CategoryEconomics

(Un)Accountable Shell Games

A shell corporation often has no active business operations or hold any productive assets. Structured as an efficient financial vehicle, a shell corporation can serve as a convenient mechanism to raise funds, to complete a hostile acquisition or to take a company public. Nevertheless, these corporate structures can also be used for nefarious purposes some of which include disguising ownership from law enforcement or the public, or to evade taxes.

For instance, the “Panama Papers” leaks revealed that banks, political leaders and wealthy individuals had allegedly hidden billions of dollars in shell companies through a Panama law firm. The scheme allowed clients to evade taxes. Reportedly 214,000 shell companies were created to facilitate illegal activities.

Shell Games

Not all shell companies are creating to siphon off funds or to evade taxes. There can be merits to creating a shell company.

  • Fortunes
  1. A startup can use a shell corporation to safeguard its assets before officially launching its business.
  2. A company preparing for a merger or an acquisition can hold its assets in a shell company for legal reasons and keep those assets separately from the acquiring entity.
  3. Foreign companies can create shell companies in tax havens like Panama (Swiss private banking, Hong Kong, Belize are some of the other dubious and prominent tax havens) and lower their taxes at home. How so one may ask? Most tax haven countries do not mandate tax information for the funds being funneled into the tax haven countries via shell companies. Further, some tax havens do not report the existence of these shell companies to the government of the owners operating the shell companies thereby creating a “black hole.”
  • Misfortunes
  1. Shell companies are often set up to mask the identity of the individual owning assets in the company or to evade taxes.
  2. Occasionally, companies take advantage of the secretive nature of shell companies and engage illegal activities like money laundering.

Limited Games in the Land of the Free 

In the U.S., we are fortunate to have monitoring agents like the Securities and Exchange Commission, the Justice Department, and the Public Company Accounting Oversight Board (PCAOB) guarding the corridors of capital markets to ensure that public companies are not actively engaged in “shell games” to defraud minority shareholders.

In sharp contrast, and most inappropriately, in emerging markets and particularly in the BRICS countries, minority shareholders may not be as fortunate where the use of shell companies to hide business ownership or to evade taxes is rampant.

What is the auditors’ role in policing dubious shell companies which are actively created by publicly listed companies to siphon off funds and to dupe minority shareholders? 

Let the Games Begin in BRICS Countries

The Securities and Exchange Board of India (the counterpart of US SEC) is scrutinizing the functioning of auditors in various public companies in India, especially if the auditor has had a long-standing relationship with the client. Under the Companies Act of 2013, auditors, have greater responsibilities to ensure that financial statements of an Indian company are not materially misstated and that auditors red flag “dubious” transactions.

The Finance Ministry in collaboration with SEBI is taking actions against 331 listed suspected shell companies. More than 100,000 directors (holy cow!) may be disqualified for their association with shell companies. Investigations are in progress to identify professionals, chartered accountants, company secretaries and cost accountants associated with the defaulting companies.

The auditors are not exempt from these inspections. Authorities are looking at the possibility of having stricter scrutiny of global auditing firms (e.g., the Big 4 audit firms) and to make them more accountable when their auditors certify companies with a clean opinion even when clients are actively engaged in corporate misconduct.

Commentary on BRICS

Similar to the initiatives in India, China, where the problems of shell games are even more pervasive, under President Xi Jinping, has been actively confronting these problems. While these are modest steps, India and China can do more to bring the unaccountable or black money back into the mainstream economy for the betterment of their citizens.  

While India and China are at least attempting to tackle this social ailment, sadly not much can be said about the other 3 countries within the BRICS which include Brazil, Russia and South Africa where their top leaders appear to be the cause and not the solution to this social ailment.

http://timesofindia.indiatimes.com/business/india-business/auditors-come-under-lens-amid-crackdown-on-shell-companies/articleshow/60496210.cms

Facebooktwittergoogle_plusredditlinkedinmailby feather

Slumdog Millionaire May be a Destiny

For the year 2017, a well-diversified portfolio consisting of US public companies generates returns anywhere between 4% and 8% (S&P MidCap 400 gained 4%, Dow gained 6%, S&P 500 gained 8%). Quite impressive.

What about a more aggressive investor, or a more flamboyant hedge fund manager, seeking even bigger alphas/returns? Is there any country offering bigger equity returns than the US equity markets? Much of continental Europe generated relatively modest returns for the year 2017. While emerging markets may be more promising, the returns were no better than the US. Key indices in China and Brazil are up between 4% and 8%. Given the risk, the US seems a much safer bet.

There is one emerging market, however, that stands-out in 2017. India has outperformed most developed and emerging markets. Most key indexes in India are up more than 11%.

