What follows is the “Looking Ahead” portion of my monthly letter to investors at T11. I have created an email list that sends this report out at the beginning of each month to those interested. The full report contains commentary about the general markets and individual positions held in managed portfolios, as well as overall performance. To be added to the list email me at mail@T11Capital.com
It goes without saying that U.S. corporations have become increasingly profitable over the past several years, generating record profits that seem to have a great deal of longevity following the efficiencies brought about by the financial crisis. Hand in hand with the record corporate profits has come a determination by corporations to use every tax loophole possible to either avoid or reduce what is the highest corporate tax in the world at 35%. When you take into account local and state taxes, corporations are paying upwards of 40% to the government.
What has become increasingly popular over the past few years is a practice called a corporate inversion, where a U.S. based corporation re-registers outside of the U.S. through a merger or acquisition. The most recent case of a corporate inversion was on June 16th, with Medtronic and Covidien. The merger then causes the company to become domiciled offshore, allowing the corporation to access cash that is generated through foreign subsidiaries.
Repatriating large amounts of cash that companies such Apple, Google, Medtronic and Pfizer have stashed offshore incurs massive tax liability that most corporations are unwilling to take on. As a result, a corporate inversion will allow the company to redomicile and repatriate the funds without much of a tax liability at all.
Research firm Audit Analytics recently estimated that the amount of profit being moved offshore by U.S. corporations has risen by 70% in the last five years, hitting $2 trillion in 2013.
What this says is that U.S. corporate management is more infatuated than ever, not just with operational efficiency, but also tax efficiency as a means of creating the bottom-line results that shareholders demand.
The future of tax avoidance by U.S. corporations is murky, however, as Congress has caught onto the amount of governmental revenue being lost. Just recently, Senator Carl Levin proposed a bill to all but stop corporate inversions through a set of rules that would effectively close the loophole.
According to Bloomberg: “The bill would consider inverted companies to be domestic for U.S. tax purposes if executive control remains in the U.S. and if 25 percent of sales, employees or assets remain in the U.S. The measure would be retroactive to May 8 and be in place for two years while Congress considers broader tax-code changes.” While the bill is considered unlikely to go through, it is simply a matter of time before Congress tightens this loophole as corporations increasingly become “tax conscious” in the face of a waterfall of profits.
With offshore loopholes eventually to be tightened, within an environment that has become increasingly tax conscious, if not completely tax averse, the next obvious step for U.S. corporations will be creative strategies that utilize loopholes that have not yet drawn the ire of Congress or any other public officials, for that matter.
It is with this mind that I am increasingly fond of NOL shell plays as a domestic tax haven that will become increasingly creative in nature, with structures and strategies taking place that are led primarily by private equity and hedge funds. There are already a host of corporations that have taken advantage of the large amount of NOLs created by the financial crisis. The most obvious and largest that comes to mind is AIG, a stock that is up over 100% since 2012, mostly as a result of tremendous profitability gained by over $25 billion in NOLs that were created during the financial crisis.
What is becoming increasingly en vogue is not just simply utilizing NOLs for the host corporation, but delivering NOLs from the host to a profitable recipient through creative merger or acquisition that is not meant to trigger IRS Section 382 limitations on the use of the NOLs.
In fact, by the time this decade is done, I believe that corporate exploitation of NOLs will be one of the great legacies of the financial crisis, creating an outcry from Congress that will be as great, if not greater than what we are seeing currently with respect to corporate inversions.
In the meantime, it is fair to assume that corporate profits in the U.S. will continue to increase in the face of limited options for tax efficiency. As a result, I expect NOL shells or corporations with an operating structure that preserves an inordinate amount of NOLs to become increasingly valuable, in proportion to growth in U.S. corporate profits.
This is well ahead of the curve thinking that I feel will benefit our portfolio returns going forward. Our two largest holdings – WMIH & KFS – are both NOL shells. In the case of WMIH it is a pure NOL shell without an operating entity (WMMRC is a legacy operation in runoff) and KFS is a revitalized shell, with a vast majority of its operations being newly formed entities that had no part in creating the NOLs in the first place. In other words, the structure of the balance sheet and operational profitability has been deliberately set around the NOLs. The eventuality in the case of both KFS and WMIH is a much larger entity taking shape that eats through the NOLs in 3-5 years, resulting in a tremendous surge of profitability for both companies going forward.
The potential for maximum utilization of NOLs through reinvesting tax free profits into ventures that will further provide outsized returns will best be experienced by financial companies that have the expertise to seek out a diversified portfolio of active or passive investments while possessing a history of providing a high internal rate of return.
While a company involved in technology or industrial manufacturing will divide an inordinate amount of corporate profits brought by NOLs in a variety of ways, financial companies, in particular Property & Casualty Insurers, tend to focus investments on areas that provide a high internal rate of return within their area of expertise. This type of leveraged, compounding return scenario can very well turn into a virtuous cycle of profitability for financial companies, especially when tax liability is nullified.
