Category Archives: Vocabulary

interest rates: how high?

December 5, 2016 By in bond market, bond vigilantes, interest rates, Uncategorized Tags: , , , , Leave a comment

the speed of interest rate rises

The best indicator of how fast the Fed will raise the Fed Funds rate will likely be the pace of wage gains and new job creation, as shown in the monthly Employment Situation report issued by the Bureau of Labor Statistics.  Infrastructure investment legislation that may be passed by the new Congress next year may also factor into the Fed’s thinking.  On the other hand, the continuing example of Japan, whose quarter-century of no economic growth is due in part to premature tightening of economic policy is also likely to play a part in decision making.

Much of that will be hard to be certain about in advance.  Current Wall Street thinking, for what it’s worth, is that the pace will be north of glacial but not fast at all–maybe a move of +0.50% next year, after a boost of +0.25% later this month.

The endpoint of policy, however, may be somewhat easier to forecast.

the final policy goal

 

Fed policy is aimed at holding inflation at +2.0% per year.  Its main problem recently is that it can’t get inflation that high, in spite of having flooded the economy with money for the past eight years.  So let’s say we’ll have inflation at 2%, but not higher, some time in the future.

cash

If so, and if the return on cash-like investments during normal times continues to provide protection against inflation and little else, then the final target for the Fed Funds rate is 2%.

bonds

If we consider the 30-year bond and say that the normal annual return should be inflation protection + 2% per year, then the target yield for it would be 4%–vs slightly over 3% today.

The 10-year?  subtract 50 basis points from the 30-year annual yield.  That would mean 3.5% as the target yield.

If this is correct, the important thing about the domestic bond market since the US election is the substantial steepening of the yield curve.  While cash has another 150 bp to rise to get to 2%, the long bond is within 100bp of where I think it will eventually settle in.

In other words, a substantial amount of readjustment has already occurred.

 

 

 

 

 

 

US corporate tax reform (iii)

November 23, 2016 By in Banks, deferred taxes, income tax rates, Uncategorized Tags: , , , , 1 Comment

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 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.

3Q2016 earnings for Tesla (TSLA): still a “dream” stock

October 27, 2016 By in cash flow/share vs. earnings/share, earnings conference calls, earnings surprise, Uncategorized Tags: , , Leave a comment

TSLA reported 3Q16 results yesterday after the New York close. The numbers were better than admittedly modest expectations:  the company sold a record number of cars: it had profits; cash flow was strongly positive–although flattered by better management of working capital and sale of pollution tax credits.  Still, a plus.  And the stock is up by about 4% in pre-market trading as I’m writing this.  (I should mention that other members of my family and I hold small positions in TSLA.)

The fact that a $30+ billion market cap company earned $22 million in a quarter would scarcely be considered good news under most circumstances.  Annualizing and rounding up to $100 million for a full year would imply a PE of 300x for the company’s stock!  However, TSLA is still to a considerable degree a “dream” or “concept” stock.

 

The prototypcial “dream” stock is a firm that starts up with the intention of prospecting for gold.  It makes what it thinks/says is a significant strike.  While the company creates the mine and associated processing facilities, speculation about the quality and extent of the orebody runs rampant.  After all, there’s no factual information to contradict any rumors that may float about.

Then the mine opens.  There are now facts available about ore quality and mining costs.  So there’s no more dream–only brass-tacks reality.  The stock typically peaks the day the mine opens.

TSLA’s case is an unusual one.  Auto production has been under way for some time.  Yet the stock hasn’t reverted to trading on actual results.  To some degree the dream has been dented–I find it hard to imagine TSLA could repeat today its 2014 convertible bond offering, whose conversion price was set at $350.  But Elon Musk has expanded and reset his aspirations for TSLA  often enough during its short life as a public company that at least some version of the dream remains alive.  Unless/until TSLA disappoints severely in its results, I’d think the stock will continue to trade without a strong connection to earnings for some time to come.

 

 

 

1Qfiscal17 earnings for Microsoft(MSFT)

October 21, 2016 By in earnings conference calls, strong earnings, Uncategorized Tags: , , , Leave a comment

MSFT reported a strong 1Q17 after the close last night.

Revenue was up +3% (non-GAAP) year on year.  Operating income was flat, on the same basis, and net up +6%.  EPS was up by +9%, at $.76, exceeding the high end of the expectations of the thirty-odd professional sell side analysts who follow the company.

Growth businesses, like the cloud or the Surface line of laptop/tablet hybrids, were up strongly.  Legacy businesses held their own.  Guidance is for a flattish 2Q17.

 

In many ways, the MSFT report is similar to the Intel (INTC) results from the night before.  Guidance for both companies appeared roughly the same, as well–more or less flat quarter on quarter performance, during a period that’s typically seasonally strong.

The reaction in the press and in the stock price for MSFT, however, was strongly positive.  The stock was up by 4%+ when the results were made public   …and by more than that after the conference call.  As I’m writing this on Friday afternoon, MSFT is holding onto almost all of its after-hours gain during a down day on Wall Street.

INTC, in contrast, fell at all three waypoints–announcement, conference call, next-day trading.

 

Part of the contrast in stock performance has to do with the differing nature of the two companies’ businesses, hardware vs. software.  Part is a function of the greater speed at which MSFT has been able to demonstrate that it is turning itself around.

 

On the other hand, I find it noteworthy that there should be a 10% relative performance difference in two days between the two behemoths who were once the constituents of the former Wintel alliance–and on bottom lines that, if we removed the company names, don’t look all that different.

The rest, of course, must represent two different sets of expectations.  I hold both stocks, which I’ve been studying for over a quarter century (and which I find a little scary).  My expectations aren’t that different.

I’m not simply grousing about being wrong aobut INTC.  I think of investing in the stock market as somewhat like playing a game whose rules each player has to figure out as play progresses.  I’ve often likened the difference between investing in, say, the UK or Japan vs. the US as like that between playing checkers or Sorry and playing chess.

I have a hunch that in reports like these we’re seeing evidence of a change in how the stock market game will be played in the US in the future.  If so, it will be important to catch on to the new state of things as soon as possible.