The Fed Effect: Central Banks and Equity Value

Last week, the Federal Reserve announced that it would increase the Fed Funds rate by 0.25%. While the increase was small and the overall rate still remains low, by historical standards, concerns about the implications to the stock market surfaced almost immediately.
http://www.nytimes.com/2010/02/19/business/19fed.html
While, at first sight, this seems like unmitigated bad news - higher interest rates, after all, hurt stock prices - the effects of central bank interest rate policies on equity values is a little more ambiguous. There are several forces that come into play:

a. The Interest rate effect: Did the Fed raise interest rates last week? Not really. First, the only rate that the Fed has direct control over is the Fed Funds rate, i.e., the rate at which banks borrow from the Fed for emergency short term funding, a very small proportion of overall loans. Second, while it is true that the Fed's actions can affect market interest rates, the effect is more at the short end of the term structure than the long end. Thus, an expansionary central bank can push short term rates down but has relatively little influence over long term rates. That is also the reason why yield curves can become downward sloping, when central banks adopt restrictive monetary policies. In both valuation and corporate finance, it is the long term interest rate that determines discount rates and value.

b. The Inflation effect: Monetarists have long argued that the primary job of a central bank is to keep the currency from being debased, by holding inflation in check. Building on that theme, it has also been shown fairly conclusively that the biggest factor driving long term interest rates is expected inflation. Thus, a central bank that raises short term rates may be viewed by markets as fighting inflation, which can cause long term interest rates to fall contemporaneously.

c. The Economic Growth effect: For better or worse, central banks have also been assigned the role of custodians of economic growth. Thus, central bankers have to weigh the inflation fears against the real growth consequences, when raising or lowering rates. Markets therefore view the central bank's final actions as signals of what the central bank thinks about future economic growth. Thus, it is argued that a central bank that raises rates will do so only because it has information that leads it to believe that economic growth is strong enough to withstand the rate increase. Ironically, a rate increase can then be viewed as good news about future economic growth.

So, what do I think will happen to stock prices if central banks raise interest rates? Rather than give you the classic, "It depends ..." response, let me take a stand.
- If the central bank is viewed by markets as informed, independent and credible, a rate increase should be good news for markets; the real growth effect should dominate the effect on short term rates.
- If central banks are viewed as weak and/or uninformed, their actions will have little effects on markets, in the most benign case, and have negative effects, in other cases. As an example of the former, think of Japan in the 1990s, where the central bank was viewed as ineffectual. As an example of the latter, think of almost any Latin American country's central bank in the 1980s.

The bottom line. It is in every economy's best interests to have a central bank that is viewed as strong and effective, since the actions of the bank may be the last, best defense against economic meltdowns. Unfortunately, central banks become easy scapegoats for politicians, when economies stumble. Take the president of Argentina, Christina Kirchner, who recently fired the Argentine central banker (after repeatedly misfiring):
http://online.wsj.com/article/SB10001424052748704533204575047631291330838.html
Count me among those who will not be investing in Argentine companies in the near future. And how about the US? Ben Bernanke, the Fed Chair, was made to jump through hoops by senators, before they voted on renewing his chairmanship. Not surprisingly, they wanted him to promise that he would put employment above inflation in his decision making..... Poltical short sightedness knows no borders.

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Transactions Costs and Beating the Market

One of my books, Investment Fables, is directed at answering one of the most puzzling questions in investments: How is that there seem to be so many ways to beat the market on paper but that so few money managers seem to do it in practice? A key reason, in my view, is that transactions costs have a much greater impact on returns than we realize.

Let's start with the good news. Both academics and practitioners have found dozens of ways to beat the market. To see the academic list of market inefficiencies, try this link:
http://www.amazon.com/Inefficient-Stock-Market-Robert-Haugen/dp/0130323667
And here is a link to sure fire money makers from practitioners:
http://www.amazon.com/Ways-Beat-Market-Hundred-Stock/dp/0793128544
Wow! Hundred ways to beat the market! Each new finding in academia seems to offer fresh opportunities for the "smart, informed" investor. The latest wave of schemes build off the behavioral finance literature. In fact, two prominent behavioral finance economists have set up their own money management firm (showing you that academics are not immune from greed):
http://www.fullerthaler.com/

Most of these beat-the-market approaches, and especially the well researched ones, are backed up by evidence from back testing, where the approach is tried on historical data and found to deliver "excess returns". Ergo, a money making strategy is born.. books are written.. mutual funds are created.

Now let's look at the bad news. The average active portfolio manager, who I assume is the primary user of these can't-miss strategies does not beat the market and delivers about 1-1.5% less than the index. That number has remained surprisingly stable over the last four decades and has persisted through bull and bear markets. Worse, this under performance cannot be attributed to "bad" portfolio mangers who drag the average down, since there is very little consistency in performance. Winners this year are just as likely to be losers next year...

