"Kee" Points with Jim Kee, Ph.D.


  • Spain and Europe  
  • Corporate Tax Reform
  • How Should Companies Spend Their Money?
  • Regulation
  • Banking: An Example



Spain and Europe 

Catalonia voted in favor of independence from Spain on Sunday. This was actually a follow up vote to a 2014 referendum on the same topic, which was declared illegal by the Spanish Constitutional Court (as was this one). This time there was a large clash between Spanish police and referendum supporters, and the current situation is a standoff of sorts between Catalonia (led by Carlos Puigdemont) and Madrid (led by Mariano Rajoy). My understanding is that the Catalans feel that they are subsidizing the southern provinces of Spain, sending more money in taxes to Madrid than is being invested in Catalan schools, roads, public services, etc. (that was also a theme in recent German elections, as many Germans feel that they too are bailing out profligate EU partners). So far European stocks as a whole were down just a little, with the Spanish stock index down over 1%.


Broad-based Impact of Corporate Tax Reform Proposals 

In the US, stocks continue to climb higher and remain in record territory, fueled no-doubt by corporate tax reform discussions. There is an interesting angle to this that helps explain some of the market’s enthusiasm. According to data from Credit Suisse HOLT, Information Technology and Healthcare sectors have the lowest effective tax rates, and part of this is because they are more research and development (R&D) intensive. To understand this, think about how firms grow or reinvest in their businesses. A steel company, for example, will build a new steel mill, which is accounted for in their financial statements as Plant, Property, and Equipment. Even if the company incurred this expense all in one year, it cannot count the whole mill at once as an expense and deduct it from its sales for the purposes of estimating taxable income. Instead, the company has to “depreciate” or charge off just a portion of the investment each year, meaning it has to spread the deduction for the full expense over multiple years. That means its taxable income is higher in current years than if it could subtract the entire cost of the plant during the year in which it was incurred (which would be “100% expensing”). 


In contrast, when information technology and healthcare companies (particularly pharmaceuticals and biotechnology companies) tend to grow or reinvest in their businesses, they spend more on R&D. But unlike the steel mill, under current accounting rules R&D expenditures are expensed, or subtracted during the year in which they are made, not depreciated over time. This is one of the reasons why these companies tend to have lower effective tax rates, where “effective” means the rate they actually pay after deductions, in contrast to the “statutory” rate which is the rate they would pay before deductions.


Thinking about the above for a minute, tax reform would seem to favor “older economy” types of companies or industries that invest in tangible assets and depreciate them over time. They pay higher tax rates. So why would Information Technology and Healthcare sector stocks also do well whenever enthusiasm for tax reform excites markets?  Because there is also a lot of talk about reducing taxes on income earned overseas, something I talked about last week. Over half of the cash held by S&P 500 companies is sitting overseas, and a lot of that is in Information Technology and Healthcare sector companies (e.g. Apple, Microsoft, Johnson & Johnson, Amgen, Gilead, etc.). A tax cut on profits made oversees and repatriated or brought back to the US would benefit these companies the most. So the bottom line is that there are potential tax benefits for companies in a variety of industries or sectors under current tax reform proposals.


How Should Companies Spend Their Money?  

Part of the discussion of cutting taxes on repatriated earnings centers around whether the tax cuts should be contingent upon how the company uses the money. The last time there was a “repatriation tax holiday,” companies used the money earned oversees and brought back (i.e. “repatriated”) to buy back shares and make acquisitions, with capital spending (a desired policy goal) increasing only to a much lesser extent. Also, since the repatriation tax holiday was temporary rather than permanent, the cash just built up again over time, which is why we are back in the same predicament. I would argue that the market will decide the best use of cash: if companies buy back stock or pay higher dividends, those funds will find their way into capital spending and hiring if the environment favors it. Plus, some of these companies have underfunded pension plans, so workers in those firms would probably like to see the cash used to shore up pension benefits. And if it makes sense to do it at all, it makes sense to think about doing it on a permanent basis. In the end, the exact impact on individual companies will depend upon unknown details regarding deductions, depreciation schedules, etc. We at STMM have both the data and the analytical expertise to figure out the impact of policy changes on individual company profits; at least as difficult, in my opinion, is figuring out what the market has already priced in.  


Regulation 

On the topic of an environment that favors capital spending and hiring, Jefferies’ strategist Jeff Zervos made the case last week (at an investment conference hosted by USAA) that policy makers are sending a message to a lot of businesses that they do not need to be as concerned with regulatory burdens as they have been in the past, i.e, the regulatory direction has changed. Zervos argued that this tailwind of deregulation is the largest fundamental change to the equity markets as a result of the presidential election. In this Zervos echoes ex-India central bank governor, Raghuram Rajan. As an interesting aside, Zervos argued that large corporate profits have been sourced or derived from regulatory barriers to entry, which keeps competitors from entering an industry and competing away these profits. Specifically, he argued that excessive regulation has suppressed this competition, citing as evidence the fact that the rate of entrants and exits are both at 40-year lows. That would partially explain why operating margins are near historic highs, but it wouldn’t explain the obsession with lowering costs. That is usually a response to the pressure of competition, not a lack of it. 


Banking: An Example 

Savita Subramanian (BofA-Merrill-Lynch analyst) has pointed out that regulatory and compliance costs are accounting for up to 25% of the total costs for the six largest money center banks. A major cost contributor has been consultants tasked with deciphering CCAR (Comprehensive Capital Analysis and Review) regulations. At BofA-Merrill Lynch Global Research, for example, there are more compliance individuals than analysts in the research department. In other words, there are more people telling them what they can and cannot write than individuals actually doing the research and writing (in the words of our own Michael Nance, who covered this talk at the same USAA conference).