You Are My Destiny: Slumdog Millionaire

  • Roughly, half of India’s 1.2 billion population is under 25
  • The country, especially parts of the south, west and north, is entrepreneurial
  • While educating billion people remain a daunting task, much of the Indian population understands the value of good education
  • Low oil prices have been a blessing because India imports nearly 80% of its oil to sustain growth
  • In 2014, Modi, the leader of the conservative party, captured the imagination of Indians because his economic vision is tied to domestic investments and he intends to attract foreign investments by removing various barriers to foreign capital and by pledging to eradicate corruption.

Despite the promise of tomorrow, there is no denying that India today remains a poor country. Even relative to the other BRIC countries, its per capital GDP is about half of China and a third of Brazil.

World Bank Sings Jai-Ho for the Bengal Tiger

The World Bank projected the Indian economy to expand at a rate of 7.8% this year and 7.9% over the next two years. The continuing slump in prices of oil, which is one of the major imported commodities in India, had a significant effect on the Indian economy over the past one year. The Bank said: “In contrast to other major developing countries, growth in India remained robust, buoyed by strong investor sentiment and the positive effect on real incomes of the recent fall in oil prices .”

The World Bank estimates India’s growth projections to be higher than that of the Dragon Warrior. The Bank expects Chinese GDP growth to be around 6.5% over the next two years. Brazil and South Africa, the two other BRICS countries, are embroiled in major corruption scandals involving their leaders, which injects enormous uncertainty for investors. Russia seems determined to inject global anarchy into the world while disregarding the welfare of its own citizens.

Domestic Consumption

A distinct attribute propelling India’s economic growth is its appetite for domestic consumption. According to Adrian Lim, a Singapore-based investment manager with Aberdeen Asset Management, which manages $11.5 billion of assets in India, “India is being seen as a relatively resilient place to invest because quite a bit of the economy is driven by domestic consumption.” Moreover, Lim asserted “More than two thirds of the stocks listed (on the Sensex) are driven primarily by domestic demand, something you can’t see on the Chinese benchmark.”

India’s stocks reached a new highs recently powered by foreign funds. India’s bellwether S&P BSE Sensex broke a two-year-old closing record Monday as it rose to end trading at 29,910.22.

Exposure to India

How can US investors play India?

Consider investing in one of the top 5 India-based ETFs, as per the US News and World report (http://money.usnews.com/funds/etfs/rankings/india-equity?sort=category_rank).

#1                 iShares MSCI India                                                 INDA      $5.11 billion in assets

#2                 VanEck Vectors India Small-Cap ETF         SCIF         $0.32 billion in assets

#3                  IShares MSCI India Small-Cap                        SMIN       $0.19 billion in assets

#4                  PowerShares India ETF                                       PIN           $0.26 billion in assets

#5                  Columbia India Consumer ETF                       INCO      $0.12 billion in assets

The U.S. News Best Fit ETF rankings are designed to help long-term investors evaluate and compare the structure of exchange-traded funds. Since all ETFs are intended to track an underlying index (for a variety of equities, or the price of a commodity, for example), the rankings aim to identify large, liquid funds that perform reliably. The report also compares funds’ costs and the fund’s level of diversification and success in tracking its index. We discuss each of these measures in depth below.

Consider playing Danny Boyle’s Slumdog Millionaire!

Finland, June 8, 2017

Facebooktwittergoogle_plusredditlinkedinmailby feather

Taxing on the Brain

Some U.S. multinational companies are avoiding paying high U.S. taxes through relatively simple tax strategies. If a U.S. multination company generates part of its income in a foreign jurisdiction, the foreign income is not subject to U.S. taxes until it gets repatriated back to the US. Contrary to personal income tax, which is levied on all sources of income regardless of where the income is earned, only U.S-based income is subject to taxes for U.S. corporations. The foreign income earned is subject to US taxes once the money is transferred back to the U.S. for redistribution or reinvestment.

Therefore, U.S. citizens cannot shelter foreign income from U.S. taxes, but U.S. companies are able to do so.

Another tax strategy to shelter income from U.S. taxes is more dubious in nature where the objective is to attribute a higher percentage of the income to a foreign jurisdiction with low tax rate even when the income is not economically earned in the foreign jurisdiction.

The Pillar in the Cat-and-Mouse Strategy

Caterpillar is under intense scrutiny for shifting much of the profit from its lucrative replacement-parts business to a Swiss subsidiary where the tax rates are low. The strategy, which dates back to the late 1990s, has generated an employee lawsuit, a U.S. Senate investigation, and a federal criminal investigation that led raids on Caterpillar’s headquarters and two facilities in Illinois.

How large is the tax avoidance? According to a U.S. Senator (see the April request from Sen. Carl Levin, D., Mich., for the PCAOB to look into the tax avoidance matter), Caterpillar has deferred $2.4 billion in taxes under strategies devised by PricewaterhouseCoopers LLP.