The CEO of Kingsway Financial (KFS) in a recent shareholder letter commented on this type of potential by saying: “We believe in the power of compounding. Insurance companies provide unique vehicles to compound investment results. The unfortunate history of Kingsway has resulted in hundreds of millions of dollars of tax losses (for which we have reserved from an accounting perspective) but provides us the opportunity to not pay federal income tax so long as the losses remain available to offset gains. This enhances our compounding.
He goes on to say: “So you could sum up our value-building philosophy as: Compounding capital in the long-term with investments/acquisitions/financings that offer asymmetric risk/reward potential with a margin of safety support by private market values.”
It can't be understated and in fact should be emphasized clearly what a powerful business model this is in a highly-lubricated economic environment that is filled with opportunistic companies searching for an enhancement in their possibility for achieving returns. There is no shortage of capital that is looking for deals. And there is no shortage of deals that are looking for capital.
Private equity firms are raising record amounts to put together creative acquisitions in a variety of industries. Venture capital is running at two hundred miles per hour. And hedge funds are becoming increasingly creative in their ability to structure deals that resemble a hybrid between private equity and venture capital. In essence, it is a deal environment that has no shortage of opportunities or capital to make those opportunities reality. This will benefit our portfolio investments that are concentrated in NOL plays for Property & Casualty Insurance (I have little doubt that WMIH will eventually merge into a P&C insurer) tremendously going forward as I expect the maximum benefit possible to flow into these names.
As far as the general market goes I expect there to be a fair share of volatility going forward that will likely favor the downside into August and September. The catalysts to drive the markets further forward simply don't exist at these levels without some type of reset in prices taking place during the months ahead.
From a technical perspective, many important averages are coming up on tremendously important areas of resistance that, again, will need a reset in order to be pierced with any conviction.
As with all dips over the past several years, any dip we get over the coming months will be a buying opportunity. There will be no shortage of those euphorically claiming that the bull market has seen its best days. That corporate growth will stagnate. That global tensions and their influence on energy prices will be too much for the economy to overcome. That employment growth is set to dissipate. That housing is slowing and credit is tightening. The reasons always come in bunches. They should be ignored.
The power of this bull market is continuously and deliberately in doubt by a vast majority of institutions. The investment public for which every past bull market has created a love affair in the equity space is as skeptical and pessimistic as anytime over the past few years. Aside from investments created by pensions and 401ks, the public is not participating in any substantial fashion.
The seeds of doubt create the fuel for which every bull market in history has climbed to heights that few thought possible.
When the Dow was sitting at 3,750 in 1994, the mention of Dow 11,000 by the end of the decade was scoffed at and decried as an irresponsible amount of bullishness in the face of untenable circumstances. Dow 11,000 did come just six years later for a near 200% return.
When the Dow was sitting at 1,200 in 1984, the mention of Dow 2,700 by the end of the decade would have earned an investor a dunce cap and box of rocks. Dow 2,700 did come just six years later for a 125% return.
With the Dow sitting near 17,000, a move to 30,000 would only be 75% from this point. A move to 40,000 is 135% upside from this point. Some may think this is impossible or a sign of the bullish euphoria that causes markets to grind to a halt. I, however, take the opposite stance and say that the biggest surprise will continue to be on the upside for a majority of the investment public, whether professional or otherwise.
One of the greatest and perhaps most underrated aspects of investing is the ability to possess imagination as to the type of dynamic force the market is at its essence. It is by no means a force that seeks equilibrium instead possessing the intense desire to move towards points of disequilibrium that cause the maximum level of disruption within traditional circles of finance.
Bruce Kovner is arguably one of the top hedge fund managers of the past 30 years, averaging a return of 21% net of fees over that period. In responding to a question about what makes a great investor/trader in the book Market Wizards, Mr. Kovner says: “I’m not sure one can really define why some traders make it, while others do not. For myself, I can think of two important elements. First, I have the ability to imagine configurations of the world different from today and really believe it can happen. I can imagine that soybean prices can double or that the dollar can fall to 100 yen.”
With imagination comes the ability to move beyond the limitations of financial modeling and into the realm of dynamic price behavior. And that is the essence of financial markets: Counter-intuitive price behavior that shreds any model attempting to relegate its essence within the confines of traditionalist thought.
Perhaps business schools should pursue courses in creative financial thinking that forces students to create scenarios that cannot be modeled and instead must be imagined based on unimaginable dynamics. This may finally create a breed of investor that has ability to consistently outperform their benchmark instead of sorely lagging behind it during one of the greatest bull runs of our time. A bull run, by the way, that was simply unimaginable just a few short years ago.
Regards,
Ali Meshkati
