December 2018 Retirement Revival

Stock of the Month: The Mosaic Co. (MOS)

  • MOS Current Price: $29.21
    • Ideal Buying Range: $27 – $31
    • Once you own the stock, set a stop loss 25% below your purchase price. As long as the stock increases in price, continue to trail your stop 25% below the stock’s current price; do NOT adjust your stop loss lower if the stock drops in value.

it seems like the global market has been waiting for the last couple of days for the next shoe to drop in the U.S. The Christmas holiday meant that U.S. markets closed early, and remained closed for Christmas Day itself as always, but that didn’t stop markets in Asia from their regular activity, and most seemed to operate on shaky, nervous ground. Always ready with a controversial, nerve-wracking sound bite, the Trump administration used the Christmas break to suggest the federal government’s shutdown will continue until Democrats get on board with his border wall plans, as well as to intensify speculation (since mostly dismissed) that the President is looking for a way to get rid of Fed chairman Jerome Powell.

It’s interesting to see how politics often intrude their way into the psyche of the financial markets. I’ve often written about how much the markets abhor uncertainty and change, and for all of President Trump’s bluster and blow about implementing business and market-friendly policies, the truth is that his willingness to draw a hard line and to embrace conflict – in trade abroad with the country’s largest global partners, as well as here at home on domestic issues with anybody that disagrees with him, including members of his own Republican party – has kept the market on edge all year long. No matter whether he is proven correct or misguided in the long run, the effect for now is that the market is finally submitting to that uncertainty and the fear of the unknown that it engenders.

If you look across the market, every single sector has declined significantly in the last three months. Some are harder hit than others, but even supposed defensive sectors like Utilities and Consumer Staples are down somewhere between 10% and 15% over the last month of so as the market appears to be capitulating to an increasingly bearish tone. Don’t be surprised if the pressure continues at least through the end of the year – it looks like more and more investors are starting the inevitable “flight to quality” that so often marks the end of a long-term bull market and the beginning of a brand new bearish trend.

Bearish pressure is putting almost all stocks under a lot of pressure, and driving them near to lows not seen in a year or more right now. The Mosaic Company (MOS) is a company in the Materials sector with a solid fundamental profile, but as a fertilizer and animal feed producer, it operates in a highly cyclical industry of the Materials sector. The extended health of the economy in general suggests that despite the stock market’s current woes, MOS’ cost of goods is higher than normal; whether that is a sign the company’s fortunes are about to reverse remains to be seen. Most analysts are forecasting healthy growth figures for the industry in general, and for MOS specifically right now, but if current political pressures continue, they could put even more pressure on the broader economy.

Is the stock a good value right now, given the fact that it is down about 26% in just the last month and is down around levels right now that it hasn’t seen since the beginning of this year? If the market continues to drop as most seem to expect right now, it seems unlikely the stock is going to rebound quickly; but it is reaching some interesting price levels right now that I think at least make it worth keeping on a watchlist. I’m not sure I would call it a bargain just yet, but it also isn’t very far from a “nice price” based on most of the measurements I like to use for bargain hunting.

Fundamental and Value Profile

The Mosaic Company is a producer and marketer of concentrated phosphate and potash crop nutrients. The Company operates through three segments: Phosphates, Potash and International Distribution. The Company is a supplier of phosphate- and potash-based crop nutrients and animal feed ingredients. The Phosphates segment owns and operates mines and production facilities in Florida, which produce concentrated phosphate crop nutrients and phosphate-based animal feed ingredients, and processing plants in Louisiana, which produce concentrated phosphate crop nutrients. The Potash segment mines and processes potash in Canada and the United States, and sells potash in North America and internationally. The International Distribution segment markets phosphate-, potash- and nitrogen-based crop nutrients and animal feed ingredients, and provides other ancillary services to wholesalers, cooperatives, independent retailers and farmers in South America and the Asia-Pacific regions. MOS has a current market cap of about $10.7 billion.

