Arohan’s investing life

It is kinda sad that the industry in USA is now so dependent on the tax payer largesse. It is sadder still to note that the congress is completely clueless as to the right way of deploying the tax payer capital. We, the private citizens, should expect and demand more from our elected representatives.

Bailing out Autos

The democratic congress is pushing to bailout GM and other autos. Many talking heads and pundits are calling for a bailout for the car companies as a way of saving jobs. Am I the only person around who thinks this is a singularly bad idea?

The Real Problem

I have spent my pre-entrepreunarial  career working at and strategic consulting for auto companies (all three of the big three). It is not true that these companies do not know that they need to restructure, and that they need to bring out better designs at prices that are attractive to the consumers. It is not true that these companies are not aware of their dwindling market share, or their antiquated production systems, or the quality problems in their vehicles. They have been trying their best to address these issues in the last 10 years with varying degrees of success.

But their hands are tied.

Case in point: GM is unable to shift production to Mexico. GM is unable to shift procurement of certain parts from Delphi to another vendor despite a Delphi part costing more, technologically behind, and of bad quality. Infact, even when GM agrees to continue to buy from Delphi, they are unable to implement a design change in the parts

Or the fact that Ford was required to hire back any Visteon employee who was laid off

Or the fact that some of the best ideas in these companies are shot down because it affects the relationship with the unions, or that some executive somewhere overrides a change in vendors because he knows the incombent vendor on a personal level

Or the fact that  many many employees have gotten used to 2 hour lunch breaks and frankly the management cannot do anything about it and that most of these hourly employees are being paid 3-4 times the minimum wage for what is essentially unskilled or semi-skilled jobs

Or the fact that there is an alarmingly large turnover rate amongst the engineers and designers, some of the brightest and best hires, due to the fact that they constantly see their best ideas shot down meaning Ford has to constantly relearn how to eliminate squeaks and rattles (folks, this is not rocket science)

Or the stifling bureaucracy

Or the mindless narrow focus on cutting material costs at all cost resulting in the consumers getting turned off when they look at the cheap plastic that pretends to be the dashboard

Ladies and Gentlemen, the problems of the big 3 boil down to two things:

1. The lack of flexibility and resultant high cost of change due to the existing power of the unions and the contracts negotiated with the unions, and

2. Unsustainable cost structure due to high labor costs and legacy costs (retiree benefits and pension)

And unless these two issues are tackled, no amount of bailout is going to improve the US automotive industry

Taxpayer help may be necessary, but it needs to be accompanied by and be contingent on, a. Cancelling all the union contracts and disbanding of the unions, and, b. Fresh ideas on how to restructure the legacy costs. If these two things are accomplished, then the management will have the flexibility to implement their turnaround plans. Absence of any actions on these two fronts, the bailout will only buy these companies some time and they will be back with the begging bowl sometime in the future. The problem of moral hazard is real. The fact that Chrysler was bailed out once served to instill confidence in the unions that these companies are too big to fail and the government will step in whenever it becomes necessary. And the results are now for all to see.

I firmly believe that the bankruptcy of one of the big three automakers is the only way forward. Under the protection of the bankruptcy court, the automakers can finally take tough steps to confront the unions and nullify the contracts. Under the protection of the bankruptcy court, the automakers can finally take tough steps to restructure their business model. And for the record, bankruptcy does not mean complete liquidation. In fact, that may be the best option to preserve as many jobs as possible and create jobs in the future as the industry comes out stronger when they emerge from the bankruptcy process

Many jobs are going to be lost in any conceivable action that the government chooses to take. Why not take the path that has a chance of ensuring a stronger viable US automotive industry in the future!

As for the argument of no one will buy a car from the company that is under banruptcy protection: Well, people are willing to trust their lives flying on bankrupt airlines despite not knowing whether the company is able to keep up regular maintenance of the aircrafts. And warranties on autos can be purchased from third parties. Now may be the best time to restructure the industry as even the foreign competition is suffering from sales declines.

AIG Junkets

Here is a story about the most recent AIG sales/training event that the congress is so affronted by that they are demanding the CEO to step down. While avoiding excesses is important, do we as a taxpayer really think that shutting off AIG’s chances of selling new insurance policies is the best way to get our money back? I watched congressman Cummings on CNBC this morning and he was asked if he wants AIG to stop training its agents so they can sell more policies and whether he thinks this is the best for the tax payers. He had no answer to this question.

Why do we elect such clueless people to represent us in the Congress?

Related posts:

1. Bailout proposal fails to clear the house, what now?
2. Metal working and service industry in North America
3. Paulson plan and the Democrats

There are some that believe that raising taxes on the rich increases tax revenues so the government can expand its social programs. The facts and historically observed data are stacked against them.The Democrats and the Obama campaign argue for increasing taxes on wealthy and business thus:

- They can afford to pay more

- This will increase tax revenues

- Increased tax revenues will allow the government to undertake more social programs for the benefit of poor and disadvantaged and job creation, and

- It is patriotic duty for the rich and the businesses to pay more taxes in the name of fairness

However, the tax theory and history lends no support for this argument. Historically it has been observed that tax yield (defined as tax revenues as a percent of GDP) has remained constant at 19.5% regardless of the marginal tax rates. This yield has held when the top marginal tax rate was 91%, and it holds true today when the top marginal tax rate is 35%. What this means of course is that to increase the tax revenues that the government is able to collect, the GDP will have to rise. And only way the tax policy can affect an increase in GDP is by lowering taxes on businesses so businesses can reinvest the savings in capital expenditures and creation of new jobs. The following article lays this relationship out quite clearly

With this in mind, let us revisit the Democratic arguments

- The rich can afford to pay more in taxes. 

