The Crisis of 2008: Lessons learned, unlearned and reinforced

The one thing I can say about 2008 was this it was not boring. I know that there will be a flood of books coming out over the next few months telling us what happened, why it happened and most important of all, who to blame. I don't think that they will tell us much that we don't know already.  I have a different book in mind and this is what I want to do. I want to look inward and ask myself what I have learned from these last few weeks that I can incorporate into my "view of the world" looking forward. I The market collapse and investor reaction has been a humbling experience and has revealed how much I do not know or fully understand about finance.  Here is my initial list:

Things that I know now that I did not know on September 12....

1. Nominal interest rates can become negative.
   
2. There is no riskfree asset.
   
3. Equity risk premiums can change dramatically even in mature markets.

Things that I thought I knew on September 12, that I am not so sure about now...

1. Large companies in developed markets can always raise new capital.
   
2. Bank runs are things of the past, with the regulatory oversight, accounting rules (mark to market) and risk management tools that we have today.
   
3. Value investing (investing in low PE , high dividend yield and low PBV stocks) is less risky than growth investing.
4. Dividends are sticky.
5. Diversification across asset classes provides protection.

Things that I kind of knew on September 12 that have been reinforced since....

1. Debt is a double edged sword. (The costs and likelihood of distress can be much higher than I thought...)
2. A large cash balance is not just a wasting asset but protection against danger.
3. The line between hedging and speculation is a very fine one... and easy to cross...
4. Main Street and Wall Street are co-dependent. One cannot be healthy, if the other is not.
5. We are in a global economy.
6. Ignore illiquidity at your own peril.... Its cost can vary across time and across markets
7. Risk is not just a number.
8. Stocks don't always win in the long term.
9. Smart money is not that smart!!! 
10. Even great investors make mistakes! 

In fact, I have been collecting ammunition for each of these points, by scouring news stories from the the last three months. Sometime over the next year, I will sit down and start putting it down on paper. All I need is a good title!

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Sticky dividends!

When we look at how companies have set dividends in most markets, the word that comes to mind is "sticky". Put another way, most companies set absolute dividends and stick with those dividends through good times and bad. A few even have a policy of consistently raising dividends and continue to do so, even in the worst of times. This has been true for decades in the United States, but I was curious about whether the last three months of market turmoil have made significant inroads into changing the policy. The answer seems to be yes, but with caveats...

1. S & P keeps track of how many companies in the S&P 500 index increase, decrease and suspend dividends, by month. In the last quarter of 2008, 32 firms increased dividends, 17 firms cut dividends and 10 suspended dividends. No firm initiated dividends during the period. If you are surprised that more firms increased dividends than cut or suspended dividends, here are the statistics for the previous three quarters.

• First quarter, 2008: 93 increases, 7 decreases, 4 suspensions
• Second quarter, 2008: 65 increases, 9 decreases, no suspensions
• Third quarter, 2008: 45 increases, 6 decreases, 8 suspensions
• Just as a further contrast, in all of 2007, there were 299 dividend increases, 7 decreases and 3 suspensions.

2. Some companies did deviate from long-standing dividend behavior in these last three months. To provide an illustration, Pfizer did not increase its dividends in 2008, for the first time in 42 years, evoking an article in the Wall Street journal wondering why they decided to do so...

I think 2009 will lead to even more conservative behavior, at least when it comes to dividend policy. After all, one reason that companies felt comfortable maintaining dividend payments, even in the face of declining earnings or losses, was the belief that they could raise funds from capital markets, if they needed them. If the last quarter of 2008 has taught them a lesson, it is that capital markets can shut down even for the largest companies in the most developed markets. There is a new found respect for large cash balances at companies, though I am not sure how long it will last.

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Hard wired to deceive?

As the Madoff story runs its course and investors express surprise and shock that they were taken to the cleaners, it may be worth noting that research in the social sciences suggests that this may be par for the course, given our genetic make-up. Here is the evidence:

1. Brain size and potential for deceit are correlated: Studies of primates have uncovered an interesting finding. The larger the brain of a primate, the more likely it is that it will indulge in deceitful behavior. The great apes, for instance, are masterful deceivers but as the primates with the largest brains (arguably), human beings are at the top of this deceitful heap... And smart human beings are much better at deceiving others than dumb human beings!!
Bottom line for investing: You are at greatest risk of being lied to, when you invest with the smartest portfolio managers (hedge funds?)...

2. We lie and we do so habitually: A study that tracked students (by inviting them to keep track of their lies in a journal) uncovered the fact that they typically lied about two times a day.
Bottom line for investing: The standard investment sales pitch contains more than its share of half truths.

3. We do feel guilty when we lie, but that does not stop us from lying again: The same study that uncovered the fact that students lie two times a day, on average, also found that while they felt guilt at doing it, the fact that they were able to get away with it reinforced the behavior. Put another way, if you get away with lying once, you will will try it again...

Bottom line for investing: All the ethics classes in the world and forcing everyone to attend religious services every week won't stop the next big fraud or even reduce its likelihood.

4. We often want to be lied to: Here was the most interesting conclusion. The researchers who have looked at this phenomenon and noted that it has been going on for as long as we have been on earth have determined that, deep down, we want to be lied to. In some cases, this is because the truth will hurt too much (That dress does really make you look fat) and in other cases, because the lie makes us feel better (You are brilliant!!!)..

Bottom line for investing: Every fraud has two players - the fraudster and the victim. While we tend to think of the former as the villain and the latter as the victim, they need each other for it to work.

So, take the talk that you hear about this being the fraud to end all frauds with a grain of salt. This has happened before and will happen again... why? .. because we are human!!

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To zero..and beyond...

Day before yesterday, the Fed announced that is was cutting the Fed Funds rate close to zero. In the weeks preceding, the three-month US treasury bill rate has flirted with negative yields... Both phenomena raise a question: Can nominal interest rates become negative?

Let us start off by accepting the fact that real interest rates can become negative and have, for extended periods in the past. Real interest rates can happen when expected inflation is high but central banks decide to flood the market with enough funds to keep nominal interest rates below the expected inflation rate. However, a negative nominal interest rate is not only unusual but difficult to grapple with. As my sixteen-year old put it, why would someone put their money into an investment to get less in three months than they invest today? Why not stick the money in a checking account or even under the mattress for that period?

For small amounts of money, nominal interest rates should never fall below zero, because either the checking account option and the mattress option is viable. But what if you are a portfolio manager or a corporation with $ 3 billion in cash? Holding the cash balance as currency in your corporate headquarters is an invitation for the heist of the century (Think Oceans 11, 12 or 13..) Putting the cash into a bank account is not completely secure, because the FDIC protection works only up to $250,000.... If the bank goes under, your principal is at risk. In normal times, we would not consider this a likely scenario but we are not in normal times.

Both the Fed move to cut the Fed funds rate close to zero and the short term treasury bill rate dropping below zero are indications of how much investors have lost faith in the banking system. Large investors are in effect saying that they would rather accept an -0.5% nominal interest rate than risk leaving large amounts of cash in a bank. That is not only astounding but scary.

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To Madoff or not to Madoff?

By now, everyone has heard the story of Bernhard Madoff, the New York city based investment advisor, who was just arrested for perpetrating a fraud estimated in the billions ($55 billions?) As we look at list of prominent people who have been snared in this web of deceit, including Mortimer Zuckerman and Elie Wiesel, we have another opportunity to examine the consequences of greed, hubris and eventual downfall.

The facts of the story seem fairly clear. Madoff made his initial reputation as a broker/dealer, and he built a business based upon computerization and quick trades for his customers. Somewhere along the way, he also became an investment advisor, though he did not file to officially become one until 2006. He moved in the highest circles of society, and wealthy investors clamored to be his clients. He made himself even more desirable to these investors by turning away several. His allure was not that he delivered super high returns but that he delivered stable and solid returns year in and year out. In effect, he seemed to have found a way to take little or no risk and deliver about 5-8% more than the treasury bond rate. Last week,. he gave away his secret. He had been operating a Ponzi scheme, i.e, using money raised from new investors to deliver returns to old ones. Like all Ponzi schemes, it was dependent on new money coming in. The market collapse of the last few months essentially cut off that inflow, leaving Madoff exposed.

Rather than make this a treatise about bad investment advisors and unquestioning investors, I would like to make a general point about investing in general and professional investors in particular. There are two questions that we can ask about these investors:

a. How much money (returns) did a particular investor make over a period or periods?

b. Why did they make the returns that they did?

