October 2, 2018

The Investment View from Prescott, Arizona

Cherry-Pick Winning Stocks

When you buy an index fund, you own all the stocks in that index – the good, the bad and the ugly.

Since its highest ever price of $60.00 per share on August 28, 2000, General Electric (Symbol: GE) lost 60% of its value over 18 years before being removed from the venerable Dow Jones Industrial Index of 30 stocks considered representative of our economy.

If you owned the Dow 30 Index during that time, you would have endured holding GE for 17 years after it was time to sell it according to my formula.

The way I see it, to be a successful investor, one should keep more money in investments going up and less in investments going down, adjusting portfolios as needed to stay within these guidelines.

Indexes that lock you into losing stocks for 17 years are recipes for mediocrity, at best, and during market declines, where every stock can become a stinker, index investing can be a disaster.

What I think works best is to screen the list of stocks in an index and own only a few of the best, leaving the losing stocks for other investors to hold.

I screen stocks looking for good earnings, lower debt and other financial characteristics. Then I focus the quality of trend of those companies, focusing on those with smoother upward momentum before turning to my charts to tell me which stocks are the timelier buys. I normally end up selecting holdings for my clients from the top 10% of an index, cherry-picking so to speak.

Our stock selection process has been so effective that we do not have to stay fully invested to keep pace with indexes, and in this way we take much less risk while pursuing growth.

What The Markets Are Doing

The stock market, represented by the S&P 500 Index**, took a breather during September, with zero gain from August 29-Sept 28, 2018, but considering that September is historically one of the worst months for stocks, no loss is a good sign.

We are experiencing an extremely strong economy with the lowest unemployment claims in 49 years. Those who want to work are finding jobs. Economic growth measured by GDP is 4.2%, much higher than we have seen in almost 4 years.

Normally we see a stock market swoon in the months before the mid-term elections as nasty rhetoric spooks investors, but despite all the ugly news out of Washington in the past few weeks, the financial markets are remaining calm, which I take as a very good sign.

Much of the market strength is due to the new tax law this year. The biggest news is that corporations now have the incentive of lower taxes here to return cash earned abroad to the US. According to CNBC, US corporations have “repatriated” over $300 billion of the $1 trillion kept overseas. This cash surge has buoyed both financial markets and the value of the dollar as corporations put that money to work.

But individuals also are reaping tax benefits that add to spendable income. Lower tax rates are one direct benefit, but as a Daily Courier article pointed out, APS, the electric provider for much of Arizona is lowering electric bills by about $8 per month to allow $119 million in tax savings they received to flow through to its customers. There are many similar stories of how the tax act has had positive effects on the average American, boosting consumer confidence.

On August 28th, a Reuters article stated “U.S. consumer confidence surged to near an 18-year high in August, as households remained upbeat on the labor market, pointing to strong consumer spending that should help to sustain the economy for the remainder of the year.”

Bonds took a hit in September as interest rates continue to climb as the FED takes advantage of strong stock markets to keep hiking interest rates. The benchmark 10-Year Treasury yields jumped about .20%, hammering the resale values of existing bonds. The iShares 7-10 Year Treasury ETF (Symbol: IEF) dropped 1.2% of its value in September.

Higher interest rates overseas are making foreign bonds more attractive compared to when many of them had negative interest rates, creating the competition for US bonds that we have not seen in several years. This, along with steady FED tightening of the money supply may be adding to the push to higher interest rates in the US.

Gold has chopped sideways for over a month, resulting in a tiny loss of value for the yellow metal in September.

Oil prices are the highest in almost 4 years. Increased energy demand is another sign of good economic activity around the world.

Foreign stock markets finished September strongly despite both developed and emerging markets indexes posting losses for the month.

What’s Happening in Your Portfolio

Letting The Clutch Out

For most of the summer we have been in capital preservation mode due to the high risk presented by the weakest year in the presidential cycle and normal summer market weakness, with September being one of the weakest months of the year, on average.

In this position, we expect to make money slowly, as our main focus is to avoid losing money if the market turns suddenly down. As I often say I would rather give up opportunity than cold hard cash, and this was one of those times.

Last week I began to shift gears and pursue more growth as we near the end of the traditionally weaker periods for the stock market. In our Shock Absorber Growth* strategies, I put some of our cash back to work by buying 6 more exciting Future Technology* stocks and 3 more in Targeted Growth*. If those stocks continue their leadership, money will be added to them, building up to a fully invested position.

This method of averaging into a holding is a risk management technique. If the stock heads south right away, we have little money at risk. After some gains, I’ll buy more of the stock, and then if it heads south we are giving up mostly our gains and not our original principal. Playing with house money as they say in Las Vegas.

It feels like I am letting the clutch out on a powerful new sports car, and when I do this the returns over the next few months are often very good. Stay tuned . . .

Gold has not been performing well, and just chopping sideways. I can make gains if gold goes up or if it goes down, but when there is no trend, I just hold that portion of the portfolios in cash until another trend presents itself.

Bonds and related income investments took a pretty good hit in September as interest rates spiked up again. Although our Flexible Income* strategy continues to perform better than the major bond index (Symbol: AGG), its performance is still sub-par and is holding back portfolios with Flexible Income* allocations. That affects Adaptive Growth*, which has a 20% allocation to Flexible Income*, and Adaptive Balance* which has a 50% allocation. Of course, accounts with a 100% allocation to Flexible Income* are also being impacted.

If you would like to improve the returns on your account, please give me a call at 928.778.4000 and we can discuss changing you to a strategy with less of an income focus.

