June 2010

What Role Should A Practice Have in Your Investment Portfolio?

By Mark J. McGaunn, CPA/PFS, CFP

Abstract:

We are reminded of the unpredictability of stock and bond market returns on not only a monthly, but even a daily basis. Just look at the momentary plummeting of the Dow Jones Industrial Average (DJIA) on May 6, 2010 by 997 points. While the vast majority of investors don’t rely solely on the DJIA to anchor their own retirement, veterinary practice owners need to balance their global investment portfolio to protect it from untoward events, and manage their practice like the investment it is.

Article:

It would seem that we can jump to an immediate “yes” or “no” when asking whether your veterinary practice should play a role in your investment portfolio. The answer is not that simple. In the investment community, each manager has their own strategy, complete with opinions on diversification, Modern Portfolio Theory (MPT), asset class composition and structure, and whether they follow active, passive or a combination of the two strategies. It’s not a plain vanilla formula, much as investors would like it to be.

Let’s discuss two relevant investing ideas before we get to the ““yes” or “no” answer we are searching for.

Every investor is searching for investments with high return and low volatility. We are often disappointed in that endless search. Modern Portfolio Theory is one of the most important and influential economic theories dealing with investment construction. Developed in 1952 by Harry Markowitz, the 1990 Nobel Prize winner in economics, the theory states that it is unacceptable to look at the risk and reward characteristics of a single stock, rather one should consider the characteristics of multiple stocks. Owning multiple stocks allows investors to maximize the reduction in portfolio risk by diversification. Markowitz recommends portfolios whose returns are not too highly correlated with your own personal income (i.e. your veterinary practice). I explain it to clients as “resisting the temptation to bury all one’s dog bones in a single hole!”

Markowitz showed that investment construction is not about pure stock selection, but about choosing the right combination of stocks. Stocks with different risk/reward characteristics can minimize the impact of one stock’s potential loss versus the rest of the portfolio’s gain.

According to Warren Buffett, MPT is just as it says, a “theory,” and not absolute. He waits for out-of-favor investments to rise to greatness. Not employing diversification in order to sidestep portfolio volatility would mandate investing in a single stock, quite a gamble for veterinary practice owners already invested in a concentrated set of asset classes (“micro-micro” cap healthcare and commercial real estate).

Another school of investment thought is that of “black swan” events. These were described by Nassim Taleb in the 2007 book, “The Black Swan.” Taleb regards almost all major scientific discoveries and historical events as black swans, as they lie outside of regular expectations, produce extreme impacts, and make us rationalize their occurrence after happening.

Taleb doesn’t attempt to predict black swan events, but advises investors to build portfolio robustness against negative black swans and exploit positive ones. Taleb’s 2009 Boston speech gave many examples of black swan events hitting the investment community (Long Term Capital Management’s hedge fund implosion in 1998, Madoff’s Ponzi scheme, 9/11, etc.).

How do these investment theories relate to the role of your own veterinary practice in your asset allocation model? As I stated before, it’s not a simple answer.

1. One tenet of retail investment management is that you must be able to readily assign value to an investment in your portfolio. A colleague from the CFP Board of Standards Council on Examinations, David Shen, CFA, asset allocation and risk manager for Washington University’s endowment (5th largest in U.S.), opines that  illiquid asset classes such as private equity and operating businesses like veterinary practices are particularly difficult to value as portfolio investments. A Veterinary Industry Exchange-Traded Fund (ETF) comprised of veterinary-related companies would be far better to include in your portfolio than a practice. But we have to play the cards we are dealt. Independent practice valuations would serve as a baseline investment value.
2. Once practice owners have their baseline practice value, what do they do with it? What asset class does it belong to? Small-cap, micro-cap, “micro”-micro cap? Another CFP Board colleague, Philip Fazio, CFP, CIMA, of Morgan Stanley Smith Barney in Miami, thinks that a veterinary practice would be classified as a private equity investment in an overall asset allocation model in part due to its illiquidity. In that vein, to treat it as a private equity investment, subject to venture capital (VC) type parameters, VC owners would set targets and benchmarks, re-evaluate fees and services, compensation, and staffing.
3. What happens if a “black swan” event occurs in your veterinary practice? Could you suffer a 24.92% private equity-type loss for three years and bounce back? Family practice physicians in 560 communities across the U.S. are contending with CVS/ Pharmacy MinuteClinics that provide “Quick-Affordable-Convenient” treatment. What would happen if a similar facility providing veterinary care situated itself next to your veterinary practice? Would the drop in value of your investment be swift and severe? Is another third-party valuation required to ascertain its new value?
4. Commenting about the AAHA State of the Industry Report for 2010 in JAVMA, attorney Philip R. Homsey II, JD believes that the veterinary industry has 40% excess capacity in U.S. practice locations. Could this be another black swan when other competing practices merge or consolidate to increase their combined investment value while yours diminishes? Could owning a practice be a huge risk in and of itself? Should you beat your competitors to the punch and merge or consolidate before they do to protect your investment against future declines, much like a collar or hedging strategy?

Seems like we are back to using Markowitz’ MPT for diversification’s benefits and avoiding Nassim Taleb’s black swan events. How should we proceed?

By investing in both a veterinary practice and real estate, you have succeeded in filling up two primary asset class holdings. To ensure an appropriate reward for taking the ownership “plunge,” continually evaluate financial and non-financial targets and benchmarks, as VC investors would do if funding your practice. Profitability, efficiency, protocols, and medical success factors should help decide whether you made the right choice of investments for the risk assumed. Management and HR responsibilities may also warrant extra “return” for additional headaches assumed. As manager of your portfolio and practice, you possess the tools to turn around either if they are performing poorly.

Though investment managers may cringe at your owning concentrated positions in two potentially risky asset classes, a great next step is your effort to reduce global portfolio volatility (that all assets may fall in lockstep based on some market event) by building a diversified portfolio of complementary assets around your practice in assets (mutual funds, ETF’s, stocks) that have different risk characteristics and liquidity. Implement this by developing a regular savings plan (using practice profits) and incorporate some combination of 401(k) and defined benefit pension plans, ROTH and traditional IRA’s, and taxable accounts to hold these investments.

You will be well on your way from a few concentrated holdings to a well-diversified investment portfolio. Good luck!

Mark J. McGaunn, CPA/PFS, CFP leads the veterinary/dental/financial planning divisions at McGaunn & Schwadron, CPA’s, LLC and can be reached via mark@mcgaunnschwadron.com or (781) 489-6651.

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