Friday, February 16, 2024

Catastrophic Risk: Investing and Business Implications

    In the context of valuing companies, and sharing those valuations, I do get suggestions from readers on companies that I should value next. While I don't have the time or the bandwidth to value all of the suggested companies, a reader from Iceland, a couple of weeks ago, made a suggestion on a company to value that I found intriguing. He suggested Blue Lagoon, a well-regarded Icelandic Spa with a history of profitability, that was finding its existence under threat, as a result of volcanic activity in Southwest Iceland. In another story that made the rounds in recent weeks, 23andMe, a genetics testing company that offers its customers genetic and health information, based upon saliva sample, found itself facing the brink, after a hacker claimed to have hacked the site and accessed the genetic information of millions of its customers. Stepping back a bit, one claim that climate change advocates have made not just about fossil fuel companies, but about all businesses, is that investors are underestimating the effects that climate change will have on economic systems and on value. These are three very different stories, but what they share in common is a fear, imminent or expected, of a catastrophic event that may put a company's business at risk. 

Deconstructing Risk

   While we may use statistical measures like volatility or correlation to measure risk in practice, risk is not a statistical abstraction. Its impact is not just financial, but emotional and physical, and it predates markets. The risks that our ancestors faced, in the early stages of humanity, were physical, coming from natural disasters and predators, and physical risks remained the dominant form of risk that humans were exposed to, almost until the Middle Ages. In fact, the separation of risk into physical and financial risk took form just a few hundred years ago, when trade between Europe and Asia required ships to survive storms, disease and pirates to make it to their destinations; shipowners, ensconced in London and Lisbon, bore the financial risk, but the sailors bore the physical risk. It is no coincidence that the insurance business, as we know it, traces its history back to those days as well.

    I have no particular insights to offer on physical risk, other than to note that while taking on physical risks for some has become a leisure activity, I have no desire to climb Mount Everest or jump out of an aircraft. Much of the risk that I think about is related to risks that businesses face, how that risk affects their decision-making and how much it affects their value. If you start enumerating every risk a business is exposed to, you will find yourself being overwhelmed by that list, and it is for that reason that I categorize risk into the groupings that I described in an earlier post on risk. I want to focus in this post on the third distinction I drew on risk, where I grouped risk into discrete risk and continuous risk, with the later affecting businesses all the time and the former showing up infrequently, but often having much larger impact. Another, albeit closely related, distinction is between incremental risk, i.e., risk that can change earnings, growth, and thus value, by material amounts, and catastrophic risk, which is risk that can put a company's survival at risk, or alter its trajectory dramatically.

    There are a multitude of factors that can give rise to catastrophic risk, and it is worth highlighting them, and examining the variations that you will observe across different catastrophic risk. Put simply, a  volcanic eruption, a global pandemic, a hack of a company's database and the death of a key CEO are all catastrophic events, but they differ on three dimensions:

  1. Source: I started this post with a mention of a volcano eruption in Iceland put an Icelandic business at risk, and natural disasters can still be a major factor determining the success or failure of businesses. It is true that there are insurance products available to protect against some of these risks, at least in some parts of the world, and that may allow companies in Florida (California) to live through the risks from hurricanes (earthquakes), albeit at a cost.  Human beings add to nature's catastrophes with wars and terrorism wreaking havoc not just on human lives, but also on businesses that are in their crosshairs. As I noted in my post on country risk, it is difficult, and sometimes impossible, to build and preserve a business, when you operate in a part of the world where violence surrounds you. In some cases, a change in regulatory or tax law can put the business model for a company or many company at risk. I confess that the line between whether nature or man is to blame for some catastrophes is a gray one and to illustrate, consider the COVID crisis in 2020. Even if you believe you know the origins of COVID (a lab leak or a natural zoonotic spillover), it is undeniable that the choices made by governments and people exacerbated its consequences. 
  2. Locus of Damage: Some catastrophes created limited damage, perhaps isolated to a single business, but others can create damage that extends across a sector geographies or the entire economy. The reason that the volcano eruptions in Iceland are not creating market tremors is because the damage is likely to be isolated to the businesses, like Blue Lagoon, in the path of the lava, and more generally to Iceland, an astonishingly beautiful country, but one with a small economic footprint. An earthquake in California will affect a far bigger swath of companies, partly because the state is home to the fifth largest economy in the world, and the pandemic in 2020 caused an economic shutdown that had consequences across all business, and was catastrophic for the hospitality and travel businesses.
  3. Likelihood: There is a third dimension on which catastrophic risks can vary, and that is in terms of likelihood of occurrence. Most catastrophic risks are low-probability events, but those low probabilities can become high likelihood events, with the passage of time. Going back to the stories that I started this post with, Iceland has always had volcanos, as have other parts of the world, and until recently, the likelihood that those volcanos would become active was low. In a similar vein, pandemics have always been with us, with a history of wreaking havoc, but in the last few decades, with the advance of medical science, we assumed that they would stay contained. In both cases, the probabilities shifted dramatically, and with it, the expected consequences.

Business owners can try to insulate themselves from catastrophic risk, but as we will see in the next sections those protections may not exist, and even if they do, they may not be complete. In fact, as the probabilities of catastrophic risk increase, it will become more and more difficult to protect yourself against the risk.

Dealing with catastrophic risk

    It is undeniable that catastrophic risk affects the values of businesses, and their market pricing, and it is worth examining how it plays out in each domain. I will start this section with what, at least for me, I is familiar ground, and look at how to incorporate the presence of catastrophic risk, when valuing businesses and markets. I will close the section by looking at the equally interesting question of how markets price catastrophic risk, and why pricing and value can diverge (again).

Catastrophic Risk and Intrinsic Value

    Much as we like to dress up intrinsic value with models and inputs, the truth is that intrinsic valuation at its core is built around a simple proposition: the value of an asset or business is the present value of the expected cash flows on it:

That equation gives rise to what I term the "It Proposition", which is that for "it" to have value, "it" has to affect either the expected cashflows or the risk of an asset or business. This simplistic proposition has served me well when looking at everything from the value of intangibles, as you can see in this post that I had on Birkenstock, to the emptiness at the heart of the claim that ESG is good for value, in this post. Using that framework to analyze catastrophic risk, in all of its forms, its effects can show in almost every input into intrinsic value:

Looking at this picture, your first reaction might be confusion, since the practical question you will face when you value Blue Lagoon, in the face of a volcanic eruption, and 23andMe, after a data hack, is which of the different paths to incorporating catastrophic risks into value you should adopt. To address this, I created a flowchart that looks at catastrophic risk on two dimensions, with the first built around whether you can buy insurance or protection that insulates the company against its impact and the other around whether it is risk that is specific to a business or one that can spill over and affect many businesses.

As you can see from this flowchart, your adjustments to intrinsic value, to reflect catastrophic risk will vary, depending upon the risk in question, whether it is insurable and whether it will affect one/few companies or many/all companies. 

