Thank you for ten years in business!

The year 2004 marks our 10th anniversary as Fee-Only Investment Advisers. We believe your long-term relationships with us are responsible for this important achievement, and we wish to express our sincere thanks. We will endeavor to continue to earn your business in the years ahead.

DJIA 10,453.92
Prime Rate 4.00%
Three-Month Treasury Bill Yield 0.89%
Six-Month CD Yield 1.15%
Five-Year Govt Bond Yield 3.27%
Ten-Year Govt Bond Yield 4.25%

Popular Stock & Bond Indices:

Interest rates remain low compared to previous years, and stocks, as measured by the Dow Jones Industrial Averages (DJIA), have rallied substantially from thier low points of 2002.

Should you have a 529 College Savings Plan for your children or grandchildren?
Yes, but not for the reasons the promoters would like you to believe.

• We are in the midst of writing an article comparing various ways to save for our children’s grandchildren’s college educations. (Contact us if you would like to receive a copy of this article when it is complete.) Basically, investors can save for their children’s or grandchildren’s college education in three ways. 1. Keep the money in their own accounts until it is needed for college. 2. Establish a Unified Gift To Minors Act brokerage or bank account and fund it annually to the tune of $11,000 ($22,000 for a married couple). 3. Make a donation to a 529 Plan of up to $55,000 ($110,000 for a married couple).

1. By keeping the money until college, parents or grandparents retain control of the money. Taxes on the interest, dividends and capital gains will be paid by the parents or grandparents in their respective tax brackets. By saving in this manner, investors can use the money for any purpose. For instance, if the child gets a scholarship to pay for college, the parents or grandparents can use the savings to help the child buy a car or house, or even start a business. There are no restrictions because the money was always the investor’s.

2. Establishing a UGMA passes the ownership of the money to the minor. The trustee (usually a parent or grandparent) controls the account until the minor is legally an adult, then the money belongs to the child. If the child wants to use the money for college, he can; but he is not obligated to do so. It is his money and he can use it to buy a car, house, etc. So in comparison to the first alternative, the flexibility stays in place, but the control passes to the student (whether or not he decides to go to school). Taxes on interest, dividends and capital gains receive very favorable treatment during the accumulation stage.

For children under age 14, the first $750 of investment income is not taxable. The next $750 is taxable in the child’s bracket, so the first $1,500 of investment income may generate income tax liability of only $75. Investment income for children under age 14 that exceeds $1,500 is taxed in the trustee’s bracket. However, with today’s new tax rates for dividends and capital gains, it is possible that the maximum tax on this investment income would be 15%.

When the child reaches age 14, all the income is taxable in the child’s bracket, which ordinarily would be lower than the parents or grandparents.

3. Contributing to a 529 College Savings Plan, it is possible to carry the tax treatment of the UGMA one step further and eliminate income and capital gains tax altogether. We emphasize the word POSSIBLE, because everything has to work out just right for this to happen. Income and capital gains taxes are deferred while the funds remain in a 529 Plan, and if distributions from these plans meet their respective requirements (used for tuition, room and board, etc at qualified institutions of higher learning) they are not taxed.

Other advantages:

529 funds can be transferred to another family member if the original member does not use the money. This control element is lost under UGMA, but of course it is retained under the first scenario, wherein the parents or grandparents keep the funds in their own account.

Larger sums can be invested. As described, initial contributions can be as much as $55,000 for a single parent or grandparent, or $110,000 for a couple.

Some states allow Plan contributions to be deducted from reported income when figuring state income tax liability.

Be careful. These added features that characterize 529 Plans can be costly if everything doesn’t work out just right.

529 Plans are administered by states. A recent article in Financial Advisor reminds us that there are over 80 state plans in operation today. Each state has its own definition of what expenditures qualify for higher education, and each selects the money managers for its plans. 529 Plan contributors need to examine these different plans in an attempt to find the best match for the student. Of course, this can never be done with certainty, and the ability to change plans is hampered by additional rules and regulations. Additionally:

While some states give tax deductions for residents, other states levy state income taxes on distributions for non-residents, or other state plans.

If your children or grandchildren don’t go to college, liquidation of 529 Plans triggers income taxes and additional tax penalties. Ditto if you need the money for an emergency.

