I’ve decided that it’s time for me to overhaul PSI so it looks better and it’s easier to access past information. I’m not going to be posting on Sundays while my repair work is under way–unless, of course, there’s some piece of investment information that’s so urgent it can’t wait a day. So far, in my thirty years of involvement with stock markets, nothing like that has ever happened–but you never can tell.
Mitt Romney’s taxes
Mitt Romney’s partial disclosure of his tax situation has reopened debate on the issue of how private equity managers and some hedge funds use carried interest as a device to shelter their earnings from tax.
Since Mr. Romney left the private equity business a decade ago, it seems to me that he isn’t currently using carried interest as a tax shelter. In all likelihood, it’s some combination of itemized deductions, like charitable contributions or state and local taxes paid, and the favorable treatment of long-term gains on investments that’s producing his low tax rate. But he was a prominent figure in the private equity community, so the press–and his political opponents–have made the connection anyway.
Powerful lobbying efforts by the private equity industry have defeated repeated attempts to close the tax loophole it uses to lower its executives’ tax burden.
I wrote about this topic in mid-2010. But I haven’t read anything, wither in the current discussion or in the past, that explains exactly what a carried interest is. Hence this post.
A carried interest is a participation in an investment venture where the holder gets a share of the cash generated by the project (profits or cash flow) without having to contribute anything to the venture’s costs. The holder of such an interest is “carried” in the sense that the other venture participants pick up the burden of his share of project expenses.
Carried interests aren’t just a private equity phenomenon. They’re very common in the mining industry, which is where I first encountered them thirty years ago. But they also occur in lots of other industries, particularly those where highly specialized experience or skills, or possession of crucial physical resources are key to a project’s success. In the extractive industries, holders of mineral rights may be carried. The fund raisers or organizers of any sort of projects may be carried, as well. So, too, famous actors or holders of key intellectual property.
variations on the theme
As with everything in practical economic life, there are myriad variations on this basic idea. For example,
–a party may not be carried for the entire life of the project, but only up to a certain point–say, when cash flow turns positive.
–the other parties may be entitled to recover the “extra” costs they’ve paid to subsidize the carried interest before the carried interest receives a dime (there are also lots of variations on the cost recovery theme), or
–the carried interest may only be paid if the project exceeds specified return criteria.
In plain-vanilla projects, the carried interest receives a portion of the recurring revenue that the venture generates. This is ordinary income and taxed as such. The private equity case is different.
private equity and carried interest
Private equity raises equity money from institutions or wealthy individuals, arranges financing of, say, 3x -5x that amount, and uses the assembled war chest to make acquisitions. It targets mostly badly run companies. It spruces them up and resells them a few years later. There’s no conclusive evidence that this process adds any economic value, although it certainly sets the process of “creative destruction” in motion in the affected company–but that’s another issue.
Private equity companies appear to me to act as a blend of business consultants and managers of a highly concentrated (and extremely highly leveraged) equity portfolio. What’s really unique about them is their pay structure.
Private equity charges its clients a recurring management fee of, say, 2% of the assets under management plus a large performance bonus if the turnaround projects they select are successful. This bonus is structured as a carried interest (an equity holding) in each individual project. Because the projects last several years and result in an equity sale, the bonus payments are capital gains, not ordinary income. This means the private equity executives’ tax bill is much less than half what it would be if the payments were income.
You’ve got to admit that turning investment management income into capital gains is a clever trick. Should the loophole be closed? When I first wrote about this I thought so. I still do. But I’d prefer to see more comprehensive tax reform that achieves this result rather than specific legislation that targets the private equity industry. I also find it somewhat disturbing that private equity political contributions and lobbying allow them to “own” this issue in Congress, despite the fact that private equity’s taxation is clearly different from other investment managers’, from management consultants’ and from corporate executives’ for basically the same activities.
Risk and Return
Bond investors will face some difficult choices in the months ahead. Our base case for 2012 includes a modest acceleration of GDP growth accompanied by an improvement in employment and personal income. US housing prices will finally stabilize and inflation, as measured by the Consumer Price Index less food and energy costs, will continue to rise. (This inflation measure bottomed at 0.6% year over year in October and now stands at 2.2%.) The Federal Reserve, however, is likely to keep short term interest rates at virtually zero. All this points to a significant rise in government bond yields.
The current yield curve for government bonds looks strikingly similar to that which prevailed at the close of 2008. Based on the improving domestic economy and our assumption that the European debt problems will be contained (admittedly, not a universally held point of view), we think the changes in bond market yields will be very similar to those which occurred in 2009. If so, it implies interest rate increases in excess of 150 basis points for US Treasury securities with maturities of five years or more. That translates into a near 12% price decline for ten year government securities. To avoid these possible losses, investors would need to shrink the average maturity of their portfolios to two years or less and accept current returns of 0.25% versus the 2%-plus yields now available on longer dated investments.
