D-Day 2021
Change is occurring rapidly in business and markets across the world.
Dear Clients,
I hope this letter finds you well. It has been several months since I have written - please pardon me, I have just been extremely busy in all areas of life and finding time has been difficult. Hopefully, this will catch us up.
At New Capital, we have a number of large projects going on, including and especially a conversion of our portfolio accounting, reporting, trading, and billing system to Orion Systems, one of our industry’s major providers. We expect to go live with the new system later in the summer and will be hosting webinars beginning around that time to introduce you to it. We will continue to use Morningstar, but only for portfolio analytics. We continue to build our proprietary NCM360 information system, and have begun to release it to a few test clients. NCM360 is already providing all of our internal client information functions, including task and meeting management.
I am also gratified to report that we are experiencing a strong inflow of new clients and prospective clients. Our client households now number approximately 100 and our assets under management are approximately $400 million. We expect to bring on an additional administrative hire very soon and look forward to making that announcement. Thank you for your trust and confidence and please feel free to introduce anyone in your world who might benefit from our services, we still have some capacity available.
Your trust and confidence has been highly rewarded over the past six to nine months, as our portfolios have performed very strongly against their benchmarks. This is a big change from early 2020, when the pandemic vaulted US growth stocks, almost alone, into the valuation stratosphere, leaving more diversified portfolios in the dust. I indicated at the time in letters and webinars that the gap between more expensive and less expensive stocks had become untenable and that a reversal, at some point, was likely. That reversal began in October 2020, and has continued into 2021, as less expensive value stocks, small company stocks, and international stocks have very substantially outperformed the names that were all the rage last year. The following table shows the relative returns YTD between value and growth asset classes, with all value categories very substantially outperforming:
The largest move I made in portfolios last year was to jettison a large portion of our core bond holdings when interest rates reached their lows last August, opting instead to move two-thirds of bond portfolios into short-term and inflation protected bonds. This was a very good move, as longer-term core bonds have suffered since that time, while inflation protected bonds have done particularly well with the well-publicized resurgence of US inflation driven by seemingly ubiquitous supply shortages and a very hot demand-driven economy resulting from waning of the pandemic, and massive monetary and fiscal stimuli. Here is the difference in performance YTD between “regular” core bonds and shorter-term inflation protected bonds:
I regularly get asked by clients what I think of markets right now. Over the past year we have seen greed-driven behavior behind “meme stocks” (GameStop and now AMC), “SPACs” (special purpose public vehicles), pandemic stocks, and of course, cryptocurrencies. I am never averse to exploring any potential investment (and I spend a lot of time reading and researching new investments and ideas), but not at any price, and I refuse to invest your money in unproven and potentially unsound ways. Our one single non-negotiable goal is to help you meet your own goals, and that means first defining and understanding those goals, and then making a plan and portfolio to get there using trusted tools. I encourage all clients to keep their annual meeting with us, so that we can update your financial plan, re-test your risk tolerance, and make any adjustments that we agree are prudent.
Change is occurring rapidly in business and markets across the world. As you probably already know, Exxon Mobil’s management lost a shareholder vote to deny election of new directors from Engine Number One, an investor focused on reforming fossil fuel company resistance to addressing global warming. Several years ago I began to tell clients that the most effective way for change to occur in boardrooms would be for the large mutual funds that control a vast portion of the nation’s, and world’s, public equities, to begin to assert more influence through their shareholdings. And I also said that New Capital has an important role to play in this, because we are an institutional investor, on your behalf, in such funds, and we therefore have some influence with them.
When we hold our regular meetings with our representatives from Vanguard, Blackrock, DFA, Fidelity, and more, I tell these firms that our clients want good, honest, and forward-thinking behavior from their investee companies. Our clients want to see executive pay that is reasonable and not obscene; you want to see employee pay that is appropriate and not miserly; you want to see community involvement that helps bring everyone up and breaks down systems of bias and discrimination; you want to see corporate behavior that does not attempt to circumvent laws and regulations; and you want to see corporate support of the environment, democracy, and justice, among other things.
In the Exxon vote, one set of shareholders was crucial in determining the outcome: the large institutional shareholders - Blackrock, Vanguard, Fidelity, etc. - who visit our offices, compete for our decisions about where to entrust our clients’ money, and who must listen to me when I speak with them about what is important to you.
On the other hand, shareholders who supported Exxon management’s attempts to deny the Engine Number One slate of directors were heavily composed of individual, “retail” shareholders voting with management. In other words, one of the most powerful tools you may have for prompting change within corporations is hiring New Capital to speak for you. In the weeks and months ahead, I will have a spate of announcements about additional innovative tools we are creating to ensure that your voice is heard, with whatever concerns you have, directly with the fund managers in which we invest you.
I am not at all averse, on the other hand, to selling company shares when appropriate. For several years, as I expected the value of fossil fuel stocks to fall along with the rise of renewable energy, I have advised charitably-minded clients with large shareholdings in Exxon and other oil companies, and in Houston you can imagine that there are quite of few such clients, to turn their shares into charitable funds using Fidelity’s donor advised fund (Fidelity has informed me that New Capital is their most productive advisor using this tool). In so doing, these clients (1) received perhaps the only remaining large-scale income tax deduction, (2) avoided paying a large capital gains tax had they sold their XOM shares, (3) avoided the total meltdown in the value of XOM shares that culminated last year as the pandemic raged and oil demand fell off the cliff, and (4) funded their charitable goals for years to come. Clients who have taken my advice (and most did) have enjoyed a quadruple grand slam by turning their oil company stocks into charitable gifts. Let us know if we can help you in such ways.
I turn now to the issue of potential tax law changes under the new Congress, specifically potential changes to the capital gains tax and the estate tax.
