Category Archives: Accounting

the administration, the economy and the stock market

August 15, 2018 By in corporate income tax reform, corporate tax reform in the US, government economic policy, income tax rates, taxes, Trump, taxes and trade, Uncategorized Tags: , , , , , 1 Comment

I’m taking off my hat as an American and putting on my hat as an investor for this post.

That is, I’m putting aside questions like whether the Trump agenda forms a coherent whole, whether Mr. Trump understands much/any of what he’s doing, whether Trump is implementing policies whispered in his ear by backers in the shadows–and why congressmen of both parties have been little more than rubber stamps for his proposals.

My main concern is the effect of his economic policies on stocks.

the tax cut

The top corporate tax rate was reduced from 35% to 21% late last year.  In addition, the wealthiest individuals received tax breaks, a continuation of the “trickle down” economics that has been the mainstay of Washington tax policy since the 1980s.

The new 21% rate is about average for the rest of the world.  This suggests that US corporations will no longer see much advantage in reincorporating abroad in low-tax jurisdictions.  The evidence so far is that they are also dismantling the elaborate tax avoidance schemes they have created by holding their intellectual property, and recognizing most of their profits, in foreign low-tax jurisdictions.  (An aside:  this should have a positive effect on the trade deficit since we are now recognizing the value of American IP as part of the cost of goods made by American companies overseas (think: smartphones.)

My view is that this development was fully discounted in share prices last year.

The original idea was that tax reform would also encompass tax simplification–the elimination of at least part of the rats nest of special interest tax breaks that plagues the federal tax code.  It’s conceivable that Mr. Trump could have used his enormous power over the majority Republican Party to achieve this laudable goal.  But he seems to have made no effort to do so.

Two important consequences of this last:

–the tax cut is a beg reduction in government income, meaning that it is a strong stimulus to economic activity.  That would have been extremely useful, say, nine years ago, but at full employment and above-trend growth, it puts the US at risk of overheating.

–who pays for this?  The bill’s proponents claim that the tax cut will pay for itself through higher growth.  The more likely outcome as things stand now, I think, is that Millennials will inherit a country with a least a trillion dollars more in sovereign debt than would otherwise be the case.

One positive consequence of the untimely fiscal stimulus is that it makes room for the Fed to remove its monetary stimulus (it now has rates at least 100 basis points lower than they should be) faster, and with greater confidence that will do no harm.

Two complications:  Mr. Trump has begun to jawbone the Fed not to do this, apparently thinking a supercharged, unstable economy will be to his advantage.  Also, higher rates raise the cost of borrowing to fund a higher government budget deficit + burgeoning government debt.

 

Tomorrow: the messy trade arena

figuring out price-earnings ratios (PEs)

January 30, 2018 By in cash flow/share vs. earnings/share, price earnings multiple, strong earnings, Uncategorized Tags: , , 2 Comments

One part of this is easy.

PE is industry jargon.  It’s a shorthand way of expressing the value of an individual stock, an industry group or a whole stock market, in terms of how many times one year’s earnings we’d be willing to pay to own whichever it is.

On the face of it, a low PE, say, 4x, would seem to be good; a high PE, say, 50x, bad.

But how do we know?  What factors enter into determining a PE?

 

A point that I’m maybe too fond of making is that, strictly speaking, there’s no demand for stocks.  There is demand for liquid investments, though (for most people in the US, it’s so they can save to send their children to college and to retire).  Bonds and cash are the other two big categories of liquid investments.  The apparent hair-splitting distinction is important, however, because each fixed income markets is much larger in size than stocks.  They’re also less risky.  The potential returns on these alternatives have a deep influence on what people are willing to pay for stocks.  In fact, academics turn the PE upside down (1/PE) to get what they call the earnings yield on stocks.  If you make the assumption that $1 in earnings in the hands of company management is more or less the equivalent as $1 in interest paid to you by the US Treasury, then the yield on Treasury bonds should (and virtually always does) have a powerful influence on what the earnings yield, and PE of stocks should be.  Why pay 20x for stocks if bonds are yielding 10%?

As I’m writing this, the 10-year Treasury bond is yielding 2.68%.  That’s the equivalent of a PE of 37.  This compares with a PE of 26 on the S&P 500, based on current earnings.   So either stocks are cheap or bonds are overpriced.

