January 2018 Newsletter

Stephen Merritt, CPA, PC  |  Certified Public Accountants  |  (757) 420-5778
233 Business Park Drive, Suite 104, Virginia Beach, VA 23462

What’s Inside:

Investing In 2018: Dividend Stocks
Investing In 2018: Defensive Funds 
Small Companies Need Plans for Natural Disasters
Tax Calendar

Investing In 2018: Dividend Stocks

As of this writing, it appears that 2018 may be a difficult year for investors. Yields on bonds, bank accounts, money market funds, and other savings vehicles are extremely low, with questionable prospects for substantial increases. Stock market indexes, on the other hand, are at or near record levels.

In essence, relatively low-risk places to put your money this year appear to offer scant returns. Equity markets have been rising since early 2009, so the chance of a pullback may be just as great as the possibility of solid gains.

Given this environment, where might investors go for opportunities for respectable returns with some protection against a steep decline? One possibility is in the stock market.

Paying dividends

Equity markets are notoriously difficult to predict. Nevertheless, dividend paying stocks might tilt the risk-reward odds in your favor. During recent bear markets, dividend payers generally fared better than those that didn’t pay dividends.

This seems reasonable because dividend paying companies may be enterprises that generate ample cash flow—enough to distribute some profits to investors. Companies in strong financial condition could be favored by investors in stormy economic weather, and the prospect of ongoing dividend payouts might stem panicked selling.

Floor and ceiling

Whereas dividend paying stocks may offer some protection during down markets, they also might deliver solid returns. The yield on the benchmark Standard & Poor’s 500 Index currently is nearly 2%. That’s the yield for the broad index, so some of the large companies included in the index have dividend yields of 3% or more. When an investment starts with such a payout, it’s less likely to fall into negative territory and is already on the way to possible robust returns.

Dividends can grow, too. Indeed, many public companies have long histories of raising their payouts.

Example: Nancy King is a widow who depends on investment income for her lifestyle. She invests $50,000 in shares of GHI Corp., currently paying a 4% dividend, or $2,000 a year. If GHI raises its annual dividend to $2,500 over the next few years, Nancy will collect a 5% return on her initial investment.

In addition, qualified dividends (see Trusted Advice box) receive favorable tax treatment. Nancy, in a low tax bracket in our example, could owe 0% on qualified dividends. Other taxpayers owe 15% or, for those in the highest ordinary tax bracket, 20%. These rates are lower than ordinary income tax rates. The Trump Administration’s tax reform framework, released in the fall of 2017, does not mention the possibility of ending this tax break.

Go with a pro

It’s true that dividend paying stocks can offer many advantages. However, investing in equities carries risks; even the most established company, with excellent management, can see its share price tumble in a broad selloff. Selecting individual dividend paying stocks can require thorough research and portfolio monitoring.

Therefore, many investors prefer to invest in mutual funds or ETFs that focus on dividend stocks. There are dozens of such funds available, with portfolio managers who are responsible for stock selection. Other funds track a custom index of dividend paying stocks. Dividend stock funds tend to fall into two broad categories:

High payout. Some funds are designed to pay higher yields than the S&P 500, perhaps 3% or 4%. They may use “dividend capture” strategies, buying funds just before a dividend payout. High dividends may be appealing, but a robust payout can indicate a relatively low share price due to concerns about the company’s growth prospects.

Dividend growth. These funds may have yields similar to the S&P 500 or lower. However, the stocks they hold are chosen because the companies have enjoyed growing earnings along with rising dividends and are considered likely to continue such profitability.

Quality counts

Dividend oriented investors may hold individual stocks, specialized funds, or a combination. They aim to own successful, profitable companies that will provide a steady stream of cash flow, bull market or bad. There’s no magic about dividend paying stocks and there have been instances in which a dividend cut has been followed by a plunging stock price. Still, buying successful companies that pay appealing dividends is one way to approach equity investing this year, with current prices at lofty levels.

Qualified Dividends

Most stock dividends paid to U.S. investors are qualified dividends that are subject to the low 0%, 15%, and 20% tax rates.

To be qualified dividends, the dividends must be paid by a domestic corporation or a foreign corporation that meets certain requirements (a qualified foreign corporation).

To get the low rates, investors must hold onto a stock for more than 60 days during the 121‑day period, which begins 60 days before the ex‑dividend date.

The ex-dividend date is the first day of trading when the buyer of a stock is no longer entitled to the most recently announced dividend payment. If the ex-dividend date is December 12, a December 11 buyer would receive the latest dividend, but a December 12 buyer would not receive it.

Investing In 2018: Defensive Funds

As the previous article suggests, 2018 might be a difficult year for stock market investing. Yes, a 9-year bull market could stretch to 10 years. However, the longer the bulls keep running, the greater the chance that they’ll have to pause for breath, and an exhausted equities market will sag. Risk reduction can be just as important as profit potential at current stock values.

One approach to risk reduction is to sell stocks and put the proceeds into cash. That may turn out to be a good move now, but it’s also possible that you’ll miss another good year in the market while earning virtually nothing in cash.

Another way to play defense is to review your asset allocation. If your investment plan is to have a 60/40 portfolio, stocks to bonds, equity gains might have moved that ratio to 70/30, for example. Trimming stocks and increasing bonds to get back to 60/40 probably would make your portfolio less volatile.

