Symposium on Money Management
Surplus Dollars: Past, Present, and Future Jolyon H. Gissell*
Congratulations! You now can do a urethrostomy on a seal point Siamese. You have succeeded in navigating the treacherous waters of 10 drug detail men a day. Hopefully, you have been equally successful in your personal financial planning. You have built some equity in your home or maybe you own it completely. The kid's schooling is provided for by a college fund you are accumulating. You have a reasonable amount of insurance, hopefully term insurance. Finally, you have been able to set aside a comfortable cash reserve for emergencies. But wait a minute, you are still finding you are accumulating cash and it is going straight into the bank. Now, this is a real problem, as funny as it may seem. Why, you ask. Because those dollars may earn 6 per cent in the bank. Then you pay tax on your interest, between 40 and 60 per cent, which leaves you earning a net 3.6 per cent or 3 per cent on your money. At this point, along comes inflation. Let us say inflation is 7 per cent. You gained 3 to 3.6 per cent on your surplus but lost 7 per cent from inflation which leaves you losing around 4 per cent per year on your money and it just sat in the savings and loan. · The question now arises what can be done with those surplus dollars. Visions may now appear of income producing apartment houses, tax sheltered cattle feeding programs, high flying common stocks, commodity futures, and gilt-edged bonds. Which of these areas do we look into? Before we determine which way we go, let us see where we have been. Looking back does not predict what will happen in the future. However, one must not forget Santayana's famous dictum that a man who cannot remember history is condemned to relive it. *Account Executive, Dean Witter & Co .. Inc., Beverly Hills, California Veterinary Clinics of North America- Vol. 6, No. l, February 1976
61
62
jOLYON
H.
CISSELL
PAST In the past 10 years inflation has been a major concern with the dollar losing nearly 40 per cent of its purchasing power. Our job is to find a reasonable way to protect our investment dollar from that type of devastation. Ih 1967 the Dow Jones average of 30 industrial stocks stood at 865. Today, it stands at around 830, a little less than even. A number of stocks like the coal stocks, gold mining, as well as some blue chip growth stocks have had better results, but the average portfolio did not. The record of mutual funds has been as equally dismal. Gold soared from $35 per ounce to $200 per ounce at the turn of the year in 1975 but American citizens were not permitted to buy the yellow metal until it was at its high. Real estate, both urban and suburban, and especially farmland, have been excellent hedges. Semi-investments such as fine art, antiques, rare stamps, and numismatics all did well but are hardly suitable for most investors. They require much expertise and lack any real liquidity. Triple A bonds of American Telephone and Telegraph that pay 5 1/s per cent on your principal and mature in 2001 that were issued at $1 ,000 per bond in 1966, now are worth about $650 per bond if sold today. Of course, the bonds will be redeemed at their full value in 2001 but those will be dollars after almost 40 years of inflation. Similar bonds today pay 9 per cent but where will they sell if inflation is 15 per cent or 20 per cent or more? There are probably as many reasons why we have had the inflation problem as there are economists to give you those reasons. In the stage play "Give 'Em Hell, Harry," Mr. Truman was quoted as saying that if you took all the economists and layed them end to end across the country they would point in all directions. So it is with the causes of inflation. However, inflation in this country did not come into being until the World War II price controls were lifted. Prices then exploded. To get a complete view of what inflation has done in the last 30 or 40 years, let us compare some prices. The New York Times cost 2 cents then and 20 cents today. Subway fares in New York were 5 cents and today are 50 cents. Cars were $800 then and $4,000 now. Life insurance bought in the 1930's and 1940's and thought to be ample protection at the time is now painfully inadequate. Now let us see how some of our investment vehicles performed. American Telephone and Telegraph in 1946 issued a 25/s per cent bond maturing in 1986. That bond is worth 40 per cent less in today's market. Again we will eventually receive our original dollars, but dollars that are worth less than 1946 dollars because of inflation. Using Standard and Poor's indices of 425 common stocks based ~n the average prices between 1941 -43 equalling 10- the average was 97 at its peak in 1975. This group of 425 stocks of industrial companies performed creditably, showing a better than 9-fold increase which actu-
SURPLUS DOLLARS: PAST, PRESENT, AND FUTURE
63
ally outpaced inflation. One can say that you can prove anything with numbers, but the Standard and Poor's composite index of all companies averaged 19.75 in 1970, 56.60 in 1960, and now 86 which is to say that common stocks, over time, have had a good record compared with the plight of the purchasing power of the dollar. PRESENT It is an understatement to say that we are in a rapid state of flux. Today's best investment decision could be rendered useless by government decree or government policy either foreign or domestic. One is forced to take this fact into consideration. It is increasingly difficult for an individual to invest in anything and hold on for the long term without some degree of protection from either world conditions, or increasing government encroachment, not to mention the . normal business risk and/or stock market risk one assumes in investing. Also, in case you have not noticed, the government is your largest, single, silent partner, yet he won't even answer your phone for you. Of course, taxes provide some good services, but the specter of the government taking an ever increasingly larger bite from your dollar is something to be considered. Investing Today In formulating an investment program for today, four major areas are of utmost importance: capital preservation, reasonable rate of return, reasonable tax consequences, and liquidity. All four are basically self explanatory. Capital preservation is essentially protecting your principal