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Author: Curtis Trimble

When Reinvesting Dividends Can Do You Wrong

Reinvesting dividends paid on shares of common stock frequently represents an outstanding way in which to benefit from the long-term compounding effect of common stock ownership. Investing website The Motley Fool calculated that the value of $10,000 invested in the S&P 500 in 1960 – with dividends reinvested through 2021– would have compounded to a cool $4.95 million. The value of the reinvested dividends accounted for $4.16 million, or 84%, of the gain, while simple share price appreciation made up only $795,800 of the increase.

Depending on reinvested dividends from single stocks, though, may present unforeseen risks for investors. Consider a hypothetical example in which an investor initially pays $10 per share for 2,500 shares of common stock in a company that pays an attractive 8% yield. The investor chooses to reinvest their dividend proceeds back into more common shares of stock in the company. In the first year these dividend reinvestments result in an additional $23, or 0.1% of dividend yield, as compared to not reinvesting the dividends.

All initially appears well with respect to dividend income and rate in Year 1 of our hypothetical example. However, negative dynamics in asset markets begin to erode the underlying value of the $25,000 initial investment made in our example. Possibly interest rates increased, reducing the relative attraction of an 8% dividend yield as compared to other investments. Or, maybe the company lost a key management member, incurred a lawsuit, or experienced cost overruns on a large project. Potentially, management adopted too aggressive of a dividend policy and, as a result, its cost of capital in the higher interest rate environment negatively altered its investment proposition as it needed more capital from outside sources to fund its operations. 

Whatever: the company in our example sees its shares decline 5% annually over a five-year period. Management, however, continued to believe that a relatively high dividend policy attracted shareholders despite ongoing share-price declines for the company; they ratcheted up the original $0.80 per share, 8% dividend rate by 2% annually. As shown in the table below, the combination of declining share price and escalating dividend rate actually enhanced the dividend rate for the company to ~8.5% over the five-year period. Also, the quarterly dividend payment to the investor grew considerably – $133, or 26.6%,  – over the five-year period. In year 5 of our example the investor receives an estimated $2,497 in dividends versus $2,023 of estimated Year 1 dividend payments. Finally, the overall value of the investment grew to $29,503 from our initial $25,000 stake, an increase of 17.1%. 

All of that may appear not horrible at first glance: growing dividend payments and a positive total return, sign me up! The catch, though, is that the investor paid an additional $11,251 in reinvested dividends in order to achieve that $29,503 Year 5 value. In effect, they lost $6,747 as the share price in our hypothetical example moved from $10 per share to $7.78. This share price decline may appear relatively benign as compared to the moves for many stocks in 2022, but the actual compounded annual rate of return for our investor calculates to a measly 3.37%. Even with the S&P 500’s abysmal 2022 total return, this rate pales in comparison to that index’s 9.5% five-year compounded average annual growth rate from 2018 to 2022.

Also, this 3.37% annual rate of return is a far cry from the anticipated 8% rate implied by the dividend and only slightly better than one-half the 6.5% rate of inflation posted in 2022. In purchasing power, the investor would find themself noticeably worse off. The rate of annual dividend growth would need to leap to 17.5%, implying a Year 5 dividend yield of 14.3%, for the value of this investment to keep pace with 2022’s rate of inflation. Similarly, our investor would keep pace with a 6.5% rate of inflation were the shares in our example to only decline 2% annually, all other factors remaining equal. 

Hypothetical Value of Reinvested Dividends with Declining Share Price
Quarter Qtr Dividend Rate Qtr Dividend Amount Annual Dividend Dividend Share Price New Shares Value of Investment Annual Dividend Rate
1Q01 2.00% $0.20 $0.80 $500 $9.88 2,551 $25,188  
2Q01 2.00% $0.20 $0.80 $504 $9.75 2,602 $25,376  
3Q01 2.00% $0.20 $0.80 $508 $9.63 2,655 $25,567  
4Q01 2.00% $0.20 $0.80 $511 $9.51 2,709 $25,758 7.85%
1Q02 2.04% $0.20 $0.82 $525 $9.39 2,765 $25,962  
2Q02 2.04% $0.20 $0.82 $530 $9.27 2,822 $26,167  
3Q02 2.04% $0.20 $0.82 $534 $9.16 2,880 $26,374  
4Q02 2.04% $0.20 $0.82 $538 $9.04 2,940 $26,582 8.00%
1Q03 2.08% $0.21 $0.83 $553 $8.93 3,002 $26,803  
2Q03 2.08% $0.21 $0.83 $558 $8.82 3,065 $27,026  
3Q03 2.08% $0.21 $0.83 $562 $8.71 3,129 $27,250  
4Q03 2.08% $0.21 $0.83 $567 $8.60 3,195 $27,477 8.15%
1Q04 2.12% $0.21 $0.85 $583 $8.49 3,264 $27,716  
2Q04 2.12% $0.21 $0.85 $588 $8.39 3,334 $27,958  
3Q04 2.12% $0.21 $0.85 $593 $8.28 3,406 $28,202  
4Q04 2.12% $0.21 $0.85 $599 $8.18 3,479 $28,448 8.31%
1Q05 2.16% $0.22 $0.87 $616 $8.07 3,555 $28,708  
2Q05 2.16% $0.22 $0.87 $621 $7.97 3,633 $28,971  
3Q05 2.16% $0.22 $0.87 $627 $7.87 3,713 $29,236  
4Q05 2.16% $0.22 $0.87 $633 $7.78 3,794 $29,503 8.46%

2023 Investing Views from Solyco Wealth

The investment climate in 2023 likely will reflect a tale of two halves. Through the first two quarters of the year, we anticipate ongoing discussions of inflation, Fed interest rate policy, and stalling economies to dominate the investing landscape, much as they did throughout last year. The second half of 2023, however, we envision that abating inflationary pressures will lead to fading concerns for higher interest rates and more constructive thoughts of economic recovery and growth.

We possess little certainty about the magnitude for any of the above conditions, however, but expect directionality will rule the day rather than absolute movements. As a result, we expect investing successes in 2023 will hinge heavily on securities selection. The retail sector already offers an excellent example of the probable difficulties posed to investors this year and the prospective benefits of holding the right assets. Whereas American Eagle (AEI) and Urban Outfitters (URBN) reported record 2022 holiday sales with better-than-anticipated margins that recently bolstered their share prices, Macy’s (M) and Lululemon (LULU) experienced fine rates of sales growth but apparently of discounted items that negatively impacted margins and, thus, their share prices. We are fairly certain that specificity likely will matter more for investing success in 2023 than in prior years.

Earnings season for 4Q22 kicks off later this week with Delta (DAL), which Solyco Wealth includes in its model portfolios and client accounts, joining several of the large money-center banks like JPMorgan (JPM) and Bank of America (BAC). We should get very quick reads of the strength of the US consumer via credit card and consumer lending data from the banks as well as travel-and-leisure booking trends from DAL. We expect banks’ views on consumer strength to remain modestly positive but with a decidedly stronger optimistic bias for their travel-and-leisure budgets. Overall through 4Q22 earnings season, however, we would not be surprised to hear a healthy degree of “sandbagging” from company management teams with respect to their earnings and cash flow expectations for 2023.

