Friday, September 4, 2015

The Fed, Interest Rates and Stock Prices: Fighting the Fear Factor

If it feels like you are reading last year’s business stories in today's paper, there is a simple reason. The Federal Reserve's Open Markets Committee (FOMC) meeting date is approaching, and in a replay of what we have seen ahead of previous meetings, we are being told that this is the one where the Fed will lower the boom on stock markets, by raising interest rates. While this navel gazing may keep market oracles, Fed watchers and CNBC pundits occupied, I think that the Fed’s role in setting interest rates is vastly overstated, and that this fiction is maintained because it is convenient both for the Fed and for the rest of us. I think that there are multiple myths about the Fed’s powers that have taken hold of our collective consciousness, and led us into an investing netherworld. So at the risk of provoking the wrath of Fed watchers everywhere, and repeating what I have said in earlier posts, here are my top four myths about central banks.

1. The Fed sets interest rates
Myth: The Federal Reserve (or the Central Bank of whichever country you are in) sets interest rates, short term as well as long term. In my last post on this topic, I mentioned my tour of the Federal Reserve Building, with my wife and children, and how sorely tempted I was to ask the tour guide whether I could see the interest rate room, the one where Janet Yellen sits, with levers that she can move up or down to change our mortgage rates, the rate at which companies borrow from banks and the market and the rates on US treasuries. 
Reality: There is only one rate that the Federal Reserve sets, and it is the Fed Funds rate. It is the rate at which banks trade funds, that they hold at the Federal Reserve, with each other. Needless to say, not only is this an overnight rate, but it is of little relevance to most of us who don't have access to the Fed windows. While there is a tenuous link of Fed Funds rate to short term market interest rates,  that link becomes much weaker when we look at long term rates and their derivatives.
Why preserve the myth: Giving the Fed the power to set interest rates gives us all a false sense of control over our economic destinies. Thus, if rates are high, we assume that the Fed can lower them by edict and if rates are too low, it can raise it by dictate. If only..

2. Low interest rates are the Fed’s doing
Myth: Interest rates are at historic lows not just in the United States but in much of the developed world, and it is central banking policy that has kept them there, through a policy of quantitative easing The myth acquires additional sheen when accompanied by acronyms such as QE1 and QE2, which bring ocean liners to my mind and a nagging fear that the next Fed move will be titled the Titanic!
Reality: The Fed has had a bond-buying program that is unprecedented and large, but only relative to the Fed's own history. Relative to the size of the US treasury bond market (about $500 billion a day in 2014), the Fed bond-buying (about $60-$85 billion a month) is modest and unlikely to have the influence on interest rates that is attributed to it. So, what has kept rates low? At the risk of rehashing a graph that I have used multiple times, it is far simpler and more fundamental, and it lies in the Fisher equation, which decomposes the nominal interest rate into its expected inflation and real interest rate components:
Nominal Interest Rate = Expected Inflation + Expected Real Interest Rate
If you make the assumption that in the long term, the real interest rate in an economy converges on real growth rate, you have an equation for what I call an intrinsic risk free rate.  In the graph below, I graph out the actual US 10-year treasury bond rate against this intrinsic risk free rate and you can make your own judgment on why rates have been low for the last five years.'

To me, the answer seems self evident. Interest rates in the US (and Europe) have been low because inflation has been non-existent and real growth has been anemic, and it is my guess that rates would have been low, with or without the Fed’s exertions. In fact, the cumulative effect of the Fed's exertions can be measured as the difference between the intrinsic risk free rate and the US treasury bond rate, and during the entire quantitative easing period of 2008-2014, it amounted to about 0.13%. It is true that the jump in US GDP in the most recent quarter  has widened the difference between the treasury bond rate and the intrinsic interest rate, but it remains to be seen whether this increase is a precursor to more healthy growth in the future, or just an one-quarter aberration. 
Why preserve the myth: I think it is much more comforting for developed market investors to think of low interest rates as an unmitigated good, pushing up stock and bond prices, rather than as a depressing signal of future growth and low inflation (perhaps even deflation) in much of the developed world. That problem will not be fixed by Fed meetings and is symptomatic of shifts in global economic power and a re-apportioning of the world economic pie.

3. The reason stock prices are so high is because rates are low
Myth: Stock prices are high today because interest rates are at historic lows. If interest rates revert back to normal levels, stock prices will collapse. 
Reality: Low interest rates have been a mixed blessing for stocks. The low rates, by themselves, make stocks more attractive relative to the alternative of investing in bonds. But if the low rates are symptomatic of low inflation and low real growth, they do have effects on the cash flows that can partially or completely offset the effect of low rates. One way to decompose the effects is to compute forward-looking expected returns on stocks, given stock prices today and expected cash flows from dividends and buybacks in the future to see how much of the stock price effect is fueled by interest rates and how much by cash flow changes. If this bull market has been entirely or mostly driven by the drop in interest rates, the expected return on stocks should have declined in line with the drop in interest rates. In my most recent update on this number at close of trading on August 31, 2015, I estimated an expected return of 8.50%, almost unchanged from the level in 2009 and higher than the expected return in 2007. 
At least based on my estimates, the primary driver of stock prices has been the extraordinary fountain of cash that companies have been able to return in the last few years, combined with a capacity to grow earnings over the same period. By the same token, if you are concerned about cash flows, it should be with the sustainability of these cash flows, for two reasons. The first is that earnings will be under pressure, given the strength of the dollar and the weakness in China, and this is starting to show up already, with 2015 earnings about 5-10% below 2014 levels.  The second is that companies will not be able to keep returning as much as they are in cash flows; in 2015, the cash returned to stockholders stood at 91% of earnings, a number well above historic norms. In the table below, I check to see how much the index, which was at 1951.13 at the close of trading on September 3, would be affected by an increase in interest rates (increasing the US 10-year T.Bond rate from the 2.27% on September 3, to 5%) as contrasted with a drop in cash flows (with a maximum drop of 25%, coming from a combination of earnings decline and reduced cash payout):
Base: S&P 500 on September 3= 1951.13, T.Bond rate = 2.27%; ERP = 6.34%, g=6.30%
If you hold cash flows constant, an increase in interest rates has a relatively small effect on stock prices, with stock prices dropping 8.76%, even if the US T.Bond rate rises to 5%.  In contrast, if cash flows drop, the index drops proportionately, even if interest rates remain unchanged. You are welcome to make your own "bad news" assumptions and check out the effect on value in this spreadsheet.
Why preserve the myth: For perpetual bears, wrong time and again in the last five years about stocks, the Fed (and low interest rates) have become a convenient bogeyman for why their market bets have gone wrong. If only the Fed had behaved sensibly and if only interest rates were at normal levels (though normal is theirs to define), they bemoan, their market timing forecasts would have been vindicated. 

