A High Price for a Cheery Consensus? Real GDP, corporate profits and broad U.S. stock market averages are all at new record highs. The global financial crisis of 2008-2009 is rapidly becoming a distant memory. Return on capital is replacing return of capital as investors' top priority. So, we concluded, what better time to revisit the subject of risk?
Defining Risk: A Moving Target Risk is always a challenging concept to deal with as it clearly means different things to different investors. We continue to struggle to find a truly satisfying definition that incorporates all of the elements that we believe “How likely am I to incur constitute risk. For a loss? How much could working purposes, the I potentially lose? And most useful definition of how sure can I be that risk is probably the same funds will be readily one that Justice Potter available when needed?” Stewart settled on in seeking to define pornography in his Supreme Court ruling many years ago: "I know it when I see it." In its broadest sense, risk is about describing outcomes that are different than what was expected. Outcomes can certainly be more favorable than expected, but, in practice, risk is almost invariably associated with outcomes that fall short of expectations. In this context, we believe that most investors approach the issue of deciding how much risk they are comfortable taking by considering the following three questions: “How likely am I to incur a loss?” “How much could I potentially lose?” and “How sure can I be that funds will be readily available when needed?”
Assessing Market Risk: Don’t Forget the Past When the stock market has performed as well Kevin Bannon as it has over the past Managing Director few years and liquidity is firstname.lastname@example.org abundant, it can be hard (646) 217-3304 to resist the temptation to lower both the likely probability and prospective magnitude of a negative outcome in calculating an acceptable level of risk. We are not turning bearish or urging investors to become more defensive. We do, however, caution against forgetting what 2008-2009 was like to live through. In almost direct contradiction of economic theory, the higher share prices go, the more attractive stocks seem to become. When supported by earnings rising at the same rate as prices, this behavior is completely understandable. When price gains outstrip earnings gains by a significant margin -- which has been the case over the last year, as stock prices rose by more than 20% while earnings grew just 5% -- the resulting increase in Price/Earnings (P/E) ratios only serves to make stocks riskier. Riskier, however, is not necessarily the same thing as risky. At current levels, the S&P 500 is trading at a P/E ratio of approximately 15.7x the $119.00 consensus earnings forecast for 2014. While this P/E is up significantly from a year ago, it is not far above the market's long-term average of just over 15.0x. Were stocks very cheap last year and now fairly priced, or was the market fairly priced last year and rich now?
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Given the risks confronting investors at the time, our answer is that valuation levels were fair at both points. The market's performance over the past year has been a perfect example of an unexpectedly favorable outcome. Among the many legitimate fears that never materialized, the Eurozone did not come undone, gridlock in Washington did not push the U.S. to the brink of default, the U.S. did not become militarily involved in Syria, and China's economy seems to have avoided a hard landing.
Current Consensus: The Price Still Seems Right
As the pendulum of “The market's performance investor sentiment over the past year has been a continues to swing perfect example of an away from fear and unexpectedly favorable outcome.” closer to greed, we think investors will do well to heed Warren Buffett's advice: "Be fearful when others are greedy and greedy when others are fearful."
“The biggest risk we see involves the winding down of the Federal Reserve's quantitative easing policy and the normalization of interest rates that this will lead to.”
We believe the list of concerns that investors are facing today seems to be shorter, justifying the current higher P/E ratio. The jury is still out on whether China will be able to make a smooth transition from investment-led growth to consumption-led growth. Geopolitical tensions remain high, although Russia's annexation of Crimea so far appears to be a non-event for financial markets. The biggest risk we see involves the winding down of the Federal Reserve's quantitative easing policy and the normalization of interest rates that this will lead to. Investors may understand that this is coming, but are they fully prepared to deal with higher interest rates? Developments on all of these fronts may continue to unfold along favorable lines, in which case Price/Earnings (P/E) ratios still have room to go higher. Expectations, however, are higher than normal and leave little room for disappointment.
How to Avoid a Post-Mortem Cash Flow Crisis In the last newsletter, I trotted out the post-mortem parade of horribles that can occur in the absence of planning for one’s “digital estate.” Continuing in that vein, I would like to illustrate the ramifications of neglecting to plan for the immediate cash flow needs of one’s estate, and present some planning solutions.
