The market value of Tiger Woods

Tiger Woods has been in the news in these last few weeks, though not in the way he has been in the past. As his personal travails have mounted, his endorsements have dropped off. Now comes a study by two professors at UC Davis, looking at the companies that sponsor Tiger.
http://www.news.ucdavis.edu/search/printable_news.lasso?id=9352&table=news
They find that the collective market value of these firms dropped $10-$12 billion between November 27, the fateful day when Tiger drove into a fire hydrant outside his house, to December 17 (thirteen trading days later).

Note that Tiger is not the first high profile athlete whose market impact has been studied. A study of Michael Jordan's announcement that he would return to basketball (after he retired and tried baseball for a year) resulted in an increase of 2% in market value of his sponsor firms. In fact, an earlier study of firms endorsed by Tiger Woods in his glory days found that Nike and American Express gained about 1% in market value around the endorsement dates.

As an interesting aside, the UC Davis study also found that three firms, Tiger Woods PGA Tour Golf, Gatorade, and Nike, fared worst during the period after the Woods scandal came to light. Accenture, a consulting firm, showed no signs of loss in value. I would take this as an indication that Accenture has been wasting its money all these years, using Tiger Woods as a spokesperson.

On a more general note, I think this incident points to both the upside and downside of using celebrity endorsements. While there is a commercial benefit, it has to be weighed off against the potential cost of celebrities behaving badly and affecting the sponsor's reputations. For firms like Nike, both the benefits and the costs are large, since their customers are more likely to be swayed by celebrity endorsements and misadventures, but the net effect is likely to be positive. For firms like Accenture, I really do not see the net plus of using celebrity endorsements. As a business, it is unlikely that I pick my management consultant, based upon an endorsement by Tiger Woods.

Greece, EU and more on Implicit Backing for Debt

Building on the theme of my last post, i.e., that implicit guarantees for debt are common and potentially dangerous, Greece offers an illustration of both the upside and downside of implicit guarantees.

Greece has been in the news as both S&P and Moody's have lowered its sovereign rating, from A- to BBB+ (for S&P) and from A2 to A1 (for Moody's). The harsher downgrade from S&P drew Greece's ire:
http://www.ft.com/cms/s/0/d4bdc8f2-eb13-11de-a0e1-00144feab49a,dwp_uuid=2b8f1fea-e570-11de-81b4-00144feab49a.html
Questions have been swirling about Greece defaulting and how the rest of the EU will react to potential default.

Taking a longer term view, though, Greece's debt travails are a test of the EU as implicit guarantor. I visited Greece in 1998, before the Euro came into being, to talk about valuation and at the risk of infuriating Greeks, the country was more an "emerging" than a "developed" market. The Greek currency, the Drachma, had little power outside the domestic market and Greece had a sovereign rating of BBB- (below investment grade) in 1995.

Becoming part of the EU and adopting the Euro as currency in 2002 improved the credit standing of the Greece, Spain and Portugal. While some of the improvement can be attributed to the fiscal discipline required by the EU (including restrictions on budget deficits), some of it can also be traced to the belief that the stronger countries in the EU would provide backing in the event of debt problems.

The bigger question is whether this umbrella has been a net plus for the EU countries as a whole. For Greece, Portugal and Spain, the benefits clearly have exceeded the costs over the period. For Germany and France, the effect has been more ambiguous, with the benefits of having a bigger and more prosperous market weighed off against the costs of the subsidies offered to the weaker economies. The subsidies also skewed economic activity in strange ways:
http://www.nytimes.com/2009/12/28/world/europe/28olives.html

Collectively, having one currency has made it easier for businesses to operate across Europe and those European firms that have adapted to this reality have emerged as more vibrant. While it has made Europe more competitive with the US, the big winners over the last decade have been the emerging markets, especially India and China. The biggest cost, as I see it, has been the bureaucracy that the EU has created to regulate itself and the companies that operate within its borders. In a dynamic global economy, putting more shackles on European companies will not make them more competitive.

Dubai and the "implicit" guarantee

In the last two weeks, we have seen the damage wrought by the potential default of Dubai World, a Dubai-government controlled company that funded some of the most extravagant projects on the face of the earth over the last decade.
http://www.bloomberg.com/apps/news?pid=20601087&sid=aoFe12bwzZ2M

While the magnitude of the default was large, it is interesting that it has shaken markets as much as it has. After all, there have been other large loan defaults in markets over the decades. So, why the panic? I think the reason lies in the unraveling of what I would call the "implicit guarantee".

What is the implicit guarantee? Consider a standard loan agreement, where a lender assesses a borrower's credit worthiness in determining how much to lend and on what terms. Through the ages, though, lenders have been willing to lend to borrowers who may not meet their credit worthiness tests, because their loans are backed up implicitly by others with deep pockets. Thus the money lender who granted a loan to the wastrel son of a wealthy merchant was trusting in the "implicit guarantee" of the father to pay back the loan; family honor was assumed to trump the absence of a legal obligation.

So, what does this have to do with Dubai World? Dubai is a city-state, with limited resources and economic capacity. The projects that were funded with the loans showed little potential of generating the cash flows needed to service the debt. However, Dubai is part of the United Arab Emirates, which has significant oil wealth and lenders assumed that the UAE would step in and provide backing, when the payments came due. At least so far, that has not happened.

Why does this have global consequences? Let's face it. A significant proportion of all lending is based on implicit guarantees. From bondholders in companies that are too big to fail (where the government is the implicit guarantor) to banks that lend to troubled family group companies (expecting the parent group to step in and save them), it is the implicit guarantee that allows for the lending. To those lenders, the Dubai World default is the stuff of which nightmares are made. The initial worry was that other implicit guarantors would use this crisis as the opportunity to walk away from their implicit obligations. While that has not materialized, it should serve as a wake up call to those who have been cavalier about implicit guarantees.

What is the bottom line? I am not suggesting that implicit guarantees are necessarily bad but they can pose a danger when too large a proportion of the debt in a system is dependent on them. Since none of the parties involved - the lender, borrower and implicit guarantor - make the obligation explicit, it is possible for them to misjudge the extent of their indebtedness and for investors to make the same mistake. I have seen many Asian and Latin American family group companies that have little or no debt on their balance sheets but have unconsolidated subsidiaries with massive debt on their balance sheets (backed up by the implicit guarantee). If we assume that these firms will honor their implicit guarantees, they should be treated as highly levered firms.

The CRU Scandals: A Reflection on Academia

I am sure that you have been tracking the story of the hacked emails between top climatologists and the ensuing debate about whether those atop the discipline have stifled skeptics in the global warming debate. If you have not, here is a quick review:

http://www.washingtonpost.com/wp-dyn/content/article/2009/11/21/AR2009112102186.html?nav=hcmodule

I do not intend to wade into that debate but the entire controversy has held up a mirror to academic research in general and I don't think the reflected image is flattering.

Let us start with the ideal. Seekers of truth (Scientists, professors, Phd students... the academic research community) come up with interesting and provocative questions to answer, look at these questions objectively (and with no financial interests at stake) and with no preconceptions, develop theories and test them rigorously and then report these results without skewing them. Their research is reviewed by their peers, who bring the same objectivity and fairness to their assessments, and decide whether the research should be published.

As with most ideals, this one is utopian. Here is my more cynical view of how the process works.

1. Research what will be published, not what is interesting: When you first start climbing the academic ladder, the name of the game is to get published. Would you rather publish a ground breaking paper than an incremental one? Of course. But would you rather publish an incremental paper than have a ground breaking paper that does not get published? The answer again is affirmative. It is far easier to publish a paper than nibbles at the edges of big questions than one that asks and tries to answer big questions. If you pick up any academic journal and browse through the contents, you will see the evidence of this marginalization.

2, Bias in, bias out: Researchers are human and come in with biases and preconceptions, some of which are formed early in life, some during their academic experiences and some of which they acquire from their mentors and peers. Those biases then drive not only the topics that they choose to research but also how they set up the research agenda and in some cases how they look at the data.

3. Who you are matters: Where you went to school to get your doctorate, who your mentor is and what school you teach at right now all affect your chances of getting published. If you went to an elite school (and the elite can vary from discipline to discipline), worked with the right mentor (preferably a journal editor) and teach at another elite school, your chances of publication increase significantly.

4. Every discipline has an "establishment" view: There is an establishment view in every discipline. Papers that hew to this view have a much easier path to publication than papers that challenge the view. In finance, the establishment view for decades was that markets were efficient and that any evidence of inefficiency was more a problem with the models we had than with the underlying efficient market hypothesis. It has taken almost two decades for behavioral economists to breach this wall. Now, I sense that they are becoming part of the establishment and don't quite know what to do.

