Newsletter - Q3, 2010

May 10, 2010

Government vs. Private Sector and Valuations

By James C. King

About 15 years ago, I made my first trip to China.  At that time, most of the Chinese population rode bicycles or scooters and small cabs, probably made of recycled tin cans.  The interesting observation was that government officials typically rode in black Audi’s with drivers. During a more recent visit, this contrast had modified significantly, presumably as a result of more affluence of the general population.

During this same period in the US, the average total compensation of Federal government workers has grown at a rate more than double the private sector.  According to the Bureau of Economic Analysis, Federal employees earn an average pay and benefits of $123,049, while private workers make only $61,051 in total compensation. Of these totals, benefits were at $41,791 for government employees vs. $10,589 for the private sector (see chart below).  Additionally, government employees are not covered under the ‘troubled’ Medicare or Social Security, but instead are covered as civil servants, with their equivalent healthcare and retirement plans paid for by us, the taxpayers.


Average compensation in 2009:

Federal Civilian   State/Local Gov't       Private
Source:  Bureau of Economic Analysis

This compensation contrast is unprecedented in the U.S. and, in my opinion, is evidence of our country’s further move toward a bigger and more intrusive government.  Both Democrats and Republicans have continued to contribute to this.  How our politicians can continue this deficit spending is astounding to me.  All in, our Federal and State Governments produce a limited amount of goods and services that contribute to GDP growth.

On another front, the number of publicly traded companies has fallen from about 9,000 a decade ago (year 2000) to about 4,200 companies today.  It is interesting to note that in a decade of an expanding US economy, the number of publicly traded companies has shrunk in half.  In the early 70’s, Salomon Brothers (the Goldman Sachs of its day) was discussing that due to the scarcity of equity alternatives, common stocks would trade at premium prices.  This however, does not seem to be the case today.

On a final note, we are seeing compellingly lower valuations on many Large Cap US equities, especially the ones that consistently grow their dividends.  I noticed that for the week ending August 4, stock funds had an outflow of $2.87 billion ($4.08 billion a week earlier), and bond funds took in $7.8 billion during that same week.  This trend has continued throughout 2010, contributing to lower equity valuations.  It reminds me of the adage “the markets ultimately move in the direction that embarrasses the greatest number of people”.

Registered Investment Advisors vs. Brokers

By E. Thomas Welch, JD

In talking with prospective clients, we are often asked, “What is the difference between Palisade as a Registered Investment Advisor (RIA) and a Broker?”  This is an important question and one which I will attempt to answer as succinctly as possible.

Fiduciary Duty

First and most importantly, Palisade as an RIA has a fiduciary duty to manage our client’s accounts free from conflicts of interest, from ‘self-dealing’ and, most importantly, always with our client’s best interest in mind.  A fiduciary must act within the ‘punctilio’ of duties according to legal authors and the courts.

Brokers are not under such fiduciary standards.  They routinely have conflicts of interest between their proprietary trading and their underwriting functions.  Additionally they are in conflict between their proprietary mutual funds and outside funds that they represent.  Brokers can sell a stock that they hold in their company account to a client account; self-dealing, which an RIA, as a fiduciary, cannot do.  Brokers underwrite a stock or bond issue for a fee and sell it to a client account.

Source of RevenueAnother larger distinction is the revenue sources between RIAs and brokers.  RIAs most often charge a fee based on the market value of the portfolio managed.  These fees are disclosed on client statements or paid by the client directly.  Such fees align with the client desires in that they are tied directly to the value of their portfolio.

Brokers, on the other hand, are generally paid by transaction fees – either on a per trade or underwriting fees basis.  Quite often, all fees are not disclosed on account statements; examples of this are load fees, internal 12b(1) fees on mutual funds, or ‘principal’ trades from the broker inventory.  Thus, their proclivity has been to have a higher number of trades which is often not tax efficient for the client.

Performance ReportingRIAs report performance at least annually, and in most instances, quarterly.  Additionally, RIAs report their performance vs. the ‘market’ determined by certain indexes or pre-established guidelines. When RIAs meet with clients, they review both how their portfolio and how their individual holdings have performed.  Performance is more technical than just measuring beginning vs. ending dollars.  True performance must take into consideration the timing of flows in and out of the portfolio.  Our regulator, the SEC, strictly monitors how RIAs disclose performance.

Brokers generally do not report specific performance on each account and when they do, it is not done vs. a comparable index.  The general exception is when an outside money manager or Separately Managed Account (SMA) is recommended for a client.  These money managers/SMAs are generally RIAs who, like Palisade, must report their performance.

To conclude, there are other distinctions between RIAs and brokers, but I have highlighted the main ones.  It is key to understand that the primary distinction connecting the differences is that RIAs act as a fiduciary and a broker does not.

Core Growth Equity Portfolio Strategy

By Paul J. Kronlokken, CAIA

With the growth of our portfolio management team at Palisade, my colleague Dennis Ott and I are introducing a second equity strategy that we call the Core Growth equity strategy.

Similar to Palisade’s High Quality Growth equity strategy, the Core Growth equity strategy seeks to produce long-term growth by holding a portfolio of High Quality individual stocks which are diversified by sector and industry.  Our disciplined investment process offers clients the flexibility to customize a portfolio around their particular needs such as a concentrated stock position and any tax sensitivity.

Building the Core Growth equity strategy begins by identifying long-term economic themes that drive structural change in both domestic and international economies.  From this base, we determine which sectors and industries will benefit from these long term themes.  Within these sectors/industries, our next step is to research and analyze which high quality companies we believe will benefit most from these themes.  From this list of companies, we then identify those stocks that, at current valuations, present the best long term growth potential.  We then construct individual diversified portfolios, keeping in mind the specialized needs of each client.

Some examples of the themes we are currently pursuing are globalization of economies, spreading consumerism, growth opportunities in emerging markets, the demand for a better quality of life, and the continuing information explosion.  Once our universe has narrowed, we focus on stocks that have understandable and established businesses.  Since we also focus on the higher quality companies, we tend to own the leading companies within their particular sector or industry.

Although this is a new strategy to Palisade Asset Management, we have been employing this strategy for individuals, trusts, foundations, and institutions since the mid 1990’s.  The Core Growth equity strategy has proven successful at providing competitive returns, while still offering clients the necessary flexibility to meet their respective investment needs.