Corporate Hedging: Answers to questions

A couple of posts ago, I presented six examples of risk hedging/ taking that I would like to take through my three bucket test - risk to pass through, risk to avoid/hedge and risk to exploit.

1. Southwest has always hedged against oil price risk, using futures contracts. Is what they are doing make sense? Given that Southwest's core competence (see, I can speak like a corporate strategist) is running an airline (not forecasting fuel prices), that fuel prices are such a large portion of total costs, and Southwest has done this through high and low oil prices (and are thus not trying to time the oil market) , I think it makes sense.
   
2. In the last two years, other airlines that had never hedged against oil price risk decided to start because oil prices had gone up so much. Is what they are doing make sense? I am much more suspicious of this activity. The very fact that they are hedging only after oil prices have run up, suggests to me that there is an element of market timing here. Not surprisiingly, firms that do this end up with the worst of both worlds. They hedge against oil prices after they have run up and stop doing it after oil prices have gone down.
   
3. A publicly traded soccer team buys insurance against it's leading player getting injured. Does that make sense? I think this does, since investors in the firm would have a difficult time doing this on their own. The team also has information on the player's physical status that an investor would have no access to.
   
4. As the Brazilian Real increased in value against the US dollar, Aracruz decided to make a bet of tens of millions on the continued strengthening of the Real. Good idea, bad idea? This is plain dumb. Aracruz is a paper and pulp company. As an investor in the company, the last thing I want them to try and do is time exchange rate movements (and I would have said the same thing even if they had made money)
   
5. A trader at an investment bank decides to bet, with proprietary capital, that interest rates in the US will rise over the next year. Makes sense? I have always been skeptical about propreitary trading profits reported at investment banks, since I see little that they bring to the table as competitive advantages. They trade with each other, using the same information base and often the same traders (who move from bank to bank). I see no reason to believe that a trader at an investment bank (and the economists at the bank) have any special insight into the future direction of rates.
   
6. Barrick Resources, a gold mining company, decides to sell futures contracts to lock in the price of golf for the next five years. What do you think? I invest in gold mining stocks because I am optimistic about gold prices going up. If Barrick goes out and hedges against gold price movements in the future, it is undercutting my rationale for investing.

The bottom line, though, is that we should not judge any of these firms by the outcomes of their actions, but by whether their actions make sense. (Aracruz could have made hundreds of millions on its currency bets and Southwest is probably losing money, now that oil prices are declining)

Happy Thanksgiving!

Time to take a break from pontificating and navel gazing. While there is much to worry about and anguish over, there is so much more to be thankful for. Have a wonderful Thanksgiving!

Corporate Hedging: The Down Side

There is a news story in the New York Times today about Asian airlines and the losses that they are facing because of put options that they had sold against oil prices, months ago, that are now coming due as large costs. They sold these puts to offset the costs of buying calls against oil, where were, in turn, designed to hedge against higher oil prices.

In these days of risk and uncertainty, I am sure that many companies will be on the lookout for ways to hedge against risk, and they will find plenty of entities willing to tell them how to do it or sell them products or services that provide protection. After all, every macro uncertainty from interest rates to inflation to commodity prices can be hedged using derivatives or insurance. But is this a good idea?

In my book on risk, titled "Strategic Risk Taking", I have argued that the essence of good risk managment is separating risk into three buckets:

a. Risk that should be passed through to investors, because they either want to be exposed to this risk or because they can protect themselves at a far lower cost. Included in the first group would be commodity risk to a commodity company: investors buy stock in oil companies because they want to make a bet on oil prices. An oil company that hedges against oil price risk is undercutting that bet. Included in the second group would be risk that cuts in different directions for different companies. I think it is generally a bad idea for companeis to hedge against exchange rate risk, simply because a stronger dollar helps some companies and hurts others. As an investor with stakes in both Coca Cola and Boeing, I think about exchange rate risk in my overall portfolio (which I can choose to hedge if I want to) rather than in individual companies.

