Monthly Archives: October 2015

transfer pricing

October 23, 2015 By in Uncategorized Tags: , , , , , , Leave a comment

transfer pricing

Consider the case of a Japanese company that makes cars in Brazil, which it then sells in the US.  Its internal control books will allocate a portion of the revenues and costs of a given car to operations in Japan for use of the brand name and the firm’s intellectual property, another portion to the manufacturing operations in Brazil and a third to the sales operations in the US.

This allocation process is called transfer pricing.  This in itself is a benign process.  After all, the firm has to understand whether Brazil is a profitable place to make cars and whether the Brazilian output should be allocated to the US or to other, potentially more profitable, markets.

What makes transfer pricing controversial, however, is that the firm also has tax books.  And the logic that dictates the management control profit decisions may not be the same as the one that minimizes taxes.

An example:

When I began working as a global portfolio manager in the mid-1980s, Tokyo was a very important stock market.  Multinational brokers all had lavish offices in swanky downtown districts and very large staffs–all of which seemed to be growing by the day.  Yet, I kept reading, at my then glacial, now non-existent, kanji speed–in the Nihon Keizai Shimbun that these same brokers were losing tens of millions of dollars a year.  This state of affairs had been going on for years, with no relief in sight.

I began asking around.  What I learned , after a long time of digging, was that all of the Japanese securities trades that customers placed with these brokers were funneled through their Hong Kong offices.  In an operational sense, this was crazy.  I knew most of the Hong Kong operations of these firms.  They knew nothing about Japan, in my opinion.  And, of course, this was an extra, possible mistake-inducing, step.  Why?

The answer is simple.  Japan had, along with the US, the highest corporate tax rates in the world.  In Hong Kong, the tax on foreign corporations’ profits was zero.  So every foreigner in any line of business established a Hong Kong office and recognized on its tax books as much international profit there as it thought it could get away with.

What’s in this for Hong Kong ?  Again, simple.  The move created employment, commerce and taxable salary income that the now-SAR would not have had otherwise.  The price was only forgoing tax income it would never have had anyway.

The general transfer pricing tax strategy:  recognize as much profit as possible in low-tax jurisdictions, the minimum amount in high-tax locations.

turning to the EU today…

Margrethe Vestager, the new EU competition commissioner, is starting a crackdown on what the union considers abusive tax practices.  Her first targets are Starbucks and Fiat.

In the Starbucks case, Vestager has two gripes.  Both relate to a low-tax corporate subsidiary set up by Starbucks in the Netherlands, using an aggressive tax strategy endorsed as legal by that government thorough an informal tax letter.   (The situation is outlined best, I think, in a New York Times article).  The subsidiary allegedly:

–bought coffee beans for Starbucks worldwide from Switzerland and marked them up by 20% before selling them to other parts of the company, thus shifting profits away from higher-tax jurisdictions around the globe, and

–levied charges for the use in the EU of the Starbucks name and its secret coffee roasting recipe (which the EU competition commission claims was basically a temperature setting).  In the case of the large UK subsidiary of Starbucks these fees for intellectual property apparently amounted to most of its pre-tax income.

 

Vestager is not saying that Starbucks, Fiat and others did anything wrong.  She’s saying the Netherlands, and other countries that offered sweetheart tax deals did.  And she wants those countries to collect back taxes.

It will be interesting to see what develops, since presumably every multinational doing business in the EU is employing similar devices.

 

 

 

thinking about 2016: currencies

October 22, 2015 By in Basic Concepts, currency effects, Strategy Tags: , , , , , , , Leave a comment

There’s no overall theory of how world currencies interact with one another.  Rather, there’s  patchwork of general relationships.  I find two most useful:

—general creditworthiness, or would I lend money to these guys (WILMTTG)?.

Another way of asking the same question is whether a country can generate enough foreign exchange to pay for its imports and meet the minimum service requirements on its foreign borrowings.  A “No” answer means trouble.

Natural resources-oriented emerging countries, both in the Middle East and in Latin America, are going to flunk this test, suggesting that for them currency depreciation is in store.

—relative interest rates 

Generally speaking, countries where interest rates are rising will have stronger currencies than those where rates are stable or falling.

This rule suggests that the US$ will continue to rise against the euro, yen renminbi and emerging markets currencies–meaning just about everything.

 

As a practical matter, domestic stock markets seem to work best when a currency is stable or depreciating slightly.  A rising currency, because it lowers the domestic currency value of foreign earnings, acts as an earnings headwind.

 

I’ve found that the currency markets–read: traders in the big multinational commercial banks–are always three or four steps ahead of me in figuring out where currencies are going.  For equity investors, there may also be an issue of how the companies whose stocks they hold are acting internally to hedge their foreign currency exposure.