Driving our cherry-picked example just a little further, this investor also could have benefited from repurchasing the same 1,000 SLB shares four months later at $33. To maintain the symmetry to our example, they also recently reestablished their 133-share MSFT position at $244. So, our investor now not only retains the same 1,000 shares of SLB and 133 shares of MSFT, For one thing, as the above graph from Morningstar relays, expectations for 1Q23 economic growth remain anemic. With a backdrop of such low expectations for the economy and “margin pressure” like that experienced by Macy’s and Lululemon all but omnipresent, it probably will prove too attractive for all but the most bullish (or bad) of public company management teams to not take the opportunity to lower the bar of investor expectations. Some companies will need to do this as their businesses actually are flagging. Others, however, will do it just because they can (aka “sandbagging”). Environments like the current one that likely lead to wide-spread sandbagging of expectations all too often see companies segmented into three types of opportunities: 

  1. Strong buys for companies with excellent and/or opportunistic leaderships that proactively managed inventories to maintain margins with solid views on the direction of their operations in ’23 that, therefore, do not need to sandbag. We think Delta falls into this category for 4Q22/2023.
  2. Speculative buys or holds for companies that post solid 4Q22 results but that fail to exhibit much knowledge regarding the directionality of their businesses in 2023.
  3. Strong avoids for companies that blame exogenous factors for underwhelming 4Q22 results coupled with little insight as to what 2023 may hold for them, their company, or their employees.

As analysts aggressively reduced their 4Q22 earnings estimates (see graph below) we expect a healthy “beat rate” for the quarter. According to FactSet analysts overall cut their S&P 500 earnings projections by 6.5% since 3Q22, a rate 1.5x that of the average decrease over the past 20 years. 

Earnings expectations for 2023 – the crux of our “sandbagging” claim – call for 4.8% growth for the S&P 500 versus 2022 earnings. By comparison S&P 500 earnings in 2022 exceeded those of 2021 by 4.7%. The likes of Macy’s and Lululemon will need to see some extensive inventory turnover early in ’23 to realize margin recoveries sufficient for this year’s earnings growth to exceed that of last year; we expect more than a few companies will be in similar positions with even more posting declining margins due to wage pressures. Also, the Energy sector appears highly unlikely to generate earnings growth this year comparable to what it did last year without crude oil prices staging a significant rebound from their recent $75 per barrel level. Due to recession and economic growth concerns and their estimated impact on crude oil demand, barring another unforeseen shock to crude oil supply we do not see this price appreciation occurring until 2H23. The necessary downward revisions to 2023 earnings estimates probably materialize (the lowering of the bar) with analysts’s 4Q22 reports, creating the proverbial “low bar” for much of 2023. Given very low expectations for equities late in 2022 and very high levels of ongoing uncertainty for 2023 operating conditions, little motivation existed for analysts to make these reductions prior to 4Q22 reporting season.

Despite our expectations for muted 1H23 earnings growth, we remain constructive on equities this year. Stock prices trade in response to future expectations and 2H23 offers immense opportunities for equities to clear the low bar of expectations set early in 2023. As shown in the following graph, the challenging investing environment in 2022 developed not in response to poor earnings, which likely grew 4.8%, but rather to investors substantially discounting those growing earnings. As a result, the price-to-earnings ratio for the S&P 500 fell to 18.6x at year-end 2022 a level 24.4% lower than 2021’s year-end P/E of 24.6x in spite of the aforementioned earnings growth. 

Rapidly escalating interest rates – a key component of companies’ cost of capital, or discount rates – at the hands of the Fed in response to even more rapidly escalating inflation explained this significant discounting of S&P 500 earnings. As shown in the table below, which reflects a stream of cash flows discounted in perpetuity at the stated rate, a 24.2% decline in P/E implies a 31.8% relative increase in a company’s discount rate: 10% to 13.2%, for instance. In other words, $20 of cash flow in 2021 is only worth $15.17 in 2022, irrespective of whether or not the company needed more or less capital to generate that cash flow. While we anticipate higher costs of capital persisting through 2023 and into 2024, the above graph of P/Es – albeit through environment with much lower and less volatile interest rates – exhibits the more or less whimsical nature of the relationship between prices and earnings. In our view it probably will not take much evidence of moderating interest rate increases for investors to begin propelling P/Es higher in response to prospectively lower estimated costs of capital. We point to the number and strength of 2022’s “bear market rallies” in support of this conclusion as well as to the magnitude of cash sitting on the sidelines (discussed below).

Discount Rate 10.0% 11.0% 12.0% 13.0% 13.2% 14.0% 15.0% 16.0% 17.0%
Implied Change in Value   -9.1% -16.7% -23.1% -24.1% -28.6% -33.3% -37.5% -41.2%
% Change in Discount Rate   10.0% 20.0% 30.0% 31.8% 40.0% 50.0% 60.0%  70.0%

Source: Solyco Wealth

The three graphs below, which convey the percentage of high-yield, or junk, debt coming due over the next three years, the recent default rate of high-yield issuers, and the recent rate of interest coverage for these issuers, exhibit the cumulative capital situation for the subset of companies most sensitive to changes in the cost of capital. Overall, despite the very negative environment in 2022 and the significant economic uncertainty entering 2023, it appears that the companies most susceptible to a rising cost of capital environment remain in a relatively strong position. Sentiment, which we judge whimsical by nature, appears to be the primary driver of this increase in cost of capital and not fundamental demand for additional capital.

Substantial cash on the sidelines waiting for the “all clear” signal to deploy fulfills the final cog underpinning a constructive backdrop for risk assets in 2023, in our view. FactSet data, as presented in the following graph, calculated approximately $4.5 trillion in money market accounts exiting 2022. These money market balances represent about 13.8% of the total $32.5 trillion market capitalization of the S&P 500. Deployment of this magnitude of available capital and the positive momentum created would, in our view, signal the “all clear” and mark a persistent reversal of investor sentiment.

Solyco Wealth allocates assets to equity, fixed income and cash across four risk gradients ranging from Conservative to Aggressive using a model portfolio concept. While equity allocations to these four model portfolios range from 25% for the Conservative portfolio to 90% for the Aggressive portfolio, Fixed Income allocations span 5% for Aggressive to 65% for Conservative. The Cash allocation amounts to 10% for the three most conservative portfolios while the Aggressive portfolio maintains a 5% cash position. 

Risk Tolerance Equity Fixed Income Cash Total
Conservative 25.0%  65.0%  10.0%   100.0%
Moderate 45.0%  45.0%   10.0% 100.0%
Moderately Aggressive  65.0% 25.0%   10.0%  100.0%
Aggressive  90.0%  5.0%  5.0%  100.0%

While we anticipate that the pace and magnitude of increases in the Fed Funds Rate will slow significantly in the coming months, we expect to maintain our Fixed Income allocations through at least 1Q23. For the most conservative portfolios we likely will pull cash allocations down to 5% in favor of heavier weightings to Fixed Income rather than change the portfolios’ equity allocations. Notably, we achieve all of Solyco Wealth’s Fixed Income exposures by investing in Exchange Traded Funds (ETFs) and not in individual bonds.

Within the Fixed Income allocations, we continue to favor shorter duration securities. The outsized volatility at the long-end of the interest rate curve remains a concern to us vis-à-vis the relatively short period and magnitude of declines in the inflation numbers. We favor, as a result, greater equity exposure over long-duration fixed income assets. We also employ a decided preference for Credit and Municipals exposures over Treasuries. 

As for equity exposure for our four model portfolios, Solyco Wealth invests in shares of individual companies. We continue to favor the Industrials and Materials sectors, as we have since mid-October 2022, while underweighting Information Technology and avoiding Utilities altogether, as shown in the following table. 

