Ten Morsels in Sixty Minutes

August 1, 2011

Some of my Loyal Readers (hi, Mom and Dad!) have expressed interest in hearing my take on all the many ways in which our government and economy are dysfunctional, but they have been too respectful of my hectic life to really insist on it (thanks).  Herewith, some observations and conjectures, most of which have probably been debated in greater factual detail elsewhere, and which reflect my views as of this point in time.  Unlike politicians, I reserve the right to change my mind if the facts, or my understanding of them, change!

  1. Public finance operates on totally counter-intuitive principles.  Responsible households and companies try to forecast what their revenues will look like and attempt to calibrate their expenses accordingly.  Sometimes expenses will outpace revenues for short-term reasons (e.g., the car breaks down) or long-term reasons (e.g., Junior goes to college increase his lifetime earnings potential).  In such cases, borrowing that is matched in tenor to the underlying reason, and for which there is a clear path to payback, may be advisable.  But, ultimately, the “top line” should drive the thinking.  Government, particularly in the last decade, evidently prefers to start with the level of expenditures it wants (i.e., generally, “more”) and then hope that the economy will grow enough to bring revenue into balance (and/or hope that it will be the other team that gets stuck with the task of raising revenues).  This strikes me as profoundly silly and probably intractable.
  2. There should be more outrage that the government’s fall-back option is always to cut discretionary spending.  I’d wager that some of the best rates of “return on investment” from government dollars come from spending under this rubric.  I’m pretty comfortable asserting that, compared to some schmancy new weapons program, it would be significantly more beneficial to America, for example, to triple the budget of the FDA and the US Patent Office to eliminate bureaucratic bottlenecks to innovation and improve the capacity to monitor, say, safety and effectiveness in the one case, and true novelty to weed out patent trolling (a cost to the economy) in the other.
  3. There is a corollary to #2 that I’m going to put in as stark and non-PC terms as possible just to make the point.  Instead of making investments that will increase America’s productive capacity (and future ability to generate revenue!) we are collectively committing the public purse to keeping old people alive as long as humanly possible.  This is a choice that we always want to make for our own family, but which in aggregate constitutes an extremely unproductive way to allocate resources.
  4. Here is another corollary to #2, also framed as starkly as possible: this is basically the Boomers’ own fault (albeit indirectly).  The tax revenues generated from their peak years of productivity should have given our government an amazing war chest with which to pay for their future care.  Instead, they (and their parents) elected politicians who chose to pour this money into the wealth-destroying enterprises of war and lots of healthcare for their parents.  Privately, many who could have saved during their peak earning years to fund healthcare in old age also failed to do so, because they generally, in aggregate, chose current consumption.  Unfortunately, the consequences of these decisions (i.e., what’s happening now) are likely to fall in a regressive manner, when they could have been funded progressively (via taxes already assessed and spent).
  5. An interesting dynamic related to #3 is that the current cohort of retirees and near-retirees is exceptionally rich in benefits-terms, whatever their wealth looks like otherwise.  Put another way, the government’s contingent liabilities to Medicaid Medicare [thanks Alison 😉 ] are, by accounting logic, assets to individuals that may or may not be monetized.  (When monetized, of course, the cash actually goes to healthcare providers – but the right to receive services is an asset of the individual.)  I wonder whether, if you offered the average 70 year-old a choice between (a) Medicaid Medicare status quo and (b) a much more limited entitlement and $100k for their grandkids, lots of them wouldn’t take (b).  Right now we give the elderly no incentive to consume less healthcare, even if they might derive significantly greater joy and happiness from other uses of the funds government was willing to spend on them anyway.
  6. I actually think my conclusion in #5 is the general case of what’s wrong with healthcare in America.  It’s impossible to rein in costs when a large cohort of consumers (i.e., the well-insured) are price insensitive.  In the abstract, everyone wants above-average healthcare at below-average cost.  Paging Dr. Wobegon!
  7. Politicians like bashing the wealthy who have done extraordinarily well but apparently have not incurred their fair share of society’s burdens.  This reasoning ignores the bug (or feature, depending on your persuasion) that we tax income, not wealth.  Once a person has made her fortune, we can perhaps squeeze out more at the margins, but the wealth horse has basically left the barn.  The estate tax should be the principal remedy for this.  Progressives should be mortally ashamed that they’ve lost this debate by allowing it to be anchored around how many small business owners will be “punished for dying” because their estate is worth some middling number of millions of dollars.  This is ludicrous.  Set the cap at $50 million, or some arbitrary number that doesn’t have a ‘B’ in it.  Confiscatory policies are un-American, yes.  But so is the entrenchment of wealth and privilege that is the destination this freight train is heading to, anyway.
  8. I’m more inclined than ever to think that political parties are The Problem in terms of why government can’t seem to act in the national interest instead of in political interests (and they clearly doth protest too much to the contrary).  I still don’t know how to fix this.  Attacking the gerrymandering of Congressional districts seems absolutely like one good way to start, although I am not holding my breath that this will be a Congressional priority…
  9. And, by the way, there is a lot that is profoundly screwed up and not at all in our national interest about how we as a society use prisons.  Besides the obvious dollar costs, I would love to see a thoughtful estimate of how much human capital we have essentially destroyed by imposing prison sentences for minor offenses, particularly those solely related to drug possession.  This may seem like a random point to make here, but the connection is that I think cornerstones of our prison system represent a massive nationwide misallocation of resources that we just can’t afford.
  10. That all said, I actually think a reasonable proprtion of politicians understand all of the above, but just don’t have the courage or influence to do anything about them.  I hope this dynamic will change, but I am not optimistic.

