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.

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Valuing Young Companies

One of the biggest challenges in valuation is valuing a young company, early in its life cycle, especially when that company has not established products. There are six reasons why valuation is difficult under these conditions:
1. No history: At the risk of stating the obvious, young companies have very limited histories. Many of them have only one or two years of data available on operations and financing and some have financials for only a portion of a year, for instance.
2. Small or no revenues, operating losses: The limited history that is available for young companies is rendered even less useful by the fact that there is little operating detail in them. Revenues are small or non-existent for idea companies and the expenses often are associated with getting the business established, rather than generating revenues. In combination, they result in significant operating losses.
3. Dependent on private equity: While there are a few exceptions, young businesses are dependent upon equity from private sources, rather than public markets. At the earlier stages, the equity is provided almost entirely by the founder (and friends and family). As the promise of future success increases, and with it the need for more capital, venture capitalists become a source of equity capital, in return for a share of the ownership in the firm.
4. Many don’t survive: Most young companies don’t survive the test of commercial success and fail. There are several studies that back up this statement, though they vary in the failure rates that they find. A study of 5196 start-ups in Australia found that the annual failure rate was in excess of 9% and that 64% of the businesses failed in a 10-year period. Knaup and Piazza (2005,2008) used data from the Bureau of Labor Statistics Quarterly Census of Employment and Wages (QCEW) to compute survival statistics across firms. This census contains information on more than 8.9 million U.S. businesses in both the public and private sector. Using a seven-year database from 1998 to 2005, the authors concluded that only 44% of all businesses that were founded in 1998 survived at least 4 years and only 31% made it through all seven years.
5. Multiple claims on equity: The repeated forays made by young companies to raise equity does expose equity investors, who invested earlier in the process, to the possibility that their value can be reduced by deals offered to subsequent equity investors. To protect their interests, equity investors in young companies often demand and get protection against this eventuality in the form of first claims on cash flows from operations and in liquidation and with control or veto rights, allowing them to have a say in the firm’s actions. As a result, different equity claims in a young company can vary on many dimensions that can affect their value.
6. Investments are illiquid: Since equity investments in young firms tend to be privately held and in non-standardized units, they are also much more illiquid than investments in their publicly traded counterparts.
In the new edition of my book titled "The Dark Side of Valuation", I have a chapter dedicated to young companies. I have excerpted the section of the book on young companies in this paper:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1418687
I hope you find it useful.

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Macro and Market Timers

I am sure that you have sensed a bias that I bring to the table about market and macro timers but I think I should make it explicit. I believe that there are ways in which you can beat the market in the long term, but very few of those ways involve market timing or calls about the macro economy. I know that there are stories in every market about great market timers, i.e., investors who made exactly the right call at exactly the right time about a market: Japan in 1989, dot-com stocks in 2000, housing in 2007 and financial assets in late 2008. Here is why I remain a skeptic:

a. Small sample: Unlike stock pickers who have to put out recommendations on hundreds of firms, the nature of market timing and macro calls (about exchange rates or the economy) is such that even the most long-standing forecasters have made only about 15-20 calls in their entire lifetime. As a result, rejecting the null hypothesis that successful calls are due to luck becomes much more difficult. For instance, a stock picker who gets 60 out of 100 calls right, is statistically beating randomness but we cannot reject the hypotheis that a market timer who is right 10 times out of 15 is just lucky.

b. Fuzzy recommendations: One aspect of market timing and macro forecasting that is frustrating and makes testing difficult is the fact that market timers often do not make specific recommendations. Again, the contrast with a stock picker is stark: when a stock picker tells you a stock is cheap, you can buy the stock and test out the recommendation. Market timers and macro forecasters often make recommendations that are not just difficult to convert into action but also impossible to put to the test.

c. Timing is everything: Anyone who makes a market call and sticks with it for a long period will eventually be right. However, the call itself becomes a bad one for investors who followed it, since they often would have lost far more money in the period where the call was wrong than they made back at the time the call turns out to be right. Thus, calling the dot-com bubble in 1997, the housing crisis in 2004 and the Japanese stock market bubble in 1986 should all be classified as mistakes rather than the right calls.

Historically, there have been far more investors who have been successful, over long periods, picking stocks than timing markets, but the allure of market timing remains strong. Here are three tests that I would suggest you put any market timer or strategy to:

1. Has the market timer been right often enough to reject the hypothesis that his or her success is entirely random?
t statistic for success = Proportion of calls that are right/ (0.5/ Square root of the number of calls)
Thus, a market timer who has been right 15 times out of 25, will have the following t statistic:
t = (15/25)/ (.5/5) = 1.00
Statistically, this does not beat randomness?

2. Is the market timer right at the right time or is he or she a Cassandra?
Market timers who are consistently bullish or bearish are dangerous. There is more of a personal psychological component to their recommendation than an analytical component.