CtW, an investment group, wants to shake up the company’s audit committee following the terminator’s (machinery giant) offshore tax strategy. The investment group, has issued a public letter asking shareholders to vote against Caterpillar’s three board members because of inadequate oversight of tax strategy and dysfunctional monitoring of the external auditor. In the case of Caterpillar, PricewaterhouseCoopers LLP happens to be both the external auditor and the  tax consultant!

The audit committee members of Caterpillar include

  • Daniel Dickinson, a private-equity executive
  • Dennis Muilenburg, Chairman and CEO of Boeing Co.
  • William Osborn, former Chairman and CEO of Northern Trust Corp.

Conflict or Efficiency

By serving as the tax consulting and external auditor, does PricewaterhouseCoopers LLP generate efficiencies for the company or is there a conflict of interest whereby the audit quality suffers because the external auditor is no longer an independent monitor of the company’s financial statements.   

Independent or Dependent

PricewaterhouseCoopers has been Caterpillar’s independent auditor since 1925, according to the 2017 proxy statements filed by Caterpillar, which means the big accounting firm has been with this client for almost a century! Can an auditor with a century long relationship with a client provide high quality audit assurance?

How much has the accounting firm earned from this company?

Audit services              Tax consulting             Total Fees

2016                                        $33 million                  $0.1 million                 $35 million

2015                                        $32 million                  $20 million                  $54 million

Why did tax consulting fees drop suddenly in 2016? Too much political heat?

If you use 2016 fees as a proxy for annual fees earned by the auditor for the prior years, which is an exaggerated assumption, PricewaterhouseCoopers has earned around $3 billion from the Terminator since 1925.

I wish we could buy shares of PricewaterhouseCoopers!

Is PricewaterhouseCoopers a tax consultant or an “external” auditor for Caterpillar? Does PricewaterhouseCoopers have the conviction to question accounting practices adopted by Caterpillar and confront questionable accounting practices in light of this money train?

Your guess is as good as mine…..

May 29, 2017

Facebooktwittergoogle_plusredditlinkedinmailby feather

The Art of Presidential Pay

CEOs of for-profit companies are paid handsomely for their nifty management skills and for creating shareholder value. According to Associated Press study, the median annual CEO pay for S&P 500 companies in 2016 was $11 million (average pay was even higher at $14 million). When compared to the value created by these companies, the pay appears economically insignificant and immaterial. In 2016 alone, nearly $1.5 trillion of shareholder wealth was created by the S&P 500 companies.

What about the pay of the top bosses in nonprofit organizations like academic institutions? Much less. The average pay of a University President is less than $0.5 million. Therefore, S&P-500 CEOs get about 30 times more than a typical University-CEO.

The Art of Presidential Pay

The highest paid academic top gun was not from an Ivy League institution but a leader of an arts college in Georgia. According to the Wall Street Journal, in 2014, Paula Wallace, the president of the Savannah College of Art and Design (say what?), earned a whopping $9.6 million in 2014. That is, the pay was about 20 times a traditional academic presidential pay.

Ms. Wallace earned a base salary of $859,000 and a bonus of $1 million. In addition, the board/trustees of Savannah College of Art and Design voted to pay Ms. Wallace supplementary deferred compensation of $7.5 million as a cumulative reward for her prior 14 years of service (this is in addition to the annual salary she drew over the past 14 years).

Deferred compensation refers to the portion of an employee’s compensation that is set aside to be paid at a later date in the form of retirement plans or pension plans. In most cases, taxes on deferred compensation are delayed until income is paid. In common parlance, deferred compensation is the ability to provide for a “highly prosperous retired life” by leveraging current position and power.

Stellar Savanah College

Ms. Wallace is one of the founders of the college. Her achievements include overseeing enrollment growth, and the expansion of academic majors and branch campuses. According to a consulting firm retained by the arts college in Georgia to approve presidential pay, “the compensation is fitting given her four decades of contribution towards the success of the institution.”

Reality Bites

Tuition, fees, and living expenses can exceed $50,000 a year. Students at this institution collectively received about $115 million in federal student loans. Among nonprofit art and music colleges, students of Savannah College of Art and Design rank among the top quartile for graduation rates and earnings. About two-thirds of full-time students graduate within six years, and their students receiving financial aid reported median earnings of roughly $35,000 a decade after entering.

Scarcely stellar when you consider that a representative student can potential rack-up federal loans of up to $250,000 to get this coveted arts and design degree from Georgia.

Raymond Cotton, a lawyer who advises university boards on presidential pay, called Ms. Wallace’s compensation “..such an outlier in the world of higher education; it’s really incredible.”

Benchmark: Harvard’s Presidential Pay

How does this pay compare to the Presidential pay at country’s leading academic institution with a largest endowment?

