Wednesday, August 5, 2020

From Class Rooms to Class Zooms: Teaching during COVID times!

As some of you who have visited my website and read my bio know, I describe myself first and foremost as a teacher,  and every semester, for the last decade, I have invited anyone who is interested to join in my classes. In December 2019, when I posted my last invite, I fully expected to be teaching corporate finance and valuation, in person, at the Stern School of Business at NYU, in the spring of 2020, and I invited people to join in virtually, albeit for no credit. Needless to say, COVID upended my plans, as it has everyone else’s, and we had to move classes online in early March, and spent the last half of the semester, meeting on Zoom, and taking exams online. As the fall semester approaches, I have the luxury of sitting back and waiting, since I am not scheduled to teach until the spring again. I am thankful that I will not have to deal with the chaos that September will bring to classrooms around the world, in both schools and colleges, but that will not stop me from extending an invite to my classes in the fall.

A Teacher's Lament
I have been a long time advocate of using technology to deliver classes online, and my first attempts to do so date back to the 1990s, well before the appearance of Coursera, EdX and a host of other online platforms. When classes had to be moved online mid-semester in the spring of 2020, I was more prepared than most to deliver my classes online, having had some experience in the game. As this crisis has stretched from days to weeks, and from weeks to months, my office at home has become a home recording studio, but my updated camera still captures me in shades of dishevelment, and my new microphone cannot completely shut out the sounds of home, from my dog barking at the front door, to Alexa notifying me that a new package has arrived, to the microwave pinging.  

That said, this semester was a reminder, in case I needed one, of how much of what I love about teaching comes from physically being a classroom. Don't get me wrong! I love what Zoom, Cisco WebEx, Microsoft Team and Google Classes have created as platforms,  to allow me to teach my classes online, but as I explain in this long-ago session I did on teaching as a craft, there is an element of magic that can show up only in a classroom, and even there only rarely. If you ask me where the magic comes from or how it is created, my answer would be that I do not know, and that if I did, I would bottle it and drink it myself. I am aware, though, when it happens, and it does so suddenly, and in settings and moments where you least expect it, and when it does, there is no experience quite like it.  It is the reason that I would not trade in what I do for a living for any other profession in the world, no matter how lucrative the payoffs. 

I am sure many of you find yourself working in unfamiliar settings, as you struggle to get your job done from home, and juggle multiple roles (parents, teachers, handymen). I also know that some of you were expecting to be back in school soon and have been disappointed to find out that you will be taking your classes online again. The last thing that many of you may want to do is to add another online task to your to-do list, but just in case you do have the time and the inclination, I thought I would give you a look at the courses that I teach (or have taught) and the platforms that I offer them on, to find a course/platform combination that is to your liking. 

Picking your Poison
I have been lucky in my academic life that I have never been good enough at any one area of finance to become a specialist/expert, and have had to develop diverse interests in both teaching and research and different ways of delivering (timing, platform) what I know, to create something resembling a niche.

In 1985, in my very first year of teaching at the University of California at Berkeley, I taught five different classes from corporate finance to investments to central banking, knowing just enough of each to stay one step ahead of my students. In the years since, my primary teaching at the Stern School of Business has been focused on two courses, corporate finance to the first year MBAs, and valuation to the second year MBAs, with occasional forays into undergraduate teaching. Along the way, I also developed the material to teach a third course on investment philosophies that I have never delivered in a classroom at NYU but have taught in shorter programs elsewhere. In fact, over the last three decades, I have unpacked and repacked these three classes and delivered them on every continent, and in different durations, ranging from an hour (yes, really!) to a day to three days. I don’t require much in terms of pre-prep for any of these classes, but there are a few very basic financial building blocks and economic concepts that I draw on repeatedly that I have now packaged into a course that I unimaginatively call my foundations of finance class. 

1. Foundations of Finance
Coverage: I have always thought of finance as a hybrid discipline, with roots in economics, and substantial contributions from statistics, accounting and psychology. In this short class, more a collection of tools and topics than a real course, I look at how the time value of money, an incredibly simple construct built around cash flows and risk, underlies much of what we do in finance, and the mechanics of putting it into practice. I also do a brief introduction to three macroeconomic variables that show up repeatedly in finance, inflation, interest rates and exchange rates, more from the perspective of a practitioner who has to deal with them on a daily basis and less from that of an economist.
Objective: To provide a basic understanding of the building blocks that I will use in my corporate finance and valuation classes. 
Intended audience: If you have no background in finance or economics, the topics that I cover in this class will be useful. If you do, you may find the sessions going over familiar ground, and may find yourself skipping forward. 
Structure: The class is built around 12 sessions, starting with an introduction to how finance views businesses, moving on to the time value of money and a basic introduction to how we value contractual, residual and contingent cash flows and closing with sessions on three macroeconomic variables (inflation, interest rates, exchange rates) that show up repeatedly in financial analysis.

2. Corporate Finance
Coverage: Corporate finance is the ultimate big-picture class laying out the first financial principles that govern how to run a business. Consequently, it covers every aspect of business, from whether and how much to invest back into the business to how to finance (borrowed money or your own) these investments to how much cash to take out of the business (dividends and cash return).
(1) To provide perspective on the core principles that govern investing, financing and dividend decisions, and how choices on one of these dimensions can and often do affect choices on the other.
(2) To get comfortable with the tools, models and theories that lead to the "right" corporate finance decisions.
(3) To understand why managers and owners often choose to deviate from the script and make sub-optimal decisions.
Intended audience: Everyone, from business owners to managers to consultants to investors, but I am biased... 
Structure: This class starts with an assessment of corporate governance (and where power resides in a  company), moves on to how best assess investments, then to financing mix and type and ends with dividend policy. Since it is an applied class, I use corporate finance tools on a diverse group of companies to see how they work.

