The human zoo
Monday, November 22, 2004 at 10amBy John Friedman
I’ve been meaning to take a break from writing this blog, to get back to my knitting, as they say, and was well on my way to doing that today, until I read a story about 10 top-rated internet stocks [as of checking the former link to the article on 12/13/12, the story it is gone so the link it was dead and now removed] story, a story from Investors Business Daily, a trade paper for serious investors that many people just refer to as IBD (for anyone whose had a cat with irritable bowel disease, which is also referred to as IBD, the moniker is an unfortunate one).
But anyway . . .
. . . In the top top-rated slot was eBay, a success story known to many, and a success story transpiring on a scale enjoyed by very few companies in history. eBay is the second great natural monopoly of the information age, right after MSFT and, so, so long as Meg Whitman and the other folks at eBay don’t do anything unwise, eBay has a clear shot at being equally ubiquitous, equally powerful, equally profitable, and equally wealthy as MSFT — or at least something close to akin to being in the same league.
It’s important to note that I am an eBay shareholder and have been for a good long while. It’s been a homerun stock for a lot of people, having gone up about three-fold in the last three years, and having not suffered all that badly during the bursting of the bubble.
Now, as noted in earlier posts, this blog is not about touting and de-touting stocks, so this particular piece is not about to tell you about whether it’s a good idea to buy or sell eBay shares. It won’t do that because that’s a decision that is very much dependent on a person’s personal circumstances and is therefore not appropriate for a publicly accessed, generically inclined blog. And it also won’t talk about buying or selling because I haven’t the foggiest idea what the stock will do, and am proud to admit that that’s the case and in fact believe that many of the people out there who tell you that they know which way a stock is going to go should not be doing so, for all sorts of reasons.
Nonetheless, it can be very interesting to take a look at highflying stocks, to see how they stack up or, as is sometimes the case, how they hole down. Ands it can very good for a person’s financial knowledge and therefore very good for a person’s overall financial health to have some understanding of this realm.
So let’s compare eBay to Travelzoo, ticker symbols EBAY and TZOO, shall we? And let’s scale them against MSFT.
Here are some eBay metrics:
| Market Cap (intraday): | 71.27B |
| Enterprise Value (22-Nov-04)³: | 69.87B |
| Trailing P/E (ttm, intraday): | 101.81 |
| Forward P/E (fye 31-Dec-05)¹: | 67.62 |
| PEG Ratio (5 yr expected)¹: | 2.54 |
| Price/Sales (ttm): | 24.07 |
| Price/Book (mrq): | 11.79 |
| Enterprise Value/Revenue (ttm)³: | 23.41 |
| Enterprise Value/EBITDA (ttm)³: | 67.45 |
| Income Statement | |
| Revenue (ttm): | 2.98B |
| Revenue Per Share (ttm): | 4.409 |
| Revenue Growth (lfy)³: | 78.30% |
| Gross Profit (ttm)²: | 1.75B |
| EBITDA (ttm): | 1.04B |
| Net Income Avl to Common (ttm): | 715.31M |
| Diluted EPS (ttm): | 1.056 |
| Earnings Growth (lfy)³: | 76.80% |
And here are the same TZOO metrics:
| Market Cap (intraday): | 1.28B |
| Enterprise Value (22-Nov-04)³: | 1.36B |
| Trailing P/E (ttm, intraday): | 302.69 |
| Forward P/E (fye 31-Dec-05)¹: | 102.21 |
| PEG Ratio (5 yr expected)¹: | N/A |
| Price/Sales (ttm): | 48.14 |
| Price/Book (mrq): | 137.92 |
| Enterprise Value/Revenue (ttm)³: | 47.92 |
| Enterprise Value/EBITDA (ttm)³: | 156.1 |
| Income Statement | |
| Revenue (ttm): | 28.37M |
| Revenue Per Share (ttm): | 1.488 |
| Revenue Growth (lfy)³: | 82.70% |
| Gross Profit (ttm)²: | 17.59M |
| EBITDA (ttm): | 8.71M |
| Net Income Avl to Common (ttm): | 4.76M |
| Diluted EPS (ttm): | 0.26 |
| Earnings Growth (lfy)³: | 140.30% |
Now there’s neither the space nor the time to do all the comparisons, so let’s just focus on one:
Probably the most basic metric is the price-to-sales ratio, shown as Price/Sales up above.
This metric says, for the moment, let’s forget about profitablity and margins and whatnot, and just look at how much money is coming into the company, because the value of a company has a lot to do with how many people are parting with how many dollars and shooting them into this particular company, because no sales happening = no company, right? So let’s take the total of all dollars coming into the company and divide it by the number of shares of stock the company has outstanding, reflecting the fact that owning one share of the company’s stock is tantamount to owning that number of dollars coming into each single share of the company’s stock.
A typical rule of thumb for price-to-sales ratios, or P/S ratios, is that any company selling at 3 times sales is getting a high valuation, and anything more than that is very high.