• Shock Absorber Growth* is our 100% growth portfolio. 
• Flexible Income* is our 100% income portfolio.  
• Adaptive Growth Portfolios* are currently allocated with 80% Shock Absorber Growth* and 20% Flexible Income*. 
• Adaptive Balance* is 50/50 between growth and income. 

Mental Floss

What We Were Saying Back Then

I have commented several times over the years on Tesla stock (Ticker Symbol: TSLA) and why I don’t recommend owning it. In short, it is what I call a “story stock”, with no earnings, very little value, a ton of debt and formidable competition as BMW, Honda, GM and other giants now have their own electric vehicles on the market.

On Friday TSLA dropped over 13% after the Securities and Exchange Commission announced it was suing Tesla chairman Elon Musk for manipulation of Tesla share prices. Over the weekend Musk stepped down as chairman in an ultra-quick settlement with the SEC, and today, Monday, October 1, 2018, the stock price bounced right back.

I have often said that rising volatility is not a good sign for a stock, and TSLA shares prices are now mimicking the erratic behavior of Elon Musk, Tesla’s promoter in chief.

Tesla makes sexy cars, no doubt about it, but my avoidance of their stock was due to TSLA being a financial accident waiting to happen. In my mind it was not a question of “If,” but only “When” the wheels would come off its share price.

In my mind, the bounce in TSLA share prices as of this writing on Monday, October 1st, 2018, is much more due to having 28% of its traded shares sold short by investors betting that the price will go down, than it is due to Musk’s dodging a legal bullet.

Twenty-eight percent of all outstanding shares is a massive amount of “short interest” as it is called, the most I have ever seen for any one company in my 32 years in the business.

Shorting is another example of why the investment markets often seem backward. Investors borrow shares they don’t own from brokerage firms and sell the shares. They are required to buy shares at some point to repay the ones borrowed for the short sale. This is called “covering a short”.

If you think about his, those who have sold short are no longer potential sellers with the ability to push the price down, but have become potential buyers.

Since the market for a stock is merely the balance between the numbers of buyers and sellers, short covering will eventually create a wave of buying and holding up a share price. In my opinion, that is what happened this morning when many short sellers bought shares to repay to the lenders and close out their trade.

I’m guessing that short covering will only postpone the inevitable continued decline in Tesla share prices. Tesla as a car company is in a long-term decline, in my opinion.

Disclosure: I do not own, and have not sold short TSLA shares in my own or client portfolios. 

TCA Suspending Some Fees

The acquisition of our primary custodian, Trust Company of America by E*TRADE was expected to give us numerous benefits. One just announced was that TCA by E*TRADE is suspending trading fees on taxable accounts.

Before the merger we only paid 45 cents per 100 shares to trade, one of the lowest trade execution fees in the industry, but TCA by E*TRADE just lowered that cost to zero. Thank you, TCA! 

Our Spotlight Strategy – Flexible Income

With our Flexible Income strategy we strive to provide high total return consistent with Capital Preservation.

Your money will be invested in bond mutual funds and exchange traded funds (ETFs), including inverse and leveraged funds, currency funds, including precious metals that may be used as currencies and equity-income investments whose price trend is up. If the price cycles down, holdings are replaced with new investments that are going up, repeating as needed. Growth stocks are not used.

Click here to read more about Flexible Income.

A Slice of Life… 

I am being dragged kicking and screaming into the 21st century as Hepburn Capital creates a social media presence for itself. This newsletter will migrate to a summary of blog posts from the previous month, with those blog items being fed into streams on Google, Facebook, Twitter, Instagram, and a few other services that I don’t really use or understand.

But younger investors increasingly use social media for their news and contacts with friends and service providers like Hepburn Capital, and we are changing with the times.

Long time clients and readers of this newsletter should notice very few changes, but we believe that more and more prospective clients will come to HCM through social media, so we are thinking ahead here at HCM.

Despite my initial resistance, I really do love the adventure of figuring out things that I have never done before! 

* The model accounts mentioned in this article are hypothetical examples of how the strategy may work as designed. Performance and activity in client accounts may be different from that in the model in amount of each investment, specific timing of trades, and actual security used, which may vary from account to account. Not all trades are profitable. It should not be assumed that current or future holdings will be profitable. A list of all trades in these accounts for the past 12 months will be provided upon written request.

** Indexes are unmanaged lists of stocks considered representative of a broad stock market segment. Investors cannot invest directly in an Index.

This newsletter may contain forward-looking statements, including, but not limited to, statements as to future events that involve various risks and uncertainties. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause actual events or results to differ materially from those that were forecasted. Information in this newsletter may be derived from sources deemed to be reliable, however we cannot guarantee its accuracy. Please discuss any legal or tax matters with your advisors in those areas. Neither the information presented nor any opinions expressed herein constitute a solicitation for the purchase or sale of any security.

In all investing, past performance cannot assure future results, and as such, our efforts are not guaranteed. Losses can occur. All strategies offered by Hepburn Capital Management, LLC, adapt to changes in the markets by changing the investments they hold, therefore, comparisons to broad stock market indexes such as the unmanaged indexes mentioned may not be appropriate. Sometimes client accounts are invested in stocks or markets not included in these indexes. Past performance does not guarantee future results. Investment return and principal value will vary so that when redeemed, an investor’s account values may be worth more or less than when purchased. Mutual fund shares and other investments used in our managed accounts are not insured by the FDIC or any other agency, are not obligations of or guaranteed by any financial institution and involve investment risk, including possible loss of principal. Advisory services offered through Hepburn Capital Management, LLC, an Arizona Registered Investment Advisor. Adviser will not transact business unless properly registered and licensed in the potential client’s state of residence.

Copyright (C) 2018 William T. Hepburn. All rights reserved.