Friday, July 22, 2016

May you live in "exciting" times! An Updated Picture of Country Risk

About a year ago, I completed my first  update of a paper looking at all aspects of country risk, from political risk to default risk to equity risk, and wrote about my findings in three posts, one on how to incorporate risk in company value, the second on the pricing of country risk and the last one on decoding currencies. The twelve months since have been interesting, to say the least, and unsettling to many as markets were buffeted by crises. In August 2015, a month after my posts, we had questions about China, its economy and markets play out on the global arena, leading to this post with my China story. Towards the end of June 2016, we had UK voters choosing to exit the EU, and that too caused waves (or at least ripples) through markets, which I talked about in this post. It is a good time to update my global country risk database and the paper that goes with it, and in this post, I would like to focus on updating numbers and providing risk pictures of the world, as it looks today.

Country Risk: Non-market measures
This should go without saying, but since there is still resistance in some practitioner circles to this notion, I will say it anyway. Some countries are riskier to invest in, either as an investor or as a business, than others. The risk differences can be traced to a variety of factors including where the country is in the life cycle (growing, stable or declining?), the maturity of its political institutions (democracy or dictatorship?, smoothness of political transitions), the state of its legal system (in terms of both efficiency and fairness) and its exposure to violence. Not surprisingly, how you perceive risk differences will depend in large part on which dimension of risk you are looking at in a country.

While I look at risk measures that look at threat of violence, degree of corruption, dependence of the economy on a commodity (or commodities) and protection of property rights individually in the full paper, I also report on a composite measure of risk that I obtain from Political Risk Services (PRS), a Europe-based service that measures country risk on a numerical scale, with lower (higher) numbers representing more (less) risk. The picture provides a heat map of the world using this measure as of July 2016. (The heat maps don't seem to show up on some browsers. So, I have replaced them with snapshots. If you click on the links below the snapshots, you should be able to see the heat maps.. I think).
Link to heat map

As we move from 2015 to 2016, it is interesting to see how much risk changed in countries, rather than the level of risk, and again using political risk score, the heat map above reports on changes in the PRS score over the last year (if you hover over a country, you should see it).

Finally, there is an alternate and more widely used measure of country risk that focuses on country default risk, with sovereign ratings for countries from Moody's and Standard & Poors (among others) and the picture below provides these ratings, as of July 1, 2016, globally:
Link to heat map
I know that ratings agencies are much maligned after their failures during the 2008 crisis, but I do think that some of the abuse that they take is unwarranted. They often move in tandem and are generally slow to respond to big risk shifts, but I am glad that I have their snapshots of risk at my disposal, when I do valuation and corporate finance.

Country Risk: Market Measures
There are two problems with non-market measures like risk scores or sovereign ratings. The first is that they are neither intuitive nor standardized. Thus, a PRS score of 80 does not make a country twice as safe as one with a PRS score of 40. In fact, there are other services that measure country risk scores, where high numbers indicate high risk, reversing the PRS scoring. The second is that these non-market measures are static. Much as risk measurement services and ratings agencies try, they cannot keep up with the pace of real world developments. Thus, while markets reacted almost instantaneously to Brexit by knocking down the value of the British Pound and scaling down stock prices around the globe, changes in risk scores and ratings happened (if at all) more slowly.

The first market measure of country risk that I would like to present is one that captures default risk changes in real time, the sovereign credit default swap (CDS) market. The heat map below captures sovereign CDS spreads globally, as of July 1, 2016:
Link to heat map
Note that the map, if you scroll across countries,  reports three numbers: the CDS spread as of July1, 2016, a CDS spread net of the US CDS (of 0.41%) as of July 1, 2016 and the in the sovereign CDS spread over the last twelve months. Reflecting the market's capacity to adjust quickly, the UK, for instance, saw a doubling in the market assessment of default risk over the last year. The limitation is that sovereign CDS spreads are available for only 64 countries, with more than half of the countries in the world, especially in Africa, uncovered.

The second market measure of country risk is one that I have concocted that is based upon the default spread, but also incorporates the higher risk of equities, relative to government bonds, i.e., an equity risk premium (ERP) for each country. The process by which I estimate these equity risk premiums, which I build on top of a premium that I estimate every month for the S&P 500 (and by extension, use for all AAA ratted countries), is described more fully in this post from the start of the year. The updated ERPs for countries is captured in the heat map below.
Link to heat map
Note that as companies globalize, you need the entire map to estimate the equity risk premium  to value or analyze a multinational, since its risk does not come from where it is incorporated but where it does business.