Looking at the charts above, you can see that eBay sells at 24 times sales, and TZOO sells at 48 times sales. MSFT, by comparison, sells at 7.72 times sales.
So those are mighty, mighty high valuations for TZOO and EBAY, yes? And, not only that, but, for some reason, the market is valuing TZOO twice as high as EBAY on this metric, and three times as high as MSFT.
So ask yourself: would you rather own one dollop of TZOO revenues or two dollops of EBAY revenues or three dollops of MSFT revenues? It’s a good idea to ask yourself that question because all three of those dosings of financial dollops cost about the same amount in the market right now.: for every one dollar of TZOO sales, you could instead buy three dollars of MSFT sales or two dollars of EBAY sales.
Which would you prefer?
To most people, among the best answers to that last question is this: none of the above. Because, while it can be quite fun to stock-pick for some people, and while it can be quite thrilling when it goes well, most people are far better off never stock-picking because they are better off not investing in single stocks.
Investing in single stocks is something that is good for, and largely a creation of, stock brokers. It’s their bread and butter, and oh what wonderful bread and what wonderful butter it can be.
So if you’re an investor, ask yourself this: did you follow that P/S discussion above? Intentionally, it was not a step-by-step analysis. It assumed a modest level of knowledge.
Did you follow it?
If not, you probably should not be investing stock by stock, because P/S ratios are among the most basic of valuation metrics, and all but the most hardened technician would acknowledge that paying attention to valuation metrics has its place in that endeavor.
And did you know what the word technician, as used in that last sentence meant?
If not, you owe it to yourself to either learn or to stop investing in single stocks because not knowing this concept is s a pretty indication that you literally do not know what you’re doing. And if you don’t know what you’re doing, odds are that you are feeding the stock brokerage industry well — doing a lot of trades searching for something that works. And that means that you are betting willy nilly on stocks — maybe getting lucky here and there and not doing too badly or, if you’re like most people, not getting lucky all that often and getting hurt badly in the process.
But there’s good news: there are plenty of ways to be smart about investing, without knowing all this stuff. Yay.
And that’s a topic for another day.
What’s more broken than the healthcare system?
Thursday, November 18, 2004 at 8amBy John Friedman
No one in their right mind would argue that our healthcare system is a wonderful system.
It is, to be sure, one of the most bizarre systems imaginable — too whacked out to be believable in a Borges or Garcia-Marquez novel, too fraught with damaging outcomes to be believably scary in an Orwell or Herbert or Shelly novel.
A great example of how broken our healthcare system is is the difference between the medical lives of people who are medically insured through a group medical insurance policy — usually through their employers — and the medical lives of all other people [did I just say is is? Must be because Bill Clinton’s library is opening today, and is in the news].
People who are fortunate enough to be medically insured through a group medical insurance policy have all sorts of rights not enjoyed by others. First and most saliently, people with group medical insurance pay the lowest prices for all sorts of medical goodies, while the un-insured pay by far the most (often more than double and not unusually more than triple or quadruple), while those with individual, rather than group, medical insurance policies pay prices falling somewhere in between.
A less salient but often far more important difference is portability. Portability allows people with medical needs (i.e., those with pre-existing conditions) to move from one group to another group with relative ease (e.g. moving from one employer with group medical insurance to another employer with group medical insurance).
That ease comes from the person’s right (a) to become a member of the new group no questions asked, thank you very much, and (b) once he or she is in the new group, to get full coverage, even for his or her pre-existing conditions.
Now, try to do that outside of a group and see what happens.
The first thing that will happen is that, if you or a member of your family has a pre-existing condition, a lot of medical insurers won’t sell you an individual medical insurance policy. They don’t want your business. Bye bye.
The second thing that will happen is that, if some insurer agrees to insure you, it very well might exclude coverage of your pre-existing conditions for quite a spell. So you can get the insurance, but not for what you need it for.
It is, as a dear friend says, non-insurance insurance.
So in this one area the healthcare system is quite bizarre, isn’t it?
It says this to people: if you are sick, or if your spouse or child is sick, you have to work for an employer with group medical insurance.
Forget your entrepreneurial spirit. Forget that whole I hate working for other people thing. You have to work for someone because you have to be part of a group, and you have to be part of a group because, if you’re not part of a group, then you are going to join the tens of millions of uninsured people paying out the wazoo for everything.
To some people’s way of thinking, this amounts to the uninsured cross-subsidizing the insured. Read that again: the uninsured cross-subsidizing the insured. So well-to-do employed people, all of whom have group insurance, will spend $10 to fill a prescription for their sick child, while an uninsured person (some of whom are well-to-do) you will spend $100 for doing the same thing. And if that’s once a week and if that makes them go broke . . . why that’s just the way it is.
And don’t even think about going into a hospital . . ..
That’s the message: be employed. Do not be self-employed.