surplus dollars against inflation erosion and an inordinate amount of risk taking. Remember, the easiest thing to do is to leave the money in the bank. It is generally better to pay taxes than risk the complete loss of principal. A reasonable rate of return is a subjective term. One investor may be happy with an 8 per cent return on his principal whereas someone else might demand 16 per cent. A reasonable rate lies somewhere between. Reasonable tax consequences mean just that. It is not constructive to your financial program to receive 10 per cent taxable return on your money if you are in the 60 per cent tax bracket and end up with a 4 per cent gain after tax with inflation at 7 per cent. Your net loss after inflation is 3 per cent. Liquidity means that if you want your money you can have it in a short period of time. Treasury Obligations Treasury bills and notes are full obligations of the United States Treasury. They range in maturity from 60 days to 7 years and are state
64
JoLYON H. CISSELL
tax free. There is a ready made market in most governments with the proceeds of sale of the treasury obligation available 7 days after sale if you decide to liquidate prior to maturity. Tax-Exempt Bonds Municipal bonds are direct obligations of cities, states, and their created authorities. The principal advantage of these bonds is that the interest derived from them is exempt from federal income tax. In addition, the interest is usually exempt from state tax in the state where the bonds are issued. This tax-exempt feature is usually the most important consideration to investors, particularly those with high income. However, capital gains realized from the sale of municipal bonds may be subject to capital gains tax. Another attraction of municipal bonds lies in their relative safety. As a type of security, they are ranked second only to direct obligations of the federal government. The great depression provided the severest test to municipal bonds in which only 1/5 of 1 per cent suffered any loss of principal and less than 2 per cent defaulted or failed to pay interest or principal on time. Of course, the New York situation comes to mind. Unfortunately, there is no easy answer, although at this time, it does appear that a workable solution will bail out the city and its bond holders. The most dependable way to prevent a situation similar to New York, from an investor standpoint, is to invest in financially strong areas. Two financial rating companies, Moody's and Standard and Poor's, issue ratings on various companies and municipalities. The highest credit rating is triple A. Bank trust departments usually consider any bond between Moody's- BAA and AAA to be investment grade. I would also recommend investment grade BAA or above and with maturities of approximately 10 years. For liquidity purposes it is important to stay with municipal bonds that are actively traded. Examples in California would be California general obligation bonds, Los Angeles Department of Water and Power, and San Francisco general obligations. Corporate Bonds Corporate bonds can also be attractive (again, somewhere between 4 and 10 year maturities). Bonds maturing in 25 to 40 years from the date of purchase are usually meant for the portfolios of insurance companies that have definite liabilities to settle in specific years according to their actuarial tables. In corporate bonds you must take into consideration the tax effect because all interest is taxable as regular income. The rule of thumb is if you are in the 30 to 35 per cent tax bracket, you should look to municipal bonds as opposed to taxable corporates. Many times corporations mortgage certain specific assets for collateral for a bond issue. As you might imagine, those are called mortgage
SURPLUS DOLLARS: PAST, PRESENT, AND fUTURE
65
bonds. When a bond does not have a specific pledge of assets, they are called debentures and are backed by the full faith and credit of the issuing company. However, debentures are not necessarily less credit worthy than mortgage bonds. Some debentures receive the top credit rating. Convertible Bonds
One of the most interesting features borrowers sometimes include in their bond contracts is the opportunity for the bond holder to convert the bond into a specific number of shares of common stock of the issuing company. The characteristics of the bond are thus changed because the bond holder is able to participate in the direct growth of the company by the right to convert his bond to stock. Convertible bonds, however, are junior obligations to the other direct obligations of the company. The convertible feature is made possible by the company to attract buyers of the bond who believe in the company's growth potential. Common Stocks
When you buy a bond you are actually lending your money to someone else. However, when you buy a common stock you are becoming part owner in that company. As usual, when you are a part owner you are entitled to a share of the profits. In stock ownership your cut of the earnings is the div.ideild that the company pays. Also, when you invest in common stocks you hope the company will do so well in their field that other investors will recognize this achievement and be willing to purchase the stock at a higher price than you paid. There are, of course, common stocks of all different companies. The most popular are those that are listed on the New York and American Stock Exchanges and that give a more complete disclosure of their financial affairs. Influences on the price of a particular stock are not easy to determine. Definitely some of the most important aspects are earnings, dividends, and quality of management. However, more and more emphasis is being put on a strong solid balance sheet with little or no debt. A dominant or strong position in company's industry is also a major determinant. One would also be remiss in not mentioning government economic policy or congressional decision and our old friend interest rates. The problem, then, is that situations change rather quickly. What insurance do we have that today's strong stocks are not going to be in tomorrow's stock scrapheap? The answer is not altogether clear. One answer might be to investigate the writing of call options in an attempt to gain a higher rate of returns. This is a highly sophisticated strategy and should only be considered by experienced investors.