As individuals, we are drawn to the first question and there are services that report these numbers in mind-numbing detail. Morningstar, for instance, has returns on every mutual fund in the US, going back in time. Others then build on these numbers: the funds themselves advertise with evidence of superior returns and ranking and reputations are built on past returns. The second question, however, is viewed as intellectual and in some cases, as academic, and seldom gets answered seriously. If we want to entrust our money to a professional, though, we need both questions answered well. In other words, I not only need to know how much you (as a professional money manager) have made over time but also why you made this return: was it superior information, your analytical ability or your trading skills? Using the language of corporate strategy, I would like to know what your competitive edge is and how you plan to maintain it.

 Any investor asking the second question about Madoff would have uncovered red flags. The man was not (and never claimed) to be a sophisticated number cruncher and he clearly did not enunciate an innovative investment strategy. The only potential advantage that he might have had came from his access to the trading data of investors (through his broker/dealer firm) and front running (trading ahead of) his brokerage clients. That, of course, is illegal and would eventually be uncovered. In other words, there was no basis for his solid, stable returns. He was either lucky (but that is tough to pull off over 30 years) or committing fraud. Last week we found out the answer.

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Enterprise value is negative... Is that possible?

There are three measures that can be used to capture the market value in a business. We can measure the market value of equity, i.e., the market capitalization of the equity in the firm. We can add the market value of equity to the market value of debt to get the total market value of the entire firm: think of this as the market value of all of the assets of the firm. We can add the market value of equity to the market value of debt and subtract out cash and marketable securities to get to the enterprise value: this, in effect, is the market value of the operating assets of the firm.
We see the first number in equity multiples; the PE ratio and the Price to book equity are computed using the market value of equity. We see the last number in multiples of EBITDA and revenues; the rationale for netting out cash is that the income from cash is not part of either EBITDA or revenues.
All of this leads me to a curious phenomenon that has occurred at some large firms, where the enterprise value has become negative. Here, for instance, is a Bloomberg article on the topic:
http://www.bloomberg.com/apps/news?pid=20601087&sid=ahiVT6vmGNEA&refer=home
In other words, the cash and marketable securities exceed the cumulated market values of debt and equity. In theory, at least, this seems to be an easy arbitrage opportunity, where you can buy all of the debt and equity in a firm and use its cash balance to cover your investment costs and keep the difference. Here are some reasons why you should be cautious:
1. The computed enterprise value may not have captured all of the debt outstanding in the firm. With a retail firm, for instance, enterprise value should include the present value of lease commitments as debt. What you see reported as enterprise values for WalMart, Target and Best Buy is understated because of this failure. In the Bloomberg list, for instance, there are a preponderance of banks and financial service firms. I have always had a tough time defining debt and enterprise value at these firms and am dubious about most of these firms.
2,. The cash that is netted out to get to enterprise value is usually from the most recent financial statement (rather than the current date used for market cap). Given how quickly firms burn through cash, what you see on the balance sheet may not reflect what the firm currently has as a cash balance.
3. Some services are sloppy about their definition of market value and seem to mix up market value of equity with market value of the firm.
The core of the article, though, is that stocks are cheap on a historical basis but history also tells us that there are no slam dunk investment profits. There is a many a slip between the cup and the lip when it comes to arbitrage profits.

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Corporate Hedging: Answers to questions

A couple of posts ago, I presented six examples of risk hedging/ taking that I would like to take through my three bucket test - risk to pass through, risk to avoid/hedge and risk to exploit.

1. Southwest has always hedged against oil price risk, using futures contracts. Is what they are doing make sense? Given that Southwest's core competence (see, I can speak like a corporate strategist) is running an airline (not forecasting fuel prices), that fuel prices are such a large portion of total costs, and Southwest has done this through high and low oil prices (and are thus not trying to time the oil market) , I think it makes sense.
   
2. In the last two years, other airlines that had never hedged against oil price risk decided to start because oil prices had gone up so much. Is what they are doing make sense? I am much more suspicious of this activity. The very fact that they are hedging only after oil prices have run up, suggests to me that there is an element of market timing here. Not surprisiingly, firms that do this end up with the worst of both worlds. They hedge against oil prices after they have run up and stop doing it after oil prices have gone down.
   
3. A publicly traded soccer team buys insurance against it's leading player getting injured. Does that make sense? I think this does, since investors in the firm would have a difficult time doing this on their own. The team also has information on the player's physical status that an investor would have no access to.
   
4. As the Brazilian Real increased in value against the US dollar, Aracruz decided to make a bet of tens of millions on the continued strengthening of the Real. Good idea, bad idea? This is plain dumb. Aracruz is a paper and pulp company. As an investor in the company, the last thing I want them to try and do is time exchange rate movements (and I would have said the same thing even if they had made money)
   
5. A trader at an investment bank decides to bet, with proprietary capital, that interest rates in the US will rise over the next year. Makes sense? I have always been skeptical about propreitary trading profits reported at investment banks, since I see little that they bring to the table as competitive advantages. They trade with each other, using the same information base and often the same traders (who move from bank to bank). I see no reason to believe that a trader at an investment bank (and the economists at the bank) have any special insight into the future direction of rates.
   
6. Barrick Resources, a gold mining company, decides to sell futures contracts to lock in the price of golf for the next five years. What do you think? I invest in gold mining stocks because I am optimistic about gold prices going up. If Barrick goes out and hedges against gold price movements in the future, it is undercutting my rationale for investing.

The bottom line, though, is that we should not judge any of these firms by the outcomes of their actions, but by whether their actions make sense. (Aracruz could have made hundreds of millions on its currency bets and Southwest is probably losing money, now that oil prices are declining)

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Happy Thanksgiving!

Time to take a break from pontificating and navel gazing. While there is much to worry about and anguish over, there is so much more to be thankful for. Have a wonderful Thanksgiving!

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Corporate Hedging: The Down Side

There is a news story in the New York Times today about Asian airlines and the losses that they are facing because of put options that they had sold against oil prices, months ago, that are now coming due as large costs. They sold these puts to offset the costs of buying calls against oil, where were, in turn, designed to hedge against higher oil prices.

In these days of risk and uncertainty, I am sure that many companies will be on the lookout for ways to hedge against risk, and they will find plenty of entities willing to tell them how to do it or sell them products or services that provide protection. After all, every macro uncertainty from interest rates to inflation to commodity prices can be hedged using derivatives or insurance. But is this a good idea?

In my book on risk, titled "Strategic Risk Taking", I have argued that the essence of good risk managment is separating risk into three buckets:

a. Risk that should be passed through to investors, because they either want to be exposed to this risk or because they can protect themselves at a far lower cost. Included in the first group would be commodity risk to a commodity company: investors buy stock in oil companies because they want to make a bet on oil prices. An oil company that hedges against oil price risk is undercutting that bet. Included in the second group would be risk that cuts in different directions for different companies. I think it is generally a bad idea for companeis to hedge against exchange rate risk, simply because a stronger dollar helps some companies and hurts others. As an investor with stakes in both Coca Cola and Boeing, I think about exchange rate risk in my overall portfolio (which I can choose to hedge if I want to) rather than in individual companies.

b. Risk that should be avoided/ hedged: This would include risks that are not easily visible or difficult to hedge for investors in the firm, but are large enough to affect it's operations or survival. Included in here would be the risk of physical damage to property (against which you can buy insurance) and the costs of inputs into the production process. Thus, there is a rationale for an airline buying oil price futures to lock in the cost of fuel, Not that the action will not make the firm more profitable over time but may improve its operating efficiency; the airline can set ticket prices, knowing what their costs will be, and focus on improving efficiency in areas where it can make a difference.

c. Risk that should be sought out and exploited: Firms become successful by seeking out and exploiting risks and not be avoiding them. However, they have to find those risks on which they have a competitive advantage to do this. This is where corporate strategy meets corporate finance/ risk management. The edge could be technology, brand name or information...

Since this post has become way too long, I will leave you with questions about risk hedging/taking in general that you can try answering with this framework (if that is how you want to waste your day):

1. Southwest has always hedged against oil price risk, using futures contracts. Is what they are doing make sense?
2. In the last two years, other airlines that have never hedged against oil price risk decided to start because oil prices had gone up so much. Is what they are doing make sense?
3. A publicly traded soccer team buys insurance against it's leading player getting injured. Does that make sense?
4. As the Brazilian Real increased in value against the US dollar, Aracruz decided to make a bet of tens of millions on the continued strengthening of the Real. Good idea, bad idea?
   
