Apple: News, Noise and Value

As has been the case for much of the last two years, the Apple earnings report on April 24, 2013 was a media event, previewed endlessly on investment sites, covered heavily by the media and tweeted about by both Apple fans and foes. While I try to stay away from the hype around earnings reports, this is a good occasion to revisit my earlier posts on Apple, and especially the one I made at the start of this year on its valuation.

The Signal amidst the Noise

One of the most difficult parts of being an investor in Apple has become dealing with the cacophony of rumors, stories and news releases that seem to permeate the day-to-day coverage of the stock. Not only do we, as investors, have to determine whether there is truth to a story but we also have to evaluate its impact on value (and indirectly on whether to continue holding the stock). To keep my perspective, as I read these stories, I go back to basics and draw on my “financial balance sheet” view of a company. While it resembles an accounting balance sheet in broad terms, it is different on two dimensions. First, it is a forward looking and value based assessment of a company, rather than being backward looking and historical cost based. Second, it is flexible enough to allow me to record the potential for future growth as an asset, thus giving businesses credit for value that they may create in the future from growth. In very broad terms, here is what Apple’s financial balance sheet  looked like just before the most recent earnings report:
There is nothing surprising about this balance sheet but it brings together much of what has happened to the company between April 2012 and April 2013. During the year, the company has become increasingly dependent upon its smartphone business, accounting for 60% of revenues and even more of operating income, generating immense amounts of cash for the company (with the cash balance climbing $50 billion over the course of the year to hit $145 billion). During the course of the year, we have seen a slowing of revenue growth and pressure on margins, both of which have contributed to declining stock prices. The other big change over the course of the year is that the value of growth potential (from unspecified future products) has faded, at least in the market’s eyes, and this is reflected in the decline of $200 billion in market value over the last nine months.
The Last Earnings Report (April 23, 2013)
The most recent earnings report contained a mix of good news on the financial front (cash and financing mix) and bad or neutral news on the operating asset front. Using the same framework that I used in the last section, here is how I parsed the news in the report:
First, in the no news category, revenue growth is no longer in the double digits and smartphones continue to increase their share of overall revenues & operating income. Well, we knew that already and the revenue growth was well within the expected bounds. Second, the bad news is that margins are shrinking faster than we expected them to, though I get the sense that Apple is understating its margins (by moving some expenses forward) and its guidance for the future with the intent of getting ahead of the expectations game. Third, in near term bad news, the fact there is no mention of any new products or breakthroughs suggests that there will be no revolutionary product announcement (iWatch, iTV, iWhatever) in the next quarter. However, if you are a long term investor, it is mildly disappointing that it looks like that there will be no blockbuster announcements in the next three months but it is clearly not the end of the world.
On the financial side, there was substantial news, much of which I think is positive. 
  1. Cash return to stockholders: The decision to decision to return about $100 billion more in  cash to stockholders in buybacks and dividends by 2015  has to be viewed as vindication for those (like David Einhorn) who have arguing that Apple should be explicit about its future plans for cash and that it should distribute a large chunk cash with stockholders. 
  2. Buybacks versus Dividends: In a bit of a surprise, the cash return will be more in the form of buybacks than dividends. I, for one, am on board with that decision because hiking the dividends further will essentially make this stock a “dividend” play, with an investor base that will put dividend growth in the future ahead of all other considerations.  If Apple wants to retain the option of entering a new and perhaps more capital intensive business in the future, it is better positioned as a consequence of this decision. 
  3. Debt coming? In an even bigger surprise, Apple has opened the door to taking on conventional debt. While the details are still fuzzy and the initial bond issue may be for only about $10 billion, it seems likely that the debt issued will grow beyond that amount. To those who would take issue with this decision, arguing that Apple does not need to borrow with all of its cash reserves, you may be missing the reason why this debt will add to value. If the trade off on debt is that you weigh the tax benefits of debt against the bankruptcy cost, there can be no arguing against the fact that borrowing money will add value for stockholders. To those who feel that it is in some way immoral or unethical, based upon the argument that Apple is sheltering its foreign income from additional US taxes while claiming a tax deduction for interest expenses, I would be more inclined to listen to you if you showed me convincing proof that you make mortgage interest payments every year but did not claim the mortgage tax deduction in your tax returns, because you think that it deprives the treasury of much needed revenue. The US tax code is an abomination, with its treatment of foreign income as exhibit 1, but to ask Apple (and its stockholders) to pay the price for the tax code’s failures makes little sense to me. 

In summary, the net effect of the earnings report is negative on operating cash flows (with the declining margins) but positive on the financial side (with any discount on cash dissipating, as a result of the cash return announcement, and the tax benefits from debt augmenting value). 

Intrinsic value impact
In my post from the end of last year, I had reported on an intrinsic valuation of Apple of $609/share, using data as of December 2012, with a distribution of values in a later post. Given that there have been two earnings reports since, I decided to revisit that valuation. In addition to updating the company’s numbers (all of the numbers except leases) to reflect the trailing 12 months (through March 31, 2013), I also incorporated the information from the most recent earnings reports to update my forecasts on three variables in particular:

  1. Revenue growth: As the competition in the smartphone business continues to increase, I am inclined to lower my expected revenue growth rate for the next 5 years to 5% from my original estimate of 6%. While this is well below the revenue growth of 11.28% over the last year (even using the last ‘bad” quarter comparison to the same quarter the previous year), it is the prudent call to make, especially in the absence of news about new products in the near term.
  2. Operating margin: I had projected a target  pre-tax operating margin of 30% in my December 31, 2012, valuation, about 5% below the prevailing margin of 35.30% from the last annual report (the 10K in September). The pre-tax operating margin has dropped to 30.92% in the trailing 12 months ending March 31, 2012, and was about 29%, just in the last quarter. Since margins are coming down faster than expected, I lowered my target margin to 25%. 
  3. Cost of capital: The cost of capital that I had used in my December 2012 valuation was 12.49% reflecting my expectation that Apple would stay an all equity funded firm in the foreseeable future. The decision to use debt upends that process and adding $50 billion in debt to the capital structure, while buying back $50 billion in stock raises the debt ratio in the cost of capital calculation to about 13%, while lowering the cost of capital to about 11.29%. 

The net effect of these changes is that the value per share that I obtain for Apple is about $588, about 3.5% lower than the value of $609 that I estimated in early January. You can download the spreadsheet with my valuation of Apple. Again, make your own judgments and come to your own conclusions. If you are so inclined, go to the Google shared spreadsheet  and enter your estimates of value.

