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STA Weekly Report – Trade War: The New Weather Vane For Market Direction

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INSIDE THIS EDITION:
Trade War: The New Weather Vane For Market Direction
Weekly Technical Comment
Weekly Snapshot of Global Asset Class Performance
401k Plan Manager

The ETF universe has grown in terms of both offerings and assets over the last 10 years as investors have looked to replace expensive actively managed mutual funds with inexpensive index ETF’s.

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This market response is not surprising to us considering that the U.S. and China are the world’s two largest economies. Together, the two countries have generated nearly 40% of world GDP between 2014 and 2018, an increase from a decade ago when the aggregate total was 33%. More importantly, the U.S. has the fastest-growing economy among developed countries and China continues to serve as the growth engine for developing nations. Together, they take the lion’s share of global growth, contributing nearly 88% of it over the last five years as growth in Europe, Japan, and Latin America has lagged.      

On September 1, the Trump administration imposed new tariffs of 15% on roughly $110 billion of Chinese imports, ranging from clothes, kitchenware, footwear, and certain technology products. On October 1, tariffs on $290 billion Chinese goods that were placed prior to May 2019, will be further increased from 25% to 30%. Additionally, a separate batch of about $160 billion in Chinese goods, including smartphones, laptops, and toys, will be hit with 15% tariffs on December 15. In response, China announced higher tariffs of their own on $75 billion of U.S. goods, to be implemented in two stages.

In contrast to the previous rounds of tariffs, which were focused mostly on capital goods and intermediate inputs, the U.S. consumer will start to feel the pain as the new tariffs focus on consumer goods. According to JPMorgan strategists, tariffs may cost an average of $1,000 annually per household, which would largely offset the benefits of tax cuts which were estimated at approximately $1,300 per household. 

Since the trade war escalated last September, the global economy has entered a synchrozied slowdown. The pain has been felt disproporationately across industry sectors, with exporters and manufacturers getting hit hardest. Global manufacturing PMIs, a leading indicator of economic trends, has fallen sharply since early 2018. The Eurozone, Japan, and China PMI’s have now also all fallen below 50 percent, indicating that manufacturing sectors in these regions have been contracting while the U.S. struggles to stay above water. 

The direction of trade negotiations has been and will likely continue to be a wild card for near-term market performance, as it creates uncertainty for business owners, dampens investor’s confidence, and increases the odds of economic recession. While we recommend building a defensive and high-quality portfolio to weather policy uncertainties ahead, we also believe investors should remain disciplined and avoid being distracted as doing so could compromise their longer-term financial goals. 

Stock Indexes Achieve Upside Breakouts

A rally in global stocks has taken a turn for the better with major stock indexes clearing some upside resistance barriers. The three major stock indexes shown below have all cleared their August highs and 50-day moving averages. At the same time, their 14-day RSI lines (upper boxes) have risen above 50; and their daily MACD lines (below charts) have turned more positive. That strong price action has pushed all three indexes out of their August trading ranges to the upside. Small caps and transports are also strong. Foreign stocks are rallying as well.

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Eight of eleven U.S. sectors are in the black, and are being led higher by financials, technology, and industrials. Defensive sectors like staples, utilities, and real estate are in the red and lagging behind. A rebound in global bond yields is hurting bond proxies while boosting banks and other financial stocks.  Semiconductors are leading technology stocks higher. 

A pullback in the dollar over the last two days is helping to boost economically-sensitive copper and oil prices; while safe haven precious metals are seeing some profit-taking. After starting the week in risk-off mood, investors are taking a more risk-on attitude recently as we near the end of the week. Some positive trade news and stronger economic data are behind today’s more optimistic mood. But that can change very quickly. All we can do is follow the action on price charts which has turned more positive. While stocks are trading higher, it’s important that they hold onto those gains.

Weekly Global Asset Class Performance

If you have any questions, please feel free to email me at luke@stawealth.com.

Luke

STA Investment Committee
Luke Patterson, CEO & Chief Investment Officer
Andrei Costas, Portfolio Manager
Nan Lu, Senior Portfolio Manager
Robin Chan, Senior Trader


Most Business Owners Have No Succession Plan or Exit Strategy

By Scott A. Bishop, MBA, CPA/PFS, CFP

Are you a business owner without a complete and coordinated Succession Plan?  If so, please attend our workshop on September 26, 2019 (invitation via the link or below):

Invitation:  Succession Planning and Life After The Sale

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 2016 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 63 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.

In my 20 years of experience, I 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 circumstances, such as illness, disability or divorce.

Five Key Elements of a Succession Plan or Exit Strategy

The benefits of a thoughtful Succession Plan or Exit Strategy 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 I 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, I find that it can be a little easier…but not easy).

It’s for that reason, I 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, 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, I suggest a review and/or 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 the 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).

If you want to hear more on these ideas, check out two of my interviews from my radio show, The STA Money Hour (on 950AM KPRC Radio, weekdays from 1 pm to 2 pm Central Time):

Interview:  Alex W. Howard, CFA, ASA

Interview: Jennifer Mailhes, CPA


Important Disclosure:
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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