Tuesday, October 16, 2018

High and higher: The Money in Marijuana!

In 1992, when Bill Clinton was running for president of the United States, and was asked whether he had ever smoked marijuana, he responded that he had, but that he did not inhale, reflecting the fear that being viewed as a weed-smoker would lay low his presidential ambitions. How times have changed! Today, smoking marijuana recreationally is legal in nine states, and medical marijuana in twenty nine states, in the United States. Outside the United States, much of Europe has always taken a much more sanguine view of cannabis, and on October 17, 2018, Canada will become the second country (after Uruguay) in the world to legalize the recreational use of the product. In conjunction with this development, new companies are entering the market, hoping to take advantage of what they see as a “big” market, and excited investors are rewarding them with large market capitalizations. I have never smoked marijuana, but on my daily walks on the boardwalks of San Diego, I have been inhaling a lot of second-hand smoke, leaving me a little light headed as I write this post. So, read on at your own risk!

The Macro Big Picture
While there is much to debate about how this market will evolve over time, and whether investors and businesses can make money of that evolution, there is one fact that is not debatable. The cannabis market will be a big one, in terms of users and revenues, drawing in large numbers of the population. To get a sense of the growth in this business, consider some nascent statistics from the soon-to-be legalized Canadian recreational market:
  1. Lots of people smoke weed: According to the Canadian national census, 42.5% of Canadians have tried Marijuana and about 16% had used it in the recent past (last 3 months), with the percentages climbing among younger Canadians, where one in three being recent users.
  2. And spend money to do so: The total revenues from recreational marijuana sales in Canada alone is expected to be $7-8 billion in 2020 and grow at a healthy rate after that. Some of this will represent a shifting from the illegal market (estimated at close to $5 billion in 2017) and some of it will represent new users drawn in its legal status.
There is also information that can be gleaned about the future of this business from the states in the United States that have legalized marijuana.
  1. In California, where legalization occurred at the start of 2018, revenues from cannabis are expected to be about $3.4 billion in 2018, but that is not a huge jump from the $3 billion in revenues in the illegal market in 2017. One reason, at least in California, is that legal marijuana, with testing, regulation and taxes, is much more expensive than that obtained in the illegal markets that existed pre-legalization. 
  2. In Colorado, where recreational marijuana use has been legal since 2014, the revenues from selling marijuana have increased from $996 million in 2015 to $1,25 billion in 2016 to $1,47 billion in 2017, representing solid, but not spectacular, growth. Marijuana-related businesses in Colorado have benefited from the revenue growth but have, for the most part, been unable to convert that growth into solid profits, partly because of the regulatory and tax overlay that they have had to navigate. 
With the limited data that we have from both Canada and the US states that have legalized marijuana, here are some general conclusions that come to mind.
  1. The illegal marijuana market will persist after legalization: The illegal weed business will continue, even after legalization, for many reasons. One is that legalization brings costs, regulations and taxes, which make the cost of legal weed higher than its illegal counterpart. The other is cultural, where a segment of long-time weed smokers will be reluctant to give up their traditional ways of acquiring and using weed. From a business standpoint, this will mean that the legal weed businesses will have to share the market with unregulated and untaxed competitors, reducing both revenues and profitability.
  2. There will be growth in recreational marijuana sales, but it will not be exponential: For those who are expecting a sudden surge of new users, as a result of legalization, the results from the parts of the world that have legalized should be sobering. In most of these parts, to the extent that society and law enforcement had already turned a blind eye to enforcing marijuana laws before legalization, there was no sea change in legal consequences from weed smoking. 
  3. The medical marijuana market growth will be driven more by research indicating its value in health care than by popularity contests. The bad news is that this will require navigating the time-consuming and cash-burning FDA regulatory approval process but the good news is that once approved, there is less likely to be pushback, cultural or legal, against its use. It is a safe prediction that medical marijuana will be legal in all of the United States far sooner than recreational marijuana.
  4. Federal laws matter: If you are a company in the weed business in one of the nine states that has legalized recreational marijuana, you still face a quandary. While your operations may be legal in the state that you operate in, you are at risk any time your operations require you to cross state lines and as we noted with Colorado businesses, when you pay federal taxes. Since most financial service firms operate across state borders and are regulated by Federal entities, it has also meant that even legal businesses in this space have had trouble raising funding or borrowing money from banks.
In spite of all of these caveats, there is optimism about growth in this market, with the more conservative forecasters predicting that global revenues from marijuana sales will increase to $70 billion in 2024, triple the sales today, and the more daring ones predicting close to $150 billion in sales.

The Business Question
If the marijuana market is likely to grow strongly, it should be a good market to operate a business in, right? Not all big businesses are profitable or value creating, since for a big business to be value creating, it has to come with competitive advantages or barriers to entry. If you are an investor in this space, you also have to start thinking about how companies will set themselves apart from each other, once the business matures. To see how companies in this business will evolve, it is important that you separate the recreational from the medical cannabis businesses, since each will face different challenges.

I. Recreational Cannabis
Like tobacco and alcohol, the recreational marijuana business will grow with a wink and a nod towards its  side costs, and potential to be a gateway to more potent and addictive substances. Like tobacco and alcohol, marijuana will face both constraints on who it can be sold to, as well as lawsuits down the road. Before you take issue with me for taking a negative view of marijuana, note that this is not a bad path to follow, given that tobacco and alcohol have been solid money-makers for decades. The question then becomes whether, like alcohol and tobacco, cannabis will become a brand-name driven business, where having a stronger brand name allows the winners to charge higher prices and earn better margins, or whether it devolves into a commodity business, where there is little to differentiate between the offerings of different companies, leading to commoditization and low margins. If it is the former, the most successful businesses in the space will bring marketing and branding skills to the table and if it is the latter, it will be economies of scale, and low-cost production that will be the differentiator.

II. Medical Cannabis
The medical marijuana business will more closely resemble the pharmaceutical business, where you will have to work with health care regulations and economics. Success in this business will come from finding a blockbuster cannabis-based drug that can then be sold at premium prices. If our experience with young pharmaceutical and biotech companies is an indicator, this would suggest that to succeed in this business, a company will need continued access to capital from investors with patience, a strong research presence and an understanding of the regulatory approval process. The company will also generate more value in health care systems where drug companies have pricing power, making the US market a much more lucrative one than the Canadian one. The differences between the two businesses are stark enough that you can argue that it will be difficult for a company to operate in both businesses without running into problems, sooner or later.

Investment considerations
So, should you invest in this business or stay away until it becomes more mature? While there is an argument for waiting, if you are risk averse, it will also mean that you will lose out on the biggest rewards. If you are exploring your options today, you have to start by assessing your investment choices and pick the one that you are most comfortable with.

The Investment Landscape
This is a young and evolving business, with the  Canadian legalization drawing more firms into the market. Not only are the companies on the list of public companies in the sector recent listings, but almost all of them have small revenues and big losses. While that, by itself, is likely to drive away old time value investors, it is worth noting that at a this early stage in the business life cycle, these losses are a feature, not a bug. Looking at just the top 10 companies, in terms of market cap, on the cannabis business, here is what I see:
Largest Publicly Traded Cannabis Companies- October 2018 
Note that the biggest company on the list is Tilray, a company that went publicly only a few months ago, with revenues that barely register ($28 million) and operating losses. Tilray made the news right after its IPO, with its stock price increasing ten-fold in the weeks after, before losing almost half of its value in the weeks after. Canopy Growth, the largest and most established company on this list, has the highest revenues at $68 million. More generally, Canadian companies dominate the list and all of them trade at astronomical multiples of book value.

