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Lessons from 2015: Premiums

Dimensional Vice President Joel Hefner uses historical index data to illustrate why, despite periods of underperformance, investors should continue to expect equity, small cap, value, and profitability premiums to continue.

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Swedroe – Buffetts Advice Widely Respected, Seldom Followed

If investors were asked, “Who do you think is the greatest investor of our generation?” I’d bet an overwhelming majority would answer, “Warren Buffett.” If they were then asked, “Do you think you should follow his advice?” you might think that they would say, “Yes!”

The sad truth is that while Buffett is widely admired, a majority of investors not only fail to consider his advice, but tend to do exactly the opposite of what he recommends.

Buffett has said that “investing is simple, but not easy.” He has also said that “the most important quality for an investor is temperament, not intellect.” By that he meant the ability to stay disciplined, ignore recent events and returns, and adhere to your well-thought-out plan. He explained: “Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”

While financial economists consider 10 years of data as nothing more than “noise,” my more than 20 years of work as an investment advisor have taught me that, when contemplating investment returns, the typical investor considers three years a long time, five years a very long time and 10 years an eternity. (What inspired me to write this piece was a new record set when an investor expressed concern over the fact that a fund had underperformed in the 11 weeks he owned it.)

10 Years Is Not A Long Time
For investors to be successful, they must understand that, in the market, even 10 years is a relatively brief period. No more proof is required than the -1.0% per year return to the S&P 500 Index over the first decade of this century.

That’s an underperformance of 3.8% a year relative to riskless one-month Treasury bills and a total return underperformance in excess of 40%. Investors in stocks shouldn’t have lost faith in their belief that stocks should no longer be expected to outperform safe Treasury bills due to the experience of that decade.

The following table shows the annual premium, Sharpe ratio (a measure of risk-adjusted returns) and the odds of outperformance for the six equity factors (beta, size, value, momentum, profitability and quality) that have provided persistent premiums, not only in the U.S. but around the globe.

Note that these six factors also explain almost all of the variation in returns between diversified equity portfolios. With a single exception, what the table shows is that, no matter the investment horizon, there is always some probability that the factor will deliver a negative return. The sole exception was the momentum premium, which was positive during each of the 20-year periods. Of course, even this is not a guarantee that it will be positive over all future 20-year periods.

buffett1

There are two other important takeaways. The first is that, no matter what the investment horizon may be, you are putting the odds into your favor by gaining exposure to these different factors. The second takeaway is that, as demonstrated in Table 2 below, the factors all have low-to-negative correlations to each other, resulting in a diversification benefit.

buffett2

Benefits Of Diversification
The diversification benefits can be seen in Table 3. This table shows the mean premium for each of the factors, the volatility of the factor and its Sharpe ratio. It also provides the same information for three portfolios.

Portfolio 1 (P1) is allocated 25% to each of four factors (beta, size, value and momentum). Portfolio 2 (P2) is allocated 20% to each of the same four factors and adds an allocation to the profitability factor. Portfolio 3 (P3) is allocated the same way, substituting the quality factor for the profitability factor.

buffett3

The low correlations among the factors resulted in each of the three portfolios producing higher Sharpe ratios than any of the individual factors. Furthermore, we can see the benefits of diversifying across factors in the table below, which shows the odds of underperformance over various time horizons.

buffett4

As you can observe, no matter the horizon, the odds of underperformance are lower for each of the three portfolios than for any of the individual factors.

Playing The Odds
There is one other important takeaway that relates to an issue I am often asked to address. Some investors will see this data and say: “But I don’t have 20 years to wait for a premium to be realized.” The best way to think about this, however, is relatively simple.

Unfortunately, there are no clear crystal balls in investing. Thus, the best we can do is to put the odds of success in our favor as much as possible. As the above tables show, regardless of your investment horizon, be it one year or 20, you are always putting the odds in your favor by gaining exposure to any of these factors. It’s just that the odds grow increasingly in your favor the longer the horizon.

Because any factor can deliver a negative premium over even long horizons, the prudent strategy is obvious: Diversify across factors and don’t put too many of your investment eggs in any one of them. But, as Buffett said, while investing really can be that simple, it’s not easy to ignore what feels like long periods of underperformance. And that leads to impatience and the loss of discipline.

The bottom line is that an investor’s worst enemy is staring right back at him when he looks in the mirror. One of my favorite expressions is that knowledge is the armor that can protect you from making bad decisions. You have the knowledge. Now all you need is the discipline.

This commentary originally appeared June 10 on ETF.com

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An Agreement is Not A Plan

When co-owners are united in striving toward common business goals such as growing revenue, building business value and increasing cash flow, the business dynamics can be wonderfully positive and strong. Contrast that bright picture with what can happen when the goals of the owners diverge.

As you read further, ask yourself if the real issue facing owners in our examples is the misalignment of goals or a lack of planning for the day one owner wants to leave.

