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We have now discussed all violations from the assumptions necessary for our perfect market Utopia. So, what are we doing now? If you return to our perfect markets assumptions, you will see that “no inflation” was not among them. Inflation is the process by which goods cost more in the future than they cost today—in which the price level is rising and money is losing its value. So, inflation is actually not a market imperfection per se. If today we quoted everything in dollars, and tomorrow we quote everything in cents—so that an apple that cost 1 currency unit today will cost 100 currency units tomorrow, an inflation of 10,000%—would it make any difference? Not really. The apple would still cost the same in terms of foregone other opportunities, whether it is 1 dollar or 100 cents.
However, we have made a big assumption here—inflation applied equally to everything, and especially applied equally to all contracts across time. See, if you had contracted to deliver apples at 1 currency unit tomorrow, whatever currency units may be, you could be in big trouble—you would have promised to sell your apples at 1 cent (1 currency unit) instead of $1. Most financial contracts are denominated in such “nominal” terms—that is, in plain currency units—so inflation would matter. Of course, inflation would not be much of a concern for a financial contract that would be “inflation-indexed.”
February 19th, 2010 in
Uncategorized |
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In many situations, the IRS does not allow reinvestment of funds generated by a project without an interim tax penalty. This can be important when you compare one long-term investment to multiple short-term investments that are otherwise identical. For example, consider a farmer in the 40% tax bracket who purchases grain that costs $300, and that triples its value every year.
• If the IRS considers this farm to be one long-term two-year project, the farmer can use the first harvest to reseed, so $300 seed turns into $900 in one year and then into a $2,700 harvest in two years. Uncle Sam considers the profit to be $2,400 and so collects taxes of $960. The farmer is left with post-tax profits of $1,440.
• If the IRS considers this production to be two consecutive one-year projects, then the farmer ends up with $900 at the end of the first year. Uncle Sam collects 40% ·$600 = $240, leaving the farmer with $660. Replanted, the $660 grows to $1,980, of which the IRS collects another 40% ·$1, 980 = $792. The farmer is left with post-tax profits of 60% ·$1, 980 = $1, 188.
The discrepancy between $1,440 and $1,188 is due to the fact that the long-term project can avoid the interim taxation. Similar issues arise whenever an expense can be reclassified from “reinvested profits” (taxed, if not with some credit at reinvestment time) into “necessary maintenance.”
Although you should always get taxes right—and really know the details of the tax situation that applies to you—be aware that you must particularly pay attention to getting taxes right if you are planning to undertake real estate transactions. These have special tax exemptions and tax depreciation writeoffs that are essential to getting the project valuation right.
October 13th, 2009 in
Tax Timing | tags:
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In the United States, there are bonds that are issued by governmental entities, whose interest payments are legally tax-exempt—the reasoning of the federal government being that it does not want to burden states’ or local governments’ efforts to raise money. If you own one of these bonds, you do not need to declare the interest on your federal income tax forms, and sometimes not even on your state’s income tax form, either. (The arrangement differs from bond to bond.) The most prominent tax-exempt bonds are called municipal bonds or muni bonds or even munis for short. As their name suggests, they are usually issued by municipalities such as the City of Los Angeles (CA) or the City of Canton (OH).
On May 31, 2002, the Wall Street Journal reported on Page C12 that tax-exempt municipal 7-12 year highly rated bonds (AA) offered an annualized interest rate of 5.24%. Bonds of similar risk issued by corporations offered an interest rate of about 6.76%. Which one would be a better investment for you? Well, it depends.
If you invested $1,000 into munis at a 5.24% interest rate, you would receive $52.40 at year’s end. You would get to keep all of it, because these bonds are tax-exempt. If you invested $1,000 in taxable bonds at a 6.76% interest rate, you would receive $67.60 at year’s end. If your income tax rate is 0%, you would clearly prefer the $67.60 to the $52.40. However, if your marginal income tax rate is 30%, Uncle Sam would collect $20.28 and leave you with $47.32. Your after-tax rate of return is rpost-tax = (1 − 30%) · 6.76% = 70% · 6.76% ≈ 4.73% rpost-tax = (1 − τ ) · rpre-tax.