4. The biggest danger to the Fed is that the market will react violently to a change in its interest rate policy
Myth: The biggest danger to the Fed is that, if it reverses its policy of zero interest rates and stops its bond buying, stock and bond markets will drop dramatically.
Reality: While no central bank wants to be blamed for a market meltdown, the bigger danger, in my view, is that the Fed does what it has been promising to for so long, and nothing happens. That is a good thing, you might say, and while I agree with you in the short term, the long-term consequences for Fed credibility are damaging and here is why. The best analogy that I can offer for the Fed and its role on interest rates is the story of Chanticleer, a rooster that is the strutting master of the barnyard that he lives in, revered by the other farm animals because he is the one who causes the sun to rise every morning with his crowing (or so they think). In the story, Chanticleer’s hubris leads him to abandon his post one morning, and when the sun comes up anyway, the rooster loses his exalted standing. Given the build up we have had over the last few years to the momentous decision to change interest rate policy, think of how much our perceptions of Fed power will change, if stock and bond markets respond with yawns to an interest rate policy shift.
Why we hold on to the myth: If you buy into the first three myths, this one follows. After all, if you believe that the Fed sets interest rates, that it has deliberately kept interest rates low for the last five years and that stock prices are high because interest rates are low, you should fear a change in that policy. Coupled with China, you have the excuses for your underperformance this year, thus absolving yourself of all responsibility for your choices. How convenient?

What next?
Over the last five years, we have developed an unhealthy obsession with the Federal Reserve, in particular, and central banks, in general, and I think that there is plenty of blame to go around. Investors have abdicated their responsibilities for assessing growth, cash flows and value, and taken to watching the Fed and wondering what it is going to do next, as if that were the primary driver of stock prices. The Fed has happily accepted the role of market puppet master, with Federal Bank governors seeking celebrity status, and piping up about inflation, the level of stock prices and interest rate policy. Market watchers, journalists and economists have found stories about the Fed to be great fillers that they can use to fill financial TV shows, newspaper and opinion columns.

I don't know what will happen at the FOMC meeting, but I hope that it announces an end to it's "interest rate magic show". I think that there is enough pent up fear in markets that the initial reaction will be negative, but I am hoping that investors move on to healthier, and more real, concerns about economic growth and earnings sustainability. If the Fed does make its move, the best news will be that we will not have to go through more rounds of obsessive Fed watching, second-guessing and punditry.

Past Posts
  1. The Fed and Interest Rates: Lessons from Oz (June 21, 2013)
  2. Dealing with Low Interest Rates: Investing and Corporate Finance Lessons (April 2015)
Data
  1. Interest Rates, Stock Prices and Expected Returns
Spreadsheets

Friday, August 28, 2015

Big Markets, Over Confidence and the Macro Delusion!

In early October of 2013, I was sitting in CNBC, waiting to talk about Twitter, which had just filed its prospectus (for its initial public offering). I was sharing the room with an analyst who was very bullish on the company, and he asked me what I thought Twitter was worth. When I replied that I had not had a chance to value the company yet, he suggested that I should save myself the trouble, and that the stock was worth at least $60 a share. Curious, I asked him why, and he said that Twitter would use its large user base to make money in the "huge" online advertising market. When I questioned him on how huge the market was, his answer was that he did not have a number, but he just knew that it was "really big". I am thankful to him, since he framed how I started my valuation of Twitter, which is with an assessment of the size of the online advertising market globally. Since I talked to that analyst, I have also become more more aware of the big market argument, and I have seen it used over and over in other markets, often as the primary and sometimes the only reason for assigning high values to companies in these markets. These analysts may very well be right about these markets being very big, but I think that suggesting that a company will be assured growth and profits, just because it targets these markets, not only misses several intermediate steps, but also exposes investors and business-owners to the macro delusion.

Big Markets! Really, Really Big Markets!
Would I rather that my company operate in a big market than a small one? Of course. Increasing market potential, holding all else constant, is good for value, but for that value to be generated, a whole host of other pieces have to fall into place. First, the company has to be able to capture a reasonable market share of that big market, a task that can be made difficult if the market is splintered, localized or intensely competitive. Second, the company has to be able to generate profits in that big market and create value from growth, also a function of the firm's competitive advantages and market pricing constraints. Third, once profitable, the company has to be able to keep new entrants out, easier in some sectors than in others.

It is therefore dangerous to base your argument for investing in a company and assigning it high value entirely on the size of the market that it serves, but that danger does not seem stop analysts and investors from doing so. Here are four examples:

China: A billion-plus people makes any market large, and if you add rapid economic growth and a
burgeoning middle class to the mix, you have the makings of a marketing wet dream. Visions of millions of cell phones, refrigerators and cars being sold were enough to justify attaching large premiums to companies that had even a peripheral connection to China. The events of the last few weeks have made the China story a little shakier, but it will undoubtedly return, once things settle down.
Online Advertising: It is undeniable that more and more of business advertising is moving online, and this shift has not only pushed Google, Facebook and Alibaba to the front lines of large market cap companies but has been the impetus behind Twitter, Yelp, Linkedin and a host of other social media companies capturing market capitalizations that seem outsized, relative to their operating metrics.


The Sharing Economy: Even as private businesses, Uber and Airbnb have not only captured the attention of investors, with multi-billion dollar valuations, but have also disrupted conventional approaches to doing business. In the process, they have opened up the sharing paradigm, where private property (car, house) owners can put excess capacity in what they own to profitable use. 


The Cloud: This is a recent entrant to the "big" market parade, as both technology titans such as Intel, Google and Amazon and new entrants such as Box vie to put our music, video, data and even our computing capabilities on large shared computers. Bessemer Venture Partners, which tracks companies that generate revenues from cloud computing, estimated a collective market capitalization of $170 billion for these companies in August 2015.

I am sure that you will find more examples add to the list. For example, just a couple of weeks ago, Morgan Stanley issued a strong buy recommendation on Tesla and based it entirely on its potential growth in the "mobility services" market. It took me two readings of the report for me to figure out that the mobility service market was a hybrid of the car sharing and driverless car markets, a potentially huge market, that would have become even enormous, if you were able to slap ads on the cars and put them in China.

The Macro Delusion: Individual Rationality, Collective Irrationality
When you label a market as a bubble, you take the easy way out, since a market bubble suggests that the investors who push prices to unsustainably high levels are being irrational, crazy and perhaps even stupid. It is for that reason that I have used the word guardedly (and when I have, regretted it), and taken issue with "market bubblers" in earlier posts. Even if you believe that assets (real estate, stocks, bonds) are being over priced, you will almost always be better served assuming that investors setting these prices have their own reasons for doing so, and understanding those reasons (even if you disagree with them).

To see how (almost) rational and (mostly) smart individuals can be fooled by big market potential into being collectively irrational, assume that you are an entrepreneur who has come up with a product that you see as having a large potential market and that, based on that assessment, you are able to convince venture capitalists to fund your business.

Note that everyone in this picture is behaving sensibly. The entrepreneur has created a product that he sees as fulfilling a large market need and the venture capitalists backing the entrepreneur see the potential for profit from the product.

Now assume that six other entrepreneurs see the same big market potential at about the same time you do, and create their own products to fulfill that market need, and that each finds venture capitalists to back his or her product and vision. 

To make the game interesting, let's make each of these entrepreneurs bright and knowledgeable about their products, and let's make the VCs also smart and business savvy. If this were a rational market place, each entrepreneur and his/her VC backers should be valuing his/her business, based on assessments of market potential and success, and the existence of current and future competitors.

