2017 Q4 Newsletter


Playing the Right Game


“Before figuring out how you will win the game, figure out which game to play.”

– Michael Mauboussin


Turning $100,000 into $200,000, $1,000,000 into $2,000,000, or $10 million into $20 million over time is what we are all trying to do when we invest our hard-earned capital. On Wall Street there are a lot of ways you can try to accomplish this goal. How we do it should depend on who we are and what we know. When we step off the sidelines and invest money, we should do so with the idea that we have a time-tested advantage over other folks that are trying to compound their capital the same way. For example, a floor trader on the Chicago Board Options Exchange is going to attempt to use his speed, agility and formulas to extract profits as he matches up against people (on the other side of his trades) with similar skills and experience. Time and profits will be the judge as to how successful an investor is.

Likewise, on January 14th, when the Vikings lined up against the Saints in a game to determine who was going to get a chance to play in the Super Bowl, it was a game between two similarly-matched teams. They were both professional football organizations with rich histories. They had both played a successful season, studied each other, prepared for the game physically, and had a well-thought-out game plan. In the end, the result was determined by a single final play (a gloriously successful “Hail-Mary” pass for us long-suffering Vikings fans).

But what if instead of playing a formidable opponent like the Saints, the Vikings could have chosen to play a lesser opponent for the same reward? Let’s say they could choose to play the Wichita State Shockers for the right to move on in the playoffs. They would do that, right? That would be an easier game to play with a more predictable outcome. The Vikings, a studied group of professionals who are bigger, faster, and stronger would overwhelm a group of twenty-year-old, part-time, college athletes. This scenario, of course, is not possible. We don’t pay good money to watch such a mismatch. But that’s sports entertainment, not the stock market.

In the stock market, there are mismatches like this that occur every day. There is the equivalent of Wichita State taking on the Vikings or the Patriots. There exist people who are ill-prepared to enter the games that they are entering.  Maybe they think they can win. Maybe they are mesmerized by the spoils of victory. Early in my career I made these mistakes chronically. I am still guilty today.


“Most investors want to do today what they should have done yesterday.”

– Lawrence H. Summers.


Markets Create Opinions

These days you can hardly broach any investment topic without entering into a conversation about Bitcoin. During 2017, the cryptocurrency unit ascended from below $1,000 to over $19,000. Needless to say, such advances are rare and eye-opening. If you are in the money game, 20-fold moves in anything – whether it’s tulip bulbs, dot-com companies or digital currencies – create opinions. Some are informed; most are not. I am quite certain that there are people involved in these types of securities that are in over their heads. I am not sure how this one plays out, but I know that I am ill-prepared to enter this game, so I will not.


Picking the Right Games to Play.

We are often asked how we narrow down what appears to be a vast universe of potential investments for our clients. What game do we choose to play? This is a very involved question, perhaps too vast to encapsulate in a newsletter. We start by simply asking ourselves, “Do we have a chance of understanding this investment opportunity? Do we understand why this opportunity exists?” If we can answer these two questions, we have a starting point for our research.

We gravitate toward many public companies which others do not. Some of our favorite companies are doing well. They have a solid product or service offering, but they are too small to attract significant attention from Wall Street, and therefore appear less expensive than their better-known public competitors. Other companies that appear attractive to us are in less sexy industry niches, or have temporarily fallen on tough conditions and may currently be in turnaround mode. We like situations where long-time investors may be frustrated, and ready to “throw in the towel”. We believe these are great research opportunities.