3. Valuation
Coverage: This class is about attaching a number to an asset, item or investment, and given that broad mission, it draws a contrast between valuing and pricing an investment and develops the tools of each  approach, with intrinsic and discounted cash flows determining value, and multiples/comparable assets driving pricing. 
(1) To value and price publicly traded companies, small and large, young and old, developed and emerging markets, as an investor.
(2) To value and price privately owned and non-traded businesses
(3) To value and price stand-alone assets
(4) To price collectibles
Intended audience: Investors of every stripe, from individuals to venture capitalists to fund managers, equity research analysts, value consultants and financial managers at public companies.
Structure: The class begins with an examination of broad themes that animate valuation and pricing, and then spends a significant portion of time in the weeks of intrinsic value, talking about cash flows, growth and risk, before moving on to pricing and real option valuation. Along the way, we will look at valuation through different perspectives (investors, acquirers, managers).

4. Investment Philosophies
Coverage: This class is designed to provide you with a menu of investment philosophies, from old-time value investing to day trading, with descriptions of the market beliefs that underlie each one, the historical evidence on how well each philosophy as performed, as well as the skills and strengths you will need to make that philosophy work.
Objective: To find the investment philosophy that is right for you, given your risk preferences, strengths and personal make up.
Intended audience: Investors of all types, from individuals to professionals, novice to experienced and young to old.
Structure: In keeping with the idea that there is no one best investment philosophy, the class will begin with the much maligned philosophy of technical analysis and charting, before moving on to value investing and growth investing in its different forms. We then look at trading strategies built around information and arbitrage-based strategy, before ending with a sobering assessment of how difficult it has proved for active investors to beat the market.

Sequencing and Overlap
If you an uninterested in any of these classes, there is clearly nothing more to say. If you are, I can offer my subjective road map through the classes. 
  • The course to start with is the Foundations class, since it is only twelve sessions and covers the basics. Feel free to jump ahead if you find the material too basic or just do the sessions that you are interested in.
  • Of the remaining three classes, the one that I think has the widest reach is corporate finance, since understanding how to run a business is something that I believe everyone can benefit from. Put simply, whether you are corporate lawyer, a marketing executive, a consultant or a strategist, understanding corporate finance can make you better at your job. In terms of sequencing, it also lays the foundations for getting more out of the valuations class and should precede it.
  • Valuation builds on corporate finance, but is most useful to those in the business of valuing companies (appraisers, equity research analysts, M&A analysts), but understanding what drives value can also help entrepreneurs and private equity investors. I think that understanding value can be useful even if you consider yourself more of a trader, but that may be my biases speaking.
  • The investment philosophies class is aimed at people interested in investing, whether they be individual investors or professional money managers. Thus, if you have little interest in actually valuing companies from scratch, and more interest in getting a broad perspective on how to invest money, you can skip both corporate finance and valuation and just take this class.
Will there be some topics that get covered in more than one of these classes? Of course, but in my view (and remember again that I am biased), these are topics that are worth repeating and looking at through a different lens. Thus, I will cover the basics of estimating cost of capital in corporate finance, but with the perspective of estimating hurdle rates for companies that are evaluating projects, and again in valuation, but from the perspective of investors trying to value a company. 

Delivery Platforms
With each class that I teach, I have multiple versions that you can access, and you are welcome to pick the one that best fits the time you have available to spend on the class, and what you hope to get out of it. I have tried to make the content equally accessible in all of the platforms.

1. Regular classes (Free): For the corporate finance and valuation classes, the classes that I teach at Stern are available in unvarnished, but complete, form (classroom recordings of lectures, slides, exams and even class emails). That detail, though, can be overwhelming, since no one was meant to watch a session that last 80 minutes (my regular class time) online, and you can drown in the weekly assignments, quizzes and other components that make for a regular class. That said, this is the closest you will get to a full time class experience in terms of content and if have patience and tolerance, you can make your way through these classes. You can find the entry pages to the classes below:
With each class, you can stream the class from the NYU server, at least for the latest semesters. The spring 2020 class was distorted by the crisis, and if you prefer a more conventional class, I have the 2019 versions listed as well:
As you will see on these pages, each recorded lecture comes with the slides that I used for that lecture and a post-class test and solution. Since the NYU server gets wiped clean every two or three years, I have YouTube playlists of the same classes at the links below:
2. Online Classes (Free): If you don't have the time or the patience to sit through 26 sessions of 80 minutes apiece (and who can blame you?), I have created online versions of all four classes, where I have tried to compress what I would say in an 80-minute session into a 12-15 minute session, and honesty requires me to confess that it was not that difficult, a testimonial to how much padding we put into two-year MBA programs. The webcast pages for all four classes are available below:
The videos are also available as YouTube playlists for each class:
3. NYU Certificate Classes (definitely not free): The regular and online classes that I list above are free, but there are two catches. The first is that they come with no certification, since I have neither the inclination nor the resources to keep track of who is taking the class, how well they are doing and providing the certification. The second is that online classes require self-discipline, since there is no mechanism for me to prod or nag you to keep up with the class. For many of you, these are not deal breakers, and I know of many who have persevered to finish these classes. If you believe that you need both the structure of a real class (with deadlines and time schedules) and certification, there is a third option and that is to take these classes through New York University's Executive Education program. The links to the certificate versions of the classes are below:
  1. Foundations of Finance Online (Included in Corporate Finance and Valuation certificate classes)
  2. NYU Certificate in Corporate Finance
  3. NYU Certificate in Advanced Valuation 
  4. NYU Certificate in Investment Philosophies
These classes have more polished versions of the videos that I recorded for my online class, come with exams and projects, and I do live Zoom sessions every two weeks, with each class, for the clearing up of doubts and questions. They also include quizzes, an exam and a final project, the last of which I will grade and return to you with feedback. Since these are offered through NYU, they come with a price tag, that some of you may find too high. Since the content on these courses is identical to the free online versions (even though NYU has chosen to add advanced to the valuation class and applied to the corporate finance class names), you will have to decide whether these add ons are worth the price that NYU charges for them. And for those of you find that price to be too high, there is always the free version!