If you are concerned about whether borrowing $50 billion will put Apple in danger of being over levered, I did make an assessment of how much debt Apple could borrow, by looking at the effects of the added debt on the costs of equity, debt and capital, with the objective being a lower cost of capital. I try to be realistic in my estimates of cost of equity (adjusting it upwards as a company borrows more) and the cost of debt (by coming up with a prospective rating at each dollar debt level and cost of debt at each debt ratio). If Apple can maintain its existing operating income, its debt capacity is huge ($200 billion plus) but even allowing for a halving of their operating income, it has debt capacity in excess of $100 billion. As with the valuation spreadsheet, you are welcome to download my capital structure spreadsheet for Apple and play with they numbers.

Clear and present dangers
Given the price collapse over the last few months, it would be foolhardy not to stress test the numbers in this valuation. In the first set of tests, I went back to the discounted cash flow valuation and computed my break even numbers for growth, operating margins and cost of capital, changing each of these variables, holding all else constant. The table below lists the current numbers for Apple for these variables, my estimates and the break even that yields today’s stock price ($420 on April 28, 2013).

Holding all else constant, Apple’s revenues would have to decline 5% a year for the next 5 years to justify a value per share of $420. Similarly, the pre-tax operating margin would have to drop to 12% from 30% today, holding the other variables at base case levels, to get to the same price. As an investor in Apple, there seems to be plenty of buffer built in, at least at current stock prices.

Will Apple go the way of Dell and Microsoft?
As a technology firm, though, your concerns may be about the company hitting a cliff and essentially either losing value or becoming a value trap. In particular, you may be worried that Apple may follow in the footsteps of two technology giants that have had trouble delivering value to stockholders in the last decade. One is Dell Computers, where Michael Dell’s attempts to rediscover growth have failed and the company is now facing a more levered, low growth future. The other is Microsoft, a less dire case, but a stock that hit its peak about a decade ago and has plateaued since. Can Apple be “Delled” or “Microsofted”?

To be Delled: What awaits a company when it’s product/service becomes a commodity and it operates at a cost disadvantage. 
Dell was an success story in the growing PC business through much of the late 1990s and the early part of the last decade. As the market for PCs grew, Dell used its cost advantages over Compaq, IBM and HP to make itself the most profitable player in the market. What’s changed? First, the market for PCs hit a growth wall, as consumers turned to tablets and other connected devices. Second, PCs became a commodity, just as Dell lost its cost advantage to Lenovo and other lower cost manufacturers. With Apple, the peril is that their biggest and most profitable business, smartphones, may be heading in that direction. Unlike Dell, though, Apple is more than a hardware manufacturer and it’s success at premium pricing in the PC business is indicative of the pricing power that comes from creating the operating system that runs the hardware. I believe that the risk of Apple being Delled is small.

To be Microsofted: The destiny of a business that has a profitable, cash-cow product(s) but runs low on imagination/creativity.
 Riding the success of Windows and Office, Microsoft became the largest market cap company about a decade ago. Like Apple, it seemed unstoppable. So, what happened? From the market’s perspective, the company seemed to run out of imagination and creativity and investors got tired of waiting for the next big hit and moved on. Note, though, that while the stock price and market capitalization have not moved much over the last ten years, the company has returned billions in cash to its stockholders. Could this value stagnation happen to Apple? Yes, but to me (and I have never been shy about my Apple bias), there are is a big difference between the companies. One is that I don’t think that Microsoft lost its imagination and creative impulses a decade ago. I don’t think it ever had any. While Windows nor Office were workmanlike and professional products, neither can ever be called elegant or creative (and I speak as a heavy user of Office products). Apple, on the other hand, has created iconic products through the decades, some less successful than others (remember the Newton), and I find it hard to believe that those creative juices just dried up last September.

Buy or Sell? Hold or Fold?

If Apple was being priced as a high growth stock, with sustained margins and on the expectations of “big” new hits in the future, I would be worried about the last earnings report. It is not. As you can see from the break even table in the last section, it is being priced as a low growth, declining margin company, with no great hits to come. I find it striking that the same investors who have priced the stock on this basis react to incremental news on these items (growth, margins, new products), as if they had not already priced it in.

As I see it, if I have Apple in my portfolio at $420 and the company continues to disappoint on every dimension (growth, margins, new products), I will have a boring stock that delivers billions in earnings and pays a solid dividend. However, if the company surprises by stopping margin leakage and increasing revenue growth in the smartphone market or by introducing the iWatch or the iTV, it will be icing on my investment cake. In a market, where my alternative investments are richly priced, Apple looks like a winner, to me. It stays in my portfolio, the price disappointments of the last few months notwithstanding.

My earlier posts on Apple

  1. Apple: Thoughts on Bias, Value, Excess Cash & Dividends (March 1, 2012)
  2. Apple: Know when to hold ’em, know when to fold ’em (April 3, 2012)
  3. Emotions, Intrinsic value and Dividend Clienteles: The Apple postscript (April 6, 2012)
  4. Apple’s Crown Jewel: Valuing the iPhone Franchise (August 29, 2012)
  5. Winning by Losing: The power of expectations (October 9, 2012)
  6. The Year in Review: Apple’s Universe (December 27, 2012)
  7. Are you a value investor? Take the Apple test (January 27, 2013)
  8. Market Mayhem: Lessons for Apple (January 31, 2013)
  9. Back to Apple: Thoughts on value, price and the confidence gap (February 7, 2013)
  10. Financial Alchemy: David Einhorn’s value play for Apple (February 8, 2013)

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Equity Risk Premiums (ERP) and Stocks: Bullish or Bearish Indicator

If you have been following my blog postings, you are probably aware that I have an obsession with equity risk premiums (ERP), and have done an annual survey paper on the topic  every year since 2008 (with the 2013 update here). I also post a monthly update for the ERP for the S&P 500 at the start of the month on my website. As a consequence, my attention was drawn to a post by Fernando Duarte and Carlo Rosa, economists at the Fed in New York, on the topic. They argue that equity risk premiums are at historic highs, primarily because the US treasury rates are low, and note that these high equity risk premiums are a precursor to good stock returns in the future. I don’t disagree with their authors that equity risk premiums are high, relative to history and that the low risk free rate is in large part responsible these large premiums, but I am less sanguine about using the ERP as a market timing device, especially at this time in history.

Measurement approaches

There are three ways of estimating an equity risk premium. One is to look at the difference between the average historical return you would have earned investing in stocks and the return on a risk free investment. This historical premium for the 1928-2013 time period would have stood at about 4.20%, if computed as the difference in compounded returns on US stocks and on the 10-year US treasury bond. (I know. I know. We can have a debate about whether the US treasury is truly risk free, but that is a discussion for a different forum.) The second is to survey portfolio managers, CFOs or investors about what they think stocks will generate as returns in future periods and back out the equity risk premium from these survey numbers. In early 2013, that survey premium would have yielded between 3.8% (from the CFO survey) to 4.8% (portfolio managers) to 5% (analysts). Finally, you can back out a forward looking premium, based upon current stock prices and expected cash flows, akin to estimating the yield to maturity on a bond. That is the process that I use at the start of every month to compute the ERP for US stocks, and that number stood at 5.45% On May 18, 2013

What is the ERP? 

