Catalysts in Action
- Using Tax Cuts to Help US Defined Benefit Plans
- How ESG Affects Stock Selection
- New Valuation Calculus for R&D Assets
Using Tax Cuts to Help US Defined Benefit Plans
In the US, corporate tax cuts open possibilities for businesses with defined benefit (DB) plans to improve their funded status or make asset allocation shifts that could ease pension burdens over the long run.
For example, changes to the tax treatment of interest deductibility might incentivize additional voluntary contributions to a plan to reduce the funding deficit. And the lower corporate tax rate could boost net income and offset the decline in expected return on assets (EROA) from shifting a plan’s allocation to lower-risk investments.
Voluntary Plan Contributions
Firms have until September 15, 2018 to make voluntary pension plan contributions for 2017, which allows them to take advantage of a higher tax shield than the one in effect for 2018. Hypothetically, a pension deficit of USD 100 could be funded with USD 65 at the old 35% rate, before that goes up to USD 79 at the new 21% rate.
Plan sponsors can accelerate the pace of contributions either from available cash or by borrowing. Corporate bond yields may be rising, but they are still relatively low by historical standards. So there is a case for companies with good credit to issue debt to fund their pension plans.
From an accounting perspective, plan sponsors are allowed to use their EROA to compute the pension cost on their income statements. Depending on the spread between the EROA of the new plan contributions and the interest paid on the new debt issued — and taking the new limits on interest deductions into account1 — borrowing to fund the plan could boost earnings per share.
From an equity perspective, quantitative analysis suggests that performance measured by beta has been more sensitive to pension underfunding than to other forms of corporate debt.2 Stocks of companies with shortfalls above a 5% threshold have been perceived as higher risk with lower risk-adjusted return, and tend to lag within their sectors. Past performance is no guarantee of future performance, but if this historical relationship holds, reducing the underfunding risk factor could have a positive impact on return. Figure 1 below shows the extent of underfunding across companies with pension plans in the S&P 500 Index.
There are other benefits to pre-funding. Reducing pension underfunding would limit the variable component of the annual premium that corporate DB plans must pay to the Pension Benefit Guaranty Corporation (PBGC). Plan sponsors that build up funding balances can also accrue credits against future contributions required by the Employee Retirement Income Security Act (ERISA). And fully funded plans can adopt LDI strategies that match income from investments to liabilities for pension benefits, which helps to maintain a stable funded status.
Now the lower corporate tax rate could add to net income, which could be used to lower the expected return on assets (EROA), and the sponsor can have more leeway in shifting the asset allocation to a less risky posture.
Strategic Allocation Changes
Take, for example, a hypothetical DB plan sponsor with a glidepath that de-risks the plan’s asset allocation over time, based on the plan’s funded status. As the funding ratio improves, the plan would not need as much future return and could therefore afford to take less funded status risk. By investing a higher percentage in risk-reducing assets like bonds and a lower percentage in return-seeking assets such as equities or alternatives, the plan would increase its allocations to assets that behave more like the liabilities — and reduce the volatility of its future funded status.
Under the previous tax regime, the plan sponsor in this example would have been reluctant to de-risk the allocation because of the implications for its income statement. Assuming this firm, like most corporations, uses smoothing when accounting for pensions, allocating more of the plan to fixed income assets could lower overall return expectations in future years. That would reduce the official EROA and lead to a decline in accounting net income.3
Now the lower corporate tax rate could add to net income, and this additional income could be used to lower the sponsor’s EROA. Without so much pressure to maintain a higher EROA, the sponsor can have more leeway in shifting the asset allocation to a less risky posture. That could be a particularly timely shift if the plan’s funded status deteriorated after the equity market pullback in early February.
1 Deductibility of interest payments on debt is capped at 30% of EBITDA through 2022, 30% of EBIT after that.
2 Morgan Stanley Research, “Time to Fund: New Pension Dimensions Post Tax Reform,” January 18, 2018.
3 For firms that choose to use mark-to-market methodology, changes in EROA generally do not impactnet income.
How ESG Affects Stock Selection
Research undertaken by State Street’s active quantitative equity (AQE) team showed that environmental, social and governance (ESG) issues could provide a differentiated quality factor in its investment process to include or exclude companies. The hypothesis underpinning the research was that companies behaving in a sustainable way should achieve better longterm performance, while firms that rank poorly on ESG criteria might be more prone to chronic operational issues or more exposed to regulatory risk and the prospect of public scandals, which could impair their stock valuations.
While some investors might think that an ESG focus is only relevant for large, developed market (DM) companies with the resources to finance ESG-related projects in more regulated countries, AQE’s research shows that emerging market (EM) and smaller DM companies with higher ESG scores have outperformed those with lower scores. In fact, this analysis finds that such companies are increasingly standing out, since participating in the global marketplace requires ESG awareness.
