Time to rethink your risk tolerance

The dilemma that most investors face is markets no longer appear cheap and many are forced to accept a greater degree of risk in order to meet an objective, avoid a shortfall, or miss a goal. The major risk you now face is inflation, while, at the same time, sustaining a significant capital loss. Inflation eats away at the value of your money, and you lose purchasing power. If inflation outstrips the rate of return on your investments, then your nest egg will be unable to maintain the lifestyle that you envision during retirement.  I believe the worst case scenario you now face is incurring a large capital loss in bonds or equities while interest rates and inflation rise.

In the past, investors favored bonds to generate an income to sustain them in retirement. This week Billionaire Warren Buffett said that “bonds are very overvalued,” and he’d short-sell 30-year debt if he could. Reading between the lines, I believe Buffett thinks there is too much “free” money and liquidity in the system. In addition, Federal Reserve Chair Janet Yellen has stated this week on record that that equity market valuations at this point generally are quite high.

Over the past few weeks, losses have been piling up in the bond markets as rates have risen in anticipation of the Federal Reserve decision to potentially raise rates for the first time since June 2006. While it is impossible to predict the short-term direction of interest rates, it is safe to say low rates are penalizing savers. The challenge we face is whether to invest into a fully valued equity market or invest in low yielding shorter-term bonds. We are now entering the 3rd longest bull market since 1900 where we haven’t experienced a correction of 20% or more. Your capacity to take a substantial loss in your portfolio has not been challenged in some time.

I believe that now is the time to reevaluate and rethink your risk profile. If you are working with an advisor you should  ask them what risks that they are considering in today’s markets. This answer should cover your objectives, time horizon, tolerance for loss, and current financial situation. The best answer will not only include your willingness, ability, and need to take risks but will cover market risks.

The best way to minimize market risks is through diversification. Neither asset allocation nor diversification guarantee a profit or protect against a loss in a declining market. However, they are methods used to help manage investment risk. My solution to beat inflation is through global asset allocation and understanding the risks associated with each investment. Your asset allocation and investments should match up with your risk profile. The major risk you now face is that you fail to understand the risks associated with the investments in your portfolio. It is best to work with advisor who thoroughly understands fixed income investing and how to uncover opportunities in the equity markets.

Summary

You can never predict when a correction will occur but you can prepare.  If you understand the risks that you are willing to take before any market correction then you will be more mentally prepared and better positioned to take advantage of future market opportunities. There are many ways to lower the volatility in your portfolio but you first need to understand these risks. My recommendation is to work with a financial advisor who understands asset allocation and the benefits of diversifying your portfolio. If you would like to learn more on how I can help you navigate these uncertain markets, feel free to give me a call at 508-207-8049 or send me an email to mitch@cgfadvisor.com.

Please read our disclosure statement regarding the contents of this post and our website as a whole.

Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.

Learn from these Investment Follies

We have all committed financial blunders in our lives. The most successful investors recognize their past follies and will make adjustments to learn from their mistakes. Even legendary investor Warren Buffett has admitted to making enormous mistakes. He often cites his $400 million purchase of Dexter Shoes in 1998 using Berkshire stock as costing shareholders now in excess of over $5 billion as one of his worst investments.

While this mistake is large in scale, it was not critical given Buffett’s other successful investments. The difference between Buffett and many other investors is that he takes the time to calculate his mistakes and learns from them.  In my fee only practice, I tend to find two types of financial follies that you can learn from:

1) No yardstick – A proper benchmark helps you gauge financial success. These yardsticks are the benchmarks that you can judge total investment results. For equity investors, popular indexes include the S&P 500, Dow Jones Industrial Average, MSCI World, or the Nasdaq 100.

Investment Advice – Consider your risk profile, goals, liquidity constraints, tax situation, and time horizon. These life factors and constraints are unique to you. A good financial advisor will help you find the proper benchmark and then create an asset allocation that is tailored to your current situation.

