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Zomato, an Indian online food-delivery company, was opened up to public market investors on July 14, 2021, Ìýand its market debut is being watched for clues by a number of other online ventures in India, waiting in the wings to go public. The primary attraction of the company, to investors, comes not from its current standing (modest revenues and big losses), but from its positioning to take advantage of the potential growth in the Indian food delivery market. In this post, I will value Zomato, and rather than just make a value judgment (which I will), I will also tie the value per share to macro expectations about the overall market. In short, I will argue that a bet on Zomato is as much a bet on the company’s business model, as it is a bet on Indian consumers not only acquiring more buying power and digital access, but also changing their eating behavior.

Setting the Stage

As a lead in to valuing Zomato, it makes sense to look not just at the company’s history, but also at its business model. In addition, since so much of the excitement about the stock comes from the potential for growth in the Indian food delivery market, I set the stage for that analysis by comparing the Indian market to food delivery markets in other parts of the world, as a prelude to forecasting its future path.

History and Business Model

Zomato was founded in 2008 by Deepinder Goyal and Pankaj Chaddah, as Foodiebay, in response to the difficulties that they noticed that their office mates were having in downloading menus for restaurants. Their initial response was a simple one, where they uploaded soft copies of menus of local restaurants, in Delhi, on to their website, initially for people in their office, and then to everyone in the city. As the popularity grew, they expanded their service to other large Indian cities, and in 2010, they renamed the company "Zomato", with the tagline of "never have a bad meal". The business model for the company is built upon intermediation, where customers can connect to restaurants on the platform, and order food, for pick up or delivery, and advertising. Along the way, the company has transitioned from an almost entirely an advertising company to one that has become increasingly focused on food delivery, and in 2021, the company derived its revenues primarily from four sources:

Transaction Fees: The bulk of Zomato's revenues come from the transactions on its platform, from food ordering and delivery, as the company keeps a percentage of the total order value for itself. While Zomato's revenue slice varies across restaurants, decreasing with restaurant profile and reach, it remains about 20-25% of gross order value. It is worth noting that Swiggy, Zomato's primary competitor in India, also takes a similar percentage of order revenues, but Amazon Food, a new entrant into the market, aims to take a smaller portion (around 10%) of restaurant revenues.Advertising: Restaurants that list on Zomato have to pay a fixed fee to get listed, but they can Ìýalso spend more on advertising, based upon customer visits and resetting revenues, to get additional visibility.ÌýSubscriptions to Zomato Gold (Pro): Zomato also offers a subscription service, and subscribers to Zomato Gold () get discounts on food and faster deliveries. The service was initiated in 2017 and it had 1.5 million plus members in 2021, delivering subscription revenues of 600 million rupees (a little less than $ 10 million, and less than 5% of overall revenues) in 2021.Restaurant Raw Material: In 2018, Zomato introduced HyperPure, a service directed at restaurants, offering groceries and meats that are source-checked for quality. While direct measures of revenues from HyperPure are difficult to come by, the revenues that the company shows under traded goods (which include HyperPure revenues) suggests that it accounts for about 10% of the total revenues.In conjunction with the other services it offers to restaurants, including consulting and data, itÌýsuggests that while food delivery and advertising areÌýthe company's primary revenue generatorsÌýtoday, it has ambitions extending into the broader food business.ÌýZomato has grown at exponential rates for much of the last decade, with a surge in the number of cities that it serves in India, especially in the last few years, from 38 in 2017 to 63 in 2018 to more than 500 in 2021, extending its reach into smaller urban settings.

Revenues did drop in 2020, as COVID restrictions put a crimp on the restaurant business, but the quarterly data suggests that business is coming back. ÌýAlong the way, the company has expanded its business outside India, with the United Arab Emirates being its biggest foreign market. That revenue growth has been driven partly by acquisitions that the company has made along the way:

Source: Crunchbase

To fund these acquisitions and other internal growth investments, the company has been reliant on venture capitalists, who have supplied it with capital in multiple rounds since 2011:

Source: Crunchbase

These capital infusions created a diverse ownership structure at the company, even prior to its going public:Ìý

The share of the equity owned but the original founders of the company has dropped dramatically over time, as the company has had to raise capital to fund its ambitious growth agenda, and Deepinder Goyal owns only 5.55% of the company's shares, prior to the IPO. Uber's ownership in Zomato is a result of Zomato's acquisition of Uber Eats India, where Uber received a share of Zomato's equity in exchange. As revenues have grown, the business model for the company has been slower to evolve, as the company has reported extensive losses along the way, as you will see in the next section. Ìý

The Market

Zomato's business model is neither innovative, nor groundbreaking, resembling other online food delivery companies in other parts of the world, like DoorDash, which had its initial public offering in 2020. The allure to investors comes from Zomato's core market in India, and the potential for growth in that market. To get a measure of this potential, I start by comparing the size of food delivery markets in India to the food delivery markets in China, the United States and the EU.Ìý

and Other Sources for EU data

The Indian food delivery market is small, relative to markets elsewhere in the world, and especially compared to China, Ìýthe only other market of equivalent size in terms of population. There are three reasons for the smaller food delivery market in India, and they are highlighted in the table above:

Lower per-capita income: Eating out and prosperity don't always go hand in hand, but you are more likely to eat out, as your discretionary income rises. Thus, it should come as no surprise that the number of restaurants increases with per capita GDP, and that one reason for the paucity of restaurants(and food delivery) in India is its low GDP, less than a fifth of per capital GDP in China and a fraction of per capital GDP in the US & EU.Less digital reach: To use online restaurant services, you first need to be online, and digital reach in India, in spite of advances in recent years, lags digital reach in China, and is about half the reach in the US and the EU.Eating habits: Looking across the regions, it seems clear that there is a third factor at play, a pre-disposition on the part of the populace, to eat out. Looking at the number of restaurants in China and the size of its food delivery market, it is quite clear that Chinese consumers are far more willing to eat out (either in person at or with delivery from restaurants) than people living in the US and EU, especially if you control for per capita income differences.ÌýThe Zomato story, or at least the upbeat version of it, is that the Indian food delivery/restaurant market will grow, as Indians become more prosperous and have increased online access. A simplistic way to illustrate the difference is to adjust the size of the market for per-capita income and digital reach, and I attempt to do that, relative to the Chinese market, in the table below:
Put simply, even if Indians had the same per-capita income and digital reach as Chinese consumers, the food delivery market in India would be far smaller than the Chinese market, perhaps because eating out is not as much as entrenched in Indian eating behavior. You can find multiple flaws with these comparisons, but the core fundamentals that will determine the size of the Indian food delivery market are clear. The size of the market in future years will be determined by how robustly the Indian economy will grow in the next few years, how quickly digitization continues its advance in the country and if and whether Indians become more open to eating out than they have historically.

Zomato: Story and Valuation

With the lead in on Zomato's history and business model, I can start constructing a story and valuation for the company, with the recognition that the biggest part of the story is in its macro elements. It stands to reason that disagreements about the story will be largely on those macro components, rather than in the company-specific components.

The Prospectus

To get the assessment of the company started, I began by looking at Zomato's prospectus and all of the concerns I noted about excessive and distracting disclosure that I laid out in on the topic, came rushing back to me. The Zomato IPO clocksÌý, much of it designed to bore readers into submission. Let's start with the useless or close to useless parts:

Definitions and abbreviations: The prospectus starts, and I wonder whether this is by design, with 17 pages of abbreviations of terms, some of which are obvious and need no definition (board of directors, shareholders), some of which are meaningless even when expanded (19 classes of preferred shares, all of which will be replaced with common shares after the IPO) and some of which are just corporate names.Risk Profile: If you did not believe my assertions about the pointlessness of risk sections in IPOs, please do read all 30 pages of Zomato's risk profile (pages 39-68 of the prospectus). The company lists 69 different risks investors may face from investing in the company, and after you have read them all, I dare you to list three on that list that you would remember. The risk profile starts with a statement that the company has a history of net losses and anticipates increased expenses in the future and goes on to add invaluable nuggets such as the "COVID-19 pandemic, or a similar public health hazard, has had an impact on the our business".ÌýSubsidiary/Holdings Mess: I find it mind boggling that a company that is only thirteen years old has managed to accumulate as many subsidiaries, both in India and overseas, as Zomato has done. Since Zomato owns 100% of most of these subsidiaries, there may be legal or tax reasons for this structure, but there is no denying that it adds complexity (and pages) to the prospectus, with no real information benefits.ÌýIf you do make your way through this mush, there is useful information in the prospectus about the company's economics:Growth & Profitability trends: The company provides three years of financial statements in the prospectus (2018-19, 2019-20 and 2020-21) and you can get a sense of the company's growth and profitability trends by looking at the annual numbers:
Since the numbers for 2020 are distorted by the COVID shutdown, the company provides quarterly numbers for the most recent quarters to argue that the growth reversal in 2020 will be quickly put in the rearview mirror:Ìý, with 2020 Q1 & Q2 numbers estimatedNote the sharp and predictable drops in gross orders in the first two quarters of the 2021 fiscal year, but also the increase in gross orders in the last quarter of FY 2021 (the first quarter of the 2021 calendar year), as the shut downs ease up.Unit Economics: The company does provide a sprinkling of unit economics to suggest that the underlying business is moving towards profitability. The lead in their argument is the contribution margin, i.e., the slice of the a typical order that is left as profits, after covering the costs of catering to that order:Zomato Prospectus
While the graph shows improvement, it is worth noting that the improvement is based upon a single year's (2021) numbers. There are, however, other facts about the unit economics that lend to optimism on the story. In particular, there is some evidence in the cohort table, where Zomato customers are broken down by how long they have been using the platform, that usage increases for more long-standing customers: The users who joined the Zomato platform in 2017 were not only ordering three times more than they were initially by the time they had been on the platform four years, but were also more likely to continue ordering at those levels in the 2021 fiscal year, when COVID put a dent in the Indian food delivery business. This is good news, but to make full sense of it, it would have been informative to see what percent of each year's users stayed active on the platform in subsequent years, but I could not find that statistic in the prospectus.Competitive Advantages: The competitive advantage section could have been cut and pasted from a dozen Silicon Valley companies in the last decade, with the networking benefit captured in a loop, where the more a platform gets used, the more benefits it provides to those on it, thus creating more usage: and Uber Prospectus
Note the similarities between the picture to the left, from the Zomato prospectus, and the picture to the right is from the Uber prospectus, from 2019. That said, there is an element of truth in these pictures about how growth can lead to more growth, but neither picture addresses the fundamental business question of how to monetize this growth, since neither ride sharing nor food delivery has figured out how to be profitable.ÌýProceeds: The company's plans for what it intends to do with the proceeds are mixed. A portion of the initial offering will represent the cashing out of Info Edge, one of the first venture capital providers to Zomato, and that has no direct effect on the valuation. Another portion, amounting to approximately 9 billion INR will remain in the firm, to cover future cash needs.ÌýIt would be churlish on my part to take issue with the bloat and selective disclosure in Zomato's prospectus, since they are following the script that other technology companies around the world have written for going public, but it is frustrating to read through 420 pages, and still be left in the dark on key numbers.

The Story & Valuation

Ìý Ìý The story that I will tell for Zomato has several moving parts to it, but it can be broken down into the following components:

Total Market: This is the assumption that will make or break Zomato as a company, since so much of the potential in the company is dependent on how the food delivery/restaurant market in India evolves over the next decade. As I noted in an earlier section, even allowing for robust growth in India and improved digital access, I find it hard to see the total market exceeding $40 billion, with US $25 billion, in ten years, being a more likely outcome. (In rupee terms, this will translate into a market that is roughly 1800-2000 billion INR.)Market Share: The Indian food delivery market is dominated by two big players, Zomato and Swiggy, with a third player, Amazon Foods, that is unlikely to fade away. In my story, I will assume that the market will continue to be dominated by two or three large players, albeit with lots of localized and niche competitors who will continue to command a significant slice of the market. Expecting any company to have a market share that exceeds 40% of this market is a reach, and I will assume that Zomato will be one of the winners/survivors. In making this judgment, it is worth noting that the online food delivery markets in other parts of the world (US, China) seem to be also approaching a steady state of a few large players.Revenue Share: While the market share and total market yield the gross order value for Zomato, the company posts only its share of these orders, as revenues. That number was 23.13% in FY 2020, but dropped to 21.03% in FY 2021, as shut downs put a crimp on business. I will assume a partial bounce back to 22% of GOV, starting in 2022, but the presence of Amazon Food will prevent a return to higher values in the future.Profitability: The profitability of intermediary businesses (ride sharing, apartment renting, food delivery) that use platforms to connect users to service or product providers is still being worked out, but the contours of how this will play out are visible. The biggest expenses at these companies are often on customer acquisition and marketing, and as growth scales down, these expenses should decrease, as a percent of revenues, delivering a profitability bonus. The biggest challenge that these businesses face are in the absence of stickiness and exclusivity, since users can have multiple food delivery apps on their devices and pick the cheapest one, and in balancing the competing needs of users and service/product providers with very different needs. For a food delivery service, restaurants and customers are integral to the business, and providing a better deal for one may come at the expense of the other. Online food delivery businesses around the world, and Zomato is no exception, are facing backlash from restaurants and delivery personnel, who believe that they are getting the short end of the stick, as the company seeks to offer lower prices and better delivery deals from customers. I will assume that pre-tax operating margins will trend towards 30%, largely because I believe that the market will be dominated by a few big players, but with the very real possibility that one rogue player that is unwilling to play the game can upend profitability. The scariest part of the food delivery market for Zomato is the identity of its new entrant (Amazon Food), since Amazon is the most fearsome competitor on the planet, willing to out-wait any company, if its intent is to capture a market.ÌýReinvestment: One of the advantages of being an intermediary business is that you can grow with relatively little capital investment, defined in conventional form (as plant, equipment or manufacturing facilities). That said, reinvestment takes a different form for companies like Zomato, with investments in technology and in acquisitions, driving future growth. I highlighted the acquisitions that Zomato has made over its lifetime, with UberEats India as its most recent and most expensive illustration, but also noted that the company has burned through billions in cash to get to where it is today. I will assume that this need will continue in the near future, with a lightening up in later years, as growth declines.Risk: In terms of operating risk, the company, in spite of its global ambitions, is still primarily an Indian company, dependent on Indian macroeconomic growth to succeed, and my rupee cost of capital will incorporate the country risk.ÌýZomato is a money losing company, but it is not a start-up, facing imminent failure. On the plus side, its size and access to capital, as well as its post-IPO augmented cash balance, push down the risk of failure. On the minus side, this is a company that is still burning through cash and will need access to capital in future years to continue to survive. Overall, I will attach a likelihood of failure of 10%, reflecting this balance. Ìý

With the story in place, and the inputs that come out of it, the valuation, in a sense, does itself, and you Ìýcan see the summary of the numbers below:

With my upbeat story of growth and profitability, the value that I derive for equity is close to 394 billion INR (about $5.25 billion), translating into a value per share of 41 INR. That may seem like a lot to pay for a money-losing company with less than 20 billion INR in revenues in the most recent year, but promise and potential have value, especially when you have a leader in a market of immense size. That said, the stock's pricing (72-75 INR, per share) makes it too expensive, notwithstanding my story.

Facing up to Uncertainty

If you who are wondering whether the assumptions that underlie my Zomato valuation could be wrong, let me set your mind at rest by assuring you that they most certainly are, and it does not bother me in the least. The reason that they are wrong is simple. I do not control the future, and no matter how many tools and current information I bring to the process, there will be surprises down the road. The reason it does not bother me is because, as I have said many times before, you don't have to be right to make money, just less wrong than everyone else. I do think there is a benefit to being open about uncertainty and facing up to it, rather than viewing it as something to be avoided or acting as if it is not there. I will use one of my favorite tools, a Monte Carlo simulation, and quantify the uncertainty I foresee in three of my most critical assumptions.

Total Market Size: A major driver of Zomato's value is the expected evolution of the Indian food delivery market. While I projected the market to increase to about $25 billion in my base case, that is based upon assumptions about economic growth and digital reach in India that could be wrong. In the simulation, I allow for a market size of between $10 billion (about 750-800 billion rupees) to $40 billion (3000-3200 billion INR).Market Share: In the base case, I assume that Zomato's share of the market will stabilize around 40% by year 5, premised on the belief that this will be a market with two or three big players, a a multitude of niche businesses. Given the regional diversity of the Indian market, it is possible that there may be more players in the market, in steady state, resulting in a Ìýlower market share (as low as 20%) or that the niche players will get pushed out, because of economies of scale, yielding a higher market share (up to 50%).Operating Margin: The operating margin of 30% that I predicted in my base case for Zomato is built on the presumption that the status quo will prevail, and that the delivery companies will be able to continue to see economies of scale, while holding their slice of the order value stable. If one of the players decides to aggressively go for higher market share (by offering discounts or bidding more for delivery personnel), operating margins will tend lower (15% is my low end). If, on the other hand, Zomato is able to keep its advertising business intact as it moves forward, it could delivery higher margin (45% is my upper end).Notice that there are two assumptions that analysts often lose sleep over that I am ignoring. The first is the reinvestment each year, that I estimate using a sales to capital ratio that varies across time. It affects my cash flows, but its effect on value is dwarfed by changes in assumptions about market size and share. The second is the cost of capital, a number that most valuation classes and books (including mine) belabor to the point of diminishing returns. Raising or lowering the cost of capital has an effect on value, but changing my assumptions about risk premiums, betas or debt ratios has a much smaller effect that changing assumptions that alter cash flows. The results of the simulations that I ran with distributions replacing point estimates for market size, share and operating margin are shown below:


Put simply, I think it is hubris to dismiss those who invested in Zomato at 72 INR per share or higher, as speculators or ill-informed, since there are plausible stories that get you to values higher than 100 INR per share. That said, given my story and valuation for the company, I think that at a Ìý70-75 INR per share price, the stock looks over valued to me.

Add ons and Distractions

The most dangerous moments, when valuing a company, are after you think you are done, as those who disagree with your valuation (on either side) come up with reasons for adding premiums for positives about the company that you may have missed, if they want a higher value, or discounts for negatives about the company that you should have incorporated, if they want a lower value. In this section, I will start with the argument that a platform with millions of users offers optionality, a reasonable basis for a premium, but one where it can be difficult to attach a number to the value. Second, I will consider whether the fact that India is a big market makes Zomato deserving of a premium, and make a case that it is not. Third, I will confront the oft used contention that value is in the eye of the beholder, i.e., that Zomato is worth a lot because other investors believe it to be worth a lot, and examine a pricing rationale for Zomato. Finally, dismissing Zomato as an investment, Ìýjust because it does not make money now, or fails to meet some conventional value tests on pricing (PE, Price to Book), is investing malpractice.

1. Platform Optionality

Ìý Ìý As a company with millions of users on its platform, there is an added layer to value for Zomato or any other platform-based company, thatÌýgoes beyond the intrinsic valuation above. In effect, if Zomato can deliver other products and services to the users ofÌýtheÌýplatform, it can augment its earnings and value. This is the "optionality" that some investors highlight in companies with large user bases (Amazon Prime, Uber, Netflix), but while I see the basis for the argument, I would offer some caveats.

First, not all platforms are created equal, in terms of being adding value, with platforms with more intense users and proprietary data having more value than platforms where users are transitory and there is little exclusive data being collected. One reason that I bought Facebook shares in 2018, after the Cambridge Analytica scandal, was my belief that its platform has immense value because of its reach (more than 2 billion users in its ecosystem), their engagement (Facebook users stay in the ecosystem for long periods) and the data that Facebook collects, through their engagement (posts, comments etc.).ÌýSecond, even if you believe that there is optionality, attach a numerical value to that option is one of the most difficult tasks in investment. While there are option pricing models that can be adapted to do the valuation, getting the inputs for these models, especially before the optionality takes form, is difficult to do. With Facebook, in 2018, I arrived at an intrinsic value that was only modestly higher than the price (<10%), but used the optionality as the argument for pulling the buy trigger.Zomato's platform has the benefit of large numbers, but it falls short on both intensity and proprietary data. Thus, Zomato app users are on the system only when they order food, and the engagement is often restricted to food ordering and delivery. If Zomato plans to expand its offerings to its platform-users, it is very likely that these add-on businesses will be food-related, perhaps extending into grocery shopping, creating some option value.

