Yahoo’s shareholders and many pundits were happy with Yahoo until Monday when the company announced that it is buying back 40 million of its shares from one of its largest shareholders and current board member, Dan Loeb of hedge fund Third Point LLC at last Friday’s closing price of $29.11. In addition, Loeb announced that he and two of his associates will step down from the company’s board. Since then Henry Blodget of Business Insider absurdly suggested insider trading, while Steven Davidoff of DealBook questioned the timing of the deal and its impact on other shareholders.

I will not address the insider trading charge since it was brilliantly refuted in this Bloomberg piece by Jonathan Weil. However, I will address the other charges, mainly that the timing is suspect given that Loeb got a sweetheart deal by selling at Friday’s closing price and not paying a discount as is ‘supposedly’ customary in all large share sale transactions. The main gripe here is borne out of the fact that the stock dropped by 4% on Monday when the transaction was announced. I do not know Dan Loeb nor do I have any position in Yahoo right now.

What most investors fail to realize is that the stock dropped not because Yahoo was the buyer but because Loeb announced the sale of two thirds of his stake irrespective of who the buyer was. Loeb, as the main catalyst for change at Yahoo, and later as board member and an insider, was followed into the stock by many investors and other hedge funds after he first purchased his stake claiming that the shares were deeply undervalued at the time. So when he announces an exit by dumping a majority of his holdings, rest assured that all the other investors who followed him will take notice and many will do the same as this will be taken as a signal that Yahoo’s shares are at, or near, fair value. Moreover, there is a precedent of this. Earlier this year, on Friday February 1 after the markets closed, Loeb announced that he has sold 11million of his roughly 74 million shares at the time or 15% in the open market. Not surprisingly, Yahoo’s stock dropped by 2% in heavy volume on Monday. So a 4% drop when that same big, and well informed, investor announces that he sold 65% of his shares is not surprising and has nothing to do with who the buyer is. This is what can be called a “signaling discount”. Arguing that Yahoo should have negotiated a discount to the Friday closing price would have only made the drop on Monday even worse as it would signal to the market that the company believed its shares were overvalued at Friday’s close. A 4% drop because of Loeb’s signaling that shares are nearing fair value would have been exacerbated by an acknowledgement from the company that this was not only true but that Friday’s close actually exceeds fair value. A large share sale between two private parties is a lot different than a buyback by the issuer.

Another criticism is that Yahoo’s buyback program was used to buy Dan Loeb’s shares while other shareholders “went to the back of the line”as Robert Cyran from Breakingviews put it. The problem with this reasoning is that it fails to acknowledge that when a company buys back its shares, all shareholders benefit irrespective of whom those shares were bought from since it decreases the supply of shares, or float, and boosts earnings per share. In hindsight and as of now, it looks like Loeb may have indeed made a good trade but that does not mean that other shareholders lost because Yahoo bought his shares. Had he not sold his shares to Yahoo he would have been selling them on the open market at a slower pace and putting downward pressure on the shares (let’s call that a liquidity discount) in the process to the detriment of all other shareholders. Furthermore, as I explained above, this liquidity discount is in addition to the signaling discount that will occur when Loeb publicly announces that he sold his shares. What Yahoo did is remove this liquidity discount from its shares to the benefit of all shareholders including Loeb.

The third most frequent condemnation of Loeb is that there was some dereliction of duty when he announced that he will be stepping down from Yahoo’s board before the company’s turnaround was complete and that he has “issued an enormously damaging vote of no confidence in the company”. This view is utopian to say the least and fails to take into consideration the initial motive for Loeb’s involvement with Yahoo in the first place. Loeb, just like any other hedge fund manager, got involved with Yahoo to realize value for his fund investors first and foremost. When he was elected to Yahoo’s board he had a fiduciary duty towards all Yahoo shareholders. When his respective fiduciary duties to his fund investors and Yahoo shareholders conflict, make no mistake about it, Loeb’s allegiance and commitment is to his fund investors first and foremost. It is only natural that he steps down if he sees that his fund investors are better served if his time and energy are invested elsewhere.