2) Buying financially engineered products – The second type of error is the purchase of unsuitable investment products. The most abused products sold to the general public are annuities, non-traded REITs, leveraged exchange-traded funds, long-term care policies, gimmicky mutual funds, and buying closed-end funds during the initial public offering (IPO) period. These types of products tend to be sold on commission by advisors who may misstate or omit material facts in connection with selling these products.

Investment Advice – Understand the basics – know how they work and the charges that you will pay. The best way to accomplish this and compound wealth over time is through asset allocation and diversification. Be sure to ask the right questions and you should always seek a second opinion before you make a major decision such as locking into an annuity or buying a long-term care policy. In certain circumstances, insurance products such as long-term care and annuities are suitable only if your entire estate plan is considered.

As a fee only financial planner, I do my best to recommend the financial products and investments that I believe are the most appropriate for you to achieve your goals. I follow a fiduciary standard that requires me to put your best interest first. I can help you minimize investment blunders by constructing portfolios that are well diversified in ETFs and active mutual funds across asset classes, geographic regions, sectors, and market capitalizations.

Please read our disclosure statement regarding the contents of this post and our website as a whole.

Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.

All indices are unmanaged and cannot be invested into directly.

Investment Regrets?

The National Basketball Association recently released statistics that evaluated all calls and pertinent non-calls occurring in the final two minutes of games, including overtime, in which the score was within five points.

Out of the 288 plays, they found a total of 41 incorrect calls or 14.2 percent of the time. The number of no-calls was much higher and included 34 out of the 41 reviewed calls.  Warren Buffett would categorize these non-calls as “errors of omission rather than commission”. Applied to investing, it is hard to believe that Buffett often states he misses more big winners than he loses in bad investments.

Another big error of omission this week was the Dow Jones Industrial Average adding Apple to the index. According to Bloomberg, if Apple was added back in 2008, the 30-company gauge would have reached 21,944.66 on 3/10/15 — almost 4,300 points above its actual level.

Similar to NBA referees, we subconsciously are making decisions by what Behavioral Finance theorists term “regret theory”. This theory states investors experience regret if they make a wrong choice, then take anticipation of regret into consideration when making future decisions. Investors’ regret can result in unnecessary risk aversion or lead investors to irrationally take more risk.

This week also happens to be the 5-year anniversary of the Dow Jones index hitting a low of 6,507 in 2009.  We can all reflect back to this time and determine if our portfolios were shaped by “regret theory” through the investment decisions that we may or may not have made at this time. Many people may not realize the major impact this market crash had on whether or not they will be able to meet their retirement goals. If you did not sell through this storm you should feel no regret. However, many investors look back and wish that they had taken even more risk.

I believe there are a few ways to avoid this regret. Investors that pay absolutely no attention to their portfolios and stay diversified, normally do well over the long-term. On the other hand, investors that are looking for the next hot stock tend to experience the most regret.  As a fee-only financial planner, I do my best to help my clients accumulate wealth over time by investing in businesses at a reasonable price, do their own analysis, stay diversified, take a value approach, and slowly compound returns over time.  Feel free to give me a call if you have any regrets on your investments or if you want to see how a customized portfolio would look based on your personal risk tolerance, values, and goals.

Please read our disclosure statement regarding the contents of this post and our website as a whole.

Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.

The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 actively traded “blue chip” stocks, primarily industrials, but includes financials and other service-oriented companies. The components, which change from time to time, represent between 15% and 20% of the market value of NYSE stocks.

Are you taking appropriate investment risk?

Since 2009, the U.S. equity markets have been on an unbelievable run – much like the 18-0 run the Kentucky Wildcats basketball team has accomplished this season. The similarities don’t end there.  The leadership in U.S. markets has been in Technology 2.0 companies, most of which have short operating histories. Similarly, the Kentucky Wildcats success is attributed to sophomores and freshman. This bull market has been frustrating to those investors who have either not participated nor taken enough risk. Even the Wildcat’s head coach, John Calipari, thinks his team is not taking enough risk. With only 3 turnovers in their last game, Coach Calipari thought his team needed to push the limits more and increase the amount of turnovers to around 11 per game in order to have continued success.