Conclusion
I think that the way we think about and measure country risk is in its nascency and that we need richer and more dynamic measures of that risk. I don't claim to have all of the answers, or even most of the answers, but I will continue to learn from market behavior and make my equity risk premiums more closely reflective of the risk in each country. I will probably regret this resolution next July, but I plan to make my country risk premium an annual update, just as I have my work on equity risk premiums.

Charts update: The charts don't seem to be working on some browsers. They seem to work on Safari.

Papers
  1. Country Risk Premium: Determinants, Measures and Implications - The 2016 Update
Data)
  1. Sovereign Ratings, by Country (July 2016)
  2. Sovereign CDS Spreads, by Country (July 2016)
  3. Equity Risk Premiums, by Country (July 2016)
Last year's Posts on Country Risk

    Thursday, July 14, 2016

    Tesla: It's a story stock, but what's the story?

    The last few weeks have tested Tesla’s shareholders and frustrated short sellers in the stock. Shareholders have had to weather a series of bad news stories, ranging from a failure to meet its shipment targets in the last few months to a fatality with a driver using its autopilot function to a surprise acquisition of Solar City. While each of those stories has created pressure on the stock, the price has held up surprisingly well, frustrating long-time short sellers who have been waiting for a correction in what they see as an overhyped stock.
    Tesla Stock Price: Google Finance
    So, what gives here? Why has Tesla’s stock price not collapsed facing this adversity? I think that Tesla's price action illustrates the power of the “big story” and the sometimes difficult-to-understand market dynamics of story stocks.

    Story Stocks
    In earlier posts, I have made a case for valuation being a bridge between story and numbers, with every number telling a story and every story being captured in a number. Thus, while your final valuation may be composed of forecasts of revenue growth, profit margins and reinvestment, it is the story that binds together these numbers that represent the soul of the valuation.

    That said, the balance between stories and numbers can vary across companies and for the same company, can change across time. For most companies, it is the story that comes first, with numbers following, and for others, it is the numbers that tell the story. 

    There are some companies that I would classify as story stocks, where the story is so dominant in both how people price the stock and what determines its value that the numbers either fade into the background or have only a secondary effect. There are three characteristics that story stocks share:

    Amazon remains one of my longest-standing examples of a story stock, a company, with a CEO (Jeff Bezos) who was and continues to be clear about his ambitions to conquer big markets, told that story well and acted consistently with it. You can see why Tesla also has the makings of a story stock, going after a big market (automobiles and perhaps even clean energy), with an unconventional strategy for that market and a larger-than-life CEO in Elon Musk. With story stocks, it is the story that dominates how the market perceives the stock, and that has consequences:
    1. Story changes and information: it is shifts in the story that cause price and value changes. An earnings report that beats expectations (in either direction) or a news story of significance (good or bad) may not have any effect on either (value or price) if it does not change the story. Conversely, a shift in perceptions about the business story, triggered by minor news or even no news at all, can trigger major price changes. 
    2. Wider disagreements: When a company’s value is driven primarily by numbers, there is less room for disagreement among investors. Thus, when valuing a company in a market with steady revenue growth and sustainable profit margins, there will be less divergence in what investors think the stock is worth. In contrast, with a story stock, investor stories can span a much wider spectrum, leading to a much bigger range in values, as illustrated with Uber in this post
    The key to understanding story stocks is deciphering the story behind the company, then checking that story for reasonability and making it your own.

    The Tesla Story
    So, what is Tesla’s story? To structure the process, let me lay out the dimensions where investors can differ on the story and how these differences play out valuation. The first is Tesla's business, i.e., whether you see Tesla primarily as an automobile company that incorporates technology into its cars, a technology company that uses automobiles to deliver superior electronics (battery and software) or even a clean energy company with its focus on electric cars. The second is focus,  i.e., whether you believe that Tesla will cater more to the high end of whichever business you see it in or have mass market appeal. The third is the competitive edge that you see it bringing to the market, with the choices ranging from being first to the market, superior styling & brand name and superior (proprietary) technology. The fourth is the investment intensity needed to deliver your expected growth, with much higher reinvestment needed if you consider Tesla a conventional manufacturing company (like autos) than if you see it as a tech company. Finally, there is the risk in the company, with the auto story bringing with it the risks of cyclicality and high fixed costs and the tech story the risks of being rendered obsolete by new technologies and shorter life cycles.


    The value that you attach to Tesla will be very different if you consider it to be an automobile company, catering to a high-end clientele than if you view it as an electronics company with a superior technology (in electric batteries) and a mass market audience.

    My thinking on Tesla has changed over time. In my first valuation of the company in September 2013, I valued it as a high-end automobile company, which would use its competitive edges in branding and technology to generate high margins, with investment and risk characteristics more reflective of being an auto than a tech company. The resulting inputs into my valuation and valuation are summarized below:
    Download spreadsheet
    The value that I obtained for Tesla’s equity was $12.15 billion (with a value per share of $70) well below the market capitalization of $28 billion (and a stock price of $168.76) at the time.