Equity Sector Rating S&P 500 Weighting Solyco Wealth Weighting Difference
Communications Services Equalweight 7.5% 7.5% 0.0%
Consumer Discretionary Equalweight 11.3% 11.3% 0.0%
Consumer Staples Equalweight 6.1% 6.1% 0.1%
Energy Equalweight 5.3% 5.3% 0.0%
Financials Equalweight 11.7% 11.7% 0.0%
Health Care Equalweight 14.7% 14.7% 0.0%
Industrials Overweight 9.1% 13.7% 4.6%
Information Technology Underweight 25.5% 21.1% -4.4%
Materials Overweight 2.8% 5.6% 2.8%
Real Estate Equalweight 3.2% 3.0% -0.2%
Utilities Underweight 2.9% 0.0% -2.9%
    100.0% 100.0% 0.0%

Providing that economic growth rekindles and increases in interest rates cease as we expect by 2H23, we anticipate opportunities to upgrade the pro-cyclical sectors Consumer Discretionary and Information Technology to Overweights. In order to fund these moves we likely would move Consumer Staples to an Underweight rating and Industrials and Materials back to Equalweights. Energy represents a significant “wildcard” for 2023, in our view, as it hinges heavily on crude oil demand which we anticipate will swing wildly in response to Ukraine-Russia and geopolitical developments as well as to global economic growth (or the lack thereof).

Asset class allocation and sector weightings offer valuable buffers against portfolio underperformance. However, in our view, picking equities that offer compelling risk-reward ratios represents the best protection from lagging performance. We spend an inordinate amount of time pouring over equity research, company news flows and financials, and relevant sector, industry, and geopolitical commentaries, from a wide variety of sources. In our view these efforts in combination with a significant amount of successful investing experience across a broad array of market conditions give Solyco Wealth “the edge” many firms lack. Below we offer the stocks, grouped by sector, that compose the current equity holdings of our four model portfolios:

Communication Services: Comcast (CMCSA), Alphabet (GOOGL)
Consumer Discretionary: Amazon (AMZN), Borg-Warner (BWA), Mercadolibre (MELI), Nike (NKE), Texas Roadhouse (TXRH), YETI (YETI)
Consumer Staples: Anheuser-Busch (BUD), Boston Beer (SAM), Performance Food Group (PFGC), Wal-Mart (WMT)
Energy: Earthstone Energy (ESTE), Pioneer Natural Resources (PXD), Totalenergies (TTE)
Financials: CBOE Global Markets (CBOE), Citizens Financial Group (CFG), Chubb (CB), Goldman Sachs (GS), Intercontinental Exchange (ICE), Traveler’s (TRV)
Health Care: Abbot Labs (ABT), Biontech (BNTX), Boston Scientific (BSX), Centene (CNC), CVS (CVS), Incyte (INCY), Johnson & Johnson (JNJ), Nuvasive (NUVA), Universal Health Services (UHS), Zimmer Biomed (ZBH)
Industrials: ABB (ABB), Chart Industries (GTLS), Delta (DAL), Honeywell (HON), Lockheed-Martin (LMT), WESCO (WCC)
Information Technology: Applied Materials (AMAT), Advanced Micro Devices (AMD), Autodesk (ADSK), Arista Networks (ANET), Cisco (CSCO), Corning (GLW), MicroChip (MCHP), Microsoft (MSFT), Salesforce (CRM), ServiceNow (NOW), Shopify (SHOP), Splunk (SPLK),
Materials: Eastman Chemical (EMN), Sociedad Quimica y Minera (SQM)
Real Estate: American Tower (AMT)
Utilities: No Holdings

The above companies represent the entirety of the equity positions across all four Solyco Wealth model portfolios: no portfolio holds each of these stocks. In our view the risk-reward ratio offered by YETI, for instance, is inappropriate for the Conservative portfolio vis-à-vis that of Nike. Generally, our portfolios hold between one and seven Fixed Income ETFs and between 24 and 32 individual equities. We desire to manage relatively concentrated positions as we only want to hold securities in which we harbor great conviction. Looking forward we anticipate that from the above list DAL, ESTE, GTLS, SHOP and SQM, may offer the most compelling risk-reward characteristics in 2023. Conversely, ABT, NKE, UHS, and TXRH, currently trade the closest to the upper bounds of our valuation estimates, barring upside from 4Q22 performance and/or escalating expectations for 2023. We remain happy to share our individual models and securities allocations with anyone interested upon request.

Solyco Wealth Model Portfolios Substantially Outperform Benchmarks, S&P 500 in 4Q22 and 2022

The four model portfolios managed by Solyco Wealth generated relatively very strong performances for 4Q22, full-year 2022, and since their September 8, 2021, inception, as shown in the charts below. Except the performance of the Conservative Model Portfolio in 4Q22 vs. the S&P 500, each of the portfolios’ performances exceeded that of its benchmark as well as that of the S&P 500 and Bloomberg US Aggregate Bond Index. Since inception the Conservative, Moderate, Moderately Aggressive and Aggressive Model Portfolios averaged 9.72% of out-performance versus their respective benchmarks and 8.45% out-performance versus the S&P 500.

Stock-picking remained the key strength underpinning the success of Solyco Wealth as across all portfolios equity out-performance averaged exceeding that of the S&P 500 by 11.34%, or 1,134 basis points (bps). Meanwhile, out-performance of the fixed income exchange traded funds (ETFs) held in the model portfolios only averaged 0.84%, or 84 bps. As a matter of investment policy, Solyco Wealth populates its model portfolios with individual equities while allocating capital to bond ETFs to achieve the desired fixed income weighting. The four portfolios hold between 25 and 30 stocks of individual companies and two to seven bond ETFs. The three more conservative portfolios also utilize the common stocks of private debt providers Ares Capital (ARCC) and Hercules Technology (HTGC) to achieve diversified fixed income exposures.

Conservative Model Portfolio

As shown in the following table, the Conservative model portfolio posted a positive 6.62% result for 4Q22 but dropped 8.48% in 2022 and 6.78% since inception. These results outpaced Conservative’s benchmark by 260 bps in 4Q22, 484 bps in 2022, and 591 bps SI. Solyco Wealth runs the Conservative Model Portfolio with a 65% allocation to fixed income securities, a 22.8% domestic equity securities allocation, a 2.2% international equity securities allocation, and a 10% cash position. The Conservative portfolio benefited from out-performance from both its equity and fixed income allocations as performances to each of these asset class allocations outdistanced those of the S&P 500 and the Bloomberg US Aggregate Bond Index. By design the Conservative Model Portfolio under-weighted international equities throughout 2022 in anticipation of greater worldwide volatility relative to that of the US. Although this positioning served the portfolios well last year, we anticipate it reversing and will commence to adding more international exposure with subsequent portfolio changes.

Solyco Wealth Conservative Model Portfolio Comparative Performance: 4Q22, 2022, and Since Inception
    4Q22 2022 Since SW Inception
Benchmarks S&P 500 7.56% -18.11% -13.28%
Russell 3000 7.18% -19.21% -15.69%
MSCI All-World ex-US 16.18% -14.29% -15.68%
Bloomberg US Agg Bond 0.72% -12.46% -12.95%
Conservate Model Portfolio Portfolio Return 6.62% -8.48% -6.78%
Benchmark Return 4.02% -13.32% -12.69%
   +/- Benchmark 2.60% 4.84% 5.91%
   +/- S&P 500 -0.94% 9.63% 6.50%
   +/- Equities vs. S&P 500 8.23% 9.48% 11.00%
   +/- Fixed Income vs. Agg 1.47% 2.09% 2.18%

The above table reflects a 1% annual management fee for 2022 as well as 0.25% for 4Q22 and 1.33% since exception.
Actual client investment performance likely will differ from respective model portfolio performance due to several factors including: 1) Timing of securities purchases and sales, 2) Dividend reinvestment choices, 3) Securities held outside the model portfolio, 4) Weighting differentials for certain securities relating to whole versus partial share accounting, 5) Timing and pricing of rebalancing actions, and other minor factors.
Conservative benchmark = total returns for 10.0% Russell 3000 Index, 65.0% Bloomberg US Aggregate Bond Index, and 10.0% MSCI World ex-US Index and 15.0% cash allocations.