3. Does the market timer provide fuzzy stories or make specific recommendations?
I have more respect for market timers who are categorical about what investors should do - buy or sell short a specific market - than those who tell meandering stories (that may actually read well) but leave investors confused at the end.

Finally, ask the question that needs to be asked of any successful investor or strategy? Why does the investor or strategy succeed? Every successful strategy needs an edge. Since that edge cannot be better information with market timing (whereas it can for individual companies), what is it?

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Culprit found for market crisis!!!!

You can now sleep better at night. Jeremy Grantham, market strategist for GMO, an institutional asset management firm, has found the culprit for the market crisis. According to Grantham, the efficient market hypothesis is to blame for the financial crisis. Quoting Mr. Grantham, "The incredibly inaccurate efficient market theory was believed in totality by our financial leaders.... It left our economic and government establishment sitting by confidently, even as a lethally dangerous combination of asset bubbles, lax controls, pernicious incentives and wickedly complicated instruments led to our current plight". Clearly Mr. Grantham has a gift for hyperbole but is he speaking the truth? Let's take apart his claims:

1. "Incredibly inaccurate efficient market theory": Perhaps, but my understanding of efficient markets is different from Mr. Grantham. My understanding is that very few investors can beat the market in an efficient market, and there is a catch in almost any strategy that claims to make money easily. I am not sure what part of this statement is inaccurate and I would love to be enlightened. It does take a lot of gumption for someone with Mr. Grantham's track record to talk about inaccuracy, but you are welcome to check out his history:
http://www.cxoadvisory.com/gurus/Grantham/

2. "Believed in totality by our financial leaders": Interesting. I did not know that we had financial leaders, but I guess Mr. Grantham is talking about the academia and investment banks. If it is academia, he is wrong, because almost every problem with market efficiency has been uncovered by academia, and academics (such as Robert Shiller) were among the first to draw attention to the dot-com and housing bubbles. It could not be investment bankers that he is referring to, because almost everything they do is premised on markets being inefficient. After all, what would the point of securitization be, if every one paid a fair price and there were no easy profits? Or of acquisitions, when all target companies trade at the right price?

3. "Lethally dangerous combination of asset bubbles, lax controls, pernicious incentives and wickedly complicated instruments": Market efficiency is to blame for all of these? Really? So, let's see.
- The efficient market hypothesis is about 40 years old. There must have been no asset bubbles before then. I wonder how those investors in South Sea stock (London in 1711) and tulip bulbs (Amsterdam in 1637) got their hands on the efficient market hypothesis.
- Lax controls? The financial services sector, the most controlled and regulated sector in the economy, was the one that precipitated this crisis.
- Pernicious incentives? I don't disagree, but how can you blame the efficient market hypothesis for compensation contracts that tied traders' pay to how much profit they made in a yer.
- And wickedly complicated instruments? Sure, but there would be no point to these instruments in an efficient market, since everything would be fairly priced. It was people who believed that markets were inefficient who created these instruments with the intent of exploiting inefficiencies.

I guess I must be a dreamer to even think that efficient markets have a shot in the face of Grantham's well thought out arguments. After all, in an efficient market, active portfolio managers will, on average, under perform the market, returns will decrease with trading activity, equity research analysts will provide little value added to investors and market strategists will be useless appendages at investment houses, making meaningless forecasts about future market movements. Never mind! I think I have made my case.

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MBAs and Ethics

Yesterday's New York Times had an article on the graduating Harvard MBA class. About 20% of the class have signed off on an ethics oath, which you can find here:
http://mbaoath.org/
If you follow the lead, you will find the list of what these students have promised to do:

• I will act with utmost integrity and pursue my work in an ethical manner.
• I will safeguard the interests of my shareholders, co-workers, customers, and the society in which we operate.
• I will manage my enterprise in good faith, guarding against decisions and behavior that advance my own narrow ambitions but harm the enterprise and the societies it serves.
• I will understand and uphold, both in letter and in spirit, the laws and contracts governing my own conduct and that of my enterprise.
• I will take responsibility for my actions, and I will represent the performance and risks of my enterprise accurately and honestly.
• I will develop both myself and other managers under my supervision so that the profession continues to grow and contribute to the well-being of society.
• I will strive to create sustainable economic, social, and environmental prosperity worldwide.
• I will be accountable to my peers and they will be accountable to me for living by this oath.

It sounds awfully good and I should probably rejoice at this rebirth of ethics in business, but I am not particularly moved for the following reasons:

1. Life is about making choices: From the sounds of this oath, these students plan to keep everyone happy for the rest of their lives. I wish them well, but the real questions will come up when the interests of stakeholders clash (stockholders versus co-workers, stockholders versus society). They will have to make hard choices and someone will be unhappy, oath or no oath. This sounds about as good as stakeholder wealth maximization and about as useless.

