selling: average cost or specific shares?

I’ve had a Fidelity brokerage account for a long time.  I’ve been relatively happy, with only two complaints:

–The first is a “just me” concern.  The Hong Kong stocks I own are always mispriced, except during Hong Kong trading hours.  Other than when that market is live, prices are typically two days old.

I’ve discussed this numerous times with Fidelity representatives (who probably think:  “Oh, him again!”);  I’ve also mentioned this in many surveys I’ve filled out over the years.  Apparently, it isn’t important enough to fix.  Every once in a while a Fidelity trader will advise me to trade these shares on the OTC market in the US, where they will be priced in my account, if accurate quotes are so important.  I don’t see the advantage for me, since my experience is that in times of stress US volumes for stocks like these evaporates.   In such circumstances, my observation is that prices can easily be 5% -10% less favorable in the US than in Hong Kong.  They’re also cheaper to trade in Hong Kong, too, but that’s a lesser issue.

 

–The second is more serious.  For some years, brokers have been required to report gains an losses from trading in taxable accounts to the IRS.  Determining selling price is straightforward.  The default option Fidelity uses for the cost of the shares sold, however, is the average price paid for all the shares in the position.

This is apparently the easiest thing for Fidelity to deliver.  But it’s not always the best for the client.  And the layout of the Fidelity online trade ticket doesn’t really highlight this important issue.  Unless you click on the expanded ticket link at the bottom of the form, you won’t be able to specify the tax lots that will be sold.

What is this about?

Two considerations:

–gains from stocks held for a year or less are taxed as ordinary income;  gains on stocks held longer than that are taxed at the (lower) long-term gains rate (more information from Turbotax).  So all other things being equal, it’s better to recognize a long-term gain than a short-term one.

–I generally try to sell my highest-cost shares first.  This results in recognizing the largest loss or smallest gain.  A net loss can have a tax value (see the Turbotax link above); subject to the holding period rules, the smallest gain should also mean the smallest income tax payment.

An example:

Suppose I hold 100 shares of JPM that I’ve bought at $50 and another 100 at $80.  Both lots are short-term.

I decide to sell 100 shares and net $9000 for them.

If at the time of sale I specify the shares with the $80 cost, my taxable gain is $1000.

If I specify the $50 shares, my gain is $4000. (I would probably only do this if I expected to offset this gain with a loss from other stock sales or from losses carried forward from prior years.)

If I let the Fidelity computer do the work, my capital gain is $2500.

 

If I’m in the 25% tax bracket, my income tax on the sale will be $250, $625 or $1000–depending on how I handle my cost basis.

 

Yes, I’ll likely sell the remainder of the position eventually, so I’m only postponing tax by choosing the highest cost shares.  Even so, in the meantime I have more money to put back to work today if I minimize current taxes.

 

 

 

technical analysis in the 21st century

A reader asked last week what I think about technical analysis.  This is my answer.

what it is

Technical analysis in the stock market is the attempt to predict future stock prices by studying current and past patterns in the buying and selling of stocks, stock indices and associated derivatives.  The primary focus is on price and trading volume data.

Technical analysis is typically contrasted with fundamental analysis, the attempt to predict future stock prices by studying macro- and microeconomic data relevant to publicly traded companies.  The primary sources of these data are SEC-mandated disclosure of publicly traded company operating results and government and industry economic statistics.

what the market is

The stock market as the intersection of the objective financial/economic characteristics of publicly traded companies with the hopes and fears of the investors who buy and sell shares.  Fundamental analysis addresses primarily the companies; technical analysis primarily addresses the hopes and fears.

ebbing and flowing

To be clear, I think there’s an awful lot of ridiculous stuff passing itself off as technical “wisdom.”  The technical analyst’s bible (which I actually read a long time ago), the 1948 Technical Analysis of Stock Trends by Edwards and Magee, is now somewhere in my basement.  I’ve never been able to make heads nor tails of most of it.

On the other hand, in the US a century ago–and in markets today where reliable company financials aren’t available–individual investors had little else to guide them.

the old days–technicals rule (by default)

What individual investors looked for back then was unusual, pattern-breaking behavior in stock prices–because they had little else to alert them to positive/negative company developments.