Mortgages, normally a refuge for investors in a rising rate environment, pprobably won’t be a good port of call in 2012. The market prices of high coupon mortgage securities are astronomical–GNMA pass-thru mortgages with coupons between 5% and 7% are being valued at 110% to 115% of par value. These premiums are much higher than during previous low yield episodes; for example, GNMA 7% coupons never traded above 106 until mid 2010. The current mortgage market bubble has occurred because mortgage refinance activity in these premium coupon mortgages has been exceptionally low, limiting prepayment losses for investors. Borrowers have been unable to refinance because they are underwater on their existing mortgages and lack the equity to meet requirements on new mortgages. That could all change with the stroke of a pen.
It is rumored that President Obama wants to replace the acting Federal Housing Finance Agency head with a more activist chairman and push for a multi-trillion dollar refinancing plan. It would permit current borrowers in the government agency guaranteed programs to refinance into lower coupon mortgages with no requirements other than being current on the existing mortgage. No appraisals, no income verification, no upfront payments. This is actually a great idea. It would save consumers tens of billions of dollars a year, increase housing demand and lift home prices, and boost economic growth–in an election year no less. The losers under the plan would be holders of high coupon mortgage securities who would probably see the market value of their investments drop at least 5%.
While a change in the rules could hurt high coupon mortgages, their lower coupon cousins–the mortgage pass through securities with 3.5% to 4.5% coupons–would be crushed if interest rates rise. Given the already inflated prices of even these securities, their upside appreciation potential, even in a declining interest rate environment is very limited. (And we could see that further reduced if government actions unleash a flood of new low coupon securities.) Meanwhile, they would suffer sizeable price declines and negative total returns if interest rates rise.
As we begin 2012, most of our accounts are 20% to 30% below their benchmark maturity targets. This is at the outer end of our usual duration bands and represents a significant call on the direction of interest rates. During the fourth quarter of 2011, we added to our holdings of short term US Treasury notes. We are generally overweight US Treasury securities compared with mortgages. Nonetheless, a large rise in market yields would result in losses for most of our portfolios. Accordingly, it is possible in the months ahead we may adopt an even more defensive maturity stance if the economic and political scenario we envision begins to materialize.
In closing, we thank you, our clients, for your support during 2011 and we will continue to work to merit your loyalty in the year ahead. We wish you a healthy and prosperous New Year.
Note: The Market Environment reflects the vies of the Investment Advisor only through the date of this report. The Investment Advisor’s views are subject to change at any time based on market and other conditions. December 31, 2011.
Thanks again to Strategy Asset Managers for allowing PSI to publish “Bond Market Environment, Fourth Quarter 2011.”
This is the second of three installments of a yearend analysis of the bond market by Strategy Asset Managers, LLC.
Follow the money
The Federal Reserve recently released its quarterly flow of funds study for the period ending September 30th. Despite a brisk pace of federal government borrowing, aggregate credit demands remained weak. Total non-financial debt grew at about a 4% pace as households shrank their borrowings. This provided plenty of space for federal government debt to expand. Meanwhile, the Federal Reserve was dumping huge amounts of money into the economy. A broad measure of money supply–so-called M2–increased 9.8% over the last year. Lots of money and little credit demand resulted in very low interest rates. This could change quickly, however.
The US consumer has been tightening his/her belt since 2007. The bursting of the housing bubble resulted in lower home prices, lower turnover and a decline in mortgage debt outstanding–from $14.8 trillion in June 2008 to $13.6 trillion in September 2011. Faced with a troubling job market, consumers reduced non-mortgage debt as well. This peaked at $2.6 trillion in 2008 and now stands at $2.47 trillion. This borrowing metric seems to have stabilized recently as consumer confidence in future economic prospects has improved.
While the household sector of the economy has been paring back debt, the financial sector–commercial banks and savings & loans–has been reducing debt and balance sheet leverage. This explains why few are worried about the leakage of European banking problems into our financial system. So, once folks are ready to buy a new car or upgrade to a bigger house, banks will be able to provide them credit. Despite the massive (+300%) growth in federal government borrowings over the last decade, households remain the largest sector of the credit market with $13.2 trillion of debt outstanding versus $10.1 trillion of federal government debt. If household borrowings increase by just 5%–less than half the rate experienced in the first half of the last decade–aggregate credit demand could rise by 7%. This rate of expansion is not compatible with the current low level of interest rates.
That’s it for today. SAM, LLC’s conclusions tomorrow.
Here’s yesterday’s initial post in this series.
My first boss on Wall Street, who taught me securities analysis in the late 1970s, switched to the fixed income arena in the early 1980s. He runs Jamison and McCarthy Investment Advisors LLC, which manages money for institutions and high net worth individuals. His 4Q11 letter to clients gives a polished industry veteran’s view of the current global economic situation and its implications for bonds. He’s relatively bearish.
The analysis is very worthwhile reading. It’s long enough, however, that I’m going to publish it in three posts, all sans charts. Here’s the first, an outline of the current bond situation:
Is it time to get off the bus?
2011 was a remarkable year. The bond market encored its 2008 performance as investors flocked to the safety and liquidity of US Treasury securities. We brought back the same actors–inept central bankers, anxious politicians, sketchy borrowers and frightened investors. The accents were a little different–more European–but the plot was the same–a financial system supposedly on the verge of collapse. And the ending for investors was also the same–the frugal, risk averse bond buyer won the prize in the final scene. The prize in this case was a whopping 30% return from investing in long term US Treasury bonds. And this came on top of a good showing in 2010–a 9.4% return for US Treasury bonds. But as all moviegoers know–the third installment in a series is usually a dud.
