Shenzhen Connect starts next week

…on December 5th.

That’s according to the Hong Kong Exchanges and Clearing Limited (HKEX), whose Stock Exchange of Hong Kong subsidiary signed an agreement with its Shenzhen counterpart on rules for Shenzhen Connect last month.  The agreement was just approved by mainland Chinese regulators.

what is Shenzhen Connect?

It’s a mechanism that allows investors in Hong Kong to buy or sell Shenzhen-listed stocks, up to a specified (but large) total daily limit.  It also allows China-based investors to buy and sell Hong Kong-listed stocks through the Shenzhen Exchange.

The start of Shenzhen Connect trading follows the successful establishment of a similar arrangement between Hong Kong and Shanghai, called Stock Connect, a little more than two years ago.

significance?

In a practical sense, Shenzhen Connect and Stock Connect together end the closed nature of the Chinese stock market.  Doing so is an important economic objective of Beijing.  It’s another step down the road to dismantling the central planning and control that has characterized Chinese socialism since WWII.

rising Shenzhen shares?

Will this signal a boom in Hong Kong interest in China-listed shares?  I don’t think so, but it will be interesting to watch and find out.

Stock Connect, which opened the Shanghai stock market to foreigners wasn’t such a big deal, in my view.  That exchange is dominated by state-controlled banks and by stodgy old industrials headed mostly by state functionaries with no idea of how to run a profitable business.  Beijing will protect the banks but is content to let the  gradually wither and die.  So I didn’t see any rush to be the first foreigner to arrive in 2014.

The Shenzhen Exchange, on the other hand, is home to much more entrepreneurial firms, with little or no official state involvement.  So, in theory, yes, I might want to participate.

A big roadblock for me, though:  I have no idea whether I can trust the financial reports that companies issue.

Two ways to find out: listen carefully to what local players say and do; and visit the companies that sound interesting, interview the managements–and then watch to see how what they say matches up with operating results and what the financials report.

Even then, my experience is that you may not be safe.  Years ago, I visited a small Hong Kong manufacturing company at the urging (I didn’t need much) of a friend.  The firm told me a fabulous story of its success making computers for children.  I went back to see the management some months later.  They didn’t recognize me as a person they’d spoken with before.  This time they told me an equally dollar-sign-filled story, but this time they were an auto parts firm.  Whoops.

I’m not willing/able to put in the effort required to understand how the stock market game is played in Shenzhen.  So, Shenzhen Connect won’t tempt me away from the sidelines.

 

 

Trump and the Trans-Pacific Partnership

globalization and comparative advantage

In 1817, David Ricardo wrote On the Principles of Economy and Taxation, in which he advanced the theory of comparative advantage (I wrote about this at length in a post some years ago).  The basic idea:  rather than each country producing all it needs internally, each country should focus on the industries it does best and trade extra output with others for everything else it needs.  Ricardo’s assertion, which has been the general guiding light of trade policy since, is that every country is better off this way, even those who aren’t particularly good at anything.  A corollary: erecting trade barriers makes not only the world as a whole, but in particular the country that does so, worse off, not better.

TPP

The latest iteration of free trade policy is the Trans-Pacific Partnership, a proposed agreement that would govern trade in almost half the world.  It has two main characteristics that I think have big implications for Americans.  It offers new protections for American intellectual property abroad, which I think is a big plus; and–my main objection–China is deliberately excluded.

Trump on TPP

President-elect Trump says he’ll withdraw the US from TPP on his first day in office.  Withdrawal will likely have several negative consequences, however:

1.IT, entertainment, pharmaceutical and other industries that export intellectual property will lose promised protections

2.To the degree that Americans lose favorable trading arrangements, our standard of living will decline, at least in comparison with TPP insiders, if not in absolute terms

3.China is advancing an alternative to TPP called the Regional Comprehensive Economic Partnership.  Although this is at present a trade agreement focused on the Pacific–and which excludes the US–the collapse of TPP on US withdrawal could prompt China to expand the RCEP to include TPP countries ex the US.  That would presumably leave us on the outside looking in on getting preferential trading arrangements with two-thirds or more of the world.

