CategoryFinancial Statement Analysis

(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

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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

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Bite of the Big Apple

New York City or the “Big Apple” is the financial capital of the world—the city that never sleeps. Walk down the streets of Broadway, and you can hear someone humming the tune “New York, New York” immortalized by Liza Minnelli and Frank Sinatra. With access to Central Park, I believe a more appropriate label for New York City is the “Garden of Eden.” The trees in this Garden sustain life, support knowledge, and generate forbidden fruits. One serpentine bite of the forbidden apple and we are at the cross roads with Genesis!

Why was New York City baptized as the “Big Apple?”

Big Apple

In the early 1920s, “Big Apple” was a nickname for large monetary awards associated with horse racing contests, many of which were organized in and around New York City. The name was commercialized by prominent writers from the New York Morning Telegraph reporting on the City’s horse-racing. Because the city hosted important races, rewards associated with the races were substantial, which may explain the term Big Apple.

Big Apple was subsequently adopted by the City’s jazz musicians. An old saying in show business was “there are many apples on the tree, but only one Big Apple.” New York City being the premier place for jazz musicians to perform made it customary to designate New York City as the Big Apple.

The City in 1971 started a campaign to increase tourism and officially adopted the nickname Big Apple. The campaign featured red apples as reminder of the bright and cheery side of the City, in stark contrast to the common belief that New York City was dark and dangerous. Since then, New York City has officially been designated as the Big Apple.

Jobs’ Apple

What if a bite of the Big Apple eludes you? There is a solution to this biblical dilemma—own a piece of Steve Jobs’ Apple. Apple Inc. designs and manufactures computer hardware, software and other consumer electronics. The company is best known for its Macintosh personal computer line, iTunes media application, the iPod personal music player, and the iPhone.

The original logo of the company, which portrays a man sitting under an apple tree, draws on the Newtonian inspiration from a falling apple. Subsequently, Apple redesigned its logo depicting a bite of an apple. I believe the bite taken out of the Apple represents the story of Adam and Eve from the Garden of Eden with apple representing knowledge.

  • Holy Cash Cow

The company today is a colossal holy cash-cow. Based on data from the most recent financial statements, i.e., April 2017, the company has a cash balance including short term marketable securities of around $67 billion. If you add long-term marketable securities, the balance increases to nearly $260 billion, which is larger than the GDP of Greece!

What is the genesis of the cash balance? iSimple, high margins. The company’s gross profit margin is around 40%, which means for every $1 of sales, the company generates 40 cents of profit after deducting the cost of sales. The operating margins are equally staggeringly high (around 27%). Even after netting out all operating costs, the company generates $27 of profits for every $100 of sales. The sales for the first quarter of 2017 alone was $52 billion, a mind- blowing number.

  • Investments and Acquisitions

Apple is all about organic growth. The company is very frugal with its investments and acquisitions. Much of the excess cash is heavily invested in marketable securities (parking the cash and generating returns on those dollars). Its corporate investments, i.e, purchase of other companies or fixed assets, is rather modest at less than 5% of total assets.

  • Giving Back

What does the company do with its surplus cash balance? It pays dividend and buys back its own stock. Over the 6-months period ending April 2017, the company paid $6 billion as dividend. Over the same period, it repurchased $18 billion of its common stock. Thus, the cash returned to its shareholders was around $24 billion over a period of six months only.

No wonder shareholders are elated and appear flying on Elon Musk’s spaceship to the red planet. Over just under a year, the stock price of the company has increased from around $93 to $155, which translates into a 67% annual return. No legal business in the world can come close to generating these holy numbers.

If you cannot get a bite of the Big Apple, I suggest you consider a bite of the Apple company. Apple’s history is being cooked with a hint of exotic spices by its own “Cook.” The taste is simply divine.

Bon Appétit!

May 16, 2017

 
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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

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Italian Job

BT shares, which trade in the US as ADRs (BT Group plc), have declined by more than 45% in less than a year. Around half of that descent was confined to a single day last month (Jan 23) when the company announced accounting improprieties associated with its Italy-based operations. The company also noted that some senior management personnel may have embezzled funds. UK’s parent BT shares have shed more than 8 billion pounds because of this accounting scandal.