5. Peer review is wildly variable and sometimes biased: When you write a paper in a particular area, it will be sent out to other "experts" in the area for review. Some of them are scrupulously fair, read your paper in detail and provide you with extraordinary feedback that improves your paper. Others are defensive, especially if the paper challenges one of their pet theories, and find reasons to reject the paper. Still others are extremely casual about feedback and make suggestions that border on the absurd. While peer review, on average, improves papers, it does so at considerable cost.

6. Data abuse happens: As the volume of and access to data improves, it has become far easier to abuse the data by (a) selecting the slices of data that best fit your story (b) expanding sample sizes to the point that the sheer amount of data overwhelms the opposition and (c) reporting only a subset of the results that you get with the data.

I think peer review is useful and empirical testing is crucial. However, my advice to laymen looking at academic research is the following.

1. Don't assume that academics don't have an agenda and don't play politics. They do.

2. Don't let "research findings" sway you too much - for every conclusive result in one direction, there is almost always just as conclusive a result in the opposite one.

3. Just because something has been published does not make it the truth. Conversely, the failure to publish does not mean that a paper is unworthy.

4, Develop your own vision of the world before you start reading papers in an area. Take what you find to be interesting and provocative and abandon the fluff (and there is plenty in the typical published paper).

5. Learn statistics. It is amazing how much of what you see reported as the truth fails the "standard error" test.

One final note on the CRU email story. For the most part the faults of academic research create no significant damage because so much of the research is inconsequential. The scandal of the data manipulation and stonewalling of critics in this case is that it is so consequential, no matter what you think about global warming. If there is no global warming and the data has been manipulated to show that there is warming, the academics at the heart of this affair should be forced to answer to the coal miners, SUV assembly workers and others who lost their jobs because of warming-related environmental legislation. If there is global warming and the numbers were being cooked to make the case stronger, there is the real possibility that people will turn skeptical about warming about revert back to old habits. In either case, it behooves those involved in this mess to step down.

A tax on financial transactions: Good or Bad Idea?

In recent days, we have heard talk from Congress about imposing a tax on financial transactions. While there has been heated debate on the topic, there seems be more smoke than substance in most of the arguments. This morning, Paul Krugman, who seems to have made a speedy and seamless transition from economist to polemicist, has an article on why such a tax is a good idea:
http://www.nytimes.com/2009/11/27/opinion/27krugman.html?ref=opinion
As always, Krugman sees the villains here (the speculators, who else?), decides that this tax will not have much effect on the good guys (a group of long term investors, into which he puts himself and his readers) and sees potential benefits to markets from the action.

Very convenient, but not very balanced!!! I would like to provide a counter, by first examining the motives for a transactions tax and then considering the laws of unintended consequences.

Motives
As I see it, there are three motives for a transactions tax.
1. Revenue generation: As government budgets get squeezed and deficits mount, legislators are flailing around for ways to raise revenues in fragile economies. Given the sheer volume of trading volume in financial markets, even a small tax seems likely to raise huge revenues. (In a classic example of how governments compute potential revenues from taxes, the estimated tax receipts are computed by taking the existing dollar value of trades in a market and multiplying by the tax rate.... If only we lived in a static world...)

2. Punish bad behavior: As a bonus, the tax will fall most heavily on those who trade short term or in derivatives markets. If we assume, as Krugman has, that these trades are for the most part speculative, the tax punishes that "bad" behavior. (It is the same rationale that allows governments to raise taxes on tobacco and alcohol...)

3. Target the "right" entities: The perception on the part of many is that the biggest traders in derivatives markets are investment banks and hedge funds. The billions of dollars that these entities are reporting in profits, in conjunction with their absence of suitable remorse for their role in creating the banking crisis of last year, has made them easy targets. (I am quite surprised that legislators have not proposed a windfall profits tax on just the bad guys, at least as they see them... they would probably call it the Goldman tax!!)

So, what can go wrong?
1. Motives are internally inconsistent: There seems to me to be a direct contradiction between motives 1 and 2. Put another way, the only way in which this transactions cost will raise revenues is if the bad behavior in question (short term trading) continues in the future. I think legislators need to specify what their primary objective and not try to argue out of both sides of their mouths. (I know little or no chance of this happening, but no harm hoping..)

2. Speculation versus Investing: As I have argued before, I am very uncomfortable drawing the line between speculation and investing. While I might not see much benefit to short term trading, I can see how others might. To label myself as the investor and the others as speculators is self serving and wrong. Furthermore, the notion that derivatives trading is driven primarily by speculation is fantasy. I can see plenty of reasons why a long-term, value investor may use derivatives to protect and augment his returns.

3. Liquidity costs: Even if we accept the premise that short term investors create noise and pricing bubbles, long term investors benefit from the liquidity they bring to the system. In fact, the markets where long term investing is most difficult are markets where there no short term investors. (Consider the market for fine art or even real estate.... Transactions costs inflate for everyone and insiders end up dominating the market)

4. Market mobility: As trading moves of exchange floors into ether space, it is difficult to visualize how a transactions tax will work, unless it is globally coordinated. All you need is one rogue player for the system to start coming apart at the seams. Krugman argues that the clearing systems for many of these markets are centralized and that the tax can be therefore collected at these locations. While this may work in the short term, how long will it take for an offshore location (say the Cayman Islands) to set up a competitive system? (It will cost money but the potential benefits from the system will be huge.) Once that happens, any chance of regulating these markets, even in sensible ways, becomes remote.

All in all, I think this is a dumb idea that should be throttled early in the process. I am sure that you will hear variants of the concept, and they will all share a common feature. They will try to focus the tax on what they view as the markets or securities that they view as most speculative and argue that only the entities in these markets will be affected by the tax. I don't think so. Ultimately, we will all bear the cost.

Macro Bets: A general framework..

As many of you are aware, I am not a great believer in macro bets but I recognis4 that there are investors out there who not only like to make big bets on interest rates, currencies or commodities, but also make tons of money in the process. In fact, the subject of my last post, John Paulson, made a macro bet on housing and it paid off big time for him. Consequently, I thought it would make sense for me to put down my thoughts on macro bets.

Should you make macro bets?

The old rule in investing applies. If you are going to make macro bets, you need to bring something unique to the table - a competitive advantage that sets you apart from the hordes of other investors. Here are some potential advantages that you may be able to build on:

a. Time: If you have a much longer time horizon than the rest of the market (remember that this requires that you have patience and that you can live with the loss of liquidity), you may be able to bet on macro mis-pricing that is expected to persist for the short term but not the long term.

b. Trading: The second skill set you can exploit is your capacity to trade on a macro bet that others may not possess. This will generally require that you either create your own securities (synthetic calls and puts, forwards) to make money on the macro bet or that you creatively exploit securities that already exist out there (as Paulson did with the CDS market)

c. Information: As with individual stocks, there are two ways in which you can exploit information. The first is short term, where you can get ahead of macro information announcements and game them for gain. Thus, you you can try to forecast how the next Federal Open Market Committee is going to vote (I cannot think of a way legally that you could get access to this information...but you never know). The second is long term. As an example, you may be able to collect information on copper production at individual mines globally and make judgments on copper supply (and prices) in future periods.

d. Behavioral: There is evidence that investors behave in quirky (notice that I did not say irrational) ways when making investing choices. You can try to take advantage of these behavioral quirks as long as you are immune from them and believe that they will be reversed in the future. Thus, the "herd behavior" of investors can cause short term momentum in currency markets before the same behavior creates a "big correction". To take advantage of this, though, you have to be less affected by the herd than the average investor (As a kid, did you fight peer pressure or did you bend to it?) and you have to be able to gauge when the herd will turn...

What is the best way to make a macro bet?

If you are going to make a macro bet, keep it simple and make it a focused bet. If you believe that gold prices will keep going up, the best investing strategy is to buy gold futures or options.

All too often, we hear of investors finding convoluted ways of making macro bets. Buying a gold mining company, say Barrick Resources, because you believe that gold prices will go up exposes you to all kinds of other risk. The stock price of a gold mining company reflects multiple other factors: its success at finding new gold reserves, whether it hedges against gold prices or not and whether its gold reserves are in an unstable country.

It is true that in some cases, a macro bet can be combined with a micro bet. Thus, if you like Petrobras as a company (because you like its management and investment strategy), you could buy Petrobras and also make bullish bets on Brazil and oil. You should be clear, though, as to which factor is front and center in your investment decision, i.e., Are you buying Petrobras because you like the company? Like Brazil? Think oil prices are going to go up?

