About a year ago, I agreed to do a series of seminars for the IFC, an arm of the World Bank that invests in privately owned businesses, primarily in emerging markets. The focus of the seminars was risk governance and the audience was directors in companies. While I was leery of getting entangled in the layers of bureaucracy that characterize the World Bank, I agreed to do it for two reasons. First, I had done the bulk of the work already in my book on Strategic Risk Taking (published by Wharton Press), published a couple of years ago. Second, I thought it would be interesting to talk about risk management, from a broader perspective.
Risk management, as practiced currently, is splintered among different disciplines. The risk hedging and measuring part has been taken over and reshaped by the finance folks, using numerical measures of risk such as beta and Value at Risk. The risk taking part has been hijacked by strategists, many of whom talk a good game, but are reluctant to put their ideas to any numerical test. Economists have largely sat out the debate, preferring to debate risk aversion in the rarefied world of utility functions. Statisticians have nipped at the edges, primarily pointing out what the rest of the crowd is doing badly.
I put together a presentation for a one-day seminar on risk management, from a corporate governance standpoint, and delivered it in four venues: Antigua (Caribbean), Bogota (Colombia), Lima (Peru) and St. Petersburg (Russia). I have turned over my slides for others to use in more venues, but my task is done. For closure, I decided to pull together the slides and create a manual for directors. While the IFC will be officially printing and distributing a variant of this manual, I want to make it available to anyone who wants it. You can download this manual by going to the following link:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1681017
For those of you who have my Strategic Risk Taking book, this is a compressed version, with the added bonus of tasks that you can use to assess how good risk management is in your firm. For those of you who do not have the strategic risk taking book, this manual captures the essence of my argument.
Saturday, September 25, 2010
Sunday, September 19, 2010
Past performance is no guarantee of future performance... but is anyone listening?
Most mutual funds end their advertisements with this statement: "past performance is no guarantee of future results". I don't know why they bother because investors don't seem to act like they care. In fact, one phenomenon that we know characterizes investors is that many of them try to invest in whatever asset class, fund or stock has done well in the past.
I was reminded of this return chasing phenomenon by an article I read on Permanent Portfolio, a fund that has been around a while but has generally struggled to survive for most of its life, with about $ 50 million in money under management a few years ago. Starting in 2007, the fund's assets have exploded and it is now up to $ 5 billion. Its growth coincides with its superb performance over the period.
http://online.wsj.com/article/SB10001424052748704858304575497662644720960.html?mod=WSJ_hps_MIDDLEThirdNews
So what? Only about a third of the fund is invested in stocks; 25% is invested in gold and silver and 35% in cash. Its performance over the last three years can be explained largely by the fact that it is under weighted in stocks and over weighted in precious metals. In other words, its success comes almost entirely from its asset allocation, rather than asset selection.
History provides a cautionary note on why return chasing often comes to a bad end. Momentum investing, which is what this comprises, requires two components to succeed:
1. Long runs in returns. You need asset prices to move in the same direction for long periods. If good years are followed by bad years and vice versa, you will end up with whip lash as a momentum investor. In statistical terms, you need strong positive correlation in returns across time. Whether there are long runs in returns is an empirical question and there is evidence that is hopeful. There have been long historical runs (positive and negative) in returns in stock and bond markets and even longer runs in currency and commodity markets. The evidence is less positive when it comes to individual stocks; while there is some short term momentum, it is much weaker than in the asset marekts. Thus suggests that momentum investing is more likely to pay off for market timers playing the asset allocation game than for individual stock pickers.