Italian prosecutors have initiated their own investigation into BT Italia’s accounting fraud. BT Group Plc has been hit by at least two shareholder lawsuits in the U.S. A number of other US law firms specializing in shareholder class action suits are considering filing lawsuits against the company and senior management.

British Telecommunications (BT)

BT Group plc is a holding company which owns British Telecommunications plc, a British multinational telecommunications services company with head offices in London. The company has operations in around 180 countries. The company’s shares are among the most widely owned stocks in the UK. The ownership of BT shares is widely dispersed ̶ about 700,000 of its 827,000 shareholders own 1,600 or fewer shares of the company.

BT ADRs

American depositary receipts (ADRs) were introduced in 1927 as an easier way for U.S. investors to purchase stock in foreign companies. Non-U.S. companies also benefit from ADRs as it makes it easier to attract American investors. ADRs are negotiable certificates issued by a U.S. bank representing a specified number of shares (or one share) in a foreign stock traded on a U.S. exchange.

ADRs are denominated in U.S. dollars, with the underlying security held by a U.S. financial institution overseas, and holders of ADRs realize any dividends and capital gains in U.S. dollars, but dividend payments in euros are converted to U.S. dollars, net of conversion expenses and foreign taxes. ADRs are listed on either the NYSE, AMEX or Nasdaq but they are also sold OTC.

Italian Job

The fraudulent transactions related to BT-Italy emerged sometime during the summer of 2016 following an internal probe into its Italian business after a “whistleblower” flagged concerns. A whistleblower is an employee who discloses information about illegal acts, mismanagement, abuse of power, or general wrongdoing occurring in the company. If the company is publicly traded and subject to the filing requirements of the Securities and Exchange Commission, whistleblowers are protected by law from retaliation in the US. Some of the major US companies perpetrating accounting fraud were caught and brought to justice by their own employees (e.g., Enron, Freddie Mac, Madoff).

Upon investigation, BT discovered “inappropriate management behavior” within the Italian division. The expected cost of the rent extraction initiated by the Italian subsidiary was estimated to be around £145 million. Sometime in January this year, just days prior to the announcement of the third-quarter results, the company released a statement declaring that, according to an independent investigation by the Big 4 accounting firm KPMG, the losses to BT from the accounting irregularities related to Italian operations were being reassessed at £530m, which is almost 4 times larger than the previously estimated number.

The company suspended several BT Italy’s senior management team. BT has also appointed a new chief executive of BT Italy who took charge of Italy’s operations from Feb. 1.

Telecom Blues

What remains troubling is why wasn’t the accounting irregularity detected by UK’s parent company much earlier. Nick Rose, the chairman of the BT’s audit committee, flagged internal-control issues in Italy in every annual report since May 2013. Yet, the persistent accounting fraud was not detected until 3 years later. By blaming BT-Italy for all the current problems, the CEO of BT may be attempting to distance the parent company, and himself, from the Italian operations by censuring a few perpetrators.

What is even more worrisome is why didn’t the auditors detect this size of an accounting fraud earlier? Independent auditors are expected to provide an assurance that the financial statement are free of material misstatements. One would agree a misstatement exceeding $600 million is material.

Who was BT’s independent auditor? The answer is PwC, which a Big 4 global accounting giant. PwC has been BT’s auditor for the last 30-year since 1984. It is unclear whether BT intends to end its business relationship with PwC. The big accounting firms are renowned for rendering high audit quality so this type of an accounting fraud is likely to a huge set-back for PwC.

Moody’s has warned it may cut BT’s credit ratings. Analysts are skeptical whether the company can afford to maintain a 10 percent growth in its dividend.