The University Model: Disruption Coming?
You can accuse me of biting the hand that feeds me, but I have always though that the university model of education, especially as practiced by research universities, is dysfunctional and ripe for disruption.  If a university were treated as a business, and we were asked to objectively assess its performance, we would give it failing grades on multiple counts. The university governance system stinks, investments are driven by ego and me-tooism, the funding process is unsustainable, and universities seem to revel in mistreating their primary customers, the students, who deliver the tuition revenues that represent the bulk of their revenues. That said, this mistreatment is not a new phenomenon and the university model has endured for centuries, foiling and co-opting potential challengers over this period. As recently as a decade ago, there were some who proclaimed that MOOCs (massive open online courses) would upend universities, but that assault, like others before, failed and EdX and Coursera now operate as extensions of universities, rather than competitors. I argued a few years ago that technology-driven disruptors of education were failing because of a fundamental misunderstanding of what a university degree package offers students, viewing a university education as a collection of courses. At the same time, I offered a cautionary note to my university colleagues that change was already here, undermining the moats that universities have erected against competitors. If you are interested in that presentation, you can click here.

In 2020, COVID may have accomplished what hundreds of years of competitors and critics have not, and exposed the underbelly of the university model. 
  • First, as classes moved online, there were many where students hardly noticed the difference, as classes taught without energy, enthusiasm and engagement in a physical classroom sound the same online, and are easier to mute. 
  • Second, of the many things that students misses after classes moved online, the classes themselves were low down the list, well below friends, college sports and parties. 
  • Third, the fact that most universities were unable or unwilling to cut tuition, even as classes move online, drew attention to the magnitude of the tuition and how little of it is directly connected to student education. 
  • Finally, it forced students and parents, who had been have been conditioned to believe that the only way to get an education is to spend four years at a university, out of their pre-conceptions and to experiment with alternative routes.
My good friend, Scott Galloway, has been vocal in arguing that COVID is the tipping point that is going to upend the university model. He sees a world, where the strongest and most prestigious schools will survive and perhaps even thrive, while many small colleges and tuition-dependent universities will be decimated. While Scott and I agree on the trends and many of the problems with the university model,  I have more hope than Scott does for the model. I  think that COVID provides an opportunity for universities to remake themselves into institutions where real learning is delivered in classrooms, good teaching is valued, and the focus returns to educating students. This change will come with pain, felt disproportionately by the tenured faculty and administrators, who have benefited the most from the existing model, with the question of tenure itself being debated. As someone with tenure, I believe that no one is entitled to a job for life, and arguing that tenure is needed to allow researchers to express themselves freely sounds good, but is disingenuous. Much of academic research is so abstract and separated from reality that it is unlikely to be read, let alone be the basis for a firing. 

The Bottom Line
It has always been true that learning is not restricted to classrooms, and that your education may begin in a classroom, but it finds its grounding when you practice it in the real world, warts and all. There is almost nothing I teach in my classes that is timeless or profound, and I have learned that there is so much more that I do not know about the topics that I teach, than I do. I don't believe that I have either the knowledge or the intellect to answer every question that I am asked, but my job in teaching is to expose the process by which I try to get an answer, misguided and incorrect though it may be. As I have said repeatedly, and in many contexts, I would rather be transparently wrong than opaquely right, and I hope that if you take one or more of my classes, you will not only learn from my mistakes but also develop your own processes for answering the big questions in finance. Good luck and Godspeed!

YouTube Video
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Thursday, July 23, 2020

A Viral Market Update XII: The Resilience of Private Risk Capital

In the midst of chaos and confusion, it is human nature to look for order and for a unifying theory that explains the world. As I have navigated my way through this crisis, I have used data from markets to try to come up with explanations for why markets have rebounded as quickly and as much as they have, and in the process, why they have added value to some companies, while reducing the value of others. It is in this pursuit that I noted that the crisis has enriched growth companies at the expense of value companies, flexible companies have gained at the expense of rigid ones, and young companies have gained on older, more mature businesses. But why have these shifts occurred? In this post, I look at a factor that lies behind all of them, and that is the resilience of private risk capital, taking the form of venture capital for start ups and private business, initial public offerings in public markets and debt (in the form bonds and bank loans) to the riskiest companies, as the crisis has unfolded. 

