The start of the third year

Thanks to Linkedin, I got to know that the Asif Khan Blog has just passed two years. It has been a rewarding two years. Writing these posts helped me clear up my own concepts. Additionally seeing people from all around the world read and subscribe to the blog gives me extra confidence.

One of the goals for 2016 that I have is to write better quality and more well researched posts. This will make the posts longer (which is against the conventional wisdom cited by social media experts) but for the type of content I write, they are ideal. On the flip side, as work and other activities take away more and more time the number of posts will surely come down.

As a new years gift to readers I bring link to a talk show “Weathtrack” which I recently stumbled upon. It was love at first sight (or in my case love at first listen as I use my podcast app to listen to these episodes). Here are two great episodes that I listened to recently. Coincidentally both the guests have worked in the First Eagle Fund.

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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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A visionary ecosystem

Microfinance is not innovative. Many will be understandably aghast at such a statement. The origins of microfinance is of a hapless yet determined economist, Muhammad Yunus, attempting to sell the novel idea that the poor can be creditworthy, a notion that was shunned by virtually all the banks existent in the late 1970s. Banks could not imagine loaning to those without collateral. It was simply too big a risk. This is precisely what is not innovative about microfinance. It was just another example of a loan to a customer. It is not like a bond, which is also a loan, as bonds are transferable securities; nor is it like a derivative, whose value depends on another financial asset.

Instead, what makes microfinance unique, though not innovative, is its success depends on monitoring and mentoring. Without observation or the support required to set up small enterprises, the likelihood is that the poor, in general, would fail to pay back their loans. This is not an indictment on the poor, far from it. Rather it is to say that the presence of an overseer and an enabler can lead to ideal outcomes.Hardly a novel insight, it is not only a characteristic of microfinance; we see the importance of mentors in other industries, particularly venture capital and private equity industries.


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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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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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Greece, Please Let Me Introduce You to Mr.Tony Soprano

In the HBO drama, the Sopranos, there is a scene in which the anti-hero, Tony Soprano, mob-boss and sociopath, chases a middle aged gangster across the streets of New Jersey. The unfortunate pursuant crashes his car and injures himself, much to the glee of Mr. Soprano. He stops, gets out his car, walks to the injured man still sitting in the driver’s seat moaning in pain, and opens the door. Feigning care for a stunned public that gathers around, Mr.Soprano grabs the hapless man’s neck, proceeds to threaten the anguished driver and demands the money that is owed to him to be given within 24 hours. Mr. Soprano then casually leaves quietly and unperturbed.

If one could find a most appropriate metaphor for the current situation in Greece, perhaps this is it. Greece, shattered and devastated, has an unemployment rate of 25.4%, and is struggling to pay its public sector workers. Its manufacturing sector contracted for the 8th consecutive month according to the Purchasing Managing Index, and its GDP has been falling rapidly since 2009 when it was at $341.6 billion. Greek’s GDP is currently at $241.72 billion. With high unemployment, an anemic manufacturing sector and declining GDP, Greece is still expected to pay 6.74 billion Euros in June, 5.95 billion Euros in July, and 4.38 billion Euros in August. They owe the IMF 2 billion Euros and 6.7 billion Euros to the European Central Bank.

The ECB have pushed Greece to increase taxes and more importantly collect taxes the Greek government is owed. At the end of 2014, Greeks owed their government about €76 billion in unpaid taxes accrued over decades. The government says most of that has been lost to insolvency and only €9 billion can be recovered. Nevertheless, the incumbent Syriza government is attempting to negotiate better terms with creditors in order not to default on its impeding payments.

Unsympathetic creditors argue that Greece’s descent into economic chaos is a product of their own financial indiscipline and corruption. Up to 2009, Greece had accumulated high debts and prices were high making the country uncompetitive. There were even accusations of the unproductive Greek work force that chose to slack rather than to work hard. One could certainly argue that Greece is a victim of their own opulence, chasing loans without building a sufficiently strong growth stimulating sector. Indeed, in 2010 the Greek Ministry of Finance identified a bloated public sector and an inordinate focus in channeling investments into non-growth sectors (such as the military).

But Greece is also trapped by the rigidities of being part of the Euro. As economists such as Paul Krugman argue monetary policy instruments as a means of combating economic problems are more or less absent for countries that are under a common currency. Greece cannot increase interest rates in order to incentivize saving; neither can they print money in order to encourage banks to loan to productive industries. They have to rely on fiscal policies solely that require the participation of a public that is witnessing unemployment and salary cuts.

With high debts, high unemployment, lack of a monetary policy, shackled by the Euro, and condemned by a haughty international community, Greece’s condition is remisicent of Germany in the early 1930s. The Weimar Republic was beset with problems emanating from WW1. The Treaty of Versailles in 1919 had imposed a reparation bill that Germany continually complained was too high to pay. Throughout the 20s Germany had to borrow heavily, particularly from the US, in order to reconstruct. Once an industrial center, the Allies had sought to weaken Germany following the war, with France being particularly belligerent. She took over Germany’s industrial heartland, the Rhur, in 1921. This led to the famous hyperinflation bout in 1923.

But perhaps the one key shackle for Germany was being part of the Gold Standard. The Standard which had worked reasonably well in the 19th century was causing distortions in the global economy at the time. The four great powers – US, France, UK and Germany – faced differing economic scenarios which impacted the other. US and France had most of the world’s gold bullion, whereas UK and Germany were hamstrung by a lack of it. The abundance of Gold allowed the US to divest capital into Germany, who were only too happy to accept the largesse as it sought to rebuild and pay off its debts and reparations. The problem was that in 1928 when America raised interest rates in fear of a overheating stock market, Germany were left with a decreasing flow of capital, and fell into recession. The tap had been closed, and with it Germany’s ability to suitably build its own industrial sector. It could not increase its deficit in order to invest, and with pressures from UK and France to repay, it had little room to manoeuvre.

The Great Depression changed the situation dramatically, as the world began to suffer, and countries experienced their own financial crisis. They were less concerned about Germany’s ability to repay, and by 1932, forgave Germany’s reparations bill. In the 13 years since the Treaty of Versailles, where the bill was set at $32 billion, Germany had only paid $4 billion. Thereafter, Hitler came into power, and the central bank, led by the enigmatic and ill-tempered Hjalmar Schacht, started to print money to invest in public works, mostly those industries that related to rearmament. Even though Germany remained on the Gold standard (unlike the other great powers) it had the breathing space to build its own economy. While by 1937 cracks began to appear as Germany were priced out of the world markets and austerity at home affected the living standards of its people, perhaps a key lesson from this situation, was less oversight and greater freedom allowed Germany to work out its own destiny.

Returning to Greece, there is an irony that Germany is acting with an iron fist, condemning Greece for its profligacy and imposing directives. Greece, like the Germany of old, has to turn to more creditors just to pay the bill, and being part of the Euro, it cannot devalue its overvalued currency thereby cheapening domestic prices. Certainly, Greece is a victim of its own detrimental actions – just as Germany of old were – but being hamstrung by the Euro and with a supercilious international community, it can hardly atone for its economic actions without being condemned. Like Mr. Tony Soprano the international community is acting like gangsters without sympathy. All Greece can then do is remain servile, looking for loans to pay its creditors, and hope its people do not descend further into impoverishment. But without a flourishing economy, it is hard to see how in the future Greece can improve. And like Germany of old it may have to eventually ignore the international community in order to settle its own affairs.

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