Passing It On: Death and Taxes After 2012

Diane Lane in Secretariat

In the 2010 movie Secretariat, Diane Lane portrays Penny Chenery, the main two-legged character in the story, who takes over running her ailing father's Meadow Stables in Virginia--and with it the fate of the future Triple Crown champion. After the father dies, Penny's brother informs her that they will need to sell Secretariat (then known as "Red") in order to pay the $6 million or so in taxes levied on their father's estate. Penny will have none of that, and she comes up with a successful plan to raise the needed cash by creating a breeding rights syndicate. Even though all ends well in the movie, the estate tax challenge here makes for a cautionary tale, especially given that estate and other taxes are set to return to more onerous--confiscatory, actually--levels on January 1, 2013.

Unless Congress acts to extend or modify the law, we will all wake up on the first day of 2013 to the expiration of the current tax arrangement known as the "Bush tax cuts," and that will mean at least two unwelcome tax increases. First, the estate tax personal exemption (the amount that an individual can pass on to his or her heirs free of estate tax) will go from the current $5 million amount to the $1 million amount in place before the tax cuts; estate tax rates will also return to their previous higher levels. The current maximum tax rate of 15% on qualified dividends will also expire, meaning that dividends will be taxed as ordinary income, at rates almost triple the current 15%. When I remind people of the potential for this coming change, the typical response I hear is that "Congress wouldn't do that." I then have to remind them that Congress doesn't have to do anything for this tax increase to happen--and doing nothing seems to be something at which Congress excels.

The movie actually does an excellent, albeit brief, job of dramatizing the problems with--and arguments against--the estate tax. The bottom line is that the government will take the majority of your lifetime's worth of saving, investing, or building a business with money that has already been taxed. Yes, the assets in your estate have been accumulated with after-tax dollars, but the government just has to extract more pounds of flesh at your death. As horrific as this is, it gets even worse when those estate assets are not liquid, the situation in the movie. If your estate mainly consists of stocks, bonds, and cash, then you know the worth of your assets at any hour of any given day. As ridiculous and frustrating as it is to hand over the bulk of that value to the government, at least there is the tiny consolation that the cash can be raised fairly easily to pay the taxes. However, if your main asset is a family farm or closely-held family business, then your heirs may have to sell the farm or the business in order to pay Uncle Sam. If you have been accumulating cash as a reserve to pay those future taxes, you must also realize that the cash will be taxed along with the rest of your assets because it is in your estate. One of the few ways to make provisions for the payment of those future taxes is with life insurance that is not held as part of your estate. If any of this is touching a nerve, I suggest that you pick up the phone and call your estate attorney without delay.

The estate tax is bad enough as a concept, but the situation is more pernicious if the exemption goes back to the $1 million amount. It is just not that uncommon today for someone who has been successful in life to accumulate an estate worth more than this threshold amount. Just add up the value of a home where the mortgage has been paid off; the market value of all jewelry, art, silver, and other personal items and collectibles; the market value of a vacation home; and an investment portfolio that has been built over a lifetime. Now throw in ownership of a small business. The point is that there are many people who don't think of themselves as millionaires, but who nonetheless will owe estate taxes at their death.

What are the odds that the worst will happen? The problem is that nobody knows, but I wouldn't bet heavily against it, because the worst is already baked into the cake. This is an election year, so we can expect more than the usual political demagoguery on the issue. The Republicans, I suspect, will not want to push an extension or other favorable outcome before the November elections, because the Democrats will then portray them as pursuing a policy that benefits only the affluent. Even if Republicans keep the House and gain control of the Senate and the White House, the newly-elected won't take office until after January 1. The path of least resistance, then, leads to the destination of the most pain.

From an investment standpoint, what will be the effect of a higher tax on dividend income? In theory, that depends partly on how much differential there is between the tax rate on dividends versus that on capital gains. Qualified dividends and long-term capital gains are taxed at the same rate under current law, but for years capital gains were taxed at the lower rate. Ceteris paribus (a Latin phrase favored by economists that means "all other things being equal"), taxing dividends at a higher rate than capital gains should cause investors to prefer growth stocks that don't pay dividends over more established companies that do, given the potential for investors to receive their return as a capital gain. Another attraction here is that you don't pay taxes on capital gains unless you take them, and investors do not have such control over the payment of dividends. However, there is no ceteris paribus in real life, because all other things are neither controllable nor constant. A dividend is a "bird in the hand," while a capital gain can be a more elusive winged creature. There is understandably much debate over the extent to which dividend-paying stocks will be affected by a tax increase, and the reality is that many other factors, including risk tolerance, come into play here. So, don't be in too big of a hurry to sell your Johnson and Johnson (JNJ, $65; 3.47% dividend yield) shares to buy more Priceline (PCLN, $720; no dividend). Also, the fact that seldom is mentioned in the tax debate is that dividends are taxed at a lower rate because that money has already been taxed at the corporate level. Instead, the politicians prefer the class warfare approach that paints dividend recipients as fat cats who get preferential tax treatment.

The mind-numbing absurdity of the tax increase is matched only by the mind-boggling ludicrousness of the surrounding political debate. Paul Krugman, the columnist for The New York Times, argues against major cuts in government spending because such reductions would be a threat to the fragile economy. I actually agree with him to an extent here, because draconian cuts could have such an effect if they were implemented right now. I would favor a multi-year plan that reduces government spending dramatically through major entitlement reform and other spending reductions, with those cuts agreed to now but phased in over the next few years as the economy strengthens. However, Mr. Krugman also opposes tax cuts, which would stimulate the economy arguably more than government spending; he is actually in favor of increasing taxes. So, how can he argue against spending cuts based on a concern for the economy and at the same time support tax increases? The answer is simple. Mr. Krugman is fine with the government taking more of your money in taxes as long as the government spends it all. His is an ideological position, not an economic one: he favors the government over the private sector.

