Growth (Part 3): The Value of Growth

Consider a firm that has $ 100 million invested in capital that generated $ 10 million in after-tax income in the most recent year. For this firm to generate more income next year, it has to do one of two things:

1. Manage its existing capital (assets) more efficiently: Thus, if the firm can cut its operating expenses and increase its income to $12 million next period, it will have a growth rate of 20% for the next period. Let's call this efficiency growth.
2. Add to its capital base: If the firm can add another $ 10 million to its capital base and maintain its current return on capital (10%), its income next period will be $ 11 million, with a growth rate of 10% over the prior year. Let's call this "new investment" growth.

While both components feed into observed growth, they are not equal in their effect on value on two dimensions:

• Time: A firm can cut costs and make itself more efficient over time but only to the extent that these inefficiencies exist. Thus, a firm that is badly managed may be able to generate efficiency growth for 3, 4 or maybe even 5 years, but not forever. New investment growth is called sustainable growth because it can be continued for as long as the firm can maintain its policy on reinvestment and the return it generates on its investment. 
• Value: Efficiency growth always creates value, since no investments are needed and earnings and cash flows will go up.  Whether new investment growth creates value revolves around whether the higher earnings created are justified by the additional investment that is required to generate them. Since it costs companies to raise capital (the cost of equity for equity and the cost of debt for borrowed money), the return generated on that capital has to exceed the cost of capital for growth to add value. In the example above, introducing a cost of capital of 10% into the analysis will make the new investment growth "worthless", since what is added in value through the higher growth  will be exactly offset by the higher reinvestment (and lower cash flows) needed to generate that growth. As an exercise, you can try entering different combinations of growth, return on capital and reinvestment and measure the value effect in this spreadsheet.

Looking at any company's past, you can draw conclusions about whether the growth registered in the past was valuable, neutral or value destroying, by comparing the return on capital generated on the growth investments to the cost of capital. The return on capital itself is computed based on operating income and the book value of capital invested:
Return on capital = Operating income (1- tax rate)/ (Book value of equity + Book value of debt - Cash)
This calculation is also in the spreadsheet referenced in the last paragraph. It is the only place in valuation/corporate finance, where we use book value and we do so because we are looking at the profits generated on what was originally invested in existing assets (rather than their updated market values). There are a host of dangers associated with trusting accounting numbers and I have written about them and what to do to compensate in a paper on measuring returns.

So, how well do publicly traded companies do in terms of delivering returns? Which sectors do the best? To answer the first question, I computed the return on capital and cost of capital for all publicly traded companies listed globally in 2007 and 2008 and found the following:

While the crisis in 2008 took at toll on returns, even in 2007, a good year for most companies globally, about a third of all companies in the US and a higher proportion elsewhere generated returns on capital that were less than the cost of capital. While you may quibble with the year and have issues with how I computed cost of capital and return on capital, I think you will agree that value destruction is far more common at companies than we would like to believe and that quality growth (that increases value) is rare. To answer the second question, I compute returns on capital and cost of capital, by sector, for US companies and report them on my website at the start of every year. You can get the most recent update (from the start of 2011) by clicking here.

For those of you who do not want to go through the process of computing return on capital and cost of capital, I have a simpler proxy for measuring the quality of growth. Start by computing the capital invested thus:
Capital invested = Book value of equity + Book value of debt - Cash
Divide the change in operating income over the period by the change in capital invested over the period; the ratio is a measure of the the quality of the growth, with higher ratios representing higher quality. In the table below, I have computed the number for Google going back to 2003:

In the last column, I computed the marginal return on capital in that year by dividing the change in operating income that year by the change in capital. Based on this measure, in 2009 and 2010, Google saw a drop off in its quality of growth, a drop off I would attribute to acquisitions made by the company to keep its growth rate high. Its pre-tax marginal return has dropped to about 20%; in after-tax terms that would be closer to 13 or 14%, a good return on capital, but not a great one.  Investors have had wake up calls in Amazon and Netflix as well in recent days, as the costs of delivering growth have come to the surface. In most growth companies that disappoint, the clues are available in the years before.

Blog post series on growth

Growth and Value: Thoughts on Google, Groupon and Green Mountain

Growth (Part 1): The Limits of Growth

Growth (Part 2): Scaling up Growth

Growth (Part 3): The Value of Growth

Growth (Part 4): Growth and Management Credibility

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Growth (Part 2): Scaling up Growth

As companies get larger, it becomes more difficult to sustain high percentage growth rates in revenues for two reasons. The first is that the same percentage growth rate will require larger and larger absolute changes in revenues each period and thus will be more difficult to deliver. The second is that a company's success  will attract the attention of other firms; the resulting competition will act as a damper on growth.

I know! I know! You have your counter examples ready: Apple and Google come to mind. First, note that even these exemplars of success have seen growth rates decline over time. In fact, I posted Google's revenue growth (in dollar and percentage terms) in a prior post and while growth rates remain healthy, they have declined over the last decade. Second, the very fact that you can name these great growth companies is an indication that you are talking about the exceptions rather than the rule. Could the company you are looking at right now be the next exceptional company? Sure, but do you want to value your company to be the exception? I would not, since pricing your company for perfection will open you up to mostly negative surprises in the future.

