Wednesday, May 27, 2015

The Value and Pricing of Cash: Why low interest rates & large cash balances skew PE ratios

For an asset that should be easy to value and analyze, cash has been in the news a lot in the last few months, both when it has been returned (in buybacks especially) and also when it has been accumulated either domestically or offshore. Since companies have always returned cash and held cash balances, you may wonder why these stories are news worthy but I think that the cash is under the spotlight because of a convergence of factors, including the rise of technology companies in the market cap ranks, a tax law in the US that is increasingly a global outlier, and low interest rates.

Accounting for, Valuing, and Pricing Cash
I start my valuation class with a simple exercise. I hold up an envelope with a $20 bill in it (which everyone in the class has seen me put into the envelope) and ask people how much they would pay for the envelope.  While some find this exercise to be absurd, it does bring home a very simple rule, which is that valuing cash should not require complicated valuation models or the use of multiples. Unfortunately, I see this rule broken on a daily basis as investors mishandle cash in companies, both in intrinsic valuation and pricing models.

To illustrate the divide between risky assets and cash, assume that you are trying to value a software company, with a cash balance (which is invested in liquid, riskless or close-to-riskless investments) of $200 million. Let's assume that the accounting income statement & balance sheet for the company looks as follows:

If you believe the accounting balance sheet, this company is half software and half cash but that is misleading for two reasons. The first is that assets on accounting balance sheets are not marked to market and can remain at low values, even as their earnings power rises. The second is that accounting rules (absurdly) treat R&D, the biggest capital expenditure at technology firms, as operating expenses, which then results in those assets never showing up on the balance sheet. The ripple effects of understating the book value of equity can be seen in the high returns on equity that I report for the firm.

Having established that book-value cash ratios will be skewed by the changing composition of the market, let's turn to the question of valuing this company. For simplicity, let's assume that the cost of equity for investing in the software business is 10% and that the expected growth in income from software is 2% in perpetuity. If we assume that the company can maintain its existing return on equity of 36% on its new investments in perpetuity, the value of the software business is:

  • Expected net income from software = $72 million
  • Expected reinvestment to generate growth = 2%/36% = 5.56%
  • Value of Software business = 72 (1-.0556)/ (.10-.02) = $850 million
The cash is invested in liquid, riskless investments earning 2% (pre-tax). The fact that cash earns a low rate of return does not make it a bad investment, because that low rate of return is what you should expect to make on a short-term, riskfree investment. If you decide to do an intrinsic valuation of the income from cash, you should discount the income at the risk free rate:

  • Expected pre-tax income from cash = $ 200 (.02) = $4 million
  • Cost of equity = Riskfree rate = 2%
  • Value of equity = 4/.02 = $200 million
The intrinsic value balance sheet for this company is shown below:
Note that the software business is now worth a lot more than it was in the accounting balance sheet but that cash value remains unchanged. The value of equity on the balance sheet is an intrinsic equity value.

In pricing, the tool used in comparisons is usually a multiple and the most commonly used multiple is the PE ratio. To set the table for that discussion, I have restated the intrinsic value balance sheet in the form of PE ratios for the software business, cash and equity overall.

The PE ratios for software and cash are computed by dividing the intrinsic values of each one by the after income generated by each. The PE ratio for cash can be simplified and stated as a function of the risk free rate and tax rate:
The PE ratio for cash is much higher than the PE for software (11.81) and it is pushing up the PE ratio for equity in the company to 14.11. Put differently, if the stock is priced based on its intrinsic value, it should trade at a PE ratio of 14.11.

Cash Balances and PE: Determinants
In the market, we observe the PE ratios for equity in companies, and those PE ratios will be affected by both how much cash the company holds and the interest rate it earns on that cash.  To the extent that cash balances (as a percent of value) vary across time, across sectors and across companies, the conclusions we draw from looking at PE ratios can be skewed by these variations. To observe how much of an impact the cash holdings have on the observed PE ratio for a company, I varied the cash balance in my software company from 0% to 50% of the intrinsic value of the company; at 50%, the cash balance is $850 million and is equal to the value of the software business. The PE ratio for equity in the company is shown in the graph below, with the cash effect on PE highlighted:

The effect of holding cash is accentuated when the interest rate earned on cash, which should be a short term risk free (or close to risk free) rate, is low relative to the cost of equity. In the table below, I highlight the interest rate effect, by holding the cost of equity fixed at 8% and varying the risk free rate from 1% to 5%:
Thus, a cash balance that amounts to 20% of firm value will push PE ratios from 15.38, when the short-term, risk free rate is 1% and to only 14.08, when it is 5%.

It is true that companies with global operations are accumulating some of their cash overseas to avoid US taxes. Bringing in trapped cash into this process is easy to do and requires you to separate cash balances into domestic and trapped cash; the biggest problem that you face is getting that information, since most companies are not explicit about the division. While the domestic cash balance is its stated value, the trapped cash will see its value reduced by the expected tax liability that will be incurred when the cash is repatriated (which will require assumptions about when that will be and what the differential tax rate paid on repatriation will amount to.)

