The Investment Scientist

Tojas_eltort.jpgA few days ago, I was approached by an employee of Nvidia regarding his $5mm worth of NVDA stock. A Morgan Stanley broker had pitched him the idea of using exchange funds to diversify his holdings and he wanted my second opinion.

If you are an employee of any of those high flying tech companies like Amazon, Facebook, Google, Apple, Microsoft, Netflix, and etc., you are likely to have been pitched such an idea. Talk to me before you execute anything.

So what exactly are exchange funds? Exchange funds are unregistered private-placement limited partnerships or LLCs designed specially for investors with concentrated positions in highly appreciated stocks to help them diversify without triggering taxes.

How do they work? Investors transfer shares of their concentrated stocks to the fund in exchange for an equal value of units of the fund. These transfers are not taxable since they are considered partnership capital contributions under the tax law. There are a few caveats to the law though: investors have to stay in the fund for a minimum of seven years and the fund must invest 20% of its capital in illiquid assets.

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In my last newsletter I discussed the profitability premium.  It, along with the small cap premium and value premium, form the three established directions whereby investors can improve their expected returns on their stock investments.

To be more specific, to improve expected returns, an investor should tilt their portfolio towards profitable companies, small cap stocks and value stocks.

However, one must keep in mind that return premiums are not certainties. There will be periods, sometimes rather extended periods,  during which:

  • Small cap stocks underperform large cap stocks
  • Value stock underperform growth stocks and
  • Profitable stocks underperform unprofitable stocks

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Ever since Fama and French published their seminal paper “The Cross-Section of Expected Stock Returns” in 1992, the world (at least the academic world) has come to understand that over the long run, small cap stocks outperform large cap stocks and value stocks outperform growth stocks.

This quest to understand stock returns has not stopped. In 2013, Robert Novy-Marx published “The Other Side of Value: The Gross Profitability Premium” in the Journal of Financial Economics. In the course of this research, he discovered that profitability, measured by gross profits-to-assets, has roughly the same power as book-to-market in predicting the cross-section of average returns. Profitable firms generate significantly higher returns than unprofitable firms, despite having higher valuation ratios.

Almost concurrently, other researchers confirmed Novy-Marx’ discovery, notably Fama and French’s new paper “A Five Factor Asset Pricing Model” and Hou, Xue and Zhang’s “Digesting Anomalies: An Investment Approach.” Both papers were published in 2015.

Unlike the small cap premium and value premium, the profitability premium does not have a satisfactory risk-based explanation.

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Early on the morning of May 13, President Trump tweeted:

“President Xi of China, and I, are working together to give massive Chinese phone company, ZTE, a way to get back into business, fast. Too many jobs in China lost. Commerce Department has been instructed to get it done!”

What?!?!?! Trump wants to save Chinese jobs? To say that I am caught by surprise is an understatement.

Let me give you a little background just in case you don’t pay attention to the news (God Bless You!)

When ZTE was caught selling telecom equipment to Iran and North Korea in 2016, they entered into a plea agreement with the US commerce department (Obama administration) that included the following stipulations:

  1. They will pay a $1.19 billion fine, the largest fine ever paid by a company.
  2. They will fire the four executives involved.
  3. They will discipline the 35 employees involved.

Fast forward to May 2018, just before the US trade delegation headed over to Beijing for negotiations, the US commerce department announced a 7-year ban on component exports to ZTE because they did not carry out the third stipulation of the plea agreement. It turns out the 35 employees were not disciplined, they were given their 2016 year-end bonus!

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The following is the content of my June 2012 newsletter. It’s still very relevant today.

As I am writing this, the markets are falling like a rock. The Dow has entered negative territory for the first time this year; Nasdaq, which was up 20% a mere two months ago, is up only 5% for the year. The S&P 500 has lost close to 10% of its value since its April 1 peak.

I wrote the above paragraph using typical financial press lingo. This type of language has the tendency to cause amygdala hijack.

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The amygdala is a part of our brain that processes threats. When we perceive a threat, the amygdala takes over the whole brain. fMRI scans show that blood supplies are Read the rest of this entry »

 

trade-deficit.jpgIn 1971, Nixon ended the gold standard and since then the US has been consistently running a trade deficit. The US has not gotten poorer but instead has benefited tremendously from trade deficits.

Prior to that time, foreign holders of dollars could  redeem the money in gold and ship it out of the country, resulting in the loss of national wealth. That’s why prior to 1971, the US generally had a trade surplus.

After the ending of the gold standard, the US dollar became a fiat money that can theoretically be printed at will. When the trade deficit with China was $350 billion last year, what it actually meant was that China sent us $350 billion worth of goods, and we gave them our printed paper(fiat money dollar) in exchange. The USA is the only country that can do that because the dollar is the world currency! I suspect China is secretly envious of our position. Read the rest of this entry »

trade war .jpgLet’s start with some basic facts. As of 2017, the US imports goods worth about $550 billion from China, while only exporting about $175 billion to China. The trade imbalance is about $375 billion in China’s favor. President Trump believes China is making off with $375 billion of the US’s money every year and he is out to stop that. He announced tariffs on $60 billion worth of Chinese goods yesterday, mostly targeting high-tech imports from China.

The biggest high-tech import item from China is … round of applause …the iPhone, totalling about $70 billion a year since China is the final assembly place of all iPhones using parts from Japan, Korea, Taiwan, the US and China.

If an iPhone sells for $1000 in the US, it is counted as $1000 worth of Chinese imports, but 60% of all its economic value is captured by Apple. China probably captures less than 10% of the economic value. The rest is shared primarily by Japan, Korea, Taiwan. A tariff on the iPhone will harm Apple more than China, and also hurt Japan, Korea and Taiwan along the way.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



You may also get his monthly newsletter, or join his Facebook page for regular wealth management insights. Michael's email is info[at]mzcap.com.

Twitter: @mzhuang

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