Randoph, February 2, 2017

 

 

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Mardi Gras Float in Trouble: First NBC

mardigrasIn the absence of major national banks in New Orleans, regional banks have floated the NOLA (New Orleans, Louisiana) economy. Through its wholly-owned subsidiary First NBC Bank, First NBC Bank Holding Company provides a wide range of financial services in New Orleans, Florida, and Mississippi Gulf Coast with 39 banking offices.

Following Hurricane Katrina, First NBC invested heavily in New Orleans construction projects that included generous tax credits established by federal and state governments. These investments collectively helped propel First NBC to become the city’s largest bank based on assets under the leadership of CEO Ashton Ryan.

Halloween Scare: Stress Test

The Federal Reserve Bank of Atlanta and the Louisiana Office of Financial Institutions informed First NBC on Oct 11 that the bank is under “troubled condition.”  As troubled bank, it must seek regulatory approval before adding any new directors or senior executives or changing the responsibilities. The bank is also prohibited from increasing its debt, distributing interest on subordinated debt or paying dividends on its stock.

To add to the stress, the Federal Deposit Insurance Corp. (FDIC) recently declared that First NBC is no longer “well capitalized,” restricting its ability to take on certain deposits and pay interest. First NBC was recently downgraded to junk status by Kroll Bond Rating Agency Inc., which specializes in rating smaller lenders. HoldCo Asset Management, which owns the banks’s debt has shorted the bank’s stock and as a way to hedge its risk against a bank default has also publicly questioned the bank’s accounting policies.

Uncle Sam’s Subsidies: Tax Credits

First NBC invested heavily in New Orleans in construction projects following Katrina and thereby benefited from the generous tax credits from federal and state governments. Because the tax credits received by First NBC were more than the taxes being paid, the bank was able to use the unused portion of the tax credits to reduce future tax payments by offsetting future taxes against the unused portion. For instance, if the government gives a $1,000 tax credit to a single parent for raising a child alone, and the parent must pay $800 as federal income taxes based on his/her income, the parent does not pay any taxes for the current period because the tax credit fully offsets the $800 taxes payable for the current year. More importantly, even after the tax offset, the remaining $200 tax credit balance can be used to reduce future taxes.

Accounting rules allow this $200 future tax benefit to be capitalized (i.e., treated as an asset) and booked as a deferred tax benefit. As of the first quarter of 2015, the bank’s deferred tax assets—the benefits from reduction of future taxes—are $247 million, up from $95.8 million a year earlier.

In 2014, the company reported $28.6 million as income before taxes yet it reported a net income of $55.6 million because it had an income tax benefit of $27 million (instead of having an income tax expense which normally reduces net income).

Mardi Gras Float in Trouble: Recanting Previously Issued Statements

First NBC announced in August 2016 that it expects a delay in filing its 2015 Form 10-K (annual report filing with the SEC) because of restatement of previously issued financial results! The prior results included errors because of the following reasons:

  • Use of an inappropriate amortization method in accounting for investments in tax credit (Halloween Hullaballoo)
  • Consolidation of certain investments in Federal Low-Income Housing Tax Credit entities because such entities were determined to be variable interest entities in which the Company was the primary beneficiary (Enron Phantom).
  • The result of the consolidation has adverse effect on the financials (Hurricane)

Following the error corrections, the 2014 net income was now being restated (or reduced) by 20% ($55.6 million being revised to $44.7 million). Similarly, the 2013 net income was being restated (or reduced) by 18% ($40.9 million being reduced to $33.6 million). Accumulated earnings for 2012 and prior periods was being reduced by 16% from $59.8 million to $50.3 million. The company in its 2015 10-K stated “We determined that we had insufficient qualified personnel at both the executive management and staff levels with appropriate knowledge, experience and training on accounting and reporting matters, which contributed to the material weaknesses that resulted in the restatement, as well as the inability to timely file this report.”

To make matters worse, the bank was in violation of NASDAQ listing rules because it had not filed its 2016 quarterly statements. To avoid delisting from NASDAQ, First NBC submitted a plan to regain compliance with Nasdaq’s listing rules.

