Saturday, July 28, 2007

Effects of income tax changes

Changes to the corporate income tax affect all businesses in important and divergent ways. The main tax change that affects Singapore businesses was tax is reduced from 20% to 18%. This change obviously affects businesses positively.

Over the years, there has been a lot of fuzzy and often partisan commentary about who really pays income taxes – businesses or their customers. The argument, of course, has usually hovered around tax increases, not decreases. Those people resisting increases in corporate rates frequently argue that corporations in reality pay none of the taxes levied on them but, instead, act as a sort of economic pipeline, passing all taxes through to customers. According to these advocates, any corporate-tax increase will simply lead to higher prices that, for the corporation, offset the increase. Having taken this position, proponents for the “pipeline” theory must also conclude that a tax decrease for corporations will not help profits but will instead flow through, leading to correspondingly lower prices for consumers.

Conversely, others argue that corporations not only pay the taxes levied on them, but absorb them as well. Consumers, this school says, will be unaffected by changes in corporate rates.
What really happens? When the corporate rate is cut, do companies themselves soak up the benefits, or do these companies pass the benefits along to their customers in the form of lower prices? This is an important question for investors and managers, as well as policymakers.

The more logical conclusion is that in some cases the benefits of lower corporate taxes fall exclusively, or almost exclusively, upon the corporation and its stakeholders, and that in other cases, the benefits are entirely, or almost entirely, passed through to the customers. What determines the outcome is the strength of the corporation’s business franchise and whether the profitability of that franchise is regulated.

For example, when the franchise is strong and after-tax profits are regulated in a relatively precise manner, as is the case with electric utilities, changes in corporate tax rates are largely reflected in prices, not in profits. When taxes are cut, prices will usually be reduced in short order. When taxes are increased, prices will raise, though often not as promptly.

A similar result occurs in a second arena – in the price-competitive industry, whose companies typically operate with very weak business franchises. In such industries, the free market “regulates” after-tax profits in a delayed and irregular, but generally effective, manner. The marketplace, in effect, performs much the same function in dealing with the price-competitive industry as the Commission for Public Utilities does in dealing with electric utilities. In these industries, therefore, tax changes eventually affect prices more than profits.

In the case of unregulated businesses blessed with strong business franchises, however, it is a different story: the corporation and its stakeholders are then the major beneficiaries of tax cut. These companies benefit from a tax cut much as the electric company would if it lacked a regulator to force down prices.

Many of such businesses, like P&G, Coca Cola, Wrigleys, Kelloggs, possess such franchises. Consequently, reductions in their taxes largely end up in the stakeholders pocket rather than the pockets of their customers. While this may be impolitic to state, it is impossible to deny. If you are tempted to believe otherwise, think for a moment of the most able brain surgeon or lawyer. Do you really believe the fees of this expert (the “franchise-holder in his or her specialty) will be reduced now that his top personal income tax rate has been cut?

Monday, July 23, 2007

An investing lesson

The purchase of the Washington Post Company (WPC) by Berkshire Hathaway in 1973 provides an almost perfect blueprint in investing. Here’s a brief history of this classic investment example.

In 1973, Berkshire Hathaway bought all of her WPC holding at a price of not more than one-forth of the then per-share business value of the enterprise. Calculating the price-to-value ratio required no unusual insights. It was around the nifty-fifty years at that time, either at its peaks or the turn of the peak. Most of the security analysts, or media executives then would have estimated WPC’s intrinsic business value at $400 to $500 million just as Berkshire Hathaway did. And its $100 million stock market valuation then was published daily for all to see. The advantage Berkshire then had was attitude: They learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values even if there’s a chance prices would drop much further.

Most institutional investors in the early 1970s, on the other hand, regarded business value as of only minor relevance when they were deciding the prices at which they would buy or sell. If you look at WPC’s market value in 1985, this would seem hard to believe. By 1985, WPC’s market value was $205 million for Berkshire’s share of the business. However, these institutions were then under the spell of academics at prestigious business schools who were preaching a newly-fashioned theory: the stock market was totally efficient, and therefore, calculations of business value were of no importance in investment activities.

Through 1973 and 1974, WPC continued to do fine as a business, and intrinsic value grew. Nevertheless, by yearend 1974, Berkshire’s WPC holding showed a loss of about 25%, with market value at $8 million against their cost of $10.6 million. What Berkshire had thought to be ridiculously cheap a year ago had became a good bit cheaper as the market, in its infinite wisdom, marked WPC’s stock down to well below 20 cents on the dollar of intrinsic value.

Like Skim milk masquerades cream, WPC’s golden goose was hidden ten feet under the soil. To yet fatten the goose, WPC had an able steward in place – the late Katherine Graham. She had the brains and courage to repurchases large quantities of stock for the company at those bargain prices, as well as the managerial skills essential to dramatically increase business values. In the midst of these events, investors began to recognize the exceptional economics of the business and the stock price inched closer to the underlying value. Thus, Berkshire experienced a triple dip: the company’s business value soared upward, per-share business value increased considerably faster because of stock repurchases and, with a narrowing of the discount, the stock price outpaced the gain in per-share business value.

