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The Independent Investor: ETFs Are Tax Efficient

Bill Schmick

Tax time is drawing closer and as it does, the annual barrage of questions concerning investments, portfolios, dividends and capital gains distributions are keeping financial advisors and accountants quite busy.

"One of the most frustrating issues to me," writes a Long Island investor, I'll call Joey G., "are the mutual fund capital gain distributions."

As a large holder of mutual funds, every year, between November and December, Joey is hit with substantial taxable capital gain distributions from the mutual funds he owns.

"I have no idea how much they are going to be or when they are going to be distributed until it's too late, so there's no way I can plan for them tax-wise."

Joey G. is not alone in voicing this complaint. For readers who are not familiar with mutual funds capital gains distributions, it works like this:

During the year, mutual fund manager try to buy stocks low and sell those same stocks at higher prices, generating capital gains, the more successful the manager the higher the capital gains.

That's the good news.

The bad news is that the fund manager then passes on all these taxable gains to the holder of the fund, in this case Joey G., Depending upon the size of your holdings; this tax bill can be many thousands of dollars. To some this may seem to be a high-class problem since the higher the capital gains distributions, the more expected appreciation in the price of the fund but not always.

There are years such as 2008, when, as the market declined, fund mangers sold stocks they had held for a long time. Those sales generated huge capital gain distributions for their investors. At the same time, because the markets were declining, investors sold out of mutual funds in great numbers sending the price of mutual funds to multi-year lows.

"Not only did I have to pay a huge tax bill that year," laments Joey G., "but the very same mutual funds that gave me this tax bill were now selling at deep discounts to my purchase price."

For those who are tired of these capital gains issues, I would suggest looking at exchange-traded funds or ETFs. Since they are index funds, once their indexes are created, they rarely change (no need to buy or sell) so there are relatively few, if any, capital gains distributions.

On occasion there may be a gain (or loss) generated but only if the underlying index the ETF tracks changes in composition. For example, if you purchased the SPDR S&P 500 (SPY), that ETF tracks the performance of the S&P 500 Index. If at some point the S&P were to replace one or more stocks in the index, the ETF manager of SPY would also do the same. In that case, there could be a gain or loss (and a distribution) in the ETF. Those kinds of changes occur infrequently.

There are exceptions to this rule; however, since not all exchange-traded funds are created equal. There are some "black box" ETFs that are actively managed. Their marketing managers claim that because of their internal strategies, their ETF can out perform whatever index they represent. Sticking with the S&P 500 example, the actively-managed ETF might only select a sub-set of the index, or buy and sell various stocks within the index, in an effort to provide outperformance. The results of these black box beauties are checkered at best. To me, these hybrids rarely fulfill their promise while their expense ratios are higher than plain vanilla ETFs and there can be capital gain distributions as well.

Since more than 75 percent of mutual fund managers fail to outperform the indexes anyway, ETFs make sense on the performance side as well. They are cheaper to own, the tax advantages are clear and the next time you compare an ETF to a mutual fund remember that the mutual fund performance does not include the taxable consequences of capital gain distributions.

Bill Schmick is an independent investor with Berkshire Money Management. (See "About" for more information.) None of the information presented in any of these articles is intended to be and should not be construed as an endorsement of BMM or a solicitation to become a client of BMM. The reader should not assume that any strategies, or specific investments discussed are employed, bought, sold or held by BMM. Direct your inquiries to Bill at 1-888-232-6072 (toll free) or e-mail him at wschmick@fairpoint.net. Visit www.afewdollarsmore.com for more of Bill's insights.

Tags: ETFs, capital gains, taxes      

The Independent Investor: Emerging Markets Are Still on Hold

Bill Schmick

A few months ago in my market column, I warned investors that emerging markets overall were pulling back and additional downside was probable. Thanks to the problems in the Middle East and elsewhere, that forecast has been fulfilled. Now what?

At the time, I advised that any further downside could prove to be a buying opportunity. The lower the stock markets of places like China, India and Brazil decline, the more tempted I am to begin to nibble at stocks and other securities in these countries.

In the second week of February, investors pulled $5.45 billion from emerging market funds and invested it into developed nations such as the U.S., Europe and Japan. That was the largest inflow of money into those regions in 30 months. Since the beginning of the year, worried investors have withdrawn 20 percent of the $95 billion that was invested in the region in 2010. China alone has lost more than $1 billion of outflows since the beginning of January.

The stock markets of these countries have taken it on the chin this year as a result. Emerging markets have suffered an overall decline of 3.8 percent year-to-date, while stock markets in the U.S., for example, are up close to 6 percent. The one big exception has been Russia, one of the four BRIC countries that also include Brazil, China and India.