Market Outlook
Let me start, as I have in my prior posts on this crisis, start with a market overview. In the three weeks since my last update, equity indices have continued their recovery, albeit at a more modest pace, from the worst days of the crisis:

Download data
Note that I have broken returns down into two periods for every index, the first period (2/14-3/20) marking the worst days of this crisis, and the weeks since (3/20-7/17) representing the comeback. By July 17, the NASDAQ had not just recouped its losses but was up 9.61% since February 14, my starting date for the crisis. Within each region, there remain divergences, with the DAX outperforming the FTSE and CAC in Europe, and the Nikkei and Shanghai doing much better than the Sensex in Asia. As stocks have gone through a roller coaster ride, US treasuries seem to have gone into a coma, after an initial period of frenetic activity:

The rates on US treasuries dropped significantly in the first four weeks of the crisis, but since the middle of March, have shown almost no movement, with short term treasuries staying close to zero, and 10-year treasuries at or around 0.7%. Tracking oil and copper, two economically sensitive commodities, here is what I see:

Both commodities saw prices drop between February 14 and the end of March, but oil dropped significantly more than copper in that period. In the weeks since, both commodities have recovered, with copper now trading 12.5% higher than it was on February 14, but oil his still down more than 20%.  As the crisis has played out in the equity and bond markets, I also tracked gold and bitcoin price movements over the period:

Download data
Since February 14, gold prices are up more than 14%, reaffirming its role as a crisis asset, but bitcoin has been on a wild ride, dropping more than 50% between February 14 and March 20, as stock prices dropped, and rising almost 75% in the weeks since, as stocks have recovered. In short, it has behaved like very risky equity, not a crisis asset.

Equity Breakdown
While looking at indices, treasuries and commodities gives big picture perspective on this crisis, the real lessons are in the company-level data and to learn them, I examined market capitalization changes across all publicly traded companies, classified by region:

Download data
Emerging markets, at least collectively, have lost more value than developed markets, with Latin America, Eastern Europe and Africa showing the biggest losses. Asian stocks have done better, with China being the best performing region of the world and India being the laggard in that region. Updating the values globally, stocks have lost $3.6 trillion in market capitalization since the start of the crisis, but that is quite a turn around from the $26 trillion that had been lost through March 20. Breaking down the changes in value, by sector:

Download data
While every sector has seen improvement since the bottom on March 20, energy, financials and real estate still show substantial losses in market cap over the entire period, but six of the eleven sectors now show positive returns, with health care leading the way, up 9.5% since February 14. Breaking the sectors down further into industries, here is the list of the ten best and worst performing industries:
There are two striking features in this table. The first is that the worst performing industries are a mix of  capital intensive businesses and financial services and the best performing industries are dominated by capital-light businesses and health care. The second is the divergence between the best and worst performing industries is striking, with the best performing industries (online retail and internet software) up more than 30% since February 14, while the worst performing industries (oil and airlines) are down more than 40% over the same period.

Risk Capital
There is little that I have said in this post, so far, that is new, since it is a continuation of trends that I have seen since March. That said, and now that we have information on winners and losers over the last five months, it is worth taking a closer look at the broader forces that are driving the market to reward some companies, and punish others, and what it is that is making market behavior so disconcerting to long-time market observers. Specifically, I will argue that the behavior of risk capital during this crisis has been very different from prior ones, and it is that difference that explains anomalous market behavior.

Definition and Crisis Effects
Risk capital is capital that is invested in the riskiest assets and markets, and it encompasses a wide range of investment activity. For young companies, private and in need of capital to be able to deliver on their potential, it takes the form of venture capital. In public markets, it manifests itself in the money that flows into initial public offerings and to the riskiest companies, often smaller and more money losing. It can also take the form of debt, lending to firms that are in or on the verge of distress, and investing in high yield bonds. In most market crises, risk capital becomes less accessible and available, as fear dominates greed, and investors look for safety. Thus, you will see venture capital, always a boom and bust business, become scarcer, and the young companies that are dependent on it have to either shut down or sell themselves to deep-pocketed and more established companies, often at bargain basement prices. In public markets, initial public offerings become rare or non-existent, and money flows out of the riskiest companies to safer companies (generally with stable earnings and large dividends). In corporate bond market, new issuance of corporate bonds drops off, across the board, but much more so for the riskiest companies (those below investment grade). As I will argue in the rest of this section, that has not been the case in this crisis. While the flight to safety was clearly a dominant theme in the first three or four weeks of this crisis, risk capital has not only stayed in the market through this crisis, but has become more accessible rather than less, at least in some segments. 

Venture Capital
Investing in young companies, especially start-ups and angel ventures, has always been a high-risk endeavors for two reasons. First, these businesses have to be priced or valued with much less information on business models or history than more mature companies, and many investors are uncomfortable making that leap. Second, the failure rate among these companies is high, since more than two-thirds of start ups do not make the transition to being viable businesses. Venture capital's role is to nurture these young companies through these early dangers, and in return, the hope is that the investment will earn outsize returns, when they exit.  This accentuated risk return trade off makes venture capital the canary in the coal mine, during a crisis, and you can see that play out in the following graph, tracking venture capital raised by year, both in the US and globally:

Source: NVCA Yearbook

In the last quarter of 2008 and in 2009, as the public markets plunged into crisis, note the drop of in venture capital invested, down more than 50% globally, and 60% in the United States. In fact, it took until 2014 for venture capital to return to levels seen before the crisis (in 2007), but once it did, it found new buoyancy leading into 2020. When the COVID crisis hit in February, the question was whether venture capital would retreat as it did in 2008, and the numbers so far don't seem to indicate that it will:
Download data
Venture capital infusions did drop off in the first quarter of 2020, but not precipitously, and staged a recovery int he second quarter. It is true that less money is being invested in angel seed companies, presumably the riskiest class, and more in later stage businesses, but it does not look like venture capital has shrunk back into its shell, at least so far. 

Public Equity Risk Capital
In public markets, risk capital plays out in more subtle ways than in private markets, flowing in and out of the riskiest segments of the market, as fears rise during a crisis. In most crises, as I noted earlier, the money flow favors the safer companies, pushing up their pricing and valuation, and works against the riskiest companies.

