Who Watches the Watchman?

[Intelligent Income Daily]( Welcome to Intelligent Income Daily, the free newsletter from wealth and income expert Brad Thomas. In it, Brad and his team share the safest, most reliable ways to earn and grow your income in any market condition. You can find all past issues [here](. And if you have any questions, please contact Brad and his team [here](. Who Watches the Watchman? By Stephen Hester, Analyst, Wide Moat Research That phrase is 2,000 years old. In the original Latin, it reads: Quis custodiet ipsos custodes? It’s still with us… and for good reason. Consider the stock pundits on TV or your neighbor the part-time financial. Ever get the uneasy feeling they know less about the markets than you do? Well, you’re probably right. “But they are experts,” you say to reassure yourself. After all, the Securities and Exchange Commission (SEC) or some other authority must be paying attention to all of this… right? The entire SEC has 4,807 employees. Compare that to the 330,300 financial advisors in the U.S., according to the Bureau of Labor Statistics. Add another 16,000+ investment companies, which may have hundreds of employees each, and you get the picture. I haven’t mentioned investment banks, brokers/dealers, or other areas the regulators are theoretically monitoring. Maybe these dedicated bureaucrats work 24/7 and are extremely effective at their jobs. The truth is it doesn’t matter. The sooner you understand this, the better. It won’t just save you a lot of money. It’ll help you preserve the most important thing of all: time. The regulators aren’t checking what your financial advisor does on a daily basis. The talking heads on business channels have no liability if they steer you full speed in the wrong direction. A dishonest investment manager probably won’t get caught, and even if he does, there won’t be any money left over. How do I know this? Experience. My Past Job: Watching the Watchers For well over 10 years, I helped lead investment and operational due diligence at some of the largest brokers/dealers in the country. Hundreds of billions of client dollars were on our shoulders. Every type of deal you can imagine came across my desk. These brokers/dealers were responsible for thousands of financial advisors, and management knew to keep the foxes out of the henhouse. That’s why my team controlled what types of alternative or illiquid investments these advisors could pitch. We walked every inch of Wall Street to find the best opportunities for clients in private credit and equity, infrastructure, real estate, and just about anything else you can think of. You would be astounded at the types of things the less savvy advisors would like to recommend were it not for these safeguards. I’m not saying you should fire your financial advisor. But you should have at least a high-level understanding of what assets you own and why. Brad put it well in a recent issue: There are people in this world who will spend weeks researching a car before they buy it. And when they do finally buy, they know every inch of that vehicle. But ask that same person what holdings they have in their portfolio, and they can’t tell you. It happens more than you might think… I always found that a little odd. You might drive a car for several years. But for many, their investment portfolios are the cornerstone of their retirement plans. And they’re not the least bit curious what they hold? Today, I’m going to help you to take control. These four simple questions will help you decide if a stock or any other investment makes sense for your portfolio. It’s also a great test to see if your financial advisor knows if “Biopharma Medical Devices” or whatever else they recently started pitching is really worth your hard-earned dollars. Be Able to Answer These Four Questions - How does the business make money? Some businesses are sensitive to the broader economy. We call those cyclical companies. Others are closely tied to a single factor, like the real estate market or oil prices. From there, drill down to what they sell and who is the buyer. After that, it’s discovering parts of the business are key to their success (or failure). If I asked what Costco’s (COST) business model is, the average person would look at me funny. They’d say Costco sells a ton of groceries and almost every household item under the sun at the best prices in town. That’s how they make most of their money. Costco does sell over $200 billion in goods each year. But they are wrong. Over half of Costco’s profits come from its membership dues. About 80% of McDonald’s profits come from rental income on its $40 billion real estate portfolio. The real drivers of a business are not always obvious. - What can boost earnings? The stock market is an unforgiving battleground. If you’ve invested in stocks since at least 2008, you are