Lessons to be adopted:

1) If Warren Buffett had been led astray by the ticker on the Geiger counter, monitoring the price of WPC on a day to day, month to month, quarter to quarter, or year to year basis, he would not have been able to show the kind of result which he showed a dozen years later. By sticking to his principle of price versus value, and if he is able to buy at a price well below the business value, he would not allow market sentiments or personal sentiments to creep in and dictate when he should enter or exit the market. What guides him to either enter or exit the market is the business value of an enterprise. For example, if WPC is trading at a market value of $100 million while its business value is $400 million, he would not allow himself to delay his purchase just because he feels or thinks the price may goes yet lower. It is important to acknowledge it is impossible to either catch the top or the bottom stock price. The two ends at which the price of a stock will end up is in fact incalculable. However, the value is not.

2) Business value is the only wise and logical yardstick that defines proper investing. By being guided by the movement of price, the proper picture is lost.

3) Know the value, not the price. Just like if you do not know the horse, you’d better know the jockey.

4) Between 1973 and 1985, the value of DOW is pretty flat. However, the change in market value for WPC soared from $100 million to $1.8 billion. Who says you should be dictated when to invest or not to invest in a bull or bear market? In all markets, if you find a stock where the price is great, you should ignore what the general market is fairing even if it is at its peak.

5) During the end of 1974, Mr. Buffett would have looked like a fool if the market then had either been better than him or at par. But who’s the wiser by 1985? It would seems foolish and unthinkable how one could even consider buying WPC in 1973 for $100 million when the price would dip even lower by end of 1974 if you were a market participant in those early years of 1970s. But by 1985, if you were a market participant then, you would think it hard to believe that how those security analysts and the general investing community would be willing to sell WPC 20 cents on the dollar. Well, the market has been this way since the dawn of Wall Street. It happened in the past, it’ll repeats or rhymes in the future. And yet, there’re already a few stock which are probably priced at 50 to 70 cents on the dollar in today’s market, and we are talking of really fabulous businesses with brand names to match.

6) To try to get in and out of the market and winning each and every time you make an investing decision either to buy or sell, it is impossible to get it right each time. Investing based on technical means buying and selling as the risk of beta decreases or increase, this naturally leads to more trading activities. Let’s ignore the notion that technical investing does not even take into account the business economics, we shall focus on the number of attempts an investor will make between technical investing and intelligent investing. In technical, a typical investor will make numerous tries, each time trying to push the buy or sell button faster or harder than the next buyer or seller. In intelligent investing, a typical investor will only make a couple of trading activities based on the changes in the price of the stock in relation to the business value. Mathematically, the more you try, the less your chances of getting it correct. The more concentrated your activities, the more you stand to win. Logically, if you concentrate on a few things, the few things would be a lot stronger in base than if you were to concentrate on many things. If you know only one woman, you’d get to know her very well. But if you have a harem of women, it’d be hard to know each of them well. If Sir Isaac Newton is alive, he would probably come up with the forth law of motion – as motion increases, return decreases. A business value does not change in a short span of time like how stock prices do unless some basic fundamental changes. To thus constantly change the price of the stock that trades between a wide price band is foolish. In technical investing, it is simply just an easy way which investors mistook that represents the value of the business. It needs no rocket scientist to figure what is the peak or the bottom of a price range for a 52-week period. That is essentially technical analysis. But for intelligent investing, it simply ignores the 52-week high and low of a stock price. It just simply measures what price you should pay for the present value that the business will produce over its remaining life time. If the present value of all future cash flow of A is $100, and it is available at $50, you buy. If it is traded at $95, you skip. So when you know the value, you insist for a discount, just like you would build a bridge, you’d insist that the bridge carries 30,000 pound. But when you drive a truck across it, you’d only carry 10,000 pound. This is margin of safety.

7) Investing is a long haul game. What can safeguard your principal and gains is to understand what you are doing. The only way is intelligent investing. Although technical investing or buying on trends or the next sexiest stock can show you a gain in the short term, it’ll not go on infinitely by not showing a loss. Technical investing is akin to gambling, an investor of such kind can win a few rounds, even up to 10 or 20 rounds on the trot. Like a typical gambler in a casino, such investor does not know the odds are stacked against them and the odds are with the house. Why? Importantly, they do not know how to calculate if the odds are on their side. If you decide to gamble, you should only gamble knowing the odds. For example, in blackjack, the card of 5 is the most valuable to the house, so if you could the number of 5s that have been dispersed, you would know the odds have reduced in the favor of the house with the remaining cards in the pack. You’d then be able to deploy more of your stake when the number of 5s left is less, and less of your stake when the number of 5s are fully in the pack. Back to investing, in a bull market, it is easy for investors to indulge in technical or buying on trends and yet win. Easy money sedates rationality and simply leads to complacency. Investors of such kind could win 10 times on the trot. But just as market sentiments turn, on the next try, investor loses all back, they’d be lucky to even retain their principal. Any mathematical formula that multiplies by a zero will always be a zero regardless if the numbers preceding it is a million by a million. What an investor wants to avoid is the probability of the zero ending up in their investing formula. If you happen to be an investor who swears by technical or buying on trends, and you’re already making a million by a million, you should think if the next multiplying number is a zero.