Back in 1985, as a newly-minted Advisor, I sat through an investment wholesaler’s sales pitch about something called a closed-end fund. It was a unique kind of mutual fund that traded like a stock. I took the bait, invested on behalf of myself and the two or three clients I had at the time, and watched the investment lag the market for the next several years. Over time, I came to learn that I wasn’t the only naïve investor who got involved in closed-end funds. Closed-end funds were mostly owned by individual investors who had little knowledge of what the vehicle was – even the advisors who sold the funds seemed to be in the dark. Rather than get discouraged and sell out at rock-bottom prices (these securities got clobbered during the 1987 stock market crash), I saw this as an opportunity to develop significant expertise in closed end funds. The funds were terrific values when investors were most discouraged, and I could quantify this emotion by measuring the size of a discount at which any given fund sold. Conversely, the valuations usually told me when the over-riding emotion turned from fear to greed and I should start getting my clients out. If I invested some energy and time, and developed a discipline for identifying funds to look at or avoid, I could improve my clients’ probability of success. I could be like the Patriots or Vikings playing Wichita State.

Today closed-end funds are important contributors to several of our investment disciplines.


 “The stock market is a no-called strike game. You don’t have to swing at everything- you can wait for your pitch. The problem when you’re a money manager is that your fans keep yelling, “swing, you bum!”

– Warren Buffett


Too often we see investors get excited about investments simply because of a recent price surge. “Get- me- some- of- that- action” seems to be the sentiment which can often lead to heartache later. Nine years into a bull market we are witnessing more evidence of investors “unconsciously” wandering outside their circle of competence. The call of the sirens’ song is starting to blot out rational fears of previously forgotten mistakes.  Big advantages can accrue to investors who have a game plan – like the game plans that we help our clients develop.  As Buffett says, “taking a pitch or two” is usually better than getting beaned.


Punch Income Strategy

Dare to be Dull

The benefits of investing for income


2017 turned out to be rather average for income-oriented investments.  With long-term interest rates ending the year almost exactly where they began (approximately 2.4% on the 10-year treasury bond), and credit spreads drifting lower throughout the year, income investors mostly “clipped the coupon” of dividends and interest payments and saw little in the way of price change.

In contrast to this steady but unremarkable performance, stock markets notched impressive gains.  The S&P 500 Index advanced 22% for the year, led by a 39% gain in technology shares.  The so-called FANG stocks (Facebook, Amazon, Netflix, Google) had an average annual return of 53%.

S&P 500 stocks with below-average dividends had an average total return of 26.5%, while stocks with above-average dividends returned only 11.2%.

In the tension between fear and greed, markets seem to be finally shaking off the long-held fears of the 2008 recession and entering a period where greed is on the rise.

In an environment like this, when stories about bitcoin billionaires abound, it can be hard to resist the temptation to abandon discipline and jump on the investment that has made the most money recently.  Our brains naturally extrapolate the immediate past into the future and assume that the next five years are going to look like the last five.  There is a very real fear of “missing out” on more exciting investment opportunities.

However, history and common sense tell us that our gut instincts and emotional reactions to markets are frequently wrong, and can significantly derail a long-term investment plan that is focused on our personal goals.  Research shows that investors in general have a poor track record of market timing, often getting into investments too late (after most of the performance has already occurred) or selling too early.

We believe that an income-oriented investment strategy plays an important role in the overall asset allocation for many investors in any market environment.  Especially now, though, the benefits of investing for income are real and should not be forgotten:

Current income.  Many growth-oriented companies reinvest the earnings that they produce every year, rather than pay them out to shareholders in the form of a dividend.  None of the FANG stocks have ever paid out a dividend to shareholders, and likely won’t for the foreseeable future.

For investors who need current income to fund retirement or spending needs and don’t want to withdraw principal, income-producing investments are a key part of overall asset allocation.  The current yield on the Punch Income Strategy is approximately 6.7%.

Lower volatility.  While growth stocks have had impressive gains this year, it is important to remember that the daily, monthly, and annual volatility of many of these stocks is also impressive.  The Nasdaq Composite Index has had over six times the annual price volatility of the Barclays Aggregate Bond Index over the past twenty years.