But there’s more bizarreness further down this path because, here in CA, a group for group insurance purposes is quite simple to build: all it takes is two or more people.
And, guess what? Medical insurers who write group insurance have to take groups, no questions asked, all comers accepted. So all you need to do is have a partner in your business and you can get a group policy. And once you’re in a group policy, you are ensconced within the world of group insurance and the world of portability, and, so long as you stay within the group world, you’ll be fully insured.
So you can form a fake-me-out group to get into the group world, and once you’re in a group, so long as you stay in group-land, you’re hunky-dory insofar as medical insurance goes.
Bizarre, eh?
So here the system says: if you are recently self-employed and happen to have some medical issues, then you sure had better hire someone because, unless you are part of a group, you sure as hell ain’t gonna get insurance (COBRA only lasts so long . . . )
Now, you can say what you will about how wonderful our medical care is. You can say that the U.S. has the finest medical care in the world or you can say that any country that has tens of millions of people fending for themselves on the medical front cannot be considered to have wonderful medical care.
But when you look at the broader system — the healthcare system, which includes the medical care system with its doctors and nurses and machines, together with the administrative and insurance envelopes through which the medical care system reaches its patients — you cannot say it isn’t way Way WAY broken.
But there’s a very important system in all of our lives that’s even more broken than the healthcare system is broken. It’s a system touching a part of our lives that, for most of us, is third in the hierarchy of what it takes to have our wellbeing up to snuff, right after physical health and love.
What might it be?
If you’re thinking that it’s the financial health system, then you’d d be right.
So who out there has a doctor for his or her financial health? Or a nurse? Or even a nutritionist?
The answer is: pretty much no one. Such people pretty much don’t exist.
Instead, people have, at best, financial salespeople who might, or might not, be mindful of the conflicts of interest inherent in caring for somebody’s wellbeing only as an adjunct to selling products out of his or her necessarily-limited product line.
Now how would you feel if your doctor worked on commission, and whose prescriptions had to be filled by a pharmacist within the doctor’s business who only carried 25% of the prescription drugs out there?
That would be scary, wouldn’t it?
One medical context in which many people experience something akin to this is at the eye doctor, because a lot of eye doctors give away (relatively speaking) their doctoring in order to get a clean, unobstructed shot at the commission on the expensive eyewear.
Doesn’t feel so great does it? How do you know if their advice is self-less or selfish? As in: Do I really need that fancy contact lense — the one that costs three times as much as the other one, the one I’ve been using for years?
And how about laser surgery on your eyeball? That costs a whole lot, and you just have to wonder: the doctor knows that there’s a machine s/he bought a while ago and knows to the penny how much that machine cost, so what’s to say that the doctor doesn’t look at every patient as a way to make back that investment?
That’s just human nature, isn’t’ it? Put a rat in a box and the box will dictate, at least to some extent, the rat’s behavior. And so too it is with people.
So maybe it’s time for a new box for the rat?
This is, indeed, how our financial health care system operates. It is a products-based system that sells products through a network of financial services providers acting as sales agents and distributors.
Now when most of us go in for a checkup at the doctors, we feel pretty assured that the doctor really truly is there to help us, don’t we? We don’t view the doctor as simply scoping us out, to discern our willingness-to-pay curve and to then suck all the economic utility for him- or herself out of our marrow, do we?
Or at least we remember that feeling from our childhood . . .
But how about our financial health? How many of us have someone who helps us with our financial health in that way? Someone who truly cares about our wellbeing above all, and way down the list is trying to make a living?
The answer is this: essentially, zero. The financial services industry has not evolved towards that end. It has, in fact, evolved in precisely the opposite direction: suck the financial marrow out to the max. More for me, less for my customers.
There are many, many exceptions to this, but overall, that is the modus operandi.
That is the box in which the FSP rats live. And we all respond to the boxes in which we live.
So what’s a mother to do? Or a father?
The financial health care system needs to change. But it won’t be easy.
But just as fixing the healthcare system is a fight that must be fought just because we can’t be a wonderful, beautiful, caring people when the healthcare system is this broken, so too we cannot be a wonderful, beautiful, caring people when the financial healthcare system is based on sales.
So how is that fight fought, and what does a financial health care industry look like?
Well, not only is that the topic for another day, but that is also the topic for the next many decades of my endeavoring.
Bright moments . . .
The charge of the flat-landers
Wednesday, November 17, 2004 at 9amBy John Friedman
Yesterday’s piece talked about the tension between tax simplification and tax fairness, the idea being that treating people fairly tax-wise often involves paying attention to the details of their financial lives, which in turn means adding complexity. So increased fairness often trades-off with decreased simplicity.
Let’s take that further down the road, shall we? Yes, let’s do that — let’s look at simplification . . . in more detail.
San Franciscans recently voted on a very simple tax, via Prop K, which iminposed a very small tax on a business’s gross receipts — i.e., on a business’s revenues, not on its profits.