8) When conditions are right like WPC – the right business economics and good management that sell well below the business value – will produce grand-slam home runs. People like Warren Buffett does not try to predict the stock market, whether the market is going up, down, or sideways in the near or intermediate future. What Warren does know is that occasional outbreaks of two super-contagious diseases – fear and greed – which will forever occur in the investment community. The timing of these epidemics will be unpredictable, both as to the duration and degree. Thus, investors of Warren type would never try to anticipate the arrival or departure of either disease – they simply do not try to play god. When people are greedy, Warren is fearful, when people are fearful, Warren is greedy. He should get scared when people start agreeing with him. As this is written, certain hot sectors show little fear on the Singapore scene. Instead, euphoria prevails – and why not? What could be more exhilarating than to participate in a bull market in which the rewards to owners of businesses become gloriously uncoupled from the plodding performances of the businesses themselves. Nothing simply gets better than effortless money. Unfortunately, stocks cannot outperform businesses indefinitely. Indeed, because of the heavy transaction and investment management costs they bear, stockholders as a whole and over the long term must inevitably underperform the company they hold. If Singapore businesses, on aggregate, earn about 12% on equity annually, investors must end up earning significantly less. Bull markets can obscure mathematical laws, but they cannot repeal them.

Sunday, July 22, 2007

Profile of a superinvestor - Mohnish Pabrai

Occasionally a cult forms around an investor. In the case of Mohnish Pabrai (by now, he should be quite famous as an ardent follower of Warren Buffett), it’s a sub-cult of the mother of all investing cults.

While searching Amazon for classic investing books, two must-read books were discovered, both out-of-print, were selling for considerable sums. Seth Klarman’s Margin of Safety was going for $1,700 and Mohnish Pabrai’s Mosaic sold for $340. You might think the price on Klarman’s book the more remarkable. On calculation, by buying and selling, Margin of Safety, first published in 1991, would have turned in 29% a year. On the other hand, Mosaic, in just three years since its publication, has put in 144% a year.

The price on Mohnish’s book is only one of a number of indications that a cult is developing around him. He’s all over the internet.

No doubt one of the reasons is his new book, “The Dhandho Invesor.” A value blog likes it as to say, “If you want a book to help you understand value investing, this book can help you accomplish your goal.”

Before becoming a value investor like Mr. Pabrai, you’ve got to admire a pundit who, unperturbed by the incredulity of his Bloomberg hosts, won’t be drawn into breathless comment on the recent 100-200 point moves in the stock market.

Investors, says Mr. Pabrai, should think like a businessman, not a Bloomberg presenter.

“I talk in the book about this concept of low risk, high uncertainty. So there’s a perception that entrepreneurs are risk takers. Well, in reality entrepreneurs avoid risk. They try to minimize risk…They do absolutely everything to minimize the downside. But they are also humans that are very comfortable with uncertainty. So they can believe a wide range of outcomes and be very comfortable.”

Minimizing the downside means buying stocks that are hated and unloved, often ignored by Wall Street, that have already reached a “floor.” Sounds familiar? It should. Mr. Pabrai describes himself as a follower of Mr. Warren Buffett, often referred as the world’s greatest investor:

“I’m just a humble disciple, or like you say I’m a shameless cloner.”

One of Mr. Buffett’s many insights run against conventional investment thinking, and by the sound of it, it’s the origin of Mr. Pabrai’s contrarianism. Conventionally, risk means volatility (measured by a share’s beta), so a falling price makes a share more risky. But, as Mr. Buffett explained, in a speech at Colombia Business School in 1984, subsequently became one of the best investment speeches that gives a profile into the genes of a superinvestor, in a value portfolio the bigger the expectation of reward, the lower the risk.

For example, in 1973, the Washington Post Company had a market capitalization of $80m although its assets were worth at least $400m, Mr Buffett said:

“Now, if the stock had declined even further to a price that made the valuation $40m instead of $80m, its beta would have been greater. And to people who think beta measures risk, the cheaper the price would have made it look riskier. This is truly Alice in Wonderland, I have never been able to figure out why it’s riskier to buy $400m worth of properties for $40m than $80m.”

Mr. Buffett was paying homage to a concept developed by Benjamin Graham, the father of the cult of value investing. That concept was the “Margin of Safety,” purloined by Seth Klarman for the title of his book. Mr. Buffett explains it this way:

“You don’t try and buy businesses worth $83m for $80m. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And the same principle works in investing.”

In other words, the lower the price relative to the company’s valuation, the higher the margin of safety. A low price reduces risk. If you watched the interview with Mr. Pabrai, you’ll have noticed he really has shamelessly cloned that model, passed down, as it were, from Mr. Graham, to Buffett, to him.

So why listen to Mr. Pabrai, when you have the works of Benjamin Graham and Warren Buffett? Well, Mr. Graham died in 1976, so the focus must, to an extent, switch to his disciples.