Arohan’s investing life

Senator Barack Obama outlined his economic policy highlights today, were he to become the next President of United States. His position on Capital Gains taxes is quite alarming and can have a profound effect on the US economy if it becomes a reality

Senator Obama is willing to increase the Capital Gains tax rate to 25% range (but definitely not more than 28% according to him). Ostensibly the higher tax revenue will go towards funding more government social programs

Double Taxation: All will agree that taxing dividends is a form of double taxation. Dividends are paid out of the after tax earnings of a business. It is however worth noting that taxing capital gains is also, maybe a bit subtly, a form of double taxation. Stock price of a company over a long term is directly linked to the growth of the business’s equity. Positive Net Income increases the the equity of a business. When the business pays taxes on its net income, the equity of the enterprise is decreased, thereby decreasing the value of the stock that an investor holds in the company (meaning the capital gains to the investor are reduced because the company pays income taxes on its income). This is the first instance of taxation (although indirect) on the investors assets. The second instance of taxation of course occurs when the investor sells stock and realizes a capital gains

In my mind, double taxation is simply wrong and just serves to discourage investment activity which is crucial for any capitalist economy to work. Much as I fault the current administration in many of the things they have done (or not done), they were on the correct path of reducing (and hopefully ultimately eliminating) the capital gains tax

Now back to Mr Obama’s proposal to raise the capital gains tax. I can think of many implications it has for the business environment in this country.

For investors:

• Low capital gains tax rate was an indirect way of encouraging the citizenry to migrate to an ‘Ownership model’ and invest in public assets. With Mr Obama’s proposal, owning stocks will become less attractive
• Countless studies have shown that over long term, stocks as an asset class outperform all other publicly investable asset classes. This is specially true if you compare the long term tax-adjusted returns of various asset classes. With increased capital gains tax rates, this gap will shrink. While this may not be a immediate game changer for young investors who have a long time frame, it is certain to change age based asset allocation models with people moving to more conservative assets earlier than they currently do (as the risk/reward ratio becomes worse and risk appetite lessens). This of course is a problem magnified when you consider that the older investors typically have more money invested in the markets. This may have an unintended result of depressing stock prices over a long term and therefore make owning stocks even less attractive
• Venture funding and Private Equity are essential to the business eco-system in this country. It drives innovation, new business models, new products, provides liquidity to the markets so inefficiency in the system is continuously removed by various restructuring and other market machinations. Firms in this industry take a long view and extraordinary risks for that capital gain when they execute their exit strategy. Raising taxes on this industry will put a damper on the startup and SMB activities thereby taking the shine off the core growth engine of the economy. Mr Obama will indeed need more money to fund social programs as the job creation in this country will slow down and those social programs will be in great demand.
• Growth companies will be pressured to return capital earlier in form of dividends or other distributions as investors become indifferent to dividends versus capital gains AND as the companies themselves see some lessening in attractiveness of reinvesting in other growth projects

For Businesses:

• As investors demand higher returns to compensate for the increased government’s take, businesses will likely increase their exposure to the debt markets, leveraging up their balance sheets. More interest payments and possibly more dividend payments imply a reduction in the balance sheet quality and a reduction in the risk appetite for the businesses
• more stakes in American companies will be sold to overseas investors who may not be burdened with such high capital gains taxes in their countries

For the general public:

• Less employment, less asset ownership, more social programs, bad deal all around

This may sound alarmist, but the fact is that all this will come to pass. It will not happen overnight, more like a slowly boiling frog. Of course, when this starts being a problem, Mr Obama will have ended his term and it will be someone else’s mess to fix …

All this will come to pass as a large portion of our workforce (babyboomers) will leave the workforce and retire.

Senator Obama is a likable candidate and will bring Statesmanship and Oratory back to the office and may even be a hit on the international circuit but with policies like this he will surely destroy the economic standing of USA in the globe. Oh, and more regulations that he espouses will not help

Better increase your allocation to international assets if it becomes likely that he may be the next President of USA

Two interesting articles/stories caught my eye today

The first one talks about the mind boggling 2007 total compensation (earnings + stock) to Blackstone Group’s co-founder Stephen Schwarzman. According to this AP story, his compensation in 2007 was $350.7 million and along with stock grants valued at $4.77 B during Blackstone’s IPO, his total takeaway was $5.13 Billion in 2007 alone

With earnings like this, it is no surprise that many hedge fund managers are now counted among the Forbes Global Richest list.

This brings us to the second article that examines what would have happened if Warren Buffett had followed the hedge fund model of compensation instead of just staying with his equity position in Berkshire Hathaway and let the investment compound. To quote from the FT article,

At “2 and 20″, the split is $57bn for Buffett Investment Management and $5bn to the Buffett Foundation. The effect of compounding at 14 per cent, rather than at 20 per cent, is to reduce the accumulated pot by over 90 per cent.

