More...
617-529-2913
20 Adams Street | Suite 200 | Boston, MA 02129

Category Archives: Equity Strategies

Cutting US Corporate Tax Rates

taxpapers-1557352-639x852In this US electoral season the issue of corporate tax reform comes up frequently. Both parties seem to understand the competitive disadvantage in which US corporations find themselves often due to much more generous tax policies in other countries.

Where does the US stand in terms of corporate tax rates? KPMG, the large accounting firm, provides an excellent guide to Global Corporate Tax Rates . The current corporate tax rate for US domiciled companies is shown as 40% which is composed of the top federal rate of 35% plus applicable state and local authority taxes.  The KPMG guide is meant as a guide but clearly the ultimate corporate tax rate faced by companies is a function of many variables including importantly the location of foreign subsidiaries.

According to the KPMG data the US ranks highest in terms of corporate tax rates among major industrialized nations.  The global average in the KPMG sample is 23.6% with rates in OECD countries slightly higher at 24.8%.

In the last ten years there has been a race to the bottom in terms of corporate tax rates.  Countries have been lowering their tax rates as an incentive for companies to relocate to their jurisdictions.  In the KPMG sample we find seven countries with a zero corporate tax rate.  Some well-known tax locales with no corporate taxes include Bahamas, Bermuda, Guernsey and the Isle of Man.

What are the investment implications of lower US corporate taxes?  Lower corporate taxes would most likely make US domiciled companies more valuable as after-tax profitability would be enhanced.  By how much? To address this question we resort to using a simple discounted cash flow approach.

The basic idea behind using a discounted cash flow approach relies on using estimates of future cash flows to the company and discounting those cash flows back to the present by using the weighted cost of capital.

Our analysis is based on a discounted cash flow model built for a hypothetical company where the only two parameter inputs that we vary are the applicable corporate tax rate and the level of debt financing.  What do we learn from this exercise?

From a pure valuation perspective it is unambiguous that a lower corporate tax rate will result in greater gains for shareholders. Basically, the revenue foregone by tax authorities is now available to shareholders of the company.

But there is an offset in the valuation model via the discount factor of those now higher corporate cash flows.  Specifically, assuming the same capital structure, the cost of capital will increase as the tax advantages of debt financing are diminished.

Say corporate taxes go from 35% to 20%.  The after-tax cost of debt to the company yielding 5% goes from 3.25% to 4% (the calculation is (1-Tax rate)*Yield).  The net effect of lower corporate taxes is a higher weighted cost of capital (assuming no changes to the capital structure or risk profile of the business). A higher cost of capital implies lower a lower valuation assuming unchanged cash flows to equity holders.

The offsetting impact of a higher cost of capital in discounting cash flows is under most scenarios likely to be of lesser importance to the valuation of the firm compared to the value enhancing effect of higher after tax cash flows

Some of our conclusions:

  • A lower corporate tax rate will under most scenarios result in higher firm valuations
  • The effects of tax cuts are non-linear as the first few percentage points of tax cuts lead to proportionally higher rates of firm value appreciation
    • Going from a 35 to a 30% tax rate results in a greater increase in firm valuation than going from a 30 to a 25% tax rate
  • Firms using more debt financing will benefit from lower tax rates but less so compared to firms who do not use debt very much
    • Firms with low debt to equity in their capital structures will increase the most in value
    • This is due to the diminished value of the deductibility of interest expense and the increase in the weighted cost of capital
  • Companies in the Health Care and Technology sectors typically rely less on debt financing and will thus benefit the most from lower corporate taxes
  • Firms in industries with traditionally high levels of debt financing such as Telecom and Financials will benefit the least from a valuation perspective
  • Firms with significant tax loss carry-forwards will not be as enticing to merge with as the value of their tax credits are diminished under lower corporate tax rates
  • We don’t believe that foreign cash repatriation will instantaneously convince US corporations to invest more domestically

To access the full report click here!

 

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Feel free to contact us at Global Focus Capital LLC (mailto:eweigel@gf-cap.com or visit our website at http://gf-cap.com to find out more about our asset management strategies, consulting/OCIO solutions, and research subscriptions.

DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERRORS

 

 

Migration Patterns in Company Profitability

ROE's Tend to be Pretty Stable

ROE’s Tend to be Pretty Stable

Firm profitability is a characteristic highly sought out by investors in private market transactions.  In public markets firm profitability tends to be frequently lumped together among “quality” factors.

Over the years I have always thought that “quality” is very much in the eye of the beholder while profitability as a concept can be measured in an unambiguous manner and stand on its own feet.

That is why in our stock selection and top-down sector and country allocation models we treat profitability as a separate conceptual category.

After all what more powerful combination can one have for long-term value creation than a company that is growing and doing so in a profitable way.  Some of the best known stocks in the world such as Apple and Google are living proof that a combination of growth and profitability is highly rewarding for long-term investors.

While market-wide ROE’s tend to be pretty stable across time we would expect some variability caused by the business cycle, the degree of leverage in the system, changes in the cost of money and tax rates among others.  The above chart shows the year-to-year median ROE along with points along the 3rd and 1st quartiles.  The average calendar year ROE in our global sample is 11.2 with a standard deviation of 2.1.

The conventional wisdom holds that in a competitive economy it is virtually impossible to remain a highly profitable company over the long-term.

In the case of a frictionless free market system, companies should all gravitate long-term to an economy-wide level of profitability.  The idea is that companies that are currently below a normal level of profitability will restructure and/or change their business strategy thus hopefully improving profitability.  Conversely, companies with above average levels of profitability will face increased competitive forces and revert back over time to a normal level of profitability.

In a free market open economy company profitability will exhibit a mean reverting pattern.  That is in theory. In the real world of partially competitive markets we would still expect to see mean reverting levels of profitability but with a lot more noise. We would also expect to see stronger mean reverting patterns over longer holding periods while in the short-term we would expect to see minimal competitive re-alignment.

In this note we present some high level findings on how Return on Equity (ROE), a common measure of firm profitability, evolves over time. ROE is calculated as Net Income / Shareholder Equity. For some background on what motivated our interest in profitability factors please take a look at a recent video Eric J. Weigel – The Manual of Ideas Interview available on YouTube.

What does the data show in terms of how companies migrate between profitability stages?

ROE MIGRATION MATRIX

Note: Decile 1 contains the highest ROE stocks in our balanced panel global equity sample

Some high level conclusions:

  • ROEs do not fluctuate that much over time and there is a high persistence in relative universe profitability rankings. We call this the “status quo” effect
    • Mean reversion in ROE (estimated over a five year window) is best found in the middle portion (Deciles 4-6) of the profitability spectrum
  • The highest ROE stocks tend to, over the subsequent five years, remain in the higher portions of our sample profitability at a greater rate than expected.
    • Buying a high ROE stock and five years down the road ending up with a company in the bottom end of profitability occurs with a frequency less than expected by pure chance
    • Deciles 2 and 3 appear to be the place for finding companies with high sustainable levels of relative profitability
  • The greatest rate of improvement in relative profitability rankings occurs in Decile 10 comprising those companies with the lowest ROEs, but the rate of improvement fails to beat expectations. Going long Decile 10 stocks is fraught with significant risk of disappointment
  • A contrarian investor investing in low relative ROE stocks such as those in Deciles 7-9 is taking a bet with unfavorable odds of success. The improvement rate of these ROE laggards tends to fall below expectations

As a final note, our view is that stock picking is a multi-dimensional endeavor balancing among others valuation, profitability, and growth concepts.  The behavior of any one factor should always be viewed in the context of the current capital market environment.  Our current view on the attractiveness of stock factors augurs well for favorable returns to stocks with high sustainable levels of company profitability.

To read the full report please click here Migration Patterns In Company Profitability

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Feel free to contact us at Global Focus Capital LLC (mailto:eweigel@gf-cap.com or visit our website at http://gf-cap.com to find out more about our asset management strategies, consulting/OCIO solutions, and research subscriptions.

DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERRORS

Is it Really All About Oil?

oil&stocks levels

A large number of stories in the financial press this year have revolved around the relationship between equity prices and oil.  In fact some commentators have focused on a recovering oil price as the key lynchpin for rising equity prices.

As an example, the Wall Street Journal published an article this year “Oil, Stocks at Tightest Correlation in 26 Years”. Many other publications and strategists have written pieces this year noting the close relationship between oil prices and equity index performance.

The human mind is conditioned to look for patterns and in the tumult of early 2016 the oil market meltdown started playing a leading role in explanations of why global equity markets were under stress.  But as any econometrics professor will say “correlation is not causation“.

In this note we look at the sensitivity of asset class returns to changes in the price of oil.  We take a risk management perspective and find that while oil price sensitivity is significant when analyzing one-on-one relationships, the effect is close to zero and statistically insignificant in a multivariate context.

Eq Beta to OilWhat you see is not always what you get.  We conclude that rising oil prices have little long-term significance for broad equity market prospects and that a rising oil price is more of a reflection of supply curtailment efforts.

 

The key lesson to us from our analysis is that commonly heard explanations for asset return drivers are often incomplete and in some cases highly misleading.

Every market environment has its own context and no single factor in isolation will ever be able to fully explain the complexities of market behavior.  Even in hindsight it is often hard to pin down a story that holds up to serious scrutiny.

Best to stay humble and realize that over shorter time periods capital markets will always be subject to a lot of noise of no material significance to long-term investors.

Click here to download the report: Is It All About Oil

Sincerely,

Eric J. Weigel
Managing Partner and Founder of Global Focus Capital LLC

eweigel@gf-cap.com

Global-Logo

Low Volatility – One Factor or Several?

park-bench-waterfall-1202609-639x427Once a month in our Equity Observer  publication we share our analysis of what stock selection factors are working.  This year the best performing factor in our global sample is “low volatility”.

The issue of what constitutes a factor will be endlessly debated, but while “low vol” does not quite rank up there among academics with the original Fama-French-Carhart variables (market, size, value, momentum) there is nevertheless a growing investor demand for lower volatility strategies.

The growing demand for “low vol” strategies does not seem entirely driven by the performance of these strategies relative to core benchmarks.  For example over the 2015-2013 period the S&P Low Volatility Index under-performed the S&P 500 core index by 3.4% annualized.  Yet demand for these strategies appears to have grown as manifested by the large number of new ETF’s launches in this space.

Investors seem particularly interested in the capital preservation characteristics of “low vol” strategies and appear willing to sacrifice returns during the good times in return for less pronounced equity market downdrafts.

Low volatility strategies seem here to stay.  Given their market beating returns thus far in 2016 it is reasonable to expect growing interest.  We therefore analyze our global sample of 13,000 stocks to ascertain the basic characteristics of low volatility stocks. Vol_decile

Stocks in the lowest volatility decile have an average return volatility of 20%

Higher volatility stocks exhibit low levels of market sensitivity (beta)

During periods of equity market stress ‘low vol” strategies should out-perform broad market indices

The lowest volatility decile enjoys the highest current yields while the “high vol” names in Decile 10 barely register for income

Lower volatility stocks have lost their historical valuation advantages.  The growing demand for ‘low vol” and its close cousin dividend income have eroded the typically lower valuations seen in lower volatility sectors and stocks.

low vol returnsEven after adjusting for sector and region/country effects we observe a strong monotonic relationship in YTD returns across volatility deciles.

The lowest volatility stocks (Decile 1) have had the highest 2016 returns while the highest volatility stocks have shown the greatest losses.

 

Our general conclusion is that “low volatility” strategies play a useful role for investors looking to provide short-term downward protection in their equity portfolios.  However, we think of “low vol” as part of a package of stock attributes designed to lessen market exposure during periods of equity market stress.  These strategies along with lower betas, higher yields and exposure to more stable sectors should exhibit lower levels of downside capture.

Investors worried about equity market downturns should not view these strategies as a substitute for properly assessing and managing the risk of their overall portfolios.

Click here to download the report: Low Volatility – One Factor or Several?