As new companies flock into the market, the list of publicly traded companies is only going to get longer, and at least for the foreseeable future, most of them will continue to lose money. Adding to the chaos, existing companies that have logical reasons to enter this business (tobacco & alcohol in the recreational and pharmaceuticals in the medical) but have held back will enter, as the stigma of being in the business fades, and with it, the federal handicaps imposed for being in the business. Put simply, this business, like many other young and potentially big markets, seems to be in the throes of what I called the big market delusion in a post that I had about online advertising companies a few years ago.

Trading and Investing
Like all young businesses, this segment is currently dominated by trading and pricing, not investing and valuation. Put differently, companies are being priced based upon the size of the potential market and incremental information. Put simply, small and seemingly insignificant news stories will cause big swings in stock prices. Thus, there is no fundamental rationale you can give for why Tilray’s stock has behaved the way it has since it's IPO. It is driven by mood and momentum. If you are a good trader, this is a great time to play the game, since you can use your skills at detecting momentum shifts to make money as the stock goes up and again as it goes down. Since I am a terrible trader, I will leave it up to to you to decide whether you want to play the game.

If you are an investor, you want to invest on the expectation that there is more value in these companies than you are paying up front, for your equity stake. As I see it, here are your choices:
  1. The Concentrated Pick: Pick a stock or two that you believe is most suited to succeed in the  business, as it matures. Thus, if you believe that the business is going to get commoditized and that the winner will be the one with the lowest costs, you should target a company like Canopy Growth, a company that seems to be pushing towards making itself the low-cost leader in the growth end of the business. If, in contrast, you believe that this is a business where branding and marketing will set you apart, you should focus on a company that is building itself up through marketing and celebrity endorsements. To succeed at this strategy, you have to be right on both your macro assessment and your company pick, but if you are, this approach has the potential to have the biggest payoff. 
  2. Spread your bets: If your views about how the business will evolve are diffuse, but you do believe that there will be strong overall revenue growth and ultimate profitability, you can buy a portfolio of marijuana stocks. In fact, there is an ETF (MJ) composed primarily of cannabis-related stocks, with a modest expense ratio; its ten biggest holdings are all marijuana stocks, comprising 62% of the portfolio. The upside is that you just have to be right, on average, for this strategy to pay off, but the downside is that these companies are all richly priced, given the overall optimism about the market today. You also have to worry that the ultimate winner may not be on the list of stocks that are listed today, but a new entrant who has not shown up yet. If you are willing to wait for a correction, and there will be one, you may be able to get into the ETF at a much more reasonable price.
  3. The Indirect Play: Watch for established players to also jump in, with tobacco and alcohol stocks entering the recreational weed business, and pharmaceutical companies the medical weed business. You may get a better payoff investing in these established companies, many of which are priced for low growth and declining margins. One example is Scott’s Miracle-Gro, for instance, which has a growing weed subsidiary called Hawthorne Gardening. Another is GW Pharmaceuticals that has cannabis-based drugs in production for epilepsy and MS.
It may be indication of my age, but I really don’t have a strong enough handle on this market and what makes it tick to make an early bet on competitive advantages. So, I will pass on picking the one or two winners in the market. Given how euphoric investors have been since the legalization of weed in Canada in pushing up cannabis stock prices, I think this is the wrong time to buy the ETF, especially since sector is going to draw in new players.  That leaves me with the third and final choice, which is to invest in a company that is not viewed as being in the business but has a significant stake in it nevertheless. At current stock prices, neither Scott Miracle-Gro nor GW Pharmaceuticals looks like a good bet (I valued Scott Miracle-Gro at about $55, below its current stock price of $70.), but I think that my choices will get richer in the years to come.  I can wait, and while I do, I think I will take another walk on the boardwalk!

YouTube Video

Friday, September 21, 2018

Amazon and Apple at a Trillion $: A Follow-up on Uncertainty and Catalysts!

In my last post, I looked at Apple and Amazon, as their market caps exceeded a trillion dollars, tracing the journey that they took over the last two decades to get to that threshold and valuing them  given their current standing. While you can check out the stories that I told and the details of my valuation in that post, I valued Apple at $200, about 9% less than the market price, and Amazon at abut $1255, about 35% lower than its market price. I concluded the post with a teaser, promising to come back with my decisions on whether I would sell my existing Apple shareholding and/or sell short on Amazon, after reviewing two loose ends. The first is to lay bare the uncertainties inherent in both valuations, to see if there is something in those uncertainties that I can use to make a better decision. The second is to evaluate whether there are catalysts that will convert the gap that I see between value and price into actual profits.

Facing up to Uncertainty
One of the recurrent themes in this blog is that we (as human beings) are not good at dealing with uncertainty. We avoid, evade and deny its existence, and in the process end up making unhealthy choices. When valuing companies, uncertainty is a given, a feature and not a bug, and traditional valuation models often give it short shrift. In fact, looking at my valuations of Apple and Amazon, you can see that the only place that I explicitly deal with uncertainty is in the discount rate, and even that process is rendered opaque, because I use betas and equity risk premiums to get to my final numbers. My cash flows reflect my expectations, and even in my moments of greatest hubris, I don't believe that I know, with precision, what will happen to Apple's revenue growth over time or how Amazon's operating margin will evolve in the future. So, why bother? In investing, you have no choice but to make your best estimates and value companies, knowing fully well that you will be wrong, no matter how much information you have and how good your models are. 

That said, it is puzzling that we still stick with point estimates (single numbers for revenue growth and operating margins) in conventional valuation, when we have the tools to bring in uncertainty  into our valuation judgments. While our statistics classes in college are a distant (and often painful) memory for most of us, there are statistical tools that can help us. While these tools may have been impractical even a decade ago, they are now more accessible, and when coupled with the richer data that we now have, we have the pieces in place to go beyond single value judgments. It is with this objective in mind that I recently updated a paper that I have on using probabilistic and statistical techniques to enrich valuation online, and you can get the paper by going to this link. Consider it a companion to another paper that I wrote a while back, dealing more expansively with uncertainty and healthy ways of dealing with it in investing and valuation.

Summarizing the probabilistic techniques that may help in valuation, I suggest three: (1) Scenario Analysis, for valuing companies that may have different valuations depending upon specific and usually discrete scenarios unfolding (for example a change in regulatory regimes for a bank or telecommunications company), (2) Decision Trees, for valuing companies that face sequential risk, i.e., you have to get through one phase of risk to arrive at the next one, as is the case with young drug companies that have new drugs in the regulatory pipeline and (3) Monte Carlo Simulations, the most general technique that can accommodate continuous and even correlated risks that you face in valuation, as is the case when you forecast revenue growth and operating margins for Apple and Amazon, in pursuit of their values.

Simulated Values: Apple and Amazon
Before delving into the simulations for Apple and Amazon, it is important that we set up the structure of the simulations first by first deciding what variables to build distributions around. While you may be tempted by the power of the tool to make every input (from risk free rates to terminal growth rates) into a distribution, my suggestion is that you focus on the variables that not only matter the most, but where you feel most uncertain. With Apple, the three inputs that I will build distributions around are revenue growth, operating margins and cost of capital. With Amazon, I will add a fourth variable to the mix, in the sales to invested capital, measuring how efficiently Amazon can deliver its revenue growth.