Today’s situation is very unusual, given that the financial meltdown in 2007-08 compelled the Federal Reserve to push interest rates down to intensive-care lows.  The consensus judgment of financial professionals, which I think is correct, is that bonds are unusually expensive today, not that stocks are dirt cheap.  If the 10-year is on the way to a 3.5% yield as the Fed returns rates to normal over the next year or two, then the equivalent PE on the S&P would be 28.5x.

That’s about where US stocks are now priced vs. bonds, which suggests that stocks are fully valued if we factor in the likely course of the Fed.  This suggests that only new positive information will move the overall market higher.

Now the going gets harder.

The second important point is the the stock market is a futures market.  That is, it is always pricing in tomorrow’s prospects as well as current earnings.  Willingness to pay for future earnings ebbs and flows with the business cycle, however.  During recessions, investors play their cards very close to the chest and look at most a few months into the future when pricing stocks.  In normal times, the market begins to price in the following year’s earnings in June or July.  In a very buoyant market, investors may pay for earnings two or three years into the future.

 

A third consideration, related to the second, and applying to individual stocks, is the rate of earnings growth.  The importance of this factor changes from time to time.  But a useful general rule is that the PE based on this year’s earnings can reach as high as the long-term growth rate of the company.  In other words, if earnings per share are growing at a 50% annual clip–and will likely continue to do so for the next several years (or at least there’s no easily visible bar to growth like this)–then the PE can be as high as 50x.

 

Generally speaking, the US economy can probably grow at about 4%-5% a year in nominal terms (meaning, including inflation).  If so, publicly traded companies, which are arguably the cream of the crop, will grow earnings per share by about 8% – 10% annually.  All other things being equal, this latter figure should be the trend growth for stocks in general.Put a different way, a company that can sustain growth of 50% a year in an economic environment like this must have something extra special going for it.

This rule of thumb doesn’t work for many “value” stocks, since no growth/earnings declines would imply a zero multiple–which in most (academics would say “all”) cases is clearly wrong (Academics say every stock retains at least a kind of option value).

 

 

corporate taxes, consumer spending and the stock market

December 18, 2017 By in consumer confidence, corporate income tax reform, corporate tax reform in the US, income tax rates, Industry Analysis, Retail, Strategy, strong earnings, taxes, Uncategorized Tags: , , , , , , , 1 Comment

It looks as if the top Federal corporate tax rate will be declining from the current world-high 35% to a more median-ish 20% or so.  The consensus guess, which I think is as good as any, is that this change will mean about a 15% one-time increase in profits reported by S&P 500 stocks next year.

However, Wall Street has held the strong belief for a long time that this would happen in a Trump administration.  Arguably (and this is my opinion, too), one big reason for the strength in US publicly traded stocks this year has been that the benefits of corporate tax reform are being steadily, and increasingly, factored into stock quotes.  The action of computers reading news reports about passage is likely, I think, to be the last gasp of tax news bolstering stocks.  And even that bump is likely to be relatively mild.

In fact, one effect of the increased economic stimulus that may come from lower domestic corporate taxes is that the Federal Reserve will feel freer to lean against this strength by moving interest rates up from the current emergency-room lows more quickly than the consensus expects.  Although weening the economy from the addiction to very low-cost borrowing is an unambiguous long-term positive, the increasing attractiveness of fixed income will serve as a brake on nearer-term enthusiasm for stocks.

 

What I do find very bullish for stocks, though, is the surprising strength of consumer spending, both online and in physical stores, this holiday season.  We are now nine years past the worst of the recession, which saw deeply frightening and scarring events–bank failures, massive layoffs, the collapse of world trade.  It seems to me that the consumer spending we are now seeing in the US means that, after almost a decade, people are seeing recession in the rear view mirror for the first time.  I think this has very positive implications for the Consumer discretionary sector–and retail in particular–in 2018.

the Republican income tax plan and the stock market

September 28, 2017 By in corporate income tax reform, corporate tax reform in the US, income tax rates, taxes, Uncategorized Tags: , , , 1 Comment

The general outline of the Trump administration’s proposed revision of the corporate and individual income tax systems was announced yesterday.

