A Proactive and Analytical Approach to Conservative Investing

Transcription

1 R E P R I N T E D F R O M J U L Y 2 4, A Proactive and Analytical Approach to Conservative Investing JOHN G. ULLMAN is President, CEO and Founder of John G. Ullman & Associates, Inc. Earlier, he was President of USGM Securities, Inc., and at Corning Inc., worked in financial management. He received an MBA from the University of Chicago, with a focus in financial management. He received a bachelor s degree in economics from Johns Hopkins University. He was named the Corning Chamber of Commerce Small Business Person of the Year in SECTOR GENERAL INVESTING TWST: Could you please identify yourself? Mr. Ullman: John G. Ullman in Corning, New York. TWST: Could you tell me your firm? Mr. Ullman: That s John G. Ullman & Associates, Inc. headquartered in Corning, New York. We start our 40th year of operations on August 28 this summer. TWST: And I understand that you are involved in a lot of diverse financial activities, so maybe you can talk for a couple of minutes about that. Mr. Ullman: Our concept, which started in 1978, is to provide essentially all financial-related matters under one roof with a firm that has broad capabilities and most importantly, the highest of ethical standards. Everything we do is fee-based. For accounts above certain levels, we include tax preparation services. Outside of tax preparation for smaller accounts, everything that we do is included within our fee. We do not accept any commissions, and we avoid conflicts of interest. We manage our clients assets, complete their tax returns and restructure their estate plans. We will shortly add our sixth attorney, but we do not prepare wills or perform legal services, as we re not a law firm. But we get a complete plan developed, structured and written in detail. We handle insurance reviews, general financial planning and essentially all financialrelated matters, upon request, in a busy family s existence. Corporate executive programs are often areas where we are active. Non-directly managed assets such as 401(k), 403(b), risk analysis, purchase and sales of properties are examples of projects for clients. Our firm has a very long-term team that s in place to work with client families. We have our own Securities Research Department. Equities on our buy/ sell lists are followed directly by our highly experienced securities research analysts. We provide portfolio management and trading functions within the company as well. To lead in the preparation of over 1,400 tax returns per year, we have a fully staffed tax department that also provides tax planning and handles audits. Our advisers are skilled in each of these areas as well and contribute in managing tax matters in addition to the tax department. TWST: And I understand among the things you work on include municipal bonds? Mr. Ullman: We have a balanced portfolio model. All accounts with us for the assets we are managing should have a percentage, which is 50% or more, that would be in other than growth equities. These conservative investments include cash and equivalents, taxable and tax-free bonds, utility stocks, high-quality corporate and government issues including entities overseas that have high-quality issues in foreign denominations. Equities in clients accounts are very closely followed through our securities research department. We do have a significant amount of assets in municipal bonds, some are taxable, although most are taxexempt, at least for federal taxes. Exemptions from state income taxes depend on the geography of the holder. We view our fixed income strategies and management to be a very important part of our asset management program. M O N E Y M A N A G E R I N T E R V I E W

2 TWST: And what s been going on recently with municipal bonds that investors may want to know about? Mr. Ullman: There has been a lot of upheaval over the years, although such has recently lessened with the economy improving dramatically over the last nearly 10-year period. While problems and defaults have settled down, we had periods where I think the expectations of municipal bonds in terms of safety were underestimated by the market. We have a highly proactive and analytical approach to bonds. For conservative investments our approach for both corporate and municipal bonds has very much insulated our clients accounts from adverse impact from the significant numbers of bankruptcies that have occurred. When one reviews the municipal market, over a reasonable number of years, we have seen cities like Detroit, Michigan and Harrisburg, Pennsylvania, a state capital, go bankrupt. There were three regions in California: Stockton, San Bernardino County and Mammoth Lakes, essentially also go bankrupt in late 2012 and Earlier, there were other defaults such as in 1994, which I believe include Orange County, California, and Jefferson County, Alabama, financially failing. Much more recently, a major effective bankruptcy in Puerto Rico represented a very large and severe financial challenge. Other problems have included Central Falls, Rhode Island. New York City was in trouble in the early mid-1970s, and worked through substantial financial strains through New York State assistance by issuance of bonds issued under the Municipal Assistance Corporation of New York in New Highlights John Ullman discusses his firm s portfolio management strategy. Mr. Ullman has a balanced portfolio model, with 50% or more in conservative investments. A significant amount of the assets are in municipal bonds, where Mr. Ullman employs a highly proactive and analytical approach. the