Apple: A September 2018 Simulation
I build around my core story for Apple, which is that it will be a slow growth, cash machine, deriving the bulk of its revenues, profits and value from the iPhone, but allow for uncertainty in each of my key inputs:
  1. Revenue growth: While my expected growth rate stays 3%, I allow for a range of growth rates from no growth (flat revenues) , if the iPhone's higher prices cost it signifiant market share) to 6% growth, which would require that Apple find a new growth source, perhaps from services or a new product.
  2. Operating Margin: In my story, I assumed that operating margin would decline to 25% (from  the current 30%) over the next five years. While I still feel that this is the best estimate, I allow for the possibility that competition will be stronger than expected (with margins dropping to 20%), at one end, and that Apple will be able to use its brand name to keep margins at 30%, at the other. 
  3. Cost of capital: My base case cost of capital is 8.20%, reflecting Apple's mix of businesses, but allowing for errors in my sector risk measures and changes in business mix, I build a distribution centered around 8.20% but with a small standard error (0.40%).  
Since I want to stay market neutral, taking no stand on either the level of interest rates or overall stock prices, I am leaving the ten-year bond rate and equity risk premium untouched. The results of the simulation are below:

Valuation & Simulation Output
Note that the median, mean and base case valuations are all bunched up at $200 and that the range in value, using the 10th and 90th percentiles, is tight ($176 to $229).

Amazon: A September 2018 Simulation
Moving from Apple to Amazon, my uncertainties multiply partly because my story is of a company that will move into any business where it believes its disruptive platform can deliver results, and there are very few businesses that are immune. Consequently, every input into the valuation is much more volatile, but I will focus on four:
  1. Revenue Growth: I used an expected growth rate for Amazon of 15% a year for the next 5 years, tapering down to lower levels in the future, to push revenues to $626 billion, ten years from now. While that is an ambitious target, Amazon has proved itself capable of beating sky high expectations before and it is plausible that the growth rate could be as high as 25% (which would translate to revenues of $1.13 trillion, ten years out). There is also the possibility that regulators and anti-trust enforcers may step in and restrain Amazon's growth plans, which could cause the growth rate to drop significantly to 5% (resulting in revenues of $330 billion in year 10).
  2. Operating Margin: While Amazon's margins have been on a slow, but steady, climb in the last few years, much of that improvement has come from the cloud services business, and the future course of margins will depend not only on how well Amazon can bring logistics costs under control but also on what new businesses it targets. I will stay with my base cash assumption of a target operating margin of 12.5%, but allow for the possibility that Amazon's margins will stay stagnant (close to today's margins of about 7%), at one extreme, and that there might be a new, very profitable business that Amazon can enter, pushing up the margins above 18%, at the other.
  3. Sales to Invested Capital: Currently, Amazon is an efficient utilizer of capital, generating $5.95 in revenues for every dollar of capital invested. While this will remain my base case, there may be future businesses that Amazon is targeting that may be more or less capital intensive than its current ones, leading to a significant range (3.95 for the more capital intensive - 7.95 to the less  capital intensive).
  4. Cost of Capital: I will stick with my base case cost of capital of 7.97%, with the possibility that that it could drop as Amazon's older businesses become profitable (but not by much, since the current cost of capital is close to the median for global companies) as well as the very real chance that it could go up significantly, if Amazon targets risky businesses in emerging markets for its growth.
Valuation & Simulation Output
The median value across the simulations is $1242, close to the base case valuation of $1,255. The range on value, using the 10th and 90th percentiles is $705 - $2,152, much wider than the range for Apple.

Lessons from Apple and Amazon Simulations
Simulations yield pretty pictures and if that is all you get out of them, it is time and energy wasted. There are lessons that we can eke out of the Apple and Amazon simulations that may help us in making more informed judgments:
  1. This is not about getting better estimates of value: If you are running simulations because you think they will give you more precise or better estimates of value than point estimate valuations, you will be disappointed. Since my input distributions are centered around my base case assumptions, and they should be, the median values across 100,000 simulations are close to my base case valuations for both Apple and Amazon.
  2. If it is a risk proxy, it is a very noisy and dangerous one: It is true that the spread of the distributions provides a measure of estimation uncertainty that you bring into your valuation. Using the Apple and Amazon simulations to illustrate, I face far greater uncertainty with my Amazon story than with my Apple story, and you can see it reflected in a larger range of value for the former. You may be puzzled that my cost of capital is lower for Amazon than for Apple, but that reflects the fact that much of the uncertainty that I face with Amazon is company-specific and should be buffered by other stocks in my portfolio. As a diversified investor, the variance in simulated values is a poor proxy for risk. However, if you are an investor who prefers concentrated portfolios, you can use the variance in simulated value as a measure of risk. 
  3. There can be no one margin of safety for all companies: I have written about the margin of safety before, often with skepticism, and one of my critiques has been with the way it is used in practice, where it is set at a fixed number for all companies. Thus, you will find value investors who use a margin of safety of 15% or 20% for all stocks, and the Apple and Amazon simulations show the danger in this practice. A 15% margin of safety for Apple may be too large, given how tightly values are distributed for the company, whereas the same 15% margin of safety may be too small for Amazon, with its wider band of values.
  4. Tails matter: Symmetry or the lack of it in distributions may seem like an inside statistics topic, but with simulated values, it has investment consequences. You can see that Apple's value distribution is  much more symmetric than Amazon's distribution, with the latter having a significant positive skew, reflecting a greater likelihood of big positive surprises in value, than negative ones. With companies with exposure to large and potentially catastrophic news stories (a large lawsuit or debt covenants), you can have value distributions that are negatively skewed.  In general, positive skewed distributions are better for (long) investors than negatively skewed ones, and the reverse is true for investors who are shorting a company.
I ran the simulations after my base case valuations suggested that Apple and Amazon were over valued, to see how they might affect my decision on whether to sell short on either company. The results are mixed.
  • While the simulations confirm my over valuations (no surprise there), with both companies, the current stock price is well within the realm of possibilities. While my base case valuation suggested that Apple was far less over valued (10%) than Amazon (55%), there is roughly a 15-20% chance that both companies are under valued, not over valued.
  • In addition, with Amazon, there is the added risk, if you are selling short, given the long positive tail on the distribution, that if I am wrong, the price I will pay will be much greater than if I am wrong with Apple.
The bottom line is that while Amazon seemed like a much better short selling target, after my base case valuations, because it was far more over valued than Apple, the simulations that I did on the two companies even out the scales, at least marginally. Apple is more over valued, but the probability of making money, assuming my valuations are on target is about the same with both stocks, and the downside of being wrong is far greater with Amazon than with Apple.

Value and Price: The Search for Catalysts
In the post that initiated this series, I looked at why crossing a trillion-dollar threshold may matter to investors, using the contrast between the value process and the pricing process. In effect, I argued that there can be a gap between value and price, and that even if you are right about your value judgment, you will make money only if the gap between the two closes:

Investment success thus rides not only on the quality of your value judgment, and how much faith you have in it, but on whether there are catalysts that can cause the gap to change. With companies, these catalysts can take different forms:
  1. Earnings reports: In their earnings reports, in addition to the proverbial bottom line (earnings per share), companies provide information about operating details (growth, margins, capital invested). To the extent that the pricing reflects unrealistic expectations about the future, information that highlights this in an earnings report may cause investors to reassess price. 
  2. Corporate news: News stories about a company's plans to expand, acquire or divest businesses  or to update or introduce new products can reset the pricing game and change the gap.
  3. Management Change/Behavior: A change in the ranks of top management or a managerial misjudgment that is made public can cause investors to hit the pause button, and this is especially true for companies that are bound to a single personality (usually a powerful founder/CEO) or derive their value from a key person. 
  4. Macro/ Government: A change in the macro environment or the regulatory overlay for a company can also cause a reassessment of the gap.
With all of these catalysts, there may be value effects (because the cash flows, growth and risk) as well, and it should also be noted that when the gap changes, it may not always close. In fact, these catalysts can sometime make a gap bigger, by feeding into pricing momentum.