2. A Big Market Premium?

Indian and Chinese companies, especially in young and nascent businesses, have an advantage that they often play to, which is immense local markets. It is not surprising that companies play up this advantage, when marketing themselves to investors, with some analysts attaching premiums to value, just because of market size. I believe that this is a distraction, because that market size should already by incorporated into the intrinsic value, through growth and margin expectations. In my base case valuation of Zomato, I assume that revenues will increase more than twenty-fold over the next 10 years, because the Indian market is expected to grow so strongly. ÌýIn fact, the danger to investors, when faced with Indian and Chinese companies, is not that they will under value these companies, but that they will over value them, precisely because the markets are so big. In and , I describe this as the big market delusion, where investors do not factor in the competition that will come from existing and new players, drawn into the business by the size of the market, and the resulting drop in profitability.

3. A Pricing Rationale

When you value young companies with promise, the most common push back that you will get is that value is whatever people perceive it to be, and young companies can therefore have any value that investors will sustain. This is a distortion of the word value, but it is true that young companies are more likely to be priced than valued, and the pricing will be based upon a simple pricing metric (anything from PE to EV/Sales) and what investors perceive to be the peer group. With Zomato, for instance, there are two ways in which investors may attach a pricing to the company.Ìý

VC Pricing: The first is to look at venture capitalists priced the company at, in their most recent funding rounds, and extrapolating from that number. In its February 2021 VC round, Zomato was priced at close to 400 billion INR ($5.4 billion) by a group of venture capitalists (including Fidelity and Tiger Global), who invested almost 50 billion INR (about $660 million) in the company.ÌýComparable companies: The only direct comparable that Zomato has in India is Swiggy, which is still privately funded, At the risk of stretching the definition of "comparable firm", I compare Zomato's pricing (using the projected 72-75 INR share price on the IPO) to the pricing of Doordash, which went public in 2020:

One of the perils of pricing is that you can find almost always find a way to back up your preconceptions, if you try hard enough. Thus, if you are a Zomato bull, you could point to the EV/User and argue that it is cheap, relative to Doordash, whereas if you are a bear, you can point to Current revenue and GOV multiples, to make the case that Doordash is cheaper. To make the argument even messier, using forward multiples, where you scale the current enterprise value to expected revenues or earnings in 2031, make the Zomato case stronger, since it has higher expected growth than Doordash does.

The bottom line is that pricing is not a panacea for uncertainty or a cure for bias, since the uncertainty is just pushed into the background and there is plenty of room for biases to play out, in how you standardize price (which multiple you use) and and what your comparable are.Ìý

4. It is a money loser

There are good arguments to be made against investing in Zomato at is proposed offering price, but one of the emptiest, and laziest, is that it is losing money right now. I know that for some value investors, trained to believe that anything that trades at more than 10 or 15 times earnings or at well above book value, this argument suffices, but given how badly this has served them over the last two decades, they should revisit the argument. ÌýThe biggest reason that Zomato is losing money is because it is a young company that is trying to take advantage of a market with immense growth potential, not because it cannot make money. In fact, if Zomato cut back on customer acquisitions and platform investments, my guess is that it could show an accounting profit, but if it did so, it would be worth a fraction of what it is today.Ìý

Conclusion

In investing and valuation, there is the presumption that rules and even the first principles of investing change as you go from one market to another, and this is particularly true when comparisons are made between developed and emerging markets. I believe that the first principles of valuation are the same in all markets, and I hope that I have stayed true to that belief in this post. I valued Zomato, using the same process that I used to value Doordash, with the country-specific effects being incorporated into my growth and risk projections. While I did take issue with some of the holes and over reach in Zomato's disclosures, I ran into the same challenges, when I valued Doordash. ÌýZomato is a money-losing, cash burning enterprise now, but it has immense market potential and is on track to delivering on a viable business model. It will face plenty of challenges on that path, both at the micro level (management, competition) and at the macro level (economic and political developments in India). ÌýI believe that the company is currently over priced, given its potential, but I would have no qualms about investing in the stock, if the price drops in the near future, with the full understanding that this is a joint wager on a company, a sector and a country.

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Data & Spreadsheets

Posts/PapersThe Big Market Delusion ( and )

In the last few decades, as disclosure requirements for publicly traded firms have increased, annual reports and regulatory filings have become heftier. Some of this surge can be attributed to companies becoming more complex and geographically diversified, but much of it can be traced to increased disclosure requirements from accounting rule writers and market regulators. Driven by the belief that more disclosure is always better for investors, each market meltdown and corporate scandal has given rise to new reporting additions. In this post, I look at trends in corporate reporting and filings over time, and why well-meaning attempts to help investors have had the perverse effect of leaving them more confused and lost than ever before.

Time Trends in Reporting

Ìý ÌýPublicly traded firms have always had to report their results to their shareholders, but over time, the requirements on what they need to report, and how accessible those reports are to the public (including non-shareholders) has shifted. Until the early 1900s, reporting by public companies was meager, varied widely across firms, andÌýdepended largely on the whims of managers, with smaller, closely held firms among the most secretive. Between 1897 and 1905, for instance, Westinghouse Electric & Manufacturing neither published an annual report, not held a shareholder meeting. In the years before the First World War, theÌýdemands for more disclosure came from critics of big business, concerned about their market power, but few companies responded. It took theÌýGreat Depression forÌýthe New York Stock Exchange toÌýwake up to the need for improved and standardized disclosureÌýrequirements, and for the government to create a regulatory body, the Securities and Exchange Commission (SEC). The SEC was created by the Securities Act of 1933, which was characterized as "an act to provide full and fair disclosure of theÌýcharacter of the securities sold in interstate and foreign commerce", and augmented by the Securities Exchange Act of 1934, covering secondary trading of securities. Almost in parallel, accounting as a profession found its footing and worked on creating rules that would apply to reporting, at least at publicly traded companies, with GAAP (GenerallyÌýAccepted Accounting Principles) making its appearance in 1933. In the years since, disclosure requirements have changed and expanded, with companies in foreign markets creating their own rules in IFRS (International Financial Reporting Standards), with many commonalities and a few differences from GAAP. To get a measure of how disclosures have changed over time, I will focus on two filings that companies have been required to make with the SEC for decades. The first is the 10-K, an annual filing that all publicly traded companies have to make, in the United States. The second is the S-1, a prospectus that private companies planning to go public have to file, as a prelude to offering shares to public market investors.

The 10-K (Annual Filing)

ÌýÌý ÌýThe Securities Exchange Act of 1934 initiated the rule that companies of a certain size and number of shareholders have to file company information with the SEC both annually and quarterly. The threshold levels of company size and shareholder count have changed over time (it currently stands at $10 million in Ìýassets and 2000 shareholders), as have the information requirements for the filing. In the early years, the SEC summarized the company filings in reports to Congress, but the general public and investors had little access to the filings, relying instead on annual reports from the companies, for their information. It was the SEC's institution of an electronic filing system (EDGAR) in 1994 that has made both annual (10-K) and quarterly (10-Q) filings easily and more freely accessible to investors, leveling the playing field.

ÌýÌý ÌýI valued my first company in 1981, using an annual report as the basis for financial data, but my usage of 10-Ks did not begin until the 1990s. I have always struggled with both the language and the length of these filings, but I must confess that these struggles have become worse over time. Put simply, there is less and less that I find useful in a 10-K filing, and more verbiage that seems more intended to confuse rather than inform. Let me start with how this filing has evolved at one company, Coca Cola, between 1994 and 2020, using the most simplistic metric that I can think of, i.e., the number of pages in the filing:

This is clearly anecdotal evidence, and may reflect company-specific factors, but there is evidence to indicate that Coca Cola is not alone in bulking up its SEC filings. In a focused almost entirely on how 10-K disclosures have evolved over time, Dyers, Lang and Stice-Lawrence count not just the words in 10-K filings (one advantage of having electronic filings is that this gets easier), but also what they term redundant, boilerplate and sticky words (see descriptions below chart):

Redundant words: Number of words in sentence repeated verbatim in other portions of reportBoilerplate words: Words in sentences with 4-word phrases used in at least 75% of all firms' 10KsSticky words: Words in sentences with 8-word phrase used in prior year's 10KWhile this paper goes only through 2013, a more updated study suggests that the word count has continued to climb in recent years:Both studies referenced to above also point to another troubling trend in the 10-K filings, which is that they have become less readable over time. Lesmy, Muchnik and Mugerman use two popular measures of readability, the Gunning-Fog Index and the Flesch-Kincaid readability test on 10-Ks, and find that not only are 10-Ks much less readable than most texts (they use the Corpus of Contemporary English or COCA Academic texts) and the newspapers (they use the financial and general section of The Daily Telegraph, a UK paper), but that the gap is also getting wider:
To be honest, I think that the authors are being charitable in their assessment of 10-Ks, by linking their reading to higher education. The complexity in the filings does not come from using bigger words or advanced language, but from using a mix of legalese, double-talk and buzzwords to leave readers, no matter how educated they are, in a complete fog. Why have 10-Ks become longer and less readable?ÌýÌýmake a creative attempt to answer this question, by first breaking down the filing information into thirteen topic categories and graphing howÌý
After placing the lion’s share of the blame for bloat on the SEC and rule writers, ÌýDyers et al, also note three topics account not just for much of the verbosity, but also the redundancy, stickiness and lack of readability: risk factors, internal control and fair value/impairment.Ìý
While the risk factor section may provide employment for lawyers, internal control for auditors and fair value/impairment for accountants, I have always found these sections to be, for the most part, useless, as an investor. The risk factors are legalese that state the obvious, the internal controls section (a special thanks to for this add-on) is a self-assessment of management that they are "in control", and the fair value/impairment by accountants happens too late to be helpful to investors; by the time accountants get around to impairing or fairly valuing assets, the rest of the world has moved on.Ìý

The S-1 (Prospectus)

The S-1 is a prospectus filing that companies that plan to go public in the US have to make, and it plays multiple roles, a recording of the company’s financial history, a descriptor of its business models and risks and a planner for its offerings and proceeds. As with the 10-K, the requirements for the prospectus go back to the Securities Exchange Act of 1934, but the disclosure requirements have become more expansive over time. To provide a measure of how much the S-1 has bulked up over time, consider the table below, where I compare the number of pages in the prospectus filings of two high profile companies from each decade, from the 1980s to today:

SEC Filings
Consider two high profile offerings from the 1980s, Apple and Microsoft, and contrast them with the filings from IPOs in more recent years. Apple’s prospectus from 1980 was considered long, running 73 pages, and Microsoft’s prospectus in 1986 was 69 pages long, with the appendices containing the financials. In contrast, Uber’s prospectus in 2019 was 285 pages long, with a separate section of 94 pages for the financial statements and other disclosures, itself an increase on the Facebook prospectus from 2012, which was 150 pages, with 36 pages added on for financial statements and other add-ons.ÌýAlong the way, prospectuses have become more complex and less readable, and there are three forces that have caused these changes.ÌýThe first is that the added verbiage on key inputs has made them more difficult to understand, rather than provide clarity. Consider, for instance, the disclosure requirements for share count, which have not changed substantially since the 1980s, but share structures have become more complex at companies, creating more confusion about shares outstanding. Airbnb, in its final prospectus, before its initial public offering asserted that there would 47.36 million class A and 490.89 million class B shares, after its offering, but then added that this share count excluded not only 30.87 million options on class A shares and 13.79 million options on class B shares, but also 37.51 million restricted stock units, subject to service and vesting requirements. While this is technically "disclosure", note that the key question of why restricted stock units are being ignored in share count is unanswered.The second is that companies have used the SEC's restrictions on making projections to their advantage, to tell big stories about value, while holding back details. For some companies, a key metric that is emphasized is the total addressable market (TAM), a critical number in determining value, but one that can be stretched to mean whatever you want it to, with little accountability built in. In 2019, Uber claimed that its TAM was $5.2 trillion, counting in all car sales and mass transit in that number, and Airbnb contended that its TAM was $3.4 trillion, five times larger than the entire hotel market's revenues in that year.Finally, while most companies, that are on the verge of going public, lose money and burn through cash, they have found creative ways of recomputing or adjusting earnings to make it look like they are making money. Thus, adding back stock-based compensation, capitalizing expenses that are designed to generate growth (like customer acquisition costs) and treating operating expenses as one-time or extraordinary, when they are neither, have become accepted practice.In sum, prospectuses like 10-Ks have become bigger, more complex and less readable over time, and as with 10-Ks, investors find themselves more adrift than ever before, when trying to price initial public offerings.
The Investor Perspective

As companies disclose more and more, investors should be becoming more informed and valuing/pricing companies should be getting easier, right? In my view, the answer is no, and I think that investors are being hurt by the relentless urge to add more disclosures. I am not the first, nor will I be the last one, arguing that the disclosure demon is out of control, but many of the arguments are framed in terms of the disclosure costs exceeding benefits, but these arguments cede the high ground to disclosure advocates, by accepting their premise that more disclosure is always good for investors and markets. On the contrary, I believe that the push for more disclosure is hurting investors and creating perverse consequences, for many reasons:

Information Overload: Is more disclosure always better than less? There are some who believe so, arguing that you always have the option of ignoring the disclosures that you don't want to use, and focusing on the disclosures that you do. Not surprisingly, their views on disclosure tend to be expansive, since as long as someone, somewhere, can find a use for disclosed data, it should be. The research accumulating on information overload suggests that they wrong, and that more data can lead to less rational and reasoned decision for three reasons. First, the human mind is easily distracted and as filings get longer and more rambling, it is easy to lose sight of the mission on hand and get lost on tangents. Second, as disclosures mount up on multiple dimensions, it is worth remembering that not all details matter equally. Put simply, sifting though the details that matter from the many data points that do not becomes more difficult, when you have 250 pages in a 10-K or S-1 filing. Third, behavioral research indicates that as people are inundated with more data, their minds often shut down and they revert back to "mental short cuts", simplistic decision making tools that throw out much or all of the data designed to help them on that decision. Is it any surprise that potential investors in an IPO price it based upon a user count or the size of the total accessible markets, choosing to ignore the tens of pages spent describing the risk profile or business structures of a company?ÌýFeedback loop: As companies are increasingly required to disclose details about corporate governance and environmental practices in their filings, some of them have decided to use this as an excuse for adopting unfair rules and practices, and then disclosing them, operating on the precept that sins, once confessed, are forgiven.. This trend has been particularly true in corporate governance, where we have seen a surge in companies with shares with different voting rights and captive boards, since the advent of rules mandating corporate governance disclosure. For a particularly egregious example of overreach, with full disclosure, take a .Cater to your audience: Company disclose data to multiple groups, to governments to meet regulatory requirements and for taxes, to consumers about the goods and services they they sell, to their bankers about loan obligations due and to shareholders about their overeat financial performance. Rule writers on disclosure sometimes seem to forget that each of these groups need different information, and trying to meet all their needs in one disclosure is a disservice to all of them. ÌýIt is worth remembering that the reason that we have 10-Ks and S-1s at companies is for shareholders, interested in investing in the company, not regulators, consumers, accountants or lawyers. That said, it is also worth remembering that not everyone investing in a Ìýcompany is an investor and that many are traders. Drawing on a contrast that I have used many times before, investors are interested in the value of a stock, which, in turn, is determined by cash flows, growth and risk, and buying stocks that they believe trade at a price less than the value. Traders, on the other hand, have little interested in fundamentals, focusing Ìýinstead on mood and momentum, and how those forces can lead to prices increase.Much of the regulatory disclosure has been focused on what investors need to value companies, albeit often with an accounting bias. However, there are for more traders than investors in the market, and their information needs are often simpler and more basic than investors. Put simply, they want metrics that are uniformly estimated across companies and can be used in pricing, whether it be on revenues or earnings. With young companies, they may even prefer to use user or subscriber counts over any numbers on the financial statements.ÌýMake itÌýaboutÌýthe future, not just the past: While I don't think that anyone would dispute the contention that investing is always about the future, not the past, the regulatory disclosure rules in the US and elsewhere seem to ignore it. In fact, much of regulatory rule making is about forcing companies to reveal what has happened in their past, and while I would not take issue with that, I do take issue with the restrictions that disclosure laws put on forecasting the future. With the prospectus, for instance, I find it odd that companies are tightly constrained on what they can say about their future, but that they can wax eloquently about what has happened in the past. Given that much or all of the value of these companies comes from their future growth, what is the harm in allowing companies to be more explicit about their beliefs for the future? Is it possible that they will exaggerate their strengths and minimize their weaknesses? Of course, but investors know that already and can make their own corrections to these forecasts. More importantly, stopping companies from making these forecasts does not block others (analysts, market experts, sales people), often less scrupulous and less informed than the companies, from making their own forecasts.Mission Confusion: Should disclosures be primarily directed at informing investors or protecting them? While it is easy to argue that you should do both, regulators have to decide which mission takes primacy, and from my perspective, it looks like protection is often given the lead position. Not surprisingly, it follows that disclosures become risk averse and lawyerly, and that companies follow templates that are designed to keep them on the straight and narrow, rather than ones that are more creative and focused on telling their business stories to investors.

Disclosure Fixes

The nature of dysfunctional processes is that they create vested interests that benefit from the dysfunction, and the disclosure process is no exception. I am under no illusions that what I am suggesting as guiding principles on disclosure will be quickly dismissed by the rule writers, but I am okay with that.Ìý

Less is more: I do think that most regulators and investors are aware that we are well past the point of diminishing returns on more disclosure, and that disclosures need slimming down. That is easier said than done, since it is far more difficult to pull back disclosure requirements than it is to add them. There are three suggestions that I would make, though there will be interest groups that will push back on each one. First, the risk profile, internal control and fair value/impairment sections need to be drastically reduced, and one way to prune is to ask investors (not accountants or lawyers) whether they find these disclosures useful. A more objective test of the value to investors of these disclosures is to look at the market price reaction to them, and if there is none, to assume that investors are not helped. (If you apply that test on goodwill impairment, you would not only save dozens of pages in disclosures, but also millions of dollars that are wasted every year on this absolutely useless exercise) Second, I would use a rule that has stood me in good stead, when trying to keep my clothes from overflowing my limited closet space, in the disclosure space. When a new disclosure is added, an old one of equivalent length has to be eliminated, which of course will set up a contest between competing needs, but that is healthy. Third, any disclosures that draw disproportionately on boilerplate language (risk sections are notorious for this) need to be shrunk or even eliminated.Don't forget traders: Almost all of the disclosure, as written today, is focused on investor needs for information. Thus, there is almost no attention paid to the pricing metric being used in a sector, and to peer group comparisons. Rather than adopt a laissez fare approach, and let companies choose to provide these numbers, often on their own terms and with little oversight, it may make more sense that disclosure requirements on pricing and peer groups be more specific, allowing for different metrics in different sectors. Just to provide one illustration, I believe that the prospectus for a company aspiring to go public should include details of all past venture capital rounds, with imputed pricing in each round. While investors may not care much about this data, it is central for traders who are interested in pricing the company.ÌýLet companies tell stories and make projections:ÌýThe idea that allowing companies to make projections and fill in details about what they see in their future will lead to misleading and even fraudulent claims does not give potential buyers of its shares enough credit for being able to make their own judgments.With the S-1, the disclosure status quo is letting young companies off the hook, since they can provide the outlines of a story (TAM, multitude of users, growth in subscribers) without filling in the details that matter (market share, subscriber renewal and pricing).With triggered disclosures: To the extent that some companies want to tell stories built around non-financial metrics like users, subscribers, customers or download, let them. That said, rather than requiring all companies to reveal unit economicsÌýdata, given the misgivings we have about disclosures becoming denser and longer, we would argue for triggered disclosure, where any company that wants to build its story around its user or subscriber numbers (Uber, Netflix and Airbnb) will have to then provide full information about these users and subscribers (user acquisition costs, churn/renewal rates, cohort tables etc.)I hope that we can keep these principles in mind, as we embark on what is now almost certain to become the , which is what companies should be required to report on environmental, social and governance (ESG) issues. You are probably aware of , and I am wary about the disclosure aspects as well. If we let ESG measurement services and consultants become the arbiters of what aspects of goodness and badness need to be measured and how, we are going to see disclosures become even more complex and lengthy than they already are. If you truly want companies to be good corporate citizens, you should fight to keep these disclosures in financial filings limited to only those ESG dimensions that are material, written in plain language (rather than in ESG buzzwords) and focused on specifics, rather than generalities. Speaking from the perspective of a teacher, put a word limit on these disclosures, take points off for obfuscation and then think of what existing disclosures should be removed to make room for it!
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Company FilingsÌý(US companies)(UK company filings)Research

For decades, the process that companies in the United States have used to go public has followed a familiar script. The company files a prospectus, providing prospective investors with information about its business model and financials, and hires an investment banker or bankers to manage the issuance process. The bankers, in addition to doing a roadshow where they market the company to investors, also Ìýpriceâ€� the company for the offering, having tested out what investors are willing to pay, and guarantee that they will deliver that price, all in return for underwriting commissions. During the last decade, as that process revealed its weaknesses, many have questioned whether the services provided by banks merited the fees that they earned. Some have argued that direct listings, where companies dispense with bankers, and go directly to the market, serve the needs of investors and issuing companies much better, but the constraints on direct listings have made them unsuitable or unacceptable alternatives for many private companies. In the last three years, SPACs (special purpose acquisition companies) have given traditional IPOs a run for their money, and in this post, I look at whether they offer a better way to go public or are more of a stop on the road to a better way to go public.