5. A trader at an investment bank decides to bet, with proprietary capital, that interest rates in the US will rise over the next year. Makes sense?
   
6. Barrick Resources, a gold mining company, decides to sell futures contracts to lock in the price of golf for the next five years. What do you think?
   

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Jekyll and Hyde revisited!

Yesterday's Financial Times had this headline: "Citi plans good bank, bad bank structure". In effect, Citi plan to separate all the toxic assets and put them in the bad bank and keep all the money making assets in the good bank. Well, I guess we should carry this to its logical extreme and let every company do this - break up into good and bad parts. Thus, Microsoft can consign Office and Windows to the good part and throw Xbox into the bad part.. The next step would be to have two listings for every company - with investors allowed to trade each part separately (we could call them MSFT-G and MSFT-B).

Here is the practical problem. Investors will undoubtedly mark up the prices for the good part, but how are we going to induce them to buy the bad part? After all, if the assets in this part are proven money losers, you would have to pay people to take parts of these assets. In the case of Citi, the plan is obvious. They want to keep the good part and spin off the toxic part to the government; in effect, tax payers will be left holding pieces of assets that will generate negative cash flows as far as the eye can see. If I were negotiating for the Treasury, I would demand a large chunk of the good part (in options or equity) in return for taking the bad part. Otherwise, it seems like a bad deal!

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Dividend Yield and T.Bond rate

The last few weeks have seen their share of the strange and the unusual. Last Wednesday, another milestone was reached. The dividend yield on the S&P 500 exceeded the 10-year treasury bond rate for the first time since 1958; just to add, the dividend yield went up only because stock prices have dropped so much this year. So. what is the significance of this occurrence?

a. The Bargain Basement view: If we assume that dividends are stable - and they have been remarkably predictable for the last few decades - investing long term in stocks seems like a no-brainer. The income you get from the dividends is greater than what you would make investing in treasuries, and when stocks eventually recover, you get the upside of price appreciation as well.

b. Dividends will drop: The counter to this viewpoint is that the recession and a desire for liquidity will cause companies to cut back on dividends. When they do, it is argued that this aberration will disappear.

I tend to agree more with the first viewpoint than the second. After all, companies in the US have not increased dividends much over the last 40 years and chosen instead to buy back stock. Last year, stock buybacks accounted for two thirds of the cash returned by corporations. I believe that companies that are facing hard times and desirous of liquidity are more likely to reduce stock buybacks than cut dividends.

However, I would fine tune the strategy. I would focus on companies paying high dividends - the list is long - and have little debt & large cash reserves. The collective dividend yield on these companies will be higher than what you can make on most safe investments currently...

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Good companies in bad businesses

All this talk about a federal bailout of GM and Ford has started me thinking about something that has always bothered me. There are some businesses where even the best companies seem to barely make it and everyone else is under water. The automobile business is a good example. Take Toyota, a company that most analysts would consider to be the star of the sector. The company earned a return on capital that matched its cost of capital last year and that was a good year. If the best company in the sector breaks even in a good year, where is the upside in this business? The airline business, since deregulation, is another example of a business that has few profitable companies. I know.. I know.. There are Southwest and Ryanair, but even these paragons of corporate profitability earn returns on capital that trail their costs of capital. The rest of the business is a disaster.

I opened up my economics and corporate strategy books to see if I could find an answer. One possibility is that these businesses are filled with irrational companies that do stupid things over extended periods, but I find that hard to believe. The other is that these businesses have not found (or have lost) a structure that can generate profits on a sustained basis. In the airlines business, deregulation opened the business up to new entrants and the new firms that entered undercut the established competition with lower prices for the most profitable routes. In the automobile business, the problem seems to be legacy costs - c0sts that firms have piled up over time, usually in return for short term labor peace. Note that the older automobile firms are in the most trouble... those pension obligations that they committed to decades ago have come back to haunt them.

Eventually, these businesses will have to find a stable structure, where the companies at least on average earn their cost of capital. When will this happen? I don't know, but we, as consumers, will continue to buy cars and travel on airlines... It is in our best interests that the companies that provide these products/services make a reasonable profit in the process.

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Some thoughts on Las Vegas!

I was in Las Vegas yesterday, staying at the Bellagio. As I walked through the casino floor to get to the convention center, where I was delivering a presentation on valuation, there were three things that struck me about the setting:
1. The first is that there is no better example of the ruthless power of the law of large numbers and probabilities than a casino. Think about it. You have hundreds of slot machines programmed to deliver about 90 cents on the dollar, on an expected value basis. No surprise, then, that they do.... The house always wins (at least on the slot machines).
2. The second is that there is no worse setting for talking about risk, risk aversion and risk premiums than a casino. After all, any individual who would spend his money in a casino has accepted an investment with an expected return of about -10% and some risk, not exactly compatible with a risk averse, rational individual. I know, I know.. Gambling is not an investment but done for entertainment. I did not see much joy in the faces of the slot machine players as I walked by.. If they were being entertained, they did a good job hiding it.
3. The final point, though, came from a movie that I saw a few months ago called "21", about six MIT students who figured out a way to beat the odds at Vegas by counting cards. Even the most secure systems (and Vegas is as close as you can get to a slam dunk as you can get..) have their weaknesses.
The bottom line... If you play a game where the odds are against you, you are likely to lose and the longer you play, the greater the chance that the odds will catch up with you.

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Blackstone's Woes: Some thoughts on Private Equity

About a year and a half ago, at the height of private equity's success, I put together a presentation on LBOs that examined what makes an LBO work and, conversely, why many of them were destined to fail. The LBO I looked at was the Harman deal, backed by two big names - Goldman and KKR. Based on my analysis then, I concluded that Harman fit none of the requirements for a good target - it did not have significant debt capacity (nullifying the leverage benefit), it was well managed (eliminating the restructuring need) and did not suffer any serious separation between management and ownership (countering the going private argument). If you are interested, I have a paper describing the deal that can be downloaded by going to: 

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1162862

My purpose in the paper was not to pick on Goldman and KKR but to make the following points:

1. Even smart people (and there are quite a few at both Goldman and KKR) sometimes do stupid things.  No one is immune from the "herd" mentality. Goldman and KKR were caught up in the mood of the moment - debt  would remain cheap and the economy would keep growing forever - and the deal was reflective of these views.

2. First principles in finance are like first principles in physics. If you violate them, they will catch up with you, no matter who you are. What are these first principles? Here is one. If you are a business that does not generate high cash flows right now, even though you may have great growth potential, you should not borrow money (even if there are people out there willing to lend you this money).

All of this pontificating brings me to Blackstone's earnings announcement due today. My guess is that "marking to market" all of their deals will have a devastating impact on their earnings. No one should be surprised and Blackstone is not alone in feeling the pain, but the lesson we should take away is that private equity and hedge fund investors make the same mistakes that other investors make - the only difference is that they do it on a bigger scale.

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Another strange incident... in a market full of anomalies!

In markets such as this one, where investors are reacting to events and rationality takes a back seat, we should not be surprised when we see anomalies... And that is where I would put what happened to Volkswagen's stock price this week. For a brief period on Tuesday, Volkswagen's market cap jumped four-fold to briefly become the largest market cap company in the world (in excess of $ 350 billion). In the process, hedge funds who had shorted the stock lost almost $ 20 billion. It was a classic "short squeeze", sometimes seen with small, market cap companies that are lightly traded, but seldom in a company of this size.
So, what happened? First, more than 60% of the shares in Volkswagen were held by investors who were not interested in selling the shares - 40%+ by Porsche and 20% by the Government of Lower Saxony; the float in the shares was low. Second, Porsche triggered the first run-up in the price by revealing that it would push its ownership stake to a higher number (60% or more). Third, the jump in the overall equity market on Tuesday added fuel to the price increase fire. Finally, the short positions that the hedge funds had were public information. Consequently, investors with net plus positions in the stock knew that they had the hedge funds over a barrel and could bargain for a higher price.
Today, the recriminations are flying. The hedge funds are accusing Porsche of misleading them, by leading them to believe that it would not increase its existing holding in VW. I think that Porsche did take advantage of these hedge funds and made billions in profits; in fact, it made more money from call options it had on Volkwagen stock last year than it made on it's entire auto business put together. At the same time, I feel not one iota of sympathy for the complaining hedge funds, since I am sure that they would have had absolutely no qualms doing exactly what Porsche did, if their roles had been reversed. You live by the sword, you die by the sword...