    In July 2015 I took another look at Tesla, keeping in mind the developments since September 2013. The company had not only sent signals that it was moving towards offering vehicles with lower price tags (expanding towards the mass market) but also made waves with its plans for a $5 billion gigafactory to manufacture batteries. The focus on batteries suggested to me that I had understated the role that technology played in Tesla’s appeal and I incorporated it more strongly into my story. Tesla remained an automobile company, but with a much stronger technology component and wider market aspirations, which in turn led the following inputs into value:
    Download spreadsheet
    The value of equity based on these inputs was 19.5 billion (share price of $123), much higher than my September 2013 estimate, but still below the value of $33 billion (share price of $220) at the time.

    I took my third shot at valuing Tesla about two weeks ago,  just prior to its Solar City acquisition announcement, and I incorporated the news since my last valuation. The announcement of the Tesla 3 clearly reinforced my story line that it was moving towards being more of a mass market company. The unprecedented demand for the car, with close to 400,000 people putting down deposits for a vehicle that will not be delivered until 2018, indicates the hold that it has on its customer base. I have tweaked the inputs to reflect these changes:
    Download spreadsheet
    The value of equity that I obtained was $25.8 billion (with a share price of $151/share), climbing from my July 2015 valuation but the market capitalization stayed at $33 billion. Before I embark on looking at how the Solar City acquisition and Musk's master plan have on the narrative, it is worth looking at how the value changes as a function of revenues, reinvestment and profit margin:
    Download spreadsheet
    Note that there are pathways that lead to the value at or above the current stock price but they all require navigating a narrow path of building up sales, earning healthy profit margins and reinvesting more like a technology company than an automobile company.

    So, what effect does acquiring Solar City have on the story? If nothing else, it muddies up the waters substantially, a dangerous development for a story stock and that is perhaps even why even long-term Tesla bulls and nonplussed. The most optimistic read is that  Tesla is now a clean energy company, with a potentially much larger market, but the catch is that Solar City's products don't have the cache that Tesla cars have as well as the competitive nature of the solar power market will push margins down. If you add the debt burden and reinvestment needs that Solar City brings into the equation, Tesla, already stretched in terms of cash flows, may be over extending itself. The most pessimistic read is that talk of synergy notwithstanding, this acquisition is more about Musk using Tesla stockholder money to preserve his legacy and perhaps get back at short sellers in Solar City.

    The X Factor: Elon Musk
    The Solar City acquisition spotlighted how difficult it is to separate Tesla, the company, from Elon Musk. Musk's strengths, and there are many, are at the core of Tesla's success but his weaknesses may hamstring the company.
    • On the plus side, Musk clearly fits the visionary mode, dreaming big, convincing customers, employees and investor to buy into his dreams and, for the most part, working on making the dreams a reality. Like Bezos at Amazon and Steve Jobs at Apple, Musk had the audacity to challenge the status quo. 
    • On the minus side, Musk is less disciplined and focused than Bezos, whose story about Amazon has remained largely unchanged for almost 20 years, even as the company has expanded into new businesses and markets. In fact, as someone who has followed Apple for more than three decades, it seems to me that Musk shares more characteristics with Steve Jobs in his first iteration at Apple (which ended with him being fired) than he does with Steve Jobs in his second stint at the company. Musk is a large social media presence, but he does strike me as thin skinned, as his recent exchange with Fortune magazine about the autopilot fatality showed. 
    Your views on  what you think Tesla is worth will be a function of what you think about Elon Musk. If you believe, as some of his most fervent defenders do, that he is that rarest of combinations, a visionary genius who will deliver on this vision, you will find Tesla to be a good buy. At the other extreme, you consider him a modern version of P.T. Barnum, a showman who promises more than he can deliver, you will view Tesla as over valued. Wherever you fall in the Musk continuum, Tesla is approaching a key transition point in its life, a bar mitzvah moment so to speak, where the focus will shift from the story to execution, from master plans to supply chains, and we will find out whether Musk is as good at the latter as he is in the former.

    Can Musk the visionary become Musk the builder? He certainly has the capacity. After all, if you can get spaceships into outer space and back to earth safely, you should be able to build and deliver a few hundred thousand cars, right? Given Tesla's missteps on delivery and execution, though, Musk may not have the interest in the nitty gritty of operations, and if he does not, he may need someone who can take care of those details, replicating the role that Tim Cook played at Apple during Steve Job's last few years at the company.  

