Cost of Capital

Working as an equity analyst one of the most important questions to ask is ‘Is this company beating its cost of capital?’  Ultimately if a company fails to do this over time then it will cease to exist, albeit with one or two rescue rights along the way.

What is the most accurate way to estimate a company’s cost of capital?  This has been the subject of much debate recently and there have emerged several conflicting schools of thought.  What is agreed is that this metric must be nailed if companies are to be valued with any confidence.  Too many times as a professional investor I came across analysts willing to use arbitrary or ill-conceived costs of capital to discount future cash-flows and justify fair value opinions.  I think the term ‘rubbish-in rubbish-out’ was coined for sell-side DCF modelling.

The cost of capital is the weighted average of the cost of debt and the cost of equity (COE).  The cost of debt is the interest rate that the company pays on its existing borrowings.  Traditionally, the COE is derived from modern portfolio theory (MPT) and is essentially the risk free rate plus a company specific equity risk premium.  The risk free rate is considered to be the local government bond… let’s stop there.  As you can see the controversy has already begun.   Another key tenet of MPT is ‘beta’ which, when multiplied by market risk, is supposed to estimate company specific risk.  In fact, beta is a measure of historic share price volatility and has been widely criticised as inappropriate.

The build-up method is an alternative for estimating COE and is often used for small caps and privately held companies to whom presumably modern portfolio theory does not apply.   Here, components of systematic risk (market, size) and specific risk (industry sector, balance sheet, liquidity, control) are added to the risk free rate to build up the COE.  Share price volatility is not used as a proxy for risk in this method which is a major advantage.   

A key issue is that these methods rely on empirical data or the ‘rear view mirror’ to estimate future risk.  Each component is derived from an historical data series.  Even if very long-term series are used, backward looking fallacies can occur.   I really like the following quote from Taleb’s Fooled by Randomness (pp. 55-56): “Things are always obvious after the fact… It has to do with the way that our mind handles historical information. When you look at the past, the past will always be deterministic, since only one single observation took place.”

‘Real world’ cost of capital calculations are gaining credibility and can be readily applied to privately held companies.  Here the cost of debt is the actual coupon rate the company would pay if it raised debt today from an external source such as a bank.  Cost of equity is trickier but can be estimated by surveying the required returns of venture capital companies or derived from the expected selling price if the company was placed today on the open market.  Although this approach is more pragmatic, the results it produces will always be driven by the availability or scarcity of finance capital at any point in time.  

Further Reading

http://www.ericnath.com/articles/TheBigMyth.pdf

http://bschool.pepperdine.edu/privatecapital

The Small Cap 'Liquidity Trap'

Executives of small cap companies increasingly complain to me that their shares are illiquid and performing poorly as a result.  Is this association really valid?

First of all, one must not confuse liquidity with access to capital.  The large pension funds that dominate UK plc. still allocate a good proportion of their funds to small caps.  Institutional small cap OEICs offered by the likes of Standard Life and Henderson remain extremely popular with retail investors.  Private client demand for small caps appears to be growing if anything.  Consider the commercial success of small cap/private client interface advisors such as Edison and Broker Profile. 

Capital markets generally work in the UK.  Like the hapless dwarves in the BBC comedy Life’s Too Short, many small-caps are not being ignored simply because of their size.  Management must understand that professional investors are sophisticated and need to be convinced of future capital and income growth before buying into a company.  This is especially true for sub FTSE 250 and AIM listed stocks since index funds are less prevalent in these areas of the market. 

Management have a duty to maximise value for their shareholders and their methods should be readily communicated to the market.  Over the long-term, capital should be allocated efficiently and economic moats of competitive advantage established.  It’s amazing how well a share price responds to credible shareholder value initiatives, no matter the market cap.  Share price performance and liquidity both improve as investment risk falls.

Short-term, management of small cap companies may also look outside the company in their efforts to realise value.  If the company has in fact been neglected by the stock-market (as is so often claimed) then there exist a plethora of venture capital trusts/ private equity funds/industrial buyers etc. to take advantage of the situation. Management should be open to considering all external approaches.

