Musings on Markets: April 2020

Friday, April 24, 2020

A Viral Market Update VII: Mayhem with Multiples

I get a sense that I am approaching the end of this series of weekly posts, or perhaps I am just hoping that it is true, as the COVID crisis continued to play out in markets in the last two weeks, albeit on a more subdued scale and with a more positive twist. In this post, I will, as in the prior weeks, update the prior weeks’ market action (for two weeks, from April 4 to April 17) in different asset classes, and within equities, across regions, sectors and stock classifications. I will close this post by looking at how pricing tools, including a range of multiples (from PE ratios to price to book to EV to EBITDA multiples) will become shakier and less reliable in the aftermath of the crisis, and suggest ways in which we can compensate for the uncertainties.

Asset Classes

I started my crisis clock on February 14, reflecting the fact that I am US-based, and markets outside China did not wake up to the crisis until that week. In the weeks since, we have seen volatility rise and equity markets get whipsawed, with much of the pain being dispensed in February and the first three weeks in March. In the last month, equity indices around the world have seen positive returns, and in some cases, very good positive returns, as can be seen in the table below.

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The week of April 10 to April 17 was a benign week, at least in sum, even though individual days still brought big movements, with most indices flat for the week. Moving on to the treasury market, we also saw steadiness, with both short and long term rates staying close to the lows that they hit just two weeks ago.

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Looking at commodity prices, the divergence between oil and copper illustrated again the unique travails of oil, where a detente between Russia and China did little to stop oil prices from continuing to drop, while copper prices changed little.

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In the two months since February 14, oil prices have dropped more than 65%, providing a contrast to copper, another commodity sensitive to the global economy, which has declined less than 10%. (To top of the craziness, the price of futures on Texas crude dropped below zero on April 20, but that is a story for another day/post.)

To complete the picture, I looked at gold and bitcoin, and while both have settled into holding patterns, the divergence since February 14 is stark.

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In sum, gold has held its own, increasing 6.3% since February 14, though investors holding it were undoubtedly expecting a bigger pop, given the economic and market chaos, but bitcoin has disappointed those who believed it would play the role of a crisis asset, down 31% since the start of this crisis.

Risk Update

In my last post, I focused on how the price of risk has changed since February 14, 2020, starting with the corporate bond market, where default spreads have changed significantly over the last few weeks.

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Note the surge in default spreads across bond ratings classes from February 14, 2020 to March 3, 2020, though there has been a drop off from highs in the last two weeks. The fear that has played out in the bond market has also affected the price of risk in equity markets. In the graph below, I updated the equity risk premiums, by day, that I computed in my post two weeks ago, through April 17.

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The implied equity risk premium which I computed to be 6.01% on April 1, 2020, has declined to 6.27% if I compute the risk premium using the (now stale) earnings and cash flows, and 5.60%, if I assume a 30% drop in S&P 500 earnings this year and a substantial drop in buybacks. I have a feeling that this roller coaster ride is not quite done and I will continue to estimate the numbers daily.

Equities Breakdown

In keeping with my practice in my prior posts, I looked at market capitalizations of all publicly traded companies (36,481 companies with market caps exceeding $5 million on February 14, 2020) and started by computing changes in market capitalization, by region:

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Looking at the aggregated returns since February 14, 2020, the worst performing regions in the world are Africa and Latin America, and China remains the standout as the best performing market. Australian and Canadian stocks have been punished, largely because of their natural resource focus, and globally, stocks have lost $15.2 trillion in value, a huge amount but about half as large as the loss was four weeks ago. In the next table, I break market cap changes down by sector:

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There are few surprises in this table, with healthcare and consumer staples being the best performers, and energy and financial services the worst. Breaking down the sectors into finer detail, I look at companies classified into 95 industries, and list the ten best and worst performers over the crisis period (2/14 - 4/17):

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I know that it fashionable to talk about how inefficient and volatile markets are but this crisis, in many ways, has been surprisingly orderly and markets have dispensed punishment judiciously, for the most part.

I also looked at other classifications, from pricing levels (PE and PBV) to momentum to dividends/buybacks and found no significant differences across companies. In fact, the evidence seems to more strongly support the notion that the market is punishing low PE, high dividend yield stocks that had little momentum coming into this crisis more than high PE , non-dividend paying stocks. That is disappointing news for value purists who have been waiting a long time to say "I told you so" to momentum and growth investors. In fact, the only variable that seems to offer support for financial moralists is financial leverage, as can be seen in the table below, where I break down global stocks based upon how much debt they had at the start of the crisis:

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The most highly levered companies, with leverage measured as debt scaled to EBITDA, have suffered more damage as this crisis has played out.