As a fee only financial planner, many investors have taken me up on my offer for a free second opinion on their portfolios. I find a majority of these investors are not taking the appropriate risks to reach their goals. These portfolios are either too conservative or are not diversified enough. Using the Wildcats analogy, these portfolios are either at 3 turnovers per game or risk 25 turnovers per game. I believe that in order to take appropriate risks, you first need to understand how to manage risk.  My job as a fee only financial planner and portfolio manager is to determine your risk profile, financial situation, values, and goals. Next, we need to make one of the following four choices to manage your investment risk.

1) Avoid it – Don’t invest
2) Transfer it – Shift the risk to an annuity or other type of insurance product.
3) Retain it – Invest yourself or follow Warren Buffett’s advice and invest in the S&P 500 index or passive fund.
4) Control it –Find an active portfolio manager who invests in undervalued companies that have high free cash flows, recurring revenues, increasing earnings, and defensible balance sheets. Even though Buffett recommends that the general public select option 3, all of his investments are in this option because he clearly understands risks and would rather buy companies that offer better value and have superior downside protection characteristics.

As a fee only financial planner and portfolio manager, all of my clients are put into category 4. Rather than follow the ETF trend, I believe that now is the time for option 4 and you need to invest with a fee only financial planner or in an active mutual fund. I believe the major drawback to investing in option 3 (major market ETF) is that your portfolio will likely participate in 100% of the downside. If you prefer to invest in a mutual fund, my recommendation is to review Barron’s Magazine The Best Fund Families of 2014. I believe investors with a long time horizon who are saving for retirement need to position for 11 turnovers per game because you will not be able to compound wealth over time if you don’t take calculated risks.

Please read our disclosure statement regarding the contents of this post and our website as a whole.

Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.

The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value weighted index with each stock’s weight in the index proportionate to its market value.

Investment Lesson from “Deflate-gate”

Both poker and investing are games of incomplete information. You have a certain set of facts and you are looking for situations where you have an edge, whether the edge is psychological or statistical. – David Einhorn

David Einhorn, who is the founder and president of Greenlight Capital, manages a $10 billion “long-short value-oriented hedge fund.” David started Greenlight Capital in 1996 with only $900,000 and he has generated roughly a 20% annualized return for investors.  David has taken advantage of misinformation from the media and used his edge to post outsized gains.  The media has recently turned its attention on deflate-gate. We will describe how Einhorn would make an investment decision using incomplete information on the subject of deflate-gate.

We believe that if the New England Patriots were a publicly traded company it would represent a once in a lifetime buying opportunity. The biased media coverage would have scared investors into a selling panic of Patriots shares. Since it is best not to invest with emotions, analyzing the known facts is your edge. Value investors use a method of discounting cash flows or calculating the asset value/replacement of a business. If the intrinsic value that they calculated is less than what the company is trading for in the open market than it’s a potential new buying opportunity.

The media has a very good track record of misinforming and confusing the public into making terrible investment decisions at some of the most inopportune times. As we have seen from much of the coverage of “deflation-gate”, many media members have labeled the Patriots as cheaters and liars. This rush to judgment may have tarnished the franchise brand and tainted the reputation of their hall of fame coach and quarterback but only temporarily. For an investor trying to determine whether or not to buy the Patriots stock, they would need to gain an advantage by taking all the known facts in the story and arriving at their own decision.

The one piece of information that they would need to make an investment decision would be to try and determine what happened to the air pressure in the football during the first half of the Patriots AFC championship playoff game. An astute investor would buy an NFL football and conduct their own experiment and put the ball through vigorous tests in different weather environments. One way to calculate the change in air pressure would be to calculate a physics equation called the Ideal Gas Law (pV=nRT).  This would give the value investor a statistical edge much the same how David Einhorn calculates the intrinsic value of a company. David would not rely on CNBC to give him a gut feeling whether or not to buy or sell. In the case of the Patriots, an investor would not watch and listen to ESPN talking heads test a football by throwing it around an indoor studio at room temperature.

