Apparently, it was Benjamin Franklin who said “In this world, nothing can be said to be certain, except death and taxes.” Without going into a detailed analysis of whether death is certain, and whether there are tax-haven countries with sufficiently low taxes to stretch the point a little, I have some comments to make on the throw-away use of the word “certain”.
Taxes are not certain. Even if some amount of tax is unavoidable, the actual tax payable is not certain. This is not a massively complex idea, but does require a shift in mindset to consider taxes as something other than merely a cost that must be paid, something that reduces profits and returns to the owners of a business. I’m not even talking about optimising the amount of tax paid through careful tax structuring (which can be a good idea, if it is legal, and if the loophole stays open long enough to be beneficial, and if the extent of structuring makes business and moral sense).
I’m talking about considering the impact that tax has on business strategy, target market selection, business mix choices and competitive advantage.
A current example for me is the taxation of life insurance companies in Lebanon. Corporate tax on profits is 15% in Lebanon. However, for life insurers, the tax authorities have deemed it too difficult to nail down a clear measure of insurer profitability (another point for another blog, but in fairness to the tax authorities, insurers are rather notorious for adjusting actuarial reserves to arrive at the desired financial result …). Thus, insurers are taxed on “assumed profit” which is set to be 5% of revenue (mostly premiums written, which are considered as revenue, and investment income).
Some things to note:
- The tax calculation is thus simple, which for most business is a good thing.
- The effective rate of tax is then 15% x 5% x revenue = 0.75% x revenue.
- If a company can make a higher margin than 5% of revenue, then they will benefit from the simplified tax system. If a company’s margins are thin and their net profit is less than 5% of premiums, they will pay a disproportionately large amount of tax.
The last point is where tax becomes interesting, and this is particularly ironic because in this case tax is more certain than usual (given it depends only on a single factor, revenue, rather than revenue and expenses). I’ll expand in my next posts on two important impacts this has for insurers and the economy as a whole.
Ok, so the title will only make sense within the context of Blizzard’s hugely popular (and financially successful) World of Warcraft. WoW is, very simply, a multiplayer online game (and by multiplayer we’re not talking of 4 players here, but rather millions of players around the world) where players interact with other players and the virtual world of the game.
A key component of the game is that special items can be purchased. The currency is “gold” and gold can be earned in a variety of ways. The least interesting of which is by performing basic tasks and completing basic quests. These are, in general, not very difficult or challenging, but do still take a fair amount of time. The other piece of the puzzle that is relevant to this post is that gold can be transferred from one player to another.
Without too much difficulty, it should be clear that players with lots of time and little money are incentivised to spend their time earning “in game currency” to sell to time-poor and money-rich players for real world cash (i.e. as in US Dollars). The sale of in-game currency in the real world is a free market, so free-market economics forces act on the allocation of resources (time and money) in a way as to more optimally allocate resources.
Picture if you will the far-eastern sweat-shops manufacturing shoes. Now replace the glue and sewing machines with computers, and replace the shoes with in-game WoW currency. Cheap labour comes to the fore and a business is born. In-game currency is the product, salaries (and a bit of computer, WoW and internet expenses) are the Cost of Sales, and real hard cash from time-poor First World teenagers and adult is the revenue.
- Is purchasing vast quantities of in-game gold with real-world currency (presumably earned from applying one’s particular real-world skills and talents in gainful employment) cheating? Is there a moral or ethical angle here? What is it?
- How do the “entrepreneurs” boost sales? They advertise! How? By spamming in-game players with messages.
The first point is interesting, and worthy of a blog (and quite likely a UN commission as well). The second point that has seen some recent action from Blizzard, who are suing one of the companies behind the in-game spamming. Will be interesting to see how that develops. Slashdot also picked up the story.
But, understanding how the problem arose is clear with the benefit of hindsight. However, I am quite certain that with some basic analysis of the economic forces in the game, and an understanding of consequences, these problems should have been anticipated by Blizzard. Seems like they have fallen one step behind the spammers, which could also be interpreted as the power of the free market.