Pricing Update

In my earlier posts, I argued that just because uncertainty has increased, there is no excuse for abandoning valuation first principles or process; you can still value companies, albeit with a much wider range of outcomes. One common counter that I got to this argument was that valuation is pointless when the uncertainty is so great and while most of those marking this argument did not bother presenting alternatives, my guess is that many will fall back on pricing metrics to decide what to buy or sell. Put simply, they will use a PE ratio or an enterprise value multiple of EBITDA or sales to decide what stocks to buy or sell, acting under the delusion that this will allow them to escape having to make assumptions in the future. In this section, I will start by breaking down pricing multiples and then use simple valuation algebra to argue that there are assumptions about cash flows, growth and risk embedded in every pricing multiple. I will close by noting how multiples behave in a crisis, and report on pricing multiples, broken down by region, sector and industry, pre and post crisis.

Anatomy of a Multiple

I think of multiples as standardized prices, allowing investors to get past the challenge of comparing per share values, which are determined by share count. That said, it is easy to be overwhelmed by the number of multiples you see in practice, with some in wide use (PE, Price to Book, EV to EBITDA) and some obscure (EV per subscriber, EV to Invested capital). To put these in perspective, I will start by breaking down the choices that you have in constructing a multiple and using it to make a pricing judgment:

The numerator for any pricing multiple is a market value of equity, firm or operating assets, and the denominator is a scaling variable: revenues, earnings, cash flows or book value. There is no one "best" multiple or timing choice, since that will vary across time and across sectors, but here are two simple consistency rules to keep in mind, when constructing and using multiples:

Equity/Firm: If the numerator is an equity value, the denominator should be an equity value as well, while if the numerator is a firm or enterprise value, the denominator has to be an operating value. Thus, PE (market cap, an equity value, is divided by earnings per share, an equity value) and EV to EBITDA (EV is a market value of operating assets and EBITDA is a measure of operating cash flow) are consistent, but Price to EBITDA is an inconsistent abomination and Price to Sales is almost as badly constructed.
Timing: Multiples are constructed for comparisons across companies, not as stand alone measures. It follows therefore that you should be consistent in the timing you use for your scaling variable (revenues, book value, earnings) across companies. Thus, if you choose to use trailing earnings for your company to compute PE, you have to use trailing earnings for all your companies.

Put simply, in pricing, you estimate a value for a business or its equity, based upon how "similar" companies (equities) are being priced in the market place.

Determinants of Multiples

Many analysts who use multiples to find under and over priced stocks do so because they do not want to confront the uncertainty associated with forecasting future growth, margins and cash flows in intrinsic valuation. That is an illusion, since embedded in every multiple are assumptions about growth, risk and investment efficiency. When you pay a hundred times earnings for a stock or ten times book value, you are assuming high growth in earnings for the former and a monstrously high return on equity for the latter. In the picture below, I list out the fundamentals that are embedded in each multiple:

This cheat sheet, designed to find the variables that are embedded in a multiple, brings home a reality about pricing that should make anyone using it uncomfortable. The difference between intrinsic value, where you try (sometimes desperately) to forecast future growth and cash flows, and pricing, where you use a multiple, is that you are explicit about your assumptions in the future, making them both more transparent and easier to critique, and that you are implicit in your assumptions with the latter, making them easier to defend but also more dangerous.

Pricing and Crisis - A Time Line
In the aftermath of every crisis, investors abandon fealty to fundamentals, on the premise that they are in unique times and fall back on pricing. I am sure that will happen with this one as well, but if you decide to go this route, the nature of this crisis will make pricing much more difficult. To see why, take a look at how multiples will move as this crisis unfolds:

In phase one of this crisis, the market reacts to the crisis by marking down stock prices almost immediately, but the scaling variable (revenues, earnings, book value) does not, partly because it takes time for the crisis to show up in operating numbers and even longer for accountants to record that in the financial statements. Consequently, as the crisis first unfolds, stocks will look cheaper on a trailing basis, as the market price drops and earnings/revenues/cashflows stay stagnant, and analysts/companies are too uncertain to offer guidance about future operating results.
In phase two, analysts and companies start to provide forward guidance, and you can switch to forward values, if you trust them, but since the crisis can cause more companies to lose money, you will also see a greater dependence on revenue multiples in pricing.
In phase three, as operating results more completely reflect crisis effects, trailing multiples will reflect the updated operating results, but you should not be surprised to see companies trade at much higher multiples of trailing earnings (if earnings are still positive), or have earnings multiples that are not meaningful. Again, a naive comparison of the trailing PE to historic norms will lead you to conclude that everything is over priced, even when that is not the case.