Energy and Defense propelled Conservative’s results, led by SLB’s +84.1% return since inception as well as TotalEnergies (TTE) 50.8% move higher and Lockheed Martin’s (LMT) 44.1% rate of appreciation for the same time period. From the fixed income side Ares Capital (ARCC), in which the portfolio carries a 5% weighting, generated a +5.3%, over 1,800 bps better than the fixed income benchmark. 

On the downside Conservative suffered significantly from a 25.1% move lower for the Vanguard Emerging Markets Government Bond ETF (VWOB) prior to removing it from the portfolio in 3Q22. In fact, fixed income ETFs defined six of the seven worst performing assets held in the portfolio. Amazon (AMZN), falling 52.1% SI, provided the stiffest headwind for Conservative’s performance, followed by Alphabet’s (GOOGL) 38.9% drop and the 38.9% decline in Comcast’s stock price since portfolio inception.

Moderate Model Portfolio

With a returns profile of +8.53% for 4Q22, -8.25% for 2022, and -4.81% SI, Solyco Wealth’s Moderate Model Portfolio exceeded benchmark performances respectively by 237 bps, 757 bps, and 992 bps. The Moderate portfolio carried a 52% weighting to equities along with a 38% bond allocation and a 10% cash position. As Moderate’s fixed income holdings only outperformed the -14.73% performance of the benchmark by 35 bps, equity holdings that outpaced the S&P 500 by 13.09% SI drove portfolio outperformance.

Solyco Wealth Conservative Model Portfolio Comparative Performance: 4Q22, 2022, and Since Inception
    4Q22 2022 Since SW Inception
Benchmarks S&P 500 7.56% -18.11% -13.28%
Russell 3000 7.18% -19.21% -15.69%
MSCI All-World ex-US 16.18% -14.29% -15.68%
Bloomberg US Agg Bond 0.72% -12.46% -12.95%
Moderate Model Portfolio Portfolio Return 8.53% -8.25% -4.81%
Benchmark Return 6.16% -15.82% -14.73%
   +/- Benchmark 2.37% 7.57% 9.92%
   +/- S&P 500 0.97% 9.86% 8.47%
   +/- Equities vs. S&P 500 7.85% 10.68% 13.09%
   +/- Fixed Income vs. Agg 1.35% 0.71% 0.35%

The above table reflects a 1% annual management fee for 2022 as well as 0.25% for 4Q22 and 1.33% since exception.
Actual client investment performance likely will differ from respective model portfolio performance due to several factors including: 1) Timing of securities purchases and sales, 2) Dividend reinvestment choices, 3) Securities held outside the model portfolio, 4) Weighting differentials for certain securities relating to whole versus partial share accounting, 5) Timing and pricing of rebalancing actions, and other minor factors.
Moderate benchmark = total returns for 22.5% Russell 3000 Index, 45.0% Bloomberg US Aggregate Bond Index, and 22.5% MSCI World ex-US Index, and 10.0% cash allocations.

As with the Conservative Model Portfolio, Moderate’s Energy holdings paced performance. SLB moved 84.1% while held in the portfolio while Pioneer Natural Resources (PXD), which remains a 1.73% weighting, appreciated 75.2% SI. Health care companies Vertex Pharmaceuticals (VRTX) and AbbVie (ABBV) were sold out of the portfolio at respective gains of 63.5% and 49.7%.

The 25.1% move lower for the Vanguard Emerging Markets Government Bond ETF (VWOB), Amazon’s (AMZN) 52.1% decline, and entertainment company Paramount’s (PARA) 53.5% move lower disproportionately detracted from Moderate’s performance. Twelve positions were sold out of Moderate since inception, including four at a loss. Centene (CNC) was sold and subsequently repurchased in exchange for VRTX.

Moderately Aggressive Model Portfolio

Solyco Wealth’s Moderately Aggressive Model Portfolio remained the firm’s top-performing portfolio as it gained 8.98% for 4Q22, reducing its 2022 loss to 6.46% and its fall since inception to only 1.22%. These results exceeded those of the S&P 500 by 142 bps for 4Q22, 1,165 bps for full-year 2022, and 1,206 bps since its 9/8/21 inception. Moderately Aggressive deploys 65% of its capital to equities with 25% allocated to debt ETFs, and 10% reserved in cash. As compared to the blended benchmark, which equally splits its equity allocation with 32.5% allocated to domestic and to international stocks, we underweighted international equities throughout 2022. As shown in the following table, equity performance accounted for the vast majority of the portfolio’s out-performance.

Solyco Wealth Moderately Aggressive Model Portfolio Comparative Performance: 4Q22, 2022, and Since Inception
    4Q22 2022 Since SW Inception
Benchmarks S&P 500 7.56% -18.11% -13.28%
Russell 3000 7.18% -19.21% -15.69%
MSCI All-World ex-US 16.18% -14.29% -15.68%
Bloomberg US Agg Bond 0.72% -12.46% -12.95%
Moderate Model Portfolio Portfolio Return 8.98% -6.46% -1.22%
Benchmark Return 7.65% -16.83% -15.42%
   +/- Benchmark 1.33% 10.37% 14.20%
   +/- S&P 500 1.42% 11.65% 12.06%
   +/- Equities vs. S&P 500 4.80% 11.42% 14.04%
   +/- Fixed Income vs. Agg 1.22% 2.60% 2.30%

The above table reflects a 1% annual management fee for 2022 as well as 0.25% for 4Q22 and 1.33% since exception.
Actual client investment performance likely will differ from respective model portfolio performance due to several factors including: 1) Timing of securities purchases and sales, 2) Dividend reinvestment choices, 3) Securities held outside the model portfolio, 4) Weighting differentials for certain securities relating to whole versus partial share accounting, 5) Timing and pricing of rebalancing actions, and other minor factors.
Moderately Aggressive benchmark = total returns for 32.5% Russell 3000 Index, 25.0% Bloomberg US Aggregate Bond Index, and 32.5% MSCI World ex-US Index, and 10.0% cash allocations.

Out-performing Energy stocks SLB and Pioneer Natural Resources (PXD) were joined by Chilean lithium and minerals miner Sociedad de Quimica y Minera (SQM) in aiding Moderately Aggressive’s since-inception performance as SQM shares appreciated 64.0% over that period of time. As with the more conservatively managed portfolios, Health Care entities VRTX, ABBV, and CNC (which we sold and repurchased) joined Energy and SQM to benefit the portfolio. Unfortunately, significant downside moves from AMZN, PARA, CMCSA,and cloud computing concern ServiceNow (NOW), among others more than offset positive contributions and led to the portfolio’s 122 bps loss since inception. Interestingly, Moderately Aggressive, despite the prevailingly negative investing environment, saw almost as many positive (21) contributions as negative headwinds (24) from the 45 positions held by the portfolio since its inception.

Aggressive Model Portfolio

Despite posting the strongest finish to 2022 of Solyco Wealth’s four model portfolios, up 12.56% for 4Q22, the firm’s Aggressive Model Portfolio defined its worst offering for 2022 (-9.96%) and since inception (-6.52%). The increased small-cap exposure of Aggressive explains much of this relative under-performance as 2022 proved to be a horrid year for small-cap stocks, especially small-cap growth equities. Aggressive, as its name implies, hinges substantially on equity performance as that asset class composes 90% of the portfolio’s holdings. Debt ETFs make up 5% of the portfolio with the 5% balance allocated to cash. While the worst-performing of Solyco Wealth’s model portfolios, Aggressive still handily out-performed both its blended benchmark as well as the S&P 500 across 4Q22, 2022, and since-inception, time periods, as shown in the following table.