Harvard University’s President, Drew Faust, earned a $811,000 salary and received a meagre total compensation package worth $1.2 million.

Social Narrative

Nonprofit organizations are organized for a public or mutual benefit other than generating profit for owners or investors. Because a nonprofit company’s intent is to increase the welfare of society, the government sponsors those objectives by defraying some of the nonprofit’s costs by exempting nonprofit organizations from paying taxes.

If Presidential Pay at academic institutions mimic CEO-pay at S&P 500 companies because academic institutions draw inspiration from for-profit companies, why the big need for subsidy from the federal and state government?

Midnight in the Garden of Good and Evil!

Chatham; April 17, 2017

https://www.wsj.com/articles/art-colleges-president-draws-lucrative-pay-package-1488811143

Facebooktwittergoogle_plusredditlinkedinmailby feather

Hamiltonian Hip Hop: Broadway to Wall Street

Giddy up! At more than 21,000, the Dow Jones Industrial Index has soared by 1,200 points or about 13% since January 2017. If you consider the run-up since February 2016, the stock market has delivered a staggering return of about 30%. The stock market has been on the best winning streak in 25 years.

One fundamental reason for the stock market rally is linked to the growth of Exchange Traded Funds, or ETFs, as retail investors have poured in $124 billion into this type of an investment vehicle in 2017 alone.

State Street Corp.’s SPDR S&P 500 ETF is the market’s oldest, largest and the most-traded security in the world.

Love Thy ETF

Introduced in 1993, ETFs, or Exchange Traded Funds, trade on an exchange like stocks. An ETF is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. Unlike actively traded mutual funds, an ETF trades like a common stock on a stock exchange. ETFs experience price changes throughout the day as they are bought and sold.

ETFs typically have lower fees than mutual funds, making them an attractive alternative for individual investors. Shareholders do not have any direct claim on the underlying investments in the fund, instead, they indirectly own these assets.

According to research firm XTF, there are around 1,800 ETF investment vehicles holding stock worth more than $2.7 trillion. There are no SEC rules governing ETFs which means ETFs are regulated via mutual fund regulation. Just three firms

—     BlackRock Inc.

—     State Street Corp.’s State Street Global Advisors

—     Vanguard Group

manage 80% of ETF assets.

ETF vs Actively Managed Funds

  • ETFs try to track the performance of a particular market benchmark, or “index,” as closely as possible. In contrast, Actively Managed Funds (AMFs) try to outperform their benchmarks and peer group average.
  • ETFs buy all (or a representative sample) of the securities in the benchmark, while AMFs combine research, forecasting, and experience/expertise of a portfolio manager or management team.
  • Index funds tend to be more tax-efficient and have lower expense ratios than actively managed funds because they trade less frequently than AMFs.
  • Although AMFs attempt to beat the market, quite often they may also miss their targets which results in losses for the funds’ investors. In contrast, ETFs are only undertaking the underlying risk of the market benchmark.
  • Most importantly, AMFs typically charge between five and twenty-five times what ETFs charge their investors.

Not surprisingly, the pace of ETF inflows bodes negative news for asset managers. Investors have started pulling their investments from AMFs to ETFs. The largest providers of ETFs have started reducing management fees to attract even more funds. The average annual fee of ETFs bought this year is only $23 for every $10,000 invested, sharply lower than last year. Some ultralow-cost iShares Core funds cost as little as $4 a year for a $10,000 investment, which is can be about 1/25th fraction of the fees charged by most mutual funds.

Given the low-cost structure of ETFs and the raging bull market, $7.5 billion has moved into the iShares Core S&P 500 ETF and $5.4 billion into the Vanguard S&P 500 ETF in January 2017 alone!

Hamiltonian Hip Hop and ETFs

Lately, the US stock market has generated staggering returns unmatched by almost any other country. Take for instance the returns generated from an investment in S&P 500 stocks in the last eight years.

  • 2009                26%
  • 2010                15%
  • 2011                2%
  • 2012                16%
  • 2013                32%
  • 2014                14%
  • 2015                1%
  • 2016                12%

If you invested in the S&P 500 from 1928 to 2014, the per annum compound rate of return was 9.8%. Thus, if you invested $100 in 1928, your nest egg would become $346,261 in 2014.

Join and celebrate the US goldilocks economy and consider becoming an ETF shareholder.

Vermont, February 10, 2017

Facebooktwittergoogle_plusredditlinkedinmailby feather

Academic Justices

Academic tenure is a contractual right that grants a professor permanent employment or a legal protection against summary dismissal without just cause. Principally, the status of a tenured professor is analogous to a Supreme Court Justice—a lifetime of employment guarantee. Less than one-third of all college and university faculty members are tenured in the US.

Tenure may be revoked if there is evidence of incompetence, unprofessionally behavior, or when an academic department/school is in serious financial difficulty. Nationally, about 2 percent of tenured faculty are dismissed in a typical year.