No matter which phase you are in, you ultimately have to make judgments about whether the company will come out of the crisis, and if it does, what it will generate as earnings, to make sensible investment decisions. Just as there is no room for lazy and mechanistic valuation, in the midst of a crisis, there is no payoff to lazy and mechanistic pricing.

Pricing Effects
We are still in phase one of this crisis, though we are hopefully approaching its tail end. Not surprisingly, as market prices have dropped and trailing operating numbers reflect what companies did in 2019 (pre-crisis), there has been a drop in trailing pricing multiples across all regions of the world:

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The same story unfolds across different sectors:

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In some sectors, such as financial services, energy and airlines, where the punishment meted out by the market has been severe, you should not be surprised to see stocks trade at extraordinarily low multiples of trailing earnings. At the same time, companies have been reluctant to offer guidance for the coming year, making it difficult to shift to forward values. You could, of course, get ahead of the curve and try to forecast earnings in a post-virus world, say in 2022 or even 2025, and scale market capitalizations to those values.

As companies start to report their first quarter earnings, you are starting to get a glimpse of the damage created by the crisis and my guess is that you will start to see more analysts and companies start to forecast forward numbers. For those companies where forward earnings are positive, you can switch to forward PE ratios, but expect these numbers to be much, much higher than historical norms. For those companies that expect losses in the next year, you will see revenue multiples or creative variations on future earnings, from earnings before COVID to earnings in 2025 used as the scalar. Later this year, as companies report numbers for the second and third quarters of 2020, the trailing operating numbers will finally catch up with the crisis, but they will come with caveats. Put simply, if you are abandoning or refusing to do intrinsic valuation, because you feel uncomfortable with having to make assumptions, the same uncertainty is going to pervade your pricing as well.

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Wednesday, April 8, 2020

A Viral Market Meltdown VI: The Price of Risk

It is a sign of how volatile the last few weeks have been, that a week like the last one, where index levels move only 2-3% a day, high by historic standards, felt stable. As in prior weeks, I will start this one by looking at how the market action last week played out across asset classes, and within equity, across regions and industries first, but the bulk of this post will be an update on the price of risk, and how it has changed in both bond and stock markets over the last six weeks. In the process, I will compare this six-week periods to the 2008 crisis, which was also global, and shook the faith people had in markets, institutions and companies.

The Markets last week

The market action last week was more muted than it had been in prior weeks, but that is a relative statement, as we still saw big swings in almost every asset class. Using the same sequencing that I have used for the last few weeks, I will start with a review of equity indices globally:

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It was a quiet week for most markets, with the Nikkei and the Sensex being the exceptions, dropping 8,09% and 7.46% respectively. Over the last month, every market has seen double digit negative returns, with Shanghai being the only exception. Moving on to US treasuries, we saw more calm than in prior weeks, with rates staying close to where they were in the previous week:

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The (relative) calm in equity and treasury markets also played out in the corporate bond market, with spreads decreasing slightly for higher rated bonds and increasing marginally for lower rated bonds.

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The commodity markets continued on their wild ride, with oil again diverging significantly from copper:

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Oil prices surged dramatically towards the end of the week, mostly on rumors that Saudi Arabia and Russia would come to an agreement on oil production, but copper prices stayed stable. Completing the analysis, I looked at gold and bitcoin last week:

Both gold and bitcoin saw little price action during the week, not a bad development in a crisis market. In summary, looking at returns across asset classes last week, and comparing those returns to prior weeks, it is clear that last week saw a reduction in the volatility that has characterized previous weeks. It is unclear, though, whether the week is just the calm before another storm, or a true break in the crisis. The next few weeks will tell!

