Letter number 60 of August 2011
- QUESTIONS & COMMENTS
1. Risk and return, or marriage without the possibility of divorce
One of the best possible indicators that a crisis is about to occur is the belief that at a given time, it is possible to get a very good return for a very low risk. This was what happened with the CPDOs, invented in 2006 by ABN Amro, which, rated AAA by rating agencies that were either complacent or incompetent, offered a return that was 1 to 2% higher than the rates on AAA rated government bonds. These were in fact credit default swaps (1) that had been repackaged with a leverage effect that in 2008 lost at least 30% of their value. Definitively not worth a AAA rating!
Risk has to be remunerated, if not, it will only be taken by reckless cowboys which is not enough to drive the development of the economy. Remuneration of risk comes from the discounting mechanism which ensures that expected future flows are bought/valued at a discount to their face value. The more distant the flow and/or the less certainty there is over its amount, the higher the discount will be (2).
Similarly, we should not delude ourselves – high returns can only come from a high risk. Let’s take as an example the return on equity of the UBS investment banking division until 2006:
Anyone who thinks that a company can continue long term to post returns of twice its cost of capital without taking on a greater risk than average, except for companies in a sector with massive barriers to entry or without any real competitors (which is not the case of an investment bank), is making a very big mistake, as illustrated by the earnings history of UBS:
It is true that UBS did take a hit from subprimes losses which amounted to around $50bn.
Obviously, we’d all like to post healthy returns for low risks, and since this is what we all try to achieve, by investing in these pockets of nirvana or by buying them, we drive down future returns and re-establish a balance, which is, well, logical.
2. Required returns and achieved returns, or obligatory convergence
This premise flows on from the previous one. It is not sustainably possible to earn a return on invested capital (return on capital employed) that is higher than the required return given the risk (the weighted average cost of capital).
Michelin may well be the world leader in its sector, with a well-established brand reputation and it may well invent revolutionary products and file numerous patents that constitute as many barriers to entry, but its returns, varying from good year to bad year, are more or less equal to its cost of capital:
This is all the more true given that the sector in which the company operates has reached maturity. The reason is competition and in this field, as the saying goes, “There is no such thing as an impenetrable fortress, there are only fortresses that it is difficult to besiege”.
It is inevitable that one day, Facebook’s returns will look like those of Michelin’s today, just as the returns of IBM, Microsoft and Google, which all went down the same path.
Conversely, if returns are inadequate over the long term, some players will go bankrupt, will exit the sector, and the sector will then be restructured following mergers and acquisitions. Our readers will remember the state of the European steel industry in the 1980s (bankrupt) and of its recovery in the 2000s following the regroupings of Sacilor – Usinor – Aceralia - Arbed, British Steel – Hoogovens, etc.
3. Debt, in itself, does not create value, or the illusion of the leverage effect
If debt could create value by bringing down the weighted average cost of capital, how do we explain that the top companies in the world, whose operating performances are so healthy that they have no fear of bankruptcy (Apple, L’Oréal, Hermès, Google, BMW, Nestlé, etc.) carry practically no debt and that, on the contrary, most of the time, they have cash on their books?
There are, however, two exceptions to this principle:
• when in the economy, real interest rates are negative because debt is at a fixed rate and inflation is rising in an unexpected manner, as in the 1960s and 1970s in Europe and the USA. What happens then is that lenders are despoiled because they are repaid in Mickey Mouse money, an unhappy situation that cannot last very long. The invention and the widespread use of floating rate loans means that a future reoccurrence of this phenomenon is unlikely;
• in LBOs, where debt serves as a stimulus (the fact that debt has to be repaid stimulates management to be more efficient in order to realise more free cash flows), as a stick (the fear of bankruptcy in the event of failure) and as a carrot (the impact of the leverage effect of the debt on the size of the management packages).
4. Cash is truth
Because a company will be technically bankrupt if it is unable at a given time to find the cash it needs to carry on its activity, even if the cause of the problem is upstream.
Because having cash on its books enables a company to buy assets at knock-down prices when a crises occurs (Fiat and Chrysler).
Because crooks are always unmasked by cash (if not, Bernie Madoff would probably still be wheeling and dealing, given the efficiency of the US regulator), i.e. a disconnection between figures published (performance, assets under management, etc.) and what there really is in the till in the evening or in the morning.
Because the financial analysis of a complex problem is always more easily solved by reasoning in cash.
In short, as the saying goes, Cash is King!
5. Invested capital can only be worth more than its amount if the return made is higher than the required return
Even if there is little hope that excess returns can last (see point 2), only a temporary disconnection between the two will make it possible to create value, as illustrated in these few examples:
(1) For more see chapter 47 of the Vernimmen.
(2) For more see chapter 16 of the Vernimmen.
Ferragamo, Glencore, Prada, Vallares are among the companies that successfully carried out IPOs in the first half of 2011. Atento, Canal+, ISS, Verallia, Russian Helicopters, Monclerc etc. deferred their listings because the market was not yet ready to pay the price that the sellers were hoping to get and the latter had the resources to wait for better days.