  • Dividend Yield: MOS’s annual divided is minimal, at only $.10 per share; that translates to a yield of just .36% at the stock’s current price.
  • Debt/Equity: MOS has a debt/equity ratio of .42. This is a conservative number. MOS currently has a little over $1 billion in cash and liquid assets against about $4.5 billion in long-term debt. The company’s balance sheet indicates their operating profits are more than adequate to service the debt they have.
  • Earnings/Revenue Growth: Over the last twelve months, earnings increased more than 74%, while revenues increased about 47.5%. These numbers were also impressive in the last quarter; earnings improved 87.5%, which sales increased almost 33%. The company’s margin profile shows that Net Income as a percentage of Revenues improved from a .08% over the last twelve months to 8.4% in the last quarter.
  • Free Cash Flow: MOS’s free cash flow is attractive, at $1 billion and translates to a healthy Free Cash Flow Yield of about 9.5%.
  • Return on Equity/Return on Assets: These numbers are lower than I prefer, but are really only the negative mark on an otherwise solid fundamental profile. ROE is 6.17, while ROA is 3.2.

Value Proposition for MOS

  • Current Price versus Historical Levels: MOS followed a solid upward trend from September of 2017 until this November, when it peaked around $37 per share. The stock has declined sharply from that point. It appears to forming a consolidation base right now with solid support around $27 and resistance around $30. A break above resistance, to around $30.50 should give the stock short-term room to rally to as high as about $33, while a subsequent break above that level would clear the way for the stock to test its all-time high at $37
  • P/E Ratio: MOS has a current P/E ratio of 17.28. This is slightly below the industry average, which is 18.8, but well below the stock’s 5-year average P/E ratio, which is 28.3.
  • Price/Book Value: MOS’s Book Value is is $27.64 and translates to a Price/Book ratio of 1.05 at the stock’s current price. Their historical average Price/Book ratio is 1.4, suggesting that the stock is currently trading at a discount of 24.5%.

Put Sale of the Month: CVS Health Corporation (CVS)

  • CVS Current Price: $65.52
  • Put Sale: Sell the January Week 3 (expires 1/18) 64 Put. Current Bid: $1.21
    • Yield on committed capital: 1.89%
    • This trade expires in 17 days.

Just a little less than a month ago, CVS completed a long-anticipated merger with Aetna Inc., creating an interesting combined pharmacy and healthcare insurer that I think has positioned itself at the front of a crowded field for the future of the healthcare industry. While CVS company has yet to provide any new financial data with which to analyze the combined company, it is still possible to complete enough analysis of both Aetna and CVS individually to offer up a reasonable conclusion. That means that most of the financial data that I’m going to cover is about the same as it was a month ago; but the stock’s big drop since the end of November is significant enough that I think it merits a long look at the company’s likely value proposition. Combining one of the largest pharmacy companies with a big player in the heath care provider industry offers the promise of a major shift in the way healthcare is offered and delivered in the United States; it certainly seems to put the combined company firmly at the forefront of a change that could leave the rest of both industries scrambling to catch up.

One of the interesting elements that I think it going to help this deal bear the fruit that most analysts, and certainly the company’s management expect to see is the fact that Aetna’s increasing exposure to Medicare Advantage plans, and the company’s ongoing plans to redesign customer’s in-store experience using the expansion of CVS’ existing MinuteClinics to include AET’s clinical capabilities. Those “concept clinics” are expected to start rolling in early 2019, which means investors generally should have almost immediate feedback to work with in trying to analyze the likely success of the merger. What I want to do with today’s post is to consider what folding AET into CVS’s business structure is going to mean from a fundamental point of view, and from there to try to determine if the resulting company is likely to offer a compelling value to work with.