I’d welcome any comments on the above – as I pointed out, these views are evolving.


To Waterboard a Metaphor

July 29, 2011

It’s fun to use a credit card because you get your dinner or haircut or iPod now, but your bill doesn’t come until later.  Credit cards are accepted almost everywhere.  You can put most of your monthly expenses like utility bills on them and even make arrangements to be billed automatically.  But the best part is that you can even choose not to pay your bill in full!  Sure, it costs something to carry a balance on your credit card, but it’s so much less fun to pay bills than it is to buy things.

The best way to maximize your ratio of fun to not-fun is therefore to pay the minimum on your credit card every month.  Eventually, though, you hit your credit limit and the fun threatens to stop.  At that point, there are a few options.  One option is just to keep using another credit card, but let’s assume that’s not possible.  The next option is to pay down some of the balance (or go back to making purchases in cash), but that isn’t fun, because we’ve already established that it isn’t fun to pay bills.  Another option is not to pay the bill at all, but that would be even less fun – not only would you be cut off anyway from buying more things, you’d also start getting visits at home from guys with thick necks and questionable taste in jewelry… 

But my Readers are clever enough to have spotted the most fun option: request a credit limit increase!

The credit card company might balk a little bit at how much debt you have already accumulated, not to mention your other debt (like your huge mortgage!). But, frankly, your payment history is pristine, and the credit card company likes to earn its little bit of interest and transaction fees every time you make a charge.  After all, the credit card company needs to put its money to work somewhere.  Some shareholders have trouble understanding why the company keeps lending to customers like you.  They wonder, shouldn’t the company be supporting some local small businesses instead?  The company’s decision definitely would be likely to weigh on its stock price.  Fortunately, though, you happen to know that the company actually thinks it’s a competitive advantage to have a cheap stock price.  So the company hasn’t given you any indication that they’re going to deny a request from you anytime soon.

As long as the credit card company keeps increasing your credit limit, you can have basically as much fun as you want.  That is, unless some JERK comes along and hides your cell phone and locks you in your apartment to try to prevent you from actually calling the credit card company to request that increase.  Not fun!

