The Margin of Safety Quarterly Winter 2019
Fourth Quarter 2018
- What stands out about 2018 is the breadth of negative returns across almost every asset class and financial market
- As students of financial market history, we know the headwinds our portfolios have faced over the past few years will eventually turn to tailwinds
- Our portfolios are positioned to perform well over the medium to long term and to be resilient across a range of potential scenarios
- Throughout the history of River Capital Advisors, we’ve emphasized the importance of having a long-term perspective and having adequate cash reserves for times like 2018
- Successful investing is a process of consistently making sound, well reasoned decisions over time, across market and economic cycles while keeping emotions out of the process
Fourth Quarter 2018 Investment Commentary
From a return perspective, 2018 could largely be considered the year that wasn’t. Despite a few half-hearted rallies leading into the closing day, global financial markets ended December with the worst annual returns since the great financial crisis. Larger cap U.S. stocks fell nearly 14% in the fourth quarter, wiping out year to date gains and ending down around 5%. Smaller cap stocks fared worse, falling 20% in the quarter and 8-11% for the year. Foreign stocks suffered through most of the year, with mid double digit year end losses for both European and emerging market stocks (despite their relative outperformance versus U.S. stocks in the fourth quarter). Our fourth quarter portfolio performance demonstrated the potential risk management and diversification benefits of our lower risk alternative strategies, as they outperformed global stocks in the quarter and for the year.
In addition to the global equity market declines, what stands out about 2018 is the breadth of negative returns across almost every type of asset class and financial market, whether bonds, equities, or commodities. For example, a study by Deutsche Bank noted that 90% of the 70 asset classes they track were posting negative returns late in 2018 – the highest percentage of losers in the study’s 100 year history. Of the asset classes we follow, only cash, tax exempt bonds and leveraged loans had positive 2018 returns. Net of inflation and income taxes, even these asset classes had negative returns. It was extremely difficult to make money in the financial markets last year and essentially there was no place to hide.
The lackluster performance of so many asset classes, culminating with the fourth quarter’s dramatic U.S. equity decline, is largely due to the uncertainty that prevailed throughout much of 2018. As the year wore on, early positive market indicators such as still solid U.S. economic growth and declining unemployment numbers were swamped by investors’ fears surrounding ongoing U.S. China trade tensions, political uncertainties in Europe, and continued Fed tightening, among others.
A Consistent Focus
Throughout the history of River Capital Advisors, we’ve succeeded on behalf of our clients by emphasizing the importance of having a long term perspective. With a long term perspective comes the necessity of discipline and patience in sticking to the investment process and executing it consistently over time rather than being subject to swings in investor sentiment and market consensus, which more often than not detracts from returns versus enhancing them. Sticking to our process may feel uncomfortable at times, but it’s exactly what’s necessary to achieve long term success and avoid the pitfalls of performance chasing and emotionally driven investing.
While today’s headlines may be filled with distress signals and warnings of market weakness, it’s worth remembering that just one year ago those headlines boasted 20% plus global equity gains and historically low market volatility. In fact, most investment strategists expected 2018 would bring a continuation of the synchronized global economic recovery. The sharp market pullbacks witnessed this past year only reinforce our view that no one can consistently predict short term market moves.
Over the next year, the range of potential equity market outcomes is just as wide as it was going into the 2018. Our approach and preparation remain the same. We construct and manage portfolios to meet our clients’ longer term return goals, which means successfully investing through multiple market cycles, not just the next 12 months. Given our current investments, we are confident our portfolios are positioned to perform well over the medium to long term and to be resilient across a range of potential shorter term scenarios.
If the current recession fears are overdone, we expect to generate strong overall returns with outperformance from our foreign equity positions, active managers, and flexible bond funds. On the other hand, if U.S. stocks slide into a full fledged bear market, our portfolios have “dry powder” in the form of lower-risk fixed-income and alternative strategies that should hold up much better than stocks. We’d then expect to put this capital to work more aggressively; for example, by increasing our exposure to U.S. stocks at lower prices and valuations implying much higher expected returns over our medium-term horizon.
As the time horizon lengthens, the range of reasonably expected outcomes narrows, the shorter-term cyclical spikes and dips are smoothed out, and the underlying fundamental/economic drivers of financial asset returns play out. Over the long term, we are highly confident of the benefits from owning a globally diversified portfolio.