Fundamental Profile for CVS

CVS Health Corporation, together with its subsidiaries, is an integrated pharmacy healthcare company. The Company provides pharmacy care for the senior community through Omnicare, Inc. (Omnicare) and Omnicare’s long-term care (LTC) operations, which include distribution of pharmaceuticals, related pharmacy consulting and other ancillary services to chronic care facilities and other care settings. It operates through three segments: Pharmacy Services, Retail/LTC and Corporate. The Pharmacy Services Segment provides a range of pharmacy benefit management (PBM) solutions to its clients. As of December 31, 2016, the Retail/LTC Segment included 9,709 retail locations (of which 7,980 were its stores that operated a pharmacy and 1,674 were its pharmacies located within Target Corporation (Target) stores), its online retail pharmacy Websites,, and, 38 onsite pharmacy stores, its long-term care pharmacy operations and its retail healthcare clinics. CVS has a market cap of $81 billion. Aetna Inc. is a diversified healthcare benefits company. The Company operates through three segments: Health Care, Group Insurance and Large Case Pensions. It offers a range of traditional, voluntary and consumer-directed health insurance products and related services, including medical, pharmacy, dental, behavioral health, group life and disability plans, medical management capabilities, Medicaid healthcare management services, Medicare Advantage and Medicare Supplement plans, workers’ compensation administrative services and health information technology (HIT) products and services. The Health Care segment consists of medical, pharmacy benefit management services, dental, behavioral health and vision plans offered on both an Insured basis and an employer-funded basis, and emerging businesses products and services. The Group Insurance segment includes group life insurance and group disability products. Its products are offered on an Insured basis. AET has a market cap of about $66.6 billion.

  • Dividend Yield: CVS pays an annual dividend of $2.00 per share. At the stock’s current price, that translates to an attractive dividend yield of 3.05%. This is nicely above the S&P 500 average of about 1.95%.
  • Debt/Equity: CVS has a debt/equity ratio of 1.66. This is higher than I usually prefer to see, but is primarily attributable to the massive increase in debt the company preemptively took on at the beginning of the year when the merger was first announced. Total long-term debt is $60.7 billion for CVS. AET has $7.7 billion in long-term debt, which is almost $2 billion less than their cash. CVS has also laid out an aggressive debt reduction program that they expect to lower the total debt the combined company will be working with to much more conservative levels early in 2020.
  • Earnings/Revenue Growth: Over the last twelve months, earnings for CVS increased by about 15%, while sales were mostly flat, increasing about 2%. For AET, earnings increased about 20% in the last year. CVS operates with extremely narrow operating margins, as Net Income was only 1.6% of Revenues for the last twelve months and 2.9% in the last quarter. AET has a wider margin profile, with Net Income that was 5.9% over the last year and 6.4% in the most recent quarter. Look for the combined company’s operating margins to fall somewhere in between those two extremes.
  • Free Cash Flow: CVS’s free cash flow is healthy, at about $4.3 billion, while AET’s is more modest, and about $550 million. Both companies have good liquidity, with cash and liquids assets for CVS that totaled $41.6 billion in the most recent quarter, and $9.5 billion for AET over the same period.
  • Return on Equity/Return on Assets: ROE is healthy, at 18.69, while ROA is solid, at 5.61.

Value Proposition for CVS

  • Current Price versus Historical Levels: Immediately after the Christmas holiday, CVS followed the rest of the stock market to move sharply higher to set up what looks like a strong pivot low near to its 52-week low prices. Assuming the market follows through on today’s surge over the next few weeks, the stock looks to have interesting short-term upside with the nearest likely resistance somewhere between $69 and $71 per share. The apparent bounce at support isn’t a foregone conclusion, however, and you shouldn’t ignore the possibility the stock could push back down again and break below support around $60 to establish new 52-week lows. If that happens, it would also push the stock down to levels it hasn’t seen a little over five years (not shown on this chart), with the mostly support levels around $52 per share.
  • P/E Ratio: CVS has a current P/E ratio of 9.23. This is far below the industry average, which is 19.7, and the stock’s 5-year average P/E ratio, which is 19.9.
  • Price/Book Value: CVS carries a Book Value of $35.97, which translates to a Price/Book ratio of 1.81. The stock’s historical average is 2.48, which suggests the stock is now a little more than 27% undervalued. There is an even more more compelling argument to be made for the stock on a Price/Cash Flow basis, since the stock is currently trading more than 42% below that historical average. Just before the merger was completed, AET was overvalued based on both its Price/Book and Price/Cash Flow ratios by anywhere from 5% (slightly overvalued) to 50% (very overvalued). If you factor those two elements together, the stock’s drop in price might not scream “bargain basement value,” but I do think if you consider the way the combined company has positioned itself for the years ahead, the stock’s current price looks much more interesting today than it did after Thanksgiving.