Unhappily, I see no evidence that Mr. Trump is aware of any of this. In fact, from his public persona it’s hard to disagree with Republican critics who have said that, despite his Wharton degree, he doesn’t seem to know any economics at all.

globalization’s downside

There is a downside to globalization.  As countries specialize, workers in non-competitive industries lose their jobs.  In economic theory, government steps in to support them and to offer retraining so they can be reemployed again.  As far as I can see, any such efforts from Washington to date have been way less than is needed and even less effective than the VA.  To my mind, this is at the heart of what Trump voters mean when they say they want change.

Ironically, Donald Trump’s campaign statements will likely make the situation worse, not better, for all Americans–and for his forgotten-American supporters in particular. Dawning realization may be the source of the deer-in-the-headlights vibe Mr. Trump seems to me to be giving off these days.

 

 

 

 

 

 

parking lots

It’s Black Friday, a shopping day that will likely reveal how widely wallets will be oepned this holiday season.  It’s also Recovery Day, from Thanksgiving overeating.

 

For no particular reason, other than I saw an article in Wednesday’s Wall Street Journal  in which a hedge fund manager reveals he has “discovered” parking lots as an investment form, I’m going to write about them.

There’s really nothing new about parking lots as an investment.  From forever, real estate companies-and enterprising individuals–have bought raw land on the edge of towns in the hope that urban expansion will reach their purchases, making them quantum leaps more valuable.  While they wait, the owners generate cash flow by making their purchases into parking lots.

In today’s time of gentrifying neglected parts of big cities, buying existing parking lots in poor neighborhoods can serve the same function.

For what it’s worth, real estate investors in the US used to do the same edge-of-town thing on a much larger scale–and with notably less success–by converting big speculative tracts into amusement parks.

The biggest drawback I can see to parking lot ownership is the fact that it involves controlling huge numbers of relatively small cash transactions.  Keeping track of them is one issue.  Making sure all the receipts are recorded is another.  A third is that, again from forever, parking lots have been a standard way for the underworld to launder the proceeds of their  illegal enterprises–making them look wildly more profitable that they actually are.

I’m not sure the hedge fund guy from two days ago realizes what he’s getting into.

US corporate tax reform (iii)

For years ago I wrote in detail about today’s topic, which is deferred taxes.

The basics:

–deferred taxes are an accounting device that reconciles the cheery face a company typically present to shareholders with the more down-at-the-heels look it gives the IRS, while accurately reporting to both parties the cash taxes paid

–look at the cash flow statement, which, as the name implies, shows the cash moving in and out of the company or in the income tax footnote to get the particulars for a firm you may be interested in.

accounting for a loss

The issue I’m concerned about in this post is what happens when a company makes a loss.

reporting to the IRS

The income statement  for the IRS looks like this:

pre-tax income (loss)      ($100)

income tax due                          0

after-tax income (loss)     ($100).

reporting to shareholders

Financial accounting books, in contrast, look like this:

pre-tax income (loss)         ($100)

deferred tax, at 35%                 $35

after-tax income (loss)        ($65).

what’s going on

The financial accounting idea, other than to cosmetically soften the blow of a loss, is that at some future date the company in question will again be making money.  If so, it will be able to use the loss being incurred now to offset otherwise taxable future income.  Financial accounting rules allow the company to take the future benefit today.

It’s important to note, however, that the deferred tax is an estimate of future tax relief, based on today’s tax rates.

why does this matter?

Profits add to shareholders’ equity; losses subtract from it.  Under the GAAP accounting used for reports to stockholders, a loss-making company only has to write down its shareholders’ equity (aka net worth, book value) by about two-thirds of the actual loss.  To the casual observer, and to the value investor using computer screening, it looks stronger than it probably should.

Financial stocks typically trade on price/book.  This is also the sector that took devastatingly large losses during the financial crisis (that they caused, I might add).

Suppose the corporate tax rate is reduced to 15%.

This diminishes the value of any tax loss carryforwards a firm may have.  It also may require a substantial writedown of book value, making that figure more accurate.  But the writedown may also underline that the stock isn’t as cheap as it appears.