Sincerely,

Eric J. Weigel
Managing Partner and Founder of Global Focus Capital LLC

eweigel@gf-cap.com

Global-Logo

Less Bunny, More of a Rocky Balboa Market!

Rocky Balboa View

Rocky Balboa View

The start of the year felt like a Rocky Balboa fight.  Risky assets were absolutely pummeled during the first 6 weeks of the year and were down for the count.

Most investors were taken by surprise by the strength of the first punch and the retail section started emptying out early. White towels were being thrown about but out of nowhere equity markets started gathering strength.

Just like a fighter on the ropes biding time equity markets started little by little chipping away. By the end of February stocks had stabilized and the first real signs of a competitive fight emerged during the first week of March.  The point count had evened out and by the end of the month the count had swung around in many categories. At the end of Q1 world equity markets were essentially flat but there were surprises galore.

The biggest surprise by far this year has been the re-emergence of Emerging Market Equities.  The asset class had been left for dead after many years of disappointing returns, but this year the asset class is punching above its weight – already up 4.4% (MSCI EM).

Q1 2016

Q1 2016

EM equities have vastly out-performed developed markets especially those in Asia and Europe.  A 9% gap has developed between developed and emerging international stocks (MSCI EAFE).

Despite the poor showing of the average Chinese stock how is it possible that EM equities as a whole are up for the year? No doubt investors are somewhat stunned by the YTD eye-popping returns to resource-oriented markets such as Brazil and Russia.

In our sample of global equities the average Brazilian stock is up over 24% while the average Russian equity is up about 16%.  South Africa, another major EM market, punches in at an average stock return of close to 14%.   Other emerging markets with average YTD returns exceeding 10% include Indonesia, Turkey, Chile and Malaysia.

Commodity markets have no doubt recovered, but is the strong performance of EM simply due to a recovering commodity market? 

Precious metals have done very well this year with gold up 15% and silver up 9%.  While $20 oil is still mentioned from time to time, energy markets have had a tenuous recovery but still show losses close to 10% for the year.  Smaller components of commodity indices such as grains, livestock and industrial metals are all only slightly above water this year. Our conclusion is that there is more to the re-emergence of EM equity markets than simply a direct benefit from recovering commodity markets.

While broad based equity indices have gyrated at times like a punch drunk Rocky Balboa behind the scenes we have been witnessing a strong rotation toward out of favor sectors such as Energy, Materials, Utilities and Telecom.  Momentum sectors of the past few years such as Health Care and Technology have receded.

The country and sector performance numbers indicate to us that global investors have been quietly changing their stripes.  Glamour sectors and equity markets with the best post-Financial Crisis performance are being re-priced.

2016 q1 factor perfPart of this shift toward more value-sensitive sectors and regions may be driven by a desire to better protect the downside and capture yield in what most strategists would agree is a low capital market return environment.

We perceive that investors are changing their stripes.  Valuation levels are being more carefully examined.  Investors are also showing a desire for lower risk both from a return as well as financial statement perspective. Momentum strategies have lost their punch as have sell-side analyst recommendations.

Many of the characteristics typically associated with larger capitalization companies such as lower volatility, higher yields, stock buybacks and higher levels of profitability seem to be gaining favor among global equity investors.

We see global markets being more similar to Rocky Balboa – at times exhausted and bloodied but despite great hardships triumphant in the end.  For the foreseeable future we see ourselves living in a risk on/off world with investor preferences increasingly tilted toward capital preservation strategies.

Click here to download the report: Less Bunny, More of a Rocky Balboa Market

Sincerely,

Eric J. Weigel
Managing Partner and Founder of Global Focus Capital LLC

eweigel@gf-cap.com

Global-Logo

From Bear Market to Sector Rotation – It’s All a Bit Confusing Now!

This year has been a roller coaster for global equity investors. From the weak start to the year to the recovery in early March it has left investors with more questions than answers.  Are we in a bear market? Are we just pausing until global growth resumes?

Lots of questions and few answers, but maybe we can distill some useful information from the recent price action of global equity markets. In a world where the headlines revolve around broad market indices such as the S&P 500 or the Nikkei 225 much is left unexplored.

