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The Hunt for the 2% Solution

Irwin M. Stelzer

Google wants a management structure more like Berkshire Hathaway’s. Berkshire Hathaway wants growth more like Google’s. Monsanto and Terex want to be more like Apple and other companies that minimize their tax burdens. And China wants to be more like the U.S., or at least its central bank wants to follow the Yellen brick road of devaluation to prosperity. All are seeking the 2 percent solution.

There is a growing consensus that the new normal is an annual growth rate of around 2 percent. Some Republican candidates say they have plans to double that, but until they answer the key question – “how?” – doubters will outnumber believers by a substantial margin. Yes, the auto, housing and office market sectors are providing a significant uplift to the nevertheless modest recovery. But the coming increase in interest rates will create a new headwind for those industries, there is talk of an office market bubble, and analysts are increasingly worried about the quality of the IOUs consumers are using to pay for their top-of-the-line vehicles. Also, the strengthening dollar and the entry of China into the currency-devaluation race, which will stifle American exports; the massive overhang of billions in student loan debt; Hillary Clinton’s call for higher taxes on “the rich”; the Obama administration’s assault on the coal, oil and gas industries – over 2,600 pages of new regulations that he hopes will put him in the unaccustomed position of leading from the front when 200 countries meet in Paris in December to combat climate change – combine to lend support to those economists who see 2 percent growth in America’s long-term future. Or enough support to have many companies hunting for ways to continue growing in a 2 percent economy in which in the second quarter Standard & Poor’s 500 companies saw what Reuters calls the “worst sales fall in nearly six years” and a first year-on-year quarterly profit decline (-1 percent) since 2012, after first quarter profits for all US companies fell by almost 9%compared with the fourth quarter of 2014.

So what’s a corporation to do? Take steps to beat that growth rate. For Google it means trying to step up the growth of what are now peripheral businesses by following Warren Buffett’s lead and making them independently operated entities, each controlled by its own CEO who will have complete operating authority to manage his own company. Chief executive Larry Page and co-founder Sergey Brin will head a new holding company, for some reason named Alphabet, with Google and the so-called moonshot companies – self-driving car, robots, live-forever-or-almost heath care, balloon-connectivity to the Internet — separate subsidiaries. “Fundamentally, we believe this allows us more management scale, as we can run things independently that aren’t very related,” says Mr. Page. Page and Brin, or Larry and Sergey as they now refer to each other in shareholder communications that mimic the Berkshire style of Warren and Charlie (Munger), will concentrate on allocating capital to what they see as the most attractive businesses.

The organizational structure may copy that of Berkshire Hathaway, but the vision of the future couldn’t be more different. No moonshots for Buffett. He has dipped into his $67 billion cash hoard for $37 billion to finance the largest acquisition in the fifty years since he took Berkshire Hathaway from a small textile company to the world’s largest conglomerate. Precision Castparts is no shoot-for-the-moon operation: it is a manufacturer of equipment used by the aerospace, power and other industries about which Page and Brin know little and care less. For Buffett, Precision is what he calls “an elephant”, a company of sufficient size to increase Berkshire’s earnings, assuming Precision can reverse its own recent sales declines. Add that to a railroad, GEICO, ketchup and mustard, Dairy Queen and other stalwarts, and you have a company with an idea of how to achieve growth in a slowing economy that is very different from Alphabet’s, but is run on the same principal of independence for the operating entities, combined with centralized capital allocation.

Page and Brin are looking to grow little acorns into forests of oaks, with a takeover of the auto industry by replacing accident-prone drivers with super-safe driverless cars, extending life, turning every home into a living area controlled from a cell phone being only some of their modest goals. If Geico gets to write the auto and home insurance, if those are still needed, that’s fine with Page and Brin. Buffett and Munger, on the other hand, are buying mature forests still capable of growth, and in the process using idle funds that some investors have begun to claim should be distributed to them. Each company has its own plan for maintaining growth in a 2 percent growth economy. And investors in both Alphabet and Berkshire Hathaway are in effect saying to Page/Brin and Buffett/Unger that they trust those central allocators of capital to make wiser choices than they, the owners of the company, can make with excess cash, or than advisors can earn for them.

For those who don’t happen to be sitting on $67 billion in cash, or the intellectual capital and the gleams in the eyes of the Page-Brin team, there is another way to maintain earnings growth in a slow-growing economy: reduce the government’s tax take. Tax inversions are back in style. The process is simple. An American company buys a foreign company, and adopts the acquired company’s country as its new home base – it “re-domiciles” in the jargon of the trade. Since the US corporate tax rate is among the highest in the industrial world, an inversion reduces the tax burden on the formerly American company, increasing after-tax earnings even if the merger does not increase pre-tax profits. In one recent deal, CF Industries, an Illinois-based fertilizer maker, merged with a Dutch company, and is moving the combined entity to the UK, to the consternation of Illinois senator Dick Durbin, who chastised company management for “walk[ing] away from our nation for a tax break … after benefiting from investments by U.S. taxpayers…”, by which he means infrastructure, educational facilities and other assets to which CF and its employees have already contributed their corporate and personal taxes.

In the latest inversion deal, Connecticut-based crane-maker Terex merged with Finland’s Konecranes to create a company with a market value of $5.7 billion. By basing the merged company in Finland, Terex reduced its effective tax rate from 28% to 20%, and gained access to earnings stashed overseas without paying the 35% tax due the US tax collector if it had repatriated the funds. In short, even should a 2% economy slow sales growth, after-tax earnings will rise.

This is the most recent of the six inversions consummated since a Treasury crackdown on what Obama calls these “unpatriotic” inversions. More are in active discussion in the board rooms of American companies, the most significant being Monsanto’s $45 billion pursuit of Switzerland’s reluctant Syngenta.

Then there is China’s 2 percent solution to slowing growth; a currency devaluation of almost that magnitude. But that is a story worthy of a separate essay.

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