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Why the Focus on Government Policy in My Blogs?

Sigma Investment Counselors

February 21, 2012

Many (most) of my blogs during the past few years have centered on government policy. For each, my colleague Marisa Lenhard, CFA, CFP® (who is incredibly bright and well informed) will ask me, “How does that relate to our clients’ investments?” While it seems intuitively obvious to me, just the fact that she asks the question suggests it makes sense to discuss the implications more fully. So, here goes.

When we analyze investments for our clients, we follow a fairly rigorous and disciplined process that, at its core, seeks to discern how much cash will ultimately flow from the investment. The value (target purchase and sale price) is therefore a function of how much cash we can expect to receive from the asset.

For a simple example, consider the rental housing industry. In order to determine what a rental house is worth, a prospective buyer would determine what similar houses rent for in the area, assuming comparability to other properties. If the buyer can assume a $1,000 month rental payment and (unrealistically) no property taxes, maintenance or insurance, then the buyer of the house could expect to earn $12,000 per year. If the buyer wanted to earn a 10% return for the risk being shouldered, then the value of that house to the buyer could be estimated at $120,000 ($12,000 divided by 10%). As more variables are introduced (direction of rental rates in the future, maintenance costs, etc.) the cash determination becomes trickier. But, a prospective value for the house can still be estimated.

Now, add in the impact of taxes. In our rental house example above, if the government suddenly imposed a 20% income tax on rents where one did not previously exist, then the cash available to the investor goes down by $2,400 per year. As a result, the value of the property could be expected to go down by $24,000 ($2,400 divided by 10%). Clearly, this is a substantial impact.

Similarly, if the government passed a law that made all landlords install radon sensors, then cash flows might similarly be reduced (of course, this could also be a net positive if the insurance company offered reduced premiums for the installation of the sensor).

Referencing my last blog, “A Reasonable Price To Pay? ”, I mused about the thrust of President Obama’s tax policy recommendations (since the single most concerning fiscal issue seems to be the US budget deficit, a problem for which taxes represent a solution) and resurrected the question posed to him during his 2008 Philadelphia debate with Senator Hillary Clinton about what the role of taxes should be – to maximize revenue to the government, or to reduce income inequities?

At Sigma, one of our analytical responsibilities is to study various policy proposals being proffered and handicap the odds of legislation being passed. Some policies are very straightforward and yield fairly certain outcomes (increases in cigarette taxes can be expected to discourage tobacco consumption). Others, have secondary and tertiary multiplier effects and therefore, the analytics are more complicated (economic stimulus policies, for example). Depending upon the scale, scope, thrust and momentum of policy, our eventual investment selections could be expected to differ as our objective is to maximize our clients risk adjusted, after-tax investment returns and those returns are impacted by these policies, as described above.

I would be pleased to provide similar explanations for prior blogs as to their relevance to investments. Please let me know of your interest and the particular blog in question.

Robert M. Bilkie Jr., CFA

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