The equity risk premium is the extra return that investors demand over and above a risk free rate to invest in equities as a class. Thus, it is a receptacle for investor hopes and fears, with the number rising when the fear quotient dominates the hope quotient. In buoyant times, when investors are not fazed by risk and hope is the dominant force, equity risk premiums can fall. In the graph below, you can see my estimates of the implied equity risk premium for US stocks from 1961 to 2012 (year ends) with annotations providing my rationale for the shifts over time periods. 
The average implied equity risk premium over the entire period is 4.02% and that number is the basis for the bullishness that some investors/analysts bring to the market. If the equity risk premium, currently at 5.45%, does drop to 4.02% , the S&P 500 would trade at 2270, an increase of 26.5% on current levels. And history, as Duarte and Rosa note, is on your side, albeit with significant noise, in making this assumption that equity risk premiums revert back to norms over time. As I will argue in the next section, the high ERP in 2013 is very different from high ERPs in previous time periods and extrapolating from past history can be dangerous. 

A Fed-engineered ERP?

This equity risk premium, though, is over and above the risk free rate. To provide a sense of the interplay between the risk free rate and the equity risk premium, I plot the expected return on stocks (based upon future cash flows and current stock prices), decomposed into the equity risk premium and  the and the risk free rate each year from 1962 to 2012. 
Over the last decade, the expected return on stocks has stayed surprisingly stable at between 8-9% and almost all of the variation in the ERP over the decade has come from the risk free rate. In particular, the higher ERP over the last five years can be entirely attributed to the risk free rates dropping to historic lows. In fact, the expected return on stocks on May 18, 2013 of 7.40% is close to the historic low for this number of 6.91% at the end of 1998. 

So what? While the relationship between the level of the ERP and the risk free rate has weakened over the last decade, the two numbers have historically moved in the same direction: as risk free rates go up (down), equity risk premiums have risen (fallen). In fact, a regression of the ERP on the ten-year US treasury bond rate from 1960-2012 is presented below: 
ERP = .0348                            + .0842 (US T. Bond Rate) R squared = 4.68% 
Thus, an increase of 1% in the ten-year bond rate (from 2% to 3%, for instance) increases the ERP by 0.0842%. In fact, running the regression through from 1960-2003 (excluding the last decade) yields an ever stronger result: 
ERP = .0202                           + .2592 (US T. Bond Rate) R squared = 43.52% 

During this period, a 1% increase in interest rates would have led to an increase of 0.26% in the ERP. The last decade has weakened the relationship between the ERP and the T.Bond rate dramatically.

In light of this evidence, consider again two periods with high ERPs. In 1981, the ERP was 5.73%, but it was on top of a ten-year US treasury bond rate of 13.98%, yielding an expected return for stocks of 19.71%. On May 1, 2013, the ERP is at 5.70% but it rests on a US treasury bond rate of 1.65%, resulting in an expected return on 7.35%. An investor betting on ERP declining in 1979 had two forces working in his favor: that the ERP would revert back to historic averages and that the US treasury bond rate would also decline towards past norms An investor in 2013 is faced with the reality that the US treasury bond rate does not have much room to get lower and, if mean reversion holds, has plenty of room to move up, and if history holds, it will take the ERP up with it.

In the table below, I list potential consequences for the S&P 500, in terms of percentage changes in the level of the index, of different combinations of the risk free rate and the ERP: 

Thus, if risk free rates move to 3% and the equity risk premium drops to 5%, the index is undervalued by about 5%, but if rates rise to 4% and the equity risk premium stays at 5.5%, the index is overvalued by 8.28%. There is another interesting aspect to the table that bears emphasizing. While the sum of the risk free rate and equity risk premium is the expected return on stocks, stocks are worth much more for any given expected return, if more of that expected return comes from the risk free rate. In the figure below, note the S&P index levels for an expected return of 9%, using different combinations of the risk free rate and ERP: 
Thus, the same mean reversion that market bulls point to with the ERP can be used to make a bearish case for stocks. The historical average expected return for stocks between 1960 and 2012 of 10.43%, this would translate into the S&P 500 being over valued between 12-40%, depending upon the composition of the expected return. In fact, that is the reason that you have the large divergence in the market between those who use normalized PE ratios and argue that stocks are massively overpriced and those who use the equity risk premium or the Fed model today to make the opposite case.  I am sure that you have your own views on both where the risk free rate and the equity risk premium are headed. If you want to explore the effect on stock prices of changing the variables, please use the linked spreadsheet

Bottom line

In a previous post, I noted that stocks do not look over priced. While you may feel that this post is in direct contradiction, let me hasten to provide the bridge between the two.  In the prior post, I noted that stock prices are being sustained by four legs: (1) robust cash flows, taking the form of dividends and buybacks at historic highs for US companies, (2) a recovering economy (and earnings growth that comes with it), (3) ERP at above-normal levels and (4) low risk free rates. Thus, my argument is a relative one: given how other financial assets are being priced and the level of interest rates right now, stocks look reasonably priced. 
The danger, though, is that the US T.Bond rate is not only at a historic low but that it may be too low, relative to its intrinsic level, based upon expected inflation and expected real growth (a topic for another blog post coming soon). If you believe that the T.Bond rate is too low, then you have the possibility that you are in the midst of a Fed-induced market bubble(s) and that script never has a good ending. The scary part is that there are no obvious safe havens: gold and silver have had a good run but don’t seem like a bargain and central banks around the world seem to be following the Fed’s script of low interest rates. You could use derivatives to buy short term insurance against a market collapse but, given that you are not alone in your fears about the market, you will pay a hefty price. 
There is a middle ground. In my last ERP update, I argued that stock market investors were dancing to the Fed’s tune and wondering whether the music would stop. Let me rephrase that. If the market is dancing to the Fed’s tune, it is not a question of whether the music will stop, but when. When long term interest rates move back up, as they inevitably will, the question of how much the equity markets will be affected will depend in large part on whether the ERP declines enough to offset the interest rate effect. Thus, while I would not be arguing that stocks are cheap, simply because the ERP today is higher than historic norms, I am not ready to scale down the equity portion of my portfolio (especially since I have no place to put that money). Looking at the table of market sensitivity to risk free rate/ERP combinations, there are enough soft landing scenarios for the market that I will continue to buy individual stocks, while keeping an eye on the ERP & T.Bond rate.
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The Fed and Interest Rates: Lessons from Oz

In my last post on equity risk premiums and the market, I argued that the equity markets have been priced on the presumption that the Fed has the power to control where interest rates will go in the next few years. Wednesday’s press conference by Ben Bernanke was a perfect example of how the Fed has become the center of the equity market universe and how every signal (intentional, implied or imagined) of what the Fed plans to do in the future causes large market gyrations.

