2020Q4 Quarterly Client Newsletter

Dear Clients,

First, thank you, clients, for all your referrals over their years. I’m very honored that you trust me and have recommended my services to your friends and families. Your referrals have been by far the biggest source of growth for my business, so thank you for helping in my success.

Second, we will skip politics. I have covered the important topics previously. For now, we’ll wait until we see concrete plans from the new administration. It’s one thing to hit the campaign trail and say, “If elected I promise you …” It’s another to say, “I plan on enacting policy ABC via Executive Action XYZ” or “I plan on passing Law X by getting rid of the filibuster in the Senate.” (The Senate is still technically split until one party has a filibuster-proof 60-seat majority.) When we see actual policy proposals and, most importantly, a realistic path to how they might be enacted, then we can spend time analyzing the investment ramifications of any new laws.

What’s Happening in the Market

Instead, for this letter, I want to focus on some interesting happenings in the market. During the last half of 2020 and the start of 2021, the story has been a tale of two markets. We are seeing a rotation out of large established companies into smaller (although sometimes still large) more speculative stocks, especially stocks viewed as new, cool, and disruptive.

As I’ve often said, short of interviewing every person trading stock, you will never know exactly what causes short-term movements. Some reasonable and believable theories say that the excitement around the more speculative stocks is being driven by younger retail traders, especially those using the Robinhood app. Whatever the cause, it’s led to a likely bubble in small parts of the market.

The phenomena are not widespread enough to be a cause for general alarm. It’s confined to a small portion of the market. Investors are bidding up both existing companies and IPOs, particularly in areas seen to be disruptive. For example, they bid up the stock of an alternative energy company that is losing money or barely profitable stocks to record highs.

One way to spot discrepancies is to look at price-to-sales ratios. Price-to-sales ratios show how much money an investor is paying for every one dollar of sales a company makes. For instance, a price-to-sales ratio of 3 means that for every $1 in sales a company has, an investor is paying (or valuing) the company at $3. If the company had $10B in annual sales, then the company would be valued at $30B. Where more rational thinking prevails, price-to-sales ratios are typically lower than other valuation measures because companies have all sorts of costs that reduce profits, such as the cost to manufacture their product, pay staff, marketing, R&D, and more. That company with $10B in sales may only earn $2B in profit from those sales, for a 20% profit margin.

Imagine you were a private investor looking at a for-sale business and it was priced at 10 times sales. That means to recoup your investment over a decade, you would need every dollar of sales revenue to go to you. No revenue could be spent on the cost of goods sold, no employee salaries, no research to improve existing products or develop new ones, no replacements for broken equipment, and no tax payments. If you paid 10 times sales for a company with a profit margin that was realistic, say 20% profit margins, it would take 50 years for you to earn your purchase price back! A lot can happen in 50 years! Long time horizons may be okay, if you are sure the business will be around, but 50 years might be a stretch.

But, you ask, what if sales shoot up? Obviously, if you are paying a high price for the business you are expecting growth. What if the business you bought has sales that double every year? Then it would only take about five years for you to earn back your purchase price.

Remember, what we said about having to pay expenses on each dollar of sales? Companies have different amounts of fixed costs. Some types of companies may have very low costs. Software companies, for example, have a lot of fixed costs. Employee salaries, offices, and equipment are costs that don’t change much for each additional unit they sell. Let’s go old school for this example and assume they are selling boxed software. The company has to pay a few cents to have the disc pressed and the box and manual printed but profit margins for each additional unit are in the high 90s percentile. So, for companies with high margins and high incremental margins, a high price to sales ratio may make sense.

Based on our little crash course on price-to-sales, we know that if you are going to buy stock in a company that is trading at a high price-to-sales ratio, you need three things for the investment to be successful:

1. The company needs to have a business model that has high margins, especially on each incremental unit of product (or service) they sell.
2. Sales growth needs to be high.
3. Because the pay-back period may be very long you need to be reasonably certain the business will be able to continue in its current form for a long time (e.g., little to no competition).