Why Tenure?

The notion of academic tenure dates back to the early part of the 20th century when tenure system was erected to protect professors from the abusive power of University Presidents and Trustees who were free to fire professors for their socio-political views. According to NEA, academic freedom via tenure is valuable because professors can then assert their independence. Scholars can challenge conventional wisdom, discuss and debate controversial ideas without having to worry how such exchange may affect their jobs.

Curtail Tenure

  • Florida, Missouri, North Dakota, Iowa

Faculty at State College of Florida hired after July 2016 no longer qualify for tenure-like protections. In Missouri, North Dakota and Iowa, Republican lawmakers are introducing bills to eliminate tenure. In North Dakota, the state board of higher education is considering reducing to 90 days from 12 months the amount of time administrators need to give tenured faculty before they can lay them off. The state’s 11-school college and university system is bracing for steep layoffs this year after cutting about 500 full-time positions last year. A Missouri bill would prohibit any public institution of higher education from awarding tenure after Jan. 1, 2018.

  • Wisconsin

While not eliminating the status of tenure, Wisconsin’s state legislators voted in 2015 to weaken state tenure law. Consequently, state universities in Wisconsin had to grapple with sharp reduction in budget (around $250 million) and deal with lower tenure protections. In response to the State law, Wisconsin’s University Board instituted “independent and substantive reviews” of tenured faculty once every five years. Tenured professors who are deemed as lacking in productivity have three to four semesters to improve else their tenure is revoked. The Governor of Wisconsin, Scott Walker, recently declared plans to cut tuition by 5% across all University of Wisconsin System schools while instituting “faculty accountability policy” which aims to monitor the time professors spend in classrooms.

Steep jumps in tuition, students have to accumulate large amount of debt to get quality education, and higher wage inequality may have magnified the scrutiny on the business practices of universities including questioning the concept of permanent employment of professors.

 Defense of Tenure

According to NEA, there has been a temporal decline in the proportion of tenured professors. For instance, in 1975, 45% of faculty at public and private schools was tenured or tenure-track, however, by 2014, that number had dramatically declined to 29%.

Defenders of tenure claim that state that disallow granting of tenure will be unable to attract high quality talent. Such states also risk losing valuable grants which is often linked to the human capital and innovative abilities of tenured professors. Another prediction is that salaries are expected to increase dramatically as professors would demand a higher wage rate in the absence of tenure.

Prospect Theory

Tenure at most prestigious and nationally visible universities is granted after an exhaustive and critical review. The longer the tenure clock, the more stringent is the granting of tenure. Given these parameters, most, if not all, tenured professors are eminent and productive scholars with a shared passion for teaching. 

Market theory suggests that, because tenure has endured for more than a century, the benefits must outweigh the costs from having a tenure system. While the experiment of not having a tenure-system is counter-factual in the US, one can draw on the experiences from other countries without a tenure track system. The consensus is that higher education has lagged behind in quality, scientific research and intellectual advancement in countries without a tenure system. More so, countries that have moved to a tenure track system (e.g., schools in mainland China, Hong Kong, Australia, and Europe) have seen a rise in the quality of their advanced level education.

While distinguishing the benefits of tenure, one cannot help underscore that there are some apparent costs including a classic moral hazard problem leading to potential misallocation of resources because of inadequate monitoring.  

Future of Academic Justices

Will the US tenure system survive the current predicament? Will tenure endure a refurbishment? Some states have made their decisions. Other states can only resist or follow suit. 

Chatham, February 24, 2017

Facebooktwittergoogle_plusredditlinkedinmailby feather

Spirits of East India Company

Beer is the third most consumed drink after water and tea and its production can be traced back 10,000 years. This popular beverage serves as the esprit de corps for almost every human emotion. We drink beer to rejoice, to recollect, to champion ball games, to forget, to relax, or just to get rowdy.

The production of beer is relatively straightforward—some form of starch is converted into alcohol through a fermentation process using yeast. The most common variation of starch used is malted barley, which is dried germinated barley. Hops are added during the brewing process to inject flavor and bitterness to the drink while acting as a natural preservative. Hops are dried flowers from the same family of vines as cannabis so beer may have some medicinal properties as well.

Lager versus Ale

The two overarching beer categories include ales and lagers. The crucial difference between two beer categories is the quality of yeast used in the fermentation which in turn imparts a distinctive character.

Ales are produced using “top-fermenting” yeast strains, which ferment at the top of the fermentation container. Lagers are generated using “bottom-fermenting” yeasts, which ferment at the bottom of a fermentation container. Ales are traditionally fermented at warmer temperatures (55 to 70 degrees Fahrenheit), while lagers are fermented at much cooler temperatures (38 to 50 degrees Fahrenheit). The dissimilar yeast types and the differential temperatures are a key reason why ales are bitter, darker and fruitier and while lagers are less fruity with a refreshingly clean and crisp taste.