So, why do portfolios that perform so well in back testing not deliver results in real time? The biggest culprit, in my view, is transactions costs, defined to include not only the commission and brokerage costs but two more significant costs - the spread between the bid price and the ask price and the price impact you have when you trade. The strategies that seem to do best on paper also expose you the most to these costs. Consider one simple example: Stocks that have lost the most of the previous year seem to generate much better returns over the following five years than stocks have done the best. This "loser" stock strategy was first listed in the academic literature in the mid-1980s and greeted as vindication by contrarians. Later analysis showed, though, that almost all of the excess returns from this strategy come from stocks that have dropped to below a dollar (the biggest losing stocks are often susceptible to this problem). The bid-ask spread on these stocks, as a percentage of the stock price, is huge (20-25%) and the illiquidity can also cause large price changes on trading - you push the price up as you buy and the price down as you sell. Removing these stocks from your portfolio eliminated almost all of the excess returns.

In perhaps the most telling example of slips between the cup and lip, Value Line, the data and investment services firm, got great press when Fischer Black, noted academic and believer in efficient markets, did a study where he indicated that buying stocks ranked 1 in the Value Line timeliness indicator would beat the market. Value Line, believing its own hype, decided to start mutual funds that would invest in its best ranking stocks. During the years that the funds have been in existence, the actual funds have underperformed the Value Line hypothetical fund (which is what it uses for its graphs) significantly.

In closing, I am not trying to dissuade you from being an active investor; I am one. My point is that you should be careful about taking the claims by anyone - academic on practitioner - about market-beating strategies. The market is certainly not efficient, if you define efficiency as an all-knowing, rational market, but it certainly seems efficient, if you define efficiency as investors being unable to take advantage of market mistakes. Talking about making money is easy.. actually making money is far more difficult.

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The Credit Default Swap (CDS) Market

The Credit Default Swap (CDS) market has been in the news recently, as Greece goes through the throes of imminent or not-so-imminent default. I thought it would make sense to put down my thoughts on the market:

a. What is a CDS?
A CDS allows you to buy insurance against default by a specific entity - government or corporate. Consider, for instance, the 5-year CDS against Brazilian default. On February 11, 2010, it would have cost you 137 basis points to buy this swap on the CDS market. In practical terms, if you had $ 100 million in $ denominated 5-year bonds issued by the Brazilian government, you would pay $1.37 million each year for the next 5 years for protection against default If the Brazilian government defaulted during the period, you would receive $ 100 million.

There are CDS available on more than 50 governments, dozens of quasi-government instiutions and many large corporations. You can, in effect, make your investment in any of these institutions close to riskfree by buying CDS on any of them.

One feature of the CDS market that needs attention is that there is the possibility of counter party risk on both sides. In effect, both the buyer and the seller may default. Thus, in the 5-year Brazil CDS example, the buyer may not be able to deliver $1.37 million a year for the next 5 years and the seller may not be in a position to deliver $ 100 million, in the event of default.

b. History and growth of the CDS market
The CDS market was devised by a group of bankers at J.P. Morgan as a measure to protect the bank and clients against potential default in the late 1990s. Initially, the market was a very small one, used by investors to to hedge default risk in large positions. In the last decade, the market exploded as both buyers and sellers flocked into it. By 2008, the dollar value of securities covered by Credit Default Swaps exceeded $ 50 trillion and in fact was larger than the actual bond market. Put another way, people were buying insurance against default risk in securities that did not even exist.

c. Why would anyone buy a CDS?
The answer may seem obvious. Investors will buy a CDS to protect an open position that they have in a bond with default risk. That facile answer can be challenged with an obvious riposte: if you want to take no risk, why not just buy a default-free investment in the first place. Clearly, though, the sheer volume of trading suggests that hedging is only part of the story. The other reason for buying a CDS is because you expect the default spread in an entity to widen in the near future. Thus, an investor who expects Brazil's default risk to increase in the future may buy a 5-year CDS at 137 basis points and turn around and sell it for a much higher price later, if he is right.

In fact, one critique of the CDS market is that it is less about hedging and more about speculating. The Greek and Portuguese governments have complained that the CDS markets have deepened their woes:
http://online.wsj.com/article/SB40001424052748703382904575058881703896378.html?mod=WSJ_Markets_section_Heard

d. Why would anyone sell a CDS?
Again, there are two reasons. One is to operate as a broker and make money of transaction volume. If this is the rationale, you would hedge your exposure to risk by both buying and selling CDS and keeping your net exposure close to zero. The other is to speculate. If you expect the default risk in an entity to narrow quickly, you could sell the CDS at a high price and cover at a lower price.