proverbial road than to raise taxes. For Illinois, recently, the State Senate overrode a veto by a Republican governor for an income tax increase, and I believe the governor was looking to see more spending cuts than were included in the bill in Illinois. For decades, Illinois has been under-taxing versus their spending levels placing Chicago and the state in a really terrible position. I m not sure if the tax increase is large enough, moving from 3.75% to 5%. The outcome in Illinois, over time, hopefully will lead to fiscal stability. While states typically have balanced budget requirements, very few states are willing to increase taxes when there is another financial crisis. I think municipalities are in a very difficult position with all of the entitlements that have been promised in terms of pensions and health benefits. In the private sector, pension benefits have been rapidly reduced and Social Security has become much more primary as a source of retirement income. Depending on one s political view, there are different reactions about this major trend and reality. The pension programs in some states remain extremely generous compared to most corporation plans, placing highly significant and often daunting long-term liabilities on individual municipalities. Many municipalities have extremely large unfunded pension and health care obligations. Eight or 10 years ago when we were studying this underfunding, estimates that were being projected for state and local government pensions were $3 trillion to $5 trillion underfunded. The equity markets in recent years have certainly helped, although I haven t seen a very good recent estimate. I hope the imbalance is We have a highly proactive and analytical approach to bonds. For conservative investments our approach for both corporate and municipal bonds has very much insulated our clients accounts from adverse impact from the significant numbers of bankruptcies that have occurred. York State. Philadelphia has had some very difficult times. Illinois, as a more recent example, has been very close to junk bond ratings throughout the state. I believe some of the Chicago school district bonds, if they re not general obligations, currently carry junk bond status. I believe with the level and numbers of problems that have developed as well as the disasters with the insurance agencies, MBIA and AMBAC after the 2007, 2008, 2009 financial collapse, municipal bonds have had more financial issues develop than would be indicated by the market. There s just an expectation that governments will pay. Although probably problems are severely underestimated, I think our political system has unfortunately evolved to a point where it s easier for a mayor or a governor to try to just kick the can down presently considerably lower, but it almost certainly remains very substantial. I think that there is a comfort level in the marketplace with municipal bonds, which I believe is higher than is appropriate. TWST: And do you think investors need to take a good solid look when they re looking at different municipalities that they might want to invest in? What the municipality is doing about pensions and about retirement benefits and about social programs? And also, do they have a good working relationship to attract business to the community? Are those all things that they should look at to make sure it s a solid investment? Mr. Ullman: Absolutely. I couldn t agree more and can give you, I think, a more detailed example. Ratings from the major rating

3 agencies are a part of our evaluations. It is not a major part, but at this stage, and for many years now, we generally don t buy municipal bonds with less than AA to AA2 ratings by Moody s and Standard and Poor s. We have a AA3/AA minimum for most universities. We believe that these and other ratings are, in our opinion, overly confident in the financials of many municipal issues. About four or five years ago, we were looking at some work that was done on some school districts in New York State outside of the major metropolitan areas. The concern was that the demographics because of manufacturing losses was effectively causing reductions in the population base out of those school districts with the impact that the residual amount of taxes that would be coming into the school district would also be lower over time. There were several school districts that had very high ratings that we decided to sell; as a result, it s not just about ratings, but other factors including unfunded liabilities and trends. Seven or eight years ago, we had $40 million to $45 million worth of bonds in Illinois, with the trends at that time looking quite worrisome. Many of the bonds that we held for clients had AA or AAratings at that time. Some were gradually being downgraded. We decided to sell. It took us a couple of years to sell all of them. What has subsequently happened is that there haven t been defaults, but many Illinois municipalities are in trouble. We were several years ahead of the market when we saw a trend line. These issuers generally maintained very high levels of government commitments to programs for employees and welfare benefits in urban areas, without the necessary tax revenues to support such obligations. Detroit was a problem that was not short term. We were out of any exposures well in advance. Harrisburg, Pennsylvania, was similar. These were not just sudden developments. Orange County, I think, had some things that occurred in the mid-1990s, but most of the time, these are not surprises. Similarly, for Puerto Rico. This major issuer has not been close to