I will attempt to describe the impact on the markets if no deal is reached this year and how will this impact investors and the main asset classes that will suffer or benefit from this as a result.

Markets
When it comes to financial markets the impact of the fiscal cliff will be felt the most in capital gains taxes and dividend tax rates. This will, in turn, impact some stocks for sure as well as some bonds – particularly municipal bonds.

Capital Gains Taxes: Currently taxes on profits from stocks are a maximum of your current income tax rate (currently a maximum of 35%) if you held the stock for less than a year (short term capital gains) and 15% if you held the stock for at least one year (long term capital gains). However, the top income tax rate will automatically jump to %39.6 on January 1 effectively becoming the rate for short term capital gains. Also, long term capital gains rates will automatically jump from their current 15% to 20%. So clearly if there is no fiscal cliff deal you will have to pay more taxes on your gains from stocks whether your gains are long or short term in nature. For short term gains the impact is an increase from %35 to %39.6 or roughly a 13% increase. For long term gains, your baseline scenario is an increase from 15% to 20% or a whopping 33% increase. It is expected that tax rates for long term capital gains taxes will likely shoot up over 20% in a potential compromise. So if you had $100,000 in long term capital gains this year you will pay $15,000 in taxes if you sold your stock by December 31, 2012 and at least $20,000 if you sold them on January 2nd 2013. Keep in mind that you can sell your stock on December 31 and buy it again on January 2nd without any penalty or coming foul of wash-sale rules. This increase in long term gains taxes will have a strong impact on stocks that have done extremely well this year. Look at the top performers this year and you will see a list of stocks that will likely experience increased volume and volatility in December.

Dividends: Similar to those on Capital gains, tax rates on dividends are currently expected to rise next year to a maximum of %39.6 from their current maximum level of 15%. The magnitude of the increase is significant and amounts to a 164% jump. This is a material increase if you are in the highest tax bracket. Without going into advanced financial valuations theory for stocks and securities but a stock’s dividend is an important part of any valuation formula that attempts to price a stock. Most impacted are those stocks that currently have a high dividend yield. Everything else being equal, high yielding stocks on December 31, 2012 are worth less on January 2nd, 2013 simply because the dividend component of their stock valuation will be worth less because you will keep less of it. This is a fact and not an opinion. It is not a coincidence that 1) more companies are announcing special dividends or speeding up their dividend payouts making them in 2012 versus next year and 2) the worst performing sector in the S&P 500 in November is the dividend-rich Utilities sector which is down nearly 7% in November versus a 1% decrease in the S&P 500 (up to November 27). Everything else being equal, it is a safe expectation that low growth and high yielding dividend stocks will be under pressure until year-end but may likely be a good bargain in January.

Utilities Stocks as measured by Utilities Select Sector SPDR XLU ETF have tanked in November

Municipal Bonds: Munis are tax free bonds that are exempt from federal income taxes and may be exempt from State and local taxes in many instances. If their tax exemption is maintained, they will be more valuable next year if personal income taxes go up as expected. The tax free income earned from Municipal bonds will be worth more next year compared interest gained from corporate bonds for example. Again, it is not a coincidence that while year-to-date high yield and high grade corporate bonds have been outperforming municipal bonds, that trend has reversed over the last three and one months time periods as measured by the MUB (iShares S&P National AMT-Free Muni Bond), LQD (iShares iBoxx $ Investment Grade Corp Bond) , and HYG (iShares iBoxx $ High Yield Corporate Bond) ETFs. I believe this is a good indicator of investor ‘s preference going forward till year-end.

Muni Bonds are in Blue below and have underperformed Corporate Bonds year-to-date

Muni Bonds are in Blue below and have outperformed Corporate Bonds in November

Bottom Line

Given the above it would be a good idea to sell your stocks with the most gains this year as the expected increase in capital gains taxes will have a real impact on your tax bill. You can wait till end of December to sell your winners and buy them back early next year. As for high yielding dividend stocks it may be too late to sell them but it may be a good idea to wait till the end of the year or early in January to buy any as they may go down a bit more. In the meantime it will probably be a better idea to consider municipal bonds if you are considering buying any income oriented investments.

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