A.  Insurable Risk: Some catastrophic risks can be insured against, and even if firms choose not to avail themselves of that insurance, the presence of the insurance option can ease the intrinsic valuation process. 
  • Intrinsic Value Effect: If the catastrophic risk is fully insurable, as is sometimes the case, your intrinsic valuation became simpler, since all you have to do is bring in the insurance cost into your expenses, lowering income and cash flows, leave discount rates untouched, and let the valuation play out. Note that you can do this, even if the company does not actually buy the insurance, but you will need to find out the cost of that foregone insurance and incorporate it yourself. 
  • Pluses: Simplicity and specificity, because all this approach needs is a line item in the income statement (which will either exist already, if the company is buying insurance, or can be estimated). 
  • Minuses: You may not be able to insure against some risks, either because they are uncommon (and actuaries are unable to estimate probabilities well enough, to set premiums) or imminent (the likelihood of the event happening is so high, that the premiums become unaffordable). Thus, Blue Lagoon (the Icelandic spa that is threatened by a volcanic eruption) might have been able to buy insurance against volcanic eruption a few years ago, but will not be able to do so now, because the risk is imminent. Even when risks are insurable, there is a second potential problem. The insurance may pay off, in the event of the catastrophic event, but it may not offer complete protection. Thus, using Blue Lagoon again as an example, and assuming that the company had the foresight to buy insurance against volcanic eruptions a few years ago, all the insurance may do is rebuild the spa, but it will not compensate the company for lost revenues, as customers are scared away by the fear of  volcanic eruptions. In short, while there are exceptions, much of insurance insures assets rather than cash flow streams.
  • Applications: When valuing businesses in developed markets, we tend to assume that these businesses have insured themselves against most catastrophic risks and ignore them in valuation consequently. Thus, you see many small Florida-based resorts valued, with no consideration given to hurricanes that they will be exposed to, because you assume that they are fully insured. In the spirit of the “trust, but verity” proposition, you should probably check if that is true, and then follow up by examining how complete the insurance coverage is.
2. Uninsurable Risk, Going-concern, Company-specific: When a catastrophic risk is uninsurable, the follow up questions may lead us to decide that while the risk will do substantial damage, the injured firms will continue in existence. In addition, if the risk affects only one or a few firms, rather than wide swathes of the market, there are intrinsic value implications.
  • Intrinsic Value Effect: If the catastrophic risk is not insurable, but the business will survive its occurrence even in a vastly diminished state, you should consider doing two going-concern valuations, one with the assumption that there is no catastrophe and one without, and then attaching a probability to the catastrophic event occurring. 
    Expected Value with Catastrophe = Value without Catastrophe (1 – Probability of Catastrophe) + Value with Catastrophe (Probability of Catastrophe)
    In these intrinsic valuations, much of the change created by the catastrophe will be in the cash flows, with little or no change to costs of capital, at least in companies where investors are well diversified.

  • Pluses: By separating the catastrophic risk scenario from the more benign outcomes, you make the problem more tractable, since trying to adjust expected cash flows and discount rates for widely divergent outcomes is difficult to do.
  • Minuses: Estimating the probability of the catastrophe may require specific skills that you do not have, but consulting those who do have those skills can help, drawing on meteorologists for hurricane prediction and on seismologists for earthquakes. In addition, working through the effect on value of the business, if the catastrophe occurs, will stretch your estimation skills, but what options do you have?
  • Applications: This approach comes into play for many different catastrophic risks that businesses face, including the loss of a key employee, in a personal-service business, and I used it in my post on valuing key persons in businesses. You can also use it to assess the effect on value of a loss of a big contract for a small company, where that contract accounts for a significant portion of total revenues. It can also be used to value a company whose business models is built upon the presence or absence of a regulation or law, in which case a change in that regulation or law can change value. 

3. Uninsurable Risk. Failure Risk, Company-specific: When a risk is uninsurable and its manifestation can cause a company to fail, it poses a challenge for intrinsic value, which is, at its core, designed to value going concerns. Attempts to increase the discount rate, to bring in catastrophic risk, or applying an arbitrary discount on value almost never work.
  • Intrinsic Value Effect: If the catastrophic risk is not insurable, and the business will not survive, if the risk unfolds, the approach parallels the previous one, with the difference being that that the failure value of the business, i.e, what you will generate in cash flows, if it fails, replaces the intrinsic valuation, with catastrophic risk built in:
    Expected Value with Catastrophe = Value without Catastrophe (1 – Probability of Catastrophe) + Failure Value (Probability of Catastrophe)
    The failure value will come from liquidation the assets, or what is left of them, after the catastrophe.
  • Pluses: As with the previous approach, separating the going concern from the failure values can help in the estimation process. Trying to estimate cash flows, growth rates and cost of capital for a company across both scenarios (going concern and failure) is difficult to do, and it is easy to double count risk or miscount it. It is fanciful to assume that you can leave the expected cash flows as is, and then adjust the cost of capital upwards to reflect the default risk, because discount rates are blunt instruments, designed more to capture going-concern risk than failure risk. 
  • Minuses: As in the last approach, you still have to estimate a probability that a catastrophe will occur, and in addition, and there can be challenges in estimating the value of a business, if the company fails in the face of catastrophic risk.
  • Applications: This is the approach that I use to value highly levered., cyclical or commodity companies, that can deliver solid operating and equity values in periods where they operate as going concerns, but face distress or bankruptcy, in the face of a severe recession. And for a business like the Blue Lagoon, it may be the only pathway left to estimate the value, with the volcano active, and erupting, and it may very well be true that the failure value can be zero.
4 & 5 Uninsurable Risk. Going Concern or Failure, Market or Sector wide: If a risk can affect many or most firms, it does have a secondary impact on the returns investors expect to make, pushing up costs of capital.
  • Intrinsic Value Effect: The calculations for cashflows are identical to those done when the risks are company-specific, with cash flows estimated with and without the catastrophic risk, but since these risks are sector-wide or market-wide, there will also be an effect on discount rates. Investors will either see more relative risk (or beta) in these companies, if the risks affect an entire sector, or in equity risk premiums, if they are market-wide. Note that these higher discount rates apply in both scenarios.
  • Pluses: The risk that is being built into costs of equity is the risk that cannot be diversified away and there are pathways to estimating changes in relative risk or equity risk premiums. 
  • Minuses: The conventional approaches to estimating betas, where you run a regression of past stock returns against the market, and equity risk premiums, where you trust in historical risk premiums and history, will not work at delivering the adjustments that you need to make.
  • Applications: My argument for using implied equity risk premiums is that they are dynamic and forward-looking. Thus, during COVID, when the entire market was exposed to the economic effects of the pandemic, the implied ERP for the market jumped in the first six weeks of the pandemic, when the concerns about the after effects were greatest, and then subsided in the months after, as the fear waned:

    In a different vein, one reason that I compute betas by industry grouping, and update them every year, is in the hope that risks that cut across a sector show up as changes in the industry averages. In 2009, for instance, when banks were faced with significant regulatory changes brought about in response to the 2008 crisis, the average beta for banks jumped from 0.71 at the end of 2007 to 0.85 two years later.
Catastrophic Risk and Pricing
    The intrinsic value approach assumes that we, as business owners and investors, look at catastrophic risk rationally, and make our assessments based upon how it will play out in cashflows, growth and risk. In truth, is worth remembering key insights from psychology, on how we, as human beings, deal with threats (financial and physical) that we view as existential.
  • The first response is denial, an unwillingness to think about catastrophic risks. As someone who lives in a home close to one of California's big earthquake faults, and two blocks from the Pacific Ocean, I can attest to this response, and offer the defense that in its absence, I would wither away from anxiety and fear. 
  • The second is panic, when the catastrophic risk becomes imminent, where the response is to flee, leaving much of what you have behind. 
When looking at how the market prices in the expectation of a catstrophe occurring and its consequences, both these human emotions play out, as the overpricing of businesses that face catastrophic risk, when it is low probability and distant, and the underpricing of these same businesses when catastrophic risk looms large. 