If all of this has you boiling mad, then I suggest you consult your attorneys and accountants to try to minimize the damage if the worst case, but not unlikely, scenario unfolds. At least this Tax Sword of Damocles should give heightened urgency to my customary valediction:

Life is short. Get busy.

Jim


Disclosure/Disclaimer: My family members and/or I own shares of PCLN. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as investment advice or the recommendation to buy or sell any security.

Drinking the Bond Market Kool-Aid

Sideways?

While you may have been sleeping or otherwise engaged, the yield on the 30-year Treasury bond crept up from 3.0% to just under 3.5%, before falling back to the current level of 3.3%. Whether this move is the beginning of a trend of higher interest rates remains to be seen, but it gives us the opportunity to examine in more detail some thoughts about bonds versus stocks. The Kool-Aid in question here is the willingness of bond investors to accept near zero or even negative real returns (adjusted for inflation) in exchange for the perceived safety of their principal. Such acquiescence has been driven by fear--a fear that is understandable, and perhaps justified by the harrowing losses suffered by equity investors during the Great Recession and the market volatility that has followed. At some point, though, investors will return to their more normal behavior of seeking decent real returns. When and how that might unfold is a question worthy of our attention.

Low interest rates and surging federal budget deficits are not supposed to go together like peas and carrots, or love and marriage, or Angelina and Brad. At least according to economic theory, government's need to borrow in the credit markets should put upward pressure on interest rates and thereby "crowd out" the private sector borrowers who can actually make the economy grow. The theory, in its simplest formulation, fails to account for the foreign investors who have lots of cash to invest in our bonds because we sent it their way by buying their goods. For some years now we have enjoyed the happy circumstance of having eaten our cake and still having it. The Federal Reserve has been doing its share to help as well, buying bonds to keep interest rates low to stave off another economic downturn. History has taught us that some things that are unsustainable can, in fact, be sustained for long periods of time. But not forever.

With some notable interruptions and reversals, the trend in Treasury yields was up from just after World War II until 1981. Bond prices fall as yields rise, and vice-versa, so this amounted to a 35-year bear market for bonds. When those rates hit 15% in 1981, many investors were so accustomed to the prevailing trend that they didn't see the opportunity staring them in the face. That was, of course, the opportunity to lock in those high yields for a long bull market ride in bonds. Now, with those rates at historic lows, we have to ask whether they are likely now to go lower or start moving up again. This is not a matter of calling the precise turn in interest rates, but rather an exercise in evaluating what bonds, as an asset class, are likely to offer in the way of total real return versus what stocks, as an asset class, may offer. Barring another outright recession, it is difficult to make a case for lower interest rates, and even if yields do not move up dramatically, the status quo of bond returns leaves us with what one investor has called "return-free risk" instead of the risk-free return that the safest bonds are supposed to provide.

Then there is the matter of inflation. The prospect of a sustained rise in prices can be a tempting condition for indebted governments, because inflation transfers wealth from creditors to debtors. If I borrow money from you and then can pay you back with cheaper dollars, then I win--and you lose. Reported inflation can exclude food and energy prices, and this had one observer commenting that this is only good news for people who don't eat or drive or use electricity. It is the housing component that has kept reported inflation numbers low, because housing costs are heavily weighted in the measurement. If we start to get some distressing numbers on inflation, nominal yields will rise, and investors who bought long-term bonds at lower rates will suffer capital losses if they sell before maturity--and those who don't sell will nonetheless see paper losses.

The recent strength in the equity markets, accompanied by notably lower volatility, may be an indication that investors are growing weary of the Kool-Aid. If investors perceive that interest rates are going to remain low, then the subdued volatility and renewed strength in the stock market may cause investors to move from bonds into stocks, or at least to move cash on the sidelines in money market funds into stocks. As I write this (on Monday afternoon), Federal Reserve Chairman Ben Bernanke has been in the news saying that stronger economic growth is needed for more meaningful reductions in unemployment, thus implying that the last thing the Fed wants to see is an increase in interest rates. This reinforces investor perception that interest rates will remain low for, perhaps, the next two years. The Dow is up 160 points, so maybe today investors are forsaking the Kool-Aid and seeking a more rewarding adult beverage.

Here are two lists of stocks that you may want to research further:

Growth


Apple (AAPL, $606)
Celgene (CELG, $78)
Cerner (CERN, $78)
Costco (COST, $91)
Las Vegas Sands (LVS, $58)
Priceline (PCLN, $735)
Qualcomm (QCOM, $68)
Visa (V, $120)
Whole Foods Market (WFM, $84)
Yum! Brands (YUM, $71)



Growth and Dividends:


Abbott Labs (ABT, $60; 3.38% yield)
Automatic Data Processing (ADP, $55; 2.87% yield)
Boeing (BA, $75; 2.38% yield)
Coca Cola (KO, $71; 2.85% yield)
DuPont (DD, $53; 3.12% yield)
Eaton (ETN, $50; 3.08% yield)
Johnson and Johnson (JNJ, $65; 3.53% yield)
Kellogg (K, $53; 3.28% yield)
McDonald's (MCD, $97; 2.93% yield)
Philip Morris (PM, $88; 3.55% yield)

As I have emphasized before, my preference with dividends stocks is to accept lower yields in exchange for a more modest dividend payout ratio (the percentage of earnings paid out as dividends) and a history of dividend increases. We'll take a closer look at some of these stocks in upcoming posts and also consider the possible tax increase on dividends that may be coming with the expiration of the Bush tax cuts in January 2013.

