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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