1. Risk Groupings
One measure of how risk capital has behaved in public markets is to look at market capitalization shifts from groupings of companies that are considered risky to groupings that can be considered safe. Since there can be disagreements about how best to create these groupings, I have considered multiple measures for the risk/safe continuum in the table below, and highlighted how market capitalizations have changed, in the aggregate, on each measure:

To make sense of this table, pick a grouping, say PE ratios. The Risk On/Off columns highlight the conventional wisdom that low PE stocks are safe and high PE stocks are risky. The returns columns report on what companies in the top and bottom deciles of PE ratios have earned during this crisis period, in both percentage and dollar terms. Thus, the stocks with the highest PE ratios (top decile) have seen their market capitalization increase by 10.81% ($674 billion) while stocks in the lowest PE ratio decline have seen their market values drop by 8.31% ($246 billion).  On almost every measure that I use for risk in this table, this market has pushed up the valuations of the companies that would be considered riskiest and pushed down the values of the companies that would be considered safest.  The only risk categorization where punishment has been meted out to the riskiest companies is financial leverage, with the companies that have the most debt (in net debt to EBITDA terms) seeing market capitalization decrease by 15.49% ($1,082 billion), while companies that have the least debt have seen market value increase by 12.32% ($300 billion). It is still only five months into the crisis, and markets can surprise and shift quickly, but at least from today's vantage point, this crisis has played out in a most unusual way, with the riskiest companies increasing in value, at the expense of the safest, with debt-driven risk being the exception.

2.  IPOs
One of the most observable measures of market confidence in access to risk capital is initial public offerings, since companies going public are often younger, more risky companies. The best way to illustrate this is to look at initial public offerings over time, measuring both the number and dollar value raised in these offerings:

Source: Jay Ritter IPO data
In terms of number of initial public offerings, the 1990s clearly set a standard that we are unlikely to see in the near future, and while the dot com bust brought the IPO process back to earth, you can see the damage wrought by the 2008 crisis. In the last quarter of 2008, as the crisis unfolded, there was only one initial public offering made in the US and the drought continued through 2009. While the number of IPOs has remained well below dot com era levels, the value raised from IPOs bounced back in the last decade, reflecting the fact that companies were delaying going public until they were bigger in market cap terms, with 2019 representing a year with several high-profile IPOs that disappointed investors in the after-market. When the COVID crisis hit in February, the expectation was that just as in prior crisis, the IPO process would come to a grinding halt, as private companies waited for the return on risk capital. In the graph below, I look at initial public offerings (both in numbers and dollar proceeds), by quarter:

Download data
As with venture capital, there was a pause in the IPO process, in the first few weeks, and you can see that in the first quarter numbers. However, initial public offerings returned to the market in the second quarter, in both numbers and dollars, and the pipeline of IPOs is filling up again. In fact, I have not counted IPOs of SPACs (or blank check companies) in my statistics in my analysis, and there were quite a few of those in the second quarter of 2020, another indicator of investors willing to take risk. 

3. The Price of  Risk (Equities)
When risk capital is on the move, the number that best reflects its movement is the equity risk premium, rising as risk capital becomes scarcer and falling with access. During 2008, for instance, my estimates of the equity risk premium reflected this fear factor, rising from 4.4% on September 12 yo a high of 7.83% on November 20, before dropping back to 6.43% on December 31 (still well above pre-crisis levels):

I have reported that process during this crisis, but my estimates of the equity risk premium for the S&P 500 are in the graph below:
Download data

The story embedded in this graph is the same one that you see in the VC and IPO pictures. In the first few weeks of the COVID crisis, the price of risk in the equity markets surged, just as it had in 2008, hitting a high of 7.75% on March 23. In the weeks since, equity risk premiums have almost dropped back to pre-crisis levels, as risk capital has come back into the market. Incidentally, this return of risk capital is not just a US-phenomenon, as can be seen in the picture below, where I report my estimates of the equity risk premiums, by country, through the crisis:
Download the data

With each country, I report three numbers, an equity risk premium from the start of 2020 (reflecting pre-crisis values), from April 1, 2020, at the height of the market meltdown, and from July 1, 2020, as capital has returned. Just to illustrate, Brazil saw its equity risk premium rise from 8.16% on January 1, 2020, to 11.51% on April 1, 2020, before dropping back to 9.64% on July 1, 2020. Put simply, risk capital has returned to the riskier emerging markets, though the return has not been as complete as it has been in the US.

Risky Debt
Much of the discussion about risk capital so far has been focused on equity markets, but there is risk capital in other markets as well. In the private lending market, risk capital is what supplies debt to the companies most in need of it, often distressed, and in the corporate bond market, it manifests itself as demand for the riskiest corporate bonds, usually below investment grade.

The COVID Effect - Early Days
In the first few weeks of the crisis, the key concern that investors had about the economic shut down was whether companies that carried significant debt loads would be able to survive the crisis. This fear manifested itself not only in concerns about bankruptcies, but also in government bailouts to save companies that were most exposed, such as airlines. There was also talk of how this crisis could spread to other sectors burdened with debt, and put the banking system at risk. It is these fears that led the Fed to announce on March 23, 2020, that it would be provide a backstop in the corporate lending market, proving loans to companies in distress and buying corporate bonds. There is debate about whether the Fed should be playing this role, but it cannot be denied that this action, more than any other by any entity (government or central bank) during this crisis, changed its trajectory.  It is not a coincidence that Boeing which had been having trouble raising debt, in early March, was able to borrow $25 billion in the corporate bond market a few weeks after the Fed's announcement. In fact, as you will see in the section below, the Fed's announced opened the flood gates for corporate bond issuances and caused a turnaround in corporate bond yields.