    Investment Direction
    Tesla is a company where there seems to be no middle ground. You are either for the company or against it, believe that it is on a pathway to being the next Apple or that it is worth nothing, a cheerleader or a doomsdayer. I think that both sides of this debate are over reaching. I don't buy the talk that Tesla is on its way to being the next trillion dollar company, especially since I have a tough time justifying its current valuation of $33 billion. Unlike some of the high-profile short sellers who seem to view Tesla as an over-hyped electric car company that is only a step away from tipping into default, I do believe that Tesla has a connection to its customers (and investors) that other auto companies would kill to possess, brings a technological edge to the game and has viable, albeit narrow, pathways to fair value.  I will choose to sit this investment out, letting others who are more nimble than I am or have more conviction than I do to take stronger positions in Tesla.

    YouTube Video
    1. Tesla (September 2013) valuation
    2. Tesla (July 2015) valuation
    3. Tesla (July 2016) valuation

    Wednesday, June 29, 2016

    The Brexit Effect: The Signals amidst the Noise


    There are few events that catch markets by complete surprise but the decision by British voters to leave the EU comes close. As markets struggle to adjust to the aftermath, analysts and experts are looking backward, likening the event to past crises and modeling their responses accordingly. There are some who see the seeds of a market meltdown, and believe that it is time to cash out of the market. There are others who argue that not only will markets bounce back but that it is a buying opportunity. Not finding much clarity in these arguments and suspicious of bias on both sides, I decided to open up my crisis survival kit, last in use in August 2015, in the midst of another market meltdown.

    The Pricing Effect
    I am sure that you have been bombarded with news stories about how the market has reacted to the Brexit vote and I won't bore you with the gory details. Suffice to say that, for the most part, it has followed the crisis rule book: Government bond rates in developed market currencies (the US, Germany, Japan and even the UK) have dropped, gold prices have risen, the price of risk has increased and equity markets have declined. The picture below captures the fallout of the vote:


    While most of the reactions are not surprising, there are some interesting aspects worth emphasizing. 
    1. Currency Wars: If this is a battle, the British Pound is on the front lines and taking heavy fire, down close to 10% over the last week against the US dollar and approaching three-decade lows, with the Euro seeing collateral damage against the US dollar and the Japanese Yen.
    2. Old EU, New EU and the Rest of the World : The damage is greatest in the EU, but even within the EU, it is the old EU countries (primarily West European, that joined the EU prior to 2000) that have borne the biggest pain, with sovereign CDS spreads rising and stock prices falling the most. The new EU countries (mostly East European) have been hurt less than Britain's other trading partners (US, Australia and Canada) and the damage has been muted in emerging markets. At least for the moment, this is more a European crisis first than a global one.
    3. Banking Problems? Though I have seen news stories suggesting that financial service companies are being hurt more than the rest of the market by Brexit and that smaller companies are feeling the pain more than larger ones, the evidence is not there for either proposition at the global level. At more localized levels, it is entirely possible that it does exist, especially in the UK, where the big banks (RBS, Barclays) have dropped by 30% or more and mid-cap stocks have done far worse than their  large-cap counterparts.
    While I did stop the assessment as of Friday (6/24), the first two days of this trading week have continued to be volatile, with a big down day on Monday (6/27) followed by an up day on Tuesday (6/28), with more surprises to come over the next few days.

    The Value Effect
    As markets make their moves, the advice that is being offered is contradictory. At one end of the spectrum, some are suggesting that Brexit could trigger a financial crisis similar to 2008, pulling markets further down and the global economy into a recession, and that investors should therefore reduce or eliminate their equity exposures and batten down the hatches. At the other end are those who feel that this is much ado about nothing, that Brexit will not happen or that the UK will renegotiate new terms to live with the EU and that investors should view the market drops as buying opportunities. Given how badly expert advice served us during the run-up to Brexit, I am loath to trust either side and decided to go back to basics to understand how the value of stocks could be affected by the event and perhaps pass judgment on whether the pricing effect is under or overstated. The value of stocks collectively can be written as a function of three key inputs: the cash flows from existing investment, the expected growth in earnings and cash flows and the required return on stocks (composed of a risk free rate and a price for risk). The following figure looks at the possible ways in which Brexit can affect value:

    Embedded in this picture are the most extreme arguments.  Those who believe that Brexit is Lehman-like are arguing that it will lead to systemic shocks that will lower global growth (not just growth in the UK and the EU) and increase the price of risk. In this story, these shocks will come from banking problems spilling over into the rest of the economy or an unraveling of the EU.  Those who believe that Brexit’s effects are more benign are making a case that while it may reduce UK or even EU growth in the short term, the effects of global growth are likely to be small and/or not persistent and that the risk effect will dissipate once investors feel more reassured. 

