FACTsFiscal Adjustment Cost Templates for Selecting Budget-Advantaged Stocks

2

GGA Profile

Team members include:Dick Gephardt, President and CEO Tom Blank, Executive VPTom O’Donnell, Managing Partner Scott Brenner, VP

Clients include:Anheuser-Busch NBCBoeing Peabody EnergyGE Port of OaklandGoldman Sachs UnitedHealthcareGoogle Visa

3

David AhnPrior Experience:• Director of Research, Hanover Investment

Group• Graduate Fellow, Department of State• Senior Analyst, Driehaus Capital

Management• MA, Johns Hopkins University, School of

Advanced International Studies• BA, Yale University

4

I.Fiscal cliff

II.What’s the trade? Actual examples.

III.What’s the FACT product?

1. Government shutdown threat – October 1, 2012

2. Bush tax cuts, payroll tax cut, and other provisions expire – January 1, 2013

3. Sequestration – January 20134. Debt limit – Will have to be raised in the first

quarter of 2013

5

4 Horsemen of the fiscal apocalypse

6

Tax and spending cuts per year, indefinitelyExpiration of Bush tax cuts $340bOther expiring tax cuts $ 60bAutomatic sequester cuts $ 88bExpiration of payroll tax cut $153bDoc Fix $ 25bMedicare tax $ 28bTotal $710 billion As % of GDP…………………………………………4.5%

Fiscal Cliff

7

Government shutdown threat

• The House passed a budget with discretionary spending for FY2013 of $1.028 trillion; $1.047 trillion was agreed to in last summer’s Budget Control Act.

• This sets up another government shutdown threat by the end of the fiscal year (September 30).

Preliminary forecast: We expect a series of continuing resolutions (which use the prior year’s funding levels) to fund the government until the next Congress convenes in January.

8

Tax Cuts• The Obama Administration proposes extending the Bush tax

cuts for families earning less than $250,000 a year. Cuts for those earning more would lapse when the Bush tax cuts expire at the end of 2012.

• The Republican proposal is to continue the Bush tax cuts for everyone, regardless of income.

Next Step: House Republicans plan to vote this summer to extend all the tax cuts for about 12 months. Obama has said he won’t extend them all. Both sides will have to see if they can settle their differences before the November election. If not, they’ll have to deal with the tax cuts in the lame duck session.

9

Sequestration

Bipartisan Policy Center

Preliminary forecast: Negotiations to limit the sequestration will fail, and then it will kick in for several months, if not permanently.

• 9% cut in domestic discretionary programs

• 8% cuts in mandatory programs other than Medicare

• 2% cut in Medicare provider payments

• 9% cut in defense programs

10

Debt Limit

• The U.S. is projected to reach its $16.394 trillion debt ceiling in late 2012 or early 2013.

• Because Treasury can utilize “extraordinary measures” once the limit is hit, immediate congressional action is not required; extraordinary measures may allow the US to remain within the limit until February 2013.

Preliminary forecast: We expect an increase that will last up to 12 months, but no grand bargain. Tax reform has to be part of any grand bargain. This will be late 2013 at the earliest.

11

Debt Limit

12

I.Fiscal cliff

II.What’s the trade? Actual examples.

III.What’s the FACT product?

13

Investment Planning Horizon

Short-term Future0 to 3 Years

Medium Term Future3 to 5 Years

Long- Term Future5 to 20 Years

Expected Time for Fiscal Adjustments

Rob Dugger, a former partner at Tudor, and I developed the framework of Fiscal Adjustment Cost Discounting.

The central idea is that a fiscal crisis brings investor expectations of fiscal adjustments forward and into their investment planning horizons, i.e. into the timeframe where investors price in events.

Usual expectations of Fiscal Adjustment timing

What’s the trade?

14

Investment Planning Horizon

Short-term Future0 to 3 Years

Medium Term Future3 to 5 Years

Long- Term Future5 to 20 Years

Expected Time for Fiscal Adjustments

The July 2011 debt limit fight moved expected fiscal adjustments from the long-term into the short-term

Expected Time for Fiscal Adjustments

Budget Crisis

FAC Discounting - Stock Selling and Treasury Buying

RESULT:

Crisis-Driven Expectation Shift

15

Why did Treasury bonds rally and stocks sell off in the face of a default threat?

1. In early summer 2011, federal agencies notified private contractors that they would stop payments if the debt limit was not increased. Treasury did not send such a letter to bondholders, signaling that bondholders would get priority over contractors.

2. That was the signal that Treasury bonds would rally even though there was a threat of default and then a sovereign downgrade by S&P. Stocks sold off because many companies rely heavily on government spending and taxing. Investors priced in the risk that this revenue stream could halt.

Summer 2011 Paradox

16

We made the contrarian call to buy Treasuries on June 30, 2011, ahead of the debt limit negotiations and default threat.

10-year Treasury yield in 2011

Bill Gross says he’s selling Treasuries

Client note: “Why Bill Gross is wrong on his call

to sell Treasuries”

Bond Market Rally

17

European credit markets drove U.S. stocks in 2011, but U.S. fiscal problems deepened sell-offs.

S&P 500 vs European corporate CDS index (inverted)

Default threat, Budget Control Act, U.S.

downgrade

Congress barely passes “easy” CR

Supercommittee failure

Stock Market Sell-off

18

FAC discounting is not limited to the macro level. Shifts in investor expectations of fiscal adjustments occur on the industry level as well.

