College Football Could Decide the Presidency

It’s insane how important and relevant college football is and how it will influence the presidential election. Here is a recent ad by Biden, basically blaming Trump for the shutdown of college football, and of course conversely, this week Trump spoke directly with the commissioner of the Big10 in an effort to try to get them to play football. Politics!?

There are 5 so called “power conferences” in football: SEC, ACC, Big12, Big10 and Pac12. These conferences include the biggest schools in the US and make up the majority of college football viewing.  

So get this: the SEC, ACC and Big12 are hell-bent on playing football this fall. The Big 10 and Pac12 cancelled their seasons due to Covid – but those decisions may very well be reversed…more on that later.  

Think of the Pac12 as west coast schools and the Big10 as mid-west or upper middle US. Below is a great map/graphic to help visualize where these schools are.  

The SEC, ACC and Big12 include schools and regions that live and breathe football. Think Alabama, Texas, Florida, Oklahoma, etc… Football is a lifestyle, a religion, a way of life and it shows in National championships. 

National Football Champions for the last 15 years: LSU, Clemson, Alabama, Clemson, Alabama, Ohio State, Florida State, Alabama, Alabama, Auburn, Alabama, Florida, LSU, Florida, Texas.  

No Pac12 schools on that list and Ohio State from the Big10 is on the list once. 

How important is football? Well according to this thoughtful write-up the top 25 football programs combine to earn an annual profit of $1.5 Billion dollars on $2.7 Billion of revenue. Texas A&M is #1 bringing in almost $150 million in revenue and $100 million in profit. It’s widely understood that these football programs help fund all other sports. And don’t be mistaken; college football is a business and it’s very much about money and prestige.  

So now there is a lot of hoopla about the Big10 not playing. Apparently a vote was held a few weeks back among the presidents and chancellors of those schools and it was 11 to 3 against playing (there are 14 schools in Big10). Three schools voted to play: Nebraska, Ohio State and Iowa. 

The decision to not play has been embroiled in controversy. In fact, the Big10 just this week made public the results of the votes after significant public pressure, including lawsuits. Public institutions not being transparent around how they decided to cancel football is entirely inappropriate.  

BTW, nobody seems to care that the Pac12 is not playing. It’s three-fold: (1) The Pac12 is rarely in contention for a national championship, (2) the west coast does not bleed football like Texas and (3) the west coast is led by democrats that have locked down the states. Governor Gavin Newsom still has some of the most draconian authoritarian measures in place, so it’s hard to even imagine 4 of the Pac12 schools (USC, UCLA, Stanford, Cal) playing at all. 

My personal belief is these schools should be playing football. I think the athletes would be safer and healthier hanging out with each other, practicing, working out and getting tested regularly. They could even have them all live together. If these student-athletes are not playing football, they will be out socializing and partying regardless. 

Politics

No need to talk about the Pac12 much, because three of the states there: Washington, Oregon, California are blue democratic strongholds, housing 8 of the Pac12 schools. And nobody is really complaining about not playing. The Pac12 was arguably irrelevant, and they are boldly solidifying that position.

But the Big10 is VERY interesting for a few reasons: 

  • Football is a bigger deal there. Everyone can name friends/acquaintances or famous people that went to either Michigan or Ohio state. Both those stadiums hold over 100,000 fans.  
  • There is a lot of drama and controversy swirling. Fans are irate that they’re not playing. Nebraska football players and parents are suing the Big10 and have demanded all documents around decision making be made public.  
  • Swing States. Battle Ground States. That’s right, there are a lot of them in the Big10. These are states where the presidency is decided.  

So let’s talk about the Big10 Battleground states: Michigan, Wisconsin, Minnesota and Pennsylvania.  4 states representing 56 electoral votes (Trump won 288 votes to Clinton’s 215).  Trump won Michigan, Wisconsin and Pennsylvania, but Obama won those states in 2012. Trump won Michigan by a margin of just 0.23%, Wisconsin just 0.77%, and Pennsylvania by 0.71%. Clinton took Minnesota by 1.5%. 

So in terms of Big Football programs in these states think: 

  • Michigan – Wolverines. 46,000 students
  • Michigan State – Spartans. 50,000 students
  • Wisconsin – Badgers. 44,000 students
  • Penn State – Nittany Lions. 47,000 students
  • Minnesota – Golden Gophers. 51,000 students

These are BIG Schools, with BIG followings in BIG swing states. Trump won Michigan by just 10,000 votes. That’s like 1/10th of Michigan fans in the stadium! 

So if Michigan is not playing and the fans are pissed, the presidential election could come down to “who is to blame”. Do you think it’s Trump’s fault because he mismanaged Covid? That argument could work, but it is materially weakened if SEC, ACC and Big12 start playing football. 

Or do you blame the democratic leadership? Gretchen Whitmer is another lock-down heavy democratic governor who said “I was glad that the Big Ten took the leadership role that they did”. So maybe people blame her as a democrat and therefore Biden. 

One thing is for sure Trump wants them to play and he wants credit for them playing. I don’t think it’s playing well for the democrats at this point. The Big10 is now revisiting their decision and are talking about a revote.

In the meantime a lot of college football games will kick off this weekend and next. Imagine how the players in the Big10 and Pac12 are going to feel watching. Ouch. 

More fun to come in the near weeks ahead. 

Below are the electoral results (source: Wikipedia). 

US Stock Market soared to Record Highs This Week

Stock Market up 5% for the year

Stock Market up 52% from the low this year

An investment made on the first of every month since March 1, would be up 15%

I hope you haven’t been sitting on the sidelines this year! 

Many don’t/won’t realize, but almost exactly 6 months ago US Stocks reached a record high and now almost to the day 6 months later they are reaching new all time highs! All this in the wake of the fastest drop in history: down 34% in 32 days. And fastest recovery: back up 52% 5 months later.

The previous S&P 500 record of 3386 was reached on February 19, 2020, before it started its precipitous fall down 34% on March 23. This week on Tuesday August 18, 2020 (so 6 months to the day) the US Stock Market has again reached an all time high of 3390.

In fact stocks are now up almost 5% this year. That buy itself is a return ANY investor would welcome. 

ALL THIS DURING:

  • Covid 19 pandemic shutdowns
  • Depression era unemployment rates
  • Nationwide protests, and
  • (and if you live in California) Record forest fires and rolling blackouts. 

Who woulda thought? 

Moral of the story: 

Don’t try to time the market. You can’t. Nobody can. 

Just buy it and stick with it. So if you could have timed the market bottom and invested on March 23, your investment would be up 52%. But this is dumb, because nobody can. 

