Thursday 21 November 2013

What are you smoking? The macro-economists supreme weakness: flows vs. balance sheets

In 2008, the financial sector was on the brick of collapse. Even if it accounted for only 4% to 10% of GDP (depending on the country), you could not let it implode. It's not the size of a sector itself that is relevant for assessing its economic importance. It is its connectivity with the rest of the economy. And no other sector is more at the centre of the economic system in a market economy than the financial sector. A feature it arguably shares with the electricity grid. So unless you think that because the electricity industry only accounts for 2% of GDP you can let the electricity grid collapse without causing a devastating damage on the rest of the economy, you cannot let the financial sector implode either (that instead of rescuing it via bail-outs you should rather do it via bail-ins is another story). This is the point that Larry Summers very correctly made at the latest IMF conference (8 November 2013). So far, so good.

But then he goes further and argues that monetary policy became ineffective in the developed world ("liquidity trap") because the equilibrium real interest rate is actually negative! Meaning: the FED, BoE, ECB & Co should keep their ultra-loose monetary policy for many years to come and try to create asset bubbles as without them there isn't any hope for economic growth to take place. On top of it, governments of developed countries should run large deficits and launch a massive programme of public investment financed by central banks monies for many, many years.

Here Larry Summers' "performance" in all detail:
- the video: http://www.youtube.com/watch?v=KYpVzBbQIX0&feature=youtu.be
- the text version: http://www.fulcrumasset.com/files/summersstagnation.pdf

Paul Krugman, even goes further. He argues that it would be desirable for the private corporate sector to invest in all kinds of projects, even when their rates of return were likely to be negative at inception (and way, way below their cost of capital), because it would generate employment.

Here Paul Krugman's "performance" in all detail:
- Paul Krugman: http://krugman.blogs.nytimes.com/2013/11/16/secular-stagnation-coalmines-bubbles-and-larry-summers/?_r=0

Negative real interest rates as the ideal asset allocation mechanism in a market economy? Asset bubbles as a way to generate sustainable economic growth? The government as a better investor and resource allocator than the private sector? Private companies pursuing projects with negative rates of return to generate demand and employment in the short-run and forgetting the mid-term consequences of it, i.e., sound companies today going bankrupt tomorrow as a result of bad investment decisions and....well...creating unemployment?

Larry Summers' and Paul Krugman were some of my heroes as I was an economics student. What happened? What are you smoking, guys?

To be fair, I don't think that they are smoking anything that they were not smoking years ago. But we all are the product of our education, training and experiences. Paul Krugman and Larry Summers included. And they happen to be academic (macro-)economists by education and training. Their views are simply the result and perfect example of macro-economists' supreme weakness: excellent at analyzing flows, terrible understanding balance sheets.

The reason why US and European monetary policies are ineffective is because the economies are over-leveraged. Balance sheets are impaired across the whole economy. When that happens no matter how low interest rates are, no one is neither willing nor able to take on more debt. The absolute priority is to de-leverage. Banks are impaired (even if they say otherwise) as a high percentage of the credits they conceded are de facto non-performing loans as a result of having been used to finance projects that turned out to have negative rates of return - why else would the borrowers not have been able to pay them back and in fact had to increase their levels of debt over time?

In such a scenario, a debt restructuring across the board is the only quick and effective solution. Followed by a recapitalization of the banking sector via-debt-to-equity swaps (bail-ins). Once this is done, all the problems are solved and monetary policy becomes effective again. Interest rates will start functioning, again, as the signaling mechanism for financial resource allocation across the economy they are supposed to be. Or would anyone not borrow money if he/she suddenly had no debts and lending rates were 2%?

Putting it differently: increasing leverage is a powerful economic growth accelerator until over-leverage is reached. When leverage turns into over-leverage is an interesting academic discussion for which there is no clear ex-ante answer. However, it is very easy to spot when that point is reached.....once it is reached: monetary policy becomes ineffective ("liquidity trap") and debt restructuring across the board is needed.

