The Buffett Plan: An apt name for a sanctimonious, hypocritical and superficial proposal

At the start of this week, President Obama laid the groundwork for his deficit plan, with one of the proposals being what he termed the "Buffett" tax. Like Bank of America, a few weeks prior, he was perhaps hoping to borrow on Buffett's credibility to increase support for his plan. Put briefly, here is the what the plan is designed to do. Taxpayers who earn more than a million dollars will be required to pay at least as high a tax rate as what the average tax payer pays. What  constitutes a average taxpayer (I guess it is a good thing that it is not the median taxpayer; since that would comprise an income tax cut for millionaires, not a tax increase) and how high this "alternative" tax rate should be has been left to Congress to specify.

This plan has the right moniker, since it's qualities are reflective of the man after whom it is named:

1. It is sanctimonious: The word that best comes to my mind as I read Buffett's views on investing and business is "sanctimonious". He is the noble CEO, who puts stockholders' interests first, in a world full of cynical, self interested CEOs. He is the keeper of the value investing flame, while those short-term money managers in New York and London have abandoned Ben Graham, fundamentals and first principles. He is the brilliant financial thinker, standing alone against those clueless academics and their betas & option pricing models. In his latest foray, he is the "good" billionaire, who wants to pay his fair share of taxes, unlike those bad ones who shirk paying their share. This tax plan echoes this refrain. In effect, it says, the details don't matter because the intentions are noble: the rich can not only afford to pay more in taxes but they should be happy to do so. 
2. It is hypocritical: All this sanctimony might be tolerable if it came from someone who not only talks the talk but walks the walk. Warren Buffett is a hypocrite on many of the issues that he is most vocal on. Consider corporate governance. The same man who said that managers are stewards of their shareholder capital has not always followed his lead, in structuring and running his own company. First, Berkshire Hathaway has adopted the dual-voting share plan that has been the weapon of choice for entrenched insider control in other companies (See New York Times, News Corp, Google, Washington Post... ). Second, while I admire Buffett's frugality, I don't see any transparency at Berkshire Hathaway. In fact, it looks to me like the board at the company exists to rubber stamp whatever Buffett and Munger want.  A case in point: look at the successors that have been hired to take Buffett's place: Ted Wechsler (his recent hire) and Todd Combs. Both seem like nice men with, but we know little about them (other than the fact that Buffett and Munger like them). One of the few data points we have on Wechsler is that he was the winning bidder, two years in a row, paying $2.6 million each year, in an auction where the prize was lunch with the Oracle from Omaha. If you see nothing wrong with that, you should be okay with Bob Iger picking his successor for Disney from a Mickey Mouse look-alike contest or Steve Ballmer choosing the next winner of the hot dog eating contest at Coney Island (Was that Joey Chestnut?) as the CEO for Microsoft. Third, for those who argue that Buffett can be trusted to make these judgments, I do remember that he did hand-pick his last successor and that did not end well, did it? No one is impervious from making mistakes, but people who live in glass houses should not throw stones.
   This tax proposal is just as hypocritical. While it is couched in terms of fairness, it is based on a false argument: that millionaires pay less in taxes because they exploit massive tax loopholes and have very good tax lawyers. While there may be some who do, we know why the effective tax rate for millionaires is so low. It is because a significant portion of the income comes from capital gains and dividends, which are paid out by corporations from after-tax income, and taxed at a lower rate than ordinary income (from wages and profits). I would have had much more respect for the proposal if it had directly confronted this issue. Should investment income be taxed at a lower rate? Should we be taxing consumption or income? That would be a debate worth having.
3. It is superficial: To be honest, there is really no tax proposal, because the key details of the proposal, the "average" tax payer and the "millionaire minimum tax rate" are not specified. That is very much in keeping with the Buffett rule book. I know that much has been made about the brilliance and home-spun wisdom of Buffett's aphorisms. But as I read the letters that he has written to his stockholders (which comprise the heart of his writing), I am left with the feeling that when Buffett wanders from his preferred habitat - talking about investing in and managing mature companies - there is less there than meets the eye, especially when it relates to macro and market issues. What seems profound and wise at the first reading seems less so with each subsequent reading. Put differently, when it comes to a great deal of investing wisdom, Buffett's sayings seem to draw more on the fortune cookie tradition than from Confucius. 

As far as this tax proposal goes, it looks like it was conceived by a union of a rogue economist and an over-the-top populist. (Perhaps, it was.. Has anyone seen Robert Reich and Paul Begala hanging out together?) It will, without a doubt, make the tax code more complex. As a taxpayer who has had to deal with the effect of capped itemized deductions and the alternative minimum tax rate (AMT) for the last decade, I think that they rank among the worst tax code abominations ever, and this proposal is more of the same, just directed at millionaires. It will also be ineffective. The administration estimates that it will raise $ 400 billion in tax revenues from the Buffett tax, which strikes me as unlikely. First, since the "millionaire tax rate" is unspecified, the fact that they can estimate revenues from it reveals exceptional brilliance. Second, since much of the income that will be taxed comes from dividends/price appreciation in the stock market, it would require a rising market and healthy economy.

Am I being unfair in using a tax proposal named after Buffett to attack the man? Perhaps, but this tax proposal has its roots in Buffett's assertion that the rich don't pay enough in taxes and I am sure that the administration got his permission to attach his name to it. To those Buffett acolytes who are upset at my critique of the master, I have a simple suggestion. There are plenty of people, websites and books that revere the man and write puff pieces about him. Why not stick with those? Warren Buffett is a savvy investor, who has an uncanny ability to spot weakness and take advantage of it. I admire his skill but that does not mean that I have to treat him as infallible or exalt everything that has his name attached to it as good. My view is that the "Oracle from Omaha" no longer fits and that we need to come up with something better. I like the "Nag from Nebraska", the "Berkshire Bloviator" and the "Hypocrite from Hathaway", but I am sure that you can come up with your own variations.   Any suggestions? (As some of you have pointed out, this last part is over the top and unnecessary. So, let me retract it but leave it up so that I am not erasing history.. But I stand by my overall thesis.)

