Tuesday, March 29, 2011

Breach of Trust: Bank Valuation after the banking crisis

Until the banking crisis of 2008, investors had made a Faustian bargain, when it came to valuing and investing in banks. Banks were opaque in their public disclosures and investors often had little information on either the risk of the securities held or the default probabilities of loan portfolios. However, investors were willing to accept this opacity and view banks as "safe" investments for two reasons:
  1. Banks were regulated in their risk taking: In effect, we were assuming that bank regulators would bring enough scrutiny to the process to prevent banks from taking "rash" risks. (We also assumed that the regulatory authorities had access to far more information that we did and would act accordingly.)
  2. Assets (and equity capital) were marked to market: The notion of marking to market was adopted much more quickly in financial service firms than at other sectors. Our distrust of accounting notwithstanding, we assumed that the book values for banks actually were good reflections of market value.

How did this faith in the regulatory overlay get reflected in valuation/investing?
  • In intrinsic valuation, banks remained the last holdout for the use of the dividend discount model. Unlike other companies, where our distrust in managers paying out what they could afford to had led us to move on to free cash flows, we retained the faith that bank managers, constrained by the need to meet regulatory capital constraints on one hand and "dividend seeking" investors on the other, would pay out what they could afford to in dividends. (In effect, banks that paid too much in dividends would be punished by the regulators and those that paid too little in dividends would be punished by investors.) 
  • In relative valuation, the book value of equity in a bank was given more weight than in other sectors, because it was marked to market and subject to regulatory capital rules. Thus, price to book ratios (with returns on equity as companion variables) were widely used in analysis: a bank with a low price to book ratio and a high return on equity was viewed as a bargain. Worse still, risk averse investors were asked to buy the highest dividend yield banks and assured that these yields were secure.
So, what's changed? First, our faith in both bankers and regulators has been shaken, perhaps to a point of no return. We can no longer assume that having regulatory rules on risk taking will result in sensible risk taking at individual banks. There can be, as there are in other sectors, very risky banks, risky banks, safe banks and very safe banks, as a consequence. Second, the erratic and often ill-thought out dividend policies adopted by banks since the crisis indicates that bank managers, at many banks, use dividends as a blunt weapon. How else can you explain banks with precarious capital ratios that continue to pay and increase dividends, while raising fresh capital in preferred stock at the same time? In fact, it is a sign of the times that the Fed  stepped in to stop a major money center bank from paying dividends, as it did with Bank of America a couple of weeks ago.

So, what do we do now? In intrinsic valuation, we have two choices.
1. One is to use a modified version of the dividend discount model, where we estimate future dividends based upon expected growth and the return on equity that we foresee for a bank, rather than the actual dividends in the last period. Thus, if a bank is expected to grow at 8% and has a return on equity of 10%, it an afford to pay out only 20% of its earnings as dividends:
Payout ratio = 1 - Expected growth rate/ Return on equity
Thus, we can bring in both the quality of a bank's investments and expected changes in regulatory capital rules into the valuation. Increases in regulatory capital requirements will reduce the return on equity and by extension, the capacity to pay dividends.
2. The other and more complicated route requires knowledge of regulatory capital requirements and involves the following steps. You first estimate the growth in the asset base of the bank (growth in loans, for instance). You then follow up by estimating how much regulatory capital will be required to sustain the asset base - that will depend upon the risk in the asset base and the regulatory capital ratio that the bank wants to maintain. (Note that this ratio will not necessarily be at the regulatory minimum since conservative banks will maintain a buffer.) Changes in regulatory capital from period to period than take on the role that capital expenditures do in a more conventional firm and can be used to compute free cash flows to equity:
FCFE for a bank = Net Income - Change in Regulatory capital required for future growth
These FCFE are potential dividends and can be discounted to arrive at fair value. In fact the cost of equity for a bank can then be tied to its regulatory capital buffer: banks that build in a bigger buffer will be safer and have a lower cost of equity whereas banks that are more aggressive in both their asset holdings and regulatory capital policies will have higher costs of equity.