Speaking of U.S. stocks, in the period since the financial crisis, there has seemingly been little need to own anything other than U.S. stocks. But it should be particularly clear after this year (and this past quarter) that isn’t a sound long term approach. The multiyear period of U.S. stock market outperformance versus the rest of world is reaching an extreme relative to tainable, and they won’t be repeated over the next 10 or 20 years.
Even after their fourth quarter declines, U.S. stocks are still expensive. However, many markets elsewhere are oversold, strengthening their appeal for long term, value seeking investors like ourselves. Europe is historically cheap, with a lot of the worries (e.g., Brexit, Italy’s political and debt concerns) likely already priced in. And the selloff in Asia has been particularly severe. Here again the market seems to be overreacting to potential risks (e.g., a slowdown in China) rather than reflecting the true value of emerging markets—a vast investment opportunity set that continues to expand at a faster rate compared to developed markets. Despite the risks we see over the short term, we have high conviction that our investments in European and emerging market stocks will earn significantly higher returns than U.S. stocks over the next five to 10 years.
Our allocations to foreign stocks (and emerging market bonds in our balanced portfolios) also provide diversification away from the U.S. dollar. After the dollar’s strong performance the past several years, a U.S. budget deficit not seen outside of recessions or war, and the overvaluation we see in U.S. stocks, we believe the U.S. dollar is a risk factor that investors would be prudent to diversify away from.
Successful investing is a process of consistently making sound, well reasoned decisions over time, and across market and economic cycles. Our goal is never to track or beat a particular benchmark from one year to the next, but rather to provide our clients with the optimal return for the environment we’re given and their particular risk profile (i.e. their downside goal). Given this approach, it is normal, not unusual, for us to go through periods where we will look out of sorts with the broader market. As we continue to execute our approach with discipline and patience during the inevitable periods when it is out of favor, we will continue to achieve successful and rewarding long term results for our clients, as we have over the life of our firm.
2019 Year End Tax and Financial Planning….in January
The start of a new year provides a full year to address tax and financial planning strategies. Why wait until the last few weeks of the year for planning? In addition, with the 2018 tax filing season beginning, the gathering of tax information and documents provides the perfect environment to review all aspects of your financial life. Taking what we now know about the new tax law and weaving together all of the other areas of your personal finances is one of the key ways we provide value to our clients, as their trusted financial adviser. Below are thoughts on a range of financial planning topics, to help you get off to a great start on your 2019 planning.
Income Tax Planning Ensure you are implementing tax reduction strategies like maximizing your retirement plan contributions, tax loss harvesting in portfolios and making charitable contributions can all help reduce current and future tax bills. It is also good to review and prepare a 2019 tax projection based on 2018 income, deductions and how that may be different from before.
Estate Planning Prepare a flowchart of your current estate plan to visualize what would happen to each of your assets and how the current estate tax law will impact you. Be sure that your estate planning documents are up to date – not just your will, but also your power of attorney, health care documents, and any trust agreements – and that the beneficiary designations are in line with your desires. There have been Florida law changes that impact power of attorney and health care documents. If you have recently been through a significant life event such as marriage, divorce or the death of a spouse, it is especially important right now to review your estate documents and beneficiary designations for retirement accounts, life insurance policies, etc.
Investment Strategy Market volatility has increased and it may feel uncomfortable. Market declines are a natural part of investing, and understanding the importance of maintaining discipline during these times is imperative. For our clients, we regularly rebalance portfolios and also develop an investment plan with the downside in mind. For our retired clients taking portfolio withdrawals, we develop a spending plan and ensure adequate cash reserves outside of the long term portfolio so that they do not have to sell equities in a down market. Now is a good time to revisit and revise your investment plan or develop one if you do not have a strategy in place.
Charitable Giving There are many ways to be tax efficient when making charitable gifts. For example, donating appreciated stock could make sense in order to avoid paying capital gains taxes. Due to the change in standard deduction limits for 2018, we talk with clients about bunching charitable deductions by deferring donations to another year or accelerating planned donations to the current tax year. We also discuss with our clients the benefits of qualified chartable distributions from their IRA if they are over the age of 70 ½. If the numbers are large enough, you might even consider a private foundation or donor advised fund for your charitable giving.