529 Plan advantages depend to a large extent on investment rates of return. As the rate of return declines, the attractiveness of 529 tax advantages decreases: at some point, Plan benefits do not offset the disadvantages outlined above. For example, the Virginia College Savings Plan, using the American Funds family (we like this mutual fund group a lot), in promotional literature, uses the example of investing $50,000 for ten years at 8%. Compounded semi-annually, this return would generate a lump sum of $109,556, available tax-free if used according to specifications. In a 27% tax bracket, the same investmentwould grow at 5.04% [8%X(1-.27)], resulting in approximately $81,930 in a taxable account. So the 529 Plan would create an extra $27,626 for college expenses ($109,556-$81,930).

However, using the 15% tax on the investment income to reflect the new capital gains and dividend tax rates, the after-tax rate of return for taxable investments could approach 7%: [8%X(1-.15)]. This scenario would generate approximately $99,489 after taxes, reducing the 529 Plan advantage to just $10,067 ($109,556-$99,489).

8% may not be a reasonable expectation. Consider the risk-free rate of return, in this case 10-year Government bonds. They yield approximately 4%. At this rate, our imaginary–529 Plan–investment would grow to $74,297 in ten years. Assuming a tax rate of 25% for the sake of brevity, this 4% rate translates to 3% in the taxable world: [4%X(1-.25)]. Three percent growth results in $67,342, reducing the advantage to $6,955 ($74,297-$67,342). Yes, adding risk to the investment portfolio may be appropriate with a ten-year time horizon. However, remember the lesson of 2000-2002 in the stock market: risk has a downside as well as an upside. Unlike in the taxable world, losses in a 529 Plan cannot be deducted for income tax purposes. If the promoters use a rate of return that is 4 percentage points higher than the risk-free rate ofTtreasury bonds, should we also consider a rate of return of 4 percentage points lower than the risk-free rate? IF THERE IS NO RETURN, THERE ARE NO ADVANTAGES.

Time also can be an important influence on potential advantages of 529 Plans. Just as rates of return can enhance or reduce Plan advantages, the time the money compounds tax-free has a great influence on the outcome. In the above example, money growing semi-annually at 8% for five years instead of ten, for instance, reaches $74,012, while a 5% rate would generate $64,005, and a 7% rate would generate $70,529. So the Plan advantage shrinks to $10,007 in the first instance ($74,012-$64,005), and just $3,483 in the second ($74,012-$70,529). When you think about it, college savers if they EVER have $50,000 to invest for college are much more likely to have this much to invest five years before college than ten years before college. So the time factor is important and should be taken into consideration when examining 529 Plans.

The statute granting 529 Plans is scheduled to expire in seven years. Of course, the general expectation is that it will be extended or even made permanent, but we don’t have to remind you that predicting anything in seven years is next to impossible, and as far as what the Government will do

• Bottom Line: YOU ARE IT! You are the advantage. Who will benefit from a college savings plan, regardless of whether it’s in your investment account, or a UGMA or a 529 Plan? The child. That’s what we need to keep in focus. When all of the considerations are analyzed for the different ways to save for college, it is really impossible to document that one way is better than another. The choices are complex and can be quite personal. The important thing to remember is WHY. You are benefiting the child. The child is lucky to have you. From the child’s perspective, having someone who cares is a lot more important than how they save. So we would say, should you have a 529 College Savings Plan? Yes. Should you have a UGMA account? Yes. Should you save for your grandchild’s college in your own account? Yes. The method you choose is up to you.

• In review, choosing a college savings plan can be a complex activity. It can involve income tax accounting, estate planning, investment analyses and even politics. Contact us if you would like

• our input on some methods you may be considering for your children or grandchildren. Please just remember to treat our income tax and estate observations as incidental to our work in investments, and consult with these professionals when you need to.

Are you involved in a mutual fund scandal?
Probably not. Our use of mutual funds has changed significantly during the past few years.

• Few active managers are delivering better results than their benchmarks, which are indices to measure fund performance. Literally hundreds of benchmark indices have been established to measure mutual fund performance, but few funds have shown the ability to give investors as good a return as their respective benchmarks. For example, the S&P 500 is a widely known benchmark index. The Vanguard 500 Index Fund, which replicates the investment return of the S&P 500, regularly outperforms an embarrassing number of fund managers in the large capitalization category that is represented by the S&P 500. This is the bad news about fund performance.