While banks, investment banks and hedge funds are the biggest sellers of CDS, the seller does not have to be a regulated entity though the major sellers are subject to bank capitalization requirements. There is the very real danger that an entity may be tempted to sell CDS to collect cash now and worry about the potential liabilities later (AIG and Lehman come to mind...)

e. What information is in a CDS spread (and changes in it)?
The price on a CDS market is a function of demand and supply. For better or worse, it gives you a measure of what the market thinks about the default risk in an entity at a point in time. Note that this is true, whether investors are hedgers or speculators.

The overlay of counter-party risk affects the prices of CDS. This is one reason why the CDS on even default-free entities will trade at non-zero prices. When perceptions of counter-party risk rise across the board, as they did after the Lehman default, the prices of all credit default swaps will go up.

f. How can we use that information in corporate finance/valuation?
There are at least two places where the CDS market can be put to good use:
a. Country equity risk premiums: The equity risk premium for a risky emerging market should be greater than the equity risk premium for a developed market. One way to compute the additional risk premium is to compute a default spread for the riskier market and the CDS price provides a good starting (or even ending) point. In the Brazil example above, this would translate into using an equity risk premium for Brazil that is at least 1.37% (the CDS price) higher than the premium for the US. In more sophisticated versions of this approach, the 1.37% will be modified to account for additional equity market risk.

b. Cost of debt: The cost of debt for a firm can be obtained by adding a default spread for the firm to a riskfree rate. While this default spread can be difficult to obtain for many companies, we can use the CDS spread for a company (if one exists) to the riskfree rate to get to a pre-tax cost of debt.

In closing, there is useful informaton in the CDS market that we ignore at our own peril, when doing financial analyses and valuation. While there is substantial volatility in the market, the prices in the market allow us to get a sense of what investors think about default risk in entities and the price they would charge for bearing or eliminating that default risk. While it does open the door to those betting on default risk changes, it makes no sense to shoot the messenger and to ignore the message. The default risk problems faced by the Greek, Spanish and Portuguese governments are of their own doing and have been a decade in the making. Blaming the CDS market for these problems makes no sense!

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Thoughts on the riskfree rate

Early in my blogging life, September 20, 2008, to be precise, I posted my thoughts on riskfree rates generally and about using the US treasury bond rate as a riskfree rate, in particular. With the turmoil sweeping through the European sovereign bond market right now, the time may be ripe to revisit the topic.

Let us start by stating the obvious. Knowing what you can make on a riskfree investment is a prerequisite for any type of corporate financial analysis or valuation. In most textbooks on finance, though, the riskfree rate is taken as a given.

Backing up a bit, consider the three conditions that have to be met for an investment to have a guaranteed return over its life. First, the cash flows have to be specified up front; this essentially rules out any residual cash flow investment (equity) and puts into play investments where the cash flows are contractually defined (fixed income). Second, there can be no default risk in the entity promising the cash flows; a corporate bond rate can never be a riskfree rate. Third, there can be no reinvestment risk; a six-month treasury bill is not riskfree for a five year cash flow, since the rates in the future can change. The bottom line is that we generally try to find a long-term, default-free rate to use as a riskfree rate.

Given this premise, it is not surprising that most books suggest using the US treasury rate (ten or thirty year) as the risk free rate in US dollars. Implicit in this practice is the assumption that the US treasury is default free. One troubling story from last week related to Moody's potentially downgrading the US from Aaa (and thus introducing the possibility of default into the equation).
http://abcnews.go.com/Technology/wireStory?id=9732868

Now, let's think about a Euro riskfree rate. There are a dozen European governments that issue ten-year bonds and the link below provides rates as of last Friday.
http://markets.ft.com/markets/bonds.asp
Note that the rates vary from 3.11% for Germany to 6.66% for Greece. Since the bonds are all in one currency (Euros), the differences have to be due to default risk. Thus, the German Euro bond rate is likely to be closer to the riskfree rate in Euros than any of the other bonds; in fact, the true riskfree rate is probably a little bit lower than the German bond rate.

Let's now look at an even more complex scenario. Assume that you want a riskfree rate in Indian rupees. At the start of the year, the Indian government ten-year bond rate (denominated in rupees) had an interest rate of 7%. If we accept Moody's rating for India of Ba2 and estimate a default spread of 2.5% for Ba2 rated bonds, the riskfree rate in Indian rupees is 4.5%:
Rupee riskfree rate = 7% - 2.5% = 4.5%

One last rung of complexity. In some emerging markets, there are no long term government bonds in the local currency. Here, the choices are either to do the analysis in a different currency or in real terms.

Ultimately, if riskfree rates in different currencies are measured right, differences between rates should be entirely due to expected inflation. Once that is accomplished, valuations will become currency neutral (as they should be).