What are the risks of macro bets?

The risk with macro bets as with any investment strategy is that your underlying premise may be wrong and/or that the rest of the market does not buy into it. My skepticism about macro bets is based upon the difficulty I see in establishing a competitive advantage. When there are literally millions of other playing the same game and "private" information is difficult to obtain (without breaking the law), the game is a much more difficult one to win. Obviously, it is not impossible, as John Paulson and others have shown over time, but the odds remain against you.

The secrets behind John Paulson's success...

The banking and credit crisis of 2008 had few heroes and lots of investing legends who were humbled. Very few of these so called experts saw the crisis coming, and even those who did were unable to act on that belief.

One exception is John Paulson, a hedge fund manager/investor based in New York. He saw a bubble in the housing market in 2006 and created a hedge fund to bet on the bubble bursting; what made his bet unique was that his use of the Credit Default Swap (CDS) market to bet that sub-prime securities would collapse and he was right. Greg Zuckerman, a reporter at the Wall Street Journal, has a short article reviewing Paulson's strategy in the link below.
http://online.wsj.com/article/SB125823321386948789.html?mod=googlenews_wsj

Greg, whose writing I enjoy reading, is probably the world's leading authority on Paulson (other than Paulson himself), since he has spent the last year researching the man and has written a book on his investing acumen. You can get the book, titled "The Greatest Trade Ever" at your local bestseller:
http://www.amazon.com/Greatest-Trade-Behind-Scenes-ebook/dp/B002UBRFFU/ref=sr_1_1?ie=UTF8&s=books&qid=1258333719&sr=8-1

In his Wall Street Journal article, Greg has a collection of lessons that the average investor can learn from Paulson. While I agree with most of them, I do disagree with one point that he makes, i.e., that the bond market is a better predictor of problems than the stock market. The bond market is a better predictor of credit risk and default problems than the equity market, simply because it is far more focused on that risk. Equity investors juggle a lot more balls in the air- growth, risk and cash flows - and they can get distracted, especially about default risk. History suggests, however, that equities have led bonds in predicting economic growth and profitability.

Here is where I agree with Greg. I think equity investors will gain by paying attention to bond markets, just as bond investors will gain by being aware of developments in equity markets. We have compartmentalized investing to the point that investors are often unaware of when these markets become disconnected, which are the danger signals that one market has become mispriced. In the context of valuation, here is where I think this recognition is most useful.

1. Risk Premiums: In my paper on equity risk premiums, I have a section where I compare implied equity risk premiums and default spreads on bonds and not the correlation between the two over time. The periods when they have moved in opposite directions, such as 1996-99 (when equity premiums dropped and default spreads rose) and 2004-2007 (when default spreads dropped while equity risk premiums remained stagnant) were precursors to major market corrections - the dot com bubble in the equity market in 2000 and the sub-prime bubble in the bond market in 2007-08.
2. Distressed companies: When valuing equity in distressed companies, the threat of default constants overhangs the entire valuation. I believe that we can derive valuable information from the corporate bond market that can help up refine and modify the valuation of distressed companies. I describe this process in this paper.

If Paulson's lessons are heeded, we should see more joint work between equity research analysts and bond analysts and a greater willingness to look across markets for investing clues. I am not holding my breath!!!

P.S: For those of you who are conspiracy theorists, John Paulson is not related to former treasury secretary and Goldman CEO, Hank Paulso.

P.S2: A disclosure is in order. John Paulson just gave $ 20 million to the Stern School of Business at NYU, where I teach. Since did not partake in this gift, I think I can still be objective about his investing strategies.

The Agency for Financial Stability? Good idea?

In today's big news for bankers, Senator Chris Dodd has announced his intent to create an Agency for Financial Stability, which will be responsible for "identifying and removing systemic risks in the economy".
http://online.wsj.com/article/SB125786789140341325.html
Wow! What a brilliant idea? What next? How about an Agency for Everlasting Economic Growth? And an Agency for No More Defaults? Or an Agency for Full Employment?

The key part of this proposal is that it will strip away some of the powers of the Federal Reserve over banking and move them to this agency. Implicit in this proposal is the belief that the Fed has not taken its banking oversight responsibilities seriously and that this failure was at least partially to blame for the banking crisis last year. Implicit also is the belief that a different agency more focused on controlling risk would have prevented this from happening. Let's take each part separately.

Replacing the Fed
There have been many who have blamed the Fed and its chairmen (Greenspan and Bernanke) for the banking crisis last year. However, there are just as many who have blamed other institutions for the same crisis. Without revisiting that debate, let us consider some of the reasons that have been offered for why we need to take banking regulatory powers away from the Fed and see if they are justified.

1. The Fed is not professional: I don't quite buy into this critique. While I do not claim to be a Fed insider, my interactions with those who work at the Fed have reinforced my view that most Fed economists are competent and apolitical. In fact, I would wager that there is more competence and less political meddling in the Fed than there is in almost any Federal agency.

2. The Fed has conflicts of interest: This most incendiary of allegations is thrown around by conspiracy theorists. In their world, investment bankers regularly meet in back rooms with Federal Reserve decision makers and think of ways in which they can rip off the rest of the world. Again, I don't see the conflicts of interest. There is clearly no reason why the Fed cannot set monetary policy and regulate banking at the same time. (A variant of this argument is that economists who work at the Fed are looking to move on to more lucrative careers at investment banks and are therefore amenable to entreaties from investment banks...My counter is that the top decision makers at the Fed are already at the top of the profession and don't need favors from investment bankers).

3. The Fed is distracted: The most benign reason given for stripping the Fed of its banking powers is that it has too much to do and therefore is unable to allocate enough resources to banking oversight. This may very well be true but the response then would be to give the Fed the resources it needs and not to create another Federal Agency.

In summary, I see no good reason for this new agency. The only real critique that I have heard is that oversight failures at the Fed caused the last banking crisis. Since no other regulatory agency, in the US or elsewhere in the world, seems to have foreseen this crisis, I think it is unfair to pick on the Fed alone. I see no reason to believe that an Agency for Financial Stability would have somehow protected us against the risks that precipitated this crisis and lots of reasons to believe that it would have made it worse.

Systemic Risk
The essence of systemic risk is that it is risk that affects the entire financial system rather than just the risk taking entity. We have to be more precise about why this is a problem. It is not because the risk is systemic but because it is asymmetric in its effects. Put more simply, an entity (investor, investment bank or hedge fund) that takes systemic risk gets the benefit of the upside, if the risk pays off, but that the system (government, tax payers, other investors) bear the downside if there is a bad outcome.

As I read the description of the agency in yesterday's news, the message that came through was that it was the taking of systemic risk that was the problem and that the agency would reduce the problem by regulating it. That seems to me to miss the point. What you need is action to reduce the asymmetry in the pay offs. As I see it, this will require:

a. Monitoring reward/punishment mechanisms: While I have never been a fan of regulating compensation at private firms, I think we need to require that compensation systems not exaggerate the asymmetric payoffs from taking systemic risk. For instance investment banks that reward traders for making macro bets, with house money, are pushing the systemic risk envelope.... (I have no problem with rewarding traders for taking micro risks or investment bankers for doing lucrative deals... )

b. No bailouts: Firms that make systemic bets that go bad should not only be allowed to fail but every effort should be made to recoup assets that they own to cover the losses created by these systemic bets.

c. Systemic Risk Fund: This may be the controversial part of the package, but a proportion of all profits made from systemic risk taking should go into a general fund that will be used to cover future systemic risk failures. (This will require explicit definitions of what comprises systemic risk and measurement of the profits from the same... but I don't see a way around it.) This will work only if legislators are not allowed to access this fund and use it to cover pet projects. (The reason I make this point is that the fund will become very, very large during good times and legislators will be tempted to draw on the piggy bank.)

With global markets and offshore investing, we cannot outlaw the taking of systemic risk. All we can do is to try to bring some symmetry back into the process where those who make money on these systemic risks also bear the losses from taking these risks. We don't need a new agency to do this but we do need banking authorities who are proactive, more interested in winning the next battle and less in refighting the last one.

Bad companies and good investments...

One of the big news items of the week is Berkshire Hathaway's acquisition of a Burlington Northern, a large US railroad.
http://www.nytimes.com/2009/11/04/business/04deal.html
Since Berkshire Hathaway is Warren Buffett's brainchild, this has provided a platform for many analysts to read the tea leaves. Here is some of the spin that I have seen and what I think about the spin.