66
joLYON
H.
GISSELL
The main answer to our question is that you must seek qualified advice from someone you trust. Just as you have an attorney, doctor, and dentist, you will also need an investment advisor. This will not guarantee good results but at least you will become discerning enough to be able to select the good from the bad and there are plenty of both . After selection, be active in your investments or make them yourself after determining all the facts . Do not give somebody a free hand without monitoring the situation.
FUTURE I, for one, am not sure what is going to happen in the future. I think I can be relatively sure of three things- taxes, inflation, and death. Mr. Baruch took care of death when he indicated that in the long term we are all dead; so what can we do in the meantime? Unfortunately there is not a single strategy that will cover both taxes and inflation. It therefore becomes evident that a combination of strategies is necessary to protect our surplus dollars. At this time there are no better strategies than: (1) a combination of high quality common stock investments for growth and as a hedge against inflation, and (2) a certain percentage of high grade, intermediate-term, tax-free municipal bonds. A more sophisticated investor might attempt to augment his common stock returns with an option writing program but would be advised to seek advice before doing so. It might be possible to obtain the best of all worlds in other investments, some of which are solid. However, this applies to securities also; the risk usually equals the reward. Municipal bonds and common stocks are not for everybody. It is up to you to decide which of the many investment vehicles is most suitable for your surplus dollars. 9470 Wilshire Boulevard Beverly Hills, California 90212
Surplus Dollars: Past, Present, and Future Jolyon H. Gissell*
Congratulations! You now can do a urethrostomy on a seal point Siamese. You have succeeded in navigating the treacherous waters of 10 drug detail men a day. Hopefully, you have been equally successful in your personal financial planning. You have built some equity in your home or maybe you own it completely. The kid's schooling is provided for by a college fund you are accumulating. You have a reasonable amount of insurance, hopefully term insurance. Finally, you have been able to set aside a comfortable cash reserve for emergencies. But wait a minute, you are still finding you are accumulating cash and it is going straight into the bank. Now, this is a real problem, as funny as it may seem. Why, you ask. Because those dollars may earn 6 per cent in the bank. Then you pay tax on your interest, between 40 and 60 per cent, which leaves you earning a net 3.6 per cent or 3 per cent on your money. At this point, along comes inflation. Let us say inflation is 7 per cent. You gained 3 to 3.6 per cent on your surplus but lost 7 per cent from inflation which leaves you losing around 4 per cent per year on your money and it just sat in the savings and loan. · The question now arises what can be done with those surplus dollars. Visions may now appear of income producing apartment houses, tax sheltered cattle feeding programs, high flying common stocks, commodity futures, and gilt-edged bonds. Which of these areas do we look into? Before we determine which way we go, let us see where we have been. Looking back does not predict what will happen in the future. However, one must not forget Santayana's famous dictum that a man who cannot remember history is condemned to relive it. *Account Executive, Dean Witter & Co .. Inc., Beverly Hills, California Veterinary Clinics of North America- Vol. 6, No. l, February 1976
61
62
jOLYON
H.
