Home > General > Quips From Our June 30, 2023, Client Investment Review and Outlook

Quips From Our June 30, 2023, Client Investment Review and Outlook

July 5th, 2023


Investors typically raise risk levels when normal cyclical events stare them in the face when they should have accounted for it all along, including current happenings in China.

The most significant such issue is in fact the expected dramatic population drop in China.

Japan was viewed as the world’s economic engine (Figure 1) and now China could well be on a similar track. Increasing sovereign risk further clouds their economic outlook, especially with the EU recognizing its threat to world stability. This month, Astra Zeneca announced it was spinning off its Chinese division for this reason.



 Figure 1– Stock Performance Tied to Population Growth as Seen in Japan

Firms with heavy customer/supplier exposure in China must cut operating costs and find new outlets and innovations to maintain or capture larger market shares


All our metrics are converted to real (inflation-adjusted) terms, offering insight in both inflationary and deflationary periods.

As with our Lockheed Martin, we fully expect quite a few of our holdings to continue closing out portions of their pension liabilities. Pension transfers doubled over the past year as premiums dropped as interest rates rose. Such actions improve credit, cost of capital, and valuation if key metrics remain constant or improve.

For lower credits whose asset quality (collateral) drops during periods of sector weakness, additional borrowings come at a high cost, often unable to be captured by the shrinking operating margins.

With world economies embarking on years, if not decades, of slowing nominal (relative to post-war) growth, our proprietary financial adjustments carry important significance in estimating fair value.

Example. The purchase or sale of a futures contract is listed as an investing activity in the statement of cash flows, even though the contract is intended as a hedge of a firm commitment to purchase inventory. Thusly, we would adjust to an operating cash flow. This would not be picked up by almost all analysts, if any.[1]

Starting with the following year, firms must disclose where and when derivative instruments and their related gains and losses are reported in the statement of cash flows. To the extent we derive additional information, it will be incorporated into our restatements.

It amazes us that the geniuses at the Federal Reserve do not recognize that the more they raise short-term rates from current levels, the greater long-term rates drop since the US is already experiencing a slowdown. Should such actions occur, cost of debt capital, assuming constant spreads, drops, defeating the Fed’s agenda for inflation restraint.

Any bank restraint will likely be supplanted by the “shadow banking system,” only a portion of which is regulated and could lead to future hard-to-control issues for financial regulators

[1] Ask other advisors the various adjustments they make to the published financial statements on derivative positions.


The 15% alternative minimum tax should result in unexpected consequences for many investors. Because the change is based on a rolling average three-year $1B back-test, firms may be required to pay higher taxes even though profits and cash flows drop.

In addition, an upcoming accounting standard on taxation can be expected to have a weighty impact on valuations, providing investors with essential breakouts of foreign, local, and federal tax (subject to a 5% threshold). The standard will allow for greater introspection of risk in which the various countries’ firms operate, with the result, our worksheets will have a closer margin to the estimate of fair value.

As generative AI moves up the curve, it will allow firms to prepare tax reports and insights either not possible now due to time constraints or records being held across a wide range of locations, customers, and suppliers.

When instituted, Pillar 2 requirements are complex and will cause investor havoc, but one which we will be fully prepared for. Pillar 2 has already been adopted by a large number of countries.

The 2017 Tax Cut and Jobs Act rewards our higher-than-benchmark credit portfolio, as it limits the amount of interest that may be deductible to 30% of taxable income. However, it permits depreciation and amortization to be deducted from the taxable income calculation.

Capital-intensive industries will be vulnerable to higher taxation as they can no longer fully deduct equipment expenses in the year purchased. This residual will lower valuation multiples for affected firms.


Investors tend to downplay the real cost of stock-based compensation.

As investors read the statement of cash flows, under operating activities, stock-based compensation is added, it being a non-cash item over that reported in the income statement.

But does this provide investors with all the tools they need to evaluate firms worth?

Stock-based compensation is far from a small cost, even considering the beneficial tax effect. The employer generally is eligible for a tax deduction equal to the full amount of the stock minus the exercise price when the employee vests in the restricted stock or the intrinsic value of the stock when the option is exercised


When a restricted stock vests or a nonqualified option is exercised, the amount of the employer’s corporate tax deduction is fixed.


Equity issuance, even for firms in our portfolio, given their valuations and credit profile, is costly and should be recognized as such.

We are not advocating firms not providing this incentive to current and future employees, but to generally recognize the cost into valuation when making the decision. Equity can help lower cost of debt capital when used judiciously in debt instruments.


  • Equity dilutes current shareholders, so additional cash flows could be required to maintain current valuation levels.
  • If the tax deduction is less than the book compensation cost, the employer has a “tax shortfall.”



Our fair value estimate may be altered when an investee reports a shortfall in their normalized key financial metrics. Under normal circumstances, a shortfall, either during a short-term period or cycle, has a quantifiable and limited impact in our investment process, as it has already been considered thru the cost of capital (see Commentary), or via our normalization restatements.

Such may be cause for an outright sale or, as written in our “Commentary” which follows, be already factored into our cost of equity. Each case must be tailored to the firm and issues involved, both quantitative and qualitative. As our firms are expected to see real growth from cycle to cycle, normal cycle or temporary issues of cost or revenue wash out over time, despite what investors believe at the time to be atypical.

The primary relevant factors are:

  1. How does the shortfall impact our expected normalized real free cash flows and growth rate? What is the timing of any likely recapture of revenues delayed, discounted to current and fair value?

Identify the causes and whether they can be assumed to be of a longer-term duration. If so, for how many periods? If the shortfall was due to a significant client, supplier, geography, or external factor, is it……………………BALANCE OF THIS SECTION SENT TO CLIENTS ONLY



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