What is a SPAC?

The attention that SPACs have drawn over the last few months may make it seem like they are a new phenomenon, but they have been around for a long time, though not in the numbers or the scale that we have seen in this iteration. In fact, “blank checkâ€� companies had a brief boom in the late 1980s, Ìýbefore regulation restricted their use, largely in response to their abuse, especially in the context of "pump and dump" schemes related to penny stocks.Ìý

SPAC structure

To understand how the modern SPAC is different from the blank check companies of the 1980s, let’s revisit the regulations written in 1990 to restrict their usage. To protect investors in these companies, the SEC devised a series of tests that need to be met related to the creation and management of blank check companies:

Restricted purpose: The company has to have the singular purpose of acquiring a business or entity. Thus, it cannot be used as a shell company that chooses to alter its business purpose after the acquisition.ÌýTime constraints: The acquisition has to be completed within 18 months of the company being formed or return the cash to the its investors.Use of proceeds: The IPO proceeds, net of issuance costs, from the company going public have to be kept in an escrow account, invested in close to riskless investments, and returned if a deal is not consummated.Shareholder approval: During the process of finding an acquisition target and accomplishing the acquisition, shareholder approval is required, first when the target company is identified, and later when the acquisition price and terms are agreed to. As a prelude to shareholder approval, they have to be provided with the financial information on the proposed target and the necessary information to make an informed judgment.Opt out provisions: If shareholders in the company choose to redeem their shares, they are entitled to get their initial investment back, net of specified costs, but with interest earned.

While these restrictions were onerous enough to stop the blank check company movement in its tracks, special purpose acquisition companies (SPACs) eventually were created around these restrictions. A SPAC is initiated by a sponsor, a lead investor who brings or claims to bring special skills to the acquisition process, either because of an understanding of an industry in which they plan to find a target or because of deal making skills. As sponsors, they receive a significant stake (~20%) in the SPAC (called a promote), contributing little or nothing to capital, and in addition to finding and negotiating the price for a target company, they sometimes provide more capital to the target company through PIPEs (private investment in public equity). The picture below summarizes the time line for a SPAC, and the role of the sponsor along the way:

Unlike the blank check companies of the 1980s, investors in SPACs get multiple layers of protection, both in terms of being able to approve or reject the choice of target companies and the terms of the deal, as well as being able to redeem their shares and receive their money back, with interest, if a deal is not done, or if they are dissatisfied with a proposed target/deal. That said, the SPAC sponsors are clearly in the driver's seat, not only because they are the deal makers, but also because they control a significant portion of the shares in the deal, much of it subsidized by other SPAC investors. At the end of the time window (usually, eighteen months to two years), the SPAC is wound up, with success (an approved merger) resulting in the target company becoming a publicly traded company, and failure (no target found or target deal rejected) translating into a return of cash to the SPAC investors. In a significant proportion of SPACs, the sponsors create an entity (a private or PIPE) to supply additional capital, with two reasons for the add on. The first is to provide additional capital, if needed, for the target company in the deal for its business needs. The second is to cover capital withdrawals from SPAC shareholders who choose to opt out and get their money back.

Going Public? The Choices

The process that a private company follows to go public, for the last few decades, has been built around bankers as intermediaries. Borrowing from an , I have summarized the traditional IPO process, with a list of reasons of why many venture capitalists and issuing companies have soured on the process:

Put simply, the traditional IPO process takes too long, costs too much and leaves both issuing companies and investors dissatisfied, the former because the the process takes too long and is too inefficient, and the latter because they feel that only a select few can partake at the offer price. Ìý
While banker-led IPOs will not disappear, you can see why the search is on for alternatives. In , I looked at direct listings, where the company dispenses with the banking services (setting an offering price and roadshows) and lets the market set the price on the offering date.Ìý
This process, by doing away with the banking intermediaries, is less costly but it still takes time and comes with constraints, especially in the context of raising capital from the offering to cover future business needs. It may also be difficult for low-profile private companies to list directly, when investors are reluctant to invest based upon a prospectus, without someone else doing the due diligence (asking questions of management, checking the financials).
Looking at SPACs in the context of banker-run IPOs and direct listings, you can see some of the reasons for their surge in popularity. First, since SPACs go public and raise capital first, and then go on a search for targets, they may be more time efficient, where they can do deals Ìýto take advantage of short windows of market opportunity. Second, on the disclosure front, while the information disclosure requirements for SPACs largely resemble those for conventional IPOs, SPACs have more freedom to make projections and spin stories, albeit with basis and within reason. Finally, the SPAC sponsors take on the search and deal-making roles, using their industry knowledge to do due diligence and negotiate the best prices, in effect replacing investor due diligence with their own.The benefits of the SPAC route to going public have to be weighed against its many costs. The first is that the SPAC sponsor's subsidized share of the SPAC (which can amount to more than 15-20% of the capital raised) and the deal-making costs (underwriting fees are 5%Ìýor more of the merger value) may be large enough to wipe out any potential timing and pricing benefits in the deal. The former effectively dilutes a SPAC investor's holding, right at the start, and the latter drains value from the deal. The second is that the SPAC sponsors, notwithstanding the protections built in for investors, are in control not only when it comes to the deal making, but also of the side aspects on the deal that can benefit them disproportionately. For instance, the capital provided by a PIPE in a SPAC can be at a discounted price, relative to the deal price. Finally, to the extent that SPACs are being marketed as being good for private companies planning to go public, because they allow these companies to time their offerings better and receive higher market prices, it is worth noting that these benefits come at the expense of Ìýinvestors in these SPACS. In other words, SPACs claiming that they deliver value to both issuing companies and to their own investors are trying to eat their cake and have it too.

The Rise of SPACs

As noted at the start of this post, the SEC regulations put into place in 1990 to restrict the use of blank check companies removed them from the market landscape for about a decade. It was not until 2003 that the modern SPAC was born, but its usage stayed limited until 2016. In fact, the real boom in SPACs has been in the last three years, with the pace picking up in the second half of 2020 and in 2021:
In 2020, SPACs accounted for more than half of all deals made, in terms of dollar value, and SPACs are running well ahead of that pace in 2021. ÌýSince there were no regulatory changes in 2020 that could explain the dramatic rise, the explanations for the surge have to lie in developments in the market and I would list four contributing factors:Low interest rates: Investors in SPACs effectively give up use of their proceeds, while the sponsors look for a deal. In a world, where interest rates were higher, the opportunity cost of idle cash may have repelled some investors, but in a world where interest rates, even on long term investments, is close to zero, that is not the case.High stock prices: It is no coincidence that the explosion in SPACs has come about while markets have been booming, and especially so for high-growth companies. There are two benefits that SPACs derive, as a consequence. The first is that the opt out clauses that SPAC investors possess to return their shares and ask for their money back are less likely to be triggered in up than down markets. The second is that investors tend to be sloppier and more willing to outsource their analysis and decision making, when markets are rising than when they are falling.Where pricing rules: Not only have markets been rising steeply for most of the last three years, but they have also been centered on the pricing game, where mood and momentum rule the roost, rather the value game, where fundamentals are key drivers. Since getting the timing right is key in the pricing game, it is not surprising that investors are attracted to SPACs, which at least in theory, are better positioned to take advantage of shifts in mood and momentum.And celebrities move markets: Markets have always had their sages and gurus, who move markets with their views and perspectives, but until recently these market movers were either investors with long track records of success (Warren Buffett is the iconic example) or perceived rule-changing powers (Fed chairmen, Presidents). The last decade, though, has seen the rise of celebrity market movers, including not just Mark Cuban, Elon Musk and Mark Cuban, who have some basis for their investor following, but also social media influencers, whose primary claim to fame is the number of people that track and follow their ideas. It cannot be a coincidence that , hoping perhaps to use their followers to advance their investing aims, and that some of the are masters of social media.In sum, SPACs are as much a reflection of the times that we live in, as they are a potential solution to the going-public problem. As market fervor fades, and fundamentals reassert their importance, it is inevitable that there will be a pull back from the highs, but I think that SPACs are here to stay.
Disentangling the SPAC effect:ÌýCui Bono?

I am neither a lawyer, nor do I know Latin, but I love the expression, Cui Bono (Who benefits). When faced with a shift in market practices, it is worth asking the question of who benefits and at whose cost, and with SPACs, and to answer this question, it makes sense to start by looking at who invests in SPACs, how SPACs are structured, and how investors use (or do not use) their powers to cash out, before or after a deal. In perhaps the most comprehensive look at the phenomenon, researchers at Stanford and NYU law schools took a look at SPACs last year, and in addition to finding that 85-90% of investors in SPACs are large institutions, they record a troubling fact.ÌýWhile SPAC shares raise $10 per share at the time of their offering, the median SPAC holds only $6.67 per share, at the time it seeks out a target, with the loss due to the dilution caused by subsidizing sponsor ownership and other deal-seeking costs.Ìý

SPAC Sponsors: The sponsors of SPACs, at least given their current structure, are the clear winners from this trend. When you receive shares of ownership that are three, four or even five times your invested capital stake, you have effectively tilted the game in your favor. At worst, if the deal does not go through, you return the cash to your investors, and walk away almost unscathed (at least, as an investor). If a deal does get done, you get a multiple of your original investment, presumably as compensation for finding a target, and negotiating the price. In the research study quoted above, the returns to SPAC sponsors reflect these advantages they bring to the game:
Investors in SPACs: There are clearly some deals, where SPAC investors emerge as winners, as the merged company's stock price soars in the aftermath. An investor in the SPAC that took Draftkings public in 2019, for instance, would be showing returns of more than 500% in the period since, and an investor in the Virgin Galactic IPO would have more than quadrupled their money. That anecdotal evidence, though, obscures a more mixed story, and to understand it better, you have to examine SPAC investor returns in two periods, one from the time a SPAC is taken public to when it announces a merger deal, and one from the weeks and months after the merger deal. In , researchers looked at 110 SPACs from 2010 -2018, and conclude that SPAC investors do reasonably well, earning an annual return of 9.3%. More impressively, the downside protection on these deals put a floor on their losses, with even the worst deal generating a positive return (0.51%). In contrast, if you look at returns to SPAC investors in the weeks and months after a SPAC merger, the results are not edifying:
Put simply, no matter which measure of returns you look at, and over almost every time period, investors in SPAC-merged companies lose money.ÌýIt is true that repeat sponsors do better than first-time SPAC sponsors, at least in the near term (three months), but the magic fades quickly thereafter. Finally, the median returns are much worse than the average, because of a few outsized winners, and that may explain part of the allure, is that these winner stories get told and retold to attach new investors. If there is a cautionary note in these findings, it is for investors who invest in SPAC-merged companies, after the deal is consummated, since it looks like for many of these companies, prices peak on the day of the deal, and wear down in the months after, partly because the hype fades and partly because SPAC warrant conversions continue, upping share count and the dilution drag on value per share.Owners of issuing companies: There are three levels at which you can assess whether companies that plan to go public benefit from the SPAC phenomenon. The first is in whether some of the companies that used SPACs to go public would have been unable or unwilling to do so, in their absence. ÌýThe second is whether the companies that did go public, using SPACs, generate higher proceeds than they would have received, if they have followed the traditional IPO route.ÌýWhile it is almost impossible to test either proposition, I would assume that given the number of companies that have gone public using SPACs, some of them would have chosen to stay private, if their only option had been to use the banker-run process. I would also assume that at least some of the companies that were able to take advantage of the speedier SPAC process to generate higher prices, by timing their issuances better. The third is how the company's stock price does in the period after going public, and it is here that I think SPACs have not served private companies well. By creating layers of dilution, first to sponsors, next when raising capital from PIPEs and finally from the warrants granted along the way, they impose burdens on the stock that are difficult for it to overcome. I don't think that too many private companies would be happy with the post-merger performance that SPAC-merged companies posted in the table above, since it poisons the well for both future stock issuances, as well as for owners (VCs, founders) planning to cash out later in the game.The bottom line is that SPACs, at least as constructed now, are games loaded in favor of the sponsors. There are some SPAC investors who are canny players at this game, usually cashing out at the time the deal is announced and using warrants to augment their returns, but those SPAC investors who stay on as shareholders in the merged company find themselves holding a loser's hand. Finally, while there are issuing companies that may be able to go public because of SPACs and collect higher proceeds, the dilution inherent in the process acts as an anchor dragging and holding down stock prices in the aftermarket. While there are some who are pushing for the SEC to ban or constrain SPACs, the problem, as I see it, is not that there is insufficient regulation, but that investors in SPACs who are sometimes too trusting of and too generous to big name sponsors, and too lazy to do their own homework. In fact, there is a path to redemption for SPACs and it will require the following changes:Reduce the sponsor subsidy: The sponsor subsidy in most SPACs creates a hole that is too deep for investors to dig out of, even if the SPAC merger goes smoothly and is at the right price, since there isn't enough surplus in this process to cover a 20% dilution or more.ÌýAlign SPAC sponsor and SPAC investor interests: There are too many places where sponsor and shareholder interests diverge in the SPAC structure. Since sponsors get to keep their subsidy only if the deal goes through, there is an incentive now to push deals through, even if it is not in the best interests of shareholders, and then dressing it up enough to get it approved.Level the playing field on disclosures/capital: You cannot have two sets of rules on forecasts and business stories, a tighter one for traditional IPOs and a loose one for SPAC IPOs. Rather than tighten the rules on what SPACs can spin as stories, I would suggest loosening the rules for traditional IPOs. To the response that this could create misleading disclosure, I would suggest trusting investors to make their own judgments. To be honest, I would take three pages of pie-in-the-sky forecasts from a company going public, and decide what to believe and what not to, than twenty pages of mind numbing and utterly useless risk warnings (which you get in every prospectus today). On the fairness front, I also think that the restrictions on capital raising for companies that go the direct listing route are also outmoded, and may need to be removed or eased. Given that it has the fewest encumbrances and intermediaries, without this handicap, the direct listing approach to going public may very well beat out both the banker-based and SPAC IPO approaches.Reduce deal underwriting costs: I am having a difficult time understanding why the deal fees on a SPAC deal are as high as they are (5-6%), especially if the sponsors are being compensated for finding the right target and negotiating the best price. Who is being paid these deal fees, and what exactly are the services that are being provided in return?ÌýIn an ironic twist, the SPAC process, designed to disrupt the traditional IPO, may be seeing the beginnings of a disruption of its own. Bill Ackman's Pershing Square Tontine SPAC, created in 2020, pointed to one possible variation, where the sponsors reduced their upfront subsidy and increased their holdings of out-of-the-money warrants, giving them a greater stake in getting a good deal done. Last week, that SPAC announced that it would be acquiring a 10% stake of Universal Music for $4 billion from Vivendi, and that shareholders in the company would get shares in Universal as well as the rights to invest in a SPARC (a special purpose acquisition rights company), with the intent of raising capital, in the event of a future deal. (Unlike a SPAC, which raises money first and then looks for a deal, in a SPARC, the capital raise occurs only in the event of a deal.)

Conclusion

As markets change, both in terms of investor mix and information sharing, it is not surprising that corporate finance and investing practices, that were accepted as the status quo until recently, have come under scrutiny. The banker-centric IPO process has had a good run, but it is showing its age, and it is good that alternative approaches are emerging. The problems for these alternatives is that going public, no matter which approach you use, is much easier when you are in a hot market, as we are in right now. That said, IPO markets though go through cold periods, where investor reception turns frigid and the number of public offerings drops off, and it is then that the weaknesses and failures of approaches become most visible. Neither direct listings nor SPACs have gone through that trial by fire yet, but if history is a guide, it will come sooner, rather than later.Ìý

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References

As we approach the mid point of 2021, financial markets, for the most part, have had a good year so far. Looking at US equities, the S&P 500 is up about 11% and the NASDAQ about 5%, from start of the year levels, and the underperformance of the latter has led to a wave of stories about whether this is start of the long awaited comeback of value stocks, after a decade of lagging growth stocks. Along the way, it has been a bumpy ride, as the market wrestles with two competing forces, with an economy growing faster than expected, acting as a positive, and worries that this growth will bring with it higher inflation and interest rates, as a negative. As inflation makes its way back into market consciousness, there are debates raging from whether the higher inflation numbers that we are seeing are transitory or permanent, and if it is the latter, how they will play out in financial markets.Ìý

Inflation: Measures and Drivers

For those who are under the age of forty and have grown up in the United States or Europe, inflation is an abstraction, a number that governments report on and experts talk about, but not something that is central to their investing or regular lives. For those who are older or grew up in countries with high inflation, inflation is far more than a number, wreaking havoc on savings and exposing fault lines in economies and societies.

What isÌýinflation?

Put simply, inflation is a measure of the change in purchasing power in a given currency over time. Implicit in this definition are two key components of inflation.Ìý

The first is that to define purchasing power, you have to start with a definition of what you are purchasing, and this detail, as we will see, can lead to differences in inflation measured over a given period, across measures/services.ÌýThe second is that inflation is tied to currencies, and different currencies can be exposed to different levels of inflation over the same period. Understanding these differences is key to understanding why interest rates vary across currencies and changes in exchange rates over time.With that definition in place, a loss of purchasing power over time is inflation, and an increase in purchasing power over time is deflation. If there is inflation in a currency, and the loss of purchasing power over a period is acute, you have hyper inflation, though the exact cut off that leads to that label is subject to debate and disagreement. Thus, while everyone agrees that inflation in the thousands of percent, as seen in Germany in the 1920s, Brazil in the 1990s, Zimbabwe in the last decade, or Venezuela today is hyperinflation, the cut off point in terms of inflation rates that qualifies is unclear.

How do you measure inflation?