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What is the message the market is sending?

The interesting theme that emerged from last week's market mayhem is how the story driving market movements has suddenly shifted from banking problems to the overall economy. Until last week, every market move was traced back to banks or investment banks in trouble and the governments' attempts to bail them out. Last week, the collapse of the markets was almost entirely attributed to the recession that investors/economists see looming for next year.
While I am not dismissing the notion, it is worth looking at history to see how good or bad a predictor the market is, when it comes to the real economy. Someone far wiser than I once said that the market has predicted ten of the last seven recessions. I think that saying captures both the strength and the weakness of the market. Most economic slowdowns have been preceded by market declines but not every market decline has been followed by a slowdown. A drop of the magnitude that we are witnessing is signaling that economies will slow down, but we should be not so quick to jump to the conclusion about how steep that decline is going to be.
Note that embedded in every market slowdown are also the ingredients for the recovery of the economy in the future. While we should be worried about how quickly banks can return to what their real mission is - take deposits from savers and lend them at fair (reflecting default risk) interest rates to individuals and businesses - we should also take some solace in the fact that oil prices are down more than 50% from their highs, other commodities are also down steeply and interest rates globally are likely to stay muted. Many emerging markets have seen their currencies lose significant portions of value, making easier for their manufacturers to compete in a global market place. These factors will play a role in the recovery, when it comes.

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The New World Order: How this crisis affects valuation

Given how much this market crisis has shaken our faith in systems and numbers, it is no surprise to me that the most common question that I have faced these last few weeks is about how this crisis has changed the way I do valuation.
Before I answer, let me specify what has not changed for me. The intrinsic value of a business is still a function of its capacity to generate cash flows in the future. In other words, I am not going to create new paradigms for valuation just because we are in turmoil. In terms of estimates, though, here is what I believe has changed in these last 6 weeks:
1. The risk premiums we demand for investing in equities as a class and in corporate bonds has increased significantly. On September 12, the equity risk premium in the US was 4.2%. On October 16, it was greater than 6%. The key question we face is whether this is an aberration, in which case equities are massively under valued or whether we are facing a structural break, where we face higher risk premiums from now on. I think the answer lies somewhere in the middle. This crisis has increased equity risk premiums and default spreads for the next couple of years, but I believe that risk premiums will revert back to lower values (4-4.5%) in the long term. (Equity risk premiums in emerging markets have to be scaled up accordingly)
2. It is beyond debate now that there will be consequences for economies globally. The slowdown will affect real economic growth (and consequently earnings growth) next year for companies around the world.
3. The long term consequences for individual companies is likely to be mixed. The shake out and more limited access to capital will put smaller companies at risk and drive many of them out of business. Larger companies will strong balance sheets and significant competitive advantages will emerge the winners from this turmoil. The higher excess returns that they will earn will give them higher values.
I just put together a presentation this morning on the crisis and its impact. If you are interested, you can download it by clicking on the link below.
http://www.stern.nyu.edu/~adamodar/pdfiles/country/crisis.pdf
Hope you find it useful!

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What is going on with the inflation indexed treasuries?

Strange things are happening in markets, but one development that I have seen little comment on is what is happening in the US treasury market. The Treasury has been issuing traditional bonds (where the coupon is set at the time of the issue) and inflation-indexed bonds (where a real return of return is guaranteed at the time of the issue) for more than a decade now. On September 12, 2008, the nominal 10-year treasury bond rate was about 3.8% and the interest rate on the inflation-indexed treasury was about 1.7%. In fact, the difference can be viewed as a market expectation of inflation over the 10 years (about 2.1% a year). Those numbers had been stable for years before.
For the first 10 days of the crisis, the relationship held, with the 10-year nominal and real rates staying relatively unchanged. About 2 weeks ago, the ten-year real rate started rising even though the nominal rate remained unchanged. On Friday, the nominal 1o-year rate was 3.9% (about 0.1% higher than it was at the start of the crisis) but the real rate had rised to 3%. I have attempted the following explanations but none hold up:
1. The real interest rate has risen because savers are more worried about investing in any type of financial asset. (Counter: If this is the case, why has the nominal rate also not risen)
2. Expected inflation has decreased because the economy has slowed. (Counter: If this is the case, both the nominal and real rates should have come down. It is also hard for me to believe that all these obligations taken on by the Federal government will not translate into higher inflation, not lower.)
The only explanation that I can think off is that investors who traditionally hold the inflation-indexed treasuries are selling them for liquidity reasons. If that is the case, we should expect a bounce back in the real interest rate to more conventional levels (about 1.5-2%), which would make inflation-indexed treasuries a great investment. The next few weeks should tell.

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Is preferred stock equity?

In the last few days, we have seen announcement by both the UK and US governments of their intent to invest hundreds of billions into their biggest banks. In both plans, the investment will be in preferred stock in the banks, and the announcements have described them as investments in equity. But is preferred stock equity? That is a question that is not new but acquires fresh urgency, with these infusions.

Preferred stock is a hybrid security, sharing some characteristics with equity and some with debt. Like equity, it has a perpetual life and the dividends can be skipped, if a firm is in financial trouble, without the risk of default. Unlike equity, the preferred dividend is usually fixed at the time o the issue (as a percent of the face value of the preferred stock) and is often cumulative; failure to pay dividends one year is compensated for by paying the dividends in the next year. In fact, investing in preferred stock is more akin to investing in a bond than stock, with almost all of the returns coming from the dividends. There is one final confounding factor. While interest payment on debt are tax deductible, preferred dividends are not. In my discounted cash flow valuations, I have always considered preferred stock to be more debt than equity, and very expensive debt at that, since it does not provide a tax deduction.

Among US companies, the biggest issuers of preferred stock are the financial service companies (banks, insurance companies) and there is a simple reason for it. While it may be more expensive than conventional debt, it is counted as equity by the regulatory authorities while computing capital ratios for banks. 

So what is the bottom line of these capital infusions by the governments for existing equity investors in the banks receiving the infusions? If I were an investor in a US bank receiving the infusion, I am concerned about the effect of the preferred dividends that the banks have to pay for the foreseeable future out of after-tax earnings, which will lower my earnings and returns on equity going forward on common stock. However, given that the bank will have to raise capital to cover it's mistakes from the last few years, and that the capital will not come easily in this market (Think of the problems Bank of America had last week when it tried to raise $ 10 billion), I will accept this bargain. If I were an investor in a UK bank receiving capital from the British government, I am not so sure that this works in my favor. The British government plan is much more punitive to common stockholders; the dividend rate is set much higher, the banks will not be allowed to pay common dividends until they pay off the preferred stock and the government looks like it will take a much more active role in the way the banks are run. In other words, the British preferred stock infusion seems to encroach more on common equity than the US preferred stock infusion. Not surprisingly, the British banks that are prime targets for the infusion (Lloyds, HBOS and Royal Bank of Scotland) have seen their stock prices drop since the plan was announced, whereas the US banks have seen marginal improvements in the stock price.

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Black, blue and white swans: Comments on Taleb

I want to steer clear of critiquing the work of others but my comments on long odds seem to have evoked a torrent of emails about Nassim Taleb and his work on randomness and black swans. Let me start off by sketching the points on which we agree. I think that Taleb is absolutely right that we (in academic finance and model building) have become enamored with normal distributions when building models. The real world delivers far more jumps, surprises and asymmetric movements than can be justified by a normal distribution. I also believe that what Taleb is saying was said much better by Benoit Mandelbrot several decades ago, in his argument for power distributions (which allow for bigger jumps than the normal distribution). My book on strategic risk taking has an extended discussion of Mandelbrot's work. 

Here is where I part ways with Taleb. While I agree that we are always susceptible to the unforeseen event (the black swan), I do not subscribe to his prescriptions. The first one (and I may be mistaken in this) is that planning, forecasting and valuation are useless since they will all be rendered to waste by the "black swan'' event. This is the equivalent of arguing that it is pointless planning and saving for retirement, since you may be hit by lightning tomorrow... logical, maybe, but not very sensible. The second one is that you can somehow make money off the fact that model builders have a normal distribution fixation.. Taleb argues that since models are built upon normal distributions, investors can make money by buying out of the money options and other investments that profit from big moves. I think that the mistake here is assuming that people who build models actually set market prices. If markets reflect reality rather than models, there should be no scope for profits. 

