Friday, December 31, 2010

Confusion Over Apple As An Investment

I've noted with interest this past week's flurry of comments about Apple as an investment for 2011.

In my own equity strategy, which is outperforming the S&P for the year by roughly 25% to 11%, Apple would now be a holding in four of the currently active six portfolios. Apple trails the index slightly in two recently-formed portfolios, and outperforms in the other two.

While I can't predict with certainty, I'd expect that Apple will be part of the January 2011 equity portfolio, as well.

The nearby price chart for Apple, Google, Microsoft and the S&P500 Index reveals how dominantly the former has outperformed the latter three entities, Google and Microsoft being two of the more popular alternates in the technology sector.

What surprised me somewhat is how comparatively anemic Google's performance has been, when viewed with Apple's. The S&P's and Microsoft's track records for the past five years isn't all that unexpected.

Listening to many pundits, it's tempting to believe that Apple's performance is a purely technical feat, with a parabolic curve that must descend soon.

However, on the several bases in my quantitative equity portfolio selection process, Apple probably has some life left in it. Moreover, I've seen broad consensus on prior growth equities be wrong. For example, in 1998, Dell was viewed as overpriced and unable to sustain its then-torrid fundamental growth. It ended the year as one of the S&P500's top ten total return issues, so I was thrilled to have followed my portfolio selection process and held Dell for the entire year.

Ironically, as I observed back in the late 1990s, the bulk of the analyst community views equities in aggregates, often with some technical perspective. Thus, the individual merits of many attractive equities are lost amidst broad comparisons and conventional 'rules of thumb.'

Thank God for that.

As I consider why Apple, with its lofty share price and steady march upwards in price since January of 2009, may continue to outperform the S&P500, several reasons come to mind.

One, of course, is the firm's clear, successful focus on consistent innovation and evolution of well-received products. Those products have achieved high brand preference status. Additionally, they are typically in price ranges that have made them less vulnerable during the recent US recession and continuing economic weakness. With Steve Jobs' continued leadership, the firm may outperform expectations for a little while longer still.

And, finally, there's something which many investors fail to grasp. That is, even broadly-followed, popular firms can outperform. What is required is unexpected excellent performance. Firms like Microsoft, Dell, Kolhs, in the past, and, currently, Apple, have achieved this. It can never last forever, but it can often outlast ill-informed, generically-based expectations.

What Google does seems to be less unique with time, while Microsoft has been mismanaged for over a decade, with no sign of significant change in that important parameter.

The bottom line for me is that I don't subjectively select equities. But I can and often do interpret why my quantitative approach selects those equities which appear in portfolios. And from post hoc, informal inspection, it's easy for me to see why none of the recent portfolios have held Google or Microsoft, while many have included Apple.

Thursday, December 30, 2010

Is Case-Shiller Now Portending The Dreaded "Double-Dip" Recession?

After months of being informed by many economists and pundits that risks of the much-feared "double dip" recession were nil, S&P's David Blitzer now states otherwise.

"There is no good news in October's report," said David Blitzer, chairman of the committee that released the Standard & Poor's/Case-Shiller home-price index. Citing expired tax credits for homebuyers and a lackluster national economy among the causes, Blitzer said "on a year-over-year basis, sales are down more than 25 percent and the month's supply of unsold homes is about 50 percent above where it was during the same months of last year."

The Case-Shiller index plunged unexpectedly, posting some price declines. Spinning this trend out, property values are set to slide, with more foreclosures to add to the backlog currently residing on the balance sheets of major commercial banks.

Slice it any way you wish, housing price declines mean less household net asset value and potentially lower spending levels.

Thus, the feared recessionary impact of the recent Case-Shiller data.

It adds more complexity to the already murky economic picture for early 2011.

On one hand, you have robust S&P500 earnings and balance sheets heavy with spendable, investible liquid assets, coupled with newly-legislated, extended tax rates.

Then, again, you have high unemployment, a continued bloated federal deficit, and state and municipal financial woes.

With that uncertain backdrop of conflicting influences, this week's Case-Shiller Index news landed with a worrying thud. It's hard to believe it bodes well for the US economy in the months ahead.

So much for all the Pollyanna pundits of 2010 assuring us that residential real estate woes were in the rear view mirror.

Wednesday, December 29, 2010

Scepticism On Tax Data

Yesterday I wrote this post concerning how sceptical one must be when listening to private sector supporters of administration alternative-energy policies.

