Damodaran on country and currency risk

I was reading Aswath Damodaran’s blog and much to my surprise found a series of posts on country risk. A lot of the material he talks about overlaps with my last post on currency risk and risk free rate. I did not however find confirmation of what I suggested for currencies which are ‘highly’ overvalued (my suggestion for a global investor was to adjust the fair value estimates, for assumption of a large currency depreciation which is not captured by the risk free rate).

Nevertheless, I think all 4 blog posts are relevant readings for equity investors. Here they are.

  1. Groundhog day in Greece, Hijinks in Brazil and Market Chaos in China: Pictures of Global Risk – Part I
  2. Valuing Country Risk: Pictures of Global Risk – Part II
  3. Pricing Country Risk: Pictures of Global Risk – Part III
  4. Decoding Currency Risk: Pictures of Global Risk – Part IV

While the posts become quite technical and makes it clear to the reader that a lot of what we do is subjective one key advice from Damodaran is very important. That is consistency in our cash flow assumptions and discount rate assumptions. If our discount rate implies inflation rate of 5% and cash flow assumes inflation rate of 2% we have a mismatch and our valuation could well undervalue the company. The reverse can also happen where we are using a high terminal growth rate number and a low discount rate.

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Does risk free rate compensate for currency risk in equity valuation?

The risk free rate is one of the basic inputs used for company valuation. I have done a bit of thinking on the risk free rate because it poses a number of practical challenges faced by analysts.

For example, when risk free rates are extremely high or extremely low (e.g. government bond yields are fairly low across South Asia at the moment) do we take the current yield or a historical average? If we take an average will it be a 3 year or a 5 year average? In fairly volatile times, the answers to these questions can have pretty large implication for stock valuation.

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How to value ‘brand value’ during company valuation?

‘How would you incorporate our brand value in our company valuation?’ A friend of mine was recently asked this question by a corporate professional. It is a pretty interesting question when you think of it. Let me start the answer with the definition of ‘brand equity’ according to wikipedia.

Brand equity is a phrase used in the marketing industry which describes the value of having a well-known brand name, based on the idea that the owner of a well-known brand name can generate more money from products with that brand name than from products with a less well known name, as consumers believe that a product with a well-known name is better than products with less well-known names.”

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Dealing with earnings season

With companies having started to report quarterly earnings we are back in the ‘earnings season’. This is a fairly hectic time for equity analysts on both the buy and sell side. It is quite common for sell side analysts to cover 15-20 stocks while their buy side counterparts can look at a higher number. The trade-off is however in the fact that the sell side analyst needs to look at numbers at more depth and then also perform the task of client communication. Nevertheless, the bottom line is that its a hectic time for all.

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Getting back to fitness

After a few years of not paying attention to my body I found myself in the worst physical shape I have ever been. I am 5 feet 10.5 inch tall and weigh around 81 kg. The problem was my body fat which I roughly calculated to be 23%. Most importantly I had a pretty bloated stomach.

Now my two previous experience with working out proved that I usually cannot sustain it. The greatest length I continued working out was for 6 months or so. Also, in both those occasions I was trying to gain both weight and muscle mass while this time I have no target of gaining weight. I just need to get my body fat % down to reasonable levels (numerically and aesthetically).

Its been a few months I have started my attempt to get fitter. Initially it started with just walking and light jogging. I then started some body-weight exercises like push-ups, chin-ups, dips etc. More recently I have added some weight training (3 day upper lower split). In addition to these I have started the following things.

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Cost deflation and profitability

In a world where commodity prices are under pressure companies with imported raw materials see interesting benefits. Consumer good companies which need flour, sugar, soyabean oil etc are one such example. Other examples are companies which use some sort of oil derivative that includes paints, lubricants etc. The decline in cost in the short term usually leads to margin expansion and higher profitability.

This is where we need to be a bit careful. The short term increase in margins may or may not sustain depending on competitive situation. In a highly competitive sector like cement (particularly when there is overcapacity in the sector), benefits of declining raw material prices can vanish quite rapidly as companies are forced to pass on the benefits to the customers. On the other hand, in a sector with concentrated large companies with strong brand value, companies can delay price cuts for a long time.

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How much cash in times of volatility?

One of the most difficult decisions for a fund manager in times of global uncertainty is to decide how much cash they should hold. Even if the manager feels that markets will grossly under perform it is hard to put a large part of the portfolio in cash because investors are paying them to manage equities.

Take the example of the present situation. Chinese slowdown, commodity price declines and depreciating currencies are taking massive toll on some of the emerging and frontier markets. In particular, economies with commodity focus like Russia, Nigeria and others like Argentina are getting pummeled. Even countries considered to have enough reserves to weather the storm like Saudia Arabia had its own share of scares. The only countries performing relatively better are those that are commodity importers and less correlated with the global economy. In the frontier universe this would include countries like Pakistan, Bangladesh and Sri Lanka all three of which commodity importers.

The problem however is in the fact that equities in these markets are not cheap. Thus a fund manager has 3 options overall. Allocate more to these countries even though stocks are expensive because the global volatility can run for a long period. Second option is to hold cash and try to time the market bottom (if we believe that markets are cyclical and sooner or later commodities will rebound). Final option is to start allocating risk assets to the battered countries from now on because markets always move faster than economic news. The idea is to take some near term hits on the portfolio but make money on the medium to long term.

These are all difficult decisions and just like most other things involving finance more an art than science. So far it seems to me that investors feel that Chinese situation will stay pretty bad and thus commodities will remain weak. As a result, people will continue to put money in countries with strong external accounts, limited fiscal deficit, declining inflation (through lower commodity price) etc. However, as countries like Nigeria and Argentina keep on under performing there should be a point when the prices will too low to ignore.

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