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I am not a prolific user of social media platforms, completely inactive on Facebook and a casual lurker on LinkedIn, but I do use Twitter occasionally, and have done so for a long time, with my first tweet in April 2009, making me ancient by Twitter standards. That said, I tweet less than ten times a month and follow only three people (three of my four children) on the platform. I am also fascinated by Elon Musk, and even more so by his most prominent creation, Tesla, and I have valued and written about him and the company multiple times. When Musk made news a little over two weeks ago, with his announcement that he owned a major stake in Twitter, I could not stay away from the story, and what's happened since has only made it more interesting, as it casts light on just Musk and Twitter, but on broader issues of the social and economic value of social media platforms, corporate governance, investing and how politics has become part of almost every discussion.

The Twitter Story

To get a measure of Musk's bid for Twitter, you have to also understand the company's path to its current status. In this section, I will focus on the milestones in the company's history that shape it today, with an eye on how it may affect how this acquisition bid plays out.

Inception to IPO

Twitter was founded in 2006 by Jack Dorsey, Noah Glass, Biz Stone and Evan Williams, and its platform was launched later that year. It succeeded spectacularly in attracting people to its platform, hitting a 100 million users in 2012, and then doubling those numbers again by 2013, when it went public ,with an initial public offering. In on October 5, 2013, I valued Twitter, based on the numbers in its prospectus:

In keeping with my belief that every valuation tells a story, my IPO valuation of Twitter in October 2013 reflected my story for the company, as a platform with lots of users, that had not yet figured out how to monetize them, but would do so over time. My forecasted revenues for 2023 of $11.2 billion and predicted operating margin of 25% in that year reflected my optimistic take for the company, with substantial reinvestment (in acquisitions and technology) needed along the way (as seen in my reinvestment). A few weeks later, the offering price for Twitter's shares was set at $26, by its bankers, and the stock debuted on November 7, 2013, at $45. In the weeks after, that momentum continued to carry the stock upwards, with the price reaching Ìý$73.31 by December 26, 2013.Ìý

If the story had ended then, the Twitter story would have been hailed as a success, and Jack Dorsey as a visionary. But the story continues...

The Rise and Fall of Jack Dorsey

In the years since its IPO, the Twitter story has developed in ways that none of its founders and very few of its investors would have predicted. On some measures of user engagement and influence, it has performed better than expected, but in the operating numbers measuring its success as a business, it has lagged, and the market has responded accordingly

Users: Numbers and Engagement

In terms of user numbers, Twitter came into the markets as a success, with 240 million people on its platform in November 2013, at the time of its public offering. In the years since, those user numbers have grown, as can be seen in the chart below:

In keeping with disclosure practices at other user-based companies, in 2017, Twitter also started tracking and reporting the users who were most active on its platform, by looking at daily usage, and counting daily active users (DAU). While total user numbers have leveled off in recent years, albeit with a jump in 2021, the daily active user count has continued to climb.Ìý

Over the last decade, the company's platform, and the tweets that show up on it, became a ubiquitous part of news, culture and politics, as politicians used the platform to expand their reach and spread their ideas and celebrities built their personal brands around their followers. Looking at the list of the Twitter persona with the most followers provides some measure of its reach, with a mix of politicians (Barack Obama, Narendra Modi), musicians (Justin Bieber, Katy Perry, Taylor Swift, Ariana Grande), celebrities (Kim Kardashian) and sporting figures (Cristiano Ronaldo). Sprinkled in the list are brands/businesses (YouTube, CNN Breaking News), with millions of followers, though relatively few business people make the list, with Elon Musk being the exception. ÌýIt is worth noting that many of the people on top follower list tweet rarely, and that behavior is mimicked by many of the users on the platform, many of whom never tweet. The bulk of the tweets on the platform are delivered by a subset of users, with the top 10% of users delivering 80% of the tweets.Ìý

While there are multiple reasons that Twitter users come to the platform, the demographics of its platform provides some clues, especially when contrasted with other social media platforms:

Pew Research

Twitter's user base skews younger, more male, more educated and more liberal than the US population, and especially so, when compared with Facebook, which has the biggest user base.

Revenues, Profits and Stock Prices

As Twitter user base and influence have grown, there has been one area where it has conspicuously failed, and that is on business metrics. The company's revenues have come primarily from advertising (90%) and while these revenues have grown, they have not kept up with user engagement, as can be seen in the chart below:

In the last few years, revenue growth has flattened, again with the exception of 2021, and while operating margins have finally turned positive in the last five years, there has been no sustained upward movement. To give a measure of Twitter's disappointing performance, note that the company's actual revenues in 2021 amounted to $5.1 billion, well below the $9.6 billion I estimated in 2021 (year 8 in my IPO valuation) as revenues in my IPO valuation of the company in November 2013, and its operating margin, even with generous assumptions on R&D, was 19.02% in 2021, still below my estimate of 19.76% in that year.Ìý

The disappointments on the operating metric front has played out in markets, where Twitter's stock price dropped to below IPO levels in 2016 and its performance has lagged its social media counterparts:

Source: Bloomberg

In fact, Twitter's stock prices did not breach their December 2013 high of $73.31 until February 26, 2021, when the stock peaked at $77.06, before dropping back to 2013 levels again by the end of the year. The company that provides the best contrast to Twitter is Snapchat, another company that I valued at the time of its IPO in February 2017 at $14.4 billion, with a value per share of $10.91. Like Twitter, Snapchat had a rousing debut in the market, rising 40% to hit $24.48 on its first trading day, before falling on hard times, as Instagram undercut its appeal. The stock dropped below $6 in 2019, before mounting a comeback in 2021. While Snap is a younger company than Twitter, a comparison of the operating metrics and user numbers yields interesting results:

Looking at the 2021 numbers, Snap now has more daily active users than Twitter, but delivers less in revenues and is still losing money. That said, the market clearly either sees more value in Snap's story or has more confidence in Snap's management, since there is a wide gap in market capitalizations, with Snap trading at a premium of 60% over Twitter.

Corporate governance

While Twitter can be faulted on many of its actions leading into and after its IPO, there is one area where credit is due to the company. In a period when companies, especially in the tech sector, fixed the corporate governance game in favor of insiders and incumbents, by issuing shares with different voting classes, Twitter stuck to the more traditional model, with equal voting right shares. ÌýIt is also worth noting that Twitter came into its IPO, with a history of bloodletting at the top, with Jack Dorsey, who led the company at the start, getting pushed aside by Evan Williams, his co-founder, before reclaiming his place at the top. In fact, at the time of its IPO, Twitter's CEO was Dick Costolo, but he was replaced by Dorsey again, a couple of years later. Dorsey's founder status gave him cover, but his ownership stake of the company was not overwhelming enough to stop opposition. As disappointment mounted at the company, the murmuring of discontent became louder among Twitter shareholders, especially since Jack divided his top executive duties across two companies, Twitter and Square, both of which demanded his undivided attention. Ìý

The corporate governance issues at Twitter came to a head in 2020, when Elliott Management, an activist hedge fund, purchased a billion dollars of Twitter stock, and demanded changes. While Dorsey was successful in fighting off their demands that he step down, he surprised investors and may company employees when he stepped down in November 2021, claiming that he was leaving of his own volition. That may be true, but it seemed clear that the relationship between Dorsey and his board of directors had ruptured, and that the departure might not have been completely voluntary. As a replacement, the board did stay within the firm in picking a successor, Parag Agrawal, who joined Twitter as a software engineer in 2011 and rose to become Chief Technology Officer in 2017.