Life is short. Get busy.

Jim



Disclosure/Disclaimer: My family members and/or I own shares of AAPL, CELG, CERN, COST, LVS, PCLN, QCOM, V, WFM, YUM, ABT, BA, DD, ETN, K, KO, and MCD. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as investment advice or the recommendation to buy or sell any security.

Should You Bite?

Robert Pattinson and Kristen Stewart in Twilight

Should you buy stock in a movie company this is about to release a motion picture that almost certainly will be a blockbuster hit? Tomorrow, March 23rd, Lions Gate Entertainment (LGF, $15.68) releases The Hunger Games, based on the hugely successful young adult novel by Suzanne Collins. There are more films planned in the trilogy. Also, LGF acquired Summit Entertainment in January, the company behind the popular Twilight Saga. This portfolio of movie franchises has not gone unnoticed by investors, as the stock of LGF is up some 87% since the beginning of the year. This release gives us an opportunity to look at how news--or hype--can affect stock prices, and the implications such headline-grabbing attention has for us as investors.

First, LGF is a relatively small outfit for a movie company, with a market capitalization of about $2 billion. This means that a blockbuster movie, or a series of them, is more likely to have a major impact on the stock price. Walt Disney (DIS, $43), in contrast, has a market cap of $77 billion, plus other assets such as ESPN, ABC Television, and their theme parks and resorts. Because of its sheer size, a major movie hit is not likely to move the needle very much for DIS. In fact, DIS has a major flop on their hands with the movie John Carter, which the company has said will lose them about $200 million, but that doesn't seem to be moving the stock price. The size factor comes into play with other companies and their new product launches. Proctor and Gamble (PG, $67) just came out with Tide Pods, a new version of their flagship laundry detergent that combines detergent, stain remover, and brightener in a ball that dissolves in the wash. A great product that will be a success for P&G, but the company is just too big for any one product to move the earnings and the stock price substantially. The bottom line is that The Hunger Games will be very important for LGF, and that is potentially both good news and not-so-good news for investors.

One of the basic investment principles that I like to emphasize here is that stock prices are based on expectations of the future. LGF's stock price over the last few months indicates that the expectations are running high for The Hunger Games, so it doesn't take a rocket scientist to figure out that a disappointment at the box office would crush the stock. But what if the movie is the blockbuster that everyone seems to anticipate? Well, that's the problem. If this success is already reflected in the stock price, then how much room is there for the movie to exceed expectations? Advance ticket sales are running strong, and the fact that many of them are for the initial midnight showing indicates a loyal--perhaps cult--fan base. Good news, you say? Not so fast, because everybody knows that. There is an old Wall Street maxim that says, Buy the rumor, sell the news. As that might have applied here, we would have, with remarkable 20/20 hindsight, bought LGF on the first stirrings that they had acquired the rights to a successful novel and then taken our profits as the hype of promotions and ticket sales crested with opening weekend. Following such general maxims is a bit like using your old great uncle's muscle spasms to predict the weather--you can't always rely on some old canard for investment guidance. It wouldn't surprise me at all, though, to see LGF's stock price falter a bit after a blockbuster opening.

The next logical question to ask about LGF is, What comes next? Movies are not Quarter Pounders with Cheese, and as the old show business saying goes, "You are only as good as your next big hit." I am typically not deterred from buying a stock just because it has already run up in price, but here it is important to recognize that for LGF stock to continue performing, the company will need to develop more successful movie properties. Then, of course, they have to bring those successes to the bottom line of earnings. Once we get past all of the hype surrounding the premier of The Hunger Games, I expect that the market will start focusing on the What Comes Next question.

LGF has not been a stock widely followed by Wall Street analysts, but it has been picking up some new coverage. Price targets I have seen on the stock range from $18 to $20, so the analysts who do follow the company still see some upside. So, I am not trying to dissuade you from investing in LGF, but that is a decision you have to make with your financial adviser after assessing your other risk exposure. The bigger picture (pardon the pun) here is that stock prices reflect expectations, and when those expectations are high, the only surprises are likely to be unpleasant ones. I read this week that tickets may have sold for almost every available seat at every showing for the opening weekend of The Hunger Games. There may be no disappointments when the headline numbers are evaluated Monday morning, but seating capacity alone would seem to limit the extent of any upside surprise. It is important to note, also, that LGF is about more than just this one movie franchise, although I have little doubt that the movie has been the one factor driving the stock's recent run. LGF also has a portfolio of television shows, including Nurse Jackie, Weeds, and Mad Men. The company recently was able to fend off a takeover attempt by fabled investor Carl Icahn (who reportedly sold many of his shares at $7), and has announced plans to pay down debt. If LGF can continue to develop content, especially in the popular young adult genre, they may have a long-term future as much more than just a one-trick pony with sequels. Take me to the movies.

News:

http://www.miamiherald.com/2012/03/19/2702273/lions-gate-shares-rise-before.html

http://www.bloomberg.com/news/2012-03-20/-hunger-games-transforms-ex-icahn-prey-lions-gate-into-predator.html 

http://www.lionsgate.com/

Life is short. Get busy.

Jim

Please post your questions to the Comments section of this blog, and I will answer them in upcoming posts.

Disclosure/Disclaimer: My family members and/or I own shares of DIS. Individual stocks are mentioned here for the sole purpose of illustrating investment concept, and nothing stated here should be construed as investment advice or the recommendation to buy or sell any security.