The possible elimination of the deductability from federally taxable income of individuals’ state and local tax payments could have profound–and not highly predictable–long-term economic effects.  But from a right-now stock market point of view, I think the most important items are corporate:

–lowering the top tax bracket from 35% to 20% and

–decreasing the tax on repatriated foreign cash.

the tax rate

My appallingly simple back-of-the-envelope (but not necessarily incorrect) calculation says the first could boost the US profits of publicly listed companies by almost 25%.  Figuring that domestic operations account for half of reported S&P 500 profits, that would mean an immediate contraction of the PE on S&P 500 earnings of 12% or so.

I think this has been baked in the stock market cake for a long time.  If I’m correct, passage of this provision into law won’t make stock prices go up by much. Failure to do so will make them go down–maybe by a lot.

repatriation

I wrote about this a while ago.  I think the post is still relevant, so read it if you have time.  The basic idea is that the government tried this about a decade ago.  Although $300 billion or so was repatriated back then, there was no noticeable increase in overall domestic corporate investment.  Companies used domestically available cash already earmarked for capex for other purposes and spent the repatriated dollars on capex instead.

This was, but shouldn’t have been, a shock to Washington.  Really,   …if you had a choice between building a plant in a country that took away $.10 in tax for every dollar in pre-tax profit you made vs. in a country that took $.35 away, which would you choose?  (The listed company answer:  the place where favorable tax treatment makes your return on investment 38% higher.)  Privately held firms act differently, but that’s a whole other story.

 

The combination of repatriation + a lower corporate tax rate could have two positive economic and stock market effects.  Companies should be much more willing to put this idle cash to work into domestic capital investment.  There could also be a wave of merger and acquisition activity financed by this returning money.

 

 

 

 

building a new company HQ–a sign of trouble ahead?

September 14, 2017 By in Capital Asset Pricing Model (CAPM), capital spending and the business cycle, Capital-intensive firms, capitalizing vs. expensing, human capital, Uncategorized Tags: , , , 1 Comment

This is a long-standing Wall Street belief.  The basic idea is that as companies expand and mature, their leadership gradually turns from entrepreneurs into bureaucrats.  The ultimate warning bell that rough waters are ahead for corporate profits is the announcement that a firm will spend huge amounts of money on a grandiose new corporate headquarters.

An odd article in the Wall Street Journal reminded me of this a couple of days ago.  The company coming into question in it is Amazon, which has just initiated a search for the site of a second corporate HQ.

What’s odd:

–why no comment on Apple’s new over-the-top $5 billion HQ building?

–the headquarters idea was followed by a discussion of research results from a finance professor from Dartmouth, Kenneth French, which show that publicly traded firms with the highest levels of capital spending tend to have underperforming stocks.

I’ve looked on the internet for Prof. French’s work, much of which has been done in collaboration with Eugene Fama.  I couldn’t find the paper in question, although I did come across an interesting, and humorous, one that argues the lack of predictive value of the capital asset pricing model (CAPM)–despite it’s being the staple of the finance theory taught to MBAs.  (The business school idea is apparently that reality is too complicated for non-PhD students to understand so let’s teach them something that’s simple, even though it’s wrong.)

my thoughts

–money for creating/customizing computer software, which is one of the largest uses of corporate funds in the US, is typically written off as an expense.  From a financial accounting point of view, it doesn’t show up as capital spending.

–same thing with brand creation through advertising and public relations.  I’m not sure how Prof. French deals with this issue.

Over the past quarter-century, there’s been a tendency for companies to decrease their capital intensity.  In the semiconductor industry, this was the child of necessity, since each generation of fabs seems to be hugely more expensive than its predecessor.  Hence the rise of third-party fabs like TSMC.

For hotel companies, it has been a deliberate choice to divest their physical locations, while taking back management contracts.  For light manufacturing, it has been outsourcing to the developing world, but retaining marketing and distribution.

 

What’s left as capital-intensive, then?  Mining, oil and gas, ship transport, autos, steel, cement, public utilities…  Not exactly the cream of the capital appreciation crop.

 

At the very beginning of my investment career, the common belief was that high minimum effective plant size and correspondingly large spending requirements formed an anti-competitive “moat” for the industries in question.  But technological change, from the 1970s steel mini-mill that cost a tenth the price of a blast furnace onward, has shown capital spending to be more Maginot Line than effective defense.

So it may well be that the underperformance pointed to by Prof. French has less to do with profligate management, as the WSJ suggests, than simply the nature of today’s capital-intensive businesses–namely, the ones that have no other option.