A significant number of the analysts have argued that Buffett is making a bet on the US economy recovering by making this investment. I find this puzzling at two levels. First, if you were going to make a bet on the US economy, railroads seem like a pretty poor choice. Unlike housing and consumer durables, railroads have not seen their earnings increase dramatically in good economic times. Second, Buffett has always expressed his skepticism about market timing and macro investing strategy and this investment would be a significant departure.

Here is my take on the investment. Railroads in the United States are the quintessential mature business. It is extremely unlikely that you will see much real growth in this business; constructing a new railroad or even adding new rail lines would have prohibitive costs in the US, given real estate costs and litigation issues. Companies in this business have earned returns on invested capital that have lagged the cost of capital for decades. Put another way, very few railroads would make the list of most glamorous companies or be featured in Tom Peter's list of excellent companies.

So, why would Buffett invest in a bad business? I have said some unfavorable things about Warren Buffett on this blog before. At the risk of repeating myself, I think he has been hypocritical on corporate governance and he plays the "I am just a hick from Omaha" role to perfection. However, I think his status as a great investor can be boiled down to his capacity to separate "great companies" from "great investments" . Put another way, Buffett has always recognized that a great company can be a terrible investment, if you pay too much for it, or that a mediocre company can be a great investment, at the right price.

Here is the bottom line. I don't think that Buffett's investment in Burlington Northern is a bet on the US economy or an expectation of a surge in profitability for railroads. I think it reflects a more prosaic choice. Buffett thinks he is getting a good deal for the company at the current price, and he has history on his side. The best investments in the market are often among the companies that are viewed as the least glamorous and most boring: Burlington Northern clearly fits the bill.

Insider Trading: My Perspective..

The recent arrest of Raj Rajaratnam, the founder of Galleon Group , a hedge fund, on charges of insider trading has generated responses from across the spectrum. At the one end, it is evoking the usual breast beating about insider trading and how unfair it is to the rest of us "non-inside" investors.
http://www.businessinsider.com/henry-blodget-moral-of-galleon-insider-trading-bust-only-fools-try-to-beat-the-street-2009-10
At the other, there are some who are pointing out that this case illustrates how ineffective insider trading laws are and that they should perhaps be abandoned.
http://online.wsj.com/article/SB10001424052748704224004574489324091790350.html
It is clearly a good time to offer my perspective on insider trading:

1. What is insider trading?
In it's most general form, insider trading refers to some investors trading on "proprietary information" that is not available to the rest of the market. The legal definition of insider trading, though, is a little more difficult to nail down. In the United States, insiders (managers of companies, directors etc.) are allowed to trade, as long at they meet two requirements:
a. They do not trade ahead of information events - acquisitions and earnings announcements, for instance - where they have access to the information prior to the rest of the world.
b. They report their trades to the SEC in filings.

Put another way, it is not illegal for a CEO or directors in a company to buy stock in the company, if they feel that it is under valued on a long term basis, even if that feeling is based upon information that only they have access to (project details). It is illegal for them to buy stock just before an acquisition or a big positive earnings surprise.

Looking at the allegations about Galleon, it seems clear that if the stories are true, the firm clearly broke insider trading laws by trying to get access to information about acquisitions, earnings announcements and other forbidden event-based information.

2. Does insider trading pay off?
Interesting question! At first sight, the answer seems to be obvious. Insiders know far more about the company than we do and should be able to leverage the information advantage into excess returns. The evidence, though, is surprisingly inconclusive. Studies that have looked at insider buying and selling as predictors of future stock prices find only a weak correlation, i,e., insider buying (selling) is not that good a predictor of stock price increases (decreases) in future periods.

One caveat about these studies is that they focus on the insider filings with the SEC. To the extent that the real insiders, i.e., the ones who are trading on real information rather than perception of value, will never register with the SEC, the suspicion is that these insiders make huge profits on their information.

Since Galleon is in the news, I decided to take a look at the returns that Galleon has made in recent years to see if they were able to convert their "illegal inside" information to higher returns. The Galleon Diversified fund, the flagship for the hedge fund, was up 22% this year, but is down 18% since its peak. Given the market performance over the period, the fund ranks close to the average. Across time, it is possible that Galleon made money using its access to "tips" from its moles in companies, but that does not seem to have generated a huge return.

I do not find it surprising. When you rely on tips from "insiders" for your investments, you generally find that four out of five tips never pan out (either because the information is bad or because the market reaction to the information does not follow the script), even when they come from those supposedly in the know. Insider trading is not a sure bet; it may not even be a good bet.

3. What should we do about insider trading?
I would like to live in a world where all investors have the same access to information and but I would also like to be able to go one-on-one against Lebron James. Life is not fair and investor access to information will vary across investors.

To me, the line between insider trading and savvy investing is a very hazy one, especially if you a short term investor. Analysts and investors often step across the line without even realizing they have.
http://www.nytimes.com/2009/10/20/business/20insider.html

I also think that banning insider trading is akin to laws forbidding alcohol or drugs. It does not make the problem go away but instead drives it underground and essentially leaves the profits from insider trading to those who are most unscrupulous among us.

I would suggest that we eliminate or at least reduce insider trading laws & restrictions and increase the transparency of the trading process. If you are trading on inside information but people can see you trading (and whether you are buying or selling), the benefits you will get will be time limited. Not only will this reduce profits from insider trading but also speed up how quickly prices adjust to information.

As a final note, insider trading cases provide excuses for the rest of us, who fail in our investing objectives. I have heard many small investors complain: "The reason I am not making any money on my portfolio is because the game is fixed." Enough of the self pity. The reality is that if your portfolio has lost money, insider trading is way down the list in terms of factors that caused those losses. In fact, my advice to those who worry about insider trading is simple. Trade as infrequently as you can and base your decisions on intrinsic value. Insiders hurt you only when you play their game, which is to try to trade short term on news (or what you think is news...) and rumors...

Equity Risk Premiums: An Update

As many of you are probably aware, I am fixated on equity risk premiums. To me they are at the center of almost every debate about equity markets - whether stocks are too low or too high, whether current market conditions are the norm or an aberration, and whether equity investors truly understand the risk associated with investing in equities.

I had a few posts during the crisis, where I noted that the implied equity risk premium for the S&P 500 had climbed at a rate never seen before in history during the twelve weeks between September 12, 2008 and late November. In fact, I reported an implied equity risk premium of 6.43% at the start of 2009, up from 4.37% at the start of 2008. The big debate at that point was whether this crisis had damaged investor psyches so much that it had caused a permanent upward shift in risk premiums, or whether this was just another bump in the road and that we would revert back to the 4% implied equity risk premiums, pre-crisis.

I have just posted an updated version of my equity risk premium paper online:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1492717
In the paper, I graph out the implied equity risk premium from January 2009 to September 30, 2009. On September 30, 2009, the implied equity risk premium stood at 4.86%. While I had anticipated at the start of the year that the premium would drift back down, I expected it to take much longer than 9 months. One more reason for constantly updating equity risk premiums! Markets are full of surprises.

The new debate that is unfolding is whether markets have gone up too far and too fast, thus exposing themselves to a correction. I don't know the answer to that question but it can be framed around the implied equity risk premium. If you think that the crisis should have changed people's attitudes about risk and that a 6% equity risk premium is the new steady state, markets are over bought and the correction will be painful (a 15%-20% drop in the S&P 500). On the other hand, if your view is that what happened last year is just part and parcel of equity risk and that investors will soon forget the scars and go back to the 4% risk premiums of 2007 and 2008, the bull market has a lot of steam left on it (a 10% up movement in the S&P 500). I am not giving away too much when I say that the long term equity risk premium that I am using for mature markets, when valuing companies, has been 5-6% since January 2009. At its current level of 4.86%, I am within reaching distance, but I will respond to the market on this number. I am not a market timer!

Bond Ratings: Why, how and what next?

In the aftermath of the bond market calamities (for investors and issuing companies), the ratings agencies (S&P, Moody's and Fitch) have come under assault from all sides. Legislators and regulators have accused them of being too close to the companies that they rate, with the implication that companies/bonds are being over rated. Academics have piled on, arguing that there is little information in bond ratings and that ratings agencies offer poor and delayed assessments of default risk. Finally, a few former employees have come forward with claims that bond ratings, at least in some cases, are stale and not backed up by serious research.
http://www.nytimes.com/2009/10/11/business/economy/11gret.html

I would like to at least step back and consider some broad issues related to ratings:

1. Why do we need bond ratings in the first place?
As long as there have been people on the face of this earth, there have been lenders and borrowers. For much of recorded time, a lender (money lenders in ancient times, banks in more recent periods) assessed the credit quality of a borrower and set the interest rate accordingly. It was the advent of the bond market in the last century that changed the dynamics and created the need for ratings agencies. When a company issues bonds and investors price these bonds, these investors do not have the resources to assess credit risk on their own. Ratings agencies stepped into the gap and provide this credit risk assessment. Thus, the ultimate service provided by bond ratings is to bond traders, and bond issuers benefit only indirectly.