    To see this process at work, consider again how the market initially reacted to the COVID crisis in terms of repricing companies that were at the heart of the crisis. Between February 14, 2020 and March 23, 2020, when fear peaked, the sectors most exposed to the pandemic (hospitality, airlines) saw a decimation in their market prices, during that period:

With catastrophic risk that are company-specific, you see the same phenomenon play out. The market capitalization of many young pharmaceutical company have been wiped out by the failure of blockbuster drug, in trials. PG&E, the utility company that provides power to large portions of California saw its stock price halved after wildfires swept through California, and investors worried about the culpability of the company in starting them. 
    The most fascinating twist on how markets deal with risks that are existential is their pricing of fossil fuel companies over the last two decades, as concerns about climate change have taken center stage, with fossil fuels becoming the arch villain. The expectation that many impact investors had, at least early in this game, was that relentless pressure from regulators and backlash from consumers and investors would reduce the demand for oil, reducing the profitability and expected lives of fossil fuel companies.  To examine whether markets reflect this view, I looked at the pricing of fossil fuel stocks in the aggregate, starting in 2000 and going through 2023:

In the graph to the left, I chart out the total market value for all fossil fuel companies, and note a not unsurprising link to oil prices. In fact, the one surprise is that fossil fuel stocks did not see surges in market capitalization between 2011 and 2014, even as oil prices surged.  While fossil fuel pricing multiples have gone up and down, I have computed the average on both in the 2000-2010 period and again in the 2011-2023 period. If the latter period is the one of enlightenment, at least on climate change, with warnings of climate change accompanied by trillions of dollars invested in combating it, it is striking how little impact it has had on how markets, and investors in the aggregate, view fossil fuel companies. In fact, there is evidence that the business pressure on fossil fuel companies has become less over time, with fossil fuel stocks rebounding in the last three years, and fossil fuel companies increasing investments and acquisitions in the fossil fuel space. 
    Impact investors would point to this as evidence of the market being in denial, and they may be right, but market participants may point back at impact investing, and argue that the markets may be reflecting an unpleasant reality which is that despite all of the talk of climate change being an existential problem, we are just as dependent on fossil fuels today, as we were a decade or two decades ago:

Don’t get me wrong! It is possible, perhaps even likely, that investors are not pricing in climate change not just in fossil fuel stocks, and that there is pain awaiting them down the road. It is also possible that at least in this case, that the market's assessment that doomsday is not imminent and that humanity will survive climate change, as it has other existential crises in the past. 
Mr. Market versus Mad Max Thunderdome
    The question posed about fossil fuel investors and whether they are pricing in the risks of gclimated change can be generalized to a whole host of other questions about investor behavior. Should buyers be paying hundreds of millions of dollars for a Manhattan office building, when all of New York may be underwater in a few decades? Lest I be accused of pointing fingers, what will happen to the value of my house that is currently two blocks from the beach, given the prediction of rising oceans. The painful truth is that if doomsday events (nuclear war, mega asteroid hitting the earth, the earth getting too hot for human existence) manifest, it is survival that becomes front and center, not how much money you have in your portfolio. Thus, ignoring Armageddon scenarios when valuing businesses and assets may be completely rational, and taking investors to task for not pricing assets correctly will do little to alter their trajectory! There is a lesson here for policy makers and advocates, which is that preaching that the planet is headed for the apocalypse, even if you believe it is true, will induce behavior that will make it more likely to happen, not less.
    On a different note, you probably know that I am deeply skeptical about sustainability, at least as preached from the Harvard Business School pulpit. It remains ill-defined, morphing into whatever its proponents want it to mean. The catastrophic risk discussion presents perhaps a version of sustainability that is defensible. To the extent that all businesses are exposed to catastrophic risks, some company-level and some having broader effects, there are actions that businesses can take to, if not protect to themselves, at least cushion the impact of these risks. A personal-service business, headed by an aging key person, will be well served designing a succession plan for someone to step in when the key person leaves (by his or her choice or an act of God). No global company was ready for COVID in 2020, but some were able to adapt much faster than others because they were built to be adaptable. Embedded in this discussion are also the limits to sustainability, since the notion of sustaining  a business at any cost is absurd. Building in adaptability and safeguards against catastrophic risk makes sense only if the costs of doing so are less than the potential benefits, a simple but powerful lesson that many sustainability advocates seem to ignore, when they make grandiose prescriptions for what businesses should and should not do to avoid the apocalypse.


Thursday, February 8, 2024

The Seven Samurai: How Big Tech Rescued the Market in 2023!

I was planning to finish my last two data updates for 2024, but decided to take a break and look at the seven stocks (Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia and Tesla) which carried the market in 2023. While I will use the "Magnificent Seven" moniker attached by these companies by investors and the media, my preference would have been to call them the Seven Samurai. After all, like their namesakes in that legendary Kurosawa movie, who saved a village and its inhabitants from destruction, these seven stocks saved investors from having back-to-back disastrous years in the stock market.

The What?

    It is worth remembering that the Magnificent Seven (Mag Seven) had their beginnings in the FANG (Facebook, Amazon, Netflix and Google) stocks, in the middle of the last decade, which morphed into the FANGAM (with the addition of Apple and Microsoft to the group) and then to the Mag Seven, with the removal of Netflix from the mix, and the addition of Tesla and Nvidia to the group. There is clearly hindsight bias in play here, since bringing in the best performing stocks of a period into a group can always create groups that have supernormal historical returns. That bias notwithstanding, these seven companies have been extraordinary investments, not just in 2023, but over the last decade, and there are lessons that we can learn from looking at the past.

    First, let's look at the performance of these seven stocks in 2023, when their collective market capitalization increased by a staggering $5.1 trillion during the course of the year. In a group of standout stocks, Nvidia and Meta were the best performers, with the former more than and the later almost tripling in value over the period. In terms of dollar value added, Microsoft and Apple each added a trillion dollars to their market capitalizations, during the year.

To understand how much these stocks meant for overall market performance, recognize that these seven companies accounted for more than 50% of the increase in market capitalization of the the entire US equity market (which included 6658 listed companies in 2023). With them, US equities had price appreciation of 23.25% for the year, but without them, the year would have been an average one, with returns on 12.6%.

    While these seven stocks had an exceptional year in 2023, their outperformance stretches back for a much longer period. In the graph below, I look at the cumulated market capitalization of the Mag Seven stocks, and the market capitalization of all of the remaining US stocks from 2012 to 2023:

Over the eleven-year period, the cumulative market capitalization of the seven companies has risen from $1.1 trillion in 2012 to $12 trillion in 2023, rising from 7.97% of overall US market cap in 2012 to 24.51% of overall market cap at the end of 2023.  To put these numbers in perspective, the Mag Seven companies now have a market capitalization larger than that of all listed stocks in China, the second largest market in the world in market capitalization terms.

