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STA Weekly Report – Let’s Talk About Diversification

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Let’s Talk About Diversification
Weekly Technical Comment
Most Business Owners have No Succession Plan or Exit Strategy
Upcoming Event – Business Transitioning Wrestling a Deal to Close
401k Plan Manager

The stock market had much to digest this past week: the announcement of the new Fed chair; the monthly jobs report and a first glimpse of the new tax bill. In the end, large stocks like those of the S&P 500 Index rose almost 0.4% while the small stocks of the Russell 2000 Index fell nearly 0.9%.

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Overall the market yawned at the appointment of Jerome Powell as the successor for the Fed chair. In general, he is considered mostly a “dove” and is likely to stay with current chair, Janet Yellen’s plan for gradual moves on raising interest rates and Quantitative Tightening (QT). Of course, financial conditions can change and the markets will watch him closely for any actions and speeches he may make. For now, however, it is mostly a non-event.

The jobs report is always watched with keen interest as it is typically the first major report of the month. The latest report saw 261,000 jobs created (versus Wall Street expectations of 313,000) and the unemployment rate decline to 4.1% which is the lowest number since the end of 2000. Unfortunately, these types of employment numbers are often backward looking and give investors few clues about the future.

We also have to consider the tax bill. Coming out of the House, this is likely to be the most pro-growth approach we will see. There are a few things to like. The 20% corporate tax rate should, overall, be helpful and likely generate more revenue for the government. Other areas are disappointing. The pass-thru rate for small businesses is cut to 25%. Unfortunately, this only applies to approximately 30% of covered firms’ profits. The remainder is generally taxed at the owner’s personal income rate. Also, the top tax rate on individuals is not 39.6% as stated by many of the press releases. For those making around $1.2 million, due to clawbacks, the top rate would be 45.6%.

What of the future? We see disturbing signs of froth among investors. A University of Michigan survey shows the highest level of stock market bullishness since the survey started. Nor is it alone. According to Investors’ Intelligence, the spread between bullish and bearish institutions is the widest seen since 1987. Of course this over-optimism can become even more extreme, but it is clearly at levels suggesting caution rather than adventurism for most investors.

Presently our leading indicators, while still positive, have been deteriorating over recent weeks. Given our strategic concerns for stocks, this suggests the market may still advance in the near term but a correction, possibly a sizeable one, is on the horizon. Investors are advised to keep a tight rein on their equity levels and have a plan for managing risk.

Let’s talk about Diversification

Chances are you’ve heard the word “diversification” as it relates to investments for as long as you can remember. The reason is that diversification is a well-known risk management technique that is executed by mixing a variety of investments within a portfolio. The idea is that holding a portfolio of diversified investments should, on average, produce better returns and reduce risk when compared to a portfolio with a single investment.

Source: FPI Funds

In other words, proper diversification can provide a smoother ride as you invest along the ups and downs of the markets.

Unfortunately, it is difficult to determine whether a portfolio is properly diversified without the requisite framework and tools. As a result, we see a lot of investors err on the side of over-diversifying which can generate costs that often fly under the radar and hurt long-term results.

Source: STA Wealth Management

However, we also see a fair share of investors do the opposite, not diversifying sufficiently and putting their portfolios at risk of increased volatility and loss.

To avoid these potential pitfalls of over- or under-diversifying your portfolio you should be asking some of the following questions: Do I own several funds in a single investment style? Do the Exchange Traded Funds (ETFs) I own leave me unintentionally overexposed to a certain company? Do I own an excessive number of individual stocks? How are my holdings correlated?

Do I own several mutual funds in a single investment style?