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Breaking up is easy to do...

Breaking up may have been hard to do for the Carpenters, but it seems to be easy to do for some companies. Here are just  a few examples of companies that have announced plans to dismember themselves, in the last few months:

1. Kraft Foods: Kraft Foods split itself into two companies: a division that sells candy and snacks (Oreo, Cadbury, Tang) globally and a division that sells grocery brands in the US (Oscar Meyer, Jell-O). 
2. McGraw-Hill: The company responded to demands by investors that it break itself up by dividing itself into two businesses: McGraw-Hill Markets, which includes the S&P rating and index businesses and McGraw-Hill Education, composed of the publishing and education businesses owned by McGraw-Hill.
3. Netflix: Reed Hastings, the CEO of Netflix stated that the company would separate its DVD rental business (and give it the name Qwikster) from its streaming-only service (which will continue to be called Netflix). 
4. Tyco:  Tyco announced its intention to break itself up into three separate companies: a residential security business (ADT), a unit selling valves and controls to energy, mining and water markets and a commercial fire and security business. This represents the closing salvo in a multi-year effort by Tyco to deconglomeratize (I know.. I know.. there is no such word... but there should be) itself.

What happens in a break up?

To understand the mechanics of breaking up a publicly traded company, recognize that  there are three dimensions on which break up can have varying effects, depending on how it is structured: 

1. Control of the management of the business(es), where the effect can range from a complete separation of control (with each of the broken up businesses becoming independent companies, completely delinked from the parent company) to de facto serf status for the separated units (with the parent company exercising complete or near complete control over the separated businesses).
2. Market pricing of the units, where the effect can range from the broken up businesses trading as independent units (with their own shares, market price and traded value) to no change in the status quo, with the parent company trading as a single company, composed as a holding company for the separated business units.
3. A break up can have tax implications for the investors in the parent company. To the degree that a break up can be viewed as a transition from owning stock in one consolidated company to owning shares in multiple companies, tax authorities may assess capital gains taxes (relative to what was originally paid for the stock) or treat distributions as dividends (and tax them accordingly). Again, in the continuum, you can have break ups that create no tax consequences for investors and break ups that create large tax bills.

The good news is that the details of the break up ultimately have to be made public to investors, who can then assess the control, pricing and tax implications. The bad news is that the details may not be accessible at the time of the initial announcement of the break up.

Does breaking up make sense?

There are many reasons why companies may (or should) break themselves up, and here is a synopsis for each one:

1. Market mistakes: The simplest rationale for a break up is that the market is mistakenly valuing the whole company at less than the sum of its pieces. Many analysts/ activist investors use this "sum of the parts" argument to push companies that they feel are being under valued to break up. While the story is intuitive, I would be skeptical of any argument that is premised entirely on "market mistakes", partly because most "sum of the parts" valuations are really "seat of the pants" valuations. Analysts will often take the earnings reported by division for a company, which are contaminated by accounting allocation and transfer pricing decisions made by the company, and apply sector-average earnings multiples (without correcting for differences between companies) to estimate the divisional or parts values.  (See the end of this post for a spreadsheet that will allow you to do your own sum of the parts valuation)
2. Contaminated Parts: One division of a company may be saddled with actual, perceived or potential liabilities that are so large that they drag down the valuations of the rest of the company. This was the rationale for tobacco companies, faced with potential billion-dollar payouts on lawsuits brought by smokers, spinning of their non-tobacco businesses (See, for instance, the Kraft spin off from Altria (Philip Morris) in 2007). In the same vein, a company with a heavily regulated or constrained subsidiary may find that the regulations and constraints on that subsidiary spill over into its other businesses, rendering them less profitable. If restrictions on commercial banking are tightened (think of Dodd-Frank, with teeth...), it is conceivable that the large money center banks may want to spin off their investment banking arms to operate independently.
3. The efficiency story: In the 1960s and 1970s, imperial CEOs  (Like Julius Caesar, they brooked no dissent and looked to no one for advice)  like Harold Geneen (ITT) and Charles Bludhorn (Gulf and Western) built up companies that spanned multiple businesses, arguing (with lots of help from strategists and consultants) that conglomerates would have significant advantages over their smaller competitors. Studies over the last three decades suggests that this optimism was misplaced and that conglomerates are often less efficient than competitors, earning lower returns and profit margins. In fact, markets responded by "discounting" conglomerates by about 5-15%, to reflect the inefficiencies. If conglomerates are less well run than the competition, perhaps because managers are spread too thin across business or because there is cross subsidization, then breaking them up into their individual businesses should increase efficiency, profits and value. The break up of Tyco, a company built on the conglomerate premise (and accounting gamesmanship), over the last decade can be a case study in deconglomeration.
4. The simplicity story: Multi-business companies are not only more difficult to manage but they are also more difficult to value. With companies like GE and United Technologies, different businesses within each company can have very different risk, cash flow and growth characteristics and coming up with a consolidated number can be cumbersome. In my book, the Dark Side of Valuation, I examine why valuing their "octopus" companies is so difficult (you can just download the paper... you don't have to buy the book..)  and how to do a true sum of the parts valuation. In good times, investors may overlook the complexities of valuation, trust the managers and value these multi business companies highly. In bad times, they will not be as charitable and will punish complex companies by discounting their value. Breaking up the companies in bite size pieces that are easier to value and trade may therefore increase value, especially if you are in a "crisis" market.
5. The tax story: When tax codes are complex (and when are they not?), companies may be able to lower their tax bills by artfully breaking themselves up. For instance, let us assume that the US government decides to take the populists' advice and tax all income generated by US corporations, anywhere in the world, at the US corporate tax rate in the year in which the income is generated (rather than when it is repatriated back to the US, as is the current law). Multinationals like GE and Coca Cola that generate a significant portion of their taxes in foreign locales, with lower tax rates, will be able to lower their tax bill by breaking up into independent domestic (US) and international entities, with different stockholders, managers and corporate governance structures.