    Another way to see how much owning or not owning these stocks meant for investors, I estimated the cumulated value of $100 invested in December 2012 in a market-cap weighted index of US stocks at the end of 2023, first in US equities , and then in US equities, without the Mag Seven stocks:

It is striking that removing seven stocks from a portfolio of 6658 US stocks, investing between 2012 and 2023, creates a 17.97% shortfall in the end value. In effect, this would suggest that any portfolio that did not include any of these seven stocks during the last decade would have faced a very steep, perhaps even insurmountable, climb to beat the market. That may go a long way in explaining why both value and small cap premium have essentially disappeared over this period.
    In all of the breathless coverage of the Mag Seven (and FANG and FANGAM) before it, there seems to be the implicit belief that their market dominance is unprecedented, but it is  not. In fact, equity markets have almost always owed their success to their biggest winners, and Henrik Bessimbinder highlighted this reality by documenting that of the $47 trillion in increase in market capitalization between 1926 and 2019, five companies accounted for 22% of the increase in market value.  I will wager that at the end of the next decade, looking back, we will find that a few companies accounted for the bulk of the rise in market capitalization during the decade, and another acronym will be created. 

The Why?

    When stocks soar as much as the Mag Seven stocks have in recent years, they evoke two responses. One is obviously regret on the part of those who did not partake in the rise, or sold too soon. The other is skepticism, and a sense that a correction is overdue, leading to what I call knee-jerk contrarianism, where your argument that these stocks are over priced is that they have gone up too much in the past. With these stocks, in particular, that reaction would have been costly over much of the last decade, since  other than in 2022, these stocks have found ways to deliver positive surprises. In this section, we will look at the plausible explanations for the Mag Seven outperformance in 2023, starting with a correction/momentum story, where 2023 just represented a reversal of the losses in 2022, moving on to a profitability narrative, where the market performance of these companies can be related to superior profitability and operating performance, and concluding with an examination of whether the top-heavy performance (where a few large companies account for the bulk of market performance can explained by winner-take-all economics,

1. Correction/Momentum Story: One explanation for the Mag Seven's market performance in 2023 is that they were coming off a catastrophic year in 2022, where they collectively lost $4.8 trillion in market cap, and that 2023 represented a correction back to a level only slightly above the value at the end of 2021. There is some truth to this statement, but to see whether it alone can explain the Mag Seven 2023 performance, I broke all US stocks into deciles, based upon 2022 stock price performance, with the bottom decile including the stocks that went down the most in 2022 and the top decile the stocks that went up the most in 2022, and looked at returns in 2023:

As you can see in the first comparison, the worst performing stocks in 2022 saw their market capitalizations increase by 35% in 2023, while the best performing stocks saw little change in market capitalization. Since all of the MAG 7 stocks fell into the bottom decile, I compared the performance of those stocks against the rest of the stocks in that decile, and th difference is start. While Mag Seven stocks saw their market capitalizations increase by 74%, the rest of the stocks in the bottom decile had only a 19% increase in market cap. In short, a portion of the Mag Seven stock performance in 2023  can be explained by a correction story, aided and abetted by strong momentum, but it is not the whole story.

2. Operating Performance/Profitability Narrative: While it is easy to attribute rising stock prices entirely to mood and momentum, the truth is that momentum has its roots in truth. Put differently, there are some good business reasons why the Mag Seven dominated markets in 2023:
  • Pricing power and Economic Resilience: Coming into 2023, market and the Mag Seven stocks were battered, down sharply in 2022, largely because of rising inflation and concerns about an economic downturn. There were real concerns about whether the big tech companies that had dominated markets for  the prior decade had pricing power and how well they would weather a recession. During the course of 2023, the Mag Seven set those fears to rest at least for the moment on both dimensions, increasing prices (with the exception of Tesla) on their products/services and delivering growth. In fact, if you are a Netflix subscriber or Amazon Prime member (and I would be surprised if any reader has neither, indicating their ubiquity), you saw prices increase on both services, and my guess is that you did not cancel your subscription/membership. With Alphabet and Meta, which make their money on online advertising, the rates for that advertising, measures in costs per click, rose through much of the year, and as an active Apple customer, I can guarantee that Apple has been passing through inflation into their prices all year.
  • Money Machines: The pricing power and product demand resilience exhibited by these companies have manifested as strong earnings for the companies. In fact, both Alphabet and Meta have laid off thousands of employees, without denting revenues, and their profits in 2023 reflect the cost savings: 

  • Safety Buffers: As interest rates, for both governments and corporates, has risen sharply over the last two years, it is prudent for investors to worry about companies with large debt burdens, since old debt on the books, at low rates, will have to get refinanced at higher rates. With the Mag Seven, those concerns are on the back burner, because these companies have debt loads so low that they are almost non-existent. In fact, six of the seven firms in the Mag Seven grouping have cash balances that exceed their debt loads, giving them negative net debt levels.

Put simply, there are good business reasons for why the seven companies in the Mag Seven have been elevated to superstar status. 

3. Winner take all economics: It is undeniable that as the global economy has shifted away from its manufacturing base in the last century to a technology base, it has unleashed more "winner-take-all (or most" dynamics in many industries. In advertising, which was a splintered business where even the biggest players (newspapers, broadcasting companies) commanded small market shares of the overall market, Alphabet and Meta have acquired dominant market shares of online advertising, driven by easy scaling and network benefits (where advertising flows to the platforms with the most customers). Over the last two decades, Amazon has set in motion similar dynamics in retail and Microsoft's stranglehold on application and business software has been in existence even longer. In fact, it is the two newcomers into this group, Nvidia and Tesla, where questions remain about what the end game will look like, in terms of market share. Historically, neither the chip nor car businesses have been winner-take-all businesses, but investors are clearly pricing in the possibility that the changing economics of AI chips and electric cars could alter these businesses. 

This may seem like a cop out, but I think all three factors contributed to the success of the Mag Seven stocks in 2023. There was clearly a bounce back effect, as these firms recovered from a savage beatdown in 2022, but that bounce back occurred only because they were able to deliver strong profits and solid cash flows. And looking across the decade, I don't think it is debatable that investors have not only bought into the dominant player story (coming from the winner-take-all economics), but have also anointed these seven companies as leaders in the race to dominance in each of their businesses.

The What Next?

   At the risk of stating the obvious, investing is always about the future, and a company's past market history, no matter how glorious, has little or no effect on whether it is a good investment today. I have long argued that investors need to separate what they think about the quality of a company (great, good or awful) from its quality as an investment (cheap or expensive). In fact, investing is about finding mismatches between what you think of a company and what investors have already priced in:

I think that most of you will agree that the seven companies in the Mag Seven all qualify as very good to awesome, as businesses, and the last section provides backing, but the question that remains is whether our perceptions are shared by other investors, and already priced in.