As always, remember that by selling this put, I am saying that I would be happy to buy this stock at $64 per share. Based on the value information above, I think this is a very good price for a stock with solid fundamentals behind it. If the stock is below $64 at expiration, I will accept the assignment for those shares. If you don’t want to deal with a potential assignment from a put sale, you shouldn’t make this trade.

Update on Currently Open Positions, Put Sales

Here’s a quick look at the stocks we’ve highlighted over the last several months and still held positions in as of last month’s issue.

*Note that our position on ADM came from a put sale assignment. We sold a put option on ADM in November 2015 that was assigned on December 11th 2015. The KR position came from a put sale assignment in October 2018.

The table below applies to the put selling trades we’ve listed over the last six months.

Capitulation vs. Consolidation – both are important, but ignore capitulation at your own risk

Market analysts and technicians like to use a lot of different terms to describe market conditions, patterns and trends. Using these terms around casual investors will usually leave them impressed with the sophistication of your market vocabulary, but without a really clear idea of what anything you just said really means. They’ll probably nod and pretend to understand or even agree with you, but later privately wonder, “what the heck was all of that?” For others who aren’t really interested in the market at all – my wife fits into this particular group – tossing these terms into a conversation will make their eyes glaze over just before they fall asleep.

The terms I tossed into this section’s headline are good examples of what I’m talking about. If you’re an active investor, and you’ve invested time and energy into studying the markets in much detail, you’ve certainly across these terms before, because they are actually very descriptive of a couple of a very specific market conditions, each of which carry their own implications, opportunities and risks. 

Since February of this year, the market revisited 52-week lows around the 2,600 level for the S&P 500 on multiple occasions, only to bounce and move higher again. The market’s muted upside for the year created a limited range from those pivot lows to the next resistance point, and that is what defines consolidation. Consolidation ranges are useful within longer trends, because they provide the market with time to reevaluate the strength and health of that trend before taking the next step. If you’re paying attention to those levels, and to the distance between the top and bottom end of that range, you can identify near-term trading opportunities.

Breaks out of consolidation ranges can be interpreted in pretty straightforward terms. Breaks above the top end of a consolidation are almost always a bullish indication, while breaks below the lower end of the consolidation are almost always bearish. Consolidation ranges also tend to become more useful at the extreme end of a long-term trend; at the end of the last bear market in 2009, for example, it was a break above a consolidation range from late 2008 until the end of the first quarter of that year that marked the beginning of our latest bull market. In fact, that bullish break out of a consolidation range helps to provide the context that I want to apply to the market’s current conditions.

This chart covers the last three years of market activity, because I want to try to put the market’s movement since the end of September in the most complete context possible. The horizontal green line on the chart shows the support level the market had been using repeatedly throughout the year to stabilize and look for new reasons to move higher. You may recall that I’ve referred to using 2,600 on the SPX as an important signal level, because those support bounces were pretty obvious to see. The last few days have finally seen the market break below that level – and that is where the term capitulation starts to come into play.

A break below a consolidation range isn’t automatically considered capitulation, but it certainly can be, and in this case I think it clearly is. The reason I believe that is both technical and emotional. Technically speaking, the fact that the market has followed the initial drop below the 2,600 level with multiple days of continued downward pressure is significant. It’s the kind of follow-through that most technical traders usually look for as confirmation a breakout (or breakdown) has actually occurred.

The emotional reasons I’m calling this capitulation center around the way market commentary and focus seems to be shifting. Instead of trying to look for positives to keep things stabilized, or moving higher, I’m starting to see a lot more conversation, analysis and speculation about how bad things could actually get. The market is starting to look for reasons to stay bearish, and in my experience is something that can often create a self-fulfilling prophecy; investors are afraid the market is going to keep going down, so they start selling more and more, which means that the market has to keep going down. 

The Fed earlier this month raised interest rates for the fourth time this year, as expected; but they also seemed to try to use a more accommodative tone about the economy, suggesting that rate hikes in 2019 could be fewer depending on new economic data at that time. The market’s reaction was to shrug any hint of silver lining in the news and keep selling. The continued, partial government shutdown has only added to the angst throughout the month, and not long ago news broke that the U.S. and the U.K. are combining forces to accuse and charge China of waging a sustained campaign of focused cyber theft of commercial intellectual property. The monster looks like it could be starting to consume itself.