Oh, and the Feudal System? The company being sued is “peons4hire”.
President Thabo Mbeki made reference to the adverse affect that volatility of the South African Rand has had on South Africa’s export manufacturers. I’ve posted quite a bit about hedging recently, but it seems that the issues just won’t go away.
Volatility hurts planning capabilities. Hedging can restrict the impact of volatility for certain durations. Maybe the exporters need to reconsider the “evil” that is hedging?
With a detailed, technical analysis of the financial and other risks inherent in a business, the appropriate risk management strategies can be defined. Value can be created through the application of these business tools, but only after the application of some sense and knowledge on the damage that volatility can do to a business and sensible measurement of the costs and benefits of alternatives.
Moneyweb falls into the same trap that many others have stumbled over time and again. David Carte mis-titles SAA loses as oil price falls and makes the mistake worse with the subtitle “A hedge goes the wrong way”. Mr Carte doesn’t belabour the point in the article, but his perspective on hedging is clear. I’ll repeat my comments attached to the story below:
The article reflects a common misunderstanding of hedges. This comment doesn’t necessarily support hedging (since they are good arguments for and against hedging) but it attempts to point out why hedging is not “taking a view” and therefore must not be judged with the benefit of hindsight as to whether the commodity involved (oil in this case) increased or decreased in price.
It isn’t a question of getting the hedge “wrong”. SAA is exposed to the risk of high oil prices. In order to remove this risk, they can hedge against the cost of rising oil prices. This way they are free to concentrate on the operational aspects of running an airline, rather than trying to guess the oil price of tomorrow. In this case, the oil price decreased. The “loss” they have made on the hedge isn’t really a loss – it is offset by the lower cost of fuel for their operations. Similarly, if the oil price had increased, they would have made a profit on the hedge, which would have been offset by the higher cost of fuel in future. The final impact is that changes in oil prices don’t impact them as much as they would have without the hedge.
Now, there are other risks such as “basis risk” and, more broadly, trying to estimate their future fuel needs (i.e. what exposure they need to hedge) but these technical points don’t negate the position that hedging is not about getting it “right” or “wrong”. It is about not wanting to take a view on oil and thus removing the exposure in a company.
Hedging is risk management, it is not taking a view. Having said that, there have been examples of misuse of hedges through mistake, lack of understanding, or trying to use derivatives to take a punt and still calling it a “hedge”.
Appropriate timing for a follow-up to my follow-up on WAR and hedging future gold production. The world of financial risk, hedging, derivatives and risk management require careful analysis, strong technical skills and an understanding of some fairly complicated mathematical models in order to generate value. Throwing a few ideas around because they seem popular does not fit this bill.
Gold Fields purchased Western Areas (through a share swap) and thus inherited the notoriously “toxic” hedge-book of Western Areas. This event is worth considering in the light of my previous blog on hedging. Let’s apply some analysis and critical thinking here.
First, some real-world imperfections. The hedge book was created in the time of the equally notorious Brett Kebble’s involvement in Western Areas. The structure, the banks involved and the behind-closed-doors-dealings that went into it are not the subject of this post. Definitely scope for some difficult questions here though.
Ok, but what about the hedge itself? Why was it terminated? Ian Cockerill, Chief Executive Officer of Gold Fields said:
- “We terminated the Western Areas hedge book because we believe in gold. “
- “The hedge book was significantly under water and was a crippling liability to the South Deep mine. Now we can bring the asset to account in a transparent manner.”
- “Gold Fields is of the view that the price of gold remains firmly in a long-term upward trend and, with that outlook, it does not make any sense whatsoever to be hedged.”
- “It also ensures that Gold Fields remains fully transparent to investors, and that its balance sheet remains simple to understand.”
Let’s take each of these statements in turn.
