ELF
Capital Management, LLC
(Endowment
Like Fund Management)
March
8, 2010
This is the ELF Capital Management,
LLC Market Letter for the month ended February 2010. If you do not wish to be included in our
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the letter.
Knowing When to Hold ‘em or Fold ‘em
You got to know when to hold 'em, know when to fold 'em,
Know when to walk away and know when to run.
You never count your money when you're sittin' at the table.
There'll be time enough for countin' when the dealin's done.
Chorus to Kenny
Rogers “The Gambler
These lyrics filled
the airwaves in the late 1970’s when American country music icon Kenny Rogers
released his multi-million selling album The Gambler. “The Gambler” was also the title track to
Kenny’s 1978 alum which won him the Grammy Award for best male country vocal
performance in 1980.
When the song came
out, I was in my second year at college and not a very big fan of country
music. Despite my earlier music preferences,
the song was wildly popular and frequently played on the radio. Now, every time I hear of someone struggling
with an investment decision, these lyrics immediately come to mind.
The song’s lyrics
provide some sage advice for novice investors and one particular lyrical bridge
says it all…
Ev'ry gambler knows that the secret to survivin'
Is knowin' what to throw away and knowing what to keep.
The most
common struggle I hear of from novice investors goes something like this: They own an asset whose current fair market
value is significantly down in value.
Rather than sell the asset and redeploy the cash into an opportunity
with greater potential, they want to hold the asset in the hope that the price
will recover.
When it
comes to making an investment decision, “hope” is not a good strategy. Rather than relying on hope, you’ve got to
know when to hold ‘em and know when to fold ‘em.
A couple of
weeks ago, I was having a conversation with a successful home improvement
contractor. He had just completed some
work at my home and stopped by my office to present his invoice. I was very pleased with the work done and
even more pleased that he and his crew were really good at keeping appointments
and communicating. During his visit, he asked
me about a financial decision he was struggling with.
His
business revenues for 2009 were significantly lower than prior year levels; and
most, if not all of the family’s wealth is tied up in his home and business –
the home representing the “lion’s share” of savings. He has one child readying to go off to
college and another in the next year and a half. He was very concerned about how he’d be able
to come up with the tuition. While the
business is generating enough profits to meet his family’s living expenses, unlike
the past, it is not generating much savings now. Their house and landscaping are stately and
he has more than 70% equity in it at today’s prices. From the past fruits of his business, he
renovated and transformed the modest home he purchased more than a decade ago
into an artfully created master planned grand residence and grounds. His wife has expressed thoughts of selling
the home, moving into a lesser home and using remaining proceeds to pay for the
children’s college expenses. He wants to
hold onto the current home until the real estate market improves - at which
time he hopes they can get more for it.
I thought
he might be not be considering all of his options.
In this
month’s letter, I will review some of my recommendations and discuss how a new
breed of “mom” and “pop” property managers might represent a next wave in the
recovering residential real estate market.
Providing Some Food for Thought
Good
parents want the best for their children and each has their own way of
preparing offspring to be self sufficient enough to go on their own. We want to offer opportunities – sometimes,
more than we’ve had – to allow them the ability to pursue their own
passions. We all know that passion is an
important ingredient for success. Yet,
more often than not, our children’s passions have barely developed beyond a
desire to gain social experiences instead of seriously considering any
career.
Maybe the
better route is to remain open to how we can help before committing to a costly
game plan. In this case, my contractor
friend was trying to mentally prepare himself for having to finance $40,000 per
year, per child. Maybe he does; and
maybe he doesn’t.
The first
suggestion I passed along to him was to take immediate steps to determine the
family’s eligibility for college financial aid.
This involves completing a FAFSA form and filing it with the U.S.
Department of Education. FAFSA is the
acronym for Free Application for Federal Student Aid and it is not only used for
determining qualification for federal aid, it is used to obtain financial aid
from state coffers as well as from a school itself. In addition, I explained how it worked and
why it was important that the application should be filed sooner rather than
later.
The FAFSA
is used to calculate the student’s Expected Family Contribution (EFC) for the
coming school year. The EFC is the
minimum amount that the family is expected to pay towards the student’s college
costs, at any school. So, each
school will subtract the EFC from the cost of attendance there to determine the
student’s financial need eligibility.