So instead, let’s say you simply just kept on investing at a constant rate (also known as dollar cost averaging). Six equal investments made on March 1, April 1, May 1, June 1, July 1 and August 1, would be up a combined 15%.  Again a return hedge fund managers would be quite comfortable with.

Some More Insanity

Apple is the first company to reach a $2 trillion valuation! 

Tesla is a $370 billion company. Giving them a similar market value of Ford, GM, Chrysler, BMW, Mercedes and Toyota all combined (~$376 billion). 

Netflix had a great 4th Quarter, but the Street expects more

Netflix reported its best quarter EVER and Wall Street yawned

Netflix forecast 7 million new subscribers in the quarter and came in at 16 million. By far their biggest quarter EVER.

They guided to 7.5 million in Q2, which would make that their biggest Q2 EVER.

Corona Crisis is a godsend to Netflix and will accelerate their growth and dominant market positioning.

Obviously we all expected Netflix to exceed guidance this quarter. It was conservative to begin with and people around the world were ordered to stay at home. Some even predicted double digit subscriber additions, but nobody predicted 16 million. 

So why didn’t we see a huge rally in the stock price? In fact, it actually went down! 

A big (1) is management muted the good news by implying that Q3 and Q4 subscriber numbers would be lower due to a “pull-forward” of demand. 

(2) Streaming Wars competition is still a concern and 

(3,4,5…) questionable pricing power given competition, foreign currency headwinds hurting revenue and negative cash flow. 

Pull-Forward of Demand

This is a phenomenon that Netflix has been talking about for years; usually after they crush guidance, but I cringed when I read the following in the investor letter.

Some of the lockdown growth will turn out to be pull-forward from the multi-year organic growth trend, resulting in slower growth after the lockdown is lifted country-by-country. Intuitively, the person who didn’t join Netflix during the entire confinement is not likely to join soon after the confinement.” 

They may be right, or they may not be. But, for the long-term outlook it doesn’t matter: People all over the world will continue to sign-up and pay for Netflix, because their price-to-value proposition is incredible and recession proof. 

Netflix now has over 180 million households paying for its service; so probably 3 – 4x that number of people watching. As more people join the Netflix ecosystem, Netflix will benefit from “network effects”, like Facebook. Meaning if all of your friends are talking about a particular show, you will feel compelled to also watch that show and participate in the social conversation. #TigerKing. #LoveIsBlind.

Well guess what? After the lock down a lot of people are going to be talking about Netflix shows, which will drive continued demand and new sign-ups. 

Corona Crisis is accelerating secular trends, including remote working, movie theater death and cutting the cable cord. All three actually bode well for Netflix. Globally consumers were already moving to streaming over cable and because of global stay-at-home orders we are seeing a mass acceleration in the global adoption of Streaming.

AT&T, Verizon and Comcast lost 1.5 million subscribers in Q1, while Netflix picked up 2.3 million in the US and Canada. Some haters even predicted Netflix would actually lose domestic subscribers in 2020.  

Streaming Wars Competition

Two areas must be mastered at global scale to compete with Netflix: Technology and Content.  

Amazon and Hulu are the biggest incumbent competitors but they’ve been around for many years and have not impeded Netflix growth. Also, worth noting Hulu is only available in the US and Japan. So who are the new entrants? 

  • Disney+
  • Apple TV
  • AT&T’s HBO Max (or is Now or Go?…so confusing)
  • Comcast’s Peacock

HBO and Peacock are “wait and see”. They’ll probably be ok, but the reality is (1) they are encumbered in profitable legacy businesses (broadband, cellular, cable TV, etc…) and therefore need to navigate corporate bureaucracy and innovators dilemma that will inevitably slow their path (remember Netflix is so focused they split off their DVD division and they have no other operating segments) and (2) they both lack a global technology infrastructure, one that Netflix has been building and optimizing for 10 years. 

Apple TV has the global technology infrastructure and they are off to a great start with original content. They also hired Richard Plepler the former head of HBO to a five year contract; a clear signal they are in for the long term and committed to quality. Their biggest issue currently is lack of content; most people would be hard pressed to name two original Apple shows. Nevertheless they will grow over time, but will be many years if ever that they are a substitute for Netflix. 

Disney+! 

This is the juggernaut that many expect to knock Netflix from their perch. They have global brand recognition and possibly the most valuable content library in the world (particularly when considering their acquisition of Fox). They have passed 50 million subscribers in less than two full quarters. Some question the authenticity of this number as many signed up free thru Verizon in the US and 8 million were automatic via their HotStar business in India. Nevertheless, it’s a meaningful number. 

Compelling content?

Disney’s global technology infrastructure is weak and will slow global adoption. And while the Disney Corporation owns a lot of great content it is fragmented and licensed to local providers around the world making it difficult to simply “make available” on Disney+; which is why their catalog is thin. In fact, their catalog is largely kid’s content and some blockbuster movies from Marvel and Star Wars. (Pictured is the content they pushed to me via email last week…not exactly compelling). So in short, Disney needs to spend more building their technology and global distribution platform and they need to sacrifice profitability in the short term to build their streaming library and business.  

This is where Covid-19 comes in like a wrecking ball. Think about Disney’s big businesses where the profitability comes from: 

  • Disney theme parks are closed. 
  • Disney cruise ships are docked. 
  • Movie theaters are closed.
  • Network advertising down significantly.  
  • ESPN has no sports.

Disney has gone from Streaming Rookie of the Year to a company that literally could be battling to survive the next few months. 

Covid-19 won’t kill Disney, but it’s mighty painful. 

Other Headwinds Mentioned Above

Cash Flow. Important to acknowledge here is Netflix management (Reed) chooses to be cash flow negative in order to accelerate global expansion and dominant position. This has been a smart move. Finally though, and somewhat a nod to nagging investor concern, Netflix has stated and confirmed that 2019 was peak negative cash flow. Now it’s possible that during 2021 Netflix will flip to positive cash flow, causing a number of value investors to come into the stock and drive up the price. (Netflix actually had positive free cash flow in this quarter, but it’s due to shutdown of productions, which by the way should have no effect on 2020 slate).  

Pricing Power. This is a valid concern, but as long as Netflix incrementally improves the service they’ll be able to slowly raise prices over years. Think about this: A $1 increase in price globally generates over $2 billion of annual revenue.

Foreign Currency. Can’t do much here. But the negative short-term impact came from US Dollar strengthening during this global crisis. We’ll likely see foreign currencies strengthen when this is behind us. 