The Fed speaks and markets react
Ben Bernanke’s press conference was at the end of the meetings of the Federal Open Markets Committee (FOMC) and it provided an opportunity for the market to observe the Fed’s views of the state of theeconomy and its plans for the foreseeable future. The Fed’s optimistic take on the economy (that it was on the mend) and Bernanke’s statement that the Fed could start winding down its bond buying program (and by extension, its policy of keeping interest rates low) was not viewed as good news by the market. The reaction was swift, with stocks collapsingin the two hours of trading after the Bernanke news conference and rippleeffects spreading to other global markets over night.
Implicit in this reaction is the belief that the Fed is an all-powerful entity that can choose to keep interest rates (short term and long term) low, if it so desires, for as long as it wants. While this belief in the Fed’s power to set interest rates is touching, I think it is at war with both history and fundamentals. In fact, if there is blame to be assigned for the market collapse, it has to to rest just as much on investors who have priced contradictory assumptions into stock prices as it does on the Fed for encouraging them to do so.

Fundamentals and History
As with any asset, the treasury bond market sets prices (and yields) based upon demand and supply, with perception, expectations and behavioral factors all playing a role in the ultimate price (and rate). Holding all else constant, then, it seems obvious that the Fed with its bond buying program can change the dynamics of the market, increasing bond prices and lowering long term rates.

Without contesting the basic economics of the demand/supply argument, it is worth noting that even with treasury bonds, there is an intrinsic value relationship that should govern the level of interest rates. In particular, the risk free interest rate can be decomposed into two components: the expected inflation rate in the currency in question and an expected real interest rates:

Risk free rate = Expected Inflation + Expected real Interest rate

The real interest rate itself is a function of demand and supply for capital in the economy, which should be determined by expected real growth. As the economy becomes stronger, and real growth increases, real interest rates should also increase. If we make the assumptions that actual inflation in the most recent time period is equal to expected inflation and that the actual real growth in the most recent period is the expected real interest rate, you have an equation for what I will call a fundamental risk free interest rate:

Fundamental interest rate = Actual inflation rate + Real growth rate

While the assumptions that underlie this equation can be contested (past inflation is not always the best predictor of expected inflation and actual real growth may not be a proxy for expected real growth), we can use the historical data to check how the actual interest rate on a long term treasury bond (the 10-year T.Bond) compare to the fundamental interest rate derived above:

Note that the actual inflation rate in each year and the real GDP growth in that year are aggregated to yield the fundamental interest rate. Thus, in 2006, the actual inflation rate was 2.52% and the real GDP was 2.38%, yielding a fundamental interest rate of 4.90%. Comparing it to the ten-year treasury bond rate that year of 4.56% yields a gap of -0.34% (T.Bond rate – Fundamental interest rate). There are two conclusions I would draw from this graph.

  1. Over the 1954-2012 time period, the actual T.Bond rate has moved, for the most part, with the fundamental interest rate, rising in the 1970s as inflation surged and dropping in the 1980s as inflation retreated. There have been gaps that open up between the treasury bond rate and the fundamental interest rate but they seem to close over time. In fact, when the T.Bond rate increases (decreases) relative to fundamental interest rate, the treasury bond rate is more likely to fall (increase) in the next period.
  2. Across the entire time period (1954-2012), the 10-year treasury bond rate averaged 6.11% and the fundamental interest rate average 6.83%, but breaking down into sub-periods suggest that there has been a shift in the relationship over time. In the 1954-1980 time period, T.Bond rates were 2.20% lower, on average, than the fundamental interest rates but in the 1981-2012 time period, the average treasury bond rate has been 0.52% higher than fundamental interest rates.

In January 2013, the treasury bond rate at 1.72% was about half the fundamental growth rate of 3.43% (Inflation in 2013 of 1.76% + Real GDP growth of 1.67% = 3.43%). Not only is the gap of 1.71% high by historical standards, but the ratio of the T.Bond rate to the Fundamental interest rate was close to historic lows (the lowest was 2011, when the T.Bond rate was 40% of the fundamental interest rate). If you are interested, you can download the raw data on interest rates, inflation and real GDP growth and come to your own conclusions.

The Fed Effect
Does the Fed matter? Looking at the data on interest rates and fundamentals over time, the answer is undoubtedly yes. Over the last three decades, you can see the imprint left by consecutive Fed Chairs from Paul Volcker to Alan Greenspan to Ben Bernanke on inflation, real growth and T.Bond rates. To examine the relationship between Fed policy and T.Bond rate/fundamental interest rate difference, I focused on the one number that the Fed truly controls, the Fed Funds rate, as an indicator of whether the Fed is adopting a looser or tighter monetary policy, and look at the relationship between the Fed funds rate and the gap between the T.Bond rate and the fundamental interest rate:
Looking at the graph, it seems clear that increases (decreases) in the Fed funds rate have caused the gap between treasury bond rates and fundamental interest rates to move in the same direction. In fact, running a regression of the change in the Fed funds rate each year against the change in the gap (T.Bond rate – Fundamental interest rate) in the next year yields the following:
Change in the gap in year t = – 0.0001% + 0.5333 (Change in the Fed Funds rate in year t -1)
                                                 (0.03)         (3.25)            
R squared = 14.33%
Put in more intuitive terms, based on the historical data, a cut in the Fed funds rate of 1% decreases the gap between the T.Bond rate and the fundamental growth rate by 0.53%. There are two sobering notes worth emphasizing. The first is that the Fed funds rate currently is close to zero and that effectively implies that its use as tool to make T.Bond rates decrease relative to fundamental growth rates is limited.  (I know that the Fed has been much active with the other tool in its war chest, bond buying, but that tool too has its limits). The second is that the Fed is not as powerful at setting interest rates as most investors think. Only 14.33% of the variation in the gap can be explained by the Fed funds rate and changes in real growth & inflation have far bigger impacts. 
So can the Fed really “control” interest rates and keep long term rates from rising? I may not have much company on this one, but I think that the Fed’s power comes primarily from the perception that it has power and not from its direct control over the interest rate mechanism. This may seem like heresy in a market that views the Fed both as the arbiter of interest rates and the protector of the bull market, but if long term interest rates start rising, I don’t think that the Fed can do much to stop them. In fact, as I watch investors look to Ben Bernanke to save them, here is the scene that plays out in my mind, from the Wizard of Oz. For those of you who may still be unfamiliar with the classic, here is a quick recap. A tornado plucks Dorothy from her home in Kansas and dumps her in Oz (and right on top of the Wicked Witch of the East). When Dorothy seeks help to get home, she is advised to seek out the powerful Wizard of Oz, and on her way to meet him, she gathers together a motley crew of needy characters (the Scarecrow, who needs a brain, the Tinman, who desires a heart and the Cowardly Lion, who is searching for courage). When they get to the Wizard’s lair, here is what they find:

Is that Ben Bernanke I see behind the curtain and is that contraption the Fed’s vaunted interest rate setting machine?

