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Briefly Noted

Are EPS Forecasts Too Optimistic?

Marc Goedhart of McKinsey & Company suggests that analysts might be too hopeful when making market forecasts. In a new report, he spared no punches by opining, “Analysts typically lag behind events in revising their forecasts to reflect new economic conditions.”

Goedhart and his colleagues estimate that over the past 25 years, analysts have forecast growth of 10% to 12% per year, while actual earnings only grew at a 6% pace. The margin of error was wider when economic growth slowed and narrower when economic growth accelerated. Notably, actual S&P 500 earnings coincided with forecasts in 1998, 1994–1997 and 2003–2006 (see the graph).

As mentioned in the June 10, 2010, AAII Investor Update e-mail newsletter, Goedhart’s research is notable because analysts were raising their forecasts for full-year earnings. The consensus estimate projected 2010 S&P 500 earnings at $81.29 per share at the time. This represented a 4% upward revision from the average forecast of three months prior.

The positive revisions held this spring despite worries about the European debt crisis and potentially slower economic growth in the United States. In fact, as the market corrected in May and early June, analysts remained optimistic about full-year earnings.

This does not necessarily mean that analysts are overly optimistic now, but it should reinforce the importance of allotting for a margin of error when making a buying decision. In other words, when looking at profit projections for a security, question whether the valuation would still be attractive if the forecast proves to be too high.

Sources: McKinsey & Company (exhibit from “Equity Analysts: Still Too Bullish,” April 2010, McKinsey Quarterly, www.mckinseyquarterly.com. Copyright © 2010 McKinsey & Company. All rights reserved. Reprinted by permission.); AAII Investor Update.

 

 

 

 

 

Fidelity to Stop Offering Class B Shares

Fidelity plans to discontinue Class B mutual fund shares, according to recent regulatory filings. Though Fidelity is not the first company to cease offering Class B shares, industry observers believe the announcement could speed up the demise of this share class. (American Funds, Pimco, Allianz and American Century have all previously stopped offering Class B shares.)

Class B shares carry a back-end load, meaning investors are charged a percentage fee when the fund is sold. The amount of the fee declines over the course of several years. In addition, Class B shares charge annual fees.

Class B shares are typically sold through advisors and comprise a very small percentage of all mutual fund shares sold. A shift to fee-based accounts and a preference by advisors for load-waived A and no-load share classes have lessened demand for Class B shares. In addition, the manner in which commissions are paid creates a liability for fund families. Commissions are typically paid to the advisor at the time Class B shares are bought, while the fund family does not collect the load until the shares are sold.

Regardless of whether it is a front-end load (charged at the time of purchase), annual or back-end load, these fees reduce an investor’s realized return. As a result, both the type and the level of fees must be examined and monitored. Performance should also be taken into account: The bottom line in any investment is how it performs for you, the investor, and that performance includes consideration of all loads, fees, and expenses.

AAII provides several resources for mutual fund investors, including the “Guide to the Top Mutual Funds” and the Model Mutual Fund Portfolio. The annual guide, published in February, provides detailed data—including loads and expenses—on over 700 funds. (The online version of the guide covers more than 1,400 funds.) The Model Mutual Fund Portfolio provides an example of how to build a diversified portfolio using mutual funds. Both are complimentary with your AAII membership; go to www.aaii.com for access.

Source: Ignites.com.

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New Rules for Target Date Funds

Target date mutual funds will have to more be explicit about their allocation strategies. These funds are designed to invest in a mix of stocks and bonds that becomes more conservative and income-oriented as your retirement date (the “target”) approaches. Last month, the SEC proposed rule amendments intended to better clarify what the date in a fund’s name means to an investor’s portfolio.

The proposed rules are noteworthy because even target funds with the same maturity date vary differently in terms of the allocation strategies they use, the manner in which allocations change (abruptly or gradually), and the length of time between the target date and the year in which the allocation strategy becomes final. The net result is that performance of target date funds varies greatly.

If the rules are enacted, mutual fund companies would have to be more explicit about the funds’ allocation strategies and the types of investments used to achieve those allocations (e.g., stocks, bonds, cash, etc.). This information would need to appear the first time the fund’s name is mentioned, instead of being placed deep within the prospectus.

Two other changes would also be required. First, a graphic, such as a chart, depicting the fund’s allocation strategy throughout the life of the fund will need to be included in marketing materials. Second, the fund would be required to explain what the final allocation strategy is and the length of time between the target date and when the final allocation is achieved.

The objective of these proposals is to help investors better understand what they are investing in and how the allocations change over time. As the articles starting on pages 7 and 10 in this issue discuss, whether an allocation strategy changes abruptly on a certain date or gradually over time can influence an investor’s wealth.

Though AAII supports greater transparency, we still believe it is important to read the prospectus before investing in any mutual fund. The proposed rules may bring more clarity, but they are no substitute for the information contained in the prospectus.

Source: SEC.gov.

Uncertain Dividend and Capital Gains Taxes

Several AAII members have asked about what is going to happen to the tax code next year. The Bush tax cuts are expiring this year, creating the possibility that taxes on capital gains, dividends and estates will revert back to circa–2002 levels. This means tax rates could be as high as 39.6% in 2011. (The 2009 AAII Tax Guide, published last December and available at AAII.com, has a helpful table that compares and contrasts the tax rates for 2009, 2010 and 2011.)

As of press time, no progress has been made on the expiring tax breaks. This is mostly because Congress has been preoccupied with other matters. Health care reform, financial reform, the economy, Supreme Court nominee Elena Kagan and British Petroleum’s (BP) oil spill have all taken precedence. Plus, there has been no public outcry. Brian Mattes, principal and director of government relations at Vanguard, says members of Congress are getting plenty of letters expressing concern about the size of the federal deficit, but no requests to take action on taxes.

None of this means Congress won’t act. Logic dictates that incumbents won’t want to defend a potential hike to a 39.6% tax rate during a hotly contested midterm election. On the other hand, President Obama’s deficit commission is scheduled to release its findings in December, setting the stage for a debate about taxes next year.

Mattes pointed out that the House has a limited time to act if it wants to hand off a bill to the Senate by the September session. So, it is possible that we could get some visibility on this issue later this summer. Then again, this is Washington we’re talking about.

Obviously, if you own high-dividend-yielding stocks and are in a high tax bracket, this is no small matter. The uncertainty is also problematic for those with unrealized capital gains or estate issues. While waiting to see what does or does not occur, you can lower your tax exposure by using a tax-deferred account to hold dividend-paying stocks, avoiding unnecessary trades and offsetting realized capital gains with realized losses.

Source: AAII Investor Update, June 17, 2010.


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