The US Market: PE and Cash
At this point in this discourse, you may be wondering why we should care, since companies in the US have always held cash and had to earn close to a short-term risk free rate on that cash. That is true but we live in uncommon times, where risk free rates have dropped and corporate cash holdings are high, as is evidenced in this graph that looks at cash as a percent of firm value (market value of equity+ total debt) for US companies, in the aggregate, from 1962 to 2015 and the one-year treasury bill rate (as a proxy for short term, risk free rates):
Data from Compustat & FRED: Computed across all money-making companies
With short-term risk free rates hovering around zero and cash balances close to historical highs, you would expect the cash effect on PE to be more pronounced now than in the past. To measure this effect, I computed PE ratios and non-cash PE ratios each year for US companies, using the following equations:

The interest income from cash was estimated using the average cash balance during the course of the year and average one-year T.Bill rate for that year. In the graph below, I look at the paths of both measures of PE from 1962 through 2014. Note that while while both series move in the same direction, the divergence has become larger since 2008; in 2014, the non-cash PE was almost 30% lower than the conventional PE.

I know that the talk of a bubble gets louder each day, and while there may be legitimate reasons to worry about the level of stock prices, those who base their bubble arguments entirely on PE ratios (normalized, adjusted, current) may need to revisit their numbers. All of the versions of the PE will be "pushed up" by the cash holdings of US companies and the low interest rate environment that we live in.

Sector Differences in Cash and PE
Cash balances have varied not only across time but they are also different across sectors and within sectors, across companies. Consequently, comparing PE across sectors or even across companies within a sector, without adjusting for cash, can be dangerous, biasing you away from companies with large cash balances (which will look expensive on an unadjusted PE) and especially so during periods of low interest rates.

In the first part of the analysis, I estimated cash as a percent of firm value, PE ratios and non-cash PE for each sector in 2014. (I eliminated financial service companies from my sample, since I am not sure that I can categorize cash as a non-operating asset for these companies). While all of the industry averages can be downloaded at the link below, the sectors where the cash effect on PE was greatest are listed below:

In the second part of the analysis, I computed the cash effect on PE for individual companies and then looked at the distribution of this cash effect across all companies:

It delivers the message that there is no simple rule of thumb that will work across all companies or even across companies within a sector.

Rules for dealing with cash
In an investing world full of complications, simple measures like PE retain their hold because they are easy to compute and easy to work with. However, there is a price that we sometimes pay for this simplicity, and in periods like this one, where interest rates are at historic lows, we may need to reassess how we use these measures to compare companies. In particular, I think we have to separate companies into their cash and operating parts, and deal with the two separately, because they are so different in terms of risk and earnings power. Thus, it we are using multiples, enterprise value multiples will work better than equity multiples, and with equity multiples, non-cash versions (where the cash is stripped from market capitalization and net income is cleansed of the cash effect) will be more reliable than cash versions. This will also mean that the time honored way of estimating PE, i.e., dividing the market price today by the earnings per share, will have to be replaced by an approach where we use use aggregated market value, cash and earnings, rather than per share numbers. 


  1. Intrinsic value of cash and operating assets (to back up example in post)
  2. PE Cleanser (to compute non-cash PE for a company)


  1. Cash and non-cash PE ratios by year: All US companies
  2. Cash and non-cash PE ratios by sector in 2014

Monday, May 25, 2015

No Light at the end of the Tunnel: Investing in Bad Businesses

I am a cynic when it comes to both CEOs and equity research analysts. I think that many CEOs are political animals, bereft of vision and masters at using strategic double-speak to say absolutely nothing. I also believe that many equity research analysts are creatures of mood and momentum, more market followers than leaders. Once in while, though, my cynicism is upended by a thoughtful CEO or a well-done equity research report and even more infrequently by both happening at the same time, as was the case in this recent interplay between Sergio Marchionne, Fiat Chrysler's CEO, and Max Warburton, the auto analyst at Sanford Bernstein.

The CEO/Analyst Exchange on Fiat Chrysler
Sergio Marchionne is an unusual chief executive, a man who is not afraid to talk the language of investors and is open about the problems confronting not only his company, but also the entire automobile business. While he has been arguing that case for a while, sometimes in public and sometimes with other auto company executives, he crystallized it in a presentation he made in an analyst conference call, titled "Confessions of a Capital Junkie". In the presentation, he argues that the auto business has not generated its return on capital over its last cycle and that without significant structural changes, it will continue to under perform. He then diagnoses the reason for the under performance as over investment in R&D and capital costs, with companies duplicating each other's efforts. He concludes with the remedy of consolidation, where with mergers and joint ventures, companies could co-operate and reduce their capital costs, and asks analysts and investors in auto companies to apply pressure for change. Mr. Marchionne's pitch was unusual was two reasons.  First, how many CEOs admit that their businesses have gone bad and that fundamental change is needed in how they are run? Second, it is unusual for a CEO to ask investors to become more activist and push for change, since most CEOs prefer a pliant and forgiving shareholder base.

Max Warburton, Bernstein's auto analyst who was at the conference, responded by asking "“Do you think the German [car manufacturers] have any interest in what we say?', arguing that investors and analysts were powerless to push for change. In an extended analyst report, Mr. Warburton went further, making the point that shareholders are way down the list of priorities for the typical auto company, and especially so in Europe and Asia. 