Here is what I think. We have to make our best estimates of the future and value assets accordingly. We have to assume that there will be shocks to the system that we cannot anticipate and build an appropriate risk premium to reflect these risks. We cannot plan for the unforeseeable... and live our lives expecting black swans to show up.. 

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Markets for sports outcomes- The long odds bias!

Since it is Sunday, it is time for sports, at least in the United States, I thought it would be an appropriate time to talk about markets based upon sports outcomes. People have been betting on sports for as long as there have been sports - I am sure that the ancient Romans had side-bets going on the gladiators. Today, sports betting is a multi-billion dollar business, though a big chunk of it is underground. In addition, we have markets like Tradesports.com (an online betting market), where you can bet on just about anything in the world, As with other markets, the question is whether the odds/prices you see in these markets are good predictors of success or failure. 

Studies that have looked at sporting markets have uncovered some interesting evidence that gamblers bet too little on favorites and too much on long odds. As they lose money, they seem to increase their betting on longer odds. This has been attributed to a number of factors including a general tendency among humans to under estimate large probabilities (such as the likelihood that you will get sick) and over estimate small ones (say the odds of dying in an airline accident) and the craving for the excitement that comes from betting on long odds. Extending this finding to financial markets, this would lead to us to believe that deep out-of-the-money options and stocks in deeply distressed companies are likely to be over valued, since the long shot bias will push up their prices. Conversely, companies that are in boring and predictable businesses will be under priced like favorites. 

Of course, all of the evidence from the sports betting market has to be taken with a grain of salt, since sports gamblers (at least the big ones) may be less risk averse than the rest of us. So, do what you will with that finding!! I am going back to watching my son play soccer (and no bets on that one)!!!

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Gold, fine art and collectibles...

I have always been deeply skeptical of investments in non-cashflow generating assets (gold, fine art, collectibles), where value is almost entirely driven by perception.  However, a crisis like the current one illustrates why these types of assets continue to have a hold on investors. When investors lose faith in financial assets (and the authorities and entities that back up those financial assets), they look for physical and tangible investments to buy that they can hold on to. Real estate used to be the investment of choice, but as my last posting indicates, real estate is behaving more and more like other financial assets. There is always gold, the fall back in every financial crisis in history, but the net actually has to be cast wider. I would not be surprised to see other collectible assets, including Picassos and baseball cards, go up in value.

Having said that, I still believe that these are terrible long term investments on their own. After all, an investor who bought gold in the early 1970s and reveled as the price of gold rose to $ 1000 in the last 1970s would have made about 3% a year for the last 30 years on the investment. The best role that I can see for them is as ancillary investments in a larger portfolio, where you accept that the expected return on the investment will be low but you are willing to invest in it anyway as insurance - against inflation and crises. Do I wish I had gold in my portfolio now? Of course! Am I going to sell everything that I own and buy gold? Of course not!

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Diversification: Why is it not working?

It is  a core belief in finance that investors should diversify. Whether they should diversify across all stocks or a few is what is debated, and what you think about the efficiency of markets or lack thereof determines which side of the debate you will come down on. If you are a believer in efficient markets, you would have spread your money across index funds investing globally. If you believe that markets systematically misprice classes of securities (and realize their mistakes later), you would still diversify across these securities (low PE stocks, beaten down stocks etc.)

This market has tested the core belief in diversification. Even the most diversified investor in the universe would have lost a big chunk of his or her portfolio over the last 3 weeks. Why has this happened and why is diversification not paying off like it was supposed to? The answer lies in the fact that we have sold investors too well on the "diversification" idea. Twenty years ago, when the sales pitch for adding international stocks and real estate to portfolios was made, the gains seemed obvious. Equity markets in different countries were not highly correlated; what happened in Turkey had little impact on what happened in Brazil. Having stocks in both markets therefore dampened risk in the portfolio. Real estate seemed to move in directions unrelated to equities, thus making a portfolio composed of the two asset classes less risky. As investors(individuals, private equity funds, hedge funds) diversified across markets and asset classes, there are two things that have happened:

1. The correlation across equity markets has risen dramatically. A crisis in one emerging market seems to spill over into other emerging markets. A crisis in a developed market spills over across the world. As market moves mirror each other, having your money spread out across markets has a much smaller diversification benefit than it used to.

2. Securitizing real estate and bringing it into portfolios has made risk in the real estate market more closely tied to the overall equity market. Diversifying across asset classes has a much smaller impact.

Don't get me wrong. I think that not diversifying is a deadly mistake for most investors, and I am still firm believer in diversification. However, we need to temper the sales pitch. Diversifying can create benefits for investors, but those benefits are much smaller in the global market place that we are now.

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Is it time to make the move?

Yesterday was a momentous day in many ways. The market meltdown was global and there were moments during the day when the first 1000 point drop day seemed possible for the Dow. However, there was something about yesterday that seemed different (at least to me) from the market tumult over much of the last 3 weeks:

1. The drop in the market, at least in the US, was caused more by concerns about economic growth than by fear. Put another way, while much the volatility in the markets of the last 3 weeks could be attributed to shifting equity risk premiums, yesterday's drop was caused more by more conventional concerns about an economic recession.

2. The implied equity risk premium in US equities hit 5% for the first time since October 20, 1987. That is a full percentage point higher than the average implied equity risk premium over the last 50 years. We are seeing either a structural break in equity markets or markets are oversold.

I could tell you that my gut feeling tells me that we are close to the bottom, but I frankly don't trust my gut (or anyone else's, for that matter). However, I think that I will be doing some bottom-fishing today, focusing particularly on companies that have the following characteristics:

1. Products/services that are part of everyday consumption and not particularly discretionary. 

2. Low debt ratios (and I will check for lease and rental commitments) and large cash balances.

3. Solid earnings numbers over the last 12 months.

4. Low price earnings ratios (and low EV/ EBIT)

5. Double digit return on capital

6. Medium to large market cap

I am trying to recession proof (1) and pay a reasonable price (4) for a well-run company (3 & 5) that also faces little danger from the credit squeeze (2 & 6). I don't want to put myself in the position of touting individual stocks on this blog but I will be looking globally. You are welcome to join in!

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Explaining the Market....

The last three weeks have been a boon for financial reporters. All of a sudden, they get the front page stories in their newspapers, a little akin to being the weather forecasters in the middle of a hurricane. At the end of each day, after another violent market move, they go to the experts (academics, practitioners) and ask them for reasons. They get the obligatory: "The market went up (down) because...." I have always been skeptical of this Monday-morning quarterbacking, and last week illustrates why.

On Monday, the market was down 778 points and the culprit was so obvious that experts were not even consulted. The bailout bill failed to pass in the House, and the market fall was attributed to this failure. The rest of the week was less explainable. On Tuesday, when there was little news about the bailout, the market bounced back up almost 500 points. On Wednesday, when things looked rosier for the bill's success, the market was down again. On Thursday, after the senate had passed the bill, the market did nothing. (Boring never felt so good.) On Friday, the bill finally passed around midday. Good news, right! The market promptly swooned. 

There are several reasons why the market is so difficult to decipher. First, all events have to be measured relative to expectations. There is no good news or bad news in absolute terms but only in relative terms. An earnings increase of 50% at Google may be bad news, if investors were expecting an increase of 75%. A drop in earnings of 30% at Ford may be good news, if investors were expecting a drop of 50%.  Second, there are so many events swirling around markets that it is difficult to pinpoint exactly what caused the market to move on any given day: Was it the weakening dollar? Higher interest rates? Unexpected inflation? Third, a great deal of what happens on any given day cannot be explained; putting a reason on a big move after the fact allows us to feel better about ourselves (as investors) and a little more in control of our destinies. 

Do I think that experts should stop trying to provide explanations for market moves? Not at all. In addition to their entertainment value, these explanations may help markets put the past behind and move on... 

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The Buffett Gambit: Buying (Selling) Credibility

In the last two weeks, Warren Buffett has made news by taking multi-billion dollar positions at Goldman Sachs and GE, two companies that would have topped the list of most admired firms a couple of years ago (and perhaps still). The fact that he is getting a good deal from both companies has been well publicized. In effect, both companies have given him a discount on his investment, thus giving him the potential for higher returns in the future. While part of those higher returns can be attributed to the fact that he is providing liquidity in a market where it is in short supply, that alone cannot explain the nature of the deals. After all, Goldman and GE, notwithstanding current financial problems, have recourse to other equity funding. So, why did they choose to deal with Mr. Buffett?