In inflation is the change in purchasing power, in a currency, over time, how do you measure inflation? Most inflation indices start by defining a bundle of goods and services to use in measuring inflation and a process for collecting the price levels of those goods and services, to come up with a measure of inflation. Consider the consumer price index (CPI) in the United States, perhaps the most widely reported inflation measure. It starts by creating a basket of goods and services for the average urban US consumer, with weights for each item based upon how much is spent by the consumer on the item, and then reestimate the price of the good/service in a subsequent period. The percentage change in the weighted-average price of all of the goods and services in the basket is the inflation rate for the period. Almost every country measures inflation within its borders using a variant of this approach, and you can see that inflation measures can be affected by three choices:

Consumption basket is misspecified: While inflation-measuring services try their best to get the basket of goods and services right, there are two fundamental problems that they all face. The first is that within a country, the consumption basket varies widely across consumers, and identifying the representative consumer is inherently subjective. In the US, consumption patterns vary across income levels, regionally and age, and inflation can be different, even over the same period, for different consumers. The second is that the basket is not stable over time, as consumers adjust to changing tastes and prices to alter what and how much they consume of different goods and services. You can find the most recent breakdown, for the US CPI, by going to the .Prices of goods and services are wrong/biased: Even if you had consensus on the consumption basket, the prices for goods and services still have to be estimated each period. While services use sampling techniques to obtain prices of goods and service from sellers, and often double check them against consumer expenditures, there is no practical way that you can survey every retailer and consumer. The sampling used to arrive at the final numbers can create error in the final estimate. In some countries, especially when high inflation has political consequences, the measurement services may use prices that do not reflect what consumers actually pay, to arrive at measured inflation rates that are much lower than the true inflation rates.ÌýPrices of goods and services have seasonal patterns and/or volatility: There are some goods and service, where there are seasonal patterns in prices, and services sometimes try to control for the seasonality, when measuring changes in pricing power. With other items, where prices can be volatile over short period, like gasoline, services often measure inflation with and without these items to reduce the effect of volatility.All of these measures, no matter how carefully designed, give a measure of inflation in the past, and markets are ultimately concerned more with inflation in the future. To get measures of expected inflation, there are three approaches that can be used:Inflation surveys: There are measures of expected inflation, obtained by surveying economic experts or consumers. The IMF has expected inflation rates, by country, that it updates every year that you . In the United States, the University of Michigan has been surveying consumers about their inflation expectations for decades, and reports those . That said, inflation surveys suffer from two limitations. The first is that survey projections are heavily influenced by past inflation, thus rendering them less useful, when there are structural changes leading to changing inflation. The second is that words are cheap, and those providing the surveyed numbers have no money riding on their own predictions.ÌýInterest rates: To understand the link between expected inflation and interest rates, consider the Fisher equation, where a nominal riskfree interest rate (which is what treasury bond rates) can be broken down into expected inflation and expected real interest rate components. Put simply, if you expect the annual inflation rate to be 2% in the future, you would need to set the interest rate on a bond above 2% to earn a real return. With the addition of inflation-protected treasuries, you now have the ingredients to compute expected inflation rate as the difference between the nominal riskfree rate and a inflation-protected rate of equal maturity. Thus, if the 10-year T.Bond rate is 3% and the TIPs rate is 1.25%, the expected inflation rate is approximately 1.75%. In the graph below, I look at the 10-year US T.Bond rate and the 10-year TIPs rate on a monthly basis, going back to the start of 2003, when TIPs started trading:
The advantage of using interest rates to forecast inflation is that it not only is constantly updated to reflect real world events, but also because there is money riding on these bets. The graph below contrasts the expected inflation rates from the Michigan survey with the expected inflation rate from the treasury markets.
The two estimates move together much of the time, but the consumer expectations are consistently higher, and at the end of April 2021, the consumer survey was forecasting inflation of 3.2%, about 1.1% higher than a year earlier, and the treasury markets were signaling a 2.42% expected inflation, about 1.35% higher than a year earlier.ÌýExchange rates: The third approach to estimating inflation rates is to use forward exchange rate, in conjunction with spot rates, to back out expected inflation in a currency. To use this approach, you need to have a base currency, where you can estimate expected inflation, say the US dollar and forward exchange rates in the currency in which you want to estimate inflation. The calculation is below:
Note that you are assuming purchasing power parity is the sole or at least the most critical determinant of changes in exchange rates over time, when you use this approach.There is one final way to link actual to expected inflation. In any period, the actual inflation rate can be higher or lower than what was expected during that period. That difference isÌýunexpected inflation, a positive number when inflation is greater than expected, and negative when it is lower than expected.Ìý

Unexpected inflation in period t = Actual inflation in period t - Expected inflation in period t

Later in this post, I will argue that expected and unexpected inflation play different roles in affecting the values of assets, and that while one can be protected against, the other cannot.

What causes inflation?

Inflation, at its core, is a monetary phenomenon, created by too much money chasing too few goods. For pure monetarists, all else is noise, and expansive money supply will see inflation in the aftermath. That said, it is true that in the near term (which can extend to years), inflation is affected by other forces as well.Ìý

Economic slack: When an economy has employment and production slack, as is the case after recessions or economic crises, you could see inflation stay subdued, even in the presence of fiscal and monetary stimuli, as it grows back to fill in capacity. This is the rationale that Keynesians would adopt to argue that central bankers need to ease monetary policy, in the face of economic slowdowns.Structural Changes: There are times when structural changes in the economy, arising as it transitions from a manufacturing to a service economy, or from one that is domestically focused to one that is export-oriented, can create periods where inflation stays subdued in the face of monetary expansion.Consumer/investor behavior: Consumers are the wild card in this process, as changes in demographics and behavior can have consequences for inflation. For instance, as consumers age and/or save more, relative to the past, you can see decreases in inflation or even deflation in economies.ÌýSize of the economy: It is not fair, but larger economies with currencies that are used globally, also have the capacity to absorb monetary stimuli that would put a lesser economy into an inflationary spiral. Thus, the EU and the United States have more degrees of freedom to set monetary policy than does Brazil or Chile.ÌýYou can see why forecasting inflation can be tricky, especially at times like now. As the economy climbs back from the shutdown in 2020, there are some who argue that the monetary and fiscal stimuli of the last year, unprecedented though they may be in size and scale, will not cause inflation because the economy has substantial excess capacity. There are a few arguing that the shift to a technology-based economy has removed inflationary pressures permanently, pointing to the last decade where inflation fears never came to fruition. On the other side of the debate, there are investors and economists who believe that adding trillions of dollars to an economy that is already recovering strongly will overheat it, leading to a return of inflation. In a sign of how volatile inflation expectations have been over the last year, I looked at the probabilities that the Federal Reserve Bank of St. Louis estimates for inflation rates exceeding 2.5% and for deflation on a monthly basis: Note that these probabilities are estimated from statistical models (PROBIT) that uses both real inflation data and survey expectations. The probability of inflation exceeding 2.5%, which was 0.11% in May 2020, soared to 60.86% in April 2021, whereas the probability of deflation, which was 76.63% in May 2020, Ìýdropped to 0.01% in April 2021.

Currency and Inflation

The best counter to those who somehow believe that inflation has been conquered forever is the response that inflation is currency-specific. Thus, even in this new technology-driven global economy, there remain some currencies where inflation rates are high, and others where inflation rates are not just low, but negative (deflation). In the table below, I use IMF forecasts of inflation from 2021 to 2026 to generate a geographical heat map and to find the ten countries Ìýwith the highest expected inflation and the ten with the lowest expected inflation, from 2021-26:

Drawing on my earlier point that interest rates convey inflation expectations, I would argue that the biggest, though not the only, reason for differences in riskless rates across currencies is differences in expected inflation:

It should come as no surprise that the currencies with the highest expected inflation also have the highest riskfree rates, that currencies with lower expected inflation has lower riskfree rates and currencies where deflation is expected could have negative riskfree rates. Those inflation differences also explain currency appreciation/depreciation, over time, with high inflation currencies losing value, relative to low inflation currencies, in the long term.

A History of Inflation in the United States

As I noted in the earlier section on measuring inflation, different inflation measures can yield different values, even over the same period, largely as a consequence of whose perspective (consumer, producer) is taken, how the basket of goods and services is defined and how prices are collected and aggregated. In the graph below, I look at four measures of US inflation. The first two measures are urban consumer price indices, one without seasonal adjustments that has been reported since 1913, and the other with seasonal adjustments, available since 1948. The third is a producer price index, where price changes are measured at the producer level, for goods and services that they consume. The final measure is the GDP price deflator, computed from the BEA’s estimates of nominal and real GDP, and designed to capture the price change in goods and services produced in the United States, including exports.

As you can see, the four inflation measures are highly correlated, and there is no indication, at least historically, that one measure delivers higher or lower values than the others systematically. The PPI does show a lot more volatility than the other price indices, but there is also no indication that it or any of the other measures leads the others. Over the seven decades for which we have data on all four measures, there are two standout periods. Inflation was highest in the 1970s and it spilled into the first few years of the 1980s; that was the closest the US has come to being confronted with runaway inflation, and we will look at how investments behaved during the period. Inflation was lowest in the last decase (2010-19), and that low inflation continued in 2020.Ìý

Inflation and Value

Having spent a substantial portion of this post talking about the mechanics of inflation and how it is measured, I would like to turn to the focus of this post, which is the effect inflation has on asset value. I will start with fixed income securities, and trace out the effect of expected and unexpected inflation on value, and then move on to the more complicated case of equities, and how they are affected by the same forces.

Inflation and Fixed Income Securities

To understand how inflation affects the value of a fixed income bond, let's start with the recognition that in a fixed income security, the buyer has a contractual claim to a pre-specified cash flow and that cash flow is in nominal terms. Thus, expected inflation and unexpected inflation affect bond buyers in very different ways:

Expected Inflation: At the time that the bond contract is initiated, the buyer of a bond takes into account the expected inflation, at that time, when deciding the coupon rate for the bond. Thus, if expected inflation is 5%, a rational bond buyer will demand a much higher interest rate than when expected inflation is 3%.ÌýUnexpected Inflation: Subsequent to the contract being created, and the bond being issued, both the bond buyer and seller are exposed to actual inflation, which can be higher or lower than the inflation that was expected at the time the bond was issued. If actual inflation is lower than expected inflation, the bond interest rate will drop and the bond price will increase. Alternatively, if actual inflation is higher than expected, interest rates will rise and the bond price will decrease.The return that the bond buyer will earn on the bond has two components, a coupon portion that incorporates the expected inflation at the time the bond was issued, Ìýand a price appreciation portion that will move inversely with unexpected inflation.Ìý

Inflation value proposition 1: In periods when inflation is lower than expected, treasury bond returns will be boosted by price appreciation and in periods when inflation is higher than expected, treasury bond returns will be dragged down by price depreciation.Ìý

With corporate bonds, inflation will have the same direct consequences as they would on default-free or treasury bonds, with an added factor at play. As inflation comes in above expectation, corporate borrowing rates will go up, and those higher interest rates can increase the risk of default across all corporate borrowers. This higher risk may manifest itself as higher default spreads for bonds, pushing down corporate bond prices, Ìýcreating additional pain for corporate bondholders.

Inflation value proposition 2:ÌýIn periods when inflation is higher (lower) than expected, corporate default risk can increase (decrease), leading to corporate bond returns lagging (leading) treasury bond returns.

Inflation and Equities

To understand how inflation affects equity value, I will draw on a picture that I have used many times before, where I look at the drivers of value for a business.

Embedded in this picture are the multiple pathways that inflation, expected and unexpected, Ìýcan affect the the values of businesses.

Interest Rates: The most direct link between inflation and equity value is through the risk free rate (interest rate) that forms the base for the expected returns that investors demand for investing in a company's equity, and for lending it money. If inflation is higher than expected, you can expect interest rates to rise, pushing up the returns that both equity investors and lenders demand.Risk Premiums and Failure Risk: By itself, inflation has no direct effect on equity risk premiums, but it remains true that higher levels of inflation are associated with more uncertainty about future inflation. Consequently, as inflation increases, equity risk premiums will tend to increase. The effect of higher-than-expected inflation on default spreads is more intuitive and reflects the reality that interest expenses will be higher when inflation rises, and interest rates go up, and those larger interest expenses may create a higher risk of default.Revenue Growth Rates: As inflation rises, all companies will have more freedom to raise prices, but companies with pricing power, coming from stronger competitive positions, will be able to do so more easily than companies without that pricing power, operating in businesses where customers are resistant to price increases. Consequently, when inflation rises, the former will be able to raise prices more than the inflation rate, while price rises will lag inflation for the latter group.Operating Margins: If revenues and costs both rise at the inflation rate, margins should be unaffected by changes in inflation, but it is a rare company where this is true. For companies that have costs that are sensitive to higher inflation and revenues that are less so, margins will decrease as inflation rises. Conversely, for companies where costs are slow to adjust to inflation, but revenues that can quickly margins will increase as inflation rises.Taxes: In much of the world, the tax code is written in nominal terms, and when inflation rises, the effective tax rate paid by companies can change. To see why, consider one aspect of the tax code, where companies are allowed to depreciate their investments in building and equipment over time, but only based upon what was originally invested in those assets. As inflation rises, the tax benefits from this depreciation will decrease, effectively raising the tax rate.The bottom line is that inflation that is higher than expected will have disparate effects across companies, with some benefiting, some unaffected and some losing value.Ìý Inflation value proposition 3: In periods when inflation is higher (lower) than expected, individual companies can benefit, be left unaffected or be hurt by inflation, depending on whether the benefits of inflation (higher revenue growth and margins) are greater than, equal to or less than the costs of unexpected inflation (higher risk free rates, higher risk premiums, higher default spreads and higher taxes). While individual companies may benefit from higher inflation, the question of how higher inflation affects equities in the aggregate is an open one. Even if you assume that companies are able, in the aggregate to deliver high enough revenue growth to match the increase in the riskfree rate, and premiums remain unchanged, you still have the drag in value caused by higher risk premiums, failure risk and effective tax rates. The only scenario where higher-than-expected inflationÌýcan be good for stocks in the aggregate, is if the increase in inflation is accompanied by extraordinary growth in aggregate earnings that more than offsets the inflation effect. Inflation value proposition 4: Unexpectedly high inflation will generally be a net minus for markets, at least until expectations are reset, as investors struggle to reassess risk premiums and companies try to adjust their product pricing and cost structures to deal with the higher inflation.

Inflation and Investments

In theory, and intuitively, higher than expected inflation should be bad for treasury bonds, worse for corporate bonds and good, bad or neutral for individual equities. The acid test, though, is in the numbers, and in this section, I will look at almost a 100 years of history to look at the actual performance of asset classes in response to both expected and unexpected inflation.

Inflation, Stock and Bond Returns

To assess how stocks and bonds have been affected by inflation, I started with a historical data series of returns on stocks (with the S&P 500 as proxy), treasury bonds (with the 10-year constant maturity bond standing in) and corporate bonds (with the Baa 10-year Corporate bond as its representative. For measuring inflation, I used the CPI, unadjusted for seasonal factors, since it is the only inflation series available for the entire time period, and to estimate unexpected inflation, I used a simplistic proxy:

Unexpected Inflation = Inflation in year t - Average inflation in years t-1 to t-10

I would have rather used one of the expected inflation measures that I described in the last section, but neither the Michigan survey nor the treasury rate go back in time for that long. I bring these series all together in the graph below:

Since it is almost impossible to detect patterns in this graph, I broke my data down by decade and looked at annual nominal and real returns on stock, treasury bond and corporate bonds, by decade:Looking at annual real returns, the worst decade for stocks in this time period was 2000-2009, with the 2008 banking crisis melting the gains for the entire decade, but the second worst decade for stocks was 1970-79, the period with the highest unexpected inflation. For treasury bonds, the two worst decades were the 1940s and the 1970s, both decades with the highest unexpected inflation, and the best decade was the 1980s. For corporate bonds, the only decade with negative real returns was the 1970s, and you can see the influences of both treasury bonds and stocks on performance.Ìý
Taking a deeper look at stocks, and specifically at two widely reported phenomena of the 20th century, the outperformance of small cap stocks, relative to large cap ones, and the superior returns earned by low price to book stocks, relative to high price to book stocks, through the lens of inflation (and I am in debt to Ken French who maintains these datasets on ):Small is the bottom decile and large is the top decile in market cap, of US stocks
Value is the bottom decline and growth is the top decile in price to book ratios, of US stocks.There is a risk of reading too much into the data in this table, but the three best decades for low price to book stocks were 1940-49, 1970-79 and 1980-89, the three decades when inflation was high, and in two of those decades, inflation was much higher than expected. Conversely, the decades where value underperformed growth were 1990-99 and 2010-19, when inflation was much lower than expected. There is no detectable pattern with the small cap premium that can be related to inflation, in either expected or unexpected forms. Put simply, for those value investors who have been wandering in the investment wilderness for the last decade, the silver lining in a return to higher inflation may be a tilt back towards low PE and PBV stocks.

Inflation, Gold and Real Estate

It is part of investing lore that gold is the ultimate hedge against inflation. note that over very long time periods (hundreds of years), gold preserves its purchasing power, effectively growing at the inflation rate. It is also part of investing lore that no asset class holds up better to inflationary swings than real estate. To examine the data behind the lore, I looked at the returns on gold (using gold prices, London fixing) and on real estate (using Robert Shiller's database on home prices) as a function of inflation. Note that gold prices are available only since 1970, with the effective abandonment of the gold standard.

While you can see the spike in gold prices in the 1970s and link it to the high inflation of the period, I looked at nominal and real returns on gold and real estate, by decade, just as I did with stocks:Gold clearly had a winning decade in the 1970s, but it also did well in the 2000-09 time period, when stocks were under siege and in 2020, when it played its role as a crisis asset. Real estate had solid nominal returns in the 1970s and delivered returns that meet and beat inflation, during that decade, but is best decade in both nominal and real terms was 2000-09, albeit with a housing crash at the end of the decade wiping out much of the compounded gains.Ìý

Inflation, Collectibles and Cryptos

For investors fearful of meltdowns in financial assets, there have been relatively few hiding places, but over time, some have sought refuge in fine art and collectibles, arguing that a Picasso is more likely to protect you against inflation than a stock. In the last decade, younger investors have also sought out crypto currencies, arguing that their design, with hard limits on quantity, should make them better stores of value. It is for that reason that there are some who consider Bitcoin to be Millennial Gold, but the jury is still out on whether it will serve that role well.Ìý

If the role that gold has played historically have been as a refuge from high inflation and market crisis, the question becomes whether Bitcoin can also play that role. Last year, I did check to see how Bitcoin and Ether behaved during the course of the year, and concluded that at least in 2020, Bitcoin and ether behaved less like collectibles, and more like risky stock.Ìý

Clearly, that is a single period of history, and it is possible that Bitcoin and Ether will behave better in future crises. On the question of how unexpectedly high inflation will affect crypto currencies, the fact that they have been in existence only for a little more than a dozen years, during which period inflation was at historic lows, makes it difficult to draw a conclusion.Ìý

Hiding from Inflation?

Having looked at how stocks, bonds, real estate and gold have moved with expected and unexpected inflation in the past, I used the year by year data on these asset classes to estimate the correlation with both expected and unexpected inflation.

This table tells the composite story about inflation and asset returns well. The only two asset classes that have moved with inflation, both in expected and unexpected forms, are gold and real estate, though a fair portion of that co-movement can be explained by the 1970s. ÌýWhile real estate has been a better hedge against expected inflation, gold has done much better at protecting against unexpected inflation. The asset classes that are worst affected by inflation are treasury and corporate bonds, but the damage is from unexpected inflation is much greater than from expected inflation. Stocks and expected inflation are close to uncorrelated, but the correlation of stocks with unexpected inflation is negative, albeit weaker and less statistically significant than that exhibited by bonds. Finally, while the value premium is greater when inflation is higher, the results are not statistically significant, suggesting that other forces are playing a much stronger role in the disappearance of that premium.Ìý

Are there some sectors that offer better protection against inflation than others? To examine that question, I looked at broad industry categorizations, and estimated annual returns across the decades, in conjunction with inflation numbers:

Ìý(Industry annual returns, from )

The only sector that seems to have a link to inflation is energy, an outperformer not just in the 1970s, as oil prices surged, but also in the 1940s, another high inflation decade, while underperforming between 2010 and 2019, as inflation fell to historic lows. Since inflation is currency-specific, there is another pathway to protection, but it is viable only if inflation is restricted just to the United States. If inflation remains lower in other countries, either because they have more prudent central bankers or because their economies stay weaker, you would expect their currencies to appreciate, relative to the dollar, and their equity and bond markets to behave badly. Given that central bankers around the world seem to have drunk the same Koolaid, I am not sure that I would bet on this possibility.

What now?

This post has stretched for too long, and I will let you draw your own conclusions, but here is a summary of where we stand:

Inflation is back: There is no question that we are seeing higher inflation now than we have seen in a decade, in reported numbers (CPI, PPI and GDP deflators), in expectations (from the treasury markets and surveys) and in commodity markets.ÌýUnclear whether it is transitory or permanent:ÌýThe debate, both among investors and at central banks, is whether this surge in inflation reflects a return from an economic shutdown, which will burn out once things settle down, or a sign of a permanent increase from the abnormally low inflation that we witnessed all of the last decade. While economists and investors continue to look at the tea leaves to try to decipher the answer, I am afraid that only time can answer that question. If as the economy strengthens this summer, inflation continues to beat expectations, I think that the answer will be in front of us.Return to normal:ÌýIf some or all of the inflation increase is permanent, and we are reverting back to more normal inflation levels (2-3%), there will be an adjustment, perhaps even painful, as interest rates rise and stock prices recalibrate. You can still find stock sectors that are better positioned to deal with higher inflation, with commodity companies and companies with significant pricing power (consumer brand names) holding value better than the rest of the market.With a non-trivial chance of a breakout: If it is permanent, and we see inflation rise to levels not seen since the 1970s and 1980s (>5%), stocks and bonds will have to be repriced significantly. Not only will investors need to move money out of financial into real assets and collectibles, but companies and individuals that have chosen to borrow to capacity, based upon current low rates, will face a default risk reckoning.And the Fed has to be ready: It behooves the Fed to get ahead of the inflation game. Since the probability of inflation rising to dangerous levels is non-trivial, in my view, the Fed should stop its happy talk about inflation being under control and interest rates staying low, no matter what. In fact, central bankers around the world would be well served reverting back to an old rule book of being seen very little and speaking even less, and letting their actions speak for themselves.ÌýFor those who are quick to dismiss inflation, it is worth remembering that it is insidious and sneaky, benign when it is under control, but a destructive force, when it is not, a genie that should be kept in the bottle.Ìý
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DataÌý

In my last post, I looked at the Biden Administration's proposal to increase corporate taxes, to provide funding for an infrastructure bill, and concluded that while there is room for raising corporate taxes, it would be more efficient and fairer to do so by reducing the tax credits and deductions in the code, than by raising the tax rate. In the weeks since, the administration has come up with its follow-up Ìýproposal, this one funded by increases in individual taxes, primarily on the wealthy. While one part of the proposal, reversing the 2017 tax cuts for those in the highest tax brackets from 39.6% to 37%, was anticipated, the other one, almost doubling the capital gains tax rate for those making more than a million dollars in investment income, was a surprise. While supporters of the increase point to the fact that only a very small portion of individuals will be affected by the change, those individuals, through their wealth, own a significance percentage of financial assets, and how they react to the change, assuming it happens, will determine whether their pain will become all of ours. In this post, I will start by looking at investment income and how it is taxed today, compare it to how it was taxed in the past, and finally look at how individual investor taxes play out in stock prices.Ìý

The Taxation of Investment Income

In much of the world, income from investments (interest, dividends) is treated differently than earned income (salary, wages), by the tax code, and the reasons for the divergence are both practical and political:

1. Prevent or reduce double taxation: One argument, grounded in fairness, is that it is wrong to subject the same income to multiple tax hits, and it can be argued that dividend and capital gain income is particularly exposed to this critique. The dividends that companies pay comes out of the earnings that they have left over after corporate taxes, and taxing that dividend again, when investors receive it, is clearly double taxation. It is for this reason that some countries, like the UK and Australia, allow investors to claim a tax credit, for corporate taxes paid, on dividend income. On capital gains, the same argument can be made, but it is less direct, since stock prices can go up, even if a company is money-losing and has no taxable income. ÌýOthers like Estonia and Latvia, levy taxes on corporations on the income that is returned to shareholders as dividends, and individual investors pay no taxes.