balancing their needs with revenues. As a result, they have a huge amount of debt. And I think there has been an expectation that there will be government bailouts in most cases and investors will be protected and rewarded for taking on lower-grade credits. I think that it s not something that should be presumed or expected. Additionally, we look at the specific collateral. We try to stay away from sports arenas and performance halls, and revenue bonds that are tied to activities. With very few exceptions, there are many types of municipal bonds and revenue sources that we avoid. TWST: Did you want to highlight a municipal bond or a bond fund that you find interesting? Mr. Ullman: We ve stayed away from most funds. I remember, over the years, we would have clients in the office, and they would have a particular fund in their existing portfolios. As a very hypothetical illustration, but similar to what we ve seen, they could own a unit trust. Such fund might have had 10 or 12 issues in it and in a given state. The units held much of the same issuer, and most of them were very longterm. As a result, there was essentially no diversification. For our investments, we have focused strategy and have our purchases reflect specific targeted parts of the market. For example, there is a possibility of tax rate decreases being part of tax refund law. We utilize ratios of municipals to comparable Treasuries of at least 77% of the Treasury rates for bonds with effective state exemptions in high-tax-rate states. If there is no state tax benefit, our target is 80% of comparable maturity versus Treasuries. While those rates are not near market levels, but easy to illustrate for a hypothetical 10% U.S. Treasury, we would be looking for the same maturity at the AA quality municipal at 8% without state tax benefit and 7.7% if there is a highrate state income tax associated. In May and June, for short to short intermediate issues, we were seeing 82% to 92% for municipals as a percentage of the same Treasury maturities, which was elevated versus normal. The market adjusted downward with the percentages now closer to the upper 70%. Part of this change in relative rates may reflect lower likelihood of tax rate decreases, with all of the challenges the administration now has facing it. We look very specifically at the mathematics of it. Also with interest rates at present levels, the downside risk from potentially higher interest rates of long-term bonds, both corporate and municipal, is elevated. The upside potential of rates dropping materially from here would appear to be moderate or low, and the potential for rates moving up being more considerably less, we are basically not going out more than about five years for fixed rate bonds. While there are a few issues a bit longer, our average maturity is running between two to three years at present. So we are looking for high-grade municipal bonds diversified by state and by sector, with the ratios that were mentioned. TWST: Did you want to mention an example of one you find promising? Mr. Ullman: Bonds are different than equities as you earn interest and then principal at maturity, it s not like a stock. As long as an issuer remains stable, such is the primary decision about a particular municipality. Targeting maturities is normally different than decisions about issuers. We prefer general obligation issues when possible. Also, as a generality, we often find some of the Midwestern states, counties and cities to be more stable. We are concerned about certain changes in government and outcome for the municipalities. For example, in New Jersey they cut taxes very significantly and cut spending, but not equally. The municipal situation in New Jersey has deteriorated in the last few years. So there are areas where we might sell bonds or at least not make additional purchases. For New Jersey, we are not making additional purchases but are retaining some holdings there. Pennsylvania has gotten into some problems, and we ve been limiting purchases. There are some places, such as Louisiana and Mississippi, where we have current concerns. We have stayed away from Nevada even though Las Vegas, in particular, has recovered significantly from the 2008 near U.S. financial collapse. Because of the volatile situation, we have stayed away from California municipal bonds for a very long time because things can change quickly and radically in California. New York and California were in poor financial condition in Both states have made surprisingly strong recoveries; however, when we look at the high-speed rail program that the California governor

4 has put through at $100-plus billion and all their needs in terms of water and a lot of other potentially higher government costs, it makes us uncomfortable with certain California exposures. There are other areas that we tend to avoid. To your question, there isn t a particular bond that we really like versus others. For some of us who had the privilege of attending various schools, there are bonds for example for Johns Hopkins and University of Chicago that are personally attractive for me, with other institutions appealing to their alumni. These preferences are separate from economic considerations for a given issuer. Such issues can be both very high-quality with little concern about defaults. It is nice to get the prospectuses with the details of such institutions including data which might list students average SAT scores. The same thing is true in certain other municipalities where you have an attachment whether because of the sporting team or because of having grown up in