The Wisdom of Mad Men

My wife and I are very excited that Mad Men, one of our favorite television shows, will be back on Sunday nights with new episodes after a one-and-a-half year absence. The series is engaging for a number of reasons, including the quality of the writing and the authenticity of its 1960s period setting. I am sure, also, that Don Draper serves as something of a vicarious role model for some male viewers, those who might think that drinking and smoking and having sex all day and night would be one great way to run a successful business. Mr. Draper is no model of moral rectitude, but if we look past his obvious (and entertaining) flaws, we might find some qualities that offer some insight about investing--or, more specifically, the business of investing.

In one particularly memorable episode from last season, Don and Peggy are working late in the office, and Don is hitting the bottle to deal with his latest personal crisis. During one scene, Peggy complains to Don that he doesn't express appreciation for her hard work and her contributions to the advertising agency. Don replies, "That's what the money's for." Yep, that is indeed what the money is for (although I would hasten to add that non-monetary rewards are extremely important and effective, so I can't recommend Don's playbook here). When it comes to investing, we are dealing with one pursuit that hands us an objective measure of our success 24/7. We can conduct the most thorough research in the world, but if that research is not translating into a portfolio that outperforms the market, then we can't call that success. We also need to make the fine distinction between measurement and evaluation. The former is constantly with us in the form of stock prices and portfolio values, but we need to view the latter over longer periods of time, quarters and years instead of days. The reality, though, is that if we could have achieved the same performance by investing in an index fund, then we are either wasting our time or needlessly paying commissions and fees to some investment professional. In a strong bull market, investors are especially prone to think that they are smarter than is actually the case when they are seeing their portfolio rise in value. If they aren't beating the benchmark (such as the S&P 500), though, then all they can claim is that they were along for the ride.

While Don Draper may be lacking a "true north" on his moral compass, he is a paragon of fidelity when it comes to his own business success. Draper understands the advertising business, and when you understand completely how something works, you gain a sense of when you need to break the rules. When his agency loses the major account of a tobacco company, Draper launches his own anti-smoking campaign. That's a form of jujitsu, or using your opponent's strength to gain your own advantage. Just because I wouldn't want my daughters to get anywhere near Don Draper doesn't mean that I can't admire his ability to get the job done at the office. I would hire him in a heartbeat to handle an ad campaign. As this applies to investing, I must stress my belief that Don's appeal is rooted in his business skill and not just his ability to attract some dumb luck. His understanding of--and insight about--his business are the qualities that allow him to be unconventional.

"If you don't like what's being said, change the conversation"

---Don Draper

The investment business is full of conventional thinkers, and I'll call them "The Conventionals." The Conventionals today will recommend a stock like Cisco Systems (CSCO, $20), the maker of computer networking equipment. Now, CSCO may actually be a good investment today, but what I want to know is where the Conventionals stood 20 years ago when the company was growing like kudzu. No, back then CSCO was too risky. Now that the stock trades at roughly a market P/E multiple and is down some 20% over the last five years, you might just want to wade in. That's fine, but you're not likely to see the blistering growth that the stock delivered in the 1990s. The Conventionals then were probably buying Eastman Kodak, because people will always need film for their cameras. They love to go rummaging in the dust bin of faded glory.

I have to give some credit here where credit is due, so I'll mention that The Motley Fool investment advisory service (http://www.fool.com) has a portfolio of recommended stocks they call "Rule Breakers." This is one of a number of subscription services that I use to generate stock ideas. As the name suggests, this service is all about finding those companies that are either remaking their industries or creating completely new industries. (Think of Fred Smith and FedEx.) One investment theme that I find especially interesting right now is the potential for natural gas as an energy source (if the White House would get out of the way).  Westport Innovations (WPRT, $47) is a company I have mentioned before here. They make the technology that allows diesel engines to run on natural gas. The more established Cummins Engine (CMI, $128) already has a strong presence making truck engines, and they have a joint venture with WPRT. As an investment, CMI is partially a play on China's growth, and the Chinese may very well beat us in adopting natural gas as a fuel source for heavy-duty trucks. Also, while the Conventionals are doing some bottom-fishing for the big pharmaceutical companies like Merck (MRK, $38) and Pfizer (PFE, $22), we might want to check out some of the biotechnology stocks like Celgene (CELG, $75) and Alexion Pharmaceuticals (ALXN, $89). Those are ideas for further research, and interested investors should perform the necessary due diligence and talk with their financial advisers to fully understand both the risks and the potential rewards.

I'll wrap this up with two caveats. First, CSCO, MRK, and PFE are great companies and may be rewarding as stocks. The point here is that investors who understand the risks--and can afford to take some risk with the growth portion of their portfolios--need to be aware that conventional ideas are conventional for a reason. The potential for big rewards always comes with the potential for major losses, so the unconventional ideas are not for everyone. Even those who can take the risks need to adhere to our rules for diversification. Second, when it comes to money, I am not at all suggesting that money is the chief measure of success in life. As long as we go about our business legally, honestly, and ethically, then money is just a yardstick for measuring our success at investing. More revealing of true character is what we do with our gains, and I have always believed that a person's checkbook says more about his character than what he does for a living or how much is in that checkbook. It is the love of money, not money itself, that is the root of all evil.

******************************************************

If Don Draper is the archetype of the character who achieves successful ends through unconventional means, then another such example might be Hawkeye Pierce from M*A*S*H. Unlike Don Draper, Hawkeye actually has a firmly grounded moral center, and it is Hawkeye's view of the Korean War as immoral that gives us a character who continually thumbs his nose at military authority and protocol. (Don also has a history in the Korean War, which faithful devotees of Mad Men know all about.) Hawkeye and Trapper John are able to get away with their anti-establishment antics because they are so good at what they do--they are two of the best surgeons in the U.S. Army. Were it not for their skill in the operating room, they would have certainly faced court martial for numerous infractions and insubordination. While the television series is on in reruns, I am actually thinking of the 1970 movie, which is available on dvd. It's worth watching again if you haven't seen it in some time.