In a time-span of less than a year, the stock price of First NBC declined from a high of about $40 to around about $5.30, which is a cyclonic decline of around 86%. More than $600 million in shareholder wealth was destroyed because of the accounting related aggression.  

Grateful Dead Sings Aiko Aiko Ande

Ernst & Young (E&Y), a Big 4 auditor with international reputation and stature, has been the independent auditor of First NBC leading up to the 2015 financial statements. First NBC’s restatement is likely to bring considerable negative publicity, media scrutiny and regulatory intervention for E&Y. It will not be surprising to see class action lawsuits initiated by shareholders to recover losses.

In September 2, 2016, Ernst & Young declined to stand for reappointment as the company’s independent auditor for 2016. Is it a case of too little too late? A restatement is considered an audit failure.

Did E&Y fail the shareholders of First NBC? Only courts and the SEC can render a verdict on this matter. Until then, the accounting profession sings “Aiko Aiko Ande” in Cajun style.

 My spy boy saw you spy boy sittin by the bi-yo

My spy boy told your spy boy, Im gonna set you flag on fi-yo.

I said, hey now, hey now, Aiko aiko all day, jockomo feeno na na nay, jockomo feena nay.

My grandma and your grandma were sitting by the fire

Said my grandma to your grandma, gonna get your tail on fire.

Chatham- Helsinki; October 30, 2016

 

 

 

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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/

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A Sach of Gold for the Common Man

gs_logoArguably the best financial company in the world, for almost 150 years, Goldman Sachs has served the financial needs of wealthy individuals, corporations and rich sovereign nations. Their business activities include investment banking, serving the financial needs of institutional clients, investing and lending, and wealth management. Because of their ability to attract top talent and pay handsome compensation, their payroll includes the best and the brightest talents that money can buy.

Goldman’s clients include high-net-worth individuals, families, foundations and endowments. What is the Gold standard for a high-net-worth client? Let us start with any positive number followed by a minimum of 7 or 8 zeros. Six zeros may be too modest an amount to get the attention of the Wall Street luminary. What remains indisputable is that Goldman’s business interests do not hinge around a “commoner” with modest income.

Low and behold, the company has decided to rebrand its uppity image. The financial behemoth is now in the online savings-banking business and eager to attract savings deposits as meager as $1. A cataclysmic metamorphosis.

Avant-Garde Acquisition

Recently, Goldman Sachs acquired GE’s internet-banking subsidiary with a total of $16 billion in retail deposits to get a foothold into the online banking business. The company’s online banking business called ‘GS Bank’ is keen to attract even more deposits by offering generous interest rates regardless of the amount deposited.

Online versus Traditional Banking

Traditional banks require an average of above $4,000 in average daily balance for not charging any monthly maintenance fee. Also, a checking or savings account typically pays between 0 and 0.1% in annual interest rate. The benefit is that the deposits are insured up to $250,000 by FDIC regardless of the financial health of the bank, which is intended to avoid a bank run. However, depositors pay a steep price for the benefits of a traditional bank. Customers are slapped with all types of fees/charges and the interest rates on the deposits are measly.

The online banking has changed the thrifty culture of the traditional banks. Normally, online banks do not require a minimum deposit (e.g., CapitalOne 360, Discover bank). Some online banks offer free checking facilities. More importantly, as any traditional bank, the online deposits are also insured up to $250,000 assuming that the online bank is registered with the FDIC (the online page will indicate whether it is the case). Because online banks do not operate physical locations, they do not incur the high costs of managing a network of branches. Consequently, online banks can pass on some of their cost savings to depositors in the form of higher rates.

GS Bank is offering annual interest of 1.05% for all deposits without any minimum balance and time restrictions. CDs are paying around 1.20% for one year term deposits. Compared with borrowing on the bond market, however, it is cheap.

Benefits to Goldman from Online Banking

To finance its investments, Goldman Sachs must borrow from the bond market. The interest rates in the bond market are much higher (between 3% and 4%). Therefore, assuming a constant rate of return on their investments, there is a 2%-3% spread from acquiring funds at a cheaper rate.