Metrick and Yasuda, in their book on venture capital, have a sobering study on the persistence (or lack thereof) of growth at high growth companies. They compared the revenue growth rates at companies at the time of their IPOs to the average for the sector to which they belong and then followed up by looking at these growth rates in subsequent years.

Reading the graph, the revenue growth rate of the  "median" IPO company is 15% higher than the revenue growth rate of other companies in the sector one year after the IPO, drops to 8% two years after, to 5% three years after and to the sector growth rate 5 years after. Put succinctly, company-specific growth at the typical high growth company dissipates in about 4 to 5 years. Even the star IPOs (in the 75th percentile) see precipitous drops in the differential growth rate over the five year period.

Given this evidence that growth decelerates quickly at companies, how do we explain valuations where analysts use 50% compounded growth rates for 10 to 15 years or longer? I think the problem lies in the "percentage illusion", where analysts feel that their growth assumption is not changing if they keep the growth rate unchanged. However, delivering a 25% growth rate is far easier in year 1 than the same firm delivering a 25% growth rate in year 9. The best way to introduce some realism in growth rates is to convert the percentage growth rate in revenues into dollar changes in revenues and consider what the company will have to do in terms of operations to deliver that change. When valuing a retail company, for instance, computing that the company will have to open 300 new stores to deliver a 25% growth rate in year 10 (as opposed to 30 in year 1) may quickly lead to a reassessment of that growth rate. I have a very simple spreadsheet that does little more than this: convert percentage growth rates into revenue changes each period. As an exercise, take any young, growth company that you want to value, put in the current revenues and try different compounded revenue growth rates. The power of compounding continues to amaze me!

Blog post series on growth

Growth and Value: Thoughts on Google, Groupon and Green Mountain

Growth (Part 1): The Limits of Growth

Growth (Part 2): Scaling up Growth

Growth (Part 3): The Value of Growth

Growth (Part 4): Growth and Management Credibility

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Growth (Part 1): The Limits of Growth

When valuing young, growth companies, a key input into the valuation is the expected growth rate in revenues. For these companies to become valuable, small revenues have to become big revenues (and negative operating margins have to become positive ones...) and revenue growth is the driver of value. It is a tough number to estimate and it is easy to get carried away, especially in hot sectors. In this post, I will look at the information that can be used to put limits on this estimate, reasons why some companies may be able to blow through these limits and the disconnect that often emerges between company level estimates (made by analysts) and sector-wide estimates.

The Limits on Growth
Let's start with the fundamental question. When valuing an individual company with potential for growth, how high can the revenue growth rate be? Put differently, how big can dollar revenues become at a company, assuming that it is successful? As I noted in the Green Mountain Coffee discussion in my last post, there are at least two numbers that need to be used as sanity checks.

• The first is the overall size of the market for the product(s)/services that the company offers. Clearly, the expected revenues for Whole Foods, a company operating in a huge market (groceries) can become much larger than the expected revenues for Green Mountain Coffee, operating in a narrower market. (Whether it will or not remains a judgment call you have to make when valuing the company...)
• The second are the revenues of the largest players in that market. In effect, you are looking for the point at which revenues will plateau in a particular business. Thus, the fact that Folgers, the largest company in the coffee market, made only $2 billion in revenues in 2010 operated as a cautionary note in how much revenues you could project for Green Mountain Coffee. In contrast, Safeway,one of the largest grocery store companies, had revenues of $42 billion in 2010.

If you are valuing a company in a sector that you are unfamiliar with, you should get a sense of the revenues generated by the entire sector and how much revenues the largest company or companies in the sector had. To help, I have put together a spreadsheet that lists aggregate revenues, by business, for companies in the US, as well as the highest revenue company in each one. While my business categorization may be too broad for some of you, it should help provide some perspective on what comprises large revenues. In making these estimates, though, you will have to exercise judgment, which can cause your "limits" to be different from mine (and your valuation to be higher or lower than mine). The first judgment is the potential market for the product or service provided by the company. While that may be easy for Green Mountain, what is the potential market it for Groupon or Google? In the case of Groupon, is it a slice of the retail business (which would be huge) or it is a smaller subset? In the case of Google, is it the online advertising market or the entire advertising market or is its something else altogether? The second is the market share that you see your company gaining, if it makes it through to mature firm status. In other words,  do you see your company becoming one of the largest companies in the business or remaining a smaller player?