In essence, that amounts to an income tax that brooks no deductions. It’s a tax on money-in. Period. And what a ruckus that raised.
The proposition failed — and for good reason, too. Take two businesses, a consulting practice and a grocery store, the former typically being thought of as a high profit margin business and the latter typically being thought of as a low profit margin businesses. And let’s assume that the consulting practice has a profit margin of 50 cents per each dollar of revenue while the store has a profit margin of 5 cents per each dollar of revenue. And let’s also assume that both businesses do $ 1 million in revenues per year, so that the consulting practice has an annual profit of $500k (50% of $1 million), while the grocery store has an annual profit of $50k (5% of $1 million). Finally, let’s say that the gross receipts business tax is 1%.
So here we have two businesses, both paying a 1% tax on $1 million in gross receipts, which is $10k (the zeroes go like this: 10% of $1 million is $100k, 1% of $1 million is $10k). And that means that here you have two businesses, one making $500k per year and the other making $50k per year, but both paying the same $10k gross receipts tax per year.
So the consultant loses 2% to the tax ($10k divided by $500k is the same thing as 1/50, which is the same thing as 2/100, or 2%) while the grocery store loses 20% to the tax ($10k divided by $50k is the same thing as 1/5, which is the same thing as 20/100, or 20%).
Does that seem fair to you? To most people it does not.
Now, we’re using extreme examples here, and, in doing so, oversimplifying things quite a bit, but that’s the idea, right? The Prop K tax was, after all, a very simple tax
Let’s look at another extreme example. Let’s look at a 100% simplified federal income tax.
Short of getting rid of the income tax all together in favor of a consumption tax or whathaveyou, by most people’s reckoning that would mean having a flat tax.
Most flat tax proposals call for, at the very least, the elimination of different tax brackets, so that, to the extent a tax ever applies, the tax is always at the same percentage. And most flat tax proposals also get rid of pretty much all deductions — even, in some proposals, that most hallowed of all deductions, the deduction for mortgage home interest payments.
So living in a flat-tax world, all of us would be able to, with a bit of seventh grade math spun easily within our own little brains, be smart decision-makers insofar as the impact of the tax code is concerned.
The thinking would go something like this: Let’s see, 17% of this gain is . . . and 17% of my salary is . . . so if I do such-and-such now, why then . . . . eh, forget about it. If it’s gonna be 17% regardless of which way I turn, what’s the use in thinking about the various turns?
Now that is nice and simple, and, all things being equal, simple is good, right?
But could it fly? Could a flat tax ever become reality?
Most people think not, because there are so many self-interests that cut against a flat tax — so many special interests out there that depend on a complex, divoted Internal Revenue Code, or IRC, for their livelihood — that it’s hard to imagine it happening.
Think of it: in a flat tax world, financial services professionals and providers would have less to offer because such a big chunk of financial services is tax-driven. Now that’s a big powerful industry, yes? So there’s a huge industry that would be pulling long and hard against the flat-taxers.
CPAs would get hurt too. You can just hear their thoughts now: first we lose the consulting business, and now the tax advising, what’s next, auditing goes down the tubes too?!
But we’re just getting warmed up here. Lobbyists would get hurt too, because lobbyists’ stock and trade is whacking some nice little special interest divots into the tax system, and, if the whole idea of the tax system is to have no deductions — no divots — then there is no chance of getting a divot in there, is there? (Aside: do the lobbyists have lobbyists?)
And how about those interests the lobbyists work for . . . ouch, now there’s some entrenched power for you, and a power, at that, cutting across every industry and every interest group you can imagine. Schools have a big stake in the current tax system. C
hurches have a huge stake in the current tax system. Charities have a big stake (and they already just took a big hit, via the big corporate tax bill of a month ago, that put substantial roadblocks into their “give us your car” business).And that’s not even mentioning real estate. Getting rid of the mortgage interest deduction would really get people up in arms. Everyone but the rich, that is, who have had caps placed on their mortgage interest deduction for years, would take to the streets.
That’s right: the mortgage interest deduction is already capped for rich people. And, not only is it capped, but the deduction is capped at the same level for married people as it is for single people which, to most people’s way of thinking, isn’t at all fair. So, if the flat tax ever takes hold and the mortgage interest deduction goes away, tax historians will, no doubt, look back at what happened to that deduction vis a vis the rich and characterize it as the beginning of the flat tax world.
In the end, most members of the punditocracy can’t imagine the flat tax world taking hold. So, charge as they might, the flat-landers are apt to go the way of the Light Brigade.
Famous last words? Perhaps. But most prognosticators never saw the 15% dividend tax coming either.
My, but haven’t there been a lot of surprises lately . . . .
Tax code invisibility / tax code simplification / tax code fairness
Tuesday, November 16, 2004 at 10amBy John Friedman
Most people can agree that the tax code should provide good visibility.