2. What is the information content in a bond rating?
Ratings agencies have access to all of the financial information that the rest of us do - financial statements, past and present, analyst reports, industry analysis etc. In addition, they can ask for private information specifically related to default risk, which can then be used to finesse or modify the rating. The problem with the private information is that it comes from the management of the firm, which of course has an interest in providing more good news than bad news.

The simplest way to measure whether the market thinks there is information in a bond rating is to look at whether market prices of bonds change when their ratings are changed. The evidence there is mixed. While there is a consistent price change, with bond prices increasing (decreasing) on bond upgrades (downgrades), most of the price change seems to happen before the rating is changed. In other words, markets seem to anticipate ratings changes. That does not make ratings less useful but they are often lagged measures of default risk.

3. Is there a potential for conflict of interest and bias in ratings?
Going back to the origins of ratings, it is clear that bond buyers should be the ones paying for the ratings and they do so now, albeit indirectly. Ratings agencies are compensated by the companies that are rated, which does create a conflict of interest, though the conflict is nowhere near as intense as some other conflicts that bedevil us (such as auditors who have consulting revenue from the companies they audit or investment banks operating as deal makers & advisors on M&A deals). The price paid by companies is a relatively small one (3-5 basis points of the size of the issue) and it is not as if companies that are down graded can pull up stakes and refuse to be rated. (Let's face it. There are more ratings downgrades in a quarter than equity research analyst sell recommendations in a decade.) The price paid by companies is then passed on to bond buyers as a slightly higher interest rate on the bond.

There is a bigger potential for conflict of interest with mortgage backed securities and other bonds that are issued against pools of assets, not by companies by often by intermediaries. There, Moody's and S&P do have an interest in growing the market and attaching higher ratings does increase market growth, which increases future revenues and so on...

There is much talk now of changing this model but the alternatives are not that attractive. One is to charge a small tax on every bond sold, collect the proceeds in an entity (probably government run) which will then pay the costs to have all bonds rated. The question then becomes choosing the ratings agency (ies) to do the rating and the pricing mechanism (fixed price, auction). The other is to increase competition among ratings agencies, with the argument that competition will make them worry about getting rating right, though this would exacerbate the conflict of interest, at least in the short term.

4. What should we do going forward?
Before we pile on ratings agencies and blame them for our bond losses, we have to recognize that they were not the only ones to under estimate default risk. Most banks in developed markets made the same mistake, as is clear by the losses being written off on loan portfolios. Thus, I would not blame the ratings mistakes primarily on conflicts of interest or poorly trained ratings staff or some conspiracy the0ry too dastardly to behold. Rather, I think ratings agencies were caught up in the mood of the moment, just as the rest of world was, where housing prices always went up, people had permanently stopped defaulting and recessions were a thing of the past.

In closing, my fear is that we will throw the baby out with the bath water and make radical changes in the ratings process. Having valued companies in markets with bond ratings and in markets without, I can tell you with absolute conviction that I would rather deal with lagged and flawed bond ratings than no bond ratings at all.

Crisis Lessons: Presentation...

A few posts ago, I mentioned that I was working on a presentation reflecting the lessons that I learned from the crisis. I had also promised to post the presentation when it was ready. You can get it be clicking on the link below:

Market Revelations: Lessons learned, unlearned and relearned from the Crisis

While you can read about the specific lessons that I have taken away from the last year in the presentation, here are the general points I want to make:

1. These are the lessons that I have learned. In other words, this is my personal odyssey and I do not expect everyone to have learned these lessons, nor do I feel the urge to impose them on others.

2. The common theme across the many lessons is that I am much more wary about using past or historical data, whether it be at the company level (profitability, risk etc.) or at the macro level (equity risk premiums). Mean reversion, i.e., the assumption that numbers revert back to historical averages, has served us well, at least in developed markets for a long time, but a blind adherence to it can decimate companies and portfolios.

3. At a gut level, I feel that I have a better understanding of risk and the need for risk premiums now than before the crisis. Fundamentally, I believe that this crisis was precipitated by a belief that we can measure and control risk, when the nature of risk is that it cannot be ever fully measured or controlled.

4. I would not classify myself as a behavioral economist, but I am more willing to give behavioral finance a place at the table when we think about solutions to corporate finance and investment problems, after the crisis, than before.

The bottom line is that I feel humbled by all the things I do not know about finance and markets and excited at the prospect of exploring these things more.

Leveraged Buyouts

Yesterday's New York Times had a story (a sad one) on the troubles at Simmons, a mattress company with a long and illustrious history in the United States.
http://www.nytimes.com/2009/10/05/business/economy/05simmons.html
In short, the company was targeted for a leveraged buyout by Thomas H. Lee Partners, a private equity firm, in a transaction that went awry, partly because of miscalculations by the investors and partly because of the market crisis. The article is clear about who the "bad guys" in this story are and it is the private equity investors, who profited while a good company and its employees were destroyed.

I am always suspicious when the financial press sees things in black and white, since my experience is that life is full of shades of grey, but this article gives me a chance to vent about leveraged buyouts. If the message here is that private equity investors act in their self interest, my reaction is "Duh! Who does not?". If the message is that debt is the enemy, I am afraid the culprit is not Thomas H. Lee, but the tax code, which is tilted towards debt for some reason that I cannot fathom in pretty much every market in the world.

My problem with the way leveraged buyouts have been framed by both its proponents and opponents is the focus on leverage as the center of the transaction. To me, there are three components to a leveraged buyout:
a. The change in financial leverage: Changing the mix of debt and equity can help you exploit the tax code and increase your overall value (at the expense of taxpayers).
b. Control: In badly managed firms, changing the operating characteristics, i.e. investment and dividend policy, of the firm can increase value,
c. Public to private: To the extent that being a publicly traded firm forces you to make decisions to satisfy stockholders and analysts focused on the short term (at least in theory), going private may allow firms to make hard decisions that increase their value.
A good candidate for a leveraged buyout will derive value from all three levers. It will be an under levered, poorly managed firm, where there is a substantial gap between managers and stockholders.

In a blog post from November, I pointed to an extended treatise on the topic, where I look at an LBO transaction that failed, where Goldman and KKR tried to take Harman Audio private, and failed. My conclusion was that Harman was the wrong company to target for an LBO, because it did not have significant excess debt capacity, was already fairly well managed and a big stockholder was the CEO of the company.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1162862
What does this have to do with Simmons? I think that we are making a mistake when we assume that private equity investors are brilliant villains in LBO transactions. For every winner (like Thomas H. Lee in this specific transaction), there are many losers, and I would not be surprised if private equity investors are not net winners in this process.

The dangers of relative valuation

In my last post on Twitter, I hypothesized that the valuation of Twitter was based upon what investors had assigned as a value for Facebook a few months earlier. I want to make clear that I am not suggesting that this is a good way to value businesses but that it is the status quo.

With relative valuation, the dangers of a bad initial valuation cascading into subsequent valuations is high and they get worse when the initial valuation is of a large company (Facebook is large, by the standards of networking sites) and done by what is viewed as a reputable source (private equity investors have an ill deserved reputation for valuation expertise and a big investment banking name helps..) In fact, this may be one reason for pricing bubbles in sectors.

I can carry the relative valuation lessons here to an absurd limit. I have 15,000 + members on the mailing list for my website (damodaran.com). I would argue that this is a fairly valuable potential list for anyone with an investment or valuation product. Applying the $32.5/member to each member (a bargain, given the selection bias), my site should be worth half a million. Any takers? Better still, why not just your add your name to my mailing list and increase my value $32.5 by doing so? (The incentives for sites to seek out new members, even if they are idle and do nothing, is extremely high...)

I am kidding here, since I have no intent of making my site commercial. I have always argued that relative valuation, at least as it is practiced, is a sign of laziness because analysts are not only sloppy but throw out much of the data that they have access to. Relative valuation, done right, where you use not just the averages, but also look at the differences in valuations across companies to draw lessons about how the market values assets, can be a very useful tool in valuation.

What is Twitter worth?