Thanks to Russia's vast oil and other natural resources, that country is considered a hedge against future inflation. Investors are also betting that, after years of abusing foreign investors, the Putin-controlled government is getting serious about treating all investors equally. Time will tell if Russia is blowing smoke or truly has turned over a new leaf. In the meantime, however, its equity market has more than kept pace with the U.S., gaining 11.3 percent, while India is down 12.6 percent and Brazil is off 4.4 percent year-to-date.

As readers may recall, the chief reasons for the emerging market sell-off is climbing inflation rates which has been met by tightening monetary policies by central banks in just about all the "hot" countries. Brazil, for example raised rates yet again last night in an effort to slow the economy and reign in inflation. These actions have been the impetus to trigger corrections in all these markets after two very good years for equity investors. Indonesia, for example, was up 46 percent last year so a 5.1 percent pullback so far this year is small potatoes, in my opinion.

The recent upheavals in Egypt, Tunisia and the ongoing strife in Libya have unfortunately lengthened the shadow that has darkened the prospects for emerging markets in 2011. Higher oil prices may also keep a lid on the economic prospects for some countries that have not been blessed with energy reserves.

As a contrarian, I like to buy securities when "the blood is running in the streets" as Baron Rothschild once described this style of investing at the bottom. As of yet, I don't see that bottom. Keep your powder dry for a few more weeks (or maybe months) but keep an eye on these markets. Their long-term economic prospects are extremely attractive. Their present attempts by their governments to reign in inflation just bolsters the investment case for this group of countries whose governments and economies are finally coming of age.

Bill Schmick is an independent investor with Berkshire Money Management. (See "About" for more information.) None of the information presented in any of these articles is intended to be and should not be construed as an endorsement of BMM or a solicitation to become a client of BMM. The reader should not assume that any strategies, or specific investments discussed are employed, bought, sold or held by BMM. Direct your inquiries to Bill at 1-888-232-6072 (toll free) or e-mail him at wschmick@fairpoint.net. Visit www.afewdollarsmore.com for more of Bill's insights.

Tags: emerging markets      

The Independent Investor: Oil Hits My Price Target

Bill Schmick

If there is one thing I've learned in forecasting commodity prices, you have to be disciplined. Here in the U.S. our benchmark crude for April delivery hit an overnight high of $103.41 in electronic trading. It's time to sell.

One-hundred-dollar oil has been my target now for well over a year. It is an interim price target because I still believe that over the long term (over the next few years) we will see the price of oil much higher. But for now this rally is on its last legs.

"How can you say that?" demanded one client who just recently jumped on the oil bandwagon. "Don't you read the news? The Middle East is coming apart. The world's oil supplies are in jeopardy."

That is the kind of sentiment that makes me feel even more confident that it is time to take profits. Sure, there are pressing issues over in oil land and I don't deny that there will be additional turmoil before all is said and done. However, I do not believe that the world's oil supply is in jeopardy.

Keep in mind that Libya produces less than 2 percent of the world's oil. Its "King of Kings" (as Moammar Gadhafi likes to be called these days), is in my opinion, a certifiable madman and his ultimate demise would be cause to celebrate. However, that may take some time to engineer and in the meantime oil will most likely stay at these nose-bleed levels. Ultimately, when the crisis has passed, we will once again be back to a global economy that is growing slowly and definitely not at a pace that justifies such high price levels for energy.

This temporary spike in oil is great news for the media. It has spawned an entirely new "what if" series of gloom and doom economic scenarios, which in turn has driven the stock markets down 3 percent.

"Auto sales will be decimated," says one talking head.

"Four-dollar gas is round the corner," predicts a young gas station attendant solemnly.

"The economy will be thrown back into a recession," says an economist, still smarting from his conviction that we would experience a double-dip recession in 2010.

"The consumer will be crushed."

"Restaurants will close."

"It's the end of the world." (My quote).

Those kinds of statements will certainly sell newspapers or keep you tuned into CNBC, but beyond their entertainment value, I see no point in listening to these Doctor Dooms.

Folks, my advice is to keep this present state of affairs in perspective. We were badly in need of a market correction. Now, we have it, thanks to the Middle East.

A month from now when this blows over and the price of oil is considerably lower than today you will be wishing you did two things: 1) took advantage of lower stock prices and 2) sold oil, if you owned it.

Bill Schmick is an independent investor with Berkshire Money Management. (See "About" for more information.) None of the information presented in any of these articles is intended to be and should not be construed as an endorsement of BMM or a solicitation to become a client of BMM. The reader should not assume that any strategies, or specific investments discussed are employed, bought, sold or held by BMM. Direct your inquiries to Bill at 1-888-232-6072 (toll free) or e-mail him at wschmick@fairpoint.net. Visit www.afewdollarsmore.com for more of Bill's insights.