The Musk Entree!

It is ironic that the threat to Twitter has come from Elon Musk, who has arguably used its platform to greater effect than perhaps anyone else on it. There are some Twitter personalities who have more followers than Musk, but most of them are either inactive or tweet pablum, but Musk has made Twitter his vehicle for selling both his corporate vision and his products, while engaging in distractions that sometimes frustrate his shareholders. While he has made veiled promises of alternative platforms for expression, it was a surprise to most when he announced on April 4, 2022, that he had acquired a 9.2% stake in the company. Stock prices initially soared on the announcement, but what has followed since has been one of the strangest corporate chronicles that I have ever witnessed, as you can see in the time line below:

This post is being written on April 19, and the only thing that is predictable is that everything is unpredictable, at the moment, and that should come as no surprise, when Musk is involved.

The Value Arguments: Status Quo and Potential

While Musk's acquisition bid is anything but conventional, the gaming that it initiated on the part of Twitter, the target company, and Musk, the potential acquirer, was completely predictable. The company's initial response was that it was worth great deal more than Musk's offering price, and that Twitter shareholders would be receiving too little for their shares if they sold. Musk's response was that the market clearly did not believe that current management could deliver that higher value, and that he would be able to do much better with the platform.

Twitter's argument that Musk was lowballing value, by offering $54.20 per share for the company, Ìýand that the company was worth a lot more is not a novel one, and it is heard in almost every hostile acquisition, from target company management. That argument can sometimes be true, since markets can undervalue companies, but is it the case with Twitter? To answer that question, I valued Twitter on April 4, at about the time that Musk announced his 9.2% stake, updating my story to reflect a solid performance from the company in 2021, and with Parag Agrawal, its newly anointed CEO:

In my story, which I view as upbeat, given Twitter's inability to deliver on operating metrics in the last decade, I see continued growth in revenues, with revenues reaching almost $13 billion in 2033, and a continued increase in operating margins to 25%, not quite the levels you see at the dominant online advertising players (Facebook and Google), but about what you would expect for a successful, albeit secondary, online advertising platform. (Note that I am capitalizing R&D expenses to give the company healthier margins right now, to begin my valuation). The value per share that I obtained was about $46, $ 4 higher than the prevailing stock price, but below Musk's acquisition offer of $54.20.
To the critique that revenue growth could surprise and that margins could be higher, my answer is of course, and to incorporate the uncertainty in my inputs, I fell back on one of my favored devices for dealing with uncertainty, a Monte Carlo simulation. I picked three variables, the revenue growth over the next five years, the target operating margin and the initial cost of capital, to build distributions around, and the results of the simulation are below:

The median value in the simulation is $45.17, close to the base case valuation, but at least based on my estimates, Musk's offering price is at the 75th percentile of value. It is possible that the value could be higher but making that is not a particularly strong argument to make, if you are Twitter's board.

Competing Views: The Fight for Twitter

As a company that has lived its entire life on the promise of potential, it should come as no surprise if that is where the next phase of this argument heads. In particular, Twitter's management will claim that the company's platform has the potential to deliver significantly more value, either by changing the business model (and including subscriptions and other revenue sources) or fine tuning the advertising model. On this count, Musk will agree with the argument that Twitter has untapped potential, but counter that he (and only he) can make the changes to Twitter's business model to deliver this potential. In short, investors will get to choose not only between competing visions for Twitter's future, but also who they trust to deliver those visions.

The problem that Twitter's management will face in mounting a case that Twitter is worth more, if it is run differently, is that they have been the custodians of the company for the last decade, and have been unable or unwilling to deliver these changes. Shareholders in Twitter will welcome management's willingness to consider alternative business models, but the timing makes it feel more like a deathbed conversion rather than a well thought through plan. Elon Musk's problem, on the Twitter deal, is a different one. If you think Jack Dorsey was stretching the limits of his time by running two companies, I am not sure how to characterize what Musk will be doing, if he acquires Twitter, since he does have a trillion dollar company to run, in Tesla, not to mention SpaceX, the Boring company and a host of other ventures. In addition, Musk's unpredictability makes it difficult to judge what his end game is, at least with Twitter, since he could do anything from selling his position tomorrow to bulldozing his way through a poison pill, taking Twitter down with him. I know that there are question of how Musk Ìýfinance the deal and whether he can secure funding, but of all of the impediments to this takeover, those might be the easiest to overcome. The fact that Twitter's stock price has stayed stubbornly below Musk's offering price suggests that investors have their doubts about Musk's true intentions, and whether this deal will go through.

Alternate Endings

No matter what you think about Elon Musk and how his acquisition bid will play out, it is undeniable that he has put Twitter in play here, and that it is likely that the company that emerges from this episode will look different from the company that went into it. In particular, I see four possible outcomes for Twitter:

Status Quo: It is possible that Twitter wins this round with Musk, and that the poison pill adopted by the board is sufficient to get him to walk away from the deal, perhaps selling his holdings along the way. The existing management go back to their plans for incremental change that they have already put in motion, and hope that the payoffs of higher revenue growth and profitability will unlock share value.ÌýMusk takes Twitter private: Having spent more than a decade seeing Musk pull off what most market observers would view as impossible, I have learned not to underestimate the man. For Musk to succeed at this point, he has to be able to buy enough shares in a tender offer and/or convince other shareholders to put pressure on the board to remove the poison pill, and allow him to move forward with his plans. The odds are against success, but then again, this is Elon Musk.Independent, but with corporate governance changes: Even if Twitter is able to fend off Musk, the way that the company's management and board have handled the deal does not inspire confidence in their ability to run the company. In fact, having gone through five CEOs over Twitter's life, it is worth asking the question whether the dysfunction at the company lies with the board, and not just with the CEO. In this scenario, institutional investors will follow through by pushing for change in the company, translating into new board members and perhaps even a new CEO.Someone else acquires Twitter: There may be something to Musk's claim that the changes that are needed to make Twitter a functional business can only be made, if it is taken private. If so, it is Ìýthe board may be willing to sell the company to someone other than Musk, albeit at a slightly higher price (if for no other reason than to save face). The fact that the buyer may be Silver Lake, a firm that Musk has connections with, or another private equity investor, whose plans for change are similar to Musk's, will mean that Elon Musk will have accomplished much of what he set out to do, without spending $43 billion dollars along the way or having to deal with the distractions that owning Twitter will bring to his other, more valuable, ventures.If I were to put these possibilities in terms of likelihood, I would put "staying independent with significant corporate governance changes" as most likely, followed by someone else acquiring Twitter, with the status quo and Musk succeeding getting the lowest odds.

Political Markets?