Let's now add the twist that causes the deviation from rationality and make both the entrepreneurs and VCs over confident, the former in the superiority of their products over the competition, and the latter in their capacity to pick winners. This is neither an original assumption, nor a particularly radical one, since there is substantial evidence already that both groups (entrepreneurs and venture capitalists) attract over confident individuals.  The game now changes, since each business cluster (the entrepreneur  and the venture capitalists that back his or her business) will now over estimate its capacity to succeed and its probability of success, resulting in the following. First, the businesses that are targeting the big market will be collectively over valued. Second, the market place will become more crowded and competitive over time, especially with new entrants being drawn in because of the over valuation. Thus, while revenue growth in the aggregate may very well match expectations of the market being big, the revenue growth at firms will fall below collective expectations and operating margins will be lower than expected. Third, the aggregate valuation of the sector will eventually decline and some of the entrants will fold, but there will be a few winners, where the entrepreneurs and VCs will be well rewarded for their investments.

The collective over valuation of the companies in the big market will bear resemblance to a bubble, and the correction will lead to the usual hand wringing about bubbles and market excesses, but the culprit is over confidence, a characteristic that is almost a prerequisite for successful entrepreneurship and venture capital investing. That is one reason that I feel no need to inveigh against bubbles in the social media space, since this is a feature of investing in young, start-up businesses in big markets, not a bug. That said, the extent of the over pricing will vary, depending upon the following:
  1. The Degree of Over Confidence: The greater the over confidence exhibited by entrepreneurs and investors in their own products and investment abilities, the greater will be the over pricing. While both groups are predisposed to over confidence, that over confidence tends to increase with success in the market. Not surprisingly, therefore, the longer a market boom lasts in a business space, the larger the over pricing will tend to get in that space. If fact, you can make a reasonable argument that the over pricing will be greater in markets where you have more experienced venture capitalists and serial entrepreneurs.
  2. The Size of the Market: As the target market gets bigger, it is far more likely that it will attract more entrants, and if you add in the over confidence they bring to the game, the collective over pricing will increase.
  3. Uncertainty: The more uncertainty there is about business models and the capacity to convert them into end revenues, the more over confidence will skew the numbers, leading to greater over pricing in the market. 
  4. Winner-take-all markets: The over pricing will be much greater in markets, where there are global networking benefits (i.e., growth feeds on itself) and winners can walk away with dominant market shares. Since the payoffs to success is greater in these markets, misestimating the probability of success will have a much bigger effect on value.
The Online Ad Market and Social Media Company Valuations
The market that best lends itself to run this experiment today is the online advertising market, with the influx of social media companies into the marketplace in the last few years. To run my experiment, I took the market capitalization of each company in the online advertising space and backed out of the expected revenues ten years from now. To do this, I had to make assumptions about the rest of the variables in my valuation (the cost of capital, target operating margin and sales to capital ratio) and hold them fixed, while I varied my revenue growth rate until I arrived at the current market capitalization. 

The figure below illustrates this process using Facebook with the enterprise value of $245,662 million from August 25, 2015, base revenues of $14,640 million  (trailing 12 months) and a cost of capital of 9%. Leaving the existing margins unchanged at 32.42%, we can solve for the imputed revenue in year 10:
Spreadsheet
I assume that Facebook's current proportion of revenues from advertising (91%) will remain unchanged over the next decade, yielding imputed revenues from advertising for Facebook of $117,731 million in 2025. The assumption that the advertising proportion will remain unchanged may be questionable, at least with some of the other companies on the list below, where investors may be pricing in growth in new markets into the value. You undoubtedly will disagree with this and some of my other assumptions, which is why I will let you make your own in the attached spreadsheet and solve for your estimate of future revenues.

I repeat this process with other publicly traded companies with significant online advertising revenues, using a fixed cost of capital and a target pre-tax operating margin of  either the current margin or 20%, whichever is higher, for every firm. Note that both assumptions are aggressive (the cost of capital may have been set too low and the operating margin is probably too high, given competition) and both will push imputed revenues in year 10 down.
Numbers & Valuations in US dollars for all companies (Folder with valuations)
The collective online advertising revenues imputed into the market prices of the publicly traded companies on this list, in August 2015, was $523 billion.  Note that this list is not comprehensive, since it excludes some smaller companies that also generate revenues from online advertising and the not-inconsiderable secondary revenues from online advertising, generated by firms in other businesses (such as Apple). It also does not include the online adverting revenues being imputed into the valuations of private businesses like Snapchat, that are waiting in the wings. Consequently, I am understating the imputed online advertising revenue that is being priced into the market right now.

To gauge whether these imputed revenues are viable, I looked at both the total advertising market globally and the online advertising portion of it. In 2014, the total advertising market globally was about $545 billion, with $138 billion from digital (online) advertising (Sources: Zenith Optimedia. eMarketer). The growth rate in overall advertising is likely to reflect the growth in revenues at corporations, but online advertising as a proportion of total advertising will continue to increase. In the table below, I allow for different growth rates in the overall advertising market over the 2015-2025 time period and varying proportions moving to digital advertising to arrive at these estimates of digital/online advertising revenues in 2025:
Even with optimistic assumptions about the growth in total advertising and the online advertising portion of it climbing to 50% of revenues, the total online advertising market in 2025 is expected to be $466 billion. The imputed revenues from the publicly traded companies on my list is already in excess of that number, and it seems reasonable to conclude that these companies are being over priced, relative to the market (online advertising) that they are expected to profit from.

As more companies line up to enter this space, this gap between the size of the market that is priced in and the actual market will continue to grow, but investors will continue to fund these companies, even if they are aware of the gap. After all, the nature of over confidence is that founders and investors are convinced that the over pricing is not at their firms, but in the rest of the market. There are two threats to this over confidence and they are inevitable. The first is that as companies in this space continue to report earnings and revenues, you will see more negative surprises (lower revenue growth, shrinking margins and more reinvestment) and some price adjustment. The second is that there is no better deflator of investors over confidence than a market panic, and if the China crisis does not do it, there will be others down the road.

What now?
Even if you accept my argument that big markets can create macro delusions and that these delusions can lead to a gap between collective expectations and reality, what you should do, in response, will depend on how you approach investing. If you are a trader, playing the pricing game, you may not care about the gap, since your returns will be based on timing, i.e., entering the market at the right time and exiting before the delusion is laid bare. It is possible that a lot of public investors and venture capitalists in this space are playing this pricing game and some of them will get very rich doing so. 

If you are a founder/owner or private investor interested in the long term value of your business, you may not be able to do much about your over confidence but there are a few simple steps that you can take to keep it in check. I do know that many in the start-up community view intrinsic valuations (or DCFs) with suspicion, but done right, a DCF is more than a valuation of a company. It provides a template for how you hope to convert products/users/downloads into revenues and profits, how much capital you will need to deliver the growth you so eagerly seek, and how competition will impinge on your best laid plans (by affecting growth and margins).  

If you are a public market investor, surveying a "big market" group of companies, this post is not a clarion call to abandon the group, but to approach it differently. You can still make money investing in this sector, but only if you are selective about the companies that you invest in (which requires that you grapple with estimating the size of the big market and make your best judgments on winners and losers)  and are cognizant of the price that you are paying, not only when you buy the stock but while your hold it. In fact, your very best investments may come from mis-pricing in this segment.