In summary, estimating riskfree rates is not always easy. I have a paper on the topic that examines the estimation of riskfree rates in more detail:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1317436
I hope you find it useful.

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Emerging versus Developed Markets: The margin shrinks in 2010

One final post based upon 2010 data. I have been interested in emerging markets, in general, and the challenges of valuing companies in these markets, in particular, for a long time. When I started on this endeavor in the 1990s, the fault lines between developed and emerging markets were stark and could be categorized on the following dimensions:

1. Financial markets versus Economy: In emerging economies, financial markets were a very small and unrepresentative sampling of the underlying economy. Thus, the bulk of the market capitalization in most emerging markets came from recently privatized infrastructure companies, a few large banks and family controlled corporations. In developed markets, especially the US, Japan and the UK, much of the economy was corporatized and publicly traded.

2. Liquidity and capital access: Emerging markets were subject to ebbs and flows in liquidity, with crises, where liquidity and capital access dried up for almost all firms in the market. Only those emerging market companies that had access to foreign capital were able to maintain life lines during these periods. In developed markets, it was accepted that while some segments of the economy would have trouble raising capital, liquidity and capital access would remain available to most mid cap and large cap firms.

3. Default risk in government: Investors in bonds issued by governments in emerging markets assumed that would be a significant risk of default in these governments, even when they borrowed in the local currency, and priced in this default in the form of high interest rates. Investors in bonds issued by governments in developed markets did not even give thought to the possibility of default in the local currency.

4. Government role in company/economic health: Governments in emerging markets played a much more intrusive (and larger) role in their economies and the fates of their companies (through both explicit controls and licenses and implict threats of nationalization or expropriation). They were also viewed as more volatile and unpredictable. Consequently, when valuing emerging market companies, assumptions about government competence (or incompetence) and actions (or inactions) could affect company value substantially. In developed markets, the value of a company was largely a function of its management qualities and competitive advantages, and governments were viewed as predictable, side players.

5. Currency and inflation: In emerging markets, there was distrust of the local currency, often motivated by bouts of inflation and political uncertainty in the past. This distrust manifested itself in many ways, from an unwillingness by any entity in that market to borrow/lend long term in the local currency, to all analysis being done in U.S. dollars. In developed markets, investors may have been susceptible to complaining about the strength/weakness of the local currencies but inflation was mostly viewed as a controllable problem and currency longevity was taken as a given.

The crisis of 2008 may have precipitated this shift, but it is a shift that has been occurring over much of the last decade. Today, the gap between emerging and developed markets has shrunk and, in some cases, disappeared.

a. Financial markets and economy: While there remain many emerging economies, where financial markets lag the economy, the biggest emerging markets (India, China and Brazil) have seen explosive growth in both the number of companies that are publicly traded and the portion of the economy that is covered by financial markets.

b. Liquidity and capital access: In the last quarter of 2008, we witnessed the almost unimaginable sight of GE being unable to issue commercial paper. In effect, developed markets discovered that you could have a liquidity crisis that affected all companies and all sources of capital. At the same time, the expansion of local investor bases has made emerging markets more liquid and expanded capital access to companies in these markets.

c. Default risk in government: As emerging market governments establish a track record of paying their obligations on time and without fanfare, and developed market governments (Greece, Iceland) reveal significant potential for default, the notion that there is no default risk in developed market governments is coming under assault. In fact, the argument that the US and the UK may not be AAA rated forever no longer sounds far fetched.

4. Governments and Economy: While I was valuing Citigroup and Bank of America early in 2009, I realized how much my valuations of these two firms was dependent upon government action or inaction and I found myself using techniques that I had developed to value emerging market companies in the 1990s. At the same time, I find myself valuing well run Brazilian and Indian companies, without paying much heed to the governments in the markets. (I am afraid I cannot say this yet for Chinese companies, because of corporate governance concerns)

5. Currency and Inflation: As I noted in an earlier post, I see a much greater willingness in large emerging markets to analyze investments and value companies in the local currency. Investors in these markets have more faith in their currencies and seem to be less scarred by inflation worries than in periods past. At the same time, investors in developed markets seem to be jumpy about potential inflation in the future; this fear may not be manifested in current inflation or interest rates but it can be seen in the flight to gold and talk about hyperinflation.

In closing, the gap between developed and emerging market companies is closing, both in economic and analytical terms. The former are displaying some of the most troublesome characteristics of the latter, whereas the latter are maturing. For analysts and investors, the lessons should be clear. Developed market investors who have become lazy over decades of stability need to wake up and use techniques that emerging market analysts and investors have used for that same period. Emerging market investors and analysts who have made their money by playing the macro and government forecasting game have to start thinking more seriously about company fundamentals and value. There is work to do!

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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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