Poor liquidity may be a symptom of a company that is being ignored but it does not cause poor share price performance.  If there is value in a company’s shares then it will be ‘outed’, either through management action or by an external predator.

Cash Flow - some wise words!

The global financial debacle that continues to fester appears to have taught us at least one thing: it makes little sense to place all your money in speculative investments. Where should one therefore invest? What should be the focus? Well, let's get back to basics shall we? Let's focus on simple cash flow investments.

Let's use the 2008 US economic crisis as an example. The ramifications were felt worldwide and to this day, many economies are yet to bob their head above water; let alone find the ability to float above in order to begin the long road to recovery. One of the primary roots of this crisis was the US property market which was a bubble waiting to burst; and burst it did.

So for those looking to safely invest their money to safeguard against high inflation rates, taxes and potential market pitfalls, cash flow investments like the stock market appear to make far greater sense. Most blue chip investments yield a fixed rate of income via its dividends - this is assured income. Additionally, most market upheavals tend to have far less an impact in comparison to a large speculative investment where money can be lost in rate rises etc.

It may also be wise to look beyond your own economy for cash flow investment income. An economy like Australia for example seems to have dealt with the economic crisis well and has potential in various sectors for growth. What more than a stable economy that shows clear signs of growth?

While an element of attention must always be placed on speculative investments, emphasis on building your foundation should ultimately lie with cash flow investments. Although the rate of return on investment may not be astronomical, the return may in actual fact become assured and this is a great way to safely build your net worth. As you become more confident with your investments and begin to learn more about the trends of the market though, you can certainly start to have more control by blending your simple cash flow investments with other speculative investments. The overall element of risk can essentially be determined by you!

So, simple investments equal simple returns. Simple, yet assured returns. Sounds simple doesn't it? Perhaps that's the problem we face today. Not enough simplicity is applied to our increasing demands for sustainability and comfort. We seem to have complicated our lives to the extent that economies worldwide are now at breaking point. If we stick to the basics though and focus on a simple cash flow, we will enjoy our investments and enjoy the success of investing!

Looking for more information on how to enjoy investing and how to enjoy making money now?
http://www.enjoymoneynow.com

Article Source: http://EzineArticles.com/?expert=Kingsley_Coomarawel

Article Source: http://EzineArticles.com/6231009

Message to CEOs - It's time to take up DIY

Quoted companies rely heavily on research produced by stock-brokers to persuade investors to buy their shares.  This is rather erroneous.

Stock-broker or ‘sell-side’ research does have its merits.  It can be a useful source of information and data for the market to absorb and process.  Sell-side analysts have privileged access to company management and arrange regular meetings for their fund manager clients (the ‘buy-side’).

However, broker research falls short in one critical area.  It rarely persuades fund managers to invest.

A 2008 study by State Street Global Markets showed there to be zero correlation between analyst recommendation changes and institutional investment flows in 9 of the 11 MSCI Europe sectors.  It concludes that buy-side investors disagree with sell-side upgrades or downgrades to such an extent that they are more inclined to act against the advice than with it.   

There are several reasons for this.  Statistically, sell-side analysts have a poor record in predicting future earnings.  This makes investors wary of the forecasting models that are so keenly built.  Also the use of somewhat arbitrary valuation models to justify share price targets tends to be a bit of a turn off. 

Probably the most powerful explanation, however, is that sell-side and buy-side are simply misaligned.  Stock-brokers are hugely incentivised to grow their commission income by encouraging fund managers to trade regularly.  Fund managers, on the other hand, are incentivised to beat the market after costs - a key component of costs being of course trading.  The conflict of interest is obvious.

Further, investment banks typically use income from corporate clients and other areas to subsidise their research overheads.  The sell-side analyst is unable to serve two masters and naturally defaults to keeping the internal customer happy.