Solyco Wealth Aggressive Model Portfolio Comparative Performance: 4Q22, 2022, and Since Inception
    4Q22 2022 Since SW Inception
Benchmarks S&P 500 7.56% -18.11% -13.28%
Russell 3000 7.18% -19.21% -15.69%
MSCI All-World ex-US 16.18% -14.29% -15.68%
Bloomberg US Agg Bond 0.72% -12.46% -12.95%
Moderate Model Portfolio Portfolio Return 12.56% -9.96% -6.52%
Benchmark Return 9.40% -17.32% -15.35%
   +/- Benchmark 3.18% 7.34% 8.83%
   +/- S&P 500 5.00% 8.15% 6.76%
   +/- Equities vs. S&P 500 6.83% 8.16% 7.23%
   +/- Fixed Income vs. Agg 2.07% -1.24% -1.48%

The above table reflects a 1% annual management fee for 2022 as well as 0.25% for 4Q22 and 1.33% since exception.
Actual client investment performance likely will differ from respective model portfolio performance due to several factors including: 1) Timing of securities purchases and sales, 2) Dividend reinvestment choices, 3) Securities held outside the model portfolio, 4) Weighting differentials for certain securities relating to whole versus partial share accounting, 5) Timing and pricing of rebalancing actions, and other minor factors.
Aggregate benchmark = total returns for 45% Russell 3000 Index, 5.0% Bloomberg US Aggregate Bond Index, 45% MSCI World ex-US Index, and 5.0% cash allocations.

Small-cap oil and gas producer Earthstone Energy (ESTE) joined SLB and SQM among Aggressive’s best-performing positions, joined by CNC and VRTX from the Health Care sector and Deere & Co. (DE) and Performance Food Group (PFGC) from the respective universes of Industrial and Consumer Staples companies. The out-sized positive contributions from DE and PFGC prove doubly notable as they represented 2H22 additions that generated significantly positive impacts (+32.6% and +28.3%, respectively) in relatively very short periods of time.

Shopify (SHOP), an e-commerce services provider that dropped over 70% in 2022, and consumer products company YETI, which experienced a 57.5% decline in its stock price since portfolio inception, defined Aggressive two worst-performing holdings. Joining them were PARA, CMCSA, and NOW, which we also hold in other portfolios. Chart Industries (GTLS), which engineers and manufactures equipment for Energy and Industrial concerns, presented Aggressive with a significant conundrum late in 2022 as its very positive absolute performance for the first nine months of the year gave way to a 40% share price drop by year-end due to a very, very poorly received acquisition management announced in 4Q22. We retain GTLS in the portfolio, however, as we view the concerns surrounding the transaction of less long-term impact than the potential cash flow accretion of the combination. Similarly, we continue to hold SHOP shares due to their long-term prospects.

Using Cash-Secured Puts to Manage Stock Price Volatility

With significant price swings highly characteristic of equity markets in 2022, Solyco Wealth used cash-secured puts from the options markets to manage client portfolio volatility. We anticipate many opportunities to do so in 2023 likely will arise as well as volatility appears set to persist for the foreseeable future.

Cash-secured puts offer investors two benefits:

  1. In the event that the target stock remains above the strike price of the put contract, the investor retains the premium for which their originally sold the contract; and
  2. Should the stock price of the target company break below the strike price of the put contract, the investor may purchase the stock for the equivalent of the strike price minus the premium received for selling the original put contract.

The primary risk in writing or selling put options stems from the possibility that the share price of the target company may fall significantly below the strike price of the options contract. In the event of this occurrence, the investor has a significant choice to make in that they may buy-out their put option for the difference between the lower share price and the strike price of the option or they may buy the stock at a higher price than the recent market price (again, the option’s strike price minus the already-received premium). Hence, we arrive at Rule #1 for selling cash-secured put option contracts:

Do not sell cash-secured put option contracts on stocks one does not desire to own for the long-run.

Rule #1 also carries with it a corollary:

Do not use cash-secured put options unless sufficient cash exists in the account to buy shares of stock.

Engaging in the options market to participate in a specific stock may allow patient and disciplined investors to better manage price volatility by better defining the entry point for a specific equity. For instance, envision an investor that researched a particular stock and determined a target price of $165 for its shares. As those shares recently transacted at $137.50 each, representing 20% prospective upside, the investor decides to purchase 100 shares the following day. However, the company of interest announced the following morning before the market opened a positive development with a prospective new client: shares move much higher to the $145 level in pre-market trading. The investor, unwilling to chase this move higher as they incorporated the possibility of this new development in their $165 target price, maintains price discipline. Instead of waiting to purchase the shares on a pullback, the investor checks the put options market and discovers that a put expiring in one month with a $140 strike price offers a $2.50 premium. Thus, the investor may be able to replicate their original $137.50 purchase price.

Notably, this hypothetical participation in the put option market is not exactly the same as direct participation in the stock. In the event that the company’s shares continue to move higher, gains for the investor are capped at the $2.50 premium received for the put option they sold. The investor also does not participate in any dividends that the target company might pay out, unlike they would if they owned shares of the company outright.

Reorienting Model Portfolios after Active Week, Earnings Season

After equity markets made major moves last week and in response to the results of 3Q22 earnings season, Solyco Wealth made several key changes to its four model portfolios. Notably, we:

  • Brought our 9% Energy over-weight down to an equal-weight 5.3%,
  • Increased the Consumer Staples weighting to 6.1% from 3.5%, bringing it from under-weight to equal-weight,
  • Added 1.1% to Technology, which resulted in a move to 21.1% from 20.0%, but left it effectively in a modest under-weight position.

As always, we remain agile and look to adjust our asset allocations to capture the best investing opportunities for our clients on a risk-adjusted basis.

In order to enact these asset allocation changes within our model portfolios, Solyco Wealth over the past few weeks removed Energy companies Schlumberger (SLB) and Marathon Petroleum (MPC) from model portfolios. We retain producers Total (TTE), Pioneer (PXD), and Earthstone (ESTE), in our portfolios with an obvious preference for the time being for producers versus oilfield services companies and/or refiners.

We added Anheuser-Busch (BUD) and Boston Beer (SAM) to gain the aforementioned increased exposure to the Consumer Staples sector. While transitions in consumer tastes from seltzer to hard liquor and/or beer, increased input costs, and vastly higher transportation expenses severely hampered brewers’ performances over the past year, we see these headwinds moderating in the near future. We also hold Wal-Mart and Performance Food Group from the Staples space in our model portfolios.

Additional recent changes made to our model portfolios include booking gains from Vertex Pharmaceuticals (VRTX) and Deere & Co. (DE). In the equal-weight Health Care sector we chose to replace VRTX with shares of vaccine-oriented biotech company BioNTech (BNTX). Replacing DE in the Industrials space, we chose to jump onboard with the increase in air travel and to add shares of airliner Delta (DAL). In the Financials space we rolled out of BlackRock (BLK), replacing it with investment banker Goldman Sachs (GS).

Solyco Wealth runs four risk-aware model portfolios – Conservative, Moderate, Moderately Aggressive, and Aggressive – for the benefit of its client. Upon request, we remain happy to share the composition of these portfolios; please email ctrimble@solycowealth.com for a copy of the model portfolios’ holdings and percentage allocations.

Outperformance Persists for Solyco Wealth Model Portfolios through 3Q22

Outperformance largely continued for the four model portfolios managed by Solyco Wealth in 3Q22, year-to-date in 2022 (YTD), and since inception (SI), as shown in the two graphs below. Unfortunately, with the head-fake of a recovery in risk-asset prices of July-August 2022 firmly in the rear-view mirror and the resumption of 1H22’s downward trajectory for assets prices, this outperformance translated to the four portfolios posting less negative total returns than their benchmarks and the major indices.