The younger sibling Lager is a modern creation with a maturation age less than 300 years. Ale happens to be the older, more traditional and the distinguished sibling.

British East India Company

In the 18th century, British merchants set up East India Company to trade spices, fine cotton and silk from India. Although the British stationed in India may have preferred darker and sweeter ales, the wealthy traders of British East India Company wanted a more refined and lighter/paler version of the traditional ale to accompany their long voyages to India.

To quench the thirst of the industrial revolution, British beer-producers started a new “pale ale” assembly line with a heavy injection of hops to add a bitter counterpoint to the sweetness of the malt. The added advantage of hops was that it also served as a natural preservative, which meant that the pale ale could last the long voyages to India.

As British interests in India grew, so did the beer market in UK. More and more brewers started making “Ales for the Indian Market” or just “India Pale Ale (IPA).” As IPA conquered taste buds in India, it also spread around the world, turning up in America, Australia and South-East Asia.

IPA in the US

Today, IPAs are particularly popular in the US. Craft brewers are increasingly making IPAs as part of their medley. Bars are also happy to stock an assortment of IPAs. Not surprisingly, to satisfy the discerning palate of the consumer, beer producers and suppliers are able to charge a hefty premium for IPAs. Because of the distinct flavor, a unique bitter taste, a discrete sweetness and color, brewers are able to distinguish their products from other beer selections, which allows them to charge a hefty premium for “differentiated products.”

Get ready to recall the spirits of Jack Sparrow from the Indian Ocean and not from the Caribbean. Cheers!

Helsinki, January 15, 2017

Facebooktwittergoogle_plusredditlinkedinmailby feather

Trade and Welfare: Lessons Learned

When does a country benefit from trade? Many classical and neo-classical economists claim that countries benefit from “free trade.” Two British economists, Adam Smith and David Ricardo, are credited with developing the idea of free trade in its current form. Advocates of free-trade believe that trade is the singular reason why certain well-known civilizations prospered including Egypt, Greece, Rome, Bengal (East India) and China. Many classical liberals from the 19th and 20th centuries actively sponsored the ideology that free trade promoted peace and not just prosperity.

Countries committed to a free trade policy minimize restrictions on imports from, or exports to, other countries. However, most nations today despite being members of the World Trade Organization (WTO) impose protectionist policies (e.g., tariffs, quotas, taxes, and non-tariff barriers including regulation) with the intention of supporting local employment or limiting entry/exit of certain goods and services. The reality is that most countries do not practice free trade in principle.

When is Trade Beneficial

The major industrial nations, which includes the US and the majority of Western European countries, have benefited from trade because they have pioneered innovative products with high profit margins that are valued globally. Because of access to international markets, which are manifold times larger than their local markets, the benefits of trade have been immeasurably larger for the industrial nations. Encouraging the world to commit to free trade when a nation provides goods that are both profitable to produce and desired by others allows producer-nations to amass wealth because exports exceed imports.

Exporting Models

There are at least two fundamental differences in the export lead growth adopted by the US and the approach implemented by the Western European countries including Japan.

  1. Outsourcing domestic production

The US-based producers have outsourced much their production internationally to exploit differential wage rates and lower their production costs which benefits US shareholders. However, in doing so, substantial jobs are lost to international markets which causes short term economic hardships locally. The economic hardships are more resilient unless displaced workers find alternative employment by relocating or investing in human capital through retraining programs. In sharp contrast, in much of western Europe and Japan, the model has been based almost exclusively on domestic production which implies fewer jobs losses to outsourcing.     

2. Immigration

The US, which founded the new information-based economy, has been the leader in cutting edge innovation by attracting “global talent.” Because of the attraction of high wages and a realistic opportunity to amass wealth in a relatively short period of time, there has been a large influx of legal migration. The economic prosperity has also been a haven for illegal immigration. As migrants offer comparable or better services at lower wages, one notable side effect of immigration (legal and illegal) is job losses for US citizens. Moreover, in an information-based economy, workers without necessary skills may be unable to harness the benefits from innovation which also adds to economic hardships.

In contrast, Western Europe until recently has been immune to migration problems because of stringent immigration policies and from having smaller territorial borders which are easier to patrol and ward off unwanted inflow of migrants. However, this convenient model has been tested lately. The inclusion of eastern European countries into EU increased the inflow of labor migration into the more prosperous western European economies. The political turmoil in middle east also contributed to both legal and illegal migration. The western European countries are also captive to an additional economic dilemma. Because of an attractive social welfare system, their citizens must pay for non-productive immigrants.    