Mad Men returns with a special two-hour episode this coming Sunday, March 25th, on AMC (http://www.amctv.com/shows/mad-men).

Life is short. Get busy.

Jim

Disclosure/Disclaimer: My family members and/or I own shares of WPRT, CMI, CELG, and ALXN. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as investment advice or the recommendation to buy or sell any security.

Pub Crawl

 
Regular readers of this blog know that I have found my wife's money-saving shopping habits to be a source of both fascination and inspiration. One of her favorite haunts, Dollar Tree (DLTR, $91), has saved us a few bucks and made us even more as an investment--the stock is up some 40% over the past six months. One of the many things I love about my wife is that she is the most responsible person I know when it comes to money, but she will not hesitate to pay up when quality really matters. I thought there might be more to learn from observing her ways, so a few months ago I started paying more attention to the contents of her grocery shopping bags, specifically noting when she chose to buy name brands and when she opted to save by going for the generic or store brands. She still brings home the bacon from Oscar Meyer, Kraft cheese singles (but she gets both of these by the boatload at Costco), and Kellogg's cereals. As the contents of her bags were unloaded onto the kitchen counter recently, I counted store brand versions of the following: aspirin, yogurt, milk, eggs, saltine crackers, pasta, honey, and the canned, condensed soups used in casserole recipes. And then I saw it. Amid the pile of bargains sat the gleaming treasure, a testament to rare brand indulgence: her six-pack of Sierra Nevada Pale Ale. That's when I realized that there is no such thing, at least to my knowledge, of store brand beer. Beer drinkers are fiercely loyal to their brands, and the brewers offer up varieties to appeal to every taste and pocketbook in the marketplace, from Keystone Light to Stella Artois. (I'm actually a Bud Light guy.) Just pick your price point and taste--and drink up!

With St. Patrick's Day coming up, I thought we'd take a look at some of the beer companies, and we can start by tapping the keg of history. Like many iconic American corporations, the beer breweries started out as "Mom and Pop" (mostly Pop) operations. Adolphus Busch immigrated to the United States from Germany in the middle of the 19th century and settled in St. Louis. He married Lilly Anheuser and acquired a father-in-law,  Eberhard Anheuser, who was also in the brewing business. The two men became partners and established the Anheuser-Busch company. About this same time, two other German immigrants, Adolph Coors and Jacob Schueler, were setting up a brewery in Golden, Colorado. A few years later Coors bought out his partner and became the company's sole owner. Students of the American entrepreneurial spirit will take note of how these businesses survived Prohibition. Anheuser-Busch just shifted to the production of non-alcoholic beverages, while Coors had diversified into the porcelain business. Coors also started making malted milk, an operation that they subsequently sold to the Mars candy company after Prohibition ended. For years, Coors was available only west of the Mississippi River, and it just seemed to taste better because it was a rare and unattainable treat (now that it is in all the grocery stores, it doesn't seem to taste as good as it did then). Whenever someone showed up in Memphis with the smuggled contraband it was like some sort of banned caviar had arrived--or a stash of Playboy magazines, given the male adolescent mindset (I was 17). Such Coors-smuggling escapades even made for the plot line of a 1977 movie, Smokey and the Bandit.

Beyond those origins, tracing the genealogy of brand ownership is a bit like figuring out who used to be married to whom in Memphis--it's a bit complicated. When Philip Morris was diversifying away from the tobacco business, they ended up owning everything from Miller beer to Jello-O. Philip Morris later sold Miller to South African Breweries (SAB), now known as SAB Miller. Meanwhile, Coors merged with Molson of Canada in 1995 to form Molson Coors (TAP, $42). About that same time, SAB Miller and TAP combined their U.S. operations in the joint venture known as Miller-Coors. Several years ago Anheuser Busch was bought by Belgium's InBev, which is now known as Anheuser Busch Inbev (BUD, $69), and this combination brought Budweiser and Michelob brands under the same corporate ownership as Stella Artois and Bass. Among the smaller companies known as craft brewers, Boston Beer (SAM, $102) makes Samuel Adams as well as the Twisted Tea malt beverages and hard ciders under the labels Angry Orchard and HardCore. Sierra Nevada Brewing is a private company founded by homebrewers Ken Grossman and Paul Camusi in 1980.

As potential investments, the beer companies offer the brand loyalty that I find very compelling in a stock, and their marketing prowess is evident right down to their choices for ticker symbols (TAP, SAM, BUD). However, the companies also face a few headwinds that keep me from buying shares. Commodity (barley) cost inflation has hurt margins, for one thing. The key demographic beer drinker is the legal-age male, the group where employment issues are most troubling, and the broader market seems to be undergoing a cultural shift towards wine and spirits as the beer drinkers are gravitating more towards the higher-end craft beers. There's a lot of stability here, but not very much in the way of exciting earnings growth. TAP does offer a 3.0% dividend yield, a low 35% payout ratio, and a nice track record of dividend increases, but the stock price has been, well, flat over the past year. TAP did announce last week the launch of Coors Light Iced Tea, a bid to appeal to the wine and cocktail crowd. I owned BUD for years, but sold out when the stock jumped on the Inbev acquisition. I'll stay on the sidelines for now, but any business with such brand loyalty is worth watching.