2. Detecting the end of the runs: All good things come to an end and long runs in prices (up or down) end at some point in time, with the size of the correction directly proportional to how long the run lasted in the first place. A momentum investor can see years of positive returns wiped out in the course of a few weeks or even days. The evidence is not as positive on this factor. Models and investors that claim to detect imminent market corrections don't do very well, at least in the long term. However, there may still be hope. I am not a great believer in technical analysis, but this is is one place where price and volume charts may help, especially in assessing how close to the cliff you are. I have a chapter on momentum investing in my investment philosophies book that you may find interesting and you can download it by clicking below.
http://www.stern.nyu.edu/~adamodar/pdfiles/invphil/ch7.pdf
If you are a momentum investor, making money on your gold investment right now, I am happy for you. I just hope that you have a mechanism that will tell you when it is time to get out. With momentum investing, knowing when to sell is even more important than knowing when to buy.
I was reminded of this return chasing phenomenon by an article I read on Permanent Portfolio, a fund that has been around a while but has generally struggled to survive for most of its life, with about $ 50 million in money under management a few years ago. Starting in 2007, the fund's assets have exploded and it is now up to $ 5 billion. Its growth coincides with its superb performance over the period.
http://online.wsj.com/article/SB10001424052748704858304575497662644720960.html?mod=WSJ_hps_MIDDLEThirdNews
So what? Only about a third of the fund is invested in stocks; 25% is invested in gold and silver and 35% in cash. Its performance over the last three years can be explained largely by the fact that it is under weighted in stocks and over weighted in precious metals. In other words, its success comes almost entirely from its asset allocation, rather than asset selection.
History provides a cautionary note on why return chasing often comes to a bad end. Momentum investing, which is what this comprises, requires two components to succeed:
1. Long runs in returns. You need asset prices to move in the same direction for long periods. If good years are followed by bad years and vice versa, you will end up with whip lash as a momentum investor. In statistical terms, you need strong positive correlation in returns across time. Whether there are long runs in returns is an empirical question and there is evidence that is hopeful. There have been long historical runs (positive and negative) in returns in stock and bond markets and even longer runs in currency and commodity markets. The evidence is less positive when it comes to individual stocks; while there is some short term momentum, it is much weaker than in the asset marekts. Thus suggests that momentum investing is more likely to pay off for market timers playing the asset allocation game than for individual stock pickers.
2. Detecting the end of the runs: All good things come to an end and long runs in prices (up or down) end at some point in time, with the size of the correction directly proportional to how long the run lasted in the first place. A momentum investor can see years of positive returns wiped out in the course of a few weeks or even days. The evidence is not as positive on this factor. Models and investors that claim to detect imminent market corrections don't do very well, at least in the long term. However, there may still be hope. I am not a great believer in technical analysis, but this is is one place where price and volume charts may help, especially in assessing how close to the cliff you are. I have a chapter on momentum investing in my investment philosophies book that you may find interesting and you can download it by clicking below.
http://www.stern.nyu.edu/~adamodar/pdfiles/invphil/ch7.pdf
If you are a momentum investor, making money on your gold investment right now, I am happy for you. I just hope that you have a mechanism that will tell you when it is time to get out. With momentum investing, knowing when to sell is even more important than knowing when to buy.
Friday, September 17, 2010
Checks and Balances: Eisner and Disney
I just read about a forthcoming book, written by Michael Eisner, ex-Disney CEO, titled "Working Together: Why great partnerships succeed". My first reaction was incredulity.. What next? Madonna on "The Importance of Celibacy" and Bernie Madoff on "Investing Wisely"...
As some of you may know, I have used Disney as my laboratory case study in my applied corporate finance book through three editions and fifteen years. I love the company and its products but have not always cared for its management. In fact, I have been particularly harsh about Eisner, who I think did serious damage to the company, especially in the last decade of his tenure.
While I have not had a chance to read Eisner's book yet, I was interested to read that he used his partnership with Frank Wells as one of the great partnerships that succeeded. On that count, I completely agree. When Eisner came to Disney as CEO, from Paramount, the company was moribund; its theme parks were getting old, its animated movies lacked pizzazz and the ghost of Walt Disney wandered through the halls. Eisner, with his then side-kick Jeff Katzenberg, brought a fresh energy to the company that was complimented by the operating savvy of Frank Wells, Disney's Chief Operating Officer. Wells operated as a check on Eisner, channeling his visions to practical success. By 1994, the two men had turned Disney around and put it on the path to being an entertainment powerhouse.