If you were making this investment, you have done your due diligence and determined the probability of the football losing air in cold weather conditions and calculated the physics equation of the Ideal Gas Law. If the facts support your view that the Patriots are innocent than you have gained a statistical edge on incomplete information. Your new investment will have a huge payoff when the team is exonerated and the best part of it is that you just bought into one of the most successful teams in NFL history. Much like David Einhorn, we believe that the most appropriate way to make an investment decision is by using fundamental analysis rather than relying on the biased media for recommendations.

Go Pats!

Please read our disclosure statement regarding the contents of this post and our website as a whole.

Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.

The Shadow of the Crisis Has Not Passed

President Obama in his State of the Union 2015 declared an economic resurgence by stating, “the shadow of the crisis has passed.” We couldn’t disagree more with this statement. While the U.S. consumer has experienced a significant economic rebound, the central banks around the world have printed trillions of dollars and are still printing money to counterbalance weaker GDP growth and low inflation. The European economy is actually fighting deflation. With inflation too low, they face falling wages, and consumers holding off on purchases while they wait for lower prices.  The consequence could be companies not growing their profits which may result in lower employment. We are not out of the shadow of the crisis until the following occurs: central banks stop printing money; interest rates normalize to historical averages, currencies stabilize, and U.S. companies begin to raise wages.

Trouble in Europe

The European Central Bank just announced another round of quantitative easing which will include a 60 billion euro private and public bond-buying program until September 2016. The Euro has fallen to 1.15 to the dollar, which amounts to a 15% correction over the past 6 months. Not only has European consumers lost purchasing power, their investment markets are vastly underperforming the U.S. markets by nearly 12% over this same period. Moreover, interest rates have fallen to the lowest levels on record and energy markets have collapsed in the past few months. We believe that the credit crisis which began in the U.S. is actually still being played out around the world. All markets seem addicted to monetary stimulus and central banks have not disappointed as they have expanded their balance sheets by printing cash through asset purchase programs. Gold and silver prices have responded and are part of the best performing asset class this year up 9.38% and 15.34%, respectively.

Cash flow is king

Central banks seem to have lost their independence and are now reacting to each new data point rather than focusing on the long-term. They are behaving like many of the management teams of public companies and they feel the need to exceed the streets expectations or face the consequences from their constituents and markets. Investors over the past few years have feared that all of this money printing would lead to higher interest rates and out of control inflation. To the surprise of many investors, the opposite has actually occurred and prices have not risen as expected. Inflation has not occurred because companies have no pricing power to raise prices and wage growth has not occurred. In our opinion, the consensus view now seems to have went to the extreme in that many investors believe that U.S. interest rates will go to zero and energy prices will lose another 50%. We have maintained a zero weight in energy stocks and continue to hold this position until we see either a rise in energy prices or a correction to the current supply/demand imbalance. The cash flows and dividends of these energy companies could be negatively impacted in the coming quarters. We would rather not risk the capital of our clients on a bet that oil jumps 50% or falls 50%. At this time, we are closely monitoring what the impact will be on cash flows. We are still analyzing what the scale of falling energy prices will have on capital spending and employment in the U.S. states that depend on higher energy prices. We expect both will be unfavorable.

Portfolio positioning

We are not in the business of making economic predictions but we are trying to carefully manage risk and anticipate the best opportunities in our clients’ portfolios. Our investment philosophy is cash flow is king and that the companies that are consistently growing cash flows offer the best risk/return profiles. While we are not contrarian investors, we have added a few European companies to our portfolio as well as established a small position in silver. In addition, European companies are trading at relatively lower valuations to U.S. companies. We are doing our best to play the hand that is on the table – a weak Euro, low oil prices, falling commodities, low interest rates, and a strong consumer.