Outcome of the Geo-Political Shifts

A key consequence of the socio-economic shocks is a large wage gap and wealth disparity in industrial nations. In democratic countries, if the gains from production and trade are confined to the elite, the majority of the population are expected to vote opposing the status-quo and elect candidates who promise to usher in changes to existing growth models. Some prominent examples include Brexit decision, the US elections, and the shift in the socio-political debates in France, Germany, Netherlands, Denmark, and Italy (Scandinavian countries and Switzerland are relatively immune because they are not party to the EU block or EU monetary system).

Lessons Learned

As we continue to reap the benefits from trade and free markets, we are also at the vortex of their detrimental side effects. The recent political dialogue is a reminder that to preserve trade and economic co-operation, the gains from trade must accrue to all strata of society. The alternative is a protectionist and isolationist strategy which may generate near term benefits but may be harmful for a producer nation’s long term economic welfare.

December 31, 2016; 12.02A

Facebooktwittergoogle_plusredditlinkedinmailby feather

Drugs and the Land of Lords

fdaIndia has become a dominating player in the production of generic-drugs particularly targeting the large U.S. market. Indian drug manufacturers account for 40% of generic drugs sold in the U.S. While most Indian pharmaceutical companies continue to make their money selling inexpensive generic drugs, there is a visible change in their strategy over the last few years. Indian generic-drug manufacturers have started competing intensely to develop their own products through heavy R&D spending and finding solutions to many illnesses and diseases.  

Motivated by the desire to produce innovative and patented drugs, Indian pharmaceutical companies have started applying for drug approvals with the U.S. Food and Drug Administration (US-FDA) at an unprecedented rate. Approximately, a third of all FDA applications in the last year were submitted India’s multibillion-dollar pharmaceutical industry. A year ago, the growth in application was only 19% which means the growth rate between the two consecutive years has almost doubled.

Why the Change in Strategy?

Generic drug business (production and sales) entails making money through large volume. Margins are low because there is heavy competition from other generic drug producers. Think of grocery stores as an analogy. In contrast, patented drugs generate high returns for the producer because they are the only producer, i.e., volume is high, and margins are high because they act as a monopolist (sole producer). Think of the diamond business and DeBeers as a parallel.

Medical innovation in drugs requires considerably investments in R&D with initial outlays exceeding millions, and sometimes billions, of dollars. However, following the successful development of a drug, a pharmaceutical company must first procure a patent before the drug can become a commercial product.

Patent

The economic idea behind a patent is simple. The government wants the private sector to invest and innovate in the field of medicine and find cure for illnesses. However, because the cost of finding a cure for human ailments can be prohibitively costly, the government offers through a patent a “protection period” for a drug company to sell its drug over a certain period, which is typically 20 years in the U.S.

As a result of the patent, only the pharmaceutical company holding the patent can manufacture the drugs being approved by the FDA. Therefore, in essence the drug manufacturer with a patent is akin to a monopolist, which means it can charge an exorbitant price (think of the recent Mylan case). High prices result in high profits because the cost of production is generally low. The higher profits allow the drug manufacturer to recover the initial investment in R&D and thereafter make a ‘healthy,’ and sometimes super-healthy, return.

Humans benefit, we get to live longer and are able to become more productive, which means that society benefits but all this comes at a step price. Some drugs can cost between $10,000 to $30,000 per dosage (e.g., cure for AIDs or cancer)!

Prominent Manufacturers

India’s largest drugmaker by sales, Sun Pharmaceutical Industries Ltd., received approval for an eye drop to treat swelling and prevent pain in patients undergoing cataract surgery. In 2014 it received approval for a new injection to treat a rare blood disease known as myelodysplastic syndrome. However, to receive these patent approvals, the company had to invest heavily in R&D. The company’s R&D outlay increased from about $50 in 2011 to about $261 million in 2015, which is more than a 400% increase in a span of 4 years or about 100% annual growth.

Dr. Reddy’s Laboratories, India’s second-largest drugmaker by sales, received FDA approval for a spray for treating a skin condition called plaque psoriasis, as well as an injection for migraine headaches. The company similar increased in R&D from $50 in 2011 to $253 million in 2015, which again translates into a 100% annual growth.

Lupin increased its R&D spending by 17% to $168 million in 2015. The company is  developing an injection to treat less common cancers and a nasal spray to better deliver off-patent drugs to treat some types of pulmonary diseases. The company’s U.S.-based laboratories in Florida and New Jersey are also working to improve AllerNaze, according to Wall Street Journal.

Cost versus Benefit

Dr. Reddy’s Lab spent about $25 million in developing its migraine injection and was able to get it from concept to market in less than five years so the gestation period can be long. However, the company predicts that it expects to earn more than $100 million in annual sales from the migraine injection and skin spray.