That jerk would probably think he’s being pretty clever, since you’d have to finally start paying more of your bills every month in order not to run out of cash.  That would totally not be fun for you, but the worst part would be watching his smug reaction as you scrambled to keep the electricity on, while trying not to disappoint your hairstylist and the others who have enjoyed the benefit of your spending.  You just know he’s going to call up your hairstylist at the end of the month and have a good chat with her about how disappointed in you they both are.

But, wait a minute.  If my Readers were in this position, they would have spotted something fishy about the whole scenario long ago.  How on Earth did that jerk know where you live, never mind where you keep your phone? 

The most likely explanation is that he’s your embittered ex who is, for some reason, still a co-signer on the credit card. 

It’s not like that jerk hasn’t also been having a grand old time running up the charges every month!  In fact, half the charges that you have to pay for every month are for things like his multiple gym memberships and church dues and all those other bills that he put on auto-pay years and years ago.  Sure, it’s not fun for YOU to be paying HIS bills, but you’d always had a kind of understanding that everyone would have more fun if the credit limit just kept on being increased whenever necessary.  Who does he think he is, trying to stop your fun unilaterally?

Nevertheless, suppose you found yourself locked in the apartment just as the monthly bill was coming due.  You and the jerk could have a good shouting match; but although that might be fun for you, the neighbors would probably be scandalized by the whole tacky spectacle.  (You probably will do it anyway, though.)  You are NOT going to give him the satisfaction of begging for the phone back; that’s even less fun than not being able to buy things anymore.

So, you have two options.  The first option is to climb out the fire escape and call your buddy Ben, who seems to be able to create cash out of thin air.  (You’re always surprised that he doesn’t seem to be having any fun, with that kind of magical power.)  He’s a bit of an eccentric fellow with an artistic bent, so you know you can count on him to buy whatever doodle you put on paper for him.  You can then run that cash over to the credit card company in the nick of time.  It’s not fun to pay a bill, but it is fun to make doodles; so it’s sort of a wash.  And then you get to give a big raspberry to the jerk until the next time either of you needs to use the credit card.

The other option is to hold your breath until the jerk gives you the phone or you pass out.  You may risk some permanent brain damage that way… but, hey, some people get off on that sort of thing.

Addendum: Karl Smith has something serious to say about this metaphor.  For what it’s worth, I agree with his conclusion.


Mission Accomplished

May 2, 2011

I’m not sure why, but it feels a bit tacky to write about the news that Osama bin Laden was finally killed – I think it’s possibly too fresh to be suitable for reflection.  On a personal level, it’s hard to write something that doesn’t sound trite.  The adjectives that leap to mind (cathartic, unifying) are rather obvious, but in this case I don’t think it makes them less apt.

I may come to regret writing this if I’m ever up for a Senate confirmation hearing (heaven forbid) but it has been unusual to feel such a sense of “us vs. them” American-ness.  I’m extremely grateful for the rights and privileges (and, yes, the baggage) that come with being an American, but I tend to feel divorced from the concept of American-ness when it comes to realpolitik.  We’re pretty hard-wired (and/or conditioned) towards tribalism and group identity, so it’s hard for me not to be skeptical when those levers are deployed to exert power over individuals – particularly when they become pretexts for death and destruction.

And yet, as we say in New York, I’m really fucking happy we got the bastard.

I really hope that this moment of national cohesion can be put to constructive use, although I’m certain our political culture will waste no time in defecating all over it.  It would be nice to see the Left retire the conceit that it’s possible (let alone desirable) to always have ethical purity when fighting enemies who don’t.  There have been suggestions that critical intelligence for this mission came from detainees at Guantanamo Bay.  We may never know if this is true, or if so, what methods were used to acquire this intelligence.  The Left should confront the fact that this victory may well have been tainted by connection to Guantanamo.  A certain ideological purity would demand rejection and hand-wringing that, to me, initially seem pretty ridiculous.  It would be nice to see the Right retire the conceit that liberals are all pantywaists who can’t be trusted to make hard calls that put tangible national interests ahead of vague national ideals.  Obama deserves credit for pulling the trigger.  And it would be really, really nice to avoid the fruitless debate over whether Dubya or Obama deserves “more” credit.  The reality is that each pursued policies that had some successes and failures, and that those of us outside the West Wing have no idea how little we probably know about the complexity behind any policy call (let alone a grand strategy).