that community, but that s not an economic decision as long as the bonds meet certain criterion. They re fun to get as a separate matter, but it s not about any one particular issue. What is most important is being confident of specific issuers including geographies to avoid. gone up in decades, and the amount of money that s needed for roads and bridges and tunnels from the highway program is astonishingly high. That number might need to be at least double in order to pay for increased programs. One of the concerns that I have is a form of infrastructure banks being set up with off-balance-sheet financing, as a different method of funding. Infrastructure banks with full and proper collateral could work, but if it used off-balance-sheet financing, such could rival unfunded pension obligations. When there is direct or indirect responsibility for a municipality which does not have adequate funding, such will put even more stress on a municipality. In Harrisburg, Pennsylvania, this was a bit different. They had, if I remember, a trash-recovery recycling center and spent a few hundred million dollars on it. The project was very poorly managed and it went well over plan. Harrisburg didn t have the resources to cover this investment. I believe that some other things can and will happen if creative financing is used for future infrastructure programs. Flint, Michigan, and their problems with water, they tried to cut corners on the expenses with Detroit and, to save funds, people can make some really bad mistakes. There are tunnels, one in Baltimore, I think for Amtrak, that I believe is 100-plus years old. I believe the cost It s our belief that over the next couple of decades in this country, the amount of money that will be spent on infrastructure will be more than most people are contemplating. This expectation significantly affects our equity investment strategy. TWST: Do you think, too, one of the things you want to look for is cities that don t realize that the state government and the federal government, now under the Trump administration, may not be ascending as much in revenues maybe it was the case before, and that they have to make some tough decisions? Mr. Ullman: That s a very good point. And I think that when you have municipal governments that have been highly responsible and are not just trying to please the constituents with the most services at the lowest cost. Great managers have long-term plans, which when they exist are a real plus. It s our belief that over the next couple of decades in this country, the amount of money that will be spent on infrastructure will be more than most people are contemplating. This expectation significantly affects our equity investment strategy. Roads, bridges, tunnels, water are a major part, but not the only piece of infrastructure needs. We have major concerns with municipalities that they will spend the money but they aren t going to properly fund those large programs. I think for anything that s being spent there ought to be a viable plan to pay for it, not to just defer dealing with the costs. Politically, that s an extremely hard thing to accomplish, similar to in Illinois challenge in raising taxes. Gasoline taxes haven t to replace this aged facility may be over a billion dollars. I don t know where the funds are going to come from, but the trains are running at lower speeds because of safety. There was an episode a couple of years ago in a tunnel for freight lines that actually had a collapse in parts, which they fortunately were able to repair. The tunnels going across from New York to New Jersey are in dire need of upgrade. I haven t seen recent estimates, but I m sure it s many billions of dollars. How are these much-needed repairs and upgrades going to get funded? It s really important that when you re looking at municipal bonds to avoid entities that may have taken explicit or implicit obligations presently or in the future for some of these vast programs. There is a desire to invest, but the difficulty is getting funding to pay for it. I think that s another major concern, especially with the level of needs that exist in this country for infrastructure. We re a very large country. Much of Western Europe has much, much better infrastructure at lower cost than the U.S. So there is a tremendous amount of catching up to do in the United States. Some of these programs may be funded through industrial development authorities and utilization of tax-exempt bonds which may be separate from municipalities, but may also directly or indirectly affect these government entities. Toll roads might be pretty clear, but there s some really high-ticket items that will be astonishing in

5 cost levels which I believe will be very much larger than the initial trillion dollars that the Democratic and Republican parties have proposed. We expect that this is a very low number of what s going to be committed over the next couple of decades. TWST: And when you speak with investors who are trying to put together a portfolio, how do you explain to them why they might want to have a presence of municipal bonds, whether it s from this country or another country in their portfolio along with equities and other types of strategies? We are generally, at present, more comfortable with certain well-managed corporations, highly diversified, but in terms of your question, municipals that meet the ratings and the percentages are at least marginally advantageous for people with high tax brackets and taxable accounts. We do find the spreads on costs of municipals to generally be wider than corporations. If you want