As I said at the start, this is the type of exchange between CEOs and analysts that you hope to see more of, and I agree with both Mr. Marchionne and Mr. Warburton on some aspects and disagree on others. I agree with both men that the auto business has been in trouble for a while and I made this point earlier in my post on GM buybacks. However, I don't think that the problem is one of duplication of expenses and that the answer is the consolidation of companies, as argued by Mr. Marchionne, and here is why. For consolidation to generate higher profits at auto companies, they will have to ensure that they don't  pass the cost savings on to customers by cutting car prices, and nothing in the behavior of the auto industry in the last decade leads me to believe that they are capable of this concerted action. I agree with Mr. Warburton that the auto business is not shareholder-focused and that institutional forces (governments, unions) will make it difficult for investors to be heard. While there are investors in the market who will continue to supply capital at favorable terms to this business, sensible investors are under no obligation to play this game. Abandoning the auto business is not feasible if you are the auto analyst at Sanford Bernstein, but it is a viable option for the rest of us, at least until prices reflect the quality of these businesses. This debate also raises interesting fundamental questions that I hope to examine in the rest of the post, including how we categorize businesses into good and bad ones, why businesses become bad, why companies continue to operate and sometime expand in bad businesses and why investors may still seek to put their money in these companies.

What is a bad business?
If Mr. Marchionne's point is that the automobile business is a bad one, it is worth starting this discussion with the question of what it is that make a business a bad one. At an extremely simplistic level, you can argue that a bad business is one where many or most companies lose money, but that definition would encompass young sectors (social media, biotechnology) that tend to lose money early in the life cycle. It also would imply that any sector that collectively makes profits is a good one, which would not make sense, if the sector has huge amounts of capital invested in it. Thus, any good definition of business quality has to look at not only how much money a company makes but how much it needs to make, given its risk and the capital invested in that business. In corporate finance, we try, to capture this by looking at both sides of the equation:

While there are some business (banks, investment banks and other financial service companies), where the equity comparison is more useful, in most businesses, it is the comparison on a overall capital basis that carries more weight. If you accept the proposition that the return on invested capital measures the quality of a company’s investment and the cost of capital is the hurdle rate that you need to earn, given its risk, the spread between the two becomes a snapshot of the capacity of the company to generate value.

Why a snapshot? If the return on invested capital is estimated, as it usually is, using the operating income that the company generated in the most recent time period and the cost of capital reflects the expected return, given the risk free rate and equity risk premium in that period, it is also possible that looking at a single period can give you a misleading sense of whether the company in question is generating value. With cyclical and commodity companies, in particular, where earnings tend to move through cycles, a good case can be made that we should be looking at earnings over a cycle and not just the most recent year. Finally, the return on invested capital is an accounting number and is hence handicapped by all the limitations of accounting principles & rules, a point I made in this long, torturous examination of accounting returnsIf you bring the two strands of discussion together, there are two levels at which a sector has to fail to be called a “bad” business.
  1. Collective, weighted under performance: Most companies in the sector should be earning returns on their invested capital that are less than the cost of capital, not just a few, and the aggregate return on capital earned by a sector has to lag the cost of capital.
  2. Consistent under performance: These excess returns (return on capital minus cost of capital) should be negative over many time periods.
  3. No delayed payoff: There are some infrastructure businesses that require extended periods of large investment and negative excess returns, before they pay off in profitability.
In my post on GM, I made the case that the automobile business was a bad one, using these two metrics. Collectively, the distribution of returns on capital across global automobile companies in 2014 looked as follows:

If you look at the return on capital across time for the auto industry, you see the same phenomenon play out.

It should come as no surprise that I agree with Mr. Marchionne that the auto business is a bad one and with Mr. Warburton that the companies in this business are in denial. The bad news for investors is that the auto business is not alone in this hall of shame. I computed returns on capital, costs of capital and excess returns for all non-financial US companies, by year from 2005 to 2014, and then looked for the sectors that delivered a negative excess return on average during the decade, while also generating in excess returns in at least 5 of the 10 years:
Raw data from Capital IQ with my estimates of costs of capital by year
Some of the businesses on this list have a good reason for being on the list and perhaps can be cut some slack. For instance, the green and renewable energy business has delivered negative excess returns both in the aggregate and in every year for the last decade, but in its defense, it may be a business that needs time to mature. The real estate sector is well represented on this list, with REITs, homebuilding, building materials and real estate operations & development all making the list with negative excess returns. An optimist may argue that the last decade created the perfect storm for real estate, unlikely to be repeated in the near future, and that these businesses will return to adding value in the future. There are some surprises, with entertainment software, wireless telecom and broadcasting all making the list, suggesting that you can have bad businesses that are growing. Finally, there were 169 companies that were classified as diversified, and their excess returns were negative every year for the entire decade, making a strong argument that many of these companies would be better off broken up into constituent parts. It is true that the returns on capital in this table were computed using standard accounting measures of operating income and debt, and I recomputed them, with leases capitalized as debt to derive the following table:
Operating Income and Invested Capital, adjusted for leases treated as debt
The list looks almost identical to the unadjusted excess return rankings, though the excess returns for restaurants, retailers and other larger lessees became much smaller with the adjustment and airlines make the worst business list, once you consider leases as debt.