Using the word visibility in the financial arena has become commonplace in the last decade. If a CEO says there that his or her businesses has good visibility, that means that the CEO feels like he or she can look into the future and feel reasonably assured of what the future holds in the near-term and how business will be. So good visibility means I can see the future, and I can predict it well.
Now, most folks believe that the tax code should provide good visibility — that the common Joe and the common Sue out there should be able to know that, if I do this, then my taxes will be $x.
In a word, this sort of thing ought to be, at least somewhat, eyeballable. And it certainly shouldn’t be invisible.
The federal tax code we all live with has provided less and less visibility over the years, and seems to be doing so at an ever-accelerating rate since George W. Bush became president.
One example appeared in today’s SF Chron, where Kathleen Pender, one of that paper’s financial columnists, wrote about the tax implications of the $3 per share dividend Microsoft is about to pay to people who owned the stock as of close of business yesterday (the ex-dividend date).
So let’s say that Joe and Sue own MSFT shares. Lots of people do — it’s one of the most widely owned stocks in the world, and, by most measures, is the most wealth-generating stock in the history of the world. So a lot of non-wealthy people own shares in MSFT — the sort who might not have a CPA and might not know that much about the tax code.
So how visible is the tax code for Joe and Sue MSFT shareholders? How well can they predict what will happen if they do various things with their MSFT shares?
Well, the tax code is there for Joe and Sue to see, so, in a strict sense, the tax code is visible to Joe and Sue, but it is way way way complex — so complex, in fact, that it is tantamount to being invisible to all but those most well-versed in the multi- multi-volume book called the Internal Revenue Code (which, unlike the 9/11 Commission Report, has never been nominated for a National Book Award).
How complex is it?
Well, for one instance, according to the article, if Joe gets the MSFT dividend but sells his MSFT stock before a certain date in January calculated using a 61-day holding period (why 61?), then Joe does not get the favorable tax treatment afforded to the good kind of dividends. Instead, he gets socked with taxes on that MSFT dividend at the same rate that applies to his wages and whatnot, which for most people will be double or more the other rate.
And there’s another odd, seemingly impermeable twist: if Sue (a) bought her MSFT shares, say, six months ago, and (b) sells those shares, say, next February at a loss, and (c) if the MSFT dividend she receives exceeds 10 percent of what she paid for the stock (factually an impossibility, because MSFT hasn’t been above $30 in a long long time), then she gets to treat the loss on the sale as a long term capital loss, while if there had been no dividend then she would have to treat the sale as a short-term capital loss.
Gobbledy-goop, eh?
And that’s the point: just how visible is all that to Joe and Sue? Is it visible at all?
To paraphrase Gretchen Wilson, she of the biker-mama aura, she being the big-deal country music start-up star of the year, hell no!
The Alternative Minimum Tax, usually called the AMT, is among the most complex, least visible provisions of the tax code. You will never see a CPA “eyeball” an AMT question. So if you have a CPA (most people do not) and if you say to him or her something like, will this have AMT ramifications?, the normal response will be, I’ll tell you once I go boot up the software and punch in the numbers.
That, right there, is as good a definition of tax code invisibility at the lay person level as any. If a CPA has no visibility for a certain part of the tax code absent a computer, you better believe that none of us does. And if we can’t understand it without asking a CPA to run the numbers, that means that we all either need to talk to CPAs often, or we all need to become the equivalent of one — or simply fess up to the fact that we will fall into traps for the unwary, which is a term lawyers use for something bad that happens to anyone who isn’t paying attention.
Now a trap for the unwary in the tax code is something that most everyone falls into, because most everyone is unwary when it comes to the tax code, if for no other reason than they have been stupefied by it every time they tried to understand it, and have therefore given up trying.
Someone selling MSFT before mid-January is falling into a trap for the unwary; if they wait until the end of January they’ll pay tax on their dividend at a 15% rate, but if they do it in early January they’ll pay double that.
You better believe that a ton of tons of people will do just that (that’s 4 million pounds and, at 150 pounds a person on average, that’s 26,667 people falling in to this mighty mighty big trap).
George W. Bush’s tax changes have added a lot of invisibility to the tax code, primarily through the lathering on of sunsetting, which is the term used to describe what happens when tax code changes expire as a matter of course.
In getting his tax cuts through Congress George W. Bush used the sunsetting technique more than anyone had in the past. He did so because the tax cuts he wanted to give to people were bigger than were permissible under a ten-year budgetary law that Congress had passed during the Clinton years (remember those?). That budgetary law said that, in any ten-year period, projected budget deficits couldn’t exceed a certain level. Well, the tax cuts George W. Bush wanted to give to people far exceeded that deficit level over the ten-year period, but, hey, look at that: if the tax cuts went away after, say, seven years, then the three years of reversion back to the pre-tax cut tax code saved the tax cuts from being against the 10-year law.