One extremely constructive step would be to evaluate the size, scope, and cost of our global military ambitions from this position of relative triumph.  We have an extraordinary opportunity to claim this modest victory as a pretext for accelerating our withdrawal from Afghanistan and Iraq if we think that’s an inevitable outcome, or for doubling down if we think there’s an opportunity to ride momentum for peace-keeping and institution-building.  I have no idea what’s the right answer.  But I do know that we have a clear need to repair our public finances.  It is not at all obvious to me that maintaining a military that is capable of engaging in trillion-dollar campaigns is the smartest way to invest scarce public dollars, relative, say, to education and infrastructure.  I think it is going to be much easier to have a real debate about this now that the abstract need to “get Osama” is off the table.  I doubt this debate will actually happen to a meaningful degree, but at least there is a window for it.

In the meantime: score one for Team America.


Be Thankful I Don’t Take It All

April 18, 2011

Happy Tax Deadline, America!

I happen to be part of the very small minority that doesn’t really mind the process of preparing and filing my tax return.  I enjoy it in part because I happen to generally enjoy math, organization, and logic puzzles, which are basically the main components of a tax filing.  The bigger driver, however, is that my tax situation is pretty simple.  I’m not self-employed, I don’t have dependents, I don’t trade too actively in my investment accounts, and (for better or worse) I tend not to fall into any of the myriad constituencies that have special benefits and pitfalls hidden in the tax code for them.   The types of itemized deductions I can claim are generally the same from year to year, so it’s pretty easy to keep good records of these expenses as I incur them.  H&R Block and TurboTax both make very good, inexpensive software that saves me the headaches of actual form-filling and calculation.  In all, it’s a pretty undramatic process for me, so I have very little to complain about.

There are absolutely ways I could have lived a more tax-efficient year/life, as I realize in hindsight.  In particular, I probably could have incurred a variety of meaningful, non-deductible expenses under the structure of a business or foundation that could have made use of them.  My goal would have been to fully comply with the law.  That compliance would have cost something: for example, whatever organizational books and records I would need to maintain, and the research I (or an accountant) would need to do in order to be sure my activities were all within bounds.  But if the cost of compliance were more than offset by the tax savings I could have realized, it would have been rational (if unpatriotic?) to take those steps. (In my case, I attributed an extremely high value to my own time and cognitive bandwidth, so I can live with the thought that Uncle Sam might have gotten more out of me than strictly necessary.) 

The fact that I even think about how to conduct my affairs more tax-efficiently is an example of the sort of unproductive complexity that, I think, most people agree with eliminating in the abstract, at least until it threatens to increase their effective tax rate.

In the spirit of the season, I’ll recommend a couple of very good pieces that are only slightly diminished by their points that reinforce my claim that many smart people say Ridiculous Things about taxes. 

I completely agree with the last paragraph of this piece by influential blogger Matt Yglesias, which in my mind points out the Ridiculous Thing in Arthur Laffer’s otherwise excellent op-ed in today’s WSJ.  The Ridiculous Thing he does is attribute the complexity of deriving “taxable income” from a person’s income and expenses to the fact that the tax code is progressive.  The complexity is attributable only to the provisions and loopholes that affect the derivation of taxable income.  A system like the one I proposed yesterday, with flat taxes at progressive marginal rates, and with a definition of income that eliminates the arbitrage between various flavors (e.g., wages, dividends), would be both progressive and non-complex.

Apart from that, I think Laffer’s piece nicely points out a few of the hidden costs of a complex tax code and the types of tax-efficiency games that rational actors play – and may in fact be bound to do so as fiduciaries!