The Exceptions
Now, for the follow up. Over history, a few companies have surprised us be growing beyond even the most optimistic assumptions. How did these legendary growth companies bust through the limits? I see three possible sources for these "positive" surprises:

1. Expand product/service offerings: A company can increase its potential market, by altering its product/service mix. Amazon.com, in its early days in the 1990s, was primarily an online book retailer. If it had stayed in that business, the potential market would have been small and Amazon's value would have been constrained. By remaking itself as an online retailer (of pretty much any product), Amazon expanded its potential market (and with it, its value).
2. Expand geographically: While most companies initially target domestic or local markets, the potential market can be increased by expanding geographically. The list of big name companies that have rediscovered growth by going global is long - Coca Cola, McDonald's and Procter and Gamble come to mind.
3. Expand product reach: In perhaps the most interesting scenario, a company can expand the potential market for a product or service through innovations. The secret for Apple's success in the last decade has not only been a stream of winning products - iPod, iPhone and iPad, but each product has expanded what were small markets (music players, smart phones, computer pads) into much larger ones.

Can these surprises be incorporated into conventional valuation? By their very nature, I don't think they can, since they are unexpected at the point of initial analysis. (If you invested in Apple at the time of the iPod introduction, foreseeing the iPhone and iPad, you have a far better crystal ball than I do...) However, these "market expansion possibilities" can be viewed as options, where companies use existing platforms to generate new products and enter new markets, and can be valued as such. Even if you choose not go down the road of using option pricing models, these options will translate into a premium on conventional valuations, albeit one that cannot be easily quantified. You would expect this premium to be greatest in companies that have a proprietary edge (Apple, with its ownership of its operating system, is a perfect example...) and smallest when products can be imitated at low cost. As an investor, I tend not to include these "options to expand" premium in my initial valuations. If I can find a stock that is cheap relative to intrinsic value, the option premium is just icing on the cake.

From micro to macro... It has to add up.. 
One final note on growth limits. I believe that investors (and markets) generally get the macro story right but are not always consistent on the micro story. Put in revenue growth terms, optimistic investors are right that the social media businesses collectively will generate high revenues in the future. However, here is where I think that they make their mistake. First, if you add up the expected revenue numbers (that are implicit in the valuations you see for these companies) of the individual companies that comprise the social media space, the collective revenues will significantly exceed the forecasted revenues for the entire  market. In other words, your collective market share across companies will be well in excess of 100%. Second, I think that investors are under estimating the ease with which new companies can enter these businesses, under cutting margins and profitability. You can have a growing market where companies have trouble making money.
In fact, the dot com boom provides an interesting historical perspective. In hindsight, investors clearly got the macro story right: that consumers would get more and more of their products/services online. It was in the valuation of the individual companies that they made their mistakes, over estimating growth at these companies and under estimating both the ease of entry/exit into the business and the effect of competition on profitability.

Blog post series on growth

Growth and Value: Thoughts on Google, Groupon and Green Mountain

Growth (Part 1): The Limits of Growth

Growth (Part 2): Scaling up Growth

Growth (Part 3): The Value of Growth

Growth (Part 4): Growth and Management Credibility

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Growth and Value: Thoughts on Google, Groupon and Green Mountain

In the last week, I noticed three stories that at first sight seem to be unrelated but I think share a common theme:

• The first was on Google, with the focus being on how much Google is spending to impressive growth numbers.
• The second and continuing story is on Groupon and it’s imminent or not so imminent IPO, with the emphasis being on the accounting shenanigans and market whiplash.
• The third story is on Green Mountain Coffee, an incredible success story over the last five years, and the skepticism that some investors are showing about whether it can sustain its growth.

While the stories are on different issues, the questions they raise all revolve around the sustainability of growth at these companies, the price paid to generate the growth and the relationship between growth and value. 


The feasibility of growth: With growth companies, the debate about how high growth rates can be and how long growth can be sustained falls along predictable lines. The optimists argue for high growth and the pessimists argue that this growth is not feasible and investors are caught in the middle, wondering which side to believe. Ultimately, though, a company’s growth is constrained by the size of the market in which it operates. Green Mountain Coffee, for instance, had revenues of $1.36 billion in 2010, a sizable market share of the processed coffee market. To provide a measure of what is feasible, the overall revenues from coffee sales at supermarkets, drugstores and retailers in the US in 2010 amounted to little more than $ 5 billion; Folger's is the largest of the grocery store coffee producers has revenues of about $ 2 billion. While this total revenue does not count revenues from products like Keurig, it leads me to believe that Green Mountain Coffee is not a "small" company in this market. It is always possible that Green Mountain could expand its product line but what are its choices? Green Mountain maple syrup comes to mind, but that is a tiny market; Green Mountain chocolates may work, but the premium chocolate brands carry Swiss or Belgian imprimaturs. It is also possible that Green Mountain could increase the overall size of the market by convincing tea and soda drinkers to switch to gourmet coffees... but I think that is unlikely to happen.


Scaling Growth: As companies get larger, their growth rates will decline. That is indisputable, though great growth companies may be able to slow the decline and extend it over longer periods. Google, for instance, has been more successful than most growth companies in the last decade in sustaining high growth for an extended period, but even it has found that it is far more difficult to post high growth rates in revenues as its gets bigger. In the figure below, I graph out the percentage change in revenues and the dollar change in revenues each year at Google from 2001-2010. While the $ change in revenues has increased over time, the percentage change in revenues has decreased every year (except 2009). And consider this: Google is one of the most successful growth companies of the last decade.