I think the answer lies in the mythology. As investors lose faith in the institutions that they thought were the foundation of US financial markets, from the investment banks to the Fed, Warren Buffett remains one of the few icons with any credibility left in this market. In my view, both Goldman and GE are buying a share of that credibility with these investments. They are, in effect, telling the market to trust them because Buffett is now watching over them. I should also add that I do not begrudge Mr. Buffett trading on his credibility to generate higher returns for Berkshire Hathaway stockholders. He has invested a great deal in his reputation over the last few decades and he is the ultimate capitalist!

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Mark to Market or Not to Mark to Market?

The latest issue that has emerged in the talks on the bailout is whether the practice of marking to market, required of financial service institutions under FASB rules, should be suspended or even ended. Financial service firms currently are required to revalue the securities they hold as assets on their books at market value each period. As the markets for many mortgage-backed securities have dried up, their values have plummeted, which in turn have put the limited capital that banks and investment banks at risk.

I have mixed feelings about the rule. I am a believer that investors should be provided with information that allows them to make better judgments on value. Thus, restating assets to reflect their current value seems like a good thing to do. I am not sure that accountants are in the best position to make this judgment or that balance sheets should be constantly restated to reflect the accounting estimates of value, and here is why: 

1. Accountants already have plenty to do in terms of estimating earnings, debt outstanding and capital invested. Adding one more item to their to-do list can be a distraction. 
   
2. By their very nature, accounting estimates of value have to be based on clearly defined rules and standards to prevent game playing. That works well for conventional accounting but not for valuation. For every rule in valuation, there are dozens of exceptions and it is impossible to write a FASB rule that captures the exception. 
   
3. The very notion of fair value is a nebulous one, since the fair value of even the simplest assets can vary depending upon what parameters you put on it. For instance, the fair value of a company run by its existing managers can be very different from the fair value of a company run optimally. Similarly, the fair value of a private business for sale in a private transaction can be very different from the fair value of that business to a public buyer. 
   
4. Illiquidity is a wild card in the entire process. Traditional valuation models capture the intrinsic value of an asset, but what someone is willing to pay for that asset will reflect the illiquidity in the market. The problem with pricing illiquidity is that it can not only vary across time but also across investors. A long term investor with a substantial cash cushion, will care less about illiquidity than a short term investors, and all investors care more about illiquidity during crisis.
   
5. Marking to market is applied inconsistently across asset classes. For instance, marking to market seems to followed more religiously when it comes to security holdings than it is with loan portfolios. Thus, financial service firms that have securities on their balance sheets seem to be held to account but banks with bad loans get a pass. 

So, is there an intermediate solution? I think accountants should steer away from estimating the fair value of assets that are long term assets; let's dispense with this move towards balance sheets reflecting the values of brand name, customer lists and other such assets. Fair value accounting is an oxymoron: what you will end up with will be neither fair value nor accounting. With securities that are held for trading/sale, I agree that we should have a different standard but rather than reflect what firms would get for those securities today in the market (which is a liquidation value), I would suggest that firms  either provide estimates of intrinsic value (or the raw data that will allow investors to make that estimate themselves). For mortgage backed securities, as an investor, I would like to see what types of mortgage backed securities are on the books of these companies, what the promised cash flows on the mortgages are and the default risk that they face. 

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The Market Solution!

As a believer in market solutions/mechanisms, the last few weeks have been trying, to say the least." How, in the face of all that has happened, can you still trust markets?" is a question that I have been asked. I could give you all the facile answers - it is not the market's fault... imperfect regulatory frameworks are to blame... errant traders are the reason.. but my heart is not in any of these explanations.

I think that markets did fail, at least partially, in this cycle, just as they have in other cycles in the past. The costs are being borne by all of us. Notwithstanding the failure (and others like it), here is why I still remain a believer in markets. Markets exaggerate the best and worst aspects of human nature. At their best, human beings are creative, innovative and capable of bouncing back from the worst of adversity, and markets allow them to have maximum impact. From the Model-T Ford to the Google search engine, financial markets have allowed entrepreneurs to reach beyond their local markets, reach a broader marketplace and change the world in the process. At their worst, human beings are short term, greedy and not particularly rational, and markets feed into these emotions. When markets are good, we exalt them and when they are bad, we detest them.

So, here is the question. Would we be better off without financial markets? The good of markets, in my view, vastly outweighs the bad. While that may seem debatable at this point in time, consider two of the fastest growing economies in the world - India and China. For centuries, the people in the two most populous countries in the world stagnated under controlled economies (with colonial powers, royalty and central governments - socialist or communist- all promising a better future, but not delivering). In two decades, markets have done more to bring the the poor out of poverty in these countries than the rulers from prior generations. I may be an optimist but I do trust markets more than experts, when it comes to the big issues of the day!

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Step away from the ledge!

Let's get the bad stuff out of the way first. It was an awful day for investors in every market. There was no safe haven today. I am sure that you are convinced that the end of the world is coming but let me offer you my take on the market. 

First, the bad news. The credit crisis is spreading beyond mortgage backed securities. As banking failures in Europe illustrate, the problem is a much wider one. Banks lost their perspective on default risk and lent money at rates that were far too low to borrowers who did not meet the creditworthy test - individuals, corporations and businesses. As borrowers default, loan portfolios are being savaged around the world and the banks that were most aggressive about seeking out growth are facing the consequences.  Banks spread their pain around and there is no way that the global economy will not feel the pinch. At this stage, the question seems to be no longer whether we are in a recession but how deep and long the recession lasts. The failure of the bailout bill also illustrates the precarious state that markets are in: we are really in trouble when traders on the floor are watching  congressional vote tallies and reacting to the success and failure of legislation.

Second, the neutral news. So what do I think will happen next? There will be congressional action, though I am not sure whether the action will be necessarily in the long term best interests of either Wall Street or Main Street. The market will have its relief rally, just to show that it is playing along. 

So, what is the good news? Investors, consumers and economies are a lot more resilient than we give them credit for. While the great depression seems to increasingly be a theme in business news stories, I think that the modern global economy can weather the storm and come out of it intact. My suggestion to you is to think long term (if you can afford to) and invest in companies with healthy balance sheets and solid products. The Coca Colas, Apples and Nestles of the world will still provide long term value.

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II. Why did it happen?

The blame is being spread around for the current crisis:  securitization, lax regulation and the housing bubble have all been fingered as culprits, but I think that these were contributing factors. I would attribute what has happened on financial markets to two phenomena, one of which is age-old and cannot be easily cured by regulation or laws and the other of which can be remedied.

1. Over optimism and hubris: Through history, we (as human beings) have always exhibited these traits. In good times, we become complacent and under estimate the likelihood of their ending, and we also tend, when successful, to attribute that success to our skills (rather than to luck or good fortune). It does not surprise me that there was a housing bubble and I do not believe for a moment that this is the last bubble that we will see in our lifetimes. There will be other bubbles in other markets, just as there always have been through history.

2. Risk taking and risk bearing: I know that risk is viewed as a bad word now. Rather than viewing excessive risk taking as the problem, we need to examine why it occurred in the first place. I believe that the separation between risk taking and risk bearing is at the heart of this crisis. Our risk takers (traders, bankers, mortgage brokers) sought out risks because they shared in the lucrative upside (with compensation tied to profits from activity), but the downside of risk was borne by others (the deposit insurers, taxpayers, other banks and investors). To fix this asymmetry we need to do two things: 

(a) Reform compensation systems to make them less tied to outcomes in short periods. A trader who receives a large bonus in the year in which he makes a large profit on his trading position is receiving encouragement to take the wrong types of risk. Compensation should not only be tied to more long term results but should also be linked to process (as opposed to outcome). In other words, a trader who makes money by taking the wrong types of risk should be punished and not rewarded. 

(b) Price risk correctly: A system that systematically subsidizes excessive risk taking by charging the same price for insuring all risk takers, no matter how much risk they take, is a system designed to fail in the long term. Charging all banks the same price for federal deposit   insurance, while allowing them to have very different loan/asset risks, will result in some banks gaming the system for profit. Prudent banks and taxpayers should not be providing subsidies for imprudent risk taking.

I am not suggesting that either of these actions will be easy to implement, but the task is laid out for us. It is time to get to work!

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I. What happened?