In 1994, Wells died in a helicopter crash and the only person in the company capable of reining in Eisner was gone. Eisner packed the Disney board with me-too directors, far too eager to rubber stamp whatever he did, and he let his manias and paranoia run rampant. Disney made investments it should not have made (buying Capital Cities was a mistake; it is revisionist history to claim, as Eisner does, that he bought ABC to get ESPN, since he could have bought just ESPN for a fraction of the $ 18 billion he paid for the entire company) and did not make investments it should have (buying Pixar early in the game for millions rather than wait a decade and pay billions), fired people who should not have been fired and did not fire people it should have. By 2003, stockholders in Disney were in full revolt and deservedly so; the company's earnings had plateaued and its stock under performed the market.
My larger point, though, is not about Disney, but about why we needs checks and balances in positions of power. Even the smartest, best-intentioned individuals have weaknesses. At some point in time, without constraints, these weaknesses rise to the surface and subsume the successes. When we push for stronger, more independent boards of directors, it is not because we operate under the illusion that such boards will make bad managers into good ones, but that they will keep good managers from going over to the dark side. We will never know how much good Eisner could have continued to do in Disney, if he had a strong board of directors to guide him, confront him and sometimes stop him or slow him down.
As some of you may know, I have used Disney as my laboratory case study in my applied corporate finance book through three editions and fifteen years. I love the company and its products but have not always cared for its management. In fact, I have been particularly harsh about Eisner, who I think did serious damage to the company, especially in the last decade of his tenure.
While I have not had a chance to read Eisner's book yet, I was interested to read that he used his partnership with Frank Wells as one of the great partnerships that succeeded. On that count, I completely agree. When Eisner came to Disney as CEO, from Paramount, the company was moribund; its theme parks were getting old, its animated movies lacked pizzazz and the ghost of Walt Disney wandered through the halls. Eisner, with his then side-kick Jeff Katzenberg, brought a fresh energy to the company that was complimented by the operating savvy of Frank Wells, Disney's Chief Operating Officer. Wells operated as a check on Eisner, channeling his visions to practical success. By 1994, the two men had turned Disney around and put it on the path to being an entertainment powerhouse.
In 1994, Wells died in a helicopter crash and the only person in the company capable of reining in Eisner was gone. Eisner packed the Disney board with me-too directors, far too eager to rubber stamp whatever he did, and he let his manias and paranoia run rampant. Disney made investments it should not have made (buying Capital Cities was a mistake; it is revisionist history to claim, as Eisner does, that he bought ABC to get ESPN, since he could have bought just ESPN for a fraction of the $ 18 billion he paid for the entire company) and did not make investments it should have (buying Pixar early in the game for millions rather than wait a decade and pay billions), fired people who should not have been fired and did not fire people it should have. By 2003, stockholders in Disney were in full revolt and deservedly so; the company's earnings had plateaued and its stock under performed the market.
My larger point, though, is not about Disney, but about why we needs checks and balances in positions of power. Even the smartest, best-intentioned individuals have weaknesses. At some point in time, without constraints, these weaknesses rise to the surface and subsume the successes. When we push for stronger, more independent boards of directors, it is not because we operate under the illusion that such boards will make bad managers into good ones, but that they will keep good managers from going over to the dark side. We will never know how much good Eisner could have continued to do in Disney, if he had a strong board of directors to guide him, confront him and sometimes stop him or slow him down.
Thursday, September 9, 2010
Capital Structure: Optimal or Opportunisitic?
Contrary to the prediction of doomsayers during the banking crisis of 2008, firms seem to be returning with a vengeance to the debt markets. Today's story in the Wall Street Journal provides some details:
http://online.wsj.com/article/SB10001424052748703453804575479712501514050.html?mod=WSJ_hps_LEFTWhatsNews
Finding the right mix of debt and equity to fund a business remains one of the key components of corporate finance. The contours of the choices are clearly established.
