A Holiday View on Break Even Analysis
by John Valentine and Matt A. White

As many of us seek to wrap up our holiday shopping, we're bound to spend time perusing the malls, main street boutiques, and web sites for those perfect gifts for our family and friends.  In many instances, our purchases will be guided by a wish list, constrained within the limits of a budget, often times leading the consumer to analyze the benefits of one gift versus another.  Without really giving it much thought, we’re performing a type of analysis that is very similar to that of choosing which class of mutual funds is best suited for our investment. 

We'll assume you are shopping on a budget of $100 for a youngster who's given you three options:  a remote controlled car, a digital music player, or a baseball bat.  With your list in hand, you head to the local shopping mall and plan your route: the toy store first, followed by the electronics store, and last, but certainly not least, the sporting goods store.  As usual, the youngster has given you no indication as to which gift he or she would be happiest to receive, so it’s up to you to do some research and analysis.

Upon finding the toy store, you wade through the crowds and find the remote controlled cars.  A quick glance leads you to the car within your budget, and after inquiring with a store sales assistant, you find that the car has a lifetime warranty.  However, there is an upfront $5 recycling fee for disposal of the lithium battery, thus reducing your purchasing power instantly to $95.  Keeping this in mind, you recognize that the long term cost of operating the car is minimal; as when the battery runs out of juice, simply recharge and it’s ready to go.  The box mentions that the average yearly cost of charging the battery is only around $.95. 

As you stand back and take a look at all of the options on the shelves, the whole scene reminds you of the stocks section of your favorite financial publication. Suddenly you are no longer just another Christmas shopper; you are also a savvy, well educated investor.  The toy in your hands has suddenly transformed into a Class A share of a mutual fund.  You recall that Class A shares carry an upfront fee, usually in the range of 5%, thus reducing your initial capital invested.  The annual maintenance fees, which are usually in the 1% range, typically are lower than Class B or C shares, making this a good option for a longer term investment.  As you look back down at the box, you aren’t thrilled at losing the initial purchasing power, as the $95 car isn’t nearly as appealing to you as the $100 version.  As an office, we also don’t recommend Class A Shares for these same reasons (unless we waive the upfront load).  Not 100% convinced, you decide to move on to the electronics store a couple of shops down.

The electronics store is buzzing with excitement as store associates move around to try and fill all of the customers’ holiday orders. A sales assistant happens to walk by and, upon seeing the confused look on your face, stops to help.  She explains to you that, to your amazement, the tiny music player can hold up to 1,000 songs, and just happens to be on sale today: $100 with a lifetime return policy!  She also mentions that you will need to fill the tiny device with music, and there is a subscription service that sells you 200 songs for $2 a year.  However, should you decide to return the music player and cancel that subscription, you will be required to pay a percentage of the original $100 purchase.  If you decide to cancel after 1 year, you will be charged a 5% restocking fee, or $5, after 2 years the charge declines to 4%, and so on until after the 5th year you can cancel with no charge applied.  After the 5 years is up, you have the option to continue purchasing music, but now you only have to pay $1 a year for the 200 songs. 

“The music player,” you think to yourself,  “has the same traits of a Class B share of a mutual fund.”  While there are no hidden upfront charges, your annual upkeep is higher at close to 2%, and you also pay a 5% penalty should you decide to opt out of the shares after 1 year.  Again, this percentage decreases by 1% annually until the 5 year time period is up, yet an investor is left intrinsically locked in to the investment so as to not face paying those trailing charges.   However, after the 5 year period, the Class B shares are typically converted to Class A shares, thus reducing the maintenance fees to closer to 1%.  Should you decide to sell the shares at this point, there is no trailing sales charge, and you can continue to hold the shares, continuing to pay the lower maintenance fee.  You decide that you are impressed with the music player, but this “oh, by the way” effect of selling early leaves you a little uneasy, the same reason that we don’t recommend investing in Class B Shares.  Down to your last option, you continue on to the sporting goods store. 

Now you’ve always been a fan of baseball, so the bat seems like your initial favorite choice.  (The author also has a bit of prejudice, having played baseball while studying economics at Loyola Marymount University.)  The bat rack is easy to find, and again (who knew!?) you find a bat priced to your exact budget of $100.   Your only trailing obligation will be the purchase of a baseball at a price of $1.95, assuming that once a year that ball will be lost and need to be replaced.  The youngster has the option to sell the baseball bat after the first year of use and not pay any penalty.  (Or, if he’s like Jeff Valentine and is a collector of baseball bats, he’s more than welcome to hold on to it).  He’ll only have to purchase a new baseball each time one is lost, again assuming he only looses one ball per year.  Unfortunately, the price of baseballs won’t decrease, no matter how long you decide to keep the bat.   

As you take a couple of practice swings in the store, you are reminded of your recent research on Class C shares.  Class C shares are similar to the baseball bat and Class B shares in that there isn’t an upfront sales charge, yet the deferred charge reduces over the course of only one year (instead of the 5 years with the B Shares).  At the end of that year, you are free to sell your shares without being charged a trailing percentage.  The annual maintenance fee is also typically lower than B shares, yet the fees stay the same as Class C shares won’t convert to Class A shares after any period of time. 

Placing the bat back on the rack, you decide to go to the food court to do some review.  On a napkin, you list the items and draw out the separate costs associated with each of them, forecasting forward for 7 years:

 In doing so, you notice that for the first 5 years it is cheaper to own and operate the baseball bat, and you also don’t run the risk of paying a penalty should you opt to sell or return the item.   With the remote controlled car, the Year 1 costs are impacted by the $5 fee, thus making Year 1 very costly compared to the other items.  Yet going forward, the items all tend to break even around Year 5, with the bat becoming most expensive after Year 6.  The music player is equivalent to the car if you hold for 5 years, but if you decide to discontinue usage after 3 Years you can see how costly it can become.  

If the intent was to hold the items past 6 years, you could in theory pick any of the three items and have a very close price outcome.  While the music player and remote controlled car are great options for the long run, in the short term they can be very expensive.  You recognize that the person on your list has never been the type to hold on to something long term, and is always looking for the next best thing.  In the end, you decide to go with the baseball bat, thus minimizing your annual costs and allowing for a cheap and easy exit from owning the product.  Analyzing the different options leaves you confident that you’ve made the best decision, and you can comfortably cross another name off of your shopping list.

*The hypothetical examples provided in this article are for educational purposes only, and should not be considered a recommendation to buy or sell any security, or an endorsement of any specific investment strategy. Each investor's portfolio must be constructed based on the individual's financial resources, investment goals, risk tolerance, investing time horizon, tax situation and other relevant factors. Please discuss with your financial advisor before implementing an investment plan.

Investing involves risk, including loss of principal. An investor's shares, when redeemed, may be worth less or more than the original investment price. An investor should carefully consider the investment objectives, risks, charges and expenses of a mutual fund before investing. The fund prospectus contains this and other information about the fund. Contact your advisor or the fund company for a copy of the prospectus, which should be read carefully before investing.

Securities offered through Securities America, Inc., a Registered Broker/Dealer, Member FINRA/SIPC, John Valentine, Registered Representative. Advisory services offered through Valentine Capital Asset Management, Inc., an SEC Registered Investment Advisory Firm. Valentine Capital Asset Management, Inc. and Securities America are unaffiliated.