How do businesses go bad?
So, why do businesses go bad? There are a number of reasons that can be pointed to, some rooted in sector aging, some in competition, some in business disruption and some in delusions about growth and profitability.
  1. The Life Cycle: I have used the corporate life cycle repeatedly in my posts as an anchor in trying to explains shifts in capital structure, dividend policy and valuation challenges. It is a useful device for explaining why some sectors fail to deliver returns that meet their costs of capital. In particular, as sectors age, their returns seem to drift down and if the sector goes into decline, with revenues stagnant or falling, companies are hard pressed to generate their costs of capital. At the other end of the life cycle, young sectors that require large infrastructure investments often deliver extended periods of negative excess returns.
  2. Competitive Changes: A business can be changed fundamentally if the competitive landscape changes. This can happen in many ways. A legal barrier to competition (patents, exclusive licenses) can be removed, opening up existing companies to price competition and lower margins. Globalization has played a role as well, as companies that used to generate excess returns with little effort in protected domestic markets find themselves at a disadvantage, relative to foreign competitors. 
  3. Disruption: Disruption is the catchword in strategy and in Silicon Valley, and while it is often hyped and over used, technology has disrupted established businesses. Uber and its counterparts are laying to waste the taxi business in many cities and Amazon has changed the retail business beyond recognition, driving many of its brick and mortar competitors out of business.
  4. Macro Delusion: While all of the above can be used to explain why an old business can become a bad one, there are new businesses that sometimes never make it off the ground, even though they are launched in markets with significant growth potential. One reason is what I have termed the macro delusion, where the sum of the dreams and forecasts of individual companies
Why do companies stay in bad businesses?
If you are a company that finds itself in a  bad business, there are four options to consider. The first is to exit the business, extracting as much of your capital you can to invest in other businesses or return to the suppliers of capital. While this may seem like the most logical choice (at least from a capital allocation standpoint), there is a catch. It is unlikely that you will be able to get your original capital back on exit, because buyers will have reassessed the value of your assets, based on their diminished earnings power. Consider, for instance, a company that generates a 3% return on capital on invested capital of $1 billion and assume that its cost of capital is 6%. If a sale of the assets or business will deliver less than $500 million, the best option for the company is to continue to operate in the bad business. The second is to retrench or shrink the business, by not reinvesting back into the business and returning cash from operations back to stockholders (as dividends or buybacks). That was the rationale that I used in supporting the GM buyback. The third is to continue to run the business the way you used to when the business was a good one, hoping (and praying) that things turn around. That seems to be the response of most in the auto business and explains the cold shoulder that they gave to Mr. Marchionne's prescription (of consolidation). The last is to aggressively attack a bad business, with the intent of changing its characteristics, to make it a good one. This is a strategy, with the potential for high returns if you do succeed, but with low odds of success. Not surprisingly, it is the strategy that appeals the most to CEOs who want to burnish their reputations and it one reason that I posited that my returns on my Yahoo! investment would be inversely proportional to Marissa Mayer's ambitions.

Of the four strategies, the one that is least defensible is to the third one (doing nothing), but that seems to be most common strategy adopted by companies in bad businesses and I can think of four reasons why it continues to dominate. The first is inertia, where managers are unwilling or unable to change their learned behavior, with the resistance become greater, if they have long tenure in the business. The second is poor corporate governance, where those who run firms view shareholders as just another stakeholder group and view costs of capital as abstractions rather than as opportunity costs. The third are institutional factors which can conspire to preserve the status quo, because there are benefits derived by others (labor unions, governments) from that status quo.  The final factor is behavioral, where the easiest path for managers, when faced with fundamental changes in their businesses, is to do nothing and hope that the problem resolves itself. 

Why do investors invest in these companies?
If it is difficult to explain why companies choose to stay and sometimes grow in bad businesses, it is far easier to explain why investors may invest in these companies. At the right price, any company, no matter how bad its business, is a good investment, just as at the wrong price, any company, no matter how good its business, is a bad investment. To decide whether to invest in a company in a bad business, investors have to value these companies and there are challenges. The first is that with these companies, growth is almost always more likely to destroy value than to increase it. Consequently, the value of these companies is maximized as they minimize reinvestment, shrink their businesses and liquidate themselves over time. The second problem is that while designing a valuation model that allows for a shrinking company is easy enough to do, the value that you get is operational only if management in the company does not undercut you, by aggressively seeking out growth with expensive reinvestment. I present responses to these problems in this paper.

As a passive investor, you have to accept your powerlessness over management and build, into your expectations, what you believe that the management will do in terms of investment, financing and dividend policy, no matter how irrational or value destroying those actions may be. As an activist investor, though, you may be able to force managers to reassess the way they run the company. It should come as no surprise that the classic targets of activist investors tend to be companies in bad business that are run by managers in denial. Finally, while the debate about corporate governance has atrophied into one about director independence, corporate governance scores and CEO pay, the real costs of poor corporate governance are felt most intensely in companies that operate in bad businesses, where without the threat of shareholder activism, managers often behave in irrational, value-destructive ways.

Closing Thoughts
As I look at the excess returns generated by companies in different sectors, I am struck by how little margin for error there seem to in many businesses, with excess returns hovering around zero. If we attach large values to the disruptors of existing businesses, consistency requires us to reassess the values of the disrupted companies. Thus, if we are bidding up the values of Tesla,  Uber and Google (driverless cars) because they might disrupt the automotive business, does it not stand to reason that we should be bidding down (at least collectively) the values of Volkswagen, Ford and Toyota? More generally, we seem to be more willing to anoint the winners from disruption than we are in identifying and repricing the losers.

  1. Industry averages excess returns, by year: 2005-2014
  2. Industry average costs of capital: US
  3. Industry average cost of capital: Global

Wednesday, April 29, 2015

Is your CEO worth his (her) pay? The Pricing and Valuing of Top Managers!

It is the time of the year when stories about CEO compensation are the news of the day, and investors and onlookers alike get to ask whether a CEO can really be worth tens or even hundreds of millions of dollars, in annual compensation. Before I join the crowd, it behooves me to list my biases to start, because it will allow you to make a judgment on whether I am letting these biases color my conclusions. First, I believe that in some companies, CEOs not only add very little in value to the company but may actively be value destroyers, and that in many companies, what CEOs get paid is out of sync with the value that is created by them. Second, before you put me in the economic populist camp, I also believe the only group that should have a role in deciding how much a CEO gets paid in a publicly traded company is its stockholders, and that politicians, regulators and societal nannies should not get involved. Third, if you, as a stockholder, are disconcerted by the disconnect between CEO pay at your company, and CEO value added, you should be cheering on activist investors and pushing for more power to stockholders, rather than less.