On the plus side: Using debt instead of equity to fund investments generates tax benefits in most countries, since interest expenses are tax deductible and dividends are not. Debt may also provide some "discipline" to managers of mature companies with large positive cash flows.
On the minus side: Debt increases the possibility of financial distress and/or bankruptcy, with all its potential costs. The tussle between whats good for stockholders and bondholders' interests manifests itself in covenants that restrict investment and financing choices and in monitoring costs.
There are tools for assessing optimal capital structure as well. One is the cost of capital; in effect, the mix of debt and equity that yields the lowest cost of capital is the "optimal" mix. Another is Adjusted Present Value (APV), where a firm is first valued as if it were all equity funded (unlevered) and the net value added from debt is computed as the difference between the tax benefits and the expected bankruptcy costs. The mix that maximizes overall firm value is the "optimal" mix.
So, what has changed between a few months ago and now that would explain this surge of debt financing? It is unlikely that the tax benefits of borrowing have surged or that expected bankruptcy costs have dropped; the former explanation would have made sense if corporate tax rates were expected to rise in the future and the latter would have worked if the economy had strengthened significantly over the period. I think the answer lies in evidence that behavioral finance has uncovered about how companies make financing decisions; my colleague at NYU, Jeff Wurgler, has the seminal paper on the topic. Rather than weigh the costs and benefits of debt and come up with optimal or target debt ratios, firms seem to make their financing choices based upon perceptions of the cheapness (or costliness) or debt as opposed to equity. Thus, they tend to flood the market with bond offerings, when they perceive the cost of debt to be low and with equity offerings, when they perceive their stock to be over priced. I would term this "opportunistic capital structure". The drop in treasury bond rates and the decline in default spreads (as the Greek crisis has receded) has led to much lower borrowing rates, especially for highly rated companies.
What's wrong with this? There are two potential dangers:
a. Perception may not be reality: Perceiving the cost of debt is low does not make it so. When CFOs make assessments of the relative costs of debt and equity, they are trying to be market timers. Given the sorry track record that portfolio managers have on timing equity and bond markets, I would be wary about CFOs who claim special powers on this issue.
b. Short term gain versus long term pain: Even if CFOs are good market timers and the cost of debt is low (relative to equity), is it a good idea to go out and fund your projects predominantly with debt? I don't think so. Over time, the firm will end up with too much debt, and over time, the cost of debt will revert back to historic norms. As with homeowners who borrowed because rates were low between 2004 and 2007, the day of reckoning will come and it will be painful.
Here is my compromise solution. Rather than pick an optimal or target debt ratio, a firm should choose a range for the optimal; in other words, a 20-40% optimal debt ratio, rather than 30%. Firms can then be opportunistic but only within this range; thus, you would move to a 40% debt ratio, if you believe that that the cost of debt is low or to a 20% debt ratio, if you think your equity is over priced. That would constrain over confident CFOs from pushing the debt ratio to unsustainable levels.
http://online.wsj.com/article/SB10001424052748703453804575479712501514050.html?mod=WSJ_hps_LEFTWhatsNews
Finding the right mix of debt and equity to fund a business remains one of the key components of corporate finance. The contours of the choices are clearly established.
On the plus side: Using debt instead of equity to fund investments generates tax benefits in most countries, since interest expenses are tax deductible and dividends are not. Debt may also provide some "discipline" to managers of mature companies with large positive cash flows.
On the minus side: Debt increases the possibility of financial distress and/or bankruptcy, with all its potential costs. The tussle between whats good for stockholders and bondholders' interests manifests itself in covenants that restrict investment and financing choices and in monitoring costs.