Thanks to an excellent Wall Street Journal editorial last Thursday, 23 December, by Alan Reynolds, entitled Taxes and the Top Percentile Myth, we now know that similar scepticism must be exercised concerning taxpayer data, as well.

Specifically, Reynolds debunks an oft-cited study purporting to reveal that the wealthiest US taxpayers also earn a disproportionate share of "income." The term "income," Reynolds notes, is the Achilles Heel of the study.

Reynolds begins,

"Despite the deficit commission's call for tax reform with fewer tax credits and lower marginal tax rates, the left wing of the Democratic Party remains passionate about making the U.S. tax system more and more progressive. They claim this is all about payback—that raising the highest tax rates is the fair thing to do because top income groups supposedly received huge windfalls from the Bush tax cuts. As the headline of a Robert Creamer column in the Huffington Post put it: "The Crowd that Had the Party Should Pick up the Tab."

Arguments for these retaliatory tax penalties invariably begin with estimates by economists Thomas Piketty of the Paris School of Economics and Emmanuel Saez of U.C. Berkeley that the wealthiest 1% of U.S. households now take home more than 20% of all household income.

This estimate suffers two obvious and fatal flaws. The first is that the "more than 20%" figure does not refer to "take home" income at all. It refers to income before taxes (including capital gains) as a share of income before transfers. Such figures tell us nothing about whether the top percentile pays too much or too little in income taxes.

In The Journal of Economic Perspectives (Winter 2007), Messrs. Piketty and Saez estimated that "the upper 1% of the income distribution earned 19.6% of total income before tax [in 2004], and paid 41% of the individual federal income tax." No other major country is so dependent on so few taxpayers."

Reynolds has pointed out a critical problem with the Piketty and Saez study, i.e., they don't use appropriate measures. Instead, they use inflated, pre-tax income for the wealthy, while using pre-transfer payments income for those at the other income extreme. He continues,
"A second fatal flaw is that the large share of income reported by the upper 1% is largely a consequence of lower tax rates. In a 2010 paper on top incomes co-authored with Anthony Atkinson of Nuffield College, Messrs. Piketty and Saez note that "higher top marginal tax rates can reduce top reported earnings." They say "all studies" agree that higher "top marginal tax rates do seem to negatively affect top income shares."

What appears to be an increase in top incomes reported on individual tax returns is often just a predictable taxpayer reaction to lower tax rates. That should be readily apparent from the nearby table, which uses data from Messrs. Piketty and Saez to break down the real incomes of the top 1% by source (excluding interest income and rent).

The first column ("salaries") shows average labor income among the top 1% reported on W2 forms—from salaries, bonuses and exercised stock options. A Dec. 13 New York Times article, citing Messrs. Piketty and Saez, claims, "A big reason for the huge gains at the top is the outsize pay of executives, bankers and traders." On the contrary, the table shows that average real pay among the top 1% was no higher at the 2007 peak than it had been in 1999.

In a January 2008 New York Times article, Austan Goolsbee (now chairman of the President's Council of Economic Advisers) claimed that "average real salaries (subtracting inflation) for the top 1% of earners . . . have been growing rapidly regardless of what happened to tax rates." On the contrary, the top 1% did report higher salaries after the mid-2003 reduction in top tax rates, but not by enough to offset losses of the previous three years. By examining the sources of income Mr. Goolsbee chose to ignore—dividends, capital gains and business income—a powerful taxpayer response to changing tax rates becomes quite clear.

The second column, for example, shows real capital gains reported in taxable accounts. President Obama proposes raising the capital gains tax to 20% on top incomes after the two-year reprieve is over. Yet the chart shows that the top 1% reported fewer capital gains in the tech-stock euphoria of 1999-2000 (when the tax rate was 20%) than during the middling market of 2006-2007. It is doubtful so many gains would have been reported in 2006-2007 if the tax rate had been 20%. Lower tax rates on capital gains increase the frequency of asset sales and thus result in more taxable capital gains on tax returns.

The third column shows a near tripling of average dividend income from 2002 to 2007. That can only be explained as a behavioral response to the sharp reduction in top tax rates on dividends, to 15% from 38.6%. Raising the dividend tax to 20% could easily yield no additional revenue if it resulted in high-income investors holding fewer dividend- paying stocks and more corporations using stock buybacks rather than dividends to reward stockholders.