Based on its 2015 annual reports (FORM 10-K), Goldman has $97.519 billion in deposits. Additionally, it has 42.787 billion in short term borrowings. If Goldman can replace all of its short term loans with online banking deposits, an extreme case scenario, the annual interest cost savings generated would be around $1.3 billion. Assuming that the savings are in perpetuity, the present value of the cost savings using modest discount rates is around $13 billion. Because presently there are 426.4 million shares outstanding, the potential cost savings alone could generate a pop in the stock price by $30.

As a common Man, are you ready to invest in a Sach of Gold?

Helsinki, Finland, August 5, 2016.

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Equestrian Polo Designer Fails to Score

198_Polo_Ralph_Lauren_logo_profileThe stock price of Ralph Lauren, an upscale apparel company renowned for its Polo brand, has taken a thrashing lately. The stock has declined by about 50% over the past one year because of sluggish demand in the US and a decline in the value of its overseas sales from a strong dollar. In the third quarter of this year, the company reported a colossal 39% drop in  earnings.  The company also lowered its fiscal 2017 guidance numbers. Investors fear that the company may be at the vortex of a long-term slump.

End of an Era

To energize the polo pony, Mr. Ralph Lauren, the iconic designer-founder of Ralph Lauren and its sole Chief Executive Officer (CEO) and Chief Creative Officer, finally decided to step down as the CEO after being at the helm for almost 50 years. Mr. Lauren is hoping to inject some youthfulness into the septuagenarian polo team. Stefan Larsson, who is a former H&M executive and president of Old Navy, was hand-picked by Mr. Lauren to take charge of a company that is under attack.

Mr. Larsson will report to Mr. Lauren, although Mr. Lauren characterized their relationship as a “partnership” which is understandable considering that Mr. Lauren is the largest individual shareholder in his company and is expected to play a role in major decisions. Essentially, the company is separating the roles of the professional manager from that of the creative manager. The separation of the two roles will help assure Wall Street that the creative aspirations do not bleed the financial foundations of company.

Brutal Cost Cutting

Under the new strategy labelled as “New Plan Forward,” the incoming CEO intends to slash costs to fashion a reversal in downward profits. The company intends to close 50 stores, lay-off about 1,000 employees (or 7% of its workforce), and remove three of the nine layers of management that stand between the CEO and sales team.

The clothing production lead times will be amended from 15 to 9 months. Certain clothing lines will be on a hyper fast production time whereby it will be moved from the development stage to the shop floor within eight weeks.

The cost cutting strategy is bold and brutal, the Swedish CEO intends to slash costs by about $180 million to $220 million per year which is in addition to the $125 million in cost cutting completed last year.

Restructuring Costs

According to the plans, the company is projecting $400 million in restructuring charges and additionally the company intends to write off as much as $150 million in inventory that is scheduled to be liquidated. Evidently, near term earnings numbers are going to take a big hit before increasing.

Uncertain Prospects

The reasons for Mr. Lauren giving up some operational and financial control of the company after 50 years are notable and praiseworthy. Once a founder-owner company becomes sufficiently complex, the natural economic progression for the company is to retain a high quality professional manager who is responsible for supervising day-to-day operations, mange investments, and make optimal financing decisions with the objective of maximizing firm value. The advent of a professional managers also assures investors that the financial aspects of the company are not being compromised as creative side blossoms.

However, some of the restructuring plans are hard to assess. Some immediate concerns include,

  1. Why hire a CEO from outside the company? Why not hire an insider who understands the value of the brand?
  2. Can young CEO render value while being under the influence of a powerful founder-owner?
  3. Why pick a CEO from a low-priced apparel designer company that is not a direct competitor?
  4. Why are the business models that helped revive the fortunes at Old Navy and H&M likely to be useful for Ralph Lauren?
  5. Cost cutting strategies can only render value up to a point, eventually the principal driver of earnings is revenue growth.
  6. Too much cost cutting can also harm the brand value because of a loss in human capital.

Considering all these questions, the future of Ralph Lauren remains highly uncertain.