In one sense, taxes are very similar to transaction costs—they take a “cut,” making investments less profitable. However, taxes are often orders of magnitude bigger and thus more important than ordinary transaction costs and—except for illustrative examples—you should not simply assume them away, which is quite different from what you can sometimes do with transaction costs. (Ignoring taxes may be a good assumption for the tax-exempt Red Cross, but probably not for you or for the ordinary corporation!) Another difference between taxes and transaction costs is that taxes are higher on profitable transactions, whereas plain transaction costs do not care whether you made money or lost money. In addition, taxes often have many more nuances.
We now try to understand better how to work with income taxes.
September 28th, 2009 in
Taxes | tags:
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tax,
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On March 17, 1997, the ADT soap opera came to an end. On that day, Tyco International, a diversified company seeking to expand its security alarm operations, offered to buy ADT for $28 in stock. That $28 takeover bid represented an 86 percent premium over the original recommended price of $15 just 1 year earlier, a recommendation that was touched off by a seemingly innocuous news item about Laidlaw selling a portion of its ADT stake to a midwestern utility company, Western Resources. Although the vast majority of investors and Wall Street analysts completely missed the significance of that news item, new paradigm thinkers would have immediately recognized it and realized that ADT was “in play” as a potential takeover target. And although ADT rose 86 percent over the next year, the handful of investors who followed the ADT story would have had numerous opportunities to add to their ADT stake along the way, sometimes at prices below which Western Resources had paid for the stock on the open market. As more evidence accumulated that ADT would be acquired, a perfectly efficient stock market should have removed such bargain-purchase opportunities from the equation; instead the opposite occurred. As it became more obvious that ADT would be bought by someone, the stock market offered additional lower-priced entry points for those who were becoming increasingly convinced that a takeover would occur. ADT eventually rose to $33 as Tyco stock moved higher.
Wall Street has become obsessed with short-term performance, and traders seem more interested in short-term swings and buying stocks with momentum than they are in positioning themselves for a solid profit over time. As a result, what you will find in these ongoing, drawn-out takeover situations is that when several weeks or months go by without a new development, interest in these takeover candidates seems to wane. Much like a child with too many toys will quickly lose interest in one toy and move on to the next, for Wall Street there’s always a new story, always another stock moving. The “hot” money, obsessed with short-term performance, can quickly lose interest in a takeover situation that temporarily runs out of steam. When the “hot” money sells to move into something temporarily more exciting, it creates buying opportunities in the genuine takeover candidates for those with the insight, foresight, and patience to take advantage of these opportunities.
So it’s not just the 120 percent you could have made in ADT if you’d bought the stock at $15 in March 1996 and tendered to Tyco International at $33 a year later that is significant, but also the fact that if you were thinking like a “takeover detective,” you would have become increasingly confident along the way that ADT would be bought, and you could have added to your position with confidence at several junctures prior to the final takeover bid. Even if you had paid higher prices than your original $15 purchase price, you would have been doing so based on much more evidence of a probable bid at much higher prices.
And, of course, the best part of the ADT story was that ADT turned out to be a superstock. It would not have mattered what the stock market was doing between March 1996 and March 1997, because ADT was on its way tofinding its proper value as a business.
Instead of being tossed about by the whims of the market, responding to analysts’ estimates and interest rate movements, ADT was being analyzed as a businessby three potential acquirers. And eventually that bid by Tyco forced the stock market to place a realistic value on ADT as a business.
In other words, ADT would have gone from $15 to $33 even if the stock market had gone sideways or down during that period of time, and that is the reason for spending so much time and effort looking for superstocks.
September 22nd, 2009 in
takeover | tags:
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During the discussion of the Rexel Inc. takeover, you learned how many opportunities a patient, informed investor can get to buy a genuine takeover candidate at bargain prices, even as additional evidence of an imminent takeover bid accumulates to enormous proportions. The reason for this apparent defect in the “efficient market” theory is that information is only properly discounted when the Wall Street powerhouses are paying attention. Mutual funds, pension funds, and other institutional investors do indeed take all new information immediately into account when the information involves the large-cap stocks these institutions, and the analysts who serve them, are following with the precision of an electron microscope.
