-out, you’ll likely eliminate many prospective buyers who’d be more than willing to pay a premium.

Converting part of the business value to tax deferred proceeds

For a larger business, the use of an Individual Pension Plan (“IPP”) or a Retirement Compensation Arrangement (“RCA”), could help you save a substantial amount in taxes by spreading taxes out over several years or by being able to shift part of the company value to tax deferred assets.

An IPP can be thought of as a super RRSP.  In most cases, IPP contributions can be substantially higher than RRSP contributions – possibly more than double what you’d otherwise be able to save in an RRSP.

Should business liability be an issue for you, an IPP comes with creditor protection (note that there is some degree of creditor protection through provincial legislation for RRSPs and RRIFs).  Although an IPP has setup fees and maintenance costs, for some people, the added savings and creditor protection are well worth the costs.

An RCA might be used to spread proceeds over several years.  It might be especially of value where you are considering becoming a non-resident and take up residency in a lower tax jurisdiction.

Either or both of these techniques should be considered many years in advance (read more at least 10 years), in order for the real power of these tools to be spectacularly effective.

Spreading the gain over time – the Capital Gains Reserve

When you sell your business, you might find it tough to get all of your money up front – it might instead be spread over a number of years.

So you might consider offering the buyer financing that may be more attractive than might otherwise be available through traditional bank financing.  And in the process you might receive some tax relief through a capital gains reserve.

This reserve allows you to bring the capital gain into income over a maximum five-year period.  Without the capital gains reserve mechanism, you’d be liable for tax on the entire capital gain triggered by the disposition in the year of sale, even though you would not yet have received the entire sale proceeds.

Note that if you are selling the shares of a QSBC, qualified farm property, or qualified fishing property, you can claim a reserve over a 10-year period.  That might be just the thing to consider if selling to your children or grandchildren.

Buy/Sell Agreement

A Buy/Sell Agreement is a contract between two parties that defines how an owner will sell a particular business interest and how a buyer will buy that interest under certain situations.

A Buy/Sell Agreement may be general in nature to cover unplanned sales (in case of death or incapacity) or it may be very definite in nature tailored to a planned sale to a known buyer (in the case of a planned retirement).

Whether you leave by choice or by chance, a Buy/Sell Agreement ensures your business interest will be transferred at a guaranteed price and on guaranteed terms.

Having the agreement in place improves the odds of the business successfully transferring at a price that can provide adequately for your family and removing uncertainty to employees and partners that depend on the business.

Non-competition agreements

Whether you sell your company’s shares or assets, the buyer will likely want you to sign a non-competition agreement to protect the value of the business.  The payment you receive for signing this (or the implied value associated with this) may be fully taxed as regular income.  However, if requirements, such as filing an election with the CRA, are met, it may be taxed at a lower rate as a capital gain.

Maximizing after tax business proceeds on death

On the last to die of you and your spouse, shares of your incorporated business is deemed disposed at market value resulting in capital gains taxes.  Taxes are payable a second time where company assets are disposed of (creating taxable capital gains) and proceeds distributed to shareholders (which might be in the form of dividends subject to tax).  So, your company investments are subjected to double tax – once at your death and then again when realized and distributed.

If your company has surplus assets, it may be possible to reduce these taxes where the company owns an insurance policy on the life of the shareholder.  Here surplus company assets are used to pay insurance costs which reduces the pool of surplus assets.  What this does is convert surplus assets to a death benefit that can be excluded in valuing the company for tax purposes.  Most or all of this death benefit (above the policy ACB) is credited to the Capital Dividend Account that can then be paid to your heirs as a tax-free capital dividend.

The result is that through insurance you may be able to reduce capital gains taxes at death.  And this reduction in taxes can be greater than a plan to simply redeem company shares at death.  The sooner you plan for this, the cheaper your cost of insurance.

Are there holes in your business exit plans?

Below are some questions to help you begin thinking about your business planning and the status of your business succession.