Unfortunately, it is not enough to look at the name of a fund to determine what exposure it provides your portfolio. In fact, the way funds are named often comes down to marketing. While a fund may imply exposure to a certain sector, geography or even asset class, studying the underlying holdings often yields a vastly different result than the one you might expect. Despite SEC rules that require at least 80% of a fund’s assets to be in the type of investment implied by the fund’s name, there are ways that some mutual fund companies get around this which can leave you overexposed to a segment of the market. For example, instead of naming a fund the China High-Tech Venture Fund, a fund could instead choose a name like International High-Tech Venture Fund which might lead you to believe that the fund is not invested heavily in China. This can create diversification issues, if for example, you have other funds that are heavily exposed to China.

Do the ETF’s I own leave me unintentionally overexposed to a certain company or sector?

One of the most important things to ask yourself and investigate is whether the ETF’s you hold in your portfolio leave you unintentionally overexposed to certain companies or sectors. Take for example, the case of the Consumer Discretionary Select Sector SPDR Fund (XLY). Currently, this ETF holds a 16.959% allocation to (AMZN).

Source: STA Wealth Management; Bloomberg

Now consider an investor that already holds a meaningful allocation to either through funds and/or through the individual stock itself. It is possible that adding XLY to the investor’s portfolio might unintentionally increase portfolio concentration to a single stock, thus increasing overall portfolio risk in a manner that could be misaligned with their risk tolerance.

Do I own an excessive number of positions?

There is some disagreement on the optimal number of positions that should be held in a portfolio to maximize the benefits of diversification because factors including sector or asset class diversification can play a role. However, in Burton Markiel’s book “A Random Walk Down Wall Street”, he argues that a portfolio of 20 stocks from different industries is sufficient. This is fewer stocks than most investors might naturally think leads to sufficient diversification.  Instead investors often hold too many securities with very small allocations to each. By doing this, they dilute potential portfolio returns, increase cost and complexity, and don’t reap meaningful reductions in volatility. As the chart below shows, beyond a certain number of stocks, each additional stock added to a portfolio delivers a reduced marginal benefit from a portfolio risk perspective until the benefit virtually disappears.

How are my holdings correlated?

This might be one of the most important questions you can seek to answer as an investor. The reason is that achieving diversification requires understanding correlations between securities, asset classes, sectors, and geographies to name a few. Correlations always range from -1 to 1. When correlation is 1, that means that the change in price of one asset is equally reflected in the other asset. In other words, if asset A decreases in price by 15% then asset B will also decrease in price by 15%. This is the scenario that a well-diversified portfolio should aim to avoid. Instead, you want a reduced correlation between portfolio assets. Unfortunately, many portfolios aim to achieve this goal but fall dramatically short of success because correlations between portfolio holdings are not fully understood. This can lead to larger drawdowns and higher volatility.

How to avoid poor portfolio diversification?

Properly diversifying a portfolio is more challenging than following the widely accepted “don’t put all your eggs in one basket” rule. While helpful, you can still end up with a portfolio that isn’t properly diversified. To deal with this challenge, we diversify across asset classes, investment strategies, and geographies. We also work to understand correlations between investments, use allocation ranges in our portfolio models to prevent us from over- or under-exposing portfolios to any one investment, and systematically rebalance semi-annually as it helps mitigate the possibility of portfolio concentration due to asset performance. Additionally, we spend considerable effort in our investment selection process to look under the hood of each ETF and/or mutual fund under consideration for our models. This helps us avoid overlapping exposures that aren’t intentionally put in the portfolio. The work doesn’t stop there however. We then continually monitor the underlying baskets of securities represented by funds and ETF’s to ensure that portfolios don’t drift from our intended exposures.

The bottom line is that we understand that over- or under-diversifying a portfolio is risky and can put capital at risk of loss. If you haven’t assessed how appropriately diversified your portfolio is, we encourage you to do so as it can only help you accomplish your long-term goals and objectives.











Oil Makes Bullish Breakout

The weekly bars in our first chart below shows WTIC Light Crude Oil ending the week above its early 2017 peak near $55 for the first time in more than two years. That upside breakout puts WTIC in sync with Brent Crude Oil which rose over $60 for the first time in two years the previous week. That puts both versions of the oil market in chart uptrends. Brent’s $6 premium over WTIC is also helping to pull the latter higher. That carries good news for energy shares which have been the market’s weakest sector this year. But that may be changing. Energy was the past week’s strongest sector.