But when it comes to smaller-cap stocks that are not on the institutional radar screen, you can throw the efficient market theory right out the window.
By July 26, 1996, Western Resources owned 24 percent of ADT and there was a $26 takeover bid on the table from Republic Industries. That $26 bid involved Republic Industries stock, however, which had been weak since the takeover bid was announced. As a result, on July 26, 1996, an investor following the ADT story could have bought ADT for—would you believe it?—$173⁄4. The reason for this price disparity was that Republic shares had begun to slide. As a result, ADT shares fell along with Republic, since the agreement was that Republic would exchange .928 of its shares for each ADT share. Also contributing to weakness in ADT was a general question over whether this deal could ever take place. Why? Because neither ADT nor Republic thought it important to check with Western Resources, which owned 24 percent of ADT.
You heard it correctly. Republic Industries and ADT had entered into a takeover agreement without bothering to seek the blessing of Western Resources, owner of 24 percent of ADT. In response to the Republic–ADT agreement, Western said only that it was “exploring its alternatives.”
The intent of that statement was probably an indication that Western Resources had intended to ultimately buy the rest of ADT, and its management was angry about not being consulted about the deal. Also, it was highly unlikely that Western Resources would accept shares of Republic Industries for its stake in ADT, because Republic shares carried with them a substantial “personality premium,” based on the popularity of Wayne Huizenga.
At this point, most Wall Street commentators were saying it would be impossible for Western Resources to mount a competing bid for ADT. Was it impossible? Not necessarily, but another possibility was that Western Resources would find another buyer for ADT who was willing to pay cash or stock with a more stable or reasonable value than Republic Industries. Athird possibility was for Western Resources to force Republic to substantially increase its offer in light of the decline in Republic shares. All three of these scenarios should have resulted in a sharp rise in ADT shares from their trading level of $17 to $18—a price level lower than where ADT traded prior to the Republic bid! Yet another possibility was for Western to simply oppose the merger but do nothing but vote against it—possible but unlikely considering Western’s aggressive personality.
Finally, the Republic Industries–ADT agreement carried with it an unusual arrangement that seemed to indicate that both Republic and ADT were actually expectinga higher bid: ADT granted Republic a warrant to purchase 15 million ADT shares at $20 if the agreement was terminated for any reason. This, by the way, is another reason why Western Resources was understandably miffed. In effect, it meant that anybody making a competing bid for ADT at any price over $20 had to buy 15 million additional shares and hand Republic Industries an instant profit. Why would ADT and Republic agree to such a warrant unless they both felt that a competing bid from Western Resources or someone else was possible?
Now, a reasonably perceptive superstock observor would have to say that the Republic bid for ADT appeared to be only the opening salvo in a bitter war for control of ADT. Based on what you’ve observed of Western Resources to this point, you would probably have agreed it was highly unlikely that Western would simply hand ADT over to Republic Industries and simply abandon its plans to become a security alarm powerhouse without at least putting up some semblance of a fight.
And you would expect that a “perfectly efficient stock market” would have processed all of this public information and decided that ADT should be selling perhaps in the low to mid $20 range, especially in light of the fact that Republic had already offered $26 in stock to acquire the company.
Because of the drop in its own stock price by early October 1996, Republic Industries had withdrawn its bid for ADT, and ADT shares had dropped back to $18, following a brief run up toward the $22 area. This provided yet another opportunity for savvy investors to buy ADT stock at a significant discount to the $19.75 price Western Resources had paid for part of its 1.3 million share purchase just a couple of months earlier. Republic withdrew its bid even though Western had not uttered one public comment on the Republic–ADT takeover deal. But, Western really didn’t have to say anything to Republic. Western’s purchase of an additional 1.3 million shares of ADT in August, after the Republic bid was announced, was Western’s way of saying: “Get lost.”
