Letter number 128 of March 2020
- QUESTIONS & COMMENTS
The demand by shopkeepers, forced to close, that their rents be cancelled and not just postponed by their landlords illustrates the difference between solvency and liquidity, but also, it seems to us, the difference between the financial crisis of 2008 and the coronavirus crisis of 2020.
The temporary suspension of certain rental payments is, of course, helping tenants to stabilise their cash flow. Cancelling them exceptionally would help to stabilise the cash flow AND secure the solvency of tenants who would be able to make a cost disappear, reducing their losses and thus mitigating the negative impact of these on the amount of their equity, improving their solvency in total (or rather avoiding the severe deterioration thereof).
It should be remembered that solvency measures a firm's ability to meet its debts in the event of difficulties and is measured by the ratio of equity to net debt and by the liquidating quality of the assets.
In 2008, the perceived deterioration in the solvency of banks, because they were suspected of holding assets that were losing value (sub-prime loans), led to a liquidity crisis when lenders became fearful and stopped lending to banks, which in turn sharply reduced their lending to businesses. But for the latter, the liquidity crisis did not translate into a solvency crisis because, with few exceptions, companies' economic activity did not collapse, and although results may have declined, they did not become massively negative.
And those most affected were able to carry out massive capital increases in the spring of 2019 (Lafarge, Xstarta, Wolseley, Gas Natural, CRH, ArcelorMittal, etc.).
Today, there are both liquidity problems for certain companies, of which the public authorities, banks and central banks are aware, judging by the thousands of billions of euros mobilised to deal with them, and potentially solvency problems in the near future, if business is slow to pick up again. Failure to operate, with fixed costs on the other side of the coin, will in fact lead either to losses which will eat away at equity, or, for those who do not have enough equity, to negative equity, which will then require rapid injections of new equity, or conversions of debt into equity, or bankruptcies.
Hence the comments of certain government officials who are not ruling out nationalisations, which will certainly not be carried out by buying the shares of current shareholders, but by capital increases designed to restore the solvency of the companies concerned, and therefore their ability to continue to operate when the time comes.
When business picks up again, there is a risk that some companies will find it difficult to obtain supplier credit, as their suppliers will have doubts about their solvency and will not want to take the risk of delivering and not being paid.
As there is no miracle in finance, the problem of solvency is transferred from the tenant to the owner, from companies that put employees on short-time working to limit the damage to their solvency to the State, which takes over. For the moment, this is where we stop as central banks that buy up government debts solve their liquidity issue but not their solvency issue.
Since there is a real loss in the economy, given that wealth that should have been produced is not, the loss in value at the global level does not disappear. At best, it is pooled and borne by those who can afford it, shareholders, who, as everyone knows, bring in risk capital: equity. Hence the fall in share prices, which, at the global level, is currently (21 March) in the region of $30,000 billion since 1 January.
As for governments, we believe that after such a shock, central banks will simply cancel, in one way or another, a good part of the debts they hold on them. The sooner and more clearly this is said, the better. We are not there yet. But we will get there.
Otherwise, the recovery will be hampered by the fears of taxpayers anticipating tax increases to cope with massively increased state debt, which could make it difficult for them to finance themselves on normal terms in the new world we have entered in recent days.
In the context of the 1960s, 1970s, 1980s and 1990s, there could have been fears of a surge in inflation. The disappearance of inflation more than 20 years ago, the experience of 2008, which resulted in a massive injection of liquidity to offset the massive deleveraging of financial players, and even more so in Japan, where the central bank finances the banks that finance the Japanese Treasury, show that these fears are probably unfounded.
But in any event, what choice do we have?
 For more on sub-prime loans, see the Vernimmen.com Newsletter N° 28, November 2007.
Statistics : Easier said than done: the vote of institutional investors in favour of environmental issues during AGMs
Majority Action is an NGO that has compiled a record of the votes of the 25 largest institutional investors at the shareholders' meetings of listed companies on resolutions on environmental issues.
The results of its work, as presented by the Financial Times in the following graph, show the very clear separation of positions according to the geographical origin of investors:
Of the 10 institutional investors that voted most frequently in favour of environmental resolutions, 7 are European, including the top 4 and 3 are North American.
Of the 10 institutional investors that voted most frequently against environmental resolutions, all are North American, including the world's largest in size, BlackRock, whose chairman is well known for expressing strong ideas in this area.
Thus, in his annual letter to the directors of companies in which BlackRock is a shareholder, sent in January 2020, Larry Finck stated, speaking of climate change and its impact on investment risk: "Awareness is rapidly changing and I believe we are on the edge of a fundamental reshaping of finance".