We don’t think the numbers add up for another bond market rally in 2012. Last year’s increase in bond prices lowered yields sharply. For example, the Barclay’s Long-Term US Treasury Index closed the year with an effective yield to maturity of just 2.7%. This compares with 4.1% a year ago. The smaller yield means a smaller cushion against any price decline. Meanwhile, the mathematics of bonds is such that lower yields equal greater price risk for any given change in interest rates. The measure of risk is called duration and the duration of the Barclay’s Long-Term US Treasury Bond Index on December 31st was 16.2 compared with 13.9 for a similar basket of bonds a year earlier. Now, investors should expect that a one percentage point change in interest rates would cause a 16.2% change in the price of the bonds, a very nice gain if interest rates for twenty year government bonds fall to 1.7%. If, however, the yield of such securities rises to just 3.7%–a level 50 basis points below the average of the last five years–get ready to book a 13.5% negative total return (yield plus price change). Of course, the returns from bonds with shorter maturities would be less damaged. Nonetheless, there would be plenty of red ink for all.
If you think current bond market returns aren’t very generous, you’re right. The sub-2% ten year government bond yields produced during the final quarter of 2011 were the lowest on record. In fact, they were lower than the rate of inflation. This has rarely occurred. This occurred during the inflation tsunami of the Seventies, and again, briefly, in 2005 and early 2008 when oil prices spiked.
The bond market has reached these low levels because of:
(1) fears of a European banking crisis,
(2) the free money policies of the Federal Reserve, and
(3) modest non-government domestic credit demands.
The impact of these factors is being amplified by hedge fund “risk-on, risk-off” trading that pushes short term money between various capital markets. If any of the three legs supporting the bond market cracks in the months ahead, a substantial interest rate increase is in the cards.
When TIF reported 3Q11 earnings (Tiffany’s fiscal year, like that of most retailers, ends in January), it lowered its 4Q profit guidance (see my post).
By then, the company had seen sales for virtually the entire month of November and had detected weakness in spending by residents of the Northeast and Mid-Atlantic regions of the US. At that time, it still expected a “low-teens percentage increase” in worldwide sales during 4Q11. But it effectively clipped $.10 from its estimate of per share profits for the year’s final three months, saying it expected to earn $1.48 – $1.58 per share during the period. That would be 6.3% more than the $1.44 it earned in the comparable period of fiscal 2010.
the weakening holiday selling season
Last week, TIF reported the results of its worldwide sales for November plus December.
The news wasn’t good–especially in the US and Europe.
Rather than the low-teens increase in sales the company had been anticipating, revenues were only up by 7%.
By region, they broke out as follows:
Americas total sales = +4%, comp store sales = +2% (3Q11 comps = +15%) ←
Asia-Pacific (ex Japan) +19%, +12%, (+36%) ←
Japan +13%, +6%, (+4%)
Europe +1%, -4%, (+6%).
In the US, sales to residents were down year on year. Buying by foreign tourists pushed results into the plus column.
In its press release, TIF reduced its eps forecast for 4Q11 by another $.10-$.15. It now expects to earn $3.60 – $3.65 for the full year.
The stock fell 10% on the news. Unlike other stocks with negative earnings surprises, TIF hasn’t rebounded.
December must have been a particularly disappointing month for TIF, since management had already revised down its expectations based on November weakness.
Recent macroeconomic reports are almost universally signalling that the US economy is improving. In the jewelry industry in particular, Signet reported on the same day as TIF that its same store sales in its Kay business were up +9.8% and in Jared, +10.0%. Similarly, Zale reported that its non-kiosk US jewelry business had same store sales growth of +9.0%. Neither is showing anything like the weakness in TIF’s business.
TIF is much farther up-market than either Signet or Zale. Presumably, that’s the source of the difference. It looks like TIF’s high-end US customers left their credit cards at home last month. My guess is that the problem resides in the waning fortunes of executives in financial services and the industries, like legal, which support it.
Look at the Asia-Pacific figures above, as well. TIF didn’t highlight this area. Same store sales are still high at +12%. But three months ago they were growing at a +36% pace, or 3x the current rate.
what to do
At last Friday’s price of $59 or so, TIF is trading at 16x fiscal 1011 eps and yielding 2%. That looks cheap to me.
On the other hand, we have only guesses as to what’s causing the current deceleration in company sales. They’re probably good guesses, but still…
For investors, the more pertinent question is probably when earnings comparisons will begin to pick up again. My tentative answer is–not soon. In fact, earnings comparisons could be negative or flat until late in 2012.
So my thoughts remain unchanged from late November. I don’t feel any need to sell the stock I own, but I don’t think I have to hurry to buy more. If I didn’t own any I might buy a small part of a position now, but no more than that.
I’ve must updated Current Market Tactics. If you’re on the blog, you can click the tab at the top of the page.