What you can’t do is pay a high price-to-sales multiple for say a computer hardware company that only meets one of the three requirements listed above, high sales growth. Manufacturing businesses typically have mediocre profit margins so they fail number 1. The hardware industry is always changing, so it fails 3. If you invested in Sun Microsystems near the height of the tech bubble when it was trading at 10 times sales, then you should not have been surprised when it didn’t work out well. In fact, if you’ve been following the markets since then and have a good memory, you may recognize this little example in price-to-sales ratios and Scott McNealy’s (the founder and CEO of Sun) famous quote about the crazy valuation of Sun’s stock:

“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”

The Current Bubble

Below is a small selection of current hot stocks

(data as of 1/15/21)

Many of the hot stocks are manufacturing companies with low gross margins, while others are more of hybrid product/services companies. Only one, Tesla, actually turns a profit but even that is due to the sale of regulatory credits and perhaps some accounting jujitsu rather than underlying business profitability. Sales growth can only help so much. Remember in our example, for a five-year payback on 10 times sales, we needed sales to DOUBLE. All these stocks are well over 10 times sales. Additionally, many operate in competitive industries, such as automobiles and food products.

As a consequence of this speculation over the past six months, many stocks we own have fallen out of favor a bit. While the market fawns over the more speculative names, we will be sitting tight. There is no compelling reason to buy a fake meat company trading at 20 times sales or an electrical equipment manufacturer trading at almost 100 times sales rather than a solid company like MasterCard or Microsoft.

Market Update

With the current bubble in mostly unprofitable speculative companies it’s important to keep in mind the long  term performance of a strategy based on investing in quality companies. The chart below shows the long-term growth of $10,000 invested in our stock strategy compared to both the US market and the global stock market.

Global stocks returned 16.63% and the S&P 500 returned 18.40% for the year.

Here’s how other assets performed in 2020 so far:

US Total Bond Market: 7.75%
International Government Bonds: 4.75%
Investment Grade Corporate Bonds: 9.75%
Inflation Protected Bonds: 10.94%
Long Term Treasury Bonds: 17.7%
Real Estate: -4.55%
Emerging Market Stocks:15.51%

(All the returns listed are those of the ETFs we use.)

Again, as a reminder, your portfolio will contain a combination of most or all the investments listed, so its performance will be a blend of all the returns.

Reminder

Although you are all familiar with my investment management and retirement planning services, I want to take time in this newsletter to remind you of the other financial services I offer.

These services are available to clients as part of their comprehensive fee. I work with clients to build monthly budgets, help pick the best credit card offer, and give advice on their existing company retirement plans. Almost anything related to finance or money is something I’m available to help you with. I’ve even helped clients with non-financial things, such as picking out a new car. I enjoy helping clients, so please do not hesitate to give me a call. Shoot me an email or text if there is any way I can be of assistance.

How is Ben Invested?

Here is how my personal portfolio (my SEP IRA at FOLIO Institutional) is positioned for 2018.

My investment breakdown is as follows:

• 31% in our Capital Appreciation Folio
• 32% in our Concentrated Stock Folio
• 31% in our Aggressive Growth ETF Portfolio
• 1% in Real Estate (Vanguard Real Estate Index, VNQ)
• 1% in Emerging Market Stocks (Vanguard Emerging Market Index, VWO)
• 1% in Investment Grade Bonds (Vanguard Total Bond Market Index, BND)
• 1% in Inflation Protected Bonds (Barclays iShares TIPS Index, TIP)
• 1% in Municipal Bonds (iShares S&P National AMT-Free Municipal Bond Index, MUB)
• 1% in International Investment Grade Bonds (Vanguard Intermediate Term International Bond Index, BNDX)

As you can see, I have a stock-heavy portfolio. I believe our strategies for investing offer the best opportunity for long-term wealth creation.

Note: I also have an older IRA account opened during grad school. That account is invested in one stock, Philip Morris International (PM).

Sincerely,

Performance Disclosure:

The performance data presented prior to 2011 represents a composite of all discretionary equity investments in accounts that have been open for at least one year. Any accounts open for less than one year are excluded from the composite performance shown. From time to time clients have made special requests that SIM hold securities in their account that are not included in SIMs recommended equity portfolio, so those investments are excluded from the composite results shown.Performance is calculated using a holding period return formula, reflects the deduction of a management fee of 1% of assets per year, and reflects the reinvestment of capital gains and dividends.

Performance data presented for 2011 and after represents the performance of the model portfolio that client accounts are linked too, reflects the deduction of management fees of 1% of assets per year, and reflects the reinvestment of capital gains and dividends.

The S&P 500 and Dow Jones Developed Market Index are used for comparison purposes and may have a significantly different volatility than the portfolios used for the presentation of SIM’s returns.

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In providing you with financial products and services, or information about such products and services, SIM may collect public and non-public personal information about you from the following sources:

• Your account agreements and other related documents and forms (for example, name, address, social security number, birth date and financial information)
• Transactions with SIM

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