stock market implications of a global minimum corporate tax (ii)

The S&P 500 gained just under 20% in 2017, the year the large cut in the US corporate tax rate was passed. The new law, which took effect on 1/1/2018, boosted US-sourced earnings by about 21%. In 2018, however, the index lost a little over 6%. That’s because, I think, the stock market began to discount the better earnings prospects as soon at it became clear that the law would pass.

The same will likely happen in the case of a global minimum tax as well. Only this time the effect will be negative, and likely most keenly experienced by companies who have placed the greatest reliance on financial engineering, rather than operations, to boost their profit growth.

It’s also possible that this will be the trigger for investors to once again begin to read a low tax rate as a bad sign for a company, and to adjust the PE multiple down because of this vs. full tax rate-paying competitors as they commonly did a generation ago.

It’s thinkable, as well, that deeper consideration of the information in corporate tax disclosures will lead to a more seismic shift in the assessment of company value of the kind that Warren Buffett caused a generation ago in his stress on the value of intangible assets–intellectual property, brand names, distribution networks…–that the market regards as obvious plusses today, but had ignored until Buffett came along.

There’s already a bit of worry in the air about managements losing touch with the nuts and bolts of the industries they compete in, focusing on propping up current earnings rather than on creating cutting-edge products. Witness investor dismay at the apparent loss of operational competence in once iconic names like Boeing or Intel or ATT. At the very least, in my view, the draining of the ocean of monetary stimulus we are now swimming in will force investors to discriminate more sharply between potential winners and losers as the cost of funding operations begins to rise. As I’ve mentioned before, the only environment remotely like the current one that I’ve experienced is the high-yen, low interest rate environment of Japan in the late 1980s. The early Nineties there were particularly ugly for hidebound traditional zaibatsu/keiretsu firms whose greatest merit was their being in the rising tide of the previous decade. I can imagine a similar changing of the guard happening here.

This would tilt the field of play away from factor investing and toward the more traditional skills of analyzing balance sheets and income statements, and projecting them forward.

stock market implications of a global minimum corporate tax (i)

1980s tax planning

I got my first job as the lead (and only) manager of a global fund in 1986. I’d worked for six years as an analyst and manager in the US market and for a couple in the smaller Asian markets. I knew my first task would be to understand Japan, then the largest–and hottest–stock market in the world.

Commissions and fees were high there, trading volume was enormous. At the same time, local brokers had no interest in foreign customers, whom they regarded as not fully human, and were analytically pretty backward anyway. So I was surprised to learn that virtually all the big international brokers operating in Tokyo were posting gigantic losses from their Japan business–high expenses, understandable given the high price of real estate and of imported goods like food, but low revenues. Then I learned why.

Corporate taxes were very high in Japan back then. So foreigners executed all their trades through their Hong Kong offices, where the corporate tax for foreign companies was zero.

today’s world

Ireland is the poster child of large-cap corporate tax avoidance because its corporate income tax rate is 12.5%.

How the shelter works:

–a non-Irish multinational bundles up its intellectual property–brand names, R&D…–, consolidates it in an Irish subsidiary and for its use around the world agrees to pay a royalty to the Irish sub.

–the firm has sales of $1,000,000 in Germany, where the corporate tax rate is 30%. Let’s say expenses, ex royalty, are $600,000, meaning pre-tax income is $400,000. The firm pays a royalty of $200,000 to the Irish subsidiary, however. This is another expense for German operations and cuts pre-income there to $200,000.

–in Germany, after-tax income is $140,000. The royalty income is taxed at 12.5% in Ireland, netting the firm $175,000. Total income for the firm is therefore $315,000. Without the financial engineering, total income would have been $280,000. Overall, good for the firm, good for Ireland, bad for Germany.

my experience

When I started on Wall Street, such financial engineering was frowned upon. Most analysts and portfolio managers at least mentally reduced the resulting earnings downward to remove the zaitech benefit. One prominent UK broker even made it a feature of its research to “normalize” earnings to reflect the home country statutory rate.