 

Growth and Value: While many analysts view higher growth as good for value, it is clearly not that simple. After all, going for higher growth requires companies to make a trade off. On the one side, there is the good stuff: higher growth boosts revenues and earnings. On the other side, there is the bad stuff: growth is not free. Companies have to invest to generate sustainable growth: those investments can be in long term assets (factories if you are a manufacturing firm, R&D if you are a technology or a pharmaceutical firm, recruiting & training if you are a consulting firm), short term assets (inventory or accounts receivable) or acquisitions of other companies. All of these investments reduce cash flows. The net effect can therefore be positive or negative and is captured by looking at whether the firm generates a return on its investments (return on invested capital or return on equity) that exceeds its cost of funding (cost of capital or cost of equity). In the case of Google, the price of growth has risen over time, as the company seems to be caught in a cycle of making acquisitions that get larger each year, to post the same growth rates. With Groupon, this debate has morphed into an accounting question. Even if we accept the company’s argument that customer acquisition costs should be capitalized (see my earlier post on the issue), the question that follows is a simple one. How much value is added by a new customer? (To answer this question, the company will have to provide more information on customer behavior.) More critically, is it becoming less positive over time as the company gets bigger and goes after more elusive customers, in the face of  increased competition from Amazon and LivingSocial? Unfortunately, the firm is providing little information on these key questions.


 Growth and Credibility: My favorite framework for thinking about businesses is a financial balance sheet.

Within this framework, here is the key difference between mature and growth companies. The former derive most of their value from assets in place, whereas the latter get the bulk of their value from growth assets. Since the value of growth assets rests entirely on perceptions and expectations about the future, it also rides on the credibility of management. In other words, you need to believe managers when they tell you their plans for the future and you expect them to be disciplined in following through. If managers are not credible and disciplined, the value of growth assets can very quickly melt away. That is the lesson that Groupon and its investment bankers do not seem to get. As a potential investor in Groupon, I am not valuing it based on how much money it made or lost last year but on my expectations about its future. All the accounting moves made by Groupon over the last year seem to be centered around making their numbers (revenues, earnings etc.) from last year look better. Even if they succeed in this endeavor, all they will do with these actions is change the value of their existing assets marginally. In the process, though, they have damaged the trust that investors have in them and put the value of their growth assets at risk. When 90% or more of your value comes from growth assets, that is just dumb.


Each of these issues deserves a full post and I will make a series of posts in the next few days on each one. In the meantime, these companies will continue to entertain us for the next few months. Let's face it! Growth companies are a lot more fun to assess than mature companies. 

Blog post series on growth
Growth and Value: Thoughts on Google, Groupon and Green Mountain
Growth (Part 1): The Limits of Growth
Growth (Part 2): Scaling up Growth
Growth (Part 3): The Value of Growth
Growth (Part 4): Growth and Management Credibility

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Risk free rates and value: Dealing with historically low risk free rates

Last week, the 10-year US treasury bond rate dropped to 1.75%. While it has risen since to about 2%, there can be no denying a  basic fact. Government bond rates have dropped in almost all of the developed market currencies: the Euro, the British Pound, the Swiss Franc and the Yen. Since government bond rates are used as risk free rates to estimate discount rates in valuation or hurdle rates in corporate finance, there has been a great deal of hand wringing and angst among valuation practitioners on the consequences. In fact, if you allow for the increase in sovereign risk across the globe, you could argue that the "true" risk free rates are even lower than the already low government bond rates. In my previous post on the sovereign rating downgrade for the US, I noted that the default spread would have to be netted out against the government bond rate to get to the risk free rate. If, for instance, you accepted the S&P rating of AA+ for the US and estimated a default spread of 0.20% for that rating, the US dollar risk free rate right now would be about 1.80% (2% minus 0.20%).

So what effect do lower risk free rates have on value? The answer, if you follow conventional valuation practice, seems obvious. Lower risk free rates, holding all else constant, result in lower discount rates, and lower discount rates, all else held the same, will result in higher value. In fact, this seems to be the implicit message in the Fed's Operation Twist 2: that lower risk free rates are good for the economy and markets. It is also this facile conclusion that makes some practitioners uncomfortable with using today's rates in valuations; the angst gets deeper when the practitioner in question wants a "low" value for an asset (for tax assessments or to tilt the scales in a legal tussle). It is not surprising then that these practitioners flirt with an alternative: why not use "normalized" risk free rates instead of today's "abnormally" low risk free rates? The normalized risk free rates are generally computed by looking at the past: thus, the average 10-year treasury bond rate over the last 30 years, which is closer to 4%, is suggested as an option. Alluring though this option seems, not only is it the wrong solution to the perceived problem (of low risk free rates and out of control valuations), there may be no problem to solve in the first place. And here is why..