    The tool that most investors use in making this assessment is pricing, and specifically, pricing multiples. In the table below, I compute pricing metrics for the Mag Seven, and compare them to that of the S&P 500:

Trailing 12-month operating metrics used
On every pricing metric, the Mag Seven stocks trade at a premium over the rest of the stocks in the S&P 500, and therein lies the weakest link in pricing. That premium can be justified by pointing to higher growth and margins at the Mag Seven stocks, but that is followed by a great deal of hand waving, since how much of a premium is up for grabs. Concocting growth-adjusted pricing multiples like PEG ratios is one solution, but the PEG ratio is an absolutely abysmal measuring of pricing, making assumptions about PE and growth that are untenable. The pricing game becomes even more unstable, when analysts replace current with forward earnings, with bias entering at every step.

    I know that some of you don't buy into intrinsic valuation and note quite correctly that there are lots of assumptions that you have to make about growth, profitability and risk to arrive at a value and that no matter how hard you try, you will be wrong. I agree, but I remain a believer that intrinsic valuation is the only tool that I have for assessing whether the market is incorporating what I see in a company (awful to awesome). I have valued every company in the Mag Seven multiple times over the last decade, and based my judgments on investing in these companies on a comparison of my value estimates and price. With the operating numbers (revenues, earnings) coming in for the 2023 calendar year, I have updated my valuations, and here are my summary estimates:

Expected CAGR Revenue (next 5 years)8.00%12.00%7.50%15.00%12.00%32.20%31.10%
Target Operating Margin30.00%14.00%36.00%45.00%40.00%40.00%13.07%
Cost of Capital8.84%8.60%8.64%9.23%8.83%8.84%9.17%
Value per share$138.14$155.72$176.79$355.88$445.10$436.34$183.75
Price per share$145.00$169.15$188.00$405.49$456.08$680.00$185.07
% Under or Over Valued4.97%8.62%6.34%13.94%2.47%55.84%0.72%
Internal Rate of Return8.41%7.85%7.89%8.06%8.53%7.18%9.16%
Full Valuation (Excel)LinkLinkLinkLinkLinkLinkLink

* NVidia and Tesla were valued as the sum of the valuations of their different businesses. The growth and margins reported are for the consolidated company.

First, while all of the companies in the Mag Seven have values that exceed their prices, Tesla and Meta look close to fairly valued, at current prices, Alphabet, Apple and Amazon are within striking distance of value, and Microsoft and Nvidia look over valued, with the latter especially so. It may be coincidence, but these are the two companies that have benefited most directly from the AI buzz, and my findings of over valuation may just reflect my lack of imagination on how big AI can get as a business. Just to be clear, though, I have built in substantial value from AI in my valuation of Nvidia, and given Microsoft significantly higher growth because of it, but it is plausible that I have not done enough.  If intrinsic value is not your cup of tea, you can look at the internal rates of return that you would earn on these companies, at current market prices, and with my expected cash flows. For perspective, the median cost of capital for a US company at the start of 2024 was 8.60%, and while only Tesla delivers an expected return higher than that number, the test, with the exception of Nvidia, are close.

    I own all seven of these companies, which may strike you as contradictory, but with the exception of Tesla that I bought just last week, my acquisitions of the other seven companies occurred well in the past, and reflected my judgments that they were undervalued (at the time). To the question of whether I should be selling, which would be consistent with my current assessment that these stocks are overvalued, I hesitate for three reasons: The first is that my assessments of value come with error, and for at least five of the companies, the price is well within my range of value.  The second is that I will have to pay a capital gains tax that will amount to close to 30%, with state taxes included. The third is psychological, since selling everything or nothing would leave me with regrets either way. Last summer, when I valued Nvidia in this post, I found it over valued at a price of $450, and sold half my holdings, choosing to hold the other half. Now that the price has hit $680, I plan to repeat that process, and sell half of my remaining holdings.


    As I noted at the start of this post, the benefit of hindsight allows us to pick the biggest winners in the market, bundle them together in a group and then argue that the market would be lost without them. That is true, but it is neither original nor unique to this market. The Mag Seven stocks have had a great run, but their pricing now reflects, in my view, the fact that they are great companies, with business models that deliver growth, at scale, with profitability. If you have never owned any of these companies, your portfolio will reflect that choice, and jumping on to the bandwagon now will not bring back lost gains. You should bide your time, since in my experience, even the very best companies deliver disappointments, and that markets over react to these disappointments, simply because expectations have been set so high. It is at those times that you will find that the price is right!

YouTube Video

Intrinsic Valuations

  1. Alphabet in February 2024
  2. Amazon in February 2024
  3. Apple in February 2024
  4. Microsoft in February 2024
  5. Meta in February 2024
  6. NVidia in February 2024
  7. Tesla in February 2024

Wednesday, January 31, 2024

Data Update 5 for 2024: Profitability - The End Game for Business?

In my last three posts, I looked at the macro (equity risk premiums, default spreads, risk free rates) and micro (company risk measures) that feed into the expected returns we demand on investments, and argued that these expected returns become hurdle rates for businesses, in the form of costs of equity and capital. Since businesses invest that capital in their operations, generally, and in individual projects (or assets), specifically, the big question is whether they generate enough in profits to meet these hurdle rate requirements. In this post, I start by looking at the end game for businesses, and how that choice plays out in investment rules for these businesses, and then examine how much businesses generated in profits in 2023, scaled to both revenues and invested capital. 

The End Game in Business

    If you start a business, what is your end game? Your answer to that question will determine not just how you approach running the business, but also the details of how you pick investments, choose a financing mix and decide how much to return to shareholders, as dividend or buybacks. While private businesses are often described as profit maximizers, the truth is that if they should be value maximizers. In fact, that objective of value maximization drives every aspect of the business, as can be seen in this big picture perspective in corporate finance:

For some companies, especially mature ones, value and profit maximization may converge, but for most, they will not. Thus, a company with growth potential may be willing to generate less in profits now, or even make losses, to advance its growth prospects. In fact, the biggest critique of the companies that have emerged in this century, many in social media, tech and green energy, is that they have  prioritized scaling up and growth so much that they have failed to pay enough attention to their business models and profitability.

    For decades, the notion of maximizing value has been central to corporate finance, though there have been disagreements about whether maximizing stock prices would get you the same outcome, since that latter requires assumptions about market efficiency. In the last two decades, though, there are many who have argued that maximizing value and stockholder wealth is far too narrow an objective, for businesses, because it puts shareholders ahead of the other stakeholders in enterprises:

It is the belief that stockholder wealth maximization shortchanges other stakeholders that has given rise to stakeholder wealth maximization, a misguided concept where the end game for businesses is redefined to maximize the interests of all stakeholders. In addition to being impractical, it misses the fact that shareholders are given primacy in businesses because they are the only claim holders that have no contractual claims against the business, accepting  residual cash flows, If stakeholder wealth maximization is allowed to play out, it will result in confused corporatism, good for top managers who use stakeholder interests to become accountable to none of the stakeholders:

As you can see, I am not a fan of confused corporatism, arguing that giving a business multiple objectives will mangle decision making, leaving businesses looking like government companies and universities, wasteful entities unsure about their missions. In fact, it is that skepticism that has made me a critic of ESG and sustainability, offshoots of stakeholder wealth maximization, suffering from all of its faults, with greed and messy scoring making them worse. 