On the other side of the ledger, there are costs to breaking up as well:

1. Loss of economies of scale: Combining businesses into a company can create cost savings. Thus, a group of consumer product businesses may benefit from being consolidated into one unit, with shared advertising and distribution costs. Breaking up with result in a  loss of these savings. 
2. Reduced access to capital (and higher cost): If external capital markets (stock and bond) are undeveloped or under stress, combining businesses into a consolidated company can provide access to capital. How? The excess cash flows from cash rich businesses can be used to finance reinvestment needs in cash poor businesses. 
3. Lost synergies: I am generally a skeptic about synergy but it does exist. In some multi-business companies, businesses feed off each other's successes, thus making the whole greater than the sum of its parts. Disney is a good example, especially in its kid-oriented products: its movie business generates opportunities for its licensing businesses and increases revenues at its theme parks. Separating Disney into independent movie, toy and theme park businesses will result in a loss of these benefits.

If companies were rational, they would be looking at this trade off and making judgments on whether to break up, based upon the net effect. A rational explanation for the surge in break ups is that we are in a market phase, where risk is front and center, and complexity is being punished.

By focusing on sensible reasons for breaking up firms, we do miss the most important factor that explains corporate actions: herd behavior. Investment banks, consultants and corporations often get stuck on the same page in the value creation cookbook and dole out the same advice for each company that comes looking for help at a point in time. Break ups may be the flavor of the moment, and companies are jumping on the bandwagon, expecting stock prices to go up, even if the break up makes no economic sense.

Assessing break ups and potential break ups...

As investors, the breaking up of a company can be good, neutral or bad news. In assessing either announced or potential break ups, here are some things to consider:
a. Past performance: I know.. I know.. I have read the disclaimers too, but if you are performing well (both in terms of earnings and stock prices), why mess with a winning formula? A firm that is performing well (both in terms of profitability and stock price measures) should therefore be less inclined to consider breaking up than a firm that is under performing its competition.
b. Separate and independent businesses: The benefits of breaking up increase and the costs decrease if the businesses that are being broken up are stand alone, independent businesses, with few or no cross business links. Conversely, companies with interlocked businesses that have synergies should be wary of break up plans.
c. Management rationale and consistent actions: A break-up is more likely to succeed if  the managers of the parent company are  clear about their objectives and structure the break up consistently. For instance, if the rationale for a break up of a company is that one business is contaminating the remaining businesses, the break up makes sense only if it creates separate legal entities that operate independently.

So, how do the break ups in the news measure up?

• The Tyco break up makes the most sense: the businesses are separate and independent and managers seem clear on the rationale. It is also part of a long term plan and is not a knee-jerk response to market developments.
• The McGraw-Hill merger also makes sense, since there is little overlap between S&P and the education businesses. These firms operated independently until a few years ago and the transition back to independence should be easier. Finally, the current legal and public relations problems with the ratings agencies could hurt the rest of McGraw Hill. (In fact, a surprising number of break ups are reversals of acquisitions done in prior years, an admission that the acquisitions did not work.)
• The Netflix break up seems like a clumsy solution to a pricing problem: the cost of maintaining a DVD customer is higher than the cost of a streaming customer and that cost difference will widen as fewer people use DVDs. But do you have to break up a company to accomplish this? 
• I am at a loss on the Kraft break-up. The businesses that are being divided have more in common than they are different. Oreo, Cadbury, Jell-O and Oscar Meyer are all strong brand names with a global presence. The fact that the latter two may get more of their revenues from US grocery story sales does not strike me as a big difference. Perhaps, there are differences in growth prospects, but the costs of breaking up (lost economies of scale and synergies) seem to vastly outweigh the benefits. In short, this break up seems to fit into "action is better than inaction" rationale for break ups.

Finally, are there other companies that meet the criteria for "good" break up candidates? There are plenty, but let me suggest three high profile candidates:

1. Time Warner: Time Warner is a company with tentacles in every aspect of entertainment. Unlike Disney, which does get significant cross business synergies, Time Warner has less overlap across businesses. The company has had trouble on both profitability and stock performance measures and a management that will never outlive the consequences of having made the worst acquisition in history.
2. GE: In the days of Jack Welch, GE was a case study of a large company that seemed to have found the fountain of everlasting growth. Not only have we discovered in hindsight that this growth (mostly from acquisitions) was more expensive than it seemed at the outset, but GE Capital has taken on an outsized role in determining the value of GE as a company. As one of the largest financial service companies in the world, with its own share of costly mistakes, GE Capital is an impediment to valuing GE and an brake on its stock price. Unlike other captive financing arms (Ford Capital, GMAC), where the bulk of the revenues come from within the company and separation is difficult, GE Capital derives a significant portion of its revenues outside GE and should be easier to separate from the company.
3. Citigroup/Bank of America/ JPM Chase: The strategies that the big money center banks embarked on, a decade or more ago, of being financial supermarkets, with business interests in banking, real estate, portfolio management and housing finance has blown up in their faces. Instead of the diversification helping the company, one or two portions of each bank (with bad lending practices or toxic assets) is threatening to bring down the rest of the institution. Perhaps, it is time to break up.. or in the case of Bank of America, put one of its businesses into bankruptcy..