There are tools for assessing optimal capital structure as well. One is the cost of capital; in effect, the mix of debt and equity that yields the lowest cost of capital is the "optimal" mix. Another is Adjusted Present Value (APV), where a firm is first valued as if it were all equity funded (unlevered) and the net value added from debt is computed as the difference between the tax benefits and the expected bankruptcy costs. The mix that maximizes overall firm value is the "optimal" mix.
So, what has changed between a few months ago and now that would explain this surge of debt financing? It is unlikely that the tax benefits of borrowing have surged or that expected bankruptcy costs have dropped; the former explanation would have made sense if corporate tax rates were expected to rise in the future and the latter would have worked if the economy had strengthened significantly over the period. I think the answer lies in evidence that behavioral finance has uncovered about how companies make financing decisions; my colleague at NYU, Jeff Wurgler, has the seminal paper on the topic. Rather than weigh the costs and benefits of debt and come up with optimal or target debt ratios, firms seem to make their financing choices based upon perceptions of the cheapness (or costliness) or debt as opposed to equity. Thus, they tend to flood the market with bond offerings, when they perceive the cost of debt to be low and with equity offerings, when they perceive their stock to be over priced. I would term this "opportunistic capital structure". The drop in treasury bond rates and the decline in default spreads (as the Greek crisis has receded) has led to much lower borrowing rates, especially for highly rated companies.
What's wrong with this? There are two potential dangers:
a. Perception may not be reality: Perceiving the cost of debt is low does not make it so. When CFOs make assessments of the relative costs of debt and equity, they are trying to be market timers. Given the sorry track record that portfolio managers have on timing equity and bond markets, I would be wary about CFOs who claim special powers on this issue.
b. Short term gain versus long term pain: Even if CFOs are good market timers and the cost of debt is low (relative to equity), is it a good idea to go out and fund your projects predominantly with debt? I don't think so. Over time, the firm will end up with too much debt, and over time, the cost of debt will revert back to historic norms. As with homeowners who borrowed because rates were low between 2004 and 2007, the day of reckoning will come and it will be painful.
Here is my compromise solution. Rather than pick an optimal or target debt ratio, a firm should choose a range for the optimal; in other words, a 20-40% optimal debt ratio, rather than 30%. Firms can then be opportunistic but only within this range; thus, you would move to a 40% debt ratio, if you believe that that the cost of debt is low or to a 20% debt ratio, if you think your equity is over priced. That would constrain over confident CFOs from pushing the debt ratio to unsustainable levels.
Wednesday, September 8, 2010
Time for class!!
I am getting ready for the first day of my Fall 2010 Valuation class and am just as excited as I was the day that I taught my first class. I taught my first valuation class in 1986 and have taught it every year since (twice a year, in most years). I am often asked whether I get bored, teaching the same class over and over. Not for a second, and here is why:
1. The issues that we face in valuation change constantly. When I first started teaching the class, the big issue was recapitalization, as many large US companies were shifting to using more debt in their capital structure. In the 1990s, interest shifted to valuing technology companies, in general, and young technology companies, in particular. The last decade saw the rise of emerging market companies in the first part and the banking crisis, towards the end. My lectures and notes reflect these shifts.
2. First principles endure: While the issues and challenges that we face in valuation change constantly, I have adhered to the same first principles over time. In fact, it is these first principles of valuation that I return to, at times of uncertainty and crisis, to look for answers. I truly believe that if you "get" these first principles, you are capable of answering any question in valuation, and I view that as one of the primary objectives for this class.
3. The audience changes: As any teacher knows, the material may stay the same but the experience of a class can change, depending on audience interaction and background.
4. It is theater: I love having an audience (even if it is a captive one), especially since I get to review their performance, rather than the other way around. What actor would not kill for this set up?
I invite you to join in and follow the class. The lectures will be webcast, though not in real time. You can download them and watch them on your computer or iPod, or watch it as a streaming video. You can get the lecture notes, follow my emails and even take the quizzes/exam (you have to grade them yourself, but I will put my grading template online). Everything you need should be at this link:
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/equity.html
Just a note of caution. You will not get credit for the class but I hope that the material is worth the effort. Let me know if there is something I can add (at low cost in terms of time) to the website to make your experience better.