As an investor, I look for catalysts when I invest, but I am even more intent on finding them, when I sell short than when I am long a stock. The reason for that divergence is that I am in far greater control of my time horizon, when I buy a stock, since, as long as I stay disciplined and retain faith in my value, only liquidity needs can cause me to sell. When I sell short, my time horizon is far less under my control, exposing me to timing risk. Put different, I can bet on a company being over valued, be right on my thesis, but still lose money on a short sale, because I am forced to close out my position, in the absence of a catalyst.

Going through the list of catalysts with Apple and Amazon, with both stocks approaching all-time highs, there is no obvious pricing trigger than I can point to, though my technical analyst friends will undoubtedly point to indicators that I did not even know existed. On the earnings front, the earnings reports for both companies are so heavily scripted to expectations that it would take a big surprise to reset stories, and I don't see that happening. In fact, I will predict that Amazon's earnings reports will continue to deliver double digit revenue growth and improving margins for the next few quarters, and investors will react positively, even though the growth may not be high enough or the margin improvement substantial enough to justify the market pricing. On the corporate news front, Apple's smart phone business model, with the pressure it puts on the company every year or two to reinvent itself, with the latest and the best, coupled with its big announcement events, creates catalyst moments. Looking back at Apple's ups and downs over the last few years, the triggers for substantial up and down movements on the stock have been new iPhone models doing better or worse than expected. In contrast, Amazon is remarkably low key in new product introductions, preferring to slip in under the radar. Both companies have well regarded and established CEOs, and neither company is personality-driven, making it unlikely that you will see management changes triggering big price changes. Finally, on the macro front, both companies face potential catalyst moments. For Apple, it is the possibility of a trade war with China, a huge market for its products and devices, and for Amazon, it is talk of regulatory restrictions and anti-trust actions that can constrain the company.  Since I cannot filibuster my way to a non-decision, I decided to compare my Apple and Amazon numbers/analysis, side by side:

I sold my Apple shares at $220, at the start of trading on Friday (9/21), but while I have not sold short any more shares. I have put in a limit (short) sell, if the price hits $230 (roughly my 90th percentile of value) in the near future. With Amazon, I sold short at $1950 at the start of trading on Friday (9/21).  the first time in twenty years that I have sold short on the company, and one reason that I am pulling the trigger is because I believe that the pushback from regulators and anti-trust enforcers will slow the company down in ways that no competitor ever could. I am doing so, with open eyes, since I believe that Amazon is in one of the best run companies in the world, adept at setting market expectations and beating them, and with a track record of taking short sellers to the graveyard. Time will tell, and I am sure that some of you reading this post will let me know, if my bet goes awry, but I don't plan to lose any sleep over this. 

YouTube Video


Trillion Dollar Posts


Spreadsheets

  1. Apple valuation and simulation results
  2. Amazon valuation and simulation results
(I use Crystal Ball, an add-on to Excel, for my simulations. If you don't have that extension (available only on the PC version), you cannot recreate my simulations, but you can download the program for a trial run on the Oracle website)

Papers/Reading
  1. Facing up to Uncertainty: Using Probabilistic Approaches in Valuation
  2. Living with Noise: Investing and Valuation in the Face of Uncertainty

Wednesday, September 19, 2018

Apple and Amazon at a Trillion $: Looking Back and Looking Forward!

For most of us, even envisioning a trillion dollars is difficult to do, a few more zeros than we are used to seeing in numbers. Thus, when Apple’s market capitalization exceeded a trillion on August 2, 2018, it was greeted with commentary, and when Amazon’s market capitalization also exceeded a trillion just over a month later on September 4, 2018, there was more of the same. I have not only admired both companies, but tracked and valued them repeatedly over the last twenty years. There is much that I have learned about business and finance from both companies, and I thought this would be a good occasion to look at how these two companies got to where they are today, as well as their similarities and differences. In the process, I will make my assessment of where Apple and Amazon stand today, and update my valuations and investment judgments on both companies. I am sure that your assessments will be different, but it is of these differences that markets are made.

The Road to a Trillion Dollars

Markets give and markets take away, and this is true not just for the laggards in the market, but even the most successful companies. Apple and Amazon have had amazing runs, but without taking anything away from their success, it is worth noting that during their march towards trillion dollar market capitalizations, each has had to endure periods in the wilderness, and the way they dealt with market adversity is what has made them the companies that they are today.

Apple is the older of the two companies, founded in 1976, and igniting the shift away from mainframe computers to personal computers, first with its Apple computers and later with its Macs. My first personal computer was a Mac 128K, which I still own, and I have been an investor in the stock off and on, for decades. In the chart below, I graph the market capitalization of the company from 1990 to September 2018:

After its auspicious beginnings, Apple endured a decade in the wilderness in the 1990s, after the departure of Steve Jobs, its visionary but headstrong co-founder, in 1975, and a series of inept successors. As testimonial that there are sometimes second acts for both people and companies, Apple found its mojo in the first decade of this century, headed again by Steve Jobs but this time with a stronger supporting cast. That success has continued into this decade, with Tim Cook stepping in as CEO, after the untimely demise of Jobs. In the last few years, the company has also chosen to use its capacity to borrow money, increasing its debt ratio from close to nothing to just over 10% of equity (in market value terms).

Just as Apple presided over one major change in our lives, Amazon’s entrĂ©e into markets reflected a different shift, one that has changed the way we buy goods, and, in the process, and has upended the retail business. Amazon's sprint from start-up to trillion dollar value is captured below:
From a barely registering market capitalization in 1996, Amazon zoomed to success during the dot-com boom, but as that boom turned to bust, the company lost more than 80% of its market capitalization in 2000. After its near-death experience in 2000, Amazon spent the bulk of the following decade, consolidating and getting ready for its next phase of growth, increasing its market capitalization almost eight-fold between 2012 and 2018.

Along the way, both companies have had their detractors, who have not only scoffed at the capacity both companies to scale up, but have also sold short on the stock, making both stocks among the most shorted in the market. Little seems to have changed on that front, since Apple and Amazon remain among the most heavily shorted stocks in September 2018, though neither Jeff Bezos nor Tim Cook seems to be paying any attention to the short sellers. (Elon Musk, Please take note!)

The Back Story: Revenues and Operating Income

We can debate whether Amazon and Apple are worth a trillion dollars, but there can be no denying that both companies have been successful in their businesses, and that it is these operating success that best explain their high market values. That said, as we will see in the section following, the way these companies have evolved over time have been very different, and looking at the pathways that they used to get to where they are,  I will lay the foundations for valuing them today.

Revenue Growth and Profitability
Every investigation of operations starts with revenues and operating income, and with Apple, the picture of revenues and operating income over the last three decades illustrates the transformation wrought by its decision to shift away from personal computers to hand held devices, starting with the iPod and then expanding into the iPhone and iPad, in the the last decade:


The revenue growth rate, which languished in the 1990s, zoomed in 2000-08 time period, and operating margins almost doubled. However, it was in the 2009-13 period that Apple saw the full benefits of its rebirth, with operating margins almost quadrupling, with the iPhone being the primary contributor. During the 2014-18 period, the good news for Apple is that margins have stayed mostly intact but it has seen a fairly dramatic drop off in growth, as the smart phone market matures.