If the T.Bond rate does rise next year towards the fundamental interest rate, it will ironically make investors attribute even more power to the Fed, since it will coincide with the winding down of the bond buyback by the Fed. The Fed, we will be told, allowed long term interest rates to rise by using it extensive powers. Here is what I believe. Thus, if the economy improves, interest rates will rise, with or without the Fed buying bonds and if the economy falters, interest rates will stay low, with our without the Fed buying bonds.

The way forward
As my last two posts on the market indicate, my biggest concern with markets right now is that investors may be pricing inconsistent assumptions about the macro environment. In other words, investors are pricing stocks on the assumption that the US economy will return to growth, while interest rates stay low. While each assumption can be defended separately, I don’t see how they can co-exist, no matter what the Fed or any other entity may tell us.
As investors, therefore, we have to think through the possible scenarios and adjust our portfolios accordingly. Here is my very crude attempt to delineate the possible scenarios, with permutations of real growth/inflation:
Real Economic Growth
Negative for bonds
Mildly positive for stocks
Negative for bonds
Negative for stocks
Negative  for bonds
Negative for stocks
Negative for bonds
Positive for stocks
Negative for bonds
Mild positive for stocks
Neutral/ Positive for bonds
Negative for stocks
Neutral for bonds
Positive for stocks
Neutral for bonds
Negative for stocks
Positive for bonds
Negative for stocks

There are two things to note about these scenarios. The first that some of these scenarios are more likely than others, though I am sure that opinions will vary about which one. For instance, the soft landing scenario, favored by many economists/investors today, sees moderate growth with low inflation, one that is negative for bonds (because interest rates will start creeping back towards the fundamental growth rate) and mildly positive for stocks. I think that the high real growth/deflation scenario is unlikely, since it is difficult to see the economy growing at a robust rate and prices falling at the same time (especially given monetary policy over the last few years). I also have to believe (and perhaps hope is winning out here) that the negative real growth/deflation scenario has a low chance of occurring, and it would be very negative for stocks, though it will help bond holders. The second is that there are far more scenarios which are negative for bonds than positive, a direct result of interest rates being at historic lows and the Fed running low on ammunition. 
My personal investing foibles should be of little interest to you, but I have tried to build in some degree of protection into my overall portfolio, especially against interest rate changes. A few weeks ago, I invested in ProShares UltraShort 20+ year (TBT), an ETF that sells short (with leverage) on long term treasuries; it is one of many ETFs that offers this choice. (As some of my readers have pointed out, the ultrashort funds come with baggage. For those who prefer a more predictable play, go with TBF, which also shorts the treasury bond, but without leverage).  I did not buy full protection against interest rate changes, since that would have required me to invest a huge amount of my portfolio in this ETF and because I don’t attach a high probability to the most disastrous scenarios for bonds. The partial protection that I did buy has worked as advertised.

That may not be your preference, either because your assessment of the likelihood of the scenarios will be different from mine or because you feel that there is a different asset class (gold, emerging market equities etc.) that will provide you better protection. In my view, the one scenario that is unlikely to unfold, no matter how much you wish it to be true, is the one where real economic growth (2-2.5%) returns, inflation stays at moderate levels (2-2.5%) and the 10-year treasury bond rate stays at 2%. I understand that the Fed is doing a difficult job (that the executive and legislate branches have shirked), that it is well intentioned and has some very smart policy makers, but when you fight markets and fundamentals, you have to capitulate at the end. No one is bigger than the Market, not even Ben Bernanke.

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A tangled web of values: Enterprise value, Firm Value and Market Cap

Investors, analysts and financial journalists use different measures of value to make their investment cases and it is not a surprise that these different value measures sometimes lead to confusion. For instance, at the peak of Apple’s glory early last year, there were several articles making the point that Apple had become the most valuable company in history, using the market capitalization of the company to back the assertion. A few days ago, in a reflection of Apple’s fall from grace,  an article in WSJ noted that Google had exceeded Apple’s value, using enterprise value as the measure of value. What are these different measures of value for the same firm? Why do they differ and what do they measure? Which one is the best measure of value?

What are the different measures of value?
To see the distinction between different measures of value, I find it useful to go back to a balance sheet format, with market values replacing accounting book values. Thus, the market value balance sheet of a company looks as follows:

Note that operating assets include not only fixed assets, but also any intangible assets (brand name, customer loyalty, patents etc.) as well as the net working capital needed to operate those assets and that debt is inclusive of all non-equity claims (including preferred equity).

Let’s start with the market value of equity. Rearranging the financial balance sheet, the market value of equity measures the difference between the market value of all assets and the market value of debt.

The second measure of market value is firm value, the sum of the market value of equity and the market value of debt. Using the balance sheet format again, the market value of the firm measures the market’s assessment of the values of all assets.

The third measure of market value nets out the market value of cash & other non-operating assets from firm value to arrive at enterprise value. With the balance sheet format, you can see that enterprise value should be equal to the market value of the operating assets of the company.

One of the features of enterprise value is that it is relatively immune (though not completely so) from purely financial transactions. A stock buyback funded with debt, a dividend paid for from an existing cash balance or a debt repayment from cash should leave enterprise value unchanged, unless the resulting shift in capital structure changes the cost of capital for operating assets, which, in turn, can change the estimated value of these assets.

The measurement questions
To arrive at the market values of equity, firm and enterprise, you need updated “market” values for equity, debt and cash/non-operating assets. In practice, the only number that you can get on an updated (and current) basis for most companies is the market price of the traded shares. To get from that price to composite market values often requires assumptions and approximations, which sometimes are merited but can sometimes lead to systematic errors in value estimates.

I. Market value of equity
While the conventional practice is to multiply the shares outstanding in the company by the share price to get to a market capitalization and to use this market capitalization as the market value of equity, there are three potential measurement issues that have to be confronted:

  1. Non-traded shares: There are some publicly traded companies with multiple classes of shares, with one or more of these classes being non-traded. Though these non-traded shares are often aggregated with the traded shares to arrive at share count and market cap, the differences in voting rights and dividend payout across share classes can make this a dangerous assumption. If you assume that the non-traded share have higher voting rights, it is likely to you will understate the market value of equity by assigning the share price of the traded shares to them. 
  2. Management options: The market value of equity should include all equity claims on the company, not just its common shares. When there are management options outstanding, they have value, even if they are not traded, and that value should be added to the market capitalization of the traded shares to arrive at the market value of equity in the company. For a company like Cisco, this can make a significant difference in the estimated market value of equity (and in the ratios like PE that are computed based on that market value). Again, using short cuts (such as multiply the fully diluted number of shares by the share price to get to market capitalization) will give you shoddy estimates of market value of equity.
  3. Convertible securities: To the extent that a company raised funds from the use of bonds or preferred stock that are convertible into common equity, the conversion option should technically be treated as part of the value of equity (and not as debt or preferred stock). Failing to do so will understate the market value of equity in companies with lots of convertible securities outstanding.