1. The risk free rate is not just a number in a discount rate computation but an opportunity cost. One way to think about the risk free rate is that it is the rate you will earn if you choose not to take the risky investments that are out there (stocks, corporate bonds, real estate, a business venture). So, let's carry this to its logical extreme. Let's assume that you do replace today's risk free rate (2% or lower) with your normalized rate (4%) and that the resulting high discount rate gives you a low value for your risky asset. Let's then assume that you choose not to invest in that risky asset. Where do you plan to invest that money instead? In your normalized bond earning 4%? Since it exists only on your spreadsheet, I am afraid that you will have to settle for that "abnormally" low 2% interest rate.

2. The risk free rate is a reflection of what people expect in the overall economy for the foreseeable future. Harking back to an equation that I have used before, note that the risk free rate is the sum of two market expectations: an expectation of inflation for the future and an expectation of real growth.
Risk free rate = Expected inflation + Expected real growth
Viewed through these lens, it is quite clear that a very low risk free rate is not generally compatible with a vibrant high growth economy. In fact, the biggest factor driving down ten-year bond rates this year from 3.29% to 2% has been the increasing pessimism about global economic health, pushing down both expected real growth and expected inflation. That is the basis for my argument that the Fed has become a side player in this game and that its push for lower risk free rates is actually at odds with its desire that the US return to healthy economic growth.

3. The risk free asset is also where investors flee when the fear factor rises, the much vaunted "flight to safety" during crises. But this flight does not just affect the risk free rate.... It affects risk premiums for all risky asset classes: equity risk premiums rise, default spreads on corporate bonds widen and cap rates on real estate become higher. If you define the expected return from stocks as the sum of the risk free rate and the equity risk premium, the last decade has seen changes in that composition:

Note that while the overall expected return on stocks (backed out from level of the S&P 500 index and expected cash flows from stocks) has been in a fairly tight range (8%-9%), the proportions coming from the risk free rate and equity risk premium have changed. And there are consequences for value as well. To see why assume that you are valuing a  mature, average risk company (growing at the same rate as the economy) with $ 100 million in cash flows to equity currently in a market where the risk free rate is 4% and the equity risk premium is also 4% (thus creating a cost of equity of 8%). Since the risk free rate is the proxy for nominal growth in the economy, this company's value is:
Value of company = 100 (1.04) / (.08-.04) = $2,600 million
Now consider valuing the same company when the risk free rate is 2% and the equity risk premium is 6%. Since the nominal growth rate expectation is down to 2%, the value of the company is:
Value of company = 100 (1.02)/ (.08 - .02) = $1,700 million
The effect on value will be greater for higher risk companies, where the risk premium is magnified, and lower for lower risk companies, but it will be significant across the board. Note that the first scenario resembles the market numbers in 2007 whereas the second is close to where we are today. The shift in risk free rates/ risk premiums may explain why stocks look cheap today, relative to historic metrics.

So, what do we do about low risk free rates? As I see it, you can choose one of four routes, ranging from dysfunctional to dynamic:
1. The dysfunctional valuation: You leave risk free rates at today's low levels, while your risk premiums and growth rates come from happier, more stable times. Implicitly, this is exactly what you will do, if you use equity risk premiums from historical data (Ibbotson, for instance) and earnings growth rates that reflect the "good old days". Using the example above, you would value the average risk, mature company, using a 2% risk free rate, a 4% nominal growth rate and a 4% equity risk premium:
Value of company  = 100 (1.04)/ (.06-.04) = $5,200 million
You will find everything you look at to be dramatically under valued, but the model is internally inconsistent. In effect, though, you are combining a crisis risk free rate with a good times risk premium/growth rate to estimate too high a value.
2. The depressed valuation: You could replace the risk free rate today with a higher, normalized risk free rate, while using the higher risk premiums and growth rates that characterize crisis marks. Thus, in the valuation example, you would be using a 4% risk free rate in conjunction with a 2% nominal growth rate and a 6% equity risk premium, leading unsurprisingly to a low value:
Value of company = 100 (1.02) / (.10 - .02) = $1,275 million
Here, the inconsistency is that you have combined a good times risk free rate with a crisis risk premium/growth rate to estimate too low a value.
3. The denial valuation:You could be a normalizer, replacing current numbers with normal numbers, not just on the risk free rate but on the other inputs (equity risk premiums, cash flows, growth rates) as well. This faith in mean reversion leaves the intrinsic value of the hypothetical company stuck at $2,600 million, as risk free rates and risk premiums change, and views the crisis as "nightmare" that will soon be forgotten. Unlike the first two choices, this one is internally consistent and may, in fact, be the valuation that is used by a classic contrarian investor, who believes that markets over react and adjust back to norms over time.
4. The dynamic valuation: You could use today's combination of a low risk free rate, high risk premium and low nominal growth to estimate a value of $1,700 million for the company. The valuation is internally consistent but the downside is that it will be volatile and change as the macro environment changes, creating discomfort for those who believe that intrinsic value is a stable number that stays unchanged over time.