  1. Have you thought about what will give you a full and meaningful life? Have you priced this out so you know when you can afford to retire?  If your business is worth more than what you need, why are you not planning your exit?  What are the costs to your spouse and family of working hard in the business versus retiring where they get to spend time with you?
  2. Have you thought through the implications to you and your family in the event of a serious illness, disability, or premature death? In such events, have you developed a disaster plan to ensure that you’ll get a good price for your business backed up contractually with a Buy-Sell Agreement or a Shareholder’s Agreement?  Or have you obtained sufficient disability, critical illness and life insurance to financially ensure you and your family’s well-being?
  3. Are you dependent on your business to meet your retirement cash flow needs? Are you growing your investment portfolio so that it will eventually be able to provide you with a satisfactory pension?
  4. Do you know what your business is really worth if it were sold tomorrow? (Have you had an independent person appraise your business so you know what a market offer looks like?)
  5. Do you have enough liquidity to avoid the forced sale of your business on death? Is there enough other assets available to satisfy the tax bill?
  6. Who will be taking over, or will you sell the business? Have you considered the importance of family involvement in leadership and ownership of the company?  If family is involved in leadership, have you thought through how to fairly deal with your family who are active and those that aren’t active in the business?
  7. Is selling your business to a successor (like a capable employee or employees) the best way to maximize the proceeds from selling your business? Do you have a successor in mind for your business?  Is the successor competent, honest and trustworthy?  Is your successor someone who would want to own your business?  Is the successor ready to succeed you – does he / she have the qualifications needed?  Is there an incentive plan for your successor with effective non-compete clauses?  Have you developed a training plan for your successor?  Have you put in place a Buy-Sell or Shareholder’s Agreement with the successor?  Is the agreement secured with resources or funded by insurance to guarantee cash will be available to be paid to you or your family on your planned or unplanned departure?
  8. Are you currently using techniques to reduce or eliminate income tax and estate tax?
  9. Are you planning to utilize the Small Business Capital Gains Exemption as a way to obtain tax-free proceeds on your business exit? Have you structured the ownership of your business so that the company qualifies?  Have you structured the ownership so that you’ll be able to multiply the exemption?
  10. Have you considered alternative corporate structures, stock-transfer techniques, IPPs and RCAs to reduce or defer taxes as part of your exit plan?
  11. Are you doing everything you can do to make your business more valuable to a buyer? Are you making yourself redundant so that it can eventually operate without your showing up to work every day? Have you looked at your staff to determine the effect should on or more persons leave?  Are your staff happy and properly compensated compared to your competitors?  Do you have a backup for each key staff person should someone leave so that your business can continue to operate?

The next step

If you’ve got a saleable business and would like to put together your exit plan, please call our financial planner, Steve Nyvik. Some of the things that Steve can assist you with include:

  • reviewing your current plans and provide some constructive comments;
  • preparing a financial roadmap (otherwise called a retirement projection) so that you can know when you can afford to retire;
  • structuring your investment portfolio to resemble a pension so that it can eventually replace the income provided from your business so that you are financially independent;
  • working together with you and your tax accountants, lawyers and pension benefits consultants to help you implement a tax effective plan backed with a Buy-Sell Agreement or Shareholder’s Agreement;
  • reviewing your insurance program to determine its adequacy to fully fund the buy-out in the event of your serious illness, disability or premature death.

Written by Steve Nyvik, BBA, MBA ,CIM, CFP, R.F.P.
Financial Planner and Portfolio Manager, Lycos Asset Management Inc.

Index and Sector ETFs: Mutual Funds: Speculation X3

How many of you remember the immortal words of P. T. Barnum? On Wall Street, the incubation period for new product scams may be measured in years instead of minutes, but the end result is always a greed-driven rush to financial disaster.

The dot.com meltdown spawned index mutual funds, and their dismal failure gave life to “enhanced” index funds, a wide variety of speculative hedge funds, and a rapidly growing assortment of Index ETFs. Deja Vu all over again, with the popular ishare variety of ETF leading the lemmings to the cliffs.

How far will we allow Wall Street to move us away from the basic building blocks of investing? Whatever happened to stocks and bonds? The Investment Gods are appalled.

A market or sector index is a statistical measuring device that tracks prices in securities selected to represent a portion of the overall market. ETF creators:

  • select a sampling of the market that they expect to be representative of the whole,
  • purchase the securities, and then
  • issue the ishares, SPDRS, CUBEs, etc. that speculators then trade on the exchanges just like equities.

Unlike ordinary index funds, ETF shares are not handled directly by the fund. As a result, they can move either up or down from the value of the securities in the fund, which, in turn, may or may not mirror the index they were selected to track. Confused? There’s more — these things are designed for manipulation.

Unlike managed Closed-End Funds (CEFs), ETF shares can be created or redeemed by market specialists, and Institutional Investors can redeem 50,000 share lots (in kind) if there is a gap between the net-asset-value and the market price of the fund.

These activities create artificial demand in an attempt to minimize the gap between NAV and market price. Clearly, arbitrage activities provide profit-making opportunities to the fund sponsors that are not available to the shareholders. Perhaps that is why the fund expenses are so low — and why there are now thousands of the things to choose from.

Two other ETF idiosyncrasies need to be appreciated:

a) performance return statistics for index funds may not include expenses, but it should be obvious that none will ever outperform their market, and

b) index funds may publish P/E numbers that only include the profitable companies in the portfolio.

So, in addition to the normal risks associated with investing, we add: speculating in narrowly focused sectors, guessing on the prospects of unproven small cap companies, experimenting with securities in single countries, rolling the dice on commodities, and hoping for the eventual success of new technologies.

We then call this hodge-podge of speculation a diversified, passively managed, inexpensive approach to Modern Asset Management — based solely on the mathematical hocus pocus of Modern Portfolio Theory (MPT).

Once upon a time, but not so long ago, there were high yield junk bond funds that the financial community insisted were appropriate investments because of their diversification. Does diversified junk become un-junk? Isn’t passive management as much of an oxymoron as variable annuity? Who are they kidding?