You don't solve the problem of an impaired balance sheet by trying to artificially increase the value of the assets - if a balance sheet is impaired that must mean that the quality of the assets is bad, i.e., they were not and are not able to generate sustainable positive returns. The result of bad investment decisions. You solve the problem of an impaired balance sheet by accepting that the assets are worth much less than they are accounted for and restructuring the balance sheet's right side, where equity and debt sit.

That public investment in areas where clear positive externalities exist, able to generate a positive impact on the economy's supply side (improvement of education system, internet / telecom infrastructure, transport infrastructure, R&D) and lead to an increase of potential GDP does make sense is undisputed. No one with a reasonable degree of common sense challenges that. But it has to be a complement to a comprehensive balance sheet restructuring in the private and public sector. Not a substitute for it.

PS Look at the Japanese total level of debt (both public and private) at the beginning of the 1950s and in 1989, when the country's two lost decades started. Do the same for the US and Europe: in both cases starting at the beginning of the 1950s up to 2007.

What do you see? A continuous increase in total debt as a % of GDP and since 1989 in Japan and 2007 in US / Europe a completely ineffective monetary policy in terms of generating economic growth. These were the points in time were over-leverage and impaired balance sheets finally revealed themselves.

Monday 18 November 2013

DCF (II): a far more sensible approach to valuation than a detailed DCF

As said in my last post, a detailed DCF is a highly valuable M&A and marketing tool. But not a sensible approach to value a company. The question then is: what is a sensible approach to valuation?

One that meets the following conditions:

1. Keep it simple. Forget the 50 variable detailed DCF. Focus on sales, profit margins and make sure that the company's asset base is in line with your growth assumptions

2. Focus on the big picture. Just focusing on three variables may seem to be superficial. It is not. If you have a highly complex problem to solve you don't develop a highly complex model to analyse and solve it. That would only create confusion, intellectual distress and lead to poor decision making. It would be the planning fallacy at its worst.

The solution is to follow simple principles for complex problems. And broad framing: take a step back, think hard about what are the critical factors to understand and solve the problem and focus on these. For any problem, explanatory factors 8, 9 and 10 are always pure, simple and irrelevant details. Factors 1, 2 and 3 will explain (almost) everything you need to know in the vast majority of the cases you will be confronted with. And factors 8, 9 and 10 will tend to be highly correlated with 1, 2, 3 anyhow making them redundant. Besides, if you start to focus on 10 explanatory factors you will end up i) not really focusing on any, ii) spend time paying attention to things that are irrelevant, iii) missing out critical information because you are too busy dealing with irrelevant details. Allocate your time to understand what is key. To understand it really, really well. The rest are peanuts.

And what is key? Quality of the business and quality of the management.

Does the business benefit from a moat? Has it true pricing power? (first quick test to answer both questions: has the return on capital employed been consistently above the cost of capital over the entire economic cycle?) Is the entire industry potentially exposed to disruption from outsiders? Is the management team of high quality, i.e. intelligent people with high ethical standards? Are the top managers interests aligned with that of the shareholders? Does the pay structure incentivise managers' long-term thinking and decision-making (way, way beyond the next quarterly report)? Are the top managers respected and admired by the vast majority of their employees or rather resented?

3. Quantify! If you can't quantify reality, your understanding of it is very shallow. When it comes to valuing a company, it is easy to find people that use a detailed DCF and put a number on 20 different variables. However, it is very difficult to find people that actually quantify and challenge the underlying assumptions of the valuation model.

