BI > JULY 1995

Why Wait a Month to Pay a Withdrawing Member?

Q. At our last investment club meeting, some of our members asked why a payment to a withdrawing partner is based on the value of the statement for the month following the request for payment. I thought it was because it gives members enough time to raise the money, but I'm not sure if I had the full reason. Could you give an explanation?

A. There is more than one reason for that provision being in the sample partnership agreement that appears in the Investors Manual and you have already mentioned one of them. With younger clubs, we have found that it might be easier for the club to raise cash by having members invest a little more at the following meeting if they want to do so. That is done when the withdrawing partner does not have a substantial amount in the account. The other members may not be in a position to invest more at the current meeting, but would be able to do so the following month.

There are also times when the withdrawal is small enough that the remaining members' regular investments could meet the need in two months without having to raise any additional cash.

If stocks have to be sold to raise cash for the withdrawal, as is often the case for older clubs, waiting until the following month can give members time to make a thorough portfolio review. Instead of making an emotional decision on which stock, or stocks, to sell, all of the holdings can be studied as members try to determine which have the least upside potential or greatest downside risk.

The club's treasurer can also prepare a report as to the status of capital gains or losses for the year, which might influence the club's decision. Members can then attend the next meeting more prepared since they know a sell decision has to be made.

Rather than sell stock, there is also the possibility of transferring stock to the member to satisfy the withdrawal. For the details on how that can be done, read the Investors Manual. The normal procedure is to transfer the shares and have them sold in the withdrawing partner's account the same day. Any difference in the value of the partner's account can be made up in cash. Members should remember that it can be to their advantage to transfer a stock in which there has been a very large paper gain, where the average cost per share is significantly below the current market price per share.

The withdrawing partner will have the same tax consequences regardless if his or her withdrawal is made in cash or in securities, and transferring highly-appreciated shares on a full withdrawal can defer a capital gains tax for the remaining partners. Remember, however, that if this is done, the requirement to pay capital gains tax on the appreciated stock is not eliminated -- it is simply deferred.

Perhaps the most important reason for waiting until the following month to make the payment to a withdrawing partner is to be fair to all of the members. The monthly statement is usually prepared one, two or three weeks prior to the meeting. For example, the July statement might reflect the closing prices on June 30th. Much can happen in the stock market during that period of time.

An extreme example would be October, 1987. If the meeting was held on the third Monday of each month and the statement prepared at the end of the previous month, prices on October 19, 1987 would hardly represent the true value of the club. From October 12th to the close on October 19, the DJIA declined 31 percent. It was down 22.6 percent on just one day -- October 19.

If there wasn't the one-month waiting period to value the account, a member could inform the club of a desire to withdraw at that October meeting and receive 31 percent more than the actual value of the account if the partnership agreement didn't read the way it does in the Investors Manual. By setting the valuation date one month in the future, this problem is eliminated. No one knows for sure what is going to happen to stock prices from one meeting to the next. The procedure becomes fair for everyone.

There is one final thought about a withdrawal. It has been my experience that remaining members hate to see a withdrawal because it lowers the total value of the club. In my opinion, the total worth of the club is not as important as the value of a unit. I would rather belong to an investment club with a modest total worth, but a high unit value.

To put it another way, profitability is more important than size. There may be one or two stocks in the portfolio which should have been sold, but are being held for one reason or another. Not every purchase a club makes turns out exactly as planned. The fundamentals may have changed. There could be a slower growth rate, or even a drop in profits. The stock may be selling at twice its normal price-earnings ratio.

It could also be that a stock continues to be held because the member who originally presented it doesn't want to admit that a mistake was made and other members don't want to hurt his or her feelings. Sell decisions should be based on a fundamental study of all the stocks held, not on their price action over a period of time. Too many times, I have seen a club make a decision to sell a stock simply because the price hasn't moved.

Instead of doing that, look at the progress being made in revenues and earnings per share for the companies in the portfolio. A withdrawal gives the club an opportunity to weed out the weak stocks and keep those that members feel have the most potential.

Q. You were the final speaker at our Investors Fair and you mentioned some things that could be predicted and others that could not. I thought it was a good way to stay focused, but didn't have a chance to write them down. Could you repeat them in your column?

A. The list comes from a successful investment counselor, David Wendell. I have received his comments for a number of years and always felt that he came up with some gems for those smart enough to heed his advice. In 1992, he wrote, "Some investors allow their judgment to be swayed from time to time by too much obsession with future uncertainties. Yet this obstacle can be avoided if the major economic and investment trends which can be predicted are weighed against those which cannot."

Here are his lists:

The Unpredictables

1. What stock prices will do next week, next month or next year.
2. How and when investor moods will change from optimism to pessimism, or vice versa.
3. Which stocks will become the next fad.
4. Whether international developments will bring war or peace.
5. When business activity will swing up or down.

The Predictables

1. The population of the U. S. and the rest of the world will keep on growing.
2. More people will need more goods and services.
3. Research will develop new products and techniques, leading to more demand and greater productivity.
4. The burden of taxation will become even heavier.
5. The dollar's buying power will continue to decline.
6. Well-managed corporations will, as a group, maintain their long-term progress of earnings and dividends.

The list of predictables has a greater influence on a person's stocks than the unpredictables over a long period of time.