CISSELL
PAST In the past 10 years inflation has been a major concern with the dollar losing nearly 40 per cent of its purchasing power. Our job is to find a reasonable way to protect our investment dollar from that type of devastation. Ih 1967 the Dow Jones average of 30 industrial stocks stood at 865. Today, it stands at around 830, a little less than even. A number of stocks like the coal stocks, gold mining, as well as some blue chip growth stocks have had better results, but the average portfolio did not. The record of mutual funds has been as equally dismal. Gold soared from $35 per ounce to $200 per ounce at the turn of the year in 1975 but American citizens were not permitted to buy the yellow metal until it was at its high. Real estate, both urban and suburban, and especially farmland, have been excellent hedges. Semi-investments such as fine art, antiques, rare stamps, and numismatics all did well but are hardly suitable for most investors. They require much expertise and lack any real liquidity. Triple A bonds of American Telephone and Telegraph that pay 5 1/s per cent on your principal and mature in 2001 that were issued at $1 ,000 per bond in 1966, now are worth about $650 per bond if sold today. Of course, the bonds will be redeemed at their full value in 2001 but those will be dollars after almost 40 years of inflation. Similar bonds today pay 9 per cent but where will they sell if inflation is 15 per cent or 20 per cent or more? There are probably as many reasons why we have had the inflation problem as there are economists to give you those reasons. In the stage play "Give 'Em Hell, Harry," Mr. Truman was quoted as saying that if you took all the economists and layed them end to end across the country they would point in all directions. So it is with the causes of inflation. However, inflation in this country did not come into being until the World War II price controls were lifted. Prices then exploded. To get a complete view of what inflation has done in the last 30 or 40 years, let us compare some prices. The New York Times cost 2 cents then and 20 cents today. Subway fares in New York were 5 cents and today are 50 cents. Cars were $800 then and $4,000 now. Life insurance bought in the 1930's and 1940's and thought to be ample protection at the time is now painfully inadequate. Now let us see how some of our investment vehicles performed. American Telephone and Telegraph in 1946 issued a 25/s per cent bond maturing in 1986. That bond is worth 40 per cent less in today's market. Again we will eventually receive our original dollars, but dollars that are worth less than 1946 dollars because of inflation. Using Standard and Poor's indices of 425 common stocks based ~n the average prices between 1941 -43 equalling 10- the average was 97 at its peak in 1975. This group of 425 stocks of industrial companies performed creditably, showing a better than 9-fold increase which actu-
SURPLUS DOLLARS: PAST, PRESENT, AND FUTURE
63
ally outpaced inflation. One can say that you can prove anything with numbers, but the Standard and Poor's composite index of all companies averaged 19.75 in 1970, 56.60 in 1960, and now 86 which is to say that common stocks, over time, have had a good record compared with the plight of the purchasing power of the dollar. PRESENT It is an understatement to say that we are in a rapid state of flux. Today's best investment decision could be rendered useless by government decree or government policy either foreign or domestic. One is forced to take this fact into consideration. It is increasingly difficult for an individual to invest in anything and hold on for the long term without some degree of protection from either world conditions, or increasing government encroachment, not to mention the . normal business risk and/or stock market risk one assumes in investing. Also, in case you have not noticed, the government is your largest, single, silent partner, yet he won't even answer your phone for you. Of course, taxes provide some good services, but the specter of the government taking an ever increasingly larger bite from your dollar is something to be considered. Investing Today In formulating an investment program for today, four major areas are of utmost importance: capital preservation, reasonable rate of return, reasonable tax consequences, and liquidity. All four are basically self explanatory. Capital preservation is essentially protecting your principal surplus dollars against inflation erosion and an inordinate amount of risk taking. Remember, the easiest thing to do is to leave the money in the bank. It is generally better to pay taxes than risk the complete loss of principal. A reasonable rate of return is a subjective term. One investor may be happy with an 8 per cent return on his principal whereas someone else might demand 16 per cent. A reasonable rate lies somewhere between. Reasonable tax consequences mean just that. It is not constructive to your financial program to receive 10 per cent taxable return on your money if you are in the 60 per cent tax bracket and end up with a 4 per cent gain after tax with inflation at 7 per cent. Your net loss after inflation is 3 per cent. Liquidity means that if you want your money you can have it in a short period of time. Treasury Obligations Treasury bills and notes are full obligations of the United States Treasury. They range in maturity from 60 days to 7 years and are state
64
JoLYON H. CISSELL