And here is another bit of trivia. You may be aware of the annual tradition of dyeing the Chicago River green for St. Patrick's Day, but you may not know how that tradition started. It seems that about 40 years ago some plumbers were using dye to detect pollution leaks into the river when they realized that the dye created a hue reminiscent of Ireland. That's the Luck of the Irish for you.

On a personal note, one thing I will say about beer is that I like its self-control mechanism. My tummy gets full long before I get the idea that a lampshade might make a nice fedora, or that my friends really want to see how cute I look in my Lilly Pulitzer boxer shorts. My advice would be to just forget about the investments on St. Patrick's Day and enjoy the beer and revelry. Oh, and take a taxi--unless you want your last stop on the Pub Crawl to be the holding tank at 201 Poplar.

Life is short. Get busy. And Cheers!

Jim


Note: Wikipedia was the source for the historical information in this post. For non-Memphis readers, 201 Poplar is the address of our local jail.

Disclosure/Disclaimer: My family members and/or I own shares in DLTR. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as advice to buy or sell any security.

Hooking the Big Marlin

Deep sea fishing is one of the few outdoor activities that I truly enjoy (the others involve sitting on a nice beach with some cold beer and a good detective novel), and one key to a successful expedition--in addition to the cold beer--is an experienced captain. Whenever I am looking to book a private charter, I like to conduct a little due diligence by walking the docks in the late afternoon after the boats have come in for the day. I want to find myself a captain who wears his experience on his face, that weathered and crusty look that suggests many a day spent on the high seas, a modern-day Ahab with instinct to supplement his instruments. (I definitely don't want the captain who looks like a moonlighting Armani model.) Someone like Quint in Jaws--who never got the chance to buy the "bigger boat" that Brody recommended because he was an afternoon snack for the Great White. Great captains know where to go to catch the fish.

Now, you probably wouldn't charter a deep sea fishing trip and then insist to the captain that he take you to  that one place in the ocean where no one ever catches any fish. If you did, the captain would tell you that all you'll get for your money is a boat ride, and if he's crusty and grizzled enough he might tell you to your face that you were nuts. At least he would suggest that there are reasons why fish aren't caught in certain places. But you would then remind him that you're paying and you want to avoid the hot fishing spots and discover something that every other fisherman has overlooked. You might even call this your contrarian approach to hooking a big one. As crazy as this sounds, it is how some investors go about choosing stocks. When investors look at those stocks that have been moving up strongly on continued good news from the companies, they may tend to assume that it is too late to invest in those stocks. They then turn their attention to some stocks that have not made such impressive moves. Especially in a strong market, which we have certainly been experiencing lately, investors may conclude that they have missed out on some opportunities and then go trolling for the laggards.

Investing is not fishing, of course, and we definitely want to "buy low and sell high." The challenge is that what has moved up is not always as high as we might conclude, and what has lagged is not always as cheap as it might appear to be. I always emphasize that diversification is crucial, and here we want to understand that diversifying means more than just buying a lot of stocks in different industries. We should also think about diversifying across different investment styles. The value approach can be quite rewarding, but we have to distinguish between those stocks that are under-priced for some temporary reason and those stocks that are down for very good reasons. When we looked at the potential for "bear traps," I cited Radio Shack (RSH, $7.00) as a stock that looked cheap because it had declined significantly--but one that seemed to lack any catalyst to move in the other direction. If we can steer clear of such traps we can realize very good returns by focusing on value. However, we might also think about devoting a portion of our portfolios to more aggressive growth situations. These stocks, sometimes known as "momentum" stocks or high relative strength stocks (meaning they have been strong relative to the market and thus outperforming), look anything but cheap, at least at first glance. Priceline (PCLN, $640), the online travel booking company, has a price-to-earnings (P/E) ratio above 30 and shows a total return of over 1,000% over the past five years. The company reported stellar earnings after-hours on February 27th of $5.37 per share versus a consensus estimate of $5.05, and the next day the stock was up 41 points, about 7%. A move like that is enough to scare some investors away from buying (and give them some bruises from kicking themselves for not having bought earlier). However, we need to look a little deeper. PCLN has shown earnings growth well above the P/E ratio, and they are projected to continue growing earnings at about a 30% annual rate over the next three years. When we compare the P/E multiple to the growth rate (to get the PEG, or price/earnings to growth number), the valuation seems less daunting. A good rule of thumb is that the PEG ratio should be less than 2. A higher P/E is consistent with higher earnings growth, and that's what investors are paying for. After the earnings report several research analysts raised their price targets on the stock, now ranging from about $725 to $850 per share.Remember, also, that the absolute price of a stock means nothing unless we compare it with  earnings and earnings growth. With stocks trading in the triple digits, I find it helpful to divide the stock price by 10 in my thinking, so that the move in PCLN is like a $59 stock going to $64.

We'll take a brief look at some other names in a moment, but first let me emphasize (again) a couple of key points. First, always do your homework on a stock's fundamentals. A stock can rise dramatically based more on speculation than on sound fundamentals, so we always want to make sure that we've studied sales, margins, and earnings. Also, we need to read the reports from the analysts. I want to see earnings estimates and price targets moving up, not staying put. Second, diversify, diversify, diversify. Don't put all of your eggs (especially your nest eggs) in one basket. Momentum-type stocks can fall dramatically at the first whiff that the growth story may be faltering. Just look at NetFlix (NFLX, $108), once a tremendous growth story that traded at around $300 last July, but has plunged over concerns about the future viability of the company's business model. Knowing the fundamentals and being diversified are the two best ways to protect ourselves, and it's a good idea to take some profits when stocks have had major moves. We can hang on to our winners, but trim them back so that no one stock represents too great a percentage of our portfolio.

