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.