But let’s not dwell upon the three or more levels of speculation that are the very foundation of all index and sector funds. Let’s move on to the two basic ideas that led to the development of plain vanilla Mutual Funds in the first place: diversification and professional management.

Mutual Funds were a monumental breakthrough that changed the investment world. Hands-on investing became possible for everyone. Self-directed retirement programs and cheap to administer employee benefit programs became doable.

The investment markets, once the domain of the wealthy, became the savings accounts of choice for the employed masses — because the “separate accounts” were both trusteed and professionally managed. When security self-direction came along, professional management was gone forever. Mutual fund management was delegated to the financially uneducated masses.

ETFs are not the antidote for the mob-managed & dismal long term performance of open end Mutual Funds, where professionals are always forced to sell low and to buy high. ETFs are the vehicles of choice for Wall Street to ram MPT mumbo jumbo down the throats of busy, inexperienced investors… and the regulators who love them because they are cheap.

Mutual fund performance is bad (long term, again) because managers have to do what the mob tells them to do — so Wall Street sells “passive products” with controlled content that they can manipulate more cheaply.

Here’s a thumbnail sketch of how well passive ETFs may have performed from the turn of the century through 2013: the DJIA growth rate was about 0% per year, the S & P 500 was negative; the NASDAQ Composite has just recently regained its 2000 value.

How many positive sectors, technologies, commodities, or capitalization categories could there have been?

Now subtract the fees… hmmmm. Again, how would those ETFs have fared? Hey, when you buy cheap and easy, it’s usually worth it. Now if you want performance, I suggest you try real management, as opposed to Mutual Fund management… but you need to take the time to understand the process.

If you can’t understand or accept the strategy, don’t hire the manager. Mutual Funds and ETFs cannot “beat the market” (not a well thought out investment objective anyway) because both are effectively managed by investor/speculators… not by professionals.

Sure, you might find some temporary smiles in your ETFs, but only if you take your profits will the smiles last. There may be times when it makes sense to use these products to hedge against a specific risk. But stop kidding yourself every time Wall Street comes up with a new short cut to investment success.

There is no reason why all of you can’t either run your own investment portfolio, or instruct someone as to how you want it done. Every guess, every estimate, every hedge, every sector bet, and every shortcut increases portfolio risk.

Products and gimmicks are never the answer. ETFs, a combination of the two, don’t even address the question properly — AND their rising popularity has raised the risk level throughout the Stock Market. How’s that, you ask?

The demand for the individual stocks included in ETFs is raising their prices without having anything to do with company fundamentals.

What’s in your portfolio?

How will ETFs and Mutual Funds fare in the next correction?

Are YOU ready.

Brave Old World: Market Cycle Investment Management

The Market Cycle Investment Management (MCIM) methodology is the sum of all the strategies, procedures, controls, and guidelines explained and illustrated in the “The Brainwashing of the American Investor” — the Greatest Investment Story Never Told.

Most investors, and many investment professionals, choose their securities, run their portfolios, and base their decisions on the emotional energy they pick up on the Internet, in media sound bytes, and through the product offerings of Wall Street institutions. They move cyclically from fear to greed and back again, most often gyrating in precisely the wrong direction, at or near precisely the wrong time.

MCIM combines risk minimization, asset allocation, equity trading, investment grade value stock investing, and “base income” generation in an environment which recognizes and embraces the reality of cycles. It attempts to take advantage of both “fear and greed” decision-making by others, using a disciplined, patient, and common sense process.

This methodology thrives on the cyclical nature of markets, interest rates, and economies — and the political, social, and natural events that trigger changes in cyclical direction. Little weight is given to the short-term movement of market indices and averages, or to the idea that the calendar year is the playing field for the investment “game”.

Interestingly, the cycles themselves prove the irrelevance of calendar year analysis, and a little extra volatility throws Modern Portfolio Theory into a tailspin. No market index or average can reflect the content of YOUR unique portfolio of securities.

The MCIM methodology is not a market timing device, but its disciplines will force managers to add equities during corrections and to take profits enthusiastically during rallies. As a natural (and planned) affect, equity bucket “smart cash” levels will increase during upward cycles, and decrease as buying opportunities increase during downward cycles.

MCIM managers make no attempt to pick market bottoms or tops, and strict rules apply to both buying and selling disciplines.

NOTE: All of these rules are covered in detail in “The Brainwashing of the American Investor” .

Managing an MCIM portfolio requires disciplined attention to rules that minimize the risks of investing. Stocks are selected from a universe of Investment Grade Value Stocks… under 400 that are mostly large cap, multi-national, profitable, dividend paying, NYSE companies.

LIVE INTERVIEW – Investment Management expert Steve Selengut Discusses MCIM Strategies – LIVE INTERVIEW

Income securities (at least 30% of portfolios), include actively managed, closed-end funds (CEFs), investing in corporate, federal, and municipal fixed income securities, income paying real estate, energy royalties, tax exempt securities, etc. Multi level, and speculation heavy funds are avoided, and most have long term distribution histories.