So, embark on your proactive exercise of looking for potential break up candidates: if you can get ahead of the curve, you should profit, even if only a fraction of these companies do break up. Just to help you along, I have attached a very simple spreadsheet for assessing the effect on value of a break up, in both intrinsic and relative valuation terms. Have fun with it! 

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Operation Twist II: The Fed as Chubby Checker

            Since the banking crisis of 2008, neither fiscal nor monetary policy has proved up to the task of rejuvenating the US economy. The Federal Reserve, in particular, has explored almost every tool in its arsenal to increase economic growth. In 2009, there was Quantitative Easing II (QE II), where an influx of $ 600 billion was used to buy long-term bonds and lower long term interest rates. Those lower rates, it was argued, would help get housing back on track and increase real economic growth. At the time, I argued (though I admitted my limited credentials to be involved in this debate) that I did not think it would work, for the simple reason that interest rates were already low, with the 10-year T. Bond rate at 3.3%.

            Two years later, the 10-year T. Bond rate stands at 2.09% and treasury bill rates are close to zero. The Fed is now planning to get back into the game with a maneuver that it has last tried in 1961: Operation Twist. Simply put, here is what the Fed hopes to do. Rather than introduce more funds into the system (like QE2 did), Operation Twist is a shift in what securities the Fed invests in, rather than how much. The Fed, which holds about $1.7 trillion of US treasuries is planning of reducing its purchases of short term treasuries (1 month, 3 month etc.) and increasing its holdings of long term treasuries (10 years and higher). Assuming that the rest of the market stays in a holding pattern, the increased demand for long term bonds should lower those rates, while the rate for the short term notes and bills will increase.

            Now, let’s look at the why. There seem to be three stories offered:  an “interest rate” story, where real growth will increase as a consequence of this maneuver, a “confidence” story, where US companies and consumers will be heartened by the Fed’s activism and and a “valuation” story, where stock prices will react favorably to the shift in the term structure:

1. The “interest rate” story goes as follows. There are a number of key consumer (mortgage financing) and corporate interest rates (corporate bonds, long term bank loans) that are tied to the long term rate.  In its optimistic version, for consumers, QE3 will reduce the rates on mortgages, inducing those staying on the sidelines to either borrow and buy a new house or to refinance an existing house at the lower rate, with the savings going into consumption. Companies, it is argued, will also be more likely to borrow more, if corporate bond rates decrease, and make new capital investments.
2. The “confidence” story is based upon the presumption that both producers and consumers in the United States prefer a Fed that acts to one that does not. Since QE3 would qualify as action, both groups, it is argued, will become more inclined to invest, consume and take risks.
3.  The valuation story builds on the first two. Here is what the optimistic take is: a lower long term rate will trump higher short term rates, pushing discount rates down. The higher real growth, coming from the interest rate story, and lower risk premiums, emanating from the confidence story, will then augment this impact, causing stock prices to increase even more.

Nice stories, but QE2 was also supposed to make a real difference in real growth and put the economy back on track. Here is why I think QE3 is destined for the same fate:

• For the interest rate story to work, long-term interest rates have to go down significantly without short term rates shooting up too much. In the figure below, I have the yield curve in September 2011. If the 10-year bond rate is at 2%, how much lower can it go? Even the optimists at the Fed seem to foresee a drop of about 20 basis points as the outcome and no one seems to have an estimate on the concurrent increase in short term rates. Since mortgage rates are already at historic lows, I don’t see a further drop of 0.20% making much difference.

•  I don’t buy the confidence story, simply because I don’t think action always trumps inaction. In fact, my reaction to hearing that the Fed was trying to twist the yield curve is that they must be scraping the bottom of the barrel, if this is the best that they can do.
• Finally, the valuation story. Does the level of interest rates affect stock prices? Of course! Does the slope of the yield curve matter for equities? Also, yes! One way to see this is to look at the Earnings to Price (EP) ratio (the inverse of the PE ratio) for the S&P 500 (using trailing earnings) in relationship to the 10-year T. bond rate (measuring the level of rates) and the difference between the 10-year rate and the T.Bill rate (measuring the slope of the yield curve) from 1960-2010. Regressing the EP ratio against the ten-year rate and the yield spread differential (with t statistics in brackets):

EP = 2.66% + 0.67 Ten-year T.Bond rate  - 0.31% (T.Bond rate - 3 month T.Bill rate)

        (3.37)     (6.41)                                  (1.36)

How would I read this? At least between 1960 and 2010, every 1% increase in the long term bond rate increases the EP rate by 0.67% and every 1% increase in the slope of the yield curve decreases the EP ratio by 0.31%.

The EP ratio for the S&P 500 right now is about 6.97%, based upon a trailing PE of 14.34. Assume that the best case scenario unfolds and that long term rates drop by 0.20% and that short term rates increase by 0.20%. By my estimates, the EP ratio for the S&P 500 will remain almost unchanged at 6.96%, resulting in the trailing PE of 14.36. Thus, stock prices will not change by much as a result of this action. Perhaps, long term rates will drop by more and/or short term rates will rise less. You can download the spreadsheet that I used for my computation and input your best estimates: this spreadsheet has four worksheets: the raw data on the index and fundamentals, the chart of the historical EP ratios, the regression output (backing the regression above) and a prediction worksheet (where you can estimate the effect on stock prices). Have a go at it! As for myself, I will stick with my favored version of the twist.

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Class is in session...

