Letter number 89 of October 2015
- QUESTIONS & COMMENTS
Are you looking for some autumnal reading to keep you busy? If you’ve got a few spare weeks, you could attack the annual reports of the Eurostoxx50 companies, a grand opus of over 14,000 pages (that’s six times as long as Remembrance of Things Past, 10 times as long as Lord of the Rings and 14 times as long as the latest Vernimmen!). Twenty years ago, it would have taken you one-third of the time to savour these annual reports. We’ve seen the average annual report grow from around 100 pages at that time to 350 pages today. The switch to IFRS (and the amendments to these standards) is certainly responsible for a large share of this increase, but the growing amount of non-accounting data that has to be included (environmental information, corporate governance data) has also played a role.
This was all that was needed for a large number of the natural users of these documents (investors, analysts, bankers, etc.) to consider that they were now exonerated from reading these reports, which are, nonetheless, very instructive. It is true that there are many who as early as the 2000s demonstrated that the reading of annual reports was optional as far as they were concerned, often at their own cost.
Over and above annual reports and other periodic documents, listed companies (and especially large groups) today have many means of communication, starting with their web sites, the social networks and analysts’ presentations.
The quality, quantity and organisation of written periodic information vary from one company to another. The level of periodic information is very variable. In terms of annual information, over and above the annual document (whether it is called annual report on form 10-K or a registration document) or its equivalent, some groups publish an annual report, others publish an activity and sustainable development report, or an environmental and social report.
So, the quantity of information available today is far greater and also much more difficult to understand and to summarise.
This overabundance of information is an issue that the regulatory authorities will have to deal with. In 2013, the IASB launched the Disclosure Initiative project, which led initially to the amendment of IAS 1 but which should be extended. These recommendations focus on financial statements but do not deal with extra-accounting information.
A new company communication tool is in the process of emerging – integrated reporting. This is a summary document that provides the reader with an understanding of the business model of the company (in practice large groups), and thus the way in which it creates value.
The development of this project has been (highly) structured around the International Integrated Reporting Council (IIRC) and its partner companies. The idea is to achieve a consensual approach through highlighting proposals and publishing reactions to these proposals. A number of large groups have undertaken to implement this idea at an international level and some of them have published their first integrated reports (ENI, Akzo Nobel, Novo Nordisk. Engie). The two aims of integrated reporting are:
on the one hand, to include in a single document, financial figures, economic information, elements relating to strategy and social and environmental commitments and achievements;
on the other hand, to produce a summary document, which accordingly, is short.
For example, the Engie document (2015 Integrated Report) contains 50 pages split into eight chapters:
Aims and strategy
Corporate governance and decision-making process
The report is very broad and is thus intended to be useful to a wide range of users - investors, partners, customers, suppliers, and authorities. Disciples of IR highlight the fact that over and above information on the stakeholders, the system also makes it possible to de-compartmentalise the company and force a dialogue between the different teams (HR, Finance, CSR). But by seeking to group all of this information together in a summary way, won’t we be sacrificing the usefulness of the report for most of its readers? Won’t the report just become a brochure of “key figures” or “essential facts” which already existed but in a more modern format?
There are some who cite the formal nature of annual reports as the reason why they avoid reading them. Or why they rely on more summary documents. This is definitely not a solution! Integrated reports can only be considered by the financial community as a complement to the annual report. The promotors of IR claim that this is what it is. So this means that it's yet another report!
The usefulness of the integrated report thus seems to lie in its approach to the company’s strategy but then either the document remains very general and is not of much use, or it reveals more and risks being very useful to the competition. But isn’t this exactly the balance that has to be struck with any financial communication?
We should remember that we live in a world that operates at two (even three) speeds. Companies that have issued listed instruments (shares or bonds) publish a plethora of information while unlisted companies jealously guard their information. This is what discourages many from listing or from issuing bonds.
There is a lot of marketing noise around IR, which makes us naturally suspicious. It reminds us a bit about the fuss made about EVA which had its supporters before being consigned to history.
If the idea of IR takes off, it will certainly generate its own economy (politically correct way of saying “costs”) though consultants (the large accounting firms are already moving their guns into position) and the mobilisation of companies’ internal resources. Nevertheless, the interest expressed by a large number of major groups shows that they see it as something useful and thus potentially advantageous (better valuation of their stock, greater involvement of employees and other stakeholders). So let's not condemn it outright. Time will tell whether this document is useful to some users, whether it will replace other documents or be an added extra thereto. One this is sure though, for the financial analyst, the annual report will remain the essential document!