The market still isn’t in bear market territory; as of this writing it is still only down about 16% from its October high point. And there are a few technical levels ahead that could act as new support based on previous pivots if the market can find some bullish headwinds; 2,400 isn’t far away, and that looks like it could provide a solid support point. Considering some of the emotional, buzz-worthy news items that are hitting the markets right now, however, it looks like we might not see another viable level for any kind of consolidation or stabilization until somewhere between 2,000 and 2,100. That puts a real bear market in clear view right now.

What does that mean for taking on new positions, or seeing new trades in Retirement Revival? I’m still not afraid to initiate a new trade, even under these conditions, if I think the value proposition in the stock I’m working with justifies it; however I am going to keep my position sizing rules very conservative. The same right I’ve reserved for several months now, to suspend new trades at any point, or to skip on a trade during any given month remains in force. It’s smarter right now to be cautious, and to wait for a great opportunity to come your way than it is to try to keep making new trades.

Passive vs. Active Investing and Retirement Revival

In February 2017, Warren Buffet – otherwise know as the Sage of Wall Street – made some waves with his annual letter to Berkshire Hathaway shareholders. This letter has become quite famous, and is widely anticipated each year, in part because Mr. Buffett has never hesitated to share his investment method and philosophy, along with his evaluation of current economic and market conditions, with anybody who cares to take the time to read. This year’s letter caused a stir because he used it as an opportunity to expound on his beliefs about “active” versus “passive” investing. I think that if you’re interested in understanding what Mr. Buffett is driving at, you need to first know he means by “active” investing and “passive” investing. I’m also going to add some of my own opinions on the matter to the discussion, because if you claim to be a follower (as I am) of the value-oriented investing style that Mr. Buffett has made famous, you also need to know where it fits into this conversation.

Active Investing: Hedge Funds and Mutual Funds

When he refers to “active” investing, Mr. Buffett is generally referring specifically to hedge funds. Interestingly, he doesn’t necessarily say that the investing methods many of these funds use is bad or flawed; he mostly takes issue with the high fees these types of funds invariably charge. Not only do these funds charge an annual management fee (usually about 2% of the funds assets per year) regardless of the fund’s actual performance, during positive years they may also capture as much as 20% of the fund’s trading profits, as well as additional costs and fees (that were also not dependent on the fund’s performance in any given year). I am officially in the same camp with Mr. Buffett when it comes to these kinds of funds: I believe their only real purpose is to enrich the lives of their managers, not the clients who entrust their hard-earned dollars to them.

I am also inclined to lump most mutual funds into this same “active” category. Mutual funds generally don’t charge the same kind of exorbitant fees that hedge funds do; but in almost every case the fee structure they do impose is just as immune to the fund’s actual performance versus the broad market as a hedge funds. The biggest difference between the two, besides a hedge fund’s generally higher fees, is that hedge funds generally require high initial investment amounts, and so are really only available to those with large sums of money to invest, while mutual funds have more affordable initial deposit requirements and so are available to just about anybody who is looking for a way to start investing in the stock market no matter how much or how little money they have. I lump both types into the “active” investing category because most they both (index funds aside, which I will talk about later) buy and sell stocks quite frequently as they try to reposition their portfolios over time to take advantage of a fund manager’s analysis of current market conditions.

More than two decades ago, I worked at one of the largest mutual fund and discount brokerage firms in the U.S. Being thoroughly indoctrinated in their culture, I quickly learned how they wanted me to explain the myriad of fees associated with their funds to prospective and future customers. Most of our funds were front-loaded, meaning that every time you bought shares in the fund, about 3% of your money was deducted before the shares were purchased. I learned to explain it by contrasting it against other competing funds that charged higher fees on the front end or on the back end, when you decided to sell your shares and take money out. For the really detail-oriented people who combed over every part of a fund’s prospectus and wanted to know about the fund’s administrative and management fees (non-negotiable, of course, since the fund manager, his or her research team, and the trading desk all had to take their share), I did the same thing, pointing to other competing funds that carried higher fees. If somebody wanted to talk about “no-load” funds, which meant there were no front-end or back-end charges for new purchases or redemptions, I’d usually point to the fact most of those funds had higher administrative and management fees.