tax free. There is a ready made market in most governments with the proceeds of sale of the treasury obligation available 7 days after sale if you decide to liquidate prior to maturity. Tax-Exempt Bonds Municipal bonds are direct obligations of cities, states, and their created authorities. The principal advantage of these bonds is that the interest derived from them is exempt from federal income tax. In addition, the interest is usually exempt from state tax in the state where the bonds are issued. This tax-exempt feature is usually the most important consideration to investors, particularly those with high income. However, capital gains realized from the sale of municipal bonds may be subject to capital gains tax. Another attraction of municipal bonds lies in their relative safety. As a type of security, they are ranked second only to direct obligations of the federal government. The great depression provided the severest test to municipal bonds in which only 1/5 of 1 per cent suffered any loss of principal and less than 2 per cent defaulted or failed to pay interest or principal on time. Of course, the New York situation comes to mind. Unfortunately, there is no easy answer, although at this time, it does appear that a workable solution will bail out the city and its bond holders. The most dependable way to prevent a situation similar to New York, from an investor standpoint, is to invest in financially strong areas. Two financial rating companies, Moody's and Standard and Poor's, issue ratings on various companies and municipalities. The highest credit rating is triple A. Bank trust departments usually consider any bond between Moody's- BAA and AAA to be investment grade. I would also recommend investment grade BAA or above and with maturities of approximately 10 years. For liquidity purposes it is important to stay with municipal bonds that are actively traded. Examples in California would be California general obligation bonds, Los Angeles Department of Water and Power, and San Francisco general obligations. Corporate Bonds Corporate bonds can also be attractive (again, somewhere between 4 and 10 year maturities). Bonds maturing in 25 to 40 years from the date of purchase are usually meant for the portfolios of insurance companies that have definite liabilities to settle in specific years according to their actuarial tables. In corporate bonds you must take into consideration the tax effect because all interest is taxable as regular income. The rule of thumb is if you are in the 30 to 35 per cent tax bracket, you should look to municipal bonds as opposed to taxable corporates. Many times corporations mortgage certain specific assets for collateral for a bond issue. As you might imagine, those are called mortgage
SURPLUS DOLLARS: PAST, PRESENT, AND fUTURE
65
bonds. When a bond does not have a specific pledge of assets, they are called debentures and are backed by the full faith and credit of the issuing company. However, debentures are not necessarily less credit worthy than mortgage bonds. Some debentures receive the top credit rating. Convertible Bonds
One of the most interesting features borrowers sometimes include in their bond contracts is the opportunity for the bond holder to convert the bond into a specific number of shares of common stock of the issuing company. The characteristics of the bond are thus changed because the bond holder is able to participate in the direct growth of the company by the right to convert his bond to stock. Convertible bonds, however, are junior obligations to the other direct obligations of the company. The convertible feature is made possible by the company to attract buyers of the bond who believe in the company's growth potential. Common Stocks
When you buy a bond you are actually lending your money to someone else. However, when you buy a common stock you are becoming part owner in that company. As usual, when you are a part owner you are entitled to a share of the profits. In stock ownership your cut of the earnings is the div.ideild that the company pays. Also, when you invest in common stocks you hope the company will do so well in their field that other investors will recognize this achievement and be willing to purchase the stock at a higher price than you paid. There are, of course, common stocks of all different companies. The most popular are those that are listed on the New York and American Stock Exchanges and that give a more complete disclosure of their financial affairs. Influences on the price of a particular stock are not easy to determine. Definitely some of the most important aspects are earnings, dividends, and quality of management. However, more and more emphasis is being put on a strong solid balance sheet with little or no debt. A dominant or strong position in company's industry is also a major determinant. One would also be remiss in not mentioning government economic policy or congressional decision and our old friend interest rates. The problem, then, is that situations change rather quickly. What insurance do we have that today's strong stocks are not going to be in tomorrow's stock scrapheap? The answer is not altogether clear. One answer might be to investigate the writing of call options in an attempt to gain a higher rate of returns. This is a highly sophisticated strategy and should only be considered by experienced investors.
66
joLYON
H.
GISSELL
The main answer to our question is that you must seek qualified advice from someone you trust. Just as you have an attorney, doctor, and dentist, you will also need an investment advisor. This will not guarantee good results but at least you will become discerning enough to be able to select the good from the bad and there are plenty of both . After selection, be active in your investments or make them yourself after determining all the facts . Do not give somebody a free hand without monitoring the situation.
FUTURE I, for one, am not sure what is going to happen in the future. I think I can be relatively sure of three things- taxes, inflation, and death. Mr. Baruch took care of death when he indicated that in the long term we are all dead; so what can we do in the meantime? Unfortunately there is not a single strategy that will cover both taxes and inflation. It therefore becomes evident that a combination of strategies is necessary to protect our surplus dollars. At this time there are no better strategies than: (1) a combination of high quality common stock investments for growth and as a hedge against inflation, and (2) a certain percentage of high grade, intermediate-term, tax-free municipal bonds. A more sophisticated investor might attempt to augment his common stock returns with an option writing program but would be advised to seek advice before doing so. It might be possible to obtain the best of all worlds in other investments, some of which are solid. However, this applies to securities also; the risk usually equals the reward. Municipal bonds and common stocks are not for everybody. It is up to you to decide which of the many investment vehicles is most suitable for your surplus dollars. 9470 Wilshire Boulevard Beverly Hills, California 90212