    It may seem odd to you that I am spending so much time defending the centrality of profitability  to a business, but it is a sign of how distorted this discussion has become that it is even necessary. In fact, you may find my full-throated defense of generating profits and creating value to be distasteful, but if you are an advocate for the point of view that businesses have broader social purposes, the reality is that for businesses to do good, they have  to be financial healthy and profitable. Consequently, you should be just as interested, as I am, in the profitability of companies around the world, albeit for different reasons. My interest is in judging them on their capacity to generate value, and yours would be to see if they are generating enough as surplus so that they can do good for the world. 

Profitability: Measures and Scalars

   Measuring profitability at a business is messier than you may think, since it is not just enough for a business to make money, but it has to make enough money to justify the capital invested in it. The first step is understanding profitability is recognizing that there are multiple measures of profit, and that each measure they captures a different aspect of a business:

It is worth emphasizing that these profit numbers reflect two influences, both of which can skew the numbers. The first is the explicit role of accountants in measuring profits implies that inconsistent accounting rules will lead to profits being systematically mis-measured, a point I have made in my posts on how R&D is routinely mis-categorized by accountants. The other is the implicit effect of tax laws, since taxes are based upon earnings, creating an incentive to understate earnings or even report losses, on the part of some businesses. That said, global (US) companies collectively generated $5.3 trillion ($1.8 trillion) in net income in 2023, and the pie charts below provide the sector breakdowns for global and US companies:

Notwithstanding their trials and tribulations since 2008, financial service firms (banks, insurance companies, investment banks and brokerage firms) account for the largest slice of the income pie, for both US and global companies, with energy and technology next on the list.

Profit Margins

    While aggregate income earned is an important number, it is an inadequate measure of profitability, especially when comparisons across firms, when it is not scaled to something that companies share. As as a first scalar, I look at profits, relative to revenues, which yields margins, with multiple measures, depending upon the profit measure used:

Looking across US and global companies, broken down by sector, I  look at profit margins in 2023:

Note that financial service companies are conspicuously absent from the margin list, for a simple reason. Most financial service firms have no revenues, though they have their analogs - loans for banks, insurance premiums for insurance companies etc. Among the sectors, energy stands out, generating the highest margins globally, and the second highest, after technology firms in the United States. Before the sector gets targeted as being excessively profitable, it is also one that is subject to volatility, caused by swings in oil prices; in 2020, the sector was the worst performing on profitability, as oil prices plummeted that year.
    Does profitability vary across the globe? To answer that question, I look at differences in margins across sub-regions of the world:

You may be surprised to see Eastern European and Russian companies with the highest margins in the world, but that can be explained by two phenomena. The first is the preponderance of natural resource companies in this region, and energy companies had a profitable year in 2023. The second is that the sanctions imposed after 2021 on doing business in Russia drove  foreign competitors out of the market, leaving the market almost entirely to domestic companies. At the other end of the spectrum, Chinese and Southeast Asian companies have the lowest net margins, highlighting the reality that big markets are not always profitable ones.
  Finally, there is a relationship between corporate age and profitability, with younger companies often struggling more to deliver profits, with business models still in flux and no economies of scale. In the fact, the pathway of a company through the life cycle can be seen through the lens of profit margins:

Early in the life cycle, the focus will be on gross margins, partly because there are losses on almost every other earnings measure. As companies enter growth, the focus will shift to operating margins, albeit before taxes, as companies still are sheltered from paying taxes by past losses. In maturity, with debt entering the financing mix, net margins become good measures of profitability, and in decline, as earnings decline and capital expenditures ease, EBITDA margins dominate. In the table below, I look at global companies, broken down into decals, based upon corporate age, and compute profit margins across the deciles:

The youngest companies hold their own on gross and EBITDA margins, but they drop off as you move to operating nnd net margins.
    In summary, profit margins are a useful measure of profitability, but they vary across sectors for many reasons, and you can have great companies with low margins and below-average companies that have higher margins. Costco has sub-par operating margins, barely hitting 5%, but makes up for it with high sales volume, whereas there are luxury retailers with two or three times higher margins that struggle to create value.

Return on Investment

    The second scalar for profits is the capital invested in the assets that generate these profits. Here again, there are two paths to measuring returns on investment, and the best way to differentiate them is to think of them in the context of a financial balance sheet:

The accounting return on equity is computed by dividing the net income, the equity investor's income measure, by the book value of equity and the return on invested capital is computed, relative to the book value of invested capital, the cumulative values of book values of equity and debt, with cash netted out. Looking at accounting returns, broken down by sector, for US and global companies, here is what 2023 delivered:

In both the US and globally, technology companies deliver the highest accounting returns, but these returns are skewed by the accounting inconsistencies in capitalizing R&D expenses. While I partially correct for this by capitalizing R&D expenses, it is only a partial correction, and the returns are still overstated. The worst accounting returns are delivered by real estate companies, though they too are skewed by tax considerations, with expensing  to reduce taxes paid, rather than getting earnings right.

Excess Returns

    In the final assessment, I bring together the costs of equity and capital estimated in the last post and the accounting returns in this one, to answer a critical question that every business faces, i.e,, whether the returns earned on its investment exceed its hurdle rate. As with the measurement of returns, excess returns require consistent comparisons, with accounting returns on equity compared to costs of equity, and returns on capital to costs of capital:

These excess returns are not perfect or precise, by any stretch of the imagination, with mistakes made in assessing risk parameters (betas and ratings) causing errors in the cost of capital and accounting choices and inconsistencies affecting accounting returns. That said, they remain noisy estimates of a company's competitive advantages and moats, with strong moats going with positive excess returns, no moats translating into excess returns close to zero and bad businesses generating negative excess returns.
    I start again by looking at the sector breakdown,  both US and global, of excess returns in 2023, in the table below:

In computing excess returns, I did add a qualifier, which is that I would do the comparison only among money making companies; after all, money losing companies will have accounting returns that are negative and less than hurdle rates. With each sector, to assess profitability, you have to look at the percentage of companies that make money and then at the percent of these money making firms that earn more than the hurdle rate. With financial service firms, where only the return on equity is meaningful, 57% (64%) of US (global) firms have positive net income, and of these firms, 82% (60%) generated returns on equity that exceeded their cost of equity. In contrast, with health care firms, only 13% (35%) of US (global) firms have positive net income, and about 68% (53%) of these firms earn returns on equity that exceed the cost of equity.  
    In a final cut, I looked at excess returns by region of the world, again looking at only money-making companies in each region:

To assess the profitability of companies in each region, I again look at t the percent of companies that are money-making, and then at the percent of these money-making companies that generate accounting returns that exceed the cost of capital. To provide an example, 82% of Japanese companies make money, the highest percentage of money-makers in the world, but only 40% of these money-making companies earn returns that exceed the hurdle rate, second only to China on that statistic. The US has the highest percentage (73%) of money-making companies that generate returns on equity that exceed their hurdle rates, but only 37% of US companies have positive net income. Australian and Canadian companies stand out again, in terms of percentages of companies that are money losers, and out of curiosity, I did take a closer look at the individual companies in these markets. It turns out that the money-losing is endemic among smaller publicly traded companies in these markets, with many operating in materials and mining, and the losses reflect both company health and life cycle, as well as the tax code (which allows generous depreciation of assets). In fact, the largest companies in Australia and Canada deliver enough profits to carry the aggregated accounting returns (estimated by dividing the total earnings across all companies by the total invested capital) to respectable levels.
    In the most sobering statistic, if you aggregate money-losers with the companies that earn less than their hurdle rates, as you should, there is not a single sector or region of the world, where a majority of firms earn more than their hurdle rates

In 2023, close to 80% of all firms globally earned returns on capital that lagged their costs of capital. Creating value is clearly far more difficult in practice than on paper or in case studies!