So that’s what George W. Bush did: he put tax cuts through that, but for their sunset provisions, wouldn’t have been legal. Sunsetting, then, allowed him to take the figurative governor of the tax cut engine, hot wire it, so to speak, with the hope that he would then be able to make them permanent later on.
When an opponent does it, you call it smoke and mirrors. If you do it, you call it sound budgetary discipline.
Among the sunsetting changes George W. Bush put through in the past four years were (a) the 15% maximum capital gains rate, (b) the 15% dividend tax rate, (c) the tax forgiveness on distributions of 529 Plan earnings when those earnings are used to pay for college, and (d) significant increases to the amount of a dead person’s estate that could be given to heirs free of estate tax.
Those sunset provisions clouded visibility for the past four years. Were those tax goodies for the wealthy and the quite comfortable going to sunset or not? Who was to know? And that made it hard to plan, because you just didn’t know what the rules were going to be. So chalk up a good deal more invisibility
George W. Bush never couched his past tax changes in terms of simplification. He didn’t need to because the un-spun truth behind his tax cuts was just fine and was exactly what a lot of people wanted to hear the government say: less for us, more for you!
But now he’s talking about simplification.
Reagan talked about it too. One of his tax-simplifications was to increase the limited martial deduction for estate taxes to an unlimited deduction. People of most any persuasion would say that that was an OK thing to do — spouses should be able to leave everything to their surviving spouse without the government first coming in and taking dibs and shortstops and such.
Another of Reagan’s simplifications was getting rid of — clobbering really — the real estate tax shelters that were so ubiquitous back then as well. Sheesh, did he ever shoot those in the head. A lot of people never saw it coming, and, brother and sister, come it did, and with quite a wallop.
But he also got rid of income averaging, which many people feel was a step away from fairness. Without income averaging people who had lumpy income streams (e.g., lots of income one year, non-existent income the next, OK income the next year, non-existent income the next) were taxed like the rich one year and taxed like the destitute the next, with the overall result being that they were taxed like upper-middle class or lower-upper middle class people even though they were solidly middle class. Income averaging, then, allowed them to average out their lumps over a handful of years, so that they were taxed in keeping with their average income over those years.
Getting rid of income averaging made things simpler — taking alternatives out of the mix is, by definition, a simplification, yes? — but was it a step towards fairness?
Hell no!
If you had lumpy income back then and still have it today, because you’ve chosen to make your economic way through the world outside of the W-2 world, you know that it was more complex before but also more fair. True, the difference in tax rates for the rich and the middle-class is miniscule these days, so not having income averaging is less of a big deal, but all during the 1990s when the difference was fairly significant you were paying more than your fair share simply because you had lumpy income.
And that’s the point: sometimes to treat people fairly you have to add some complexity into things because of the infinite variety of ways that people make their way in this world.
Treating everyone as if that is not the case will, inevitably then, treat like things differently and different things likely.
And that means that flat-taxing everyone or simplifying the tax code might be treating everyone alike at one level, but vastly differently at another.
So there’s a very real, very irreconcilable tension between simplification and fairness.
Adding more visibility into the tax code is a good thing. It will make it easier for all us to be financially healthy because we won’t need to study the tax code quite so much or be talking to our CPAs quite so much or simply falling into traps for the unwary repeatedly. So kudos to those who succeed in doing so.
Getting rid of sunsetting , in and of itself, would be a good thing (though making budget-busting tax cuts permanent would not be — see yesterday’s piece). And getting rid of the AMT would be a good thing too because it is just way too complicated.
But most of us should be afraid — very afraid — because we might lose fairness as we gain simplicity.
We saw some of that with Reagan, and we can expect more of it from Bush. In fact, dollars to doughnuts, any simplification coming at us will also poke a bit of finger into our eyes because, when interests collide — and when it comes to economics, they always do — we all know which interests have had the upper hand the last four years, and those interests ain’t us.
That means that we are likely to get some shifting of the tax burden along with tax simplification.
So picture this: Joe and Sue, you and me, and all of our parents and relatives, kids and grandkids, all getting taxed exactly the same as Donald Trump or Bill Gates or Rupert Murdoch, all in the name of simplification.
It would add visibility, but would it be fair?
A money manager’s worst nightmare
Monday, November 15, 2004 at 8amBy John Friedman
In an earlier piece I talked about how many of us don’t know how much we pay our FSPs (our financial services providers).
And I mentioned how this lack of knowledge came about because many of us are at our consumer-worst when it comes to FSPs and because some FSPs tend to hide that information, or at least not shout it from the hilltops.
Today we’ll look at an FSP who, much to its chagrin, had to shout it from the rooftops,
Now before going on, it’s important to state that we won’t be naming names in here. The primary motivation behind not naming names in here is our intention to keep the FHB at the generic, conceptual level, rather than at the specific, advisory level. That is in keeping with the public nature of this blog, and in keeping with making these pieces capable of general application.