This is the first of three posts that I hope to put up on my thoughts on what we see unfolding in financial markets. Here is my take on what happened:

1. The ultimate sources of this turmoil are the real estate market and the bond market. Between 2002 and 2007, housing prices increased at rates unseen in decades and well above the inflation rate. At the same time, default spreads on bond markets converged on historical lows.

2. As housing prices increased, funded by cheap mortgage financing, the mortgages themselves were bundled into mortgage backed securities, entitling buyers to different layers of the collective cash flows on the mortgages, with the first layers having the least risk and the last layers of the cash flows having the most risk.

3. The same optimism that pervaded the housing market (about future housing prices) and the bond market (about future default spreads) led to the mispricing of every layer of these mortgate backed securities, with the mispricing being greatest at the riskiest (or top) layers of the cashflows.

4. Financial services companies (banks, investment banks, insurance companies) were the primary investors in these mortgage backed securities, with the former using debt to fund much of their holdings. In some cases, investment banks were buying the riskiest layers of the mortgage backed debt, using short term financing.

Here is how it unraveled:

1. Housing prices started their decline at the end of 2006 and accelerated into 2007. The contemporaneous economic slow-down also started pushing up default spreads in bond markets.

2. The values of the mortgage backed securities on the books of buyers started dropping as the built in assumptions about increasing housing prices and low default risk came under assault.

3. A few financial service companies reacted quickly and sold some or most of their holdings by mid-2007, taking their losses. Most held on, hoping for a market turn-around. 

4. Accounting requirements on marking-to-market required banks to begin restating the values of their securities to reflect current value. As the values of mortgage backed securities dropped, the liquidity in these markets also dried up, leading to big write-offs in value, which in turn reduced the book equity at these firms. 

5. As the book capital dropped, these firms started showing up on regulatory warning screens as being under capitalized, based on book equity. (In late 2007, firms like Lehman and Bear Stearns could have made equity issues or raised fresh equity to provide a safety margin, but they believed they could ride out the storm).

6. As the liquidity problems in the mortgage backed security market worsened, the write downs continued. By the beginning of the summer of 2008, firms like Bear Stearns and Lehman had lost any buffer they might have had, and the equity options available at the end of the prior year had also dried up.

7. Bear Stearns is liquidated, with the Fed's help. If Lehman had one last chance to raise fresh equity, it would have been in the weeks after the Bear liquidation. 

8. The hits keep coming and Lehman falls. The question, given the absence of liquidity in the mortgage securities market, is who's next? That turns out to be AIG, but it is quite clear that there will be always someone else next in line who will be targeted to fall. 

9. The recognition that this is as much a liquidity problem as a valuation problem comes to the Treasury and the Fed. The Paulson bailout is a liquidity plan, where the illiquid securities will be taken off the books of financial service firms, and held by the Federal Government, the only institution that can create its own liquidity (nice to control those printing presses).

I am hoping that the next phase is a happier one but we are watching financial history get written as we speak!

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GE's aborted buybacks...

In news that was overshadowed by the bailout debate, GE announced today that it was suspending its stock buyback program. While the suspension was precipitated by declining earnings and worries about GE Capital, there are some general comments that I want to make about the action that relate to stock buybacks in general

1. Flexibility: One of the biggest reasons for the shift among US companies from dividends to buybacks was that firms can respond much more quickly to adverse circumstances with the latter. GE's announcement on buybacks was greeted with sanguinity by markets today. If GE had cut dividends, the market reaction would have been much more negative than it was this announcement.

2. Announcement versus Action: Investor should take stock buyback programs announced by companies with a pinch of salt. Many company announce buyback programs with fanfare but do not carry through all the way.

3. Valuation: Last year, companies in the S&P 500 returned twice as much cash to stockholders in the form of stock buybacks than dividends, resulting in a total yield of 5.34% on the index (about 1.9% from dividends and the rest from buybacks). One measure of whether the equity market will be able to sustain the body blows it is receiving now will be in how well the buyback number holds up for the next year or so. A bunch of companies, including Microsoft ($40 billion), have announced buyback programs.

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The Bailout

The news of the week has been the proposed Federal (or Paulson) Bailout, with $700 billion being the price tag associated with it. Let me state at the outset that there is a crisis looming over many financial service firms and drastic action is unavoidable. So, is this bailout the solution? 

1. The price tag on the bailout is a little misleading. The $700 billion is what the government will pay to buy mortgage backed securities off banks, but the net cost will be lower. In fact, if everyone goes back to paying their mortgages on time, the Federal Government will make money on the deal. It is very unlikely that this optimistic scenario will unfold. What is far more likely is that there will be defaults, and how much this bailout will cost us will depend upon how quickly housing recovers.

2. There are two keys to making this not a "bailout". The first is to pay fair value (See below) for these mortgage backed securities, rather than an optimistic value or face value. This fair value may still be a bargain for banks that face the problems of having to mark these securities to market every period. To the extent that liquidity has dried up in this market, these securities may well have to written down below fair value. The second is for taxpayers to get something in return for taking these problem securities off the books. I would use the Buffett model (from his Goldman acquisition) and ask for warrants or equity to compensate for at least a portion of the difference between the fair value and the current value (which will reflect the illiquidity).

(What is fair value? It is the present value of the cumulative cashflows on these mortgage backed securities, discounted back at a rate that realistically reflects default risk. This will be well below face value, since these securities were misvalued using default risk estimates that we too low.)

3. I know that the zeal for punitive measures is strong and that people want to punish the bankers who have put us in this position. While I will not defend sloppy valuations and poor oversight, I also believe that there is plenty of blame to go around. In fact, anyone who bought a house in the last 5 years and traded up, using a cheap mortgage to fund the move, participated in the benefits of the boom. I am not eager to seek out these homeowners and punish them either.

4. Regulation is not the answer. After all, this problem was created by a patchwork of regulations that left loopholes to be exploited. What we need is a consistent regulatory environment that covers all types of risky assets, rather than different regulatory environments for real estate, mortgage backed securities,  corporate bonds and equities. In fact, I think trying to regulate trading and restrict risk taking in a global marketplace is akin to trying to stop unauthorized downloads of movies on the internet... A waste of time and money!

I think that the bailout will not end the troubles at banks, but it is a solution to the liquidity crisis that is haunting this market. 

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The end of investment banking?

The big news of the morning is that Goldman Sachs and Morgan Stanley will reorganize themselves as bank holding companies, thus ending a decades-long experiment with stand-alone public investment banking. Before we buy into the hyperbole that this represents the end of of investment banking as we know it, it behooves to us to look both back in time and into the future and examine the implications. 

Independent investment banks have been in existence for a long time, but for much of their existence, they were private partnerships that made the bulk of their profits from transactions and as advisors. They seldom put their own capital at risk, largely because they had so little to begin with and it was their own money (partners). Part of the impetus in their going public was the need to raise more capital, which in turn, freed them to indulge in more capital-intensive businesses including proprietary trading. That model worked well for much of the last two decades, but three things (in my view) destroyed it. The first was that it became easier to access low cost, short term debt (especially in the last few years) to fund the capital bets that these firms were making, whether in mortgage backed securities or in other investments. The second was that the compensation structure at investment banks encouraged bad risk-taking, since it rewarded risk-takers for upside gains (extraordinary bonuses tied to trading profits) and punished them inadequately for the downside (at worst, you lost your job but you were not required to disgorge bonuses in prior years... in many cases, finding another trading job on the Street or at a hedge fund was not difficult to do even for the most egregious violators). The third was a patchwork of government regulation that was often exploited by investors to make risky bets and to pass the risk on elsewhere, while pocketing the returns. The combination worked in deadly fashion these last two years to devastate the capital bases at these institutions. Lehman, Bear Stearns and Merrill have fallen...

So, what will change now that Goldman and Morgan Stanley have chosen the bank route? The plus is that it opens more sources of long term capital since they can now attract deposits from investors. Having never done this before, they start off at a disadvantage. The minus is that they will now be covered by banking regulation, where the equity capital they be required to have will be based upon the risk of their investments. This will effectively mean that they will need more equity capital, if they want to keep taking high risk investments, or that they will have to bring down the risk exposure on their investments. My guess is that they would have gone down one of these roads anyway. In pragmatic terms, it will also mean that their returns on equity at investment banks will drop to banking levels - more in the low teens than in the low twenties. I think the stock prices for both investment banks already reflects this expectation.