No open end Mutual Funds, index derivatives, hedge funds, or futures betting mechanisms are allowed inside any MCIM portfolio.

All securities must generate regular income to qualify, and no security is ever permitted to become too large of a holding. Diversification is a major concern on an industry, or sector, level, but global diversification is a given with IGVSI companies.

Risk Minimization, The Essence of Market Cycle Investment Management

Risk is compounded by ignorance, multiplied by gimmickry, and exacerbated by emotion. It is halved with education, ameliorated with cost-based asset allocation, and managed with disciplined: selection quality, diversification, and income rules— The QDI. (Read that again… often.)

Risk minimization requires the identification of what’s inside a portfolio. Risk control requires daily decision-making. Risk management requires security selection from a universe of securities that meet a known set of qualitative standards.

The Market Cycle Investment Management methodology helps to minimize financial risk:

  • It creates an intellectual “fire wall” that precludes you from investing in excessively speculative products and processes.
  • It focuses your decision making with clear rules for security selection, purchase price criteria, and profit-taking guidelines.
  • Cost based asset allocation keeps you goal focused while constantly increasing your base income.
  • It keeps poor diversification from creeping into your portfolio and eliminates unproductive assets in a rational manner.

Strategic Investment Mixology – Creating The Holy Grail Cocktail

So what do your Investment Manager and your neighborhood bartender have in common, other than the probability that you spend more time with the latter during market corrections?

Antoine Tedesco, in his “The History of Cocktails“, lists three things that mixologists consider important to understand when making a cocktail: 1) the base spirit, which gives the drink its main flavor; 2) the mixer or modifier, which blends well with the main spirit but does not overpower it; and 3) the flavoring, which brings it all together.

Similarly, your Investment Manager needs to: 1) put together a portfolio that is based on your financial situation, goals, and plans, providing both a sense of direction and a framework for decision making; 2) use a well defined and consistent investment methodology that fits well with the plan without leading it in tangential directions; and 3) exercise experienced judgment in the day-to-day decision making that brings the whole thing together and makes it grow.

Tedesco explains that: new cocktails are the result of experimentation and curiosity; they reflect the moods of society; and they change rapidly as both bartenders and their customers seek out new and different concoctions to popularize. The popularity of most newbies is fleeting; the reign of the old stalwarts is history — with the exception, perhaps, of “Goat’s Delight” and “Hoptoad”. But, rest assured, the “Old Tom Martini” is here to stay!

It’s likely that many of the products, derivatives, funds, and fairy tales that emanate from Modern Portfolio Theory (MPT) were thrown together over “ti many martunies” at Bobby Van’s or Cipriani’s, and just like alcohol, the addictive products created in lower Manhattan have led many a Hummer load of speculators down the Holland tubes.

The financial products of the day are themselves, created by the mood of society. The “Wizards” experiment tirelessly; the customers’ search for the Holy Grail cocktail is never ending. Curiosity kills too many retirement “cats”.

Investment portfolio mixology doesn’t take place in the smiley faced environment that brought us the Cosmo and the Kamikaze, but putting an investment cocktail together without the risk of addictive speculations, or bad after- tastes, is a valuable talent worth finding or developing for yourself. The starting point should be a trip to portfolio-tending school, where the following courses of study are included in the Investment Mixology Program:

Understanding Investment Securities: Investment securities can be divided into two major classes that make the planning exercise called asset allocation relatively straightforward. The purpose of the equity class is to generate profits in the form of capital gains. Income securities are expected to produce a predictable and stable cash flow in the form of dividends, interest, royalties, rents, etc.

All investment securities involve both financial and market risk, but risk can be minimized with appropriate diversification disciplines and sensible selection criteria. Still, regardless of your skills in selection and diversification, all securities will fluctuate in market price and should be expected to do so with semi-predictable, cyclical regularity.

Planning Securities Decisions: There are three basic decision processes that require guideline development and procedural disciplines: what to buy and when; when to sell and what; and what to hold on to and why.

Market Cycle Investment Management: Most portfolio market values are influenced by the semi-predictable movements of several inter-related cycles: interest rates, the IGVSI, the US economy, and the world economy. The cycles themselves will be influenced by Mother Nature, politics, and other short-term concerns and disruptions.

Performance Evaluation: Historically, Peak-to-Peak analysis was most popular for judging the performance of individual and mutual fund growth in market value because it could be separately applied to the long-term cyclical movement of both classes of investment security. More recently, short-term fluctuations in the DJIA and S & P 500 are being used as performance benchmarks to fan the emotional fear and greed of most market participants.

Information Filtering: It’s important to limit information inputs, and to develop filters and synthesizers that simplify decision-making. What to listen to, and what to allow into the decision making process is part of the experienced manager’s skill set. There is too much information out there, mostly self-motivated, to deal with in the time allowed.

Wall Street investment mixologists promote a cocktail that has broad popular appeal but which typically creates an unpleasant aftertaste in the form of bursting bubbles, market crashes, and shareholder lawsuits. Many of the most creative financial nightclubs have been fined by regulators and beaten up by angry mobs with terminal pocketbook cramps.