The Amazon operating story also starts with revenue growth, but the company's evolution on operating margins has followed a different path from Apple's:
The company's growth was stratospheric in the early years, partly because it was a start-up, scaling up from less than a million dollars in revenues in 1995 to $2.76 billion in 2000. While scaling up did slow down growth, the company weathered the dot com bust to grow revenues at 28.61% a year from 2000 to 2010, with revenues reaching $34.2 billion in 2010. The most impressive phase for Amazon has been the 2011-2018 period, because it has been able to continue to grow revenues at almost the same rate as in the prior decade, but this time with a much larger base, increasing revenues to $208.1 billion in the last twelve months, ending June 2018. On the income front, the story has not been as positive. While the initial losses in try 1990s can be explained by Amazon's status as a young, growth company, it becomes more difficult to justify the continuation of these losses into 2002 (six years after its public listing) and the trend lines in operating margins since then. Rather than improving over time, as economies of scale kick in, which is what you would expect in growth companies, Amazon's margins have not only stayed low but have often headed lower, suggesting either that the company is not reaping scaling benefits or that it is playing a very different game, and my bet is on the latter. 

The Cash Flow Contrast
If you are a value investor, I know that you will probably be taking me to task at this point by noting that you don't get to collect on revenues or operating income and that you invest for the cash flows. That is true, and it is on this dimension the the difference between Apple and Amazon becomes a yawning gap.  With Apple, the evolution of the company from a has-been in the 1990s to a disruptive force in the 2001-2010 period to its more mature phase between 2011 and 2018 plays out in its cash flows. Using the free cash flow to equity, which measures cash left over for equity investors after reinvestment and taxes, as the measure of cash that can potentially be returned to shareholders, here is what I see:

I have described Apple as the greatest cash machine in history and you can see why, by looking at the cumulative cash flows generated by the firm. After getting a start in the 2000-08 time period, the cash machine kicked into high gear between 2009 snd 2013, with $124 billion in free cash flow to equity generated cumulatively over the period. You can also see the company's initial reluctance to return the cash, both in the fact that only about a third of the cash flow during this period was returned in dividends and buybacks and in the increase in the cash balance of just over $122 billion. Prodded by activist investors (Einhorn and Icahn, in particular), the company switched gears and began returning more cash, increasing dividends and buying back more stock. Between 2014 and 2018, the company returned an astonishing $277 billion in cash to investors ($61 billion in dividends and $216 billion in buybacks), which is higher than the $242 billion that the firm generated as free cash flows to equity. While it was returning more cash than any other company has in history, Apple pulled off an even more amazing feat, increasing its cash balance by $96 billion, as it used it dipped into it debt capacity, to borrow almost $100 billion.

Amazon's cash flows are a distinct contrast to Apple's, though you should not be surprised, given the lead up. As noted in the earlier section, it is a company that has gone for higher revenue growth, often at the expense of profit margins, and has been willing to wait for its profits. The graph below looks at net income and free cash flows to equity at the company over its lifetime:

It is not the negative FCFE in the early years that is the surprise, since that is what you would expect in a high growth, money losing company, but the evolution of the FCFE in the later years. Initially, Amazon follows the script of a successful growth company, as both profits and FCFE turn positive between 2001 and 2010, but in the years since, Amazon seems to have reverted back to the cash flow patterns of its earlier years, albeit on a much larger scale, with huge negative free cash flows to equity. During all of this period, Amazon has never paid dividends and bought back stock in small quantities in a few years, more to cover management stock option exercises than to return cash to stockholders.

Story and Valuation

With the historical assessment of Apple and Amazon behind us, it is time to turn to the more interesting and relevant question of what to make of each company today, since Apple and Amazon are clearly are on different paths, with very different operating make ups and at different stages in the life cycle. Apple is a mature company, with low growth, and is behaving like one, returning large amounts of cash to stockholders. Amazon is not just a growing company, but one that seems intent on continuing to grow, even if it means delayed profit gratification. In the section below, I will lay out my story and valuation for each company, with the emphasis on the word "my", since I am sure that you have your own story for each company. I will leave my valuation spreadsheet open for you to download, with the story levers easily changed to reflect different stories. 

Apple: The Smartphone Cash Machine
Apple's success over the last two decades has been largely fueled by one product primarily, the iPhone, and that success has come with two costs. The first is that Apple is now predominately a smart phone company, generating almost 62% of its revenues and an even higher percentage of its profits from the iPhone. The second is that the smart phone business has not only matured, with lower growth rates globally, but is intensely competitive, with both traditional competitors like Samsung and new entrants roiling the business. While there remains a possibility that Apple will find another market to disrupt, I think it will be difficult to do so, partly because with Apple's size, any new disruptive product has to not only be of a big market, but one that is immensely profitable, to make a difference to Apple's cash flow stream.

My story for Apple is therefore relatively unchanged from my story last year, though I am a little bit more optimistic that Apple will be able to use its immense iPhone owner base to sell more services
Download spreadsheet
I am valuing Apple as a mature company, growing at the same rate as the economy in perpetuity, while seeing its operating margins decline from their current level (30%) to about 25% over the next 5 years, and with these assumptions, I estimate a $200 value per share, roughly 9% lower than the $219 stock price on September 18, 2018.

Amazon: The Disruptive Platform
In my earlier valuations of Amazon, I called it a Field of Dreams company, because investing in it required investors to buy into its vision of "if we build it (revenues), they (profits) will come". In my most recent valuation of Amazon, I noted that the company was finally starting to deliver on the second half of the promise, increasing its profits margins, with its cloud business contributing large profits, and significant investments in logistics keeping shipping costs in check. Along the way, and especially since 2012, the company has also moved from being predominantly a retailer of goods and services to one that is unafraid to enter any new business, where it can use its disruptive platform to good effect. In effect, it has seemed to have transitioned from being a disruptive retail company to a disruption platform that can be aimed at other businesses, with an army of Prime members at its command.

My story is that will continue to do more of the same, with high revenue growth coming from new businesses and markets and a continued growth in margins, as established businesses start to find their footing. 
Download spreadsheet
My revenue growth rate of 15% may seem modest, given Amazon's growth rate in the last decade, but note that if this growth rate can be delivered, Amazon's revenues will be $626 billion in 2027, and if it can improve its overall operating margin to 12.5%, its operating profit will be $78 billion in that year. With this story, I estimate a $1,255 value per share for Amazon, well below its market price of $1,944 a share, making it over valued by almost 35%. I will admit, with no shame, that Amazon is a company that I have consistently under estimated, and it is entirely possible, perhaps even plausible, that the real story for Amazon is even bigger (in terms of revenue growth) and more profitable. 

End Game
I have always operated on the premise that if you value companies, you should be willing to act on those valuations. In the case of Apple and Amazon, that would suggest that the next step that I should be taking with each company is to sell. With Apple, a stock that I have held for close to three years and which has served me well over the period, that would be accomplished by selling my holding. With Amazon, a stock that I have not held for more than five years, that would imply joining the legions of short sellers. Like an Avengers' movie, I am going to leave you in suspense until my next post, because I have two loose ends to tie up, before I can act. The first is to grapple with the uncertainties that I have about my own stories for the two companies, and the resulting effects on their valuations. The second is what I will mysteriously term "the catalyst effect", which I believe is indispensable, especially when you sell short. 

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Valuation Spreadsheets

Monday, September 10, 2018

Trillion Dollar Toppers: Market Triggers, Value Drivers and Pricing Catalysts!

In the last few weeks, the market capitalization of Apple and Amazon each hit a trillion dollars, a threshold not seen before in public markets. Predictably, that has drawn press attention and commentary about what this moment means for markets, investors and the companies themselves. As readers of this blog know, I have followed both companies and valued them for more than two decades, and this is as good a time as any to see how they got to where they are today, and what the future holds for each company. I will do that in my next post, but in this one, I want to look at the far more basic question of whether hitting a trillion dollar value (or a hundred billion or a billion or any other number) should matter to investors.