Yesterday's big news story, at least in valuation circles, is that private equity investors have invested $ 100 million in Twitter for a roughly 10% stake, suggesting a billion-dollar valuation for the nascent company.
http://blogs.wsj.com/deals/2009/09/24/breaking-news-twitter-to-raise-100-million-from-insight-t-rowe-price-other-investors/
Twitter, for those who may be living in the middle ages, has about 30 million members who post short messages (less than 140 characters) that other members can read (if they choose to follow your tweeting). Every celebrity (sports, politics, media) seems to be tweeting now. There are three questions that came up after the story:

1. How did the equity investors in Twitter come up with the $ 1 billion value?
We assume degrees of sophistication to private equity investors and venture capitalists that they usually do not possess. In my experience, venture capital valuations often represent back-of the-envelope computations with hefty discount rates (target rates if 30-60%) taking care of the uncertainty. I was not privy to the valuation of Twitter but I can read the tea leaves and guess how they valued the company. A few months ago, Facebook (a company that Twitter aspires to be at least in the new term) raised equity from a group of Russian investors, who attached a value of $ 6.5 billion to the company. At the time. Facebook had approximately 200 million members, which works out to about $32.5/ member. As of last week, Twitter had about 30 million members. Applying the $32.5/member to this estimate, I get $975 million (suspiciously close to $ 1 billion). This may be pure coincidence but given the pull towards relative valuation on the Street, I think it may explain the valuation.

2. Could Twitter be worth $ 1 billion?
"Could" is a very weak word. Of course! What Twitter has going for it is the numbers. With 30 million members, all I need to be able to do is to generate a small cash flow from each one and the valuation will be justified. A billion dollar value for a firm requires that the firm be able to generate about $ 100 million in operating income in steady state. (I am applying a 10% cost of capital, typical of mature firms, and assuming zero growth). With 30 million members, that works out to $3.33/year from each member. If you are a Twitterer, the question I would have for you is this: Would you be willing to pay an annual membership fee of $ 5 or $ 10 to follow your favorite celebrities thoughts? If the answer is yes, the billion dollars is paid for... If not, I will keep looking...

3. Is Twitter worth $ 1 billion?
Interesting question. As an ongoing business, I don't think so and here is why:
a. You don't buy a business that does not have a business model yet. Twitter has a lot of members but it really does not know how to make money of these members (yet). Advertising alone will not do it. Any blatantly obvious way to earn money (such as charging per tweet) will very quickly decimate the membership. So, where will the additional profits come from?
b. You are buying a business that may be a fad, at the peak of its faddishness: Twitter is hot right now, because it is in the news. However, most of the tweets that I read are inane: it is tough to be profound 24 hours a day and to express that profundity (is that even a word?) in 140 characters.

However, I think that you can justify a $ 1 billion value for Twitter at least to some investors and that is to think of it as an option. What you are buying then, when you buy this firm, is access to 30 million potential customers, who may not know each other but are tied to one another. There are at least two types of investors who may find this investment appealing:
a. A firm with deep pockets and products/services that may be appealing to the membership of Twitter. The 30 million members of Twitter tend to be techno-savvy, older than Facebook members (on average) and well off. They also tend ot think well of themselves or at least their opinions. To illustrate, Microsoft did take a position in Facebook a few months ago and I can see other companies with products (especially in entertainment) do the same with Twitter.
b. Risk money: While no investor in his right mind should be investing the bulk of his portfolio in Twitter, it may be a good investment for risk money, i.e., money you want to invest in high risk, high reward investments and are willing to lose. Spreading your bets across multiple investments like Twitter may create a portfolio that has a good risk/return trade off, especially if you can bring some selection acumen to the process.

P.S: Facing the scorn of my teenage daughter, I created an account on Twitter about 6 months ago. I have never tweeted but I have 228 followers. Scary!!!!

Buybacks and Stock Prices..

Floyd Norris has an article in the New York Times on stock buybacks:
http://www.nytimes.com/2009/09/19/business/19charts.html?scp=1&sq=buybacks&st=Search
He notes that buybacks are high when stock prices are high and that they fall off when stock prices are low. His conclusion is that this is irrational because companies should be buying back more stock when the price is low and less when the stock is high. While there is a point to his argument, there are two points he is missing:

1. Buybacks are more about returning cash to stockholders and changing financial leverage than making judgments about stock price: There are two very good reasons, other than the perception that the stock is cheap, for buybacks. The first is that it is an alternative mechanism for returning cash to stockholders, instead of dividends. In addition to providing some tax advantages to investors over dividends, it also allows firms to be more flexible in returning cash over time. (Increasing dividends can be viewed as a long term commitment, whereas buybacks are not.) The second is that it can allow firms that are under levered, i.e., have too little debt in their capitalization, to increase their debt ratio. Buying back stock reduces the market value of equity and increases the debt ratio; if the buyback is funded with debt, the impact is doubled. Thus, one way to explain why companies bought back stock over 2006 and 2007 is that they felt cash rich and a combination of high equity prices and low bond default spreads led them to believe that they were under levered. The crisis may have led them to rethink both assumptions.

2. Even if it is about the price, is not the price per se that matters but the price relative to value: Even if we accept the premise that buybacks are driven by a desire to take advantage of under valued stock, that decision will be driven not by what the price is but what it is relative to perceived value. In other words, a company may buy back stock, when the price is $ 40, if it perceives the value to be $ 50. It will choose not to buy back the same stock, six months later, at $ 20, if the perceived value is only $ 10. The problem with correlating buybacks with stock prices, which is what Norris does, is that it misses the key component of value.

I do think that some US companies, especially in the financial sector, bought back too much in stock in the two years prior to the crisis. I attribute this to the "me too-ism" that is all too prevalent in corporate finance, where firms do, not what's best for them (and their stockholders), but what other firms are doing. Thus, many firms bought back stock because others were doing so, and in a sense, the trend fed on itself.

A Risk Argument: Democracies versus Dictatorships

A few days ago, Tom Friedman, the columnist for the New York Times, and best-selling author of books on globalization, evoked controversy when he opined that "one party autocracy" is not too bad if it is led by a "reasonably enlightened group of people, as China today". To be honest, I have never found Friedman's work to be particularly thought provoking, nor do I much care for his characterizations of globalization: flat earth, fat earth, round earth, whatever.... . However, his article did start me thinking about whether businesses face less risk or more risk in a democracy than in a dictatorship.

As a generalization, there is more day-to-day uncertainty when dealing with a democracy than with a dicatorship. A democratically elected government can offer policies that are favorable to business, but may either not be able to deliver them legislatively or have to modify them to meet public consent. A dictatorship operates under no such constraints and can deliver on its promises, albeit at substantial cost to some segments of its population. Furthemore, the nature of democracy is that governments change and policies change with them. The flip side is that dictatorships do not last forever, and a benign dictator today can become malignant one in the future. Policies can then be turned on their head and today's favored businesses may fall out of favor tomorrow.

The choice between democracies and dictatorships, in my view, boils down to whether you prefer to deal with the continuous, ongoing risk of operating in a democracy or the discontinuous risk of operating in a dictatorship. The former will manifest itself in a chaotic environment of changing rules, fiscal and monetary policies and exchange rate regimes. The latter may show up in periodic upheavals in policy, nationalizations (real or quasi) and a requirement that you pay due respects (or more) to policy makers.

I have argued in my book on strategic risk taking that it is far easier to deal with continuous risk than discontinuous risk for two reasons.

1. The first is that market traded instruments work better at dealing with continuous risk, whereas insurance, often imperfect, is the tool you need for discontinuous risk. To illustrate, compare floating exchange rates to fixed exchange rates. The former create more day-to-day uncertainty for businesses but is eminently hedgeable using options or futures contracts. The latter allows for long periods of stability, interspersed with sudden revaluations and devaluations of currencies, much more difficult to hedge.

2. Managers of firms in the (artificially) stable environments created by dictatorships are lulled into a false sense of complacency and are completely unprepared for the risks that inevitably follow. Managers of firms in chaotic environments learn to cope with change, one reason why I think these companies may have a competitive edge in the more uncertain global economies of the future.

Friedman's arguments are not new. Mussolini's supporters initially thought of him as benign and argued that he made the trains run on time, an incredible accomplishment in Italy. In later years, they discovered his dark side. I do not trust any group of people, no matter how well trained and intentioned, to make decisions for me for the rest of eternity. So, I come down on the side of democracy, chaotic and frustrating though it may be, because I can manage its risks better (both as an individual and a business) than I can in a dictatorship. We will have a ring side view of this tussle, and the strengths and weaknesses of both systems, as we watch the Indian and Chinese economies struggle for dominance over the next few decades.

One year later: The lessons from the crisis

It is hard to believe that it has been a year since the crisis started - September 15,2008, to be precise. The papers are full of retrospectives, with opinions often overwhelming the facts. I am working on my book on what I learned from the crisis in terms of how I approached valuation and corporate finance. I will post the presentation that I am putting together sometime in the next week.