Being charitable, let's say that all change is complex, especially in large organisations, and that a leader's vision sometimes reaches his clients more easily than it can be implemented with speed by his employees.
 See as an example, the section Comments of The Vernimmen.com Newsletter N° 127, February 2020.
With Simon Gueguen, lecturer-researcher at CY Cergy Paris University
The number of listed companies has fallen very dramatically over the last twenty years. A recent study shows that this decline is affecting all types of companies and all developed markets, but that it is particularly marked for companies with fewer than 1,000 employees.
Doidge et al refer to a famous 1989 article (entitled "The Eclipse of the Public Corporation") in which Michael Jensen argues that conflicts between owners and managers in listed companies often make this form of organisation inefficient. Jensen explains that private equity is best suited when agency problems are high and listings are no longer justified in many sectors of the economy. When Jensen's article appeared, there were 5,895 companies listed in the United States. This figure continued to rise until 1997, when it peaked at 7,509 listed companies. It then declined each year until 2013, stabilising at around 3,600 listed companies, a decrease of more than half compared to 1997.
At the same time, the GAFAMs (Google, Apple, Facebook, Amazon, Microsoft) have seen their market capitalisations reach record highs, sometimes exceeding $1 trillion. It is the number of listed companies that has collapsed, not the aggregate market capitalisation. Doidge et al note, however, that the ratio, considered by economists as an indicator of financial development, has varied widely over the past two decades and peaked in 1999 (153.5 per cent). Two phenomena are at the root of this trend.
First, since 1997, share buybacks have been much higher than capital increases. The net difference over 20 years amounts to $3.6 trillion. US listed companies have returned much more money to shareholders than they have issued new shares.
Second, the annual number of IPOs has fallen since the financial crisis of 2008. The average in the US is 179 per year between 2009 and 2016, compared to nearly 700 per year between 1995 and 2000. Doidge et al note that delistings have not increased, and that these delistings are most often the result of M&A transactions or poor performance. Voluntary delistings, which are often highlighted in the press, are in fact very marginal and do not explain the decline in the number of listed companies. The real source is the collapse of IPOs.
Over the same period, the number of companies (listed and unlisted) continued to grow in the US. The general trend comes from the drop in the propensity of young companies to go public. Since 1997, the percentage of publicly traded companies with fewer than 1,000 employees has fallen by 60%.
How can this trend be explained? The question remains open for research, but Doidge et al suggest some leads. For a young company with a lot of R&D expenses, private equity has become more attractive than listing. Specialist investors are better able to assess the value of this type of investment and, where appropriate, to advise management on its development. In the listed market, lack of visibility can result in a significant discount.
Finally, Doidge et al reject the argument that over-regulation is the cause of the reluctance to list. The sharp decline began in 1998, well before the Sarbanes-Oxley Act (2002) and the tightening of financial services rules. They point out that the removal in 1996 of the 100 investor limit for private equity funds, a market deregulation decision, probably played a more significant role in the decline in the number of listed companies.
 C. Doidge, K.M. Kahle, G.A. Karolyi and R.M. Stulz (2018), "Eclipse of the public corporation or eclipse of the public markets?", Journal of Applied Corporate Finance, vol. 133, p. 64 to 82.
 M.C. Jensen (1989), "Eclipse of the public corporation", Harvard Business Review, vol. 67, p. 61 to 74.
 The precise measure of the number of companies listed on a market may vary depending on the source. Doidge et al use CRSP (Center for Research in Security Prices). World Bank data indicate the same trend.
Having bought a share worth 106 on Monday, which paid a dividend of 6 on Tuesday, I find myself on Tuesday evening with a share worth 100 and cash for 6, corresponding to the dividend received, and a financial gain of zero (106 - 100 - 6 = 0) even though from a legal and tax point of view, I received a dividend of 6. This shows that it is wrong to say that the dividend is the shareholder's remuneration. Indeed, what remuneration did I get, since my assets are unchanged and I incurred no expenses? Anyone who owns shares is all too aware of this.
The fallacious nature of this assimilation of dividend to return on shareholders' equity is clear from a tax point of view since I am taxed on the 6 in dividends received as if it were an enrichment for me when in fact, I have not enriched myself with anything at all. The obvious response here is, if the amounts are significant, to sell the share in order to crystallise the capital loss which may reduce the taxation on the dividend received.
What then constitutes the shareholder's remuneration? It is the capital gain, but a capital gain calculated not according to the usual legal and tax criteria, but according to a simple financial criterion in which any dividend received is deducted from the financial cost price of the share. To take the initial example again, if on Wednesday the price of my share rises to 102, I would then have gained 2, the difference between the price of 102 and my cost price of 100, itself resulting from an initial purchase price of 106, minus the receipt of a dividend of 6.