In this discussion, I have deliberately stayed away from the elephant in the room, which is that this is , at its core, a political story, not a financial one. To see why, consider a simple test. If you tell me which side of the political divide you fall on, I am fairly certain that I will be able to guess whether you favor or oppose Musk's takeover bid. As with most things political, you will provide an alternate, more reasoned, argument for why you are for or opposed, but you are deluding yourself, and hypocrisy is rampant on both sides. Ìý

If you are opposed to the deal, and your argument is that billionaires should not control social media platforms, that outrage cannot be selective, and you should be just as upset about Jeff Bezos owning the Washington Post or a George Soros bid for Fox News. If it is Musk's personality that you feel is what makes him an unsuitable owner, I wonder whether we should be requiring full personality tests of the owners of other media companies.If you are for the deal, and it is because you want Twitter to be a bastion of free speech, it is worth remembering that every social media platform is involved in some degree of censoring, for legal reasons and self preservation. It should also be noted that while those disaffected with Twitter have attempted to build their own social media platforms, they still get far more mileage from their presence on Twitter than from their posts on alternate platforms, and the complaints about Twitter not being balanced seem to end up being on Twitter.The hand wringing from pundits about changes that may or may not be coming to Twitter, and the impact it will have on our collective consciousness, to be over wrought. In fact, some critics of Musk seem to have decided that Twitter, in its current form, is a national treasure that needs to be preserved or at least protected from money grubbing barbarians. I beg to differ. The brevity (of having to compress your thoughts into 280 characters) and timeliness of Twitter's platform has made it the place to go to get breaking news, but the notion that it is an educational platform shortchanges the meaning of learning, and the impulsiveness that it encourages from users is a recipe for tweeting remorse, or worse. I believe that while there are some who come to Twitter for news and witty repartee, many come to the platform for the same reasons that they slow down on highways to look at car crashes, i.e., to witness, and sometimes partake in, deranged arguments about trivial issues. Much as we like to complain about the ugliness and anger that we see on social media, it is exactly those forces that draw users to it, and arguing that Elon Musk will make it worse, misses the point that he symbolizes the strengths and weaknesses of the Twitter platform better than any other person walking the face of the earth.Ìý
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Spreadsheets

My views on ESG are not a secret. I believe that ESG is, at its core, a feel-good scam that is , while doing close to nothing for the businesses and investors it claims to help, and even less for society. That judgment may be harsh, but as the Russian hostilities in Ukraine shake up markets, the weakest links in the ESG chain are being exposed, and as the same old rationalizations and excuses get rolled out, I believe that a moment of reckoning is arriving for the concept. If you remain a true believer, I will leave it up to you to decide how much damage has been done to ESG, and what comes next.

The ESG Response To Russia

When Russian troops advanced into Ukraine in late February, the reverberations across markets were immediate. Stock, bond and commodity markets all reacted negatively, and at least initially, there was a flight to safety across the world. Since one of ESG's sales pitches has been that following it’s precepts would insulate companies and investors from the risks emanating from bad corporate behavior, both ESG advocates and critics have looked to its performance in this crisis, to get a measure of its worth. I am not an unbiased observer, but the reactions from ESG defenders to this crisis can be broadly categorized into three groups.

1.ÌýThe Revisionists

In the last decade, as ESG has grown, I have been awed by the capacity of some of its advocates to attribute everything good that has happened in the history of humanity to ESG. If these ESG revisionists are to be believed, if companies had adopted ESG early enough, there would have been no banking crisis in 2008, and if investors had screened stocks for ESG quality, they would not have lost money in the corporate scandals and meltdowns of the last decade. In the last week of February 2022, in the immediate aftermath of this crisis, there were a few ESG supporters who argued that ESG-based investors were less exposed to the damage from the crisis. That was quickly exposed as untrue for three reasons:

ESG measurement services missed the Russia Effect: There is no evidence that Russia-based companies had lower ESG scores than companies without that exposure. In my last post, I looked at four Russian companies, Severstal, Sberbank, Yandex and Lukoil, all of which saw their values collapse in the last few weeks. When I checked their ESG rankings on Sustainalytics ranked each on February 23, 2022, each of them was ranked in the top quartile of their industry groups, though they all seem to have been downgraded since, with the benefit of hindsight. In a , Lev, Demeers, Hendrikse and Joos, highlight the absence of a Russia effect on ESG ratings with a simple comparison of ESG scores of companies with and without Russia exposure:
Unlike them, I will not argue that failing to foresee the Russian invasion of Ukraine is an ESG weakness, but it certainly cannot be presented as a strength.Following the ESG rulebook after the crisis has been a losing strategy: It is true that the emphasis on climate change that skews ESG scores lower for fossil fuel and mining companies would have kept you from investing in Lukoil and Gazprom, among other Russian commodity companies, but it would also have kept you from investing in other companies in these sectors, operating in the rest of the world. As I noted , that would have kept you out of the best performing sector since Russia invaded Ukraine. In short, if there is a lesson that this crisis has taught us, it is that treating fossil fuel producers as evil, when they produce much of the energy that we use, is delusional.ÌýESG funds/lenders lost substantial amounts in Russia: Investment funds and lenders who have long touted their ESG credentials do not seem to have been less exposed than non-ESG funds, early reports notwithstanding. A Bloomberg Quint study of ESG funds uncovered that they hadÌý, almost all of which was wiped out during the next few weeks. In fact, the saving grace for ESG funds has been the fact that Russia did not have a large investable market, for both ESG and non-ESG funds.In the weeks after the war, hundreds of US and European companies have announced that they were leaving Russia, and ESG advocates have pointed to this exodus as evidence that its practices are now mainstream. ÌýI would push back against the narrative that these companies were giving up lucrative businesses, because of their consciences:Small presence in Russia: In my last post, I noted that the Russian economy represents a sliver (about 2%) of the global economy. If you add the reality that Russia has a closed economy, with well established barriers to outsiders, most of the US companies pulling out of Russia are not giving up much business to begin with. In fact, for companies like Goldman Sachs, whose primary business in Russia came from acting as intermediaries between Russian businesses/investors and investors in the rest of the world, there is a question of whether any business was left to give up, after sanctions were put in place. The companies with the biggest presence in Russia are oil and commodity companies, primarily involved in joint ventures with Russian entities, where the pull out may be designed to preempt what would have been nationalization or expropriation in the future.Risk Surge and Economic Viability: In my last post, I noted the surge in Russia's default spread and country risk premium, making it one of the riskiest parts of the world to operate in, for any business. Many companies that invested in Russia, when it was lower-risk destination, have woken up to a new reality, where even if their Russian projects return to profitability, the returns that they can deliver are Ìýwell below what they need to make to break even, given the risk. Put simply, exiting Russia makes economic sense for most companies, and it may be cloaked in morality, but it is easy to pick the moral path, when economics and morality converge.Suspension versus abandonment: It is telling that many companies that have larger interests in Russia, with perhaps the possibility that investing will become economically viable again, have suspended their Russian operations, rather than abandoning them. These companies will undoubtedly come under pressure from activists, who will try to shame them into leaving, but if that is the best that ESG can do, it is pitiful.For those who continue to insist that the corporate reaction to the Russian invasion is a sign of moral awakening at companies, I propose a thought experiment. If China had invaded Taiwan, do you think that companies would have been as quick to abandon their Chinese holdings and business? Do you think that investment funds would have been so quick to write off their Chinese holdings? On a more personal level, would you be willing to give up all things “Chineseâ€�, as quickly as you were willing to give up drinking Russian vodka? They are hypothetical questions, but I think I know the answer.Ìý

2. The Expansionists

As the evidence has mounted that ESG, at least as constructed, failed to provide protection to companies and investors from the Russia fallout, there are a few in the ESG movement who have argued that the fix is to . That is easier said than done, though, because as with all things ESG, those risks are in the eyes of the beholder. For some, it will mean bringing in the nature of governments into ESG measures, with companies in countries with authoritarian governments getting lower ESG scores than companies in countries with democratic governments. Even if you believe that expansion is defensible, and that considering political risk when valuing companies is prudent, it will mean that every ESG measurement service will have the unenviable task of assessing political freedom (or its absence) in a company's operating geographies, to evaluate its ESG score. Taking a bigger picture perspective, using the benefit of hindsight to keep expanding ESG to include the missed variables in each crisis will lead to measurement bloat, as it grows more tentacles and adds more dimensions. Ultimately, if ESG tries to measure everything, it ends up measuring and meaning nothing.