Tags: oil      

The Independent Investor: Rebellion in the Mideast — The Internet Strikes Back

Bill Schmick

For my ally is the Force, and a powerful ally it is. Life creates it, makes it grow. Its energy surrounds us and binds us.

— Yoda, "Star Wars: The Empire Strikes Back"

Thousands, if not millions, of demonstrators are protesting their unhappiness from one end of the Middle East to the other. Demonstrators in Iran, Bahrain, Yemen, Iraq, Algeria, even Libya, have followed the leads of Tunisia and Egypt in taking their grievances to the streets. At the center of this revolutionary movement is the Internet.

You may have seen the young marketing manager of Google, the Egyptian Wael Ghonim, on television or the Internet recently. He is credited with starting the Facebook page that helped spark the revolution that ended in the demise of Hosni Mubarak, the autocrat who ruled Egypt with an iron fist for the last 30 years.

"This is the revolution of the youth of the Internet and now the revolution of all Egyptians," this hero of Egypt's revolution said in an interview with the Associated Press.

What struck me most was his sincerity, his matter-of-fact trust in the Internet and its members as opposed to his government. He believes that the Egyptian regime's biggest mistake was cutting off the country's access to the internet. I agree.

By its actions, the Mubarak government acknowledged its greatest fear and confirmed that they no longer had control of the dissemination of information. Middle Eastern regimes (among other repressive societies) have realized full well the value of propaganda and the tight control of communications. Up until the introduction of the Internet, it was a fairly easy job to control the main outlets of communication; namely print, television and radio.

Since these regimes controlled the media, only their special brand of the "facts" were allowed to be disseminated to the populace. The internet changed all that. Those who feel oppressed have access to alternative views of the facts and can decide for themselves whether they are being manipulated and exactly how that manipulation is unfolding. Since information is the foundation of any and all governments, the Internet has made it impossible for oppressive regimes to continue their monopoly on information dissemination.

Internet penetration in the Middle East remains modest at 29.8 percent, according to Internet World Stats, while Asia boasts a 21.5 percent penetration. Africa overall has only a 10.9 percent penetration compared to the U.S. at 77.4 percent. However, as in the rest of the world, penetration is growing by leaps and bounds in the Middle East (over 1,800 percent in the last 10 years). As computers and cell phones proliferate, governmental control of the traditional sources of information becomes much less effective.

Demographics are also aiding and abetting the Internet as a world force for change. In just about every country presently impacted by growing rebellion, the age of the population has been a contributing factor. The region is facing a demographic bulge in age with youth aged 15 to 29 comprising the largest proportion of the population.

At the same time, this segment of the population is bearing the brunt of the region's high jobless rates and skyrocketing costs of food. The traditional and growing disparity between the "haves" and the "have-nots" within their societies has not been lost on these young people who, for the most part, are highly educated. Generally speaking, patience is not a strong point with the youth and, in my opinion, has lost what little patience they had with the political, social, economic and religious oppression of their governments.

Let's face it, most of the Middle East is ruled by religious fanatics, dictators or corrupt kings. None of these regimes are fertile grounds for economic opportunity, the empowerment of women, or equitable access to resources and education. Unfortunately, these are all necessary ingredients if the region's leaders intend to harness the youth, a key human resource, in growing their economies.

What they (and other governments) are only now beginning to realize is that their youth is the Internet generation. It has become a part of their everyday experience, unlike those of us who have not grown up with this phenomenon. As such, the Internet has become the conscience of all societies.

Its adoption has facilitated a meeting ground where the world's angry and disenfranchised youth can band together, gather en masse, if need be, and deliver thousands, if not millions, of protestors into the streets with a simple tweet or the creation of a Facebook page. I expect unrest, rebellion and unfortunately, repression to continue so fasten your seat belts.

Bill Schmick is an independent investor with Berkshire Money Management. (See "About" for more information.) None of the information presented in any of these articles is intended to be and should not be construed as an endorsement of BMM or a solicitation to become a client of BMM. The reader should not assume that any strategies, or specific investments discussed are employed, bought, sold or held by BMM. Direct your inquiries to Bill at 1-888-232-6072 (toll free) or e-mail him at wschmick@fairpoint.net. Visit www.afewdollarsmore.com for more of Bill's insights.

Tags: Internet, revolution      

Independent Investor: Are Dividend Stocks a Good Investment?

Bill Schmick

Dividend stocks have outperformed nondividend paying stocks since 1972. However, the companies that had provided the best track records in paying and increasing their dividends have either been acquired, stopped raising dividends or in some cases even eliminated them. Given that a large number of baby boomers are set to retire in the next few years with definite income needs, I believe that the demand and supply of dividend paying stocks will only increase.