Breaking down the weekly movements

As in prior weeks, I start by looking at publicly traded companies around the world, and looking at how they did, in market capitalization terms, last week, and break down the information by region, sector/industry and classes (PE, momentum, debt etc.). I start with the regional breakdowns:

As with the market indices, it was a week of losses, albeit small ones, in much of the world, with the outliers being Eastern Europe & Russia, which saw a gain of 9.07%, and Japan, which lost 9.38% in market capitalization. Collectively, global stocks lost $1.6 trillion in the week of March 27-April 3, and have lost $22.7 trillion in market capitalization since February 14, 2020, a decline of 25.08%. Moving on to the sector breakdown:

The rise in oil prices pushed up the market capitalization of the energy sector by 6.31%, but most of the other sectors saw losses during the week of 3/27-4/3/20. Incorporating the last week into the data, financial service firms have now taken the dubious lead among sectors, of biggest percentage drop in market capitalization since February 14, 2020, and consumer staples and health care still lead the list of least damaged sectors. Honing down to the industry level and updating the list of ten most hurt and least hurt industries:

Data on all industries

The loser list has many of the same infrastructure industries that showed up in last week’s list, but the winner list has a healthy sprinkling of energy stocks, pushed up by the rise in oil prices during the week. I also did the breakdown, looking at companies in PE classes, momentum classes (based upon price change over the year leading into 2/14/20, net debt classes and dividend/buyback classes) and found that the only categorization where there is significant differentiation in market damage is net debt, where more highly levered companies continue to be punished more than less levered companies. You can find these categorizations and results by clicking on this link. I did extend the analysis to look at companies that have bond ratings, a subset of 2271 Firms out of the total sample of 36,789 firms, and the results reinforce the finding that leverage has the biggest explanatory power for damage from this crisis:

As bond ratings drop, the decline in market value is more precipitous, with the ratings below investment grade (below BBB, in red) being particularly hit.

The Price of Risk

In the last few weeks, as markets have tumbled, I have held back on reporting on a measure that I update every month, which is the equity risk premium. That said, the last six weeks reinforces a lesson that I learned the hard way in 2008, which is that dependence on a static, historical estimate makes no sense in a dynamic, shifting market. In this section, I want to focus on how the price of risk has changed over the last six weeks, and what lessons, if any, we can glean from those changes.

Determinants

In a post from earlier this year on the topic, I argued that every risky asset class market has a price of risk, though that price is more observable in some markets than others. The price of risk changes on a day-to-day basis, and is determined by a combination of variables that encompass almost everything going on in the world from uncertainty about future economic growth (more uncertainty -> higher price for risk) to political stability (more instability -> higher price for risk) to worries about catastrophes/disasters (more worries -> higher price for risk) to investor risk aversion (greater risk aversion -> higher price for risk) to information availability/reliability (less reliable and accessible information -> higher risk premiums). I know that I am giving short shrift to weighty topics, and if you are interested in a more in depth assessment of these variables, you can read my 2020 update on equity risk premiums here. (Be warned. It is long and boring, and may put you to sleep, but that may be a good thing..) The more general point though that emerges from identifying the determinants is that changes in these variables will change the prices for risk, and since investing and valuation has to be based upon updated prices for risk, you need measurement approaches that capture these changes.

Bond Market Price of Risk

In the bond market, the price of risk is observable, since as investors see more default risk in the future, and demand higher prices for risk, bond prices drop and interest rates on bonds increase. That is what I chronicled when I reported on the default spreads on bonds in different ratings classes in the last section, and looked at how these spreads changed over the last few weeks of this crisis. It is true that default spreads, for a given default risk class, don't change much in mature markets during periods of stability, and this can be seen in the graph below, where I look at the default spreads on Moody's Baa rated bonds (translating into an S&P BBB rating) since 1960:

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Even during this period, there have been sub-periods of tumult, as evidenced by the change in default spreads in the 2008 crisis. Looking more closely at the the period between September 12, 2008 to December 31, 2008 at the spreads on bonds, here is what you saw:

In 2008, default spreads doubled between September 12, 2008 and December 31, 2008. In the last six weeks (February 14, 2020- April 3, 2020), the default spreads on bonds in every ratings class have widened, not surprising given both the economic damage done by the crisis and the higher likelihood of default and the fear factor:

It is interesting that the default spreads did not show much effect during the first two weeks of this crisis (February 14- February 28), but woke up to the crisis in the third week. Over the six weeks, spreads have almost doubled for the highest risk classes, and have increased significantly even for higher rated bonds.