Across the portfolios prescient moves at end-2Q22 to add Deere & Co. [DE (+11.4% in 3Q22)] and Marathon Petroleum [MPC (+18.3% in 3Q22)] led performance for the quarter. Adding these positions produced a dual benefit as they replaced Technology positions that continued their declines over the course of the quarter. The DE and MPC moves higher, however, failed to offset the declines among Communication Services stocks Comcast [CMCSA (-24.9% in 3Q22)] and Paramount [PARA (-23.3% in 3Q22)], which were the worst performing securities across the portfolios last quarter.

As has been the case since the September 8, 2021, inception of Solyco Wealth’s model portfolios, stock-picking drove outperformance across all time frames. Unlike in 1H22, though, price dispersion across fixed income-related assets materialized in 3Q22. For instance, the SPDR Bloomberg High-Yield Bond ETF (SJNK) posted a +0.2% total return for the quarter. Thus, asset allocation, or the proportion of bonds versus stocks in the portfolios along with the choice of bond ETFs within the portfolios, contributed to outperformance for almost 80% of the 12 time-period observations across the four model portfolios.

Conservative Model Portfolio

The Conservative model portfolio, which offers a 65% allocation to fixed income securities, a 22.8% domestic equity securities allocation, a 2.2% international equity securities allocation, and a 10% cash position, after fees lost 4.2% for 3Q22, 14.5% year-to-date, and 12.9% since inception. The Conservative portfolio underweighted international equities since inception in order to overweight domestic equities. While the 3Q22 and since-inception performances outpaced the Conservative Model Portfolio’s benchmark after fees, YTD Conservative’s return lagged by a basis point.

Solyco Wealth Conservative Model Portfolio Comparative Performance: 3Q22, YTD, and Since Inception
    3Q22 Year-to-Date Since SW Inception
Benchmarks S&P 500 -5.70% -23.87% -19.38%
Russell 3000 -5.35% -24.62% -21.34%
MSCI All-World ex-US -10.45% -26.71% -28.17%
Bloomberg US Agg Bond -4.34% -14.50% -15.07%
Conservate Model Portfolio Portfolio Return -4.17% -14.49% -12.91%
Benchmark Return -4.34% -14.49% -14.67%
   +/- Benchmark 0.17% -0.01% 1.76%
   +/- S&P 500 1.53% 9.37% 6.46%
   +/- Equities vs. S&P 500 -2.13% 2.36% 4.11%
   +/- Fixed Income vs. Agg 1.26% 1.61% 2.71%

The above table reflects a 1% annual management fee, or 0.25% for 3Q22, 0.75% year-to-date through 9/30/2022, and 1.075% since exception.
Actual client investment performance likely will differ from respective model portfolio performance due to several factors including: 1) Timing of securities purchases and sales, 2) Dividend reinvestment choices, 3) Securities held outside the model portfolio, 4) Weighting differentials for certain securities relating to whole versus partial share accounting, 5) Timing and pricing of rebalancing actions, and other minor factors.
Conservative benchmark = total returns for 10.0% Russell 3000 Index, 65.0% Bloomberg US Aggregate Bond Index, and 10.0% MSCI World ex-US Index and 15.0% cash allocations.

Not counting its allocation to cash, five of Conservative’s 35 holdings in 3Q22 generated a positive performance contribution: the aforementioned DE, MPC, and SJNK, as well as Amazon [AMZN (+3.7%)] and CVS Health [CVS (+2.8%)]. For the YTD and Since Inception periods Energy companies Schlumberger (SLB) and Total (TTE), health insurer Cigna (CI), and defense and aerospace concern Lockheed Martin (LMT) also contributed positively to portfolio returns. Semiconductor equipment manufacturer Applied Materials [AMAT (-39.5% SI) along with Nike [NKE (-48.4% SI)] joined Communication Services companies CMCSA and PARA in presenting the stiffest headwinds for portfolio performance.  

Moderate Model Portfolio

The Moderate Model Portfolio performance exceeded benchmark and S&P 500 performance for 3Q22, YTD, and SI, time periods, returning -4.5% for 3Q22, -15.8% YTD, and -12.1% SI. The Moderate portfolio allocates 45% of assets to fixed income, 3.5% to international equities, 41.5% to domestic equities, and 10% to cash. These allocations place Moderate at a significant overweight position to domestic equities vis-à-vis the benchmark’s 22.5% allocation, reflective of the view (correct thus far since inception) that U.S. equities will outperform international stocks.

Solyco Wealth Moderate Model Portfolio Comparative Performance: 3Q22, YTD, and Since Inception
    3Q22 Year-to-Date Since SW Inception
Benchmarks S&P 500 -5.70% -23.87% -19.38%
Russell 3000 -5.35% -24.62% -21.34%
MSCI All-World ex-US -10.45% -26.71% -28.17%
Bloomberg US Agg Bond -4.34% -14.50% -15.07%
Moderate Model Portfolio Portfolio Return -4.48% -15.80% -12.05%
Benchmark Return -5.47% -18.03% -17.87%
   +/- Benchmark 0.99% 2.22% 5.82%
   +/- S&P 500 1.22% 8.06% 7.33%
   +/- Equities vs. S&P 500 -0.15% 4.52% 9.02%
   +/- Fixed Income vs. Agg 0.70% 0.29% 0.92%

The above table reflects a 1% annual management fee, or 0.25% for 3Q22, 0.75% year-to-date through 9/30/2022, and 1.075% since exception.
Actual client investment performance likely will differ from respective model portfolio performance due to several factors including: 1) Timing of securities purchases and sales, 2) Dividend reinvestment choices, 3) Securities held outside the model portfolio, 4) Weighting differentials for certain securities relating to whole versus partial share accounting, 5) Timing and pricing of rebalancing actions, and other minor factors.
Moderate benchmark = total returns for 22.5% Russell 3000 Index, 45.0% Bloomberg US Aggregate Bond Index, and 22.5% MSCI World ex-US Index, and 10.0% cash allocations.

In addition to previously mentioned positive contributions from DE, MPC, and SLB, the Moderate Model Portfolio also benefited since inception from the upside performances of:

  • Oil and gas firm Pioneer Natural Resources [PXD (+62.2% since inception)],
  • Vertex Pharmaceuticals [VRTX (+50.6% since inception)],
  • Health insurer Centene [CNC (+28.3% since inception and sold 12/10/21)],
  • Medical technology company AbbVie [ABBV (+49.7% since inception and sold 3/18/22)] and,
  • Broadcom [AVGO (+28.1% since inception and sold 12/14/21)].

Eastman Chemical [EMN (-34.1% SI)] and Advanced Micro Devices [AMD (-42.0% SI)] join CMCSA, PARA, and NKE, in presenting significant challenges to higher Moderate portfolio returns.

Moderately Aggressive Model Portfolio

As it has since inception, the Moderately Aggressive Model Portfolio defined Solyco Wealth’s top-performing portfolio for 3Q22 with a 3.8% loss. Through the first nine months of 2022 Moderately Aggressive lost 13.8%, which exceeded benchmark and S&P 500 performances for the same nine-month period by 6.5% and 10.1%, respectively. Moderately Aggressive performed modestly better since inception as its 8.9% loss exceeded by 10.9% the benchmark’s 19.8% loss and by 10.5% the S&P 500’s 19.4% loss.