Ultimately, Goldman and Morgan Stanley have sent a signal to the market that they are willing to accept a more restrictive risk taking system. In today's market, that may be the best signal to send. There will be times in the future, where I am sure that they will regret the restrictions that come with this signal, but they had no choice.

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Are you a contrarian?

In investing mythology, there is a special place reserved for the contrarian investor, i.e., the investor who goes against the crowd and makes money in the process. In fact, many investors, asked to describe themselves, describe their investment style as both contrarian and long term. But are you really a contrarian investor? Last Wednesday offered a simple test. At 3.45 pm, the S&P 500 was down to about 1150, the Dow had dropped 800 points in three days and the bottom was falling out of the market. If you were watching the screen at that time, which of the following impulses did you feel?

1. Denial: This is a bad dream... I am going to wake up from it any moment... It is not happening.

2. Panic: Sell everything. The world is coming to an end.

3. Cool Assessment: Buy now. Panic yields the best opportunities.

4. Wait and see: I think I should buy, but I am too nervous. Let me wait for things to settle down a little bit.

If you were truly a contrarian, you would have chosen (3) and done something about it: tapped out your cash reserved and invested in banking stocks, for instance..... For most of us, though, denial, panic and waiting would have been more natural impulses. At the risk of revealing more about my psyche than I should be, I did not pass the contrarian test. I chose to wait and see, which in the long terms turns out to be waiting and waiting for the right moment, which either never comes or comes too late. I think, though, that there are broader lessons to be learned from this test. 

a. It is easy in the abstract to be a rational, long-term investor. It is much more difficult in practice. The same can be said about being a contrarian.

b. The fact that information is so much more easily accessible and timely has actually made the task of being a long-term investor more difficult. Twenty years ago, most of us would have been working in blissful ignorance at our regular jobs, completely unaware (at least during the day) that Wall Street was collapsing... and that may have been healthier.

c. You cannot force yourself to adopt an investment style that does not fit your make-up as a human being. Many of us are not hard-wired to be patient, long term investors, and fewer still have the stomach to go against the crowd.

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What is the risk free rate?

The risk free rate is the building block on which we erect risk premiums. When I was taking my first finance classes a long, long time ago, I was taught that the risk free rate for U.S. dollar based returns was the treasury rate - the T.Bill rate for short term and the T.Bond rate for long term. The implicit assumption, not often stated, was that the US Treasury was incapable of default. At worst, they would print more currency to pay off bonds coming due. This is a lesson I have passed on to students in my classes and put into print in my books.

This week, that conventional wisdom was challenged for the first time. After the Federal Government stepped in to provide a backstop to AIG, and then later in the week, for an even larger package of mortgage backed securities, there was a sense in markets that the rules of the game had changed. In the Credit Default Swap (CDS) market, where investor buy and sell insurance against default risk, the price for insuring against default risk in the treasury climbed to 0.25%, on an annual basis, on September 18, 2008. While it is possible that this was an over reaction to the tumult of the week, that number should give us pause. If true, the true long term riskfree rate in U.S. dollars on September 18 was not the 10-year treasury bond rate of 3.77% but the default risk adjusted rate of 3.52% (3.77% - 0.25%).

I will wait and see what the next few weeks bring. It may be time to rewrite finance textbooks to reflect the new realities.

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The key number for stocks: The Equity Risk Premium (ERP)

If there is one number that captures what the market mood is right now and how investors feel about equities collectively, it is the equity risk premium (ERP), i.e. the additional return that investor are charging for buying equities instead of putting their money into treasuries. The equity risk premium reflects the tug-of-war between hope and fear that equity investors bring to the market, and will vary on a day-to-day basis. As investors become more risk averse, they will a higher equity risk premium, which should translate into lower stock prices.

Last week provided a laboratory to observe movements in both direction in the equity risk premium. We started Monday morning (9/15/2008) with the S&P 500 at 1250 and the equity risk premium at 4.54%, but here is what happened over the week:

9/15/2008 (End of day): S&P 500 = 1193 ; ERP = 4.75% ; Fear rules (Lehman down)

9/16/2008 (End of day): S&P 500 = 1214; ERP = 4.67% ; Recovery (Hope for AIG/)

9/17/2008 (End of day): S&P 500 = 1156 ; ERP = 4.90%; Sheer, unadulterated Panic... 

9/18/2008 (End of day): S&P 500 = 1207; ERP = 4.70%; The world did not end!!!!

9/19/2008 (End of day): S&P 500 = 1255; ERP = 4.52%: Euphoria!!!

Now, that was a week for the history books!!!!

If you are wondering how I came up with these numbers, I won't bore you with the details here but you can download a paper on the topic on my website at

http://www.damodaran.com

Check under research/papers! I would love to have your comments!

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The most exciting flat week ever?

I think we have a candidate for the most exciting flat week ever. The S&P 500 started the week at 1250 and ended the week at 1255, with two huge up days (yesterday and today) offsetting two huge down days (Monday and Wednesdays). The financial world at the end of the week looked very different from the beginning, with the ranks of investment banks thinning and government suddenly becoming the biggest player in the game. I am not willing to make a prediction of whether next week will be up or down (I know - that is quite cowardly of me) but I am willing to bet it will be volatile.  Hang on for a wild ride!

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Selling Short: The debate

One of the big news items competing for attention today was the SEC's decision to bar short selling temporarily on more than 700 financial service companies. While the SEC statement paid the usual lip service to the importance of allowing short selling in orderly markets, it also concluded that short selling was contributing to market instability and should not be allowed for the moment.

Implicit in the ban, and in the support that it is getting from many investors and portfolio managers, is the assumption that short sellers are bad people - speculators, naysayers and vultures who make money off long term investors. I think that short sellers, like long buyers (why not?), cannot be easily categorized. Some are motivated by good information, some are trading on rumor and some can be unscrupulous (floating false news stories to bolster their positions). While the ban may have helped markets today, here is why I think it is counter productive:

1. If we want market prices to reflect all news, good as well as bad, we have to allow people to trade on both types of news.

2. Investors who believe that the prices of Citi, Chase or Goldman are going to drop in the next few weeks can evade the ban by using options or other alternatives. In effect, banning short selling is either going to push it deeper underground or make the carnage worse on the financial service companies where other alternatives exist.

I do believe that investors who take positions in stock - long or short - should be held accountable when they try to manipulate the price afterwards. That is an enforcement issue that the SEC should be thinking about rather than short circuiting the process.

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First thoughts

I must confess that I have mixed feelings about blogs. I do read quite a few on a variety of topics, but I have held back on starting one of my own for two reasons - first, I am not sure that I have enough to say that is interesting on a continuous basis and second, everything I say will be online for better or worse. Anyway, now that I have made the leap, here is what I hope to put on this blog on a regular basis. 

1. I will try to put down my thoughts and reactions to the news of the day, with an emphasis on how the news fits into my big picture view of corporate finance and valuation.

2. I will t follow some central themes in finance - equity risk premiums, the measurement of risk - and provide regular updates on interesting research in the area and how my thinking is evolving on the topic.

3. Once in a while, I will highlight a company that I am valuing and ask for your thoughts on the valuation.

I hope you will enjoy my ranting. 

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Market Meltdown

This has been a horrendous week for markets. As markets collapse globally, and doomsday scenarios are envisioned, it is time to take a step back and assess where we are. 

1. Equity indices are down about 8-9% for the week in the United States and more in some emerging markets. The S&P 500 is down almost 20% for the year, a bad year by most standards but not quite a catastrophe (yet). 

2. The damage to equities has been uneven. The most pain has been inflicted in financial service companies (banks and investment banks). The decline in the rest of the market is far more muted.

3. While fear and panic are in the air in financial markets, the real economy, other than housing, has held up fairly well so far.

I do not know what tomorrow will bring, but if you have bragged about being a "contrarian", now is the time to put your money where your mouth is....

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Risk = Danger + Opportunity

I have always believed that the Chinese symbol for risk, which combines the symbols for danger and opportunity, is the best definition of risk. Danger and opportunity are connected at the hip, something worth remembering in both good times and bad. In good times, opportunities abound, and the salespeople for these opportunities (brokers, hedge funds) tell us that there is little or no danger: those 70% returns are touted as "low-risk". In scary times, all we see is danger and no investment looks good. In both cases, we would be well served stepping back and looking for the link. Lucrative opportunities always expose us to risk, even in the best of times. And dangerous times bring opportunities, if we keep our eyes open and our wits about us! 

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