Tax Avoidance Article

Thanks again to Seeking Alpha, which published another article. Link and text below:

http://seekingalpha.com/article/400371-dodging-taxes-hold-garmin-mcdonald-s-and-visa-then-sell




I am no David Einhorn, but I was fortunate to have one of my stocks make a run recently: Garmin (GRMN) rose to $48 because of strong earnings, giving me a nice return from my purchase price of $33 in May 2011.

If you bought McDonald's (MCD) or Visa (V) in May, you are in the same boat that I am:

Stock	Garmin	McDonald's	Visa
Price on May 2 '11	$34	$78	$79
Price today	$48	$101	$117
Percent return	41%	42%	48%

My initial reaction when Garmin hit $48 was to sell and reallocate the capital to another undervalued stock. But then I decided to channel my inner-Mitt Romney and research the capital gains tax laws before pulling the trigger on the sale. Capital gains are taxed at your regular income tax rate if the shares were held one year or less, but at a lower, special rate if they were held over a year.
By holding three months longer to reach the twelve-month plateau, an investor's tax burden on selling the stock declines. The following table demonstrates this for the 15% and the 33% tax brackets, assuming 1% transaction costs and share purchases at the May 2, 2011 price listed in the table above:

Actual returns after short-term capital gains tax
Share price today	GRMN: $48		MCD: $101		V: $117
Tax bracket	15%	33%	15%	33%	15%	33%
$ Realized per share	45.49	43.06	96.69	92.73	110.30	103.67

Actual returns after long-term capital gains tax
Price May 3 '12	GRMN: $48		MCD: $101		V: $117
Tax bracket	15%	33%	15%	33%	15%	33%
$ Realized per share	47.52	45.49	99.99	96.69	115.83	110.30

You can see that by holding the stock for a year, you are essentially paid a bonus by the government. Not bad. Of course, you are taking the risk that the stock might go down beyond the tax benefit, but then it also might go up.

Some clever investors may want to have their cake and eat it too: by shorting about three-fourths of his or her current holdings, an investor nearly can lock in the current price and wait to sell when the long-term capital gains rate hits, then cover the short for a smaller short-term gain or loss and pay fewer taxes as a whole. But the IRS does not allow this practice, with a prohibition against "wash sale" trades designed to turn maximize short-term losses and long-term gains. Wash sale rules prevent you from using tax losses on stocks you are short and long at the same time, or that you sell and re-buy within 30 days. For more info on wash sale rules, click here.

Here's a tax tactic that the IRS does allow: Say you bought one lot of shares in May and another in November. You want to minimize your taxes, but you also want to get rid of your shares as soon as you can. You can tell your broker or the trading web site you use to alter the cost basis calculation from first in, first out (FIFO) to last in, first out (LIFO). Then sell your November shares today. You will be taxed at the short-term rate for those shares. But you can sell your remaining shares in May to get the long-term capital gains rate on that lot and exit the position. Be sure that you do not employ dividend reinvestment on your shares, because that may cause the wash sale rule to kick in.
Even if you are a buy-and-hold kind of guy/gal not concerned about tax management, one quick tip: You may want to sell around October 2012. That's because the capital gains taxes for 2013 are increasing. This is an incentive for investors and fund managers to sell in late 2012 and capture gains while the tax rate is still low. In turn, those gains will prompt investors to sell their losing stocks as well to realize capital losses that further minimize the current tax burden. A Graham-and-Doddsville investor may choose to ride the wave, but someone who likes to play the market's ups and downs may want to consider selling shares before November '12 and jumping back in by late December.

Disclaimer: I am not a CPA. This is an opinion based on research. There could be wrinkles in the tax laws that my research did not reveal. I advise you to talk to an accountant about your specific tax situation before you wholeheartedly rely on this advice.


For those scoring at home, a reader sent me a message with another strategy that is an effective hedge against losses while you are waiting until twelve months pass: buy put options on your stock, then sell them around the same time you sell your shares. As long as your options are not deep in the money, you may avoid the wash sale rules:

http://bit.ly/xNobXv 

The market will probably drop in the last quarter of 2012

The capital gains tax rate is increasing in 2013. The taxes that investors pay on winning stock positions will go up in 2013. So that is an incentive to sell toward the end of 2012. I think we will see a market correction at the end of this year. But is that enough to make it smart for investors to sell around the summer? It depends on the liquidity, the ease of buying and repurchasing, and your transaction costs.

Alternatively, Congress might pass a law that puts off the hike in capital gains taxes. That would make this point null.

Article

Thank you to the Seeking Alpha moderators who ran my last blog post as an article that I submitted to them. Here is the link:

http://seekingalpha.com/article/378271-9-stocks-to-take-advantage-of-the-market-s-misuse-of-discount-rates

The trouble with discount rates

Discount rates are an elegant way to whittle a three dimensional concept down to one dimension. But they are inexact.

For starters, a brief definition of a discount rate: A discount rate is a percentage amount by which you reduce future cash flows to calculate what they would be worth today. (My definition)

Investopedia's definition:
The interest rate used in discounted cash flow analysis to determine the present value of future cash flows. The discount rate takes into account the time value of money (the idea that money available now is worth more than the same amount of money available in the future because it could be earning interest) and the risk or uncertainty of the anticipated future cash flows (which might be less than expected).

Pretty good definition.

Ok. So which would you rather have - one dollar today, or one dollar and ten cents next year? Discount rates attempt to tackle that problem.

 

In terms of an investment, your cash and assets today is the "first dimension."

There are two risks that discount rates account for. 1. The risk that you will not be paid tomorrow (uncertainty/variance of cash flows, the "second dimension") and 2. The risk that inflation will make money tomorrow worth less than it is today, (risk of time and inflation, the "third dimension")

Now, what you are really looking at, in reality is a series of cash flows with a probability associated with each one.  Let's say you have one dollar today, and you can invest that in a loan that 95% of the time will pay you $1.10 next year and 5% of the time will pay you $0 next year.  A discount rate takes the $1.10 and reduces it by the risk of default. The higher the probability that you are paid $0, the higher the discount rate. If you determine your discount rate is 10%, then it is a theoretically neutral present value project, with a $1 net present value and a $1 price. An investor should be ambivalent.

The trouble is that the probability trees of payments on investments are not shaped the same. Some investments are all-or-nothing, like the one above. Some are closer to normal probability curves. Some are oddly shaped. For example, as used in a post mentioned before, the future cash flows of USEC, Inc. are dependent on whether it receives a loan guarantee from the U.S. Department of Energy. Any future income projections for five years from now will be skewed away from the average because the loan will have such a big impact on the results of the company. But that might have the same discount rate as a set of returns that are highly volatile and centered around a mean. And those might share the same discount rate as a junk bond with probability skewed toward either full repayment or zero payment. But to investors, the differences between these returns are meaningful. Investors have different capital needs, so they care whether their returns are more centered or skewed toward 0.  So that's the first way discount rates can fail: they take different arrays of returns in a fixed period of time and try to put a single price on them. Taking two dimensions and bringing it to one.

The third dimension of cash flows is the timing. Discount rates put a single price on differently timed cash flows. So if you have one investment of $1 that pays $1.10 next year, and another one that pays $1.46 in four years, a discount rate might find these two investments of equal value. But to an investor, there is a big difference. Some people need money earlier, and some people can wait and are more long-term investors.

In addition to providing a little too much simplicity, discount rates are difficult to calculate. Wall Street uses a CAPM formula, but that formula is incorrect, as discussed in a previous post. I have put a lot of thought into the correct way to determine a discount rate for an investment, and I have yet to figure it out. One day I'll come up with something.

Until then...

The most accurate way to analyze an investment is to project the actual cash flows into the future, without discounting them. Note the shape of the probability curve, and the timing of the cash flows. If you foresee everything being normalized, with nothing skewed in terms of the probability curve or the timing of returns, then apply a discount rate based on the chance that inflation will reduce your spending power, and the spread, or standard deviation of the probability curve. The longer you have to wait for your returns, and the greater the standard deviation, the higher the discount rate should be. As a baseline, a discount rate low-risk, constant payment, such as an annuity from a company with good credit, should be in the 5-8% range.

Small caps high cash

I used a stock screener at FinViz.com to pick out some cheap stocks by the numbers. They are very small cap stocks with low trailing price to cash flow or low price to book value. I will take a look at them one-by-one and post analysis on a few select ones to see if there are any good buys. Here is the list of cheap stocks:

Industry	Name	Tick
Electronics Wholesale	ADDvantage Technologies Group Inc.	AEY
Home Health Care	Almost Family	AFAM
Sporting Goods	Aldila, Inc.	ALDA
Processed, Packaged Goods	American Lorain Corp	ALN
Health Svcs	American Caresource Holdings	ANCI
Wireless	ARC Wireless Solutions	ARCW
Property Management	AMREP Corp.	AXR
Communication Equipment	Blonder Tongue Labs	BDR
Biotech	Bionovo, Inc.	BNVI
Financial	Broadway Financial Corp	BYFC
Savings & Loans	Central Federal Corp	CFBK
Scientific Instruments	Digital Ally	DGLY
Footwear	Exceed Company	EDS
Savings & Loans	First Bancshares	FBSI
Regional Banks	First Community Bank Corp of Am	FCFL
Machinery	Gencor Industries	GENC
Insurance	Hallmark Financial Svcs	HALL
Technology	Himax Technologies, Inc.	HIMX
Electronics Wholesale	Infosonics Corp.	IFON
Regional Banks	Independence Federal Savings Bank	IFSB
Bus Svcs	Innotrac Corp	INOC
Apparel Clothing	Joe's Jeans	JOEZ
Scientific Instruments	The LGL Group	LGL
Regional Banks	MBT Financial Corp	MBTF
Regional Banks	Monarch Community Bancorp	MCBF
Electronic Equipment	Emerson Radio Corp	MSN
Medicla Instruments	NeuroMetrix, Inc.	NURO
Life Insurance	National Western Life Insurance Company	NWLI
Medical Instruments	Pro-Dex Inc.	PDEX
Regional Banks	Park Bankcorp	PFED
Periodical Publishing	Private Media Group Inc.	PRVT
Specialty Chemicals	REX American Resources Corp	REX
Regional Banks	Savannah Bancorp	SAVB
Credit Services	Security National Financial Corp	SNFCA
Semiconductor	Tegal Corp	TGAL
Regional Banks	Tower Financial	TOFC
Semiconductor Equip	Trio-Tech International	TRT
Savings & Loans	Teche Holding Company	TSH
Internet Information	The Street, Inc.	TST
Music And Video Stores	Trans World Ent. Corp	TWMC
Auto Parts	Tongxin, International	TXIC
Insurance	United American Healthcare	UAHC
Regional Banks	United Security Bancshares	UBFO
Medical Appliances	World Heart Corp	WHRT
Regional Banks	Western Liberty Bancorp	WLBC
Communication Svcs	WPCS Int'l Inc	WPCS
Wineries	Willamette Valley Vineyards	WVVI

But just because a stock is cheap according to multiples doesn't mean it's a good buy. The first stock I looked at from this list confirms this.

Company: Joe's Jeans
What they do: Sell expensive jeans, retail and wholesale. In the $120+ range. They design the jeans and pay a manufacturer to sew them together.
Competitors: Many competitors in this industry. For example, 7 for all mankind.
Why can't somebody else do what they do: Joe's designs their jeans well, as evidenced by these generally good reviews:


http://www.yelp.com/biz/joes-jeans-boutique-san-francisco

http://reviews.macys.com/7129/325960/joes-jeans-honey-boot-cut-jeans-gigi-wash-reviews/reviews.htm


 I believe other companies can mimic Joe's success. Joe's has experience in the jeans field, but experience can be hired. They have a brand, but that is not too well known. I think they don't have much of a sustainable competitive advantage. But trends come and go, so maybe if they become a trend, the company could take off. But a general rule is to never invest in a conjecture. I don't know the first thing about fashion trends, so I am not going to put my money on a company hoping they go in style. It has to be about the numbers, or something that plays to the expertise of the investor.

Balance sheet:
Cash and equivalents $11.5 million
Inventory $24 million
Receivables, PPE $10 million
Payables $16 million
Net Realizable Asset Value, maybe $25 million

Net Income:
Trailing 12 months, negative $2 million
Trailing 36 mos, positive

Cut to the chase
Here is the reason I don't want to invest in JOEZ. Looking at their most recent quarterly report, they lost money on their retail sales, and they have upcoming lease obligations that increase from about 3.5 million per year to 4.5 million over the next five years. They have about 4 million options to grant, 6% of the total shares outstanding, which will probably be issued if the stock price rises. Right now many options are underwater so are not counted on the balance sheet. The reason the company has high cash is because it has a factoring agreement whereby it sells its accounts receivable. Not a bad thing, but it's not like the company is a cash machine on its own. Finally, the company has a profit sharing agreement with its top board member based on a 2007 licensing deal. It gives this guy 11% of its gross margin (Revs - COGS, NOT profit margin!) from 11 million to 21 million, and about 2% of all gross margin after that. With $80 mill annual sales, it's a slam dunk that gross margin will hit these levels, so the company is taking $1.6 million out of its annual profits to pay this licensing agreement. This is already a low profit margin business, and this licensing agreement will continue through 2017. So JOEZ is not a safe enough investment for me in particular. If I were a fashion aficionado and had inside information that Joe's Jeans would be promoted at the world-class fashion show in Milan, then I'd purchase some shares. But I'm not.

Remember, this doesn't mean the stock will go down or that it is a bad investment. It just means I am not comfortable enough with the company to put my money up for it.

Corning Analysis

Here is the promised analysis of Corning (GLW). I think at $14 or so it is a good buy.

Company: Corning is a glass maker company. It makes display glass for LCD TVs, smartphones, tablets, fiber optic cables, and other random items such as some sort of car catalytic converter emissions item. Corning owns half of joint ventures with Dow (producing polysilicon glass for semiconductors and solar panels) and Samsung (display glass).

Industry: Specialty glass makers. Corning and Asahi (Japan), Nippon Electric Glass is a smaller third players. There are many fringe glass makers in different segments.

You might know it for: The video "A Day Made of Glass" on YouTube. Cool video.

Margins: Gross margin 43%, Net Profit Margin about 20%

Why can't other people do what Corning does: It requires R&D, engineering and high capital expenses to get going. It takes a while to build these big blower furnaces to make the glass, and the technology is always changing.

Market Cap: $21 billion

Current Balance Sheet:
Cash and Short Term Investments: $6 b
Inventory, LT Investments: $5.5 b
PPE and Other Tangible Assets: $12 b
-----
Total Tangible Assets: $23 b

Accounts Payable: $1 b
LT Debt, Pension, Other Liabilities: $5.5 b
-----
Total Liabilities $6.5 b

FY 2011 Net Income: $2.8 billion


Factors that affect Net Income in the future:

75% LCD
Demand for LCD TVs: Will probably remain flat
Supply chain and utilization rate for LCD glass: Should decrease demand slightly
Pricing for LCD glass: Should go down
Profits should marginally decrease

5% Dow Corning
Profits should go down as the solar craze subsides

5% Fiber Optic Cable
Profits should incrementally rise

5% Gorilla Glass (Specialty glass, tablet glass)
Profits - Faster rise. Gorilla glass 2, thinner and just as strong.

5% Environmental
Profits - Slight rise

4% Life Sciences (Lab Glass)
Profits - slight rise

1% OLED
A new type of glass for a better, more expensive flat-screen TV. Not sure how to model this. Should not affect profitability in the near future, but perhaps by 2015 this will be a big market for TVs

Amortization:  CapEx has been higher recently, so Net Income will come down a bit due to amortization.
Strength of the Yen to Dollar exchange: A stronger yen helps Corning's profits. There was a strong yen in 2009-2011 which added a significant amount to the bottom line. The future is uncertain.



Future income will probably be lower than $2.8 billion in 2011. There are some pricing pressures that will cut into margins. Revenue will probably improve slightly. A floor for income is about $1.5 billion. If the Gorilla Glass or other segments can outperform, you could see it go up from there.

Converting Net Income to Cash Flow:
Capital Expenditures: These were up around $2 billion in 2011. Higher than in the past, so you are going to see a higher amortization in the future. 2012 is planned just below that. It would be nice to see Corning reduce this number in 2013.

Converting Cash Flow to Share Value:
Shares outstanding : Pretty constant at 1.56-1.58 billion over the last two years. Corning just implemented a buyback program which should reduce shares just below 1.5 billion outstanding. Corning also pays regular dividends to shareholders. No planned spinoffs and Corning is not a rumored acquisition target.

Bottom Line:
Paying about $20 billion for maybe $8 billion in realizable asset value plus $1.5 billion per year. Good deal in my opinion.

Missed opportunity

A month ago I mentioned Corinthian Colleges (COCO) in a post. I sort of tuned them out because I don't really think they add value to society.  Their business model is a hustle (signing people up for loans to pay for expensive education that is not that valuable). But in the investing world, a dollar from a hustle is worth just as much as a dollar from a brilliant invention. Buying stocks, you are simply trading money today for a set of assets plus a stream of cash flows in the future.

A company with a decent balance sheet, trading at 1/6 of annual revenues profitable two out of the last three years, may not be a bad bet. The two things to watch out for would be an industry change, such as a change in the education loan laws, or fraudulent accounting practices.

Anyway, COCO is up 30% today on good earnings. So the lesson is to keep an open mind even if you find a stock distasteful.