On a different note, the events of the recent weeks have also pointed to the elasticity of the ESG concept. In the weeks right after the war started, , as long as they were selling them to the “right� side of the conflict. While ESG advocates were dismissive, I think that what the Citigroup analysts were proposing is more in line with the true nature of ESG, an amorphous, anything goes concept that shifts shape and form, depending on who is defining it, and when.

3. The Utopians

There is a group within the ESG movement that has been unfazed by any critiques of ESG or evidence that it has not done what it set out to do. To these true believers, the problems with ESG come from it being misappropriated, mis-measured and misused, and in their view, ESG, done right, will always deliver its promised rewards. I call this group the "if only" chorus, since in their view, if only services measured ESG correctly, if only companies did not indulge in greenwashing, and, if only, ESG funds did not pick under performers, ESG would work at making the world a better place. I believe that their wait for this awakening will be long because:

ESG mis-measurement is endemic, not transient: Even ESG measurement services are willing to admit that the , but they all contend that better measurement is around the corner, premised on two assumptions. The first is that ESG disclosures will improve, as regulators force companies to reveal more about their environmental and social performance, and that this data will improve measurement. The second is that as ESG ages, we will develop consensus on what comprises goodness, and when that occurs, there will be a higher correlation across services. I don't believe that either assumption is realistic. Drawing on the experience with corporate governance and stock based compensation, both areas where the volume of disclosure has ballooned over the last two decades, I would argue that disclosure has actually created more distraction than clarity, and I don't see why ESG will be any different. As for converging on what comprises “goodâ€�, why in God’s name, in a world where everything is partisan, would you expect consensus to magically form in the investment community? In fact, if a consensus on measurement occurs across services on how to measure ESG, it will be driven more by marketing concerns (since the differences across ratings is getting in the way of selling the concept) than by learning.Greenwashing is an ESG feature, not a bug: There is probably no phenomenon on which there is , where companies substitute "looking good" for "doing good". Those complaints, though, ignore an unpleasant truth, which is that greenwashing is exactly the outcome of making ESG a system of scores and rankings. I am willing to take a wager with any ESG true believer that the more ESG services and regulators try to crack down on greenwashing, the more ubiquitous and sophisticated it will become. The largest and most profitable companies will have the resources to game the system better, exacerbating biases that already exist in current ESG scores.ESG Investing underperformance is steady state, not a passing phase: For the last decade, ESG sales pitches were helped out by the seeming over performance of ESG-based investing, though almost all of the out performance could be attributed to ESG's tech focus and sector concentrations. As the market has shifted, and , ESG investment fund managers are scrambling, trying to explain to clients why this is just a Ìýpassing phase, and that good days are just around the corner. That is nonsense! In steady state, once the components of ESG that matter get priced in, ESG-constrained funds will deliver lower returns than funds that don't operate under those constraints. As I noted in one of my earlier posts on ESG, arguing that a constrained optimal can consistently beat an unconstrained optimal is sophistry, and the fact that some of the biggest names in the investment business have made these arguments tells us more about them than it does about ESG.ESG is not about actual change, but the perception of change: Over the last decade, ESG advocates have argued that even if following ESG precepts does not increase shareholder value or generate higher returns, it does good for society, by stopping bad practices. Some of ESG's biggest "wins" have been in the fossil fuel space, with to adopt a smaller carbon footprint, being presented as a prime exhibit. Under investment pressure, there is no denying that publicly traded oil companies, primarily in the West, have scaled back their search for oil and gas, and sometimes scaled back and sold reserves. The key word here is "sold", since those reserves have often been bought by private equity investors, who have collectively over the last decade. Is it any surprise then that despite all of the ESG wins, the world remains overwhelmingly dependent on fossil fuels? In fact, all that ESG activists have managed to do is move fossil fuel reserves from the hands of publicly traded oil companies in the US and Europe, who would feel pressured to develop those reserves responsibly, into the hands of people who will be far less scrupulous in their development. If this is what winning looks like in the ESG world, I would hate to see what constitutes losing!If you are an optimist on ESG, you may keep seeing light at the end of the tunnel, but the more this concept plays out, the more likely it is that the light you are seeing is that of a train bearing down on you.Ìý

The Next Big Thing?

When a concept is as widely sold and bought into as ESG, it is unlikely to be abandoned in a hurry, no matter how much evidence accumulates that it does not work or that it has perverse consequences. In my experience, though, hollow concepts that promise the world and deliver little, eventually hit a tipping point, where even the most loyal adherents abandon them and move on. That moment will come for ESG, and if you are an ESG consultant, advisor or measurer, you will need something to replace its place, the next big thing, that you can sell as the answer to every question in business. Playing the role of a cynic, I will offer you a five step process that you can use to develop this "next big thing", which for generality, I will call “it�.

Give "it" a name: Give your next big thing a name, and pick one that sounds good, and if you want to add an aura of mystery, make it an acronym, with three letters seeming to do the trick, in most cases.Give "it" meaning and purpose: As you write the description of the word or acronym, make that description as fuzzy as possible, preferably throwing in the word "long term" and "good for the world" into it, for good measure. (See step 5 for why this works in your favor.)Use history to reverse engineer it’s components: Before you add specifics to your description, examine business and investing history, focusing on the most successful, and looking for characteristics that they share in common in terms. To round “itâ€� out, you should also find failures and see what common features bind them together. Then incorporate these characteristics into your description, with the shared features of successful companies as your must-haves, and those of the failures are things to avoid.Use self-interest to sell "it": To get the business establishment behind you, draw on its powerful drivers, self interest, greed and self delusion. If you have done your job well in step 3, you will have no trouble gaining institutional support, since you have already primed the pump. Case writers and consultants should have no trouble finding supporting cases studies and anecdotal evidence, academic researchers will unearth statistical evidence that your concept works and investment fund managers will unearth its capacity to create "alpha" in past returns. ÌýDelay and deflect: If you get pushback from critics or those with evidence that is contradictory,Ìýattribute failures to growing pains and argue that what is needed is a doubling down of fidelity to the concept. Since you have provided no clear or even discernible targets, you can always move the goalposts or claim to have accomplished what you set out to, and thus not be held accountable. Finally, use the “goodnessâ€� shield, since that makes any questioning of your big idea seem small minded and mercenary.So, what will the next big thing be? I don't know for sure, but I am willing to make a guess, since so many ESG experts and advocates have slipped into already using it as an alternative. It is "sustainability", a word that can mean whatever you want it to mean. In its most benign form, I believe that it is just another word for "long term", though the only benefit of replacing one set of words with another is that it offers a chance for those using the new and updated word to state the obvious, claim the outrageous and charge the absurd. In its more malignant form, it becomes a way to try to keep corporations alive forever, a dreadful idea, where zombie and walking dead companies suck up capital and resources, and drag the rest of us down into the abyss with them.Ìý

Conclusion

When I first wrote about ESG two years ago, I did so because I was skeptical of the unquestioning belief that people had in its success. I initially believed that it was a flawed concept that needed fixing , but after two years of interactions with people who claim to know the concept really well, but don't seem to be capable of making solid cases for it, and witnessing its takeover by well heeled entities with agendas, I am convinced that there will soon be room for only two types of people in the ESG space. The first will be the useful idiots, well meaning individuals who believe that they are advancing the cause of goodness, as they toil in the trenches of ESG measurement services, ESG arms of consulting firms and ESG investment funds. The second will be the feckless knaves, who know fully well the void behind the concept, but see an opportunity to make money. I know that those are not edifying choices, but I don't see any good ones, other than leaving the space completely. Good luck!