As some of you probably already know, I teach at the Stern School of Business at NYU. Well, summer is officially over and a new semester is beginning. In a rite that I repeat at the start of every semester that I teach, I want to invite you to be part of my class this semester. Note, though, that this invitation is completely unofficial and approaching NYU for credit for taking the class is a definite no no.

This semester's class:Valuation
The only class that I will be teaching this fall is Valuation. A little history, though it may bore you, is in order here. I came to NYU in 1986 and the very first class that I was asked to teach was a Security Analysis course, a class with deep and venerable roots (Ben Graham taught this class at Columbia and Warren Buffett took it in the 1950s). It was a class on valuing securities of all types, bonds, futures, options and stocks, but it had outlived its useful life by the mid 1980s, partly because there were other electives that focused on bonds and derivatives and partly because there was no narrative left that fit the class. I hijacked the class, revamped its content (without renaming it), and made it a semester-long class on valuing businesses: small and large, public and privately owned, growth and mature and developed and emerging markets. About 4 years ago, the administration recognized the obvious and changed the name of the class to reflect its content.

What is this class about?
While the class is centered around intrinsic valuation (or discounted cash flow valuation, if you prefer to use its applied form), and I am a firm believer that intrinsic value matters, I try (though I do not always succeed) to keep an open mind and not force feed my views. Consequently, you will hear me talk a lot about the limitations of discounted cash flow valuation and what I see as its dark side. In addition, a significant portion of the class is devoted to multiples and comparables (what I term relative valuation), since it is the dominant approach used by analysts to value companies. I do also bring in the role that option pricing has played in valuation, in the form of real options. Thus, I try to make this class as broad as possible in terms of approaches covered and businesses valued.. My objective is that you should be able to value any asset or business, using any approach, and from any perspective (investor, acquirer, appraiser), by the end of this class.

What background do I need to take the class?
This class is an elective that is taken primarily by second year MBAs, most of whom have had the misfortune to take a full semester class in Corporate Finance from me in the previous year. However, I do make the assumption that a summer is all you need to wipe out everything you have learned over the previous year and the first three or four weeks of this class provide a quick review of the corporate finance class.
I do assume that you have some working knowledge of accounting, present value and statistics. If you do not, I would recommend quick primers that I have online that may be useful to you:
http://people.stern.nyu.edu/adamodar/New_Home_Page/background.html
But even if you don't have time to do these things, why not just drop by and listen to a lecture or two?

How do I take this class?
a. The first thing to do is to visit the website for the class:
http://www.stern.nyu.edu/~adamodar/New_Home_Page/equity.html
This is the central repository for everything to do with the class.
b. The second is to download the lecture notes for the class and watch the webcasts for the class. Both are available on this page:
http://people.stern.nyu.edu/adamodar/New_Home_Page/webcasteqfall11.htm
You have two choices with the lecture notes. You can print them off on paper and use them in conjunction with the webcasts. Alternatively, you can download them as pdf files and read them on your iPad or Kindle (if you have one). On the webcasts, you have three choices:

1. Streaming video (The file will be streamed to your computer. This will work only if you have a good internet connection, but should be of the best quality)
2. Video podcast (The .m4v file will be downloaded to your computer and you can watch the video using Quicktime or video software or on your iPad or Smartphone)
3. Audio podcast (The .mp3 file will be downloaded as an audio file and can be played on any audio player)

c. If you really want to feel involved in this class, you can go further:

• Get emails: I send out emails almost every day for this class, relating to what's coming up in the class and topics of general interest. You can read the emails by going to 
• http://people.stern.nyu.edu/adamodar/New_Home_Page/eqemail.html

• Take quizzes/exam: I will post the quizzes on the website, right after I give it in class and the solutions the day after (with grading guidelines). You can take the quizzes/exam and grade yourself (follow the honor code).
• Valuation project: This class has a big project that is a valuation of a company. You can pick any company and follow along on the project. On this one, unfortunately, I cannot be a full service operation. While I do give feedback to those who are officially in the class, I cannot do the same with everyone who is taking the class unofficially. If you do get stuck on a concept, and I can help, I will try.

One final resource that you may want to use. I am trying out a new device put together by a few very smart, enterprising young people called coursekit. It essentially pulls together everything that is on the website for the class and adds a social media component (think Facebook embedded in the course page). I like the look and you can see it by going to:
http://www.coursekit.com
Enter the code FHGN2P and you will become part of the course online. I will put the emails that I send on here and it will let you raise questions/issues related to valuation that can be discussed. 


In closing, I hope you do drop by and become part of this experience.... See you in class!

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Buffett and Bank of America: Playing Poker with Patsies...

Warren Buffet is famously quoted as saying, "If you have been playing poker for half an hour and you still don't know who the patsy is, you're the patsy". Today, we got a glimpse of Buffett playing poker with Bank of America, and at least from my perspective, it seems clear who the patsy in this game is... it is either Bank of America's stockholders or the rest of us who attribute mystical properties (and uncommon ethics) to the Oracle from Omaha...

So, let's recap what happened. It has been a rough few months for Bank of America stock, prior to today. The stock price had halved between November and yesterday:

Macro factors (the Euro crisis and the S&P downgrade) did play a role in the price decline but the company had itself to blame as well.  It reported a loss of $8.8 billion for the second quarter of 2011, reflecting payments to settle legal claims related to troubled mortgages.While the stock price decline suggested that the market was increasingly pessimistic about the company's future profitability, the company itself indicated that it was sufficiently capitalized to make it through these travails. Earlier this month, the company announced that it would lay off 3500 employees and cut costs, but evoked little positive response from the market.