In relative valuation, I think that the use of price to book ratios, in conjunction with return on equity, still makes sense, but risk now has to be treated as a third dimension. The risk itself can be measured using a variety of measures: regulatory capital ratios (higher ratios are safer), losses on bad loans (higher is riskier) or holdings of toxic securities (higher is riskier). A bargain bank will then be one that trades at a low price to book ratio, has a high return on equity and is well capitalized. I expand on both notions in this paper that I wrote a couple of years ago on valuing banks (which subsequently became a chapter in one of my books):

I think that there are broader policy implications.
  1. More transparency in financial statements: Since banks have broken their side of the bargain with investors, we need to respond by removing the opacity from the financial statements of banks. Banks should be forced to provide far more detail about the riskiness of their security holdings and the default risk in the loans that they make. Much more information needs to be provided about regulatory capital requirements and the policies that banks adopt on regulatory capital should be more transparent.
  2. Regulatory capital has to be common equity: Banks that are under capitalized should be required to issue common stock, and face up to their fears of dilution. We need to scrap the notion that preferred stock (a tax-inefficient mismash) or convoluted hybrids (such as these) will be treated as equity, since it exposes us to game playing and worse.

I am not ready to give up on investing in banks. In fact, I am sure that some banks are great bargains and the payoff to finding these, in this time of greater uncertainty, is higher than ever before. But I will be more careful in my assessments of banks and not take numbers for given, just because they have been rubber stamped by regulators and appraised by accountants. That is more a promise to myself than to you!

Tuesday, March 22, 2011

Catastrophe and consequences for value

The airwaves have been inundated with news about natural disasters in Japan and their aftermath. Without minimizing the human impact - the thousands who have lost their lives and belongings - and the dangers of a nuclear meltdown, I want to focus on the impact of catastrophes, natural or man-made, on markets and asset values. While each disaster is different, here are some common themes that emerge after the disaster:

a. Our definition of "long time periods" is woefully inadequate: After the quake, which measured 8.9 on the Richter scale and ranked as one of the five strongest in recorded history, it was noted that nothing of this magnitude had been seen in Japan over the last 300 years. Since much of the regulation (of construction and nuclear power plants) had been structured based upon past history, they proved inadequate for the quake. As I look at how much of what we do in corporate finance and valuation is based upon time periods of 80-100 years (if we are lucky) and 10-20 years (if we are not), I wonder how much we are missing as a consequence of our dependence on the past.
 b. Experts are always "surprised" and are exceptionally good at ex-post rationalization: I am not that knowledgeable about earthquakes, but as I watched earthquake experts on the news in the days following the quake, I was struck by how much they reminded me of financial experts after the banking crisis in 2008 in their messages. First, for the most part, they admitted to be surprised by both the magnitude and the location of the quake (just as banking experts were surprised by the magnitude of and players in the sub-prime crisis). Second, they waxed eloquent about how uncertain they were about  long term consequences.... which leaves me wondering why we call them experts in the first place.
c. The doomsayers will have their day in the sun:  In the aftermath of every crisis, there will be people who emerge from the woodwork to say "I told you so". They will be feted as celebrities and treated as oracles, at least for a while. My response is less positive. After all, I have walked by the crazy preacher in Times Square almost every weekday, for close to 25 years, and he has warned me every single time that I have passed him that the end of the world was coming... He did sound prescient on September 12, 2001, but he was bound to, sooner or later. That is the reaction I have to those who preach doom and gloom all the time. They will be right at times but I will not attribute that success to wisdom but to accident....
d. Managing catastrophic risk exposure is much more difficult than managing continuous risk exposure: As companies and investors with Japanese risk exposure struggled with the aftermath of the disaster, I was reminded again of how much more difficult it is to manage and deal with discontinuous risk than continuous risk, especially if that risk occurs infrequently and has large economic consequences. In fact, this is the reason that I argued that companies that think that operating in authoritarian, stable regimes is less risky than operating in democratic chaos are mistaken. It is also the reason why managing exchange rate risk in a floating rate currency is much easier than managing that risk in a fixed rate currency.