The last column of the table shows average business income reported on the top 1% of individual tax returns by subchapter S corporations, partnerships, proprietorships and many limited liability companies. After the individual tax rate was brought down to the level of the corporate tax rate in 2003, business income reported on individual tax returns became quite large. For the Obama team to argue that higher taxes on individual incomes would have little impact on business denies these facts.

The overall points Reynolds so clearly makes are that the declared incomes of the wealthy are responsive to tax rates, and much corporate income flows through individual returns for many businesses. Thus it's neither fair nor correct to classify all 1040 form income as 'personal.'

Reynolds concludes his instructive piece by noting,

"The Piketty and Saez estimates are irrelevant to questions about income distribution because they exclude taxes and transfers. What those figures do show, however, is that if tax rates on high incomes, capital gains and dividends were increased in 2013, the top 1%'s reported share of before-tax income would indeed go way down. That would be partly because of reduced effort, investment and entrepreneurship. Yet simpler ways of reducing reported income can leave the after-tax income about the same (switching from dividend-paying stocks to tax-exempt bonds, or holding stocks for years).

Once higher tax rates cause the top 1% to report less income, then top taxpayers would likely pay a much smaller share of taxes, just as they do in, say, France or Sweden. That would be an ironic consequence of listening to economists and journalists who form strong opinions about tax policy on the basis of an essentially irrelevant statistic about what the top 1%'s share might be if there were not taxes or transfers."

It's almost comical how simple is Reynolds' identification of this major flaw in Piketty's and Saez' work. Yet many in the current administration apparently swear by the study. Even the president's own chief economist seems to have fallen prey to similar measurement mistakes.

It goes to show how important it is to, as a grad school professor taught me, critically read such articles to ascertain the quality of the research before giving it credibility. In the case of Piketty's and Saez' taxation-related work, it's clear that many have come to rely on the study's incorrect conclusions without even understanding how it measured the rather nebulous concept of 'income.'

Fortunately, Alan Reynolds was up to the task of deconstructing the earlier, flawed study and providing instructive guidance on how to actually interpret the phenomenon under examination.

Tuesday, December 28, 2010

On Scepticism & EPA Policy Support by Utilities

The lead staff editorial in one of last week's Wall Street Journal editorials teaches scepticism when one hears private sector support for EPA energy policies.

Specifically, the EPA is issuing new pollutant rulings aimed at coal-fired plants. The intended result is to force the mothballing of large amounts of comparatively inexpensive existing electricity generation capacity.

Guess who the supportive private sector utility execs are? Why, the leaders of predominantly non-coal-fired utilities, of course. Folks who have bet on other technologies, like John Rowe of Exelon. NextEra, a wind- and solar-power generator, is also lining up behind the EPA.

Clearly, one has to take private sector endorsements of government policy with a grain of salt. They are unlikely to be altruistic or without an agenda.

Instead, we see the age-old game of one group of executives getting behind a political issue and piling on those who are less-advantaged.

This is hardly the way our society should be allocating capital or choosing winners and losers in the energy generation sector.

Monday, December 27, 2010

Auditors Now Blamed for Lehman Collapse

Thursday's Wall Street Journal reported that Ernst & Young has now been charged with civil fraud in the collapse of Lehman Brothers in late 2008. As the defunct firm's auditors, E&Y is being accused of helping Lehman hide the consequences of its lethal excesses.

Observers are accusing auditing firms of going easy on valuation methodologies used by their clients. In the case of PricewaterhouseCoopers, both AIG and Goldman Sachs used the firm, yet posted differing values for the same swaps on their respective balance sheets.

Auditors, for their part, contend that they are only to assure that proper processes are in place, not that those processes are actually used correctly.

It's not a complete surprise that things have come to this. Perhaps it's more surprising that it took so long. After Arthur Andersen was improperly attacked by the US and driven to bankruptcy, the remaining large auditors know they are in government crosshairs anytime a firm goes under for reasons that have anything to do with its accounting and/or financial statements.

However, at least one hedge fund bear, which, if memory serves, was David Einhorn, was on to Lehman's financial statement problems just by analysis of those published items. It's not like any investor didn't have reason to question what was going on.

I think the larger issue is, again, expecting poorly-compensated auditors doing SEC-mandated work to surface every corporate financial impropriety. As with so much government regulation, all the SEC-required statements have done is falsely assure naive investors that audited statements which don't expressly find problems are, in fact, a clean bill of health.

How much more meaningful if no statements were required, and those that were published had to pass truly useful standards.