I think this can still be a very useful thing to do, provided you’ve watched the daily price movements of a lot of stocks over a long enough period of time that you can recognize when something strange is happening.

the rise of fundamental analysis

Starting in the 1930s, federal regulation began to force publicly traded companies to make fuller and more accurate disclosure of financial results.  The Employee Retirement Income Security Act (ERISA) of 1974 mandated minimum levels of competence in the management of pension plan assets, laying the foundation for the fundamentals-driven securities analysis and portfolio management professions we have today in the US.

past the peak

The rise of passive investing and the rationalization of investment banking after the financial crisis have together reduced the amount of high-quality fundamental research being done in the US.  Academic investment theory, mostly lost in its wacky dreamworld of efficient markets, has never been a good training ground for analytic talent.

The waning of the profession of fundamental analysis is opening the door, I think, to alternatives.

algorithmic trading

Let’s say it takes three years working under the supervision of a research director or a portfolio manager to become an analyst who can work independently.  That’s expensive.  Plus, good research directors are very hard to find.  And the marketing people who generally run investment organizations have, in my experience, little ability to evaluate younger investment talent.

In addition, traditional investment organizations are in trouble in part because they’ve been unable to keep pace with the markets despite their high-priced talent.

The solution to beefing up research without breaking the bank?  Algorithmic trading.  I imagine investment management companies think that this is like replacing craft workers with the assembly line–more product at lower cost.

Many of the software-engineered trading products will, I think, be based on technical analysis.  Why?  The data are readily available.  Often, also, the simplest relationships are the most powerful.   I don’t think that’s true in the stock market, but it will probably take time for algos to figure this out.

My bottom line:  technical analysis will increase in importance in the coming years for two reasons:  the fading of traditional fundamental analysis, and the likelihood that software engineers hired by investment management companies will emphasize technicals, at least initially.

 

 

 

 

Warren Buffett’s latest portfolio moves: the 4Q14 13-f

Investment managers subject to SEC regulation (meaning basically everyone other than hedge funds) must file a quarterly report with the agency detailing significant changes in their portfolios.  It’s called a 13-f.  Today Berkshire Hathaway filed its 13-f for 4Q14.  I can’t find it yet on the Edgar website, but there has been plenty of media coverage.

Mr. Buffett has built up his media and industrial holdings, as well as adding to his IBM.  The more interesting aspect of the report is that it shows him selling off major energy holdings–ExxonMobil, which he had acquired about two years ago, and ConocoPhillips, which he had been selling for some time.  Neither has worked out well.

There’s also a smaller sale of shares in oilfield services firm National Oilwell Varco and a buy of tar sands miner Suncor–both presumably moves made by one of the two prospective heirs working as portfolio managers at the firm (whose portfolios are much smaller than Buffett’s.  Buffett has told investors to figure smaller buys and sells are theirs.)

Three observations:

–the Buffett moves would have been exciting–maybe even daring–in 1980.  Today, they seem more like changing exhibits in a museum.

–if I were interested in Energy and thought it more likely that oil prices would rise than fall, I’d be selling XOM, too.  After all, it’s one of the lowest beta (that is, least sensitive to oil price changes) members of the sector.

But I’d be buying shale oil and tar sands companies that have solid operations and that have been trampled on Wall Street in the rush to the door of the past half-year or so.  That doesn’t appear to be Mr. Buffett’s strategy, however.  His idea seems to be to cut his losses and shift to areas like Consumer discretionary. (A more aggressive stance would be to increase energy holdings by buying the high beta stocks now, with the intention of paring back later by selling things like XOM as prices begin to rise.)  NOTE:  I’m not recommending that anyone actually do this stuff.  I’m just commenting on what the holdings changes imply about what Mr. Buffett’s strategy must be.

–early in my career, I interviewed for a job (which I didn’t get) with a CIO who was building a research department for a new venture.  I was a candidate because I was, at the time, an expert on natural resources.   The CIO said the thought there were three key positions any research department must fill:  technology, finance and natural resources.  All require specialized knowledge.    I’d toss healthcare into the ring, as well.  I’d also observe that stock performance in these more technical areas is influenced much less by the companies’ financial statements than is the case with standard industrial or consumer names.

Mr. Buffett is an expert on financials–he runs a gigantic insurance company, after all.  On tech and resources, not so much, in my opinion.  Financials are the second-largest sector in the S&P 500, making up 16% of the total.  Tech makes up 19.5%; Energy is 8.3%; Healthcare 14.9%.  The latter three total 42.7% of the index.  As a portfolio manager, it’s hard enough to beat the index in the first place.  Being weak in two-fifths of it makes the task even harder.

what will a soft dollar-less world look like

Yesterday I wrote about an EU regulatory movement to eliminate the use of soft dollars by investment managers–that is, paying for research-related goods and services through higher-than-normal brokerage commissions/fees.

Today, the effects of a ban…

hedge funds?

I think the most crucial issue is whether new rules will include hedge funds as well.  The WSJ says “Yes.”  Since hedge fund commissions are generally thought to make up at least half of the revenues (and a larger proportion of the profits) of brokerage trading desks, this would be devastating to the latter’s profitability.

Looking at traditional money managers,

 $10 billion under management

in yesterday’s example, I concluded that a medium-sized money manager might collect $50 million in management fees and use $2.5 million in soft dollars on research goods and services.  This is the equivalent of about $1.6 million in “hard,” or real dollars.

My guess is that such a firm would have market information and trading infrastructure and services that cost $500,000 – $750,000 a year in hard dollars to rent–all of which would now be being paid for through soft dollars.  The remaining $1 million or so would be spent on security analysis, provided either by the brokers themselves or by third-party boutiques (filled with ex brokerage house analysts laid off since the financial crisis).

That $1 million arguably substitutes for having to hire two or three in-house security analysts–and would end up being distributed as higher bonuses to the existing professional staff.

How will a firm pay the $1.6 million in expenses once soft dollars are gone?

–I think its first move will be to pare back that figure.  The infrastructure and hardware are probably must-haves.  So all the chopping will be in purchased research.  The first to go will be “just in case” or “nice to have” services.  I think the overwhelming majority of such fare is now provided by small boutiques, some of which will doubtless go out of business.

–Professional compensation will decline.  Lots of internal arguing between marketing and research as to where the cuts will be most severe.

smaller managers

There’s a considerable amount of overhead in a money management operation.  Bare bones, you must have offices, a compliance function, a trader, a manager and maybe an analyst.  At some point, the $100,000-$200,000 in yearly expenses a small firm now pays for with soft dollars represents the difference between survival and going out of business.

Maybe managers will be more likely to stick with big firms.

brokers

If history is any guide, the loss of lucrative soft dollar trades will be mostly seen more through layoffs of researchers than of traders.

publicly traded companies

Currently, most companies still embrace the now dated concept of communicating with actual and potential shareholders through brokerage and third-party boutique analysts.   As regular readers will know, I consider this system crazy, since it forces you and me to pay for information about our stocks that our company gives to (non-owner) brokers for free.

I think smart companies will come up with better strategies–and be rewarded with premium PEs.  Or it may turn out that backward-looking firms will begin to trade at discounts.

you and me

It seems to me that fewer sell-side analysts and smaller money manager investment staffs will make the stock market less efficient.  That should make it easier for you and me to find bargains.

 

 

 

the demise of soft dollars

This is the first of two posts.  Today’s lays out the issue, tomorrow’s the implications for the investment management industry.

so long, soft dollars

“Soft dollars” is the name the investment industry has given to the practice of investment managers of paying for research services from brokerage houses by allowing higher than normal commissions on trading.

Well understood by institutional, but probably not individual, clients, this practice transfers the cost of buying these services–from detailed security analysis of industries or companies to Bloomberg machines and financial newspapers–from the manager to the client.  In a sense, soft dollars are a semi-hidden charge on top of the management fee.

In the US, soft dollars are reconciled with the regulatory mandate that managers strive for “best price/best execution” in trading by citing industry practice.  This is another way of saying:   whatever Fidelity is doing–which probably means having commissions marked up on no more 15%-20% of trades.

In 2007, Fidelity decided to end the practice and began negotiating with brokers to pay a flat fee for research.  As I recall, media reports at the time said Fidelity had offered $7 million in cash to Lehman for an all-you-can-eat plan.  Brokerage houses resisted, presumably both because they made much more from Fidelity under the existing system and because trading departments were claiming credit for (and collecting bonuses based on) revenue that actually belonged to research.

theWall Street Journal

Yesterday’s Wall Street Journal reports that the EU is preparing to ban soft dollars in Europe for all investment managers, including hedge funds, starting in 2017.

not just the EU, however

Big multinational money management and brokerage firms are planning to implement the new EU rules not just in the EU, but around the world.

Why?

Other jurisdictions are likely to follow the EU’s lead.  Doing so also avoids potential accusations of illegally circumventing EU regulations by shifting trades overseas.

soft dollars in perspective

in the US

Let’s say an investment management firm has $10 billion in US equities under management.  If it charges a 50 basis point management fee, the firm collects $50 million a year.  Out of this it pays salaries of portfolio managers and analysts, as well as for research travel, marketing, offices… (Yes, 12b1 fees charged to mutual fund clients pay for some marketing expenses, but that’s another story.)

If the firm turns over 75% of its portfolio each year, it racks up $7.5 billion in buys and $7.5 billion in sells.  Plucking a figure out of the air, let’s assume that the price of the average share traded is $35.  The $15 billion in transactions amounts to about 425 million shares traded.  If we say that the manager allows the broker to add $.03 to the tab as a soft dollar payment, and does so on 20% of its transactions, the total annual soft dollars paid amount to $2.5 million.

foreign trades

Generally speaking, commissions in foreign markets are much higher than in the US, and soft dollar limitations are    …well, softer.  So the soft dollar issue is much more crucial abroad.

hedge funds

Then there are hedge funds, which are not subject to the best price/best execution regulations.  I have no practical experience here.  I do know that if I were a hedge fund manager I would care (almost) infinitely more about getting access to high quality research in a timely way (meaning ahead of most everyone else) than I would about whether I paid a trading fee of $.05, $.10 (or more) a share.

We know that hedge funds are brokers’ best customers.  Arguably, banning the use of soft dollars–enforcing the best price/best execution mandate–with hedge funds would be devastating both to them and to brokerage trading desks.

translating soft dollars to hard

When I was working, the accepted ratio was that $1.75 soft = $1.00 hard.  I presume it’s still the same.  In other words, if I wanted a broker to supply me with a Bloomberg machine that cost $40,000 a year to rent, I would have to allow it to tack on 1.75 * $40,000  =  $70,000 to (the clients’) commission tab.

 

Tomorrow, implications of eliminating soft dollars

 

 

 

 

 

 

’tis the season to be jolly, but…

At the end of last week I wrote a bit about one of my pet peeves, the inconsistent way in which the SEC treats inside information.  As one of my former colleagues, an SEC investigator hired by my employer at that time to advise analysts and portfolio managers how to stay on the right side of the law, once told me, “Inside information is whatever the SEC decides it is on a given day.  The cardinal rule is never to do anything that catches the SEC’s attention.”

Not very helpful counsel, is it?    …although it does accurately describe the Eliot Spitzer school of law enforcement.

Don’t get me wrong.  Honest professional investors don’t want inside information.  It taints their own research efforts and prevents them from trading on hard-won insights.  And I applaud the SEC’s efforts to shut down peddlers of stolen company information and the people who buy it from them.  What I don’t like–and what may be changing now–is the inability by the SEC so far to separate legitimate research from theft.

a second peeve

On now to my second pet peeve…selective release of information by publicly traded companies.  Yes, it still goes on, despite the fact that Regulation FD is supposed to have made this practice illegal.

Again, I’m all for a level playing field.  And I’ll admit that when I was a large shareholder by virtue of representing my money management clients I didn’t worry too much about how companies treated the average individual investor.