I am not a deep thinker and am more interested in the prosaic than in the profound,  but I would like to address two questions that I have been asked in the last two weeks:

i. Are the markets reacting appropriately to the news?
While my instincts, based upon everything I know about behavioral finance, would lead me to say that markets  overreact to crises, I am not convinced by the analysis that I have read that make this argument with the Japanese tsunami. While much of the commentary has noted that the market value lost (in the Nikkei) has been disproportionally large, relative to the cost of of the damage, the definition of cost (as damage to existing assets) seems crimped.

As I see it, there are three levels of cost from any catastrophe:
a. Damage to existing assets: This is measured, either in terms of book value (or what was originally spent to build or acquire these assets) or replacement cost (to replace the damaged assets).
b. Loss of earnings power: The true value lost in a catastrophe is not the original cost, replacement cost or book value of the assets destroyed but the present value of cash flows lost in future periods as a result of the loss. Thus, when a factory with a book value or replacement cost of $50 million collapses, the value lost is the present value of the expected cash flows that would have been generated by the factory. If the firm was generating returns that exceeded its cost of capital, the value from the foregone cash flows will exceed $ 50 million.
c. Psychic damage: Catastrophes create psychic damage by reminding investors not only of their own mortality but of the fragility of the assumptions that they make to justify value. After all, in discounted cash flow valuations, we assume that cash flows  continue in perpetuity for most companies and that big chunks of value (especially for growth companies) come from expectations of excess returns from investments that firms will make in the future. To the extent that catastrophes shake this faith that investors have in the future, they can create significant damage to the value of growth assets.

The change in market value after a catastrophe will reflect these costs to varying degrees.
  • For mature businesses that generate little in terms of excess returns, the loss in value will approximate just the damage to existing assets (since the present value of cash flows should be close or equal to the book value). 
  • For mature businesses that generate returns on their investments that exceed the cost of capital, the value loss will be higher than the replacement cost or book value of existing assets and be more reflective of the lost cash flows. 
  • For growth firms, the loss in value can be extensive (as expectations of future growth get downgraded) even though they may suffer the least losses to existing assets.
If you are a contrarian or value investor, who believes that the psychic damage is transitory, there is an investment strategy that emerges from the rubble. It is not to invest in the entire market (all Japanese stocks) or in companies that have dropped the most in price (because some  may be mature companies like Tokyo Electric Power that have suffered significant loss of earning power), but to pick those companies where the price drop is more the result of the psychic reaction than the economic costs. (Multinationals like Honda, Toyota and Fuji that are Japanese in origin but have both their revenues and operations spread over the world would be a good place to start looking.) The risk, of course, is that the psychic damage is long term and not easily reversed.

ii. How do you incorporate the risk that catastrophes can occur in the future into valuation models?
If we define catastrophes as low-probability, high-impact events that affect most companies in an economy, there are three ways in which we can incorporate those events into value:
a. Adjust cash flows for an expected insurance cost: The simplest mechanism for building in the potential for catastrophes is to estimate the cost of insuring against catastrophes and building that cost into the expected cash flows. This, in turn, will lower the cash flows and value of every asset. It may be difficult to do for two reasons. The first is that some catastrophes may be uninsurable and getting an estimate of the insurance cost is not easy. The second is that even if there are insurers willing to provide coverage, a large enough catastrophe may render them incapable of backing up their promises (by making them insolvent). Note also that insurance covers only the first of the three levels of costs - damage to existing assets - and provides little protection against the other two levels - loss of expected cash flows and loss in growth asset value.
b. Use a higher risk premium: When buying risky assets, investors attach a risk premium to their required returns- an equity risk premium in the equity market and default spreads in the bond market. Since catastrophes affect entire markets, one way in which investors can build their likelihood (and consequent damage) into value is by charging higher risk premiums. As a consequence, the potential for catastrophe will have a much larger effect on risky, high growth firms than on safer,  mature companies. (The higher risk premium will push up costs of capital for all firms, but growth firms will be more affected since they get more of their value from cash flows way into the future.) To me, this seems to be the most viable option, especially when faced with risks that occur rarely, have large effects and are difficult to quantify in cash flow terms. I had an extended post on this a few months ago.
c. Allow for a higher probability of truncation risk: As I noted earlier, we value companies assuming cash flows in perpetuity (or at least for very long time periods), and catastrophes can put firms at risk of default or distress. When valuing companies (especially those with significant debt or other obligations), we should not only be more cautious about long term assumptions but also explicitly build into value, the likelihood that the firm will not survive.