CEO Compensation: The Landscape
Companies in the United States are required to break out and report what they pay their CEOs in summary compensation tables, filed with the Securities Exchange Commission (SEC). The numbers are still trickling in from 2014, but here is what we have learned so far:
  1. The early returns suggest that CEOs were paid more this year than they were last year, with collective pay increasing about 12.1% at the largest companies. 
  2. The portion of that compensation that was in cash increased to 37% from 35% in the prior year, with the bulk of the the remaining coming from stock grants (31%) and options (23%); pension gains (6%) and perks (2%) rounded out the rest. 
  3. The highest paid CEO in 2014 was Nick Woodman, CEO of GoPro, who was granted 4.5 million restricted stock units, valued at $284.5 million. 
Both the New York Times and the Wall Street Journal have visual links, where you can compare CEO pay across sectors, at least for larger companies, though the data is still from 2013.

It is true, as many others have pointed out, that CEO pay has been increasing at rates far higher than pay for those lower in the pay scale, for much of the last three decades. In the graph below, I look at the evolution of average CEO pay since 1992, broken down broadly by sector:

Source: Compustat ExecuComp
Since 1992, the annual compounded increase in CEO pay of 7.64% has been higher than the growth in revenues, earnings or other profitability measures.  Of all the drivers of CEO pay changes over time, none seems to be as powerful as stock market performance, as is clear in this graph going back further to 1965:

Source: Economic Policy Institute (EPI)
For those clamoring for legislative restrictions on CEO pay, note that it was a law designed to restrict executive compensation, passed by Congress in 1993, that set in motion an explosion of stock-based compensation that we have seen since. If you break down CEO compensation by its component parts (salary, bonus, equity-based compensation and other), you can see the shift towards equity-based compensation over time:

Source: Compustat ExecuComp

While there has been much talk about the ratio of CEO pay to that of an average employee, and that ratio has indisputably jumped over the last three decades, I found this ratio of how much a CEO gets paid, relative to the next highest paid employee in the company, for S&P 500 companies, using 2012-2014 data to be a more useful statistic.
Source: Compensation Advisory Partners
The median CEO is paid 2.30 times the next highest-paid employee at an S&P 500 company, which raises the follow up question of whether he or she adds that much more in value. While we can debate that question, the bottom line is that CEO compensation is large, rising and increasingly equity-based, that the growth in pay has accelerated in the last 20 years, and more so in the United States than in the rest of the world.

Determinants of CEO Pay 
Not only is CEO pay high, but it varies across time and across companies. There are three broad theories, not mutually exclusive, as to why you see that variance.
  1. Reward for performance: If a CEO is paid to run a company, it stands to reason that he or she should do well when the company does well, though you can measure "doing well" on three dimensions. The first is profitability, with higher profits (and growth in those profits) translating into higher pay. The second is the quality of the profitability, where the focus is on profit margins and returns on invested capital, with higher numbers on either measure resulting in bigger payoffs for CEOs. The third is to use a market measure of performance, by looking at stock price movements, with CEOs who deliver superior returns (either in absolute terms or relative to the market or the sector) getting fatter paychecks.
  2. CEO Market: If you start off with the presumption that it takes a unique skill set to become a CEO and that there is a market for CEOs, the compensation package that the company negotiates with a CEO will be determined by how the market prices his or her skills.
  3. CEO Power: If a CEO is powerful, he or she may be able to get a pay package (from a captive board) that is at odds with performance and much higher than what the market price would have been. There are multiple factors that determine CEO power, starting with his or her stock ownership. CEOs who own controlling stakes (and control does not require 50%+) in companies will be more powerful than CEOs that do not. The second is corporate governance, with all of the inputs that determine whether it is strong or weak; companies with weak or compliant boards of directors and little accountability to shareholders will be more likely to over pay their CEOs. The third is CEO tenure, since there is evidence that the longer a CEO stays in place, the more likely it is that the board will be moulded to meet his or her needs.
This excellent survey article on the topic  summarizes the evidence, and it is both supportive and inconsistent with each of these theories. Xavier Gabaix, my colleague at the Stern School of business, finds that dominant variable explaining changes in CEO pay over the last three decades has been changes in market value, with CEO pay increasing as market value increases. However, that theory in inconsistent with what happened in the 1950s and 1960s, when US stock market capitalization increased with no dramatic jump in CEO pay. There is some evidence that there are market forces at play, especially in the variation of CEO pay across sectors, but it is difficult to see how market forces can explain the rise in CEO pay in the aggregate. Finally, there is evidence that CEO pay is both more constrained and more tied to performance at companies where activist investors have stakes. At the same time, CEO pay seems to increase (rather than decrease) at firms, after they adopt good corporate governance practices or at least the appearance of such practices. In addition, none of these theories explain why CEO compensation in the US has gone up so much more than CEO compensation in the rest of the world. At the risk of muddying the waters further, I would suggest three more theories that may better explain the pricing of CEOs across time, companies and markets.
  1. The Stock Compensation Delusion: The delusion that stock-based compensation is cheap or even costless seems to be widespread among accountants, analysts and companies. Until the accounting rules changed in 2007, options were valued at exercise value in accounting statements, creating the illusion that you could give away millions of options to CEOs costlessly. Even though the accounting rules have changed, analysts and companies seem intent of reversing the effect of the rules, adding back stock-based compensation to earnings, a senseless practice that I have taken issue with before. One of the more dangerous consequences of this mistreatment of stock-based compensation is that boards of directors continue to be cavalier about granting large stock-based compensation awards to CEOs.
  2. The Momentum Game: The way companies set CEO pay is more evidence of the me-tooism that characterizes so much of what companies do in corporate finance, where they base how much to invest, how much to borrow and how much to pay in dividends/stock buybacks on what other companies in their peer group do. In deciding pay packages for CEOs, boards look at how much CEOs are paid at the peer groups (a subjective grouping to begin with). Like any other market, this relative pricing game can lead to CEO compensation packages climbing the ladder, since all it takes is one company over paying its CEO to set off overpayments across the entire sector. Put more bluntly, the answer that a board generally offers to the question of why it is paying so much to a CEO is that everyone else is doing it.
  3. The Celebrity CEO: In the last two decades, we have seen the rise of celebrity CEOs, more interested in developing superstar status than in managing the companies they are put in charge of, and boards that are willing to pay premium prices (in pay packages) to attract them. The consequences are predictable, with CEOs making big bets (even if the odds are against them), hoping that they will pay off, with the payoff measured less in profits and performance and more in social media mentions and online exposure. (Rakesh Khurana, a professor at the Harvard Business School and Dean of Harvard College, had made this point persuasively in his work on superstar CEOs.)
There is little new or original that I am adding to the discussion. There is a market for CEOs that sets compensation levels, but the prices that emerge from this market may have little correlation with performance and have more to do with mood, momentum and celebrity status. If you add to that the fact that directors seem to either have no interest or no understanding of the value of stock-based compensation grants, you have the makings of a perfect storm.