 

US corporate income tax reform (ii)

To summarize yesterday’s post:

firms with taxable income

Lowering the corporate tax rate in the US, while eliminating special interest tax preferences/exemptions, will benefit companies that have a high current tax rate.  It will boost such a firm’s earnings by as much as 30%.

On the other hand, companies that have a low income tax rate will receive little or no benefit.  Continuing to spend resources on what are in effect tax shelters for themselves will make no sense.  To the extent that they are able to unwind these arrangements, they will benefit by doing so.  If, however, they are recipients of special interest tax reduction deals, they may be absolute losers, as well as relative ones, if/when these special preferences are eliminated.

The greatest uncertainty here is whether industries that are recipients of large tax breaks, like real estate and oil and gas, will have their special interest preferences eliminated.  This will be a key indicator of whether the “Drain the Swamp” rhetoric is more than an empty slogan.

firms with losses

This case is not as straightforward, thanks to wrinkles in the Generally Accepted Accounting Principles used by publicly traded companies in their reports to shareholders.

for the IRS

Let’s assume a firm makes a pre-tax loss in the current year.

 

The company has a limited ability to use this loss to offset taxes paid in past years ( it carries the loss back).  It restates its past returns and gets a refund.

If it still has a portion of the loss that can’t be used in this way, it carries the loss forward to potentially use to shield income in future years from tax.

If the corporate income tax rate drops from 35% to 15%, the amount of pre-tax income that can be sheltered from tax by loss carryforwards remains the same.  But the value of the carryforward is reduced by 60%.

for financial reporting

That’s tomorrow’s topic.

 

US corporate tax reform: stock market implications (i)

high US corporate taxes

The headline rate for US federal tax on corporate profits is 35%.  That’s higher than just about anyplace else on the planet and, in itself, a deterrent to business formation in the United States.  It’s also the reason for the big business of advising corporations on how to finesse the tax code that has sprung up over the past decade or so.  In addition, it’s also why tax havens such as Ireland, Switzerland, Hong Kong and assorted islands in the Atlantic Ocean have become so popular with Americans.

A generation ago, world stock markets paid particular attention the rate at which a given company paid corporate tax.  The assumption back then, which has turned out to be incorrect, was that a firm could only sustain a low tax rate for a limited period of time.  So no matter what the rate shown in the financial statements, professional securities analysts would “normalize” it  to the top marginal rate.  Portfolio managers wouldn’t pay a full price for a low tax payer, either.

Not so in today’s world.  As far as I can see, Wall Street has long since stopped believing that the “quality” of earnings taxed at below the statutory tax rate is less than those same earnings taxed at a higher one.

Trump’s proposed reform

Given that the Republican party controls both houses of Congress and the presidency, it seems to me that the corporate tax reform championed by Donald Trump has a good chance for becoming law.  This would mean that for a company having $100 in fully-taxed pretax US income, after-tax profit would rise from $65 to $85–a 30+% boost.

big stock market implications

A change like this would have enormous implications for US-traded stocks.  In particular:

–investor interest would rotate toward purely domestic companies.  This would favor mid- and small-caps over large, and dollar earners over multinationals.  I think this is already starting to happen

–to the degree that they could be, elaborate tax avoidance schemes that have become common for US firms will be unwound.  Tax havens will suffer.  On the other hand, profits from future earnings that would otherwise be held in tax-haven banks will begin to be repatriated to the US.  Trump is also proposing to allow money now “trapped” in tax havens to be brought back to the US on payment of a 10% income tax.

–tax inversions by US-based companies–that is, flight of high-rate US taxpayers to tax havens abroad (or, actually, just about anywhere else) will come to a halt.  Arguably, companies that have recently inverted may begin to trade at discounts to un-inverted peers

–the price US firms would be willing to pay for foreign companies using funds parked abroad should fall

–it’s possible that US investors will begin to become interested once again in the ins and outs of the tax line on the income statement.  That might mean that 1980-style quality-of-earnings differentials will be in vogue again

–there are also possible negative implications for firms that have substantial tax loss carryforwards or who benefit from the many industry-specific tax preferences of the current tax code.

 

More tomorrow.