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

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.

There is a brewing opposition to Bank of America’s proposed acquisition of Countrywide

First there was a news that the hedge fund SRM Global Fund with its 5.2% stake in Countrywide is opposing the BAC deal . The feeling in the market at that time was SRM may not be able to find any allies in other shareholders

Then comes the new yesterday that Capital World has acquired a 6.1% stake in Countrywide recently. Although Capital World appears to be a passive investor who may or may not side with SRM, they clearly think that the current price is a good value

Today it is revealed that Legg Mason as requested and received approval to raise its stake in Countrywide upto 25%, and its stake has already been increased upto 15% of the company. Additionally, Bill Miller of Legg Mason in a note to investors indicates that he is not in favor of Countrywide sale at the current prices

With many investors now gearing up to oppose the CFC sale to BAC, expect more buying in the stock and gradual appreciation of the stock price. A likely scenario that eventually plays out may include BAC sweetening its offer for Countrywide by possibly offering more BAC stock in exchange for CFC stock. This is getting interesting and even if buying CFC may not work out as a way of getting BAC cheap as suggested in an earlier article (that is if the sale does not go through. If the sale goes through at the current or higher prices than the strategy works beautifully), all the institutional support that is coming back to Countrywide bodes well for a good return on investment on CFC stock itself

If you are invested in CFC I would recommend to stay put. (Of course, there is always a risk of bankruptcy and that is something that you need to weigh)

Economists are generally an optimistic bunch. A lot of them would not speak the R word unless it is staring them in the face. The Institute of Supply Management (ISM) service sector report shows a drop in business activity, first such drop in nearly 5 years. This has caused some economists to finally agree that Recession may already be here.

On this site we insisted that the recession is already here, even though it may be in pockets, in an earlier article.

Wasn’t this also the message the feds were sending when they aggressively started cutting the interest rates. The message was, as I saw it, that recession was now a bigger threat to the economy than, say, inflation

Recessionary cycles are normally self correcting, the only question remains how quickly will the economy turn. Since this time around the genesis appears to be in the credit markets, it is logical (and indeed happening now) that the credit will become scarce for most except the most credit worthy businesses.

These are the times when the mind wanders in the direction of asset preservation rather than growth. Nothing wrong with that.But remember, Toyota continued to grow as a company throughout the decades that Japan has been in its extended recession

What should an investor do in recessionary times?

First of all, if you are a patient value investor with a long time horizon, the best advice is to wait it out (or rather be opportunistic and add to your holdings). Here I assume that you do not depend on your portfolio for your living expenses

If you are a short term speculator (technical traders), than you need to be careful as the volatility trends that you may have come to rely on may not work as well. Bankruptcies, sudden changes in fortune, etc are singular events which can distort any system that you may be employing.

For most though, it may be wise to evaluate what companies you may want to remain invested in. Besides looking for undervalued securities, you should look for companies with the following characteristics

• Cash flow generating companies with highly rated debt. These companies have flexibility to manage their operations and cash  based on the economic environment
• Cash rich companies
• Companies with a diversified product portfolio, that includes what may be necessities for most people to live on
• Companies that are geographically diverse
• And strong companies in weak sectors, where new market share can be gained

These are the kind of businesses that will not only survive recession but can come out stronger

Additionally, you may wish to look for a good dividend yield, which you should promptly reinvest. Most brokers now offer free dividend reinvestment so this should not be a problem. One of the benefits of this recession is that the low taxes on dividends in US are more likely to continue

Many of the established consumer staples and  pharmaceutical companies qualify according to these guidelines. My favorite in this sector is Johnson and Johnson (JNJ)

Some financials also qualify. Bank of America (BAC) is my favorite

There are two other types of companies that can do well but may be for a slightly more adventurous investor.

1. Companies that make their profits preying on weak and restructuring them. Leucadia National (LUK) is one. American Capital Strategies (ACAS) is another one with a very attractive and increasing dividend yield to boot
2. Companies that make money insuring risk. Markel (MKL) is one speciality insurer I really like, if only because they have excellent investment credentials in addition to a top notch underwriting team

Added benefit is that all these companies currently trade at an attractive valuation.

I will be interested to know what you think and what steps you are taking (if any) as we settle into this winter of recession

You read this headline and say, Duhh!

But really, the economy was kind of stalled for some time now with many institutions taking a wait and see approach. Not that the basic industrial sectors were suffering much, they were still humming along, albeit at a reduced pace. However, what had really taken a hit was the consumer confidence and the risk appetite of the financial firms

A total of 1.25% rate cut is nothing to sneeze at. All of a sudden, many homeowners who were looking at unaffordable resets on their adjustable mortgages will get some room to breathe. The more money that is left in the consumers pockets, the more the American consumer is willing to go out and spend. At this point though I really hope that the consumers have learnt the lesson and start putting some money towards savings and building an emergency cash portfolio

Look for increased mortgage refinancing activity in the coming months. 1.25% drop in ARMs (or close to it, depends on the lender on how much will actually flow through to the consumer) should be enough to make re-financing the mortgage an economical proposition for many homeowners

What this also means is that for many lenders, this will be an opportunity to replace riskier loans with more traditional and discipline-infused product. Should do wonders for their asset quality

Another effect of the rate cut would be to bring the liquidity back in the credit markets. Many institutions were having difficulty syndicating debt as there were no buyers. This situation should ease

And finally, CD and money market rates should decline. This along with the juicy yields now available on many stocks should help investors slowly come back into the stock market

Is inflation still a risk given the scale of the interest rate cuts? Probably, but with everything else going on in the economy and the stress on the housing sector (a house is probably still the most prominent part of any American’s net worth), I really think that the consumers are not likely to embark on a shopping spree anytime soon. I think we will start seeing a fundamental change in how the public spends their money. There will be a move towards smarter spending. That is my hope anyway

My best stock play for a recovering economy remains Bank of America. In the next post I will outline the best way to buy Bank of America today. Stay tuned