Today, we woke up to the news story that Warren Buffett, white knight extraordinaire, had ridden to the rescue of Bank of America. 

http://on.wsj.com/nUOWBS

Here were the terms of the deal:

- Buffett invests $ 5 billion in preferred stock, with a 6% cumulative dividend, redeemable by the company at a 5% premium on face value.

- If Bank of America is unable to pay the preferred dividend, not only do the dividends cumulate but they do so at 8% per annum and the bank is restricted from paying dividends or buying back stock, in the meantime.

- Buffett get options to buy 700 million shares in BofA at $7.14/share, exercisable any time over the next 10 years.

Let's see what Buffett gets out of the deal. Valuing the options with a strike price of $7.14, even using yesterday's low price of $6.40/share, an annualized standard deviation of 50% in the stock price (significantly lower than the 3-year historical standard deviation of 79% and the implied standard deviation in excess of 100% from the option market)  and a ten-year maturity, I estimate a value of $4.30/option or an overall value of approximately $ 3 billion (700*4.30) for the options. (I know.. I know..  Buffett does not like using the Black-Scholes model for long term options...Perhaps, he sold Bank of America's managers on the idea of using the famous Buffett-Munger long term option value model to derive a value of zero for these options...) Netting the $ 3 billion value of the options out of the $ 5 billion investment in the preferred stock makes it a $ 2 billion investment, on which $ 300 million is being paid in dividends. That works out to an effective dividend yield of 15% on the investment. By exercising his veto power over dividends and stock buybacks, Buffett can ensure that he is always the first person to be paid after debt holders in the firm. To cap it off, Berkshire Hathaway will be able to exclude 70% of the dividends received from Bank of America in computing taxable income (this is the rule with inter-company dividends), when paying taxes next year.   That is an incredibly sweet deal! 

What did Bank of America get out of this deal? Let's look at what it did not get first:

1. It did not get Tier 1 capital (the most stringent measure of bank capital), which includes only common equity, and thus does not get any stronger on that dimension. (Update: I have been getting mixed responses on this issue from those who are well versed in bank regulatory capital rules, some saying that I am right and others that I am wrong. The fact that it is cumulative preferred stock, according to some, makes it ineligible for Tier 1 capital, whereas others note that Citi was allowed in 2008 to count cumulative preferred as Tier 1. Here is one article that seems to provide clarity  on the topic. My final response. Whether this passes the regulatory rule requirement or not, it does not pass the common sense rule for Tier 1 capital. If financing results in a commitment of $ 300 million each year that you have to meet, or roll over, it cannot be true Tier 1 capital, no matter what the rules say... )


2. It gets no tax deductions, since preferred dividends are not tax deductible. So, the $ 300 million in dividends will have to be paid out of after-tax income.


3. It risks losing flexibility on dividend policy and stock buybacks, as a consequence of the restrictions imposed on this deal.

The only conceivable benefit I see accruing from this transaction to the company is that Buffett has provided some cover for the managers of Bank of America to make two arguments: that the bank is not in immediate financial trouble and that it is, in fact, a well managed bank. I, for one, am not willing to accept Buffett's investment (or his words) as proof of either, and the way the deal is structured is not consistent with any of the arguments I have been hearing all day (from those who think it is good for Bank of America stockholders).

• First, let us assume that the bank is not in financial trouble and that the market has run away with its fears over the last few months. But, why would a bank that is not on the verge of collapse agree to raising capital at an after-tax rate of 15% and give up power over its dividend and buyback policy? And given the extremely generous terms offered to Buffett on this deal, how can this action be viewed as an indicator of good management? 


• Playing devil's advocate, let's look at the other possibility, which is that the bank has been hiding its problems and is in far worse shape than the rest of us think. If so, perhaps the terms of the deal make sense to Buffett (high risk/high return), but the deal still does not make sense to Bank of America. If the bank is in that much trouble, it should be raising tier 1 capital, and adding $ 300 million in preferred dividends to its required payments each year makes no sense. And, if it is in fact the case that the bank is in a lot more trouble that we thought, how can Buffett in good conscience then claim that BofA is a "strong, well-led company"?

Either the terms of deal are way too favorable to Mr. Buffett or he is not being forthright in his description of the company... In either case, this does not pass the smell test.

I know that there are some who are comparing Buffett's deal with Bank of America to his earlier deal with Goldman Sachs. But there is a key difference. The Goldman deal was entered into at the depths of the banking crisis, and in a period where liquidity had dried up, Buffett was providing capital. Even in that case, you could argue that Goldman Sachs paid a hefty price for taking money from Buffett to shore up their standing... Perhaps, this has become Buffett's competitive advantage. Rather than buy and hold under valued companies, which is what he used to do, he focuses on companies that have lost credibility and he sells them his credibility at a hefty price.  I know that Buffett has accumulated a great deal of trust with investors over the decades, but even his stock will run dry at some point in time, especially if he keeps dissembling after each intervention about the company, its management and his own motives.

In summary, is this deal good for Buffett? Absolutely, and I don't begrudge him any money he makes on this deal or the fact that the tax law may work in his favor. Does the deal make sense to Bank of America's stockholders? I don't think so, notwithstanding some of the cheerleading you are hearing from some equity research analysts and the market's positive reaction. Is Bank of America a "strong, well-led" company? Only if you have a very perverse definition of strong and well-led... 

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Trapped Cash: Measurement and Consequences

It is an open secret that US companies have accumulated huge cash balances over the last two years. In fact, there were a few mentions that Apple's cash balance of $76 billion gave it more cash than the US treasury a few weeks ago, and I did a post on a while back on whether Apple had too much cash. While this "sitting on cash story" is an interesting one, there is a sub-story that we need to pay attention to and that may affect how we value companies. Not all of cash balances are equally benign. In fact, a significant portion of the cash balance, at some companies, may be "trapped" and thus not easily accessible, either for investments or paying dividends.