Sunday, March 13, 2011

A tide in the affairs of men...

In my last post, I noted how difficult it is to separate luck from skill in  both investment and corporate finance.  While I remain leery of stock picking success stories (and believe me when I say I hear dozens each week), I continue to admire successful businesses of all stripes, from the bagel shop in my town that manages to sell out every day to Facebook in the social media world.

It is not that luck does not play a role in business success. In fact, most successful individuals and businesses can point to a stroke of good luck that got them started.  Microsoft was lucky that IBM allowed it to write the code that made the first personal computers work and Apple was lucky that music companies were too bullheaded to deviate from their traditional sales model of bundling a dozen songs on an album and forcing people to buy the entire package. It is what great companies do with that initial lucky break that set them apart: when they get lucky, they take that success and build on it. Most other businesses, however, view good luck as a windfall, report higher earnings for the year, but have little to show for it in the long term.

In fact, this was the reason I wrote my book on strategic risk taking. If the essence of risk taking is that you are going to be right some of the time and wrong the rest of the time, here is what I see separating good risk takers from bad ones. When good risk taking organizations get lucky and see upside from risk taking, they find ways to build on that upside. When they are confronted with unpleasant surprises, they manage to minimize their losses and move on. In option terminology, successful risk takers create their own call options to augment upside risk and put options to minimize downside risk. Of course, I am not the first to recognize this. Here is one of my favorite quotes from Shakespeare:
There is a tide in the affairs of men.
Which, taken at the flood, leads on to fortune;
Omitted, all the voyage of their life
Is bound in shallows and in miseries.
On such a full sea are we now afloat,
And we must take the current when it serves,
Or lose our ventures.

Brutus had a splendid grasp of risk taking (though I don't quite know where to put the stabbing of Julius Caesar in the risk taking scale).

Put in less lofty terms, each of us will be blessed with good luck in our investment and business endeavors at some point in time. What we do with that luck will determine whether it leaves a lasting mark or not. In the same vein, each of us will also be unlucky at some point in time and how prepared we are for that contingency will determine whether it will bring us down or just dent us.

Saturday, March 12, 2011

Luck versus skill: How can you tell?

A hedge fund manager doubles her investors' money over the course of a year.. A company's stock increases four fold over the course of six months.... these are not unusual news stories but they give rise to one of those enduring questions in finance: Was it luck or skill? The answer of course is critical. If it was "luck", we should not be giving the hedge fund manager 2% of our wealth and 20% of the profits. If it was skill, the company's managers deserve not just a huge thank you but commensurate financial rewards.

As always in finance, there are two extreme outlooks. At one end, there are those who view any superior performance as evidence of skill and extended superior performance as almost super natural. At the other end, there are those who who contend that it is all "luck" and that portfolio managers have any "discernible skill". As an illustration, Fama and French have a damning article on active portfolio management, where they note that all of the excess returns in practice can be explained by randomness:
In their assessment, all "superior performance" in portfolio management  can be attributed to luck. Here is a more recent paper by Andrew Mauboussin and Sam Arbesman that argues that there is some evidence of differential skill:
Needless to say, this is an issue where researchers have disagreed and continue to do so.