With those caveats, I still say that venturing into these waters can be extremely rewarding. Please note that the focus here is on companies that already have a successful track record of strong growth and profitability, not on smaller and newer enterprises that, for all the potential they may offer, have not yet "shown us the money." As an example, Zipcar (ZIP, $13) is a car-sharing service that has had success in urban areas where many people don't own cars but may need one for just a few hours every so often. ZIP hasn't gotten any real traction yet, and the shares are down more than 50% over the past year. It's an interesting concept, but the big guys like Avis and Hertz already have rental fleets and likely pose a competitive threat. Nobody really knows yet whether ZIP can make a real success out of this. Here we are looking at companies that are already quite successful, and their success is reflected in their stock prices. I recall quite clearly how hard it was to buy shares of Microsoft (MSFT, $31) back in the early 1990s--hard because the stock had already increased substantially in value and the P/E multiple was high. Investors who bought anyway were handsomely rewarded, as the stock continued to outperform the market.With this type of growth investing we are putting our money in strength--strength in the stock price that is backed up by strength in the company's fundamentals. Some people cynically refer to this type of investing as "buy high, sell higher." That may be true, but we have to accept the fact that a truly successful company is not going to go unnoticed by the stock market. When we devote, as we should, some portion of our portfolios to value stocks, the ones that the market is not rewarding with buying pressure, we are essentially taking the position that the market is wrong, and that we are smarter than the market. That approach also carries risk--the risk that the market is right and the stocks are cheap for a reason and may get cheaper. With the growth portion of a portfolio, I am willing to take the risk that the market is right, but that the company's prospects are even more favorable, for a long period of time, than the market has priced into the stock.

In addition to PCLN, here are some names that are showing momentum in terms of earnings and stock price. Potential investors should pursue additional research and consult their financial advisers before committing funds to these stocks.

Apple (AAPL, $534)--In the unique position of being both a growth stock and, arguably, a value stock. If AAPL were to trade at a P/E multiple closer to that of PCLN, the shares would be priced close to $1,000. As it stands, AAPL trades at close to a market multiple.

Autozone (AZO, $383)--The "Do-It-Yourself" retailer of auto parts also has growth opportunities in the "Do-It-For-Me" (commercial) market. A play on the increasing age of the average car in America, there is some concern that a sustained rise in gas prices could prompt consumers to accelerate their purchases of newer, more fuel  efficient vehicles.

Cerner (CERN, $75)--A leader in health care technology that should benefit with the continued adoption of electronic health records.

Dollar Tree (DLTR, $91)--Several of the discount stores fit this profile, including Ross Stores and TJ Maxx. Somewhat of a defensive play, the thesis here is that the companies would still do well as the economy improves, because they save consumers money.

Intuitive Surgical (ISRG, $508)--Makes robotic surgical systems.

Lululemon Athletica (LULU, $68)--The growing source for high-end yoga and fitness apparel.

Verifone (PAY, $51)--Electronic payment terminals and other payment technologies.

Whole Foods Market (WFM, $80)--A major trend toward healthier eating.

Yum! Brands (YUM, $66)--Not healthy, but growth opportunities for Kentucky Friend Chicken, Pizza Hut, and Taco Bell in other countries.

Following this strategy will no doubt produce a few losers. That's why there is something known as "catch and release"--we can sell them. If we are skilled at picking our stocks, however, we may end up with a few stocks that are multi-year winners, long-term successful companies that can make up for the ones that didn't work. When you do end up reeling in the big one, you might want to consider having it mounted as a trophy you can hang on the wall. That would be called your child's college diploma.

Life is short. Get busy.

Jim


Disclosure/Disclaimer: My family members and/or I own shares of AAPL, AZO, CERN, DLTR, ISRG, LULU, PAY, PCLN, WFM, and YUM. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as a recommendation to buy or sell any security. Prospective investors should consult their financial advisers before investing in any stock.

Why Dividends Matter

When I talk with people about investments and mention how much I like dividend-paying stocks, they often look at me as if I had suggested they spend their next vacation watching marathon reruns of Murder, She Wrote on cable. Boring, in other words. Many people who look at investing in an abstract sense, as opposed to the nuts-and-bolts experience of stock selection, intuitively understand that there is some trade-off between dividends and growth. Since most investors want stocks that offer them growth in the form of capital appreciation, their assumption is that dividends are anathema to their goals, a signal that the company does not have superior growth prospects in which to invest. To some extent they are correct, since companies can do one of two things, essentially, with their earnings--they can invest in the company, or they can return that money to shareholders, either by buying back stock or paying dividends. The problem with such an overly simplistic view is that it represents a form of binary thinking--a company either pays dividends or it doesn't. Today we'll critique that view and examine the most productive way to look at dividend-paying stocks as part of a diversified portfolio.

Let's start with some basics, and most basic of all is that the fundamental role of the corporation is to create and maximize shareholder wealth. If you have been reading Paul Krugman's column in The New York Times or listening to a certain brand of political commentary, you may think that the corporation's basic role is to save the whales, or eliminate income inequality, or solve a host of other societal ills. Now, don't get me wrong here. I firmly believe that businesses should be good corporate citizens, and that they should be held to account when their actions cause harm to society. What I am saying is that if corporations aren't successful at their basic responsibility to their shareholders (owners), then they will not be around to create jobs, contribute positively to their communities, or do anything else that falls under the heading of "corporate responsibility." The payment of dividends is one way that a company can be "shareholder-friendly." The average annual return from stocks in general over the last 80 years has been just under 10%, and about 40% of that return has come from dividends. Dividends are often referred to as the "bird in the hand" part of total return, because even if a stock's price might rise, fall, or remain stagnant with the up and down movements of the overall market, the dividend return is typically more stable and reliable. This is also known as being "paid to wait" for the capital appreciation part of a stock's total return.