This is true but then they will have less money left over for investments and business development. Additionally, higher taxes changes attitudes about risk taking to the detriment of the society as a whole. This risk taking drives innovation which drives (and has for the past century driven) the American economic growth

- This will increase tax revenues

This is patently false and has no basis in facts.

- Increased tax revenues will allow the government to undertake more social programs for the benefit of poor and disadvantaged and job creation

True but tax revenues will only increase when the taxes on the businesses are lowered. Resultant economic growth will then create new and more jobs thereby reducing the need for government programs for job creation.

- It is patriotic duty for the rich and the businesses to pay more taxes in the name of fairness

Don’t know how it is patriotic to accept policies that are detrimental to the prosperity of the country as a whole. This is a nice slogan but is just an empty rhetoric. Fairness is to allow every citizen an opportunity to realize the American dream. Fairness does not lie in hampering businesses from growing and creating new jobs even if the government decides to give handouts to the unemployed.

Related posts:

1. Obama has a plan to slow down the economic growth engine of US
2. The taxes, the Rich, the Poor and fairness
3. Tax cuts, Obama style! Are we ready for more socialism?
4. Obama’s tax proposal, who is middle class?

Why do the rich get the biggest tax breaks? Is the system unfair?

Here is a short parable, source unknown. You decide!

US Tax System Explained in Beer

Suppose that every day ten men go out for beer and the bill for all ten comes to $100. If they paid their bill the way we pay our taxes, it would go something like this:

The first four men (the poorest) would pay nothing

The fifth would pay $1

The sixth would pay $3

The seventh would pay $7

The eighth would pay $12

The ninth would pay $18

The tenth man (the richest) would pay $59

So that is what they decided to do. The ten men drank in the bar every day and seemed quite happy with the arrangement, until one day, the owner threw them a curve. ‘Since you are all such good customers’, he said, ‘I’m going to reduce the cost of your daily beer by $20′. The drinks for the ten now cost just $80. The group still wanted to pay their bill the way we pay our taxes so the first four men were unaffected. They would still drink for free. But what about the other six men - the paying customers?

How could they divide the $20 windfall so that everyone would get his ‘fair share’? They realized that $20 divided by six is $3.33. But if they subtracted that from everybody’s share, then the fifth man and the sixth man would each end up being paid to drink his beer. So, the bar owner suggested that it would be fair to reduce  each man’s bill by roughly the same proportional amount (rounded off), and he proceeded to work out the amounts each should pay.

And so the fifth man, like the first four, now paid nothing (100% savings).

The sixth now paid $2 instead of $3 (33% savings).

The seventh now paid $5 instead of $7 (28% savings)

The eighth now paid $9 instead of $12 (25% savings)

The ninth now paid $14 instead of $18 (22% savings)

The tenth now paid $49 instead of $59 (16% savings)

Each of the six was better off than before and the first four continued to drink for free. But once outside the restaurant, the men began to compare their savings.

‘I only got a dollar out of the $20′, declared the sixth man. He pointed to the tenth man, ‘but he got $10!’.

‘Yeah, that is right’, exclaimed the fifth man. ‘I only saved a dollar too… It is unfair that he got ten times more than I!’.

‘That is true!’ shouted the seventh man. ‘Why should he get $10 back when I got only two? The wealthy get all the breaks!’.

‘Wait a minute’, yelled the first four men in unison. ‘We didn’t get anything at all. The system exploits the poor!’.

The nine men surrounded the tenth and beat him up. The next night the tenth man (the richest) didn’t show up for drinks, so the nine sat down and had beers without him. But when it came time to pay the bill, they discovered something important. They didn’t have enough money between all of them for even half the bill!

And that, ladies and gentlemen, is how our tax system works. The people who pay the highest taxes get the most benefit from a tax reduction. Tax them too much, attack them for being wealthy, and they just may not show up anymore. In fact, they might start drinking overseas where the atmosphere is somewhat friendlier.

Related posts:

1. Hauser’s law and why raising taxes on businesses hurt more than it helps
2. Obama’s tax proposal, who is middle class?
3. Tax cuts, Obama style! Are we ready for more socialism?

Many will argue that the bailout or the rescue plan adds a tinge of socialism to our markets. I agree, but let’s be clear, Treasury and the Feds have taken pains to construct the capital injections in the banking system carefully and have put in ‘outs’ for the banks receiving the Fed dollars to buy the Feds out and thereby convert to private enterprises that they truly are. I also commend the congress to insist on adding the option of taking equity stakes in the banks  to the rescue plan proposed by the Treasury. Sometimes extraordinary measures need to be taken to preserve the capitalist system we have in our country, a system that has proven over the long term as the best way to ensure prosperity for its citizens.