The Ridiculous Thing in Yglesias’ piece, however, is the suggestion to pre-populate tax returns for individuals the IRS thinks are likely to have relatively simple tax situations (i.e., a significant population of lower-earning households).  In my ideal world of a non-complex, progressive tax code, this would work pretty well.  In the status quo, however, this suggestion is both inefficient and unfair to the people it purports to help. 

I doubt the IRS has a good way to predict a priori whether a taxpayer is better off itemizing.  A family’s unreimbursed medical expenditures may be very high in some years, for example, which the IRS wouldn’t know.  Similarly, there are tax credits for child and dependent care expenses that are very meaningful to lower-income households that the IRS wouldn’t know about, either.  Maybe the IRS could write in big letters: “If you have a lot of X, Y, or Z expenses, you should file a tax return yourself and not just send in a check.”  But the point is that the IRS can only err on the side of overcharging these taxpayers; if you believe that people don’t want to be bothered to file their tax returns, this is what will happen.  Otherwise, you end up building an infrastructure to pre-populate tax returns that people will have to double-check themselves anyway.

I used to volunteer as an income tax preparer for low-income families – one of several services, by the way, that make it easier for individuals with simple tax situations to reduce their burden of compliance. (The free versions of H&R Block and TurboTax software are another.)  Inevitably there were clients who decided they would rather take a lower refund than return home to pick up the paperwork they would need to claim the credits they were entitled to.  I’m worried about the prospect of replicating this on a larger scale by creating a default that can only overcharge taxpayers.

Here’s to a non-complex, tax-efficient 2011 for all of us!


Yeah, I’m the Taxman

April 17, 2011

As the deadline for filing tax returns approaches, amidst a great political pseudo-debate about whether to finally get serious about the deficit (hint: the answer will be, “not really”), it seems timely to reflect on just how our tax payments fit into the overall picture of America’s public finances.  The Washington Post and New York Times have put out some great interactive graphics that are well worth browsing for a few minutes to pick up some facts.

I think people generally become pretty irrational when asked to think about taxes.  My guess is that more than 95% of people feel that they are individually paying their “fair share” of taxes, but that they also believe that at least 25% of the country does not – this 25% for the Left tends to consist of high-earners, whereas for the Right it tends to consist of net recipients of government largesse.  People have religious debates over how to define one’s “fair share” of the burden of paying for public services, which are difficult to disaggregate from questions about: the proper role of government, the relative merits of publicly-managed vs. privately-managed provision of government services (even those that are ultimately funded with public dollars), whether (or, better: which kind) of taxes are good or bad for growth and by extension aggregate social welfare (not to mention whether this is a fair link to make), and the general fitness of government agents to spend public funds as wisely as they would their own.  These are all difficult and worthwhile questions, but I call these religious debates because I think they are usually not informed by facts – actually, people look at the same facts (e.g., that the top 1% of earners pay N% of all taxes) and draw different conclusions about whether N is too high or too low based on their prior views on all of the questions above.

My favorite ridiculous claim about taxes from the Left is that high-earners actually want to pay higher taxes, but they just haven’t been asked to do so.  When the President says it, it’s almost too incredible to imagine.  I also find it amusing when billionaires make the same claim, without any apparent sense of irony that they have deliberately (1) taken advantage of the arbitrage between income tax rates and capital gains tax rates to build enormous tax-deferred wealth over time & (2) dispensed the overwhelming majority of that wealth into tax-exempt non-profits who do the bulk of their work outside of America.  These claims clearly fail the revealed-preferences test: of course Obama or Buffett or I can pay higher taxes if we want to.  The Treasury department is very clear that gifts to the United States are always welcome as a patriotic expression.  I think it’s fair to ask why anyone who claims to be in favor of higher taxes for his income bracket doesn’t voluntarily pay those taxes himself.