II. Debt
In theory, the firm and enterprise values of a company should reflect the market value of all debt claims on the company. In practice, this is almost never the case for two reasons:

  1. Non-traded debt: The problem of non-trading is far greater with debt than equity, because bank debt is a large proportion of overall debt, even for many companies that issue bonds, and is the only source of debt for companies that don’t issue bonds. Lacking a market value, many analysts have resorted to using book value of debt in their firm value and enterprise value computations. Though the effect of doing so is relatively small for healthy companies (book values of debt are close to market values of debt), it can be large for distressed companies, where the book value of debt will be far higher than the market value of that debt, leading to much higher estimates of enterprise and firm value for these firms than is merited.
  2. Off balance sheet debt: To the extent that firms use off-balance sheet debt, we will understate the firm and enterprise values for these firms. While this may sound like a problem only with esoteric firms that play financing games, it is actually far more prevalent, if you recognize lease commitments as debt. Most retailers and restaurant companies have substantial lease commitments that should be converted into debt for purposes of computing firm or enterprise value. 

III. Cash 
Cash should be simple to value, right? That is generally true but even with cash there are questions that analysts have to answer:

  1. Operating versus non-operating cash: To the extent that some or a large portion of the cash balance that you see at a company may be needed for its ongoing operations, you should be separating this portion of the cash from the overall cash balance and bringing into the operating asset column (under working capital). There are two problems we face in making this distinction between operating and excess cash. The first is that operating cash needs will be different across different businesses, with some businesses requiring little or no operating cash and others requiring more. The second is that cash needs have changed over time, with a shift away from cash based transactions in many markets and companies collectively require less cash than they used to a few decades ago. Analysts and investors, for the most part, have no stomach for making the distinction between operating and non-operating cash on a company-by-company basis and use one of two approximations. The first is to assume no operating cash and treat the entire cash balance as excess cash in computing enterprise value. The second is to use a rule of thumb to compute operating cash, such as setting cash at 2% of revenues for all firms. Again, while either approach may do little damage to value estimates at the typical firm, they will both fail at exceptional firms, where the cash balances are very large (as a proportion of value) but are untouchable because they are is needed for operations.
  2. Trapped cash: In the last decade, US companies with global operations have accumulated cash balances from their foreign operations that are trapped, because using the cash for investments in the US or for dividends/buybacks will trigger tax liabilities.  If a company has a very large cash balance and a significant portion of that cash is trapped, it is possible that the market attaches a discount to the stated value to reflect future tax payments. Netting out the entire cash balance to get to enterprise value will therefore give you too low an estimate of enterprise value, a point to ponder when netting out the $145 billion (with >$100 billion trapped) in cash to get to Apple’s enterprise value.

IV. Other non-operating assets
When companies have non-cash assets that are non-operating, your problems start to multiply. With many family group companies, where cross holdings are the rule rather than the exception, the effect of miscalculating the value of non-operating assets can be dramatic.

  1. Cross holdings in other companies: When a company has non-controlling stakes in other companies, the market value of these holdings should be netted out to get to the enterprise value of the parent company. Doing so may be straightforward if the cross holdings are in other publicly traded companies, where market prices are available, but it will be difficult if it is in a private business. In the latter case, the value of the cross holding on the balance sheet will, in most cases, reflect the book value of the investment, with little information provided to estimate market value. The problems become worse if there are dozens of cross holdings, rather than just a handful. Not surprisingly, most analysts completely ignore cross holdings in computing enterprise value and the remaining net out the book value of the holdings. For companies that derive a large proportion of their value from cross holdings, this will lead to an upwardly biased estimate of enterprise value. When a company has a controlling or a majority stake in another company, a different kind of problem is created when computing enterprise value. The market value of equity in the parent company reflects only the majority stake in the subsidiary but the debt and cash in the computation are usually obtained from consolidated balance sheets, which reflect 100% of the subsidiary. To counter this inconsistency, analysts add the minority interest (which is the accountant’s estimate of the equity in the non-owned portion of the subsidiary) to arrive at enterprise value, but the minority interest is a book value measure.
  2. Double counting of operating assets: One of the real dangers of fair value accounting and its push to bring more invisible or intangible assets to the balance sheet is that it increases the risk that analysts will double count. Thus, even if brand name and customer lists are valued and put on the balance sheet, they are very much part of the operations of the firm and should not be netted out as non-operating assets. Only assets that don’t contribute (and are never expected to contribute) to operating income can be treated as non-operating assets.

Mismatches and Measurement Errors
Looking at the standard practices in value estimation, there are two clear inconsistency problems that you see crop up. One is in the mixing of market values, estimated values and book values for different items in the computation. The other and related question is that the market values can be updated constantly but the book value based numbers are as of the last financial statement.

I. Market versus Book value
In a typical enterprise value computation, the only number that comes from the market is the market capitalization, reflecting the market value of equity in common shares. The remaining numbers all come from accounting statements and reflect accounting estimates of value, with varying implications. With debt, as we noted, the difference between book and market value is likely to be small for healthy firms but much larger for distressed companies. With cash, the accounting estimates of value should be close, with the caveat that trapped cash may be discounted by the market to reflect expected tax liabilities. With cross holdings, the gap between book and market value can vary depending on how old the holding is (with older holdings have larger gaps) and the accounting for that holding.
While getting true market values for bank debt and cross holdings may be a pipe dream, there is no reason why we cannot estimate the market values for both. For debt, this will require using the interest expenses and average maturity on the debt to compute an estimated market value of the debt (akin to pricing a coupon bond). With cross holdings (minority holdings and interests), it may require us to use sector average price to book ratios to estimate the values of the cross holdings.

II. Timing Differences
While you would like values to be current (since your investment decisions have to reflect current numbers), only market-based numbers can be updated on a continuous basis. The only market-based number in most enterprise value calculations is the market capitalization number (reflecting current stock prices), with the other numbers either directly coming out of accounting statements (debt, cash) or indirectly dependent on information in them (options outstanding, lease commitments). There are two questions, therefore, that you have to confront: (a) Should you try for timing consistency or current value? (b) If you go current value, what types of biases/problems will you face because of the timing mismatch?

  1. Consistency versus Current Values: If you are using the value estimates to look at how values change over time or why values have varied across companies in the past, consistency may win over updating. Thus, rather than using the current market value of equity, you may use the market value of equity as of date of the last financial statement. If you using the value estimates to make investment or transaction judgments today, the current value rule should win out. After all, if you find a company to be cheap, you get to buy it at today’s price (and not the price as of the last financial statement). 
  2. Biases/Errors from Time mismatches: Assuming that the need to be updated wins out, your biggest concern with using dated estimates of debt, cash and other non-operating assets is that their values may have shifted significantly since the last reporting date. Not only can companies borrow new debt or repay old debt, which can affect the cash balance, but the operating needs of the company can lead to a decline or augmentation in the cash. For young growth companies, with large investment needs and/or operating losses, the cash balance today can be much lower than it was in the last financial statement. For mature companies in cashflow-rich businesses, cash balances can be much higher than in the last financial statement.