Sure enough, just 1 month later, Western Resources purchased another 1.3 million shares of ADT in the open market, this time paying between $181⁄4and $19. ADT shares once again rose above $20, but just barely, trading around $203⁄4.
Now, those of you who are thinking, “Aha! Acreeping takeover!” can go to the head of the class. By saying nothing and continuing to accumulate ADT shares well below $20, Western Resources was creating a situation in which the final price it would pay for ADT would be lower. The more shares Western purchased before making a formal bid, the less it would ultimately have to pay for the entire company. To anyone trained to think like a takeover detective—in other words, trained to think in superstock paradigm terms—it was perfectly obvious what Western Resources was up to as it continued to buy ADT shares on the open market while saying nothing about the Republic bid or its own intentions.
Finally, after buying another 209,500 ADT shares at the end of October at $193⁄4, Western Resources made its move: Western offered $22.50 per share for ADT, making the offer in a hostile manner (surprise!) directly to ADT shareholders and completely bypassing ADT management. In addition, Western called for a special ADT stock-holders meeting to replace the ADT Board of Directors. This move was just what you would have expected from Western Resources in light of the company’s hostile takeover bid for Kansas City Power & Light and also in light of the arrogant and cavalier manner in which ADT had disregarded Western’s interests when it accepted the Republic takeover bid.
Ahostile bid from Western Resources, in other words, should have come as no surprise to any new paradigm thinker who had been following this situation. Western’s anger, by the way, was evident in the fact that its $22.50 takeover bid was significantly less than Republic’s previous $26 bid. In fact, Western’s bid was so stingy that we advised subscribers to hold ADT based on the possibility that Western Resources would raise its bid or that the situation would turn so hostile that ADT would find a competing bidder.
And once again, subscribers were reminded that two other smaller security alarm companies, Protection One and Holmes Protection, could also get caught up in the takeover frenzy in this industry.
On July 1, 1996, ADT became a superstock, jumping 51⁄2points in one day, to $241⁄2, on news that ADT had received a takeover bid. That 51⁄2-point one-day gain amounted to a 29 percent gain on the day and a 63 percent gain from the original recommended price of $15 just 4 months earlier.
But the takeover bid for ADT did not come from Western Resources. Instead, it came from Republic Industries, a company run by Wayne Huizenga, who had previously built both Waste Management and Blockbuster Entertainment into major growth companies. Republic Industries had determined that it too wanted to be a leader in the home security business. The takeover bid for ADT was valued at $26, a 73 percent gain over the original recommended price. Western Resources was strangely silent over the Republic Industries bid from ADT. And the strangest twist in this story was yet to come.
An example of this approach is ADT Ltd., a security alarm monitoring company.
In February 1996 a small news item appeared about ADT Ltd., which at the time was the largest home security alarm company in the United States. The news item did not seem to raise any alarm bells on Wall Street. It seemed that Laidlaw Inc., a Canadian company that owned approximately 24 percent of ADT, had agreed to sell half of its ADT stake to a Kansas-based utility company, Western Resources, for $14 per share, roughly the price at which ADT shares were trading on the New York Stock Exchange. As part of the deal, Laidlaw had also granted Western Resources an option to buy the other 12 percent of ADT owned by Laidlaw by May 15, 1997.
One additional interesting part of the new item: ADT was actively attempting to sell its automobile auction business, which accounted for about 27 percent of its revenues. As you learned earlier, companies that sell or spin off “noncore” operations are often preparing to sell themselves as a pure play to a larger company. So the fact that a block of ADT shares had been sold to a third party, combined with the fact that ADT was setting itself up as a pure play, added up to this conclusion: ADT was about to be “in play” as a genuine takeover candidate.
My first response to this news item was to do a little research on Western Resources. Why would a midwestern utility want to buy a 24 percent interest in a security alarm company?
The answer was intriguing. Wester Resources, formerly Kansas Power & Light, was seeking to diversify into the nonutility business. In fact, recent press releases from Western Resources indicated that the company had publicly stated it was thinking of expanding into the home security alarm business through acquisitions.