What are the success factors for an IPO in a rather jittery stock market context?
Intelligent marketing. In the Introduction to the Vernimmen, we explain how a good financial director is first and foremost someone who understands and practises marketing. So this should come as no surprise to the reader and involves:
• raising investor awareness about the stock market candidate a few months or quarters before the roadshows of the actual placement;
• the entry into the share capital of investors seen as anchor investors a few weeks before the IPO when permitted by regulations, or at the time of the IPO, which will encourage other investors to follow suit. For example, the Ferragamos sold an 8% stake in their company to the Hong Kong businessman Peter Woo, three months before listing on the stock market;
• controlled management over communication on the envisaged price. For example, Glencore let it be known that it was envisaging listing at over $60bn, and when the announced price was below this figure, this was perceived as good news. This is behavioural finance par excellence (1) ! We note in passing that the difficulty involved in valuing this strange animal did facilitate this manoeuvre;
• and a price perceived as being lower than the balanced value, allowing investors to hope for capital gains within a few months. Ferragamo, to take the same example, fixed its listing price in the middle of the indicative bracket and five days after the IPO, the share price had stabilised at 14% above the IPO price. These days, the market is a market of buyers who do not hesitate to twist the arm of IPO candidate companies. Best to know it in advance and not try to play at another game if you want to get onto the stock market.
(1) See chapter 15 of the Vernimmen.
This month we discuss an article that looks at the contribution of independent directors to the value of firms. Two corporate finance specialists (1) have shown that the announcement of the sudden death of an independent director leads to an average drop in share price of 0.85%. Their analyses also focus on the degree of independence of the deceased director. The greater this independence, the greater market reaction.
What sets this article apart from other articles on independent directors is its approach, which consists of using sudden death as an external factor vis-à-vis the characteristics of the company. Most empirical studies on the value created by independent directors have to deal with a major problem, i.e., the fact that the presence of independent directors is itself partially explained by the company’s situation. In particular, it has been established that poor performances lead to a more independent board of directors. This could explain why a lot of researchers conclude that independent directors have a zero, or even negative, impact on the value of the firm. By identifying 229 cases of sudden death of independent directors (2), Nguyen and Nielsen constructed a data base that enabled them to study market reaction to the unexpected death of an independent director. The main conclusions of this study are as follows:
• over the 4-day period around the official announcement of the death (between D-1 and D+2), the share price underperforms by an average of 0.85%;
• negative reaction is greater for directors with a higher degree of independence. This is the case for directors who have not been on the board for long, as on the other hand, directors who have been on their boards for a long time become attached to the company and to its management. It is also the case for directors who were not appointed by the existing CEO of the company (3);
• the effect is also more noticeable when the deceased director has the casting vote to ensure the majority of independents, or when he/she is a member of the company’s audit committee;
• market reaction is clearly linked to the director's independence, and not to his/her intrinsic abilities or experience (4).
Through its original approach and the quality of the data base exploited, this article provides a highly convincing empirical demonstration of the contribution of independent directors to the value of the firm.
(1) B.D.Nguyen and K.M.Nielsen (2010), The value of independent directors: evidence from sudden deaths, Journal of Financial Economics, n°98, pages 550-567.
(2) The study covers listed companies on the US markets between 1994 and 2007.
(3) This effect is of course measured, all other things being equal, i.e., after factoring in the duration of the board of directors.
(4) Nguyen and Nielsen rely on the fact that some directors sit on several boards, in order to isolate the "fixed effects" related to competence. They also factor in the qualification level of independent directors.
ASR stands for Accelerated Share Repurchase which is a US technique for repurchasing shares on the market that is different from the standard OMR or Open Market Repurchase.
In an OMR, the company, through a broker, buys its shares on the market over several months, if not quarters, in order not to affect / manipulate its stock market price. Impacts on EPS are slow to materialise as they take place as progressively as the repurchases.
In an ASR, the impact on EPS is immediate. It is positive provided the reverse of the P/E ratio at which price shares are purchased is higher than the after-tax cost of debt used to finance the repurchase or the after-tax return on cash used to finance the repurchase (1).
In practice, the company buys from an investment bank the total amount of shares it wishes to buy back. The investment bank itself has borrowed these shares from several investors and will buy shares on the open market over several weeks / months / quarters to repay its initial loans.
If the average price at which the investment bank buys the shares on the market is higher than the price paid by the company to buy this initial block of shares, then the company pays the difference to the bank. If it is lower, then the company benefits from the difference. To achieve this, the company and the investment bank enter into a forward contract.
On the assumption that the announcement of an ASR has no impact on the share price, the company will be pay the same price for the share it buys back through an ASR or an OMR.
In the first five months of 2011, 25 US companies announced ASRs for a total value of $8.5bn versus 39 for $11bn in 2010 and 117 deals in 2007 for $79bn.
As example, Home Depot and Donnelly have each completed ASRs for $1bn.
(1) For more on this, see chapter 38 of the 2009 Vernimmen.