1. The issues that we face in valuation change constantly. When I first started teaching the class, the big issue was recapitalization, as many large US companies were shifting to using more debt in their capital structure. In the 1990s, interest shifted to valuing technology companies, in general, and young technology companies, in particular. The last decade saw the rise of emerging market companies in the first part and the banking crisis, towards the end. My lectures and notes reflect these shifts.
2. First principles endure: While the issues and challenges that we face in valuation change constantly, I have adhered to the same first principles over time. In fact, it is these first principles of valuation that I return to, at times of uncertainty and crisis, to look for answers. I truly believe that if you "get" these first principles, you are capable of answering any question in valuation, and I view that as one of the primary objectives for this class.
3. The audience changes: As any teacher knows, the material may stay the same but the experience of a class can change, depending on audience interaction and background.
4. It is theater: I love having an audience (even if it is a captive one), especially since I get to review their performance, rather than the other way around. What actor would not kill for this set up?
I invite you to join in and follow the class. The lectures will be webcast, though not in real time. You can download them and watch them on your computer or iPod, or watch it as a streaming video. You can get the lecture notes, follow my emails and even take the quizzes/exam (you have to grade them yourself, but I will put my grading template online). Everything you need should be at this link:
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/equity.html
Just a note of caution. You will not get credit for the class but I hope that the material is worth the effort. Let me know if there is something I can add (at low cost in terms of time) to the website to make your experience better.
Wednesday, September 1, 2010
Unstable risk premiums: A new paper
I am back from a long hiatus from posting, but I had nothing profound (even mildly so) to post and I was on vacation for a couple of weeks and Latin America last week.
As many of you have read in my postings, I am working on a book where I look at shaking up some of the fundamental assumptions that underlie modern finance. My first chapter on "what if nothing is risk free?" was posted about four weeks ago and you can still get to it by going to:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1648164
My second chapter builds on a theme that has been a bit of an obsession for me on risk premiums and how they have become more unstable, unpredictable and linked across markets. The paper titled,
A New Risky World Order: Unstable Risk Premiums - Implications for Practice, is now ready to download and you can get to it by clicking on the link below.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1669398
The paper is long (about 60 pages) but hopefully not verbose. A great deal of what I say in the paper, I have said before in my papers and posts on equity risk premiums. The difference in this paper is two fold.
I am working on my third chapter of the book: What if nothing is liquid?, where I hope to look at what would happen to valuation and corporate finance practice, if markets essentially shut down. I hope I will have something interesting to say.
As many of you have read in my postings, I am working on a book where I look at shaking up some of the fundamental assumptions that underlie modern finance. My first chapter on "what if nothing is risk free?" was posted about four weeks ago and you can still get to it by going to:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1648164
My second chapter builds on a theme that has been a bit of an obsession for me on risk premiums and how they have become more unstable, unpredictable and linked across markets. The paper titled,
A New Risky World Order: Unstable Risk Premiums - Implications for Practice, is now ready to download and you can get to it by clicking on the link below.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1669398
The paper is long (about 60 pages) but hopefully not verbose. A great deal of what I say in the paper, I have said before in my papers and posts on equity risk premiums. The difference in this paper is two fold.
- I expand my analysis to look at risk premiums in different markets - default spreads in bond markets and real asset premiums in real asset markets. In the process, I can examine how risk premiums in different markets have begun more moving together and how divergences across markets can be used to fine tune both investment and corporate financial decisions.
- I do present a template that can be used by practitioners to choose between the bewildering array of risk premium estimates that are out there. When should you use a current premium and when should you use a historical premium?
I am working on my third chapter of the book: What if nothing is liquid?, where I hope to look at what would happen to valuation and corporate finance practice, if markets essentially shut down. I hope I will have something interesting to say.
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