2. Self interest is not a bad thing: Embedded in this oath is the view that self interest is a bad thing and that we should be serving broader interests, but whose interests are those? Ultimately, the most productive societies have been built around individuals acting in their own self interest. I think the bigger challenge is to set up processes where what we do in our own self interest works to further the collective interest. It suggests to me that we need to expand reading lists in MBA programs to include a little more Adam Smith and Milton Friedman... and a little less of whatever is on the list right now.

3. Watch out for those who are holier than thou: I don't know the people who signed this oath and I am sure that many of them are well intentioned, good people but I do remain suspicious of people who sign oaths like these. My experience is that the people who indulge in breast beating about honor, ethics and honesty are often the least dependable in the face of an ethical challenge.

Finally,the article finds the obligatory ethics professor to quote. Not surprisingly, she proclaims the beginning of a new age of ethics in business. That's baloney. After every crisis, this type of talk abounds, in conjunction with business schools flaunting their newest ethics offerings. Notice how frequently they have to make these classes required courses rather than electives. Tells you something about how much of it is window dressing... Human beings are human beings, and by the time we get them in MBA programs, their ethics are already well formed. It takes incredible conceit to think that we can put grown ups through an ethics class and change their definitions of good and bad...

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Stockholder democracy...

Today's New York Times carries an article on shareholder democracy that illustrates why there are shades of gray even with proposals that seem absolutely cut and dry at the outset. This one has to do with the proposal from the SEC, allowing institutional investors to propose board members who would then be listed in the proxies that companies send out to stockholders. (Only investors who are not interested in doing an acquisition and have held the stock for more than a year can propose new directors, and even then, only 25% of the directors can be challenged) The idea seems unexceptional. Until now, shareholders have had to vote for those directors proposed by the company or write in their own alternates; only in a proxy fight do shareholders get choices. This rule change would presumably give them more choices even in the absence of a proxy fight.

The fear voiced in this article is that some shareholders may have other interests in the company that overwhelm their interests in seeing stock prices improve. The example given is of a shareholder who has taken a large position on the credit default swap market, betting that the company will fail. Such a shareholder may gain more from seeing the company default than continue as a going concern; consequently he or she may nominate directors who will drive the company into the ground.

I think that the article has a point, though I think it is also a little over the top in terms of hysteria. There are two phenomena muddying the waters of shareholder democracy. The first is investors who own hybrids - convertible bonds, debt with equity options etc., who do have multiple and sometimes conflicting interests in the firm. This is not new but it is a much bigger factor now than two decades ago. The second is that increasing presence of investors who bet not on the direction of the stock price but on its volatility. Many option based strategies are directionless - investors don't care whether the stock goes up or down - but make or lose money depending upon how volatile the stock is. The SEC's implicit assumption that all stockholders have a shared interest in the stock price going up is coming into conflict with the consequences of a more diverse set of interests in stockholders: some want the stock price to increase but some do not.

I do not have an easy solution. We could try restricting shareholder voting only to those investors who have no conflicting interests, but I don't think that proposal can be easily policed and it would not be fair. A bondholder who has an equity position is just as much an equity investor as one who does not, even though the former's interests may diverge from the remaining stockholders. I am also not comfortable with any rule that tries to define "good" shareholders and "bad" shareholders. Good and bad are in the eyes of the beholder... Ultimately, as in any democracy, we have to trust the voters to make the right judgments, even though they may bring in very different interests into the voting booth.

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Keep it simple!!

While I took issue with a great deal of what Mr. Buffett said in the last post, there is one point on which I completely agree. Keep it simple! In my valuation classes, I begin my class by promoting the principle of parsimony. In the physical sciences, this principle (also known as Occam's razor) specifies that when trying to explain any phenomenon, you start with the simplest possible explanation before moving on to more complicated theories.

In valuation, the principle of parsimony calls on us to use the simplest possible model to value any asset. However, there is a catch. The definiton of simplest will vary, depending upon the asset you are valuing. When valuing cash, for instance, you can just count the cash on hand; you don't need a model or elaborate assumption. When valuing a mature company, with stable and predictable, profits, knowing what the firm generated in cash flows last year may be sufficient to value the firm. When valuing a young, growth company, the simplest model may require you to forecast earnings and cash flows for an extended period. You may not like to do it (I don't think anyone does) but there is no real choice..

So, here is the bottom line. I oppose detail for the sake of detail and complexity designed to show the world how smart and sophisticated an analyst is. I think you risk mangling the valuations of simple assets by doing so. However, I think to argue that detail is always bad and that forecasting is dangerous works only if you decide that your investment space is going to be populated only by mature companies. If you, as an investor, are interested in buying growth companies (and there is no law that says you have to be) or valuing them, you have to face up to the truth. There is no way to value these companies without peeking into the future and making forecasts, and then adjusting your value for the uncertainty you feel about these forecasts.

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