Tag Archives: investment

Where Do I Put Cash When Interest Rates Are So Low?

Let’s face it.  It’s been quite the dry spell for conservative savers.  Interest rates are historically low, and they have been quite low for some time.

Risk vs. Reward

In such an environment, it is really easy to get discouraged.  After all, what is the point of putting cash into a savings account when I am hardly compensated to do so?  At the same time, it is also easy to be tantalized by the prospect of pursuing higher yields elsewhere.  Generally speaking, the tradeoff with higher yields is that you incur additional risk – either to the sustainability of the yield received, or to the certainty that you will receive all of your initial investment back.

In this post, I’m going to consider the available options and the criteria to assess what might make sense.

Safety of Principal

In theory, investors demand a certain rate of return even when they incur zero risk to their principal.  In practice, however, there is no such thing as a perfect investment with zero risk.

When I was taking finance classes, the commonly accepted assumption for an appropriate risk-free rate was around 4%.  Generally, this was taken from the prevailing rates from U.S. Treasuries.  Current rates have not been very appealing.  As of June 2015, the 3-month T-bill yields a whopping 0.00%.  Since the U.S. has seen its credit rating downgraded in the past few years, it’s not even clear to me whether U.S. Treasuries still represent the closest proxy for a risk-free instrument.

I would break down safety of principal into what is perceived and what is realistic.  The most apparent form of perceived protection comes from Federal Depository Insurance Corporation (FDIC) insurance, which is an implicit government insurance program that protects deposits up to a certain amount (currently $250k).  This coverage amount is per depositor, per insured bank, and for each account, so an investor could actually receive quite a bit of coverage once all of those coverage limits are aggregated.  The types of accounts covered include checking accounts, savings accounts, money market deposit accounts, and certificates of deposit.

FDIC coverage has provided the most comfort to investors, as that coverage is backed by the “full faith and credit of the United States government.”  Moreover, the FDIC can also draw on a line of credit with the U.S. Treasury if it is ever necessary.  Since its founding in 1933, no depositor has ever lost any money of FDIC-insured deposits.

The counter to this protection is whether the FDIC is sufficiently capitalized to survive a bona fide financial crisis.  A viable insurance company would need to have adequate funds to cover its obligations.  The FDIC should be subject to similar standards.  It certainly surprised me to discover that the FDIC does not actually receive funding from the government.  To cover any bank failures, the FDIC maintains a Deposit Insurance Fund (DIF) that is funded by premiums paid by member banks.  The FDIC is required to maintain a designated reserve ratio in this fund, which has been determined to be 2.0%.  On the surface, that seems pretty low.  In actuality, it’s even lower.  As of December 31, 2014, the DIF has a balance of $62.8 billion and a reserve ratio of 1.01%.   This marked five straight years of DIF balance growth from a low of negative $21 billion in 2009.  The Dodd-Frank Act set a minimum reserve ratio of 1.35% that the FDIC needs to reach by 2020.

When the FDIC was first started in 1933, the insurance coverage limit was $2,500.  The coverage limit has since been raised multiple times.  The most recent raise occurred in 2008 in the depths of the financial crisis when the limit was moved from $100,000 to $250,000.  While inflation has been significant since 1933, I’m pretty sure that it hasn’t been 100x.

For an insurance fund that is meant to cover bank deposits measured in the trillions of dollars, it is a bit scary for me to imagine what might happen if we did experience multiple bank failures.  The FDIC is a “symbol of confidence,” but is it actually a legitimate insurance fund?  In a major crisis or other black swan event, it would seem likely that special emergency injection by the federal government would be essential to cover any shortfalls.  These symbols are perceived to be bulletproof until they are not.  Credit ratings had been regarded nearly as gospel until their integrity was questioned during the crisis.

This is not meant to incite panic.  It is meant to illustrate what the reality of the situation is.  As with any potential investment, you cannot take the marketing at face value.  This is what I mean when I say there is a difference between what is perceived and what is realistic.