Research supplied to investors by independent houses such as Edison does in part mitigate the problem. However there is no substitute for direct marketing – the DIY solution.  Meeting investors face to face is the most powerful marketing tool that company executives possess.

Listed companies, especially the smaller ones, must revert to Shanks’ pony if they are serious about growing their institutional shareholder base. 

This is nothing new of course.  Many fund managers have corporate access as central to their investment process, and most companies have in place a systematic programme of institutional investor meetings.  In fact the FSA goes so far as to classify the investor road-show as a ‘financial promotion’ (presumably of the company’s own shares).  

Why then do so many of these meetings end in frustration – for both parties?

The answer lies in the approach of management and the type of information they provide.     

For instance, any professional investor worth his salt can spot a bluffer at a hundred paces.  Failure to demonstrate integrity and candour is a one way ticket to the spin graveyard!  Fund manager respect goes hand in hand with a stable, supportive institutional shareholder base and must never be compromised.

Most companies do not identify clearly enough the information that is required by professional investors.

Management must learn to concentrate less on short term issues, such as the latest earnings release, and more on how they allocate capital for the long term benefit of the shareholder.  What levels of return are expected from current projects and what are the risks to those returns? Where in the profits cycle is the business and when is the optimum time for the company to invest in new projects?  Is it better to invest capital in the business or return capital to allow the shareholder to seek higher returns elsewhere? 

Management rarely spend enough time explaining their company’s financial position. Peter Lynch, famed manager of the Fidelity Magellan mutual fund, once advised ‘Never invest in a company without understanding its finances.  The biggest losses in stocks come from companies with poor balance sheets’.  The same can be said for companies that consistently fail to convert profits into cash-flow.  Management must do more to convince investors that their balance sheet and cash generation are both in order.  If the company has an inferior financial position, then management should detail a realistic timetable for improvement.    

Information is the lifeblood of the fund management industry.  Good information supplied by management can go a long way to building a high quality, supportive shareholder base.  Bad information can be fatal!

Trading Statements - The Do's and Don'ts

At this time of year there is a gentle frenzy in the plc. community.  Pre-close trading statements are released and preliminary annual result statements are being prepared in earnest.  

How much value is actually added by pre-close trading statements?   Twelve months ago, pub retailer Enterprise Inns stopped issuing them, claiming the market had become “too data hungry”.  Expeditors, a US logistics company, have long deemed them totally unnecessary.  The move by these two companies and others to abandon the ritual is easy to understand.

Trading statements can in practice be a complete waste of time, let’s face it.  They range from the sublime to the farcical at times.

Some companies prefer to populate their one pager with a litany of excuses rather than inform their audience of the real economic drivers of revenues and profits.  Top of the excuse list has to be… the weather!  Apparently a few inches of snow not only causes commuter trains to stop running, but also impacts footfall at house building sites (wellies anyone?) and poor sales of CDs at HMV (online competition and downloads?). 

Next on the list is the general state of the world economy.  Anything but runaway growth across the western world inspires struggling companies to claim that demand is sluggish/flat due to ‘general economic conditions’.  This of course is baloney and usually a euphemism for more sinister micro-economic factors at play such as obsolete products, low cost competition, and market share erosion.    

Another classic is explaining away weak results on one less trading day compared to the previous year.  This is often due to the scheduling of public holidays - how inconsiderate of the Roman Emperor Constantine to make Easter such a moveable feast! 

One has to ask - what sort of investors do trading statements target?  Any investor, or more accurately speculator, who has a panic attack when earnings 'miss the street' does not tend to last too long and rarely controls large pools of money.  Let’s be clear about this – minor, random events that are beyond management’s control have zero impact on the long term development of a share price.  Of infinitely greater importance are high or improving financial quality, sustainable franchises, and the efficient allocation of shareholder funds.  These criteria are the core of intelligent equity investment and the foundations for management to build a long term, supportive investor base. 

CEOs worried about communicating to short term investors would be wise to pay heed to Clint Eastwood.  ‘If you want a guarantee buy a toaster’.