I’ve just updated my Keeping Score page for Trumpmania in November.
Tag Archives: Portfolio management
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.
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 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.
REITs when interest rates are rising
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.