Diversification.  Most investors’ asset allocation plans should include a mix of both growth-oriented investments and income-oriented ones, depending on individual goals and a willingness and ability to stomach risk.  An “all-weather” portfolio should dampen volatility and boost long-term returns if it includes securities and strategies that do not typically rise or fall in tandem.


Punch Large Cap Strategy

History Often Rhymes

The distorting effects of Exchange Traded Funds (ETFs)


“History doesn’t repeat itself, but it often rhymes.”

– Mark Twain


The trend toward passive investing is certainly not new, but it is accelerating at an astonishing pace. Flows into exchange-traded funds (ETFs) reached $476.1 billion in 2017, up a whopping 65.6% over 2016. Investors are changing their investment philosophies, knowingly or unknowingly, but few seem to be paying attention to the associated risks.

The deluge into indexation helped drive the S&P 500 Index up 22% last year. We believe it’s also creating distortions in the market. Steven Bregman, President of Horizon Kinetics, a New York-based research firm, is quickly becoming a leading expert on the subject. In short, Bregman believes (and we agree) that market cap weighted ETFs, like the Spider S&P 500 ETF (SPY), continue to dump money into the biggest and most liquid stocks in their respective funds. Why? Because ETFs need to have a fluid process to accommodate the redemption of shares. This creates an artificially high bid and drives up the perceived value of the most liquid stocks. It’s the main reason Apple is in over 150 ETFs. Valuation is not a consideration for ETFs. Risk becomes a matter of inflows and outflows and has nothing to do with the underlying securities in the fund. No one is evaluating what’s inside beyond a minimum fiduciary level that maybe checks a box or two.

Howard Marks, a legendary value investor, addressed this issue in his July 2017 “Letter from the Chairman”. Marks was asked by a pension fund client if all actively managed funds should be put into index funds and ETFs. He replied, “How much of the fund are you comfortable having in assets no one is analyzing?”

At Punch we do not own the FANG stocks. Our active share of 86.3% in the large cap strategy is intentionally high and our turnover of 14.2% is deliberately low. Active share is simply a measure of how different your portfolio is (including position weighting) from the benchmark index, in this case the S&P 500. In fact, only 56% of the positions in the large cap strategy are in the S&P 500 index. Individually, the FANG stocks are incredible companies with relatively high valuations, but valuation is not being considered when an investor pours money into one of a hundred or so ETFs that own their shares. We evaluate each company we invest in based on its own merits, from the bottom up.

Here’s the part that rhymes. Before we had large cap ETFs, we had the “Nifty Fifty” stocks in the 1970s. We have mentioned this group of stocks before in our newsletters – they provide a valuable example of what can go wrong. The Nifty Fifty were a group of 50 stocks that the masses bought and planned to hold long-term, regardless of valuation. It was a bullet proof strategy. It worked, until it didn’t. Valuations spiked to 42x on a price to earnings basis. A bear market showed up in the mid-1970s and investors that bought the Nifty Fifty at their peak saw two-thirds of their investment disappear a few years later.

In his 2005 Berkshire Hathaway Annual Letter, Warren Buffett briefly discussed what he considered to be the Fourth Law of Motion – a law of motion unique to investing. Buffett described the law this way, “Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, “I can calculate the movement of the stars, but not the madness of men.” If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.

Here’s the bottom line. The increased motion of money flowing into ETFs has been growing at a staggering pace for several years, each year out-growing the prior. Extrapolation is not a strategy that lasts forever. Few investors are talking about what happens when inflows into ETFs slow or even reverse. That’s not a ride we want to be on.


Punch Small Cap Strategy

Quants and Coffee

An increasing focus on fundamental research as fewer investors practice it

On a sunny morning in Texas last fall, several members of our portfolio management team arrived at one of the newest, most modern coffee roasting facilities in the country.  Located on the outskirts of Fort Worth, the facility is the headquarters of one of the larger coffee companies in the country, and a new addition to the Punch Small Cap Strategy.  Our research team was there to tour the new facility, hear about the company’s strategy, and interview management.  We also got to sample some coffee.