Conclusion

Back in July 2018 Netflix stock price hit $419. So here we are almost 2 years later and the stock floats around the same level, but with 60 million more subscribers and an even more dominant market position. 

My guess is that 2020 will be a record year of subscriber adds and new Netflix stock highs and more great original content! 

Thank you Netflix for providing some much needed relief and entertainment in these times! 

We’re going to get through this crisis and 12 months from now we’ll be stronger

No doubt this is a scary time. This isn’t just a financial crisis, like 2008-09, this is a global health crisis crippling our economy. We are reminded daily of:

  • New corona virus cases and deaths
  • Reports of hospitals full and running out of supplies
  • Unemployment rising and companies running out of money. 

This is all real and should not be minimized. 

However, we also need to recognize that we are making great progress and this will all end at some point. Our financial and economic engine is intact and when we neutralize the corona virus our economy – and stock market – should snapback relatively quickly. There will be some financial restructurings for sure, but restaurants and stores will reopen, people will go shopping, start travelling and return to work.  

Today New York announced the closing of all non-essential business and yesterday California announced state-wide stay-at-home provisions (many states will follow this weekend). These are necessary and very effective ways to mitigate the spread of the corona virus. This is good news that demonstrates we are taking this threat seriously and addressing it head-on. I hope that we’ll look back and say we over-corrected; certainly better than not doing enough.  

If you’re interested in some good news: 

On to the markets.   

During the 2008-09 financial crisis US Stocks fell 56%. As of today March 20, US Stocks are down 33%. There were reports today in the news that some big spending billionaires like Buffet and Icahn jumped into the markets.  

Be Greedy When Others are Fearful, and Fearful when others are greedy – Warren Buffet

I love that quote. Way easier to say than do. History shows, systemic shocks to our economy are always followed by significant economic and market growth. 

It’s very possible this is NOT the bottom and the market will go down more. A lot of people will be quarantined at home worrying over the next 3-4 weeks. However, it is likely the market will be higher 12 months from now than it is today. 

Overall, the US Stock Market is down 34% (green line) over the last month. Our Big 3 trillion dollar tech companies: Apple, Amazon and Microsoft have held up remarkably well down between 15% and 30%. Netflix has really proved resilient only being down about 14% (makes sense right?).  

One way of thinking about all of this is these stocks, or the whole market is “on-sale”. Now they could get even cheaper, but the real question to answer is will they go up eventually? There are a lot of companies that are really cheap, like Zillow, down almost 60%. 

Also, this is a great time to fund long-term investments, like 529s and IRA. Maybe 401ks, but don’t fund too early and sacrifice employer match.  

Can’t wait to see what next week brings.  

Stay healthy and positive! 

Environmentally Conscious Investing

A Company’s environmental practices will more profoundly impact cost of capital and investor returns.

Significant momentum behind investors voting with their wallets. Millenials have and will continue to lead this trend. 

It’s ok if you don’t know who Larry Fink is. Most don’t. He is the 67 year old white self-made billionaire CEO of BlackRock, a company that controls over $7 trillion of investments; only the US and China have annual GDP higher than that.

Each year he writes an open letter to CEOs’ — a presumptuous act in nature — but hey, here we are talking about it. In very short, his letter this year says: 

  • Climate change is real and it’s a defining factor in companies’ long term prospects.
  • Climate change is causing a fundamental reshaping of finance, AND 
  • There will be a significant reallocation of capital as a result.

“Reallocation of Capital” is finance jargon meaning investors are beginning to prioritize environmental responsibility and sustainability over profitability. The responsibility of business is a question economists, business leaders and society have extensively debated during the last century, with the seemingly dominant capitalist position memorialized by Milton Friedman as: 

There is one and only one social responsibility of business — to use its resources and engage in activities designed to increase its profits.” 

Fink overtly states as example that Blackrock will be “exiting investments that present a high sustainability-related risk, such as thermal coal producers.” Jeez; sucks to be a coal producer I guess. In all seriousness though, you could be a profitable coal producer generating electric power for many homes and Teslas, and now business just got tougher and more expensive (will be harder to raise capital in theory). 

This isn’t just Fink. Also, this month, Tom Steyer emphasized in the democratic debates that fighting climate would be his number one priority as President. And Satya Nadella the CEO of Microsoft committed to eliminate Microsoft’s carbon emissions and invest $1 billion in climate initiatives. Microsoft actually cited the Xbox as one of its largest carbon footprints. Who would’ve thought? 

These are not entirely new concepts to finance. The Dow Jones began publishing in 1999 global sustainability indexes based on their environmental, social and governance practices (known as ESG criteria). Mr. Fink’s company Blackrock offers ETFs, for example, that are based on these ESG indexes and can even exclude businesses involving alcohol, tobacco, gambling, firearms and adult entertainment. 

We are in the midst of a paradigm shift in thinking: acknowledging that real-economic value can and will be derived from social impact. And we should go ahead and thank the millenials, led by Greta Thunberg 17 year old Swedish environmental activist and 2019 Time Person of the Year, for driving us here hard and fast.

Personally, I have not historically advocated an investment approach that is “environmentally conscious”. Not because I’m opposed to it, but more because I subscribed to the Milton Freidman and Adam Smith school of thought. And it just didn’t seem that practical: Do I boycott a company that uses styrofoam packaging? I’m now amenable to an ESG investment approach, because I think doing something is better than nothing and I believe there will be financial rewards. A good excuse to buy a Tesla as well.  

My point in all of this? We all think about the environment and debate climate change and global warming, etc… The difference NOW, is we are going to see a monumental shift in how capital is allocated. Or said another way the millennial generation is going to be much more serious voting with their wallets; and savvy investors recognize this. 
Questions relating to this column can be directed to Sean Hathaway, Investment Advisor and Manager; (971) 409-4180; or visit: www.HathawayFinancial.com

Netflix had a great 4th Quarter, but the Street expects more

Netflix had a great 4th Quarter, but the Street expects more

Slowing domestic (US) growth disappoints investors. International positioning is under-appreciated.

Advertising? No. And for good reason. 

Netflix will continue to grow steadily for many years, likely decades.

Stock Price: 

The stock needs a few things to stay on track and go to $500:

  • Cash Flow needs to improve, i.e. 2019 better be “peak negative cash flow” as Reed declared in the earnings call. 
  • Global subscriber growth needs to stay on track, i.e. 28m+ for 2020, and no more net decreases domestically.  
  • Netflix needs another break-out hit along the lines of Stranger Things or better yet their ever elusive Game of Thrones. Could it be The Witcher

To really break-out, like $700+ in next 2-3 years: 

  • New Subs: Need to accelerate past 30m subs per year. 
  • Content: A must-see title in magnitude and zeitgeist of Game of Thrones, would help. Or a globally demanded film in the neighborhood of Star Wars or Avengers, but frankly very tough without existing IP. But it can be done: Titanic, for example. 
  • China: Open for business. 
  • Sports. For the US they likely could grab a significant cohort of non-subscribers with high demand sporting events like Sunday or Monday night football. Or possibly Nascar, which is more congruous to no commercial format. Globally, something like the World cup, cricket or tennis.

