Sunday, January 31, 2010

Emerging versus Developed Markets: The margin shrinks in 2010

One final post based upon 2010 data. I have been interested in emerging markets, in general, and the challenges of valuing companies in these markets, in particular, for a long time. When I started on this endeavor in the 1990s, the fault lines between developed and emerging markets were stark and could be categorized on the following dimensions:

1. Financial markets versus Economy: In emerging economies, financial markets were a very small and unrepresentative sampling of the underlying economy. Thus, the bulk of the market capitalization in most emerging markets came from recently privatized infrastructure companies, a few large banks and family controlled corporations. In developed markets, especially the US, Japan and the UK, much of the economy was corporatized and publicly traded.

2. Liquidity and capital access: Emerging markets were subject to ebbs and flows in liquidity, with crises, where liquidity and capital access dried up for almost all firms in the market. Only those emerging market companies that had access to foreign capital were able to maintain life lines during these periods. In developed markets, it was accepted that while some segments of the economy would have trouble raising capital, liquidity and capital access would remain available to most mid cap and large cap firms.

3. Default risk in government: Investors in bonds issued by governments in emerging markets assumed that would be a significant risk of default in these governments, even when they borrowed in the local currency, and priced in this default in the form of high interest rates. Investors in bonds issued by governments in developed markets did not even give thought to the possibility of default in the local currency.

4. Government role in company/economic health: Governments in emerging markets played a much more intrusive (and larger) role in their economies and the fates of their companies (through both explicit controls and licenses and implict threats of nationalization or expropriation). They were also viewed as more volatile and unpredictable. Consequently, when valuing emerging market companies, assumptions about government competence (or incompetence) and actions (or inactions) could affect company value substantially. In developed markets, the value of a company was largely a function of its management qualities and competitive advantages, and governments were viewed as predictable, side players.

5. Currency and inflation: In emerging markets, there was distrust of the local currency, often motivated by bouts of inflation and political uncertainty in the past. This distrust manifested itself in many ways, from an unwillingness by any entity in that market to borrow/lend long term in the local currency, to all analysis being done in U.S. dollars. In developed markets, investors may have been susceptible to complaining about the strength/weakness of the local currencies but inflation was mostly viewed as a controllable problem and currency longevity was taken as a given.

The crisis of 2008 may have precipitated this shift, but it is a shift that has been occurring over much of the last decade. Today, the gap between emerging and developed markets has shrunk and, in some cases, disappeared.

a. Financial markets and economy: While there remain many emerging economies, where financial markets lag the economy, the biggest emerging markets (India, China and Brazil) have seen explosive growth in both the number of companies that are publicly traded and the portion of the economy that is covered by financial markets.

b. Liquidity and capital access
: In the last quarter of 2008, we witnessed the almost unimaginable sight of GE being unable to issue commercial paper. In effect, developed markets discovered that you could have a liquidity crisis that affected all companies and all sources of capital. At the same time, the expansion of local investor bases has made emerging markets more liquid and expanded capital access to companies in these markets.

c. Default risk in government
: As emerging market governments establish a track record of paying their obligations on time and without fanfare, and developed market governments (Greece, Iceland) reveal significant potential for default, the notion that there is no default risk in developed market governments is coming under assault. In fact, the argument that the US and the UK may not be AAA rated forever no longer sounds far fetched.

4. Governments and Economy: While I was valuing Citigroup and Bank of America early in 2009, I realized how much my valuations of these two firms was dependent upon government action or inaction and I found myself using techniques that I had developed to value emerging market companies in the 1990s. At the same time, I find myself valuing well run Brazilian and Indian companies, without paying much heed to the governments in the markets. (I am afraid I cannot say this yet for Chinese companies, because of corporate governance concerns)

5. Currency and Inflation: As I noted in an earlier post, I see a much greater willingness in large emerging markets to analyze investments and value companies in the local currency. Investors in these markets have more faith in their currencies and seem to be less scarred by inflation worries than in periods past. At the same time, investors in developed markets seem to be jumpy about potential inflation in the future; this fear may not be manifested in current inflation or interest rates but it can be seen in the flight to gold and talk about hyperinflation.