As with many of our portfolio companies, we like to spend time getting to know the business, the operations, and the folks in charge because we plan on being shareholders for three-to-five years, or longer.  And because we specifically look for companies that are not well-known or may even be misunderstood, it’s important for us do hands-on research so that we can know and understand a company better than almost any other investor.

This coffee company fits the mold of what we look for in an investment for the Punch Small Cap Strategy.  Besides being a relatively small company ($520 million market capitalization) and having only three analysts who publish research on the stock (Apple Inc. has 50 analysts), we think the positive changes going on inside the company are not well-understood or appreciated by investors.  The facility tour was our team’s fifth meeting with company management in the past year alone.

Founded in 1912, the company was owned and operated by its founding family until 2012 when the first-ever external CEO was brought in to modernize the operations and pursue a more aggressive growth strategy.   Since then, the new management has reduced costs, streamlined operations, and acquired several large coffee roasting operations.  These changes ultimately culminated in the construction of a new large-capacity roasting facility and company headquarters in Texas.  We think that many investors still associate the company with the old, antiquated operations under family control and have yet to recognize the value and potential of the “new” business.

In a world where investing is increasingly driven by quantitative (“quant”) strategies and “mindless” index and ETF funds, we think the value of fundamental research is growing as it becomes scarcer.  Quant strategies cannot, by definition, incorporate qualitative research into their investment processes because things like management quality, competitive advantages, and changes in strategy cannot be analyzed in a systematic way by computer programs.  Quantitative metrics, at best, only partially capture these qualitative characteristics and often miss changes until they are already reflected in stock prices.

Research recently cited by the Wall Street Journal (“The Quants Run Wall Street Now,” May 2017) points out that, for the first time ever, quantitative strategies now account for a majority of stock market trading.  At 27% of all U.S. stock trades, quant funds are larger than banks, asset managers, and other hedge funds in terms of trading activity.  Ultimately, we believe this means that non-quantitative factors in investing are being increasingly underappreciated and undervalued by markets.

Our opportunity, especially in small-cap investing, is to find those areas where fundamental changes are happening (for example, a lagging industry is beginning to lead or a new management team is transforming a company) and where share prices do not yet reflect these new realities.  In a world where quantitative research is on the rise, we believe that those investors willing to roll up their sleeves and do fundamental research will be increasingly rewarded.


Punch Wealth Planning Group

What Experts Want You to Know About the New Tax Law


At some point over the next few months, you will probably think about taxes whether you want to or not. Our wealth strategies group works together with your tax and legal advisors to ensure we are engaging all perspectives and producing the best results for you and your family. We regularly look for new planning opportunities as laws, the economy, your business, and your family change over time.

Congress recently passed the Tax Cuts and Jobs Act, and President Trump signed the legislation into law on December 22, 2017. To give you a head start on understanding how the new law may impact you, we interviewed two tax experts who provided us with details on what you need to know about the new tax law.

Cory Kiner is a CPA and partner at E.T. Kelly & Associates, LLC in Bloomington, Minnesota. The firm specializes in tax preparation and tax planning for families, trusts, small businesses, and high net worth individuals.

Jim Lamm is a third-generation Minnesota estate planning and tax attorney and the chair of Gray Plant Mooty’s Trust, Estate & Charitable Planning group. He focuses his practice on estate planning, tax planning, family business succession planning, and charitable giving. Jim also works with families to help them through the probate and estate settlement process, as well as to administer trusts, prepare tax returns, and resolve trust, estate, and tax disputes.


What is the most frequent question you are receiving from clients about the new tax law?