Subscriber Growth

Netflix reported Q4 2019 earnings this week, including record revenue of $5.5b and 167m global subscribers. However, US sub growth of 0.5m, disappointed, as it was down from 1.2m in Q4 2018. 

Netflix has penetrated 60-70% of US Broadband households, reaching a point of saturation, and facing headwinds from new streaming competition of Apple and Disney in Q4 and HBO/AT&T and NBC/Peacock coming in 2020. The fact is Investors weigh heavily US performance, because the US is a reasonable indicator of potential growth in foreign markets. 

Why is US Sub-growth slipping? It’s getting incrementally harder to acquire each new sub. 

But consider this… 

For every $1 Netflix spends there is an opportunity cost, and it’s not the same opportunity US competitors have. Netflix must choose how to allocate their spending regionally. For example,  say they are hypothetically debating to spend $500m in marketing and content in either the US or International. Maybe that $500m spent in the US gets 400,000 new subscribers, but spend it in EMEA or APAC and it gets you 1,600,000 subs. They should choose the latter, and generate more cash. This analysis is over-simplified, but it’s illustrative. 

As an investor, I’d love to see domestic subs growing more, but on the other hand, I’m glad investment is being made with cash generation and international growth in mind. 

Here’s a bigger theoretical question: Given $500m who can allocate that more efficiently to generate revenue? Apple, Disney, Peacock, Netflix? My bet is on Netflix, because of their global scale and platform; hard to prove, but time will tell. For example, when Netflix spends on a great piece of content, like Stranger Things, not only does that benefit US demand, but subs in Vietnam and France are signing up.  

That all said the more concerning point is that total sub growth in 2019 was 27.8m, about 1m less than 2018. However, it must be noted that year-over-year Netflix increased average global pricing by 5%, which also created a headwind for decreased subs. Netflix will have less pricing power in the US for the next couple of years until this competition shakes out a little.

International 

The international penetration of streaming that Netflix has achieved and will continue is under-appreciated. Disney, Amazon, Apple will figure it out, but it will take years. (I’m more skeptical of Peacock and HBO figuring it out). 

Consider this: Netflix is producing 130 series of local language television in 2020. And local originals were the most popular 2019 titles in many countries, including India, Korea, Japan, Turkey, Thailand, Sweden and the UK. Further in order to scale US and local titles across the platform Netflix is commonly dubbing into nine languages: French, Italian, German, Turkish, Polish, Japanese, Castilian Spanish, Latin American Spanish and Brazilian Portuguese, and it offers subtitles in 27 languages. WHAT!? Subtitles in 27 languages is not an easy feat when you consider not only the language/artistic effort, but the technology and infrastructure required behind the scenes to make that work. 

When I watched the Newsroom on Apple (a really great show by the way) the English Audio and subtitles were screwed up on parts. 

Advertising 

Every quarter it seems Netflix Management reiterates they don’t expect to start advertising, but this quarter Reed offered some enlightening – arguably intuitive – thoughts. Advertising is not easy money. Amazon, Facebook and Google have become the most powerful effective advertising machines in the world, partly through their insidious collection and utilization of user data. With the exception of viewing, Netflix does not collect user-data. These big 3 are getting better every day and Netflix would have to compete with them. Obviously, Netflix could attract some advertising dollars, from linear TV for example, but would it really prove profitable. And at what expense? 

Netflix benefits from not being embroiled in user data scandals and government inquiries. So in short: (1) Contrary to popular belief it is not easy to monetize from advertising and (2) because there is no personal data collection – save viewing – Netflix is a more comfortable and “safe” place for users. 

Conclusion

In the long-term, investors’ demands are simple: more subscribers, revenue, profitability (check, check, check) and particularly in the case of Netflix, more positive cash flow. We’ll see on the last one. 

Netflix’s international growth opportunity is tremendous and they will continue to grow significantly for years to come. The professionals that work there are extremely smart and determined, and so will continue to solve the puzzle of US subscriber growth. So while US growth has slowed, it will not stop.

About 10 years ago Netflix started “streaming” and since then we are seeing a monumental historical shift in TV viewing from the cable advertisement supported model to on-demand streaming. This shift in viewing is happening globally and will continue for many years. Netflix is on the frontlines and leading the charge Content-wise and technologically.  

Netflix will not stop growing Revenue any time in the next two decades, probably more. In thinking about the stock price growing it’s not a matter of if, but simply when. 

Sean Hathaway is an Investment Advisor and Manager at HathawayFinancial.com


Merry Money Christmas!! 2 Perfect Gifts for Kids

One of the most memorable gifts I ever received for Christmas was a roll of toilet paper. I think I was probably 9 or 10 and in 4th grade.
We always had two celebrations: Christmas eve with mom and dad and Christmas day with the extended fam, at Grandma and Grandpa’s house in Tillamook, Oregon. Cousins, aunts, uncles, new boyfriends and girlfriends of the aforementioned, random strangers maybe, etc… And the whole crowd fueled by insane amounts of food, dessert, booze and nicotine. As a child it was an exhilarating event. As an adult you either hated it or loved it.
So here’s the thing, everyone opened gifts simultaneously; with 40 or so people taking turns viewing was impractical. But every once in awhile, a fantastic electrifying present would draw the room’s attention.
That was the roll of toilet paper from my grandparents. You see the roll didn’t look quite as tight as a new one…had the look of being re-rolled. The end tissue flapped freely, not glued down. So I started to play with it and unroll it, and low and behold a $1 bill fell out, and as I continued to unroll the paper more dollar bills fell out, in fact dozens fell out and some $5s too, and the bills piled up around me, while the entire room gaped with astonishment and a touch of jealousy.
TP money
So here are some financial-minded gift ideas for Christmas and for children: 
– Roll of toilet paper (see above). 
– Investment account (see below).
– Runner-up: Monopoly.
Possibly the most impactful effective way to teach children about the stock market is to open an investment account on their behalf. This is known as a custodial account. The adult controls the account until the minor reaches the age of 18 (you can extend this to 25). Also, this could be a gifting strategy for other loved ones, like your niece, nephew or grandkids. Now we’re not going to just open the account, you want to fund it with some stock pics. 
So think about the technologies, toys or hobbies that touch your children and associate them to their respective public companies (needs to be a publicly traded company). If they’re on Instagram, could be Facebook. Playstation, then buy Sony. They have an iPhone, then buy Apple. Barbie, buy Mattel. Watch Netflix, then Netflix. Etc. Then when you open the account, consider buying one share of each company. 
Now have them track their portfolio on an ongoing basis. For their birthday, offer to buy them more stock, but have them assist in the decision of which stocks to purchase. As part of this exercise, have them analyze the performance of each stock/company since Christmas. Ask them and discuss with them why some stocks perform better than others. Finally – and I’d be remiss if I didn’t say this – consider buying an ETF of the US Broad Stock Market (ex SCHB), so they can see how their individual companies/stocks perform against the broader market.
A spin on the above, is opening a 529 College Savings plan and sharing those numbers with your kids; mine are always excited to hear what the balance is. 
If these two finance gifts are too much work, then default to Monopoly and enjoy with family.  
Have a safe and Happy Holiday Season. Cherish this time with loved ones and family, because in the end they matter most. 
Questions relating to this column can be directed to Sean Hathaway, Financial Planning and Investment Advisor; (971) 409-4180; or visit: www.HathawayFinancial.com. 
IMG_9637
Hathaway Clan. Circa 1980