As illustrated by the graph below, there are two curves which evolve in opposite directions:
Data: BNP Paribas, Stoxx.
When share prices are low or falling, banks that guarantee capital increases impose heavy discounts which limit their risks. When share prices rise again, discounts may be lower because the risk is then perceived as being lower.
The discounts on the graph represent a discount on the issue price compared with the share price once the preferential subscription right has been detached (the theoretical ex-rights price - TERP).
With Simon Gueguen – Lecturer-researcher at the University of Paris Dauphine
Rating agencies are often the butt of criticism, which is sometimes legitimate. Recently they were accused of having encouraged the sub-primes crises by being too indulgent in their ratings of structured products. The article that we present this month argues against the received idea that these agencies systematically attribute lenient ratings to their clients because of their business model. In any event, the long term trend is towards greater severity for firms’ debts.
Most of the study covers ratings given by Standard & Poor’s, but the correlation with ratings from Moody’s and Fitch is striking (94%). S&P’s ratings grid has 21 levels, from AAA to C. Between 1985 and 2009, the number of good ratings fell and the number of bad ratings increased. At the same time, the default rate by companies with equivalent ratings decreased. Accordingly, the cause of the phenomenon will doubtless not be found in the more difficult macro-economic conditions, but rather in the rating methods used by agencies. Most especially, firms with equivalent characteristics (short- and long-term debt levels, cash levels, profitability, size, tangibility of assets, etc.) are rated more severely. The difference is noteworthy – the rating drops by an average of three notches! A firm that was among the average of firms rated AAA in 1985, would only be rated AA- in 2009.
In the rest of the article, Baghai et al measure “severity” using the difference between the rating obtained and the theoretical rating if the 1985 model had been maintained. This enables them to empirically measure the consequences of this conservatism on the behaviour of firms on the one hand, and on the debt market on the other hand. They show that a firm that is rated one notch more severely issues substantially less debt. The difference corresponds to 0.2% of total assets (for an average issue of 2.6%). Similarly, the number of acquisitions declines and the level of cash kept on the books increases.
With regard to the credit markets, unsurprisingly, the rating has an impact on the price. One notch of rating lost corresponds to an increase in the margin of 74 base points (bp). More interestingly, for an equivalent rating, the spread is lower (by 9.5 bp) for firms that are severely rated (and so which would have had a better rating in 1985). In other words, the markets make up slightly for the effects of this greater severity.
The article provides a very comprehensive empirical analysis and shows that agencies rated firms with increasing severity between 1985 and 2009, and that firms and the market factored this in. Why this trend? A question of learning from past mistakes? And what about the rating of structured products? And sovereign debt? So many questions for future articles to tackle!
 R.P.BAGHAI, H.SERVAES and A.TAMAYO, Have rating agencies become more conservative? Implications for capital structure and debt pricing, Journal of Finance, vol.69, n°5, pages 1961 to 2005.
The answer is yes, but that’s irrelevant because you don’t buy real estate just to reduce your cost of capital. And you get cost of capital and cost of capital.
From a teaching point of view, it has always seemed to us that the best way to gain a good understanding of the concept of cost of capital is to reason on the basis of the firm’s operating assets, rather than to think about the sources of financing that finance these assets. The cost of capital is the rate of return that investors who finance the firm’s capital employed are entitled to expect. By acquiring real estate, one of the least risky assets that there is, the risk of the firm’s operating assets is reduced. So, the minimum rate of return required by its providers of funds falls, since the latter are now running less of a risk on a pool of assets that is no longer exactly the same.
What we’ve got is a reduction in the firm's cost of capital. Does this mean that the firm is going to ask for a lower rate of return on its non-real estate assets (construction of logistics premises, acquisition of a competitor, extension of a factory, etc.)? No, of course not, because the risk on these non-real estate investments hasn’t changed just on the pretext that the firm now owns real estate.
Let’s not forget that the firm has as many different costs of capital as it has different business lines and different geographic areas where it operates. And that each of these costs of capital is specific to each of its business lines. Collectively, their weighted average forms the firm’s overall cost of capital. This is not relied on for taking investment decisions in this or that business line or in this or that area, but simply for appreciating the overall ROCE of the firm.
In conclusion, as real estate is one of the least risky assets, its cost of capital is one of the lowest you can get. Acquiring real estate thus reduces the firm’s overall cost of capital, but in no way modifies the cost(s) of capital used in the firm’s operational activities.