A 20-year patent period means that the sales over the duration of the patent period would generate about $2 billion sales. The “bottom line,” it pays to invest in R&D for a company and switch from generic production to patented products. But, the company must first succeed in its innovation efforts otherwise all the investment is lost, which is the typical risk associated with R&D investments.

Chatham, Feb. 29, 2016; 11.22P

http://www.wsj.com/articles/indian-drugmakers-target-niche-markets-1461024100

Facebooktwittergoogle_plusredditlinkedinmailby feather

Van Guarding your Assets: US Market The Best Bet

sp_chartThe annual return for investing in the U.S. stock market over the last 50 years has been around 7-8%. How can one explain this remarkable growth in the U.S. stock market? The Sage from Omaha, Warren Buffett, has a lucid and precise response. The U.S. economy, as measured by gross domestic product (GDP), has been growing, and is expected to grow, at an annual rate of about 3%. The inflation is about 2 to 3% which pushes nominal GDP growth to 5-6 %. Stocks pay about 1-2 % of dividend which increases the growth rate to about 6-8 %.

If you were fortunate enough to have invested during the bull market, i.e., 1982 to 1999, the S&P 500 Index, a common benchmark for U.S. stocks, would have crowned you with returns of about 18 percent per year. You surecannot beat these numbers unless you happen to be the humanitarian George Clooney with the reliable Ocean’s Eleven to back you up!

Risk

So where is the risk if you make 6-8% each year when the period is dull and about 18% during the bull period, which is no bull.

While these numbers are average returns, for some decades you could have easily lost money (e.g., 1970s and 2000s). Sadly, more than half the adult American population gets deprived of the “vintage bourbon” offered by the US equity market. Only 48% of adult Americans have a claim on the returns offered by the US stock market, which is such a travesty. A considerable majority has foregone the benefits of the goldilocks economy.

The Best Bet

The stock market remains the best bet for growing and preserving your financial assets. If you invested in Certificate of Deposits (CDs) with banks, you would earn about 7% in the early 1990s and about 1-2% in the last 5 years. If you invested in government bonds, which is only possible via an authorized stock broker, you would have earned between 2 and 6% in the last 30 years. If you had invested in AAA corporate bonds, you would have earned between 3 and 6% per year.

Clearly, the US stock market offers the best returns in the long run with very little risk when the investment horizon is sufficiently long.

The Van Guard(ing) your Assets

The million-dollar question for your million-dollar investment is what stocks do you pick or what fund/portfolio-manager do you choose?

The relatively safest and least costly method is to pick an index mutual fund. Instead of hiring fund managers to actively select which stocks or bonds the fund will hold, an index fund buys all (or a representative sample) of the securities in a specific index, like the S&P 500 Index. The goal of an index fund is to track the performance of a specific market benchmark as closely as possible, which is why index funds are also referred to as a “passively managed” fund.

The all-time favorite financial company offering index funds happens to be Vanguard Group because they charge very little commission or administrative fee for managing your assets. Vanguard’s 500 Index Fund started business with $11.3 million in assets. Today, the same fund holds more than $252 billion, i.e., the Fund’s assets grew by around 23,000 times.

By investing in the Index Funds like the S&P 500, you must calibrate your expectations. You should not expect staggering returns from investing in a few darling stocks like Tesla or Amazon or Apple. Why? Because those are much riskier bets. You sure make money when the market loves those stocks, but you could also lose your shirt when the market turns its roving eye towards other more attractive beauties. By investing in the Index Fund, you have committed yourself to getting whatever returns the market offers which, in this case, happens to be returns on the S&P 500 index.

Alpha-Males

Some would advise that you seek “alphas” by investing your money in hedge funds or mutual funds choreographed by “superstar” portfolio managers. While this seems like an attractive proposition, chasing these types of funds or portfolio managers can be akin to making a million through lotto tickets. The odds are heavily stacked against you; you might as well give your money to some charity.

There is another caveat. Superstar managers and high profile mutual funds will charge you a bulky administrative fees (> 1%). In addition, you must pay about 20% performance fees, especially to hedge funds.

Possible because of the realization that it is impossible to beat the market consistently over the long run (academics have been saying this for more than 30 years), or for the fear of paying exorbitant fees, index funds have grown in astounding popularity. From their start at $11 million in 1976, index funds grew only to $511 million by 1985, and thereafter expanded more than 100-fold over the next decade to $55 billion in 1995. Their assets hit $868 billion by 2005, and the future still looks very bright so you need wear shades.

Are you ready to invest in the stock market and Index Funds to help grow your financial assets. It sure beats any other form of legitimate financial investment.

Chatham, September 20, 2016; 11A

http://blogs.wsj.com/moneybeat/2016/08/31/birth-of-the-index-mutual-fund-bogles-folly-turns-40/

Facebooktwittergoogle_plusredditlinkedinmailby feather

© 2017 Aloke Ghosh

Theme by Anders NorénUp ↑