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A Volatile Month for the Model
The month of March was an unusually volatile one for The Prudent Investor’s Model Stock Portfolio for two reasons. The first reason was related to two of the stocks in our portfolio, COHT and DRL. Both reported quarterly results in March. While on the surface the results looked reasonable, the “fine print” in both company’s annual reports filed with the SEC gave cause for worry. Apparently, we were not the only ones to reach this conclusion since in a matter of days COHT had dropped by 25%. DRL’s shares dropped by a much more drastic 50%. Of course, corrections of 25% or even more are not unheard of in our portfolio. We often use such dips to purchase additional shares as long as the underlying fundamentals have not changed. It is not common for us to have two stocks (out of a total of 20-25) in the same month show significantly deteriorating fundamentals. In the future we may consider issuing a mid-month update to our newsletter to alert our subscribers of such events.
The second (and primary) cause of our underperformance for March is related to the fact that a number of the stocks in our portfolio are interest-rate sensitive. This has been true for the past two and a half years, and has contributed to our strong out-performance during that time. We are slowly rotating out of such stocks, but continue to believe that the interest-rate sensitive stocks we hold represent compelling valuations that outweigh the interest rate risk. In April 2004 there was a similar interest rate scare that also negatively impacted our performance by -7.6% (which was worse than our current month’s performance—see Table 1).
The are strong parallels between April 2004 and March 2005 in terms of interest rate jumps (with concurrent inflation worries) and stock declines. Last year after the panic on Wall Street, those same interest-rate sensitive stocks went on to turn in stellar gains for the rest of 2004. We think a repeat of such performance is unlikely for 2005. However, we still believe all the stocks in our portfolio, including the interest-rate sensitive ones, should continue to do better than the market overall.
Saving for College and Retirement
This editor recently had a question posed from a friend regarding the best way to save for their children’s college education. At the risk of propagating some less-than-sound financial advice [Disclaimer: We encourage you to seek the help of a professional advisor before executing any ideas suggested in this newsletter.], and as way to finish this newsletter a little more quickly, we offer the edited except below from that written dialogue. For those of you who have to worry about getting your children through college, you may find the thoughts helpful. (We welcome readers’ comments regarding any corrections to the information given below):
“Are you and your husband maxing out your Roth IRAs each year? If not, consider doing so. After you've held a Roth IRA for five years, you can withdraw the principal at any time with no tax and no penalty (just don't withdraw the earnings). If you're tempted not to max out the Roth in any given year, consider this: it's an excellent way to save for college education. Why? Because when it comes time to apply for financial aid, the schools are much less likely to penalize you for having money in the Roth than they are for regular savings or (heaven forbid!) in an education savings vehicle.
“If you are making full use of the Roth IRA each year (preferably for retirement purposes) and still have extra money to save for college, you need to consider other alternatives. I may be wrong about the educational savings vehicles that you are considering (e.g., the 529 plan or education IRAs), but my gut instinct is that, while they look like a good idea, they will in the end create a heavy penalty at the college financial aid office. As a general rule, those who are the most diligent to prepare for college by saving are penalized by lower aid packages while those who blow their income and fail to save are rewarded. But since you want to/need to save, the question is how best to do so?
“I'm sure you've looked into the 529 (and similar) plans more than I have. One of the plans in MA I vaguely recall had some way to lock in the future cost of college today--if that's true, then such a plan may be worth it. But if all these plans do is allow you to save tax-free or tax-deferred, then I'm more inclined to steer clear. I'm tempted to say one of the very best ways to save for college is to "invest" the money in your home, i.e., pay off your mortgage as quickly as possible. You would effectively earn the interest rate of your mortgage (I know you get a tax deduction when you itemize, but when you compare your after-tax return with after-tax returns on investing elsewhere, I think the tax benefits/liabilities more or less cancel each other out....) So if your mortgage rate is 5.5% right now, you'd earn 5.5% on any money you use to pay off the mortgage. I know you're tempted to think investing in the stock market would earn a higher rate of return. Maybe, but these days it's far from guaranteed.
“Anyway, the rationale for this is, when it comes time to apply for financial aid, you won't have a large sum of money sitting in an education savings vehicle and you won't have a pile of money sitting in a taxable investment account, either of which count against you for financial aid. A school is less likely to require you to take out a line of credit on your house in order to help pay for your kid's college, although that's exactly what you should be prepared to do. You'd be taking out the college education money you "invested" in your house rather than in some other savings vehicle.
“Now this idea doesn't work as well if short term rates are very high when your kids go to college (unlikely), because it means the interest rate on your line of credit could be much higher than your current mortgage rate. And of course if the stock market does well over the next 10 years (also unlikely if you are taking a “buy and hold” approach with index funds), you might have wished you’d invested in the market instead.
“For myself, I'm following a little different strategy. I'm paying my mortgage off as slowly as possible and investing as much as possible in a regular taxable account (following The Prudent Investor’s Model Stock Portfolio, of course!), after maxing out my wife’s and my Roth IRA. I don't want to use the Roth for education unless I’m forced to, but in the back of my mind I know I can if I need to.
“When my son gets close to college age, I will consider taking the money in my taxable account and using that to pay off the remainder of my mortgage, so when it's time to apply for aid, I'll have less cash sitting around. In the meantime, since I use stocks to give to charity, I will be able to give the most highly appreciated stocks each year to charity, keeping my total tax bill lower.
“Remember, I'm not an expert on this, so ‘buyer beware!’”
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