Please read our disclosure statement regarding the contents of this post and our website as a whole.

Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.

Energy Stock Dividends and Falling Oil Prices – Something Has to Give

Energy Stock Dividends and Falling Oil Prices – Something Has to Give

The 60% decline in oil prices, which accelerated during the fourth quarter of 2014, has continued into 2015. This unexpected swift decline has left many investors flat-footed and utterly confused. Kenneth Rogoff, a Harvard University economics professor, believes oil prices are the big story for 2015 and this once-in-a-generation shock will have huge reverberations. We would add that this drop in energy prices could have serious implications on your investment portfolio. Thus far the exploration and drilling energy companies have dropped significantly in price but the stock prices of the large integrated energy companies have fallen more modestly. Many investors have considered the following reasons why energy prices have crashed.

  • Organization of Petroleum Exporting Countries’ (OPEC’s) decision to maintain production levels and market share vs. the US
  • Slowing growth overseas in China and Europe
  • Relatively warm weather
  • Too much supply from US producers
  • A geopolitical squeeze on Putin

The question that we are now examining is whether or not equity investors are still holding out for a quick rebound in energy prices. The last time oil prices was below $50 a barrel many of the integrated energy companies were trading almost 30% lower. It is possible that some investors are attracted to the high dividend yields of these companies as well as the low P/E’s. At this point, we believe that dividend cuts are at serious risk and P/E’s could rise. The future earnings estimates for the large integrated energy companies have already been cut by analysts and their valuations are not as cheap as they first appear. The table below shows the potential worst case scenario if dividends are cut back to 2009 levels based when oil was trading below $50 a barrel.

2009 P/E

2014 P/E

Forward P/E (Year)

Today’s Dividend Yield

Hypothetical Dividend Yield based on 2009 annual dividend and 1/6/15 stock price

Chevron Corp

6x

9x

15x

4.10%

2.50%

ConocoPhillips

5x

10x

18x

4.60%

2.90%

Exxon Mobil

7x

11x

17x

2.90%

1.80%

Source: Constant Guidance Financial and Morningstar. This is a hypothetical example that is demonstrating a mathematical principle. It does not illustrate any investment products and does not show past or future results.

We believe that the hypothetical dividend yield based on the 2009 annual dividend could be a possibility if energy prices remain low for an extended period of time. According to data complied by Bloomberg News, the tumble in crude prices has prompted energy-stock analysts to slash estimates for capital expenditure for the next year, cutting them as much as 9.1 percent since July. Typically, when capital expenditures drop so will the profits of many of these companies which could ultimately impact dividends. Another way we analyzed this question on the potential for dividend cuts was by illustrating the yearly dividend of the Energy Select XLE dividend since 2009 and comparing it to the change of oil prices and the price vs. the Energy Select XLE ETF. The last time oil traded at $50 a barrel dividends for the energy sector was over 50% lower. In 2009, the Energy Select XLE dividend was $1.03 and rose year over year until hitting $1.96 in 2014. We conclude that one of two things need to happen, either dividends could be cut or the price of oil will need to rebound significantly.

 

Source: Constant Guidance Financial and bigcharts.com – This is a hypothetical example that is demonstrating a mathematical principle. It does not illustrate any investment products and does not show past or future results.

In our opinion, the table and chart show that there could be downside risk remaining for these stocks if energy prices do not rise. We believe these companies may represent a classic “value trap”. The following quote from legendary investor Benjamin Graham applies well to today’s energy sector,

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Many investors are voting that energy prices will rise and these large integrated energy companies will continue to pay their dividends. The weighing machine will be the ability for these companies to actually pay their future dividends. We believe that either those stock prices will need to adjust or energy prices will need to rally significantly.