    I see the truth as falling somewhere in the middle.  I think that doomsayers who see this as another Lehman have to provide more tangible evidence of systemic risks that come from Brexit. At least at the moment, while UK banks are being hard hit, there is little evidence of the capital crises and market breakdowns that characterized 2008. It is true that Brexit may open the door to the unraveling of the EU, a bad sign given the size of that market but buffered by the fact that growth has been non-existent in the EU for much of the last six years. If the European experiment hits a wall, it accelerate the shift towards Asia that is already occurring in the global economy. I also think that those who believe that is just another tempest in a teapot are too sanguine. The UK may be only the fifth largest economy in the world but it has a punch that exceeds its weight because London is one of the world's financial centers. I think that this crisis has potential to slow an already anemic global economy further. If that slowdown happens, the central banks of the world, which already have pushed interest rates to zero and below in many currencies will run out of ammunition. Consequently, I see an extended period of political and economic confusion that will affect global growth and some banks, primarily in the UK and the US, will find their capital stretched by the crisis and their stock prices will react accordingly. 

    The Bigger Lessons
    It is easy to get caught up in the crisis of the moment but there are general lessons that I draw from Brexit that I hope to use in molding my investment strategies.
    1. Markets are not just counting machines: One of the oft-touted statements about markets is that they are counting machines, prone to mistakes but not to bias. If nothing else, the way markets behaved in the lead-up to Brexit is evidence that markets collectively can suffer from many of the biases that individual investors are exposed to. For most of the last few months, the British Pound operated as a quasi bet on Brexit, rising as optimism that Remain would prevail rose and falling as the Leave campaign looked like it was succeeding. There was a more direct bet that you would make on Brexit in a gamblers' market, where odds were constantly updated and probabilities could be computed from these odds. Since Brexit was also one of the most highly polled referendums in history, you would expect the gambling to be closely tied to the polling numbers, right? The graph below illustrates the divide.
      While the odds in the Betfair did move with the polls, the odds of the Leave camp winning never exceeded 40% in the betting market, even as the Leave camp acquired a small lead in the weeks leading up to the vote. In fact, the betting odds were so sticky that they did not shift to the Leave side until almost a third of the votes had been counted. So, why were markets so consistently wrong on this vote? One reason, as this story notes,  is that the big bets in these markets were being made by London-based investors tilting the odds in favor of Remain. It is possible that these investors so wanted the Remain vote to win and so separated from this with a different point of view that they were guilty of confirmation bias (looking for pieces of data or opinion that backed their view). In short, Brexit reminds us that markets are weighted, biased counting machines, where if big investors with biases can cause prices to deviate from fair value for extended periods, a lesson perhaps that we learned from value investors piling into Valeant Pharmaceuticals.
    2. No one listens to the experts (and deservedly so): I have never seen an event where the experts were all so collectively wrong in their predictions and so completely ignored by the public. Economists, policy experts and central banks all inveighed against exiting the EU, arguing that is would be catastrophic, and their warnings fell on deaf years as voters tuned them out. As someone who cringes when called a valuation expert, and finds some of them to be insufferably pompous,  I can see why experts have lost their cache. First, in almost every field including economics and finance, expertise has become narrower and more specialized than ever before, leading to prognosticators who are incapable of seeing the big picture. Second, while economic experts have always had a mixed track record on forecasting, their mistakes now are not only more visible but also more public than ever before. Third, the mistakes experts make have become bigger and more common as we have globalized, partly because the interconnections between economies means there are far more uncontrollable variables than in the past. Drawing a parallel to the investment world, even as experts get more forums to be public, their prognostications, predictions and recommendations are getting far less respect than they used to, and deservedly so.
    3. Narrative beats numbers: One of the themes for this blog for the last few years has been the importance of stories in a world where numbers have become more plentiful. In the Brexit debate, it seemed to me that the Leave side had the more compelling narrative (of a return to an an old Britain that some voters found appealing) and while the Remain side argued that this narrative was not plausible in today's world, its counter consisted mostly of numbers (the costs that Britain would face from Brexit). Looking ahead to similar referendums in other EU countries,  I am afraid that the same dynamic is going to play out, since few politicians in any EU country seem to want to make a full-throated defense of being Europeans first. 
    4. Democracy can disappoint (you): The parallels between political and corporate governance are plentiful and Brexit has brought to the surface the age-old debate about the merits of direct democracy. While some (mostly on the winning side) celebrate the power of free will, those who have never trusted people to make  reasoned judgments on their futures view the vote as vindication of their fears. In corporate governance, this tussle has been playing out for a while, with those who believe that shareholders, as the owners of public corporations, should control outcomes, at one end, and those who argue that incumbent managers and/or insiders are more knowledgeable about businesses and should therefore be allowed to operate unencumbered, at the other. I am sure that there are many in the corporate world who will look at the Brexit results and cheer for the Facebook/Google model of corporate governance, where shares with different voting rights give insiders control in perpetuity. As someone who has argued strongly for corporate democracy and against entrenching incumbent managers, it would be inconsistent of me to find fault with the British public for voting for Brexit.  In a democracy, you will get outcomes you do not like and throwing a tantrum (as some in the Remain camp are doing right now) or threatening to move (to Canada or Switzerland) are not grown-up responses.  You may not like the outcome, but as an American political consultant said after his candidate lost an election, "the people have spoken... the bastards".
    The End Game
    I have not bought or sold anything since the Brexit results for the simple reason that almost anything I do in the midst of a panic is more likely to be counter productive than helpful. To those who would argue that I should move my money away from Europe, the markets have already done that for me (by marking down my European stocks) and I see little to be gained by overdoing it. To those who assert that this is the time to buy, I am not a fan of blind contrarianism but I will be looking at UK-based companies that have significant non-European operating exposure in the hope that markets have knocked down their prices too much. Finally, to those who posit that this is a financial meltdown, I will keep a wary eye on the numbers, looking for early signs that the worst case scenario is playing out. In my view, bank stocks will be the canaries in the coal mine, and especially so if the damage spreads to non-UK banks, and I will continue to estimate equity risk premiums for the S&P 500 and perhaps add the UK and Germany to the list to get a measure of how equity markets are repricing risk.