A Wrap!

I started this post by talking about the end game in business, arguing for profitability as a starting point and value as the end goal. The critics of that view, who want to expand the end game to include more stakeholders and a broader mission (ESG, Sustainability) seem to be operating on the presumption that shareholders are getting a much larger slice of the pie than they deserve. That may be true, if you look at the biggest winners in the economy and markets, but in the aggregate, the game of business has only become harder to play over time, as globalization has left companies scrabbling to earn their costs of capital. In fact, a decade of low interest rates and inflation have only made things worse, by making risk capital accessible to young companies, eager to disrupt the status quo.

YouTube Video


  1. Profit Margins, by Industry (US, Global)
  2. Accounting Returns and Excess Returns, by Industry (US, Global)

Sunday, January 28, 2024

Data Update 4 for 2024: Danger and Opportunity - Bringing Risk into the Equation!

In my last data updates for this year, I looked first at how equity markets rebounded in 2023, driven by a stronger-than-expected economy and inflation coming down, and then at how interest rates mirrored this rebound. In this post, I look at risk, a central theme in finance and investing, but one that is surprisingly misunderstood and misconstrued. In particular, there are wide variations in how risk is measured, and once measured, across companies and countries, and those variations can lead to differences in expected returns and hurdle rates, central to both corporate finance and investing judgments.

Risk Measures

    There is almost no conversation or discussion that you can have about business or investing, where risk is not a part of that discussion. That said, and notwithstanding decades of research and debate on the topic, there are still wide differences in how risk is defined and measured.

What is risk?

    I do believe that, in finance, we have significant advances in understanding what risk, I also think that as a discipline, finance has missed the mark on risk, in three ways. First, it has put too much emphasis on market-price driven measures of risk, where price volatility has become the default measure of risk, in spite of evidence indicating that a great deal of this volatility has nothing to do with fundamentals. Second, in our zeal to measure risk with numbers, we have lost sight of the reality that the effects of risk are as much on human psyche, as they are on economics. Third, by making investing a choice between good (higher returns) and bad (higher risk), a message is sent, perhaps unwittingly, that risk is something to be avoided or hedged.  It is perhaps to counter all of these that I start my session on risk with the Chinese symbol for crisis:

Chinese symbol for crisis = 危機 = Danger + Opportunity

I have been taken to task for using this symbol by native Chinese speakers pointing out mistakes in my symbols (and I have corrected them multiple times  in response), but thinking of risk as a combination of danger and opportunity is, in my view, a perfect pairing, and this perspective offers two benefits. First, by linking the two at the hip, it sends the clear and very important signal that you cannot have one (opportunity), without exposing yourself to the other (danger), and that understanding alone would immunize individuals from financial scams that offer the best of both worlds - high returns with no risk. Second, it removes the negativity associated to risk, and brings home the truth that you build a great business, not by avoiding danger (risk), but by seeking out the right risks (where you have an advantage), and getting more than your share of opportunities. 

Breaking down risk

    One reason that we have trouble wrapping our heads around risk is that it has so many sources, and our capacity to deal with varies, as a consequence. When assessing risk in a project or a company, I find it useful to make a list of every risk that I see in the investment, big and small, but I then classify these risks into buckets, based upon type, with very different ways of dealing with and incorporating that risk into investment analysis. The table below provides a breakdown of those buckets, with economic uncertainty contrasted with estimation uncertainty, micro risk separated from macro risks and discrete risks distinguished from continuous risks:

While risk breakdowns may seem like an abstraction, they do open the door to healthier practices in risk analysis, including the following:
  1. Know when to stop: In a world, where data is plentiful and analytical tools are accessible, it is easy to put off a decision or a final analysis, with the excuse that you need to  collect more information. That is understandable, but digger deeper into the data and doing more analysis will lead to better estimates, only if the risk that you are looking at is estimation risk. In my experience, much of the risk that we face when valuing companies or analyzing investments is economic uncertainty, impervious to more data and analysis. It is therefore healthy to know when to stop researching, accepting that your analysis is always a work-in-progress and that decisions have to be made in the face of uncertainty.
  2. Don't overthink the discount rate: One of my contentions of discount rates is that they cannot become receptacles for all your hopes and fears. Analysts often try to bring company-specific components, i.e, micro uncertainties, into discount rates, and in the process, they end up incorporating risk that investors can eliminate, often at no cost. Separating the risks that do affect discount rates from the risks that do not, make the discount rate estimation simpler and more precise.
  3. Use more probabilistic & statistical tools: The best tools for bringing in discrete risk are probabilistic, i.e., decision trees and scenario analysis, and using them in that context may open the door to other statistical tools, many of which are tailor-made for  the problems that we face routinely in finance, and are underutilized.

Measuring risk

  The financial thinking on risk, at least in its current form, had its origins in the 1950s, when Harry Markowitz uncovered the simple truth that the risk of an investment is not the risk of it standing alone, but the risk it adds to an investor's portfolio. He followed up by showing that holding diversified portfolios can deliver much higher returns, for given levels of risk, for all investors. That insight gave rise not only to modern portfolio theory, but it also laid the foundations for how we measure and deal with risk in finance. In fact, almost every risk and return model in finance is built on pairing two assumptions, the first being that the marginal investors in a company or business are diversified and the second being that investors convey their risk concerns through market prices:

By building on the assumptions that the investors pricing a business are diversified, and make prices capture that risk, modern portfolio theory has exposed itself to criticism from those who disagree with one or both of these assumptions. Thus, there are value investors, whose primary disagreement is on the use of pricing measures for risk, arguing that risk has to come from numbers that drive intrinsic value - earnings and cash flows. There are other investors who are at peace with price-based risk measures , but disagree with the "diversified marginal investor" assumption, and they are more intent on finding risk measures that incorporate total risk, not just risk that cannot be diversified away. I do believe that the critiques of both groups have legitimate basis, and while I don't feel as strongly as they do, I can offer modifications of risk measures to counter the critiques;

For investors who do not trust market prices, you can create risk analogs that look at accounting earnings or cash flows, and for those who believe that the diversified investor assumption is an overreach, you can adapt risk measures to capture all risk, not just market risk. In short, if you don't like betas and have disdain for modern portfolio theory, your choice should not be to abandon risk measurement all together, but to come up with an alternative risk measure that is more in sync with your view of the world. 

Risk Differences across Companies

    With that long lead-in on risk, we are positioned to take a look at how risk played out, at the company level, in 2024. Using the construct from the last section, I will start by looking at price-based risk measures and then move on to intrinsic risk measures in the second section.

a. Price-based Risk Measures

    My data universe includes all publicly traded companies, and since they are publicly traded, computing price-based risk measures is straight forward. That said, it should be noted that liquidity  varies widely across these companies, with some located in markets where trading is rare and others in markets, with huge trading volumes. With that caveat in mind, I computed three risk-based measures - a simplistic measure of range, where I look at the distance between the high and low prices, and scale it to the mid-point, the standard deviation in stock prices, a conventional measure of volatility and beta, a measure of that portion of a company's risk that is market-driven. 