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Energy Stocks Are Lagging Behind The Commodity

Not only have energy stocks been this year’s weakest sector, they’re the only sector still in the red for the year (-6.4%). Since the second half of August, however, the Energy SPDR (XLE) has gained twice as much as the S&P 500 (by a 12% to 6% margin). Over that same time span, WTIC has risen 21%. Which brings us to our next chart. The box in Chart 2 shows the weekly price bars for WTIC Crude Oil (the U.S. benchmark) bottoming in late June and rising throughout the third quarter, before achieving this past week’s bullish breakout. The solid line is a relative strength ratio of the Energy SPDR (XLE) divided by the S&P 500. The circle shows the sector performance improving since the end of August, suggesting that rising crude oil is having a positive effect on energy stocks. The bigger message from Chart 2, however, may be the fact that energy stocks have performed so poorly this year in the face of the relatively stronger commodity. Over the years, a close correlation has usually existed between the price of oil and the performance of energy shares. The chart suggests that energy shares have a lot of catching up to do to reflect the stronger picture for crude oil and energy prices in general.

Ratio of Crude Oil To Oil Stocks (XLE) Is Also Breaking Out

There’s another intermarket factor which appears to favor higher energy shares. And that’s the premium (or spread) between the price of the commodity and its related stock sector. The weekly bars in Chart 3 plot a relative strength ratio of WTIC Crude Oil divided by the Energy Sector SPDR (XLE). Historically, the two usually trend in the same direction. Over the last 10 and 20-year periods, the 12-month correlation coefficient between WTIC and XLE has been .80. [That means they trend in the same direction 80% of the time]. Which makes today’s final chart even more interesting. The chart shows the commodity rising faster than the XLE since the start of 2016 (when oil bottomed). To the far right, the WTIC/XLE ratio has just touched the highest level in two years (mainly because of the upside breakout in WTIC). Assuming their historic relationship remains intact, the upside breakout in the ratio should start to exert a more upward pull on energy shares. Not only are they lagging too far behind the rest of the market. They’re also lagging too far behind the price of crude oil.


Weekly Snapshot of Global Asset Class Performance

If you have any questions, please feel free to email me at


STA Investment Committee

Luke Patterson, CEO & Chief Investment Officer
Mike Smith, President
Andrei Costas, Senior Investment Analyst (Equity Strategies)
Nan Lu, Senior Investment Analyst (Fixed Income Strategies)

For decades vast wealth has been created for millions of Americans through growing private businesses. However as business owners, especially Baby Boomers, reach the later stages of their careers, a new study by US Trust shows that the majority do not have a formal succession plan or Exit Strategy.

For decades vast wealth has been created for millions of Americans through growing private businesses. However as business owners, especially Baby Boomers, reach the later stages of their careers, a new study by US Trust shows that the majority do not have a formal succession plan or Exit Strategy.

U.S. Trust recently released its 2015 US Wealth and Worth Survey, which sampled a group of millionaire business owners with at least $3 million in investable assets.  In this study, nearly two-thirds of business owners do not have a succession plan (which could include either a sale or transfer of the company). Since most of the business owners rely on their businesses for income, the lack of such planning means that their main source of income could be in jeopardy.

Additionally, the results showed many owners have failed to think about the future of their businesses beyond their own lives. Only 16 percent plan to pass the business on to their families, and 64 percent of older business owners (those over 50) have no formal succession plan. In addition, the majority of business owners have not formulated a strategy for ensuring the highest possible valuation of the business or its continuity beyond the life of the current owner.

Many business owners, whose finances and identity are so closely tied to their companies, simply don’t want to think about giving them up. According to the report, three-quarters of the millionaire business owners founded their companies and only 8 percent inherited them.  Thus, most are first generation businesses. Without a plan, many may intend to simply work well past retirement age.

