Dr. and Mrs. Millhalf's (Ret.) Portfolio

Last month we visited with Dr. and Mrs. Millhalf who just moved here full-time and who have $500,000 to invest. Their goal is to leave a million dollars to grandchildren. They made a few initial investments last month which are highlighted in the box below with prices as of November 25th.

Dr. and Mrs. Millhalf’s Portfolio (11/25/05)
Security	Amount	Current Price	Value
BAC	1,125 shares	46.99	52,864
GLD	1,050 shares	49.42	51,891
UST	1,250 shares	39.46	49,325
Short term tax free bonds			$350,003
Total Portfolio			$504,083

Dow Jones Industrial Average
10/28/05	Initial Purchase	10,400
11/25/05	Most Current	10,932

Question: In only a few weeks this portfolio has gained $4,083. Should we be excited?
Answer: No. Don’t look at short term gains or losses as being an indication of how a long term portfolio should perform. Annualized, this gain represents only a 9.8% annual increase in value.

Question: Why do you say “only”? 9.8% is a lot better than bonds at this point. What should we be looking at over a period of years?
Answer: Our goal should be a 15% compounded return.

Question: Why 15%?
Answer: The market, with dividends, over the last several decades has produced an average return of just over 10%. We should do better.

Question: Shouldn’t we be happy with the average?
Answer: No. Did you want to be average in school, or in sports, or as a parent? A 15% compounded return is 50% better than average. Furthermore, a 15% compounded rate of growth doubles the value of an investment every five years. Theoretically then, if your goal is to leave a million dollars to your grandchildren, within 5 years your $500,000 portfolio (fully invested in high grade growth stocks that pay a dividend of 4%, or better, and sell for 12 times earnings, or less) should be worth a million dollars.

Question: How can we be expected to out perform the market when 70% of our funds are in low yielding tax free securities? Why don’t we invest that money right now in bank stocks, tobacco stocks and pharmaceuticals, all of which are depressed?
Answer: The pharmaceuticals are currently so unstable that we should take a pass now and just watch them. Merck, Bristol Meyers and Pfizer are three monsters that are all cheap. Pfizer, at least, should be a stock we take a good hard look at some point down the road. The tobaccos, primarily Phillip Morris (Altria) and UST, have an element of risk attached to them because of litigation. That dictates limiting one’s risk to no more than 10% of the portfolio. And while bank stocks are cheap, BAC already represents an investment of 10% of your portfolio. JPMorgan-Chase and Citigroup are also cheap, but they have such huge international, and third world loans, that they carry a degree of risk which Bank of America does not have. Furthermore, BAC is the biggest retail bank in the world; it is extremely well managed; and their credit card operations, unlike a lot of banks, are sound. As buys become available, if they become available, we will sell a little bit of the tax free fund and use those proceeds to build this portfolio.

Question: Should we expect this to be done in a 10-12 month period?
Answer: We should not let time dictate the decision making process. We should be concerned only with value. When values become available in stocks that are well managed and which have a proprietary position in their markets, that is the time to buy. It is unlikely we would be fully invested in 10-12 months. It is more likely it will take two or more years to be fully invested in growth stock positions.

Current Status of the Market
The dollar has become very strong again. A strong dollar is not good for our trade imbalance. The stronger dollar means higher prices for American goods and lower prices for foreign goods.

Question: What turned the dollar around?
Answer: There are several reasons why the dollar has strengthened:

1)		Central banks, like the Federal Reserve System, are engines of inflation. Our central bank has “only” increased the money supply by 6% this year. Europe’s central banks have increased their money supply over 8% this year, Brittan is up over 10%, Australia at 9%, Canada at 10%, and so forth. That type of liquidity indicates the potential for inflation in America is less than that in other parts of the world, which makes the dollar more attractive.

2)		The problems in France, and the Middle East, are areas in which a substantial amount of the world’s wealth, that is not denominated in dollars, resides. The escalation of problems of this magnitude in France, Europe and the Middle East encourages wealthy investors to get their funds into a safer currency, like the dollar. There has been a great effort recently by European and Middle Eastern investors to flee their own currency and find safety in the dollar.

3)		The sell off in the price of oil, which is traded in dollars in world markets, means less dollars would be needed to buy petrochemicals. Fossil fuels represent the energy required to run all advanced economies, so a decrease in the price of oil is a boost for the dollar.

4)		America is the safest place in the world to invest capital.

5)		U. S. interest rates are increasing, making dollar returns more attractive to foreign investors.

Question: Can you sum up concerns Market Watch has about the markets in only a few sentences?
Answer: Yes. We are in a bear market. A bear market attacks areas of vulnerability. Bear markets are always contractionary, and areas of debt are vulnerable to contraction. Not only is this nation sitting on an ocean of debt, but we are borrowing more than 80% of the world’s savings to fund our $650 billion trade deficit. Such behavior is unsustainable and must come home to roost at some period in time. Our hope can only be that this country is less poorly managed than other countries around the world who are our economic competitors.

Question: How can we expect the federal government to manage our tax dollars well when the volume of federal government spending is 2.5 trillion dollars? That’s about ten times larger than General Motors, and GM is a mess.
Answer: Our government is horribly inefficient, as is General Motors. Whether or not we are less efficiently managed than governments in the rest of the world is, sadly, a standard by which we must evaluate the effectiveness of our own government. As messed up as our government is, it’s not as invasive, or confiscatory, as most other governments in the “free” world.

Conclusion

Our Founding Fathers did make it difficult to get too far away from the Constitution, a document written strictly to preserve individual property rights and individual liberty. George Washington, who knew of the failures of governments in history, said it best: “Government is not reason; it is not eloquence. It is force”. In spite of our government, there are still restrictions on their behavior. At this point, it’s just enough citizen control to ensure America remains the best place to live in the world, and the best place to try to make a buck. Reasonable government policies are key to business growth and a healthy economic environment.

The stock markets, however, still bear a great deal of risk. With interest rates rising, and a strengthening dollar, business revenues are under tremendous pressure. Business revenues are poised to remain stable or go down. Decreasing, or stable, sales revenues are not the shot in the arm we’re looking for to turn around this bear market.

Caveat Emptor.
George Rauch
November 25, 2005

*In future months, we will track these investments to see how they are doing and to commit further amounts of capital to the stock market when good buys become available.

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