Cory: Beyond the overall question of how the new law will affect clients, the most frequently asked question we receive is, “How will the higher standard deduction affect me?” Most taxpayers will find that their itemized deductions are limited to the following items: state income taxes and real estate taxes paid (with a $10,000 maximum deduction for the two), home mortgage interest, and charitable donations. The new standard deduction for single taxpayers is $12,000 with double that amount, $24,000, available for married taxpayers filing jointly. The taxpayers who continue to itemize will be those with relatively higher mortgage interest payments and charitable donations. Because of the lower standard deduction for single taxpayers, they will be more likely to itemize than married taxpayers filing jointly. In theory, the limitation of available itemized deductions is offset by lower tax rates. Generally speaking, we believe most taxpayers will see a decrease in their overall federal tax, but the difference is unique to each person. For some, the decrease will be significant. For others, it will be more modest, and there will be a few people who experience an increase in their tax bill.

Jim: As an estate planning attorney, one of the most frequently-asked questions that I’m receiving from clients about the new tax law is whether it changes the client’s will or revocable trust. Some of these documents are written using a formula to transfer the portion of a client’s property that can pass free of federal estate tax or generation-skipping transfer (GST) tax. For example, a client’s will or revocable trust may distribute the portion of the client’s property that can pass free of federal estate tax to the client’s children and distribute the rest of the client’s property to a list of charitable organizations. Because the new tax law more than doubles the amount that can pass free of federal estate tax for tax year 2018 compared to tax year 2017, the new tax law may have changed your estate plan. While many distribution formulas in wills and revocable trusts will continue to operate under the new tax law exactly as they were intended before the law changed, it is important to work with your estate planning attorney to make sure that the changes do not negatively impact your estate plan, especially if your estate plan has not been updated in the past ten years.


What are new planning ideas you are sharing with clients?

Cory: The concept of grouping income or deductions into a given year will become very important. For example, assume a married couple has $10,000 in mortgage interest, is capped at $10,000 on their combined state income and real estate taxes, and donates $5,000 annually to charities. This produces $25,000 of overall deductions which would allow the couple to itemize each and every year; however, their total itemized deductions of $25,000 exceed the $24,000 standard deduction by only $1,000 each year. Instead of donating $5,000 each year, the taxpayers could donate $10,000 to charity on an every-other-year basis. In years in which they make no donations, the couple would use the $24,000 standard deduction. In the year in which they make the $10,000 donation, the couple would claim itemized deductions of $30,000 in this example. The overall effect over the two-year period is to increase tax deductions from $50,000 (two years of $25,000 each) to $54,000 (standard deduction of $24,000 plus itemized deductions of $30,000). Donor advised funds are a terrific vehicle to use for this purpose.

The same concept of grouping deductions may be useful for some business owners due to the new deduction for a portion of flow-through income. Business owners may be able to group deductions into certain years to avoid the phaseout of the deduction for a portion of qualified business income.

Jim: When I talk with clients about the new tax law, one point that I like to make is that many of the changes in the new tax law are temporary. The gift and estate tax law changes and many of the income tax law changes are in effect for tax years 2018 through 2025, then those laws revert back to the way they were before the new tax law. Congress and the President could change the tax laws again before 2026, and they also could make the recent tax law changes permanent. But, as the tax laws are written today, there’s an opportunity to make gifts as part of your estate plan before the laws change. It’s a use-it-or-lose-it situation. Under the new tax law, for 2018, an individual can make up to $11,180,000 (up from $5,490,000 in 2017) of cumulative taxable gifts without paying any federal gift taxes, and a married couple with proper planning can make up to $22,360,000 (up from $10,980,000) of cumulative taxable gifts without paying any federal gift taxes. In general, making a gift today saves transfer taxes on future income and appreciation that may otherwise occur in your taxable estate. Lifetime gifts have an additional benefit for Minnesota residents, because Minnesota has a state-level estate tax but no state-level gift tax. But, Minnesota’s estate tax does include gifts made within three years of death.


What surprised you about the new law?