In fact, the mismatch can sometimes lead to strange results, especially for young, growth companies that have had operating/financial/legal problems in the very recent past. A drop in market capitalization combined with a cash balance from a recent financial statement that is much higher than the true cash balance can combine to create negative enterprise values for some firms.

Financial service companies
This discussion has been premised on two assumptions, that debt is a source of capital and that cash is a non-operating asset to businesses. There is a subset of the market where both assumptions break down and it is especially so with financial service companies, where debt is more raw material than source of capital and cash & marketable securities cannot be claimed by investors. With banks, investment banks and insurance companies, the only estimate of value that should carry weight is the market value of equity. You can compute the enterprise values for JP Morgan Chase and Citigroup but it will be an academic exercise that will yield absurdly high numbers but will provide little information to investors.

The Numbers
To illustrate the difference between the different measures of value, I first screened for global non-financial service companies with market capitalizations exceeding $25 billion and computed the firm and enterprise values for each of them. You can download the entire spreadsheet of 292 companies by clicking here. I then created a list of the top 20 companies by market capitalization and ranked them based upon the other measures of value as well.

Apple is more valuable than Google, if you use market capitalization as your measure of value, whereas Google is more valuable than Apple, if you use enterprise value, and GE dwarfs both companies, based upon enterprise value, because it has $415 billion in debt outstanding. Note that much of this debt is held by GE Capital and given my earlier point about debt, cash and enterprise value being meaningless in a financial service company, I would view GE’s enterprise value with skepticism. Nothing in this table tells me which companies are good investments and which ones are over priced and all the caveats about mixing market and book value, timing differences and missing numbers apply.

Why have different measures of value?
Having multiple measures of value can create confusion, but there are two good reasons why you may see different measures of value and one bad one.

1. Transactional considerations
The measure of value that you use can vary, depending on what you are planning to acquire as an investment. For instance, in acquisitions, where the acquiring firm is planning on acquiring the operating assets of the target firm, it is enterprise value that matters, since the acquiring firm will use its own mix of debt and equity to fund the acquisition and will not lay claim on the target company’s cash. In contrast, if you are an individual investor in a publicly traded company, the market capitalization may be your best measure of value since you have little control over how much debt the company has or how much cash it holds. In fact, enterprise value based calculations can be misleading for individual investors, since they can mask default risk: a firm on the verge of default can look cheap on an EV basis.

2. Consistency in multiples
In investing, we use estimates of market value to arrive at measures of relative value (multiples), so that we can compare how the market is pricing comparable companies. Relative value requires that the market value be scaled to a common variable (earnings, revenues, book value) and is governed by a simple consistency rule. The measure of value that we use in the numerator of a multiple should be consistent with the measure of earnings or book value that we use in the denominator. Equity values should be matched up to equity earnings or book equity and enterprise values to operating income or book capital. Consider, for instance, PE ratios and EV/EBITDA multiples. The PE ratio is obtained by dividing the market value of equity by the net income (or price per share by earnings per share); both the numerator and denominator are equity values. The EV/EBITDA is obtained by dividing the enterprise value (market value of operating assets) by the EBITDA (the cash flow generated by these operating assets). In the table below, I list the potential choices when it comes to consistent multiples:

3. Agenda-based value estimation
In some cases, the choice of value measure may depend upon the agenda or biases of the analyst in question. Thus, an analyst that is bullish on Apple will latch on to its enterprise value to make his or her case, since it makes Apple look much cheaper.

Closing thoughts
When it comes to which value estimate is the best, I am an agnostic and I think each one carries information to investors. The PE ratio may be old fashioned but it still is a useful measure of value for individual investors in companies, and enterprise value has its appeal in other contexts. Understanding what each value measure is capturing and being consistent in how it is computed, compared and scaled is far more important than finding the one best measure of value.

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Rediscovering risk in emerging markets: A Country Risk Premium update

Investors have a mixed relationship with risk, forgetting that it exists in the good times and obsessing about in bad times, and nowhere is this dysfunction more visible than in emerging markets. After a few years where investors seemed convinced that emerging markets were no riskier than developed markets, they seem to have woken up to the existence of risk in emerging markets, with a vengeance, in the last few months. As emerging markets around the world have been pummeled, analysts have sought to assign blame. Some have pointed the finger at the Federal Reserve, claiming that mixed signals on quantitative easing and the steep rise in US interest rates have caused currency and market fluctuations globally. Others attribute dropping stock prices to slowing economic growth in the largest emerging markets, with China at the top of the list. There are a few who point to the rise of country-specific political factors, with governments in Brazil and Egypt facing pressure from their populace.

While there is some truth to all of these explanations, there is a more general lesson about risk in recent market movements. While the last five years have seen a narrowing of the risk differences between developed and emerging markets, partly due to the maturation of emerging markets and partly because developed markets seem to have acquired some of the worst traits of emerging markets, emerging markets still remain more vulnerable to global economic shocks than developed markets. That does not make them bad investments but it does mean that investors should demand premiums for investing in emerging markets, with higher premiums for riskier markets.
If you accept this proposition, it follows that you cannot value or invest in companies with emerging market risk exposures without having estimates of risk premiums by country. At the start of each year, for the last two decades, I have put up my estimates of risk premiums, by country, on my website. For the last three years, in response to the rapid intra-year shifts in country risk, I have also done mid-year updates. After the turmoil of the last few weeks, I decided that this would be a good time for a mid-year country risk update.

I. Default Risk Measures

The most easily accessible data on country risk takes the form of sovereign default risk measures. While ratings agencies have been assigning ratings to sovereign bonds issued by countries for decades, the growth of the credit default swap (CDS) markets have given us access to CDS spreads for a subset of these countries. 
a. Sovereign Ratings & Default Spreads
Ratings agencies have been critiqued since the banking crisis of 2008 for being being biased (in favor of issuers) and overlooking major risks, but I think the bigger problem with them is that they are slow in reacting to change. That effectively makes sovereign ratings into lagging indicators of country risk.

The slow process of ratings change can be seen by looking at the changes in sovereign ratings between January and June 2013. In the attached spreadsheet, I have the local currency sovereign ratings from Moody’s for 118 countries (You can also get the sovereign ratings directly from Moody’s and Standard & Poor’s). During this turbulent six-month period for emerging markets, there were only 15 countries that saw ratings changes, with 10 downgrades and 5 upgrades, and they are listed below: 
Note that 9 of the 15 ratings changes were only a single notch, four were two notches and two countries saw their ratings improve three notches (with the Cayman Islands moving up three notches to Aaa and Cyprus moving down three notches to Caa3).