We could be told: If I buy a share worth 1000 on 1 January 2019; that the company makes a profit of 60 in 2019, that this profit is valued at 60 by the market and that therefore the share is worth 1060 at 31 December 2019; that a dividend of 60 is paid on 1 January 2020, then the dividend corresponds to the remuneration of the shareholder. Admittedly, but if the dividend had not been paid, the capital gain for the shareholder would still have been 1060 - 1000 = 60. This is indeed my remuneration, even if the dividend is nil (as is the case in Warren Buffett's investment holding company, Berkshire Hathaway, which does not have the reputation of under-remunerating its shareholders and yet has never paid a dividend). And if the dividend of 60 had been paid, I would also have made a financial capital gain of 60 (1000 - 940) since my financial cost price would have moved from 1000 to 940, and the share, after payment of the dividend of 60, would be worth 1000.
If, now, the market had only reflected part of the value creation in the share price by valuing the share at 1010, the payment of a dividend of 60, reducing the share price to 950, people would have been led to believe that I had received remuneration of 60, whereas I would only have been enriched by 10 (950 + 60 - 1000) corresponding to my financial capital gain (950 - (1000-60)).
More generally, the formula for calculating the return of a share over one year, bought V0, resold V1, with a dividend D1 in the meantime, which is : (V1 - V0 + D1) / V0, is of course correct, but the dividend D1 does not play the role that is most often attributed to it, that of income received that is added to the capital gain. This is true from a tax and legal point of view, but not from a financial point of view. In fact, from a pedagogical point of view, the formula should rather be written as follows: (V1 - (V0 - D1)) / V0, because the dividend is a correction of the initial value, almost as if you had been reimbursed a part of your capital, since through the dividend, you are allocated a part of the assets (liquid assets) of the company.
Over a period longer than one year, the rate of return is of course calculated as the IRR of the chronic flow of the share purchased and supposedly sold at the end of the period. This calculation includes dividends AND capital gains. The reason why we have put the conjunction AND in bold capital letters in the expression "dividends AND capital gains" is to underline the inseparable nature of these two parameters in their currently accepted definition, and the impossibility of taking only one, the dividend, into account when assessing the investor's remuneration, since the dividend automatically creates a capital loss. This explains our conception of financial capital gain, set out above, which encompasses both.
Regularly on the Vernimmen.com Facebook page we publish comments on financial news that we deem to be of interest.
We have limited ourselves to those published since 13 March and refer you to Vernimmen's Facebook page for comments published in February and early March, with the exception of the one devoted to the bridge built by Danone between the financial and the extra-financial, which makes visible the cost of the carbon footprint in financial performance, as the coronavirus has not made the energy transition issue disappear.
Danone builds a first bridge between financial and extra-financial criteria.
Danone announces in the publication of its 2019 results a "First step to make visible the cost of the carbon footprint in financial performance". Danone now publishes current earnings per share (EPS) adjusted for the cost of carbon emissions caused by Danone and this figure is based on a cost per ton of carbon of €35. To our knowledge, this is a first.
Beyond the extra-financial communication through which Danone announces that this year it has reached its CO2 emission peak (5 years ahead of its objectives), the direct integration of environmental criteria into the traditional financial tools for measuring value creation seems to us to be an excellent initiative that finally links the two worlds of the financial and extra-financial.
Perhaps current EPS adjusted for the cost of carbon will not ultimately be the criterion retained by the market or the most relevant, but we have to start somewhere... and above all, someone has to start. So, well done to Danone!
The equity market risk premium
An equity market risk premium that remained high post-2008 at around 7% compared with a pre-2008 average of 4% has no other justification than that investors perceive an environment that has become structurally riskier, without it being possible to clearly identify where the risk will come from. For example, who would have thought that one of the Americans with the best knowledge of how financial markets work, because of his duties as head of Goldman Sachs, who became Finance Minister, would take the risk of not coming to the rescue of a secondary bank in difficulty (Lehmann Brothers)?
Companies are drawing on their credit lines. Boeing, for example, which has just drawn down its entire $13.8 billion line in order to protect itself and face a certain drop in revenues. We have no doubt that the banks, given the liquidity they have accumulated due to post-2008 prudential constraints and the support of the central banks, will honour their signatures, allowing the major groups to survive and help their suppliers who need it by extending payment terms. Readers of Vernimmen who are familiar with chapter 39 will not have been unprepared.