Optionality (0% Yield)

Cash is king.  I realize that with lofty prices in many asset classes, cash seems to be in abundance right now.  But there has never been a boom that has persisted.  When the environment eventually normalizes and potentially swings to the opposite extreme, having available cash on hand will prove to be very valuable.  Here is an interesting post that demonstrates that doing nothing for 5 years but then finding superior returns for the ensuing 10 years will yield better results than 15 years of mediocre returns.

Cash held in brokerage accounts will likely not earn much in interest.  Fortunately, there are options that will let you earn a bit more yield while keeping liquidity constraints to a minimum.

FDIC-Insured Alternatives (1% Yield)

Having opened your eyes to the limitations of the FDIC, it is still generally preferable to hold money in an account that is FDIC-insured as opposed to an account that is not FDIC-insured.  I say generally because it really depends on how you are compensated for the risk that you are taking on.  We’ll examine those later on, but understanding what you are

Chances are you are being paid a pittance in your current FDIC-insured account.  Most of the major banks have rates that are measured in basis points.

A quick scan of Bankrate shows multiple options that will produce a 1% yield.  I use GE Capital bank which currently has a 1.05% yield.  Surprisingly, these rates are higher than most short-term CDs, even though these accounts do not require you to keep your funds there for a set time period.

CD ladders are also a popular option.  There are several 5-year CD options that yield about 2%.  It’s admittedly not a super compelling rate, and I’m not sure if tying up funds for that period of time is worth an extra point of yield.

A quick note on taxes too.  If you happen to be in an Obamacare income bracket, and if you happen to live in a state with high income taxes like California, the net income that you receive from your interest income is going to be paltry – approximately 45% to 50% of your interest income will be paid out in taxes.

Index Funds / ETFs: Bond or Equity or Dividend (2%+ Yield)

Once you let go of the FDIC-insurance requirement, there are opportunities to get more yield.  Unfortunately, you are now also subject to volatility in your principal.

Time horizon is a pretty critical consideration here.  As a place to stash cash for the short-term, this is probably not the best alternative.  If there is a sudden downturn, you will not want to be in a position where you would need to liquidate at a loss.  Once again, you need to ensure that you are being adequately compensated for the risk you are taking on above the FDIC-insured alternatives.

However, if you have a long time horizon and would be willing to hold on (by tapping other investments or savings for necessary cash) or tax harvest in a downturn, then it might make sense to take on this risk.  Most prudent investors are likely contributing periodic amounts to these types of investments anyway, and this is a way to add more yield by adding amounts that might have gone toward cash.  If the price increases, then you would happily liquidate and use the cash elsewhere as originally intended.  If the price decreases, then you would just attribute it as a long-term investment and hold on.  This assumes that you don’t actually need to use the cash in the first place, which might be a luxury that not many of us have.

An interesting way to tailor your holdings here would be to consult the credit ratings of the individual companies in the major index funds and ETFs.  For example, you could choose to invest only in companies with a certain credit rating or better.  There are actually only 3 companies that currently possess an AAA rating: Exxon Mobil (3.4% dividend yield), Johnson & Johnson (3.0%), and Microsoft (2.7%).  You might choose to widen your net to include A or AA companies, and you’ll need to pay attention to transaction costs.  However, the benefit of the credit ratings in this context, while not a pure assessment of the likelihood of the business to continue to support and grow the dividend, is that you’ll at least have some comfort in the financial strength of these businesses.

The tax implications are also worth highlighting.  Most dividends will be paid at long-term capital gains tax rates, which means more of the income stream will net to the investor relative to interest income.

Preferred Stock (~5%)

Now, we are looking at some more unconventional alternatives, so be sure to do your own research beforehand.  Preferred stock is senior to common stock, but is junior to most debt.  They also generally pay a heftier dividend than common stock and bonds.  However, these securities also have a lot of terms that may vary depending on the specific issuance.

I use Quantum Online for most of my research into preferred stock.  You’ll notice that most of the issuers are financial institutions, and that you can often earn a higher yield on their securities than in their saving account products.  Take Wells Fargo as an example:

Wells Fargo likely has one of the strongest reputations among financial institutions.  Yet, relative to the rates that you can earn in the savings accounts that Wells offers, you can potentially earn a lot more investing in different parts of the company’s capital structure.