No matter which group you belong to, it is time that we stop labeling each other. If you are on the outside (of these big markets) looking in, don't be so quick to categorize players in the market as irrational, shallow and naive. If you are on the inside looking out, stop thinking of anyone who does not buy into your big market thesis as a Luddite, out of touch with technology and stuck in the past. You and I should be able to disagree about the values of Uber, Snapchat and Twitter, without our motives being impugned, our intelligence questioned and our sanity put to the test.

YouTube Version
I know that this is a long post and that your attention may have flagged half way through. To remedy that, I decided to make a YouTube video around this post. I hope you enjoy it!

Attachments
  1. Imputed Online Ad Revenues by Company (with raw data on the companies)
  2. Spreadsheet to compute Imputed Online Ad Revenues
  3. Folder with imputed revenue spreadsheets for companies

Wednesday, August 26, 2015

Another Market Crisis? My Survival Manual/Journal!

I would be lying if I said that I like down markets more than up markets, but I have learned to accept the fact that markets that go up will come down, and that when they do so quickly, you have the makings of a crisis. I find myself getting more popular during these periods, as acquaintances, friends and relatives that I have not heard from in years seem to find me. They are  invariably disappointed by my inability to forecast the future and my unwillingness to tell them what to do next, and I am sure that I move several notches down the Guru scale as a consequence, a development that I welcome. To save myself some repetitions of this already tedious sequence, I think it is best that I pull out my crisis survival journal/manual, a work in progress that I started in the 1980s and that I revisit and rewrite each time markets go into a tailspin. It is more journal than manual, more personal than general, and more about me than it is about markets. So, read on at your own risk!

The Price of Risk
For me, the first casualty in a crisis is perspective, as I find myself getting whipsawed with news stories about financial markets, each more urgent and demanding of attention than the previous one. The second casualty is common sense, as my brain shuts down and my primitive impulses take over. Consequently, I find it useful to step back and look at the big picture, hoping to see patterns that help me make sense of the drivers of market chaos.

It is my view that the key number in understanding any market crisis is the price of risk. In a market crisis, the price of risk increases abruptly, causing the value of all risky assets to drop, with that drop being greater for riskier assets. While the conventional wisdom, prior to 2008, was that the price of risk in mature markets is stable and does not change much over short periods, the last quarter of 2008 changed (or should have changed) that view. I started tracking the price of risk in different markets (equity, bond, real estate) on a monthly basis in September 2008, a practice that I have continued through the present. Getting an a forward-looking, dynamic price of risk in the bond market is simple, since it takes the form of default spreads on bonds, and FRED (the immensely useful Federal Reserve Database) has the market interest rates on a Baa rated (Moody's) bonds going back to 1919, with data available in annual, monthly or daily increments. That default spread is computed by taking the difference between this market interest rate and the US treasury bond rate  on the same date. Getting a forward-looking, dynamic price of risk in the equity markets is more complicated, since the expected cash flows are uncertain (unlike coupons on bonds) and equities don't have a specific maturity date, but I have argued that it can be done, though some may take issue with my approach. Starting with the cumulative cash flow that would have generated by investing in stocks in the most recent twelve months, I estimate expected cash flows (using analysts' top down estimates of earnings growth) and compute the rate of return that is embedded in the current level of the index. That internal rate of return is the expected return on stocks and when the US treasury bond rate is netted out, it yields an implied equity risk premium. The January 2015 equity risk premium is summarized below:
Implied ERP Spreadsheet (January 2015)
That premium had not moved much for most of this year, with a low of 5.67% on March 1, and a high of 6.01% in early February, and the ERP at the start of August was 5.90%, close to the start-of-the-year number. Given the market turmoil in the last weeks, I decided to go back and compute the implied equity risk premium each day, starting on August 1.
ERP By Day
Note that not much changes until August 17, and that almost all of the movement have been in the days between August 17 and August 245 During those seven trading days, the S&P 500 dropped by more than 11% and if you keep cash flows fixed, the expected return (IRR) for stocks increased by 0.68%. During the same period, the US treasury bond rate dropped by 0.06%, playing its usual "flight to safety" role, and the implied equity risk premium (ERP) jumped by 0.74% to 6.56%. 

I did use the trailing 12-month cash flows (from buybacks and dividends) as my base year number, in computing these equity risk premiums, and there is a reasonable argument to be made that these cash flows are too high to sustain, partly because earnings are at historic highs and partly because companies are returning more of that cash than ever before. To counter this problem, I assumed that earnings would drop back to a level that reflects the average earnings over the last 10 years, adjusted for inflation (i.e., the denominator in the Shiller CAPE model) and that the payout would revert back to the average payout over the last decade. That results in lower equity risk premiums, but the last few days have pushed that premium up by 0.53% as well.

My computed increases in ERP, using both trailing and normalized earnings, overstate the true change, because the cash flows and growth were left at what they were at the start of August, a patently unrealistic assumption, since this is also an economic crisis, and any slowing of growth in China will make itself felt on the earnings, cash flows and growth at US companies. That effect will take a while to show up, as corporate earnings, buyback plans and analyst growth estimates are adjusted in the months to come, and I am sure that some of the market drop was caused by changes in fundamentals. The argument that a large portion of the drop comes from the repricing of risk is borne out by the rise in the default spread for bonds, with the Baa default spread widening by 0.17%, and the increase in the perceived riskiness (volatility) of stocks, with the VIX posting its largest weekly jump ever, in percentage terms.

The Repricing of Risky Assets
When the price of risk changes, all risky assets will be repriced, but not by the same magnitude. Within mature markets, you should expect to see a bigger drop in stock prices at more risky companies than at safer ones, though how you define risk can affect your conclusions. If you define risk as exposure to the the precipitating factor in the crisis, I would expect the stock prices of  companies that are more dependent on China for their revenues to drop by more than the rest of the market. Since I don't have data on how much revenue individual companies get from China, I will use commodity companies, which have been aided the most by the Chinese growth machine over the last decade and therefore have the most to lose from it slowing down, as my proxy for China exposure. The table below highlights the 20 industry groups (out of 95) that have performed the worst between August 14 and August 24:


Notice that commodity companies comprise one quarter of the group, with a few cyclical and technology sectors thrown into the mix.

Looking across markets geographically, changes in the equity risk premium in mature markets will be magnified as you move into riskier countries and thus it is not surprising to see the carnage in emerging markets over the last week has exceeded that in developed markets, with currency declines adding to local stock market drops.

Percentage Return in US dollar terms
In the picture below, I capture the percentage change in market capitalizations between August 14, 2015, and August 24, 2015 in U.S. $ terms, with the PE ratios as of August 14 and August 24 highlighted for each country:

via chartsbin.com
Note that this phenomenon of emerging markets behaving badly cannot be blamed on China, since it happened in 2008 as well, when it was the banking system in developed markets that triggered the market rout.

A Premium for Liquidity?
There is another dimension, where crises come into play, and that is in the demand for liquidity. While investors always prefer more liquid assets to less liquid ones, that preference for liquidity and the price that they are willing to pay for it varies across time and tends to surge during market crisis. To see if this crisis has had the same effect, I looked at the drop in market capitalization, in US $ terms, between August 14 and 24 for companies classified by trading turnover ratios (computed by dividing the annual dollar trading value by the market capitalization of the company):
Liquidity classes, based on turnover ratio = $ Trading Value/ $ Market Cap
Surprisingly, it is the most liquid firms that have seen the biggest drop in stock prices, though the numbers may be contaminated by the fact that trading halts are often the reactions to market crises in many countries, that are home to the least liquid stocks. If this is the reason for the return divergence, there is more pain waiting for investors in these stocks as the market drop shows up in lagged returns.

