Investing In Today's Tough Regulatory Environment

by: Yale Bock

The front page of today's Washington Post has an article which details that nearly 1/3 of the current members of Congress have traded in the stocks of companies which have legislative matters before them. The article is more evidence of why the general public has very little belief in either Wall Street or Congress, both of which have record low approval ratings (congressional approval hovers at around 10%, and has done so for months). The purpose of this article is to give suggestions to investors on how best to approach a regulatory environment full of conflicts of interest and hypocrisy.

Current Investment Status and Viewpoint of the Regulatory Framework

Y H & C Investments is a very small practice and has been a state registered investment adviser since 2004. State registered investment advisers have less than $100 million in assets under management. Advisers with more than $100 million are SEC registered advisers. The threshold between the two was recently moved up from $25 million in assets under management. Since inception, the firm has experienced 3 state mandated audits, a requirement of every investment management firm in the State of Nevada. The audits are time consuming and costly, but I see it as a necessary part of the business as it helps strengthen the firm in areas which are found to be wanting.

In reading the article about our current representatives, I see the current system of democracy and capitalism as by far the best government and economics have to offer, but one which has elements which are broken and need to be fixed. As a former U.S. history teacher, I find it hard to believe when Ben Franklin, Thomas Jefferson, and the other founders thought about setting up the United States of America, they wanted the current members engaging in the blatant conflict of interests which are widely documented.

As a member of the CFA Institute, I take an oath which says I will abide by the CFA Code of Ethics. One of the principles of the Code of Ethics is to put client interests before your or your firm's interests. The members of Congress completely turn the idea around by taking actions which specifically put their own personal interests ahead of their constituents.

In addition, the votes the members cast on regulatory matters affecting all industries are tainted by a lack of objectivity. The hypocrisy which pervades the environment changes how investors have to look at the possible outcome of investment scenarios. As a result, here are some ideas about how to approach investing in the future to factor in the uncertainty of the flaws in the current system.

Rationally Evaluate the Legislation and Its Impact on Your Company or Industry

Every company is impacted by specific legislation before Congress, but the key for investors is to honestly evaluate the specific proposals which could be material for your holdings. It is critically important to exhaustively research your company and determine what percentage of the business comes from areas which could be affected by new regulations. Some proposals will have little or no impact on your holding and many could have a massive effect. Let's look at a few industries to consider:

  • Banking -- The Volcker rule banning proprietary trading from large money center banks. Banks argue the merits of prop trading as a way to help hedge the risk of existing assets.

  • Healthcare -- The Supreme Court will rule this week on the constitutionality of President Obama's healthcare legislation. The law will affect medical device manufacturers, diagnostic companies, health insurance companies and pharmaceutical companies.

  • Defense Industry -- Many military contractors are heavily dependent on expenditures by the U.S. government for a large percentage of their revenues, operating profits, cash flow, and net profit. In many specific situations, an increase or reduction in the allocation of government money to certain projects can have a tremendous impact on the financial performance of a company.

  • Credit and Debit Cards -- Credit card companies and large retailers have exposure to the huge interchange fees which the credit card companies assess.

  • Energy -- The different kinds of energy all have taxes and credits which are unique to their specific kind of resource.

Certainly, by no means is this list exhaustive and I am sure you can think of plenty of others where new legislation could severely impact a stock you own.

Make Investment Decisions Based on the Strength of the Company's Total Business

A company's business plan, market position and execution will determine how an investment performs, not a favorable legislative results. From personal experience, the idea investment success will come from a big political win or passage of a specific law is usually not a winning strategy.

As anecdotal evidence, during the internet crash in 2000, one reason I invested in NIC (NASDAQ:EGOV) was because I thought having the ex-Governor and Senator from California, Pete Wilson, on the board would help the company obtain the State of California Web Portal. Well, 12 years later, NIC has yet to be awarded the California contract. However, the investment has proven successful because of the strength of the business model, good management and a win-win situation for governments and the public.

Find Large Global Companies Which Can Survive an Adverse Regulatory Outcome

There are over 6,000 publicly traded companies in the United States. Many have enormous businesses with global scale. In fact, 50% of the S & P 500 members' profits come from outside the United States. As a result, these enterprises are so large they can withstand regulatory decisions which go against them. For example, New York City Mayor Mike Bloomberg recently proposed banning sugary drinks of 16 ounces or more from New York City street cafes, restaurants and stadiums. Boston is currently considering similar legislation.

Companies like Coca Cola (NYSE:KO), Pepsi (NYSE:PEP), McDonald's (NYSE:MCD) and Starbucks (NASDAQ:SBUX) are all potentially affected by this legislation, but whether or not it passes, these heavyweight companies will survive the outcome. Depending on their specific investment objectives, risk tolerance, liquidity situation and tax implications, investors should strongly consider having large global companies as a part of their portfolio.

Do Not Overreact If Specific Legislation Goes Against Your Holdings

Many times, legislation will go against a company which you have a position in. As a result, the stock will get hammered by investors. Initially, the typical reaction is to possibly sell the position. I would argue that could be a big mistake. Defense contractors [Raytheon (NYSE:RTN), General Dynamics (NYSE:GD) and Lockheed Martin (NYSE:LMT)] have had many situations over the last 30 years where members of Congress or a congressional committee did not vote for their weapon and still those investments have proven to be very fruitful for shareholders. If your stock gets pounded because a ruling did not go their way, you might research it even more to find out if there is an opportunity there.

Finally, there are many issues to consider when trying to allocate capital in an effort to achieve better than expected returns. It is not helpful to the capital markets, business people, all levels of government and their honest and hard working officials, or investors, to have bad actors in either house of Congress. However, for investors, the bottom line is to find ways to realize great returns on your investment regardless of the current problems in the system.

Disclosure: I am long SBUX, EGOV, LMT, KO.