Helsinki, June 21, 12.48P.

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How Mobil(e) is ExxonMobil?

Losing Triple A Credit Rating

Losing Triple A Credit Rating

ExxonMobil Corp. had the honor and distinction of having a gold-plated AAA credit rating since the post WWII period. However, fortunes can change abruptly when one is trading products of mother nature. Last week, Standard & Poor’s (S&P) downgraded Exxon Mobil’s credit rating for the first time in almost 70 years from the coveted “AAA” rating to a “AA+” rating citing expectations of continuing low oil prices. ExxonMobil joins two other US companies with S&P AA+ credit ratings; General Electric Co. and Apple Inc. The two remaining US companies with the highest possible corporate AAA debt ratings are Johnson & Johnson and Microsoft Corp.

Exxon Mobil History

ExxonMobil is an American multinational oil and gas company based in Texas. It is the largest direct descendant of John D. Rockefeller’s Standard Oil Company. Exxon Mobil was formed in 1999 by the merger of Exxon (formerly Standard Oil Company of New Jersey) and Mobil (formerly the Standard Oil Company of New York). ExxonMobil is also the Fifth largest publicly traded company by market capitalization. ExxonMobil was the second most profitable company in 2014.

Downgrade Reasons

S&P stated that the “company’s debt level has more than doubled in the recent years, reflecting high capital spending on major projects in a high commodity price environment and dividends and share repurchases that substantially exceeded internally generated cash flow.”

S&P also said that while Exxon made efforts to reduce capital spending, the maintenance of production and replacing reserves will ultimately require the company to spend more. Because the company is returning cash to shareholders, instead of building cash or reducing its debt, the company faces limits on credit improvements even when oil prices recover.

S&P cautioned that it could further lower its rating on Exxon if the company is unable to sufficiently adapt to a prolonged period of low commodity prices. The downgrade is not a complete surprise. In February, S&P downgraded rival Chevron Corp and warned that such a move was also possible for Exxon.

Shareholder Payments

ExxonMobil paid out $325 billion as dividend and share repurchases over the last 11 years which exceeded its outlays for new property, plant and equipment of $272 billion over the same period. During the fourth quarter of 2015, the company paid out $3.6 billion in dividends and share repurchases, which is more than it earned in that quarter.

In February, Exxon Mobil changed its strategy and declared that it would only repurchase shares to offset dilution, and not pay back cash as dividend.  

Why Repurchase Over Dividend

Many companies prefer stock repurchase over dividends. One explanation is accounting based therefore cosmetic and the second explanation is more economic.

Investors tend to focus on accounting earnings, mostly earnings per share (EPS), which is computed as net income divided by number of shares outstanding. When a company buys back (repurchases) its own stock, it reduces the shares outstanding and thereby increases its EPS. This type of an increase in reported EPS is cosmetic (nip and tuck). Shareholders care about the pie (earnings) and not how the pie is being shared (EPS). So stock buyback initiated to increase EPS is a akin to a magician’s show intended to circumvent reality.

The advantage of stock buyback is that it is a one-time cash payout unless the company elects to announce future buybacks. Dividends, on the other hand, are more permanent in nature and investors expect continuation of dividend payments when one is announced. Therefore, companies wanting to preserve future cash prefer stock buyback over dividend.

ExxonMobil wants to buyback stock to offset the stock price decline from declining oil prices. Given the low oil prices, it has cut back on its planned investments or production capacity. However, when oil prices bound back, it wants to preserve cash to fund its future growth which is why it prefers stock buyback over dividend.

Stock Price

ExxonMobil’s stock price went down from a high of around $103 in 2014 to a low of $72 in 2015. The stock is back at around $90. With oil prices trending up, we can only expect ExxonMobil’s stock price to continue its upward trajectory.

Chatham; June 11, 2.11P

http://www.reuters.com/article/us-exxon-mobil-ratings-s-p-idUSKCN0XN26L?feedType=RSS&feedName=businessNews&utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+reuters%2FbusinessNews+%28Business+News%29

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