A Framework for analyzing the value added by a CEO
If the market for CEOs sets CEO pay, the big question then becomes how this market pricing measures up to the value that these CEOs can be expected to add to the company. To measure the value added (or destroyed) by a CEO at a company, you have to identify how the CEO affects the drivers of value. At the risk of over generalizing, here is how I see the effect of good and bad CEOs on value:

Can you actually value a CEO? I think it can be done, though it will require you to understand how that CEO plans to change the company and quantify the effects. Thus to measure the impact of a CEO on a company's value, you would have to value the company twice, once with an Auto CEO and the other with the CEO in question. With an Auto CEO, the company will stick with the tried and the true, doing what it has done historically in terms of market focus, marketing strategies and risk profile. With the CEO in question, the value effect will depend upon the changes you see that CEO making in the company on one or more of these dimensions. If you are willing to be specific about those changes, you can use this spreadsheet to see the value added by a new CEO and how much you would be willing to pay on an annual basis for that CEO.

I took the spreadsheet for a spin, using Microsoft as my example, partly because Satya Nadella, Microsoft's CEO, topped the list of highest paid CEOs last year and partly because I have been a stockholder in Microsoft since this post in 2013. If you assume that all that Mr. Nadella can do is slow the slide in margins, he will be able to add $7.74 billion in value to the company (about 2.25% of the company's value), translating into annual compensation of $670 million a year. While I do not agree with everything that Mr. Nadella has done over the last year at Microsoft, I think that he has done enough for me as a stockholder that I don't begrudge him his $84 million pay package.  I believe that Microsoft's board will have to monitor revenue growth and margins to see if he continues delivering, but this analysis indicates how dangerous it is to conclude that a CEO is being paid too much, just because he or she has a large pay package. Using this framework, we can make judgments on the types of companies that CEOs are most likely to make a difference, in good or bad ways.
  1. Life Cycle: A CEO should be able to make a much bigger difference in value early in the life cycle, when potential markets are still being defined and setting and having a coherent and consistent narrative can make the difference between winners and losers. As the firm matures, the CEO's capacity to affect value positively will decrease, though the capability of creating damage (by over reaching) may increase.
  2. Market and Competition: A CEO should have a much bigger impact on value in companies that operate in competitive businesses, where finding and maintaining a competitive edge separates the winners from the losers. In fact, there is research that backs up this contention, with CEO pay being higher, on average, and more tied to performance in more competitive businesses.
  3. Macro versus micro firms: I believe that the value effect that a CEO has on a company is more muted at companies whose value is driven primarily by macro forces (commodity prices, exchange rates, interest rates) than at companies where value is more determined by micro factors (markets targeted, pricing policies etc.). After all, if 80% of the variation in earnings across time is caused by oil price movements, there is not a whole lot that you can do, as a CEO, to affect earnings, an argument that Harold Hamm, CEO of Continental Resources, used in his recent divorce fight.
  4. Small versus Large firms: The value impact that a CEO can have at a large firm will be much higher in absolute terms than at a small firm, simply because the effects of small operating changes in the company can translate into large absolute changes in value. While this may seem to contradict the life cycle argument, we can reconcile the two, if we think about percentage changes in value. A CEO at small, young company will have a much higher percentage effect on value than the CEO at a larger, more mature company, but the latter will still have the larger effect on dollar value.
The skill set and qualities that make for a value-adding CEO will vary across companies. For a start-up or young growth company, the qualities that create a stand out CEO will be imagination, charisma and narrative skills. For a mature company, CEO greatness may stem from understanding capital markets and sector dynamics and less from vision and imagination. In decline, a company may be best served by a CEO who can deal with slipping revenues and shrinking margins, while managing the return of cash to stockholders and lenders in the firm. It should come as no surprise then, that what makes a founder CEO an asset early in a company's life may him a liability, as the firm matures, and that the skills that made a CEO successful in turning around one company may not be the ones that work in another. 