The COVID Effect - Corporate Bond Issuances
In the corporate bond market, risk capital is the lubricant that provides liquidity in the high yield bond market, and allows companies that are below investment grade to continue raising capital. Not surprisingly, during crises, it is this portion of the corporate bond market that is affected the most, with yields climbing and new bond issues becoming rarer. You can see this phenomenon play out in the graph below, where I look at corporate bond issuances by year:

Download data

During the 2008 crisis, bond issuances declined across the board in the last quarter of 2008 and the first quarter of 2009, but the drop was much more precipitous for high yield portion. During the COVID crisis, the numbers look very different:

After a brief pause in issuances in the first few weeks (between February 14 and March 20), bond issuances returned stronger than ever, with high yield bond issuances hitting an all-time high (in dollar value) in June 2020. For the moment, at least, the Fed's backstop bet has paid off in the bond market.

The Price of Risk (Bonds)
As with the equity market, there is a market measure of access in risk capital in the bond market, and it takes the form of default spreads. During a crisis, as risk capital leaves, you see spreads increase, as was the case in the last quarter of 2008:

Default spreads increased across the board for bonds in every ratings class, but much more so for the lowest rated bonds during the 2008 crisis. To provide a contrast, I looked at default spreads for bonds in seven ratings classes on February 14, March 20 and July 17:

As in 2008, default spreads surged between February 14 and March 20, as the crisis first took hold, but unlike 2008, the spreads have rapidly scaled down and are now lower for the higher investment grade classes than they were pre-crisis and only marginally higher for the lowest rated bonds.

Explaining the Resilience
If you accept the evidence that risk capital has stayed in the market during this crisis, in contrast to its behavior in prior crises, the follow-up question is why. For some of you, I know the answer is obvious, and that is that this market recovery has been engineered and sustained by central banks. While there is some truth to the "Fed did it" argument, I think it is too facile and misses other ingredients that have contributed.
  1. Central Banks: Earlier in this post, I noted that the turnaround in this market can be traced to the Fed's announcement on March 23, that it would provide a backstop to the corporate bond/lending market. That said, the actual amount spent by the Fed on these programs has been modest, as can be seen in this graph:
    Source: Financial Times
    While there is a healthy debate to be had about whether central banks have become too activist, I believe that the Fed's corporate backstop announcement is the type of action you want central banks to take, since in its absence, bankruptcies and bailouts would have been the order of the day. In fact, the very fact that the Fed has actually not needed to use it is evidence that it worked, since private lenders stepped in to fill the gap. I concede that some risk taking investors will take the wrong cues from this action, expecting that the Fed will protect them from the downside, while they take advantage of the upside. 
  2. Investor Composition: The Fed's actions worked as well as they did because investors in both equity and bond markets responded quickly and substantively, and that response may reflect the changed composition of investors today. First, markets have become much more globalized, and investors are much more willing to invest across markets, with money moving from equity to debt markets, and across geographies, much more easily than it used to. Second, the investment world has flattened, as retail investors (the so called stupid money) catch up to institutional investors (smart money?) in terms of access to information, data and tools and are more willing to deviate from conventional wisdom. 
  3. Unique Crisis: As I have noted in prior posts, this has been an unusual crisis, in terms of sequencing. Unlike prior crises, where market meltdowns came first and the economic damage followed, in this one, the economic shutdown, precipitated by the virus, came when markets were at all-time highs and risk capital was widely accessible. It is possible that risk capital, for better or worse, believes that this is crisis comes with a timer, and that economies will revert back quickly once the virus passes, and shut downs end.
  4. Change in Corporate Structure: After two decades of disruption, it is quite clear that center of gravity has shifted for both economies and markets, with the bulk of the value in markets coming from companies that are very different from the companies that dominated the twentieth century. While much is made of the fact that the biggest companies of today's markets (in market capitalization terms) derive their value from intangible assets, I think the bigger difference is that these companies are also less capital intensive and more flexible. That flexibility, allowing them to take advantage of opportunities quickly, and scale down rapidly in the face of threats, limits downside and increases upside. At the risk of using a buzz word, there is more optionality in the biggest companies of today, making risk more an ally than an enemy for investors, and with options, risk can sometimes be more ally than enemy.
Five months into this crisis, I am still learning, and there is much that we still do not know about both the virus and markets. 

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Thursday, July 2, 2020

A Viral Market Update XI: The Flexibility Premium

I must confess that when I started these updates in February, I did not expect to be doing them in July, but a crisis is as good a time as any, to learn new lessons and relearn old ones. As the virus makes a comeback, particularly in the United States, it is not surprising that markets reflect the uncertainty that we all feel about how the rest of the year will play out in both our personal and business lives, with  mood rising and falling on positive and negative news stories. In this post, I will begin by updating the numbers for markets overall, and within the equity market, across regions, sectors and industries. I will then use the differences I see across companies to highlight flexibility in investing, operating, financing and cash return policies as the one quality that seems to be separating the winners from the losers in these last few months, and argue that this represents an acceleration of a longer term shift towards more nimble and adaptable business models.