to have a bond that is expected to be kept for a relatively shorter period of time, we would more often opt to purchase U.S. Treasuries, a taxable bond, or an actively traded corporate than a municipal because of the spreads. But To the extent there is fixed income in a portfolio, municipals are a form of diversification. At 77% to 80% depending on the state ratios with Treasuries, they would be more attractive for those clients holdings than normal corporate bonds. Mr. Ullman: Well, to the extent there is fixed income in a portfolio, municipals are a form of diversification. At 77% to 80% depending on the state ratios with Treasuries, they would be more attractive for those clients holdings than normal corporate bonds. I should point out even though we re talking about municipals, we have rating minimums for corporates of BAA1, BBB+ generally, and there are very few exceptions. The vast majority of bonds are in sectors of preferences with limited amounts of bonds in financial companies. We want to be extremely careful with the amount of exposure to financial industry issues. To reiterate, we are much more comfortable with certain corporations on a diversified basis at good but lower credit ratings than we are with any municipalities. While we have a lower threshold, the overwhelming majorities having ratings at BBB+ or BAA1 for corporate issues are ones that we would not buy. We have very similar types of requirements for corporate issuers, but we have a higher level of concern on the ratings of municipalities. Again, these factors include pension and health care retiree programs that are being maintained and the difficulty of raising funds. I really was pleased personally to see that the amount of damage to pensions for long-term employees in Detroit was less than what might have been expected. Any adverse impact for someone who worked there 20, 25, 30, 35 years is a tragedy, because they were promised those amounts. But I think that this bankruptcy was wellhandled, as it could have been much harder on retirees. From bondholders perspectives, they certainly took large losses, which is part of the risk with bonds. In thinking back possibly more than 20 years ago, Washington Public Power issued municipal issues of size for nuclear plants. They halted the project with huge losses. I think some of their exposures were pretty obvious at that time, but a lot of investors unfortunately had large holdings. the reason we buy municipals is our net return with such investors expecting net higher rate of return in that maturity than they would with the comparable corporate issues. TWST: And one last question. What about the risk that is out there with bonds from foreign countries? Is that a concern? Ullman: Yes. Our focus has been in very few countries in terms of foreign denominations. We re a U.S.-based firm. We have analysts who have an overseas background, but we have been interested at times in foreign bond issuers. In the mid-1980s, we purchased many overseas issues. At present, holdings are limited with a focus on Canada and Australia where there are natural resources. We re confident in the provinces in Canada and the Canadian government and the Australian government, Canada being financially stronger than Australia at present. Both have lots of natural resources and could have currency appreciation. In the 1980s, bonds were bought in Europe, including Swiss bonds and in Asia in Japanese yen. Overseas, we re buying extremely strong credits where there is not much concern about default. The issue is going to be exchange rate at maturity. During the last few months, we ve been adding some holdings in Canada and Australia. The dollar has recently weakened and those currencies have changed. As a result, we ve slowed down in our purchases. Our activities there are much more exchange-raterelated, and they are a very small percentage of the total account. If one is considering Chinese currency and bonds issued in that region, one needs to be in that market and know those companies very well. Our foreign bond holdings are presently quite small, currently less than 2% of the assets that we re managing, and probably between 3.0%, 3.5% of conservative investments. We believe that our highly proactive and analytical approach to bonds have been extremely effective in protecting clients accounts. With the many bankruptcies that have occurred including the

6 municipalities that were previously mentioned and issues from corporations such as Bear Stearns, Chrysler, Circuit City, Enron, General Motors and Lehman, we avoided financial exposure to any of these companies. Additionally, the vast amounts of defaults in subprime mortgages and risks from insurers such as AMBAC and MBIA were also of no impact on our clients accounts. Our strategy, which did have one issue temporarily defer a payment that was subsequently paid, has almost entirely insulated clients accounts for the impact of the severe problem of the municipalities and corporations listed in this note. We believe that during future business cycles, the very large commitments of municipalities will unfortunately place more issuers in vulnerable situations. In our view, current ratings by agencies understate the potential risks. Thus, we have and are maintaining extra vigilance of municipal issues, keeping higher standards for purchases and retention than for many corporate issues. TWST: Thank you. (ES) JOHN G. ULLMAN President, CEO & Founder John G. Ullman & Associates, Inc. 51 E. Market St. Corning, NY (607) The Wall Street Transcript, 622 3rd Avenue, New York, NY Tel: (212) Fax: (212) Website: