Aswath Damodaran's Blog, page 3
September 20, 2024
Fed up with Fed Talk? Fact-checking Central Banking Fairy Tales!
The big story on Wednesday, September 18, was that the Federal Reserve’s open market committee finally got around to “cutting rates�, and doing so by more than expected. This action, much debated and discussed during all of 2024, was greeted as "big" news, and market prognosticators argued that it was a harbinger of market moves, both in interest rates and stock prices. The market seemed to initially be disappointed in the action, dropping after the Fed’s announcement on Wednesday, but it did climb on Thursday. Overall, though, and this is my view, this was about as anticlimactic as a climactic event gets, akin to watching an elephant in labor deliver a mouse. As a long-time skeptic about the Fed’s (or any Central Bank’s) capacity to alter much in markets or the economy, I decided now would be as good a time as any to confront some widely held beliefs about central banking powers, and counter them with data. In particular, I want to star with the myth that central banks set interest rates, or at least the interest rates that you and I may face in our day-to-day lives, move on to the slightly lesser myth that the Fed's move lead market interest rates, then examine the signals that emanate supposedly from Fed actions, and finish off by evaluating how the Fed's actions affect stock prices.
The Fed as Rate Setter
As I drove to the grocery story on Fed Cut Wednesday, I had the radio on, and in the news at the top of the hour, I was told that the Fed had just cut interest rates, and that consumers would soon see lower rates on their mortgages and businesses on their loans. That delusion is not restricted to newscasters, since it seems to be widely held among politicians, economists and even market watchers.The truth, though, is that the Fed sets only one interest rate, the Fed Funds rate, and that none of the rates that we face in our lives, either as consumers (on mortgages, credit cards or fixed deposits) or businesses (business loans and bonds), are set by or even indexed to the Fed Funds Rate.
The place to start to dispel the “Fed sets rates� myth is with an understanding of the Fed Funds rate, an overnight intra-bank borrowing rate is one that most of us will never ever encounter in our lives. The Federal Open Market Committee (FOMC) has the power to change this rate, which it uses at irregular intervals, in response to economic, market and political developments. The table below lists the rate changes made by the Fed in this century:
Note that while most of these changes were made at regularly scheduled meetings, a few (eleven in the last three decades) were made at emergency meetings, called in response to market crises. As you can see from this table, the Federal Reserve goes through periods of Fed Funds rate activism, interspersed with periods of inactivity. Since the Fed Funds rate is specified as a range, there are periods where the effective Fed Funds rate may go up or down, albeit within small bounds.To gain perspective on how the Fed Funds rate has been changed over time, consider the following graph, where the effective fed funds rate is shown from 1954 to 2024:
In addition to revealing how much the Fed Funds rate has varied over time, there are two periods that stand out. The first is the spike in the Fed Funds rate to more than 20% between 1979 and 1982, when Paul Volcker was Fed Chair, and represented his attempt to break the cycle of high inflation that had entrapped the US economy. The second was the drop in the Fed Funds rate to close to zero percent, first after the 2008 crisis and then again after the COVID shock in the first quarter of 2020. In fact, coming into 2022, the Fed had kept the Fed Funds rates at or near zero for most of the previous 14 years, making the surge in rates in 2022, in response to inflation, shock therapy for markets unused to a rate-raising Fed.
While the Federal Open Market Committee controls the Fed Funds rate, there are a whole host of rates set by buyer and sellers in bond markets. These rates are dynamic and volatile, and you can see them play out in the movements of US treasury rates (with the 3-month and 10-year rates highlighted) and in corporate bond rates (with the Baa corporate bond rate shown).
There is a final set of rates, set by institutions, and sometimes indexed to market-set rates, and these are the rates that consumers are most likely to confront in their day-to-day lives. They include mortgage rates, set by lenders, credit card rates, specified by the credit card issuers, and fixed deposit rates on safety deposits at banks. They are not as dynamic as market-set rates, but they change more often than the Fed Funds rate.
There are undoubtedly other interest rates you will encounter, as a consumer or a business, either in the course of borrowing money or investing it, but all of these rates will fall into one of three buckets - market-set interest rates, rates indexed to market-set rates and institutionally-set rates. None of these rates are set by the Federal Reserve, thus rendering the "Fed sets interest rates" as myth.
The Fed as Rate Leader
Even if you accept that the Fed does not set the interest rates that we face as consumers and businesses, you may still believe that the Fed influences these rates with changes it makes to the Fed Funds rate. Thus, you are arguing that a rise (fall) in the Fed Funds rate can trigger subsequent rises (falls) in both market-set and institution-set rates. At least superficially, this hypothesis is backed up in the chart below, where I brings all the rates together into one figure:
As you can see, the rates all seem to move in sync, though market-set rates move more than institution-set rates, which, in turn, are volatile than the Fed Funds rate. The reason that this is a superficial test is because these rates all move contemporaneously, and there is nothing in this graph that supports the notion that it is the Fed that is leading the change. In fact, it is entirely possible, perhaps even plausible, that the Fed's actions on the Fed Funds rate are in response to changes in market rates, rather than the other way around.
To test whether changes in the Fed Funds rate are a precursor for shifts in market interest rates, I ran a simple (perhaps even simplistic) test. I looked at the 249 quarters that compose the 1962- 2024 time period, breaking down each quarter into whether the effective Fed Funds rate increased, decreased or remained unchanged during the quarter. I followed up by looking at the change in the 3-month and 10-year US treasury rates in the following quarter:
Looking at the key distributional metrics (the first quartile, the median, the third quartile), it seems undeniable that the "Fed as leader" hypothesis falls apart. In fact, in the quarters after the Fed Funds rate increases, US treasury rates (short and long term) are more likely to decrease than increase, and the median change in rates is negative. In contrast, in the periods after the Fed Fund decreases, treasury rates are more likely to increase than decrease, and post small median increases. Expanding this assessment to the interest rates that consumers face, and in particular mortgage rates at which they borrow and fixed deposit rates at which they can invest, the results are just as stark.
In the quarter after the Fed Funds rate increase, mortgage rates and fixed deposit rates are more likely to fall than rise, with the median change in the 15-year mortgage rate being -0.13% and the median change in the fixed deposit rate at -0.05%. In the quarter after the Fed Funds rate decreases, the mortgage rate does drop, but by less than it did during the Fed rate raising quarters. In short, those of us expecting our mortgage rates to decline in the next few months, just because the Fed lowered rates on Wednesday, are being set up for disappointment. If you are wondering why I did not check to see what credit card interest rates do in response to Fed Funds rate changes, even a casual perusal of those rates suggests that they are unmoored from any market numbers. You may still be skeptical about my argument that the Fed is more follower than leader, when it comes to interest rates. After all, you may say, how else can you explain why interest rates remained low for the last decades, other than the Fed? The answer is recognizing that market-set rates ultimately are composed of two elements: an expected inflation rate and an expected real interest rate, reflecting real economic growth. In the graph below, which I have used multiple times in prior posts, I compute an intrinsic risk free rate by just adding inflation rate and real GDP growth each year:
Interest rates were low in the last decade primarily because inflation stayed low (the lowest inflation decade in a century) and real growth was anemic. Interest rates rose in 2022, because inflation made a come back, and the Fed scrambled to catch up to markets, and most interesting, interest are down this year, because inflation is down and real growth has dropped. As you can see, in September 2024, the intrinsic riskfree rate is still higher than the 10-year treasury bond rate, suggesting that there will be no precipitous drop in interest rates in the coming months.
The Fed asSignalman
If you are willing to accept that the Fed does not set rates, and that it does not lead the market on interest rates, you may still argue that Fed rate changes convey information to markets, leading them to reprice bonds and stocks. That argument is built on the fact that the Fed has access to data about the economy that the rest of us don't have, and that its actions tell you implicitly what it is seeing in that data.
It is undeniable that the Federal Reserve, with its twelve regional districts acting as outposts, collects information about the economy that become an input into its decision making. Thus, the argument that Fed actions send signals to the markets has basis, but signaling arguments come with a caveat, which is that the signals can be tough to gauge. In particular, there are two major macroeconomic dimensions on which the Fed collects data, with the first being real economic growth (how robust it is, and whether there are changes happening) and inflation (how high it is and whether it too is changing). The Fed's major signaling device remains the changes in the Fed Funds rate, and it is worth pondering what the signal the Fed is sending when it raises or lowers the Fed Funds rate.On the inflation front, an increase or decrease in the Fed Funds rate can be viewed as a signal that the Fed sees inflationary pressures picking up, with an increase, or declining, with a decrease. On the economic growth front, an increase or decrease in the Fed Funds rate, can be viewed as a signal that the Fed sees the economy growing too fast, with an increase, or slowing down too much, with a decrease. These signals get amplified with the size of the cut, with larger cuts representing bigger signals.
Viewed through this mix, you can see that there are two contrary reads of the Fed Funds rate cut of 50 basis points on Wednesdays. If you are an optimist, you could take the action to mean that the Fed is finally convinced that inflation has been vanquished, and that lower inflation is here to stay. If you are a pessimist, the fact that it was a fifty basis point decrease, rather than the expected twenty five basis points, can be construed as a sign that the Fed is seeing more worrying signs of an economic slowdown than have shown up in the public data on employment and growth. There is of course the cynical third perspective, which is that the Fed rate cut has little to do with inflation and real growth, and more to do with an election that is less than fifty days away.In sum, signaling stories are alluring, and you will hear them in the coming days, from all sides of the spectrum (optimists, pessimists and cynics), but the truth lies in the middle, where this rate cut is good news, bad news and no news at the same time, albeit to different groups.
The Fed as Equity Market Whisperer
It is entirely possible that you are with me so far, in my arguments that the Fed's capacity to influence the interest rates that matter is limited, but you may still hold on to the belief that the Fed's actions have consequences for stock returns. In fact, Wall Street has its share of investing mantras, including "Don't fight the Fed", where the implicit argument is that the direction of the stock market can be altered by Fed actions.
There is some basis for this argument, and especially during market crises, where timely actions by the Fed may alter market mood and momentum. During the COVID crisis, , especially so towards the end of March 2023, when markets were melting down, and argued that one reason that market came back as quickly as they did was because of the Fed. That said, it was not so much the 100 basis point drop in the Fed Funds rate that turned the tide, but the accompanying message that the Federal Reserve to companies that were rocked by the COVID shutdown, and were teetering on the edge. While the Fed did not have to commit much in capital to back up this pledge, that decision seemed to provide enough reassurance to lenders and prevent a host of bankruptcies at the time.
If you remove the Fed's role in crisis, and focus on the effects of just its actions on the Fed Funds rate, the effect of the Fed on equity market becomes murkier. I extended the analysis that I did with interest rates to stocks, and looked at the change in the S&P 500 in the quarter after Fed Funds rates were increased, decreased or left unchanged:
The Fed as Chanticleer
If the Fed does not set rates, is not a interest rate driver, sends out murky signals about the economy and has little effect on how stocks move, you are probably wondering why we have central banks in the first place. To answer, I am going to digress, and repeat an ancient story about Chanticleer, a rooster that was anointed the ruler of the farmyard that he lived in, because the other barnyard animals believed that it was his crowing every morning that caused the sun to rise, and that without him, they would be destined for a lifetime of darkness. That belief came from the undeniable fact that every morning, Chanticleer's crowing coincided with sun rise and daylight. The story now takes a dark turn, when one day, Chanticleer sleeps in and the sun rises anyway, revealing his absence of power, and he loses his place at the top of the barnyard hierarchy.
The Fed (and every other central bank) in my view is like Chanticleer, with investors endowing it with powers to set interest rates and drive stock prices, since the Fed's actions and market movements seem synchronized. As with Chanticleer, the truth is that the Fed is acting in response to changes in markets rather than driving those actions, and it is thus more follower than leader.That said, there is the very real possibility that the Fed may start to believe its own hype, and that hubristic central bankers may decide that they set rates and drive stock markets, rather than the other way around. That would be disastrous, since the power of the Fed comes from the perception that it has power, and an over reach can lay bare the truth.
Conclusion
I know that this post cuts against the grain, since the notion that the Fed has superpowers has only become stronger over the last two decades. Pushed to explain why interest rates were at historic lows for much of the last decade, the response you often heard was "the Fed did it". Active investors, when asked why active investing had its worst decade in history, losing out to index funds and to passive investors, pointed fingers the Fed. Market timers, who had built their reputations around using metrics like the Shiller PE, defended their failure to call market moves in the last fifteen years, by pointing to the Fed. Economists who argued that inverted yield curves were a surefire predictor of recessions blamed the Fed for the absence of a recession, after years of two years plus of the phenomena.
I believe that it is time for us to put the Fed delusion to rest. It has distracted us from talking about things that truly matter, which include growing government debt, inflation, growth and how globalization may be feeding into risk, and allowed us to believe that central bankers have the power to rescue us from whatever mistakes we may be making. I am a realist, though, and I am afraid that the Fed Delusion has destroyed enough investing brain cells, that those who holding on to the delusion cannot let go. I am already hearing talk among this group about what the FOMC may or may not do at its next meeting (and the meeting after that), and what this may mean for markets, restarting the Fed Watch. The insanity of it all!
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September 9, 2024
Dealing with Aging: Updating the Intel, Walgreens and Starbucks Stories!
A few weeks ago, I , the subject of my latest book. I argued that the corporate life cycle can explain what happens to companies as they age, and why they have to adapt to aging with their actions and choices. In parallel, I also noted that investors have to change the way they value and price companies, to reflect where they are in the life cycle, and how different investment philosophies lead you to concentrated picks in different phases of the life cycle. In the closing section, I contended that managing and investing in companies becomes most difficult when companies enter the last phases of their life cycles, with revenues stagnating or even declining and margins under pressure. While consultants, bankers and even some investors push companies to reinvent themselves, and find growth again, the truth is that for most companies, the best pathway, when facing aging, is to accept decline, shrink and even shut down. In this post, I will look at three high profile companies, Intel, Starbucks and Walgreens, that have seen market turmoil and management change, and examine what the options are for the future.
Setting the stage
The three companies that I picked for this post on decline present very different portraits. Intel was a tech superstar not that long ago, a company founded by Gordon Moore, Robert Noyce and Arthur Rock in 1968, whose computer chips have helped create the tech revolution.Walgreens is an American institution, founded in Chicago in 1901, and after its merger with Alliance Boots in 2014, one of the largest pharmacy chains in the country.Finally,Starbucks, which was born in 1971 as acoffee bean wholesaler in Pike Place Market in Seattle, was converted into a coffee shop chain by Howard Schultz, and to the dismay of Italians, has redefined espresso drinks around the world. While they are in very different businesses, what they share in common is that over the recent year or two, they have all not only lost favor in financial markets, but have also seen their business models come under threat, with their operating metrics (revenue growth, margins) reflecting that threat.
The Market turns
With hundreds of stocks listed and traded in the market, why am I paying attention to these three? First, the companies are familiar names. Our personal computes are often Intel-chip powered, there is a Walgreen's a few blocks from my home, and all of us have a Starbucks around the corner from where we live and work. Second, they have all been in the news in the last few weeks, with Starbucks getting a new CEO, Walgreens announcing that they will be shutting down hundreds of their stores and Intel coming up in the Nvidia conversation, often as a contrast. Third, they have all seen the market turn against them, though Starbucks has had .
A Tech Star Stumbles: Intel’s Endgame
In my book on corporate life cycles, I noted that even superstar companies age and lose their luster, and Intel could be a case study. The company is fifty six years old (it was founded in 1968) and the question is whether its best years are behind it. In fact, the company's growth in the 1990s to reach the peak of the semiconductor business is the stuff of case studies, and it stayed at the top for longer than most of its tech contemporaries. Intel's CEO for its glory years was Andy Grove, who joined the company on its date of incorporation in 1968, and stayed on to become chairman and CEO before stepping down in 1998. He argued for constant experimentation and adaptive leadership, and the title of his book, , captured his management ethos.
To get a measure of why Intel's fortunes have changed in the last decade, it is worth looking at its key operating metrics - revenues, gross income and operating income - over time:
As you can see in this graph, Intel's current troubles did not occur overnight, and its change over time is almost textbook corporate life cycle. As Intel has scaled up as a company, its revenue growth has slackened and its growth rate in the last decade (2012-21) is more reflective of a mature company than a growth company. That said, it was a healthy and profitable company during that decade, with solid unit economics (as reflected in its high gross margin) and profitability (its operating margin was higher in the last decade than in prior periods). In the last three years, though, the bottom seems to fallen out of Intel's business model, as revenues have shrunk and margins have collapsed. The market has responded accordingly, and Intel, which stood at the top of the semiconductor business, in terms of market capitalization for almost three decades, has dropped off the list of top ten semiconductor companies in 2024, in market cap terms:
Intel's troubles cannot be blamed on industry-wide issues, since Intel's decline has occurred at the same time (2022-2024) as the cumulative market capitalization of semiconductor companies has risen, and one of its peer group (Nvidia) has carried the market to new heights.
Before you blame the management of Intel for not trying hard enough to stop its decline, it is worth noting that if anything, they have been trying too hard. In the last few years, Intel has invested massive amounts into its chip manufacturing business (), trying to compete with TSMC, and almost as much into its , hoping to claim market share of the fastest growing markets for AI chips from Nvidia. In fact, a benign assessment of Intel would be that they are making the right moves, but that these moves will take time to pay off, and that the market is being impatient. A not-so-benign reading is that the market does not believe that Intel can compete effectively against either TSMC (on chip manufacture) or Nvidia (on AI chip design), and that the money spent on both endeavors will be wasted. The latter group is clearly winning out in markets, at the moment, but as I will argue in the next section, the question of whether Intel is a good investment at its current depressed price may rest in which group you think has right on its side.
Drugstore Blues: Walgreen Wobbles
From humble beginnings in Chicago, Walgreen has grown to become a key part of the US health care system as a dispenser of pharmacy drugs and products. The company went public in 1927, and in the century since, the company has acquired the characteristics of a mature company, with growth spurts along the way. Its gave it a larger global presence, albeit at a high price, with the acquisition costing $15.3 billion. Again, to understand, Walgreen's current position, we looked at the company's operating history by looking revenue growth and profit margins over time:
After double digit growth from 1994 to 2011, the company has struggled to grow in a business, with daunting unit economics and slim operating margins, and the last three years have only seen things worsen on all fronts, with revenue growth down, and margins slipping further, below the Maginot line; with an 1.88% operating margin, it is impossible to generate enough to cover interest expenses and taxes, thus triggering distress.
While management decisions have clearly contributed to the problems, it is also true that the pharmacy business, which forms Walgreen's core, has deteriorated over the last two years, and that can be seen by comparing its market performance to CVS, its highest profile competitor.
As you can see, both CVS and Walgreens have seen their market capitalizations drop since mid-2022, but the decline in Walgreens has been far more precipitous than at CVS; Walgreens whose market cap exceeded that of CVS in 2016 currently has one tenth of the market capitalization of CVS. In response to the slowing down of the pharmacy business, Walgreens has tried to find a pathway back to growth, albeit with acquired growth. A new CEO, Roz Brewer, was brought into the company in 2021, from Sam's Club, and wagered the company's future on acquisitions, buying four companies in 2021, with a , a chain of doctor practices and clinics, representing the biggest one. That acquisition, which cost Walgreens $5.2 billion, has been , and in 2024, Ms. Brewer was replaced as CEO by Tim Wentworth, and Village MD scaled back its growth plans.Venti no more The Humbling of Starbucks
On my last visit to Italy, I did make frequent stops at local cafes, to get my espresso shots, and I can say with confidence that none of them had a caramel macchiato or an iced brown sugar oatmilk shaken espresso on the menu. Much as we make fun of the myriad offerings at Starbucks, it is undeniable that the company has found a way into the daily lives of many people, whose day cannot begin without their favorite Starbucks drink in hand. Early on, Starbucks eased the process by opening more and more stores, often within blocks of each other, and more recently, by offering online ordering and pick up, with rewards supercharging the process. Howard Schultz, who nursed the company from a single store front in Seattle to an ubiquitous presence across America, was CEO of the company from 1986, and while he retired from the position in 2000, he returned from 2008 to 2017, to restore the company after the financial crisis, and again from 2022 to 2023, as an interim CEO to bridge the gap between the retirement of Kevin Johnson in 2022 and the hiring of Laxman Narasimhan in 2023. To get a measure of how Starbucks has evolved over time, I looked the revenues and margins at the company, over time:
Unlike Intel and Walgreens, where the aging pattern (of slowing growth and steadying margins) is clearly visible, Starbucks is a tougher case. Revenue growth at Starbucks has slackened over time, but it has remained robust even in the most recent period (2022-2024). Profit margins have actually improved over time, and are much higher than they were in the first two decades of the company's existence. One reason for improving profitability is that the company has become more cautious about store openings, at least in the United States, and sales have increased on a per-store basis:
In fact, the shift towards online ordering has accelerated this trend, since there is less need for expansive store locations, if a third or more of sales come from customers ordering online, and picking up their orders. In short, these graphs suggest that it is unfair to lump Starbuck with Intel and Walgreens, since its struggles are more reflecting of a growth company facing middle age.
So, why the market angst? The first is that there are some Starbucks investors who continue to hold on to the hope that the company will be able to return to double digitgrowth, and the only pathway to get there requires that Starbucks be able to succeed in China and India. However, Starbucks has had trouble in China competing with domestic lower-priced competitors (Luckin' Coffee and others), and there are restrictions on what Starbucks can do with its joint venture with the Tata Group in India. The second problem is that the narrative for the company, that Howard Schultz sold the market on, where coffee shops become a gathering spot for friends and acquaintances, has broken down, partly because of the success of its online ordering expansion. The third problem is that inflation in product and employee costs has made its products expensive, leading to less spending even from its most loyal customers.
A Life Cycle Perspective
It is undeniable that Intel and Walgreens are in trouble, not just with markets but operationally, and Starbucks is struggling with its story line. However, they face different challenges, and perhaps different pathways going forward. To make that assessment, I will more use , with a special emphasis on the the choices that agin companies face, with determinants on what should drive those choices.
The Corporate Life Cycle
I won't bore you with the details, but the corporate life cycle resembles the human life cycle, withstart-ups (as babies), very young companies (as toddlers), high growth companies (as teenagers) moving on to mature companies (in middle age) and old companies facing decline and demise:
The phase of the life cycle that this post is focused on is the last one, and as we will see in the next section, it is the most difficult one to navigate, partly because shrinking as a firm is viewed as failure., and that lesson gets reinforced in business schools and books about business success. I have argued that more money is wasted by companies refusing to act their age, and much of that waste occurs in the decline phase, as companies desperately try to find their way back to their youth, and bankers and consultants egg them on.
The Choices
There is no more difficult phase of a company's life to navigate than decline, since you are often faced with unappetizing choices. Given how badly we (as human beings) face aging, it should come as no surprise that companies (which are entities still run by human beings) also fight aging, often in destructive ways. In this section, I will start with what I believe are the most destructive choices made by declining firms, move on to a middling choice (where there is a possibility of success) before examining the most constructive responses to aging.
a. Destructive
Denial: When management of a declining business is in denial about its problems, attributing the decline in revenues and profit margins to extraordinary circumstances, macro developments or bad luck, it will act accordingly, staying with existing practices on investing, financing and dividends. If that management stays in place, the truth will eventually catch up with the company, but not before more money has been sunk into a bad business that is un-investable.Desperation: Management may be aware that their business is in decline, but it may be incentivized, by money or fame, to make big bets (acquisitions, for example), with low odds, hoping for a hit. While the owners of these businesses lose much of the time, the managers who get hits become superstars (and get labeled as turnaround specialists) and increase their earning power, perhaps at other firms.Survival at any cost: In some declining businesses, top managers believe that it is corporate survival that should be given priority over corporate health, and they act accordingly. In the process, they create zombie or walking dead companies that survive, but as bad businesses that shed value over time.b. It dependsMe-too-ism: In this choice, management starts with awareness that their existing business model has run out of fuel and faces decline, but believe that a pathway exists back to health (and perhaps even growth) if they can imitate the more successful players in their peer groups. Consequently, their investments will be directed towards the markets or products where success has been found (albeit by others), and financing and cash return policies will follow. Many firms adopt this strategy find themselves at a disadvantage, since they are late to the party, and the winners often have moats that are difficult to broach or a head start that cannot be overcome. For a few firms, imitation does provide a respite and at least a temporary return to mature growth, if not high growth.c. ConstructiveAcceptance: Some firms accept that their business is in decline and that reversing that decline is either impossible to do or will cost too much capital. They follow up by divesting poor-performing assets, spinning off or splitting off their better-performing businesses, paying down debt and returning more cash to the owners. If they can, they settle in on being smaller firms that can continue to operate in subparts of their old business, where they can still create value, and if this is not possible, they will liquidate and go out of business.Renewals and Revamps: In a renewal (where a company spruces up its existing products to appeal to a larger market) or a revamp (where it adds to its products and service offering to make them more appealing), the hope is that the market is large enough to allow for a return to steady growth and profitability. To pull this off, managers have to be clear eyed about what they offer customers, and recognize that they cannot abandon or neglect their existing customer base in their zeal to find new ones.Rebirths: This is perhaps every declining company's dream, where you can find a new market or product that will reset where the company in the life cycle. This pitch is powered by case studies of companies that have succeeded in pulling off this feat (Apple with the iPhone, Microsoft with Azure), but these successes are rare and difficult to replicate. While one can point to common features including visionary management and organic growth (where the new business is built within the company rather than acquired), there is a strong element of luck even in the success stories.The Determinants
Clearly, not all declining companies adopt the same pathway, when faced with decline, and more companies, in my view, take the destructive paths than the constructive one. To understand why and how declining companies choose to do what they do, you may want to consider the following:
In the figure below, I summarize the discussion from this section, looking at both the choices that companies can make, and the determinants:
With this framework in place, I am going to try to make my best judgments (which you may disagree with) on what the three companies highlighted in this post should do, and how they will play out for me, as an investor:
Intel: It is my view that Intel's problems stem largely from too much me-too-ism and aspiring for growth levels that they cannot reach. On both Ai and the chip manufacturing business, Intel is going up against competition (Nvidia on AI and TSMC on manufacturing) that has a clear lead and significant competitive advantages. However, the market is large enough and has sufficient growth for Intel to find a place in both, but not as a leader. For a company that is used to being at the top of the leaderboard, that will be a step down, but less ambition and more focus is what fits the company, at this stage in the life cycle. It is likely that even if it succeeds, Intel will revert to middle age, not high growth, but that should still make it a good investment. In the table below, you can see that at its prevailing stock price of $18.89 (on Sept 8, 2024), all you need is a reversion back towards more normal margins for the price to be justified:With 3% growth and 25% operating margins, Intel's value per share is already at $23.70 and any success that the company is in the AI chip market or benefits it derives from the CHIPs act, from federal largesse, are icing on the cake. I do believe that Intel will derive some payoff from both, and I am buying Intel, to twin with what is left of my Nvidia investment from six years ago.Walgreens: For Walgreens, the options are dwindling, as its core businesses face challenges. That said, and even with its store closures, Walgreens remains the second largest drugstore chain in the United States, after CVS. Shrinking its presence to its most productive stores and shedding the rest may be the pathway to survival, but the company will have to figure out a way to bring down its debt proportionately. There is the risk that a macro slowdown or a capital market shock, causing default risk and spreads to widen, could wipe out equity investors. With all of that said, and building in a risk of failure to the assessment, I estimated the value per share under different growth and profitability assumptions:The valuation pivots entirely on whether operating margins improve to historical levels, with margins of 4% or higher translating into values per share that exceed the stock price. I believe that the pharmacy business is ripe for disruption, and that the margins will not revert back to pre-2021 levels, making Walgreens a "no go" for me.Starbucks: Starbucks is the outlier among the three companies, insofar as its revenue growth is still robust and it remains a money-making firm. Its biggest problem is that it has lost its story line, and it needs to rediscover a narrative that can not only give investors a sense of where it is going, but will redirect how it is managed. As I noted in my post on corporate life cycle, story telling requires visionaries, and in the case of Starbucks, that visionary also has to understand the logistical challenges of running coffee shops. I do not know enough about Brian Niccol to determine whether he fits the bill. As someone who led Taco Bell and Chipotle, I think that he can get the second part (understanding restaurant logistics) nailed down, but is he a visionary? He might be, but visionary CEOs generally do not live a thousand miles from corporate headquarters, and , and Niccol has provided no sense of what he sees as the new Starbucks narrative yet. For the moment, thought, there seems to be euphoria in the market that change is coming, though no one seems clear on what that change is, and the stock price has almost fully recovered from its swoon to reach $91 on September 8, 2024. That price is well above any value per share that I can get for the company, even assuming that they go back to historic norms:I must be missing some of the Starbucks magic that investors are seeing, since there is no combination of historical growth/margins that gets me close to the current stock price. In fact, the only way my value per share reaches current pricing levels is if I see the company maintaining its revenue growth rates from 2002-2011, while delivering the much higher operating margins that it earned between 2012-2021. That, to me, is a bridge too far to cross.
The Endgame
There is a reason that so many people want to be entrepreneurs and start new businesses. Notwithstanding the high mortality rate, building a new business is exciting and, if successful, hugely rewarding. A healthy economy will encourage entrepreneurship, providing risk capital and not tilting the playing field towards established players; it remains the strongest advantage that the United States has over much of the rest of the world. However, it is also true that the measure of a healthy economy is in how it deals with declining businesses and firms. If as Joseph Schumpeter put it, capitalism is all about creative destruction, it follows that companies, which are after all legal entities that operate businesses, should fade away as the reasons for their existence fade. That is one reason I critique the entire notion of corporate sustainability (as opposed to planet sustainability), since keeping declining companies alive, and supplying them with additional capital, redirects that capital away from firms that could do far more good (for the economy and society) with that capital.
If there is a subtext to this post, it is that we need a healthier framing of corporate decline, as inevitable at all firms, at some stage in their life cycle, rather than something that should be fought. In business schools and books, we need to highlight not just the empire builders and the company saviors, i.e., CEOs who rescued failing companies and made their companies bigger, but the empire shrinkers, i.e., CEOs who are brought into declining firms, who preside over an orderly (and value adding) shrinkage or breaking of their firms. In investing, it is true that the glory gets reserved for the Mag Seven and the FANGAM stocks, companies that seem to have found the magic to keep growing even as they scale up, but we should also pay attention to companies that find their way to deliver value for shareholders in bad businesses.
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September 5, 2024
The Power of Expectations: Nvidia's Earnings and the Market Reaction!
Earnings Reports: The Components When I was first exposed to financial markets in a classroom, I was taught about information being delivered to markets, where that information is processed and converted into prices. I was fascinated by the process, an interplay of accounting, finance and psychology, and it was the subject of my doctoral thesis, on how distortions in information delivery (delays, lies, mistakes) affects stock returns. In the real world, that fascination has led me to pay attention to earnings reports, which while overplayed, remain the primary mechanism for companies to convey information about their performance and prospects to markets.
The Timing Publicly traded companies have had disclosure requirements for much of their existence, but those requirements have become formalized and more extensive over time, partly in response to investor demands for more information and partly to even the playing field between institutional and individual investors. In the aftermath of the great depression, the Securities Exchange Commission was created as part of the, and that act also required any company issuing securities under that act, i.e., all publicly traded firms, make annual filings (10Ks) and quarterly filings (10Qs), that would be accessible to investors. The act also specifies that these filings be made in a timely manner, with a 1946 stipulation the annual filings being made within 90 days of the fiscal year-end, and the quarterly reports within 45 calendar days of the quarter-end. With technology speeding up the filing process, a 2002 rule changed those requirements to 60 days, for annual reports, and 40 days for quarterly reports, for companies with market capitalizations exceeding $700 million. While there are some companies that test out these limits, most companies file well within these deadlines, often within a couple of weeks of the year or quarter ending, and many of them file their reports on about the same date every year. If you couple the timing regularity in company filings with the fact that almost 65% of listed companies have fiscal years that coincide with calendar years, it should come as no surprise that earnings reports tend to get bunched up at certain times of the year (mid-January, mid-April, mid-July and mid-October), creating “earnings seasons�. That said, there are quite a few companies, many of them high-profile, that preserve quirky fiscal years, and since Nvidia’s earnings report triggered this post, it is worth noting that Nvidia has a fiscal year that ends on January 31 of each year, with quarters ending on April 30, July 31 and October 31. In fact, the Nvidia earnings report on August 28 covered the second quarter of this fiscal year (which is Nvidia's 2025 fiscal year).
The Expectations Game While corporate earnings reports are delivered once a quarter, the work of anticipating what you expect these reports to contain, especially in terms of earnings per share, starts almost immediately after the previous earnings report is delivered. In fact, a significant portion of sell side equity research is dedicated to this activity, with revisions made to the expected earnings, as you get closer and closer to the next earnings report. In making their earnings judgments and revisions, analysts draw on many sources, including:The company’s history/news: With the standard caveat that the past does not guarantee future results, analysts consider a company’s historical trend lines in forecasting revenues and earnings. This can be augmented with other information that is released by the company during the course of the quarter.Peer group reporting: To the extent that the company’s peer group is affected by common factors, it is natural to consider the positive or negative the operating results from other companies in the group, that may have reported earnings ahead of your company.Other analysts� estimates: Much as analysts claim to be independent thinkers, it is human nature to be affected by what others in the group are doing. Thus, an upward revision in earnings by one analyst, especially an influential one, can lead to revisions upwards on the part of other analysts.Macro news: While macroeconomic news (about the economy, inflation or currency exchange rates) cuts across the market, in terms of impact, some companies are more exposed to macroeconomic factors than others, and analysts will have to revisit earnings estimates in light of new information.The earnings expectations for individual companies, from sell side equity research analysts are publicly accessible, giving us a window on trend lines. Nvidia is one of the most widely followed companies in the world, and most of the seventy plus analysts who publicly follow the firm play the estimation game, leading into the earnings reports. Ahead of the most recent second quarter earnings report, the analyst consensus was that the company would report revenues of $28.42 billion for the quarter, and fully diluted earnings per share of 64 cents; in the 30 days leading into the report, the earnings estimates had drifted up mildly (about 0.1%), with the delay in the Blackwell (NVidia’s new AI chip) talked about but not expected to affect revenue growth near term. It is worth noting that not all analysts tracking the stock forecast every metric, and that there was disagreement among them, which is also captured in the range on the estimates; on earnings per share, for instance, the estimates ranged from 60 to 68 cents, and on revenues, from $26 to $30 billion. The pre-game show is not restricted to analysts and investors, and markets partake in the expectations game in two ways.Stock prices adjust up or down, as earnings expectations are revised upwards or downwards, in the weeks leading up to the earnings report. Nvidia, which traded at $104 on May 23rd, right after the company reported its results for the first quarter of 2024, had its ups and down during the quarter, hitting an all-time high of $135.58 on June 18, 2024, and a low of $92.06, on August 5, before ending at $125.61 on August 28, just ahead of the earnings report:
During that period, the company also split its shares, ten to one, on June 10, a week ahead of reaching its highs.
Stock volatility can also changes, depending upon disagreements among analysts about expected earnings, and the expected market reaction to earnings surprises. That effect is visible not only in observed stock price volatility, but also in the options market, as implied volatility. For Nvidia, there was clearly much more disagreement among investors about the contents of the second quarter earnings report, with implied volatility spiking in the weeks ahead of the report:
While volatility tends to increase just ahead of earnings reports, the surge in volatility ahead of the second quarter earnings for Nvidia was unusually large, a reflection of the disagreement among investors about how the earnings report would play out in the market. Put simply, even before Nvidia reported earnings on August 28, markets were indicating more unease about both the contents of the report and the market reaction to the report, than they were with prior earnings releases.
The Event Given the lead-in to earnings reports, what exactly do they contain as news? The SEC strictures that companies disclose both annual and quarterly results have been buffered by accounting requirements on what those disclosures should contain. In the United States, at least, quarterly reports contain almost all of the relevant information that is included in annual reports, and both have suffered from the disclosure bloat that I called attention to in . Nvidia’s second quarter earnings report, weighing in at 80 pages, was shorter than its annual report, which ran 96 pages, and both are less bloated than the filings of other large market-cap companies. The centerpieces of the earnings report, not surprisingly, are the financial statements, as operating numbers are compared to expectations, and Nvidia’s second quarter numbers, at least at first sight, are dazzling:
The company’s astonishing run of the last few years continues, as its revenues, powered by AI chip sales, more than doubled over the same quarter last year, and profit margins came in at stratospheric levels. The problem, though, is that the company's performance over the last three quarters, in particular, have created expectations that no company can meet. While it is just one quarter, there are clear signs of more slowing to come, as scaling will continue to push revenue growth down, the unit economics will be pressured as chip manufacturers (TSMC) push for a larger slice and operating margins will decrease, as competition increases. Over the last two decades, companies have supplemented the financial reports with guidance on key metrics, particularly revenues, margins and earnings, in future quarters. That guidance has two objectives, with the first directed at investors, with the intent of providing information, and the second at analysts, to frame expectations for the next quarter. As a company that has played the expectations game well, it should come as no surprise that Nvidia provided guidance for future quarters in its second quarter report, and here too, there were reminders that comparisons would get more challenging in future quarters, as they predicted that revenue growth rates would come back to earth, and that margins would, at best, level off or perhaps even decline. Finally, in an overlooked news story, Nvidia announced that it would had authorized $50 billion in buybacks, over an unspecified time frame. While that cash return is not surprising for a company that has became a profit machine, it is at odds with the story that some investors were pricing into the stock of a company with almost unlimited growth opportunities in an immense new market (AI). Just as Meta and Alphabet’s dividend initiations signaled that they were approaching middle age, Nvidia’s buyback announcement may be signaling that the company is entering a new phase in the life cycle, intentionally or by accident.
The Scoring The final piece of the earning release story, and the one that gets the most news attention, is the market reaction to the earnings reports. There is evidence in market history that earnings reports affect stock prices, with the direction of the effect depending on how actual earnings measure up to expectations. While there have been dozens of academic papers that focus on market reactions to earnings reports, their findings can be captured in a composite graph that classifies earnings reports into deciles, based upon the earnings surprise, defined as the difference between actual and predicted earnings:
As you can see, positive surprises cause stock prices to increase, whereas negative surprises lead to price drops, on the announcement date, but there is drift both before and after surprises in the same direction. The former (prices drifting up before positive and down before negative surprises) is consistent with the notion that information about earnings surprises leaks to markets in the days before the report, but the latter (prices continuing to drift up after positive or down after negative surprises) indicates a slow-learning market that can perhaps be exploited to earn excess returns. Breaking down the findings on earnings reports, there seems to be evidence that the that the earnings surprise effect has moderated over time, perhaps because there are more pathways for information to get to markets. Nvidia is not only one of the most widely followed and talked about stocks in the market, but one that has learned to play the expectations game well, insofar as it seems to find a way to beat them consistently, as can be seen in the following table, which looks at their earnings surprises over the last 5 years:Nvidia Earnings Surprise (%)Barring two quarters in 2022, Nvidia has managed to beat expectations on earnings per share every quarter for the last five years. There are two interpretations of these results, and there is truth in both of them. The first is that Nvidia, as with many other technology companies, has enough discretion in both its expenditures (especially in R&D) and in its revenue recognition, that it can use it to beat what analysts expect. The second is that the speed with which the demand for AI chips has grown has surprised everyone in the space (company, analysts, investors) and that the results reflect the undershooting on forecasts. Focusing specifically on the 2025 second quarter, Nvidia beat analyst expectations, delivering earnings per share of 68 cents (above the 64 cents forecast) and revenues of $30 billion (again higher than the $28.4 billion forecast), but the percentage by which it beat expectations was smaller than in the most recent quarters. That may sound like nitpicking, but the expectations game is an insidious one, where investors move the goal posts constantly, and more so, if you have been successful in the past. On August 28, after the earnings report, Nvidia saw share prices drop by 8% and not only did that loss persist through the next trading day, the stock has continued to lose ground, and was trading at $106 at the start of trading on September 6, 2028.
Earnings Reports: Reading the Tea Leaves So what do you learn from earnings reports that may cause you to reassess what a stock is worth? The answer will depend upon whether you consider yourself more of a trader or primarily an investor. If that distinction is lost on you, I will start this section by drawing the contrast between the two approaches, and what each approach is looking for in an earnings report.
Value versus Price At the risk of revisiting a theme that I have used many times before, there are key differences in philosophy and approach between valuing an asset and pricing it.The value of an asset is determined by its fundamentals � cash flows, growth and risk, and we attempt to estimate that value by bringing in these fundamentals into a construct like discounted cash flow valuation or a DCF. Looking past the modeling and the numbers, though, the value of a business ultimately comes from the story you tell about that business, and how that story plays out in the valuation inputs.The price of an asset is set by demand and supply, and while fundamentals play a role, five decades of behavioral finance has also taught us that momentum and mood have a much greater effect in pricing, and that the most effective approach to pricing an asset is to find out what others are paying for similar assets. Thus, determining how much to pay for a stock by using a PE ratio derived from looking its peer group is pricing the stock, not valuing it.The difference between investing and trading stems from this distinction between value and price. Investing is about valuing an asset, buying it at a price less than value and hoping that the gap will close, whereas trading is almost entirely a pricing game, buying at a low price and selling at a higher one, taking advantage of momentum or mood shifts. Given the very different perspectives the two groups bring to markets, it should come as no surprise that what traders look for in an earnings report is very different from what investors see in that same earnings report.
Earnings Reports: The Trading Read If prices are driven by mood and momentum, it should come as no surprise that what traders are looking for in an earnings report are clues about how whether the prevailing mood and momentum will prevail or shift. It follows that traders tend to focus on the earnings per share surprises, since its centrality to the report makes it more likely to be a momentum-driver. In addition, traders are also swayed more by the theater around how earnings news gets delivered, as evidenced, for instance, by the negative reaction to a recent earnings report from Tesla, where Elon Musk sounded downbeat, during the earnings call. Finally, there is a significant feedback loop, in pricing, where the initial reaction to an earnings report, either online or in the after market, can affect subsequent reaction. As a trader, you may learn more about how an earnings report will play out by watching social media and market reaction to it than by poring over the financial statements. For Nvidia, the second quarter report contained good news, if good is defined as beating expectations, but the earnings beat was lower than in prior quarters. Coupled with sober guidance and a concern the stock had gone up too much and too fast, as its market cap had increased from less than half a trillion to three trillion over the course of two years, the stage was set for a mood and momentum shift, and the trading since the earnings release indicates that it has happened. Note, though, that this does not mean that something else could not cause the momentum to shift back, but before you, as an Nvidia manager or shareholder, are tempted to complain about the vagaries of momentum, recognize that for much of the last two years, no stock has benefited more from momentum than Nvidia.
The Investing Read For investors, the takeaways from earnings reports should be very different. If value comes from key value inputs (revenues growth, profitability, reinvestment and risk), and these value inputs themselves come from your company narrative, as an investor, you are looking at the earnings reports to see if there is information in them that would change your core narrative for the company. Thus, an earnings report can have a significant effect on value, if it significantly changes the growth, profitability or risk parts of your company’s story, even though the company’s bottom line (earnings per share) might have come in at expectations. Here are a few examples:A company reporting revenue growth, small or even negligible for the moment, but coming from a geography or product that has large market potential, can see its value jump as a consequence. In 2012, I reassessed the value of Facebook upwards, a few months after it had gone public and seen its stock price collapse, because its first earnings report, while disappointing in terms of the bottom line, contained indications that the company was starting to succeed in getting its platform working on smart phones, a historical weak spot for the firm.You can also have a company reporting higher than expected revenue growth accompanied by lower than anticipated profit margins, suggesting a changing business model, and thus a changed story and valuation. Earlier this year, I valued Tesla, and argued that their lower margins, while bad news standing alone, was good news if your story for Tesla was that it would emerge as a mass market automobile company, capable of selling more cars than Volkswagen and Toyota. Since the only pathway to that story is with lower-priced cars, the Tesla strategy of cutting prices was in line with that story, albeit at the expense of profit margins.A company reporting regulatory or legal actions directed against it, that make its business model more costly or more risky to operate, even though its current numbers (revenues, earnings etc.) are unscathed (so far).In short, if you are an investor, the most interesting components of the report are not in the proverbial bottom line, i.e., whether earnings per share came in below or above expectations, but in the details. Finally, as investors, you may be interested in how earnings reports change market mood, usually a trading focus, because that mood change can operate as a catalyst that causes the price-value gap to close, enriching you in the process.
The figure below summarizes this section, by first contrasting the value and pricing processes, and then looking at how earnings releases can have different meanings to different market participants.
As in other aspects of the market, it should therefore come as no surprise that the same earnings report can have different consequences for different market participants, and it is also possible that what is good news for one group (traders) may be bad news for another group (investors).
Nvidia: Earnings and Value My trading skills are limited, and that I am incapable of playing the momentum game with any success. Consequently, I am not qualified to weigh in on the debate on whether the momentum shift on Nvidia is temporary or long term, but I will use the Nvidia second quarter earnings report as an opportunity to revisit my Nvidia story and to deliver a September 2024 valuation for the company. My intrinsic valuation models are parsimonious, built around revenue growth, profit margins and reinvestment, and I used the second quarter earnings report to review my story (and inputs) on each one:
Nvidia: Valuation Inputs (Sept 2024)With these input changes in place, I revalued Nvidia at the start of September 2024, breaking its revenues, earnings and cash flows down into three businesses: an AI chip business that remains its central growth opportunity, and one in which it has a significant lead on the competition, an auto chip business where it is a small player in a small game, but one where there is potential coming from demand for more powerful chips in cars, and the rest, including its existing business in crypto and gaming, where growth and margins are solid, but unlikely to move dramatically. While traders may be disappointed with Nvidia’s earnings release, and wish it could keep its current pace going, I think it is both unrealistic and dangerous to expect it to do so. In fact, one reason that my story for Nvidia has become more expansive, relative to my assessment in June 2023, is that the speed with which AI architecture is being put in place is allowing the total market to grow at a rate far faster than I had forecast last year. In short, relative to where I was about a year ago, the last four earnings reports from the company indicate that the company can scale up more than I thought it could, has higher and more sustainable margins than I predicted and is perhaps less exposed to the cycles that the chip business has historically been victimized by. With those changes in place, my value per share for Nvidia in is about $87, still about 22% below the stock price of $106 that the stock was trading at on September 5, 2024, a significant difference but one that is far smaller than the divergence that I noted last year.
As always, the normal caveats apply. The first is that I value companies for myself, and while my valuations drive my decisions to buy or sell stocks, they should not determine your choices. That is why my is available not just for download, but for modification, to allow you to tell your own story for Nvidia, yielding a different value and decision. The second is that this is a tool for investors, not traders, and if you are playing the trading game, you will have to reframe the analysis and think in terms of mood and momentum. Looking back, I am at peace with the decision made in the summer of 2023 to shed half my Nvidia shares, and hold on to half. While I left money on the table, with the half that I sold, I have been richly compensated for holding on to the other half. I am going to count that as a win and move on!
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August 28, 2024
Beat your Bot: Building your moat against AI
It seems like a lifetime has passed since artificial intelligence (AI) became the market's biggest mover, but Open AI introduced the world to ChatGPT on November 30, 2022. While ChatGPT itself represented a low-tech variation of AI, it opened the door to AI not only as a business driver, but one that had the potential to change the way we work and live. In a, I looked at the AI effect on businesses, arguing that it had the potential to ferment revolutionary change, but that it would also create a few big winners, a whole host of wannabes, and many losers, as its disruption worked its way through the economy. In this post, I would like to explore that disruption effect, but this time at a personal level, as we are by our AI counterparts. I want to focus on that question, trying to find the middle ground between irrational terror, where AI consigns us all to redundancy, and foolish denial, where we dismiss it as a fad.
The Damodaran Bot I was in the eleventh week of teaching my 2024 spring semester classes at Stern, when Vasant Dhar, who teaches a range of classes from machine learning to data science at NYU's Stern School (where I teach as well), and has forgotten more about AI than I will ever know, called me. He mentioned that he had developed a Damodaran Bot, and explained that it was an AI creation, which had read every blog post that I had ever written, watched every webcast that I had ever posted and reviewed every valuation that I had made public. Since almost everything that I have ever written or done is in the public domain, in , and , that effectively meant that my bot was better informed than I was about my own work, since its memory is perfect and mine is definitely not. He also went on to tell me that the Bot was ready for a trial run, ready to to value companies, and see how those valuations measured up against valuations done by the best students in my class.The results of the contest are still being tabulated, and I am not sure what results I would like to see, since either of the end outcomes would reflect poorly on me. If the Bot's valuations work really well, i.e., it values companies as well, or better, than the students in my class, that is about as strong a signal that I am facing obsolescence, that I can get. If the Bot's valuations work really badly, that would be a reflection that I have failed as a teacher, since the entire rationale for my postings and public valuations is to teach people how to do valuation.
Gauging the threat In the months since I was made aware of the Damodaran Bot, I have thought in general terms about what AI will be able to do as well or better than we can, and the areas where it might have trouble. Ultimately, AI is the coming together of two forces that have become more powerful over the last few decades. The first is increasing (and cheaper) computing power, often coming into smaller and smaller packages; our phones are now computationally more powerful than the very first personal computers. The second is the cumulation of data, both quantitative and qualitative, especially with social media accelerating personal data sharing. As an AI novice, it is entirely possible that I am not gauging the threat correctly, but there are three dimensions on which I see the AI playing out (well or badly).Mechanical/Formulaic vs Intuitive/Adaptable: Well before ChatGPT broke into the public consciousness, was making a splash playing chess, and beating some of the world's greatest chess players. Deep Blue's strength at chess came from the fact that it had access to every chess game ever played (data) and the computing power to evaluate 200 million chess positions per second, putting even the most brilliant human chess player at a disadvantage. In contrast, AI has struggled more with automated driving, not because driving is mechanically complicated, but because there are human drivers on the surface roads, behaving in unpredictable ways. While AI is making progress on making intuitive leaps, and being adaptable, it will always struggle more on those tasks than on the purely mechanical ones.Rules-based vs Principle-based: Expanding the mechanical/intuitive divide, AI will be better positioned to work smoothly in rules-based disciplines, and will be at a disadvantage in principle-based disciplines. Using valuation to illustrate my point, accounting and legal valuations are mostly rule-based, with the rules sometimes coming from theory and practice, and sometimes from rule writers drawing arbitrary lines in the sand. AI can not only replicate those valuations, but can do so at no cost and with a much closer adherence to the rules. In contrast, financial valuations done right, are built around principles, requiring judgment calls and analytical choices on the part of appraisers, on how these principles get applied, and should be more difficult to replace with AI.Biased vs Open minded: There is a third dimension on which we can look at how easy or difficult it will be for AI to replace humans and that is in the human capacity to bring bias into decisions and analyses, while claiming to be objective and unbiased. Using appraisal valuation to illustrate, it is worth remembering that clients often come to appraisers, especially in legal or accounting settings, with specific views about what they would like to see in their valuations, and want affirmation of those views from their appraisers, rather than the objective truth. A business person valuing his or her business, ahead of a divorce, where half the estimated value of that business has to be paid out to a soon-to-be ex-spouse, wants a low value estimate, not a high one, and much as the appraiser of the business will claim objectivity, that bias will find its way into the numbers and value. It is true that you can build AI systems to replicate this bias, but it will be much more difficult to convince those systems that the appraisals that emerge are unbiased.Bringing this down to the personal, the threat to your job or profession, from AI, will be greater if your job is mostly mechanical, rule-based and objective, and less if it is intuitive, principle-based and open to biases.
Responding to AI While AI, at least in its current form, may be unable to replace you at your job, the truth is that AI will get better and more powerful over time, and it will learn more from watching what you do. So, what can we do to make it more difficult to be outsourced by machines or replaced by AI? It is a question that I have thought about for three decades, as machines have become more powerful, and data more ubiquitous, and while I don't have all of the answers, I have four thoughts.
Generalist vs Specialist: In the last century, we have seen a push towards specialization in almost every discipline. In medicine, the general practitioner has become the oddity, as specialists abound to treat individual organs and diseases, and in finance, there are specialists in sub-areas that are so esoteric that no one outside those areas can even comprehend the intricacies of what they do. In the process, there are fewer and fewer people who are comfortable operating outside their domains, and humanity has lost something of value. It is the point I made in 2016, after a visit to Florence, where like hundreds of thousands of tourists before me, I marveled at the beauty of the , one of the largest free-standing domes in the world, at the time of its construction.
The Duomo built by , an artist who taught himself enough engineering and construction to be able to build the dome, and he was carrying on a tradition of others during that period whose interests and knowledge spanned multiple disciplines. right after the visit, I argued that the world needed more Renaissance men (and women), individuals who can operate across multiple disciplines, and with AI looming as a threat, I feel even more strongly about this need. A Leonardo Da Vinci Bot may be able to match the master in one of his many dimensions (painter, sculptor, scientist), but can it span all of them? I don't think so!Practice bounded story telling: Starting about a decade ago, I drew attention to a contradiction at the heart of valuation practice, where as access to data and more powerful models has increased, in the last few decades, the quality of valuations has actually become worse. I argued that one reason for that depletion in quality is that valuations have become much too mechanical, exercises in financial modeling, rather than assessments of business quality and value. I went on to make the case that good valuations are bridges between stories and numbers, and wrote a book on the topic.
At the time of the book's publication, I , and with the AI threat looming, connecting stories to numbers comes with a bonus. If your valuation is all about extrapolating historical data on a spreadsheet, AI can do it quicker, and with far fewer errors than you can. If, however, your valuation is built around a business story, where you have considered the soft data (management quality, the barriers to entry), AI will have a tougher time replicating what you do.Reasoning muscle: I have never been good at reading physical maps, and I must confess that I have completely lost even my rudimentary map reading skills, having become dependent on GPS to get to where I need to go. While this inability to read maps may not make or break me, there are other skills that we have has human beings, where letting machines step in and help us, because of convenience and speed, will have much worse long term consequences. In a few years, I called attention to the "Google Search" curse, where when faced with a question, we often are quick to look up the answer online, rather than try to work out the answer. While that is benign, if you are looking up answers to trivia, it can be malignant, when used to answer questions that we should be reasoning out answers to, on our own. That reasoning may take longer, and sometimes even lead you to the wrong answers, but it is a learned skill, and one that I am afraid that we risk losing, if we let it languish. You may think that I am overreacting, but evolution has removed skill sets that we used to use as human beings, when we stopped using or needing them, and reasoning may be next on the list.Wandering mind: An empty mind may the devil's workshop, at least according to puritans, but it is also the birthplace for creativity. I have always marveled at the capacity that we have as human beings to connect unrelated thoughts and occurrences, to come up with marvelous insights. Like Archimedes in his bath and Newton under the apple tree, we too can make discoveries, albeit much weighty ones, from our own ruminations. Again, making this personal, two of my favorite posts had their roots in unrelated activities. The first one, , emerged while I was shoveling snow after a blizzard about a decade ago, and as I and my adult neighbors struggled dourly with the heavy snow, our kids were out building snowmen, and laughing. I thought of a market analogy, where the same shock (snowstorm) evokes both misery (from some investors) and joy (on the part of others), and used it to contest value with growth investing. The second post, written more recently, came together while I walked my dog, and pondered how earthquakes in Iceland, a data leak at a genetics company and climate change affected value, and that became a more general discourse on how human beings respond (not well) to .It is disconcerting that on every one of these four fronts, progress has made it more difficult rather than less so, to practice. In fact, if you were a conspiracy theorist, you could spin a story of technology companies conspiring to deliver us products, often free and convenient to use, that make us more specialized, more one dimensional and less reason-based, that consume our free time. This may be delusional on my part, but if want to keep the Damodaran Bot at bay, and I take these lessons to heart, I should continue to be a dabbler in all that interests me, work on my weak side (which is story telling), try reasoning my way to answers before looking them up online and take my dog for more walks (without my phone accompanying me).
Beat your bot! I am in an unusual position, insofar as my life’s work is in the public domain, and I have a bot with my name on it not only tracking all of that work, but also shadowing me on any new work that I do. In short, my AI threat is here, and I don’t have the choice of denying its existence or downplaying what it can do. Your work may not be public, and you may not have a bot with your name on it, but it behooves you to act like there is one that tracks you at your job. As you consider how best to respond, there are three strategies you can try:
Be secretive about what you do: My bot has learned how I think and what I do because everything I do is public - on my blog, on YouTube and in my recorded classes. I know that some of you may argue that I have facilitated my own disruption, and that being more secretive with my work would have kept my bot at bay. As a teacher, I neither want that secrecy, nor do I think it is feasible, but your work may lend itself better to this strategy. There are two reasons to be wary, though. The first is that if others do what you do, an AI entity can still imitate you, making it unlikely that you will escape unscathed. The second is that your actions may give away your methods and work process, and AI can thus reverse engineer what you do, and replicate it. Active investing, where portfolio managers claim to use secret sauces to find good investments, can be replicated at relatively low cost, if we can observe what these managers buy and sell. There is a good reason why ETFs have taken away market share from fund managers.Get system protection: I have bought and sold houses multiple times in my lifetime, and it is not only a process that is filled with intermediaries (lawyers, realtors, title deed checkers), all of whom get a slice from the deal, but one where you wonder what they all do in return for their fees. The answer often is not rooted in logic, but in the process, where the system (legal, real estate) requires these intermediaries to be there for the house ownership to transfer. This system protection for incumbents is not just restricted to real estate, and cuts across almost every aspect of our lives, and it creates barriers to disruption. Thus, even if AI can replicate what appraisers do, at close to no cost, I will wager that courts and accounting rule writers will be persuaded by the appraisal ecosystem that the only acceptable appraisals can come from human appraisers.Build your moat: In business, companies with large, sustainable competitive advantages are viewed as having moats that are difficult to competitors to breach, and are thus more valuable. That same idea applies at the personal level, especially as you look at the possibility of AI replacing you. It is your job, and mine, to think of the moats that we can erect (or already have) that will make it more difficult for our bots to replace us. As to what those moats might be, I cannot answer for you, but the last section lays out my thinking on what I need to do to stay a step ahead.Needless to say, I am a work in progress, even at this stage of my life, and rather than complain or worry about my bot replacing me, I will work on staying ahead. It is entirely possible that I am embarking on an impossible mission, but I will keep you posted on my progress (or absence of it). Of course, my bot can get so much better at what I do than I am, in which case, this blog may very well be written and maintained by it, and you will never know!
YouTube Video
Blog Posts (referenced)
August 19, 2024
The Corporate Life Cycle: Managing, Valuation and Investing Implications!
As I reveal my ignorance about TikTok trends, social media celebrities and Gen Z slang, my children are quick to point out my age, and I accept that reality, for the most part. I understand that I am too old to exercise without stretching first or eat a heaping plate of cheese fries and not suffer heartburn, but that does not stop me from trying occasionally. For the last decade or so, I have argued that businesses, like human beings, age, and struggle with aging, and that much of the dysfunction we observe in their decision making stems from refusing to act their age. In fact, the business life cycle has become an integral part of the corporate finance, valuation and investing classes that I teach, and in many of the posts that I have written on this blog. In 2022, I decided that I had hit critical mass, in terms of corporate life cycle content, and that the material could be organized as a book. While the writing for the book was largely done by November 2022, publishing does have a long lead time, and the book, published by Penguin Random House, will be available on August 20, 2024, at a book shop near you. If you are concerned that you are going to be hit with a sales pitch for that book, far from it! Rather than try to part you from your money, I thought I would give a compressed version of the book in this post, and for most of you, that will suffice.
Setting the Stage
The notion of a business life cycle is neither new nor original, since versions of it have floated around in management circles for decades, but its applications in finance have been spotty, with some attempts to tie where a company is in the life cycle to its corporate governance and others to accounting ratios. In fact, and this should come as no surprise to anyone who is familiar with his work, the tying excess returns (return on invested capital minus cost of capital) to the corporate life cycle was penned by Michael Mauboussin (with Dan Callahan) just a few months ago. My version of the corporate life cycle is built around six stages with the first stage being an idea business (a start-up) and the last one representing decline and demise.As you can see, the key tasks shift as business age, from building business models in the high growth phase to scaling up the business in high growth to defending against competition in the mature phase to managing decline int he last phase. Not surprisingly, the operating metrics change as companies age, with high revenue growth accompanied by big losses (from work-in-progress business models) and large reinvestment needs (to delivery future growth) in early-stage companies to large profits and free cash flows in the mature phase to stresses on growth and margins in decline. Consequently, in terms of cash flows, young companies burn through cash, with the burn increasing with potential, cash buildup is common as companies mature followed by cash return, as the realization kicks in that a company’s high growth days are in the past. As companies move through the life cycle, they will hit transition points in operations and in capital raising that have to be navigated, with high failure rates at each transition. Thus, most idea businesses never make it to the product phase, many product companies are unable to scale up, and quite a few scaled up firms are unable to defend their businesses from competitors. In short, the corporate life cycle has far higher mortality rates as businesses age than the human life cycle, making it imperative, if you are a business person, that you find the uncommon pathways to survive and grow.
Measures and Determinants
If you buy into the notion of a corporate life cycle, it stands to reason that you would like a way to determine where a company stands in the life cycle. There are three choices, each with pluses and minuses.
The first is to focus on corporate age, where you estimate how old a company is, relative its founding date; it is easy to obtain, but companies age at different rates (as well will argue in the following section), making it a blunt weapon.The second is to look at the industry group or sector that a company is in, and then follow up by classifying that industry group or sector into high or low growth; for the last four decades, in US equity markets, tech has been viewed as growth and utilities as mature. Here again, the problem is that high growth industry groups begin to mature, just as companies do, and this has been true for some segments of the tech sector.The third is to focus on the operating metrics of the firm, with firms that deliver high revenue growth, with low/negative profits and negative free cash flows being treated as young firms. It is more data-intensive, since making a judgment on what comprises high (revenue growth or margins) requires estimating these metrics across all firms.While I delve into the details of all three measures, corporate age works surprisingly well as a proxy for where a company falls in the life cycle, as can be seen in this table of all publicly traded companies listed globally, broken down by corporate age into ten deciles:As you can see, the youngest companies have much higher revenue growth and more negative operating margins than older companies.
Ultimately, the life cycles for companies can vary on three dimensions - length (how long a business lasts), height (how much it can scale up before it plateaus) and slope (how quickly it can scale up). Even a cursory glance at the companies that surround you should tell you that there are wide variations across companies, on these dimensions. To see why, consider the factors that determine these life cycle dimensions:
Companies in capital-light businesses, where customers are willing to switch from the status quo, can scale up much faster than companies in capital-intensive businesses, where brand names and customer inertia can make breakthroughs more difficult. It is worth noting, though, that the forces that allow a business to scale up quickly often limit how long it can stay at the top and cause decline to be quicker, a trade off that was ignored during the last decade, where scaling up was given primacy. The drivers of the corporate life cycle can also explain why the typical twenty-first century company faces a compressed life cycle, relative to its twentieth century counterpart. In the manufacturing-centered twentieth century, it took decades for companies like GE and Ford to scale up, but they also stayed at the top for long periods, before declining over decades. The tech-centered economy that we live in is dominated by companies that can scale up quickly, but they have brief periods at the top and scale down just as fast. Yahoo! and BlackBerry soared from start ups to being worth tens of billions of dollars in a blink of an eye, had brief reigns at the top and melted down to nothing almost as quickly.
Corporate Finance across the Life Cycle
Corporate finance, as a discipline, lays out the first principles that govern how to run a business, and with a focus on maximizing value, all decisions that a business makes can be categorized into investing (deciding what assets/projects to invest in), financing (choosing a mix of debt and equity, as well as debt type) and dividend decisions (determining how much, if any, cash to return to owners, and in what form).
While the first principles of corporate finance do not change as a company ages, the focus and estimation processes will shift, as shown in the picture below:
With young companies, where the bulk of the value lies in future growth, and earnings and cash flows are often negative, it is the investment decision that dominates; these companies cannot afford to borrow or pay dividends. With more mature companies, as investment opportunities become scarcer, at least relative to available capital, the focus not surprisingly shifts to financing mix, with a lower hurdle rate being the pay off. With declining businesses, facing shrinking revenues and margins, it is cash return or dividend policy that moves into the front seat.
Valuation across the Life Cycle
I am fascinated by valuation, and the link between the value of a business and its fundamentals - cash flows, growth and risk. I am also a realist and recognize that I live in a world, where pricing dominates, with what you pay for a company or asset being determined by what others are paying for similar companies and assets:
For pre-revenue and very young companies, the pricing metrics will standardize the price paid (by venture capitalists and other investors) to the number of users or subscribers that a company has or to the total market that its product is aimed at. As business models develop, and revenues come into play, you are likely to see a shift to revenue multiples, albeit often to estimated revenues in a future year (forward numbers). In the mature phase, you will see earnings multiples become more widely used, with equity versions (like PE) in peer groups where leverage is similar across companies, and enterprise value versions (EV to EBITDA) in peer groups, where leverage is different across companies. In decline, multiples of book value will become more common, with book value serving as a (poor) proxy for liquidation or break up value. In short, if you want to be open to investing in companies across the life cycle, it behooves you to become comfortable with different pricing ratios, since no one pricing multiple will work on all firms.
Investing across the Life Cycle
In my class (and book) on investment philosophies, I start by noting that every investment philosophy is rooted in a belief about markets making (and correcting) mistakes, and that there is no one best philosophy for all investors. I use the investment process, starting with asset allocation, moving to stock/asset selection and ending with execution to show the range of views that investors bring to the game:
Value investors believe that the best investment bargains are in mature companies, where assets in place (investments already made) are being underpriced by the market, whereas growth investors build their investment theses around the idea that it is growth assets where markets make mistakes. Finally, there are market players who try to make money from market frictions, by locking in market mispricing (with pure or near arbitrage).
Drawing on the earlier discussion of value versus price, you can classify market players into investors (who value companies, and try to buy them at a lower price, while hoping that the gap closes) and traders (who make them money on the pricing game, buying at a low price and selling at a higher one).While investors and traders are part of the market in every company, you are likely to see the balance between the two groups shift as companies move through the life cycle:
Early in the life cycle, it is undeniable that traders dominate, and for investors in these companies, even if they are right in their value assessments, winning will require much longer time horizons and stronger stomachs. As companies mature, you are likely to see more investors become part of the game, with bargain hunters entering when the stock drops too much and short sellers more willing to counter when it goes up too much. In decline, as legal and restructuring challenges mount, and a company can have multiple securities (convertibles, bonds, warrants) trading on it, hedge funds and activists become bigger players.
In sum, the investment philosophy you choose can lead you to over invest in companies in some phases of the life cycle, and while that by itself is not a problem, denying that this skew exists can become one. Thus, deep value investing, where you buy stocks that trade at lowmultiples of earnings and book value, will result in larger portions of the portfolio being invested in mature and declining companies. That portfolio will have the benefit of stability, but expecting it to contain ten-baggers and hundred-baggers is a reach. In contrast, a venture capital portfolio, invested almost entirely in very young companies, will have a large number of wipeouts, but it can still outperform, if it has a few large winners. Advice on concentrating your portfolio and having a margin of safety, both value investing nostrums, may work with the former but not with the latter.
Managing across the Life Cycle
Management experts who teach at business schools and populate the premier consulting firms have much to gain by propagating the myth that there is a . After all, it gives them a reason to charge nose-bleed prices for an MBA (to be imbued with these qualities) or for consulting advice, with the same end game. The truth is that there is no one-size-fits-all for a great CEO, since the qualities that you are looking for in top management will shift as companies age:
While the possibilities of mismatches have always been part of business, the compression of corporate life cycles has made them both much more likely, as well as more damaging. After all, time took care of management transitions for long-lived twentieth century firms, but with firms that can scale up to become market cap giants in a decade, before scaling down and disappearing in the next one, you can very well see a founder/CEO go from being a hero in one phase to a zero in the next one. As we have allowed many of the most successful firms that have gone public in this century to skew the corporate finance game, with shares with different voting rights, we may be losing our power to change management at those firms where the need for change is greatest.
Aging gracefully?
Thehealthiest response to aging is acceptance, where a business accepts where it is in the life cycle, and behaves accordingly. Thus, a young firm that derives much of its value from future growth should not put that at risk by borrowing money or by buying back stock, just as a mature firm, where value comes from its existing assets and competitive advantages, should not risk that value by acquiring companies in new and unfamiliar businesses, in an attempt to return to its growth days. Acceptance is most difficult for declining firms, since the management and investors have to make peace with downsizing the firm. For these firms, it is worth emphasizing that acceptance does not imply passivity, a distorted and defeatist view of karma, where you do nothing in the face of decline, but requires actions that allow the firm to navigate the process with the least pain and most value to its stakeholders.
It should come as no surprise that many firms, especially in decline, choose denial, where managers and investors come up with excuses for poor performance and lay blame on outside factors. On this path, declining firms will continue to act the way they did when they were mature or even growth companies, with large costs to everyone involved. When the promised turnaround does not ensue, desperation becomes the alternative path, with managers gambling large sums of other people’s money on long shots, with predictable results.
The siren song that draws declining firms to make these attempts to recreate themselves, is the hope of arebirth, and an ecosystem of bankers and consultants offers them magic potions (taking the form of proprietary acronyms that either restate the obvious or are built on foundations of made-up data) that will make them young again. They are aided and abetted by case studies of companies that found pathways to reincarnation (IBM in 1992, Apple in 2000 and Microsoft in 2013), with the added bonus that their CEOs were elevated to legendary status. While it is undeniable that companies do sometimes reincarnate, it is worth recognizing that they remain the exception rather than the rule, and while their top management deserves plaudits, luck played a key role as well.
I am a skeptic on sustainability, at least as applied to companies, since its makes corporate survival the end game, sometimes with substantial costs for many stakeholders, as well as for society. Like the EgyptianPharaohs who sought immortality by wrapping their bodies in bandages and being buried with their favorite possessions, companies that seek to live forever will become mummies (and sometimes zombies), sucking up resources that could be better used elsewhere.
In conclusion
It is the dream, in every discipline, to come up with a theory or construct that explains everything in that disciple. Unlike the physical sciences, where that search is constrained by the laws of nature, the social sciences reflect more trial and error, with the unpredictability of human nature being the wild card. In finance, a discipline that started as an offshoot of economics in the 1950s, that search began with theory-based models, with portfolio theory and the CAPM, veered into data-based constructs (proxy models, factor analysis), and behavioral finance, with its marriage of finance and psychology. I am grateful for those contributions, but the corporate life cycle has offered me a low-tech, but surprisingly wide reaching, construct to explain much of what I see in business and investment behavior.
If you find yourself interested in the topic, you can try the book, and in the interests of making it accessible to a diverse reader base, I have triedto make it both modular and self-standing. Thus, if you are interested in how running a business changes, as it ages, you can focus on the four chapters that look at corporate finance implications, with the lead-in chapter providing you enough of a corporate finance foundation (even if you have never taken a corporate finance class) to be able to understand the investing, financing and dividend effects. If you are an appraiser or analyst, interested in valuing companies across the life cycle, it is the five chapters on valuation that may draw your interest, again with a lead-in chapter containing an introduction to valuation and pricing. As an investor, no matter what your investment philosophy, it is the four chapters on investing across the life cycle that may appeal to you the most. While I am sure that you will have no trouble finding the book, I have a list of book retailers listed below that you can use, if you choose, and the webpage .
If you are budget-constrained or just don't like reading (and there is no shame in that), I have also created an online class, with twenty sessions of 25-35 minutes apiece, that delivers the material from the book. It includes exercises that you can use to check your understanding, and the .
YouTube Video
Book and Class Webpages
Book webpage:Class webpage:YouTube Playlist for class:_Links to booksellers
Amazon: Barnes & Noble: : Apple: (There is an Indian edition that will be released in September, which should be available in bookstores there.)The Corporate Life Cycle: Corporate Finance, Valuation and Investing Implications!
As I reveal my ignorance about TikTok trends, social media celebrities and Gen Z slang, my children are quick to point out my age, and I accept that reality, for the most part. I understand that I am too old to exercise without stretching first or eat a heaping plate of cheese fries and not suffer heartburn, but that does not stop me from trying occasionally. For the last decade or so, I have argued that businesses, like human beings, age, and struggle with aging, and that much of the dysfunction we observe in their decision making stems from refusing to act their age. In fact, the business life cycle has become an integral part of the corporate finance, valuation and investing classes that I teach, and in many of the posts that I have written on this blog. In 2022, I decided that I had hit critical mass, in terms of corporate life cycle content, and that the material could be organized as a book. While the writing for the book was largely done by November 2022, publishing does have a long lead time, and the book, published by Penguin Random House, will be available on August 20, 2024, at a book shop near you. If you are concerned that you are going to be hit with a sales pitch for that book, far from it! Rather than try to part you from your money, I thought I would give a compressed version of the book in this post, and for most of you, that will suffice.
Setting the Stage
The notion of a business life cycle is neither new nor original, since versions of it have floated around in management circles for decades, but its applications in finance have been spotty, with some attempts to tie where a company is in the life cycle to its corporate governance and others to accounting ratios. In fact, and this should come as no surprise to anyone who is familiar with his work, the tying excess returns (return on invested capital minus cost of capital) to the corporate life cycle was penned by Michael Mauboussin (with Dan Callahan) just a few months ago. My version of the corporate life cycle is built around six stages with the first stage being an idea business (a start-up) and the last one representing decline and demise.As you can see, the key tasks shift as business age, from building business models in the high growth phase to scaling up the business in high growth to defending against competition in the mature phase to managing decline int he last phase. Not surprisingly, the operating metrics change as companies age, with high revenue growth accompanied by big losses (from work-in-progress business models) and large reinvestment needs (to delivery future growth) in early-stage companies to large profits and free cash flows in the mature phase to stresses on growth and margins in decline. Consequently, in terms of cash flows, young companies burn through cash, with the burn increasing with potential, cash buildup is common as companies mature followed by cash return, as the realization kicks in that a company’s high growth days are in the past. As companies move through the life cycle, they will hit transition points in operations and in capital raising that have to be navigated, with high failure rates at each transition. Thus, most idea businesses never make it to the product phase, many product companies are unable to scale up, and quite a few scaled up firms are unable to defend their businesses from competitors. In short, the corporate life cycle has far higher mortality rates as businesses age than the human life cycle, making it imperative, if you are a business person, that you find the uncommon pathways to survive and grow.
Measures and Determinants
If you buy into the notion of a corporate life cycle, it stands to reason that you would like a way to determine where a company stands in the life cycle. There are three choices, each with pluses and minuses.
The first is to focus on corporate age, where you estimate how old a company is, relative its founding date; it is easy to obtain, but companies age at different rates (as well will argue in the following section), making it a blunt weapon.The second is to look at the industry group or sector that a company is in, and then follow up by classifying that industry group or sector into high or low growth; for the last four decades, in US equity markets, tech has been viewed as growth and utilities as mature. Here again, the problem is that high growth industry groups begin to mature, just as companies do, and this has been true for some segments of the tech sector.The third is to focus on the operating metrics of the firm, with firms that deliver high revenue growth, with low/negative profits and negative free cash flows being treated as young firms. It is more data-intensive, since making a judgment on what comprises high (revenue growth or margins) requires estimating these metrics across all firms.While I delve into the details of all three measures, corporate age works surprisingly well as a proxy for where a company falls in the life cycle, as can be seen in this table of all publicly traded companies listed globally, broken down by corporate age into ten deciles:As you can see, the youngest companies have much higher revenue growth and more negative operating margins than older companies.
Ultimately, the life cycles for companies can vary on three dimensions - length (how long a business lasts), height (how much it can scale up before it plateaus) and slope (how quickly it can scale up). Even a cursory glance at the companies that surround you should tell you that there are wide variations across companies, on these dimensions. To see why, consider the factors that determine these life cycle dimensions:
Companies in capital-light businesses, where customers are willing to switch from the status quo, can scale up much faster than companies in capital-intensive businesses, where brand names and customer inertia can make breakthroughs more difficult. It is worth noting, though, that the forces that allow a business to scale up quickly often limit how long it can stay at the top and cause decline to be quicker, a trade off that was ignored during the last decade, where scaling up was given primacy. The drivers of the corporate life cycle can also explain why the typical twenty-first century company faces a compressed life cycle, relative to its twentieth century counterpart. In the manufacturing-centered twentieth century, it took decades for companies like GE and Ford to scale up, but they also stayed at the top for long periods, before declining over decades. The tech-centered economy that we live in is dominated by companies that can scale up quickly, but they have brief periods at the top and scale down just as fast. Yahoo! and BlackBerry soared from start ups to being worth tens of billions of dollars in a blink of an eye, had brief reigns at the top and melted down to nothing almost as quickly.
Corporate Finance across the Life Cycle
Corporate finance, as a discipline, lays out the first principles that govern how to run a business, and with a focus on maximizing value, all decisions that a business makes can be categorized into investing (deciding what assets/projects to invest in), financing (choosing a mix of debt and equity, as well as debt type) and dividend decisions (determining how much, if any, cash to return to owners, and in what form).
While the first principles of corporate finance do not change as a company ages, the focus and estimation processes will shift, as shown in the picture below:
With young companies, where the bulk of the value lies in future growth, and earnings and cash flows are often negative, it is the investment decision that dominates; these companies cannot afford to borrow or pay dividends. With more mature companies, as investment opportunities become scarcer, at least relative to available capital, the focus not surprisingly shifts to financing mix, with a lower hurdle rate being the pay off. With declining businesses, facing shrinking revenues and margins, it is cash return or dividend policy that moves into the front seat.
Valuation across the Life Cycle
I am fascinated by valuation, and the link between the value of a business and its fundamentals - cash flows, growth and risk. I am also a realist and recognize that I live in a world, where pricing dominates, with what you pay for a company or asset being determined by what others are paying for similar companies and assets:
For pre-revenue and very young companies, the pricing metrics will standardize the price paid (by venture capitalists and other investors) to the number of users or subscribers that a company has or to the total market that its product is aimed at. As business models develop, and revenues come into play, you are likely to see a shift to revenue multiples, albeit often to estimated revenues in a future year (forward numbers). In the mature phase, you will see earnings multiples become more widely used, with equity versions (like PE) in peer groups where leverage is similar across companies, and enterprise value versions (EV to EBITDA) in peer groups, where leverage is different across companies. In decline, multiples of book value will become more common, with book value serving as a (poor) proxy for liquidation or break up value. In short, if you want to be open to investing in companies across the life cycle, it behooves you to become comfortable with different pricing ratios, since no one pricing multiple will work on all firms.
Investing across the Life Cycle
In my class (and book) on investment philosophies, I start by noting that every investment philosophy is rooted in a belief about markets making (and correcting) mistakes, and that there is no one best philosophy for all investors. I use the investment process, starting with asset allocation, moving to stock/asset selection and ending with execution to show the range of views that investors bring to the game:
Value investors believe that the best investment bargains are in mature companies, where assets in place (investments already made) are being underpriced by the market, whereas growth investors build their investment theses around the idea that it is growth assets where markets make mistakes. Finally, there are market players who try to make money from market frictions, by locking in market mispricing (with pure or near arbitrage).
Drawing on the earlier discussion of value versus price, you can classify market players into investors (who value companies, and try to buy them at a lower price, while hoping that the gap closes) and traders (who make them money on the pricing game, buying at a low price and selling at a higher one).While investors and traders are part of the market in every company, you are likely to see the balance between the two groups shift as companies move through the life cycle:
Early in the life cycle, it is undeniable that traders dominate, and for investors in these companies, even if they are right in their value assessments, winning will require much longer time horizons and stronger stomachs. As companies mature, you are likely to see more investors become part of the game, with bargain hunters entering when the stock drops too much and short sellers more willing to counter when it goes up too much. In decline, as legal and restructuring challenges mount, and a company can have multiple securities (convertibles, bonds, warrants) trading on it, hedge funds and activists become bigger players.
In sum, the investment philosophy you choose can lead you to over invest in companies in some phases of the life cycle, and while that by itself is not a problem, denying that this skew exists can become one. Thus, deep value investing, where you buy stocks that trade at lowmultiples of earnings and book value, will result in larger portions of the portfolio being invested in mature and declining companies. That portfolio will have the benefit of stability, but expecting it to contain ten-baggers and hundred-baggers is a reach. In contrast, a venture capital portfolio, invested almost entirely in very young companies, will have a large number of wipeouts, but it can still outperform, if it has a few large winners. Advice on concentrating your portfolio and having a margin of safety, both value investing nostrums, may work with the former but not with the latter.
Managing across the Life Cycle
Management experts who teach at business schools and populate the premier consulting firms have much to gain by propagating the myth that there is a . After all, it gives them a reason to charge nose-bleed prices for an MBA (to be imbued with these qualities) or for consulting advice, with the same end game. The truth is that there is no one-size-fits-all for a great CEO, since the qualities that you are looking for in top management will shift as companies age:
While the possibilities of mismatches have always been part of business, the compression of corporate life cycles has made them both much more likely, as well as more damaging. After all, time took care of management transitions for long-lived twentieth century firms, but with firms that can scale up to become market cap giants in a decade, before scaling down and disappearing in the next one, you can very well see a founder/CEO go from being a hero in one phase to a zero in the next one. As we have allowed many of the most successful firms that have gone public in this century to skew the corporate finance game, with shares with different voting rights, we may be losing our power to change management at those firms where the need for change is greatest.
Aging gracefully?
Thehealthiest response to aging is acceptance, where a business accepts where it is in the life cycle, and behaves accordingly. Thus, a young firm that derives much of its value from future growth should not put that at risk by borrowing money or by buying back stock, just as a mature firm, where value comes from its existing assets and competitive advantages, should not risk that value by acquiring companies in new and unfamiliar businesses, in an attempt to return to its growth days. Acceptance is most difficult for declining firms, since the management and investors have to make peace with downsizing the firm. For these firms, it is worth emphasizing that acceptance does not imply passivity, a distorted and defeatist view of karma, where you do nothing in the face of decline, but requires actions that allow the firm to navigate the process with the least pain and most value to its stakeholders.
It should come as no surprise that many firms, especially in decline, choose denial, where managers and investors come up with excuses for poor performance and lay blame on outside factors. On this path, declining firms will continue to act the way they did when they were mature or even growth companies, with large costs to everyone involved. When the promised turnaround does not ensue, desperation becomes the alternative path, with managers gambling large sums of other people’s money on long shots, with predictable results.
The siren song that draws declining firms to make these attempts to recreate themselves, is the hope of arebirth, and an ecosystem of bankers and consultants offers them magic potions (taking the form of proprietary acronyms that either restate the obvious or are built on foundations of made-up data) that will make them young again. They are aided and abetted by case studies of companies that found pathways to reincarnation (IBM in 1992, Apple in 2000 and Microsoft in 2013), with the added bonus that their CEOs were elevated to legendary status. While it is undeniable that companies do sometimes reincarnate, it is worth recognizing that they remain the exception rather than the rule, and while their top management deserves plaudits, luck played a key role as well.
I am a skeptic on sustainability, at least as applied to companies, since its makes corporate survival the end game, sometimes with substantial costs for many stakeholders, as well as for society. Like the EgyptianPharaohs who sought immortality by wrapping their bodies in bandages and being buried with their favorite possessions, companies that seek to live forever will become mummies (and sometimes zombies), sucking up resources that could be better used elsewhere.
In conclusion
It is the dream, in every discipline, to come up with a theory or construct that explains everything in that disciple. Unlike the physical sciences, where that search is constrained by the laws of nature, the social sciences reflect more trial and error, with the unpredictability of human nature being the wild card. In finance, a discipline that started as an offshoot of economics in the 1950s, that search began with theory-based models, with portfolio theory and the CAPM, veered into data-based constructs (proxy models, factor analysis), and behavioral finance, with its marriage of finance and psychology. I am grateful for those contributions, but the corporate life cycle has offered me a low-tech, but surprisingly wide reaching, construct to explain much of what I see in business and investment behavior.
If you find yourself interested in the topic, you can try the book, and in the interests of making it accessible to a diverse reader base, I have triedto make it both modular and self-standing. Thus, if you are interested in how running a business changes, as it ages, you can focus on the four chapters that look at corporate finance implications, with the lead-in chapter providing you enough of a corporate finance foundation (even if you have never taken a corporate finance class) to be able to understand the investing, financing and dividend effects. If you are an appraiser or analyst, interested in valuing companies across the life cycle, it is the five chapters on valuation that may draw your interest, again with a lead-in chapter containing an introduction to valuation and pricing. As an investor, no matter what your investment philosophy, it is the four chapters on investing across the life cycle that may appeal to you the most. While I am sure that you will have no trouble finding the book, I have a list of book retailers listed below that you can use, if you choose, and the webpage .
If you are budget-constrained or just don't like reading (and there is no shame in that), I have also created an online class, with twenty sessions of 25-35 minutes apiece, that delivers the material from the book. It includes exercises that you can use to check your understanding, and the .
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Book and Class Webpages
Book webpage:Class webpage:YouTube Playlist for class:_Links to booksellers
Amazon: Barnes & Noble: : Apple: (There is an Indian edition that will be released in September, which should be available in bookstores there.)July 24, 2024
Country Risk: My 2024 Data Update
After the 2008 market crisis, I resolved that I would be far more organized in my assessments and updating of equity risk premiums, in the United States and abroad, as I looked at the damage that can be inflicted on intrinsic value by significant shifts in risk premiums, i.e., my definition of a crisis. That precipitated my practice of estimating implied equity risk premiums for the S&P 500, at the start of every month, and following up of using those estimated premiums when valuing companies during that month. The 2008 crisis also gave rise to two risk premium papers that I have updated each year: the first looks at equity risk premiums, what they measure, how they vary across time and how best to estimate them, with the . The second focuses on country risk and how it varies across geographies, with the focus again on determinants, measures and estimation, which I update mid-year each year. This post reflects my most recent update from July 2024 of country risk, and while you can , I thought I would give you a mildly abridged version in this post.
Country Risk: Determinants
At the risk of stating the obvious, investing and operating in some countries is much riskier than investing and operating in others, with variations in risk on multiple dimensions. In the section below, I highlight the differences on four major dimensions - political structure, exposure to war/violence, extent of corruption and protections for legal and property rights, with the focus firmly on the economic risks rather than on social consequences.
a. Political Structure
Would you rather invest/operate in a democracy than in an autocracy? From a business risk perspective, I would argue that there is a trade off, sometimes making the former more risky than the latter, and sometimes less so. The nature of a democracy is that a government will be less able to promise or deliver long term predictable/stable tax and regulatory law, since losing an election can cause shifts in policy. Consequently, operating and investing in a democratic country will generally come with more risk on a continuous basis, with the risk increasing with partisanship in the country. Autocratic governments are in a better position to promise and deliver stable and predictable business environments, with two caveats. The first is that when change comes in autocracies, it will be both unexpected and large, with wrenching and discontinuous shifts in economic policy. The second is that the absence of checks and balance (legal, legislative, public opinion) will also mean that policy changes can be capricious, often driven by factors that have little to do with business or public welfare.
Any attempt to measure political freedom comes with qualifiers, since the biases of the measuring service on what freedoms to elevate and which ones to ignore will play a role, but in the figure below, I report the Economist's Democracy Index, which is based upon five measures - electoral process andpluralism, government functioning, political participation, democratic social culture and civil liberties:
Based upon the Economist's democracy measures, much of the world remains skewed towards authoritarianism, changing the risk exposures that investors and businesses face when operating in those parts of the world.
b. War and Violence Operating a business becomes much more difficult, when surrounded by war and violence, from both within and outside the country. That difficulty also translates into higher costs, with those businesses that can buy protection or insurance doing so, and those that cannot suffering from damage and lost revenues. Drawing again on an external service, the Institute for Economics and Peace measures exposure to war and violence with a global peace index (with higher scores indicating more propensity towards violence):
While Africa and large swaths of Asia are exposed to violence, and Northern Europe and Canada remain peaceful, businesses in much of the world (including the United States) remain exposed to violence, at least according to this measure.
c. Corruption As I have argued in , corruption operates as an implicit tax on businesses, with the tax revenues accruing to middlemen or third parties, rather than the government.
Again, while you can argue with the scores and the rankings, it remains undeniable that businesses in much of the world face corruption (and its associated costs). While there are some who attribute it to culture, I believe that the overriding reasons for corruption are systems that are built around licensing and regulatory constraints, with poorly paid bureaucrats operating as the overseers There areother insidious consequences to corruption. First, as corruption becomes brazen, as it is in some parts of the world, there is evidence that companies operating in those settings are more likely to evade paying taxes to the government, thus redirecting tax revenues from the government to private players. Second, companies that are able and willing to play the corruption game will be put at an advantage over companies that are unable or unwilling to do so, creating a in businesses, where the least honorable businesses win out at the expense of the most honorable and honest ones.
d. Legal and Property Rights When operating a business or making an investment, you are reliant on a legal system to back up your ownership rights, and to the extent that it does not do so, your business and investment will be worth less. The Property Rights Alliance, an entity that attempts to measure the strength of property rights, by country, measured property rights (physical and intellectual) around the world, to come up with a composite measure of these rights, with higher values translating into more rights. Their most recent update, from 2023, is captured in the picture below:
Again, there are wide differences in property rights across the world; they are strongest in the North America and Europe and weakest in Africa and Latin America. Within each of these regions, though, there are variations across countries; within Latin America, Chile and Uruguay rank in the top quartile of countries with stronger property rights, but Venezuela and Bolivia are towards the bottom of the list. In assessing protections of property rights, it is worth noting that it is not only the laws that protect them that need to be looked at, but also the timeliness of legal action. A court that takes decades to act on violations of property rights is almost as bad as a court that does not enforce those rights at all. One manifestation of property right violation is nationalization, and here again there remain parts of the world, especially with natural resource businesses, where the risks of expropriation have increased. A Sustainalytics report that looked at metal miners documented 165 incidents of resources nationalization between 2017 and 2021, impacting 87 mining companies, with 22 extreme cases, where local governments ending contracts with foreign miners. Maplecroft, a risk management company, mapped out the trendline on nationalization risk in natural resources in the figure below:
National security is the reason that some governments use to justify public ownership of key resources. For instance, in 2022, Mexico created a state-owned company, Litio Para Mexico, to have a monopoly on lithium mining in the country, and announced a plan to renegotiate previously granted concessions to private companies to extract the resource.
Country Risk: External factors Looking at the last section, you would not be faulted for believing that country risk exposure is self-determined, and that countries can become less risky by working on reducing corruption, increasing legal protections for property rights, making themselves safer and working on more predictable economic policies. That is true, but there are three factors that are largely out of their control that can still drive country risk upwards.
1. Commodity Dependence Some countries are dependent upon a specific commodity, product or service for their economic success. That dependence can create additional risk for investors and businesses, since a drop in the commodity’s price or demand for the product/service can create severe economic pain that spreads well beyond the companies immediately affected. Thus, if a country derives 50% of its economic output from iron ore, a drop in the price of iron ore will cause pain not only for mining companies but also for retailers, restaurants and consumer product companies in the country. The United Nations Conference on Trade and Development (UNCTAD) measures the degree to which a country is dependent on commodities, by looking at the percentage of its export revenues come from a commodities, and the figure below captures their findings:
Why don’t countries that derive a disproportionate amount of their economy from a single source diversify their economies? That is easier said than done, for two reasons. First, while it is feasible for larger countries like Brazil, India, and China to try to broaden their economic bases, it is much more difficult for small countries like Peru or Angola to do the same. Like small companies, these small countries have to find a niche where they can specialize, and by definition, niches will lead to over dependence upon one or a few sources. Second, and this is especially the case with natural resource dependent countries, the wealth that can be created by exploiting the natural resource will usually be far greater than using resources elsewhere in the economy, which may explain the inability of economies in the Middle East to wean itself away from oil.
II. Life Cycle dynamics As readers of this blog should be aware, I am fond of using the corporate life cycle structure to explain why companies behave (or misbehave) and how investment philosophies vary. At the risk of pushing that structure to its limits, I believe that countries also go through a life cycle, with different challenges and risks at each stage:
The link between life cycle and economic risk is worth emphasizing because it illustrates the limitations on the powers that countries have over their exposure to risk. A country that is still in the early stages of economic growth will generally have more risk exposure than a mature country, even if it is well governed and has a solid legal system. The old investment saying that gain usually comes with pain, also applies to operating and investing across the globe. While your risk averse side may lead you to direct your investments and operations to the safest parts of the world (say, Canada and Northern Europe), the highest growth is generally in the riskiest parts of the world.
3. Climate Change The globe is warming up, and no matter where you fall on the human versus nature debate, on causation, some countries are more exposed to global warming than others. That risk is not just to the health and wellbeing of those who live within the borders of these countries, but represents economic risks, manifesting as higher costs of maintaining day-to-day activity or less economic production. To measure climate change, we turned to ResourceWatch, a global partnership of public, private and civil society organizations convened by the World Resources Institute. This institute measure climate change exposure with a climate risk index (CRI), measuring the extent to which countries have been affected by extreme weather events (meteorological, hydrological, and climatological), and their most recent measures (from 2021, with an update expected late in 2024) of global exposure to climate risk is in the figure below:
Note that higher scores on the index indicate more exposure to country risk, and much of Africa, Latin America and Asia are exposed. In fact, since this map was last updated in 2021, it is conceivable that climate risk exposure has increased across the globe and that even the green regions are at risk of slipping away into dangerous territory.
Country Life Cycle - Measures With that long lead in on the determinants of country risk, and the forces that can leave risk elevated, let us look at how best to measure country risk exposure. We will start with sovereign ratings, which are focused on country default risk, because they are the most widely used country risk proxies, before moving on to country risk scores, from public and private services, and closing with measures of risk premiums that equity investors in these countries should charge.
1. Sovereign Default Risk The ratings agencies that rate corporate bonds for default risk also rate countries, with sovereign ratings, with countries with higher (lower) perceived default risk receiving lower (higher) ratings. I know that ratings agencies are viewed with skepticism, and much of that skepticism is deserved, but it is undeniable that ratings and default risk are closely tied, especially over longer periods. The figure below summarizes sovereign ratings from Moody's in July 2024:Moody's Sovereign Ratings in July 2024; Source: Moody's
If you compare these ratings to those that I reported in my last update, a year ago, you will notice that the ratings are stagnant for most countries, and when there is change, it is small. That remains my pet peeve with the rating agencies, which is not that they are biased or even wrong, but that they are slow to react to changes on the ground. For those searching for an alternative, there is the sovereign credit default swap (CDS) market, where you can market assessments of default risk. The figure below summarizes the spreads for the roughly 80 countries, where they are available:Sovereign CDS Spreads on June 30, 2024: Source: Bloomberg
Sovereign CDS spreads reflect the pluses and minuses of a market-based measure, adjusting quickly to changes on the ground in a country, but sometimes overshooting as markets overreact. As you can see, the sovereign CDS market views India as safer than suggested by the ratings agencies, and for the first time, in my tracking, as safer than China (Sovereign CDS for India is 0.83% and for China is 1.05%, as of June 30, 2024).
2. Country Risk Scores Ubiquitous as sovereign ratings are, they represent a narrow measure of country risk, focused entirely on default risk. Thus, much of the Middle East looks safe, from a default risk perspective, but there are clearly political and economic risks that are not being captured. One antidote is to use a risk score that brings in these missed risks, and while there are many services that provide these scores, I use the ones supplied by Political Risk Services (PRS). PRS uses twenty two variables to measure country risk, whey then capture with a country risk score, from 0 to 100, with the riskiest countries having the lowest scores and the safest countries, the highest:
While I appreciate the effort that goes into these scores, I have issues with some of the scoring, as I am sure that you do. For instance, I find it incomprehensible that Libya and the United States share roughly the same PRS score, and that Saudi Arabia is safer than much of Europe. That said, I have tried other country risk scoring services (the Economist, The World Bank) and I find myself disagreeing with individual country scoring there as well.
3. Equity Risk Premiums Looking at operations and investing, through the eyes of equity investors, the risk that you care about is the equity risk premium, a composite measure that you then incorporate into expected returns. I don't claim to have prescience or even the best approach for estimating these equity risk premiums, but I have consistently followed the same approach for the last three decades. I start with the sovereign ratings, if available, and estimate default spreads based upon these ratings, and I then scale up these ratings for the fact that equities are riskier than government bonds. I then add these country risk premiums to my estimate of the implied equity risk premium for the S&P 500, to arrive at equity risk premiums, by country.
For countries which have no sovereign ratings, I start with the country risk score from PRS for that country, find other (rated) countries with similar PRS scores, and extrapolate their ratings-based equity risk premiums. The final picture, at least as I see it in 2024, for equity risk premiums is below:
You will undoubtedly disagree with the equity risk premiums that I attach to at least some of the countries on this list, and perhaps strongly disagree with my estimate for your native country, but you should perhaps take issue with Moody's or PRS, if that is so.
Country Risk in Decision Making
At this point, your reaction to this discussion might be "so what?", since you may see little use for these concepts in practice, either as a business or as an investor. In this section, I will argue that understanding equity risk premiums, and how they vary across geographies, can be critical in both businessand personal investing.
Country Risk in Business
Most corporate finance classes and textbooks leave students with the proposition that the right hurdle rate to use in assessing business investments is the cost of capital, but create a host of confusion about what exactly that cost of capital measures. Contrary to popular wisdom, the cost of capital to use when assessing investment quality has little to do with the cost of raising financing for a company and more to do with coming up with an opportunity cost, i.e., a rate of return that the company can generate on investments of equivalent risk. Thus defined, you can see that the cost of capital that a company uses for an investment should reflect both the business risk as well as where in the world that investment is located. For a multinational consumer product company, such as Coca Cola, the cost of capital used to assess the quality of a Brazilian beverage project should be very different from the cost of capital estimated for a German beverage project, even if both are estimated in US dollars. The picture below captures the ingredients that go into a hurdle rate:
Thus, in computing costs of equity and capital for its Brazil and German projects, Coca Cola will be drawing on the equity risk premiums for Brazil (7.87%) and Germany (4.11%), leading to higher hurdle rates for the former.
The implications for multi-business, multi-national companies is that there is no one corporate cost of capital that can be used in assessing investments, since it will vary both across businesses and across geographies. A company in five businesses and ten geographies, with have fifty different costs of capital, and while you complaint may that this is too complicated, ignoring it and using one corporate cost of capital will lead you to cross subsidization, with the safest businesses and geographies subsidizing the riskiest.
Country Risk in Investing
As investors, we invest in companies, not projects, with those companies often having exposures in many countries. While it is possible to value a company in pieces, by valuing each its operations in each country, the absence of information at the country level often leads us to valuing the entire company, and when doing so, the risk exposure for that company comes from where it operates, not where it does business. Thus, when computing its cost of equity, you should look not only at its businesss risk, but what parts of the world it operates in:
In intrinsic valuation, this will imply that a company with more of its operations in risky countries will be worth less than a company with equivalent earnings, growth and cash flows with operations in safer countries. Thus, rather than look at where a company is incorporated and traded, we should be looking at where it operates, both in terms of production and revenues; Nvidia is a company incorporated and traded in the United States, but as a chip designed almost entirely dependent on TSMC for its chip manufacture, it is exposed to China risk.
It is true that most investors price companies, rather than value them, and use pricing metrics (PE ratios, EV to EBITDA) to judge cheap or expensive. If our assessment of country risk hold, we should expect to see variations in these pricing metrics across geographies. We computed EV to EBITDA multiples, based upon aggregate enterprise value and EBITDA, by country, in July 2024, and the results are captured in the figure below:
The results are mixed. While some of the riskiest parts of the world trade at low multiples of EBITDA, a significant part of Europe also does, including France and Norway. In fact, India trades at the highest multiple of EBITDA of any country in the world, representing how growth expectations can trump risk concerns.
Currency Effects
You may find it odd that I have spent so much of this post talking about country risk, without bringing up currencies, but that was not an oversight. It is true that riskier countries often have more volatile currencies that depreciate over time, but this more a symptom of country risk, than a cause. As I will argue in this section, currency choice affects your growth, cash flow and discount rate estimates, but ultimately should have no effect on intrinsic value.
If you value a company in US dollars, rather than Indian rupees, should the numbers in your valuation be different? Of course, but the reason for the differences lies in the fact that different currencies bring different inflation expectations with them, and the key is to stay consistent:
If expected inflation is lower in US dollars than in rupees, the cost of capital that you should obtain for a company in US dollars will be lower than the cost of capital in rupees, with the difference reflecting the expected inflation differential. However, since your cash flows will also then have to be in US dollars, the expected growth that you should use should reflect the lower inflation rate in dollars, and if you stay consistent in your inflation estimates, the effects should cancel out. This is not just theory, but common sense. Currency is a measurement mechanism, and to claim that a company is undervalued in one currency (say, the rupee) while claiming that it is overvalued at the same time in another currency (say, the US dollar) makes no sense. To practitioners who will counter with examples, where the value is different, when you switch currencies, my response is that there is a currency view (that the rupee is under or over priced relative to the dollar) in your valuation in your valuation, and that view should not be bundled together with your company story in a valuation.
As we noted in the last section, the place that currency enters your valuation is in the riskfree rate, and if my assertion about expected inflation is right, variations in riskfree rates can be attributed entirely to difference in expected inflation. At the start of July 2024, for instance, I estimated the riskfree rates in every currency, using the US treasury bond rate as my dollar riskfree rate, and the differential inflation between the currency in question and the US dollar:
My . In the same vein, inflation also enters into expected exchange rate calculations:
This is, of course, the purchasing power parity theorem, and while currencies can deviate from this in the short term, it remains the best way to ensure that your currency views do not hijack your valuation.YouTube Video
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February 16, 2024
Catastrophic Risk: Investing and Business Implications
In the context of valuing companies, and sharing those valuations, I do get suggestions from readers on companies that I should value next. While I don't have the time or the bandwidth to value all of the suggested companies, a reader from Iceland, a couple of weeks ago, made a suggestion on a company to value that I found intriguing. He suggested Blue Lagoon, a well-regarded Icelandic Spa with a history of profitability, that was finding its existence under threat, as a inSouthwest Iceland. In another story that made the rounds in recent weeks, 23andMe, a genetics testing company that offers its customers genetic and health information, based upon saliva sample, found itself facing the brink, after a hacker claimed to have and accessed the genetic information of millions of its customers. Stepping back a bit, one claim that climate change advocates have made not just about fossil fuel companies, but about all businesses, is that i will have on economic systems and on value. These are three very different stories, but what they share in common is a fear, imminent or expected, of a catastrophic event that may put a company's business at risk.
Deconstructing Risk
While we may use statistical measures like volatility or correlation to measure risk in practice, risk is not a statistical abstraction. Its impact is not just financial, but emotional and physical, and it predates markets. The risks that our ancestors faced, in the early stages of humanity, were physical, coming from natural disasters and predators, and physical risks remained the dominant form of risk that humans were exposed to, almost until the Middle Ages. In fact, the separation of risk into physical and financial risk took form just a few hundred years ago, when trade between Europe and Asia required ships to survive storms, disease and pirates to make it to their destinations; shipowners, ensconced in London and Lisbon, bore the financial risk, but the sailors bore the physical risk. It is no coincidence that the insurance business, as we know it, as well.
I have no particular insights to offer on physical risk, other than to note that while taking on physical risks for some has become a leisure activity, I have no desire to climb Mount Everest or jump out of an aircraft. Much of the risk that I think about is related to risks that businesses face, how that risk affects their decision-making and how much it affects their value. If you start enumerating every risk a business is exposed to, you will find yourself being overwhelmed by that list, and it is for that reason that I categorize risk into the groupings that I described in an . I want to focus in this post on the third distinction I drew on risk, where I grouped risk into discrete risk and continuous risk, with the later affecting businesses all the time and the former showing up infrequently, but often having much larger impact. Another, albeit closely related, distinction is between incremental risk, i.e., risk that can change earnings, growth, and thus value, by material amounts, and catastrophic risk, which is risk that can put a company's survival at risk, or alter its trajectory dramatically.
There are a multitude of factors that can give rise to catastrophic risk, and it is worth highlighting them, and examining the variations that you will observe across different catastrophic risk. Put simply, a volcanic eruption, a global pandemic, a hack of a company's database and the death of a key CEO are all catastrophic events, but they differ on three dimensions:
Source: I started this post with a mention of a volcano eruption in Iceland put an Icelandic business at risk, and natural disasters can still be a major factor determining the success or failure of businesses. It is true that there are insurance products available to protect against some of these risks, at least in some parts of the world, and that may allow companies in Florida (California) to live through the risks from hurricanes (earthquakes), albeit at a cost. Human beings add to nature's catastrophes with wars and terrorism wreaking havoc not just on human lives, but also on businesses that are in their crosshairs. As I noted in my post on country risk, it is difficult, and sometimes impossible, to build and preserve a business, when you operate in a part of the world where violence surrounds you. In some cases, a change in regulatory or tax law can put the business model for a company or many company at risk. I confess that the line between whether nature or man is to blame for some catastrophes is a gray one and to illustrate, consider the COVID crisis in 2020. Even if you believe you know the origins of COVID (a lab leak or a natural zoonotic spillover), it is undeniable that the choices made by governments and people exacerbated its consequences.Locus of Damage: Some catastrophes created limited damage, perhaps isolated to a single business, but others can create damage that extends across a sector geographies or the entire economy. The reason that the volcano eruptions in Iceland are not creating market tremors is because the damage is likely to be isolated to the businesses, like Blue Lagoon, in the path of the lava, and more generally to Iceland, an astonishingly beautiful country, but one with a small economic footprint. An earthquake in California will affect a far bigger swath of companies, partly because the state is home to the fifth largest economy in the world, and the pandemic in 2020 caused an economic shutdown that had consequences across all business, and was catastrophic for the hospitality and travel businesses.Likelihood: There is a third dimension on which catastrophic risks can vary, and that is in terms of likelihood of occurrence. Most catastrophic risks are low-probability events, but those low probabilities can become high likelihood events, with the passage of time. Going back to the stories that I started this post with, Iceland has always had volcanos, as have other parts of the world, and until recently, the likelihood that those volcanos would become active was low. In a similar vein, pandemics have always been with us, with a history of wreaking havoc, but in the last few decades, with the advance of medical science, we assumed that they would stay contained. In both cases, the probabilities shifted dramatically, and with it, the expected consequences.Business owners can try to insulate themselves from catastrophic risk, but as we will see in the next sections those protections may not exist, and even if they do, they may not be complete. In fact, as the probabilities of catastrophic risk increase, it will become more and more difficult to protect yourself against the risk.
Dealing with catastrophic risk
It is undeniable that catastrophic risk affects the values of businesses, and their market pricing, and it is worth examining how it plays out in each domain. I will start this section with what, at least for me, I is familiar ground, and look at how to incorporate the presence of catastrophic risk, when valuing businesses and markets. I will close the section by looking at the equally interesting question of how markets price catastrophic risk, and why pricing and value can diverge (again).
Catastrophic Risk and Intrinsic Value
Much as we like to dress up intrinsic value with models and inputs, the truth is that intrinsic valuation at its core is built around a simple proposition: the value of an asset or business is the present value of the expected cash flows on it:
That equation gives rise to what I term the "It Proposition", which is that for "it" to have value, "it" has to affect either the expected cashflows or the risk of an asset or business. This simplistic proposition has served me well when looking at everything from the value of intangibles, as you can see in , to the emptiness at the heart of the claim that ESG is good for value, in . Using that framework to analyze catastrophic risk, in all of its forms, its effects can show in almost every input into intrinsic value:
Looking at this picture, your first reaction might be confusion, since the practical question you will face when you value Blue Lagoon, in the face of a volcanic eruption, and 23andMe, after a data hack, is which of the different paths to incorporating catastrophic risks into value you should adopt. To address this, I created a flowchart that looks at catastrophic risk on two dimensions, with the first built around whether you can buy insurance or protection that insulates the company against its impact and the other around whether it is risk that is specific to a business or one that can spill over and affect many businesses.
As you can see from this flowchart, your adjustments to intrinsic value, to reflect catastrophic risk will vary, depending upon the risk in question, whether it is insurable and whether it will affect one/few companies or many/all companies.
A. Insurable Risk: Some catastrophic risks can be insured against, and even if firms choose not to avail themselves of that insurance, the presence of the insurance option can ease the intrinsic valuation process.Intrinsic Value Effect: If the catastrophic risk is fully insurable, as is sometimes the case, your intrinsic valuation became simpler, since all you have to do is bring in the insurance cost into your expenses, lowering income and cash flows, leave discount rates untouched, and let the valuation play out. Note that you can do this, even if the company does not actually buy the insurance, but you will need to find out the cost of that foregone insurance and incorporate it yourself.Pluses: Simplicity and specificity, because all this approach needs is a line item in the income statement (which will either exist already, if the company is buying insurance, or can be estimated).Minuses: You may not be able to insure against some risks, either because they are uncommon (and actuaries are unable to estimate probabilities well enough, to set premiums) or imminent (the likelihood of the event happening is so high, that the premiums become unaffordable). Thus, Blue Lagoon (the Icelandic spa that is threatened by a volcanic eruption) might have been able to buy insurance against volcanic eruption a few years ago, but will not be able to do so now, because the risk is imminent. Even when risks are insurable, there is a second potential problem. The insurance may pay off, in the event of the catastrophic event, but it may not offer complete protection. Thus, using Blue Lagoon again as an example, and assuming that the company had the foresight to buy insurance against volcanic eruptions a few years ago, all the insurance may do is rebuild the spa, but it will not compensate the company for lost revenues, as customers are scared away by the fear of volcanic eruptions. In short, while there are exceptions, much of insurance insures assets rather than cash flow streams.Applications: When valuing businesses in developed markets, we tend to assume that these businesses have insured themselves against most catastrophic risks and ignore them in valuation consequently. Thus, you see many small Florida-based resorts valued, with no consideration given to hurricanes that they will be exposed to, because you assume that they are fully insured. In the spirit of the “trust, but verity� proposition, you should probably check if that is true, and then follow up by examining how complete the insurance coverage is. 2. Uninsurable Risk, Going-concern, Company-specific: When a catastrophic risk is uninsurable, the follow up questions may lead us to decide that while the risk will do substantial damage, the injured firms will continue in existence. In addition, if the risk affects only one or a few firms, rather than wide swathes of the market, there are intrinsic value implications.Intrinsic Value Effect: If the catastrophic risk is not insurable, but the business will survive its occurrence even in a vastly diminished state, you should consider doing two going-concernvaluations, one with the assumption that there is no catastrophe and one without, and then attaching a probability to the catastrophic event occurring.Expected Value with Catastrophe = Value without Catastrophe (1 � Probability of Catastrophe) + Value with Catastrophe (Probability of Catastrophe)
In these intrinsic valuations, much of the change created by the catastrophe will be in the cash flows, with little or no change to costs of capital, at least in companies where investors are well diversified.Pluses: By separating the catastrophic risk scenario from the more benign outcomes, you make the problem more tractable, since trying to adjust expected cash flows and discount rates for widely divergent outcomes is difficult to do.Minuses: Estimating the probability of the catastrophe may require specific skills that you do not have, but consulting those who do have those skills can help, drawing on meteorologists for hurricane prediction and on seismologists for earthquakes. In addition, working through the effect on value of the business, if the catastrophe occurs, will stretch your estimation skills, but what options do you have?Applications: This approach comes into play for many different catastrophic risks that businesses face, including the loss of a key employee, in a personal-service business, and I used it in . You can also use it to assess the effect on value of a loss of a big contract for a small company, where that contract accounts for a significant portion of total revenues. It can also be used to value a company whose business models is built upon the presence or absence of a regulation or law, in which case a change in that regulation or law can change value. 3. Uninsurable Risk. Failure Risk, Company-specific : When a risk is uninsurable and its manifestation can cause a company to fail, it poses a challenge for intrinsic value, which is, at its core, designed to value going concerns. Attempts to increase the discount rate, to bring in catastrophic risk, or applying an arbitrary discount on value almost never work.Intrinsic Value Effect: If the catastrophic risk is not insurable, and the business will not survive, if the risk unfolds, the approach parallels the previous one, with the difference being that that the failure value of the business, i.e, what you will generate in cash flows, if it fails, replaces theintrinsic valuation, with catastrophic risk built in: Expected Value with Catastrophe = Value without Catastrophe (1 � Probability of Catastrophe) + Failure Value (Probability of Catastrophe) The failure value will come from liquidation the assets, or what is left of them, after the catastrophe.Pluses: As with the previous approach, separating the going concern from the failure values can help in the estimation process. Trying to estimate cash flows, growth rates and cost of capital for a company across both scenarios (going concern and failure) is difficult to do, and it is easy to double count risk or miscount it. It is fanciful to assume that you can leave the expected cash flows as is, and then adjust the cost of capital upwards to reflect the default risk, because discount rates are blunt instruments, designed more to capture going-concern risk than failure risk.Minuses: As in the last approach, you still have to estimate a probability that a catastrophe will occur, and in addition, and there can be challenges in estimating the value of a business, if the company fails in the face of catastrophic risk.Applications: This is the approach that I use to value highly levered., cyclical or commodity companies, that can deliver solid operating and equity values in periods where they operate as going concerns, but face distress or bankruptcy, in the face of a severe recession. And for a business like the Blue Lagoon, it may be the only pathway left to estimate the value, with the volcano active, and erupting, and it may very well be true that the failure value can be zero. 4 & 5 Uninsurable Risk. Going Concern or Failure, Market or Sector wide: If a risk can affect many or most firms, it does have a secondary impact on the returns investors expect to make, pushing up costs of capital.Intrinsic Value Effect: The calculations for cashflows are identical to those done when the risks are company-specific, with cash flows estimated with and without the catastrophic risk, but since these risks are sector-wide or market-wide, there will also be an effect on discount rates. Investors will either see more relative risk (or beta) in these companies, if the risks affect an entire sector, or in equity risk premiums, if they are market-wide. Note that these higher discount rates apply in both scenarios.Pluses: The risk that is being built into costs of equity is the risk that cannot be diversified away and there are pathways to estimating changes in relative risk or equity risk premiums.Minuses: The conventional approaches to estimating betas, where you run a regression of past stock returns against the market, and equity risk premiums, where you trust in historical risk premiums and history, will not work at delivering the adjustments that you need to make.Applications: My argument for using implied equity risk premiums is that they are dynamic and forward-looking. Thus, during COVID, when the entire market was exposed to the economic effects of the pandemic, the implied ERP for the market jumped in the first six weeks of the pandemic, when the concerns about the after effects were greatest, and then subsided in the months after, as the fear waned:
In a different vein, one reason that I compute betas by industry grouping, and update them every year, is in the hope that risks that cut across a sector show up as changes in the industry averages. In 2009, for instance, when banks were faced with significant regulatory changes brought about in response to the 2008 crisis, the average beta for banks jumped from 0.71 at the end of 2007 to 0.85 two years later.Catastrophic Risk and Pricing
The intrinsic value approach assumes that we, as business owners and investors, look at catastrophic risk rationally, and make our assessments based upon how it will play out in cashflows, growth and risk. In truth, is worth remembering key insights from psychology, on how we, as human beings, deal with threats (financial and physical) that we view as existential.
The first response is denial, an unwillingness to think about catastrophic risks. As someone who lives in a home close to one of California's big earthquake faults, and two blocks from the Pacific Ocean, I can attest to this response, and offer the defense that in its absence, I would wither away from anxiety and fear.The second is panic, when the catastrophic risk becomes imminent, where the response is to flee, leaving much of what you have behind.When looking at how the market prices in the expectation of a catstrophe occurring and its consequences, both these human emotions play out, as the overpricing of businesses that face catastrophic risk, when it is low probability and distant, and the underpricing of these same businesses when catastrophic risk looms large.
To see this process at work, consider again how the market initially reacted to the COVID crisis in terms of repricing companies that were at the heart of the crisis. Between February 14, 2020 and March 23, 2020, when fear peaked, the sectors most exposed to the pandemic (hospitality, airlines) saw a decimation in their market prices, during that period:
With catastrophic risk that are company-specific, you see the same phenomenon play out. The market capitalization of many young pharmaceutical company have been wiped out by the failure of blockbuster drug, in trials. PG&E, the utility company that provides power to large portions of California saw its stock price halved after wildfires swept through California, and investors worried about the culpability of the company in starting them. The most fascinating twist on how markets deal with risks that are existential is their pricing of fossil fuel companies over the last two decades, as concerns about climate change have taken center stage, with fossil fuels becoming the arch villain. The expectation that many impact investors had, at least early in this game, was that relentless pressure from regulators and backlash from consumers and investors would reduce the demand for oil, reducing the profitability and expected lives of fossil fuel companies. To examine whether markets reflect this view, I looked at the pricing of fossil fuel stocks in the aggregate, starting in 2000 and going through 2023:
In the graph to the left, I chart out the total market value for all fossil fuel companies, and note a not unsurprising link to oil prices. In fact, the one surprise is that fossil fuel stocks did not see surges in market capitalization between 2011 and 2014, even as oil prices surged. While fossil fuel pricing multiples have gone up and down, I have computed the average on both in the 2000-2010 period and again in the 2011-2023 period. If the latter period is the one of enlightenment, at least on climate change, with warnings of climate change accompanied by trillions of dollars invested in combating it, it is striking how little impact it has had on how markets, and investors in the aggregate, view fossil fuel companies. In fact, there is evidence that the business pressure on fossil fuel companies has become less over time, with fossil fuel stocks rebounding in the last three years, and fossil fuel companies increasing investments and acquisitions in the fossil fuel space. Impact investors would point to this as evidence of the market being in denial, and they may be right, but market participants may point back at impact investing, and argue that the markets may be reflecting an unpleasant reality which is that despite all of the talk of climate change being an existential problem, we are just as dependent on fossil fuels today, as we were a decade or two decades ago:
Don’t get me wrong! It is possible, perhaps even likely, that investors are not pricing in climate change not just in fossil fuel stocks, and that there is pain awaiting them down the road. It is also possible that at least in this case, that the market's assessment that doomsday is not imminent and that humanity will survive climate change, as it has other existential crises in the past. Mr. Market versus Mad Max Thunderdome The question posed about fossil fuel investors and whether they are pricing in the risks of gclimated change can be generalized to a whole host of other questions about investor behavior.Should buyers be paying hundreds of millions of dollars for a Manhattan office building, when all of New York may be underwater in a few decades? Lest I be accused of pointing fingers, what will happen to the value of my house that is currently two blocks from the beach, given the prediction of rising oceans. The painful truth is that if doomsday events (nuclear war, mega asteroid hitting the earth, the earth getting too hot for human existence) manifest, it is survival that becomes front and center, not how much money you have in your portfolio. Thus, ignoring Armageddon scenarios when valuing businesses and assets may be completely rational, and taking investors to task for not pricing assets correctly will do little to alter their trajectory! On a different note, you probably know that I am deeply skeptical about sustainability, at least as preached from the Harvard Business School pulpit. It remains ill-defined, morphing into whatever its proponents want it to mean. The catastrophic risk discussion presents perhaps a version of sustainability that is defensible. To the extent that all businesses are exposed to catastrophic risks, some company-level and some having broader effects, there are actions that businesses can take to, if not protect to themselves, at least cushion the impact of these risks. A personal-service business, headed by an aging key person, will be well served designing a succession plan for someone to step in when the key person leaves (by his or her choice or an act of God). No global company was ready for COVID in 2020, but some were able to adapt much faster than others because they were built to be adaptable. Embedded in this discussion are also the limits to sustainability, since the notion of sustainability at any cost is absurd. Building in adaptability and safeguards against catastrophic risk makes sense only if the costs of doing so are less than the potential benefits, a simple but powerful lesson that many sustainability advocates seem to ignore, when they make grandiose prescriptions for what businesses should and should not do to avoid the apocalypse.
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February 8, 2024
The Seven Samurai: How Big Tech Rescued the Market in 2023!
I was planning to finish my last two data updates for 2024, but decided to take a break and look at the seven stocks (Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia and Tesla) which carried the market in 2023. While I will use the "Magnificent Seven" moniker attached by these companies by investors and the media, my preference would have been to call them the Seven Samurai. After all, like their namesakes in that , who saved a village and its inhabitants from destruction, these seven stocks saved investors from having back-to-back disastrous years in the stock market.
The What?
It is worth remembering that the Magnificent Seven (Mag Seven) had their beginnings in the FANG (Facebook, Amazon, Netflix and Google) stocks, in the middle of the last decade, which morphed into the FANGAM (with the addition of Apple and Microsoft to the group) and then to the Mag Seven, with the removal of Netflix from the mix, and the addition of Tesla and Nvidia to the group. There is clearly hindsight bias in play here, since bringing in the best performing stocks of a period into a group can always create groups that have supernormal historical returns. That bias notwithstanding, these seven companies have been extraordinary investments, not just in 2023, but over the last decade, and there are lessons that we can learn from looking at the past.
First, let's look at the performance of these seven stocks in 2023, when their collective market capitalization increased by a staggering $5.1 trillion during the course of the year. In a group of standout stocks,Nvidia and Meta were the best performers, with the former more than and the later almost tripling in value over the period. In terms of dollar value added, Microsoft and Apple each added a trillion dollars to their market capitalizations, during the year.
To understand how much these stocks meant for overall market performance, recognize that these seven companies accounted for more than 50% of the increase in market capitalization of the the entire US equity market (which included 6658 listed companies in 2023). With them, US equities had price appreciation of 23.25% for the year, but without them, the year would have been an average one, with returns on 12.6%.
While these seven stocks had an exceptional year in 2023, their outperformance stretches back for a much longer period. In the graph below, I look at the cumulated market capitalization of the Mag Seven stocks, and the market capitalization of all of the remaining US stocks from 2012 to 2023:
Over the eleven-year period, the cumulative market capitalization of the seven companies has risen from $1.1 trillion in 2012 to $12 trillion in 2023, rising from 7.97% of overall US market cap in 2012 to 24.51% of overall market cap at the end of 2023. To put these numbers in perspective, the Mag Seven companies now have a market capitalization larger than that of all listed stocks in China, the second largest market in the world in market capitalization terms.
Another way to see how much owning or not owning these stocks meant for investors, I estimated the cumulated value of $100 invested in December 2012 in a market-cap weighted index of US stocks at the end of 2023, first in US equities , and then in US equities, without the Mag Seven stocks:
It is striking that removing seven stocks from a portfolio of 6658 US stocks, investing between 2012 and 2023, creates a 17.97% shortfall in the end value. In effect, this would suggest that any portfolio that did not include any of these seven stocks during the last decade would have faced a very steep, perhaps even insurmountable, climb to beat the market. That may go a long way in explaining why both value and small cap premium have essentially disappeared over this period. In all of the breathless coverage of the Mag Seven (and FANG and FANGAM) before it, there seems to be the implicit belief that their market dominance is unprecedented, but it is not. In fact, equity markets have almost always owed their success to their biggest winners, and Henrik Bessimbinder highlighted this reality by documenting that of the $47 trillion in increase in market capitalization between 1926 and 2019, five companies accounted for 22% of the increase in market value. I will wager that at the end of the next decade, looking back, we will find that a few companies accounted for the bulk of the rise in market capitalization during the decade, and another acronym will be created.The Why?
When stocks soar as much as the Mag Seven stocks have in recent years, they evoke two responses. One is obviously regret on the part of those who did not partake in the rise, or sold too soon. The other is skepticism, and a sense that a correction is overdue, leading to what I call knee-jerk contrarianism, where your argument that these stocks are over priced is that they have gone up too much in the past. With these stocks, in particular, that reaction would have been costly over much of the last decade, since other than in 2022, these stocks have found ways to deliver positive surprises. In this section, we will look at the plausible explanations for the Mag Seven outperformance in 2023, starting with a correction/momentum story, where 2023 just represented a reversal of the losses in 2022, moving on to a profitability narrative, where the market performance of these companies can be related to superior profitability and operating performance, and concluding with an examination of whether the top-heavy performance (where a few large companies account for the bulk of market performance can explained by winner-take-all economics,
1. Correction/Momentum Story: One explanation for the Mag Seven's market performance in 2023 is that they were coming off a catastrophic year in 2022, where they collectively lost $4.8 trillion in market cap, and that 2023 represented a correction back to a level only slightly above the value at the end of 2021. There is some truth to this statement, but to see whether it alone can explain the Mag Seven 2023 performance, I broke all US stocks into deciles, based upon 2022 stock price performance, with the bottom decile including the stocks that went down the most in 2022 and the top decile the stocks that went up the most in 2022, and looked at returns in 2023:
As you can see in the first comparison, the worst performing stocks in 2022 saw their market capitalizations increase by 35% in 2023, while the best performing stocks saw little change in market capitalization. Since all of the MAG 7 stocks fell into the bottom decile, I compared the performance of those stocks against the rest of the stocks in that decile, and th difference is start. While Mag Seven stocks saw their market capitalizations increase by 74%, the rest of the stocks in the bottom decile had only a 19% increase in market cap. In short, a portion of the Mag Seven stock performance in 2023 can be explained by a correction story, aided and abetted by strong momentum, but it is not the whole story.2. Operating Performance/Profitability Narrative: While it is easy to attribute rising stock prices entirely to mood and momentum, the truth is that momentum has its roots in truth. Put differently, there are some good business reasons why the Mag Seven dominated markets in 2023:Pricing power and Economic Resilience: Coming into 2023, market and the Mag Seven stocks were battered, down sharply in 2022, largely because of rising inflation and concerns about an economic downturn. There were real concerns about whether the big tech companies that had dominated markets for the prior decade had pricing power and how well they would weather a recession. During the course of 2023, the Mag Seven set those fears to rest at least for the moment on both dimensions, increasing prices (with the exception of Tesla) on their products/services and delivering growth. In fact, if you are a Netflix subscriber or Amazon Prime member (and I would be surprised if any reader has neither, indicating their ubiquity), you saw prices increase on both services, and my guess is that you did not cancel your subscription/membership. With Alphabet and Meta, which make their money on online advertising, the rates for that advertising, measures in costs per click, rose through much of the year, and as an active Apple customer, I can guarantee that Apple has been passing through inflation into their prices all year.Money Machines: The pricing power and product demand resilience exhibited by these companies have manifested as strong earnings for the companies. In fact, both Alphabet and Meta have laid off thousands of employees, without denting revenues, and their profits in 2023 reflect the cost savings:
Safety Buffers: As interest rates, for both governments and corporates, has risen sharply over the last two years, it is prudent for investors to worry about companies with large debt burdens, since old debt on the books, at low rates, will have to get refinanced at higher rates. With the Mag Seven, those concerns are on the back burner, because these companies have debt loads so low that they are almost non-existent. In fact, six of the seven firms in the Mag Seven grouping have cash balances that exceed their debt loads, giving them negative net debt levels.
Put simply, there are good business reasons for why the seven companies in the Mag Seven have been elevated to superstar status.
3. Winner take all economics: It is undeniable that as the global economy has shifted away from its manufacturing base in the last century to a technology base, it has unleashed more "winner-take-all (or most" dynamics in many industries. In advertising, which was a splintered business where even the biggest players (newspapers, broadcasting companies) commanded small market shares of the overall market, Alphabet and Meta have acquired dominant market shares of online advertising, driven by easy scaling and network benefits (where advertising flows to the platforms with the most customers). Over the last two decades, Amazon has set in motion similar dynamics in retail and Microsoft's stranglehold on application and business software has been in existence even longer. In fact, it is the two newcomers into this group, Nvidia and Tesla, where questions remain about what the end game will look like, in terms of market share. Historically, neither the chip nor car businesses have been winner-take-all businesses, but investors are clearly pricing in the possibility that the changing economics of AI chips and electric cars could alter these businesses.
This may seem like a cop out, but I think all three factors contributed to the success of the Mag Seven stocks in 2023. There was clearly a bounce back effect, as these firms recovered from a savage beatdown in 2022, but that bounce back occurred only because they were able to deliver strong profits and solid cash flows. And looking across the decade, I don't think it is debatable that investors have not only bought into the dominant player story (coming from the winner-take-all economics), but have also anointed these seven companies as leaders in the race to dominance in each of their businesses.
The What Next?
At the risk of stating the obvious, investing is always about the future, and a company's past market history, no matter how glorious, has little or no effect on whether it is a good investment today. I have long argued that investors need to separate what they think about the quality of a company (great, good or awful) from its quality as an investment (cheap or expensive). In fact, investing is about finding mismatches between what you think of a company and what investors have already priced in:
I think that most of you will agree that the seven companies in the Mag Seven all qualify as very good to awesome, as businesses, and the last section provides backing, but the question that remains is whether our perceptions are shared by other investors, and already priced in.
The tool that most investors use in making this assessment is pricing, and specifically, pricing multiples. In the table below, I compute pricing metrics for the Mag Seven, and compare them to that of the S&P 500:
I know that some of you don't buy into intrinsic valuation and note quite correctly that there are lots of assumptions that you have to make about growth, profitability and risk to arrive at a value and that no matter how hard you try, you will be wrong. I agree, but I remain abeliever that intrinsic valuation is the only tool that you have for assessing whether g. I have valued every company in the Mag Seven multiple times over the last decade, and based my judgments on investing in these companies on a comparison of my value estimates and price. With the operating numbers (revenues, earnings) coming in for the 2023 calendar year, I have updated my valuations, and here are my summary estimates:
InputAlphabetAmazonAppleMicrosoftMetaNvidiaTesla Expected CAGR Revenue (next 5 years)8.00%12.00%7.50%15.00%12.00%32.20%31.10% Target Operating Margin30.00%14.00%36.00%45.00%40.00%40.00%13.07% Cost of Capital8.84%8.60%8.64%9.23%8.83%8.84%9.17% Value per share$138.14$155.72$176.79$355.88$445.10$436.34$183.75 Price per share$145.00$169.15$188.00$405.49$456.08$680.00$185.07 % Under or Over Valued4.97%8.62%6.34%13.94%2.47%55.84%0.72% Internal Rate of Return8.41%7.85%7.89%8.06%8.53%7.18%9.16% Full Valuation (Excel)* NVidia and Tesla were valued as the sum of the valuations of their different businesses. The growth and margins reported are for the consolidated company.
First, while all of the companies in the Mag Seven have values that exceed their prices, Tesla and Meta look close to fairly valued, at current prices, Alphabet, Apple and Amazon are within striking distance of value, and Microsoft and Nvidia look over valued, with the latter especially so. It may be coincidence, but these are the two companies that have benefited most directly from the AI buzz, and my findings of over valuation may just reflect my lack of imagination on how big AI can get as a business. Just to be clear, though, I have built in substantial value from AI in my valuation of Nvidia, and given Microsoft significantly higher growth because of it, but it is plausible that I have not done enough. If intrinsic value is not your cup of tea, you canlook at the internal rates of return that you would earn on these companies, at current market prices, and with my expected cash flows. For perspective, the median cost of capital for a US company at the start of 2024 was 8.60%, and while only Tesla delivers an expected return higher than that number, the test, with the exception of Nvidia, are close.
I own all seven of these companies, which may strike you as contradictory, but with the exception of Tesla that I bought just last week, my acquisitions of the other seven companies occurred well in the past, and reflected my judgments that they were undervalued (at the time). To the question of whether I should be selling, which would be consistent with my current assessment that these stocks are overvalued, I hesitate for three reasons: The first is that my assessments of value come with error, and for at least five of the companies, the price is well within my range of value. The second is that I will have to pay a capital gains tax that will amount to close to 30%, with state taxes included. The third is psychological, since selling everything or nothing would leave me with regrets either way. Last summer, when I valued Nvidia in this post, I found it over valued at a price of $450, and sold half my holdings, choosing to hold the other half. Now that the price has hit $680, I plan to repeat that process, and sell half of my remaining holdings.
Conclusion
As I noted at the start of this post, the benefit of hindsight allows us to pick the biggest winners in the market, bundle them together in a group and then argue that the market would be lost without them. That is true, but it is neither original nor unique to this market. The Mag Seven stocks have had a great run, but their pricing now reflects, in my view, the fact that they are great companies, with business models that deliver growth, at scale, with profitability. If you have never owned any of these companies, your portfolio will reflect that choice, and jumping on to the bandwagon now will not bring back lost gains. You should bide your time, since in my experience, even the very best companies deliver disappointments, and that markets over react to these disappointments, simply because expectations have been set so high. It is at those times that you will find that the price is right!
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Intrinsic Valuations
January 31, 2024
Data Update 5 for 2024: Profitability - The End Game for Business?
In my last three posts, I looked at the macro (equity risk premiums, default spreads, risk free rates) and micro (company risk measures) that feed into the expected returns we demand on investments, and argued that these expected returns become hurdle rates for businesses, in the form of costs of equity and capital. Since businesses invest that capital in their operations, generally, and in individual projects (or assets), specifically, the big question is whether they generate enough in profits to meet these hurdle rate requirements. In this post, I start by looking at the end game for businesses, and how that choice plays out in investment rules for these businesses, and then examine how much businesses generated in profits in 2023, scaled to both revenues and invested capital.
The End Game in Business
If you start a business, what is your end game? Your answer to that question will determine not just how you approach running the business, but also the details of how you pick investments, choose a financing mix and decide how much to return to shareholders, as dividend or buybacks. While private businesses are often described as profit maximizers, the truth is that if they should be value maximizers. In fact, that objective of value maximization drives every aspect of the business, as can be seen in this big picture perspective in corporate finance:
For some companies, especially mature ones, value and profit maximization may converge, but for most, they will not. Thus, a company with growth potential may be willing to generate less in profits now, or even make losses, to advance its growth prospects. In fact, the biggest critique of the companies that have emerged in this century, many in social media, tech and green energy, is that they have prioritized scaling up and growth so much that they have failed to pay enough attention to their business models and profitability.
For decades, the notion of maximizing value has been central to corporate finance, though there have been disagreements about whether maximizing stock prices would get you the same outcome, since that latter requires assumptions about market efficiency. In the last two decades, though, there are many who have argued that maximizing value and stockholder wealth is far too narrow an objective, for businesses, because it puts shareholders ahead of the other stakeholders in enterprises:
It is the belief that stockholder wealth maximization shortchanges other stakeholders that has given rise to stakeholder wealth maximization, a misguided concept where the end game for businesses is redefined to maximize the interests of all stakeholders. In addition to being impractical, it misses the fact that shareholders are given primacy in businesses because they are the only claim holders that have no contractual claims against the business, accepting residual cash flows, If stakeholder wealth maximization is allowed to play out, it will result in confused corporatism, good for top managers who use stakeholder interests to become accountable to none of the stakeholders:
As you can see, I am not a fan of confused corporatism, arguing that giving a business multiple objectives will mangle decision making, leaving businesses looking like government companies and universities, wasteful entities unsure about their missions. In fact, it is that skepticism that has made me a critic of ESG and sustainability, offshoots of stakeholder wealth maximization, suffering from all of its faults, with greed and messy scoring making them worse.
It may seem odd to you that I am spending so much time defending the centrality of profitability to a business, but it is a sign of how distorted this discussion has become that it is even necessary. In fact, you mayfind my full-throated defense of generating profits and creating value to be distasteful, but if you are an advocate for the point of view that businesses have broader social purposes, the reality is that for businesses to do good, they have to be financial healthy and profitable. Consequently, you should be just as interested, as I am, in the profitability of companies around the world, albeit for different reasons. My interest is in judging them on their capacity to generate value, and yours would be to see if they are generating enough as surplus so that they can do good for the world.
Profitability: Measures and Scalars
Measuring profitability at a business is messier than you may think, since it is not just enough for a business to make money, but it has to make enough money to justify the capital invested in it. The first step is understanding profitability is recognizing that there are multiple measures of profit, and that each measure they captures a different aspect of a business:
It is worth emphasizing that these profit numbers reflect two influences, both of which can skew the numbers. The first is the explicit role of accountants in measuring profits implies that inconsistent accounting rules will lead to profits being systematically mis-measured, a point I have made on how R&D is routinely mis-categorized by accountants. The other is the implicit effect of tax laws, since taxes are based upon earnings, creating an incentive to understate earnings or even report losses, on the part of some businesses. That said, global (US) companies collectively generated $5.3 trillion ($1.8 trillion) in net income in 2023, and the pie charts below provide the sector breakdowns for global and US companies:
Notwithstanding their trials and tribulations since 2008, financial service firms (banks, insurance companies, investment banks and brokerage firms) account for the largest slice of the income pie, for both US and global companies, with energy and technology next on the list.
Profit Margins
While aggregate income earned is an important number, it is an inadequate measure of profitability, especially when comparisons across firms, when it is not scaled to something that companies share. As as a first scalar, I look at profits, relative to revenues, which yields margins, with multiple measures, depending upon the profit measure used:
Looking across US and global companies, broken down by sector, I look at profit margins in 2023:Note that financial service companies are conspicuously absent from the margin list, for a simple reason. Most financial service firms have no revenues, though they have their analogs - loans for banks, insurance premiums for insurance companies etc. Among the sectors, energy stands out, generating the highest margins globally, and the second highest, after technology firms in the United States. Before the sector gets targeted as being excessively profitable, it is also one that is subject to volatility, caused by swings in oil prices; in 2020, the sector was the worst performing on profitability, as oil prices plummeted that year. Does profitability vary across theglobe? To answer that question, I look at differences in margins across sub-regions of the world:
You may be surprised to see Eastern European and Russian companies with the highest margins in the world, but that can be explained by two phenomena. The first is the preponderance of natural resource companies in this region, and energy companies had a profitable year in 2023. The second is that the sanctions imposed after 2021 on doing business in Russia drove foreign competitors out of the market, leaving the market almost entirely to domestic companies.At the other end of the spectrum, Chinese and Southeast Asian companies have the lowest net margins, highlighting the reality that big markets are not always profitable ones.Finally, there is a relationship between corporate age and profitability, with younger companies often struggling more to deliver profits, with business models still in flux and no economies of scale. In the fact, the pathway of a company through the life cycle can be seen through the lens of profit margins:
Early in the life cycle, the focus will be on gross margins, partly because there are losses on almost every other earnings measure. As companies enter growth, the focus will shift to operating margins, albeit before taxes, as companies still are sheltered from paying taxes by past losses. In maturity, with debt entering the financing mix, net margins become good measures of profitability, and in decline, as earnings decline and capital expenditures ease, EBITDA margins dominate. In the table below, I look at global companies, broken down into decals, based upon corporate age, and compute profit margins across the deciles:
The youngest companies hold their own on gross and EBITDA margins, but they drop off as you move to operating nnd net margins. In summary, profit margins are a useful measure of profitability, but they vary across sectors for many reasons, and you can have great companies with low margins and below-average companies that have higher margins. Costco has sub-par operating margins, barely hitting 5%, but makes up for it with high sales volume, whereas there are luxury retailers with two or three times higher margins that struggle to create value.
Return on Investment
The second scalar for profits is the capital invested in the assets that generate these profits. Here again, there are two paths to measuring returns on investment, and the best way to differentiate them is to think of them in the context of a financial balance sheet:
The accounting return on equity is computed by dividing the net income, the equity investor's income measure, by the book value of equity and the return on invested capital is computed, relative to the book value of invested capital, the cumulative values of book values of equity and debt, with cash netted out. Looking at accounting returns, broken down by sector, for US and global companies, here is what 2023 delivered:
In both the US and globally, technology companies deliver the highest accounting returns, but these returns are skewed by the accounting inconsistencies in capitalizing R&D expenses. While I partially correct for this by capitalizing R&D expenses, it is only a partial correction, and the returns are still overstated. The worst accounting returns are delivered by real estate companies, though they too are skewed by tax considerations, with expensing to reduce taxes paid, rather than getting earnings right.
Excess Returns
In the final assessment, I bring together the costs of equity and capital estimated and the accounting returns in this one, to answer a critical question that every business faces, i.e,, whether the returns earned on its investment exceed its hurdle rate. As with the measurement of returns, excess returns require consistent comparisons, with accounting returns on equity compared to costs of equity, and returns on capital to costs of capital:
These excess returns are not perfect or precise, by any stretch of the imagination, with mistakes made in assessing risk parameters (betas and ratings) causing errors in the cost of capital and accounting choices and inconsistencies affecting accounting returns. That said, they remain noisy estimates of a company's competitive advantages and moats, with strong moats going with positive excess returns, no moats translating into excess returns close to zero and bad businesses generating negative excess returns. I start again by looking at the sector breakdown, both US and global, of excessreturns in 2023, in the table below:In computing excess returns, I did add a qualifier, which is that I would do the comparison only among money making companies; after all, money losing companies will have accounting returns that are negative and less than hurdle rates. With each sector, to assess profitability, you have to look at the percentage of companies that make money and then at the percent of these money making firms that earn more than the hurdle rate. With financial service firms, where only the return on equity is meaningful, 57% (64%) of US (global) firms have positive net income, and of these firms, 82% (60%) generated returns on equity that exceeded their cost of equity. In contrast, with health care firms, only 13% (35%) of US (global) firms have positive net income, and about 68% (53%) of these firms earn returns on equity that exceed the cost of equity. In a final cut, I looked at excess returns by region of the world, again looking at only money-making companies in each region:
To assess the profitability of companies in each region, I again look at t the percent of companies that are money-making, and then at the percent of these money-making companies that generate accounting returns that exceed the cost of capital. To provide an example, 82% of Japanese companies make money, the highest percentage of money-makers in the world, but only 40% of these money-making companies earn returns that exceed the hurdle rate, second only to China on that statistic. The US has the highest percentage (73%) of money-making companies that generate returns on equity that exceed their hurdle rates, but only 37% of US companies have positive net income. Australian and Canadian companies stand out again, in terms of percentages of companies that are money losers, and out of curiosity, I did take a closer look at the individual companies in these markets. It turns out that the money-losing is endemic among smaller publicly traded companies in these markets, with many operating in materials and mining, and the losses reflect both company health and life cycle, as well as the tax code (which allows generous depreciation of assets). In fact, the largest companies in Australia and Canada deliver enough profits to carry the aggregated accounting returns (estimated by dividing the total earnings across all companies by the total invested capital) to respectable levels. In the most sobering statistic, if you aggregatemoney-losers with the companies that earn less than their hurdle rates, as you should, there is not a single sector or region of the world, where a majority of firms earn more than their hurdle rates.
In 2023, close to 80% of all firms globally earned returns on capital that lagged their costs of capital. Creating value is clearly far more difficult in practice than on paper or in case studies!
A Wrap!
I started this post by talking about the end game in business, arguing for profitability as a starting point and value as the end goal. The critics of that view, who want to expand the end game to include more stakeholders and a broader mission (ESG, Sustainability) seem to be operating on the presumption that shareholders are getting a much larger slice of the pie than they deserve. That may be true, if you look at the biggest winners in the economy and markets, but in the aggregate, the game of business has only become harder to play over time, as globalization has left companies scrabbling to earn their costs of capital. In fact, a decade of low interest rates and inflation have only made things worse, by making risk capital accessible to young companies, eager to disrupt the status quo.YouTube Video
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Profit Margins, by Industry (, Accounting Returns and Excess Returns, by Industry (, )Data Update Posts for 2024Aswath Damodaran's Blog
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