Investment Planning Horizon

Short-term Future0 to 3 Years

Medium Term Future3 to 5 Years

Long- Term Future5 to 20 Years

Expected Time for Fiscal Adjustments

Expected Time for Fiscal Adjustments

FAC Attack

FAC Discounting on the Industry Level

FAC Discounting – Stock Selling

RESULT:

19

“But Carnival’s biggest government benefit of all may be the price it pays for many of those services. Over the last five years, the company has paid total corporate taxes — federal, state, local and foreign — equal to only 1.1 percent of its cumulative $11.3 billion in profits. Thanks to an obscure loophole in the tax code, Carnival can legally avoid most taxes.”

NY Times article February 1, 2011:

“The Carnival Corporation wouldn’t have much of a business without help from various branches of the government. The United States Coast Guard keeps the seas safe for Carnival’s cruise ships. Customs officers make it possible for Carnival cruises to travel to other countries. State and local governments have built roads and bridges leading up to the ports where Carnival’s ships dock.”

Example 1: Cruise Lines

20

The NYT article triggered FAC Discounting. It brought forward investors’ expectations that cruise lines’ tax loopholes would close. We’ve isolated this effect on the stock price. This chart starts on the day the article was published.

Cruise lines underperform

21

Carried interest has long been on the chopping block of tax breaks to eliminate. A timeline:

July-September 2007: The Senate Finance Committee first held hearings on the issue.

December 2009: The House used elimination of carried interest as a “pay for” as part of H.R. 4213, the bill to extend unemployment insurance. But the final law did not eliminate carried interest.

Every February from 2009-2012: President Obama proposed repeal in each of his budgets – FY2010-2013

January 24, 2012: Mitt Romney releases his tax returns for 2010 and 2011. Carried interest is the main reason his tax rate was 13.9% and 15.4%, respectively. Romney’s campaign policy director said Romney would consider repealing the loophole as part of tax reform.

Example 2: Private Equity

22

Congressional attention on carried interest over the years made it a prime target for repeal. Romney’s tax returns and the subsequent attention triggered a FAC attack. Investors priced in higher tax rates for private equity firms.

Private equity underperforms

23

Looking ahead: Stock Options?Stock option accounting background:• On their P&L, companies count the exercised option price,

not the stock’s market value, as the cost• But for tax purposes, companies can deduct the market

value of the stock, usually much higher

Timeline:July 14, 2011: Senator Carl Levin (D-MI) introduces S.1375 - Ending Excessive Corporate Deductions for Stock Options

February 1, 2012: Facebook’s IPO filing says its stock option deduction will be so large it won’t pay taxes for 2011

24

Budget advantages by S&P sector

This is a rough calculation of how much the 10 S&P sectors relied on the government in 2010. In very general terms, we recommend rotating out of the top sectors and into the bottom ones.

25

I.Fiscal cliff

II.What’s the trade? Actual examples.

III.What’s the FACT product?

26

1. Alerts a. When the risk level of a provision changesb. Other additions to the database

2. Databasea. Hundreds of tax and spending provisionsb. Risk that their repeal will be priced inc. Which industries will be affected

3. Weekly Reporta. Macro FAC risk levelb. Discussion of political risks

FACT Product

27

We will send an alert when we see a significant change to the FAC Discounting risk level of a provision, for example:

ALERT – FDA user fee reauthorization May 30, 2012 Positive for generics over brand-name pharmaceuticals The House committee responsible for the FDA user fee reauthorization bill (H.R.5651) voted on Friday night to pass a version very similar to the Senate version (S.3187), which passed the Senate on May 24 with a 96-1 majority. Expect the House to pass H.R.5651 today. Then the bills will go to a House-Senate conference, but since they are quite similar the conference should go smoothly. We expect a bill on the President’s desk by the July 4 recess, well ahead of the 2007 reauthorization’s expiration on September 30, 2012. For the first time, generic drug companies will pay user fees to help cover the cost of the FDA approval process. Although generic companies will have to pay about $300 million per year in user fees, they will receive significantly faster approvals, eventually down from 30 months to 10 months. With generic competition coming to market sooner, we expect a cut in brand name drug revenue projections and a jump in generic drug revenue projections. Expect generic pharmaceutical stocks to begin outperforming brand name pharmaceutical stocks. More details about this provision are available on our FACT database:http://fact.spoiltvictorian.com/index.php?r=provision/view&id=6

Alerts

28

Click on the database provision for a more detailed explanation

Database Provision Page Snapshot

29

Hundreds of sortable tax and spending provisions:

Database Snapshot

30

Tax hikes are inching onto the Republican table

Wall Street is now aware of the timing and magnitude of the fiscal cliff. It’s too soon to develop possible political outcomes and trade off them, but some comments over the past week started to shape the debate, especially on taxes.

Speaker Boehner drew the same line in the sand for the next debt limit showdown, expected in February 2013. He will only accept a debt limit increase in the same proportion as spending cuts. President Obama shot back the next day and said there should be no conditions.

Boehner was likely trying to appeal to his Tea Party caucus. But there appears to be a consensus among moderate Republicans (Boehner is among them) to accept tax increases as part of a deficit reduction deal. The Wall Street Journal, the business voice of moderate Republicans, published an op-ed by Robert Rubin calling for tax increases as part of a deal. The Washington Post reported that fewer Republicans are signing Grover Norquist’s anti-tax pledge. There appears to be a slow but sure moderation in Republicans’ anti-tax stance.

This is progress, albeit a baby step. But even if Republicans put tax hikes on the table, the even harder job is to agree on which taxes to raise and which tax loopholes to eliminate.

FACTs Weekly ReportPerceived FAC risk level: LOW

FACTsFiscal Adjustment Cost Templates for Selecting Budget-Advantaged Stocks