If I wanted income, I'd invest in bonds. Oh, if I only had a dollar for every time I've heard that one. Like many misconceptions, though, there is a solid grain of truth here. My approach to dividends is not to view those payments as income, but rather as just a portion of the total return I'll get from a stock. As I noted in my last post here, the meager annual interest income available from the safest bonds right now stands a good chance of being overwhelmed by both the erosion of purchasing power and the decline in the market value of bonds should interest rates rise. My assessment of the total real return likely from stocks versus bonds leads me to favor stocks. The goal of investing, in my playbook at least, is to seek out the highest potential total return. In my hunt for potential stock investments, I regularly run a series of screens to identify stocks with certain characteristics so that I can conduct additional research. My regular readers will not be surprised that those screening parameters involve earnings growth, earnings estimate revisions, relative strength, and various valuation measures. Very rarely do I screen for dividend-paying stocks, but I definitely pay attention to the dividend characteristics of the stocks identified by my screens. The take-away here is that instead of investing for dividends per se, we should stick to those qualities that are most likely to lead to capital appreciation, but then consider how the dividend payers can either enhance total return or reduce risk.

Another mistake some investors are prone to make is to assume that a higher dividend yield is preferable to a yield that is lower. There are at least two reasons to proceed with caution here. First, the list of highest-yielding stocks is likely to confirm the "boring" perception. It is crucial to evaluate a stock's dividend payout ratio (the percentage of earnings paid out as dividends), because if that ratio is too high (above about 65%, for example) it can mean that the company really isn't investing much in its own growth, probably because it doesn't have growth opportunities. Utility companies have historically been favored by investors seeking dividend income, but that's probably not where you are going to find growth. Also, a high payout ratio can be troubling because the company does not have its dividend well covered by earnings. For companies that have stable earnings, such as those in the consumer staples sector, a higher payout ratio can be more acceptable, but for companies with more cyclical earnings, a downturn in profitability could put the dividend in jeopardy.

The icing on the cake here is the potential growth in dividends. As I've noted before, if you buy a $100,000 bond that pays you $3,000 a year in interest, the bond issuer is never going to increase your interest payment because more money is available. The second reason I actually prefer some stocks that have more modest yields is that their potential for earnings growth can also mean dividend growth. While a company's  history of increasing dividends is no guarantee that such increases will continue, most companies are loathe to cut their dividends, and a number of firms can increase dividends each year without increasing the payout ratio because earnings are growing. Here is a list of some companies that have increased dividend payments by 10% per year, on average, over the last 12 years:

Abbott Labs (ABT, $57; 3.60% yield, payout 68%)
CVS/ Caremark (CVS, $45; 1.46% yield, payout 25%)
Eaton (ETN, $52; 2.9% yield, payout 39%)
McDonalds (MCD, $100; 2.79% yield, 53% payout)
Nike (NKE, $108; 1.34% yield, 31% payout)
PepsiCo (PEP, $63; 3.25% yield, payout 51%)
Schlumberger (SLB, $78; 1.39% yield, payout 30%)
TJX (TJX, $37; 1.03% yield, payout 20%)

Worth noting here is that Walgreen (WAG, $33), chief competitor to CVS, has a dividend yield of 2.68%, payout of 31%, and a similar history of dividend growth. WAG stock has not done well since the company and Pharmacy Benefits Manager (PBM) Express Scripts (ESRX, $53) could not come to terms to renew their agreement at the end of 2011. This hurts WAG and helps CVS, which several years ago bought its own PBM, Caremark. Once again, the fundamentals of the company and its prospects always trump dividend yield alone.

The $100 billion question on the minds of many investors is, Will Apple (AAPL, $544) start paying a dividend?  My honest answer is that I don't care. I want AAPL to do whatever they see as being in the long-term best interests of the company and their shareholders. If that means investing their cash hoard in an iPhone 500 that will brush my teeth for me, then by all means they should go for it. I don't want a dividend as long as they have better investment opportunities for the money. If the company does initiate a dividend, I would expect the stock price to jump in response. Some investment accounts can own only stocks that pay dividends, so some new buyers would likely be picking up shares of AAPL.

The approach I have outlined here applies to how dividends can work in an otherwise growth-oriented portfolio, mainly by giving the investor a source of return other than capital appreciation, a "bird-in-the-hand" that can grow over time. It is certainly possible to construct an equity portfolio that is explicitly designed to generate income, possibly by investing in stocks of limited partnerships, real estate investment trusts, etc. Investors should be wary of stocks where the dividend yield is abnormally high compared with the stock's  history and its industry, as this can signal trouble. That is why it is important to know the fundamentals and check the payout ratio.

Finally, another company I'll mention here is Disney (DIS, $42; 1.44% yield, payout 23%), which recently increased their dividend payment by 50%.  The increase  sends a signal that management is confident in the company's future, which no doubt has helped lift the stock price. And when it comes to being shareholder-friendly, that move almost qualifies as pure "Southern Hospitality."

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If you have any questions, please use the "Comments" section of the blog to post those, and I will plan on devoting some space to "Questions and Answers."

Life is short. Get busy.

Jim

Disclosure/Disclaimer: My family members and/or I own shares of ABT, CVS, ETN, MCD, NKE, SLB, TJX, ESRX, AAPL, and DIS. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing  here should be construed as investment advice or the recommendation to buy or sell any security.