To the extent that market crises crimp access to capital markets, the desire for liquidity can also reach deeper into corporate balance sheets, creating premiums for companies that have substantial cash on their balance sheets and fewer debt obligations. To test this proposition, I classified firms globally, based upon the net debt as a percent of enterprise value, and looked at the price drop between August 14 and August 24:
Net Debt/EV = (Total Debt- Cash)/ (Debt + Market Cap - Cash)
The crisis seems to have spared no group of stocks, with the pain divided almost evenly across the net debt classes, with the largest price decline being in the stocks that have cash balances that exceed their debt. Note, however, that the multiples at which these companies trade at both prior and after the drop, reflect the penalty that the market is attaching to extreme leverage, with the most levered companies trading at a PE ratio of 3.11 (at least across the 15.76% of firms in this group that have positive earnings to report). If your contrarian strategy for this market is to screen for and buy low PE stocks, this table suggests caution, since a large portion of the lowest PE stocks will come with high debt ratios.

As the public markets drop, the question of how this crisis will affect private company valuations has risen to the surface, especially given the large valuations commanded by some private companies. Since many of these private businesses are young, risky startups and that investments in them are illiquid, I would guess they will be exposed to a correction,  larger than what we observe in the public marketplace. However, given that venture capitalists and public investors in these companies will be self appraising the value of their holdings, the effect of any markdown in value will take the form of fewer high-profile deals (IPO and VC financing).

What now?
A market crisis bring out my worst instincts as an investor. First out of the pack is fear pushing me to panic, with the voice yelling "Sell everything, sell it now", getting louder with each bad market day. That is followed quickly by denial, where another voice tells me that if I don't check the damage to my portfolio, perhaps it has been magically unaffected. Then, a combination of greed and hubris kicks in, arguing that the market is filled with naive, uninformed investors and that this is my time to trade my way to quick profits. I cannot make these instincts go away, but I have my own set of rules for managing them. (I am not suggesting that these are rules that you should adopt, just that they work for me..)
  1. Break the feedback loop: Being able to check your portfolio as often as you want and in real time, with our phones, tablets and computers, is a mixed blessing. I did check my portfolio this morning for the damage that the last week has done, but I don't plan to check again until the end of the week. If I find myself breaking this rule, I will consider sabotaging my wifi connection at home, going back to a flip phone or leaving for the Galapagos on vacation.
  2. Turn off the noise: I read the Wall Street Journal and Financial Times each morning, but I generally don't watch financial news channels or visit financial websites. I become religious about this avoidance during market chaos, since much of the advice that I will get is bad, most of the analysis is after-the-fact navel gazing and all of the predictions share only one quality, which is that they will be wrong. 
  3. Rediscover your faith: In my book (and class) on investment philosophies, I argue that there is no "best' investment philosophy that works for all investors but that there is one for you, that best fits what you believe about markets and your personality. My investment philosophy is built on faith in two premises, that every business has a value that I can estimate, and that  the market price will move towards that value over time. During a crisis, I find myself returning to the core of that philosophy, to make sense of what is going on.
  4. Act proactively and consistently: It is natural to want to act in response to a crisis. I am no exception and I did act on Monday, but I tried to do so consistently with my philosophy. I revisited the valuations that I have done over the past year (and you can find most of them on my website, under my valuation class) and put in limit buy orders on a half a dozen stocks (including Apple, Tesla and Facebook), with the limit prices based on my valuations of the companies. If the crisis eases, none of the limit orders may go through, but I would have protected myself from impulsive actions that will cost me more in the long term. If it worsens, all or most of the of the limit buys will be executed, but at prices that I think are reasonable, given the cash flow potential of these companies.
Will any of these protect me from losing money? Perhaps not, but I did sleep well last night and am more worried about whether the New York Yankees will score some runs tonight than I am about what the Asian markets will do overnight. That, to me, is a sign of health!
The Silver Linings
Just as recessions are a market economy's way of cleansing itself of excesses that build up during boom periods, a market crisis is a financial market's mechanism for getting back into balance. I know that is small consolation for you today, if you have lost 10% or more of your portfolio, but there are seedlings of good news, even in the dreary financial news:
  1. Live by momentum, die by itIn trading, momentum is king and investors who play the momentum game make money with ease, but with one caveat. When momentum shifts, the easy profits accumulated over months and years can be wiped out quickly, as commodity and currency traders are discovering.
  2. Deal or no deal? If you share my view that slowing down in M&A deals is bad news for deal makers, but good news for stockholders in the deal-making companies, the fact that this crisis may be imperiling deals is positive news.
  3. Rediscover fundamentals: My belief that first principles and fundamentals ultimately win out and that there are no easy ways to make money is strengthened when I read that carry traders are losing money, that currency pegs do not work when inflation rates deviate, and mismatching the currencies in which you borrow and generate cash flows is a bad idea.    
  4. The Market Guru Handoff: As with prior crises, this one will unmask a lot of economic forecasters and market gurus as fakes, but it will anoint a new group of prognosticators who got the China call right as the new stars of the investment universe. 
If a market crisis is a crucible that tests both the limits of my investment philosophy and my  faith in it, I am being tested and as with any other test, if I pass it, I will come out stronger for the experience. At least, that is what I tell myself as I look at the withered remains of my investments in Vale and Lukoil!

Spreadsheets

Monday, August 24, 2015

My Valuation Class: The Fall 2015 Model Preview

It is almost September and as the academic clock resets for a new year,  I get ready to teach a new valuation class. With three hundred registered students, it is about as diverse a class as any I have every taught, with a mix of full-time  and part-time MBA students, law and engineering graduate students and a few dozen undergraduates. And with a market meltdown framing discussions, it will be interesting to see how the class plays out. As always, I cannot wait for the class to start and as I have, each semester, for the last few years, I invite you to follow the class, if you are so inclined. 

