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At a meeting of our family office last fall, random thoughts about Charles Dickens’ Tale of Two Cities were part of the members’ discussion about investments. Seven months ago, it was both the best of times and the worst of times.
In terms of yield, cash had truly become trash; the market’s offers of yields to maturity on two and three-year Treasury notes were half what the coupons were on the same maturities we had bought in 2017 and 2018. At the same time, the shares of the common stocks of sound American companies were promising 12-month expected dividend yields higher than the current annual interest payouts on all but the worst-rated junk bonds. We found ourselves looking at a potential portfolio of companies with a Piotroski F-score of 6 offering a 4.24% annual yield. At our meeting last Friday, we all agreed that our literary references to Dickens had been hopelessly wrong. Given how wonderfully successful our “junk equity” purchases had turned out to be, we clearly should have been discussing Great Expectations instead.
On Monday April 12, Chris Whalen of Institutional Risk Analyst offered his assessment of the current situation for American banking companies: “US banks are twice as expensive as they were a year ago looking at earnings and assets but have less transparency and greater volatility in terms of (likely) future costs and income”. In his article Whalen goes on to discuss in detail his reservations about the current financial market.
One of his observations was particularly striking. For the fourth quarter of 2020, the interest expense for U.S. banks’ holdings of their $21 trillion in assets was only $12 billion.
The question of “future costs and income” is very much on the minds of our family office. With the birth of a new child on Easter morning, the family membership has increased to half a dozen: two children not yet of school age, two working parents in their mid-30s, and two grandparents who are retired. From the point of view of the U.S. Treasury, the membership still maintains a proper fiscal balance. The employment tax contributions of the two members balance the net payments to the two members who are Medicare-eligible Social Security recipients.
What remains to be considered, from the point of view of the Treasury’s books, is the future ratio of our two youngest members’ employment tax payments to their parents’ federal retirement benefits. When we met last Friday, the adults agreed that the novel for our discussion right now should be Oliver Twist. Our luck last fall in finding profitable “junk equity” investments is not likely to be repeated. The current market does not have them on offer. In September 2020, the questions of when and whether the U. S. economy would recover were serious. Now, we find ourselves asking Whalen’s question about American companies, in general. How many bad/failed companies are being carried by the forbearance of their private and public creditors and emergency injections of cash from government? As the costs of borrowing money and buying goods and services all rise – from supply chain disruptions and increases in demand, how will even nominal profits avoid being squeezed?
Our members have faith that their choices among semiconductor and medical device manufacturers will have exceptional future growth in revenues and book values, but the number of those companies is a small fraction of the total that seemed worth the risk last September. Our successful “junk equity” investments are now at prices where the tax considerations outweigh questions of value. Should we hold the shares for another 20-odd weeks to take advantage of the preferential rate for long-term capital gains? For the two adult members who are the net contributors to the federal Treasury, the question is serious: Their after-tax “take home pay” from profits on qualified capital investments increases by a third on the day the holding period becomes one year.
Stefan Jovanovich manages the portfolio for The NJT Company, Inc., a family office based in Nevada.
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