What is trapped cash?

Trapped cash refers to the portion of a company's cash that is held a company that is held in fully-owned foreign subsidiaries or units of the company. Note that there is nothing illegal or even unusual about this phenomenon. All multinationals generate revenue, earnings and cash flows in foreign markets, and those cash flows are held (at least temporarily) in those markets. As US companies generate larger proportions of their revenues overseas, the cash flows they generate from foreign markets has also increased.

Why is it trapped?

There are four reasons why cash may be trapped in foreign subsidiaries:

a. Operating reasons: To the extent that there are significant growth opportunities in foreign markets (especially in Asia), the cash is being held in abeyance to cover investment needs in these markets. 

b. Foreign restrictions: In some markets, the country in question has put significant restrictions on remittances from that country back to the United States. To be fair, these restrictions are sometimes tied to incentives or favorable tax treatment offered to the company for investing in the country.

c. US tax laws: Income generated by US companies in foreign countries is first taxed by those countries, when it is earned. However, it is not subject to US taxes until it is remitted back to the United States, with foreign taxes paid allowed as a credit. Thus, if a US company generates $ 1 billion in taxes in China, it will pay the Chinese corporate tax rate of 25% on this income. When that income is remitted back to the US, the income will be taxed at the US corporate tax rate of 35%, with the $250 million in Chinese taxes paid already as an offset. The net tax paid to the US government at the time of remittance will therefore be $100 million. By letting the cash accumulate in the foreign subsidiary, the company will be able to delay paying taxes to the US government. Since the US has one of the highest marginal corporate tax rates in the world, cash accumulation in foreign subsidiaries is a given, with the accumulation being greatest in countries that have marginal corporate tax rates much lower than the United States.

d. Accounting: Adding to the tax law is a GAAP accounting requirement that US companies with foreign income recognize the US taxes that they would have to pay on that income, in the period in which the foreign income is generated (rather than wait for remittance). There is, however, an exception. If the company makes the assertion that it never intends to bring the cash back home, it does not have to recognize US taxes. Not surprisingly, many US companies make this assertion to reduce taxes paid on income statements (and increase after-tax income).

Thus, there is both a cash flow and a reported earnings rationale for holding cash in foreign subsidiaries and the cost of remittance will increase over time, as the foreign cash balance increases.

How big is the trapped cash balance?

There are estimates floating around the blogosphere that put the total trapped cash well in excess of a trillion; a JP Morgan Chase analyst report estimated that 519 US multinationals alone accounted for about $1.4 trillion in trapped cash. The truth is that no one has a precise estimate because US companies are not required to reveal how much of their cash is held in foreign subsidiaries. There are three ways of estimating the amount of trapped cash:

a. Public reports: While companies are not required to break out their trapped cash, some companies do so voluntarily. For instance, Apple in its most recent 10K explicitly broke out the portion of its cash balance that was held overseas; it specified that more than $30 billion was invested overseas (Update: It is estimated that $41 billion of Apple's cash balance of $76 billion in mid-2011 is invested in foreign units). You could extrapolate from the numbers reported by these companies to the rest of the market. Thus, if 55% of the cash balances at companies that report foreign cash balances explicitly is trapped cash, you could assume that a similar proportion applies to companies that are not explicit. The danger, of course, is that companies that are not explicit about their cash holdings may be very different in their behavior than firm that are.

b. Operating exposure: Companies do report what proportion of their revenues and operating income is generated in foreign markets, In 2010, for instance, S&P estimated that 46.3% of revenues of the S&P 500 companies were generated overseas. One could argue that 46.3% of the cash balances of these companies are trapped, though that requires heroic assumptions about earnings and cash remittances at these companies.

c. Effective tax rates: If we assume that companies that trap cash in foreign subsidiaries also adopt the consistent accounting rule (of asserting that they do not plan to bring that cash back to the US), the effective tax rate of a company should provide some information on its cash trapping practices: the more cash that is being trapped in foreign subsidiaries, the lower the effective tax rate for the company should be.

No matter how you measure the magnitude of the trapped cash, we know that it is a very large number. How? Well, companies are spending millions of dollars lobbying Congress to change the tax laws on remittances and they would not be doing this, if there were not billions at stake.

So, what if cash is trapped?

Now, to the billion dollar question. Why does it matter whether cash is trapped or not? Put in more general terms, does this trapped cash have any consequences for corporate finance, valuation and the general well-being of US companies? I think it does and here are some reasons why:

a. Trapped cash may be wasting cash: In most valuations, we treat cash as a neutral asset, i.e., we value a dollar of cash at a dollar and add the cash balance on to the value of operating assets to arrive at firm value. However, cash is a neutral asset only if it earns a fair market return, given the risk and liquidity of the investment. Investments in treasury bills and commercial paper may earn a low rate, but a fair rate, of return and are thus neutral investments. Cash trapped in some emerging markets may not be as easily invested in fair market return investments. In fact, it is possible that the closest selection to a liquid, risk less investment is a bank deposit delivering interest income much lower than justified. That cash will have to be discounted and the value of the firm will decrease as a consequence.

b. Trapped cash may create financial constraints (and costs): It is possible that a company that has significant portions of its cash trapped in other markets may have to raise new financing (debt or equity) to carry out transactions or worse still, not take good investments because it does not have the capital available to do so. Thus, you may have the oddity of a company like Google with $20 billion in a cash balance issuing $ 3 billion in bonds to make an investment. The value of the firm will be reduced by the transactions costs associated with the new financing (if new financing is raised) or the value lost by turning down good investments (if investments are rejected).

c. Trapped cash may induce "bad" investment decisions: Companies with significant trapped cash may jump at the chance of using that cash, even if the investments taken offer sub-par returns. The defense will be that they have nothing better to do with the cash. This is the rationale that was offered by some for Microsoft's acquisition of Skype, a Luxembourg based company that allowed Microsoft to use up $8.5 billion of its trapped cash. I have argued earlier that Microsoft over paid for Skype. The fact that they were able to use trapped cash is small consolation and does not alter the value destructive aspects of that transaction.