Two reasons for this:

–with US companies, at least, repatriating foreign earnings means paying US income on them, minus a credit for foreign taxes paid. So the financial engineering savings are in a sense stranded abroad and not available for capital investment here or for paying dividends to shareholders. Corporate lawyers have long since found ways to make the funds available domestically without incurring a tax liability, however. Dividends are no longer as important to Wall Street as they were back then. And the emergence of Trump and his acolytes as standard bearers for the Republican party has pushed the US way down the list of places companies feel comfortable investing in.

–the thought in the early days of financial engineering was that any such ploy would be short-lived because governments would quickly shut down corporate loopholes.

more tomorrow

inflation/deflation (ii)

This post is mainly a link to the ARK funds website, where portfolio manager Cathie Wood argues that future deflation is a more important issue than inflation. She cites three sources of deflation. From the least to most impactful, they are

–a cyclical shift from consumption of goods to services as the world reopens post-covid

–the demise of companies that have failed to invest in innovation to provide better products/services, but have instead essentially propped up their stock prices by using cash flow + the proceeds from bank loans and bond issues to buy back shares and pay dividends to satisfy an investor base focused on current income (my addition: or to pay huge compensation to managements). Wood doesn’t name any names, but I imagine GE, IBM, Intel, GM, Ford, Boeing, JC Penney, Sears… as the kind of companies she’s talking about.

–the deflationary effect of new product development in areas the ARK funds focus on, like AI and genomics, that are rapidly reducing the cost of traditional products/services, with the door open to as yet unimagined new products and services.

I’m not sure what to say. These are all good points, but it seems to me that none of these amount to deflation.

–the only non-food commodities that even show up as a blip on the GDP radar for a country like the US are oil and steel. In today’s world, inflation/deflation is all about wages

–yes, firms like IBM and GM are mere shadows of their former selves. But their fall from prominence has been going on for almost half a century as innovating founders are gradually replaced by bureaucratic bean counters and the firms stultify. But this is the way the world works. Also, none of this has stopped the price level from rising year after year.

–in the early 1980s a 31-lb Compaq “luggable” PC cost about $3000. one floppy drive, a 4 inch (?) orange screen, the computing power of today’s pocket calculator. Thanks to incredible innovation, today we have phones, tablets, PCs… that are infinitely better, and considerably easier to get on a plane, than back then. Again, an important point. But, again, all this happened without a hint of overall deflation. Quite the contrary. The US was in the early days of the struggle to control runaway inflation while this was happening. Put another way, I find it hard to imagine that a possible side effect of innovation is the potential threat of another 1930s-style depression.

inflation/deflation (i)

This post is mainly a link to a discussion of inflation.

The link is to Musings on Markets, a blog by Aswath Damodaran, a finance professor at NYU. It’s pretty long but thorough, and well worth reading. Personally, I don’t think the chances of interest rate rises to nip incipient inflation in the bud are as high as Prof. Damodaran seems to think, but on the other hand I’m always too optimistic.

My two big reservations about the post concern real estate and gold as inflation hedges. On gold, it was money a generation ago but in my view is now just a special kind of dirt, except for in places like India, where, in effect, burying your savings in the back yard is preferable to deposits in banks no one trusts. The gold price is also subject to the ebbs and flows of pricing based on the large scale and long lead times inherent in any mining operation. Sort of like urban office buildings, there’s often either a glut or acute shortage. Gold did spike in the late 1970s on inflation fears, but added capacity produced fifteen years of no price movement. In short, there may be high correlation between gold and inflation but I don’t think there’s causation any more.

Real estate’s another funny one. The price data Prof. Damodaran cites show that house prices almost never seem to go down. My two issues:

–real estate can be highly illiquid, particularly in recession (typically caused by high interest rates). It becomes harder to get a mortgage and potential sellers withdraw because the price they would receive in a forced sale would be so low. So I’m suspicious of the price data.

–typically in the past in the US, housing has been financed through fixed-rate mortgages covering, say, 80% of the purchase price. Arguably, in times of high interest rates, the loss in value of the house is offset in large part by an increase in the now-below-market value of the loan. Today, however, many home loans are at least partially variable rate, so this offset is less than it once was.

tomorrow the deflation side