Solyco Wealth Moderately Aggressive Model Portfolio Comparative Performance: 3Q22, YTD, and Since Inception
    3Q22 Year-to-Date Since SW Inception
Benchmarks S&P 500 -5.70% -23.87% -19.38%
Russell 3000 -5.35% -24.62% -21.34%
MSCI All-World ex-US -10.45% -26.71% -28.17%
Bloomberg US Agg Bond -4.34% -14.50% -15.07%
Moderately Aggressive Model Portfolio Portfolio Return -3.78% -13.78% -8.89%
Benchmark Return -6.18% -20.26% -19.81%
   +/- Benchmark 2.39% 6.48% 10.91%
   +/- S&P 500 1.92% 10.09% 10.49%
   +/- Equities vs. S&P 500 0.77% 8.90% 11.74%
   +/- Fixed Income vs. Agg 0.58% 0.92% 2.28%

The above table reflects a 1% annual management fee, or 0.25% for 3Q22, 0.75% year-to-date through 9/30/2022, and 1.075% since exception.
Actual client investment performance likely will differ from respective model portfolio performance due to several factors including: 1) Timing of securities purchases and sales, 2) Dividend reinvestment choices, 3) Securities held outside the model portfolio, 4) Weighting differentials for certain securities relating to whole versus partial share accounting, 5) Timing and pricing of rebalancing actions, and other minor factors.
Moderately Aggressive benchmark = total returns for 32.5% Russell 3000 Index, 25.0% Bloomberg US Aggregate Bond Index, and 32.5% MSCI World ex-US Index, and 10.0% cash allocations.

With a 65% equity weighting, substantially skewed to better-performing US equities, stock-picking drove the Moderately Aggressive Model Portfolio’s relative out-performance. Stock performance in the portfolio exceeded that of the S&P 500 by 11.7% since inception. The fixed income exchange traded funds (ETFs) in Moderately Aggressive also contributed to its comparative upside as their performance exceeded that of the benchmark Bloomberg US Aggregate Bond Index by 228 basis points.

International holding Sociedad de Quimica y Minera (SQM), one of the world’s largest lithium producers, paced Moderately Aggressive performance as it moved 7.7% higher for the quarter, +83.2% for all of 2022, and up 78.2% since inception. Joining SQM in supporting the portfolio’s performance were PXD, SLB, VRTX, MPC and DE. In addition to the significant declines experienced with CMCSA and PARA, Moderately Aggressive also suffered downside from cloud tech firm Service Now [NOW (-42.9% SI)], search leader Alphabet [GOOGL (-33.7% SI)], and Vanguard Emerging Markets Government Bond ETF [VWOB (-24.5% SI)].

Aggressive Model Portfolio

Distinctly risk-off attitudes in 2022 decidedly hampered Aggressive Model Portfolio returns as it posted losses of 5.6% for 3Q22, 19.5% YTD, and 15.9% SI. These performances outpaced those of the benchmark by 1.8%, 4.3%, and 7.1%, respectively, and those of the S&P 500 by 0.2%, 4.3%, and 3.4%. Indicative of transitions in fixed income markets in 3Q22, which saw a more positive reception for credit exposure, the model’s fixed income positions outperformed the Bloomberg US Aggregate Bond Index by 2.3% in that period. For the YTD and SI periods equities remained responsible for Aggressive’s outperformance.

Solyco Wealth Aggressive Model Portfolio Comparative Performance: 3Q22, YTD, and Since Inception
    3Q22 Year-to-Date Since SW Inception
Benchmarks S&P 500 -5.70% -23.87% -19.38%
Russell 3000 -5.35% -24.62% -21.34%
MSCI All-World ex-US -10.45% -26.71% -28.17%
Bloomberg US Agg Bond -4.34% -14.50% -15.07%
Aggressive Model Portfolio Portfolio Return -5.55% -19.53% -15.94%
Benchmark Return -7.30% -23.80% -23.01%
   +/- Benchmark 1.75% 4.27% 7.07%
   +/- S&P 500 0.15% 4.33% 3.44%
   +/- Equities vs. S&P 500 -0.86% 3.78% 3.36%
   +/- Fixed Income vs. Agg 2.27% -1.36% -1.40%

The above table reflects a 1% annual management fee, or 0.25% for 3Q22, 0.75% year-to-date through 9/30/2022, and 1.075% since exception.
Actual client investment performance likely will differ from respective model portfolio performance due to several factors including: 1) Timing of securities purchases and sales, 2) Dividend reinvestment choices, 3) Securities held outside the model portfolio, 4) Weighting differentials for certain securities relating to whole versus partial share accounting, 5) Timing and pricing of rebalancing actions, and other minor factors.
Aggregate benchmark = total returns for 45% Russell 3000 Index, 5.0% Bloomberg US Aggregate Bond Index, 45% MSCI World ex-US Index, and 5.0% cash allocations.

Earthstone Energy [ESTE (+49.0% SI)] marked the only out-performing equity not held in the other portfolios and previously mentioned. Shopify [SHOP (-80.4% SI)] and Yeti [YETI (-70.6%)], despite continuing to post impressive absolute and relative growth amidst economic turmoil, posted substantial negative returns for the portfolio. Notably, active management, including dollar-cost averaging and covered-call writing, significantly reduced the actual magnitude of losses from these securities within the client portfolios that hold them and that follow the Aggressive Model Portfolio.

Tax-Loss Harvesting: Why and How

For taxable accounts tax-loss harvesting may be the most valuable portfolio management activity in which one can engage before year-end 2022. Depending on individual situations, the depth and breadth of asset market downturns this year probably offer numerous value-adding opportunities that tax consequences prohibited in prior years such as:

  • Reducing legacy and/or concentrated stock positions,
  • Rebalancing Tech-heavy portfolios for better diversification,
  • Eliminating undesired positions in favor of more favorable holdings,
  • Repositioning a growth-heavy portfolio to incorporate more value positions (or vice versa), and
  • Adapting exposures to generate more income.

Another “trick” that may accentuate the value of tax-loss harvesting, providing one starts early, is dollar-cost averaging. While many associate dollar-cost averaging with selling securities, the process also may add value exiting positions. Rarely is it better to take a larger loss and, as such, selling out of positions over multiple trading sessions could enable one to take advantage of short-term volatility. Similarly, redeploying generated funds into new positions over time, opportunistically taking advantage of downside volatility, could complement well dollar-cost averaging out of positions.

Consider the following cherry-picked example to illustrate the potential value of tax-loss selling for a portfolio with just a passing flavor of favorable timing. Assume an investor correctly read the Energy environment six months ago and decided to buy 1,000 shares of oilfield services company Schlumberger (green line in price chart below) in early April 2022 at $42 per share for $42,000. Concurrently, the same investor unfortunately decided to purchase at the same time 133 shares of Microsoft (red line) at $300 per share for $39,990. In mid-June 2022 our lucky investor analyzed the SLB move to $50 per share to be too much too soon and sold their entire 1,000 shares and booked an $8,000 gain. On their MSFT position our investor proved to be not so lucky as the stock moved to $244 per share just a few days after they sold their SLB; the investor chose to sell MSFT and created a $7,448 loss. However, from a tax standpoint this MSFT loss prospectively adds $1,788 of value to the portfolio as the loss almost entirely offsets the impact of the investor’s $8,000 SLB gain, providing our investor resides in the 24% tax bracket.   

Driving our cherry-picked example just a little further, this investor also could have benefited from repurchasing the same 1,000 SLB shares four months later at $33. To maintain the symmetry to our example, they also recently reestablished their 133-share MSFT position at $244. So, our investor now not only retains the same 1,000 shares of SLB and 133 shares of MSFT, but they also have $16,868 in cash with an estimated tax liability of only $132 (24% * the $552 in gains not offset by the MSFT share sale). Additionally, the 1,000 SLB position recently reflected ~$5 per share of appreciation, offering another $5,000 in paper gains, but…with no offsetting tax-loss. Overall, our investor hypothetically finds themself an estimated $5,420 better off with the same 1,000 SLB shares and 133 MSFT shares, but with $16,868 in cash, net of the $132 in estimated taxes payable.