But the last few years of turmoil have shaken the confidence of many dividend believers. In the S&P 500 Index about 370 stocks pay dividends at any given time. In 2009, those dividends declined by 20 percent. That's on top of a 35 percent sell-off in stock prices in 2008. For those dividend investors living on the income generated from their portfolios, this double whammy was devastating.

A great many investors finally threw in the towel, sold out and moved to the sidelines in the beginning of 2009. In hindsight, that was the wrong move. Even today a lot of those investors have not re-entered the market.

Although dividends gained back 5 percent last year, they are still 17 percent below the level companies paid in 2008. Some pundits believe that it will take until 2013 before dividends are back to the 2008 level. That may be true for some companies but not all companies are the same

For example, the 70 companies with the highest annual dividend growth rate over the past three years have outperformed 58 percent of all stocks in the S&P. They are predominantly mature businesses that have strong cash flows, stable profit outlooks and lower operational risk, on average, than other companies. In my opinion, if an investor does his due diligence on a targeted list of companies, he or she can be rewarded with both additional yield as well as some price protection. But the devil is always in the details.

Recently a reader asked if dividend payers perform well in an inflationary economy; evidence indicates they do.

In the period 1974-1980, when the inflation rate was 9.3 percent, the return on the S&P index averaged 9.9 percent a year. The dividend component of this return (4.9 percent) accounted for nearly half of the overall return. Obviously, if things go the other way (a deflationary environment), dividend payers shine because they are, by definition, defensive and provide a stream of income.

I believe we are in an economic recovery. Economic and earnings cycles typically encourage and support accelerating dividend growth and this recovery should be no different. In addition, many companies hold a record amount of their net worth in cash due to the peculiar nature of this last recession. I believe managements will use that cash to increase dividends and/or buyback stock.

This is where your due diligence comes in. If you did your homework, you would discover that just 10 stocks account for 32 percent of the cash (ex financial companies) in the S&P 500. Those 10 stocks receive an average of 56 percent of their sales from outside the U.S.

If you further believe that the dollar will continue to decline and that some overseas markets will grow at a faster clip than the U.S., then it makes sense to look at those 10 in relation to how much dividends they generate.

That is not the only criteria an investor should use in selecting dividend stocks. Free cash flow coupled with strong earnings growth, low debt to equity, a track record of increasing dividends over at least 5, if not 10 years, are just some of the variables investors should use to fashion a high-quality dividend portfolio.

Unfortunately, many investors simply look for the highest-yielding securities they can find. That only works in a bull market. At the first sign of problems, those yields evaporate along with the price of the stock. That brings up the final issue. How to invest in dividend stocks in today's markets?

Readers are aware that I am not an advocate of the buy-and-hold investment philosophy. I believe firmly that we are in a long-term bear market that could last for another 5 or 6 years. Right now we happen to be enjoying a rally that could continue for another 6 months to a year, but at some point it will end. Therefore the investor must mange risk and no longer depend on just the dividend to cushion declines in his portfolio. You might, for example, establish a rule that a company that cuts its dividend is an automatic sell or begin to liquidate stocks once the S&P 500 index breaks its 200 day moving average. The point is that you must manage your portfolio actively, which requires a lot of work.

Another highly recommended alternative is to hedge your portfolio with covered options. The cost of that protection will reduce your overall returns but you will sleep better at night knowing that if we revisit the declines of 2008-2009 your portfolio will at least be protected from price declines. Bottom line: dividend stocks do have a place in your portfolio, if you are willing to work for it.

Bill Schmick is an independent investor with Berkshire Money Management. (See "About" for more information.) None of the information presented in any of these articles is intended to be and should not be construed as an endorsement of BMM or a solicitation to become a client of BMM. The reader should not assume that any strategies, or specific investments discussed are employed, bought, sold or held by BMM. Direct your inquiries to Bill at 1-888-232-6072 (toll free) or e-mail him at wschmick@fairpoint.net. Visit www.afewdollarsmore.com for more of Bill's insights.

Tags: dividends      
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Bill Schmick is registered as an investment advisor representative and portfolio manager with Berkshire Money Management (BMM), managing over $200 million for investors in the Berkshires. Bill’s forecasts and opinions are purely his own and do not necessarily represent the views of BMM. None of his commentary is or should be considered investment advice. Anyone seeking individualized investment advice should contact a qualified investment adviser. None of the information presented in this article is intended to be and should not be construed as an endorsement of BMM or a solicitation to become a client of BMM. The reader should not assume that any strategies, or specific investments discussed are employed, bought, sold or held by BMM. Direct your inquiries to Bill at 1-888-232-6072 (toll free) or email him at Bill@afewdollarsmore.com Visit www.afewdollarsmore.com for more of Bill’s insights.

 

 

 



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