Time to Split!!

As many of you are probably aware, Berkshire Hathaway has announced its intent to split its class B shares and the requisite "deep analysis" of whatever Buffet is doing has journalists chasing the story.
http://money.cnn.com/2009/11/06/markets/thebuzz/index.htm
Since Berkshire is not the first company to ever split its stock, it is worth looking at key questions that come up anytime there is a stock split.

1. Do companies split their stock often?
The answer is yes and no. Some companies are serial stock splitters, splitting their stock at regular intervals. Other companies let their stock ride. In fact, Berkshire Hathaway is a classic example of a company that has avoided splitting its shares, with it's class A shares trading at about $100,000/share.

2. Why do companies split their stock?
There are several reasons provided, though not all of them hold up to scrutiny:

a. Attract new investors to the company: There is a belief that some small investors and even a few institutional investors either cannot or will not invest in companies if the stock price rises above a threshold level. The "level" itself seems to be a malleable number and vary across companies. There is little evidence for this proposition and even if there were evidence, so what? Inherently, there is nothing good about attracting investors who have hitherto avoided buying your stock and it is entirely possible that these investors may bring with them preferences for dividends and other corporate finance policies that put them at odds with the firm's current policies.

b. Improve liquidity: This is the time honored argument provided by many companies when they split their stock. Having a lower-priced stock, they argue, will increase trading volume and improve liquidity. The evidence, though, points in the opposite direction. Aggregate trading volume does not increase significantly after stock splits and transactions costs go up (not down). The reason for the latter effect is that the bid-ask spread, as a percent of the stock price, tends to be higher for low-priced than high-priced stock. (Try a simple experiment. Try buying 100 shares of a stock trading at $200/share, 1000 shares of a stock trading at $20/share and 10000 shares of a stock trading at $2/share and figure out your total transactions costs with each, including commissions and bid-ask spreads.)

In the case of Berkshire Hathaway, the reason for the split lies in the recent acquisition of Burlington Northern. Berkshire had offered shareholders in Burlington a choice being paid in either cash or Berkshire class B shares. Since Berkshire's class B shares were trading at more than $ 3000/share, there were many small stockholders in Burlington who could not avail themselves of the stock offer. (If you owned less than $3000 worth of Burlington stock, you had to settle for cash.) This has tax consequences. When you as a stockholder in a target company accept cash on an acquisition, you have to pay taxes on capital gains immediately. If you receive shares in the acquiring company, you can defer paying capital gains taxes until you sell those shares.

3. How do stock prices react to stock splits?
Are stock splits good or bad news? There have been several studies of stock splits over the last few decades and the findings can be summarized as follows:

a. At the time of the stock split, there is, on average, a very small positive impact on prices (about 1-2%). In other words, when there is a two for one stock split on a $50 share, the new shares trade at about $25.25. This is usually attributed to a "signaling effect", where markets view stock splits as a sign that the company expects earnings or dividends to increase in future periods.

b. There is some debate about whether investors can generate higher returns in the period after the stock split. While many of the earlier studies indicated that stocks that split did not "beat the market" in the months after, more recent studies provide evidence that "stock split" stocks generate significantly higher returns.

c. As with all investments, there is another shoe waiting to drop. Studies also indicate that the volatility increases after stock splits. In a very general sense, a stock split seems to increase both returns and risk.

If you are interested in reviewing the literature, there is a good survey paper on the topic. You can get to it by going to:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1362259

The bottom line. Stock splits, for the most part, are cosmetic and should not play a central role in whether you invest in a company or not. The reason is simple. From an intrinsic value standpoint, changing the number of units you divide the value by cannot change the overall value of a business. If everyone gets the same percentage increase in units, there cannot be winners and losers within the firm. However, the evidence does suggest that they can play a secondary role in stock picking. Thus, when faced with investing between two otherwise equal companies, one of which has split its shares recently and the other not, you would go with the first one.