Setting the table
Valuation is an intimidating title for a class, stirring up visions (and nightmares) about spreadsheets, accounting statements and financial theory. This may be the default version of the class and it serves experts in the topic well to preserve this air of mystery and intimidation. I have neither the expertise nor the desire to  teach such a class, and I hope that you will not only take my class, no matter what your background and experience, but that you will also learn to enjoy valuation as much as I do. The best way for me to start describing my class is to tell you what it is not about, rather than what it covers. So, here we go: 
  1. It is not an accounting class: Much of the raw data in my valuations comes from accounting statements, but once I get that raw data, I lose interest in the rest of the accounting details. In fact, one of my first in-practice webcasts (short webcasts about practical issues in valuation) uses the Procter and Gamble 10K to illustrate how little of a typical accounting filing gets used in valuation and how much is irrelevant or useless. I admire people who can forecast our full financial statements (income statements, balance sheets and cash flow statements) decades out, but I have never ever felt the urge to do so and I am not sure that I have the accounting skills to even do so.
  2. It is not a modeling class: As someone who did his first valuation on an old fashioned columned paper sheet with a calculator, I have mixed feelings about spreadsheets, in general, and Microsoft Excel, in particular. I like the time that I save in computational details, but I have to weigh that against the time I lose, playing pointless what-if games with the data that I would never have considered in my calculator days. I admire Excel Ninjas but I have also seen what happens when analysts become the spreadsheet's tools, rather than the other way around. Needless to say, I have never taught a session (let alone a class) built around Excel spreadsheets, though I have no qualms about using one to illustrate fundamental valuation principles.
  3. It is not a financial theory class: To be able to teach this class at a research university, I had to go through the rites of passage of a Finance doctoral student,  traversing the path that finance has followed, starting with Harry Markowitz and modern portfolio theory, moving through its Greek phase (with alphas and betas dominating the conversation first and then leading on to the expropriation of the rest of the Greek alphabet by the options theorists) to the counter-revolutionaries of behavioral finance. Unlike some who make you choose whether you are for financial theory or against it, I view it as a buffet, where I can partake on the portions of the theory that I find useful and leave behind that which I do not. In my valuation class, in particular, I would be surprised if I spent more than 5% of my time on financial theory, and if I do, it is only because I am trying to get to some place more interesting.
Now that I have established what the class is about, let me lay out the five themes around which this class is built. 
  1. Valuation is a craft, not an art or a science: I start my class with a question, "Is valuation an art or a science?", a trick since the answer, in my view, is neither. Unlike physics and mathematics, indisputably sciences with immutable laws, valuation has principles but none that meet the precision threshold of a science. At the other extreme, valuation is not an art, where your creative instincts can guide you to wherever you want to go and geniuses can make up their own rules. I believe that valuation is a craft, akin to cooking and carpentry, and that you learn what works and what does not by doing it, not by reading or listening to others talk about it. That is the reason that each week during the course of the semester, I post my valuation of a company, with a Google shared spreadsheet for everyone in the class to try their hand at valuing the same company and coming to a very different conclusion than I do.
  2. Valuing an asset is different from pricing it: I will not bore you by repeating this distinction that I drew first in this post but have returned to over and over again. It is my belief that much of what passes for valuation, in practice, is really pricing, sometimes disguised as valuation and sometimes not, but I also think that there is nothing wrong with pricing an asset, if that is what your job entails. Thus, though the bulk of this class is built around intrinsic value and its determinants, a significant portion of the class is dedicated to better pricing techniques, through the judicious use of multiples, comparable assets and statistics.
  3. Anything can be priced and most almost anything can be valued: This may be stubborn side speaking, but I have always believed that you can value any cash-flow generating asset (as I have attempted to, in these posts on valuing tracking stock on a professional athlete, a sports team, a trophy asset and young companies) and that you can price any asset (as I tried to to, in these posts on Gold and Bitcoins). While this class is centered around valuing publicly traded companies, I deviate from that script often enough, that by the end of the class, you should be able to value and price any asset.
  4. Valuation = Story + Numbers: As readers of this blog, you have heard me get on the soapbox often enough, but to me the essence of valuation is connecting stories to numbers. As I noted in this most recent post of mine, this requires me to push people out of their comfort zones, encouraging numbers people to tell more stories and stories people to work more with numbers. No matter how far on either end of the numbers/ story spectrum you are, I think that no one is beyond reach.
  5. Valuation without action is pointless: I have never felt the need to use a case study in my valuation class or value a widget company in my class, because I not only find valuing real companies  in real time more interesting, but I can act on my own valuations and I usually do, though not always with conviction. Investing requires faith in both your capacity to value companies and in markets correcting over time and I try to let people see both the source of my faith and challenges to that faith. 
I did put together a short (about two minutes) YouTube video of my class that summarize my perspective on this class. 

So, both number crunchers and story tellers, welcome to the class and we can learn from each other!

Prepping for the class
As a realist, there are a few skills that will stand you in good stead in this class and none of these skills are difficult to acquire.
  1. Read financial statements: For better or worse, our raw data comes from accounting statements and you need to be able to navigate your way through these statements. If you have a tough time deciphering the difference between gross, operating and net income, and don't quite understand what goes into book value of equity, you will have a tough time valuing companies. Don't remember your accounting classes? Don't want to go back there? Never fear! I have a primer on accounting that takes you through the absolute basics (which is about all I know anyway) and you can get to it by clicking on this link.
  2. Understand basic statistics: Statistics, I was taught in my first class, is designed to help us make sense of large and contradictory data. Since that is precisely our problem in pricing assets today, i.e., that we have too much data pulling us in too many directions, it may be time to dust off that statistics book (I hope that you did not sell it back or burn it after your last statistics class) and reacquaint yourself with simple statistics. So, start with the averages, medians and standard deviations, move on to correlations and regressions and if you can handle it, to statistical distributions. If you are lost, try this link for my statistics primer.
  3. Get comfortable with rudimentary finance: I have always found it unfair that to take some classes, you have to take the equivalent of a lifetime in pre-requisites. While having taken a corporate finance class eases the way in valuation, it is not required, nor is any other finance course. That said, your life will be easier if you have nailed down the basics of time value of money and computing present value, as well as understand the roots of modern portfolio theory, even if you don 't quite get the specifics. This link has my time value of money primer.
Getting down to Specifics
It's taken me a while to get to specifics, but the class starts on September 2, 2015 and classes are every Monday and Wednesday from 10.30 am -11.50 am (with Sept 7, 14 and 23 being holidays) until December 14. The calendar for the class is available at this link.  The class content will follow a familiar path, starting with a big picture perspective on valuing/pricing, followed by intrinsic valuation (DCF), relative valuation (pricing and multiples), asset-based valuation (accounting, liquidation & sum of the parts) and it will end with real options. There will be two add-on sessions on acquisition valuation and value enhancement.

