Stockton's Bankruptcy

A judge is allowing the Chapter 9 bankruptcy filing by Stockton, Ca., to proceed. Stockton is the largest U.S. city to ever file for bankruptcy protection. Capital market creditors, who opposed Stockton's bankruptcy, disagree with Stockton's plan to fully fund the city's pension plan. The bankruptcy is being closely followed by municipal bond market participants and other municipalities as it appears Stockton will break with the long standing tradition of fully repaying principal to creditors in a municipal bankruptcy.

Rental Property Investment

We know several people who have rental property as part of their investment portfolio and at least as many who would like to own rental property. An article in the New York Times outlines some of the potential risks in rental property investing that many people overlook. For example, vacancy or natural disasters are possibilities. There are other potential risks such as a fire at the property and maintenance risks like pipes bursting or a leaking roof. By now, you should be well versed in risk and realize that these are idiosyncratic, or firm-specific, risks. Another potential risk with rental property that is often overlooked is that typically a large investment is required, which can result in the rental property being a large portion of a portfolio. This means you are left with a portfolio that is not diversified. While we are not saying that rental property cannot be a good investment, hopefully you have enough knowledge to consider how the risk of such an investment fits in your overall portfolio.

The DuPont Identity And Equity Multiplier

As you know, the DuPont Identity decomposes ROE into the profit margin, total asset turnover, and equity multiplier. To see how these factors can impact ROE, consider Goldman Sachs. Although the main topic of this article is pay on Wall Street and in professional baseball, partway through, it discusses the equity multiplier (called the leverage ratio in the article) for Goldman Sachs. During the credit bubble period, probably 2005 to 2008, Goldman's equity multiplier exceeded 25 and the company's ROE was above 30 percent. Now, Goldman's equity multiplier has dropped to about 12 and the ROE has dropped to the low teens.

A Corporate Bond Market Primer

According to a recent article in CFO, about $4 trillion in corporate debt was issued in 2012, besting the previous high of $3.89 trillion in 2009. But what may be more interesting in the article is a primer in the workings of the bond market. Before shelf registration was adopted in 1982, investment banks spent considerable time and effort premarketing bond offerings, essentially a road show for bonds sold in the primary market. After the advent of shelf registration, investment banks had less time for premarketing bonds so they essentially purchased an entire bond issue off the shelf and sold the bonds, taking all of the pricing risk of the new issue. Recently, investment banks appear to have gone back to premarketing bond issues. The downside to this model is that investment banks have reduced incentives to sell smaller, more complex bonds and instead focus on larger, regular bond offerings. Additionally, there appears to be evidence that the current method of using a syndicate to premarket bond offerings increases the yield premium on new bonds about 10 basis points higher than it should be.

Buffett's Dividend Irrelevance

Many investors view Warren Buffett, the Oracle of Omaha, with a great deal of reverence. For that reason, most people never doubt his comments, but we are not most people. In his recent letter to Berkshire Hathaway shareholders (see page 19), Mr. Buffett extols the virtue of dividends that Berkshire receives from the companies that it owns. In fact, he states that “we relish the dividends we receive from most of the stocks that Berkshire owns,” while at the same time steadfastly refusing to pay dividends to Berkshire shareholders. Does that sound a little like your parents telling you “Do what I say, not what I do?”

Mr. Buffett justifies his views with an example that is eerily similar to the Modigliani-Miller dividend irrelevance argument, but he makes a mistake as pointed out in this letter to Mr. Buffett from Brad Jordan (coauthor of our favorite textbook). We'll let you know if we get a response.

Foreign Cash Balances Grow

U.S.-based companies saw their offshore cash balances grow by $183 billion last year, to more than $1.9 trillion. One of the main reasons for the growth in offshore cash balances by U.S. companies is the worldwide tax system, which requires U.S.-based companies to pay income tax on earnings from any country when repatriated. In contrast, most other industrialized countries charge little, if any, tax on foreign earnings. The comparison of international tax rates can be seen by examining the potential taxes owed by Microsoft and Citigroup on foreign cash balances. Microsoft would owe $19.4 billion if it repatriated its $60.8 billion in offshore cash, implying it had paid a foreign tax rate of 3.1 percent. Meanwhile, Citigroup would owe $11.5 billion in taxes on its $42.6 billion in foreign tax, implying a foreign tax rate of 8 percent.

Delisting Increases

The Jumpstart Our Business Startup (JOBS) Act is allowing companies to deregister from stock markets. Previously, a company with over 500 shareholders was required to be listed, which also meant filing financial reports with the SEC. The JOBS Act allows companies with as many as 2,000 shareholders to delist, and allows the company to avoid SEC reporting requirements. The Coastal Banking Company recently delisted its securities, saving $150,000 to $200,000 per year. And Harleysville Savings Financial saved 6 cents per share by delisting. While going dark used to have negative connotations, OTC Markets is trying to make unregistered securities more respectable. OTC Markets has five tiers of stocks based on the information made available by the company. OTC Markets combines the company's financial results with the stock price and trading information in an effort to increase transparency.