My favorite ridiculous claim about taxes from the Right is that high-earners are chomping at the bit to use any incremental after-tax income from lower marginal income tax rates solely for the purpose of creating jobs (rather than, say, hoarding wealth).  It is true that tax rates are relevant for businesses’ and individuals’ investment decisions.  I think there are worthwhile arguments to be made about lowering business tax rates (at the level of payrolls and of the corporate entity) while raising them for dividends and long-term capital gains (and possibly also individual consumption) if we want to change the relative incentives for businesses to reinvest earnings rather than distribute them to their generally affluent stakeholders.  But, even though I think Buffett is disingenuous in discussing his willingness to pay higher taxes, I think he is correct in asserting that “trickle down” has worked much better in theory than practice.

Even though I’m skeptical that our political process will be able to make meaningful progress on tax reform, I’m glad that the subject is at least being discussed.  Since our plan seems to be to borrow trillions of dollars during the next decade anyway, it seems hard to imagine that we can construct a tax code that is worse-equipped to generate the growth and revenue we will need to have any shot at fiscal balance.  Now would seem like a perfect time to conduct a radical experiment in simplification.  I think the concept of multiple income tax brackets with progressive marginal rates is sensible.  There probably should be something like a millionaire’s bracket with an even higher marginal rate.  Crucially, though, we would need to stop using the tax code as a set of levers for social engineering if we want to stop people from paying lower effective tax rates than we intend for them to from a public finance perspective.  If we want to incentivize specific behavior, it seems drastically more efficient to do so through a mechanism like a “mail-in rebate” – at the very least it would make clear the cost of the policy, and make it easier to monitor for fraud.

I’m convinced that there are ways to increase total tax revenue without compromising economic growth, competitiveness, and job creation: when the pie is bigger, everyone gets more pie.  But I think it will be hard to figure out what exactly those ways are, if we’re forced to consider them in the context of a system that is already complex, opaque, and under-resourced to stop cheating and fraud.


Other Than the Crash, Captain Smith, How Was the Cruise?

April 5, 2011

I wrote recently about the importance in investment analysis of distinguishing between the recurring cash flows of a business and those variations in earnings that are more properly attributed to cyclical factors or one-off developments.  In practice, this is often easier said than done, particularly during periods of economic weakness.  To name a few examples, recent investors in newspaper publishers, telephone directory services, and video rental chains may now be wondering if their expectations for performance during a ‘normal’ cyclical downturn obscured signs of fundamental, secular changes to the viability of particular businesses.  This type of thinking is also important for companies themselves.  Critical decisions from managing daily cash balances to budgeting for capital expenditures to financing the enterprise as a whole depend on a sober assessment of the typical timing and quantity of cash flows.  One might think this is common sense (it is) – but human vulnerability to cognitive bias, to say nothing of corporate politics, introduces ample opportunity for error.

My motivation for this discussion was the scary, if not surprising, suggestion that a thoughtful analysis of the sources and sustainability of government revenues has been conspicuously absent from the debate over how to fill and distribute the public purse.  There are fair and important questions of principle involved in how we think about income distribution, income redistribution, and the role of the state as intermediary in that process.  But, to me, these questions are overwhelmingly less important than whether the liabilities the government currently has (and those it may want to incur in pursuit of future social objectives) are likely to be satisfied by the normalized cash flows it can reasonably anticipate receiving.  If not, we are not just rearranging the deck chairs by engaging in principled debates; we’re wrangling over the buffet menu for the Titanic’s second voyage.

(Sidebar: I prefer not to tip my hand too much as to my own thoughts on such principled debates, but since it’s fair to consider my cognitive biases – even though my thoughts are continually evolving – I’d say Matt Yglesias’ bullet points and Wil Wilkinson’s précis are collectively a good first approximation.)