It is basically saying that if Buffett had followed the Hedge Fund model of compensation, his accumulated wealth would have been just 10% of what it is today

The difference is in the business models. A hedge fund manager primarily derives his income from fees. The assets of the hedge fund are owned by investors in the fund and only a part of the growth in the value of this asset works towards increasing the net worth of the hedge fund manager. For Mr Buffett, and indeed many entrepreneurs, net worth is primarily determined by the equity stake in the business that they own. Equity ownership lets the business income continue to compound in the business. As the business grows, the net worth of the owner grows correspondingly (the story would have had a different ending if Buffett had kept diluting his stake in Berkshire Hathaway by continually bringing in new investors like a hedge fund does)

Also to note (and a point unaddressed by the FT article) is the effect of taxation. While a hedge fund manager pays taxes each year (capital gains or income, a matter of controversy for sure but not relevant to this analysis), Mr Buffett will only pay taxes if he sells his equity (again, the fact that his charitable actions have helped him avoid taxes altogether is besides the point)

If you are a superlative investor (like Mr Buffett or like many of the better hedge fund managers), business ownership model of Berkshire Hathaway will generate greater wealth over a long period of time. Sure, running a hedge fund will get you to great riches quickly (adding lot of investors quickly, in the years where the fund does very well, etc), but it is not a superior wealth creation machine over long term

Maybe that is why Warren Buffett long ago discarded the investment partnership model. Or maybe another reason why Blackstone, Fortress et al. are now choosing to go public bestowing large equity stakes on their founders

Fed in a surprise move today announced $200 Billion worth of liquidity injection in the credit markets

This fed action is different from what it has traditionally done and is clearly in response to a situation that is different from traditional recessionary period. And therefore it is more likely to succeed. Cutting interest rates helps businesses secure loans cheaper and can jump start a slowing economy, unless of course, if the banks are so unsure of their balance sheets that they are afraid to lend at any price (and the market so unsure of the asset quality that it is unable to price securitized debt). The latest fed action helps by substituting Treasuries for other debt ‘collateral’ that may include mortgage backed securities and thereby removing some of the uncertainity in the credit markets.

Some in financial media are reporting this as Fed pumping cash in the economy (including the article linked above). There is a better way of looking at this. It is a loan against a collateral (a collateral that is otherwise useless under current conditions). Think of it as Fed trying to restore the original value of some of the securities that people were not willing to touch. This is just a liquidity enhancement operation.

The loan comes due in 28 days. Hopefully the banks that avail of this facility are able to make good use of it in this time.

You will notice that I have put in a new copy protection on my website today. It appears that there are websites that have been gleefully copying the entire articles from my blog without my permission.

If you would like to syndicate my articles, please ask me for permission. I am pretty open to any and all such requests and will grant permission as long as the article links back to this blog for attribution and the attribution is very visible and the reader is encouraged to visit this site to read the full story and comment (and of course, your website is a relevant and credible site)

I am sorry to have to bring this up. Thanks for understanding!

Two years ago I expended considerable time and effort to find a way to invest in Indian companies on local Indian exchanges. Yes, we can buy ADS/ADRs on American exchanges and for some companies that do not trade in US, one may be able to buy GDRs on some European exchanges (depending on whether your broker is capable of executing these international trades). I called up Indian brokers with no luck. Called up the international trading desk with my US broker and they told me that they can transact on most exchanges in the world but not in India. Buying GDRs on European exchanges was always an expensive proposition

There were very few options to invest in Indian companies. Few Open ended mutual funds did exist (Eaton Vance (ETGIX) and the excellent Matthews India (MINDX) that came later). There were also a few close-ended funds (India Fund (IFN) and Morgan Stanley India Investment Fund (IIF)) but the expense ratios were always on the high side

My issues with all these options were that they were invariably overloaded with IT and Software names. While this industry has been the driver behind India’s past growth, I believed that the future growth in India will likely come from more basic industries such as materials, steel, cement, banking, communications, etc. Industries that are core to what can be the largest national infrastructure buildout (along with China) in the next decade or so

It has been a long time coming. Two new ETFs were launched recently that track indexes (separate and proprietary) based upon local Indian stocks on NSE and BSE exchanges. The expense ratios are also more reasonable now. The following is a brief introduction to these two ETFs. (If you are interested in these, please be sure to hope on to the respective sites and peruse the prospectii. A few links are provided for your dd pleasure)

1. Wisdom Tree India Earnings Fund (EPI) based on Wisdom Tree India Earnings Index

The fund tracks a proprietary index composed of profitable Indian companies weighted by Earnings. The index currently holds about 150 companies and therefore is well diversified. The expense ratio is a reasonable 0.88% and the top holdings and sector weightings are more to my liking

The fund started trading on NYSE ARCA in late February. Today’s quote is 23.94 and the NAV is around 23.4. It therefore trades at a slight premium to NAV

More Information about the fund is at the Wisdomtree site

More information about the index is here

2. Powershares India Portfolio (PIN) based on Indus India Index

This fund tracks a proprietary index based on the 50 largest companies in India and is market capitalization weighted. The expense ratio is 0.78% (besting the Wisdomtree ETF by 10 basis points) and its top 10 holdings are pretty similar to EPI (although the weightings are different)

The fund started trading today. The offer price was 25

More information on the Powershare fund can be had here

My take: I personally prefer the Wisdometree ETF despite its slightly higher expense ratio. First of all, its average PE ratio is about 17 compared to about 20 for PIN and about 27 for the Indian stocks as a whole. Secondly, EPI is more diversified across multi-caps and gives an exposure to the small and medium cap companies in India, which is where a lot of growth will occur. PIN has minimal small cap exposure and is not likely to have one based on how it index is constructed

A word of caution: These ETFs are very recent and it is generally wise to wait for sometime before buying into them. If you buy too early, you may end up paying a good premium to the NAV

Another word of caution: Investing in foreign markets is more risky than investing domestically (but than it is the same thing they tell you in India if you want to invest in American stocks …). Also you will be exposed to the currency fluctuations (which if you ask me is probably a good thing since I do expect the Indian Rupee to continue to strengthen against USD for the foreseeable future). There may be less transparency in the company financials in emerging markets (you know, as opposed to , let’s say, in US, assuming you ignore the current events here in the States). Etc, Etc.

Typically I avoid funds, instead choosing to buy individual stocks. However, I will make an exception here as these ETFs still remain the best way to buy into the Indian markets