Typically, this second isn’t as big an issue as it might seem at first.  Stock markets most often understand that hedges now protecting profits will soon expire and, in consequence, pretty much ignore the earnings per share generated by hedging.

The question of what’s already baked in the currency trading cake is a more serious one.  It has me questioning whether any interest rate rises that may come in the US next year aren’t already factored into today’s currency rates.

my conclusions

The US$ will be flat to up vs. all other currencies next year.

The yen will be down, on my “No!” answer to the WILMTTG question.

Emerging market currencies will generally be weak.

The renminbi will be flattish, on weak relative rates but “Yes to WILMTTG.

Too soon to act on, but will the euro be stronger in the second half?

stock market implications

All other things being equal, companies with costs in weak currencies and revenues in strong currencies will have the best financial results.

Multinational companies based in the US with exposure to natural resources emerging markets may do poorly.

Those with EU exposure may show slim growth, if any, in their operations there in the first half.  Better news in the second?

As a general rule, when the domestic currency is rising, look for purely domestic companies and for importers.

 

thinking about 2016: oil

October 21, 2015 By in Energy, Gold, Industry Analysis, Mining, oil and natural gas, shale oil and gas Tags: , , , , , 1 Comment

Regular reader Chris commented about yesterday’s post that we may be in the early stages of a decade+ downcycle in the oil price.  I thought I’d elaborate on that thought today.

base metals–gold, too

I think the situation with base metals is very clear.  Capacity is typically added in very large increments, and by all parties in the industry at once, creating the top of the market.  The mines can be shut down, but the orebodies don’t disappear.  Neither does the machinery.  So operations can be restarted fairly easily.  As a result, the market only comes back into balance as economic growth slowly expands, eating into the oversupply overhang.  Last time around, in the early 1980s, this process took well over a decade.

oil

Th case of oil is slightly different.  The petroleum industry is far bigger and more important than metals.  In most cases, there are no good substitutes.  Use for heating and transportation can’t be postponed.

Discovery of new reserves is a much more important factor in production.  The ability of oilfields to extract output without significant new drilling can deteriorate sharply if wells are shut down, interrupting the underground flow of oil to them.  Because of this second factor, very small differences between supply and demand can have dramatic.

 

At the last oil peak in 1980-81, two factors conspired to stretch out in time the fall in prices needed to restore supply-demand balance.

–The US, the world’s largest petroleum consumer, enacted a byzantine series of price control laws to prevent higher oil prices from being passed on to consumers.  This delayed conservation into the 1980s, when the regulations were dismantled.

–Saudi Arabia, then the largest oil producer in the world, decided to cut its production in an unsuccessful attempt to prop up prices.  It went from 10+ million barrels per day in 1980 to just over 3 million in 1985.  Although other OPEC members also agreed to curtail production, widespread cheating (typical cartel behavior) undermined the supply reduction effort.  The oil market finally bottomed at around $8 a barrel (the high was $34 in December 1980) when the Saudis got fed up and began to restore production in 1986.

 

This time, neither factor is present.  The only residual of 1970s efforts to promote oil use in the US is the country’s relatively low level of tax, by world standards, on gasoline.  Saudi Arabia, having learned a bitter lesson from the 1980s, has actually increased production slightly.

 

I think this means that the bottom for oil will come much more quickly than in the 1980s.  It may be happening now.

I don’t think there will be a quick rebound, however, even though the excess supply now present in the world may only amount to 2% – 3% of total demand.  That’s because:

–demand is growing more slowly than experts have been predicting

–hydraulic fracturing is proving less vulnerable to lower prices, as frackers streamline their procedures to lower costs (no one worried about efficiency when oil was $100 a barrel)

–removal of economic sanctions on Iran will give a one-time boost to supply of about 500,000 barrels a day (on world production of roughly 90 million bbl/’day).

my thoughts

If I had to guess, I’d say that fracking has permanently changed the supply/demand situation in oil.  New capacity can be added quickly, in lots of small increments, at around $60 a barrel.  I think this puts a (permanent?) ceiling on the oil price, or at least one that lasts for longer than we as investors need to worry about.

The bottom is harder to figure out.  If we were back in 1980, when world demand was about 60 million barrels a day and almost half came from ultra-low-cost sources in OPEC, revisiting the 1986 lows might be an ugly but realistic option.  However, with production now around 90 million and the Middle East closer to an afterthought than a real price-setting power, enough output is being curtailed at current prices that I think we’re probably in the bottoming process now.