In this note we look at the technical characteristics of our global equity sample (13,000 stocks) for clues as to what may be going on behind the scenes. We search the readings from our Technical Stage Model for clues. For further details on our methodology please read our post Getting All Technical

technical stages chart

What we find is great investor indecision – over 40% of stocks in our global sample reside in the Improving Stage.  

While historically one would expect these stocks to keep on moving up higher to the Break Out Stage there is also a non-trivial probability of regressing to the Down Turn Stage hence our characterization of the Improving Stage as indecisive.

We also find a strong rotation away from sectors and equity styles that out-performed last year toward much maligned resource-oriented sectors and countries.

Is the current technical picture more consistent with a Bear Market or an ongoing strong sector rotation toward out-of-favor sectors?  Will the recovery in resource- oriented sectors last?

Click here to download the report:Strong Sector Rotation or a Bear Market?

Sincerely,

Eric J. Weigel
Managing Partner and Founder of Global Focus Capital LLC

eweigel@gf-cap.com

Global-Logo

Can This Russian Bear Learn To Samba?

I have my own moves!

Last week we wrote about the amazing year to date performance of the Brazilian equity market. Despite all the awful headlines and negative investor sentiment the Brazilian market was up over 20% and last week it went up a further 4%.

A similarly widely disliked equity market fraught with negative headlines having a great start to the year is Russia.

Russian equities were up 2.5% last week and in 2016 they are up about 11%. Not bad for a market that like Brazil comes with lots and lots of baggage.

All resource-oriented equity markets have benefited from the resurgence of commodities and both economies are expected to contract further in 2016, but Russia and Brazil are not cut from the same cloth.

There are at least three key differences that investors should note before lumping these emerging markets together:

  • Economic Sector Composition
  • Fundamental Drivers of Return
  • Value Add of Top-Down versus Bottom-Up Implementation Approaches

Click to read the full report  Can This Russian Bear Learn To Samba?

Sincerely,

Eric J. Weigel
Managing Partner of Global Focus Capital LLC

eweigel@gf-cap.com

Global-Logo

Looking for a Second Income? Take a Look at Dividend Stocks.

newspaper-job-section-1427231-639x372How about adding dividend stocks to your portfolio to complete the job that bonds can’t at the moment?

For some ideas regarding the difference between high yield stocks and dividend growth equities take a look at our latest white paper – Click here to download the report: “Equity Income For the Yield Starved Investor

Some of our report conclusions:

►High Dividend Yield stocks tend to be inexpensive but lacking in growth and historically have been members of distressed categories

►High Dividend Growth stocks are only slightly more expensive than their lower growth peers but exhibit much higher rates of prospective earnings growth as well as superior profitability

►Our overall conclusion is that High Dividend Growth stocks are not materially over-valued versus lower growth companies and that there is an adequate margin of safety to fund dividends out of earnings growth

►We strongly suggest employing dividend growth strategies as the preferred way to implement income generation programs

►We also believe that significant dividend growth opportunities exist outside of the major equity markets so a global perspective is recommended

►Finally, priority should be given to the analysis of company fundamentals in terms of their ability to increase dividends in a financially responsible manner while also allowing the investor a margin of principal (price) protection

Sincerely,

Eric J. Weigel
Managing Partner and Founder of Global Focus Capital LLC

eweigel@gf-cap.com

Global-Logo

Is Loving My Smart Beta All That Wrong?

Investors are madly in love with “smart” beta strategies and asset managers offering such products have been shown the love. It was almost inevitable that as active management has gotten a bad rap, investors would flock to the next great thing. Just like in the comedy “If Loving You is Wrong” by Tyler Perry, there is the potential for significant turbulence ahead when falling head over heels in love with these “smart” beta strategies.

In this free report, we’ll look at the different factors that comprise smart beta strategies and why investing based on one factor exclusively may not be the best option available to today’s investor. Click here to download free report: “Is Loving My Smart Beta All That Wrong

HTML Snippets Powered By : XYZScripts.com