2. Encourage savings/ capital formation: In an economy, where private capital is Ìýbehind the bulk of economic investment and growth, governments are dependent up the health of capital markets (stocks and bonds) for continued growth. To encourage investors to put their savings into stock and bond markets, the tax code is sometimes tilted to make these investments more attractive. Thus, there are countries, where capital gains tax rates are effectively zero, to induce investors to buy and hold financial assets. In Europe, for instance, Belgium, Luxembourg, Slovenia, Slovakia, Switzerland and Turkey don't tax capital gains, and in most European countries, the capital gains tax rate is lower than the tax rate on ordinary income. In an extension of this rationale, there are many countries where capital gains on investments that have been held for longer periods is taxed at a lower rate than investments held for shorter periods.

In the United States, the discussion of what individuals pay as taxes on their investment income is complicated by where that investment income originates. For instance, income on an individual's holdings in a pension fund or a Roth IRA account are tax exempt, at least while they continue to stay in that account, but income from the rest of the individual portfolio are taxed. On top of all of this complexity is estate and inheritance tax law, where when an individual dies, the investments in his or her estate can be marked to market, without any tax consequences, allowing those capital gains to be sheltered from taxes.

A History ofÌýInvestment Income Taxation in the US

For much of the last century, investment income in the United States has been taxed differently from income earned from salaries or business. The graph provides a general framework for understanding the structure of the US tax code:

Note that there are times when income can span multiple categories, and especially so, if are a private business owner. The business that you own is an investment, but since you work actively at that business, you may generate a salary, real or imputed, earn dividends, if the business has partners, and when sold, the business may generate a capital gain. When the US government started taxing individual income more than a century ago, in 1913, there was one tax rate on all income, earned or investment, but that changed in 1920. In the graph below, I look at the highest marginal tax rates on dividends and capital gains since the advent of US individual taxes:

Starting in 1920, and for much of the rest of the century, dividends were taxed like other earned income, but capital gains tax rates were much lower; it is worth noting that these lower tax rates were only for long term capital gains, i.e., investments held for a year or longer. The divergence between tax rates on ordinary income/dividends and capital gains peaked in the 1950s, at least for those in the highest tax brackets. Note that since the capital gains tax rates have no brackets, those who faced lower taxes on ordinary income saw a much smaller divergence between dividend and capital gain taxes. In 1986, a tax reform act built around the premise that having different tax rates for different types of income created a whole host ofÌýunhealthy tax behavior, separated dividends from other earned income,Ìýand taxed dividends at the same rate (26%) as long term capital gains, but that promise of rationalÌýtaxes was very quickly forgotten as tax rates on dividends were raised again in 1992, while capital gains taxÌýrates remained unchanged. In 2003, another tax reform act with lofty objectives brought convergence on the tax rates to 15% for both capital gains and dividends, and while those rates have increased since, the convergence has remained, at least until now.

Taxes and Stock Prices

In my last post, I looked at how corporate taxes affect the company values, but personal taxes, i.e., the taxes paid by investors on the income that they receive from companies also affect value, albeit through more indirect means. In this section, I will trace out that link.

Pre and Post Tax Returns to Investors

When individuals invest in stocks, bond and other assets, they do so with an expected return in mind, but that expected return is in post-personal tax terms, and as my investment income gets taxed at a higher rate, they need to make higher returns, before personal taxes, to break even. To illustrate with a simple example, assume that you are a taxable investor who pays a 25% tax rate and that you are considering investing in a company, where you believe that you need to make 6%, after personal taxes, to break even. You will need to make 8% on a pre-personal tax basis, to break even:

Pre-personal tax return (with 25% tax rate)Ìý

= Post-personal tax/ (1- personal tax rate) = 6%/ (1- .25) = 8%

If you were valuing the company, you would use the 8% as your required return, since the earnings and cash flows that you are evaluating are after corporate, but before personal, taxes. If the tax rate were raised to 40%, all else being held equal, your expected pre-personal tax return will have to increase to 10%:

Pre-personal tax return (with 40% tax rate)Ìý

= Post-personal tax/ (1- personal tax rate) = 6%/ (1- .40) = 10%

With a 10% required return, the company will be significantly less valuable.

Extending this concept to actually investing in stocks, you are faced with complications. The first is that you pre-personal tax return on stocks is composed of dividends and price appreciation, and as we noted in the earlier section, the tax rates on the two can diverge. Thus, the post personal-tax return on stocks can be written as:

Post-personal tax return on stocks = Dividend yield (1 - tax rate on dividends) + Expected Price Appreciation (1 - tax rate on capital gains)

Thus, if a stock has a 2% dividend yield and an expected price appreciation of 6%, and your tax rates were 20% for dividends and 40% for capital gains, your post-personal tax return would be:

Post-personal tax return = 2% (1-.20) + 6% (1-.40) = 5.20%

As a final complication, you have to consider the fact that tax rates can vary across individuals, there are some investors who do not pay taxes on any investment income (pension funds) and some who pay taxes only on some types of investment income.

Historical Stock Returns: Pre and Post-tax

At the start of every year, I update a , where I look at historical returns on stocks over time, and compare these returns to returns on treasury bonds/bills, corporate bonds and gold. At first sight, stocks have had an impressive run over much of the last century, delivering substantial return premiums over treasury bonds, treasury bills and corporate bonds:

These returns, though, are prior to personal taxes, and the tax bite can be substantial. To see the most dire version of the tax effect, assume that you were in the top tax bracket through this entire period, paying the highest marginal tax rate on dividends and capital gains, and that you trade at the end of each year, thus paying capital gains taxes each year. The returns you would have made on a post-personal taxes basis are shown in the graph below:

Over this period, the taxes would have cost you more than a third of your annual returns on stocks, but the extent of the damage can be seen when you look at the cumulative effect. An investment of $1000 in stocks at the end of 1927, assuming that dividends and price appreciation are reinvested back each year, would have amounted to $5.93 million by the end of 2020. However, paying the highest marginal tax rate each year on dividends and price appreciation would have reduced the end value of this investment to $278,489, a drop of 95.3% in value. It is no wonder that those most heavily invested in stocks look for ways to reduce their tax hit, starting with steering away from stocks that pay dividends to holding on to stocks for long periods, since capital gains apply only when stocks are sold. It is also not surprising that they are targets for investment vehicles that claim to protect them from taxes.

Forward-looking Expected Returns

If you start with the premise that investors have a post-personal tax return in mind, when they invest, can you back out that expected return? I think so, but to do it, you have to start with a pre-personal tax expected return. With stocks, I compute this pre-personal tax return at the start of every month, using the current level of index and expected cash flows to back out an internal rate of return; this is the basis for the implied equity risk premium. At the end of trading on May 7, with the S&P 500 trading at 4201.62, I compute this expected return to be 5.73%:

This expected return is prior to personal taxes, and to compute the post-personal tax return, at current tax rates, I have to make assumptions about what percentage of investors in the stock market are tax paying and that number will be different for dividends and capital gains. For dividends, since about 37% of equities are held by tax exempt investors (pension funds) that pay no taxes, I will assume that the remaining 63% pay taxes). ÌýWith capital gains, in addition to pension funds, foreign investors are not required to pay capital gains taxes (though they face taxes on dividends), resulting in an even smaller percentage of tax paying investors (I estimate 50%, but it is a shifting number). Starting with the 5.73% pre-personal-tax return, and using 23.80% as the tax rates for dividends and capital gains, I back into a post-personal tax return of 5.01% for the aggregate market:

The Biden Capital Gains Tax Plan

The Biden proposal on capital gains is still in nascent form and will morph as it goes throughÌýthe CongressionalÌýmeat grinder, but as it stands now, it is built on two building blocks. The first is that tax rates on capital gains will be raised to 39.60% (effectively 43.4%, with the health care add on tax) but only for those who earnÌýmore than $ 1 million in investment income (not all income). The second is a change in estate tax law to require that inheritors of investments will be required to pay capital gains taxes, at the time of inheritance, on capital gains on these investments. That is a change from the current law where these capital gains are effectively not taxed. This change will affect a broader swath of individuals. To assess the impact of the first of these proposed tax changes, I had to start with an estimate of theÌýpercentage of stocks that are held by those that will be impacted by the law. While the administration is pointing out that only 0.3% of individuals will be affected by the law, these individuals hold a disproportionate share of stocks,Ìýbecause of their wealth. If it is estimated that the top 1% (in terms of wealth) in the UnitedÌýStates hold 51.8% of stocks, and it stands toÌýreason thatÌýthe top 0.3% hold 30% or more of stocks. UsingÌýthe 30%Ìýthreshold, I can recompute the returns you would need to make on a pre-personal tax basis to arrive at the same post-personal tax return earned before the tax change:

With the increase in capital gains tax rates for the wealthy, the pre-personal tax expected return has to rise to 6.05% to get the same post-tax expected return of 5.01%.Ìý
Revaluing the index using theÌýsame cash flows as we did before, but with the higher expected return, we can estimate a new value for the index:If nothing else changes in the estimation, an increase in the capital gains tax rate for the wealthiest subset of investors will cause value to decline by about 7.09%. This computation ignoresÌýwhat may be the bigger change in the taxÌýcode, which is the capital gains assessment on inherited assets. That effect will affect more investors, and thus potentially cause a further reassessment of pre-personal tax returns. ÌýIn defense of the Biden proposal, the counter argument could be that the funds raised from these taxes will be invested back in the economy, and create higher economic growth, which, in turn, will benefit businesses by delivering higher earnings.ÌýÌý Ìý Even though the effects ofÌýthis tax code change on stock prices are likely to be modest, there are aspects of this tax proposal that I do not like.ÌýNot only does it pick on a tiny group of individuals as deserving of paying more in taxes, but it seems to be motivated less by the desire to raise revenues, and more by the urge to punish. As always, this is rationalized by arguing that the richÌýdon't pay their fair share of taxes, though theÌýevidence for that proposition is either anecdotal, or based upon aÌýselective reading ofÌýthe data. The wealthiest among us can afford to pay more in taxes, but insulting them or treating them as a pariah class,Ìýwhile asking them to pay more, will only induce them to find ways to avoid doing so, and who can blame them? If they decide to do so, this is also the group with the most weapons at its disposal for sheltering income from taxes, and I have aÌýfeeling that one group that will clearly benefit, if this proposalÌýgoes through, are tax accountants and lawyers.ÌýIf you are not among thatÌýtiny targeted group, it is delusional to think that forcing individuals in this group to pay more in taxes will have no effect on you, since this group punches well above its weight. There is a very realÌýdanger here that as we take aim at what we think are the idle rich, we risk shooting ourselves in the foot.ÌýFinally, if the most effective tax codes are simple and direct, changes like the proposed one, where segments of taxpayers are assessed aÌýhigher tax rate on portions of income are exactly what cause them to become complex and inefficient.ÌýI have a feeling that both sides of this tax debate will find my analysis wanting, with those in support of the proposal feeling that I am taking too narrow a perspective, by just changing the tax rates, and those opposed arguing that an increase in the tax rates will have negative consequences that stretch well beyond the tax rate effect, driving investors out of stocks into more opaque (from a tax perspective) investments.

The Bottom Line

ÌýÌý ÌýMay intent in this post was less to focus in on the Biden proposal, and more to open a discussion of how personal taxes affect not only valuation, but also corporate finance behavior. That effect is often missed by analysts because it is not explicitly part of the valuation of publicly traded companies, but it implicitly plays a role, and perhaps even a key one.Ìý

As capital gains and dividend tax rates are changed, the changes percolate through into expected returns and risk premiums, and through those into value. It is one more reason that blindly using historical risk premiums can lead to static and strange values.ÌýCompanies, faced with investing, financing and dividend questions, may answer them differently, when personal taxes change. Thus, is it possible that the increase in capital gains taxes could reduce cash returned, especially in the form of buybacks? Absolutely, and especially so at closely held firms.ÌýFor governments, changing the tax rates on investment income to increase tax revenues is fraught with uncertainties. For instance, if the capital gains tax change goes through, it will almost certainly not begin until 2022, and there will be a significant amount of selling towards the end of 2021, as some wealthy investors lock in the current favorable capital gains tax rate. Going forward, a higher required return on stocks will mean lower market valuations, which reduces capital gains in general, and tax collection from those capital gains, as a consequence. One reason to be wary of government forecasts of large tax collections from increases in capital gains tax rates is that these forecasts are built on the presumption that the market that is the goose that lays this golden egg will continue going up, since rising markets deliver higher capital gains, and the tax rate hike may kill that goose.Ìý

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The Biden Administration's $ 2 trillion infrastructure plan, announced with fanfare a few weeks ago, has opened up a debate about not only what comprises infrastructure, but also about how to pay for it. Not surprisingly. it is corporate taxes that are the primary vehicle for delivering the revenues needed for the plan, with an increase in the federal corporate tax rate from 21% to 28% being the central proposal. I will leave the debate on what comprises infrastructure to others, and focus entirely on the corporate tax question in this post. I do this, knowing fully well that tax debates quickly turn toxic, as people have strong priors on whether corporations pay their fair share of taxes, and selectively find inforrmation to back their positions. I will begin by laying out the pathways through which corporate taxes affect company value, and then looking at how the 2017 tax reform act, which lowered the federal tax rate from 35% to 21%, has affected corporate behavior.

Taxes, Earnings and Value

At first sight, this section may seem useless, because the effect of tax rates on value seems blindingly obvious. As the corporate tax rate rises, all else being held constant, companies will pay more of their earnings in taxes, and should be worth less. That facile assessment, though, can falter for the following reasons:

Feedback effect on taxable income: This may seem cynical, but it is nevertheless true that the amount that companies report as taxable income and how much they choose to defer taxes into future years is a function of the corporate tax rate. As tax rates rise, corporations use the discretion built into the tax code to report less taxable income and to defer more taxes to future years. It is for this reason that legislatures around the world over estimate how much additional revenue they will generate, when they raise taxes, and investors over estimate how much corporate earnings will rise when tax rates are decreased.ÌýContemporaneous changes in the tax code: When corporate tax rates are changed, it is a given that there will be other changes in the tax code that may either counter the tax rate change or add to it. For instance, the 2017 US tax reform act, in addition to lowering the corporate tax rate, also changed the way that foreign income to US companies was taxed and put limits on the tax deductibility of debt.Financing Mix: Companies can raise capital either from equity or debt, and the costs of equity and debt can be altered when the tax rate changes. That is because interest on debt is tax deductible, and as the corporate tax rate rises, the after-tax cost of debt falls, making debt more attractive as a financing option for companies, relative to equity.The picture below maps out how tax rates can affect earnings, cash flows and value:
Note that it is the effective tax rate, determined by tax deferrals and other tax management tools, that drives after-tax earnings and cash flows, and the marginal tax rate, i.e., the tax rate on the last dollar of income earned that determines the corporate after-tax borrowing cost. It is this reason that the effect of raising or lowering corporate tax rates on value can get murky, with the following general propositions:Tax Deferral Options: Companies that have more options when it comes to deferring taxes than others can buffer the impact of higher corporate taxes by choosing to defer taxes and report less taxable income. The most significant of those options, in my view, is foreign sales, with companies that generate more of their income overseas acquiring more tax freedom than purely domestic companies. There are other options embedded in the tax code allowing for tax credits and deductions for some investments and expenses, with sectors like real estate being prime beneficiaries.Debt funding: Firms that are heavier users of debt financing will be able to offset some or even all of the impact of a higher corporate tax rate, by increasing their debt funding and using the tax advantages that come with the higher tax rate to lower their costs of capital.Put simply, when corporate tax rates are raised, not all companies will lose equally, and there may even be a few companies that emerge as net winners.
Marginal Tax Rates

ÌýÌý ÌýMuch of the discussion about corporate taxes is centered on the corporate tax rate, enumerated in the corporate tax code. As the proposal to raise the US corporate tax rate from 21% to 28% (or some number in the middle) is discussed, it is worth looking at the history of US corporate tax rates, going back to their inception early in the twentieth century:

For proponents of raising corporate taxes, this picture is their strongest suit, since corporate tax rates are now lower than they have been since the 1930s. ÌýFor much of this history, the US also adopted a global tax model, which required US companies to pay the US tax rate not just on income earned in the US, but also in foreign markets, with the caveat that the foreign income would be taxed, when repatriated to the US. In a predictable consequence, US multinationals chose to leave their foreign income outside the US, creating the phenomenon of trapped cash, i.e., income held in foreign locales to avoid taxes, but also trapped because that income could not be used to pay dividends, buy back stock or invest in projects in the United States.

While that system worked well for most of the twentieth century, it started to break down towards the end of that century, as the US became a less dominant player in the global economy, and otherÌýcountries lowered theirÌýcorporate tax rates. The first development meant that larger proportions of USÌýcorporate income was generated overseas, and the second increased the differential tax rates and thus the repatriation penalty. By 2014, when I , the US tax code had become dysfunctional, as the trapped cash cumulated to trillions of dollars and some US companies sought to move their incorporation to other countries. ÌýThis history is worth emphasizing, because the change in the US corporate tax rate in 2021, from 35% to 21%, accompanied by theÌýabandonment of the global tax model just brought the US closer to the rest ofÌýthe world in terms of both tax rates and treatment of foreign income. In fact, atÌýthe start of 2021, the picture below summarizes corporate tax rates around the world:

Source: KPMGNote that the marginal tax rate for US companies is close to 25%-27%, with state and local taxes added on, and isÌýroughly equal to theÌýaverage tax rates in almost every region of the world.Ìý

Effective Tax Rates

Governments set corporate tax rates, but companies use the tax code to full advantage to try to minimize taxes paid and delay the payment of taxes. The effective tax rate measures the actual taxes paid, relative to taxable income, and it is the number that determines how much governments collect as tax revenues.Ìý

Measures of Taxes Paid

To measure how much companies pay in taxes, you have to start with the financial statements of the company, recognizing that these are reporting documents, not tax documents. Put simply, what you see as taxable income in the annual report or public financial filing for a company can be very different from the taxable income in the tax filings made by the same company. Since we have no access to the latter, at least for individual companies, there are clues in the reported financials that can nevertheless help us assess how much a company pays in taxes:

Note that effective tax rate is computed based upon the income statement, and is computed by dividing the accrual measure of taxes by the accrual taxable income. While that is the tax rate that most databases report, it may fail to capture the true tax burden for two reasons:

Accrual income: It is worth remembering that accrual income is after accounting expenses, some of which are related to operations (cost of goods sold, marketing), some to financial (interest expenses) and some of which are determined by the tax code (depreciation and amortization, write offs, special charges). A company that is savvy about using tax provisions to lower its accrual income may be able to look like it is paying a high effective tax rate, but is actually paying very little in absolute terms.Cash taxes versus Accrual taxes: The actual taxes paid by to the government (cash taxes) can be higher or lower than the accrual taxes, and the difference should be visible in the cash flow statement in the form of deferred taxes.ÌýPast tax behavior: One final factor that can affect a company's tax burden is its past history. A company that has lost considerable amounts in prior years can accumulate net operating losses and reduce taxes paid in the current period. Alternatively, a company that has deferred taxes in prior years will find itself playing catch-up and paying more in taxes in the current year, just as companies that have pre-paid taxes in previous years may be able to pay far less in taxes in the current year.As a result of these three phenomena, you can sometimes see effective tax rates that look implausible or even impossible, ranging from rates in excess of 100% to rates less than zero. You can already see, from this description, that computing effective and cash tax rates for individual companies and then averaging across those tax rates can be problematic for a few reasons. The first is that any grouping of companies, where a fairly large number are money-losing and not paying taxes, will give you an average tax rate that is low, even if companies are paying their fair share. The second is that extreme values on tax rates for some companies can skew averages, and if your grouping includes both small and large companies, looking at the average tax rate across companies will not accurately reflect whether companies collectively are bearing a fair burden. If it sounds like I am spending time in the weeds, it is because I face this challenge every year when I report average effective tax rates by sector for companies around the world . To cater to different needs, I report four different tax measures, each of which can yield different values and come with different caveats:Taxes paid in dollar value (Accrual and Cash): This reflects the aggregate amount paid by all companies in a grouping Ìýduring the most recent year. Ultimately, this is the number that matters most from a tax collection perspective.Average effective tax rate across all companies: This is the average tax rate across all companies in a grouping, including money losing companies. Not surprisingly, the average will be pushed down as the number of money losing firms increases.Average effective tax rate across money making companies: This deals with the problem of money losing companies, but it is a simple average and it weights very small companies and very large companies equally.Aggregate tax rate: This is the tax rate that best captures how much companies pay in a sector, and is computed by dividing the sum of taxes paid by all companies in a sector by the sum of taxable income. It thus weights bigger companies more than smaller companies.To illustrate, for US pharmaceutical companies, at the start of 2021, and using income from the trailing 12 months (through September 2020), we find that the these companies collectively paid $9.43 billion in accrual taxes and $15.98 billion in cash taxes. This translated into an average tax rate across all companies of 1.88%, an average tax rate of 16.30% across only money making companies, an aggregate tax rate of 18.19% with accrual taxes (and 32.96% based upon cash taxes).