At some point, aggressive investors will sift through left-for-dead small exploration companies to find survivors.  I’m sure industry experts are already doing so.  I’m not an expert any more.  I’m not doing so yet.  My inclination is to look for consumer or tech companies that stand to benefit from the boost to economic activity created by lower oil.

 

thinking about 2016: commodities

October 20, 2015 By in Current Market Thoughts, Portfolio management, Recent Market Action, stock market, Strategy Tags: , , , , , , , , , , 4 Comments

commodities

In the broadest sense, commodities are undifferentiated products or services.  Producers are price takers–that is, they are forced to accept whatever price the market offers.

Commodity products are often marked by boom and bust cycles, that is, periods where supply exceeds demand, in which case prices can plummet, followed by ones where supplies fall short and prices soar.

 

For agricultural commodities, the cycle can be very short.  For crops, the move from boom to bust and back may be as little at one planting season, or three-six months.  For farm animals, like pigs, chickens or cows, it may be two years.

 

For minerals, which right now is probably the most important commodity category for stock market investors, cycles can be much longer.  Base and precious metals have recently entered a period of overcapacity.  The previous one lasted around 15 years.  One might argue that prices for many metals have already bottomed.  I’m not sure.  But I think it’s highly unlikely that they will rise significantly for an extended period of time.

 

Oil is a special case among mined commodities.  Lots of reasons

–the market is huge, dwarfing all the metals other than iron/steel.

–there’s a significant mismatch between countries where oil is produced and where it’s consumed.

–there’s one gigantic user, the US.

–for many years, there was an effective cartel, OPEC, that regulated prices.

To my mind, the most important characteristic of oil for investors at present is the wide disparity in out-of-pocket production costs between Saudi crude ($2 a barrel) on the one hand, and Canadian tar sands ($70? a barrel) on the other.  US fracked oil ($40? a barrel) is somewhere in the middle.  The lower-cost producers have gigantic capacity, and the potential to ramp output up if they choose.  This wide variation in costs makes it very difficult to figure out at what price enough capacity is forced off the market that the price will stabilize.  For example, Goldman, which has an extensive commodities expertise, has argued that under certain conditions crude might have to fall to $20 a barrel before it bottoms.

 

The oil and metals situation is important for any assessment of 2016, because:

–about 25% of the earnings of the S&P come from commerce with emerging markets, many of which depend heavily on exports of metals and/or oil for their GDP growth

–the earnings for about 10% of the S&P 500–the Energy, Materials and Industrials sectors–are positively correlated withe the price of metals and oil.

–a low oil price is a significant economic stimulus for most developed countries, meaning margins expand for companies that use oil as an input  and consumers spending less on oil will have more money left to spend elsewhere.

As a result, one of the biggest variables in figuring out earnings fo the S&P next year will be one’s assumptions about mining commodities prices, especially oil.

 

More tomorrow.

 

 

thinking about 2016

October 19, 2015 By in Current Market Thoughts, Long-term themes, Recent Market Action, Strategy Tags: , , , , , , , , Leave a comment

At present, world stock markets appear to me to be obsessively focused on the smallest details of the here and now.  This may be fine for short-term traders, but getting caught up in this mindset is the surest recipe for trouble for us as long-term investors.  Our biggest advantage against professional traders is taking a longer view.

So it makes sense that we should be shifting our focus toward the new year, even though (actually, because) I think the markets have yet to do so.

My thoughts (which will be presented in more detail in my yearly strategy posts in a few weeks):

interest rates

Rates will be somewhat higher a year from now than today.  The Fed, however, has made it clear that the journey back from emergency-low rates to normal–that is to say, from zero to perhaps 2% for overnight money–will take years.  In theory, higher rates make fixed income relatively more attractive to investors than stocks, mimplying that the stock market suffers price-earning multiple contraction.  I’ve written a number of times, and I still believe, that virtually all of this contraction has long since been factored into today’s stock prices.  Even if this is incorrect, next year’s rise is going to be quite small.  Absent a crazy panic, the potential headwind from PE contraction is likely to be extremely small.  

world economies

–the US will continue to be strong

–the EU has bottomed and will gradually strengthen, so next year will be better than this

–China ‘s transition from export-oriented growth to expansion led by domestic consumer spending is happening at a satisfactory pace.  While traditional economic indicators, which are generally speaking all focused on exports (the wrong place to look), continue to be ugly, overall economic growth next year will be at least as good as in 2015

–natural resource-producing emerging countries will continue to have troubles.  The main issue will not be lower commodity prices.  It will be dealing with excessive debt taken on when companies/governments believed in a perpetual commodities boom, and adjusting private/government spending downward to deal with lower levels of commodity income.

 

More tomorrow.