I am not at all concerned about an increase in the capital gains tax because at New Capital your portfolio is invested for the long haul: you hold a diversified, global, market-based portfolio with proven factor-based performance enhancers, and so there will never be a reason to sell unless you require funds. In other words, there is no better investment that will come along and cause me to want to sell what we own. My own money is invested the same way.
In approximately 2008, I began to invest my own family’s accounts in this fashion. Thirteen years later here is the scorecard: in US stocks, for every $1 I invested in 2008, we now have an additional $3 in unrealized gains, the holding remains every bit as diversified as it was on the first day, and there is still nothing better for compounding long term wealth that has come along since. That $3 in unrecognized gains constitutes an enormous interest free loan from the US government to our family. The capital gains tax is a voluntary tax, you only pay it if you volunteer to sell your appreciated investment, and I cannot currently foresee such a need developing.
The combined gift/estate tax is a different story - changes could have significant impacts on many clients. I’ll focus my comments on contemplated changes related to two estate tax elements: the step-up on death and the exemption threshold.
When someone dies, and if they have appreciated investments, their heirs may choose to “step up” the cost basis of those investments from their original purchase price to the market value of the investments on the date of death. In so doing, the capital gains tax, at that moment, is potentially eliminated if a sale is made. The logic in the government allowing this is to not simultaneously tax the assets with both capital gains and estate taxes. Almost always, I as a wealth advisor recommend that an heir step up the basis and sell the investment if it can be better diversified. This is an enormous tax benefit to heirs, and combined with a very high estate tax exemption threshold (described below), essentially results in wealth being both passed without taxes, and made entirely liquid without taxes. Proposals are now circulating to do away with the step up, and to make the passing of appreciated investments taxable upon death. This means that the government would regard all investments as essentially “sold upon death”, with the resulting capital gains tax - remember, no step-up allowed - due at that time. This would be a very dramatic change to the entire estate planning landscape. New Capital has assisted many clients with stepping up inherited assets and diversifying them with no taxes owed. In fact, new clients often come to us to help with this process, which can be complicated for novices.
In addition to the dramatic potential change of eliminating the step-up, there are proposals to lower the current estate/gift tax exemption of approximately $11 million per person ($22 million for a married couple). A recent estate planning session I attended with a client and a well-connected estate attorney yielded the opinion that a reduction of the threshold to approximately $3-5 million is, if not probable, then at least conceivable. A lower exemption combined with the elimination of the step-up would mean that we could see both higher capital gains taxes and higher estate taxes in the future.
Under such changes, we would likely have to change our prescriptions to include enhanced charitable gifting of appreciated investments, enhanced use of special trusts, and enhanced use of life insurance tools. And even then we would likely not come that close to achieving the extraordinary tax-free efficiency of the step-up and currently high estate/gift tax exemption threshold. If you have an estate in excess of, say, $10 million, then we may want to undertake a review of potential actions. And even if your estate is below this marker, we may want to undertake a review given the possibility of the loss of the step-up.
I’ll turn now to politics, that enormous elephant in the American room that seems to get larger every day.
There are many people concerned about the government issuing more debt to fund large infrastructure and other projects. I am not at all concerned about it. The government has issued large amounts of debt in the past to go to the Second World War, to the Vietnam War, to the Iraq War, and to the Afghanistan War - four wars, with only one “victory” among them. War is essentially an exercise in destroying large swaths of capital after failing to negotiate peaceful solutions, and so I am not at all concerned about our government issuing large amounts of debt to fund the creation, rather than the destruction, of large amounts of infrastructure and other forms of capital. Our country must decide if it wants to pay for its large and important projects with taxes, or with debt. But the United States has deferred maintenance in many areas of our civic life, and we should delay no longer. In the past months I have somehow incurred component failures or total loss to my pool/spa heater, A/C unit, washer, dryer, refrigerator, oven range, rainwater collection system, driver side auto seat, and put a pretty good dent in the rear panel of my pickup. Whether I put these many repairs on my credit card or write a check, I have to make the repairs (at least Hannah says I do). America is in the same place right now: we have a lot of broken stuff, and we really don’t need to waste a lot of time arguing about how to pay for it. Luckily, we are good for the money, one way or another.
The actions by many American politicians to limit voting rights, if successful, are likely to have negative impacts on your wealth, and I encourage you to reject such efforts, if for nothing else, then on behalf of your money. Overall wealth, individual wealth, and wealth distribution, have all improved over the centuries commensurate with expansions, not restrictions, in voting rights. In regions of the country where voting (and other) rights have been curtailed, such as in the American South after Reconstruction, economic growth and development have significantly lagged behind. So it will inevitably be in the current period.
Just as the nation needs to expand its infrastructure capital, it also needs to expand its human capital, and that includes the right for all Americans to vote in fair and modern elections. Many countries have moved already toward elections conducted using advanced technologies, and that is the future here as well.
Seventy-seven years ago to this day, American, British, and Canadian troops landed on the beaches of Normandy to fight victoriously for democracy over European fascist totalitarianism. I fully expect their sacrifices to be honored by this nation. But if that does not happen, and civil strife in the United States does not abate, New Capital will be ready to offer alternative custody of your assets outside of the country if need be - I expect to make an announcement about this later this year.
I will be traveling in July, but will have regular, even daily, access to our standard communication tools. If I or any of our staff can help you, please let us know. In the meantime, I wish you a wonderful summer, and as we all begin to emerge from the unprecedented pandemic lockdowns, may you reconnect with the people, places, and things that are important to you.
I am grateful for your trust, and we work every day to hold it with the utmost care.
Leonard Golub, CFA
Fiduciary Financial Advisor