It is also in keeping with the nature of blogging, which is to write ’em fast and get ’em out, which means that you should not expect intricately detailed, infinitely fact-checked pieces in here.
So the names haven’t been changed to protect the innocent, or to protect the guilty for that matter. Rather, the names have been left out because the idea here is to convey a general principal — to tell a story that has application well beyond the specifics.
By way of introduction, this is a money manager that gets its customers both going and coming, in the sense that this money manager both (a) runs mutual funds, and (b) helps its customers jump in and out of its mutual funds, and gets paid exceedingly well for doing so.
So these folks sell two different sorts of investment wrappers. The first investment wrapper is a familiar one — it’s a mutual fund wrapper. Here the company, in its role as an investment company, exchanges its customers’ cash for shares in a pool of investments, in the sense that, when its customers buy its mutual fund shares, they are putting money into the company’s investing pool which the company then invests, along with all the other money that has come into the pool before it.
Now this particular mutual fund family mostly does stock sector funds. Stock sector funds invest nearly all their cash into stocks of companies in a particular segment of the economy, such as health care stocks, financial stocks, technology stocks, utility stocks, etc., or in a particular geography , such as Europe (in this case, mostly the old Europe), emerging
countries, etc.
The figure usually bandied about for the average cost of an actively managed, we-can-beat-the-market sort of mutual fund wrapper is 1.5% of assets under management per year. Bond mutual funds are typically substantially less than that, and quite a few stock funds are considerably more.
Now that 1.5% annual fee is not all inclusive. Most importantly, it doesn’t include trading costs. Yes, mutual funds have to pay stock commissions just like everyone else (well . . . almost like everyone else, but that is a topic for another day and perhaps even another blog). Trading costs show up as lesser gains or larger losses, rather than as part of the management fee the fund is required to disclose to the public.
This is an incredibly complicated topic — probably intentionally so — so all of this is very much an overview.The second wrapper this company sells is an investment advisor wrapper. Here, for another fee, the company helps customers jump in and out of its mutual funds, timing, as it were, sector bets.
Now, we won’t go into detail here about how great an idea that is or is not, but will note that, to most people’s way of thinking,
sector-timing is something that should be left to professionals and to note that many people further believe that sector-timing shouldn’t even be entrusted to professionals because it simply doesn’t work.And it’s pretty much beyond debate that none of the universally celebrated all-time great investors, like Peter Lynch, Warren Buffet and Benjamin Graham, made their mark using that technique, and mostly poo-poo’ed it.
So that’s what this company does: as an investment company it runs sector funds, and, wearing a different hat, this one the hat of an investment advisor, it helps customers jump back and forth between those sector funds.
This money manger is now going through the worst kind of nightmare, brought about by Ken Lay and Enron, Bernie Ebbers and MCI, who, with plenty of help from plenty of others, brought about the Sarbanes-Oxley Act. SOX, as it is often called, is a piece of corporate good-governance legislation that most public companies deeply despise. It has been good for accounting firms and technology firms, because it has added an entirely new layer to public companies’ bookkeeping chores, but keep-the-government-off-our-backs CEOs hate it hate it hate it.
Now, it’s hard to make heads or tails out of this money manager’s letter — perhaps intentionally so — but apparently, due to SOX, this money manager, because it changed its name, has to get many, and perhaps all, all of its customers to re-sign their account agreements and, worse still, in doing so it must highlight its fee schedule.
And that, right there, is a money manager’s worst nightmare, because the awful beauty of the AUM business model (the Assets Under Management business model) is that customers can, and usually do, totally forget about the fees they are paying. And that is a great business model: if the customer just does nothing (which is, after all, the easiest of all things to do), then the money manager gets paid.
And if the customer never looks at a statement (which is, after all, the easiest of things to do, especially when the statements bring nothing but woe and misery), then the customer won’t even have an inkling or a reminder of the fees the manager is receiving. And if the manager designs its statements so that its fees end up on the second to last page of a five- or twenty-page statement (entries on the last page being too noticeable), and also makes it hard to even know that the fee is a fee (what’s a debit? ), the manager can just keep going along, getting paid for . . . doing nothing (which is, after all, the easiest of things to do) or, worse still, getting paid for losing its customers’ money hand over fist.
So pity this poor money manager. My hunch is that when it changed its name at the beginning of this year it had no idea that it would have to have its clients re-sign their account agreements, and that then SOX came along and dropped a total bomb-shell on the name-change, i.e., needing to re-up with its customers.
That’s my hunch because I don’t think it would have changed its name if it had known that, not only would the name-change involve getting new stationery, but it would also require it to re-establish relations with each of its customers and disclose its fees in a big way.
But that is in fact what is now going on.
And what do you think its fees are? Well, I have read this letter several times and I am still not sure.
This much is clear, though. For the funds themselves, the AUM fees range from a low of 0.60% (for a plain vanilla bond fund) to 1.0% (for the stock sector funds). Those fees, in and of themselves, aren’t bad for actively managed mutual funds.