Over the past few months, we have recommended a zero weighting in energy companies and we continue to believe that there are more attractive sectors within the U.S. stock market to invest. We are advising that our risk-averse clients continue to underweight much of the energy sector but remain invested in other industries that are benefiting from the drop in energy prices. Given the huge volatility in the energy sector, there could be more interesting buying opportunities sooner then we originally thought from just a few weeks ago.

We are closely following comments made by the managements of major energy companies on the stability of their dividends. If energy companies cut their dividends many investors may be forced to sell their positions. This could create a potential buying opportunity. There is a chance that many energy producers suffer the same fate that gold miners have experienced in the past few years. Many of these gold stocks have seen huge rallies followed by ensuing reversals. We believe that active traders might target many E&P companies in the Permian Basin, Bakken, and Eagle Ford shale areas as very good tradable opportunities.

Overall, we believe risks remain and it is prudent to remain overly cautious. We will gladly sacrifice any potential upside off the bottom in exchange for not risking the permanent impairment of capital. We believe dividend cuts and potential bankruptcies could be around the corner for highly leveraged explorers with higher marginal costs if oil remains at these levels.

Please read our disclosure statement regarding the contents of this post and our website as a whole.

Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.

Invest More Like a Shark

Those of us who watch the hit TV show Shark Tank are very familiar with the panel of potential investors who consider offers from aspiring entrepreneurs seeking capital for their ideas. As investors, we are actually all “sharks” who make capital decisions on where to invest our money. Some investors hire wealth managers to make decisions for them and others prefer to make the decisions themselves. We believe the ultimate sharks are famed investors Warren Buffett and Charles Munger but the current panel of “sharks” are all well connected and great capital allocators. The sharks are never afraid of losing money as long as they believe the odds are tipped in their favor. We believe that thinking with the same mindset as the “sharks” will help you take some of the emotions out of these volatile markets.

We are all fortunate enough to live in country that offers some of the best investment opportunities in the world. However, some investors continuously monitor the markets for economic signs that might indirectly impact their investments. These questions usually apply to current events or headlines that capture readers attention. A few questions below seem to be the ones currently being debated.

  • After the enormous relief rally, has the current correction ended?
  • How low will the price of energy fall?
  • How will falling energy prices impact the economy in 2015?
  • Will the global contagion from the slowdown occurring in the rest of the world spillover into the US?
  • Is it possible that Russia will default on its debt and will Putin lose power?
  • Can the deflation/recession in Europe move to the US?
  • If the Federal Reserve starts to raise rates at some point, will my investments lose value?

We can state with a large degree of confidence that very few investors can accurately predict the answers to these questions. However, most of the responses you hear will make for entertaining commentary on TV. As value investors, we think it’s best to have a mindset of a “shark”. The successful investors on the Shark Tank have an entirely different set of questions they try to answer before taking ownership in the business.

  • How long will it take me to get my cash back and how much can this investment return?
  • What is my potential downside risk in this investment?
  • How much money can I possibly lose vs. the potential for upside?
  • Do I understand how this investment works and what are the potential risks?
  • Is this a scalable opportunity that can be leveraged?
  • Are there high recurring capital expenditures to fund this investment?
  • Can competitors easily replicate this idea and take market share?
  • Will I be able to work with this management team/entrepreneur seeking capital?

We believe that the second set of questions is how you should be evaluating your investments. The first set of questions are all irrelevant to long-term investors who are properly diversified to their risk tolerances and goals. The second set of questions are much more relevant to making ongoing capital allocation decisions. If you think of yourself as a “shark”, your investment process will be much more decisive and your long-term investment results may improve.

Please read our disclosure statement regarding the contents of this post and our website as a whole.

Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.