Retirement Planning Think about a future when working becomes optional. Whether you expect a typical full retirement or a career change to something different, determining an appropriate balance between spending and saving, both now and in the future is important. There are many options available for saving for retirement, and we can help you understand which option is best for you. Please contact us if you would like a sample, written financial plan.
Cash Flow Planning Review or prepare a 2019 spending plan at this time. Understanding your cash flow needs is an important aspect of determining if you have sufficient assets to meet your goals. If you are retired, it is particularly important to maintain a tax efficient withdrawal strategy to cover your spending needs – something we incorporate into our clients’ financial plan. If you have not yet reached age 70 1/2, it is prudent to ensure you are making tax efficient withdrawal decisions. If you are over age 70 1/2 make sure you are taking your required minimum distributions (“RMDs”) because the penalties are significant if you don’t.
You do not need to wait until year end to take RMDs either – taking them in the beginning of the year is one less year end matter to deal with. Lastly, although RMDs need to be taken from tax deferred accounts, you do not need to spend the money! Dollars not needed for current spending can continue to be invested in a taxable brokerage account.
Risk Management It is always a good idea to periodically review your insurance coverages in various areas. Recent catastrophic events like hurricanes serve as a powerful reminder to make sure your property insurance coverage is right for your needs. If you are in a Federal disaster area, there are additional steps necessary to recover what you can and explore the tax treatment of casualty losses. Other areas of risk management that may need to be revisited include life and disability insurance. We review various insurance coverages for our clients and provide feedback, recommendations and potential cost saving opportunities to revise coverages.
Education Funding Funding education costs for children or grandchildren is important to many people. While the increase in college costs have slowed some lately, this is still a major expense for most families. It is important to know the many different ways you can save for education to determine the optimal strategy. Often, funding a 529 plan comes with tax benefits, so making contributions before the end of the year is key. We have developed an informational booklet that discusses a number of educating funding strategies – contact us if you would like a free copy.
Elder Planning There are many financial planning elements to consider as you age, and it is important to consider these things before it’s too late. Having a plan in place for who will handle your financial affairs should you suffer cognitive decline is critical. Making sure your spouse and/or family understands your plans will help reduce future family conflicts and ensure your wishes are considered.
The decisions you make each year with your personal finances will have a lasting impact.
A Wish for 2019 and Beyond
There has been a lot of discussion about developing a uniform set of standards for firms and professionals providing investment advice. We do not yet have a uniform set of rules and this causes a lot of confusion amongst individuals. We would like to see a uniform set of standards applied to anyone giving investment advice, regardless of title or who employs them. Under proposed rules, broker dealers would have to follow a “best interest” standard – which is much weaker than the current “fiduciary” standards for registered investment advisors like River Capital Advisors. The proposed rules, in addition to causing confusion, makes it harder for investors to determine who really has their back (hint-it’s probably not a broker). Regulators ought to scrap the dual set of rules, hold everyone to a fiduciary standard, and put investors’ best interests first.
River Capital News
The 2018 tax filing season is upon us and we have a number of new tax laws in play for 2018 – a reduction in tax brackets for individuals and C corporations, a higher standard deduction, a cap on itemized deductions for taxes and the elimination of miscellaneous itemized deductions and a new “qualified income deduction” that may apply to businesses such as sole proprietors, partnerships, limited liability entities, S corporations and trusts. The new tax law is anything but simple, especially when the IRS has not released all of the regulations and guidance needed for the wide ranging changes. The lower rates for qualified dividends and capital gains are still applicable for 2018 and unfortunately, a number of the changes will expire in the not too distant future. The CPA firm of Smoak, Davis & Nixon, along with River Capital Advisors, is the exception and not the norm in the financial services industry – our clients have a single advisory firm that can coordinate all of their investment, tax and financial planning needs.
Our retirement planning workshop discussed last quarter went well. We had a small group, which did allow for a lot of interaction. The goal of the workshop was to bring to top of mind a number of nonfinancial life style changes that occur with retirement. For many, the social circle emanates from work, due to work schedules, hobbies may be ignored and as one client reminded us, “When you are retired, every day is like Saturday!”. We talk with clients who are near to retirement about the nonfinancial changes, which will also impact their lifestyle and ultimately cash flow needs. We may do another workshop in the future.
For our clients, we have also enclosed our annual Privacy Notice for your review.