• The good news about fund performance is that today’s technology allows investors to bypass the actively managed funds and buy the benchmarks. The Vanguard 500 Index Fund is the most widely known example of this. There are numerous other, low-cost funds that provide investors with the ability to participate in diverse investments ranging from short-term Government bonds to long-term Government bonds to corporate bonds; or biotechnology, or foreign countries, or small capitalization stocks (like the Russell 2000 Index) or even small capitalization growth versus value stocks. It goes on and on. The main point is that investors can buy low-cost index funds to gain investment exposure to a wide diversity of choices.

• Many of these benchmark funds are EXCHANGE-TRADED FUNDS, or ETF’s. This simply means the funds are traded on stock exchanges like ordinary stocks. Because of arbitrage hedging by large investors, smaller investors like ourselves can buy and sell these funds without having to worry about the relation of their prices to their net asset values. Unlike regular, open-end funds, which investors buy and sell directly with the fund based on the day’s closing prices, ETF’s can be traded anytime during market hours.

• This difference eliminates the most widely known fund scandal to date, namely: special privileges given to large investors to trade funds after market hours. We have been using more of these ETF’s to give you exposure to special segments of the stock and bond markets. Combined with the low transaction costs that characterize today’s commission structure, we believe these new ETF’s will eventually replace many of today’s regular open-end funds.

This doesn’t mean we’re bullet proof.

• While we would like to believe the mutual fund managers we select for you are not involved in any wrongdoing, we are constantly surprised by the number of heretofore highly respected companies that have participated in illegal and immoral activities. The ongoing investigations are very broad, and new potential offenders are being discovered almost weekly.

• For the record, we have sold funds for our clients in the past because of behavior we deemed inappropriate. We believe our job is to make selections. We literally have thousands of choices. As far as we’re concerned, when a mutual fund’s management is implicitly stealing form its shareholders, this just makes our selection process easier: we can scratch this choice and go on to the next one.

What is Schwab’s involvement in the mutual fund mess?

• Schwab acquired The U.S. Trust Corporation in 2000. In the company’s recent quarterly earnings report filed on Form 10Q with the Securities and Exchange Commission, the firm disclosed that some of U.S. Trust Corporations’s mutual funds were involved in inappropriate behavior involving late trades. In the process of disclosing and correcting these practices, Schwab made the point that, in relation to the mutual fund business it processes on a yearly basis, these funds do not represent a statistically significant portion of the firm’s business, and that the firm should not be judged on the activities of this very small infraction. Additionally, Schwab said they were responsible for discovering the improprieties and made full and proper disclosure, indicating the effectiveness of the firm’s internal operating procedures. Importantly, the firm also took responsibility for the infractions.

• Our clients are not involved in these funds because we don’t use them.

• We agree with Schwab that their internal procedures are working well. In our opinion, the company is clearly the leader in this and many other industry fields.

Although you are not involved, the odds are that you will be affected. In the  be-careful-what-you-wish-for department, it is good to remember who pays for regulation. In other words, beware of politicians offering to fix everything. Remember, we can’t legislate risk out of the markets; if we could, everyone would be rich. We believe that proper enforcement of the laws already on the books will/and is going a long way toward resolving the issues. Unfortunately, some of the violations are so egregious, coming from individuals and companies in positions of trust, that some additional regulation will be required. The sad result is that as a capitalist nation we’ll have more regulation in our economy: just what we don’t want but what was brought on by the very organizations that profit from our free-market system. These regulations will be paid for by consumers and small business operators.

Are we going to continue our reports on the Stick-A-Fat-Hog Portfolios?
No. At least we have no plans to maintain this stock list. The SAFH portfolio, while interesting to us, does not really apply to our clients, because the portfolio represents only a small portion of the diversified approach we take in developing our clients Investment Strategies. Future letters will attempt to discuss topics that interest you. Comments and suggestions are welcome.

Sincerely,

Sam Dreher & Tom Veleivs, CFP

Copyright 2004, H.S. Dreher Capital Management, LLC. All rights reserved. This letter is for the information of clients of H.S. Dreher Capital Management, LLC: 275 SE Broad St, Southern Pines, NC 28387, #910-692-4330. Information is taken from sources believed to be reliable, but is not represented to be complete; is not guaranteed for accuracy by the firm and is subject to change without notice. More information on specific companies and topics mentioned in this letter is available upon request.