2015 Portfolio Positioning: Beware the “Black Swan” in Oil

As we prepare for our year-end reviews with our clients, we are highlighting how the rout in energy prices has impacted their portfolios as they save for retirement or other financial goals. In our view, we continue to see major downside risks within certain industries and countries that rely on high oil prices. We believe that prudent sector rotation, where some industries do better than others, will be critical to adding some downside protection to your portfolio. One of my favorite quotes from Warren Buffett applies well to today’s market environment, “Risk comes from not knowing what you’re doing.” As we head into 2015, the market environment has become unpredictable as investors struggle with the uncertainty created from the drop in energy prices. With stocks falling off all-time highs and bond yields at all-time lows, we believe wary investors should seek a second opinion on their investments if they are uncertain of the likely outcomes from this difficult market environment. If your advisor is not providing you with timely market updates, they might be struggling with how to reposition your portfolio from this “Black Swan” event in oil prices, which has caused such capital loss in the energy sector.

Over the past few months, we have recommended a zero weighting in energy companies and we continue to believe that there are more attractive sectors within the U.S. stock market to invest. We are advising that our risk-averse clients continue to underweight much of the energy sector but remain invested in other industries that are benefiting from the drop in energy prices. Lower unemployment and lower energy bills should underpin the economy as we begin 2015. Economic data has shown that the drop in energy is positively impacting the consumer and many consumer discretionary and industrial companies stand to benefit. However, we now becoming more cautious on many of these companies as they have seen substantial gains in their stock prices. As we read press coverage about how consumers should benefit from lower fuel costs, we believe that investors have already priced in much the future cash flow gains from the drop in energy.

The greatest opportunity now might be uncovering potential opportunities in the energy sector but we remain cautious. We believe that low oil prices may continue to make markets volatile and this could create many interesting opportunities for investors as we head into 2015. Below are a few things that we are watching closely.

  • After the substantial drop in many Energy stocks the sector looks relatively cheap based on price-to-earnings (P/E) and price-to-free-cash flow (P/FCF) relative to the S&P 500 Index but this could be a classic “value trap” if the price per barrel of oil does not rebound.
  • If oil prices do not rebound there could be a number of bankruptcies and this time the government will not step in bail out the over-leveraged oil producers much like they did the banks in 2008. We expect continued volatility in the high yield credit markets, where energy issues makes up a significant portion of the overall asset class.
  • The bottoming process for oil companies will be marked by extreme volatility. A number of U.S. exploration and production (E&P) companies that have key strategic advantages might be acquisition targets for larger oil producers who have cash to spend and are not leveraged themselves. These companies we believe are becoming very attractive buying opportunities and we hope they become even cheaper.
  • We anticipate dividend cuts and/or capital write-downs if prices do not rebound. We are closely following comments made by the managements of major energy companies on the stability of their dividends. If energy companies cut their dividends many investors may be forced to sell their positions. This could create a potential buying opportunity.
  • There is a chance that many energy producers suffer the same fate that gold miners have experienced in the past few years. Many of these gold stocks have seen huge rallies followed by ensuing reversals. We believe that active traders might target many E&P companies in the Permian Basin, Bakken, and Eagle Ford shale areas as very good tradable opportunities.
  • A recent blue print that was created from the market crisis of 2008 might play-out for energy companies in 2015. The companies that were the most leveraged and experienced the closest near death experience were actually some of the best investments to make when the crisis ended.
  • If oil remains low, we believe that many U.S producers might be forced out of the market, but this could cause the price of oil to rise as fast as it has fallen when supply tightens.
  • As the tide goes out on many of the managements in the energy sector, we could be in store for a few more major surprises.
  • If prices continue to drop, we believe that larger investors such as Warren Buffett might step in and buy infrastructure companies that transport energy. These companies offer very good long-term investment opportunities when the dust settles.
  • Foreign governments that depend on high oil prices to sustain their government may experience political upheaval.
  • The falling price of oil might help many struggling European countries at the expense of Emerging Market countries that rely on higher oil to fund their governments.
  • The result from substantially lower deflation may result in a further drop in U.S. interest rates. A subsequent drop in mortgage rates could result in another refinancing boom, as young investors might look to this market as an opportunity to lock-in low fixed rates and take advantage of a stable housing market.
  • We are very wary of margin calls due to the highly leveraged market. The drop in oil prices might cause an unwinding of entire positions, which may result in a full market correction. Many tax sensitive investors might sell their 2015 winners to offset losses in their energy positions. This tax harvesting might add to market volatility as we close out 2015.