How can this cash be released?

If you accept the premise that trapped cash can be value destructive, at least for some companies, then the question becomes one of how best to "untrap" this cash. Here are the options:

a. The punitive solution: The tax law can be changed to require that all income generated by US-based corporations will be taxed at the US tax rate, when the income is generated, even if it is in foreign subsidiaries. While this solution may be appealing to those angry at corporations, it will be counter productive and may very well backfire. In particular, note that a multi-national does not need to be US-based and it is conceivable that many multi-nationals will chose to switch their incorporation to a more benign tax regime rather than pay billions more in taxes each year.

b. The benign solution: The tax law can be changed to eliminate the "differential tax" (reflecting the difference between the US corporate tax rate and the foreign corporate tax rate) when income is remitted back to the United States. That will eliminate both the tax and the accounting rationales for trapped cash but will be a tough sell politically.

c. The bad solution: The worst solution to adopt is one that provides the illusion of being punitive without the tax revenues to go with the punishment. That is effectively what we have right now, where remitted income is subject to a differential tax but where every decade or so, we have a tax holiday where companies are allowed to bring trapped cash home without paying the differential tax. 

What do I see happening? I think that there will be a tax holiday, either explicitly or implicitly allowing companies to bring trapped cash home without the differential tax bite (or at least a fraction of the tax bite). The legislation will be accompanied by face saving adjuncts: a requirement (toothless and unenforceable) that companies that bring home cash invest in "job creating" investments and a promise that this will be the last tax holiday ever (Yeah... right...) The stock price impact of the legislation will be minimal even for companies with large trapped cash balances. The day after the tax holiday firms will go back to accumulating more foreign cash and waiting for the next tax holiday.

If the cash is released, what will happen?

As talk of a tax fix fills the air, proponents of the tax holiday are already thinking about what they see emerging in the aftermath, with each group seeing their preferred option winning out.

1. The first group believes that the freed cash will be used by companies to make new investments and "create jobs". In my view, that's not going to happen! US companies have plenty of cash on hand already and are not taking new investments. Why would adding to the hoard change that? The roots for sagging real investment in the US are in a stagnant economy with excess capacity on most fronts, where good investments are scarce. I know that there is talk of linking a change in the tax law to "forced investment", where firms will have to invest remitted cash into job-creating investments to qualify for the tax benefits. That will create more harm than good.


2. The second group is convinced that they will see stock prices pop up for companies with significant cash balances, as the discounts that markets have applied to the trapped cash disappear. That too is a misconception. To the extent that the expectation that the tax law will be changed has already been built into market prices, the actual change (if and when it happens) will not be a surprise. 


3. The third group sees the released cash as potential dividends and buybacks. History suggests that they have some reason to be optimistic, since that is exactly what happened the last time there was a tax holiday for foreign cash. While the higher dividends and buybacks will increase cash returned to stockholders, it will be partially (or perhaps even fully) offset by a decrease in equity value as cash leaves these companies.

In summary, a tax holiday is likely to be a non-event for markets and have little impact on corporate investment or economic growth. 

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Momentum versus Contrarian: Two Reads of the ERP

I am not much of a market timer but there is one number I do track on a consistent basis: the equity risk premium. I follow it for two reasons. First, it is a key input in estimating the cost of equity, when valuing individual companies. Second, it offers a window into the market mood, rising during market crises.

For the ERP to play this role, it has to be forward looking and dynamic. The. conventional approach of looking at the past won't accomplish this. You can however use the current level of the index, with expected cashflows, to back out an expected return on stocks. (Think of it as an IRR for equities.) You can check out the spreadsheet that does this, on my website (http://www.damodaran.com) on the front page.Here is the link for the July 1 spreadsheet. Just replace the index and T.Bond rate with the current level and use the Goal seek in excel:
http://pages.stern.nyu.edu/~adamodar/pc/implprem/ERPJune11.xls

A little history on this "implied ERP": it was between 3 and 3.5% through much of the 1960s, rose during the 1970s to peak at 6.5% in 1978 and embarked on a two decade decline to an astoundingly low 2% at the end of 1999 (the peak of the dot com boom). The dot com correction pushed it back to about 4% in 2002, where it stagnated until September 2008. The banking-induced crisis caused it to almost double by late November 2008. As the fear subsided, the premium dropped back to pre-crisis levels by January 2010. I have the month-by-month gyrations on my site, also on the front page.
http://pages.stern.nyu.edu/~adamodar/pc/implprem/ERPbymonth.xls

Now, to the present. The ERP started this year at 5.20% and gradually climbed to 5.92% at the start of August. Today (8/8/11) at 11.15 am, in the midst of market carnage, with the S&P 500 at 1166 and the 10-year T. Bond at 2.41%, the implied ERP stood at 6.62%.

So what? If you are a contrarian, you could view this as an opportunity: a return to past norms (4-5% ERP) would translate into a 30-40% jump in the index). If you are a momentum investor, you see the thundering herd and join in, selling short or buying puts. If you are a fence sitter, you are liquidating your stocks and holding cash, waiting for steady state (which may be a long time coming). My last post should provide enough clues as to where I stand but if you are in one of the other camps, I will not try to convert you. Different strokes for different folks!

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