Socialist model has also been discredited by the world events over the last 100 years. It is a failed system, more and more people around the world understand that it is a failed system. Sadly, it appears (if the polls can be believed) that we are on the verge of selecting a candidate to be the next President of the United States whose proposals if implemented will move the American economy towards greater socialism and less free enterprise.

Here is an opinion column from WSJ that dissects the Obama campaign’s claims of giving tax cuts to 95% of all Americans. Yes indeed, Obama’s 95% figure includes about 32% of those households that do not currently pay any income taxes due to the level of their incomes (adjusting for the credits currently available to them). Under Obama’s plan, approximately 44% of the households will not owe any taxes to the government due to the increase in the number and the amount of tax credits available to them.  In fact a large number of households not paying any taxes will receive checks from the IRS. The remaining 5% of the ‘rich’ households will see significant tax increases. The ‘rich’ business owners are expected to accept the tax increases (read lower profits and lower reinvestment in job creating activities) in the name of patriotism. The proposal also provides a real dis-incentive for a ‘poor’ employed worker to work harder or improve him/herself by enacting a significantly high marginal tax rate (in the form of disappearing credits)

Welfare being such a dirty word, Mr Obama’s genius is to couch it in the form of tax ‘reform’

Here is another article that discusses Obama’s tax proposals as a form of income re-distribution. Granted that this article is from a right leaning website but in this election (more than ever before) it is important to listen to all sides of the story rather than just imbibe what the campaign PR machine pours.

Christian Science Monitor weighs in as well

I have written earlier about how I feel that Obama’s tax proposals are counterproductive to the long term growth of US economy. Any tax regime that penalizes success and rewards mediocrity does not belong in a great capitalistic society that America has built over the last century.

Now is not the time for a socialist experiment!

Related posts:

1. Obama’s tax proposal, who is middle class?
2. Obama has a plan to slow down the economic growth engine of US
3. Paulson plan and the Democrats
4. Hauser’s law and why raising taxes on businesses hurt more than it helps
5. New fed plan to slow foreclosures

There are so many cliches that come to mind … blood running through the streets… separating men from boys… catching a falling knife… oversexed guy in a ‘harem’… last one holding the bag… you get the point. The question, though remains, what is a value investor to do?

This is the time when taking a long term perspective helps. This, unfortunately, is also the time when the crystal ball is the foggiest. But let’s give it a try anyways and see what we find. I will ask a few questions which I think are probably foremost in any investors mind today. Many of your answers may differ from mine but hopefully this exercise helps bring some rationality in our thinking. Let me know what conclusions you draw

1. Are we heading towards Great Depression II?

- Maybe or maybe not. Although no two depressions are alike, I do believe that the global markets are more interconnected now than ever before. True that this means that a contagion can spread globally very quickly, but it also means that there are far more investors in the market looking to buy up undervalued assets than ever before. Besides, a depression has to mean that the slowdown in economy is pervasive to all sectors, which hasn’t happened yet. It can still happen but it is also quite possible that the credit markets may start thawing in time to let the other sectors continue to grow, even if it is in spurts, while the housing/financials find their bottom

2. Will the US economic system fail?

- No. The system still remains free and flexible and can survive the ups and downs. In fact, these ups and downs from time to time help in keeping the system healthy over the long term. It helps us find the weak spots in the system and strengthen them

3. Will the Treasury bailout avert an economic crisis? A recession?

- The bailout is aimed at unlocking the credit markets. It does not change the current economic reality. Therefore it is unlikely that a recession can be averted. In fact, I personally believe that we have been in recession in US for the last one year or so. When the credit starts flowing again, it should help the business activity pick up as the businesses start getting credit for working capital and expansion. However, since there is also a lack of ‘Trust’ in the market today, these benefits may be slow to realize. It may be six months to a year before the economic indicators start reflecting an uptick

4. Should I sell all my stocks?

- No!!! The stock market recovery leads an economic recovery and these days the stocks are valued at distressed levels. It is never a good idea to sell stocks low. If you can weather some volatility and are willing to stay invested for a long term, this is a good time to buy stocks. I would however advise any investor to review their portfolio holdings and consider focusing on equities that are most undervalued. This may involve selling some of the other holdings to re-focus.

5. What stocks should I buy?

- This depends on your risk appetite and how long are you willing to hold a position. Personally, my favorite stocks right now are a few select financials and a few asset management stocks with long history of outperformance. I have discussed many of these stocks in the past on this blog

Final thought: It is said that for outsized returns, you need to take outsized risks. However, there are so many businesses selling at such low prices today that buying them carries less risk than ever before. All it requires is some fortitude. I do not think that successful investors take more risk. I believe that successful investors actually have more guts to buy when everyone is in a hurry to get assets off their hands

Related posts:

1. Will US fall into recession this year - or is it already in one
2. Fed trying to break the back of the credit crunch
3. The other side of the recession debate
4. Recession is here! What should an investor do?
5. Global markets decline - is there a value in international diversification?