Western Resources had already told Wall Street that it was seeking to buy security alarm companies. Following this public statement, Western purchased a 12 percent interest in ADT from Laidlaw at $14 and held an option to buy another 12 percent. And yet, ADT shares were sitting right there, in the $14 to $15 range, as though nothing fundamental had changed as a result of these two separate, but related news items.
ADT became part of the master list of recommended stocks in our Superstock Investor newsletter.
At the time, some utilities, including telephone companies, viewed home security companies as a cost-efficient “add-on” service. Due to these supposed economies of scale in a utility acquisition of a home security company, it seemed logical for Western Resources to eventually exercise its option to buy Laidlaw’s remaining 12 percent of ADT and then to make a bid for the rest of the company. The same reasoning suggested that two smaller companies, Protection One (ALRM), then trading near $11, and Holmes Protection (HLMS), then trading below the $8 area, were also potential takeover targets. This analysis of the security alarm industry provided a detailed road map for investors for an upcoming takeover wave in the security alarm industry.
By mid-March Western Resources had exercised its option to purchase the additional 12 percent of ADT owned by Laidlaw at $14.80 per share. It was not expected that Western Resources would buy the additional 12 percent of ADT so soon, but since the option exercise price related to ADT’s market price, Western Resources may have acted as quickly as it did because they thought ADT shares would move higher.
In May 1996 a rather curious development took place: ADT’s management team had exchanged their low-priced ADT stock options (with an exercise price of $9 per share) for a larger number of higher-priced options (exercisable at $15 per share).
In effect, ADT management exchanged a guaranteed profit for a chance to make more money, but only if ADT rose significantly above $15.
Why did they do it? To me, there was only one possible conclusion: ADT management expected the company to be acquired at a price much higher than $15. And yet despite this growing evidence that ADT was about to be acquired at a price much higher than $15, you would have had no problem buying ADT shares in the $16 to $17 range. Following my ADT update, subscribers were once again reminded that Protection One (then trading at $73⁄4) could also get caught up in a takeover wave involving security alarm companies. On March 16, 1996, CNBC’s Dan Dorfman reported on the recommendation of ADT as a takeover candidate. At the time, ADT shares had drifted back toward the $16 area again, demonstrating once again that it is surprising how many chances you will receive to buy underfollowed stocks at bargain prices even when takeover storm clouds are obviously gathering overhead.
In a May 3 report an item was included about a hostile takeover bid that Western Resources had just made for Kansas City Power & Light. It was reported that Western’s bid for Kansas City Power & Light was unsolicitated and that it disrupted a friendly merger agreement that had already been negotiated between KCP&Land another company. Western Resources had entered into an aggressive acquisition mode. One of the tricks to picking genuine takeover candidates is to look for companies that are already partly owned by other companies and have demonstrated they are in an acquisition mode. Western Resources’ unsolicited bid for Kansas City Power & Light was a clear signal that Western was looking to grow through takeovers.
This observation demonstrates another strategy of picking takeover targets: It pays to know the track record of the outside beneficial owners. Just as our experience with Rexel S.A. and Rexel Inc. led us to the takeover of Brylane, this hostile bid by Western Resources for Kansas City Power & Light was a strong clue that Western Resources was in high-gear acquisition mode, and that should it want to buy ADT, would not easily take no for an answer. Next, ADT announced a 5 million share buyback, another
Telltale Sign that ADT was seriously worried about a takeover bid at an unreasonably low price. Remember the Telltale Sign: When a company whose stock is being bought by a third-party “beneficial owner” announces a stock buyback, it is usually a strong signal that (1) the company is worried about a takeover, and (2) the company believes its stock is severely undervalued and the potential acquirer will attempt a “low-ball” bid that might be above the current market price but still below the true value of the company as a business.
Both Western Resources and Kansas City Power & Light ran amazingly hostile advertisements about one another in The Wall Street Journal, again indicating Western Resources was in an aggressive acquisition mode. This type of aggressive action made an eventual bid for ADT all the more likely.
By this time ADT had crossed the $18 level and was trading at $181⁄8, up 20 percent in less than three months since the news that Western Resources had bought 12 percent of ADT from Laidlaw.