For preferred shares, there are a lot of unique risks that are introduced, including default risk and the risk that the company suspends its dividend payments.  However, this is an example where the additional yield may adequately compensate the added risk exposure.

Options (~5%+)

There are many option strategies that can generate income, but I’m going to focus on one particularly strategy that is fairly conservative as far as option strategies go: selling cash-secured put options.

We can take a look at Wells Fargo again as an example, which is trading at about $57.  If we are comfortable owning the stock at a lower price (say $55), we can sell a cash secured put to take the option premium today.  An option that expires in January 2017, or in about 18 months, currently sells for $5 per option contract, or at an implied 9% yield based on the strike price of $55.  Annualized, this is about 5%.

Wells Fargo is not even the best example, since it tends to not be very volatile.  The higher the implied volatility of the stock, the greater the potential yield by selling puts.  This strategy works on ETFs as well, and might be a good way to earn extra income while waiting for a good entry price.

The risk is that if there is a downturn, you may be committed to purchasing the stock at a higher price than the prevailing market price at the time of expiration.  However, as long as you consider only stocks that you would be willing to own, and at prices that you would be willing to own them at when you set the strike price, then all of the potential outcomes should be fine.

Conclusion

So where does that leave us?  This might seem like dodging the original question, but to me, the only solution to all of this uncertainty is to be diversified across all of these options.  How one chooses to allocate assets across these options is a personal decision since each option has its own risk/reward tradeoff, and it’s not necessary to be exposed to all of these alternatives.  I would probably prioritize optionality and safety of principal, which means that I’ll be holding on to more cash, even though I will still deploy some capital in the other categories.

As always, remember Warren Buffett’s first two rules of investing.

Disclosure: I may at any time hold, initiate or exit positions of any or all of the securities mentioned in this article.

 

Notes on the Berkshire Hathaway 2014 letter

It’s that time of year again – the release of Berkshire Hathaway’s annual shareholder letter.

I jotted down a few notes and thoughts as I went through it:

  • On the first page showing the historical performance of BRK, they have now started including BRK stock performance, in addition to per-share book value and S&P 500 + dividends returns.  Buffett’s commentary is that in the long-term, stock prices and intrinsic value will invariably converge, and both he and Munger believe that is true with BRK.  In the last three years, however, it’s interesting to note that BRK’s stock performance has outpaced the growth in BRK’s intrinsic value, and even the performance of the S&P 500.
  • The emphasis continues to shift to acquiring whole operating businesses, particularly finding assets where they can effectively and efficiently deploy the vast amounts of cash (~$15B in capex) that the other businesses throw off.  The most recent foray is in auto dealerships with the purchase of Van Tuyl Automotive, a group of 78 automotive dealerships (they’d be the 5th largest group in the U.S.), in October 2014.  I’m not too familiar with this segment, but Buffett makes it sound as though there is quite a bit of runway for consolidation.  There are 17,000 dealerships in the U.S., and they plan on acquiring additional dealerships at sensible prices.  I’m unclear as to the margin profile of these businesses as well as how they are valued, but it looks like Buffett thinks this is a good way to further deploy capital: “we will build a business that before long will be multiples the size of Van Tuyl’s $9 billion in sales.”
  • Speaking of reinvestment, it’s interesting that there was a referendum as to whether Berkshire should consider paying out a meaningful annual dividend.  The wording of the resolution was consider, not actually pay out.  The response from the shareholder base, for both the A and B shares, was overwhelmingly negative.  Essentially, 98% of the shareholder base voted in favor for Berkshire to continue reinvesting in Berkshire and deferring to Buffett to find effective ways to allocate capital.  As long as Buffett is running BRK, this really shouldn’t be a question at all.  The embedded premium in BRK has always been that you are hiring Buffett to make investment decisions on your behalf – for free (no absurd 2%+ management fees here).  This will be interesting to revisit once Buffett inevitably is no longer making those investment and allocation decisions, and hopefully that day is still a long way away.  Perhaps his successor might not get the same latitude from the shareholders as Buffett, and the dividend option becomes more compelling.
  • Buffett’s response to whether or not the conglomerate structure is warranted: if the conglomerate form is used judiciously, it is an ideal structure for maximizing long-term capital growth for the following reasons: (1) it’s the perfect structure to allocate capital rationally; (2) provides the ability to deploy capital across businesses in a tax-efficient manner; (3) provides flexibility to buy pieces of businesses rather than whole businesses; and (4) enables them to be the preferred buyer for certain owners (particularly family businesses) that want to exit but wish to preserve their company and culture.
  • Per-share investments value of $140,123.  The big 4 investments remain the same: IBM, KO, AXP, and WFC.  BAC should also be included on the list as Berkshire has an option through 2021 to purchase 700M shares for $5B, with a current market value of ~$11B (net value of ~$6B).  Although the media continues to scrutinize Berkshire Hathaway’s stock investments, the reality is that the company has long moved away from that.  IBM has been the one stock in which Buffett has actively increased share purchases.  The stake increases in the other stocks resulted from dividend repurchases.  It would be interesting to see if there were a dynamic intrinsic value calculator for BRK, at least for the stock investments.  Whitney Tilson at Kase Capital puts out a very good, comprehensive look at the intrinsic value of Berkshire Hathaway.  There are periodic updates to this deck, and the last update was back in September 2014.
  • A bit more color on Buffett’s successor.  Apart from the capital allocation and manager selection and retention responsibilities, Buffett mentions that his successor will need one particular strength: “the ability to fight off the ABCs of business decay, which are arrogance, bureaucracy and complacency.”  This criterion seems a bit ironic given how he has trumpeted IBM as a major stock pick.  The concern around Buffett’s successor has typically centered on whether that person would provide the same level of investment acumen, which seems to me a bit misplaced.  Buffett hasn’t really scoured the stock tables for cigar butt investments for quite some time.  The reality is that he gets his pick of investments, bets and mega-insurance deals to choose from, often at ridiculously sweet terms.  He’s not entering positions in Goldman Sachs or Bank of America through the open market like the rest of us.  This is the luxury of having built up an unparalleled reputation and a stellar collection of businesses and earnings power over the past several decades.  When he leaves, this legacy will still be there.  Deals might not happen over a handshake at first, but I could definitely see that issue quickly dissipating.  Berkshire will continue to have the pick of the litter of investments; there just isn’t any other comparable entity that can do what they do.
  • A welcome appearance from Munger.  Having eagerly read these letters for many years now, I feel fairly well-versed in how Buffett thinks.  When watching Buffett in action, I often find myself summoning the same examples that Buffett would mention in response to certain interview questions.  As a result, Munger’s contribution was quite refreshing.

All of this discussion of Buffett’s successor and the reasons for Berkshire’s success brings me to the key risk to Berkshire once Buffett departs.  In my mind, the key secret to Berkshire Hathaway’s success has been how Buffett has managed to repeatedly convince great managers to stay and run his collection of businesses.  Moreover, he also privately knows who is the likely successor for those businesses.  He has somehow determined the right incentive structure and compensation scheme to encourage long-term decision making and relatively minimal turnover among his manager ranks.  Getting this right is extremely critical as Buffett will routinely admit that he has neither the motivation nor ability to manage any of these businesses himself.

Berkshire evidently has a roster of superstar talent, but it’s relatively rare to see new CEOs of other companies with Berkshire in their background.  It seems much more common to see a GE or a top tier investment bank or consulting firm be the proving ground for an executive.  It’s also come to be sort of an accepted fact that such “talent” deserves a mind-blowing compensation package.  This has alarmingly led to the growing disparity in earnings between the top and bottom.

There must be some intangible benefits to working at Berkshire, but will the same caliber of managers still be attracted to run those businesses once Buffett leaves?  Is it possible that external opportunities become more attractive to those managers under different circumstances?  How would the incentive structures and compensation schemes have to change if Buffett is no longer in charge of capital allocation (supposing that some of the compensation is tied to Berkshire stock performance)?  These would be great questions for the shareholder meeting.