Cory: I was surprised by elimination of certain expenses as itemized deductions. Investment management fees, employee business expenses, and tax preparation fees are no longer available as itemized deductions. Due to income limitations and their add-back for alternative minimum tax purposes, many taxpayers did not realize the full benefit of these expenses anyway; however, in my mind, each of those items is an expense incurred to produce or report income. The elimination of these deductions means taxpayers still claim the income but are not able to deduct the expenses incurred to produce the income. Theoretically, the tax impact of the lost deductions is offset by lower tax rates.


How will the new law impact charitable giving?

Cory: I believe that most taxpayers give to charity because of their own desire to do good or support organizations that assist others. That said, the tax incentive of charitable gifts under prior tax law was undeniable. With the higher standard deductions now in place, some taxpayers will realize either a reduced benefit or no benefit at all for their charitable giving. I believe charitable giving will be impacted in three ways. First, taxpayers will be more likely to group their donations and donate on a biennial basis to maximize their tax benefits. Second, the law change may impact one-time gifts to organizations without a strong connection to the donor. Tax savings is often a greater incentive for these gifts than for regular ongoing gifts to a favored organization or place of worship. Finally, the benefits of donor advised funds are now even greater than they were before. They allow the best of both worlds—grouping charitable giving into specific years to maximize tax savings while allowing the donor to distribute gifts to the actual charities over the donor’s preferred timeline.

Jim: I think that the new tax law will impact some but not all charitable giving decisions. The new tax law made no changes to the federal gift and estate tax charitable deductions—those are still unlimited. And, charitable gifts are still an itemized deduction for income tax purposes. But, it’s anticipated that significantly fewer individuals will be itemizing their income tax deductions in 2018 because the standard deduction is increased and several significant deductions are reduced or eliminated. I’m concerned about the future of medium sized charitable gifts—the recurring gifts that some families make at year end to their favorite charitable organizations, which are at least partially motivated by the income tax charitable deduction. Some taxpayers who itemized their deductions in prior tax years will find that the 2018 standard deduction exceeds the amount of their 2018 itemized deductions (including their charitable gifts), and, in that situation, their charitable gifts would not reduce their income taxes. But, I don’t think that the law changes will impact small charitable gifts, because those generally are motivated by benefitting the charitable organization rather than focusing on an income tax deduction. Large charitable gifts frequently are motivated by an income tax deduction in addition to significantly benefitting the charitable organization, and these still can be deducted under the new tax laws if the donor itemizes.


Is there anything else you’d like taxpayers to know?

Cory: The impact of federal tax reform on state income taxes will be very interesting. Most states, including Minnesota, base their taxes on federal taxable income. By eliminating certain deductions, tax reform increases taxpayers’ federal taxable income in many cases. On the federal side, a reduction in tax rates offsets the higher taxable income. If states use the new, higher federal taxable income as the starting point for state tax and do not make other changes in rates or deductions to compensate, taxpayers could experience an increase in their state tax liabilities. And the fact that the deduction for state taxes is now limited on the federal return only compounds the issue. Stay tuned. There will be many developments over the coming year as states and, frankly, the federal government determine the full impact of the tax bill’s provisions.


We would like to thank Cory and Jim for sharing their expertise and comments as part of this article. As illustrated here, we believe facilitating conversation with your team of advisors, including your attorney and accountant, is an essential part of a holistic planning process. We look forward to doing so as we enter 2018 under the new tax law.


Punch & Associates is not qualified to provide legal, accounting, or tax advice, and accordingly encourages clients and potential clients to consult their professional advisers with respect to such matters.   


The material shown is for informational purposes only. Past performance is not indicative of future performance, and all investments are subject to the risk of loss. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties, and actual results may differ materially from those anticipated in forward-looking statements. As a practical matter, no entity is able to accurately and consistently predict future market activities. While efforts are made to ensure information contained herein is accurate, Punch & Associates cannot guarantee the accuracy of all such information presented. Material contained in this publication should not be construed as accounting, legal, or tax advice.