A “Perfect Storm” for a Posthumous Cash Crunch Consider this hypothetical “perfect storm”: John, age 64, dies suddenly, leaving a widow, Mary. John and Mary both had children from prior marriages, and had a “Nothing could be paid prenuptial agreement since all of John’s liquid to keep their respective assets were held in an estates and finances investment account which separate. They had no passed to his probate joint property other than estate.” a small joint checking account for paying household bills. During their marriage, John and Mary resided in John’s home. Mary has sufficient funds in her name to support herself, and kept her prior home. John had done little estate planning, even though he had enjoyed financial success as a partner in a private equity firm. He made a simple will ten years prior to his death, leaving his estate in equal shares to his four children and naming his boyhood friend as executor. Shortly after John’s death, the mortgage on his house became due. Prior to his death, John paid the mortgage with his separate funds, given that the house would pass to his children upon his
death. Several capital calls on his private equity investments were also outstanding. Nothing could be paid since all of John’s liquid Susan Milona assets were held in an Managing Director email@example.com investment account, (617) 326-0621 which passed to his probate estate. This presented a major problem since the account was frozen until the appointment of the executor (who was traveling and unreachable during the weeks immediately following John’s death). Moreover, a bank would not provide a bridge loan against the real estate until the appointment of an executor, which takes at least 60 days. Mary was not as wealthy as John, and understandably was hesitant to make significant loans to John’s estate. This was especially true given that the executor was unreachable and she had no relationship with John’s children, the nearest of whom lived 3,000 miles away. John’s children did not have the financial ability to advance the funds needed to meet the mortgage and capital calls.
Surviving the Storm: Preserving Estate Assets What can John’s family do to preserve the assets of John’s estate during the period between his death and the appointment of an executor? John’s attorney could ask the probate court to appoint a temporary executor or other fiduciary
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who would have the authority to administer the estate immediately. The temporary appointment process involves the preparation of filings and often entails a hearing before the court. Filings and hearings are expensive, and this unnecessary expense could have been avoided if John had done some estate planning.
Avoiding the Storm: Post-Mortem Cash Flow Solutions John could have arranged his affairs to have sufficient funds to pay bills and expenses during the days and weeks immediately following his death. He had several options: 1. Funded Revocable Trust: Assets transferred to a revocable “living” trust during life are not subject to the probate process. At death, John’s trustee could have stepped in to pay the mortgage and the capital calls, as well as myriad other expenses while the probate process meandered to completion. Other advantages to a “living” trust include a system for support and maintenance of the trust creator and family members during incapacity, privacy from probate (one’s will and the assets that pass through it are open to public inspection), and orderly disposition of assets at death, possibly over several generations, consistent with the trust creator’s wishes.
In addition, the life “John could have insurance proceeds arranged his affairs to should not be taxable. have sufficient funds to Usually, life insurance pay bills and expenses proceeds are paid during the days and weeks shortly after death; an immediately following his ILIT typically provides death.” that funds may be loaned to the estate of the trust creator. 3. “Payable-on-Death” or “In-Trust-For” Bank Account: John could have created a bank account which he owned during his life but that was distributed to his children at his death, provided that the state of John’s residency recognized such bank accounts. The bank account could have provided a source of funds for the children to preserve their father’s legacy. It is clear that one needs to anticipate and plan for the inevitable and immediate post-death cash requirements. Each of the above strategies has advantages and disadvantages, which your Highmount advisor would be happy to discuss with you.
“Assets transferred to a living trust during life are not subject to the probate process.”
2. Life insurance Trust: John could have created an irrevocable life insurance trust (“ILIT”) and arranged for the ILIT trustee to purchase insurance on his life. The premiums would have been paid through annual gifts by John to the ILIT. If properly prepared and administered, the gifts of the premiums would have qualified for the annual exclusion from gift tax, thereby escaping gift taxation.
Family Governance: FAQs “From shirtsleeves to shirtsleeves in three generations.” A version of this three-generation proverb exists in almost every culture…and the sheer ubiquity implies a least a hint of truth. Avoiding the “three generation trap” is a passion at Highmount -- and was the impetus for our pioneering work developing family governance concepts. Family governance is literally part of our DNA. We define family governance as the holistic process of managing your family’s enterprise. This encompasses all relevant family members, businesses, and assets. Our experience shows that successful management of this process can help to extend the wealth cycle for every family. Today, the term “family governance” is thrown around quite a lot, but it’s rarely discussed and defined in a meaningful way for clients. We’d like to share some common questions surrounding this critical issue.
What is family governance? Family governance evolved from classic concepts of corporate governance and the search for best practices. Every family has business elements to manage, with assets and holdings that can range from real estate and manufacturing operations to software and investment portfolios. Every family is also a diverse collection of personalities, emotions, aspirations, and life cycles. Family governance is the process of organizing all these elements into a coherent structure, communicating that structure to all family members, and making decisions that benefit the family as a whole.
Why does our family need family governance? We want your family to avoid the shirtsleeves-toshirtsleeves trap and flourish for many years to come. You may currently make all the family business decisions, but what happens when you are no longer able to do this? Who will govern and how will you prepare them?