Even if sovereign ratings don’t change, the default spreads associated with them as markets reassess the price of risk. Between January and June 2013, there was an uptick in default spreads across the ratings classes. The figure below summarizes average default spreads by sovereign ratings class in January and June 2013: 
Sovereign default spreads are about 10-15% higher than they were six months for most of the ratings classes. 
b. CDS Spreads 
The credit default swap market is a quasi-insurance market, where investors can insure against country default risk; thus the CDS spread of 2.50% for Brazil at the end of June 2013 can be viewed loosely as the annual cost of insuring against default on a Brazilian US$ denominated government. While I have posted on the limitations of the CDS market, it does have one significant advantage over the sovereign rating process. It can and does react (sometimes too much in the view of its critics) instantaneously to events unfolding in real time in individual countries. As a consequence, it is much more volatile than ratings-based measures of default risk.

Sovereign CDS spreads are available for 63 countries and the attached file has the CDS spreads in January and June 2013 for all of the countries. In contrast to the ratings, the CDS spreads changed for every country on the list between January and June and the changes are dramatic in some cases. Across the entire list, the median (average) change in CDS spread was 14.54% (17.45%) between January and June, consistent with the uptick in default spreads over the same period.

Looking at the changes over the six months, the ten countries that saw the biggest percentage increases and decreases in spreads are listed below: 

Thus, Brazil, which did not see any change in its sovereign local currency rating between January and June 2013, did see a 74% increase in its CDS spread, reflecting the political unrest of the last few weeks. Interestingly, every one of the ten countries that saw the biggest percentage increases was an emerging market, with six of the top ten countries on the list coming from Latin America. On the list of companies that saw the biggest decreases in CDS spreads, eight were developed markets with only two emerging markets (Costa Rica and Romania) making this list. If nothing else, this table indicates that in the market’s view, the divergence in risk between developed and emerging markets widened over the period.

II. Country Risk Scores

There are some who view both sovereign ratings and CDS as too narrow in their focus of debt. A country that has little exposure to default risk can still be exposed to other types of risk. There are services that try to provide more comprehensive measures of country risk, encompassing economic, political and legal risks. Political Risk Services (PRS), for instance, provides measures of country risk on different dimensions as well as a composite measure of country risk. These scores are numerical, with higher scores indicating safer countries and lower scores signaling more risk.

Since the PRS scores are proprietary, I cannot provide the entire list, though you can buy the list, as I did, on the PRS website for about $120. However, I did compute the percentage changes in PRS scores from January to June 2013 and discovered as with ratings agencies, that country risk scores tended to be sticky and changed relatively little. There was no change in the median PRS score between January and June 2013 and the average PRS score  median (average)  changed by only -0.19%, indicating a very mild increase in overall risk across the countries. In the table below, I highlight the ten countries that saw the biggest increases and decreases in risk based upon the PRS scores between January and June (Again, remember that a lower number indicates more risk and a higher number is less risk): 
Almost all of the countries on both lists are emerging markets, which is to be expected since you would expect the biggest volatility in risk scores in these countries. Thus, Latin American and African countries dominate both the “increased risk” and “decreased risk” lists, with this measure.

III. Equity Risk Measures

While default risk measures can be used to price sovereign government bonds, it is an open question as to whether they should affect or be used in equity pricing. While there are some who argue that country risk should be diversifiable to a global equity investor, the increasing correlation across countries has made that argument difficult to defend. I believe that equity risk premiums vary across countries and that the variation is correlated with the default spreads for these countries. In fact, I posted on country risk premiums and the different approaches for estimating country equity risk premiums a year ago, when I made my mid-year update for the 2012 data.

I use a two-step approach to estimating country risk premiums (CRP) for markets where I start with the default spread for country in question (obtained either from the sovereign rating or the sovereign CDS) and scale up that spread for the higher risk in equity markets.

Adding this country risk premium to a mature market equity risk premium (I use the implied ERP for the US as my estimate) yields a total equity risk premium for the country:
Equity risk premium for a country = Mature Market ERP + Country Risk Premium
I am using my July 1, 2013 estimate of the implied equity risk premium for the S&P 500 of 5.75% as my mature market premium.
Updating the sovereign default spreads to June 2013 and applying the relative equity risk multiple to these spreads, I get the updated equity and country risk premiums for much of the world. To get a sense of how the risks vary across the world, I created a global heat map of equity risk premiums (To be honest, even if you learn nothing from them, heat maps look cool.):

You can download the spreadsheet that contains the equity risk premiums by country by clicking here. I have added a lookup sheet to the spreadsheet, where you can pick any of the 135 countries for which I have data and pull up sovereign ratings, CDS spreads and my estimates of risk premiums. I hope you find it useful.

There are about 30 countries that don’t make this list because they do not have sovereign ratings or CDS spreads. If you happen to be investing in these countries, I do have a suggestion. I have a table of countries classified by PRS score into groups at this link, with an average equity risk premium by group. You can find the group that your country falls into and find another country in the same group that I have estimates of equity risk premiums and country risk premiums. To illustrate, neither North Korea nor the Democratic Republic of Congo is on my equity risk premium list, but based on their PRS scores, they are in the same group as Venezuela, which has an estimated equity risk premium of 12.50%, based on its rating. I know that this is simplistic but desperate times call for desperate measures.

What now?

What can we learn from the sifting of these various measures of country risk over the last six month? Overall, while investors don’t seem to think that the world as a whole is riskier than it was six months ago, their perception of where the risk is coming from has changed. They believe, rightly or wrongly, that more of the risk in the future will come from emerging markets rather than developed ones. While this is a break in the trend over the last five years, when risk premiums in developed and emerging markets converged, it is a shift back towards a pre-2008 world, when the risk differences between developed and emerging markets was stark.
As investors, there are three big questions that we face that are related to the risk shift that we are seeing globally. The first is whether the adjustment is complete or ongoing; if it is ongoing, that would imply more pain to come in emerging markets and argue for shifting money from emerging to developed markets for the near future. The second is whether the stock price adjustments that have already occurred in emerging markets are commensurate with the risk shift. If stock prices have dropped too much (little), given the risk reassessment, it would be a good (bad) time to be in emerging market stocks. That will require more than an off-the-cuff judgment and I will look at it more closely in my next post. The third is whether individual companies with global operations are being priced correctly, as country risk assessments change. In past crises where emerging markets have become more risky, global companies that are based in these markets have often seen their stock prices drop too much. I will look at this question as well in a future post.

Country risk premium posts

  1. Rediscovering risk in emerging markets: A country risk premium update
  2. Developed versus Emerging Markets: Convergence or Divergence? 
  3. Market Multiples: Global Comparison and Analysis
  4. Global Businesses and Country Risk: Investment Challenges and Opportunities (Still to come)
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