As all levels of government debate their budgets for the next fiscal year, I’d encourage readers with curiosity and time to look through the proposals in some amount of detail.  An enormous amount of human effort goes into the production, analysis, revision, and execution of the proposals contained therein, so it’s a pity that so few voters are actually aware of the scope and complexity of such an undertaking (or so I assume; I would be happy to be proven wrong!)  Honestly, I think that American citizens should be given a national holiday during which they are required to read the Federal budget in its entirety, all supplemental charts and footnotes included.  (As a corollary, if it takes the Average American two weeks to read the budget, and the economy needs to shut down for two weeks as a result – or if the Average American is unable to comprehend the budget given any amount of time – that should tell us something!)   At a minimum, maybe this should be a requirement for claiming any sort of income tax refund or, in the case of high-income earners, claiming an effective Federal tax rate anywhere south of the 25% mark.

Civic duty aside, anyone who enjoys a gripping and timely work of fiction will find governmental budgets hard to beat.  Consider, for example, the government’s forecast of future tax revenue – it speaks volumes, particularly in the context of our earlier discussion of ‘mid-cycle’ cash flows.

I am only going to focus on the column for personal income taxes, which should correlate very strongly to corporate income taxes (insofar as economic growth drives both personal and corporate incomes) and social insurance receipts (which are a function of wages).  And I’m only going to make one point:

The forecast for 2010-2016 is that individual income tax receipts will double over six years, implying an annual growth rate of approximately 12%.  Some of this growth will be a function of the economic pie growing, and some of it will likely be a function of greater marginal tax burdens.  (Since these are nominal quantities, some may also be driven by inflation – although the government forecasts 2% inflation indefinitely.)  Based on some back-of-the-envelope math, I am extremely skeptical that anything near this growth rate has been achieved over a six-year period in recent economic history.  As you may remember, sometimes the economy contracts, which can really screw with a virtuous cycle of continuous compounding. Bear in mind that this is the same forecast that shows us running trillions of dollars of cumulative deficits over the same period.

If you believe that the economic growth of the past decade was to any material degree a function of: (1) unprecedentedly cheap and accessible credit, particularly for American consumers; (2) unprecedented opportunities for American corporations to reap the low-hanging fruit of globalization, which has largely been reaped; and (3) the windfall gains realized by a small number of individuals and institutions that were fortunate enough to sit atop enormous stacks of leverage and not lose — the trillion-dollar question ought to be: are these more properly considered recurring cash flows or extraordinary cash flows?

If the former, you should be betting your entire net worth on Corporate America right now.  If the latter, you should be really worried.

(Legal Disclaimer: That said, please don’t bet your entire net worth on anything!)


Next to Normalized

March 28, 2011

Investment analysts are trained to (try to) understand the drivers of the economic performance of the companies they follow, and to translate that understanding into a view on the valuation of those companies’ securities (i.e., stocks, bonds, and the like).  In theory, this is a pretty straightforward exercise.  A company’s securities represent claims of varying priority on its assets, which correspond in turn to claims on the expected future cash flows derived from those assets.  The challenge in practice, of course, is that forecasting the future is difficult; and even if such forecasts were perfectly predictable and widely known (i.e., so that the market had no disagreement about what they are) the market can be fickle in how it prices future cash flows at any given time.

Readers familiar with very basic concepts in corporate finance can probably skip this, as I won’t really get to My Point until the next post.  I think this will be helpful background for the rest of the audience, however.

Imagine two companies, A and B, that are absolutely identical except that they exist in parallel universes.  Imagine them as exceptionally unglamorous companies: say, manufacturers of dental floss.  Assume that, year in and year out, they generate about the same amount of annual free cash flow: this is a term of art, which essentially means the amount of cash earnings that are available to distribute to company’s creditors and equity owners, and to pay taxes, after setting aside an appropriate amount of those earnings to reinvest in the business (for example, to replace depreciating equipment) in order to continue generating that same level of cash earnings (the term of art would be “maintenance capital expenditures,” which we’ll also assume is about the same each year).

We would expect A and B to have virtually identical valuations in the market, since their assets produce identical levels of free cash flow and are expected to do so indefinitely.  If the companies borrow money, clearly some of that valuation would represent claims of their creditors on the free cash flow of the companies.  But, in general, we wouldn’t think of A and B as having fundamentally different values as enterprises just because A and B have different amounts of debt; the salient difference would be what proportion of that value is attributable to creditors and equity owners in each case.