While most of the articles in the media this week either rehash old stories or focus on human interest (such as looking at where Lehman's employees are today), there are two that I found particularly thought provoking.

1. The first was an article by Joe Nocera in the New York Times asking a question that I think is important. Did Lehman have to fail so that the rest of Wall Street could be saved?
http://www.nytimes.com/2009/09/12/business/12nocera.html?_r=1&pagewanted=1&_r

His basic thesis is an interesting one. Rather than view Paulson's decision to let Lehman fail, as a catastrophic mistake (the conventional wisdom for many months after the crash), he believes that Lehman's failure and the subsequent panic allowed the government to take actions that it could never have justified before to save AIG. The failure of AIG with its tentacles in every aspect of business would have been far more disastrous than Lehman, according to Nocera.

There is some truth to his argument. The failure of Lehman was not the problem but a symptom of the problem - hopelessly over inflated securities on the books of investment banks and terrible choices on risk. Saving Lehman would not have only have not solved that problem and may in fact have made it worse, by signaling to other banks that they too would be protected. However, I believe that the real mistake was saving Bear Stearns a few months prior. If Bear had been allowed to fail, Lehman may not have had to collapse, but I do understand that I have the benefit of hindsight.

2. The second set of articles that I think are interesting look at how Wall Street has changed (or not changed) as a result of the crisis. The consensus view here seems to be that Wall Street has returned to its old ways, securitizing everything under the sun and paying outlandish bonuses to employees. That does not surprise me. I have discovered that Wall Street is incapable of introspection and has almost no historical memory, for two reasons. The first is a self selection bias: people who choose to be investment bankers and traders prefer to act, rather than analyze, and look forward, not back: that is their strength and their weakness. The second is that success on Wall Street is measured with output - deals made, trading profits generated - rather than input - the quality of the deal making, whether the trading profits came from a sensible, well thought out system.

After every crisis, you hear the cry, "Never again"!! My response is "It is only a matter of time!".

Access to webcasts...

I have been web casting my classes for a few years now and it has always been a struggle maintaining open access. New York University would prefer to have the web casts be behind a password and I would prefer that they be open access. I think I have the upper hand, at least for the moment.

I do know that access to the web casts has been curtailed over the last few days. However, this is more the result of IT system upgrades than a deliberate attempt by NYU to restrict access. The problem should be fixed by next week and access should resume. I am sorry!

Commodity companies and commodity dependent markets

My trip to Peru started me thinking about commodity based companies and markets and how best to value them. It is fairly obvious that the value of a commodity company will be a function of the price of the commodity. As oil prices go up and down, the prices of oil companies will vary. Embedded in this obvious relationship, though, are several interesting valuation issues:

a. What is the best way to forecast future commodity prices?
There are two basic approaches. One is to trust price cycles and look at average prices across time. Implicitly, we assume that commodity price cycles are pre-determined and that they will go through the same up and down cycles that they have historically (perhaps adjusted for inflation). The second is to look at the demand and supply of the commodity: arguing that higher demand from the growing Indian and Chinese economies will push up the price of oil is an example. I think there is some value in both approaches and perhaps a melding of the two will yield the most reasonable forecasts.

b. Should you bring commodity price views into the valuation of commodity companies?
Even if you have a view on commodity prices for the future, should you bring those views into the valuation of commodity companies? Put another way, if you believe that oil prices will double over the next 3 years, should you use those predicted prices in valuing oil companies. In my view, you should not. By bringing in macro views into micro valuations, you create composite estimates of value that reflect not only your views of the company being valued but also of the underlying commodity. (If you believe that oil prices will double over the next 2 years, almost every oil company you value will look cheap) As the user of your valuations, I would prefer that you be commodity price neutral when you value companies and offer your commodity views separately. That way I can decide which aspect of your forecasting - the macro or micro part - I think is of higher quality and worth following. What exactly does being price neutral mean? You do not have to assume that oil or gold prices will remain at today's level forever. You can use forward market rates but you cannot super impose your views on top of these.

c. How do you differentiate between commodity companies that hedge against commodity prices from companies that do not?
Some commodity companies hedge against commodity price volatility, and in the process, under cut investors who buy their shares to make a bet on the commodity. In general, I do not favor this type of hedging, with two caveats. If a commodity company is either highly levered or feels that is competitive advantages are at the operating level (finding the right place to explore for a resource... mining efficiencies), it may want to reduce it risk of default and increase the focus on its competitive advantages by hedging against commodity price risk.


In my latest edition of the Dark Side of Valuation, I have a chapter on valuing commodity and cyclical companies. I have modified the chapter to make it a down-loadable paper. If you are interested, you can get the paper by clicking on this link.
Paper on commodity and cyclical companies

Hope you find it useful!

Peru and Brazil

I just got back from my trip to Peru and Brazil. My first stop was Lima, and I had a blast. The people are friendly and hospitable, the weather is balmy and the food is extraordinary. While I have explored only a small sliver of the country, my impression of the Peruvian market is that it is commodity driven. As the price of copper and silver goes, so goes Peru's stock market. As a result, the market resembles a roller coaster. Peru has been among the best performing markets in recent years, as commodity prices have been on an up cycle. While I am not a pessimist by nature, it is inevitable that commodity prices will come down, and when they do, the market will reflect that fall. I hope that the Peruvian economy (and market) can use the surplus from the commodity boom to jump start other businesses - consumer products, technology or food (why not?).

I am more familiar with Brazil, this being my 15th trip to the country, and am always glad to see Rio (Sao Paulo, less so... the traffic drives me bonkers). I talked about the lessons that I have learned from the crisis for corporate finance and valuation. The presentation I used is available online on my website at:
http://www.stern.nyu.edu/~adamodar/pdfiles/country/crisislessonsUpdated.pdf
Since this will be the genesis of my next book, your comments will be appreciated.

Emerging Markets... and maturity....

Sorry about the long hiatus between posts but I took family time off to go to California. I am three weeks away from a new semester starting but I am on my way to Peru and Brazil over the next few days to talk about valuation. I have never been to Peru before and am looking forward to seeing Lima for the first time. I have been to Brazil once or twice each year since 1998 and I am looking forward to this trip just as much.

While I will never know as much about Brazil as I would like to, I have had the opportunity to watch the market change over the last decade. While each emerging market is different, I think that some of the changes I have observed in Brazil are common across emerging markets, as they mature:

1. From Macro to Micro: When I did my first valuation seminar in Brazil for the first time in 1998, almost every question that I got during the seminar related to macro variables, with little or no attention paid to individual companies. If fact, we spent more time discussing inflation than we did discount rates, cash flows or terminal value. Coming off the hyperinflation of the previous decade, this focus was understandable and reflected the belief that if you were right about the macro variables, company-specific information mattered little. In recent years, attention has shifted more towards company characteristics, including managerial competence and the quality of investing and financing choices , a healthy development, in my view

2. Foreign to Local Currency: In the late 1990s, spilling over into the first half of the decade, almost every valuation I saw of a Brazilian company and much of the capital budgeting was done in US dollars. Not only was there a profound distrust of the local currency (Brazilian Reais) among analysts, but the Brazilian government and large Brazilian corporations seemed to share that distrust by issuing long term debt only in US dollars. Estimating a risk free rate in Brazilian Reais was an impossible exercise. It is only in the last few years that the resistance has broken down, with the Brazilian government issuing long term Reai bonds and valuations in local currencies.

3. Foreign to Domestic Investors: When I did my first few sessions in Brazil, appealing to foreign investors (especially US institutional investors) seemed to be the key priority for corporate treasurers and Brazilian investment banks. One measure of maturity has been the increasing focus on domestic investors in recent years, with foreign investors being viewed as icing on the cake.

Like any emerging market, there have been political and economic shocks along the way, but the sessions that I do in Brazil in a couple of days will resemble closely the sessions I do in New York or Frankfurt. To me, that is a healthy development. The value of an asset is a function of its cash flows, growth and risk and that lesson should not vary across markets. I will let you know how this Latin American jaunt goes...

Behavioral Corporate Finance 1: The Objective in Decision Making:

Every business needs a central objective that drives decision making. In traditional corporate finance, that objective is to maximize the value of the firm. For publicly traded firms, this objective often is modified to maximizing stock prices. In effect, any decision that increases stock prices is viewed as a good decision and any decision that reduces stock prices is a bad one. Implicitly, we are assuming that investors are (for the most part) rational and that markets are efficient, that stock prices reflect the long term value of equity and that bond holders are fully protected from expropriation.