The problem is that mass produced concoctions include mixers that overwhelm and obscure the base spirits of the investment portfolio: quality, diversification, and income.

There are four conceptual ingredients that you need to siphon out of your investment cocktail, and one that must be replaced with something less “modern-portfolio-theoryesque”:

1) Considering market value alone when analyzing performance ignores the cyclical nature of the securities markets and the world economy.

2) Using indices and averages as benchmarks for evaluating your performance ignores both the asset allocation of your portfolio and the purpose of the securities you’ve selected.

3) Using the calendar year as a measuring device reduces the investment process to short-term speculation, ignores financial cycles, increases emotional volatility in markets, and guarantees that you will be unhappy with whatever strategy or methodology you employ —most of the time.

4) Buying any type or class of security, commodity, index, or contract at historically high prices and selling high quality companies or debt obligations for losses during cyclical corrections eventually causes hair loss and shortness of breath.

And the one ingredient to replace: Modern Portfolio Theory (the heartbeat of ETF cocktails) with the much more realistic Working Capital Model (operating system of Market Cycle Investment Management).

Cheers!

Stock Market Corrections Are Beautiful… When

A correction is a beautiful thing, simply the flip side of a rally, big or small. Theoretically, even technically I’m told, corrections adjust equity prices to their actual value or “support levels”. In reality, it’s much easier than that.

Prices go down because of speculator reactions to expectations of news, speculator reactions to actual news, and investor profit taking. The two former “becauses” are more potent than ever before because there is more self-directed money out there than ever before. And therein lies the core of correctional beauty!

Mutual Fund unit holders rarely take profits but often take losses. Additionally, the new breed of Index Fund Speculators over-react to news of any kind because that’s what speculators do. Thus, if any brief little market hiccup becomes considerably more serious, new investment opportunities will become abundant!

Here’s a list of ten things to think about doing, or to avoid doing, during corrections of any magnitude:

1. Your present Asset Allocation should be tuned in to your long-term goals and objectives. Resist the urge to decrease your Equity allocation because you expect a further fall in stock prices. That would be an attempt to time the market, which is (rather obviously) impossible. Asset Allocation decisions should have nothing to do with stock market expectations.

2. Take a look at the past. There has never been a correction that has not proven to be a buying opportunity, so start collecting a diverse group of high quality, dividend paying, NYSE companies as they move lower in price— Investment Grade Value Stocks. I start shopping at 20% below the 52-week high water mark— the bargain bins are filling.

3. Don’t hoard that “smart cash” you accumulated during the last rally, and don’t look back and get yourself agitated because you might buy some issues too soon. There are no crystal balls, and no place for hindsight in an investment strategy. Buying too soon, in the right portfolio percentage, is nearly as important to long-term investment success as selling too soon is during rallies.

4. Take a look at the future. Nope, you can’t tell when the rally will resume or how long it will last. If you are buying quality equities now (as you certainly could be) you will be able to love the rally even more than you did the last time— as you take yet another round of profits. Smiles broaden with each new realized gain, especially when most Wall Streeters are still just scratchin’ their heads.

5. As (or if) the correction continues, buy more slowly as opposed to more quickly, and establish new positions incompletely. Hope for a short and steep decline, but prepare for a long one. There’s more to Shop at The Gap than meets the eye, and if you are doing it properly, you’ll run out of cash well before the new rally begins.

6. Your understanding and use of the Smart Cash concept has proven the wisdom of The Investor’s Creed (look it up). You should be out of cash while the market is still correcting— it gets less scary each time. As long your cash flow continues unabated, the change in market value is merely a perceptual issue.

7. Note that your Working Capital is still growing, in spite of falling prices, and examine your holdings for opportunities to average down on cost per share or to increase yield (on fixed income securities). Examine both fundamentals and price, lean hard on your experience, and don’t force the issue.

8. Identify new buying opportunities using a consistent set of rules, rally or correction. That way you will always know which of the two you are dealing with in spite of what the Wall Street propaganda mill spits out. Focus on Investment Grade Value Stocks; it’s just easier, as well as being less risky, and better for your peace of mind. Just think where you would be today had you heeded this advice years ago—

9. Examine your portfolio’s performance: with your asset allocation and investment objectives clearly in focus; in terms of market and interest rate cycles as opposed to calendar Quarters (never do that) and Years; and only with the use of the Working Capital Model (look this up also), because it is based upon your personal asset allocation. Remember, there is really no single index number to use for comparison purposes with a properly designed portfolio.

Unfortunately, only Self Directed 401k and IRA programs are able to use Market Cycle Investment Management.

10. So long as everything is down, there is nothing to worry about. Downgraded (or simply lazy) portfolio holdings should not be discarded during general or group specific weakness. Unless of course, you don’t have the courage to get rid of them during rallies— also general or sector specifical (sic).