    YouTube

    Monday, June 6, 2016

    Icahn exits, Buffett enters, Whither Apple? Value and Price Effects of Big Name Investing

    In my last post, I looked at Apple, arguing, with a Monte Carlo simulation, that the stock was a good investment at the prevailing market price ($93 at the time of the analysis). I appreciate the many comments that I got on the analysis, some taking issue with the distributions that I used for profit margins and revenue growth and some taking me to task for ignoring the fact that big name investors were either entering and exiting the stock. Those who felt that my valuation was optimistic pointed out that Carl Icahn, a long time and very vocal investor in Apple, had decided to sell his stake in the company on April 28. Some who concurred with my value judgment on Apple pointed out that Berkshire Hathaway (and by extension, Warren Buffett or his proxies) had invested in the company on May 16.  Should Carl Icahn’s decision to sell Apple or Berkshire Hathaway’s choice to buy it change my assessments of value or views on its price? More generally, should the decisions by "big name" investors to buy or sell a specific company affect your investment judgments about that company? 

    Price versus Value: The Set Up
    To set up the discussion of whether, and if so how, the actions of other investors, especially those with big names and reputations to match, affect your investing choices, I will fall back on a device that I have used before, where I contrast the value and pricing processes.


    Put simply, the value process is driven by a company's fundamentals (cash flows, growth and risk) or at least your perception of those fundamentals, whereas  the pricing process is driven by demand and supply, with mood, momentum and liquidity all playing big roles in determining price. In an earlier post,  I argued that it these processes that separate investors from traders, with investors focused on the drivers of value and traders on the pricing process, and that the skills and tools that you need to be a successful trader are different from those that you need to be a successful investor. To understand how and why the entry of a big name investor may alter your assessments of value and price, I would suggest categorizing that investor into one of four types.
    1. An Insider, who is either part of management or has privileged access to management.
    2. An Activist, who plans to change the way the firm is run or financed.
    3. A Trader, whose skill lies in playing the pricing game, with the power to either reinforce or reverse price momentum
    4. A Value Investor, who has valued the company and is willing to take a position based upon that value, on the expectation that the pricing gap will close.
    Each type of big name investor has the potential to change how you view the dynamics of price and value, though the place where the change occurs will depend on the investor type.

    The entry (or exit) of a big name insider or big name activist can alter your estimate of value for a company, by either changing your perceptions of cash flows, growth and risk or by having the potential to change the company's operating and financing characteristics. As a trader, the entry or exit of a big name trader may cause you to move from one side of the pricing game to the other, i.e., shift you from being a buyer to a seller. Finally, as a long term value investor who believes that a stock is mis-priced but has little or no power to cause the pricing gap to close, the entry of a big name value investor can provide a catalyst for the correction.

    The Value Effect 
    If you asked a value purist whether the actions of other investors affect his or her value, the answer will almost always be "of course not". After all, the essence of intrinsic value is that it is determined not by what others think about the company but the company's capacity to generate cash flows  over time. That said, there are two ways that the investment action (to buy or sell) of a big name investor can change your assessment of value. 