b. Risk that should be avoided/ hedged: This would include risks that are not easily visible or difficult to hedge for investors in the firm, but are large enough to affect it's operations or survival. Included in here would be the risk of physical damage to property (against which you can buy insurance) and the costs of inputs into the production process. Thus, there is a rationale for an airline buying oil price futures to lock in the cost of fuel, Not that the action will not make the firm more profitable over time but may improve its operating efficiency; the airline can set ticket prices, knowing what their costs will be, and focus on improving efficiency in areas where it can make a difference.

c. Risk that should be sought out and exploited: Firms become successful by seeking out and exploiting risks and not be avoiding them. However, they have to find those risks on which they have a competitive advantage to do this. This is where corporate strategy meets corporate finance/ risk management. The edge could be technology, brand name or information...

Since this post has become way too long, I will leave you with questions about risk hedging/taking in general that you can try answering with this framework (if that is how you want to waste your day):

1. Southwest has always hedged against oil price risk, using futures contracts. Is what they are doing make sense?
2. In the last two years, other airlines that have never hedged against oil price risk decided to start because oil prices had gone up so much. Is what they are doing make sense?
3. A publicly traded soccer team buys insurance against it's leading player getting injured. Does that make sense?
4. As the Brazilian Real increased in value against the US dollar, Aracruz decided to make a bet of tens of millions on the continued strengthening of the Real. Good idea, bad idea?
   
5. A trader at an investment bank decides to bet, with proprietary capital, that interest rates in the US will rise over the next year. Makes sense?
   
6. Barrick Resources, a gold mining company, decides to sell futures contracts to lock in the price of golf for the next five years. What do you think?
   

Jekyll and Hyde revisited!

Yesterday's Financial Times had this headline: "Citi plans good bank, bad bank structure". In effect, Citi plan to separate all the toxic assets and put them in the bad bank and keep all the money making assets in the good bank. Well, I guess we should carry this to its logical extreme and let every company do this - break up into good and bad parts. Thus, Microsoft can consign Office and Windows to the good part and throw Xbox into the bad part.. The next step would be to have two listings for every company - with investors allowed to trade each part separately (we could call them MSFT-G and MSFT-B).

Here is the practical problem. Investors will undoubtedly mark up the prices for the good part, but how are we going to induce them to buy the bad part? After all, if the assets in this part are proven money losers, you would have to pay people to take parts of these assets. In the case of Citi, the plan is obvious. They want to keep the good part and spin off the toxic part to the government; in effect, tax payers will be left holding pieces of assets that will generate negative cash flows as far as the eye can see. If I were negotiating for the Treasury, I would demand a large chunk of the good part (in options or equity) in return for taking the bad part. Otherwise, it seems like a bad deal!

Dividend Yield and T.Bond rate

The last few weeks have seen their share of the strange and the unusual. Last Wednesday, another milestone was reached. The dividend yield on the S&P 500 exceeded the 10-year treasury bond rate for the first time since 1958; just to add, the dividend yield went up only because stock prices have dropped so much this year. So. what is the significance of this occurrence?

a. The Bargain Basement view: If we assume that dividends are stable - and they have been remarkably predictable for the last few decades - investing long term in stocks seems like a no-brainer. The income you get from the dividends is greater than what you would make investing in treasuries, and when stocks eventually recover, you get the upside of price appreciation as well.

b. Dividends will drop: The counter to this viewpoint is that the recession and a desire for liquidity will cause companies to cut back on dividends. When they do, it is argued that this aberration will disappear.

I tend to agree more with the first viewpoint than the second. After all, companies in the US have not increased dividends much over the last 40 years and chosen instead to buy back stock. Last year, stock buybacks accounted for two thirds of the cash returned by corporations. I believe that companies that are facing hard times and desirous of liquidity are more likely to reduce stock buybacks than cut dividends.

However, I would fine tune the strategy. I would focus on companies paying high dividends - the list is long - and have little debt & large cash reserves. The collective dividend yield on these companies will be higher than what you can make on most safe investments currently...