US Effective Tax rates

The United States is fertile ground to examine how companies manage taxes for two reasons. The first is that until very recently, US companies faced among the highest marginal tax rates of companies anywhere in the world. The second is that the US tax code also has more credits and deductions, often put in by Congress with the best of intentions, that allow companies more discretion when it comes to computing taxable income and tax deferrals. To measure how much companies pay in taxes, I look at how much US companies have, in the aggregate, paid in taxes between 2016 and 2020, in the table below:

Note that while the corporate tax rate dropped by 14% (from 35% to 21%) from 2017 to 2018, the effective tax rate decreased by 6.8% and the cash tax rate by 2.75%. In a more telling statistic, the dollar value of taxes paid increased between 2017 and 2019 by 1.4% and cash taxes by almost 18%, as companies reported more taxable income. To put corporate tax behavior in larger perspective, I looked at corporate pre-tax income and taxes reported by the Bureau of Economic Analysis, going back to 1929:

While there are differences in year to year numbers, looking at this source rather than corporate filings, the story remains the same. Over time, the effective tax rate for companies has drifted down, with the decline accelerating over the last twenty years. It is also clear that the big disruptions in tax rates have come from economic shocks, with taxes collected and tax rates paid declining economic slowdowns and recessions. While the arguments about the right tax rate for US companies and whether they pay their fair share in taxes are legitimate ones, it has to start with a reality check. The perception that US companies are now paying significantly less in taxes than they were prior to 2017, while it may fit your preconceptions about corporate tax behavior, is not backed up by facts. Of course, you could believe that they should pay more than they have historically, but that discussion has to start with the recognition that lowering the tax rate in 2017 is not the reason, and that reversing it will not be the solution.

International Tax Behavior

There is a widespread belief that US companies pay less in taxes than their global counterparts, and to see if that is true, I look at effective tax rates paid by companies in different countries in the map below:

On this measure, I do think that those who believe that US companies pay less than their "fair" share have a point, since the effective tax rate paid by US companies is lower than the effective tax rates of companies in much of the rest of the world (barring Canada). The differences are smaller when you look at the cash tax rate, but there is evidence here of the drag created by the tax credits and deductions added over multiple tax reform acts to the US tax code. The differences in tax rates across the world also underlie the challenge that Janet Yellen will face in trying to get companies to agree to a global minimum tax rate. The countries with tax rates much lower than the global average benefit because they draw in corporate subsidiaries that hope to benefit from the lower tax rates.

Sector-specific Tax BehaviorÌý

It is true that companies in different sectors are affected by the tax code differently, partly because there are tax credits and deductions that are directly specifically at specific sectors. To examine differences in tax rates paid by US companies in each industry grouping, I decided to go back to 2019, rather than 2020 numbers, because the COVID crisis wreaked havoc in some sectors.Ìý

There are clear differences in taxes paid across sectors, with some of the reasons being obvious (REITs are pass through entities that pay no federal taxes) and some not. For instance, technology companies and pharmaceutical businesses are mostly in the first two columns (with the lowest tax rates) and retail Ìýcompanies pay much higher tax rates. ÌýPharmaceutical and technology companies do share a common characteristic, which is that their primary capital expenditure takes the form of R&D, which has historically been expensed at these companies, rather than capitalized and depreciated. To see if that has explanatory power, when it comes to effective tax rates, I broke down US companies into quintiles, based upon R&D as a percent of sales, again using 2019 data, and computed effective and cash tax rates, by quintile:
Companies that have the highest percent of R&D as a percent of sales not only have the smallest proportion of firms with taxable income, but also pay the lowest effective and cash tax rates. However, these are also younger, money-losing companies, and their tax behavior may just reflect where they are in the corporate life cycle. In fact, when you compare all firms with R&D expenses to those without those expenses, the results are mixed. A larger proportion of firms with R&D expenses report taxable income, and while they pay a lower effective tax rate than non-R&D firms, they pay a highest cash tax rate.
Finally, there seems to be a perception that it is the largest companies that are not paying their fair share in taxes, fed by anecdotal evidence of high profile companies that pay no taxes; in the last few years, those examples have included , andÌý. To see if this is true, across companies, I broke US companies down my market capitalization into ten deciles and looked at the tax behavior in each grouping.There is little evidence in this table to support the notion that larger companies are more likely to evade taxes than smaller ones. In fact, the percentage of companies with taxable income rises with market capitalization, and the effective tax rates of the top deciles are clearly higher than those of the bottom deciles.

Thoughts on new tax laws

If Congress gets around to passing another tax reform act, I am sure that legislators will gets lots of opinions on what they should be doing, not to mention millions of dollars off lobbying directed at them. I am sure that my thoughts on what good tax legislation should look like matter little, but here they are:

Pinpoint your mission: In keeping with the saying that if you do not know where you going, it does not matter how you get there, the starting point for all tax legislation has to be with the end game. Early on, legislators have to decide whether they consider corporate taxes to primarily a source of revenues to the government or a weapon to punish "bad" corporate behavior and to "reward" good corporate behavior. While I understand the urge to use the tax code to mete out punishment to "bad" companies or to encourage companies to pay a living wage and keep their operations in the United States, the resulting laws may actually result in less tax revenue to the government, with only fleeting benefits.All tax talk is agenda-driven: Undoubtedly, there will be research from the Congressional budget office on the revenue consequences of tax law changes and testimony from economists and tax experts. They will use numbers that back their arguments and look like facts, but in my experience, it is easy to lie with numbers, especially when it comes to taxes. ÌýFocus on removing tax deductions/credits, not on increasing tax rates: If the end game is to get companies to pay more in taxes, removing tax deductions and credits will be more effective than increasing the tax rate. In fact, raising the tax rate will not only raise the effective tax rate paid by companies far less than expected, but it will also have disparate effects across companies, with sectors (like retail) that have fewer degrees of freedom, when it comes to changing taxable income or deferring taxes, bearing the brunt of the pain. I know that this is easier said than done, since every tax deduction/credit has a constituency that will plead for its preservation, but one reason why the tax code has become the convoluted mess that it has become, is because we have not frontally dealt with this problem. An added benefit of doing this will be that there will be less work for tax accountants and lawyers and fewer tax-driven investments and decisions.You operate in a global economy: No matter how careful you write the tax laws, multinationals will retain a substantial amount of freedom to move their operations and income around the world. A country that is an outlier when it comes to taxes, as the United States was prior to 2017, will lose out in the competition for new businesses. While I do think that a global corporate minimum tax can reduce this cost somewhat, getting countries to sign on, especially when they realize that they will be "net losers" from being part of it, will be difficult.Provide long-term predictability: Whatever Congress decides to do with the tax code, it should also provide a degree of predictability for an extended period. Changes to the tax law that are temporary or come with sunset provisions create uncertainty for businesses trying to make investment decisions for the long term. In addition, changes in tax law take a while to work their way into corporate behavior. One of the better features of the 2017 tax act was that it had provisions designed to make debt financing less attractive, relative to equity, but we will not get a chance to see if companies become less dependent on debt, if tax rates are hiked and/or the limitations on interest tax deductions are eliminated.Am I hopeful that Congress will keep these in mind, while it writes new tax laws? Not really, but there is no harm in hoping!
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The first quarter of 2021 has been, for the most part, a good time for equity markets, but there have been surprises. The first has been the steep rise in treasury rates in the last twelve weeks, as investors reassess expected economic growth over the rest of the year and worry about inflation. The second has been a shift within equity markets, a "rotation" in Wall Street terms, as the winners from last year underperformed the losers in the first quarter, raising questions about whether this shift is a long term one or just a short term adjustment. The answers are not academic, since they cut to the heart of how stockholders will do over the rest of the year, and whether value investors will finally be able to mount a comeback.

The Interest Rates StoryÌý

To me the biggest story of markets in 2021 has been the rise of interest rates, especially at the long end of the maturity spectrum. To understand the story and put it in context, I will go back more than a decade to the 2008 crisis, and note how in its aftermath, US treasury rates dropped and stayed low for the next decade.Ìý

Coming in 2020, the ten-year T.Bond rate at 1.92% was already close to historic lows. The arrival of the COVID in February 2020, and the ensuing market meltdown, causing treasury rates to plummet across the spectrum, with three-month T.bill rates dropping from 1.5% to close to zero, and the ten-year T.Bond rate declining to close to 0.70%. Those rates stayed low through the rest of 2020, even as equity markets recovered and corporate bond spreads fell back to pre-crisis levels. Coming into 2021, the ten-year T.Bond rate was at 0.93%, and I for the rest of the year, with the consensus gathered around a strong economic comeback (with earnings growth following), but with rates continuing to stay low. In the first quarter of 2021, we continued to see evidence of economic growth, bolstered by a stimulus package of $1.9 trillion, but it does seem like the treasury bond market is starting to wake up to that recognition as well, as rates have risen strongly:

These rising rates have led to some hand wringing about why the Fed is not doing more to keep rates down, mostly from people who seem to have an almost mystical faith in the Fed's capacity to keep rates wherever it wants them to be. I would argue that the Fed has tried everything it can to keep rates from rising, and the very fact that rates have risen, in spite of this effort, is an indication of the limited power it has to set any of the rates that we care about in investing. To those who use the low interest rates of the last decade as proof of the Fed's power, I would counter with a graph that I have used many times before to illustrate the fundamental drivers of interest rates (and the Fed is not on that list):

The reason interest rates have been low for the last decade is because inflation has been low and real growth has been anemic. With its bond buying programs and its "keep rates low" talk, the Fed has had influence, but only at the margin.Ìý

As for rates for the rest of the year, you may draw comfort from the Fed's assurances that it will keep rate low, but I don't. Put bluntly, the only rate that the Fed directly sets is the Fed Funds rate, and while it may send signals to the market with its words and actions, it faces two limits.Ìý

The first is that the Fed Funds rate is currently close to zero, limiting the Fed's capacity to signal with lower rates.ÌýThe second and more powerful factor is that the reason that a central bank is able to signal to markets, only if it has credibility, since the signal is more about what the Fed sees, using data that only it might have, about inflation and real growth in the future. Every time a Federal Reserve chair or any of the FOMC members make utterances that undercut that credibility, the Fed risks losing even the limited signaling power it continues to have. I believe that the most effective central bankers speak very little, and when they do, don't say much.In particular, the Fed's own assessments of real growth of 6.5% for 2021 and inflation of 2.2% for the year are at war with its concurrent promise to keep rates low; after all, adding those numbers up yields a intrinsic risk free rate of 8.7%. While I understand that much of the real growth in 2021 is a bounce back from 2020, even using a 2-3% real growth yields risk free rates that are much, much higher than today's numbers.Ìý

The Stocks Story

As treasury rates have risen in 2021, equity markets have been surprisingly resilient, with stocks up Ìýduring the first three months. However, as with last year, the gains have been uneven with some Ìýgroups of stocks doing better than others, with an interesting twist; the winners of last year seem to be lagging this year, and the losers are doing much better. While some of this reversal is to be expected in any market, there are questions about whether it has anything to do with rising rates, as well as whether there may be light at the end of the tunnel for some investor groups who were left out of the market run-up in the last decade. ÌýFor much of the last year, I tracked the S&P 500 and the NASDAQ, the first standing in for large cap stocks and the broader market, and the latter proxying for technology and growth stocks, with some very large market companies included in the mix. Continuing that practice, I look at the two indices in 2021:

Both indices are up for the year, but they have diverged in their paths. In January, the NASDAQ continued its 2020 success, and the S&P 500 lagged, losing value. In February and March, the tide shifted, and the S&P 500 outperformed the NASDAQ. Looking at the market capitalization of all stocks listed in the United States, and breaking down the market action in 2021, by sector, here is what I see:The two sectors where there is the biggest divergence between post-crisis performance in 2020 and market returns in 2021 are energy, which has gone from one of the worse performing sectors to the very best and technology, which has made a journey in the other direction. Using price to book ratios as a rough proxy for value versus growth, I looked at returns in the post-crisis period in 2020 and in 2021, to derive the following table:
It is much too early to be drawing strong conclusions, but at least so far in 2021, low price to book stocks, which lagged the market in 2020, are doing much better than higher price to book stocks.Ìý

Interest Rates and Value

As interest rates have risen, the discussion in markets has turned ito the effects that these rates will have on stock prices. While the facile answer is that higher rates will cause stock prices to fall, I will argue in this section that not only is the answer more nuanced, and depends, in large part, on why rates are rising in the first place.

Value Framework

As with any discussion about value and the variables that affect it, I find it useful to go back to basics. If you accept the proposition that the value of a business is a function of its expected cash flows (with both the benefits and costs of growth embedded in them) and the risk in these cash flows, we are in agreement on what drives value, even if we disagree about the specifics on how to measure risk and incorporate it into value:

This equation looks abstract, but it has all of the components of a business in it, as you can see in this richer version of the equation:

In this richer version, the effect of rising rates can be captured in the components that drive value. The direct effect is obviously through the base rate, i.e. the riskfree rate, on which the discount rate is built, and it is the effect that most analysts latch on to. If you stopped with that effect, rising rates always lead to lower values for equities, since holding all else constant, and raising what you require as a rate of return will translate into lower value today. That misses the indirect effects, and these indirect effects emerge from looking at why rates rose in the first place. Fundamentally, interest rates can rise because investors expectations of inflation go up, or because real economic growth increases, and these macroeconomic fundamentals can affect the other drivers of value: table.tableizer-table { font-size: 12px; border: 1px solid #CCC; font-family: Arial, Helvetica, sans-serif; } .tableizer-table td { padding: 4px; margin: 3px; border: 1px solid #CCC; } .tableizer-table th { background-color: #104E8B; color: #FFF; font-weight: bold; }

Higher real growthHigher inflation Riskfree RateRiskfree rate will rise.Riskfree rate will rise. Risk premiumsNo effect or even a decrease.Risk premia may rise as inflation increases, because higher inflation is almost always more volatile than low inflation. Revenue GrowthIncreases with economic growth, and more so economy-dependent companiesIncreases, as inflation provides a backdraft adding to existing real growth. Operating MarginsIncreases, as increased consumer spending/demand allows for price increasesFor companies with the power to pass through inflation to their customers, stable margins, but for companies without that pricing power, margins decrease. Investment EfficiencyImproves, as the same investment delivers more revenues/profits.No effect, in real terms, but in nominal terms, companies can look more efficient. Value EffectMore likely to be positive. Investors will demand higher rates of return (negative), but higher earnings and cash flows can more than offset effect.More likely to be negative. Investors will demand higher rates of return (negative), and while revenue growth will increase, lower margins will lead to lagging earnings.

Put simply, the effect of rising rates on stock prices will depend in large part on the precipitating factors.Ìý

If rising rates are primarily driven by expectations of higher real growth, the effect is more likely to be positive, as higher growth and margins offset the effect of investors demanding higher rates of return on their investments.ÌýIf rising rates areÌýprimarily driven by inflation, the effects are far more likely to be negative, since you have more negative side effects, with risk premiums rising and margins coming under pressure, especially for companies without pricing power.ÌýTo see how changes in interest rates play out in equity markets, I started with a simple, perhaps even simplistic adjustment, where I look at quarterly stock returns and T.Bond rates at the start of each quarter, to examine the linkage.
While the chart itself has too much noise to draw conclusions, the correlations that I have calculated provide more information. The negative correlation between stock returns and rate changes in the prior quarter (-.12 with the treasury bond rate) provide backing for the conventional wisdom that rising rates are more likely to be accompanied by lower stock returns. However, if you break down the reason for rising rates into higher inflation and higher real growth increases, stocks are negatively affected by the former (correlation of -0.078) and positively affected by the latter (correlation of .087). It is also worth noting that none of the correlations are significant enough to represent money making opportunities, since there seems to be much more driving stock returns than just interest rates, inflation and real growth.Ìý
I also updated my valuation (from January 2021) of the S&P to reflect current rates and earnings numbers, and played out the effect of changing rates on the intrinsic PE ratio for the index:
In making these computations, I looked at three scenarios, a neutral scenario, whereÌýchanges in the T.Bond rate are matched by changes in the expected long termÌýearningsÌýgrowth rate, a benign scenario, where expected long term earnings growth runs ahead of the change inÌýthe T.Bond rate by 0.5%, in theÌýlong term, and a malignant scenario, where earnings growth lags changes in the T.Bond rate by 0.5%, in the long term. Note that in the best case scenario, at least with my range of outcomes, where rates drop back to 1.00%, but long termÌýearnings growth runs ahead of riskfree rates by 0.5%, the intrinsic value for the index is 3919, just above current levels. In the worst case scenario, where rates rise to 3% or higher, and growth lags by 0.5%, the index is over valued significantly. Connecting to my earlier discussion of how inflation and real growth play out differently inÌýearnings growth, I would expect a real-growth driven increase in rates to yield values closer to my benign ones, where anÌýinflation-drivenÌýincrease in rates will be far more damaging for stocks.

Rates and the Corporate Life Cycle

There is a surprisingly complicated relationship between interest rates and stock prices, with higher interest rates sometimes coexisting with higher stock prices and sometimes with lower. As rates rise, though, the effects on value will vary across companies, with some companies being hurt more and others being hurt less, or even helped. To understand why, I will draw on one of my favorite structures, the corporate life cycle, where I argue that most companies go through a process of birth, growth, aging and ultimate decline and death. To see the connection with interest rates, note that there are two dimensions on which companies vary across the life cycle:

Cashflows: Young companies are more likely to have negative than positive cash flows in the early years, as their business models are in flux, economies of scale have not kicked in yet, and substantial reinvestment is needed to deliver the promised growth. As they mature, the cash flows will turn positive, as margins improve and reinvestment needs drop off.Ìý
Source of value: Drawing on another construct , the financial balance sheet, the value of a company can be broken down into the value it derives from investments it has already made (assets in place) and the value of investments it is expected to make in the future (growth assets). Young companies derive the bulk of their value from growth assets, whereas more mature firms get their value from assets in place.Ìý

Connecting to the earlier discussion on interest rates and value, you can see why increases in interest rates can have divergent effects on companies at different stages in the life cycle. When interest rates rise, the value of future growth decreases, relative to the value of assets in place, for all companies, but the effect is far greater for young companies than mature companies. This will be true even if growth Ìýrates match increases in interest rates, but it will get worse if growth does not keep up with rate increases.Ìý

To illustrate this, I will use two firms, similar in asset quality (return on equity = 15%) and risk (cost of equity is 5% above the risk free rate), but different in growth prospects; the mature firm will grow 1% higher than the riskfree rate and the growth firm will grow 10% a year higher than the risk free rate, for the next 10 years. After year 10, both firms will be mature, growing at the risk free rate. As I increase the risk free rate, note that the costs of equity and growth rates will go up for both firms, and that their reinvestment needs will change accordingly. The effects of changing the T.Bond rate in this simplistic example are illustrated below:

Both companies see a decline in PE ratios, as interest rates rise, but the high growth firm sees a bigger drop. This is captured in the growth premium (computed by comparing the PE ratio for the growth firm to the PE ratio for a mature firm). You can check out the effects of introducing malign and benign growth effects into this example, with the former exacerbating the differential effect and the latter reducing it.

