Sunday, January 31, 2010

Emerging versus Developed Markets: The margin shrinks in 2010

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

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

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

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

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

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

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

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

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

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

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

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

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

Monday, January 18, 2010

Time to Split!!

As many of you are probably aware, Berkshire Hathaway has announced its intent to split its class B shares and the requisite "deep analysis" of whatever Buffet is doing has journalists chasing the story.
Since Berkshire is not the first company to ever split its stock, it is worth looking at key questions that come up anytime there is a stock split.

1. Do companies split their stock often?
The answer is yes and no. Some companies are serial stock splitters, splitting their stock at regular intervals. Other companies let their stock ride. In fact, Berkshire Hathaway is a classic example of a company that has avoided splitting its shares, with it's class A shares trading at about $100,000/share.

2. Why do companies split their stock?
There are several reasons provided, though not all of them hold up to scrutiny:

a. Attract new investors to the company: There is a belief that some small investors and even a few institutional investors either cannot or will not invest in companies if the stock price rises above a threshold level. The "level" itself seems to be a malleable number and vary across companies. There is little evidence for this proposition and even if there were evidence, so what? Inherently, there is nothing good about attracting investors who have hitherto avoided buying your stock and it is entirely possible that these investors may bring with them preferences for dividends and other corporate finance policies that put them at odds with the firm's current policies.

b. Improve liquidity: This is the time honored argument provided by many companies when they split their stock. Having a lower-priced stock, they argue, will increase trading volume and improve liquidity. The evidence, though, points in the opposite direction. Aggregate trading volume does not increase significantly after stock splits and transactions costs go up (not down). The reason for the latter effect is that the bid-ask spread, as a percent of the stock price, tends to be higher for low-priced than high-priced stock. (Try a simple experiment. Try buying 100 shares of a stock trading at $200/share, 1000 shares of a stock trading at $20/share and 10000 shares of a stock trading at $2/share and figure out your total transactions costs with each, including commissions and bid-ask spreads.)

In the case of Berkshire Hathaway, the reason for the split lies in the recent acquisition of Burlington Northern. Berkshire had offered shareholders in Burlington a choice being paid in either cash or Berkshire class B shares. Since Berkshire's class B shares were trading at more than $ 3000/share, there were many small stockholders in Burlington who could not avail themselves of the stock offer. (If you owned less than $3000 worth of Burlington stock, you had to settle for cash.) This has tax consequences. When you as a stockholder in a target company accept cash on an acquisition, you have to pay taxes on capital gains immediately. If you receive shares in the acquiring company, you can defer paying capital gains taxes until you sell those shares.

3. How do stock prices react to stock splits?
Are stock splits good or bad news? There have been several studies of stock splits over the last few decades and the findings can be summarized as follows:

a. At the time of the stock split, there is, on average, a very small positive impact on prices (about 1-2%). In other words, when there is a two for one stock split on a $50 share, the new shares trade at about $25.25. This is usually attributed to a "signaling effect", where markets view stock splits as a sign that the company expects earnings or dividends to increase in future periods.

b. There is some debate about whether investors can generate higher returns in the period after the stock split. While many of the earlier studies indicated that stocks that split did not "beat the market" in the months after, more recent studies provide evidence that "stock split" stocks generate significantly higher returns.

c. As with all investments, there is another shoe waiting to drop. Studies also indicate that the volatility increases after stock splits. In a very general sense, a stock split seems to increase both returns and risk.

If you are interested in reviewing the literature, there is a good survey paper on the topic. You can get to it by going to:

The bottom line. Stock splits, for the most part, are cosmetic and should not play a central role in whether you invest in a company or not. The reason is simple. From an intrinsic value standpoint, changing the number of units you divide the value by cannot change the overall value of a business. If everyone gets the same percentage increase in units, there cannot be winners and losers within the firm. However, the evidence does suggest that they can play a secondary role in stock picking. Thus, when faced with investing between two otherwise equal companies, one of which has split its shares recently and the other not, you would go with the first one.