Market Triggers
Does the market capitalization rising above a trillion dollars change Amazon or Apple as companies? After all, $1,000,000,000,000 is only a dollar higher than $999,999,999,999 and nothing is changed fundamentally in either company by the event. That said, as human beings, we do make more of a fuss around some numbers than others, especially with age and birthdays. In some cases, the fuss is merited, as when you turn eighteen, since you will be able to vote and be treated as an adult in the legal system, or sixty five, since you may be entitled to your pension and social security benefits. In others, it is a concocted milestone, as is the case when you turn thirty or forty or fifty years old, since little changes in your life, as a consequence.

Investors also seem to endow some numbers with more weight than others, sometimes with reason, and sometimes without. When a publicly traded company’s stock price drops below a dollar, it is often punished, often because it risks being delisted, putting liquidity at risk. When the stock prices rises above $1,000, the company may come under pressure to do a stock split, because it has become “too expensive” for retail investors to buy. With young, privately owned companies, getting a pricing of more than a billion dollars gets you unicorn status, though it not clear what that branding entitles you to, other than a little public attention. Within corporate finance, there are similar triggers built around revenues and profits, with management contracts tied to revenues reaching a billion dollars or EBITDA cresting one hundred million. Collectively, I will call these market triggers, and the focus of this post is to examine how much attention we should pay to them, if any.

The Market Reaction to Triggers
Before we embark on the discussion on whether, and if yes, how much attention to pay to market triggers, note that the degree to which these triggers matter varies widely across investors. While some investors view them as side games, there are others who build much of their investing around market triggers. Value investors, and especially those raised on the classics, scoff at price triggers as distractions from their focus on earnings and moats but they often have their own triggers, based upon earnings or book value. In contrast, a great deal of technical analysis, as an investment philosophy, is built on triggers, many built around price per share. Support and resistance lines, the cresting of which have long been viewed as an indicator of future price movements, are based upon prices that may reflect the company’s past history but often have no intrinsic basis. Similarly, chartists often pay heed to historical high and low prices for the stock, arguing that cresting either number could have consequences for future returns. Many technical indicators are built around price or volume metrics with rules of thumb that often have no fundamental justification. 

At this stage, by making this a contest between value investors and chartists, I have probably already forced you to pick a side, and that would be a pity, since I think that both sides have something to learn from the other. For those who believe in efficient markets, it remains an enduring frustration that markets seem to move in response to what looks like, at least on the surface, to be a cosmetic change in the company. In particular, there is research that stock prices seem to react to stock splits, 
  • With stock splits, where the share count changes in proportion to existing holdings, and nothing fundamentally changes about the company, the market not only reacts positively to the split but these stocks continue to do better than expected in the months after.
  • When a stock approaches its 52-week high, there is some evidence that the high price acts as a barrier, making it more likely that the stock will go down than up.
  • There is some evidence that support and resistance lines have price effects; one study focusing on exchange rates concluded that pricing trends in currency rates are more likely to be interrupted at support and resistance lines. 
  • A general study of technical analysis (and price patterns) concludes that technical indicators, such as head-and-shoulders and double bottoms do have a price impact, though it is unclear that you can make money of these price movements.
In short, much as you may be inclined to dismiss technical research as baseless, there is evidence that past price paths can drive future returns.

Some researchers have managed to convince themselves that the market behavior is consistent with an efficient market, with the rationale that these actions operate as signals about future fundamentals, thus explaining the price changes. A stock split, we are therefore told, is a signal to markets that companies feel that they have the cash flows to sustain higher dividends in the future, translating into higher value. I find most signaling stories to be unconvincing, reflecting almost desperate attempts to reconcile a belief in efficient markets with market behavior that is not consistent with that belief. In my experience, market triggers often affect stock prices, sometimes substantially, and it has little to do with signals. Rather than dismiss these triggers as irrational and useless, I need to understand them better, with the intent of separating ones that may be able to incorporate into my investing from those that I am better off ignoring.

Value Drivers and Pricing Catalysts
In the pursuit of understanding why market triggers matter, I find it useful to go back to a contrast between pricing and value that I have talked about before, and draw a distinction between value drivers and price movers.

In short, the value of a business is driven by its fundamentals, but the pricing of a business is determined by demand and supply, and the two processes can yield different numbers, resulting in a gap between price and value. In this framework, market trigger effects can be classified into three groups:
  1. Value effects: If a market trigger has an effect on one or more of the three drivers of value, which are cash flows, growth and business risk, it can affect value. Revenue or earnings triggers set by companies can have an effect on value, if management compensation is tied to them. With some corporate borrowings, there are covenants tied to stock prices or earnings, the violation of which may lead to consequences for the firm, sometimes taking the form of higher interest expenses and sometimes a change in control. With convertible bonds and preferred shares, the conversion price can become a trigger for a change in value, if it results in a significant increase in shares outstanding and in debt ratios. Consider the grant that Tesla’s board of directors gave Elon Musk in March 2018, where he will get billions of dollars in shares and options in the company, if he can deliver on a variety of targets, some related to market capitalization and some to operating performance. Specifically, the board of directors has listed 12 market capitalization tiggers, each of which can result in shares being granted to Mr. Mush, and 16 operating triggers, with eight relating to revenues and  eight to EBITDA. For a Tesla investor, meeting each of these thresholds will be a cause for mixed feelings, joy that revenues, EBITDA and capitalization are increasing, tempered by dilution occurring at the same time. 
  2. Pricing effects: If a market trigger has an effect on market mood or momentum, it can affect prices, even though it has no effect on fundamentals. For instance, the argument that technical analysts use for paying attention to support lines, often based upon historical prices, is that when a company’s stock price drops below its support line, it creates a negative psychological effect that can cause more selling, with prices falling even further. A pricing trigger can also have a liquidity effect, which can affect prices. This has often been the rationale used by some companies, especially those with high priced shares, for stock splits, arguing that retail investors are more likely to trade a $100 stock than a $1000 stock, and that the increased liquidity can translate into higher prices. The liquidity story can also be used the push by many start-ups to get to unicorn status, since doing so may attract more venture capital money, which, in turn, can push up pricing. Finally, there is the herd effect, where crossing a pricing or value trigger can lead people who have been sitting on the sidelines to act, pushing up prices if they decide to buy and pushing down prices when they sell.
  3. Gap (Catalyst) effects: There is a third and more subtle effect from market triggers, which comes from the attention garnered by crossing even an arbitrary threshold. This is especially the case with smaller and lower profile companies, which can often be ignored by investors and analysts, in a market where larger and higher profile companies garner the bulk of coverage. To the extent that these companies are being mispriced, the attention leading from hitting a trigger can lead to a reassessment of the company and perhaps a closing of the gap. Note that this reassessment can cut in both directions, with unnoticed strengths coming to the surface, and increasing the prices of some companies, and unnoticed weaknesses being unearthed in other companies, resulting in prices dropping. 
This framework can be used to judge whether and why market triggers can affect prices. Some do so, because they have value consequences, some because they affect mood and liquidity, some because they are attention gatherers and some because they have all three effects. Most pricing and volume indicators used by technical analysts, for instance, are pure pricing effects, but since the name of the game in pricing is to gauge shifts in mood and momentum, that is understandable. With companies that have management options and convertibles outstanding, crossing some price barriers can create value effects, by diluting share ownership. With companies that have been operating under the radar, a market trigger can lead to more attention being paid to the company, leading to a closing in gaps between value and price.