End of Year Financial Reminders

Happy holidays! As we head into the holiday season of family, parties and fun, also keep in mind this is the time of year to revisit important personal finance and tax related matters (I know…sorry…but it has to be done). All these areas can be nuanced based on individual circumstances, so if you’re not sure about something, take 15-30 minutes to chat with your financial advisor or tax accountant; a few minutes that could save $1000s. 
401k and IRA Contributions
If you participate in an employer 401k this is generally the time of year to revisit your 401k contributions; raise them to the max if you can. Generally, you want them to be spread out evenly over the course of the year to ensure the maximum employer match. 
You can contribute up to $6,000 annually to an individual IRA. Technically, deadline is April 15, but good to just get it done now. 
This is also the time to review employer provided health insurance and supplemental life insurance plans. 
Charitable Giving
December 31 is the deadline to donate to a charitable cause and still get your tax deduction. But remember the standard deduction for married couples is $24,400 ($12,200 singles) for tax year 2019. So in order to get a tax benefit for charitable deduction, your total itemized deductions, which includes charitable, need to exceed the standard deduction. 
Some people are implementing a “bunching” strategy; that’s where you provide a larger charitable donation every 2 or 3 years, as opposed to annually. So instead of $15,000 per year, you might donate $30,000 every 2 years, which enables you to exceed the standard deduction of $24,400 and receive a larger tax benefit.  
You could also consider a Donor Advised Fund, which would allow you to make a large contribution in one year, take a tax deduction, but then distribute the funds to charities over the time period you desire.  
Gifting or 529 plan contributions
A single person can gift up to $15,000 in 2019 to each person or $30,000 as a married couple. So consider this, if you have 2 children and really want to kickstart their college savings fund you could “gift” $30,000 per child to a 529 college savings plan. A $30,000 gift today would be worth over $50,000 in 10 years (assuming a 6% annual return). 
Gifting is an efficient way to share your wealth in a tax free manner. 
Required Minimum Distributions (RMDs)
If you are age 70 ½ do not forget to take RMDs from your retirement accounts, including 401ks and IRAs (not required for Roth accounts), or incur up to a 50% penalty on the distribution if you forget.
If you are giving to a charity, it is likely advantageous to directly contribute your RMD (up to $100,000) to the charity, then you do not have to recognize any income for the RMD! This is known as a Qualified Charitable Distribution or QCD, and it’s a great deal.  
General
The above items are fairly common, but there may be other issues unique to you and your financial situation. Take a few minutes to think about it prior to year end and don’t forget to grab some exercise between all the meals and holiday cocktail parties.
Questions relating to this column can be directed to Sean Hathaway, Financial Planning and Investment Advisor; (971) 409-4180; or visit: www.HathawayFinancial.com. 

Scary Investing

Happy Halloween! What’s Scarier: Sitting in Cash or Investing in the Stock Market?
These days they can both be pretty spooky. Sit in Cash and miss out on a big market gains, like the 21% we’ve seen year-to-date, or Invest in the Stock Market and risk watching 20% of your hard earned cash disappear, like this time last year (Oct 3 – Dec 24, 2018).
(P.S. I’m writing this for the many people I know that are hoarding cash…it’s a real thing).
So what to do at the end of a 10+ year long US Stock market run of 350%? (BTW, that means $100,000 invested 10 years ago at the low would be worth $450,000 today. see graph below)
Cash vs Stock, always resurfaces when the US Stock market is experiencing a long rally, like the 10+ years going now. Many believe it’s time for a pullback, so better to wait and invest in the dip. The problem is that nobody can predict the highs, lows, dips, peaks, bear or bull markets.
Nevertheless, downturns and corrections will occur. So perhaps with crystal ball in hand you Sit in Cash determined to “Buy low” when the market turns. But here is where it gets spooky:
What if the big dip never comes? What if stocks continue to slowly rise for years? When will you give up and jump in? Or, more likely, when the dip comes, how do you know when to buy in? Missing even a day of big gains can have monumental effects on the size of your portfolio years down the road. Take the example above where the recent dip was Christmas Eve 2018. The market jumped 5% the day after Christmas, 15% over the following month and has been steadily rising since.
Could you really have timed that? See Graph below for the effect of missing 2 weeks!
You should expect to double your money every 7-10 years, on average and over time. This surprises most people. Compounding Interest – the 8th wonder of the world. To do this you need to attain 7-10% annual returns, which are very reachable over the long term. However, sitting in cash and missing the 5% up days (see previous bullet) will erode your long-term strategy and returns.
The alternative is Investing in the Stock Market, which admittedly can also be scary because you can lose a lot of money fast. Just ask anyone who lived the most recent crash from Oct 2007 to March 2009, an 18-month period where the market fell over 50%. But, and more important, is to keep in mind that it has since rallied over 350%. The stock market ALWAYS bounces back.
So if you had $100,000 in the US stock market on Mar 9, it would be worth $450,000 today (Oct 29, 2019). BUT and even more shocking…. if you waited just a couple of weeks to put that money to work in the market it would only be worth $370,000.
So what is one to do? If you are working, with every paycheck you should be adding to your retirement savings in a diversified tax efficient portfolio of stocks and bonds.
The more difficult question if you’ve been sitting on the sidelines, is how to move your cash to the stock market. Assuming you agree with premises (a) you can’t time the markets and (b) the markets will trend up over time, then you should invest now. If you want to assuage the potential psychological pain, you could adopt a strategy to move your cash to a diversified portfolio incrementally over the next 12 months. If the stock market turns up quickly, you’ll be happy you jumped back in and if the stock market declines over those 12 months, you’ll be happy that you caught some of the low points.
Sean Hathaway is a Financial Advisor and can be reached at sean@hathawayfinancial.com
How to Beat Stock Market Stress by Sean Hathaway

