Monthly Archives: November 2016

US corporate income tax reform (ii)

November 22, 2016 By in deferred tax, income tax rates, Uncategorized Tags: , , , , , Leave a comment

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)

November 21, 2016 By in deferred taxes, income tax rates, Uncategorized Tags: , , Leave a comment

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.

Brexit vs. the Trump election

November 17, 2016 By in Brexit, Presidential election cycle, Stock ideas, stock market, Uncategorized Tags: , , , , Leave a comment

Trump and Brexit

Right before election day, Donald Trump predicted his victory by saying that it would be just like Brexit, only more so.

That turned out to be correct, in the sense that in both cases the pre-election polls were incorrect and that the result turned on the votes of older, disaffected, less-educated citizens who came out in large numbers in response to a call to roll back the clock to days of former glory.

post-Brexit

The immediate UK stock market response to the Brexit vote was to drop through the floor, with the multinational-laden large-cap FTSE 100 index faring far better than generally domestic-focused small caps.  The FTSE has rallied since, with the index now sitting about 6% higher than its level when the election results were announced.

That does not mean, however, that the Brexit vote turned out to be a plus for UK stock market participants.  By far the largest amount of damage to their wealth was done in the 15% drop vs. the dollar that the UK currency has experienced since June.

post-Election Day

Despite the voting similarity between UK and US, the currency and stock market outcomes have been very different.  In the week+ since the US presidential election,

–the dollar has risen by about 3% against both the euro and the yen since the election result became known

–the S&P 500 is up by a bit less than 2%, with small caps significantly better than that.  Potential beneficiaries of Trump policies–oil and gas, construction, banks, pharma, prisons–have all done much better than that.

Why the difference?

Brexit

Brexit was a simple, binding in-or-out vote on an economic issue (recent legal action seems to show it’s not so clear-cut as that, however).  Leaving, which is the action voters selected, has immediate, easily predictable, severely negative economic consequences.  Hence, the continuing slide in the currency.

Trump

The Trump vote, on the other hand,  was for a charismatic reality show star with unacceptable social views, very limited economic or policy knowledge/interests and a questionable record of business (other than show business) success.   Not good.

The US vote was for a person, however flawed, not necessarily for policies.  In addition, the  legislative logjam in Washington has potentially been broken, since Republicans will control both houses and the Oval Office.

The general economic tone Trump seems to be setting is for fiscal stimulation through tax reform and deficit spending on infrastructure.  Both would relieve the extraordinary burden that has been placed on the Fed (the only adult in the Washington room).  This will likely mean larger, and faster, interest rate hikes.  Hence the rise in the currency.

knock-on effects

Democrats seem to realize the folly of having a cultural program without an economic one; a substantial restructuring of that party may now be under way.  Bipartisan cooperation in Congress seems to once again be in the air, if for no other reason than to act as a check on Mr. Trump’s more economically questionable impulses.   Trump’s “basket of deplorables” social views may make Americans more vividly aware of the issues at stake, and what progress needs to be made   …and serve as a call to arms for activism, as well.

Another thought:  yesterday’s news showed the Trump brand name being removed from several apartment buildings on the West Side of Manhattan.  Based on feedback from tenants, the owner, who licenses the Trump name, concluded that retaining the buildings’ branding would result in lower rents/higher vacancies.  Given that Trump does not intend to have his business interests run by an independent third party while he is in office, the public would seem to me to have an unusually large ability to influence his presidential actions by its attitude toward Trump-branded products.  I’m not sure whether this is good or bad   …but “good” would be my guess.

All in all, the UK seems to be lost in dreams of the days when it ruled the oceans.  The US is less clear.  We may be in the early days of a renaissance.

 

REITs when interest rates are rising

November 16, 2016 By in bond market, real estate, stock market, Uncategorized Tags: , , , , , Leave a comment

Finally, to the question of REITs (Real Estate Investment Trusts).

A REIT is a specialized type of corporation that accepts restrictions on the kind of business it can do and limits to how concentrated its ownership structure can be.  It must also distribute virtually all its profits to shareholders.  In return it gets an exemption from corporate income tax.  It’s basically the same legal structure as mutual funds or ETFs.

Traditionally, REITs have concentrated on owning income-generating real estate.  But they are also allowed to to develop and manage new projects, provided they do so to hold as part of their portfolios instead of to resell.

Because they must distribute basically all of their profits, and to the degree that their property development efforts are small relative to their overall asset size, REITs look an awful lot like bonds.  That is to say, their main attraction is their relatively steady income.  Yes, they hold tangible assets of a type that should not be badly affected by inflation.  But current holders, I think, view them as bond substitutes.

As I suggested in Monday’s post, that’s bad in a time of rising interest rates.  Both newly-issued bonds–and eventually cash as well–become increasingly attractive as lower-risk substitutes.  This is the reason REITs have underperformed the S&P by about 5 percentage points so far this month, and by 9 points since the end of September.  I don’t think we’ve yet reached the back half of this game.

How can an investor fight the negative influence of interest rate rises in the REIT sector?   …by finding REITs that look as much as they can like stocks.  That is, by finding REITs that are able to achieve earnings–that therefore distributable income–growth.

This means finding REITs that can raise rents steadily or whose development of new properties is large relative to their current asset size.