Many entrepreneurs never plan to stop working or they wait until they are ready to retire (not a good plan – what if the unthinkable happens). Others have a plan in mind that they may or may not have even communicated to key stakeholders, but leave its execution to chance by not formalizing it. In my experience not having a formal plan leaves a very low likelihood of an optimal transfer or sale of the business.

At STA Wealth, we find that succession planning is a crucial part of long-term business planning that helps prepare for a smooth, strategic exit by the owner or for an unexpected change in circumstance, such as illness, disability or divorce.

Five Key Elements of a Succession Plan or Exit Strategy

The benefits are vital to all stakeholders, whether they be the founder, the employees or the clients who have placed their trust with the firm. When they’re ready to transition, the business owners are uniquely positioned to capitalize on the value of the firms they’ve built.

The majority of business owners we work with are focused on ensuring that the businesses they’ve built will endure—they want to create a lasting legacy. But they are not always sure how to pursue that goal – especially when there is just one owner (with multiple partners, we find that it can be a little easier…but not easy).

It’s for that reason, at STA Wealth, we believe that business owners need to think through five key considerations necessary to create a successful plan and exit strategy. These elements will benefit the company’s owner(s), whether their goal is internal succession, external succession or a combination of both.

1. Create a Clear Vision

The initial challenge business owners face when developing a plan is to actually understand where to start. There must be a willingness to look closely at personal and professional goals, and an ability to look impartially at the value of their company. Rather than asking what a successful succession plan looks like, a better question for the founding principals would be to ask themselves “What does a successful transition look like—for me?”. Getting to that answer requires personal reflection and careful consideration. Please note that if there are multiple owners, that each owner’s goals need to be accounted for. Setting personal, professional and firm-related goals will help create a clear vision for the owners and the firm, as well as an improved peace of mind for employees, clients and other stakeholders.

2. Determine The Business Valuation

There are many approaches to determining a firm’s value. But operating cash flow (typically viewed as Earnings Before Interest, Taxes, Depreciation, and Amortization or EBITDA) is the common denominator used to establish fair value. Unlike book value, revenue or net income, cash flow is the best indicator of company profitability and overall operating efficiency. Prospective buyers want to see dependable, growing and predictable flows.  Quality of cash flow matters, too. Buyers typically pay a multiple (or measure of equity or firm value relative to revenue or earnings that it generates) based on the quality of cash flow and its growth rate. Companies will fetch top dollar for such things as a stable client base; revenues that are overwhelmingly from a recurring business; a track record of growth and strong margins; and a core group of professionals who are committed and incentivized to operate the firm as the founders reduce their responsibilities and ownership stake (a.k.a. Key Employees).

Many firm owners may either want a quick exit or may want to retain a degree of control in a transition – either can also impact valuations. It’s worth considering bringing in a valuation specialist or transaction intermediary to review the mix of goals, revenue streams, expense structure, legal structure, finances, clients and other available information. A specialist can help ensure that a fair and realistic firm valuation is achieved. While there are many approaches to valuation, attributes that are always considered include risk, scalability, growth and cash flow quality.  It is also time to clean up the books. As any valuation is dependent on EBITDA, it is important to make sure that the books and records are in good shape. For that, we review an audit by your CPA firm.

3. Maximizing Value

Buyers place a high value on business continuity—assurances that clients and key employees will remain in place once the firm begins its transition. Clients who can easily follow disengaged staff out the door are an obvious risk to a successful transition. This risk can be mitigated by hiring key employees and professionals who are a good long-term fit and by creating a compensation strategy with incentives that help employees share in the firm’s success. Creating a structure that allows key employees to participate in ownership is a powerful value driver in successful business succession planning.

Firm value is also enhanced by institutionalizing client relationships—which means ensuring that clients are connected to the firm rather than to any individual employee (or even the owner). Additionally, firms can reduce risk and maximize value by documenting all processes, including compliance procedures and contingency plans. Firms that demonstrate systematized business practices will yield higher valuations than those without this level of transparency.