If you are one of the 300 registered in the class, I hope to see you in class. If not, the classes will be recorded and webcast, usually by the end of each session day, and there are three forums you can use to follow the class:
  1. My website: Everything I do in this class will be accessible on this page for the class. As you will notice on the page, you can not only access the webcasts for the lectures, but you can download the lecture notes, try your hand at the valuations of the week and even take quizzes/exams (though you have to grade them yourself). If you want, you can read the emails that I send to the class at this link
  2. iTunes U: This has become one of my favorite platforms for delivering my class and it works flawlessly, if you have an Apple device, with an iPad providing a much better experience than an iPhone. (You have to download the iTunes U app, but it is free and the learning curve is barely uphill.)  However, you can tweak it to work on an Android, with an add-on app. This semester's version will be available at this link.
  3. YouTube: This was my add-on platform last semester and while it was never intended for delivering full classes, it worked surprisingly well. The webcasts come naturally to it, though the 80 minutes is a stretch, but I will add on the presentation material and the post-class tests to the webcasts to supplement them. This semester, the lectures and supporting material will be found at this channel.
Alternate Pathways
This is not the first time that I have put my classes online and this may not be the first time that you have thought about taking this particular class. As with other online classes, I know that life gets in the way, with family and work commitments taking priority, as they should, over an online valuation class that provides no credit or certification. You can follow one of the following four paths, each requiring more time and brain commitment than the prior one:
  1. Watch an occasional lecture or lectures: Rather than watch all 26 lectures, you can pick and choose a few on the topics that interest you the most. This strategy works best for those who cannot commit the time and/or are already experienced enough in valuation that they need just a brushing up of skill sets. 
  2. Watch every lecture, do post class tests/solutions: You could watch every lecture, a significant time commitment at 80 minutes apiece, and do just the post-class tests (designed to take about 5-10 minutes). Remember that you don't have to take this in real time, since the course will stay online for at least a year.
  3. Watch lectures and take quizzes/exam: In addition to watching the lectures, you can put your knowledge to the test and take the quizzes and final exam. I will post my solutions with a grading template and you can grade yourself (My advice: Be an easy grader!). Since the exams are all open-book, open-notes all you have to do is honor the time constraint (30 minutes for quizzes, 2 hours for the final).
  4. Watch lectures, take quizzes exam & value a company: In addition to doing all of the tasks in the prior path, you also pick a company to value (just as everyone else in my class will be) and try to apply what you learn in the class in that valuation. Unfortunately, there is little chance that I can offer you the feedback that I offer to those in my class, but I will try to answer a question or two, if you are stuck, and will provide my feedback template, when the time comes due.
If all of these pathways all sound like too much work/time commitment and/or watching 80 minute videos of valuation lectures on your phone or tablet is not your idea of fun, I do have an alternative. Try my online valuation class, where the sessions are about 10-15 minutes apiece, on my website, YouTube or iTunes U
Pass on it or pass it on!
If you try the class and don't like it, I will not be offended and I am sure that you will find a better use for  your time. If you try the class and you like it, I would like something in return. Please pass on a bit of what you know or have learned to at least one other person, and perhaps more. Knowledge is one of the few things in life that we can share, without being left poorer for the sharing, and while the return on this investment will be not be financial, the emotional dividends will make it worthwhile. 

Attachments

Friday, August 21, 2015

Beijing Blunders: Bull in a China Shop!

I have generally steered from using my blog as a vehicle for rants, not because I don't have my share of targets, but because I know that while ranting makes me feel better, it almost always creates more costs than benefits. It is true that I have had tantrums (mini-rants) about the practice of adding back stock-based compensation to EBITDA or expensing R&D to get to earnings, but the targets of those tend to be harmless. After all, what can sell-side  equity research analysts or accountants collectively do to retaliate? Refuse to send me their buy and sell recommendations? Threaten me with gang-audits?

This post is an exception, because the target of the rant is China, a much bigger and more powerful  adversary than those in my mini-rants, and it is only fair that I let you know my priors before you read this post. First, I am hopelessly biased against the Chinese government. I believe that its reputation for efficiency and economic stewardship is inflated and that its thirst for power and money is soft-pedaled. Second, I know very little about the Chinese economy or its markets, how they operate and what makes them tick. It it true that some of my ignorance stems from the absence of trustworthy information about the economy but a great deal of it comes from not spending any time on the ground in China. So, if you disagree with this post, you have good reason to dismiss it as the rant born of ignorance and bias. If you agree with it, you should be wary for the same reasons.

The Chinese Economic Miracle: Real or Fake?
For the last two decades, the China story has been front and center in global economics, and with good reason. In the graph below, you can see the explosive growth in Chinese GDP, measured in Chinese Yuan and US dollars:


The Chinese economy grew from being the eighth largest in the world in 1994 to the second largest in the world in 2014. It is true that many of the statistics that we use for China come from the Chinese government and there are is reason to question its reliability. In fact, there are some with conspiratorial inclinations who wonder whether the Chinese miracle is a Potemkin village, designed for show. Much as my bias would lead me down this path, there are some realities on the ground that are impossible to ignore:
  1. The China growth story is real: Any one who has visited China will tell you that the signs of real growth are around you, especially in urban China. It is not just the physical infrastructure of brand new airports, highways and high-speed trains, but the signs of prosperity among (at least some of) its people. I did my own experiment yesterday that confirmed the reality of Chinese growth. After I woke up to the alarm on my China-made iPhone, I put on my Nike exercise clothes, manufactured in China, slipped on my Asics running shoes, also from China. As I went through the day, it was easier for me to keep track of the things that were not made in China than those that were. Based just on that very unscientific sampling, I am willing to believe that China is the world's manufacturing hub.
  2. It has a Beijing puppet-master: To those who celebrate the growth of the Chinese economy as a triumph of free markets, I have to demur. The winners and losers in the Chinese economy are not always its best or most efficient players and investment choices are made by policy makers (or politicians) in Beijing, not by the market. There are those who distrust markets who would view this as good, since markets, at least in their view, are short term, but trusting a group of experts to determine how an economy should evolve can be even more dangerous.
  3. It is driven by infrastructure investment, not innovation: The Chinese economy is skilled at copying innovations in other parts of the world, but not particularly imaginative in coming up with its own. It is revealing that the current vision of innovation in China is to have a CEO dress up like Steve Jobs and make an Android phone that looks like the iPhone. Note that this should not be taken as a reflection of the Chinese capacity to be innovative but a direct consequence of centralized policy (see prior point). 
  4. The China story is now part of every business: In just the last month and a half, I have been in the US, Brazil and India, and can attest to the fact that the China story is now embedded in companies across the globe. In the US, I saw Apple report good earnings and lose $100 billion in market capitalization, with some attributing the drop to disappointing results from China. In Brazil, my Vale valuation rests heavily on how China does in the future, because China accounts for 37% of Vale's revenues and the surge in iron ore prices in the last decade came primarily from Chinese infrastructure investment. In India, I valued Tata Motors, whose acquisition of Jaguar , has made them more of a Chinese company than an Indian one, dependent on the Chinese buying oversized Land Rovers for a significant portion of their profits. 
  5. It is also a weapon of mass distraction: In a post from a few months ago, I talked about weapons of mass distraction, words that analysts use to induce you to pay premiums  for companies and to distract you from specifics. In that post, I highlighted "China" as the ultimate wild card, with mention of exposure to the country operating as an excuse for pushing up the stock price. The problems with wild cards though is that they are unpredictable, and it is entirely possible that the China card may soon become a reason to discount value, as the handwringing about earnings effects and corporate exposures of the China crisis begins.  
The Chinese Markets: All Pricing, all the time!
If you have been reading the news for the last few months, which have been about the epic collapse of Chinese stocks, I would not blame you for feeling sorry for investors in the Chinese market. I would suggest that you save your sympathy for more deserving causes, because as with everything else in markets, it depends on your time perspective. In the chart below, I look at three charts that look at the Shanghai Composite over time:
Shanghai Composite
It is undeniable that markets have been melting down since June, with the Shanghai Composite down 32% from its peak on June 12. However, if you had invested in Chinese stock at the start of this year, you have no reason to complain, with a return of 8.44% for the year to date, among the best-performing markets globally.  Stepping even further back, if you had invested in Chinese stocks in 2005, you would have earned close to 13$ as an annual return each year, with all the ups and downs in between.