Safety in numbers

One additional defensive tactic could be to reduce your holdings of individual stocks, then shift some assets into mutual funds and ETFs. A fund with 50 holdings is not as likely to be decimated as a portfolio with only 2 or 3 stocks. Funds often are managed by experienced professionals, backed by analysts who spend considerable time seeking desirable issues.

That said, there are many thousands of stock funds from which to choose. There is no certain way to predict results of a given fund, but some strategies might boost the likelihood of finding one that can provide some cushion in a down market.

Crafty capturing

One possible approach is to use “capture ratios” to evaluate funds that you’re considering. There are two types of ratios: downside capture and upside capture. The downside capture ratio shows a fund’s losses in relation to a relevant market benchmark during downturns. The upside capture ratio shows a fund’s gains in relation to a relevant market benchmark during upturns. This information can be found online on Morningstar.com.

Example 1: XYZ Fund’s 10-year downside capture ratio shows that it held losses to about 80% of its benchmark’s decline during market drops, while its 10-year upside capture ratio reports that it’s returning about 90% of the market’s gains during upward moves. This positive spread indicates the fund has held down losses while delivering largely positive results.

Comparing capture ratios can be useful but it’s not a guarantee of success. If it were, everyone would simply look up capture ratios online, invest in the funds with the best positive spread, and mint money.

Nevertheless, the idea of comparing upside with downside performance can be useful. A fund that has done relatively well—that is, limiting losses—during the bear markets of 2000-2002 and 2008-2009 may be a fund that could do the same in the bear market of 2018 or 2019, or whenever the Ursidae family comes out of hibernation. If a fund that has done well defensively also has registered strong growth in rising markets, it may be a fund worth further evaluation.

Winning the numbers game

Underlying the approach of investing defensively is some basic math that investors may overlook.

Example 2: John Lucas holds $100,000 in XYZ Fund. The market drops 25% in the next year, but XYZ only falls by 20% to $80,000.

At the same time, John’s cousin Linda James holds $100,000 of ZYX Fund, which drops the full 25% to $75,000.

Going forward, John needs a 25% gain to get back to $100,000, and Linda needs a 33.3% gain to recoup her losses. It’s certainly possible that Linda’s fund will outperform John’s in the recovery, but it has significantly more ground to make up.

Carrying this example further, investors need a return over 40% to recover from a 30% loss, a 67% return after a 40% loss, and so on. Holding down losses can put you in a better position to build wealth when market cycles turn bullish, as you’ll have more assets left to participate in future growth.

Stress reduction, too

Defensive funds may have non-mathematical attributes as well. Historically, bear markets have proven to be buying opportunities. Stock prices are “on sale,” after steep declines. Yet, many investors sell during downturns and subsequently are late to get back in, forgoing potential profits. This sort of selling may be less likely after, say, a 10% decline in asset values than with a 20% drop.

If you decide to seek a fund with a good record of playing defense, see if the manager or managers who held down losses during bear markets are still in place. Read the fund’s materials to find out if its investment philosophy meshes with yours, or discuss the fund’s approach with your investment adviser. When stock market records are falling regularly, patience and prudence can pay off.

Small Companies Need Plans for Natural Disasters

From East Coast to West Coast, hurricanes and wildfires recently created huge losses of lives, property, and emotional wellbeing. In the middle of the United States, crippling natural disasters can range from blizzards to river flooding to tornadoes. News reports naturally focus on homes and families, but local businesses also are among the victims.

There may be little a small company can do when it’s in the path of record winds or a wall of flames. However, there are steps a business owner can take when things are calm to reduce the impact of catastrophic conditions in the future.

Be sure about insurance

For example, relevant insurance should be in place. Whether you rent or own the facilities you use, you should have adequate property insurance from a well-established company. Business interruption coverage may provide cash if revenue producing operations are curtailed for any length of time. Your firm also may obtain special flood or earthquake insurance (or both) if that’s deemed necessary.

You probably won’t have the time or the inclination to evaluate all the coverage you might need. Therefore, you should work with an experienced agent or insurance consultant who can provide expertise. This professional also can suggest the scope of personal insurance needed by you and your employees, payable after a natural disaster. In the wake of a dreadful event, the less time people spend worrying about personal losses, the sooner your firm can get back to operating at full speed.

Staying online

Business interruption policies may or may not cover problems that disable information technology systems, which are vital to many small companies. Special cyber policies might be available. Besides insurance coverage, there are things you can do to proactively keep data and other records intact, even in worst case scenarios.

Backing up computer files is an obvious yet vital procedure. Store the backups offsite or use a cloud-based solution. If your company operates in different areas, one place might store backup records for the other place. Some small companies have gone from desktop computers and related accessories to laptops, which are easier to move quickly, if circumstances require swift action.

Power play

As we’ve seen, some storms bring high winds that can bring down power lines. Hurricane Irma impaired electricity for millions of users in Florida and surrounding states. If you have a generator that can supply emergency power for critical usage, that can reduce the time operations cease altogether.

Again, during and immediately after a disastrous event, it’s vital for employees to have power at home so they can go on with their lives and perhaps get some work done. Your company might inform key people about sources of backup power and even provide a financial incentive to have a residential generator installed.

These steps can serve as part of a natural disaster plan. To create a complete course of action, take on the role yourself or assign an employee to head this effort. The leader’s first job might be to find a local consultant or other expert to create a formal policy for your company. Asking your own company’s executives and staffers for suggestions can lead to valuable input from all areas of the firm. Once a plan has been adopted, it should be circulated to all employees so they know what to do and who to contact in case of a true emergency.

Tax Calendar

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