So, what effect will crossing the trillion-dollar threshold have on Apple and Amazon? Neither company has options or convertibles that will unlock at the trillion dollar capitalization and thus there should be no value effect. There may be a pricing effect, but it is not clear in which direction. On the one hand, you can argue that for some long term holders of the stock, crossing the trillion dollars may be a culmination of a long and successful journey, leading to selling. On the other hand, there are others who may have resisted both stocks as overpriced, who may decide that this is the time to capitulate and buy the stock. As two of the most widely tracked and followed companies in the world already, it is not likely that there will be any major reassessments in either company, on the part of stockholders, nullifying the gap effect. There is one potential black cloud that comes with the increased attention, at least for Amazon, which is that the company's success may be drawing the attention of anti-trust and regulatory authorities, perhaps putting a crimp on its future growth plans globally. I will return to that issue in my next post.

Market Triggers and Investment Philosophies
If market triggers can have value, price and gap effects, how do you incorporate them into investing? The answer depends upon your investment philosophy:
  1. If you are a trader: The essence of trading is that you are playing the pricing game, and to the extent that you are, your success will depend upon how well you can ride the trend and how quickly you spot changes in momentum. Thus, it does not surprise me that charting and technical indicators are built heavily around these triggers. If you are a good trader, and I believe that they are some, your strength is in assessing how these triggers change mood  and getting ahead of the market on these shifts.
  2. If you are a value investor: As someone focused on value, your first instinct may be to ignore market triggers, viewing them as a distraction from your central mission of valuing companies based upon their fundamentals, and then buying undervalued stocks and selling overvalued ones. While I understand that focus, I think that you should consider incorporating pricing triggers into your value mission for two reasons. The first is that a few of these triggers have value effects and ignoring them will mean that you are mis-valuing companies. The second is that to make money as a value investor, you not only have to get value right, but you have to trust the market to correct its mistake, by moving price towards value. Since the latter is often out of your control, I believe that one of the keys to being a good value investor is finding catalysts that can cause the price correction. If market triggers can operate as catalysts, incorporating them into your investment process can unlock the value mistake that you have found. 
I am a value investor, albeit one with perhaps a broader definition of what comprises value than some old time value investors, but I do look at pricing triggers, especially with small cap, lightly followed and emerging market companies. Thus, if I value a stock at $6 a share and it is trading at $4.10/share, but its historical low price is $4 (the support line), I may wait to buy it, hoping for one of two outcomes. The first is that it hits the support line and does not drop below it, signaling a positive shift in momentum, indicating that this would be a good time to buy. The second is that it drops below its support line, resulting in a negative shift in momentum and more selling, allowing me to buy the stock at an even lower price. Thus, while my primary decision of whether to buy or sell a stock is driven by value judgments, the question of when to do it can be affected by market triggers.

My Bottom Line
I own shares in Apple and I don’t own any (right now) in Amazon, and I have explained why in prior posts on both companies.  With my Apple shares, I have been rewarded well over my almost three-year holding period, and the question then becomes whether the trillion dollar market capitalization should make a difference in whether I continue to hold the shares. With Amazon, I saw little reason to buy the stock a few months ago, as I noted in this post, where I argued that it was a great company but not a great investment. The question then becomes whether market capitalization crossing trillion dollars changes that assessment. The final judgment has to wait until the next post, where I will revalue both companies, and look at whether the trillion-dollar trigger has made a difference.

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Wednesday, August 15, 2018

Deja Vu In Turkey: Currency Crisis and Corporate Insanity!

This has been a year of rolling crises, some originating in developed markets and some in emerging markets, and the market has been remarkably resilient through all of them. It is now Turkey's turn to be in the limelight, though not in a way it hoped to be, as the Turkish Lira enters what seems like a death spiral, that threatens to spill over into other emerging markets. There is plenty that can be said about the macro origins of this crisis, with Turkey's leaders and central bank bearing a lion's share of the blame, but that is not going to be the focus of this post. Instead, I would like to examine how Turkish business practices, and the willful ignorance of basic financial first principles, are making the effects of this crisis worse, and perhaps even catastrophic. 

The Turkish Crisis: So far!
The Turkish problem became a full fledged crisis towards the end of last week, but this is a crisis that has been brewing for months, if not years. It has its roots in both Turkish politics and dysfunctional practices on the part of Turkish regulators, banks and businesses, and has been aided and abetted by investors who have been too willing to look the other way. The most visible symbol of this crisis has been the collapse of the Turkish Lira, which has been losing value, relative to other currencies, for a while, capped off by a drop of almost 15% last Friday (August 10):
Yahoo! Finance
While it is undoubtedly true that the weaker Lira will lead to more problems, currency collapses are symptoms of fundamental problems and for Turkey, those problems are two fold. One is a surge in inflation in the Turkish economy, which can be seen in graph below:

While it easy to blame the Turkish central bank for dereliction of duty, it has been handicapped by Turkey's political leadership, which seems intent on making its own central bank toothless. Rather than allow the central bank to use the classic counter to a currency collapse of raising central bank-set interest rates, the government has put pressure on the bank to lower rates, with predictable (and disastrous) consequences.

Corporate Finance: First Principles
I teach both corporate finance and valuation, and while both are built on the same first principles, corporate finance is both wider and deeper than valuation since it looks at businesses from the inside out. i.e., how decisions made a firm's founders/managers play out in value. In my introductory corporate finance class, I list out the three common sense principles that govern all businesses and how they drive value:
The financing principle operates at the nexus of investing and dividend principles and choices you make on financing can affect both investment and dividend policy. It is true that when most analysts look at the financing principle, they zero in on the financing mix part, looking at the right mix of debt and equity for a firm. I have posted on that question many times, including the start of this year as part of my examination of global debt ratios, and have used the tools to assess whether a company should borrow money or use equity (See my posts on Tesla and Valeant). There is another part to the financing principle, though, that is often ignored, and it is that the right debt for a company should mirror its asset characteristics. Put simply, long term projects should be funded with long term debt, convertible debt is a better choice than fixed rate debt for growth companies and assets with cash flows in dollars (euros) should be funded with dollar (euro) debt. The intuition behind matching does not require elaborate mathematical reasoning but is built on common sense. When you mismatch debt (in terms of maturity, type or currency) with assets, you increase your likelihood of default, and holding debt ratios constant, your cost of debt and capital.
In effect, your perfect debt will provide you with all of the tax benefits of debt while behaving like equity, with cash flows that adapt to your cash flows from operations.

There are two ways that you can match debt up to assets. The first is to issue debt that is reflective of your projects and assets and the second is to use derivatives and swaps to fix the mismatch. Thus, a company that gets its cash flows in rupees, but has dollar debt, can use currency futures and options to protect itself, at least partially, against currency movements. While access to derivatives and swap markets has increased over time, a company that knows its long term project characteristics should issue debt that matches that long term exposure, and then use derivatives & swaps to protect itself against short term variations in exposure.

Turkey: A Debt Mismatch Outlier?
The argument for matching debt structure (maturity, currency, convertibility) to asset characteristics is not rocket-science but corporations around the world seem to revel in mismatching debt and assets, using short term debt to fund long term assets (or vice versa) and sometimes debt in one currency to fund projects that generate cashflows in another. In numerous studies, done over the decades, looking across countries, Turkish companies rank among the very worst, when it comes to mismatching currencies on debt, using foreign currency debt (Euros and dollars primarily) to fund domestic investments. 

Lest I be accused of using foreign data services that are biased against Turkey, I decided to stick with the data provided by the Turkish Central Bank on the currency breakdown of borrowings by Turkish firms. In the chart below, I trace the foreign exchange (FX) assets and liabilities, for non-financial Turkish companies, from 2008 and 2018:
Central Bank of Turkey
The numbers are staggeringly out of sync with  Turkish non-financial service companies owing $217 billion more in foreign currency terms than they own on foreign currency assets, and this imbalance (between foreign exchange assets and liabilities) has widened over time, tripling since 2008.