Take the case of two stocks in the Paper & Forestry industry that the AQE team was considering for its EM portfolio. The first company is a Brazilian manufacturer of coated and uncoated paper and a global leader in eucalyptus pulp production. The second company is a Chilean maker of forestry, pulp, paper and tissue products. In late 2017, expecting that pulp prices would remain strong, the team used ESG criteria to invest in the first company, but not the second.
AQE’s stock selection process seeks to identify companies that are well managed and therefore more likely to deliver sustainable future growth. Financial statements — and particularly balance sheets — can provide a good indication of quality, reflecting management decisions on acquisitions, debt financing, and cash flow. But other important management actions are not captured by financial statements such as the quality of their corporate governance, their environmental profile and the way they treat their employees and their community. Those are the non-traditional areas that ESG scoring seeks to encompass to give a more complete view of a company’s long-term earnings prospects.
Both South American firms had attractive characteristics based on the team’s traditional stock selection criteria. The first company ranked well across many of the earnings and cash-flow based valuation metrics. Its order book was solid, and forward earnings estimates were rising thanks to its plans for future growth and diversification. The second company also scored highly on key valuation metrics and forward earnings expectations were increasing rapidly.
Widening the lens to broader ESG issues, however, the team understood the risks associated with the industry, such as deforestation and other issues related to climate change. Using a proprietary ESG materiality methodology to see how these firms fared relative to peers in the MSCI Emerging Markets Index and the Paper & Forestry industry, AQE’s evaluations of the two companies were quite different.
For example, the first company is a signatory to the United Nations Global Compact, a voluntary initiative in which firms commit to implementing universal sustainability principles and take steps to support UN goals. It also had high scores on metrics related to greenhouse gases (GHG) and water management, corporate governance and ESG reporting standards, including a thorough sustainability report. And it scored above the industry median on supply chain monitoring, health and safety certifications, human rights policy and community involvement programs — all positive ESG signs that enhanced the favorable traditional metrics.
Companies behaving in a sustainable way should achieve better long-term performance, while firms that rank poorly on ESG criteria might be more prone to chronic operational issues or more exposed to regulatory risk and the prospect of public scandals, which could impair their stock valuations.
The same analysis for the second company raised serious issues. Several years earlier the firm had been involved in a price-fixing scandal but showed few signs of making changes to avoid future issues. While it exhibited high standards in ESG reporting, the team still had concerns about bribery and corruption issues, health and safety certifications, human rights policy and community involvement programs. Those non-traditional metrics led the team to exclude the company from its EM portfolio. The chart below shows the kinds of ESG criteria that are used to provide a more holistic view of companies in order to make better informed decisions about their long-term earnings prospects. As ESG reporting improves, the AQE team believes these issues will become even more central factors in judging the alpha potential of individual securities.
New Valuation Calculus for R&D Assets
The shift to a knowledge-based and serviceoriented economy means that for an ever growing proportion of firms, most of their value is derived from intangible intellectual property (IP) like software, patents and royalties. The challenge for investors is to understand how such intangible assets should be valued and how they drive the growth prospects of those companies — especially as traditional business models are being disrupted at an increasingly fast pace.
The magnitude of this transformation is reflected in the impact that research and development (R&D) has on separating the winners and losers among pharmaceutical, biotech and high tech firms. R&D is a major driver of technological change and plays a central role in the future growth of firms. That is why it has such important implications for firm valuations.
Traditional accounting principles separate capital expenses, which create benefits over many years, from operating expenses, which produce a payback in the current year. While this approach might be appropriate in the manufacturing sector, it is less relevant for firms with large intangible assets. When R&D spending is fully expensed in the current year because of concerns over reliability and objectivity, it is not counted as one of the important assets on the balance sheet. This is where traditional accounting fundamentals fall short for intangible-driven companies and can distort the accuracy of their valuations.
That is why the AQE team has developed a proprietary R&D factor to include in their valuations models. The team recognizes that technology and companies with intangible assets need to be looked at in a more nuanced way.
Take, for example, a US multinational healthcare company that was considered for an AQE portfolio. It exhibited attractive fundamentals from a valuation standpoint based on traditional accounting measures. After adjusting for R&D and capitalizing expenses according to the lifecycle of its IP-based assets, however, the team found that return on equity fell from 6.58% to 3.54%. Similarly, the return on capital went from 3.46% to 2.10%. These are meaningful differences — with obvious implications for investment decisions — that expected return models should be designed to capture.
Such apparent mispricings provide opportunities for active managers to identify companies that can outperform market expectations. As the rise of the intangible economy continues, we believe successful active managers will need to rethink conventional valuation measures for intangibledriven companies and sectors.
As the rise of the intangible economy continues, we believe successful active managers will need to rethink conventional valuation measures for intangible-driven companies and sectors.