I would steer away from the internally inconsistent valuations, either dysfunctional (giving you too high a number) or depressed (giving you too low a number) because your inputs are at war with each other. As for denial and dynamic valuations, I prefer dynamic valuations because I am not sanguine that reversion back to historic norms will happen soon. I can see why long term, value investors may be attracted to denial valuations but they better have a road map to their alternate pre-crisis universe, or the valuations will not come to fruition. But the bottom line about risk free rates is worth repeating. Lower risk free rates do not always translate into higher values for risky assets and it is not necessarily a "problem" that needs to be solved.

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Ruminations on Rogue Trading

We are in the midst of a "rogue trading" scandal and the media loves it. It started with this report in the Wall Street Journal about an unnamed trader who had lost $ 2 billion for the Swiss banking giant, UBS. The trader was quickly identified and named as Kewku Abodoli, a director at the UBS Delta One desk (more on that later). Today's story has more details, with a comment from Abodoli's lawyer about how much he regrets his actions (or at least getting caught). If you have a sense of deja vu, it is because you have seen this story play out before. Just to refresh your memory, here are some memorable rogue traders from times past, with one being famous enough (Nick Leeson) that he had a movie (and not a very good one) made about him.

What is rogue trading?

Rogue trading is trading by an individual, that violates his or her employer's norms and rules on investing and risk taking, exposing the entity to catastrophic risk. Note that rogue trading does not require "losses" to qualify. A rogue trader can take "catastrophic risks" and make millions or lose millions. Only the latter join the gallery of rogue traders, tarred and feathered by the media, and forced to do the perp walk. What about the rogue traders who make money? They are richly rewarded, celebrated as master traders and generally leave to start their own hedge funds. Enough said!

Why is there rogue trading?

So, why is there rogue trading? The answers are surprisingly simple and universal:

1. Trading is addictive: Anyone who has traded knows that the process can be addictive, where trades lead to more trades, and at least for some people, there is no stopping the trading. 
2. The search for the "big" payoff: It is human nature to aspire for the pot of gold at the end of the rainbow, the mega million dollar prize on the lottery and the trifecta  at the race track. In trading, that big payoff is (or at least seems) closer than in any other profession and many rogue traders start down their chosen path hoping to make the "big trade"...
3. House money and Breakeven effects: In an earlier post on Jerome Kerviel, I noted that two well documented tendencies in behavioral finance: the tendency to take more risk than you should with other people's or house money and the proclivity to reckless risk taking, once you start losing money, to get back to break even. As you look across the rogue trading episodes, they all share this characteristic. These traders all started with small losses, which they tried to recover from with bigger bets, and the process kept escalating until you get to hundreds of millions of dollars. 

How do rogue traders generate these losses and how do they get away with it?

When we read about the magnitude of the losses that are generated by rogue traders, we are faced with two questions: How do you lose hundreds of millions of dollars? How is it possible to do so undetected?

Let's start with the first question. For a trader to lose hundreds of millions, he or she has to "lever" up and there are at least three ways this can be accomplished:

1. Buy on borrowed money: You can borrow immense amounts of money on a small capital base, especially if you work at a large bank, and invest the amount in risky assets. You increase the upside on your equity investment, if you are right, but you magnify the downside, if you are wrong.
2. Derivatives: You can make bets on derivatives that have potentially unlimited losses: this is the case when you buy or sell a futures contract on a commodity or a currency or when you sell options (either calls or puts).
3. Long-short strategies: You can sell short on some risky assets, collect the proceeds and buy other risky assets, i.e., the hedge fund strategy. If the asset prices move in the right direction (your short sold assets have to drop in value while your long assets have to increase in value), you can make dramatic returns on small investments. However, if asset prices move in the wrong direction, your losses can be many times your equity investment.

Coming back to Kewku Abodoli, the rogue trader of the moment, it is worth noting that he traded on the "Delta One" desk. On the surface, Delta One desks are relatively placid and profitable places, where traders trade derivatives and exchange traded funds (ETFs) to take advantage of movements in the underlying assets (the delta in the desk name references the option delta, i.e., the percentage change in the option value for a unit change in the stock price). However, access to derivatives and ETFs can be a double edged sword, allowing a rogue trader to take very large risk exposures.

As for how rogue traders evade being caught, there are at least three possible explanations:

1. Time lags in risk measurement/management systems: Given how quickly prices move in financial markets, there can be time lags in marking investments to market and learning about risk exposures. These problems are exacerbated with ETFs, since they are themselves often portfolios of traded assets which have to be marked to market. 
2. Systematic measurement error in risk management systems: All risk management systems are based upon risk measures that are estimates. Thus, Value at Risk (VAR), a widely used risk measure at banks, has measurement error on many of its inputs, and some of these errors are systematic. For instance, a VAR that is based upon the assumption that asset prices move in a normal distribution will understate the risks of assets whose prices are discontinuous and tend to jump. Traders that learn about these systematic errors can then exploit them to hide real risks in their portfolios.
3. Avoidance and Denial: It is possible that those who monitor the rogue trader get a sense that something is wrong much earlier than the final denouement. However, in a very human response, the first response is to deny that a problem exists and avoid it, until it blows up.