I am sure that there will be some in the Turkish business establishment who will blame the mismatching on external forces, with banks in other European countries playing the role of villains, but the numbers tell a different story. Much of the FX debt has come from Turkish banks, not German or French banks, as can be seen in the chart below:
Central Bank of Turkey
In 2018, 59% of all FX liabilities at Turkish non-financial service firms came from Turkish banks and financial service firms, up from 39% in 2008. The mismatch is not just on currencies, though. Looking at the breakdown, by maturity, of FX assets and liabilities for Turkish non-financial service firms, here is what we see:
Central Bank of Turkey
In May 2018, while about 80% of FX assets are Turkish non-financial firms are short term, only 27% of the FX debt is short term, a large temporal imbalance.

It is possible that the Turkish government may be able to put pressure on domestic banks to prevent them from forcing debt payments, in the face of the collapse of the lira, but looking at when the debt owed foreign borrowers comes due (for both Turkish financial and non-financial firms), here is what we see.
Central Bank of Turkey
From a default risk perspective, though, the debt maturity schedule carries a message. About 50% of debt owed by Turkish banks and 40% of the debt owed by Turkish non-financial service companies will be coming due by 2020, and if the precipitous drop in the Lira is not reversed, there is a whole lot of pain in store for these firms.

Rationalizing the Mismatch: The Good, The Dangerous and the Deadly
Turkish firms clearly have a debt mismatch problem, and the institutions (government, bank regulators, banks) that should have been keeping the problem in check seem to have played an active role in making it worse. Worse, this is not the first time that Turkish firms and banks will be working through a debt mismatch crisis. It has happened before, in 1994, 2001 and 2008, just looking at recent decades. If insanity is doing the same thing over and over, expecting a different outcome, there is a good case to be made that Turkish institutions, from top to bottom, are insane, at least when it comes to dealing with currency in financing. So, why do Turkish companies seem willing to repeat this mistake over and over again? In fact, since this mismatching seems to occur in many emerging markets, though to a lesser scale, why do companies go for currency mismatches? Having heard the rationalizations from dozens of CFOs on every continent, I would classify the reasons on a spectrum from acceptable to absurd.

Acceptable Reasons
There are three scenarios where a company may choose to mismatch debt, borrowing in a currency other than the one in which it gets its cash flows.
  1. The mismatched debt is subsidized: If the mismatched debt is being offered to you (the borrower) at rates that are well below what you should be paying, given your default risk, you should accept that mismatched debt. That is sometimes the case when companies get funding from organizations like the IFC that offer the subsidies in the interests of meeting other objectives (such as increasing investment in under developed countries). It can also happen when lenders and bondholders become overly optimistic about an emerging market's prospects, and lend money on the assumption that high growth will continue without hiccups.
  2. Domestic debt markets are moribund: There are emerging markets where the only option for borrowing money is local banks, and during periods of uncertainty or crisis, these banks can pull back from lending. If you are a company in one of these markets and have the option of borrowing elsewhere in the world to fund what you believe are good investments, you may push forward with your borrowing, even though it is currency mismatched.
  3. Domestic debt markets are too rigid: As you can see from the debt design section, the perfect debt for your firm will often require tweaks that include not only conversion and floating rate options, but more unusual tweaks (such as commodity-linked interest rates). If domestic debt markets are unwilling or unable to offer these customized debt offerings, a company that can access bond markets overseas may do so, even if it means borrowing in a mismatched currency.
In all three cases, though, once the money has been borrowed, the company that has mismatched its debt should turn to the derivatives and swap markets to reduce or eliminate this mismatch.

Dangerous Reasons
There are two reasons that are offered by some companies that mismatch debt that may make sense, on the surface, but are inherently dangerous:

  1. Speculate on currency: Mismatching currencies, when you borrow money, can be a profitable exercise, if the currency moves in the right direction. A Turkish company that borrows in US dollars, a lower-inflation currency with lower interest rates, to fund projects that deliver cashflows in Turkish Lira, a higher-inflation currency, will book profits if the Lira strengthens against the US dollar. Since emerging market currencies can go through extended periods of deviation from purchasing power parity, i.e., the higher inflation emerging market currency strengthens (rather than weakening) against the lower inflation developed market currency, mismatching currencies can be profitable for extended periods. There will be a moment of reckoning, in the longer term, though, when exchange rates will correct, and unless the company can see this moment coming and correct its mismatch, it will not only lose all of the easy profits from prior periods, but find its survival threatened. Currency forecasting is a pointless exercise, even when practiced by professional currency traders, and I think that companies should steer away from the practice.
  2. Everyone does it: I have argued that many corporate finance practices are driven by inertia and me-tooism rather than good sense, and in many countries where currency mismatches are common, the standard defense is that everyone does it. Many of these companies argue that the government cannot let the entire corporate sector slide into default and will step in to bail them out, and true to form, governments deliver those bailouts. In effect, the taxpayers become the backstop for bad corporate behavior.
Bad Reasons
I am surprised by some of the arguments that I have heard for mismatching debt, since they suggest fundamental gaps in basic financial and economic knowledge.

  1. The mismatched debt has a lower interest rate:  I have heard CFOs of companies in emerging markets, where domestic debt carries high interest rates, argue that it is cheaper to borrow in US dollars or Euros, because interest rates are lower on loans denominated in those currencies. After all, it is cheaper to borrow at 5% than at 15%, right? Not necessarily, if the 5% rate is on a US dollar debt and the 15% debt is in Turkish Lira, and here is why. If the expected inflation rate in US dollars is 2% and in Turkish Lira is 14%, it is the Turkish Lira debt that is cheaper.
  2. Risk/Reward: There are some companies that fall back on the proposition that mismatching debt is like any other financial choice, a trade off between higher risk and higher reward. In other words, their belief is that they will earn higher profits, on average and over time, with mismatched debt than with matched debt, but with more variability in those profits. This argument stems from the misplaced belief that markets reward all risk taking, when the truth is that senseless risk taking just delivers more risk, with no reward, and mismatching debt is senseless.
The Fix
It is too late for Turkish companies to fix their debt problem for this crisis, but given that this crisis too shall pass, albeit after substantial damage has been done, there are actions that we can take to keep it from repeating, though it will require everyone involved to change their ways:
  • Governments should stop enabling debt mismatching, by not stepping in repeatedly to save corporates that have mismatched debt. That will increase the short term pain of the next crisis, but reduce the likelihood of repeating that crisis. 
  • Bank Regulators should measure how much the banks that they regulate have lent out to corporates, in mismatched debt, and require them to set aside more capital to cover the inevitable losses. That, in turn, will reduce the profitability of lending out money to companies that mismatch.
  • Banks have to incorporate whether the debt being taken by a business is mismatched in deciding how much to lend and on what terms. The interest rates on mismatched debt should be higher than on matched debt.
  • Companies and businesses have to consider what currency a loan or bond is in, when evaluating interest rates, and in their own best interests, try to match up debt to assets, either directly (in debt design) or using derivatives.
  • Investors in companies should start breaking down the profitability of firms with mismatched debt, especially in good periods, into profits from debt mismatch and profits from operations, and ignore or at least discount the former, when pricing these companies.
I don't think any of these changes will happen overnight but unless we change our behavior, we are designed to replay this crisis in other emerging markets repeatedly. 

YouTube Video


Data

  1. FX Assets & Liabilities of Turkish non-financial corporations (from Turkish Central Bank)
  2. Loans from Abroad to Turkish Private Sector

Papers

  1. Financing Innovations and Capital Structure Choices