In closing, the gap between developed and emerging market companies is closing, both in economic and analytical terms. The former are displaying some of the most troublesome characteristics of the latter, whereas the latter are maturing. For analysts and investors, the lessons should be clear. Developed market investors who have become lazy over decades of stability need to wake up and use techniques that emerging market analysts and investors have used for that same period. Emerging market investors and analysts who have made their money by playing the macro and government forecasting game have to start thinking more seriously about company fundamentals and value. There is work to do!


Vikram said...

Companies like Enron and Satyam show us how capital markets of developed nations are no better at pricing in management risk then those of developing nations.

Mahesh Sethuraman said...

Since when did India become a developed nation???

Vikram said...

Satyam is to a developing nation what Enron was to a developed one.

dimraf said...

Recent results from government bonds auctions:
Bulgaria 3,4% yield (in EUR)
Greece 6,2% yield (in EUR)

Is Bulgaria less risky than Greece? The traditions have changed...

Jaime A said...

How would you reflect the effect of government in a valuation? How would you reflect today in a model to value C?

Big Fan from MIT Sloan, keep up the good work Prof. D.

Aswath Damodaran said...

Governments can affect value in both good ways and bad ways. In bad ways, they can put a cap on value and profitability, either by restricting profits or by outright nationalization. In good ways, they an protect you against bankrutpty by bailing you out. Both are options, one a call and one a put, that can be valued.

D H Smith said...

As I was reading through, the first time I have read anything on your blog, the suspense was building to the punchline I expected at the end: "developed & emerging have changed places, we flee the risky US and UK for the relative safety of China and Brazil."

The problems of management of the formerly blue chip developed countries is that their policy establishments lack the resourcefulness of emerging market counterparts who have dealt with austerity, unconvertibility, other such issues.

James said...

Hi Aswath,

I understand that this probably isn't the best place to ask, but if you don't have time to answer then maybe another reader will.

From what I've read on your site it appears you don't include cash flows from the disposal of non-current assets (e.g. PPE) in your calculation of FCFF. Is there a reason for this? Many firms, such as equipment rental companies, have recurring cash inflows from the sale of equipment, yet the standard definition of free cash flow doesn't account for this.

I'm certain that you would be understating the value of a business (particularly a business that derives recurring cash inflows from the sale of PPE) if you exclude such cash flows, but I am interested in your view considering I couldn't find anything on your site.

Gaurav Mehta said...

James, from what i can understand of your question, businesses that have recurring cash flows from asset sales such of sale of equipment would be companies that would need to invest back that money into buying new equipment and as far as i know these should be included in the cash flows as Net Capital Expenditures i.e. (Depreication + Asset sales - New CAPEX requirement) or just (Depreciation - Net CAPEX).

The only sale of non current assets that are not included in cash flows would be something like land that the company has and is not using for operations or for generating cash flows and is vacant. That should be added (sold or unsold) on top of the valuation of the operating assets of the company.

I may be wrong so Prof Damodaran can clarify on the same.

Aswath Damodaran said...

With cash flows, it is always best to use common sense. If a firm consistently generates positive cash flows from divesting old assets to buy new ones, net divestitures out from capital expenditures.
One reason to be cautious, though, is that the divestiture line item in the cash flow statement is often volatile. I would average the numbers out over time.

James said...

Thanks for the guidance Gaurav and Aswath.

Ankit said...

Dear Sir ,

When we say that the margin has shrunk , I am bit confused with the statement .. As it has been observed and also has been very clearly explained in your post the risk profile of developed nation has increased . Infact the factors like liquidity crisis , currency depreciation , government instability and corporate fraud has been quite prevalent even in developed economies , so now if we analyze the return profile the emerging markets are providing better returns , hence the margins ( or scope/ Value ) of investing in Emerging markets has actually improved now and we should see more money flowing in these markets ..

But if we see the actual money flow and market performance the developed markets seems to be doing well in last few months ...

Just a bit confused ..