4. Maximize Scale

Efficiency is another key value driver. It’s worth exploring ways to facilitate growth without adding fixed overhead. Not only do strong margins benefit owners in the short term but they can also serve as a platform for future firm growth—always appealing to prospective buyers. But there’s an important distinction to be made here: While efficient operation is desirable, being lean to the detriment of staff workload and compromised client service is not. Buyers aren’t necessarily seeking a bargain, but they do want lower transaction costs per unit of revenue. Efficiencies can be created, for example, by automating workflows to streamline operations and by creating a segmented service offering that fits the revenue profile of each client segment. Creating proportionally lower costs will equate to higher margins and drive EBITDA and possibly the multiple you receive even higher.

5. Demonstrate Consistent Growth

Buyers will pay a premium for firms that are rigorous about new business development and that have an effective customer growth strategy. The most sought-after companies have multi-tiered growth strategies that utilize customer referral, cross-selling (where possible), marketing, and public relations programs to capture customer revenue opportunities from a number of different channels.  Successful firms tend to have well-documented business development compensation and incentive plans in place for the entire staff, to ensure that everyone has a vested interest in the firm’s growth.

Today’s business owners have spent their careers building firms on a foundation of successful relationships, the entrepreneurial spirit and the desire to grow and expand. Establishing a succession plan that secures their firm’s legacy beyond the founder’s working life is critical not just to their firm and their clients but also to the long-term success of the next generation of leadership. The succession-planning process can take as many as five to 10 years to establish and implement—and there’s just one chance to get it right…having a plan that works for you, your family, your employees and all stakeholders.

Understanding the many factors that influence a succession plan is the first step. Business owners who take the long view by starting to address their risks, scalability, growth and cash flow, will see their efforts pay dividends when it is time to implement their exit strategy (whether solicited or unsolicited).

For more on this topic, listen to Scott’s recent interview with Rick Hunter. Rick Hunter leads the Houston office of Lexbridge with over 20 years of experience in investment banking and corporate finance.

If you have any questions please feel free to email me at


STA Financial Planning Department
Scott Bishop, Executive VP of Financial Planning, Partner
Patrick Fleming, Senior Director of Wealth Management
Elena Sharma, Financial Planner
Stephen Kirby, Financial Planning

Upcoming Event: Business Transitioning: Wrestling a Deal to Close

Strategic Considerations for Business Owners and Entrepreneurs to Maximize the Value of Their Business.  We invite you to join us for an exclusive opportunity to understand the most significant milestones
in the lifecycle of a business transition. Learn first-hand from our panelists stories detailing succession planning, strategic partnerships, recapitalization and sale transactions. Hear how business owners  optimally position themselves to attract and command the most lucrative buyout offers while demystifying a myriad of issues to preserve the company’s legacy.

Business Transitioning
Wrestling a Deal to Close

November 9, 2017
4:00 pm – 6:00 pm
You are cordially invited to attend an exclusive presentation
With reception to follow

The Live Oak Room
at the Norris Conference Center in CityCentre
816 Town & Country Blvd. Houston, TX 77024

Seating will be limited. Direct inquiries to Amanda at or 713.400.1562
by Thursday, October 26.


Scott Bishop Partner, STA Wealth Management
Rick Hunter Managing Director, Lexbridge
Manish Seth Partner, ABIP CPAs and Advisors
Michael Churchill Manager, ABIP CPAs and Advisors
Peter Ellen Senior Vice President, Amegy Bank
Vibhu Sharma Wood Group Mustang
Jack Selman President, Selman, Munson & Lerner


Disclaimer: Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by STA Wealth Management, LLC), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from STA Wealth Management, LLC. Please remember to contact STA Wealth Management, LLC, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services. STA Wealth Management, LLC is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the STA Wealth Management, LLC’s current written disclosure statement discussing our advisory services and fees continues to remain available upon request.


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