I use the data through the end of 2023 to compute all three measures for every company, and in my first breakdown, I look at these risk measures, by sector (globally):

Utilities are the safest or close to the safest , on all three price-based measures, but there are divergences on the other risk measures. Technology companies have the highest betas, but health care has the riskiest companies, on standard deviation and the price range measure.  Looking across geographies, you can see the variations in price-based risk measures across the world:

There are two effects at play here. The first is liquidity, with markets with less trading and liquidity exhibiting low price-based risk scores across the board. The second is that some geographies have sector concentrations that affect their pricing risk scores; the preponderance of natural resource and mining companies in Australia and Canada, for instance, explain the high standard deviations in 2023.
    Finally, I brought in my corporate life cycle perspective to the risk question, and looked at price-based risk measures by corporate age, with the youngest companies in the first decile and the oldest ones in the top decile (with a separate grouping for companies that don't have a founding year in the database):
On both the price range and standard deviation measures, not surprisingly, younger firms are riskier than older ones, but on the beta measure, there is no relationship. That may sound like a contradiction, but it does reflect the divide between measures of total risk (like the price range and standard deviation) and measures of just market risk (like the beta). Much of the risk in young companies is company-specific, and for those investors who hold concentrated portfolios of these companies, that risk will translate into higher risk-adjusted required returns, but for investors who hold broader and more diversified portfolios, younger companies are similar to older companies, in terms of risk.

b. Intrinsic Risk Measures

    As you can see in the last section, price-based risk measures have their advantages, including being constantly updated, but they do have their limits, especially when liquidity is low or when market prices are not trustworthy. In this section, I will look at three measures of intrinsic risk - whether a company is making or losing money, with the latter being riskier, the variability in earnings, with less stable earnings translating to higher risk, and the debt load of companies, with more debt and debt charges conferring more risk on companies. 

    I begin by computing  these intrinsic risk measures across sectors, with the coefficient of variation on both net income and operating income standing in for earnings variability; the coefficient of variation is computed by dividing the standard deviation in earnings over the last ten years, divided by the average earnings over those ten years. 

Globally, health care has the highest percentage of money-losing companies and utilities have the lowest. In 2023, energy companies have the most volatile earnings (net income and operating income) and real estate companies have the most onerous debt loads. Looking at the intrinsic risk measures for sub-regions across the world, here is what I see:

Again, Australia and Canada have the highest percentage of money losing companies in the world and Japan has the lowest, Indian companies have the highest earnings variability and Chinese companies carry the largest debt load, in terms of debt as a multiple of EBITDA. In the last table, I look at the intrinsic risk measures, broken down by company age:

Not surprisingly, there are more money losing young companies than older ones, and these young companies also have more volatile earnings. On debt load, though, there is no discernible pattern in debt load across age deciles, though the youngest companies do have the lowest interest coverage ratios (and thus are exposed to the most danger, if earnings drop).

Risk Differences across Countries

    In this final section, I will look risk differences across countries, both in terms of why risk varies across, as well as how these variations play out as equity risk premiums. There are many reasons why risk exposures vary across countries, but I have tried to capture them all in the picture below (which I have used before in my country risk posts and in my paper on country risk):

Put simply, there are four broad groups of risks that lead to divergent country risk exposures; political structure, which can cause public policy volatility, corruption, which operates as an unofficial tax on income, war and violence, which can create physical risks that have economic consequences and protections for legal and property rights, without which businesses quickly lose value. 

    While it is easy to understand why risk varies across countries, it is more difficult to measure that risk, and even more so, to convert those risk differences into risk premiums. Ratings agencies like Moody's and S&P provide a measure of the default risk in countries with sovereign ratings, and I build on those ratings to estimate country and equity risk premiums, by country. The figure below summarizes the numbers used to compute these numbers at the start of 2024:

The starting point for estimating equity risk premiums, for all of the countries, is the implied  equity risk premium of 4.60% that I computed at the start of 2024, and talked about in my second data post this year. All countries that are rated Aaa (Moody's) are assigned 4.60% as equity risk premiums, but for lower-rated countries, there is an additional premium, reflecting their higher risk:

Download data

You will notice that there are countries, like North Korea, Russia and Syria, that are unrated but still have equity risk premiums, and for these countries, the equity risk premiums estimate is based upon a country risk score from Political Risk Services. If you are interested, you can review the process that I use in far more detail in this paper that I update every year on country risk.

Risk and Investing

    The discussion in the last few posts, starting with equity risk premium in my second data update, and interest rates and default spreads in my third data update, leading into risk measures that differrentiate across companies and countries in this one, all lead in to a final computation of the costs of equity and capital for companies. That may sound like a corporate finance abstraction, but the cost of capital is a pivotal number that can alter whether and how much companies invest, as well as in what they invest, how they fund their investments (debt or equity) and how much they return to owners as dividends or buybacks. For investors looking at these companies, it becomes a number that they use to estimate intrinsic values and make judgments on whether to buy or sell stocks:

The multiple uses for the cost of capital are what led me to label it "the Swiss Army knife of finance" and if you are interested, you can keep a get a deeper assessment by reading this paper.

    Using the updated numbers for the risk free rate (in US dollars), the equity risk premiums (for the US and the rest of the world) and the default spreads for debt in different ratings classes, I computed the cost of capital for the 47,698 companies in my data universe, at the start of 2024. In the graph below, I provide a distribution of corporate costs of capital, for US and global companies, in US dollars:   

If your frame of reference is another currency, be it the Euro or the Indian rupee, adding the differential inflation to these numbers will give you the ranges in that currency. At the start of 2024, the median cost of capital, in US dollars, is 7.9% (8.7%) for a US (global) company, lower than the 9.6 (10.6%) at the start of 2023, for US (global) stocks, entirely because of declines in the price of risk (equity risk premiums and default spreads), but the 2024 costs of capital are higher than the historic lows of 5.8% (6.3%) for US (Global) stocks at the start of 2022. In short, if you are a company or an investor who works with fixed hurdle rates over time, you may be using a rationale that you are just normalizing, but you have about as much chance of being right as a broken clock.

What's coming?

    Since this post has been about risk, it is a given that things will change over the course of the year. If your question is how you prepare for that change, one answer is to be dynamic and adaptable, not only reworking hurdle rates as you go through the year, but also building in escape hatches and reversibility even into long term decisions. In case things don't go the way you expected them to, and you feel the urge to complain about uncertainty, I urge you to revisit the Chinese symbol for risk. We live in dangerous times, but embedded in those dangers are opportunities. If you can gain an edge on the rest of the market in assessing and dealing with some of these dangers, you have a pathway to success. I am not suggesting that this is easy to do, or that success is guaranteed, but if investment is a game of odds, this can help tilt them in your favor.

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  1. Risk Measures, by Industry - Start of 2024
  2. Risk Measures, by Country - Start of 2024
  3. Equity Risk Premiums, by Country - Start of 2024
  4. Cost of Capital, by Industry - Start of 2024 (US & Global)