Corrections (of all types) will vary in depth and duration, and both characteristics are clearly visible only in institutional grade rear view mirrors. The short and deep ones are most lovable (kind of like men, I’m told); the long and slow ones are more difficult to deal with. Short ones (those that last a few days, weeks, or months) are nearly impossible to deal with using Mutual Funds.

So if you overthink the environment or overcook the research, you’ll miss the party. Unlike many things in life, Stock Market realities need to be dealt with quickly, decisively, and with zero hindsight.

Because amid all of the uncertainty, there is one indisputable fact that reads equally well in either market direction: there has never been a correction/rally that has not succumbed to the next rally/correction—

Think cycle instead of year, and smile more often.

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A Preemptive, Timeless, Portfolio Protection Strategy

A participant in the morning Market Cycle Investment Management (MCIM) workshop observed: I’ve noticed that my account balances are near all time high levels. People are talking down the economy and the dollar. Is there any preemptive action I need to take?

An afternoon workshop attendee spoke of a similar predicament, but cautioned that a repeat of the June 2007 through early March 2009 correction must be avoided — a portfolio protection plan is essential!

What were they missing?

These investors were taking pretty much for granted the fact that their investment portfolios had more than merely survived the most severe correction in financial market history. They had recouped all of their market value, and maintained their cash flow to boot. The market averages seemed afraid to move higher.

Their preemptive portfolio protection plan was already in place — and it worked amazingly well, as it certainly should for anyone who follows the general principles and disciplined strategies of the MCIM.

But instead of patting themselves on the back for their proper preparation and positioning, here they were, lamenting the possibility of the next dip in securities’ prices. Corrections, big and small, are a simple fact of investment life whose origination point can only be identified using rear view mirrors.

Investors constantly focus on the event instead of the opportunity that the event represents. Being retrospective instead of hindsightful helps us learn from our experiences. The length, depth, and scope of the financial crisis correction were unknowns in mid-2007. The parameters of the recent advance are just as much of a mystery now.

MCIM forces us to prepare for cyclical oscillations by requiring that: a) we take reasonable profits quickly whenever they are available, b) we maintain our “cost-based” asset allocation formula using long-term (retirement, etc.) goals, and c) we slowly move into new opportunities only after downturns that the “conventional wisdom” identifies as correction level— i. e., twenty percent.

  • So, a better question, concern, or observation during an unusually long rally, given the extraordinary performance scenario that these investors acknowledge, would be: What can I do to take advantage of the market cycle even more effectively — the next time?

The answer is as practically simple as it is emotionally difficult. You need to add to portfolios during precipitous or long term market downturns to take advantage of lower prices — just as you would do in every other aspect of your life. You need first to establish new positions, and then to add to old ones that continue to live up to WCM (Working Capital Model) quality standards.

You need to maintain your asset allocation by adding to income positions properly, and monitor cost based diversification levels closely. You need to apply cyclical patience and understanding to your thinking and hang on to the safety bar until the climb back up the hill makes you smile. Repeat the process. Repeat the process. Repeat the process.

The retrospective?

The MCIM methodology was nearly fifteen years old when the robust 1987 rally became the dreaded “Black Monday”, (computer loop?) correction of October 19th. Sudden and sharp, that 50% or so correction proved the applicability of a methodology that had fared well in earlier minor downturns.

According to the guidelines, portfolio “smart cash” was building through August; new buying overtook profit taking early in September, and continued well into 1988.

Ten years later, there was a slightly less disastrous correction, followed by clear sailing until 9/11. There was one major difference: the government didn’t kill any companies or undo market safeguards that had been in place since the Great Depression.

Dot-Com Bubble! What Dot-Com Bubble?

Working Capital Model buying rules prohibit the type of rampant speculation that became Wall Street vogue during that era. The WCM credo after the bursting was: “no NASDAQ, no Mutual Funds, no IPOs, no Problem.” Investment Grade Value Stocks (IGVSI stocks) regained their luster as the no-value-no-profits securities slip-slided away into the Hudson.

Embarrassed Wall Street investment firms used their influence to ban the “Brainwashing of the American Investor” book and sent the authorities in to stifle the free speech of WCM users — just a rumor, really.

Once again, through the “Financial Crisis”, for the umpteenth time in the forty years since its development, Working Capital Model operating systems have proven that they are an outstanding Market Cycle Investment Management Methodology.

And what was it that the workshop participants didn’t realize they had — a preemptive portfolio protection strategy for the entire market cycle. One that even a caveman can learn to use effectively.

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One Person’s Bond Crash is Another’s Income Opportunity

Today’s “Investment News” headline (from Bloomberg) is designed to make you shiver in your income portfolio boots:

“Big fixed income shop prepares for the worst”…

The Bond Portfolio “Window Dressing” sell-off has begun.

Bond funds in general are now holding 8% of assets in cash, the article reports…highest since the financial crisis, and 1999, even. Professional Bond Traders certainly have reason to worry; closed end fund income investors not so much.