Two side notes. First, everything that I have said about stock splits also applies to stock dividends. In fact, stock dividends represent an even bigger pain in the neck, since they leave investors with strange share counts - 100 shares become 102 shares. Second, reverse stock splits, where a company whose stock is trading at a very low stock price offers 1 share for every four or five shares, seem to be more defensible from an economic standpoint, since the transactions cost argument works in your favor)

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Bounceback in Multiples: The 2010 story

Building on the 2010 data, here is the other side of the data. As risk premiums have reverted back to pre-crisis levels, we are also seeing multiples also revert back to pre-crisis levels. This can be seen on a number of measures, both in the US and globally:

a. Price Earnings Ratios (PE): The median current PE ratio for US stocks, which plunged from about 19 in January 2008 to about 9 in January 2009, is now back to almost 15. Similar shifts have occurred in the trailing and forward PE ratios and in most sectors.

b. EV/EBITDA: The median EV/EBITDA multiple for US companies, which had dropped from about 9 in January 2008 to 6 in January 2008, had bounced back to 8 by January 2009.

The bounce back in multiples in emerging market companies has been even more robust. The shifts in multiples globally parallel the change in equity risk premiums that I noted in the last post.

The change in multiples in 2010 brings home a fundamental fact that the multiples of earnings, book value or revenues that we are willing to pay depends upon how risk averse we are (and the risk premiums that we consequently demand). That is one reason why I have always been wary of those who compare market multiples across time and pass easy judgments on whether stocks are cheap or expensive.

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Reversal in Risk Premiums (or premia): The 2010 story

The big story from the 2010 updates is that that risk premiums across the board have reversed the rise that we saw during the crisis. The broad based nature of the shift can be seen by looking at the following:

a. Equity Risk Premiums: I have been tracking the equity risk premium at the start of every month since the start of the market crisis on September 12, 2008. On that day, the equity risk premium for the US was 4.37%. That number exploded to almost 8% in November 2008 and settled in at 6.43% at the start of 2009. In the first three months of 2009, the equity risk premium continued to rise (to more than 7% in early April 2009). Since then, though, the equity risk premium has dropped dramatically. On January 1, 2010, the equity risk premium was down to 4.36%, roughly where it was at the start of the crisis. If you are interested in the computation, download the excel spreadsheet that I used (and feel free to modify and adapt it as you see fit)

b. Bond default spreads: The market crisis had its origins in easy lending, reflected in the low default spreads that we saw for different bond ratings classes in late 2007. Bond default spreads almost tripled during 2008, thus outstripping the change you saw in equity risk premiums. In 2009, however, bond default spreads returned to pre-crisis levels. You can get to my latest estimates of default spreads by clicking here.

c. Sovereign spreads: When the market crisis unfolded, emerging markets were affected more adversely than developed markets, as manifested in collapsing stock prices and soaring sovereign default spreads. The default spread for Brazil in the Credit Default Swap mark rose to 7% in November 2008. Those spreads have decreased to pre-crisis levels (and below, for some markets). Brazil's CDS spread in January 2010 was hovering at about 1.5%.

While I am not surprised that risk premiums have come down, I am surprised at how quickly they have reverted back to old levels. In early 2009, my prediction would have been that equity risk premiums by the end of the year would be down to about 5%. At one level, the speedy recovery in risk premiums can be considered to be evidence of mean reversion- that markets quickly revert back to historic norms even after major crisis. At another level, the quick adjustment can be viewed as a sign of a market that is in denial. My gut feeling is that the market has gone up too far, too fast and that equity risk premiums will correct themselves over this year and move back up towards 5%, but I may very well be wrong again.

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Data Update for 2010

If you have been tracking my website, you probably know that I maintain updated datasets for companies around the globe, classified by region (into the US, Emerging Markets, Europe and Japan). I report summary statistics on risk (beta etc.), profitability measures (margins and accounting returns) and debt/dividend measures for industry groups in each region.

I update the data at the start of every year and I have just completed the data update for January 2010. You can get the data by going to:
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/data.html
I have added two new datasets this year - for just Indian and Chinese companies.

In coming blog posts, I will talk about what the updates tell us about companies and markets globally.

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The market value of Tiger Woods

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

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

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

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

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Greece, EU and more on Implicit Backing for Debt

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

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

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

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

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

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

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Dubai and the "implicit" guarantee

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

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

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

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

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

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

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