I wasn’t just talking the talk; I was also enthusiastically putting my own retirement savings into many of the same funds I encouraged clients to consider. I kept doing that even after I decided to leave the industry because I thought that it made a lot more sense to have a professional fund manager handling my investment dollars so I wouldn’t have to worry about it, since I needed to focus on other things. When the tech company I had left the brokerage to work for held benefits meetings, I encouraged my colleagues to direct as much of their retirement accounts as they could into many of the same funds I had promoted before and which were staples of most retirement plans at the time. I strongly believed that actively managed mutual funds were the best alternative for most average investors because fund managers are generally incentivized to post returns that beat the S&P 500.

Through most of the 1990’s, mutual fund investing was a very smart way to make money. The dot-com boom was propelling the market to record highs, and the more the Internet and the World Wide Web grew, the more it seemed like there was no limit to how high the market could go. Of course, that wasn’t true; the dot-com boom went bust in a big way, and like most mutual fund investors, I watched with dismay as my retirement savings evaporated from one month to the next before my eyes.

I didn’t just sit on the sidelines; like a lot of people I called my mutual funds to evaluate my options. Every time I did, I was confronted with the same mantra I had used (giving me a totally unwanted appreciation for being hoisted by my own petard): “It’s a long-term investment. You have to be willing to ride it through down markets, because in the long run it will come back.” I went along with it for just about all of the bear market that lasted from March 2000 to September 2002. 

One of the things that finally convinced me that keeping my investing focus on mutual funds was really just a fool’s errand, and that I should start to take matters into my own hands was looking not only at my account balances but also performance and costs of my funds. I realized that even though my funds had performed in even worse fashion than the broad market (which most actively managed funds will tend to do during a bear market), the fund had continued to take their administrative and management fees out each year, along with any front or back-end loads that applied. That wasn’t news for me, but the truth is that when I worked in the industry I hadn’t been confronted with the reality that the fund manager wasn’t really as incentivized as I thought to outperform the broad market, or to try to protect my money when things went sour; they’ll still get paid regardless of what kind of performance they actually achieve.

The amount of money a mutual fund manager gets paid is pretty startling. It isn’t easy to determine, because most funds don’t want to disclose a manager’s full compensation structure; but a pretty standard starting point for most manager salaries, which you can estimate from the fund’s management fees, which are disclosed (but don’t include performance bonuses) is .5  to 1% of the fund’s total assets under management. For example, assume that Fidelity’s Contrafund, a large cap growth fund, has about $108 billion in assets under management. Their expense ratio (the term for management fee) is .53% of assets under management per year, which in Contrafund’s case means more than $572 million per annum are paid to manage the fund. Fidelity doesn’t disclose what portion of that amount is paid directly to the fund manager, but let’s try to be conservative and say that the number is 5% of the total management fee. That’s more than $28 million in base salary alone – it says nothing about additional performance incentives Fidelity may pay out if the fund meets or exceeds its performance benchmarks. That’s more money than most CEO’s and even many of the top professional athletes in the world make! And if you think that I’m overestimating just to make the picture look bad, check out this article from Reuters on the subject from a couple of years ago. Now think about the fact the manager is going to draw that salary no matter whether the fund performs well, or poorly, or whether you make or lose money from one year to the next. How does that make you feel? In my case, the more I thought about it, the madder I got.

To be clear, I don’t mind seeing a manager being handsomely rewarded when he does well; if his shareholders are making money, I have no problem with letting him have a reasonable portion of the pie. But when the fund underperforms one of the core benchmarks (the S&P 500), or even worse, loses money, I have a big problem with seeing him continue to draw the same big payouts year after year. This is one of the biggest criticisms I have about mutual funds in general and it’s the principal reason I lump them in to the same distasteful category Mr. Buffett uses for hedge funds. It makes even more sense to me when you consider the returns for both of these types of funds from year to year over time; their performance is generally inconsistent at best and unreliable at worst. I see both as different versions of the same scam.