How can you stop rogue trading?

So, how can you stop the next rogue trader from bringing an institution down? As an institution, you can reduce the chance that you will be the next victim by doing the following:

1. Hire the right traders: In my post on Jerome Kerviel, I pointed to the folly of entrusting trading to young men, a group that tends to take bigger and more reckless risks than any other subgroup of the population. I also suggested, only half in jest, that investment banks hire a few traders' mothers to trade alongside the traders, since older women are the perfect counterweight to young men in risk taking. I am sure that Mr. Abodoli would have been more cautious in his risk taking, if his mother had been sitting at the next desk.
2. Real time and dynamic risk measurement systems: Risk management systems should track prices in real time and capture bad risk exposures early. 
3. Restrict trading in illiquid assets: Even the most sophisticated risk management investments have trouble dealing with assets that are illiquid, where the prices are appraised values and not transaction values. As investing choices widen from traded stocks and corporate bonds to ETFs, derivatives and mortgage backed securities, risk management systems have come under more strain.
4. Simple and focused risk management systems: Since inputs into risk measurement and management systems have systematic measurement error that traders exploit, simpler risk management systems that have fewer bells and whistles are more difficult to game. In addition, investment banks can borrow a technique that El Al, the Israeli airline, has used for years to keep terrorists off their planes. Rather than spreading their resources wide and check every passenger, they profile passengers and focus on those most likely to create problems. Banks can adopt a similar practice: rather than have risk management systems that track every trade in the bank, they can identify those areas, where rules are most likely to be broken and focus attention on them.
5. Stress testing: Every risk management system will fail. It is a question of when, not whether. The key to good risk management is how you respond to failures in the system, not successes. Rather than assume that everyone is playing by the rules and measuring the consequences, it makes more sense to assume that some will not play by the rules and prepare for the consequences.
6. Look at outcome and process, not just outcome: I started this post by noting that rogue traders who make millions are feted and celebrated. As long as we continue to do that, we will incite traders to take unconscionable risks. The best way to bring home the point that you will not put up with rogue trading is to fire a rogue trader who makes millions and to deny him his bonus.

Here is the bottom line. The breast beating that happens after every rogue trading episode will subside. Banks will revamp their risk management systems and tell you that these new systems are now rogue-trader proof. I am a cynic, and I am sure that a few months or years from now, no matter what is done now, there will be another rogue trader at another bank. Consequently, I think it behooves all of us to be proactive about rogue trading:

1. Top managers at banks: The six suggestions that I have above are all directed at management, but they will reduce, not eliminate, the likelihood of rogue trading. Top managers at banks have to consider rogue trading to be one of the risks that comes with proprietary trading. When allocating capital to different businesses (corporate banking, investment banking, proprietary trading) should incorporate this risk. (Proprietary trading will have to make a higher return on the equity invested in it to break even than commercial banking...)
2. Investors in these banks: By the same token, investors in banks have to be cognizant of the risks that come with proprietary trading. A bank that generates a higher proportion of its profits from proprietary trading is riskier, other things held equal, than a bank that generates its revenues from traditional banking. If these banks trade at the same multiple of earnings, I would pick the latter over the former. In practical terms, I am suggesting that when screening for bargains among banks, we look at the percentage of profits from proprietary trading as a risk measure.
3. Regulatory authorities: If rogue trading is part and parcel of proprietary trading, then it follows that institutions where the government provides a backstop should not be allowed to indulge in it. This is the basis for the Volcker rule in the US and the new banking rules that are being discussed in the UK, both of which would bar commercial banks from proprietary trading. I agree.

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The Buffett Plan: An apt name for a sanctimonious, hypocritical and superficial proposal

At the start of this week, President Obama laid the groundwork for his deficit plan, with one of the proposals being what he termed the "Buffett" tax. Like Bank of America, a few weeks prior, he was perhaps hoping to borrow on Buffett's credibility to increase support for his plan. Put briefly, here is the what the plan is designed to do. Taxpayers who earn more than a million dollars will be required to pay at least as high a tax rate as what the average tax payer pays. What  constitutes a average taxpayer (I guess it is a good thing that it is not the median taxpayer; since that would comprise an income tax cut for millionaires, not a tax increase) and how high this "alternative" tax rate should be has been left to Congress to specify.