How to Beat Stock Market Stress

Day-to-day changes in the stock market (i.e. volatility) are stressful to most people
With the right mentality and investment approach you can be calm and confident
Here’s why and how…
It feels like the stock market is in a perpetual state of enormous flux. Everyday the stock market, Dow Jones and S&P go up and down on headlines of “Global Trade Wars” and “Inverted Yield Curves.”
This scares people for two reasons: 
(1) Uncertainty and confusion from these scary headlines. People don’t like things they don’t understand. Few can explain what either of those headlines really means, and 
(2) Change. Humans loathe change, and change is what’s happening daily in the stock market. Stock market volatility is a measure of how much prices are changing. And most people hate change and so they hate volatility. We prefer “steady as she goes…”
First let’s keep things in perspective. It’s actually been a fantastic year for US financial markets. Trade wars and Trump tweeting notwithstanding, thru Friday Sept 13, the stock market is up 20% and Bonds are up 7%, year-to-date. Those are great numbers; healthy robust returns. 
Hopefully, you didn’t panic and get out of the market too early.
How to calm down and enjoy the ride? 
It’s actually quite simple in 3 steps: Diversify, Rebalance, Plan and enjoy long steady returns. 
Diversification
The importance of diversification can not be overstated. Not only is it supported by Modern Portfolio Theory, Ray Dalio (good article here), and most every financial advisor, but possibly more impactful is the psychological well-being it delivers. If stocks are down 10%, there is nothing more satisfying than seeing your bond portfolio up 10%, even if bonds are only 30% of your portfolio. It feels like a big win. In fact, you feel like you out-smarted the market.
Below is a graphic that you can find all over the internet in various shapes and sizes (and asset class slices), the point of which is to show that every year the relative performance of asset classes moves around. The diversified portfolio virtually guarantees you healthy returns in the long run. It is less jumpy and volatile and is represented by the black line and boxes below.
Screen Shot 2019-09-16 at 10.43.15 AM
Rebalance
Rebalancing is a classic investment discipline, a mechanism for buy low sell high, and it will keep you honest and safe in the long-run. Rebalancing is the concept of keeping your portfolio in line with your goals and risk tolerance. So if your optimal balance is 70% stocks and 30% bonds (which by the way is generally a good mix for income generating middle-agers), then you should periodically “rebalance” your portfolio to ensure this allocation maintains. 
Being Diversified and Rebalancing creates win/win scenarios psychologically. This is key for reducing stress and staying positive. 
The stock market and bond markets usually move inversely. So when stocks go down, bonds go up. This is because when investors are selling stocks they are reallocating money to safer assets, like bonds (this is also referred to as “flight to safety”). Supply and demand at work. 
Here is how the win/win scenarios play out: 
Screen Shot 2019-09-16 at 10.41.32 AM
I acknowledge that you may not consider it a “win” when 70% of your stock portfolio is down, but consider the following… Between January 2000 and December 2009 the US stock market returned a cumulative -5% (i.e. negative return). This is referred to as the lost decade in the United States, but it was not lost for those with diversified portfolios. 
A diversified portfolio of 70/30 stocks and bonds would have returned 20% over that time period.
The Plan 
You need to be committed to your diversification and rebalancing strategy. It should be on “auto-pilot”. 
    (1) This helps psychologically, because you shouldn’t be burning energy in decision making. 
    (2) It helps financially, because in addition to the benefits listed above, it ensures you that you stick with a certain investment or asset class even when it is low so that you ride it high again. Remember every asset class will rebound, but far too often investors panic and sell low.  
You need a written financial plan. If you are over the age of 30 you should have a documented financial plan in place, and you should revisit it at least annually. In the workplace you set SMART goals. Likewise, to achieve results in your personal life, you also need to set goals and measure progress.
There are many excuses for not having a financial plan: 
    – I don’t make enough money to save anything. 
    – I make so much money I’m not worried about retirement. 
    – I’m maxing-out my 401k, things are probably fine.
This analogy will not resonate with everyone, but putting a financial plan in place, is like getting a comprehensive blood test. You don’t look forward to it, but once you’ve done it and spend time digging into the data and results, it can be quite interesting, and it can further motivate you to make lifestyle adjustments.
Even the ultra-rich need a plan. I think we’ve all heard the horrific stories of those that overspent their wealth; just google Johnny Depp or Allen Iverson bankruptcy. 
BUT, some ultra-rich people spend too little: you could have been enjoying the finer things in life. Or as a philanthropist contributing and participating more in your favorite causes while you are alive on earth. 
In Summary
Want to reduce or eliminate financial related stress? Simple. Get a financial plan and investment strategy and stick with it. 