Two side notes. First, everything that I have said about stock splits also applies to stock dividends. In fact, stock dividends represent an even bigger pain in the neck, since they leave investors with strange share counts - 100 shares become 102 shares. Second, reverse stock splits, where a company whose stock is trading at a very low stock price offers 1 share for every four or five shares, seem to be more defensible from an economic standpoint, since the transactions cost argument works in your favor)

Saturday, January 9, 2010

Bounceback in Multiples: The 2010 story

Building on the 2010 data, here is the other side of the data. As risk premiums have reverted back to pre-crisis levels, we are also seeing multiples also revert back to pre-crisis levels. This can be seen on a number of measures, both in the US and globally:

a. Price Earnings Ratios (PE): The median current PE ratio for US stocks, which plunged from about 19 in January 2008 to about 9 in January 2009, is now back to almost 15. Similar shifts have occurred in the trailing and forward PE ratios and in most sectors.

b. EV/EBITDA: The median EV/EBITDA multiple for US companies, which had dropped from about 9 in January 2008 to 6 in January 2008, had bounced back to 8 by January 2009.

The bounce back in multiples in emerging market companies has been even more robust. The shifts in multiples globally parallel the change in equity risk premiums that I noted in the last post.

The change in multiples in 2010 brings home a fundamental fact that the multiples of earnings, book value or revenues that we are willing to pay depends upon how risk averse we are (and the risk premiums that we consequently demand). That is one reason why I have always been wary of those who compare market multiples across time and pass easy judgments on whether stocks are cheap or expensive.

Reversal in Risk Premiums (or premia): The 2010 story

The big story from the 2010 updates is that that risk premiums across the board have reversed the rise that we saw during the crisis. The broad based nature of the shift can be seen by looking at the following:

a. Equity Risk Premiums: I have been tracking the equity risk premium at the start of every month since the start of the market crisis on September 12, 2008. On that day, the equity risk premium for the US was 4.37%. That number exploded to almost 8% in November 2008 and settled in at 6.43% at the start of 2009. In the first three months of 2009, the equity risk premium continued to rise (to more than 7% in early April 2009). Since then, though, the equity risk premium has dropped dramatically. On January 1, 2010, the equity risk premium was down to 4.36%, roughly where it was at the start of the crisis. If you are interested in the computation, download the excel spreadsheet that I used (and feel free to modify and adapt it as you see fit)

b. Bond default spreads: The market crisis had its origins in easy lending, reflected in the low default spreads that we saw for different bond ratings classes in late 2007. Bond default spreads almost tripled during 2008, thus outstripping the change you saw in equity risk premiums. In 2009, however, bond default spreads returned to pre-crisis levels. You can get to my latest estimates of default spreads by clicking here.

c. Sovereign spreads: When the market crisis unfolded, emerging markets were affected more adversely than developed markets, as manifested in collapsing stock prices and soaring sovereign default spreads. The default spread for Brazil in the Credit Default Swap mark rose to 7% in November 2008. Those spreads have decreased to pre-crisis levels (and below, for some markets). Brazil's CDS spread in January 2010 was hovering at about 1.5%.

While I am not surprised that risk premiums have come down, I am surprised at how quickly they have reverted back to old levels. In early 2009, my prediction would have been that equity risk premiums by the end of the year would be down to about 5%. At one level, the speedy recovery in risk premiums can be considered to be evidence of mean reversion- that markets quickly revert back to historic norms even after major crisis. At another level, the quick adjustment can be viewed as a sign of a market that is in denial. My gut feeling is that the market has gone up too far, too fast and that equity risk premiums will correct themselves over this year and move back up towards 5%, but I may very well be wrong again.

Friday, January 8, 2010

Data Update for 2010

If you have been tracking my website, you probably know that I maintain updated datasets for companies around the globe, classified by region (into the US, Emerging Markets, Europe and Japan). I report summary statistics on risk (beta etc.), profitability measures (margins and accounting returns) and debt/dividend measures for industry groups in each region.

I update the data at the start of every year and I have just completed the data update for January 2010. You can get the data by going to:
I have added two new datasets this year - for just Indian and Chinese companies.

In coming blog posts, I will talk about what the updates tell us about companies and markets globally.