Imagine that the fates of A and B diverge as you are reading this.

In A’s universe, there is a surge in demand for dental floss as the result of an unusually troublesome corn harvest that experts warn, as summer grilling season approaches, is much more likely to become stuck in your teeth.  Such corn harvests are once-in-a-blue-moon phenomena, thanks to advances in modern agricultural science.  But we have every reason to believe, when the books are tallied for the year, that A will have doubled its free cash flow relative to 2010.

In B’s universe, happily, we also expect B to double its free cash flow in 2011 relative to 2010.  But, in this universe, the surge in demand for dental floss is due to a nationwide oral hygiene panic!!  We’ve finally gotten religion about flossing.  Prominent dentists make the rounds on cable news and morning talk shows, warning of newly-discovered dangers of gum disease.  (Impotence! Death!)  Congress declares War on Plaque and appropriates $50 billion of Federal funds to fight it.  Professional-class parents compete for status through the quality of their children’s gums.  (Harvard is watching!)  And when hip-hop stars rap about flossing, they really mean it.

Each company will report the same free cash flow for 2011.  But should the market still ascribe the same value to each enterprise?  Our intuition is clearly no.  Company A seems to have experienced a nice windfall, but we don’t expect that its ability to generate cash flow has changed meaningfully.  It should more or less go back to the same predictable performance it has always delivered.  Put another way, it’s hard to imagine the market will be expecting a once-in-a-blue-moon corn harvest every year.  On the other hand, Company B seems to be riding a major structural change in demand for floss.  In the short run, it may well max out the capacity of its factories.  In the medium-to-long run, it may consider investing in new factories, going to market with different products, consolidating with other operators – all while potentially fending off competition from new entrants.  The Company is clearly on a different trajectory in terms of its likely ability to generate free cash flow in the future, even if we’re not sure what exactly it will be.

This example illustrates why investment analysts attempt to distinguish between recurring and non-recurring drivers of companies’ financial performance.  Related dichotomies in the jargon would be normalized versus reported earnings, and earnings excluding extraordinary items versus including them.  These drivers may play out in a particular quarter or, as in my example, fiscal year; but they may also play out over a longer time horizon.  For companies in highly cyclical industries, analysts often try to deduce a notion of mid-cycle earnings, to mitigate the temptation to take an overly optimistic or pessimistic view of companies’ potential to generate future free cash flow just based on where in an economic cycle we happen to be.

Part of the fun of investment analysis is that companies like to argue that negative performance is generally due to non-recurring factors — and that they are actually brilliant managers if earnings are measured on a Double-Secret-Adjusted basis that, in the company’s unbiased view, represents a true picture of the earnings power of the company.  When performance is unusually positive, however, the brilliance of management needs no further qualification.

Why do I bring this up?

Generally, I think it’s useful to distinguish between the recurring and non-recurring factors that influence one’s life in various ways.  Is your credit card bill high because you just moved into a new apartment, or because you are updating your wardrobe for every season?  Are you striking out romantically because you haven’t been compatible with your last few dates, or because there’s some deeper barrier to intimacy?  This is common sense wrapped in Wall Street jargon.

Specifically, though, the WSJ had a brilliant piece this past weekend that argues that the absence of this type of analysis from debates about public finances, taxes, spending, the deficit, etc., has helped bring America to its current precarious fiscal position.  Partisans of all stripes are guilty, which made this essay a refreshing if grim change from the typical rehash of religious arguments about what constitutes a “fair” distribution of income or a “right” size for the state.

As a starting point for my own opinions, which I’ll get to next time, I’ve provided the background above to show why I think it’s troubling (if not surprising) to consider that those in charge of the public purse consistently make the rookie analyst mistake of confusing the self-interested account of Double-Secret-Adjusted earnings with a more sober view of normalized financial performance.

If such mistakes would get a lowly analyst fired, why not our legislators?