I Stopped Drinking for a Month – First Time since College

– I went 35 days without any alcohol. A feat significant in itself, but not as hard as I anticipated.
– I tracked all my sleep data before and after. My average sleeping heart rate decreased by more than 6 bpm, implying 76,000 less heart beats in a one month period. 
– The results were overall positive, but enough to full-stop? 
Alcohol and me
I drink almost every Friday and Saturday night and have been since I think college. Also throw in 50% of the time on any given Wednesday or Thursday, for good measure. Sunday, Monday and Tuesday are generally off limits.
I’ve gone through the brewing-my-own-beer phase and I belong to a number of wine clubs. I’m 43 and as I’ve aged, the effects of alcohol are more pronounced, particularly on my sleep quality. After as little as one glass of heavy red wine, I often wake up at 3:00am; likely due to a circadian rhythm induced liver cleanse. 
Not only have I noticed that I wake in the night after drinking, but in analyzing my Oura Ring data, I’ve noticed that my sleep vitals improve significantly in the absence of alcohol, and more so after 2-3 nights drink free. So Tuesday and Wednesday nights, I sleep like a rock. 
Alcoholic? I’m going to save that discussion for a very long blog, or possibly book. I suppose the fact that I have so much to say on the subject is telling in itself. 
More Background
I’m a little bit of an optimal living eating sleeping fitness enthusiast. I try to eat healthy, and so avoid all processed foods and bad oils and when eating “meat”, only grass-fed naturally raised meats and wild caught fish. Grocery bills are ridiculous. I practice intermittent fasting (so skip breakfast). Regular cold water plunges and showers.
Daily workouts, including run, bike, swim, gym and yoga. Myriad of supplements. I track my workouts on Apple Watch and Strava. I practice good sleep hygiene and I sleep with an Oura Ring that tracks my sleep vitals.  
The vices most detrimental to my overall health are likely: dessert (sugar), alcohol and caffeine consumption, the latter being the most debatable I suppose. I think sugar/dessert is likely the most offensive to my overall health. Or is it alcohol? 
The Mission
I wanted to objectively compare my sleep data to a normal month vs a month of not drinking. From a subjective standpoint, also wanted to see how it affected my relationships, feelings, performance and productivity.  
My Oura Ring tracks a lot of data including sleep duration, times, sleep cycles (REM, Light and Deep), heart rates (min, max, average), heart rate variability (a measure of the variance in time between heart beats, which is an indicator of nervous system readiness), body temperature, respiration patterns, sleep efficiency (time in bed vs actually asleep) and more. 
The Test
I stopped drinking on May 5 and didn’t drink again until June 8 (35 days). BTW, I was leading a local wine night fundraiser scheduled for June 22, so I basically had to start drinking in order to taste all the wines I was in charge of sourcing; I strive for excellence in all my endeavors.
I have a lot of data, but the most “telling” and easy to understand or relate to is heart rate.  Below is a graph showing my average heart rate for the month of April (the normal drinking month) and May (the non-drinking month).
BLUE Line: My average heart rate per night for the month of April. 
RED Line: My average heart rate per night for the month of May (and some of June). 
The straight lines are trend lines. So in each month my heart rate on average trended lower as the month progressed. 

Data Analysis
Blue Line: Just looking at the Blue Line, you can see there is a lot of variability, i.e. peaks and valleys from the straight trend line. The peaks correspond to weekends. There were a few nights where I was averaging 57 bpm during my sleep; likely nights of heavier drinking combined with less than optimal sleep times and maybe poor food selection. A few times I dipped down to red line territory and that was likely a Monday, Tuesday or Wednesday night.
Red Line: Two big observations: way less variability and significantly lower than the Blue Line. Pretty incredible that my average heart rate per night started at around 48 bpm per night and decreased ultimately to 45 bpm per night. That is 6-7 beats per minute on average less than when I was drinking. 
Doing math of 6 beats per minute X 60 minutes per hour X 7 hours per night X 30 days = 76,000 heart beats. I.e. my heart beat 76,000 fewer times during sleep in the month of May. It’s likely that if I included the few hours leading up to bed this number would increase to well over 100,000. 
Subjective Analysis
Productivity increased and I would attribute that to having more energy and just tinkering around more in the evenings. As opposed to relaxing with a glass or two of wine on a Thursday night, I may instead find myself practicing the piano, fixing something or watching TV with my kids, which can actually be a healthy activity in moderation — for example, it creates funny memories and common points of reference. I also read more, because I had the mental energy to engage in a book; not that you can’t read after a drink or two, but I think you’re more likely to sober.
Relationships. I should have my wife chime in here, but she was a little nervous that I would be more irritable and edgy than typical. I don’t think we saw that, at least not after the first week. Overall, I feel it was a net positive on relationships because when I did spend time in the evenings with people, I was more engaged and concentrated.
Feelings. I was curious if I would have any mental ah-ha moments or visions induced by a perpetual clarity of mind. Or would I be a generally happier or unhappier person? Answer: inconclusive. Next time, I’ll probably need to go longer and actively journal more to conclude here.
Physical well-being. From a vanity stand-point, was curious “hey am I going to look better”? Less wrinkles, baggy eyes, etc..? Answer: Maybe. What about increased overall energy and feeling good in the morning? Answer: Probably? It was really hard to put my finger on this. Clearly, I felt more refreshed and looked better than on a Sunday morning after a Saturday night bender of 10 drinks, but the results were not super obvious. My overall body weight and composition didn’t change much either; implying my lack of drinking was compensated by increased eating. And I can relate to that…instead of grabbing a beer, a might instead go for chips and salsa.  
Final Thoughts 
People ask me if it was hard and how I did it. The anticipation was harder than actually doing it. Getting thru the first Friday and Saturday night was the toughest; it was a change in routine. And to that point, to make it easier: 
     – I started planning things for early evenings. A common one, for example, would be a hard work-out ending around 6:00pm, so I got home and was simply starving for food, with no desire to drink. 
     – I also found a buddy to stop drinking with me and found some comfort in texting with him “how we could sure use a beer right now”. 
    – And finally I listened to some podcasts and read some books on not drinking, which helped provide some motivation. 
Will I do this again? Yes. The next time however, I’d like to cut out all processed sugars – so no cookies or cake – and substitute the sugar craving with fresh fruit only. And I’d love to cut out caffeine as well…but I am only human here.  
Clearly there is hard data to support that my body is more relaxed (lower heart rate) and recovers better when I’m not drinking. I do enjoy drinking though, and am not sure the benefit of not drinking outweighs the joy at this time. However, I could see this changing as I continue to age and experiment more.  
If you have any questions, shoot me an email or comment.
Until then, Cheers! 
Sean
sean@hathawayfinancial.com 

Stock Options – When to Exercise

— Most people exercise their stock options way too early —

— You should wait as long as possible —

— Capture leverage; minimize taxes —

We’re going to attempt to answer the toughest question related to Stock Options: “When should I exercise?”

First, what is a stock option? A stock option is simply a right to buy a share of stock at an agreed upon price. The price you pay for that stock is called the exercise price, and it’s equal to the company’s stock price on the day of grant. So, if the company’s stock price doesn’t go up the option is worthless, but if the stock does go up, it can be quite valuable.

Screen Shot 2019-06-21 at 8.18.16 AM

Executive Summary

THE RULE: “Hold your options until they expire”

This is the basic rule. There are nuances and exceptions, but this is the general rule. There are two reasons for this:

Option Leverage. Options are like leverage; they provide the ability to earn money without laying down cash. But once you exercise you lose that leverage. You want to maximize your option leverage.

Double Taxation. When you exercise you pay tax. Then you pay tax again on appreciation of the stock – or any investment – you purchase subsequent to the exercise date. This is double taxation. You want to avoid double taxation.

There are a few exceptions to The Rule, when you should perhaps exercise earlier:

1.You need the money.

2.You need to diversify your portfolio (and I mean really need).