    1. The first is if the big name investor has private information or is perceived as knowing more about the firm than you do. While that may walk awfully close to the insider trading line in the United States, it is entirely possible that the investor's information is diffuse enough to not be in violation of the law. In this case, it is entirely rational for you, as an investor, to reassess your cash flows and risk, based upon the insiders' actions. That is perhaps why we are so fascinated by insider trading, where the perception is that insider buying is value increasing and insider selling is value selling. In some emerging markets, where possessing proprietary information is neither illegal nor unusual, and the decision by an investor who is perceived as having this information (an insider, manager or family member) to buy (or sell) is an indicator that your value should be increased (decreased). 
    2. The other scenario is where the big name investor is an activist who plans to push for changes in the way the company operates, how it is financed or how much and how it returns cash to investors. The potential effects of these changes can be most easily seen using a financial balance sheet:

    To the extent that you believe that the company will have to respond to activist pressure, your assessment of value will change. An asset restructuring can alter he cash flows and risk characteristics of a business, changing your estimate of value, though the direction of the value change and its magnitude will depend on how you see these operating changes playing out in cash flows and growth.  Adding debt to your financing mix can add value to a firm (because of the tilt in the tax code towards debt) or destroy value (because it exposes companies to bankruptcy risk). If you are valuing a company, the entry of a big name activist investor in the ranks with a history of pushing for more debt could lead you to reassess your value estimate as well. Returning more cash to stockholders in special dividends or buybacks can change value either upwards (if the market is discounting the cash on the presumption that the company would waste the cash on bad investments/acquisitions) or downwards (if returning the cash will expose the firm to default risk or substantial financing costs in the future).

    The Pricing Effect
    In some cases, the big name investing in the stock is a trader, doing so on the expectation that momentum will either continue, sustaining the pricing trend, or that momentum will reverse, causing the trend to reverse as well. Since this trade is not motivated by either new information or the desire to change how the company is run, there is no value effect, but there can be a price effect for two reasons. 
    1. The volume effect: If the big name trader has enough money to back his or her trade, there will be a liquidity effect, where a buy will push the price up higher and a sell will push it lower. 
    2. The bandwagon effect: To the extent that there are some in the market who perceive the big name trader as better at perceiving momentum swings than the rest of us, they will follow the investor in buying or selling the stock. 
    In contrast to a value effect, which is long term and sustained, the pricing effect will have a shorter half life. To the extent that the big name trader's time horizon may be even shorter, he or she can still make money from the bandwagon effect. To get a measure of the pricing effect of a big name trade, you have to look at both the resources commanded by the trader as well as the liquidity/trading volume in the stock. A trader with billions under his control investing in a lightly traded and lightly followed stock will have a much bigger pricing effect than in a very liquid, large market capitalization company. 

    The Catalyst Effect
    It is an undeniable and frustrating truth about value investing that for most of us, it is not just enough to be right in your assessment of value but you have to get the market to correct its mistakes to make money on your investments. If you are a small investor, there is little that you can do to close the pricing gap because you have neither the money or the megaphone to close the gap. A big name value investor, though, may be more successful for two reasons: he or she can take a larger position in the stock and as with the big name trader, create a bandwagon effect where other value investors will follow into the stock.  Again, the magnitude of the catalyst effect will vary across both investors and companies. The extent of the impact on the pricing gap will depend in large part on the history of success that the big name investor brings into the investment, with sustained success in the past going with a larger impact. 

    Apple, Icahn and Buffett
    It has taken me a while to get to the point of this post, which was ostensibly about Apple and how Icahn’s exit and Buffett’s entry into the stock affect my thinking. At first sight, this graph shows how the market reacted to their actions:

    While it does look like Icahn's sale had a negative effect (albeit mild) and Berkshire's buy had a positive effect (almost as mild), I plan to use the framework of the last section to assess each of these investors and gauge how it should affect my thinking about the stock.

    Icahn, the Activist Trader
    Through much of his tenure, Carl Icahn has been labeled an activist investor but I will take issue with at least a portion of that label. It is true that Icahn is an activist, though he is much more active on the financing/dividend dimension (pushing companies to borrow money and return cash) than on the operating dimension. I do think that Icahn is more of a trader than an activist, more focused on momentum and pricing than on value and this is illustrated by the tools that brings to the assessment. When Icahn was asked why he invested in Lyft in 2015, his response was that it looked cheap relative to Uber, a classic pricing argument. With Apple, in his bullish days, Icahn argued that it was cheap, but consider how he justified his contention in May 2015, that Apple, then trading at $100, should really be trading at $240. In effect, he forecast out earnings per share in 2016 to be $12, applied a PE ratio of 18 and added the cash balance of $24.44/share. Not only is this definitely not an intrinsic valuation, it is at best "casual pricing", i.e., the type of pricing you would do on the back of an envelope after you have had a little too much to drink.