The Rest of 2021

I hope that thisÌýdiscussion of the relationship between interest rates and value provides some insight into both why the equity market has been able to maintain its upward trend in the face of rising rates, as well as explain the divergences across growth and mature companies. The primary story driving interest rates, for much of 2021, has been one of economic resurgence, and it does not surprise me that the positives have outweighed the negatives, so far. At the same time, there is concern that inflation might be lurking under the surface, and on days when these worries surface, the market is much more susceptible to melting down. My guess is that this dance will continue for the foreseeable future, but as more real data comes out on both real growth and inflation, one or the other point of view will get vindication. Unlike some in the market, who believe that the Fed has the power to squelch inflation, if it does come back, I am old enough to remember both how stealthy inflation is, as well as how difficult it is for central banks to reassert dominance over inflation, once it emerges as a threat.

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What is a hurdle rate for a business? There are multiple definitions that you will see offered, from it being the cost of raising capital for that business to an opportunity cost, i.e., a return that you can make investing elsewhere, to a required return for investors in that business. In a sense, each of those definitions has an element of truth to it, but used loosely, each of them can also lead you to the wrong destination. In this post, I will start by looking at the role that hurdle rates play in running a business, with the consequences of setting them too high or too low, and then look at the fundamentals that should cause hurdle rates to vary across companies.

What is a hurdle rate?

Every business, small or large, public or private, faces a challenge of how to allocate capital across competing needs (projects, investments and acquisitions), though some businesses have more opportunities or face more severe constraints than others. In making these allocation or investment decisions, businesses have to make judgments on the minimum return that they would accept on an investment, given its risk, and that minimum return is referenced as the hurdle rate. ÌýHaving said that, though, it is worth noting that this is where the consensus ends, since there are deep divides on how this hurdle rate should be computed, with companies diverging and following three broad paths to get that number:

1. Cost of raising funds (capital): Since the funds that are invested by a business come from equity investors and lenders, one way in which the hurdle rate is computed is by looking at how much it costs the investing company to raise those funds. Without any loss of generality, if we define the rate of return that investors demand for investing in equity as the cost of equity and the rate that lenders charge for lending you money as the cost of debt, the weighted average of these two costs, with the weights representing how much of each source you use, is the cost of capital:

The problem with a Ìýcorporate cost of capital as a hurdle rate is that it presumes that every project the company takes has the same overall risk profile as the company. That may make sense if you are a retailer, and every investment you make is another mall store, but it clearly does not, if you are a company in multiple businesses (or geographies) and some investments are much riskier than others.Ìý

2. Opportunity Cost: The use of a corporate cost of capital as a hurdle rate exposes you to risk shifting, where safe projects subsidize risky projects, and one simple and effective fix is to shift the focus away from how much it costs a company to raise money to the risk of the project or investment under consideration. The notion of opportunity cost makes sense only if it is conditioned on risk, and the opportunity cost of investing in a project should be the rate of return you could earn on an alternative investment of equivalent risk.

If you follow this practice, you are replacing a corporate cost of capital with a project-specific hurdle rate, that reflects the risk of that project. It is more work than having one corporate hurdle rate, but you are replacing a bludgeon with a scalpel, and the more varied your projects, in terms of business and geography, the greater the payoff.

3. Capital Constrained Clearing Rate: The notion that any investment that earns more than what other investments of equivalent risk are delivering is a good one, but it is built on the presumption that businesses have the capital to take all good investments. Many companies face capital constraints, some external (lack of access to capital markets) and some internal (a refusal to issue new equity because of dilution concerns), and consequently cannot follow this rule. Instead, they find a hurdle rate that incorporates their capital constraints, yielding a hurdle rate much higher than the true opportunity cost. To illustrate, assume that you are a company with fifty projects, all of similar risk, and all earning more than the 10% that investments of equivalent risk are making in the market. If you faced no capital constraints, you would take all fifty, but assume that you have limited capital, and that you rank these projects from highest to lowest returns (IRR or accounting return). The logical thing to do is to work down the list, accepting projects with the highest returns first until you run out of capital. If the last project that you end up accepting has a 20% rate of return, you set your hurdle rate as 20%, a number that clears your capital.Ìý

By itself, this practice make sense, but inertia is one of the strongest forces in business, and that 20% hurdle rate often become embedded in practice, even as the company grows and capital constraints disappear. The consequences are both predictable and damaging, since projects making less than 20% are being turned away, even as cash builds up in these companies.

While the three approaches look divergent and you may expect them to yield different answers, they are tied together more than you realize, at least in steady state. Specifically, if market prices reflect fair value, the cost of raising funds for a company will reflect the weighted average of the opportunity costs of the investments they make as a company, and a combination of scaling up (reducing capital constraints) and increased competition (reducing returns on investments) will push the capital constrained clearing rate towards the other two measures. If you are willing to be bored, I do have a that explains how the different definitions play out, as well as the details of estimating each one.

Hurdle Rate - The Drivers

For the rest of this post, I will adopt the opportunity cost version of hurdle rates, where you are trying to measure how much you should demand on a project or investment, given its risks. In this section, I will point to the three key determinants of whether the hurdle rate on your next project should be 5% or 15%. ÌýThe first is the business that the investment is in, and the risk profile of that business. The second is geography, with hurdle rates being higher for projects in some parts of the world, than others. The third is currency, with hurdle rates, for any given project, varying across currencies.

A. Business

If you are a company with two business lines, one with predictable revenues and stable profit margins, and the other with cyclical revenues and volatile margins, you would expect to, other things remaining equal, use a lower hurdle rate for the first than the second. That said, there are two tricky components of business risk that you need to navigate:

Firm specific versus Macro risk: When you invest in a company, be it GameStop or Apple, there are two types of risks that you are exposed to, risks that are specific to the company (that GameStop's online sales will be undercut by competition or that Apple's next iPhone launch may not go well) and risks that are macroeconomic and market-wide (that the economy may not come back strongly from the shut down or that inflation will flare up). If you put all your money in one or the other of these companies, you are exposed to all these risks, but if you spread your bets across a dozen or more companies, you will find that company-specific risk gets averaged out. From a hurdle rate perspective, this implies that companies, where Ìýthe marginal investors (who own a lot of stock and trade that stock) are diversified, should incorporate only macroeconomic or market risk into hurdle rates. For small private firms, where the sole owner is not diversified, the hurdle rate will have to incorporate and be higher.Financial leverage: There are two ways you can raise funding for a company, and since lenders have contractual claims on the cash flows, the cost of debt should be lower than the cost of equity for almost every company, and that difference is increased by the tax laws tilt towards debt (with interest expenses being tax deductible). Unfortunately, there are many who take this reality and jump to the conclusion that adding debt will lower your hurdle rate, an argument that is built on false premises and lazy calculations. In truth, debt can lower the hurdle rate for some companies, but almost entirely because of the tax subsidy feature, not because it is cheaper, but it can just as easily increase the hurdle rate for others, as distress risk outweighs the tax benefits. (More on that issue in a future data update post...)

I know that many of you are not fans of modern portfolio theory or betas, but ultimately, there is no way around the requirement that you need to measure how risky a business, relative to other businesses. I am a pragmatist when it comes to betas, viewing them as relative risk measures that work reasonably well for diversified investors, but I have also been open about the fact that I will take that accomplishes the same objective.Ìý

To illustrate how costs of capital can vary across businesses, I used a very broad classification of global companies into sectors, and computed the cost of capital at the start of 2021, in US $ terms, for each one:

If you prefer a more granular breakdown, I estimate costs of capital by industry (with 95 industry groupings) in US $ and you can find the links here. (,Ìý,Ìý,Ìý,Ìý,Ìý)

2. Geography

As a business, should you demand a higher US $ hurdle rate for investing in a project in Nigeria than the US $ hurdle rate you would require for an otherwise similar project in Germany? ÌýThe answer, to me, seems to be obviously yes, though there are still some who argue otherwise, usually with the argument that country risk can be diversified away. The vehicle that I use to convey country risk into hurdle rates is the equity risk premium, the price of risk in equity markets, that I talked about in my on the topic. In that post, I computed the equity risk premium for the S&P 500 at the start of 2021 to be 4.72%, using a forward-looking, dynamic measure. If you accept that estimate, a company looking at a project in the US or a geographical market similar to the US in terms of country risk, would accept projects that delivered this risk premium to equity investors.Ìý

But what if the company is looking at a project in Nigeria or Bangladesh? To answer that question, I estimate equity risk premiums for almost every country in the world, using a very simple (or simplistic) approach. I start with the 4.72%, my estimate of the US ERP, as my base premium for mature equity markets, treating all Aaa rated countries (Germany, Australia, Singapore etc.) as mature markets. For countries not rated Aaa, I use the sovereign rating for the country to estimate a default spread for that country, and scale up that default spread for the higher risk that equities bring in, relative to government bonds.Ìý

That additional premium, which I call a country risk premium, when added to the US ERP, gives me an equity risk premium for the country in question.Ìý

What does this mean? Going back to the start of this section, a company (say Ford) would require a higher cost of equity for a Nigerian project than for an equivalent German project (using a US $ risk free rate of 1% and a beta of 1.1 for Ford).

Cost of equity in US $ for German project = 1% + 1.1 (4.72%) = 6.19%Cost of equity in US $ for a Nigerian project = 1% + 1.1 (10.05%) = 12.06%The additional 5.87% that Ford is demanding on its Nigerian investment reflects the additional risk that the country brings to the mix.

3. Currency

I have studiously avoided dealing with currencies so far, by denominating all of my illustrations in US dollars, but that may strike some of you as avoidance. After all, the currency in Nigeria is the Naira and in Germany is the Euro, and you may wonder how currencies play out in hurdle rates. My answer is that currencies are a scaling variable, and dealing with them is simple if you remember that the primary reason why hurdle rates vary across currencies is because they bring different inflation expectations into the process, with higher-inflation currencies commanding higher hurdle rates. To illustrate, if you assume that inflation in the US $ is 1% and that inflation in the Nigerian Naira is 8%, the hurdle rate that we computed for the Nigerian project in the last section can be calculated as follows:

Cost of equity in Naira for Nigerian project (approximate) = 12.06% + (8% - 1%) = 19.06%Cost of equity in Naira for Nigerian project (precise) = 1.1206 * (1.08/1.01) -1 = 19.83%

In effect, the Nigerian Naira hurdle rate will be higher by 7% (7.77%) roughly (precisely) than a US $ hurdle rate, and that difference is entirely attributable to inflation differentials. The instrument that best delivers measures of the expected inflation is the riskfree rate in a currency, which I compute by starting with a government bond rate in that currency and then cleaning up for default risk. At the start of 2021, the riskfree rates in different currencies are shown below:

These risk free rates are derived from government bond rates, and to the extent that some of the government bonds that I looked at are not liquid or widely traded, you may decide to replace those rates with synthetic versions, where you add the differential inflation to the US dollar risk free rate. Also, note that there are quite a few currencies with negative risk free rates, a phenomenon that can be unsettling, but one you can work with, as long as you stay consistent.

Implications

As we reach the end of this discussion, thankfully for all our sakes, let's look at the implications of what the numbers at the end of 2020 are for investors are companies.Ìý

Get currency nailed down: We all have our frames of reference, based often upon where we work, and not surprisingly, when we talk with others, we expect them to share the same frames of reference. When it comes to hurdle rates, that can be dangerous, since hurdle rates will vary across currencies, and cross-currency comparisons are useless. Thus, a 6% hurdle rate in Euros may look lower than a 12% hurdle rate in Turkish lira, but after inflation is considered, the latter may be the lower value. Any talk of a global risk free rate is nonsensical, since risk free rates go with currencies, and currencies matter only because they convey inflation. That is why you always have the option of completely removing inflation from your analysis, and do it in real terms.A low hurdle rate world: At the start of 2021, you are looking at hurdle rates that are lower than they have ever been in history, for most currencies. In the US dollar, for instance, a combination of historically low risk free rates and compressed equity risk premiums have brought down costs of capital across the board, and you can see that in the histogram of costs of capital in US $ of US and global companies at the start of 2021:
The median cost of capital in US $ for a US company is 5.30%, and for a global company is 5.78%, and those numbers will become even lower if you compute them in Euros, Yen or Francs. ÌýI know that if you are an analyst, those numbers look low to you, and the older you are, the lower they will look, telling you something about how your framing of what you define to be normal is a function of what you used to see in practice, when you were learning your craft. That said, unless you want to convert every company valuation into a judgment call on markets, you have to get used to working with Ìýthese lower discount rates, while adjusting your inputs for growth and cash flows to reflect the conditions that are causing those low discount rates. For companies and investors who live in the past, this is bad news. ÌýA company that uses a 15% cost of capital, because that is what it has always used, will have a hard time finding any investments that make the cut, and investors who posit that they will never invest in stocks unless they get double digit returns will find themselves holding almost mostly-cash portfolios. While both may still want to build a buffer to allow for rising interest rates or risk premiums, that buffer is still on top of a really low hurdle rate and getting to 10% or 15% is close to impossible.Don't sweat the small stuff: I spend a lot of my time talking about and doing intrinsic valuations, and for those of you who use discounted cash flow valuations to arrive at intrinsic value, it is true that discount rates are an integral part of a DCF. That said, I believe that we spend way too much time on discount rates, finessing risk measures and risk premiums, and too little time on cash flows. In fact, if you are in a hurry to value a company in US dollars, my suggestion is that you just use a cost of capital based upon the distribution in the graph above (4.16% for a safe company, 5.30% for an average risk company or 5.73% for a risky company) as your discount rate, spend your time estimating revenue growth, margins and reinvestment, and if you do have the time, come back and tweak the discount rate.Ìý

I know that some of you have been convinced about the centrality of discount rates by sensitivity analyses that show value changing dramatically as discount rates changes. These results are almost the consequence of changing discount rates, while leaving all else unchanged, an impossible trick to pull off in the real world. Put simply, if you woke up tomorrow in a world where the risk free rate was 4% and the cost of capital was 8% for the median company, do you really believe that the earnings and cash flows you projected in a COVID world will remain magically unchanged? I don't!

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Cost of capital, by industry - January 2021 (, , , , , )

There are three topics that you can write or talk about that are almost guaranteed to draw a audience, stocks (because greed drives us all), sex (no reason needed) and salvation. I am not an expert on the latter two, and I am not sure that I have that much that is original to say about the first. That said, Ìýin my niche, which is valuation, many start with the presumption that almost every topic you pick is boring. Obviously, I do not believe that, but there are some topics in valuation that are tough to care about, unless they are connected to real events or current news. One issue that I have always wanted to write about is the potential for a feedback loop between price and value (I can see you already rolling your eyes, and getting ready to move on..), but with the frenzy around GameStop and AMC, you may find it interesting. Specifically, a key question that many investors, traders and interested observers have been asking is whether a company, whose stock price and business is beleaguered, can take advantage of a soaring stock price to not just pull itself out of trouble, but make itself a more valuable firm. In other words, can there be a feedback loop, where increasing stock prices can pull value up, and conversely, could decreasing prices push value down?

Price, Value and the Gap

For the third time in three posts, I am going to fall back on my divide between value and price. Value, as I have argued is a function of cash flows, growth and risk, reflecting the quality of a company's business model. Price is determined by demand and supply, where, in addition to, or perhaps even overwhelming, fundamentals, you have mood, momentum and revenge (at least in the case of GameStop) thrown into the mix. Since the two processes are driven by different forces, there is no guarantee that the two will yield the same number for an investment or a company at a point in time:

Put simply, you can have the price be greater than value (over valued), less than value (under valued) or roughly the same (fairly valued). The last scenario is the one where markets are reasonably efficient, and in that scenario, the two processes do not leak into each other. In terms of specifics, when a stock's value is roughly equal to its price:

Issuing new shares at the market price will have no effect on the value per share or the price per share, dilution bogeyman notwithstanding.Buying back shares at the market price will have no effect on the value per share or price per share of the remaining shares, even though the earnings per share may increase as a result of decreased share count.I know these implications sound unbelievable, especially since we have been told over and over that these actions have consequences for investors, and so much analysis is built around assessments of accretion and dilution, with the former being viewed as an unalloyed good and latter as bad.
The Feedback LoopIn the real world, there are very few people who believe in absolute market efficiency, with even the strongest proponents of the idea accepting the fact that price can deviate from value for some or many companies. When this happens, and there is a gap between price and value, there is the potential for a feedback loop, where a company's pricing can affects its value. That loop can be either a virtuous one (where strong pricing for a company can push up its value) or a vicious one (where weak pricing for a company can push down value). There are three levels at which a gap between value and price can feed back into value:Perception: While nothing fundamentally has changed in the company, a rise (fall) in its stock price, makes bondholders/lenders more willing to slacken (tighten) constraints on the firm and increase (decrease) the chances of debt being renegotiated. It also affects the company's capacity to attract or repel new employees, with higher stock prices making a company a more attractive destination (especially with stock-based compensation thrown into the mix) and lower stock prices having the opposite effect.Implicit effects: When a company's stock price goes up or down, there can be tangible changes to the company's fundamentals. If a company has a significant amount of debt that is weighing it down, creating distress risk, and some of it is convertible, a surge in the stock price can result in debt being converted to equity on favorable terms (fewer shares being issued in return) and reduce default risk. Conversely, if the stock price drops, the conversion option in convertible debt will melt away, making it almost all debt, and pushing up debt as a percent of value. A surge or drop in stock prices can also affect a company's capacity to retain existing employees, especially when those employees have received large portions of their compensation in equity (options or restricted stock) in prior years. If stock prices rise (fall), both options and restricted stock will gain (lose) in value, and these employees are more (less) likely to stay on to collect on the proceeds.ÌýExplicit effects: If a company's stock price rises well above value, companies will be drawn to issue new shares at that price. While I will point out some of the limits of this strategy below, the logic is simple. Issuing shares at the higher price will bring in cash into the company and it will augment overall value per share, even though that augmentation is coming purely from the increase in cash. ÌýCompanies can use the cash proceeds to pay down debt (reducing the distress likelihood) or even to change their business models, investing in new models or acquiring them. If a company's stock price falls below value, a different set of incentives kick in. If that company buys back shares at that stock price, the value per share of the remaining shares will increase. To do this, though, the company will need cash, which may require divestitures and shrinking the business model, not a bad outcome if the business has become a bad one.I have summarized all of these effects in the table below:

These effects will play out in different inputs into valuation, with the reduction in distress risk showing up in lower costs for debt and failure probabilities, the capacity to hire new and keep existing employees in higher operating margin, the issuance or buyback of shares in cash balances and changes in the parameters of the business model (growth, profitability). Looking at the explicit effect of being able to issue shares in the over valued company or buy back shares in the under valued one, there are limits that constrain their use:Regulations and legal restrictions: A share issuance by a company that is already public is a secondary offering, and while it is less involved than a primary offering (IPO), there are still regulatory requirements that take time and require SEC approval. Specifically, a company planning a secondary offering has to file a prospectus (S-3), listing out risks that the company faces, how many shares it plans to issue and what it plans to use the proceeds for. That process is not as time consuming or as arduous as it used to be, but it is not instantaneous; put simply, a company that sees its stock price go up 10-fold in a day won't be able to issue shares the next day.Demand, supply and momentum: If the price is set by demand and supply, increasing the supply of shares will cause price to drop, but the effect is much more insidious. To the extent that the demand for an over valued stock is driven by mood and momentum, the very act of issuing shares can alter momentum, magnifying the downward pressure on stock prices. Put simply, a company that sees it stock price quadruple that then rushes a stock issuance to the market may find that the act of issuing the shares, unless pre-planned, May itself cause the price rise to unravel.Value transfer, not value creation: Even if you get past the regulatory and demand/supply obstacles, and are able to issue the shares at the high price, it is important that you not operate under the delusion that you have created value in that stock issuance. The increase in value per share that you get comes from a value transfer, from the shareholders who buy the newly issued shares at too high a price to the existing shareholders in the company.Cash and trust: If you can live with the value transfer, there is one final hurdle. The new stock issuance will leave the company with a substantial cash balance, and if the company's business model is broken, there is a very real danger that managers, rather than follow finding productive ways to fix the model, will waste the cash trying to reinvent themselves.With buybacks, the benefits of buying shares back at below value are much touted, and Warren Buffett made this precept an explicit part of the Berkshire Hathaway buyback program, but buybacks face their own constraints. A large buyback may require a tender offer, with all of the costs and restrictions that come with them, the act of buying back stock may push the price up and beyond value. The value transfer in buybacks, if they occur at below fair value, also benefit existing shareholders, but the losers will be those shareholders who sold their shares back. Finally, a buyback funded with cash that a company could have used on productive investment opportunities is lost value for the company.
Reality Check
With that long lead in, we can address the question that many of those most upbeat about GameStop and AMC were asking last week. Can the largely successful effort, at least so far, in pushing up stock prices actually make GameStop or AMC a more valuable company? The answer is nuanced and it depends on the company:Perception: For the moment, the rise in the stock price has bought breathing room in both companies, as lenders back off, but that effect is likely to be transient. Perception alone cannot drive up value.Implicit effects: On this dimension, AMC has already derived tangible benefits, , making the company far less distressed. For those Redditors primed for revenge against Wall Street, it is worth noting that the biggest beneficiary in this conversion is Silver Lake, a hedge fund that invested in these bonds in the dark days for the company. GameStop's debt is more conventional borrowing, and while bond prices have gone up, the benefits don't accrue as directly to the company.Explicit effects: On this dimension again, AMC is better positioned, having already filed a prospectus for a on December 11, well ahead of the stock run-up. In that offering, AMC filed for approval for issuance of up to 178 million additional shares, from time to time, primarily to pay down debt. If the stock price stays elevated, and that is a big if, AMC will be able to issue shares at a price > value and increase its value per share. It is unclear whether GameStop has the time to even try to do this, especially if the stock price rise dissipates in days or weeks, rather than months.To incorporate the feedback loop, I had modified my base case GameStop valuation (not the best case that you saw ), and allowed for two additional inputs: new shares issued and an issuance price. Note that the value per share that I get with no additional shares issued is $28.17, and you can see how that value per share changes, for different combinations of issuance share numbers and issuance share prices:
Note that if the issuance occurs at my estimate of intrinsic value of $28.17, the share issuance has no effect on value per share, since the increase in share count offsets the increased cash balance exactly. Even in the more upbeat scenarios, where the company is able to issue new shares at a price above this value, let's be clear that the game that is playing out is value transfer. To see this, take the most extreme scenario, where GameStop is able to issue 50 million new shares (increasing their share count from 65.1 million to 115.1 million) at a stock price of $200, viable perhaps on Friday (when the stock traded about $300) but not today, the value effect and transfer can be seen below:
The value transfer can be intuitively explained. If new shareholders pay well above value, that increment accrues to existing shareholders. Since the new shareholders are buying the shares voluntarily, you may be at peace with this transfer, but if these new shareholders are small individual investors drawn in by the frenzy, the entire notion of this price run-up being a blow for fairness and justice is undercut.Ìý

Investing Endgames!The anger and sense of unfairness that animated many of those who were on the buying end of GameStop and AMC last week has roots in real greviances, especially among those who came of age in the midst or after the 2008 crisis. I understand that, but investing with the intent of hurting another group, no matter how merited you think that punishment is, has two problems. The first is that markets are fluid, with the winners and losers from an investing episode representing a quickly shifting coalition, The people who are helped and hurt are not always the people that you set out to help or hurt.ÌýThe second is that if you truly want to punish a group that you think is deserving of punishment, you have to find a way to do damage to their investment models. Hurting some hedge funds, say the short sellers in GameStop, while helping others, like Silver Lake, will only cause investors in these funds to move their money from losing funds to winning funds. Thus, the best revenge you can have on funds is to see investors collectively pull their money out of funds, and that will happen if they under perform as a group.Ìý
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I generally try to stay out of fights, especially when they become mud-wrestling contests, but the battle between the hedge funds and Reddit investors just too juicy to ignore. As you undoubtedly know, the last few days have been filled with news stories of how small investors, brought together on online forums, have not only pushed up the stock prices of the stocks that they have targeted (GameStop, AMC, BB etc.), but in the process, driven some of the hedge funds that have sold short on these companies to edge of oblivion. The story resonates because it has all of the elements of a David versus Goliath battle, and given the low esteem that many hold Wall Street in, it has led to sideline cheerleading. Of course, as with everything in life, this story has also acquired political undertones, as populists on all sides, have found a new cause. I don't have an axe to grind in this fight, since I don't own GameStop or care much about hedge funds, but I am interested in how this episode will affect overall markets and whether I need to change the ways in which I invest and trade.

Short Sales and Squeezes

I know that you want to get to the GameStop story quickly, but at the risk of boring or perhaps even insulting you, I want to lay the groundwork by talking about the mechanics of a short sale as well as how short sellers can sometimes get squeezed. When most of look at investing, we think of stocks that we believe (based upon research, instinct or innuendo) will go up in value and buying those stocks; in investing parlance, if you do this, you have a "long" position. For those of you tempted to put all of Wall Street into one basket, it is worth noting that the biggest segment of professional money management still remains the mutual fund business, and mutual funds are almost all restricted to long only positions. But what if you think a stock is too highly priced and is likely to go down? If you already own the stock, you can sell it, but if you don't have a position in the stock and want to monetize your pessimistic point of view, you can borrow shares in the stock and sell them, with an obligation to return the shares at a specified point in time in the future. This is a “short� sale, and if you are right and the stock price drops, you can buy the shares at the now "discounted" price, return them to the original owner and keep the difference as your profit.

Short sellers have never been popular in markets, and that dislike is widely spread, not just among small investors, but also among corporate CEOs, and many institutional investors. In fact, this dislike shows up not only in restrictions on short selling in some markets, but outright bans in others, especially during periods of turmoil. I don't believe that there is anything inherently immoral about being a pessimist on markets, and that short selling serves a purpose in well-functioning markets, as a counter balance to relentless and sometimes baseless optimism. In fact, mathematically, all that you do in a short sale, relative to a conventional investment, is reverse the sequence of your actions, selling first and buying back later.

It is true that short sellers face a problem that their long counterparts generally do not, and that is they have far less control over their time horizons. While you may be able to sell short on a very liquid, widely traded stock for a longer period, on most stocks, your short sale comes with a clock that is ticking from the moment you initiate your short sale. Consequently, short sellers often try to speed the process along, going public with their reasons for why the stock is destined to fall, and they sometimes step over the line, orchestrating concerted attempts to create panic selling. While short sellers wait for the correction, they face multiple threats, some coming from shifts in fundamentals (the company reporting better earnings than expected or getting a cash infusion) and some from investors with a contrary view on the stock, buying the stock and pushing the stock price up. Since short sellers have potentially unlimited losses, these stock price increases may force them to buy back shares in the market to cover their short position, in the process pushing prices up even more. In a short squeeze, this cycle speeds up to the point that short sellers have no choice but to exit the position.

Short squeezes have a long history on Wall Street. In 1862, Cornelius Vanderbilt squeezed out short sellers in Harlem Railroad, and used his power to gain full control of the New York railroad business. During the 20th century, short sales ebbed and flowed over the decades, but lest you fall into the trap of believing that this is a purely US phenomenon, the short sale with the largest dollar consequences was the one on Volkswagen in 2008, when Porsche bought enough shares in Volkswagen to squeeze short sellers in the stock, and briefly made Volkswagen the highest market cap company in the world. Until this decade, though, most short squeezes were initiated and carried through by large investors on the other side of short sellers, with enough resources to force capitulation. In the last ten years, the game has changed, for a number of reasons that I will talk about later in this post, but the company where this changed dynamic has played out most effectively has been Tesla. In the last decade, Tesla has been at the center of a tussle between two polarized groups, one that believes that the stock is a scam and worth nothing, and the other that is convinced that this is the next multi-trillion dollar company. Those divergent viewpoints have led to the former to sell short on the stock, making Tesla one of the most widely shorted stocks of all time, and the latter buying on dips. There have been at least three and perhaps as many as five short squeezes on Tesla, with the most recent one occurring at the start of 2020. With Tesla, individual investors who adore the company have been at the front lines in squeezing short sellers, but they have had help from institutional investors who are also either true believers in the company, or are too greedy not to jump on the bandwagon.

The Story (so far)

This story is still evolving, but the best way to see it is to pick one company, GameStop, and see how it became the center of a feeding frenzy. Note that much of what I say about GameStop could be said about AMC and BB, two other companies targeted in the most recent frenzy.

A Brief History

GameStop is a familiar presence in many malls in the United States, selling computer gaming equipment and games, and it built a business model around the growth of the gaming business. That business model ran into a wall a few years ago, as online retailing and gaming pulled its mostly young customers away, causing growth to stagnate and margins to drop, as you can see in this graph of the company’s operating history:

Leading into 2020, the company was already facing headwinds, with declining store count and revenues, and lower operating margins; the company reported net losses in 2018 and 2019.

The COVID Effect

In 2020, the company, like most other brick and mortar companies, faced an existential crisis. As the shutdown put their stores out of business, the debt and lease payments that are par for the course for any brick-and-mortar retailer threatened to push them into financial distress. The stock prices for the company reflected those fears, as you can see in this graph (showing prices from 2015 through the start of 2021):

Looking at the graph, you can see that if GameStop is a train wreck, it is one in slow motion, as stock prices have slid every year since 2015, with the added pain of rumored bankruptcy in 2019 and 2020.Ìý

A Ripe Target andÌýthe Push Back

While mutual funds are often constrained to be hold only long positions, hedge funds have the capacity to play both sides of the game, though some are more active on the short side than others. While short sellers target over priced firms, adding distress to the mix sweetens the pot, since drops in stock prices can put them into death spirals. The possibility of distress at GameStop loomed large enough that hedge funds entered the fray, as can be seen in the rising percentage of shares held by short sellers in 2020:

Note that short seller interest in GameStop first picked up in 2019, and then steadily built up in 2020. Even prior to the Reddit buy in, there were clearly buyers who felt strongly enough to to push back against the short sellers, since stock prices posted a healthy increase in the last few months of 2019. To show you how quickly this game has shifted, Andrew Left, one of the short sellers, put out a thesis on January 21, where he argued that GameStop was in terminal decline, and going to zero. While his intent may have been to counter what many believed was a short squeeze on the stock in the prior two days, it backfired by drawing attention to the squeeze and drawing in more buyers. That effect can be seen in the stock price movements and trading volume in the last few days:

This surge in stock prices was catastrophic for short sellers, many of whom closed out (or tried to close out) their short positions, in the process pushing up prices even more. Melvin Capital and Citron, two of the highest profile names on the short selling list, both claimed to have fully exited their positions in the last few days, albeit with huge losses. ÌýOn January 27 and 28, regulators and trading platforms acted to curb trading on GameStop, ostensibly to bring stability back to markets, but traders were convinced that the establishment was changing the rules of the game to keep them from winning. GameStop, which had traded briefly at over $500/share was trading at about $240 at the time this post was written.

A Value Play?

When you have a pure trading play, as GameStop has become over the last few weeks, value does not even come into play, but there are investors, who pre-date the Redditors, who took counter positions against the short sellers, because they believed that the value of the company was higher. At the risk of ridicule, I will value the company, assuming the most upbeat story that I can think of, at least at the moment:

Note that this valuation is an optimistic one, assuming that probability of failure remains low, and that GameStop makes it way back to find a market in a post-COVID world, while also improving its margins to online retail levels. If you believe this valuation, you would have been a strong buyer of GameStop for much of last year, since it traded well below my $47 estimate. After the spectacular price run up in the last two weeks, though, there is no valuation justification left. To see why, take a look at how much the value per share changes as you change your assumptions about revenues and operating margins, the two key drivers of value.

Even if GameStop is able to more than double its revenues over the next decade, which would require growth in revenues of 15% a year for the next five years, and improve its margins to 12.5%, a supreme reach for a company that has never earned double digit margins over its lifetime, the value per share is about half the current stock price. Put simply, there is no plausible story that can be told about GameStop that could justify paying a $100 price, let alone $300 or $500.

The Backstory

To put the GameStop trading frenzy in perspective, let's start with the recognition that markets are not magical mechanisms, but represent aggregations of human beings making investment judgments, some buying and some selling, for a variety of reasons, ranging from the absurd to the profound. It should therefore not come as a surprise that the forces playing out in other aspects of human behavior find their way into markets. In particular, there are three broad trends from the last decade at play here:

A loss of faith in experts (economic, scientific, financial, government): During the 20th century, advances in education, and increasing specialization created expert classes in almost every aspect of human activity, from science to government to finance/economics. For the most part, we assumed that their superior knowledge and experience equipped them to take the right actions, and with our limited access to information, we often were kept in the dark, when they were wrong. That pact has been shattered by a combination of arrogance on the part of experts and catastrophic policy failures, with the 2008 banking crisis acting as a wake up call. In the years since, we have seen this loss of faith play out in economics, politics and even health, with expert opinion being cast aside, ignored or ridiculed.ÌýAnÌýunquestioning worship of crowd wisdom, combinedÌýwith an empowering of crowds: In conjunction, we have also seen the rise of big data and the elevation of "crowd" judgments over expert opinions, and it shows up in our life choices. We pick the restaurants we eat at, based on Yelp reviews, the movies we watch on Rotten Tomatoes and the items we buy on customer reviews. Social media has made it easier to get crowd input (online), and precipitate crowd actions.A conversion of disagreements in every arena into the personal and the political: While we can continue to debate the reasons, it remains inarguable that public discourse has coarsened, with the almost every debate, no matter in what realm, becoming personal and political. I can attest to that from just my personal experiences, especially when I post on what I call "third rail" topics, specifically Tesla and Bitcoin, in the last few years.ÌýAs I look at the GameStop episode play out, I see all three of these at play. One reason that the Redditors targeted GameStop is because they viewed hedge funds as part of the "expert" class, and consequently incapable of getting things right. They have used social media platforms to gather and reinforce each others' views, right or wrong, and then act in concert quickly and with extraordinary efficiency, to move stock prices. ÌýFinally, even a casual perusal of the comments on the Reddit thread exposes how much of this is personal, with far more comments about how this would teach hedge funds and Wall Street a lesson than there were about GameStop the company.
The End GameI am a realist and if you are one of those who bought GameStop or AMC in recent days, I know that there is only a small chance that you will be reading this post, since I am probably too old (my four children remind me of that every day), too establishment (I have been teaching investing and valuation for 40 years) and too expert to be worth listening to. ÌýI accept that, though if you are familiar with my history, you should know that I have been harsh on how investing gets practiced in hedge funds, investment banks and even Omaha. The difference, I think, between our views is that many of you seem to believe that hedge funds (and other Wall Streeters) have been winning the investment sweepstakes, at your expense, and I believe that they are much too incompetent to do so. In my view, many hedge funds are run by people who bring little to the investment table, other than bluster, and charge their investors obscene amounts as fees, while delivering sub-standard results, and it is the fees that make hedge fund managers rich, not their performance. It is for that reason that I have spent my lifetime trying to disrupt the banking and money management business by giving away ÌýandÌý you need to do both for free, as well as pretty much everything I know (which is admittedly only a small subset) about investing .ÌýMy sympathies lie with you, but I wonder what your end game is, and rather than pre-judge you, I will offer you the fourÌýchoices:ÌýGameStop is a good investment:ÌýThat may be a viable path, if you bought GameStop at $40 or $50, but not if you paid $200 or $300 a share. At those prices, I don’t see how you get value for your money, but that may reflect a failure of my imagination, and I encourage you to download my spreadsheet and make your own judgments.GameStop remains a good trade:ÌýYou may believe that given your numbers (as individual investors), you can sell the stock to someone else at a higher price, but to whom? You may get lucky and be able to exit before everyone else tries to, but the risk that you will be caught in a stampede is high, as everyone tries to rush the exit doors at the same time. In fact, the constant repetition of the mantra that you need to hold to meet a bigger cause (teach Wall Street a lesson) should give you pause, since it is buying time for others (who may be the ones lecturing you) to exit the stock.ÌýI hope that I am wrong, but I think that the most likely end game here is that AMC, GameStop and Blackberry will give back all of the gains that they have had from your intervention and return to pre-action prices sooner rather than later.Teach hedge funds and Wall Street a lesson:ÌýI won't patronize you by telling you either that I understand your anger or that you should not be angry. That said, driving a few hedge funds out of business will do little to change the overall business, since other funds will fill the void.ÌýIf this is your primary reason, though, just remember that the money you are investing in GameStop is more donation to a cause, than an investment. If you are investing tuition money, mortgage savings or your pension fund in GameStop and AMC, you are impoverishing yourself, trying to deliver a message that may or may not register.ÌýThe biggest threat to hedge funds does not come from Reddit investor groups or regulators, but from a combination of obscene fee structures and mediocre performance.ÌýPlay savior:ÌýIt is possible that your end game was selfless, and that you were trying to save AMC and GameStop as companies, but if that was the case, how has any of what’s happened in the last two weeks help these companies? Their stock prices may have soared, but their financial positions are just as precarious as they were two weeks ago. If your response is that they can try to issue shares at the higher prices, I think of the odds of being able to do this successfully are low for two reasons. The first is that planning a new share issuance takes time, requiring SEC filings and approval. The second is that the very act of trying to issue new shares at the higher price may deflate that price. In a perverse way, you might have made it more difficult for GameStop and AMC to find a pathway to survive as parts of larger companies, by pushing up stock prices, and making them more expensive as targets.If you are in this game, at least be clear with yourself on what your end game is and protect yourself, because no one else will. The crowds that stormed the Bastille for the French Revolution burned the prison and killed the governor, but once done, they turned on each other. Watch your enemies (and I know that you include regulators and trading platforms in here), but watch your friends even more closely!
Market LessonsIf you are not a hedge fund that sold short on the targeted stocks, or a trader who bought in on other side, are there any consequences for you, from this episode? I do think that we sometimes read too much into market events and episodes, but this short period has some lessons.Flattening of the Investment World: Borrowing a term from Tom Friedman, I believe that the investment world has flattened over the last few decades, as access to data and powerful tools widens, and trading eases. It should come as no surprise then that portfolio managers and market gurus are discovering that they no longer are the arbiters of whether markets are cheap or expensive, and that their path of least resistance might come from following what individual investors do, rather than lead them. In a prior post, I pointed to this as one reason why risk capital stayed in the game in 2020, confounding many long-term market watchers, who expected it to flee.ÌýEmptiness of Investment Expertise: Professional money management has always sold its wares (mutual funds, hedge funds, investment advice) as the products of deep thinking and serious analysis, and as long as the processes stayed opaque and information was scanty, they were able to preserve the delusion. In the last few decades, as we have stripped away the layers, we have discovered how little there is under the surface. The hand wringing on the part of money managers about the momentum trading and absence of attention to fundamentals on the part of Redditors strikes me as hypocritical, since many of these money managers are themselves momentum players, whose idea of fundamentals is looking at trailing earnings. My prediction is that this episode and others like it will accelerate the shift from active to passive investing, especially on the part of investors who are paying hefty fees, and receiving little in return.Value â‰� Price: I won’t bore you again with , but it stands me in good stead during periods like this one. During the last week, I have been asked many times how I plan to change the way I value companies, as a result of the GameStop story, and my answer is that I don’t. That is not because I am stuck in my ways, but because almost everything that is being talked about (the rising power of the individual investors, the ease of trading on apps like Robinhood, the power of social media investing forums to create crowds) are factors that drive price, not value. It does mean that increasing access to data and easing trading may have the perverse effect of causing price to vary more, relative to value, and for longer periods. My advice, if you are an investor who believes in fundamentals, is that you accept this as the new reality and not drive yourself in a frenzy because you cannot explain what other people are paying for Tesla, Airbnb or Zoom.In the next few weeks, I predict that we will hear talk of regulatory changes intended to protect investors from their own excesses. If the regulators have their way, it will get more difficult to trade options and borrow money to buy shares, and I have mixed feelings about the efficacy of these restrictions. I understand the motivation for this talk, but I think that the best lessons that you learn about risk come from taking too much or the wrong risks, and then suffering the consequences.
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