Sent: 18-05-2010 10:02:06
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Resources Tax - How Markets Work
Markets allocate capital through marginal changes not the 'all or nothing' approach being assumed in much of the resources profits tax debate.
On Lateline Business during the past week, Pauline Vamos, a spokesperson for the superannuation industry, opined that the government's super profits tax for mining projects "does not mean that superannuation funds will remove or reduce their investment in the resources sector".
She might have been, as the Lateline reporter put it, "lured by the promise of reform and bigger investments" after the government had announced extensions to compulsory superannuation coverage in the budget.
It would be unfortunate enough if the industry spokesperson had succumbed unthinkingly to the blandishments of the government simply because they favoured her employers. More worryingly, she might believe what she said.
Vamos was effectively saying that superannuation funds will make the same investment choices no matter what rate of return companies generate from the capital they have employed.
This is as mistaken as the comments of many commentators, politicians and industry participants implying that, unless they see a closed mine or an abandoned project, the tax will have had no effect.
The workings of the market are far more subtle.
Government ministers are right when they say that the fuss about the resources tax will blow over. In another year or two, corporate strategists and fund managers will no longer mention the tax in making judgments about the projects in which they should invest.
That does not mean the tax will have become irrelevant. Like hundreds of other factors affecting value, the effects of the tax will be embedded in analysts' financial models. Companies paying the tax will simply show up in the models as having a lower rate of return on capital than companies not paying the tax, everything else being the same.
Whether in resources or in other parts of the equity market, there is considerable empirical evidence that investors pay more for higher rates of return. They also pay more for dividends and for growth.
Woolworth's, for example, historically traded at a premium per dollar of earnings to fellow retail giant Coles because the former generated a higher return on the assets it deployed in its business. The fact that Coles had an inferior return did not mean it ceased to exist. The disparity in returns between the two retail majors was reflected in their respective market pricing and ability to attract capital.
After the resources super profits tax is introduced, a fund manager ranking companies according to their rates of return will find those with Australian based projects sliding down his valuation ranking. The ones operating offshore will have risen in the ranking. The same will be true of a corporate strategist working for a company choosing among alternative projects in which to invest.
A fund manager or company director will be more likely, under these circumstances, to deploy capital in favour of companies or operations located outside Australia and will find, whether they are conscious of it or not, that they are putting a smaller proportion of their investible funds into projects located within Australia.
This might not result in the failure of any projects. At the margin, capital will simply be harder to obtain for the companies paying the super profits tax, their ability to reinvest internally generated funds (or pay dividends) will be constrained and their share prices will perform less well than the shares of their peers with operations outside Australia.
Similar arguments will hold across the market. The prospective returns from resources stocks will have been reduced relative to those of industrial companies. Over time, these changes will force portfolio managers to allocate more funds to industrial companies than they otherwise would have done without the tax.
Even for fund managers who rely on an index to decide their investments, there will be an effect. Market prices will come to reflect the change in relative returns and, consequently, the weighting of stocks in indexes will change.
All of these effects depend on markets continuing to work in much the same way as they have done for as long our data is available. We have no reason to believe they will, in this instance, simply switch off at the bidding of Kevin Rudd and Wayne Swan.
That said, Rudd can be reasonably confident that his tax will probably not result in any headline grabbing closures. On this point, he is probably on safe ground and being well advised by his treasury and reserve bank officials that the more dire forecasts about its consequences are unlikely to be realized.
Nonetheless, markets work and the tax can still force changes to investment decisions and strip billions of dollars from market values as it affects the thousands of investment decisions that end up setting prices on our stock exchanges every day.
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