Typically, in detailed DCF modelling there is a macro or mega-trend underlying sales growth assumptions. But this trend is verbose and vaguely quantified. And usually relying on research reports from well know institutions. Something like "Industry experts estimate that the demand for German solar equipment is likely to grow 30% annually over the next decade. The European slowdown won't impact German solar equipment manufacturers as their main clients are Chinese solar panel manufacturers and the Chinese market will keep growing at high double digit rates. The Chinese in turn while being the world's leading solar panel manufacturers, won't be able to compete with the German solar equipment manufacturers (note: solar equipment is, simply said, the equipment needed to produce solar cells for solar panels) because they don't have the technological know-how to do so. They will remain the German solar equipment manufacturers best clients for many years". The issue is that if you simply read tens of research reports and use their main findings to derive a company's sales estimates, the chances are that you will end up way off the mark. And if you are way of the mark for the top line you will be way off the mark in your bottom line estimates as well (and trying to put numbers on 20 variables won't make it any better).

You have to quantify, pin things down, and challenge, with numbers, all aspects of reality. Reading research reports is nice and all you need to do if you are a salesperson wanting to tell your clients a persuasive investment story. But if you are an investor you have to do better. And more. You have to do your own research. Go directly to the sources of information. Get the numbers. Speak with a broad range of people holding different opinions. And challenge the underlying assumptions others are putting forward before you incorporate them in the valuation of the company you are analyzing:

a) The Chinese solar panel producers won't be impacted by the European slowdown as China will continue to grow strongly? Really? How much of their production is sold into Europe? 80%-90%? Interesting....

b) The Chinese won't be able to develop their own solar equipment technology as they don't have the know-how? What do the top Chinese students study? Philosophy or natural sciences? Natural sciences (even because discussing philosophical ideas freely in an one-party system is not really a good idea for career advancement). What's the percentage of Chinese students in post-graduate science programmes in the western world's top universities? 15% to 20%? And China will still not be able to develop its own solar equipment technology quite fast? Interesting....

4. Be sceptical and respect the power of history. Companies, like people, don't change easily. A company's past behaviour - over a 10 year timeframe (one entire economic cycle) - in terms of capital allocation efficiency and return on capital employed will tell you much more about what you can reasonably expect from it in the future than whatever the company's management says and would like you to believe

5. Operate with a margin of safety and learn to say "no". Once you have an estimate for normalized operating results and free cash flow - reached following the principles outlined above - you can start performing a company valuation. Calculate the multiples and compare them with peers' multiples, currently and over time. Try to assess the company's liquidation value whenever you can. And by all means: use discounted cash flow techniques and perform sensitivity analysis - but please forget a detailed DCF. And never, ever forget that performing a company valuation is not an exact science. Therefore, allow for a margin of safety. Don't invest if there isn't at least a 30% discount to what you reckon to be the company's fair value.

The ability to say "no" is no mean feat. And it is one of the most remarkable skills great investors share.

6. Don't overpay for growth. No matter how much a company is able to grow, if the return on capital employed is not above its cost growth has no value. On top of it, even if the return on capital employed is currently above the cost of capital it will tend to converge to the latter over a 5-6 year period, maximum. The exception to the convergence rule only occurs is if you are dealing with a true franchise business, i.e., a company that benefits from sustainable barriers-to-entry in its market. How many companies are true franchises? Let's be optimistic and say that 1% of all companies are. Do you really think that your are one of the greatest investment genius in the history of mankind and able to spot the real franchises, at least most of the time? Think again. And act accordingly.

And hey, if you do are an investment genius (or have a team and investment process in place that allows you to look like one) you just cash in the full benefits of not overpaying for growth.

7. Put in place a decision-making process that explicitly deals with the two mothers of all behavioural biases and bad decision-making: confirmation bias and loss aversion

This means putting Karl Poppers "falsification principle" at work: stimulate an open debate culture within your organisation to foster as many independent, uncorrelated opinions as possible with the aim to reject wrong assumptions and poor investment cases at inception. Remember that good writing leads to good investments: write down the investment case with its main assumptions, potential upside and risks. Especially write down the risks - and how to act in case they materialise to avoid that cognitive dissonance takes over when things start to move in the wrong direction. And learn from Kahnemann and Tversky: explicitly integrate reference-class forecasting and pre-mortems in your decision making.

Finally, accept one advise: be an optimist in all domains of your life. Except when it comes to investing. This will prove to be true genius.