Passive Investing: Index Funds

When you hear comparisons of “passive” investing to “active” investing, you’re almost always looking at hedge funds or actively managed mutual funds versus index mutual funds. That’s because index funds are perhaps the most straightforward type of fund you can buy. They are tied to an index, like the S&P 500, with the simple purpose of matching that index’ performance from one year to the next. They are considered “passive” because unlike actively managed funds, the only time they sell a stock position or buy a new one is when the index makes a change to the basket of stocks it uses in its core calculation. There is no attempt to time a trade based on a stock’s current trend, to evaluate the stock’s value proposition, or even to preserve capital when the market reverses to the downside. Where the index goes, the index fund goes as well.

In his latest letter, Mr. Buffett sang the praises of passive investing as the most effective tool for individual, retail investors, and pointed to the performance of the S&P 500 over the last several years as evidence. Up to a point, I agree with Mr. Buffett on the idea that if you don’t want to take the time to follow the markets, or learn to identify, analyze, and manage your own positions, then index investing is the most likely way you’ll be able to make money over time. Index funds also have the added benefit of being extremely cost-efficient for their shareholders; instead of the myriad of loads, fees, and expenses a hedge fund or actively managed mutual fund will have, an index fund will only charge enough to cover its expense ratio; for the Vanguard 500 Index Investor Class fund, for example, the expense ratio is .16% – less than a third of what shareholders are paying for the Fidelity Contrafund. That’s far more reasonable, in my opinion, and is a good reason that if you prefer a passive investing approach, an index fund is preferable to actively managed hedge funds or mutual funds.

The problem that seems to get overlooked by most people who are such fans of index investing is the reality that it seems to get the most attention at market tops. The media starts talking more and more about how long the latest bull market has gone on and speculating about whether it will ever stop, and the companies that run these index funds jump all over that buzz and start crowing about how great their investments are. People start thinking that the stock market is really incredibly simple: just buy the index and let it ride. They ignore the reality that if you buy at the top of the market, you’ll have to endure a long ride to the bottom that could really take years to recover from. That doesn’t just require patience; it also requires the willingness to not bother checking behind the curtain to see what the wizard is really doing.

Here’s what I mean. At the height of the dot-com boom, when I was an enthusiastic (and blind) proponent of and investor in mutual funds, the S&P 500 reached its peak in August 2000 at a little over 1,500. If we use that peak as the jumping off point for the dot-com bust, it took the market more than two years to find a sustainable bottom it could use to start rebounding again; by the time it did, the index was just a little above 900. That meant that index fund investors had lost almost 44% of the value of their investing capital (while idiots like me in actively managed funds lost a lot more). If you still bought into the “it’s a long-term investment, you have to ride it out over time” idea, you would have been encouraged to watch the market rally for the next five years to its next peak in September of 2007. Here’s what the index looked like at that point on a chart covering the seven-plus years to that point:

As a dedicated, long-term index investor, don’t you feel so much better knowing that it only took you a little over seven years to see the market get back to where it was? No, wait, it’s even better – the index is actually about 2% higher than it was at its last peak at this point, so you’re actually profitable now – with an average annual return of less than half a percent per year for the last seven years! Isn’t that fantastic? Now suppose that, like many investors at the time, you bought into your index fund shortly before August of 2000, when the index was very near to that peak around 1,500. That means you’ve waited seven years to make 2%, total, on the money you committed to this investment. That is what “passive” investing got you; in the meantime, you had to be willing to wait and ride through an extended bear market that took more than two years to finally find a legitimate bottom.

Now let’s extend the conversation a little further, because after seeing this great 2% net return after seven years, you get to go through another bear market. Don’t worry, it won’t last as long this time; the market only took 19 months from September 2007 to April 2009 to run the length of its bearish course. The difference now, however is that the decline is even steeper: you’re going to watch 52% of your capital disappear like so much vapor over 19 months. Now you’re nine years into “riding it out over time,” and how do you feel about being down a net 51.2% since just before the dot-com bust in 2000? My next chart covers the S&P 500’s movement from April 2000 to today to help provide a more current context.

The index finally broke above the 1,500 level for real in April 2013, and its progress from that point was practically uninterrupted until this year. Does that mean the passive investor won out? Well, I guess – if you were able to exercise the patience to wait thirteen years to see the market finally get back above the peak you got in at at the beginning of the century. And while it probably looks nice overall to see that your net gain to this point is about 94% from entry to current value, it’s still important to remember that context is everything. 94% over almost 18 years (assuming you bought around the April 2000 top) only translates to an annualized gain of about 5.5% per year. The truth is that if you’re doing what most passive investors do, and continuing to buy when the market is at or near a major top, you’re creating a situation that is incredibly difficult to make money in. This is what Warren Buffett, John Bogle, and every other proponent of passive, index-based investing isn’t going to want you to know!