And, financial aid is often allocated on a first come, first served
basis. So, getting the application filed
early increases chances of getting more free money than student loans.
In
April and May, most of the schools will have issued the Financial Aid Award
letters to prospective students at the same time they are issuing acceptance
notices. At this time, most, if not all
of the financial aid resources for the year have been allocated out by the
school. By the way, it is important to
note that the schools are responsible for allocating federal and state college
financial aid programs – they need qualified students to “unlock” that money to
be used at their school. It is also important
to know that not all schools can meet 100% of the family’s need; some schools
can only meet 50% and others may only meet 20%.
This could be a critical factor if you are dependent on receiving
financial aid. Now for the Good News! Generally, most of the more expensive schools
are better endowed. This means that they
have more money to give to people who want to go to their school.
I also alerted him
how he might double or triple his family’s eligibility for financial aid. This
is because usually the majority, if not all, of a student’s Expected Family
Contribution comes from the parent’s financial information. The parental side of the equation will be
divided by each household member attending college at least part time. One additional household member attending
college could potentially double eligibility and so on. If he and or his wife could find themselves
taking a college course or two, they could legitimately increase their financial
aid eligibility.
Lastly, as his
business income was more modest at present, the family might have a good chance
in qualifying for aid this year. As an
additional consideration, I suggested that
But what
about potentially selling his home?
The Next Wave in Residential Real
Estate?
As I
discussed earlier, my contractor friend’s wife had asked him to consider
selling their home and moving into a lesser one. He seemed preoccupied with that thought as he
was proud of how he developed it and enjoys living there. On the other hand, his espoused affection for
his family exceeds that for his residence and he appeared to be mentally
preparing himself to part with the home.
“If only business would return to where things were before the
[economic] downturn” is what I heard. I
hoped to inject some optimism.
First, I
began to mention that I thought the worst of the current economic downturn had
passed and that it looked like we were in the early stages of the
recovery. In addition, I encouraged him
that he was among the more polished of his industry peers and did excellent
work at my home. And, that it wasn’t
unreasonable for him to expect to gain market share as a result of these
traits. I suggested that he might want
to market himself a little more.
“Marketing?” He couldn’t remember the last time he had to market
his business before! Apparently, he had
been blessed with enough referrals in the past that he didn’t have to do
any. Come to think of it, another good
friend of mine recommended I contact him for the work I needed done. OK, marketing was something new, but he got
it.
Moving on,
I asked if he had considered borrowing against some of his home equity to pay
for school. He had, but didn’t really
feel comfortable to increase his monthly cash outflows – as servicing the loan
would cause. Then, I asked if he had
considered borrowing from or taking a distribution from his retirement
plan. Not that I’d recommend this route,
but I asked. He hadn’t really focused on
funding a retirement plan yet.
Then the
focus returned back to selling the home.
“If only the market for homes like mine would recover before I needed to
raise cash [for tuition], would I feel more comfortable with selling my
home. When I do, and after I purchase
another [lesser] home, should I diversify my money and could you help me invest
it?”
When I
heard the first comment, I immediately thought of “the Gambler” song; and, when
I heard the questions that followed, I imagined that most brokers or managers
would immediately say ‘Yes” to both.
However, I did not take that route.
I am
someone who believes in the concept of diversification; I also view the concept
in varying degrees. Most people think of
diversification in terms of the need to diversify among asset classes; while
diversifying within a specific investment type or within an asset class is
sensible as well. To understand the
distinctions, you might want to review my February 2006 article on Managing Asset Allocation.
In crafting
my response, I started with the advice that “You got to know when to hold 'em,
and know when to fold 'em”. I
asked, “isn’t the whole residential real estate market depressed right
now?” He believed so. Then I asked if he thought he could find 2 or
3 lesser homes as similarly depressed in value as his? He thought so. “So, then”, I replied “why do you need to
wait for the value of your home to improve?
You may be missing out on an opportunity to improve your financial
situation.” He leaned forward to listen.