nodding. It’s even more brutal for companies without growth prospects. The tech crash of recent years was a sobering reminder of that. One of my favorite asset classes is Business Development Companies (BDCs). Many BDCs are investment grade rated, and that allowed them to lock-in cheap long-term debt when interest rates were near zero in 2020 and 2021. When interest rates started moving higher in 2022, most income-oriented investments sold off. “Risk-free” U.S. Treasury bonds were among the worst performers. I was extremely confident BDCs would eventually trade higher and recommended several in my High-Yield Advisor service. Most BDCs make floating rate loans with borrowers. And I knew exactly which BDCs locked-in cheap debt at the right time. Higher interest rates meant an automatic and major boost in profits for these select BDCs. That’s exactly what happened. We’ve secured gains above 40% and most of the holdings are paying record dividends. Always make sure the growth story is not only convincing, but realistic. - Is the balance sheet healthy? If you’ve been around long enough, your portfolio eventually suffers three types of big losses: market corrections (e.g., everything in your brokerage account in 2009), bubbles popping (e.g., most tech in 2022), and liquidity problems (e.g., Bed Bath & Beyond in 2023). This also applies to the WeWorks, SVB Financials, Rite Aids, Tuesday Mornings, and Party Cities of the world. Did you know all those companies went bankrupt in 2023? A long list of companies has already gone under in 2024 including Red Lobster, Takeoff Technologies, Express, and Fisker Automotive. You can’t depend on “getting lucky” that your companies are well managed. Tons of otherwise good companies take on too much debt and end up in trouble. What can you do? Avoid any company with higher debt ratios than its peers. The company’s total liquidity is usually included in its SEC filings and investor reports. It should be plenty to cover any surprises and any near-term debt coming due. Lastly, check the company’s credit rating. While the full report isn’t usually publicly available, the major rating agencies will let you know the company’s score. Look for “long-term obligation” or “LT Credit Rating” since larger companies may have more than one type of credit rating. I’d stick with investment grade rated (BBB- and above) companies. If you do decide to swim in “junk” territory, pay especially close attention to the first two topics we discussed. - Price is what you pay, value is what you get. Does it have value? Warren Buffet made this line famous, but it’s not reserved for Berkshire Hathaway. As an investor, nothing is more important than getting a fair deal. And you can’t do that if you don’t understand valuation. The cornerstone is the price-to-earnings (P/E) ratio. And it applies to all businesses, not just stocks. Mary’s Coffee is for sale, and it’s your best friend’s favorite coffee shop in the world. He asks you what it’s worth and mentions his kids will learn a lot by paying for college themselves. You do some research and find out that coffee shops in your area sell for 2-3x annual profits. Mary’s Coffee earned $50,000 last year. With this simple calculation, we know $100,000-$150,000 is a reasonable price range. That’s a P/E ratio of 2-3. Since Mary’s Coffee has grown profits more quickly than its peers, and there is a lot of new real estate development in the area, a price toward the top of the range wouldn’t be out of the question. How does the current P/E ratio compare to the past? What’s above versus peers? Does the company have an advantage that isn’t priced in yet? Every company’s stock price and past earnings are public information. That means the P/E ratio over time is always there. Price is what you pay. Value is what you get. Make sure you get a good one. Conclusion In the end, we are responsible for our own health, safety, and financial well-being. Using professionals like accountants and financial advisors can be a great help. Ultimately, however, we sign the tax return. And pay the IRS penalties. Your financial advisor seems like a nice guy, but his wife isn’t going to let you borrow his Mercedes (which you helped pay for) on the weekends if inflation eats a hole in your retirement. The good news is that the right knowledge goes a long way. Go into meetings with a handful of good questions like we discussed today. You may be surprised how quickly you can tell if they are really qualified. And save you an enormous amount of time in the process. Regards, Stephen Hester Analyst, Wide Moat Research [Wide Moat Research]( Wide Moat Research 1125 N Charles St, Baltimore, MD 21201 [www.widemoatresearch.com]( To ensure our emails continue reaching your inbox, please [add our email address]( to your address book. 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