Event Price Shares Value Running Cash Balance Running Gain/Loss
Initial Capital       $81,900 0
March 2022 SLB purchase $42 1,000 -$42,000 $39,900 0
March 2022 MSFT purchase $300 133 -$39,900 $0 0
June 2022 SLB sale $50 1,000 $50,000 $50,000 $8,000
   Possible tax liability @ 24% bracket     -$1,920 $48,080 $6,080
June 2022 MSFT sale $244 133 $32,452 $80,532 -$1,368
   Possible tax liability @ 24% bracket     $1,788 $82,320 $420
July 2022 SLB purchase $33 1,000 -$33,000 $49,320 $420
September 2022 MSFT sale $244 133 -$32,452 $16,868 $420
September 2022 MSFT sale $38 1,000 $38,000 $16,868 $5,420

 

Final Portfolio Price Shares Value
September 2022 SLB holiding $38 1,000 $38,000
September 2022 MSFT holding $244 133 $32,452
Cash     $16,868
   Realized gains     $552
   Tax liability     -$132
   Unrealized gain     $5,000
Total portfolio value     $87,320
Net realized and unrealized gains     $5,420

Trade or Trade Not

I got into this business over 20 years ago as an institutional equity salesperson for an upstart investment bank staked by a mid-sized bank. Although I was green as a gourd, I worked with seasonal professionals that had worked on the largest trading floors in the country. Compelling clients to trade with my firm and thus, generate commissions was the name of the game. Admittedly, I proved to be not very good at it, but I understood the motivation: trade. From an individual retail investor to the most sophisticated hedge fund trader the motivation to trade ultimately remains the same – to make a buck or a few million bucks. How do the drivers of trading differ, though, and how might recognizing the motivations to trade aid us in making more bucks (or losing fewer of them)?

As I reflect back on my past trading behavior in relation to the volumes of commentary and research I consumed on the topic over the years, five drivers to trade come to mind:

  1. Fear: something I own is declining in value and I fear it will continue to do so: time to trade out of it.
  2. Greed: more money typically is better than less money: buy it and then, sell it before it goes down.
  3. Overconfidence: the rest of the world just fails to understand: buy it or short it until everyone else realizes how right I was.
  4. Thrill: trading as pseudo-entertainment – it just plain feels good to be in on the action.
  5. Activity: the enticement of participating – action, action, we want action!

Undoubtedly, some of us get lucky and hit a 10-bagger and buy ourselves a great story to tell for years to come about some awesome trade we made. A recent Wall Street Journal article on Mark Spitznagel and his Universa Investments claim he made a billion dollars in a day during the flash crash several years ago. That is a story so good the notoriously reclusive Spitznagel chooses not to tell it!

Terrance O’Dean, a University of California at Berkeley Haas School of Business professor, more or less made his career out of trying to convince individual investors not to trade. He published numerous studies of individual investor trading activities with ominous titles like:

  • Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors,
  • Just How Much Do Investors Lose from Trade, and
  • Boys will be Boys: Gender, Overconfidence, and Common Stock Investment

Despite admonishments to limit trading and stick to investing for the long-term from Professor O’Dean and numerous others, no-commission trades, meme stocks, and cryptocurrencies appear to have super-charged the drive to trade. Regardless of motivation, we suggest investors – traders or otherwise – follow a few simple rules as they go about their business:

  • Know what you own and why you own it, regardless of expected holding period;
  • If trading behaviors place making rent for next month in jeopardy, sell and seek counseling;
  • Keep the voice of your mother or another trusted, sage individual in the back of your head as you go about your trading. If they would call what your doing stupid/careless/unbelievable, reevaluate what it is you are doing in the context of greed, overconfidence, or just plain common sense.

Curiosier and Curiosier…Equity Markets May Get Even Sillier

The yo-yo path on which assets markets traded in 2022 finally bounced to the upside in July and early August only to traverse their downward trajectory – again – later in August and early September. Of late, Fed comments from Brainerd and Powell reinvigorated upside drivers with little more than recognition that increases in the Fed Funds Rate could push the U.S. economy into a recession. Sometimes knowing the problems half the battle…

Naysayers through the Late Summer 2022 bump in markets (bear market rally???) pointed to not only the probability, but the necessity for earnings forecasts to decline. Revisions, as shown in the following graphs from CS First Boston, commenced prior to 2Q22 earnings season as analysts updated estimates for the impending earnings announcements. Those forecasts for 2022, as shown in the left graph below, proved to be comparatively miniscule. The revisions to 2023, however, as conveyed in the graph below on the right, amounted to more than twice the magnitude of the revisions to 2022 earnings expectations.

We advise clients and investors look out for a few things as they parse out how Fed actions, economic activities, analyst earnings revisions, and company communications might impact asset markets:

  • Ongoing volatility that cuts in both directions, downward and upward, offering opportunities to:
    • Sell the peaks and buy the valleys,
    • Utilize options, if sufficient comfort and knowledge exists, to benefit from this volatility,
    • Exhibit confidence in assets owned and choose not to pay attention to the volatility.
  • “Sandbagging” from proactive company management teams that opportunistically utilize episodes of low and falling investor expectations to set a low bar which they subsequently clear amidst…
    • Unforeseen margin resilience brought on by unannounced
      • Hiring freezes,
      • Declining raw materials prices, and/or
      • Skinnier executive bonuses (I’m joking here)
    • Higher sales incited by increased promotions and/or advertising
    • Favorably managing inventories and other accounts subject to accrual accounting.
  • Straight-up gaming of the system to reduce expectations in a favorable environment.

The most effective way we found to manage through periods like this are to remain confident in assets owned and frequently to reinforce the reasons to own those assets. Distinctions in the drivers of reduced expectations matter in that structural issues like the loss of a major contract or significant declines in product/service quality may linger for much longer than more episodic challenges such as higher raw materials or labor expenses or reduced access to transportation and logistics solutions.

Leave ‘em Better Off

Few life events are as painful and undesired as dealing with the deaths of loved ones. Cleaning up the mess than many of these loved ones leave behind when they pass ranks as a close second, though. We recently spoke with a prospective client that lost multiple family members in a rather short period of time. First, in-laws died with no will and multiple properties in multiple states. Death of the spouse soon followed prior to probate closing. As it these events failed to create sufficient grief, the in-laws apparently never came across an item they did not want to keep: the propensity to hoard resulted in no less than five dumpsters of “stuff” being carried off from just one of the inherited properties. Creating positive memories after disposing of tons of unwanted “stuff” will challenge even the most gracious of us. Below, we short-list items that not only will leave your loved ones better off when you go, but also likely will aid the rest of your time with us.

  • Will – For goodness sakes, please create a will and leave your loved ones with guidance on what you would like done, who you prefer to do it, and what should happen with your “stuff,” after all is said and done.
  • Beneficiaries – Designate and/or review the named beneficiaries on your assets: life insurance policies, investment accounts, bank accounts, etc.
  • Insurance – Review policies for life, long-term care, disability, etc.
  • Clean up – Don’t leave others a mess. You wouldn’t like it if they did it to you.
  • Communicate – No one likes talking about their death or the deaths of loved ones. However, just as an ounce of prevention is worth a pound of cure, one difficult conversation could eliminate the need for many more down the road.

End-of-life care, whether it be medical, psychological, or even financial, presents a significant gap in the care continuum for many on each side of the situation. As a result already high levels of grief, anxiety, and frustration build when, probably, a large portion of this trauma could have been avoided with just a little planning and communication.