This plan has the right moniker, since it's qualities are reflective of the man after whom it is named:

1. It is sanctimonious: The word that best comes to my mind as I read Buffett's views on investing and business is "sanctimonious". He is the noble CEO, who puts stockholders' interests first, in a world full of cynical, self interested CEOs. He is the keeper of the value investing flame, while those short-term money managers in New York and London have abandoned Ben Graham, fundamentals and first principles. He is the brilliant financial thinker, standing alone against those clueless academics and their betas & option pricing models. In his latest foray, he is the "good" billionaire, who wants to pay his fair share of taxes, unlike those bad ones who shirk paying their share. This tax plan echoes this refrain. In effect, it says, the details don't matter because the intentions are noble: the rich can not only afford to pay more in taxes but they should be happy to do so. 
2. It is hypocritical: All this sanctimony might be tolerable if it came from someone who not only talks the talk but walks the walk. Warren Buffett is a hypocrite on many of the issues that he is most vocal on. Consider corporate governance. The same man who said that managers are stewards of their shareholder capital has not always followed his lead, in structuring and running his own company. First, Berkshire Hathaway has adopted the dual-voting share plan that has been the weapon of choice for entrenched insider control in other companies (See New York Times, News Corp, Google, Washington Post... ). Second, while I admire Buffett's frugality, I don't see any transparency at Berkshire Hathaway. In fact, it looks to me like the board at the company exists to rubber stamp whatever Buffett and Munger want.  A case in point: look at the successors that have been hired to take Buffett's place: Ted Wechsler (his recent hire) and Todd Combs. Both seem like nice men with, but we know little about them (other than the fact that Buffett and Munger like them). One of the few data points we have on Wechsler is that he was the winning bidder, two years in a row, paying $2.6 million each year, in an auction where the prize was lunch with the Oracle from Omaha. If you see nothing wrong with that, you should be okay with Bob Iger picking his successor for Disney from a Mickey Mouse look-alike contest or Steve Ballmer choosing the next winner of the hot dog eating contest at Coney Island (Was that Joey Chestnut?) as the CEO for Microsoft. Third, for those who argue that Buffett can be trusted to make these judgments, I do remember that he did hand-pick his last successor and that did not end well, did it? No one is impervious from making mistakes, but people who live in glass houses should not throw stones.
   This tax proposal is just as hypocritical. While it is couched in terms of fairness, it is based on a false argument: that millionaires pay less in taxes because they exploit massive tax loopholes and have very good tax lawyers. While there may be some who do, we know why the effective tax rate for millionaires is so low. It is because a significant portion of the income comes from capital gains and dividends, which are paid out by corporations from after-tax income, and taxed at a lower rate than ordinary income (from wages and profits). I would have had much more respect for the proposal if it had directly confronted this issue. Should investment income be taxed at a lower rate? Should we be taxing consumption or income? That would be a debate worth having.
3. It is superficial: To be honest, there is really no tax proposal, because the key details of the proposal, the "average" tax payer and the "millionaire minimum tax rate" are not specified. That is very much in keeping with the Buffett rule book. I know that much has been made about the brilliance and home-spun wisdom of Buffett's aphorisms. But as I read the letters that he has written to his stockholders (which comprise the heart of his writing), I am left with the feeling that when Buffett wanders from his preferred habitat - talking about investing in and managing mature companies - there is less there than meets the eye, especially when it relates to macro and market issues. What seems profound and wise at the first reading seems less so with each subsequent reading. Put differently, when it comes to a great deal of investing wisdom, Buffett's sayings seem to draw more on the fortune cookie tradition than from Confucius. 

As far as this tax proposal goes, it looks like it was conceived by a union of a rogue economist and an over-the-top populist. (Perhaps, it was.. Has anyone seen Robert Reich and Paul Begala hanging out together?) It will, without a doubt, make the tax code more complex. As a taxpayer who has had to deal with the effect of capped itemized deductions and the alternative minimum tax rate (AMT) for the last decade, I think that they rank among the worst tax code abominations ever, and this proposal is more of the same, just directed at millionaires. It will also be ineffective. The administration estimates that it will raise $ 400 billion in tax revenues from the Buffett tax, which strikes me as unlikely. First, since the "millionaire tax rate" is unspecified, the fact that they can estimate revenues from it reveals exceptional brilliance. Second, since much of the income that will be taxed comes from dividends/price appreciation in the stock market, it would require a rising market and healthy economy.

Am I being unfair in using a tax proposal named after Buffett to attack the man? Perhaps, but this tax proposal has its roots in Buffett's assertion that the rich don't pay enough in taxes and I am sure that the administration got his permission to attach his name to it. To those Buffett acolytes who are upset at my critique of the master, I have a simple suggestion. There are plenty of people, websites and books that revere the man and write puff pieces about him. Why not stick with those? Warren Buffett is a savvy investor, who has an uncanny ability to spot weakness and take advantage of it. I admire his skill but that does not mean that I have to treat him as infallible or exalt everything that has his name attached to it as good. My view is that the "Oracle from Omaha" no longer fits and that we need to come up with something better. I like the "Nag from Nebraska", the "Berkshire Bloviator" and the "Hypocrite from Hathaway", but I am sure that you can come up with your own variations.   Any suggestions? (As some of you have pointed out, this last part is over the top and unnecessary. So, let me retract it but leave it up so that I am not erasing history.. But I stand by my overall thesis.)

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