Owner Disability and Other Lifetime Transfer Events

What happens when one owner of a closely held company wants or needs to leave the company or sole owners want or need to leave theirs?

The reasons owners cite for leaving include everything from simple boredom to more dramatic and unexpected events such as the disability of an owner. As an example, let’s use an owner’s disability to illustrate some of the significant issues that arise when one owner needs to leave a company.

When disability strikes, companies undergo substantial hardships, both economic and operational. More importantly, in the absence of a buy-sell agreement, the disabled owner’s income stream from the company usually evaporates. This is the problem Steve Hughes, one of three equal shareholders in a growing advertising agency, confronted.

At age 38, Steve had a stroke and, as is the case with many stroke victims, his recovery was incomplete. Physically, he was the picture of health (his golf game even improved!); but he lost his ability to speak and read. Doctors told Steve he would never return to work.

Steve’s firm had a buy-sell agreement, but it covered only a buyout at death and an option for the company to buy Steve’s stock if he were to try to sell it to a third party.  It was silent on an owner disability or the more common situation of owners choosing to leave the company.  This glaring omission left the company and Steve in a classic dilemma.

The company, or rather the remaining shareholders, wanted to purchase Steve’s stock so that its future appreciation in value, now due to their efforts alone, would be fully attributed to them.

Consequences for Steve’s Family

 After the difficulty of the stroke and recovery period, Steve’s family was still in a difficult position.

  • Steve’s family soon realized that owners of stock in closely held companies rarely receive substantial benefits in the form of dividends or distributions because companies either accumulate or distribute (to active shareholders) profits in the form of salaries, bonuses and other perks.
  • In short, Steve’s family would not get what it needed most—cash—to replace the salary Steve was no longer earning. Steve’s co-owners learned that their efforts to increase the value of the business would reward them and Steve in equal measure.

Solving the Remaining Shareholders’ Problem

 Steve’s co-owners can buy Steve’s stock, but because they’d made no plans to do so, there are a number of obstacles.

  • There is a difference of opinion between buyer and seller related to the value of Steve’s stock.
  • Steve’s two co-owners want to pay as little as possible over as long a time period as possible because they (or the company): a) will pay with after-tax dollars; and b) they want to preserve capital rather than spend it on a non-productive asset such as stock of the company.
  • Steve’s family wants to receive full value for Steve’s stock as quickly as possible.

Before Steve’s stroke all co-owners were in sync. Steve’s disability, however, produced radically different owner wants and needs. To deal with this conflict, advisors must address four major issues with their owner-clients:

  • Agreement on business value
  • Funding for the buyout
  • Agreement on payment terms for the buyout
  • The income-tax consequences to the remaining owners on their payments to the departing owner

A buy-sell agreement drafted before Steve’s disability could have managed all these issues simply because all shareholders would have made the agreement when they shared the same ownership objectives. And, they didn’t know who would be exiting first!

Solving Steve’s Problem

Steve needs lifetime income for himself and his family.  Even if the shareholders successfully resolve the buy-out issues listed above, the underlying problem remains: How can Steve maintain his former compensation level?

Let’s assume Steve’s pre-stroke, annual compensation was $250,000 and his interest in the company was worth $1,000,000.  An all-cash sale might yield Steve after-tax investment capital of about $800,000. Can Steve expect a rate of return on his invested sale proceeds that matches his previous annual income from the company of $250,000 per year?  The buy-sell agreement likely does not address this issue.

Many advisors believe their job is finished when owners sign a well-drafted buy-sell agreement. Steve would not agree.

Had Steve engaged in the Exit Planning process he would have quickly realized that a sale of his ownership during his lifetime (or at death) would probably leave him and his family with a fraction of the income they are now spending. Planning would focus on closing this income gap using his employment and buy-sell agreements, disability insurance, the creation of a wage continuation plan and other appropriate means.

We realize that otherwise well-drafted documents, such as buy-sell agreements, can create more problems than they solve.  It is important to look at both the specific provisions of the agreement and put it in context by looking at the big picture and all possible scenarios that may occur.  In this case that means we carefully address all of the ramifications of both lifetime and death buy-outs — for the business, the departing owners, and the remaining or surviving owners.  We can talk with you about each scenario and the outcomes that you’d like to see, and then collaborate with your advisors to make sure that your agreements and planning are consistent with your goals.


The information contained in this article is general in nature and is not legal, tax or financial advice. For information regarding your particular situation, contact an attorney or a tax or financial advisor. The information in this newsletter is provided with the understanding that it does not render legal, accounting, tax or financial advice. In specific cases, clients should consult their legal, accounting, tax or financial advisor. This article is not intended to give advice or to represent our firm as being qualified to give advice in all areas of professional services. Exit Planning is a discipline that typically requires the collaboration of multiple professional advisors. To the extent that our firm does not have the expertise required on a particular matter, we will always work closely with you to help you gain access to the resources and professional advice that you need.

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