You may disagree with the broadness of the Fama/French conclusions (and I do), but they do point out how difficult it to differentiate lucky winners from skillful winners. To understand why, it is best to look at an arena where the differentiation between luck and skill is easier: sports. Even those who don't like Sachin Tendulkar, Lionel Messi, Tiger Woods or Kobe Bryant have to admit that they have skills the rest of us don't possess and that their success cannot be attributed to luck.  So, why is it so easy to separate skill from luck in sports and not so in finance? Separating luck from skill is easiest when:

a. Success is clearly defined: In basketball, you either make a basket or you do not. In cricket, you are out or you are not. In golf, you make par or you do not. In soccer, you score a goal or you do not.  An "almost a basket" or "almost par" can be a chatting point with a friend but does not count.

b. It is difficult to have a successful outcome with just luck: I will make a confession. I cannot shoot par on a golf course, make a three pointer in basketball or score a goal in soccer, even with luck.  I am awed when I see people do these things, since I know it requires skills that I do not have.

c. Number of trials: Professional sports players get hundreds of chances to show their wares, and luck very quickly drops to the wayside. You may make one three-pointer in the gym, with sheer luck, but if you were asked to shoot a few hundred three pointers, your limitations would be clear to all. There is no way that luck can explain the hundreds of sub-par rounds that Tiger Woods had (when he was a golfer and not a celebrity), the runs that Sachin scored for India, the points (and championships) for Kobe and the goals that Messi has scored for Argentina (and Barcelona) over time.

Looking at finance through these lens, it is easy to see why it is so difficult to separate luck from skill:

a. Success is not clearly defined: Is a portfolio manager who makes money for his investors a success? What about one who beats the S&P 500 each year? Is a company that delivers returns that outstrip the rest of the sector a success a "good" company? The very fact that we have to think about our answers to these questions tells you something about "success" in finance. To be successful, you have to beat your benchmark, after controlling for risk. However, since risk is a subjective measure, it is entirely possible for a portfolio manager to be classified as a success by one evaluator and not by another. With hedge funds and private equity managers, it becomes even more so, since the net risk exposure is often tough to measure.

b. It is easier being successful with just luck in finance:  I would not bet my house that my portfolio selections will deliver higher returns in the next year than those of my neighbor, who picks stocks based on astrological signs and has the financial sense of a dodo, or of my 11-year old son, who has never looked at the Wall Street Journal. As I note in my valuation class, there is no justice in the investing world. You can do everything right (collect the data, analyze it carefully, make reasoned judgments) and go bankrupt... and you can be absolutely cavalier in your investment judgments and make millions.

c. Too few trials: Can you be lucky once? Sure! How about 4 times in a row? Yes.. How about 15 years in a row? Not as easy, but with hundreds of people trying, a few will.... One problem that we face in portfolio management and corporate finance is that we get to observe outcomes too infrequently, making it difficult to separate luck from skill.

I don't mean to leave you in limbo. After all, most of us want to separate luck from skill in finance. So, here are the things that I would look for in a "skillful" portfolio manager or a CEO:

a. Consistency: As an investor, I don't want to just see that you beat the market, on average, but that you beat it consistently for an extended period. I am more likely to attribute your success to skill, if you beat the market by 2-3% each year for 15 years than if you beat the market by an average of 2-3%, with more variability and poor years intermixed, over that period.

b. Transparency: I tend to mistrust success, when that success is based on portfolio managers self-appraising the values of the properties and investments in their portfolios. A hedge fund may claim it made a 30% return last year, but if that return was based on appraised values for non-traded assets, did it really make 30%? If your success is based on skill and not luck, you should have as open a process as possible for measuring returns and risk and allow investors to observe that process.