- So Mr Cockerill is stating quite clearly that Gold Fields view is that gold is a good investment, that they expect to make profit about increases in the price of gold over time. Fair enough. And since they are in the gold mining industry, perhaps they will have a more informed view than the average Joe. However, since they are in the gold mining industry, maybe they have a biased view of gold. Most management teams are notoriously optimistic about their company, their industry and can never understand why their share prices are so far below fair value! Also, this doesn’t address my major point that shareholders can easily adjust their exposure to gold in any case. This doesn’t present any arguments for operational improvements or similar efficiencies from terminating the hedge book.
- A crippling liability? Raising cash to pay off a liability simply accelerates the cost to now. Not necessarily a bad thing, but not clearly a good thing either. This probably makes sense within the context of point 4 below.
- Hmmm, a rehash or point 1 then. Except Mr Cockerill takes it further. “It makes absolutely no sense to hedge”. Well, as I described before, there is more to the decision to hedge than a simple view on the prospects of the gold price. One wonders whether Mr Cockerill couldn’t have expanded on his logical thought process that helped him conclude that there was absolutely no sense.
- Ah. Yes! A very valid point, and possibly the only valid point we’ve seen so far. Hedge books are complicated derivative structures and an excellent mining analyst should know about mines and mining and minerals and prices and not necessarily a thing about fancy derivative structures. Fully agree on this one.
So this leaves us with 1/4 or 25% relevancy score. Ok, this is a bit harsh, but it does support my view that hedging decisions are made more on emotion and rhetoric than on rationality and facts.
Now, there is another side to the story. From http://www.mineweb.co.za:
Western Areas also stated that â€śthe hedge banks may be able to terminate the derivative structure as a result of existing circumstances or as a result of an acquisition of control of Western Areas by Gold Fields and in that event, Western Areas may need to make a material payment to the hedge banks and would seek to raise this amount from shareholders, in proportion to their shareholdings. If Gold Fields acquires 100% of Western Areas, then Gold Fields will need to deal with this issue with Western Areas and the hedge banksâ€?.
So, in other words, regardless of what Mr Cockerill and his management team think about gold, they were probably close to forced to close out the hedge book in any case. Let’s hope this was a happy coincidence and not pure spin.
Some more background on the story:
Gill Marcus on Moneyweb in early 2006
Botoxing a bling deal, also from Moneyweb
Economic data out for South Africa is painting a good, if slghtly confusing picture. The good news is that the economy is still growing healthily (not compared with China’s official growth though) and inflation has dipped down very slightly. Neither of these are truly unexpected though. Exchange rate appreciation and a relaxation in the dollar oild price will have had a muting impact on inflation.
CPIX (the basket excluding things like mortgage repayments and a few others) increased by 5% year-on-year in October. We only have data for October available now because of delays in collecting, collating and analysing data. This was slightly above forecasts, but nobody’s panicking yet. The same figure for September was 5.1%.
Meanwhile, growth in GDP is also continuing (4.7% annualised) in the third quarter, without showing much impact of the interest rate increases Tito Mboweni has put in place this year. Having said that, if one digs down into the sector details, the interest rates increases have not been completely ignored with property-related sectors showing markedly reduced growth from earlier levels.
Now for the confusing part. The previous quarter’s GDP growth has been upped to 5.5% from 4.9%.Â First quarter figurees have been upped substantially from 4% to 5%, but last year’s growth adjusted only slightly from 4.9% to 5.1%.
So why all the changes? Well, before everyone goes on about “Lies, Damined Lies, and Statistics”, one should understand that estimating GDP is a tricky task in a developed economy, let alone one with a signficant contribution from an informal sector with limited records and reporting. As it is, there are discrepancies between information such as VAT receipts, money flowing through banks and the official GDP figures. While these measurements will be affected differently by different things, they should have a strong relationship to each other.
I’m going to dig into this as well over the next few months, but any comments or inputs are very welcome!