Market Update
If you have been reading all of my viral market updates during this crisis, I admire your fortitude, and I know that you will get a sense of deja vu, as you read this section, since I follow the same road map on each of them. I start, as always, by looking at US dollar returns on selected equity indices around the world:

Download data
Looking at the entire time period (2/14-6/26), US equity indices have done better than European equity indices, with a strong rebound from the lows of March 20 allowing for a complete recoupment of losses in the NASDAQ and an almost complete retracing for the S&P 500. Asian equities have diverged, with Japan and China performing better than India. As equities have seesawed, US treasury bonds have stabilized, after a steep drop in yields in the first four weeks of the crisis:
The treasury rates have settled in, at least for the moment, at close to zero at the short end of the maturity spectrum and at about 0.65-0.75% for the 10-year bonds and 1.2-1.4% for 30-year bonds. I know that there is a widely held view that it is the Fed that has engineered the rate drop, but note that much of the decline occurred before the Fed made its quantitative easing announcements in mid-march.  I think that the Fed’s real impact has been on private lending, with its March 23rd announcement that it would operate as a backstop in corporate bond and lending markets. You can see the effects of that announcement on default spreads for corporate bonds, across ratings classes:
Note the climb in default spreads between February 14 and March 23, with investment grade (BBB) rated bonds almost tripling during that period, and the pull back in spreads since, to end at levels higher than on February 14, but well below the March 23rd levels. Mirroring the changes in the price of risk in the corporate bond markets, the price of risk in equity markets (measured with an implied equity risk premium) has been on a wild ride, rising dramatically between February 14 and March 23, before sliding down towards pre-crisis levels:
Download data
At one level, the fact that equity risk premiums are above 5% and well above historic norms (4.86% between 2000-2019 and 4.20% between 1960-2019) may seem comforting, but there is a disconcerting component to these expected values. The equity risk premium of 4.83% on February 14 was earned on top of a ten-year bond rate of 1.59%, yielding an expected return of 6.42% on equities, already low by historic standards. The equity risk premium of 5.23% on June 30 was earned over and above a ten-year bond rate of 0.66%, yielding an annual expected return of 5.89% on equities for the long term, a number well below the 7-8% that investors were pricing stocks to earn during much of the last decade. Paraphrasing Winston Churchill, equities don't look good as an investment class, until you compare them to the alternatives.

Looking at oil and copper, the two economically-sensitive commodities that I have tracked through this crisis, the divergence between the two remains, with oil prices down almost 30% since February 14 and copper prices up 4.31% since that date:

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Finally, I keep tabs on gold, a crisis investment of long standing, and bitcoin, a more recent entrant into the game. 

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If this were a contest for a crisis asset, gold wins by a knock out, since bitcoin, at least during this crisis has moved with stocks, dropping more than 50% between February 14 and March 20 and rising more than 70% from its lows after March 20. It is possible that bitcoin can still live up to the promise of being a good currency, but it has not even come close to being one yet, snd if you are a Bitcoin advocate, you have your work cut out for you.

Equities: An Overview
I stick with my practice of downloading the market capitalizations of all publicly traded companies in the world, and then computing aggregated changes in value by groupings. In my first grouping, I look at how equities have performed across the regions of the world:

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Looking at percentage change in aggregate market capitalization between February 14 and June 26, global equities have lost 9.30% of their value ($8.4 trillion), but that is quite a comeback from the 29% loss ($26.3 trillion) recorded on March 20. Emerging markets in Africa, Latin America and Eastern Europe show far more damage than developed markets over the entire period (February 14-June26), though the UK is an exception, down almost 20%. Breaking down the market action by sector:

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If you were primarily invested in technology and health care, your reaction to the crisis might be "What crisis?", since those sectors are now ahead of where they were on February 14, and consumer product companies (both discretionary and staple) are not far behind. Energy and real estate have lagged the market, as have utilities, but financials remain the worst performing sector remains. If you look at the last four columns, you can see that even in sectors that have held their own during this period, the recovery has been uneven, with more stocks down than up in every sector. Finally, I break down sectors into industries, and list the ten worst and best performing, in terms of market cap change from February 14 to June 26:
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As in my prior week updates, there is a preponderance of infrastructure and financial services in the worst performing industry list, and a dominance of health care and technology on the best perfuming list. Education is a new entrant into the best performing list, perhaps reflecting the promise and potential of online education.

The Flexibility Story
As the market makes its way back from its lows, it remains an uneven one, with wide divergences between winners and losers, and in my earlier posts, I have looked for clues in the data. In my fourth post from March 23, I noted that heavily indebted companies have under performed companies with lighter debt loads, and in my eighth post from May 13, I highlighted the fact that growth stocks are outperforming value stocks. In my last post from June 19, I used the concept of a corporate life cycle, and noted that younger companies seems to be doing much better than older companies. Others have noted that capital intensive businesses seem to have been worse affected during this crisis than capital-light businesses, and early in the crisis, buybacks were highlighted as a reason why some companies and sectors were doing worse than others. In fact, the new buzzword that business consultants are pushing is "resilience", arguing that the resilient companies have weathered this crisis better than the rest of the market. While there is some truth in all of these contentions, I would argue that if there is one quality that ties together all of these seemingly disparate factors, it is flexibility, and this crisis has reaffirmed the value of flexibility.

Flexibility across the Business Model
Simply put, the flexibility of an organization measures the speed and cost with which it responds to changed circumstances, with more flexible firms adjusting faster and at lower cost than less flexible firms. That definition, though, encompasses a range of actions that stretch across every aspect of business, covering everything from how investments are made, to how the business is operated, to how it is funded, and finally to how much cash is returned to owners (in the form of dividends and buybacks).

a. Investment Flexibility
To grow, businesses have to reinvest and investment flexibility measures how much they have to reinvest to deliver a given growth rate, and how long it will take for the investment to pay off

While it is true that companies that are in businesses that require heavy infrastructure investment (toll roads, telecommunications, automobiles) have low investment flexibility, and service and software firms generally have high investment flexibility, the divide is not necessarily on whether the investments are in tangible or intangible assets. Pharmaceutical companies, for instance, have low investment flexibility because they have to spend large amounts in R&D, with significant leakage (as some R&D will not pay off) and have to wait long periods before commercial success. Over the last decade, disruption in many businesses with a history of low investment flexibility has come from new entrants with business models that allow them to scale up quickly, with relatively low investment. Uber and Airbnb are examples of sharing economy companies that have had a decisive advantage this dimension over their established competitors. To see how this crisis has played out on the financial flexibility dimension, I classified all non-financial service companies listed globally, based upon the ratio of sales to invested capital, on the (questionable) assumption that invested capital (computed from the accounting balance sheet values of debt, equity and cash) measures reinvestment, into ten deciles:

Note that companies that can generate the most revenues per dollar of invested capital are signaling the highest investment flexibility and they have done far better during this crisis than firms that are in lowest decile of this measure. Some of this may be spurious correlation, but it is an interesting first take on how investment flexibility has been treated by the COVID market.

b. Operating Flexibility
During the course of operations, businesses will be hit by shock that cause their revenues to unexpectedly increase or drop, and operating flexibility measures how those revenue changes flow through into operating profitability. The key to decoding this effect is to break down the operating expenses of a company into fixed and variable, with the latter moving up and down with revenues, while the former stays fixed:

Companies with high fixed costs, as a percent of revenues, will see much more dramatic swings in operating income, as revenues change, than companies that have more flexible cost structures. It is not surprising, therefore, that airlines have wild swings in profitability from good years to bad ones, whereas online retailers and service businesses have more muted effects. To see how operating flexibility has played out in this market, I would have liked to have broken costs down into fixed and variable for all companies, but lacking clean accounting measures of either, I settled for gross profit margins, on the assumption that companies with high gross margins have far more flexibility in dealing with revenue shocks than companies with low margins. Breaking down companies based upon gross margin into deciles, here is what I find:

With a full admission that gross margin is a flawed measure of operating flexibility, companies with higher gross margins have done better than companies with lower gross margins, as this crisis has unfolded.

c. Financing Flexibility
As revenues go up and down, and operating income tracks those changes, financial flexibility measures how much net income (to equity investors) is altered, with firms with low financial flexibility showing much bigger swings in net income for a given change in operating income. The key drivers of financial flexibility are debt obligations and cash holdings, with the interest expenses on the former pushing up net income volatility, and the interest income from the latter dampening that volatility:

If net debt, as a percent of cash flows or value, is the driver of financial flexibility, we can see how financial flexibility has played out in this crisis by breaking companies down into deciles based upon Net Debt as a multiple of EBITDA:

Download data
Companies with high net debt ratios have low financial flexibility and they have been damaged far more than companies with low net debt ratios. Note that the lowest decile of net debt ratios includes firms that have negative net debt, i.e., cash balances that exceed the debt, and they show an increase in market capitalizations between February 14 and June 26.

d. Cash Return Flexibility
The end game, when investing in publicly traded company stocks, is to collect cash flows from that investment, and companies have two choices when it comes to returning cash. The conventional approach has been to pay dividends, but over the last three decades, US companies in particular have turned to returning cash in the form of buybacks. Both dividends and buybacks have to be funded by cashflows to equity investors, and cash return flexibility measures how quickly companies can adjust their cash returns to reflect changes in cash flows to equity:

Obviously, companies that return little or no cash, relative to their free cash flows to equity, are not only accumulating cash, but have far more cash return flexibility than companies that return a large proportion of their cash flows. Since dividends still remain the primary mechanism for returning cash across the world, I start by looking at dividend yield, classified into deciles, and looking at the market action in each decile for global companies:
Download data

Clearly non-dividend paying stocks and stocks with low dividend yields have done much better than companies with high dividend yields. Among companies that do return large portions of cash, those that return the bulk of their cash flows in the form of dividends have far less flexibility than those that buy back stock, mostly because dividends are sticky, since once they are initiated and set, companies are reluctant to change them. To examine whether the mode of cash return has been a factor in the market action, I break companies into four groups based upon whether they pay dividends and/or buy back stock:

While companies that pay both dividends and buybacks have been worst affected and companies that use neither have performed the best over the period, isolating only companies that pay only dividends or buy back stock, companies that pay only dividends have under performed companies that buy back only stock. While the results are only indicative, they do suggest that making buybacks the bogeyman in this crisis is not backed up by the evidence.

Implications and Conclusion
During this crisis, markets have rewarded flexible companies, a continuation of a trend that predate the crisis to the last one. If the last decade has been a disruptive one, that disruption has been largely driven  by companies that have not only built flexible structures, but also used that flexibility to gain competitive advantages over their status quo competitors. As companies get pushed to increase flexibility, it is worth noting that this quest comes with costs, and these trade offs have to be acknowledged:
  1. Compressed Corporate Life Cycle: Earlier in this post, I argued that one of the benefits of having high investment flexibility is that companies can scale up faster; Uber and Airbnb have been able to go from start ups to large companies (at least in terms of operations and value) in very short time periods. However, the same forces that allow these companies to scale up faster also create business models which are more difficult to defend against new competitors, leading to shorter periods of maturity and more speedy decline, with important consequences.
  2. Losses on the upside: With operating and financial flexibility, the trade off is much simpler, since companies with greater operating and financial flexibility will be more protected on the downside, but at the expense of giving up some of the upside. Having large fixed costs and/or high net debt will result in bigger losses when times are bad, but it will also create larger profits on the upside.
  3. Social costs: As new business models are built to have motor flexibility, some of the actions that increase flexibility come with costs that are borne by society, rather than the company. For instance, Uber's business model of treating drivers as independent contractors rather than employees gives the company a more flexible cost structure, but it does pass on the costs of providing a safety net (health care and pensions) to society. As a society, we need to debate whether the benefits we gain by having a more nimble economy outweigh the social costs. 
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