But it also charges for the sector-timing wrapper, and this is where jaws should probably drop because, unless you have over a million dollars under management with these folks, they will ding you anywhere from 0.17% to 0.25% of your assets per month. Per month!
Now let’s put this into perspective. You can buy really wonderful, really beautiful mutual funds — the kind that make you smile when you look at your ownership interest in them — that charge you that much per year. Per year!
So this company is twelve times more expensive than these really wonderful, really beautiful mutual funds.
So, do you think $2.50 gasoline is a rip? How about paying 12 times that much, or $30? Think about that: you go out and buy some gas and it costs you $30 a gallon. So it costs $300 bucks to drive your Prius 600 miles, and over a thousand to drive your SUV that far.
Ouch, right?
But if you bought your gas at a better, smarter gas station — one that shows some caring for its customers’ well-being — then you’d pay $2.50. Now the Prius trip costs $25 and the SUV trip costs $100
Well, how about paying the equivalent high-price for mutual funds? That’s the fee structure that this money manager is being required to disclose to its customers.
Now, those customers were given a chance to see that fee structure before, when they first signed on with the money manager. But that was a while ago, and the customers were probably brought in by an advisor they trusted, and who, unless they asked, probably did not highlight that fee structure during the sales pitch. Not a very sales’y thing to talk about, now is it?
One must emphasize benefits, not burdens, when doing sales, right?
It’s sell the holes; do not mention the price of the drill, right?
So let’s think about what this fee structure means in dollars and cents. It involves lots of zeroes, which means it’s hard for people to do in their head.
All, told, then, for a customer with, say, $250k on tap with this money manager, the tab for a yearly fill-up of mutual fund management and segment-timing would be $7,500, right?
One way to do the zeroes is as follows: 1% of $250k is $2.5k, right? But we’re talking about a 3% fee, which is 3 times the $2.5k fee we just calculated, and three times that $2.5k fee would be $7.5k, right?
And that’s owed whether the manager makes money or loses money for that customer. So, if the manager’s performance matches the market and the market goes up 6% in a year’s time, then the manager would get 3% and the customer would get to keep 3%. Likewise, if the market goes up 10% and the manager matches the market, the manager would get 3% and the customer would get to keep 7%. (Aside: the nuts ‘n bolts math is actually a bit more complicated than this simple subtraction, but usually the difference isn’t all that great.)
So the only time a customer’s account would ever match or beat the market is when the manager beat the market by 3% or more, right?
How often does that happen?
Well, that’s another topic for another day, but the short answer is this: it is really, really, really hard to beat the market on a consistent basis. Some do. But most do not. Indeed, most people who invest do not even match the market — and that’s true regardless of whether they invest with a little help from their friends the money managers or not.
But anyone who has to re-up with this company owed it to themselves to ask some questions about that topic before re-upping: they should ask the person who put them into the money manager’s business model (usually a registered investment advisor) to benchmark the performance of their accounts to a given benchmark that makes sense to use (which is a topic for another day).
And notice that we’re not talking about benchmarking the funds themselves, but rather are talking about benchmarking the customer’s particular account because, what with all the moving ins and moving outs and in-the-background fee-dingings, who’s to say or to know how your account matched up with a given fund?
So how’d the account do? If a customer’s account didn’t keep up with the benchmark, then shouldn’t t that customer consider whether it’s worth paying some company 3% to fail at accomplishing something, when there are plenty of companies out there willing to do try to accomplish the same thing for 1.5%. And if the customer simply wants to match the market rather than beat it (sounds nice for at least some of your money, doesn’t it?) then there are plenty of companies out there who are willing to try to accomplish that for the customer for a fee that is a whole lot less than that.
So Ken Lay and Bernie Ebbers might be criminals (go get ’em, Alberto, because John sure didn’t . . . ) and some of their cronies for sure are because they have pleaded guilty and are doing time.
But how about these sorts of money managers — these money manglers — the sort who charge exorbitant fees and in doing so virtually assure that their clients will underperform the market?
What they do is perfectly legal (assuming that they have dotted all their is and crossed all their Ts).
But is it right?
Are the people who sold this stuff to their customers doing the right thing by their customers, or are they simply looking out for their own interests, and in a rather twisted way? Is this a case, a la Microsoft, where marketing is everything? Forget about selling snow to the Eskimos; is this like selling scum- and bug-infested bottled water to the thirsty?
After all, how much of that 3% do you think goes back to the guy or gal who hitched the customers to the 3%-fee money managers in the first place? Maybe one percent?
So how does it feel to pay $2.5k to the guy who snookered you in the first place, and has caused you to trail the performance of the overall market by . . . oh, 3% ( if you were lucky)?
How does it feel to pay that dough to the guy who poisoned your well — the one you are going to rely on in your retirement years — when he hasn’t even called you in two years to see how you’re doing?
Hmmm . . .