A central theme of behavioral finance is that markets are not efficient and investors often behave in irrational ways. Consequently, stock prices can not only deviate from long term equity value but managers can exploit investor irrationalities for their own purposes. Asking managers to maximize stock prices in this environment can lead to decisions that hurt the long term value of the firm and in some cases put the firm's survival at risk. Behavioral finance theorists therefore argue that decision making should not be tied to stock prices, though they do not seem to have reached a consensus on what should drive business choices instead.

Here is where I come down in this debate. I agree with behavioral finance theorists that managers should not tailor decisions to keep investors (or analysts) happy in the short term. Too many firms have followed this path to destruction, by buying back stock or borrowing money, just because that is the flavor of the moment. Managers should focus on increasing long term value, but I think it is a mistake to ignore the messages that they get from market reactions to their decisions. When stock prices go up or down on the announcement of an action, there is some aspect of that action that is pleasing or troubling to investors. All too often, markets turn out to be right and managers to be wrong in the long term. In fact, managers who are convinced that their decisions will increase firm value are often operating under some of the same behavioral quirks that affect investors - they are over confident and systematically over estimate their abilities.

I think that the objective in decision making in a publicly traded firm should be value maximization with a market feedback loop.

In effect, managers should make decisions that maximize firm value but should use the stock price reaction to both frame those decisions in ways that appeal to investors, and modify the decisions themselves. Here is a simple illustration of how this process will work. Let us assume that you, as managers of a publicly traded firm, believe that the firm are over levered and that issuing new equity and retiring debt is the action you need to take to maximize long term firm value. Your initial announcement is greeted badly by investors, with your stock price going down. At one level, this reflects the fear (some may say irrational) of any action that increases shares outstanding - the dilution bogeyman. At another, it reflects skepticism about managerial claims that the firm is over levered. Here is how you could modify your decision to meet investor concerns/ beliefs. Rather than issue shares, you may raise equity using warrants (which do not seem to evoke the same fear of dilution) and provide more information to investors about why you believe that you are over levered. I know that there is no guarantee that this will work but I think it is worth a try.

Behavioral finance and corporate finance

I wrote my first corporate finance book in the 1990s and Corporate Finance remains my favorite subject to teach, since it forces me to think about how businesses should be run and not just about investing in these businesses. It is a constant reminder that it is great business people who create strong economies and not great investors. As a linear thinker who likes my ducks in a row, my vision of corporate finance has always been built around maximizing the value of a business (rather than stock prices) and how investing, financing and dividend policy should be set by a firm (private or public), with this objective in mind.

Over the last two decades, behavioral finance has become the fastest growing area in finance. Much of the early work was directed at how investors behave: studies indicated that investors suffering from over confidence, and with skewed estimates of their own ability and likelihood of success, tend to drive stock prices away from "rational" levels. In the last decade, behavioral finance has started making inroads into corporate finance, looking at how managers in publicly traded firms behave and finding, to no surprise, that they exhibit the same frailties that we see with the investing public. Over confident managers over estimate cash flows on projects, use too much debt and tend to feel that their stocks are under valued (thus explaining the reluctance to use new stock issues).

I must confess that I have been a skeptic about behavioral finance and there is almost no mention of it in any of my corporate finance books. I have tried to at least partially remedy that defect in the third edition of my Applied Corporate Finance book that will get to the book stores later this year. Why this capitulation and why now? Though it is easy to attribute everything to the market crisis of 2008, this has been building up for a longer period and these are some of my reasons:

a. Some of the initial work in behavioral finance was designed more for shock appeal and clearly aimed at shaking up establishment thinking (which needed shaking up). The early papers in the area took great glee in pointing out the failures of traditional finance but offered little in terms of how to do things better. In recent years, there have been two signs that the area is maturing. The first is that disagreements are popping up between behavioral finance researchers on key issues in behavioral finance. The second is that more of the literature in recent years has started looking beyond the descriptive component to prescriptions. In other words, rather than just tell us that managers fail to ignore sunk costs in decision making, we are seeing more discussion of how best to design systems that may minimize the costs from this tendency.

b. Traditional finance, by ignoring management (and human) proclivities, has given both theorists and practitioners an easy pass. It allows academics (who have never had to run a business) to lecture managers about how "irrational" they are in their decision making, and it allows managers to ignore basic principles on investing and financing, by pointing to the ivory towers that academics live in and the unrealistic assumptions they make to get to their conclusions.

As I tried to incorporate what I know about behavioral finance into my corporate finance big picture, I was struck by the tension between describing things as they are and describing things as they should be. It is true that managers often behave in ways that are inconsistent with traditional basic financial principles and it is also true that we can trace the way managers behave to quirks in human behavior. I understand why managers over invest, borrow too much or too little, are reluctant to issue new equity and buy back too much stock. I also believe that I cannot abandon talking about what managers should be doing and why their actions cost stockholders money. I tried my best to walk that fine line in my new edition and I will talk about my conclusions in pieces in the next few posts.

Losers and Winners: The inevitable consequence of risk taking...

I am still astounded by the incapacity of some in the financial media to see the obvious. As an example, consider this article from the Wall Street Journal today:
http://online.wsj.com/article/SB10001424052970204005504574233831651104814.html
If you cannot read the whole article, you are not missing a whole lot since I can summarize the basic theme as follows. A lot of the funds that were in the bottom 10% of last year's performers are in the top 25% of performers this year. As my 10-year old would say "Duh". Why is this a surprise? A risk taking fund will move back and forth between the best and worst performing funds on a period to period basis, based upon how the market does. A fund that is exposed to a great deal of market risk (high beta funds) will be among the best performers when markets do well and badly when markets do badly.

My problem with this article is that it tries to look for deeper meaning when there is really is none. The only good thing I can say about funds that did well this year is that they did not decide to become conservative at exactly the wrong time, but the ultimate test is whether you make money in the long term. There is little in the history of any of the funds mentioned in this article that fills me with confidence that they know what they are doing and that the returns that they are making in good years will cover what they will lose in the bad years.

Valuing declining and distressed companies

In my last post, I noted the difficulties that we face when valuing young companies. In particular, I noted both the difficulties we face in estimating cash flows for these firms and factoring in the possibility of failure. In many ways, we face the same problems at the other end of the life cycle, when valuing firms at the other end of the life cycle. In particular, declining and distressed firms share five characteristics:

1. Stagnant or declining revenues: Perhaps the most telling sign of a company in decline is the inability to increase revenues over extended periods, even when times are good. Flat revenues or revenues that grow at less than the inflation rate is an indicator of operating weakness. It is even more telling if these patterns in revenues apply not only to the company being analyzed but to the overall sector, thus eliminating the explanation that the revenue weakness is due to poor management (and can thus be fixed by bringing in a new management team).

2. Shrinking or negative margins: The stagnant revenues at declining firms are often accompanied by shrinking operating margins, partly because firms are losing pricing power and partly because they are dropping prices to keep revenues from falling further. This combination results in deteriorating or negative operating income at these firms, with occasional spurts in profits generated by asset sales or one time profits.

3. Asset divestitures: If one of the features of a declining firm is that existing assets are sometimes worth more to others, who intend to put them to different and better uses, it stands to reason that asset divestitures will be more frequent at declining firms than at firms earlier in the life cycle. If the declining firm has substantial debt obligations, the need to divest will become stronger, driven by the desire to avoid default or to pay down debt.

4. Big payouts – dividends and stock buybacks: Declining firms have few or any growth investments that generate value, existing assets that may be generating positive cashflows and asset divestitures that result in cash inflows. If the firm does not have enough debt for distress to be a concern, it stands to reason that declining firms not only pay out large dividends, sometimes exceeding their earnings, but also buy back stock.

5. Financial leverage – the downside: If debt is a double-edged sword, declining firms often are exposed to the wrong edge. With stagnant and declining earnings from existing assets and little potential for earnings growth, it is not surprising that many declining firms face debt burdens that are overwhelming. Note that much of this debt was probably acquired when the firm was in a healthier phase of the life cycle and at terms that cannot be matched today. In addition to difficulties these firms face in meeting the obligations that they have committed to meet, they will face additional trouble in refinancing the debt, since lenders will demand more stringent terms.

From a valuation perspective, using conventional discounted cash flow models can lead us to over value declining and distressed firms, where the possibility of distress is high. I think that we need to adjust the values that we obtain from DCF valuations for the likelihood that these firms will not make it. While there is no simple way to estimate the probability of failure, there are clues in the market that we can use to make reasonable estimates. I have a paper on the topic that you can download (if you are interested)

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1428022

Your comments are always appreciated.