    Before you point out to me that Icahn is worth billions and I am not, let me hasten to add that there is nothing ignoble about trading and that Icahn has been an incredibly successful trader over the last few decades, testimonial to his targeting and trading skills. It does color how I viewed Icahn’s investment in Apple in January 2014, his push at Apple for more dividends and more debt during his days as a Apple investor and his decision to sell his holdings on April 2016. I was already an investor in Apple in January 2014, when Icahn bought his shares, and while I did not view his decision to buy the shares as vindication of my valuation, I welcomed him to the shareholder ranks both because Apple was badly in need of a momentum shift and Icahn was playing both an activist and a catalyst role. I am glad that he put pressure on Apple to get over its unwillingness to borrow money and to return more cash in dividends and buybacks. His decision to depart does tells me two things. First, Icahn has recognized the limitations of financing and dividend policy changes in driving Apple’s value and is moving on to companies where the payoff is greater from financial reengineering. Second, it is possible that Icahn’s momentum detector is telling him that while Apple’s stock price may not be going lower, it has little room to go higher either, at least in the short term, and given his trading track record, I would take that signal seriously,

    Buffett Buys In?
    The decision by Berkshire Hathaway to invest in Apple about three weeks after Icahn’s departure mollified some worried Apple investors, since there is no more desirable endorsement in all of value investment than Warren Buffett’s buy order. I am not privy to the inner workings in Omaha, but I have a feeling that this decision was made more by Todd Combs and Ted Wechsler, the co-heads that Buffett hired as his successors, than by Buffett, but let’s assume that they are following the Buffett playbook. What does that tell you about Apple stock? The good news is that the greatest value investor of this generation now considers Apple to be a value stock. The bad news is that this investor's biggest investment in a technology company has been in IBM, a company that delivers solid dividends and cash flows but has been liquidating itself gradually over the last ten years. If my value judgment on Apple had required substantial growth for value to be delivered, Buffett’s investment could very well have adversely affected my view on the company. In this case, though, I agree with his assessment that Apple is a mature company, with enough cash flows to cover dividends for a generation. 

    The Apple End Game
    In early May, when I analyzed Apple, I knew that Carl Icahn had already closed out his position and it had no impact on my value estimate or investment judgment. Icahn’s decision to sell was an indication to me that the price might not recover quickly and that momentum could work against me in the near term, but I was okay with that, since my time horizon was not constrained. Buffett’s decision (if it was his) to jump in, a couple of weeks later, may be an indication that the best days of Apple are behind it, but I had already made the same judgment in my valuation. If there is a silver lining, it is that Buffett's followers, with their large numbers and unquestioning, will imitate him and perhaps get the price gap to close. 

    The Dark Side of Big Name Investing
    While I am open to the possibility that the entry of a big name into a company has the potential to change the way I think about the company and perhaps my investment decisions, there are dangers embedded in doing so.
    1. Confirmation bias: It is a well-established fact that investors look for evidence that confirms decisions that they have already made and ignore evidence that contradicts it and big name investors feed into this bias. Thus, if you have bought a stock, you are far more likely to focus in on those big name investors who agree with you (and are either bullish on the stock or buy it) and screen out big name investors who do no.
    2. Mixed Motives: It is entirely possible that you (as an investor) may be misreading or misunderstanding the motives that caused the big name trade in the first place. In particular, the insider, who you assumed was trading because he or she had private information, may be selling the stock for tax or liquidity reasons. The activist, who you assumed was pushing for real changes in the company, may be more interested in collecting a payoff from the company to leave it alone. The trader, who you assumed had skills playing the momentum game, may himself be following the crowd rather than assessing momentum shifts. Finally, the value investor, who you assumed had valued the company and was pushing for the price/value gap to close, may be more trader than investor, quick to give up, if the stock moves in the wrong direction.
    There are some investors, including many institutional investors, whose entire investment strategy seems to be built around watching what big name investors do and imitating them. While imitation may be the best form of flattery, it is inauthentic and a poor basis for an investment philosophy, no matter who the big name investor that you are imitating is and how successful he or she has been. We are too quick to attribute investment success to skill and wisdom and that much of what passes for "smart" money is really "lucky" money. My advice is that if you have an investment thesis that leads you to buy the stock, do so and stop worrying about what the talking heads on CNBC or Bloomberg tell you about it. If you have so little faith in your reasoning that you doubt it and are ready to abandon it the moment it is contested by a big name, you should consider investing in index funds instead.

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