The End Game
If it is true that CEOs are priced and not valued, and that as stockholders in many companies, we are overpaying for our CEOs, what can we do to remedy this problem? I would not look to regulators, governments or tax laws to fix this problem, since these fixes (like the 1993 compensation law) not only operate as bludgeons, but have unintended and perverse consequences. I think that the answer has to be in good corporate governance in the true sense of the words, where shareholders are provided the information and the power to make decisions about CEO pay in the companies that they invest in, and use both effectively. I believe that information on CEO compensation should be revealed to stockholders on a comprehensive and timely basis, that shareholders should have a say on how much CEOs get paid and the power to replace directors who are casual about compensation. The SEC has moved in the right direction on all three fronts, with increased disclosure requirements on CEO pay, by requiring that shareholders be given a "say on pay" at companies and by easing challenges to incumbent directors. On each one, though, there has been push back from defenders of the status quo and the SEC has been unable or unwilling to go the distance.

Even in a world where disclosure is complete and shareholders are empowered, I recognize that giving shareholders the power to challenge and change management at public companies does not mean that they will use that power often or wisely. Just as voters in a democracy get the government that they deserve, shareholders in companies get the CEOs (and CEO pay packages) that they deserve. Paraphrasing Shakespeare, shareholders who complain loudly and often about CEO excesses should recognize that "the fault is not in their stars but in themselves", have to stop looking to others to make things right and start voting with their shares rather than their feet.

  1. The Value of a CEO 
  2. Valuing Satya Nadella's value to Microsoft
  3. Microsoft 10K and historical financials
Data Attachments
  1. Aggregate CEO Compensation breakdown by sector from 1992-2013

Monday, April 20, 2015

The Search for Investment Serenity: The Look Back Test!

Late last year, in a post titled “Go where it is darkest”, I argued that the best investment opportunities are likely to be found in the midst of fear and uncertainty. I looked at two companies, Vale and Lukoil, that were caught up in perfect storms, where commodity prices had moved against them, the countries (Brazil and Russia) that they were located in were in turmoil, the local currencies were in retreat and the companies themselves faced corporate governance questions. I concluded that post with the statement that I was investing in Vale and Lukoil, notwithstanding the high risk in each one and the uncertainty that I felt about valuing them, because the risk/return trade off seemed to be tilted in my favor. A few months later, with my investment in Vale down substantially and the investment in Lukoil treading water, I decided to revisit the valuations.

Looking Back: Testing your investment serenity!
Satchel Paige is rumored to have once said “Don’t look back. Something might be gaining on you” and most of us take his advice to heart, especially when it comes to investments that have gone bad. We spend almost all of their time thinking about investments that we can add to their portfolios, we repeatedly check on our "winners", crediting ourselves for our foresight in picking them, and we studiously avoid looking at the "losers". Studies of investor behavior find substantial evidence that investors hold on to losers too long and that they are quick to blame outside sources or bad luck for these losers, while attributing winners to their stock picking skills.  

I believe that the biggest mistakes in investing are made not in what or when you buy, but in what or why you choose not to buy and what and when you sell (what you have already bought). I know that I need to look at my past investments, not to lament mistakes I have made or to wallow in regret, but because each investment in my portfolio has to meet the same test to remain in my portfolio, as it did when I first bought it. As an intrinsic value investor, that test is a simple one. I should buy when a stock trades at a price below its value and should not if it trades above value. Consequently, when I look at my portfolio this morning, I should apply the same rule to every investment in it, asking whether at today’s price and today's estimated value, I should buy more of that stock (if it has become even more under valued), hold on to it (it is remains under valued or has become fairly valued) or sell the stock (if it has become over valued).

Simple, right? Yes, if are a serene investor who can be dispassionate about past mistakes and rational in your judgments. I am anything but serene, when it comes to assessing past investments and I know that what I choose to do will often be guided by the worst of my emotions, rather than good sense. I will double up (or down) on my losing investments, not because they have become more under valued, but because of hubris, will hold on to my losers, because denial is so much easier than admitting to a mistake, and sell because of panic and fear. While I cannot will myself to rationality, there are things that I try to do to counter my all-too-human emotions. 
  1. Due Process: Left to my own devices, I know that I will selectively revalue only those investments that I like, and only at the times of my choosing, and ignore revaluations that will deliver bad news. It is for this reason that I force myself to revalue each investment in my portfolio at pre-specified intervals (at least once a year and around significant news stories). 
  2. Spread my bets: I have found that I am far more likely to both panic and be defensive about investments that are a large portion of my portfolio than for investments that are small, one reason I stay diversified across many stocks (each of which passes my investment test) rather than a few. 
  3. Be explicit in my valuation judgments: I have found that is far easier to be delusional when you buy and sell based upon secretive, complex and closed processes. It is one reason that I not only try to keep my valuation assumptions explicit but also share my valuations. I know that someone will call me out on my delusions, if I try to tweak them to deliver the results that I want.
  4. Admit publicly to being wrong: I have tried to be public about admitting mistakes, when I make them, because I have found that it frees me to clear the slate. I must admit that it does not come easily to me, but each time I do it, I find it a little easier than the last time.
  5. Have faith but don't make it doctrine: I have faith (misplaced though it might be) that I can estimate intrinsic value and that the price will eventually converge on the value and that faith is strong enough to withstand both contrary market movements and investor views. At the same time, I know that I have to be willing to modify that faith if the facts consistently contradict it. 
I can hope that one day my investment decisions will not be driven by need to defend, deny or flee from past mistakes, but I am still a work in progress in my quest for investment serenity.