In earlier posts, I have drawn a contrast between valuation and pricing and why a healthy market need both investors (who buy or sell businesses based on their perceptions of the values of these businesses) and traders (who buy and sell assets based on what they think others will pay for them). A market dominated mostly by investors will quickly become illiquid and boring, and ironically reduce the incentives to collect information and value companies. A market dominated by traders will be volatile, with price movements driven by mood, momentum and incremental information, and will be subject to booms and busts. I would characterize the Chinese stock market as a pricing market, where traders rule and investors have long since fled or have been pushed out. While there are some who will attribute this to China being a young financial market, and others to cultural factors, I believe that it is a direct consequence of self-inflicted wounds.
  1. Investor restrictions: There is perhaps no more complicated market to trade in than the Chinese markets, with most Chinese companies having multiple classes of shares: Class A shares,  and traded primarily on the mainland, denominated in Yuan, Class B shares, denominated in US $, traded on the mainland and Class H shares, traded in Hong Kong, denominated in HK$. The Chinese government imposes tight restrictions on both domestic investors (who can buy and sell class A shares and class B shares, but only if they have legal foreign currency accounts, but cannot trade in class H shares) and foreign investors (who can buy and sell only class B and class H shares). As a consequence of these restrictions, investors are forced into silos, where shares of different classes in the same company can trade at different prices and governments can keep a tight rein on where investors put their money. Note also that the highest profile technology companies in China, like Baidu and Alibaba, create shell entities (variable interest entities or VIEs) and list themselves on the NASDAQ, making them effectively off-limits to domestic investors.
  2. Opaque financials and poor corporate governance: While China has moved towards adopting international accounting standards, Chinese companies are not doyens of disclosure, often holding back key information from investors. It is therefore not surprising that almost 10% of all securities class action litigation in the US between 2009 and 2013 was against Chinese companies listed in the US, that variable interest entities hold back key information and that non-Chinese companies like Caterpillar and Lixil have had to write off significant portions of their Chinese investments, as a result of fraud. This non-disclosure problem is twinned with corporate governance concerns at Chinese companies, where shareholders are viewed more as suppliers of capital than as part-owners of the company.
  3. Markets as morality plays: The nature of markets is that they go up and down and it is that unpredictability that keeps the balance between investors and traders. In China, the response to up and down markets is asymmetric. Up markets are treated as virtuous and traders who push up stock prices (often based on rumor and greased with leverage) are viewed as "good" investors. Down markets are viewed as an affront to Chinese national interests and not only are there draconian restrictions on bearish investors (restrictions on short selling, trading stops) but investors who sell stock are called traitors, malicious market manipulators or worse. Thus, the same Chinese government that sat on its hands as stock prices surged 60% from January to June has suddenly discovered the dangers of volatility in the last few weeks as markets have given up much of that gain.   
The bottom line is that the Chinese government neither understands nor trusts markets, but it needs them and wants to control them. By restricting where investors can put their money, treating short sellers as criminals and market drops as calamities, the Chinese government has created a monster, perhaps the first one that does not respond to its dictates. The current attempt to stop the market collapse, including buying with sovereign funds, putting pressure on portfolio managers, name calling and sloganeering may very well succeed in stopping the bleeding, but the damage has been done.

Moneyball in China
The best cure for bias and ignorance is data and I decided that the first step in ridding myself of my China-phobia would be a look at how Chinese stocks are being priced in the market today. The essence of value investing is that at the right price, any company (including a Chinese company with opaque financials and non-existent corporate governance) can be a good investment and it is possible that the drop in stock prices in the last few months has made Chinese stocks attractive enough for the rest of us.

To make these comparisons, I used the market price data as of August 19, 2015, to estimate market capitalization and enterprise values. For the accounting data, I used the numbers from the trailing 12 months, generally the 12 months ending mid-year 2015, for most companies. The first comparison was on pricing multiples:

I compared China with India, Brazil and Russia, the three other countries that have been lumped together (awkwardly, in my view) as the BRIC,  as well as with the rest of the emerging markets. For comparisons, I also looked at the US and the rest of the developed markets (where I included Japan, Western Europe, Australia, Canada and New Zealand). In spite of the drop in stock prices in the last few months, Chinese stocks are collectively more expensive than stocks anywhere else in the world.

To measure the profitability of Chinese companies, I looked at three measures of margin (EBITDA, Operating Income and Net Income) and three measures of return (Return on Equity and Return on Invested Capital):

Chinese companies lag the rest of the world, when it comes to EBITDA and operating margins, but do better than other emerging market companies on net margins. On returns on equity and invested capital, Chinese companies are more profitable than Brazilian companies (reflecting the economic downturn in Brazil in the last year) but are pretty much on par with the rest of the world.

One reason for the superior net margins at Chinese companies is that they tend to borrow less than companies elsewhere in the world, perhaps the only bright light in these comparisons.


That may be at odds with some of what you may be reading about leverage in China, but it looks like the debt in China is either more in the hands of local governments or is off balance sheet.

Finally, if the straw that you are grasping for is higher growth in China, there is some backing for it when you compare growth rates across companies, but only in analyst expectations, rather than in growth delivered:

It is true that this market-level look at China may be missing bargains at the sector level and to remedy that, I looked at PE ratios and EV/EBITDA multiples regionally, by industry grouping. The industry-average values, classified by region, can be downloaded here, but across the ninety five industry groupings, Chinese companies have the highest PE ratios in the world in fifty and the highest EV/EBITDA multiples in fifty eight. You could dig even deeper and look at company-level data and you are welcome to do so, using the complete dataset here.

Overall, I am hard pressed to make a case for investing in Chinese stocks, if you have a choice of investing in other markets, even after the market drop of the last few months. If you are a domestic investor in China, your choices are more restricted, and you may very well be forced to stay in this market. It is interesting that India and China, two markets that restrict domestic investors from investing outside the country, are the two most richly priced.

Conclusion
As I confessed up front, I am not a China hand and don't claim any macro or market forecasting skills, but my experience with company valuation and pricing lead me to make the following predictions for China.
  1. Slower real growth: If I were a betting man, I would be willing to take a wager that the expected real growth rate in the Chinese economy will be closer to 5% a year for the next decade than to the double-digit growth that we have been programmed to expect. That may strike you as pessimistic, after the growth of the last two decades, but just as size eventually catches up with companies, the Chinese economy is getting too big to grow at the rates of yesteryear. The question, for me, is not whether this will happen but how the Chinese government will deal with the lower growth. While the sensible option is to accept reality and plan for lower real growth, I fear that the need to maintain appearances will lead to a cooking of the economic books, in which case we will have an number-fixing scandal of monumental proportions.
  2. More pricing ahead: I don't see much hope that investors will be welcomed back into Chinese markets any time soon. So, even if this market shakeup drives some of traders out of the game, investors motivated by value will be reluctant to step in, if the government continues to make markets into morality plays. As long as the market continues to be a pricing game, the price moves in the market will have little do with fundamentals. As a consequence, I would suggest that you ignore almost all attempts by market experts to explain what is happening in Chinese markets with economic stories. 
  3. Buyer beware: If you are drawn to Chinese markets (like moths to a flame), here is my advice for what it is worth. If you are an investor, you need to look past the hype and value companies, opacity and complexity notwithstanding, and be a realist when it comes to corporate governance. If you are a trader, this is a momentum game and if you can get ahead of momentum shifts, you will make money. If your bet is on the downside, just be ready to be maligned, abused or worse.
I understand why corporate chieftains and heads of government are unwilling to speak openly about the Chinese government, given how much of their own economic prosperity rests on maintaining good relations. Financial markets don't have such qualms and they are delivering their message to Beijing clearly and decisively. Let's hope someone is listening!
Attachments