Steven Hoch Founding Partner firstname.lastname@example.org (617) 326-0611
Don’t you want to create and implement a plan that gives you the opportunity to improve the chances for your family’s long-term success – whether you have $5 million or $500 million?
What are some specific elements of family governance? The key elements are: 1) an organizational structure consisting of holding entities (i.e. trusts, companies, foundations) designed to manage the assets in a cost-effective and tax-efficient manner, and 2) the related management process (trustees and beneficiaries or a board of directors). As with any well-run business, there needs to be agreement on business objectives, budgets, the use of outside advisers and a communication process to family stakeholders. Succession planning and clear transition plans are also critical.
Why are “holding entities” often part of family governance? In the U.S., much of the planning and creation of holding entities is driven by the desire to reduce gift and estate taxes while maximizing the financial legacy to descendants and charities.
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“From shirtsleeves to shirtsleeves in three generations.” “From clogs to clogs in three generations.” “From rice paddy to rice paddy in three generations.” - Proverbs from U.S., England and China www.illustratedpast.com
What is rarely discussed is how succeeding generations will live with the Rubik’s Cube organization chart that is often the legacy of complicated entities. Heirs often have no idea why these beasts were created or what their responsibilities are. The result can be utter confusion and psychological tension. There is a better way to organize the family! Clear family organization charts and improved communications can alleviate these issues.
How do we get started with family governance? A good first step is to identify a key influencer (often a senior or next-generation family member) who wants better organization and who is willing to serve as the catalyst for a series of family meetings (depending on family dynamics, you may want to use a meeting facilitator).
Why use Highmount for family governance? Financial governance is our specialty. Our main goal is to preserve your family’s enterprise for generations to come. We love the intellectual challenge of finding solutions for multi-generation families. For over 30 years, Highmount partners have advised multigenerational families on family governance issues. Indeed, some of our clients are fourth and fifth generation members of these family enterprises which they are actively leading. Additionally, the “shirtsleeves” challenge is global: families all over the world find themselves affected by this proverb. Highmount is one of a few boutique U.S. firms with international offices and the experience and knowledge it takes to help cross-border families.
Set realistic expectations for the first few meetings: for some families, just getting everyone to the table counts as a success. Achieve enough satisfaction so that people agree to another meeting.
Economic Report Card: Five Years after the Great Recession, Recovery Still "Incomplete."
GDP and corporate profits at all-time highs....
S&P 500 Operating Earnings
$ TRILLIONS 100
2006 2007 2008 2009 2010 2011 2012 2013 2014
Source: Bureau of Economic Analysis
Source: Standard and Poors
.. but jobs and home prices still lagging. Employment
130 128 2006 2007 2008 2009 2010 2011 2012 2013 2014 Source: Bureau of Labor Statistics
125 2006 2007 2008 2009 2010 2011 2012 2013
DISCLOSURE Information provided in this newsletter should not be construed as investment, tax or legal advice. Information presented is not an offer to buy or sell, or a solicitation of any offer to buy, sell or invest in any Highmount Fund or in any security or commodity mentioned herein. Some investments discussed herein may be suitable only for sophisticated investors. Although information in this newsletter has been obtained from sources believed to be reliable, we do not guarantee its accuracy or completeness. Highmount disclaims any responsibility to update any information provided herein. Past performance of a security or Fund does not necessarily indicate or predict future performance and investments mentioned herein may lose value. There is no assurance that any security discussed in this newsletter will continue to be held in the applicable portfolio or that securities that have previously been sold will not be repurchased. It should not be assumed that recommendations made in the future will be profitable. There are no assurances that an investorâ€™s portfolio will match or outperform any particular benchmark. If you have any questions, please call (646) 274-7470, or e-mail email@example.com, or write Highmount Capital LLC, Attention: Chief Compliance Officer, One Beacon Street, 17th Floor, Boston, MA 02108. To ensure compliance with Internal Revenue Service requirements, Highmount informs you that any tax information herein is not intended or written to be used, and cannot be used, to (i) avoid penalties under the Internal Revenue Code, or (ii) promote, market or recommend to another party any transaction or matter discussed in this newsletter. Nothing contained in this newsletter constitutes tax advice. Third-party rankings and recognition from publications or rating services is no guarantee of future investment success. Working with a highly-rated adviser does not ensure that a client or prospective client will experience a higher level of results. A more thorough disclosure of the criteria used in making these rankings is available upon request. Any views or opinions presented herein are solely those of the author and do not necessarily represent those of Highmount Capital LLC. Content should not be construed as legal, estate planning or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.