c. Awareness: If you beat the market, you are pulling off a difficult feat, since there are literally millions of investors attempting to to do the same thing. If it is not luck that is causing the superior performance, you have to be able to point to something that you are bringing to the table that others are not - better information, better analytical tools, a longer time horizon or a very different tax status. If you don't know why you are beating the market, rest assured that you will not be beating the market for very long..... In my experience, the most skillful investors tend to not only be the most self aware (of their strengths and limitations) but also have no qualms about letting you know what their investment philosophy is. (Note that you can be secretive about investment strategies but you give away little by sharing an investment philosophy).

d. Humility: This is my subjective input to the process. In my years in the market, I have discovered that it is the lucky investors (with no skill) who are most hot headed and arrogant about their skills, and that skillful investors recognize how much luck can affect their final returns.

Here is my bottom line for a skillful portfolio manager or CEO: I am looking for a person who has been able to deliver performance that beats the competition consistently over many years, can tell you why he or she can pull this off and is willing to concede that luck could explain the whole phenomena....

Update: A couple of you have drawn my attention to Mike Mauboussin's excellent and extended discussion of the topic.
Mike is one of my favorite thinkers in finance - he is always original and manages to think across disciplines - and I don't know how I missed this piece but he says what I was trying to say much better than I ever could, and in much more depth. Do read it!

Tuesday, March 1, 2011

Behavioral Economics: Thoughts on Value and Price

I must confess that I was a skeptic on behavioral finance until a few years ago. At that point, the amount of information that had been accumulated on the "irrational" behavior of investors became so overwhelming that I faced one of two choices. I could ignore reality and live in the clean, rational world of classical economics or I could face up to facts and think about how investment and corporate finance decisions should be made in the messy world that we live in. After struggling with the conflict, I think I am making some progress. In an earlier post  on the third edition of my corporate finance book, I noted my attempts to incorporate the findings from behavioral finance into every aspect of corporate finance from how to create effective boards of directors to capital budgeting and capital structure decisions.

Reconciling behavioral finance with my view of the world has been tougher in my other area of interest: valuation. Every semester that I teach the valuation class, using the tools of the trade (discounted cash flow models, relative valuation), I am asked how I would incorporate the findings from behavioral finance into valuation. Here is my reaction. I don't think intrinsic valuation approaches will change much, if at all, as a result of behavioral economics. The expected cash flows are still the expected cash flows and  the required return still has to reflect the perceived risk in the investment.

So, what does change? Remember that to make money of your valuations, not only do you have to be able to value assets but the price has to move towards that value. Behavioral economics provides us with interesting insights on three dimensions:

a. Why do different analysts arrive at different estimates of value for the same company?  When you value a company, you are one of many doing so, often drawing on the same information as other investors, and often using the same models. So why do different analysts arrive at different estimates of value?  By looking at the interaction between psychology and valuation, behavioral economics yields interesting insights into why the values that we arrive at are different (and by extension, why some of us are buyers and others are sellers) and the systematic errors (over valuation or under valuation) that we make as a consequence.

b. Why does price differs from value? In the classical world, the price can deviate from value because investors make mistakes or because the price may reflect information that the analyst may not have or vice versa. With behavioral economics, we are learning that even if investors may behave in ways (refusing to sell losers, wanting to be part of the crowd, being over confident and misassessing probabilities) that cause prices to diverge from value by significant amounts.

c. When will they converge? Behavioral economics may provide us with clues about how quickly convergence between price and value will happen and why the speed may vary across assets. That would be incredibly useful to an investor. Thus, we may be able to answer a question that has historically eluded us: If I buy a cheap stock today (and I am right about it being cheap), how long do I have to wait before my bet pays off?

As investors, it behooves us to not only become conversant with the findings in behavioral finance but to also recognize when following instinct can damage portfolios. Meir Statman, one of my favorite behavioral economists, has written a great book on how investors can overcome their base urges and make better decisions:
I hope you get a chance to read it. There is much work to be done, but the foundations are being laid.