3.You believe the company’s business is in a long-term decline. And if this is the case, you may want to look for work elsewhere.

Why I wrote this?

I spend a lot of time today and in my past corporate life explaining to people why it is beneficial for them to hold onto their stock options as long as possible. Stock options are a significant part of compensation at Netflix and other Silicon Valley companies, but there is little to no guidance explaining their value proposition. In a separate post I will explain why more companies should use options as compensation, but for now, my goal is to help those that own options understand that they need to hold on for the very long term.  

The rest of this article is detailed charts, graphs and math to help explain.

What’s a Stock Option?

A stock option is a contract between you and the company that gives you the right to buy a share of stock in the future, but at an agreed upon price today. That agreed upon price you pay is called the exercise price and its equal to the stock price on the day the option is granted to you. Like Restricted Stock Units (RSU’s), stock options often have a vesting period, like 1 or 2 years and they usually expire in 10 years. So if your company’s stock is currently worth $8, your employer may grant you some options that have an “exercise price” of $8, which is the price you would pay to acquire a share of the company’s stock at any time over the next 10 years. So if the stock goes up to $20, you will pay $8 for a share of stock worth $20, thus earning $12.

A key difference between Stock Options and RSU’s are that options are worth nothing unless the stock price increases; the stock needs to appreciate higher than the exercise price. But RSU’s are always worth the value of the stock; so there is less downside with an RSU, as they always have some value.

Option Leverage

This is a tough concept to wrap your head around, so bear with me.  

Every stock option you own increases in value as the underlying stock of the company increases. So if you own 10 options and the stock price goes up $10, then you just made $100. When you receive a stock option from your company, no money has come out of your pocket. But once you exercise that option you are laying down money to receive stock. And invariably THE NUMBER OF SHARES YOU RECEIVE IS ALWAYS GOING TO BE LESS THAN THE NUMBER OF OPTIONS YOU USED TO OWN.

Example: Assume you have 10 options with an exercise price of $8. And you decide to exercise those options when the stock is at $10. So you pay $80 to exercise those 10 options and receive stock worth $100, for a net gain of $20. Usually people will choose to “net settle” this transaction and simply receive $20.  

To illustrate my point on Option Leverage, we’re going to assume you actually receive 2 shares of stock, which are worth $20. This helps us compare our old “option position” to our new “stock position”.

Here is Key Point: BEFORE the option exercise your investment position reflected 10 shares of stock vis-a-vis 10 stock options, but AFTER the option exercise your investment position only reflects 2 shares of stock. So now if the stock price goes up $1, what used to be a $10 gain for you is now only a $2 gain.  

Screen Shot 2019-06-21 at 8.53.53 AM

In short, the higher the stock price is relative to the exercise price the more value you can derive from your options. I’ve shown this concept graphically below. As a point of comparison, let’s consider you can either (a) hold the options (blue line) or (b) exercise them and trade them for shares of stock (red line and yellow lines).

The blue line in the graph shows the value of your options given a particular stock price. And the red line shows the value of those shares – given a particular stock price – if you had exercised your options at $10. The yellow line shows the value of the shares if you exercised at $20.

Screen Shot 2019-06-21 at 8.59.03 AM

The blue line is higher than both lines, reflecting that the value of options is higher than both scenarios as long as the stock continues to appreciate. Below are the numbers reflected in the graph above.

So, if the stock appreciates to $50, your options would be worth $420 (blue line), but if you exercised at $10, and held onto those shares, then your shares and total return are only worth $100 (red line).

In summary, as long as you believe the stock is going to continue to appreciate, you should exercise your options as late as possible to maximize leverage.

Double Taxation(1)

I left taxes out of the examples above, because they complicate things and don’t add any value to illustrating the point. However, now we have to talk about taxes because they are the point.

Double taxation is the concept of being taxed at two points in time or twice. If you exercise stock you are taxed at ordinary income tax rate. And subsequently any appreciation in stock you may acquire is taxed at capital gains.

Tax event #1: Exercise options and pay tax on gain at ordinary income rate of 50%.

Tax event #2: Stock appreciates. Sell stock and pay taxes at capital gains of 30%.

You are better waiting to exercise the stock and only paying tax once at 50%.

Example: Imagine you have an investment worth $100 (i.e. your stock options). In Scenario 1, you sell it, pay tax of 50% and immediately reinvest (i.e. in stock). Then the investment doubles. You sell it and pay capital gains tax of 30%. OR, what if in Scenario 2, you hold it until it reaches $200 and sell it only once?  

Screen Shot 2019-06-21 at 9.00.24 AM

This is illustrated and perhaps more easily relatable when thinking about 401(k) plans. The value of a 401k is that it avoids double taxation. You pay taxes on earnings, invest the money and the appreciation of that investment does not get taxed.

Screen Shot 2019-06-21 at 9.02.10 AM

The key point here, is that to avoid or minimize double taxation, you should hold your options as long as possible.  

Option Leverage and Double Taxation

In the graph below we have combined the concepts of Option Leverage and Double Taxation, using the same example from above of 10 options with an exercise price of $8.

Screen Shot 2019-06-21 at 9.07.12 AM

The yellow and red areas represent “value lost” from option leverage and double taxation due to exercising too early.

The blue line and area represents the value you realize if you exercise and hold the investment. The later you delay exercising, the more value you capture.  

* If you exercise at $20, you receive $60 [((10 options * $20 stock price) – (10 options * $8 exercise price)) * (1 – 50% tax rate)]. Then your $60 is reinvested in 3 shares of stock ($60 / $20 per share), which grows to $50 per share. That investment is then worth $150 ($50 * 3), but the $90 of growth ($150 – $60) is taxed at capital gains of 30% or $27. So your net proceeds are $127 ($150 – $27).  

Question: Why do we keep talking about exercise AND reinvest or hold?  

Answer: In order to illustrate the value of holding an option over time, we have to compare it to something. An apples-to-apples comparison is a reinvestment in the same underlying stock.

Question:  Shouldn’t I exercise and sell my options/stock and diversify or reinvest in a broader portfolio, say the S&P 500.

Answer: Perhaps. But consider that if you believe the underlying stock, i.e. your company’s stock, is going to perform similar to a broader market index like the S&P 500, then you are better off holding your options so you can capture Option Leverage and minimize Double Taxation.

Footnote: 

(1) All the tax examples are super-simplified tax rates. The goal is to illustrate the concept so we assume a 50% combined federal and state tax rate for ordinary income and we assume investment income qualifies for capital gains treatment and that rate is assumed to be 30%. Both rates could be higher or lower based on individual circumstances.