Questions with Katz

This is the first installment of a new series of letters where a question is posed for Larry (and the entire Katz Family Financial team). The goal is to educate while sharing the extensive amount of experience we have in this field.

QUESTION:
Many people in the industry tell us that as you age, and especially in retirement, you need a larger allocation of bonds than stocks. Why are you less concerned with this? What gives you the confidence to be more weighted in equities?

(To be clear we have and will invest in bond opportunities, we just want to explain why we are so confident in our equity model compared to others)

ANSWER:
Here are some reasons investors still want bonds compared to what we think.

1. What they think: “I made my fortune I just want to keep it from stock market fluctuations.”What we think: In twenty-one years, the buying power of a bond portfolio will drop 50% due to inflation. And that is best case scenario which assumes the FED can get to and keep 2% inflation.
2. What they think: “I need an emergency fund.”What we think: Individuals who have emergency funds need to tap them. I cannot figure out why. Perhaps they are able to predict the future. Or the emergency fund drags down the total returns of their portfolio which then creates the emergency.

   The most popular bond funds now recommended by advisors are made up of non-traded nonrated bonds of private companies. In an emergency, selling these funds is only possible one day in a quarter, and only with limitations.

3. What they think: “I want bonds as a balance to possible stock bankruptcies.”What we think: Bankruptcies are now rare and predictable due to better corporate reporting. Also, I am ashamed to report that a high percentage of bankruptcies were of companies that were highly regulated by the government. So, we do not recommend highly regulated industries.

   Also note that lower quality bond funds recommended by advisors for higher income have a 3-4% default rate. In comparison, the S&P 1500 (which is what we require of new buys) is estimated to have a 1-2% bankruptcy rate.It did not get much publicity but the main reason for government intervention in the 2007-2009 great recession was the failure of AAA mortgage securities.

4. What they think: “Other advisors recommend a wide array of investment buckets for different goals.”What we think: That is common. We have seen portfolios rolled over from clients with reports that can span seventy-five to over one-hundred pages due to the holding list. The different buckets contain securities with different expectations. We specialize in seeking the highest returns available with safety, liquidity, and quality. That seems to solve any bucket issues.
5. What they think: “Bonds allow me to earn income from the interest payments.”What we think: We can achieve this with our model, and this leads to our happiest clients. Our model was designed to be both a growth and an income model. The companies in our portfolio often pay dividends and always are repurchasing shares. Therefore, you can earn income through dividends or by selling shares without reducing your ownership.

If a company is continuously buying back shares, then your shares are consistently increasing in ownership percentage. This means you could theoretically sell some of your shares and receive the “income” (similar to receiving the bond payments) and not reduce your ownership stake in the company.

The combination of dividends and buybacks is called Shareholder Yield. The average shareholder yield for our buy list is 10.84%. A client could sell 10.84% of their shares, take the cash and still own exactly the same percent ownership of their companies as they started the year with.

Fortunately, on top of this when we sell stocks to provide cash, whether it be for Required Minimum Distributions or living expenses, we still maintain strong performance. Those accounts with withdrawals of over 5% a year are growing only 2.4% slower than clients who are not taking withdrawals. Why? Because when we sell every month to raise funds for distribution. We do not sell a little from each stock holding which is usual. We simply sell from the least attractive security. We are right often enough in the sale selection that client’s income portfolios grow faster than they expect.

Some closing background on stocks vs bonds:

For centuries it was known that bonds were safer than stocks. Exactly as economics would predict, to get investors to buy stocks, companies would have to pay higher dividends. Investors wanted income coming in greater than the interest they would receive from bonds. It was an investment rule that when bond yields were higher than stock yields stocks were overpriced and should be sold.

The twentieth century changed all that. Dow Jones and Roger Babson started a century of security analysis. Investors used more than just dividend rates in security selection. An atypical event occurred midcentury when bond yields (interest they paid out to investors) exceeded stock dividends. This time stocks did not decline. Stocks never yielded more than bonds again. Better data and the SEC forced companies to perform or disappear. Economics would conclude that lower dividend yields than bond interest says stocks are safer than bonds. Of course, that does not mean all stocks are safer or even that all stocks will outperform bonds.

*in the case of a discrepancy between Fidelity Investments monthly statements and Katz Family Financial monthly portfolio statements, Fidelity Investment statements should be deemed as the correct and accurate report source.