Equity Market Price of Risk

Unlike the bond market, it is more difficult to measure a forward-looking and dynamic measure of equity risk, though there are short cuts that people have employed. For instance, there are some investors who use the earnings yield (the inverse of the PE ratio) as a rough proxy, arguing that it should be higher, when equity investors are demanding a higher price for risk. There are others who focus on the VIX, a traded measure of volatility that is observable and is a gauge of fear and worry, rising during crisis and market downturns. In the last six weeks, the VIX has gone on a wild ride, as can be seen in the graph below, peaking at 85.47 on March 18, 2020.

While the VIX is an instrument for measuring market fear, it is not a direct measure of the equity risk premium. My preference is an implied equity risk premium, computed by estimating the internal rate of return investors can expect to earn, given what they pay for stocks and expected cash flows in the future, and netting out the risk free rate:

As some of you who have visited my website know, I update this equity risk premium (ERP) at the start of every year, and the graph below summarizes the implied equity risk premiums on the S&P 500 at the start of every year from 1960 to 2020.

Download historical implied ERP

Note that the equity risk premium stood at 5.20% at the end of 2019, but is has been more volatile since the 2008 crisis, than prior to it. It was during that crisis that I developed the practice of computing the premium on a day-to-day basis to capture the battle between fear and greed that characterize every crisis. In the figure below,I graph the implied ERP from September 12, 2008 (the Friday before Lehman’s collapse) until December 31, 2008:

Note that on September 12, 2008, which was the triggering point for the 2008 crisis, the equity risk premium for the S&P 500 was 4.22% but during the next eight weeks, the ERP rose sharply to reach a high of 7.83% on November 20, 2008, before subsiding somewhat to end the year at 6.43%. One of the limitations that I faced during that period is that while I was able to update the index values and treasury bond rates every day, the earnings and cash flow numbers were being updated with a substantial lag, with the full changes not showing up until several months later.

I decided to do the same day-to-day calculation for the implied equity risk premium, with an augmentation. Rather than allow earnings and cash flows to remain stagnant, in the face of a crisis that will almost certaintly decimate both, I computed a COVID-adjusted ERP as well, with estimated drops in earnings and cash flows. In making these judgments, I did change my estimates across time, starting with a 15% drop in earning in the first two weeks of this crisis, and ending with a 30% drop in earnings for the S&P in the most recent two. Those changes may reflect my slow learning, as the gravity of the crisis magnified each week:

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I understand that this crisis is by no means over, and I intend to keep computing the implied equity risk premium daily for as long as I think necessary, but if your estimates are close to mine, the equity risk premium for the S&P 500 was 6.01% (with the adjusted numbers) on April 1, 2020.

Country Risk Premiums

At the start of each year, I compute equity risk premiums, by country, with the intent of using these numbers when I value companies, and leave them unchanged for the first half of the year. This year, though, the crisis has caused the numbers to change, and in some cases, dramatically. First, the base premium that I use is the US implied equity risk premium which has jumped from 5.20% to 6.01% (see above). Second, the additional risk premiums for countries are based upon sovereign default spreads, which like corporate bond spreads, have widened significantly. My updated basis for computing the country equity risk premiums is below:

My global picture of equity risk premiums at the start of April 2020 is provided below:

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Just to illustrate how much of a difference a few weeks can make to your estimates, I have also included the ERP from January 1, 2020, for comparison. Note that the premiums have not only climbed in every country, but they have increased more in the riskiest countries.

Conclusion

One of the lessons that I learned from the 2008 crisis was to move away from static approaches for computing equity risk premiums, dependent on looking at long periods of history. What I learned during the last three months of 2008 made me switch to using implied equity risk premiums in my valuation and corporate financial analysis, and to compute them on a monthly basis. This crisis has reinforced that practice. I have always found it difficult to grasp how companies can use hurdle rates that are not only set in stone, but set in stone a decade or two ago, even as the market environment shifts and the price of risk changes. The median cost of capital for a global company, which was 7.6% at the start of 2020, is now closer to 8%, with the increase in risk premiums more than compensating for the decline in risk free rates in much of the world and the rise in cost of capital, in US dollar terms, steeper in emerging markets than developed markets.

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Equity Risk Premiums: Determinants, Estimation and Implications- The 2020 Edition

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Equity Risk Premium Calculator, April 1, 2020

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