Gradually, Then Suddenly
We’re getting more than a bit tired of the debt ceiling ‘debate’ (and we use that term very loosely). The sooner this comes to head and is ‘resolved’ (again, we use the term loosely), the better. Fundamentally, it is impossible to resolve our debt problem in the next 2-3 weeks. The current challenge is to address the debt ceiling. In the long term, the more important challenge is to begin to address our rapidly mounting pile of debt.
The chart below is a clear visualization of the exponential growth of U.S. government debt. With interest rates up, the U.S. now pays more in interest expense on an annual basis than the entire defense budget! Exponential growth can be enticing when something good is growing, but exponentially growing debt has no redeeming qualities. Eventually, it eats you alive. Hemingway said it quite clearly in The Sun Also Rises:
“How did you go bankrupt?”
“Two ways. Gradually, then suddenly.”
Here is an example of how exponential growth works. Our picture this week is Wembley Stadium in England, which has a volume of about 1.1 million cubic meters, or more than 15.7 trillion drops of water. Let’s assume the irrigation system at Wembley develops a leak and in the first minute, one drop of water is released. Each minute, more water escapes, and doubles in amount each time – 2 drops the second minute, 4 drops the third minute, etc. How long will it take to fill Wembley stadium? Take a guess before you continue.
The remarkable answer is that in 44 minutes, the stadium would be overflowing. The stadium filled gradually, then suddenly, due to the exponential growth in the volume of water. (Don’t believe it? You can find the math here; dcscience.net.) The message of the debt chart below is that we may be much closer to the ‘suddenly’ phase than we realize.
While Congress searches for some political high ground on our debt problem (and make no mistake, it is OUR debt problem), nothing gets accomplished. Neither Republican nor Democrat has shown much interest in addressing the problem. There are a few very simple things that have been discussed for a very long time, yet Congress, whether controlled by Democrats or Republicans, has been unwilling to address them. Here are two examples:
1) Eliminating the carried interest provision for hedge funds and private equity funds. Carried Interest allows these fund managers to effectively have their fees taxed at the capital gains rate, and not as ordinary income.
2) Eliminating the ’taxable maximum’ of $160,200 on social security taxes, such that social security tax would be paid on all income.
The inability of Congress to act on these items, and others, leaves a simple message – Money Talks. The wealthy that benefit most also tend to be large political donors. But time is running out and while we are not projecting that clock is about to hit zero, it is time to consider how to defend your wealth against this risk. And that is a key reason to hold gold in your portfolio. In the meantime, we hope that once the short-term debt ceiling issue is resolved, Congress will begin to take our debt level more seriously.
Outside the Box
Chances are that you have seen some changes in your portfolios recently. After about 9 months of intensive research, we have modified our equity strategy. These changes can occur from time to time as we are constantly looking for ways to improve our portfolios, either with greater returns, or less risk, and ideally with both.
In an investment world that is dominated by boxes, we pride ourselves on being outside the box thinkers. One of the most stubborn boxes is the division of equity investments into ‘growth’ and ‘value’ categories. We have long hated that division as we find adds little to performance. We have now eliminated the growth/value paradigm in our thinking and we have divided our equity portfolio into two parts: the Core Portfolio and the Tactical Portfolio.
The Core Portfolio
The core portfolio is comprised of stocks that we want to own 100% of the time; in up markets, down markets, sideways markets, whatever markets. Here’s why. There are three key characteristics in the core:
- Earnings Consistency – Nothing is absolutely consistent, but in the core, we demand a long record of strong, relative consistent earnings.
- Attractive Returns on Capital – Consistency alone is not enough; we also require high returns on capital.
- High Free Cash Flow Conversion – Finally, we want at least a 70% conversion rate of net income into free cash flow.
This works for a very simple reason. Consistent earnings and returns allow the free cash flow that is generated to be reinvested in the company at very high rates. Over time, the ability to compound returns at a high rate drives the stock price. As long as these characteristics are in place, we are willing to own them for the long term, come hell or high water. When one of these characteristics is violated, we sell and replace with another stock that has these three characteristics. Our testing of the data suggests that this core portfolio holds up very well versus the S&P 500, with less risk (i.e., a lower beta). ––e core portfolio will typically be 60% to 70% of the total equity allocation.
The Tactical Portfolio
If you consider the criteria for the Core, it will clearly eliminate several investment sectors. Utilities are an example, as while earnings are consistent, regulation limits the return on capital. Energy is another example. Earnings and returns can be very attractive at times, but very unattractive at other times. There is no consistency. Despite this, there are times that we want to own energy and 2022 was a great example as Energy was the only sector to register positive returns for the year.
So, the Tactical portfolio is designed with stock and ETF strategies designed to own these sectors when conditions are ripe for strong returns and not own them when conditions are poor. No one fund or strategy is going to get this right all the time, but by diversifying the strategies used to own these sectors in a tactical way, we hope to avoid mistakes and more often than not, be able to be additive to the core portfolio.
In addition, we may use this tactical portfolio to reduce overall equity exposure in times of very high risk by utilizing hedged strategies and/or raising cash. It sounds easy, but it isn’t.
The bottom line is we believe we have better way to assess stock portfolios than the typical growth/value paradigm.
What We’re Reading
Palumbo Wealth Management (PWM) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where PWM and its representatives are properly licensed or exempt from licensure. For additional information, please visit our website at www.palumbowm.com.
The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.
The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.
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Asset Allocation, Earnings, Federal Debt, Gold, Portfolio Diversification, Risk Management, S&P 500, Stocks