The article is reporting fear of lower market values with respect to existing bonds, particularly the higher yield variety…. big players in the bond market are hoarding cash (even selling existing holdings at losses in the process).

Bond Traders and Fund Managers look foolish as inventory market values fall. The cash hoard is their way of preparing to buy similar paper at higher yields sometime in the future and/or to buy back “old” bonds after the fall in price.

In the meantime, they are holding zero interest rate cash in anticipation of the higher yields… and could care less about the negative impact this behavior has on portfolio yields.

This is the result of what I call “Total Return Crossover”… the absurd application of market value growth analysis, instead of income development criteria, to primarily income security portfolios. (An analytical atrocity that is reinforced and encouraged by retirement plan regulators.)

So bond and Income Mutual Fund managers choose to actually lose your money now to look less foolish than the competition later. This “panic selling” by professionals leads to irrational, “knee jerk” reactions in amateurs.

What I did not read in the Bloomberg “disaster scenario” (and this should calm all the frayed nerves) was any indication or expectation of default on the interest paid by the bond issuers. This is the key issue with income investing…

Bonds are corporate and government debt securities, people… so long as they pay the interest why worry about the market value?

Wall Street is always more concerned about appearances than it is about income generation. And the Masters of the Universe really do have a problem… OMG, what this could do to those year-end bonuses…

But we (the average investors out here) can simply reinvest our current CEF income in any number of portfolios of bonds, preferred stocks, loans, notes, etc., selling at discounts, not only from their maturity value, but also from their combined Net Asset Values. Read that again please.

Remember, Closed End Income Fund portfolios aren’t influenced directly by either the fear (or greed) of individual investors… they are under a “protective dome”, if you will, that is subject to all forms of volatility for a vast array of reasons.

But an Income CEF, for example, becomes the totally liquid trading vehicle for a portfolio that could contain hundreds of totally illiquid individual securities… do you believe in magic? Be it Magic, or genius, who cares. We, mere mortals that we are, can jump on the lower prices that chill the blood of Wall Street’s Master Class.

Closed End Fund investors are uniquely positioned to take advantage of both the lower prices and the higher yields that exist right now. Market Cycle Investment Management users have done it before, right?

Remember the fall in CEF prices from early 2007 (higher rates caused these) through early March 2009 (even in the face of the lowest interest rates ever)… and the ensuing rise through October 2011?

Well, do you really think that the anticipated one percentage point rise in interest rates over the next year or so will cause Financial Crisis #2?

Isn’t it great when Wall Street’s pain becomes fuel for the small investor’s gain…. but only if you take advantage of the lower price, higher yield scenario that is staring you in the face as you read this message..

Yes, YOU can be the Master of this Universe!

Income Investing: “Feed Your Head… Feed Your Head”

Jefferson Airplane has never, ever, been mistaken for a band of financial advisors, but the White Rabbit lyrics can be incredibly instructional to the generation of investors who experienced the classic first hand — as a description of their own college days’ lifestyle. If only they had heeded the dormouse’s call to “feed your head.” For the sake of your retirement sanity and security, you just have to make income investing an intellectual exercise — not an emotional one.

The Brainwashing of the American Investor has its own tale of an Alice whose “logic and proportion” had “fallen sloppy dead”. Many years ago, when interest rates soared into double digits, elderly Alice was well advised to invest her stash in a portfolio of Ginnie Maes. Broadly smiling, she bragged to her friends about the federally guaranteed 13% interest she was receiving in regular monthly intervals — much more than she needed to cover her living expenses.

But interest rates continued to move higher, and the decreasing market value of her Ginnie Maes was more than she could tolerate. “If rates continue to go up, I’ll have nothing left” she cried to her White Knight financial advisor who suggested patience and understanding. The very same pill that made her income grow larger was also making her market value become smaller.

Yet the income kept rolling in, higher yielding unit trusts were purchased with the excess, and major redemptions were nowhere to be seen. The income kept growing, the market value kept shrinking, and Alice was seeing red from seeing red on her account statements.

So Alice went to her local bank and traded in her absolutely government guaranteed 13 per centers for some laddered, non-negotiable, 8.5% CDs. “No more erosion of my nest egg”, she toasted proudly with the hookah smoking bank caterpillar who orchestrated her move to lower income levels. Within a few months, she was liquidating CDs to pay the bills that never seemed to be a problem with those terrible Ginnie Maes.

Don’t let such uniformed thinking sabotage your retirement program; don’t let the selfish advice of a product sharpshooter send you chasing rabbits when IRE (interest rate expectations) or other temporary market conditions shrink the market value of your income portfolio. Feed your head; feed—your—head.

Income pays the bills, and if the income level is both steady and adequate, there is no need to change investments. Market value should be used to determine when to buy more (at lower prices) and when to take profits (at higher ones). It is almost never necessary to take a loss on a high quality (government guaranteed in Alice’s case) income security.