A Better Choice: Educated and Informed, Income-Based Value Investing

There is a better way; ironically it’s the same way that Warren Buffett invests his own money. I have to concede that even as Mr. Buffett was extolling the virtues of index investing, he also recognized that many investors could, if properly educated and motivated, consistently beat the market over long stretches of time. He seems to differentiate between average investors like you and me, however, and appears willing to simply relegate us to index fund doom. He contends, not incorrectly, that most people just don’t have the emotional or financial capacity to endure the amount of time or expense required to really figure out what you’re doing. What is required to differentiate yourself from the mass of average, ignorant investors is a different mindset about financial and market education.

Years ago as I was learning about shorter-term strategies like swing trading and trend investing, I read a book called High Probability Trading by Marcel Link. Mr. Link addressed this issue as well, and expanded my thinking about it by equating my learning process to paying college tuition. If you are going to be a doctor or a lawyer, for example, you’re going to spend many years – very possibly a decade or more – in school, studying and learning your craft. The schools that offer that kind of specialized education aren’t cheap, of course, and most of the professionals in those fields come out having had to pay not just tens of thousands, but instead hundreds of thousands of dollars in tuition costs. The combination of time and money is, of course an investment in the next twenty, thirty, or forty years they’ll spend carrying out the work they’ve learned and begun to master.

The same idea really does apply to investing; it isn’t something that you can really just jump into and expect to find immediate success at. Those who are successful have spent years studying what they’re doing; they’ve learned a variety of different methods and approaches, and through practice and experience, they start to figure out what works and what doesn’t. The time element isn’t the only correlation, though – these same investors will all tell you, without fail, that they gave away a lot of money in lost profits as a result of poor investing decisions along the way. The smart ones realize that lost money was their graduate school tuition in finance, because that is how they were able to acquire the experience that gave them the ability to determine what methods would work best in their cases so they could start to apply them in a disciplined, systematic way, again and again and again. The difficulty with the process Mr. Link outlined, and which Mr. Buffett is alluding to in his latest letter, is that most people have neither the time, patience, nor financial resources to endure this complete process.

I believe that the income generation, value-based system I’ve built Retirement Revival on is a reflection of my own graduate-level education about investing, economics and the markets. Over my twenty-plus years in the market, I’ve tried just about every kind of investing strategy there is – buy-and-hold, mutual funds, swing trading, trend investing, day trading with futures and forex, and so on. I’ve made and lost a lot of my own money on multiple occasions, and along the way, I’ve found that for my preferences, objectives, and personality, looking for value-based opportunities that I can generate income on by selling puts gives me the best balance between what I need from my investments and how much risk I’m willing to take for them. It’s also a good strategy no matter where the market is at, because there are always good companies that are priced at bargain levels if you’re willing to work hard to find them.

After reading Mr. Link’s book, I spent a lot of time trying to figure out how somebody, having determined what did work effectively for them, could help others shorten their learning curve, both in terms of the time they have to commit to the endeavor and how much capital they’re going to be willing to spend. I’m not interested in being a high fee-charging investment advisor or money manager, but I do like the idea of providing a useful service for a reasonable cost that enables, rather than inhibits success for the people that use it. That’s what Retirement Revival has always been designed to be.

At the Retirement Revival, the objective of each of our monthly newsletters is to give you information you can use right away to impact your lifestyle in a positive way. Our biggest focus, of course is on the financial markets and the opportunities that come from finding great bargains from among fundamentally solid, dividend-paying stocks. In that context, we provide a monthly profile of one stock that we think every retirement investor needs to own in their portfolio. We also highlight one additional stock – also from the same fundamentally strong, dividend-paying, and undervalued pool – that is currently providing a terrific opportunity to generate a useful income level. Beyond this, we’ll also include information on other issues that impact a productive and enjoyable retirement lifestyle like health, money management, and travel that we find useful at  the time.