It was my impression
that he had already maximized the potential for upgrading his current
residence. And while the market was
soft, his home should be the “diamond in the ruff” so to speak. After all, of purchasers in that price range,
who wouldn’t like to own a home that a quality home improvement contractor
painstakingly improved over a decade of thoughtful planning and care? And from our dialogue, it was clear that
under current US tax laws the he wouldn’t have to pay much, if any, taxes on
profits from the sale.
If he was
willing to commit most of the proceeds – less tuition for a year or two – and
the mortgage debt he was currently paying off, he could have a new residence
and possibly two rental properties generating positive cash flow. He is in his mid to late 40’s and his wife
has a real estate license. He could
develop his new residence into another “dream home” and begin to prepare for
his retirement with two rental properties throwing off tax advantaged cash
flows. Presumably, any new properties he
might buy would also have undeveloped potential for improving upon. Then, as his business grows faster than the
economy, he could begin funding that more liquid retirement plan and diversify
those funds into something other than real estate. However, he has a special expertise that only
increases his chances to be a successful rental property owner. And he should use it.
He liked
these ideas and we are scheduled to meet more frequently.
Given the
current state of depressed housing and construction activity, I would expect
that others are already thinking about this opportunity. This leads me to believe that a new breed of
“mom” and “pop” property managers might represent a next wave in the recovering
residential real estate market.
Market Update
Global
Insight, an industry leader in economic analysis, forecasting and market
intelligence recently wrote: “Recent key economic indicators have been positive,
with evidence that the recovery is finally broadening beyond manufacturing to
services, and that positive job growth could be just around the corner. Right
now the main drag seems to be depressed housing and construction activity,
which is a key driver of employment, building materials, and freight activity.”
We continue
our optimism about the recovery and, in February, we significantly lightened
our exposure to high yield debt. We
believe the biggest gains from the high yield market have already been garnered
and are more comfortable to be in US equities at this time.
We rebounded
nicely from the correction in January and ended the month of February up 5.42%
and gained a record 72.56% for the last twelve months. Here are some comparative numbers for you to
review:
For
disclosure purposes, past performance is not necessarily indicative of future
results and ELF Capital Management LLC (ELF), formerly Hoffman White &
Kaelber Financial Services LLC, cannot guarantee the success of its
services. There is a chance that
investments managed by ELF may lose a substantial amount of their initial
value.
ELF is an
independent discretionary investment management firm established in February
2003. ELF manages a strategic allocation
of primarily exchange-traded index funds (ETFs), and may invest in other
carefully selected securities. ELF may
also employ hedging techniques, through the use of short positions and
options. ELF manages individual
portfolio accounts for both individual and business clients.
The ELF ETF
Strategy returns presented herein represents a composite of actual results from
all client portfolios managed by ELF.
Currently, it is the only composite presented by ELF and separate client
account portfolio positions are substantially similar, except as may be
modified for retirement plan accounts and accounts with net equity of $60,000
or less. There is no minimum account
size for inclusion into ELF’s ETF Strategy composite and accounts with net
equity of $60,000 or less have a tendency to downwardly skew the combined
results.
ELF’s
performance data presented herein includes the reinvestment of dividends and
capital gains; as well, ELF’s ETF Strategy composite returns are presented
after deducting actual management fees, transaction costs or other expenses, if
any. ELF charges an annual investment
management fee as follows: 1.25% on the first $250,000; 1.00% on the next
$750,000; 0.95% on the next $4,000,000; and, 0.75% thereafter.
Broad market
index information provided is solely for the purpose of comparison. This index data was obtained from third party
sources believed reliable; however, ELF does not guaranty its accuracy. An investment account managed by ELF should
not be construed as an investment in an index or in a program that seeks to
replicate any index. In most cases,
investors choose a market “index” having comparable characteristics to their
portfolio as a benchmark. An ETF is a
security that tracks an index benchmark or components thereof. As ELF actively manages a strategic
allocation of primarily ETFs, selecting a comparable benchmark poses
significant challenges. Over time, the
broad market indices provided above may exhibit more, similar or less
variability of returns and risk than ELF’s strategic allocation. As well, the broad market index information
provided above reflects gross returns and have not been reduced by any estimated
fees or expenses that a person might incur in trying to replicate an index.