More recent experimenters in much more sophisticated potions have addressed the issue with similar results, reaching mind-numbing conclusions such as these:

  • I know the income hasn’t changed throughout the debacle in the financial sector but I don’t want to buy anymore of these securities until the prices go back above what I paid for them originally. Translation: I’d rather stick with my 4.5% tax-free yield than increase it by adding to my positions at lower prices.
  • Sure, I understand the relationship between IRE and the prices of income CEFs but individual bonds and Treasuries haven’t suffered nearly as much. That’s where we should have been. Translation: I would be much happier with a 3% than with an 8% rate of realized income.
  • I’m tired of seeing all the negative positions in my portfolio. Let’s keep all the income we receive in money market until we’re back in positive territory. Translation: I’d rather accept 0.5% or so, than reduce my cost basis and increase my yield by adding to my positions at lower prices.

Modern brokerage firm monthly statement “pills” were developed during the dot-com era, when Wall Street was trying to emphasize the brilliance of its speculative prescriptions by making us all feel ten feet tall, month after month after month.

But the geniuses on the institutional chessboard produced too many mushroom product varietals and the Red Queen of corrections lopped off many of their sacred heads. The papers that were designed to make our chests burst with pride have turned on us as a haunting reminder of the reality of markets and the cycles that push them in either direction.

It should be easy to navigate a quality income portfolio through whatever circumstances, cycles, and scandals come at you, but a clear head and a clearer understanding of what to expect is required. Most brokerage firm statements make it difficult to monitor asset allocation using any methodology, including the Working Capital Model, and I don’t think that it’s by chance.

Confusion breeds unhappiness, and unhappiness brings about change, and the masters of the universe encourage you to fritter around from mushroom to mushroom in perpetual motion. To whose benefit?

It would be wonderful if an investor’s monthly statement would organize his securities based on their class and purpose, but Wall Street doesn’t want such distinctions to be made easily. It would be great if the institutions would help investors formulate reasonable expectations about various types of securities under varying conditions, but that’s not likely to happen either.

It would be spectacular if the media would produce information and explanation instead of news bites and sensationalism, but you guessed it — not much chance of that.

Income investing can be easy. Ask your hookah-smoking caterpillar to give you the how?

Income Closed End Funds and Total Return Analysis

What are the two main reasons mere mortals invest in income purpose securities: one is their inherent safety compared to equities… a 50% income asset allocation is much safer and theoretically less volatile than a 100% equity exposure.

There is less risk of total loss in XYZ company bonds or preferred stock than there is in XYZ common stock… a major fact of investment life roundly ignored by most investors/speculators in overpriced stock markets.

Equally important (as retirement looms larger) is the income these securities produce, first for compounding and then for spending.

  • Compound interest/dividends/realized capital gains is the most powerful retirement income force known to mankind… neither total return nor market value can pay your bills, take you on vacation, or pay your grandkids tuition.

Unlike Tom Wolfe’s “Masters of the Universe”, most of us are not bond traders. If our income inventory shrinks in market value, we don’t have to sell our positions. Wall Street fixed income pros don’t care about income production… buying and selling inventory is their business model, and they set the market prices.

The “higher interest rates are coming panic” you are hearing about in the media is a real problem for MOTUs, but it may be an investment opportunity for the rest of us. If I buy an Exxon 4% debenture, a 3% 30 year municipal bond, or a 10 year treasury note, three things are inherently true:

If interest rates rise, their market values will go down and it will be difficult to add to my positions… BUT my income (and their safety vis-a-vis equities) will not change; MARKET VALUE CHANGE HAS NO IMPACT ON INCOME, in high quality securities.

It is this “Interest Rate Expectation (IRE) Sensitivity” that CEF Investors are uniquely well positioned to take advantage of. All income focus securities (and funds that contain them) are impacted by IRE:

“Market Value Varies Inversely With Interest Rate Expectations”

The Net Asset Value (NAV) of CEFs is the sum of the values of hundreds of securities, inside a virtual “protective dome”, where only the manager can trade them. BUT we can “trade” the dome itself, reducing our cost basis and increasing our yield as we choose… something totally unimaginable in any othe income investment medium.

So this is precisely what is going on “inside” income CEFs right now. Individual security prices are being forced down by the expectation of rising interest rates and a significant discount is available. Absolutely nothing has changed with respect to the quality of the securities or the income being produced “Under The Dome”. The price of the dome has been reduced, and its “IN YOUR POCKET” income is rising.

Yes, that observation is correct, we can now accelerate the growing power of our Compound Earnings Machine

No change in the securities, their quality, or contractual payments… only the price of the package has changed. So there they are, investors, opportunities just waiting for you to pad your retirement portfolio pocketbooks with income over 6.5% tax free and up to 8.0% taxable.

These sweet discounts are only available through the financial genius of CEFs. Only here can “mere mortals” turn Wall Street’s blood bath into an income portfolio worth bragging about. There has been no news that suggests there is anything wrong with the “securities under the dome”.

So don’t be concerned with the “OMG, bond prices are falling” headlines… that’s Wall Street’s problem. This is the biggest CEF sale since 2011, and… the “Call to the Mall” has sounded!