Even in those days, however, I saw the tremendous preference that long-established companies gave to brokerage house analysts.  Many held private meetings for sell-side analysts only (owners of the company’s stock excluded) in which they provided detailed descriptions of their operations and offered informal access between sessions and over lunch/dinner to top technical and management employees.  This still occurs (Adobe has a similar kind of get-together that everyone can come to.  It costs $1,500 or so, however, which is probably what it costs ADM+BE to host the function and which is fine with me.).

Waht bothers me is that the firms in question givelots of  important information to brokers, that brokers turn around and charge me to get.  So I’m an owner and the only way I can obtain data about my company is to be forced to pay for it from a third party.  That’s crazy. Sometimes, too, the message gets garbled in the retelling.  At least have a broadcast of the proceedings on the company website.

Since I’ve retired I’ve also found that the Investor Relations and Public Relations departments of older, stodgier firms are much less responsive to my requests for information than they were when I ran large portfolios.  Now they sometimes ignore my repeated phone calls or emails, whether I identify myself as a shareholder, an analyst in a (small) money management firm, or a financial blogger.  Either that or they respond with a big time lag.

In a way, this lack of response is valuable information in itself.   Big, stodgy, unresponsive to owners = stay away.  In cases when new management comes in to shake up the walking dead, this is a sure sign that the turnaround hasn’t gotten as far as top management thinks.

On the other hand, I’ve also had many enjoyable conversation with CFOs or CEOs of mid-sized companies who, to my mind, get it that the idea of responsibility to their owners isn’t simply a legal fiction.  My experience is that firms of this sort tend to do better in a fast-changing world.

economy performance vs. stock market performance

Th financial media often talk about the prospects for the stocks market as closely liked to the prospects for the overall economy.   Is this right?

in a general way, yes

The most important investors in developed markets tend to be citizens, or at least residents, of the country in question.  This is partly because doemstic securities are the ones individual investors feel most comfortable with and can easily get the most information about.  It’s also partly because institutional investors like pension funds or insurance companies both want to match their domestic liabilities with domestic assets, and because they are most often legally required to do so.

When a country is booming, employment is high and wages are rising, money tends to flow into stocks.  When times are bad, not so much.  In particular, it’s been my experience as a global investor that stocks in high GDP growth countries tend to do better than very similar stocks headquartered in low GDP growth nations.

looking a little more closely, no

This is the easiest to see in Europe.  Switzerland has annual GDP of about $650 billion.  Germany’s is six times that.  Yet, the two countries have stock markets of just about the same size.  How so?

Two reasons:

–the Swiss market is dominated by international pharma and financial companies.  Only a tiny amount of their business is done in Switzerland.

–large chunks of Germany’s very important export-oriented industrial sector are unlisted.  The German stock market leaders are banks, public utilities and the autos.

In neither case–tiny country with enormous multinationals, or big countriy without many domestice companies listed on the stock exchange-os there a strong relationship between economy and stock market.

the US

–The US is the country where, thanks to the SEC, the most information about the geographical breakout of earnings is available.  Slightly over half of the companies in the S&P 500 provide geogrpahical earnings data.  If we assume that the structure of the rest of the index mirrors that of the reporting companies (a whopper of a leap, but I’m not sure what else we can do), then the earnings of the S&P break out about as follows:

US      50% of reported earnings

Europe  25%

Rest of the world    25%.

–Large parts of the US economy, like construction/property and autos have minimal representation in the S&P 500.  In the former sector, lots of companies remain private.  In the latter, a lot of the activity is by foreign companies.

significance?

If we just look at likely GDP growth for the US in 2015, we’d probably be predicting a pretty good year for stocks.  GDP may be up by 3% real, 5% nominal.  Money will likely flow into stocks.  The Fed will probably be careful not to rock the boat by raising interest rates too quickly.

However, we have two other issues to factor in:

–economic activity in the EU, Japan and emerging markets may not be so great and the dollar has been strong vs. foreign currencies.  This may mean that US-domiciled multinationals may not look so good, especially after their foreign results are translated back into dollars.

–In addition, we have to consider how we can find publicly traded stocks that are tied to potential hotspots for 2015 growth.