Good companies in bad businesses

All this talk about a federal bailout of GM and Ford has started me thinking about something that has always bothered me. There are some businesses where even the best companies seem to barely make it and everyone else is under water. The automobile business is a good example. Take Toyota, a company that most analysts would consider to be the star of the sector. The company earned a return on capital that matched its cost of capital last year and that was a good year. If the best company in the sector breaks even in a good year, where is the upside in this business? The airline business, since deregulation, is another example of a business that has few profitable companies. I know.. I know.. There are Southwest and Ryanair, but even these paragons of corporate profitability earn returns on capital that trail their costs of capital. The rest of the business is a disaster.

I opened up my economics and corporate strategy books to see if I could find an answer. One possibility is that these businesses are filled with irrational companies that do stupid things over extended periods, but I find that hard to believe. The other is that these businesses have not found (or have lost) a structure that can generate profits on a sustained basis. In the airlines business, deregulation opened the business up to new entrants and the new firms that entered undercut the established competition with lower prices for the most profitable routes. In the automobile business, the problem seems to be legacy costs - c0sts that firms have piled up over time, usually in return for short term labor peace. Note that the older automobile firms are in the most trouble... those pension obligations that they committed to decades ago have come back to haunt them.

Eventually, these businesses will have to find a stable structure, where the companies at least on average earn their cost of capital. When will this happen? I don't know, but we, as consumers, will continue to buy cars and travel on airlines... It is in our best interests that the companies that provide these products/services make a reasonable profit in the process.

Some thoughts on Las Vegas!

I was in Las Vegas yesterday, staying at the Bellagio. As I walked through the casino floor to get to the convention center, where I was delivering a presentation on valuation, there were three things that struck me about the setting:
1. The first is that there is no better example of the ruthless power of the law of large numbers and probabilities than a casino. Think about it. You have hundreds of slot machines programmed to deliver about 90 cents on the dollar, on an expected value basis. No surprise, then, that they do.... The house always wins (at least on the slot machines).
2. The second is that there is no worse setting for talking about risk, risk aversion and risk premiums than a casino. After all, any individual who would spend his money in a casino has accepted an investment with an expected return of about -10% and some risk, not exactly compatible with a risk averse, rational individual. I know, I know.. Gambling is not an investment but done for entertainment. I did not see much joy in the faces of the slot machine players as I walked by.. If they were being entertained, they did a good job hiding it.
3. The final point, though, came from a movie that I saw a few months ago called "21", about six MIT students who figured out a way to beat the odds at Vegas by counting cards. Even the most secure systems (and Vegas is as close as you can get to a slam dunk as you can get..) have their weaknesses.
The bottom line... If you play a game where the odds are against you, you are likely to lose and the longer you play, the greater the chance that the odds will catch up with you.

Blackstone's Woes: Some thoughts on Private Equity

About a year and a half ago, at the height of private equity's success, I put together a presentation on LBOs that examined what makes an LBO work and, conversely, why many of them were destined to fail. The LBO I looked at was the Harman deal, backed by two big names - Goldman and KKR. Based on my analysis then, I concluded that Harman fit none of the requirements for a good target - it did not have significant debt capacity (nullifying the leverage benefit), it was well managed (eliminating the restructuring need) and did not suffer any serious separation between management and ownership (countering the going private argument). If you are interested, I have a paper describing the deal that can be downloaded by going to: 

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1162862

My purpose in the paper was not to pick on Goldman and KKR but to make the following points:

1. Even smart people (and there are quite a few at both Goldman and KKR) sometimes do stupid things.  No one is immune from the "herd" mentality. Goldman and KKR were caught up in the mood of the moment - debt  would remain cheap and the economy would keep growing forever - and the deal was reflective of these views.

2. First principles in finance are like first principles in physics. If you violate them, they will catch up with you, no matter who you are. What are these first principles? Here is one. If you are a business that does not generate high cash flows right now, even though you may have great growth potential, you should not borrow money (even if there are people out there willing to lend you this money).

All of this pontificating brings me to Blackstone's earnings announcement due today. My guess is that "marking to market" all of their deals will have a devastating impact on their earnings. No one should be surprised and Blackstone is not alone in feeling the pain, but the lesson we should take away is that private equity and hedge fund investors make the same mistakes that other investors make - the only difference is that they do it on a bigger scale.