Vale and Lukoil: The Original Rationale
I invested in both Vale and Lukoil at the time of my original post (November 19, 2014) and justified my decisions on two fronts:
  1. The Macro Argument: I argued that since both companies were being weighed down by a combination of commodity price, country, currency and company risk, a lifting of any one of these weights would work in favor of my investment. I did confess that I had no market timing skills on any of these fronts and that I was drawing on statistical likelihood that one or another of these weights would lift.
  2. The Micro Story: I picked these companies in particular, rather than others in these markets that faced the same risks, because I felt that they were better positioned both in term of surviving continued market troubles and that they were under valued. In November 2014, I felt that Vale was a better bet than Petrobras, partly because it carried less debt and partly because the Brazilian government had not been as active in directing how the firm was run. At that time, Lukoil carried less debt, was less entangled with the Russian government and had better corporate governance (everything is relative) than Gazprom or Rosneft, two other Russian commodity companies. 
My valuation of Vale at the time of the post is summarized below:
At $8.53/share, it looked under valued to me, even with significant drops built into its operating income.

With Lukoil, the valuation at the time of the post is summarized below:
It was not as under valued as Vale was, but under valued enough that I was comfortable buying the stock. With both investments, it was the micro bet (that the stock was under valued) that drove my investment but I held out hope that one or more of the macro variables would move in my favor.

Vale: The Petrobras Blowback?
Almost five months after my initial foray, I took at look at Vale, fully aware that I would see numbers that I did not like:

The stock stands as testimonial to one of the dangers of investing on the dark side. Just as you think things are very dark, they can get even darker. In the five months, iron ore prices have dropped 31.07% and Vale, as the largest iron ore producer in the world, has felt the pain. The pain is accentuated by Brazil’s slide in international markets, as its currency has lost almost 15% of its value, relative to the US dollar. The news story that has dominated the news is the ongoing corruption scandals at Petrobras and Vale, in my view, has been caught int he under currents. Vale, after all, shares many characteristics with Petrobras, with the Brazilian government controlling management through a golden share and control of voting shares, a captive board of directors and a dividend policy on auto pilot. 

With the benefit of hindsight, you could argue that I should have waited but lacking the skills to make that timing judgment, the question I face now is whether I should continue to hold the stock. To answer that question, though, I should be asking whether I would buy the stock today at $6.19, given what the company looks like now. Updating the financials to reflect one more quarter of data and  a continued drop in iron ore prices, I revalued the company:
At the value that I obtain, $10.71 per share, the stock is under valued by about 42% at its stock price of  $6.19 on April 15, but that value is down dramatically from the $19.40/share that I estimated last November. Part of the reason lies in the fundamentals (with commodity prices dropping and country risk expanding) but part of it reflects my valuation mistakes (a failure to adjust operating income adequately for the drop in iron ore prices). Notwithstanding my failures at forecasting, at today's price and value, I would have no qualms about buying the stock.

I know that I may be letting my desire to be right override my good sense and setting myself for more pain in the future, and I am aware that there are three big dangers that await me. First, the reported earnings for 2014 reflect some, but not all, of the damage from lower iron ore prices,  and it is almost certain that there will be more bad news on earnings this year. Second, the decline in iron ore prices shows no sign of letting up and it is possible that there will be no bounce back in iron ore prices for a while. Third, now that the Petrobras goose has stopped laying golden eggs, the Brazilian government may turn its attention and interest to Vale and that would be deadly for investors. 

Lukoil: The Russian Adventure continues
The last five months have been interesting ones in the oil market, as oil prices have continued to slide. In the graph below, I look at Lukoil from the date of my original purchase through April 15.

In a period where oil prices dropped 17.75%  and the global oil index declined by 4.66%, Lukoil held up remarkably well, increasing 4.23%. Much as I would like to claim credit for my stock picking skills, it is worth noting that  the MICEX was up 10.39% in local currency terms and about 5% in US dollar terms over the same period. 

As with Vale, I revisited my valuation of Lukoil, updating the numbers to reflect an earnings report from the company and updated market numbers.
The value has dipped slightly to $48.49/share, largely as a consequence of lower oil prices, and the price has risen slightly to $51.69/share, leaving me with the end result that the stock is slightly over valued today. If I were making a decision on whether to buy the stock today, I would be not buy the stock, but since I have it in my portfolio already, I am inclined to hold on to it, since it is close to fairly valued.

The Closing
As you can sense from my ramblings during this post, what started as an assessment of whether Vale and Lukoil should continue to be part of my portfolio has become a rumination on the much bigger question of investing faith and  philosophy. In investing, I think it is dangerous to have both too little faith and too much. If you have too little faith,  you will abandon your investments too quickly, if the market moves against you or if others seem to be doing much better than you are. If you have too much faith, you can cross the line into fanaticism, where you are so convinced of your rightness that you ignore facts to the contrary. I hope that my faith in my intrinsic value is both strong enough to withstand short terms set backs and to adapt to changing market circumstances and that I can find some measure of investment serenity.

Vale: Annual Financials for 2014 (20F)
Lukoil: Annual Report for 2014 
Vale Valuations: November 2014 and April 2015 
Lukoil Valuations: November 2014 and April 2015