Overall, we believe risks remain and it is prudent to remain overly cautious. We will gladly sacrifice any potential upside off the bottom in exchange for not risking the permanent impairment of capital. We believe dividend cuts and potential bankruptcies could be around the corner for highly leveraged explorers with higher marginal costs if oil remains at these levels.

Please read our disclosure statement regarding the contents of this post and our website as a whole.

Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.

Falling Price of Oil – What Does It Mean For Your Portfolio?

Institutional Thinking for Individual Investors™

By Mitch Zides, CFA, CFP®, AIF®, NSSA® November 28, 2014

“Rule No.1 is never lose money. Rule No.2 is never forget rule number one.” – Warren Buffett.

As the price of oil has fallen sharply from nearly $110+ a barrel back in June 2014, to approximately $70 a barrel today, we reflect on Buffett’s famous quote. We all know that entails investing through uncertainty with the possibility of loss but keeping Buffett’s rule in mind can potentially keep you from avoiding major catastrophic losses. One of these losses is actually taking place in the energy sector.  This nasty reversal of over 38% is most likely having negative implications on your investments if you haven’t been correctly positioned for this this swift and unexpected drop in energy prices. Investors who have been properly diversified probably haven’t even noticed this complete meltdown in oil prices as markets have reached all time highs. However, if these unfavorable conditions persist for energy companies there could be unforeseen consequences that have yet to be played out. In particular, the chain reaction will have major ramifications on many foreign countries that are dependent on high oil prices to fund their government budgets. As these countries fall into deficit, they might actually be forced to pump more oil out of the ground to increase revenues rather than cut prices to decrease supply.

The most important assumption that investors must now make is how prolonged oil will remain at these levels. If OPEC members are trying to protect market share against the shale boom occurring in the US, we could be in for a protracted period of lower oil prices. If oil prices remain at these levels, we believe that many US shale energy companies will be forced out of business. Similar to the tech boom in the early 2000’s, the US has experienced a shale boom in recent years. There has been a substantial build up of capital in the energy sector and we could be more in a period of capital destruction in the next few years.

Another major implication will be that energy companies maybe forced to cut their dividends or even worse raise debt to sustain their dividends.  We have analyzed the cash flow statements of all the major energy producers and conclude that if these companies do not cut back on capital expenditures they will not have enough cash flow to fund dividends or buyback their company shares.

The margin of safety for investing in the energy sector is no longer in place. In our view, the true intrinsic value for energy companies is too difficult to estimate at these levels. We have completely avoided the energy sector and will continue to do so. We believe that the larger more diversified energy companies remain vulnerable at these levels. In our opinion, the time to buy the major energy producers will be when they announce dividends cuts. Many large institutional managers who are overweight energy will be forced to sell into a falling market as these cuts take place. We witnessed a similar meltdown of banking shares during the great recession as those companies were forced to cut their dividends. In hindsight, the time to buy was when banks cut their dividends. It is impossible to predict the direction of oil and we prefer not to make predictions; however, we will protect our clients’ capital from this vicious cycle. In addition, we will also not invest in any renewable energy technologies, which have seen their stocks drop 30% over the past month. Alway’s keeping Buffett’s rule at heart, we prefer to not risk investors capital during periods of unprecedented market stress.

Our recommendations are not suitable for all investors but, our clientele have trusted us to make tactical decisions on their portfolios. Our major criteria for selecting investments is that companies must actually have the financial capacity to pay their dividends from free cash flow and not from debt.  Investors with long-term investment horizons could potentially gain from buying these energy companies at lower levels, but we would rather wait for a better entry point.  Against this backdrop of falling energy prices, low interest rates, a strong US dollar, low inflation, strong corporate earnings, and falling unemployment, there are just better areas to make investments.

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Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.