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Blog Posts on ESG

As the world's attention is focused on the war in the Ukraine, it is the human toll, in death and injury, that should get our immediate attention, and you may find a focus on economics and markets to be callous. However, I am not a political expert, with solutions to offer that will bring the violence to an end, and I don't think that you have come here to read about my views on humanity. Consequently, I will concentrate this post on how this crisis is playing out in markets, and the effects it has had, so far, on businesses and investments, and whether these effects are likely to be transient or permanent.

The Lead In

To understand the market effects of the Russia-Ukraine conflict, we need to start with an assessment of the two countries, and their places in the global political, economic and market landscape, leading in. Russia was undoubtedly a military superpower, with its vast arsenal of nuclear weapons and army, but economically, it has never punched that weight. Ukraine, a part of the Soviet Union, has had its shares of ups and downs, and its economic footprint is even smaller. The pie chart below, provides a measure of the gross domestic product of Russia and Ukraine, relative to the rest of the world:

While Russia's share of the global economy is small, it does have a significant standing in the natural resource space, as a leading producer and exporter of oil/gas, coal and nickel, among other commodities. Ukraine is also primarily a natural resource producer, especially iron ore, albeit on a smaller scale.

Russia was also a leading exporter of these commodities, with a disproportionately large share of its oil and gas production going to Europe; in 2021, Russian gas accounted to 45% of EU gas imports.

The Market Reaction

Ìý ÌýAs the rhetoric of war has heated up in the last few months, markets were wary about the possibility of war, but asÌýRussian troops have advanced into the Ukraine, that wariness has turned to sell off across markets. In this section, I will begin by looking at the bond market effects and then move on to equities and other asset classes, starting by looking at the localized reaction (for Ukranian and Russian securities) and then the global ripple effects.

Bond Markets and Default Risk

ÌýÌý ÌýIn times of trouble, the first to panic are often lenders to the entities involved, and in today's markets, the extent of the reaction to country-level troubles can be captured in real time in the sovereign CDS (Credit Default Swap) markets. The graph below shows the sovereign spreads for Russia and Ukraine in the weeks leading up and including the conflict:

The sovereign CDS spread for Russia, which started the year at 1.70% soared above 25%, just after hostilities commenced, and were trading at 10.56% on March 16, after rumors that peace talks were underway brought them down. The sovereign CDS spread for the Ukraine started the year at 6.17% and climbed in the first few days of the crisis to more than 100% (effectively uninsurable) before settling in on March 16 at 28.62%. Even the ratings agencies, normally slow to act, have been moving promptly, with Moody's lowering Russia's rating from Ba2 to B3 on March 3, from B3 to Ca on March 6 and from Ca to C on March 8, and Ukraine's rating from B3 to Caa2 on March 4. Other ratings agencies have also taken similar actions.Ìý Ìý The worries about defaultÌýhave not stayed isolated to Russia and Ukraine, as ripple effectsÌýhave shown up first in the countries that are geographically closest to the conflict (Eastern Europe) and more generally on sovereign CDS spreads in the rest of the world.ÌýThe graph below looks at average spreads, by region, before and after the hostilities started:

Change in Sovereign CDS, by RegionThere are no surprises in this table, with the effects on spreads being greatest for East European countries. Note, though, that while sovereign CDS spreads increased almost 51% between January 1, 2022 and March 16, 2022, in these countries, the overall riskiness of the region remains low, the average spread at 1.30%. The Middle East is the only region that saw a decrease in sovereign CDS spreads, as oil, the primary mechanism for monetization in this region, saw its price surge during the last few weeks. The Canadian sovereign CDS spread widened, but US and EU country spreads remained relatively stable.Ìý Ìý The increase in default spreads was not restricted to foreign markets, as fear also pushed up spreads in the corporate bond market. In theÌýtable below, I look at default spreads on bonds in different ratings, across USÌýcompanies, on January 1, 2022 and March 16, 2022:
It is worth noting that corporate bond spreads, which were are at historic lows to start the year, were already starting to widen before Russia's military moved into the Ukraine on February 24, 2022, but the invasion has pushed the spreads further up at the lower ends of the default spectrum. The overriding message in all of this data is that Russia/Ukraine war hasÌýunleashed fears in the bond market, and once unleashed that fear has pushed up worries about default and default risk premia across the board.
Equity Markets and Equity Risk Premiums

Ìý Ìý Lenders may be the first to worry, when there is a crisis that puts their payments at risk, but equity investors are often with them, pushing down stock prices and pushing up equity risk premiums. Again, I will start with Russian and Ukranian equities, using country indices to capture the aggregate effect on these markets, from the invasion:

Russia: RTX Russian Traded $ Index, Ukraine: Ukraine PFTS Index
Neither index is particularly representative, and currency effects contaminate both, but they tell the story of devastation in the two markets. In fact, since trading has been suspended on both indices, the extent of the damage is probably understated. To get a better sense of how Russian equities, in particular, have fared in the aftermath of the invasion, I looked at four higher profile Russian companies,:
The four Russian companies that I picked are representative of the Russian economy: Lukoil is a stand-in for Russia's oil businesses,ÌýSberbank is Russia's most dynamic bank, a part of almost every aspect of Russian financial services, Severstal is a global steel company with roots and a significant market share in Russia and Yandex is Russia's largest technology company. In addition to being traded on the MICEX, the Russian exchange, these companies all have listings in foreign markets (Yandex has a US listing and the other three are listed on the London Exchange). The collapse in stock prices has been calamitous, with each of the four stocks losing almost all of their value, and with trading suspended since the end of February, it is still unclear whether the trading will open up, and if so at what price.A knee-jerk contrarian strategy may indicate that you should be buying all these stocks, as soon as they open for trading, but a note of caution is needed. The price drop in these companies, especially severe at Sberbank, is not necessarily an indication that these companies will cease to exist, but that the Russian government may effectively nationalize them, leaving equity worthless.Ìý Ìý As Russian equities have imploded, the ripple effects again are being felt across the globe. The table below summarizes the market cap change, by region of the world:
It is no surprise that Eastern Europe and Russia, which are in the eye of the hurricane, have seen the most damage to equities, but other than the Middle East, every other equity market in the world is down, with the US, EU and China shedding significant market capitalization. Slicing the data based on sector yields the following:Against, there are no surprises, with energy being the only sector to post positive returns and with consumer discretionary and technology generating the most negative returns. Finally, I looked at firms based upon price to book ratios as of January 1, 2022, as a rough proxy for growth/maturity, and at net debt to EBITDA multiples, as a measure of indebtedness:
In this crisis, the conventional wisdom has held, at least so far, with mature companies holding their values better than growth companies. Since these mature companies tend to carry more debt, you see more indebted companies doing much better than less indebted companies. While the value crowd, bereft of victories for a long time, may be inclined to do a victory dance, it is worth noting that the same phenomenon occurred between February and March of 2020, at the start of the COVID crisis, but that growth companies quickly recouped their losses and finished ahead of mature companies by the end of 2020.Ìý ÌýIn keeping with my belief that it is the price of riskÌýthat is changingÌýduring a crisis, causing contortions in prices, I estimated the implied equity risk premium for the S&P 500, by day, starting on January 1, 2022, going through March 16, 2022, in the graph below:

Note that equities were already under pressure in the weeks before the invasion, as inflation fears surfaced again, and then hostilities have put further pressure on them. The implied equity risk premium, which started the year at 4.24%, was Ìýat 4.73% by March 16, and the expected return on equity, which was close to an all-time low at 5.75% at the start of the year, was now up to 6.92%, still lower than historical norms, but closer to the numbers that we have seen in the last decade.
Flight to Safety and Collectibles Ìý Ìý As in any crisis, there was a rush to safety, accentuated by wealthy Russians trying to move their wealth to safe havens, with safety defined not just in terms of currency, but also in terms of beingÌýbeyond the reach of US and European regulators and legislators. In the graph below, I startÌýwith two traditional havens for US investors, the US dollarÌýand treasury bonds:Trade-weighted dollar & US 10-year T.Bond RateThe dollar has strengthened since February 23, with the trade weighted dollar rising about 3% in value, but the ten-year treasury bond, after an initial rise in prices (and drop in yields) has reversed course, perhaps as inflation concerns overwhelm safe haven benefits. I also looked at crisis investments, starting with gold, an asset that has held this status for centuries and contrasting it with bitcoin, millennial gold:

Gold, which started the year at just above $1,800 an ounce, rose from $1,850 on February 23 to peak at $2,050/oz a few days ago, before dropping back below $2,000/oz on March 16. Bitcoin, which started the year at about $46,000, had a strong first half of November, also rose at the start of this crisis, but seems to have given back almost all of its gains. To the extent that crypto holdings may be more difficulties for authorities to trace and lay claim on, it will be interesting to see if you see a rise in the prices of crypto currencies as Russian wealth looks for sanctuary.

Economic Consequences

ÌýÌý ÌýIt is difficult to argue that people were taken by surprise by the events unfolding in the Ukraine, since the lead in has been long and well documented. It can be traced back to 2014, when Russia annexed Crimea, setting in motion a period of uncertainty and sanctions, and the global economy and Russia seemed to have weathered those challenges well. As this crisis plays out in financial markets, roiling the price of risk in both bond and equity markets, the other question that has to be asked is about the long term economic consequences of the crisis for the global economy.

Commodity Prices and Inflation Expectations

Ìý Ìý Given Russia's standing as a lead player in commodity markets, and its role inÌýsupplying oil and gas to Europe specifically, it should come as no surprise that the markets for the commoditiesÌýthat Russia produces in abundance has been the most impacted, at least in the short term:

All four commodities saw their prices soar in the aftermath of February 23, with oil rising to $130 a barrel, before falling back below $100, and trading in the nickel market suspended on March 7, after prices rose about $100,000 a ton. Even as prices rose in the spot market, the futures market indicated that many participants believed that the price rise would be temporary, with futures prices closer to $80 a barrel, for a year ahead and two year ahead futures contracts.

Ìý Ìý In a market already concerned about expected inflation, the rise in commodity prices operated as fuel on fire, and pushed expectations higher. In the graph below, I list out two measures of expected inflation, one from a inflation expectations ETF () and the other from the , computed as the difference between treasury and TIPs rates.

Both measures indicate heightened concerns about future inflation, and these are undoubtedly also behind the increase in the US ten-year treasury bond rate from 1.51% to 2.19%, this year.

Consumer Confidence and Economic Growth

Ìý Ìý The question that hangs over not just markets but economic policy makers is how this crisis will affect global economic growth and prospects. It is too early to pass final judgment, but the early indications are that it has dented consumer confidence, as the latest reading from the Ìýindicates:

University of Michigan Consumer Sentiment

Consumer sentiment is now more negative than it was at any time during the COVID crisis in 2020, and if consumers pull back on purchases, especially of discretionary and durable goods, it will have a negative effect on the economy. While the contemporaneous numbers on the US economy on unemployment and production still look robust, worries about recession are rising, at least relative to where they were before the hostilities. The graph below looks at the median forecasts of recession probabilities for the US, on the left, and for the Eurozone, on the right (from Bloomberg):

Median forecast probability of recession, US (left) and Eurozone (right)

As a result of the events of the last three weeks, forecasters have increased the probabilities of recessions from 15% to 20% for the US and from 17.5% to 25% for the Eurozone.

Investment Implications: Asset Classes, Geographies and Companies

ÌýÌý ÌýThe Russian invasion of Ukraine has undoubtedly increased uncertainty, affected prices for financial assets and commodities and exacerbated issues that were already roiling markets prior to the invasion. For investors trying to recapture their footing in the aftermath, there are multiple questions that need answers. The first is whether a radical shift in asset allocation is needed, given how these perturbations, across asset classes, geographies and sectors. The second is how the disparate market sell off, small in some segments and large in others, over the last few months has altered the investment potential in individual companies in these segments. ÌýOn January 1, 2022,, building in the expectation that the economy would stay strong for the year and that interest rates would rise over the course of time from the then prevailing value (1.51%) to 2.50% over five years, and arrived , about 10.3% lower than the traded value of 4766. While that was only ten weeks ago, the index has since shed 7.03% of its value, the T.Bond rate has risen to 2.19% and Russia's invasion of the Ukraine have increased commodity prices and the likelihood of a recession. I revisited my valuation of the index, with the updated values:

There are two things to note in this valuation. The first is that I have raised the target rate for the US T.Bond to 3%, reflecting both the increase that has already occurred this year, and concerns about how current events may be adding to expected inflation. The second is that I continue to use analyst estimates of earnings, and at least as of this week (with estimates from March 14, 2022), analysts do not seem to be lowering earnings to reflect recession concerns. That may either reflect their belief that this storm will pass without affecting the US economy significantly or a delay in incorporating real world concerns. If , I offer you the option of adjusting expected earnings, if you believe analysts are being unrealistic in their forecasts. The net effect of the changes is that my estimated value of the index is now 4197, making the index over valued by 5.6% as of March 16, 2022.ÌýÌý ÌýMore generally, the question that investors face as they decide whether to reallocate their portfolios is whether the market has over or under reacted to events on the ground.ÌýIf you are a knee-jerk contrarian, your default belief is that markets over react, and you would be buying into the most damaged asset classes, which would include US, European and Chinese stocks (worst performing geographies), and especially those inÌýtechnology and consumer discretionary spaces (worst performing sectors), and selling those investments (energy companies and commodities like oil, Ìýthat have benefited the most from the turmoil.ÌýIf, on the other hand, you believe that investors are not fully incorporating the effects of the long term damage from this war, you would reverse the contrarian strategy, and buy the geographies and sectors that have benefited already and sell those that have been hurt.ÌýAs an avowed non-market-timer, I think that both these strategies represent bludgeons in a market that needs scalpels. Rather than make broad sector or geographic bets, I would suggest making more focused bets on individual companies. In picking these companies, market corrections, painful though they have been, have opened up possibilities, for investors, though their stock picks will reflect their investment philosophies and their views on economic growth:Discounted Tech:ÌýDuring the course of 2022, markets have reassessed their pricing of tech stocks, and marked down their market capitalizations, for both older, and profitable tech and young, money-losing but high growth tech. A few weeks ago, I posted my valuation of the FANGAM stocks and noted that only one of them was under valued, at the prices prevailing then. In the last few days, every company on the list has dipped in price by enough to be atÌýleastÌýfairly valued or even cheap. While there may be value in some young tech companies, any investments in these firms will be joint bets on the companies and a strong economy, and with the uncertainties about inflation and economic growth overhanging the market, I would be cautious.Safety First: If you have been spooked by market volatility and the Russian crisis, and believe that there is more volatility coming to the market in the rest of the year, your stock picks will reflect your fears. You are looking for companies with pricing power (to pass through inflation) and stable revenues, and in my view, and while you should start by looking in the conventional places (branded consumer products and food processing, pharmaceuticals), you should also take a look at some of the big names in technology.The Russia Play: ForÌýthe true bargain hunters, the wipeout of market capitalization of Russian stocks (like Sberbank, Severstal, Lukoil and Yandex) will create temptation, but I would offer two notes of caution. The first is that you have to decide whether you can buy them in good conscience, andÌýthat is your judgment to make, not mine. The second is that corporate governance at Russian companies,Ìýeven in their best days, is non-existent, and I do not know how this crisis will play out in the long term, at these companies. After all, your ownership stake inÌýthese companies is only as good as the legal structure backing it up, and in Russia, that your stake may be worthless,Ìýeven if these companies recover. A less risky route would be to tag companies with significant exposure to Russia, such as Pepsi, McDonald's and Philip Morris, and evaluate whether the market is overreacting to that exposure. I have seen no evidence, so far, that this is the case, but that may change.There is one final sobering note to add to this discussion, and that relates to low probability, potentially catastrophic events, and how markets deal with them. There is a worst case scenario in the Russia-Ukraine war, that few of us are willing to openly consider, where the conflagration spreads beyond the Ukraine, and nuclear and chemical weapons come into play. While the probability of this scenario may be very low, it is not zero, and to be honest, there is no investing strategy that will protect you from that scenario, but market pricing will reflect that fear. If we escape that doomsday scenario, and come back to something resembling normalcy, markets will bounce back, and in hindsight, it will look like they over reacted in the first place, even if the risk assessments were right, at the time. Put simply, assuming that crises will always end well, and that markets will inevitably bounce back, just because that is what you have observed in your lifetime, can be dangerous.
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ÌýÌý Ìý

The proverbial bottom line for success in business is the capacity to deliver profits, at least in the long term. Even though we live in an age where user platforms and hyper revenue growth can drive company valuations, that adage remains true. In fact, questions about profitability seem to have taken center place again, not only because a market pull back is a reminder that growth, by itself, cannot deliver value, but also because there are still unresolved debates about how much damage the COVID crisis did to earnings power at companies, and whether this damage has been healed, as economies have opened up. In this post, I will look at corporate profitability, in all its different dimensions, and how companies across the globe, and across industries, measured up in the most recent years.Ìý
Measuring ProfitabilityÌý Ìý The question of whether a company is making or losing money should be a simple one to answer, especially in an age where accounting statements are governed by a myriad of rules, and a legion of number-crunchers follow these rules to report profits generated by a firm.ÌýIn practice, though, measuring profitability is anything but straightforward, as accountants have devised multiple measures of profitability, reserving discretion on how to compute each one, and many different ways of scaling these profits, for comparisons.
Accounting Profit MeasuresÌý Ìý To understand the different measures of accounting profit, let us look at how each measure of profit is computed in an income statement. In the table below, I describe four different measures of earnings in an income statement, from gross profit, the most aggregated profit measure, to net profit, the earnings left for equity investors after taxes:
For non-financial service firms, the gross profit is a measure of what companies earn on the products/services that they sell, net of what it costs them to produce those products/services. Netting out other operating expenses, that are not directly tied to producing the goods and services (such as selling and G&A expenses), from gross profits, yields operating income. Income from financial holdings (including cash balances, investments in financial securities and minority holdings in other businesses) are added back, and interest expenses on debt are subtracted out to get to taxable income. After paying taxes on this income, the residual amount represents net income, the final measure of equity earnings, and the basis for computing earnings per share and other widely used measures of profitability used by equity investors.ÌýÌý Ìý Looking across all publicly traded companies, listed globally, and aggregating revenues on all fourÌýmeasures of earnings (gross, operating, taxable, net), byÌýsector, and aggregating the numbers yields the following:
Note that for financial service firms, where debt is raw material (rather than a source of capital) and line between financial and operating assets is difficult to draw, Ìýthe only measures of income that are relevant are taxable and net income. That said, about 31% of the net profits of all publicly traded firms listed globally in 2021 were generated by financial service firms; that percent is lower in the US and higher in emerging markets. The last few years have been eventful for all companies, with the COVID crisis and ensuing economic shut down causing pain for companies, with recovery coming in 2021, as the global economy opened up again. In the table below, I report the aggregated net income, by sector, from 2017 to 2021 (with the 2021 numbers representing last twelve month numbers, through September 2021):It is clear that there was substantial damage done to earnings in 2020, across sectors, with energy, consumer discretionary and industrials showing the most negative effects; across all companies, aggregated earnings declined by 15.03% in 2020. In 2021, companies recovered Ìýentirely from the damage done in 2021, at least in the aggregate, with earnings in 2021 higher than 2019 earnings, by almost 33%. Real estate and utilities are the two sectors that have not come back fully from the COVID effect, but materials, technology and communication services are now reporting significantly higher earnings that before the shut down.
Profit MarginsÌý Ìý Comparing absolute profits across companies and across time can be difficult, since larger firms will generate more profits than smaller ones, all else held equal. To make comparisons, profits are scaled to common metrics, with revenues and book value of investment being the most common scalar. When profits are scaled to revenues, you get margins, and as with absolute earnings, margins come in various forms, as can be seen below:

In addition to margins based upon income measures (gross, operating, after-tax operating and net), there are other margin variations, with EBITDA and after-tax operating margins coming into play. To get a sense of variation in margins across companies globally, we looked at the distribution of gross, operating and net margins in 2021:Earnings from LTM 2021, divided by revenues generated during that periodIn computing operating margins, I capitalized R&D for all companies, because R&D is a capital expense, rather than an operating expense, and extended the capitalization of operating leases to all global companies. (IFRS and GAAP now treat as leases as debt, but that is still not the case in many other markets that are not covered by either standard). The numbers yield interesting insights.ÌýFirst, note that while less than 6% of the 47,606 firms in the sample have negative gross margins, the number is significantly higher for operating margins (43.1%) and net margins (47.3%).ÌýSecond, while it is no surprise that gross margins are significantly higher than operating and net margins, the magnitude of the difference is striking; the median gross margin across all global companies in 2021 is 30.07%, but it melts down to a median operating margin of 5.67% and a median net margins of less than 4%. These margins vary widely across companies, and in the table below, we report on the statistics across sectors:

These sectors obviously are broad and each covers a range of industries. If you are interested in industry-level margins, you . In the graph below, I look at differences in margins across geographical regions:
Eastern Europe (including Russia) and Africa contain some risky markets, but firms in those regions have the highest profit margins in the world. One reason is that domestic players in these markets face less foreign competition that companies in the rest of the world. The lowest profit margins in the world are in Asia, with gross margins less than 30% in China, Japan and South East Asia, but India remains an outlier, delivering higher margins. As companies from around the globe look to Asia for growth, the ensuing competition is pushing margins down there, relative to the rest of the world.Ìý
Returns on Invested Capital (or Equity)Scaling profits to capital invested in a company provides a different pathway to measuring profitability, with more consequential effects on value. This scaling can either be done from the perspective of just the equity investors in the company, with a return on equity, or from the perspective of all capital providers (debt and equity), with a return on invested capital:
These measures are dependent on accounting estimates of not only earnings, but investment in the firm, in the form of book values of equity and invested capital, and that is their biggest weakness. To the extent that accountants mis-categorize expenses like leases and R&D, returns can be skewed, as can restructuring and one-time charges. With those caveats in place, and with my adjustments to earnings for R&D and lease capitalization, I computed the returns on equity and invested capital for all publicly traded firms at the start of 2022, using earnings in the last twelve months in the numerator and invested capital at the start of those twelve months in the denominator:
As with margins, almost a third of all firms have negative or missing accounting returns and the median return on equity, in US dollar terms, across all global firms is 4.48%, and the median return on invested capital, in US dollar terms, across firms is 6.91%. In my last post, I noted the decline in costs of capital for firms over time, noting that the median cost of capital at the start of 2022 is only 6.33%, across global firms, and argued that companies that demand double-digit hurdle rates risk being shut out of investments. That point is amplified by the accounting returns computations, since it looks like the actual returns earned by firms on their investments don't meet their own expectations.Ìý
ImplicationsIt is true that profitability measures, standing alone, give you only a snapshot of a company, in time, but used in context, they are conduits for almost every qualitative factor in investing, and put in a framework, a way of thinking of the value of growth and competitive landscapes.Ìý
Business Buzz WordsBuzzwords and catchy phrases has long been part of business, with consultants and experts offering them as recipes for corporate turnarounds, and companies using them to justify everything from acquisitions to significant business course changes. While their allure is understandable, their casual usage can lead to money ill-spent and catastrophic mistakes, and I have long argued that the best way to bring discipline to decision making is to convert these buzzwords into numbers that drive value. Put simply, every action, no matter how consequential it is framed as being, can affect value in one of three ways: by changing the growth trajectory for revenues, by altering the profitability of the business model or by modifying the risk in the business. Just to illustrate, I have a looked at some of widely used buzzwords with a link to profitability:Ìý table.tableizer-table { font-size: 12px; border: 1px solid #CCC; font-family: Arial, Helvetica, sans-serif; } .tableizer-table td { padding: 4px; margin: 3px; border: 1px solid #CCC; } .tableizer-table th { background-color: #104E8B; color: #FFF; font-weight: bold; } BuzzwordProfitability EffectReasoning Powerful Brand NameHigher operating profit margins, relative to peer groupBrand name allows you to charge higher price for the same products. Economies of scaleOperating margin improves as revenues increaseCosts grow at a slower rate than revenues Superior unit economicsHigh gross marginsExtra unit costs little to produce, relative to price. Strong competitive advantagesHigh return on capital, relative to peer groupBarriers to entry earn and sustain high returns Canny borrowerHigh return on equity, relative to return on capitalBenefits from difference between return on capital and after-tax cost of debt. Tax playerAfter-tax operating income is close to pre-tax operating incomeLower effective tax rate, across all income.
Note that I have steered away from the fuzzier phrases, such a "great management", which could mean everything or nothing, or "ESG", where goodness is not only in the eye of the beholder, but finding a link to anything that drives value resembles a wild goose chase.
AÌýLife Cycle ViewIf you have been reading my posts for a while, you know that I find the corporate life cycle a useful device in explaining everything from what companies should focus on, in corporate finance, to the balance between stories and numbers, when investor value companies. Profit margins and returns also follow the life cycle, albeit with wide differences across firms:


As you can see, young companies tend to be money-losers, and margins improve as companies make it through to maturity, before dropping as companies decline. Accounting returns follow a similar path, though they tend to peak a little later in the cycle, before declining in the last stages of the life cycle again. I am aware that there are many who disagree with my life cycle view of companies, but one way of testing whether it is a reasonable approximation of the real world is to look at the data. In the table below, I report on profit margins and accounting returns for firms, broken down by corporate age (measured from the founding year to 2021), across global companies at the start of 2022:Corporate Age = Years since foundingIt is just one table, but the patterns of margins/returns matches a life cycle view, low for young companies, rising as companies mature, before declining as companies age.Ìý
The largest sector, in the US, in terms of market capitalization, is information technology and I have argued that , with compressed life cycles. The tech sector in the United States is composed of some companies like Apple, Microsoft, HP and Intel, which are ancient by tech company standards, and other companies like Uber, Palantir and Zoom, young and money-losing, that have gone public just in the last few years. In the table below, I break down US tech companies into age cohorts, based upon corporate age (measured from founding year), and looking at profitability measures across these cohorts, in the table below:All companies in S&P technology sectorThis table illustrates the dangers of lumping all tech companies together as high growth or money losing, since older tech companies have become the profit engines in this market, delivering a combination of high margins and accounting returns that the stars of the twentieth century, mostly manufacturing and service businesses, would have envied. It also illustrates why some value investors who have an aversion to all tech companies, often for the most meaningless of reasons (such as not having a tangible book value), have lagged the market for close to two decades.

TheÌýValue of GrowthÌý Ìý As investor tastes have shifted from earnings power to growth, there has been a tendency to put growth on a pedestal, and view it as an unalloyed good, but it is not. In fact, growth requires tradeÌýoffs, where a company invests more back into itself in the near term, denying payouts (dividends or buybacks) to its investors, during that period, for higher earnings in the future. Not surprisingly, then, the net effect of growth will depend on how much is reinvested back, relative to what the company can harvest as future growth. While a fullÌýassessment ofÌýthis value will require making explicit assumptions about growth and reinvestment, there is a short hand that is useful in making this assessment, and that is a comparison of the returnsÌýthat a company makes on its investments to the cost of funding those investments. If you use accounting returns as a proxy for project returns, and the costs of equity and capital as measures of the costs of funding,Ìýyou can compute excess returns to equity investors, by comparing return on equity to the cost of equity, and excess returns to all capital providers, by netting cost of capital from return onÌýinvested capital:


Using the accounting returns and costs of equity/capital that I computed for all publicly traded firms at the start of 2022, I looked at the distribution of excess return measures across companies in the graph below:Close to 57% of firms globally earn returns lower than their funding costs, and while this may be temporary for some, it has become a permanent feature for many businesses. If you believe that the poor returns that you see in this table are a residue of COVID and economic short downs, I would suggest that you look at data that I have, on excess returns, going back almost a decade, and you will see similar results in the pre-COVID years. I will use this data to draw three broad conclusions:Low Hurdle Rate â‰� Positive Excess Returns: The notion that lower interest rates, and the resulting lower hurdle rates that companies face, has been a boon for business is clearly not supported by the facts. If anything, as rates have decreased over the last decade, and costs of capital for companies hit historic lows, companies are finding it more difficult to earn returns that exceed their costs of capital.ÌýGood and Bad Businesses: It is an undeniable truth that some businesses are easier to generate value in, than others, and that a bad business is one where most of the companies operating in it, no matter how well managed, have trouble earning their costs of capital. Using the excess returns estimated from 2021, I estimated the excess returns (ROIC - Cost of capital) in 94 industry groups, and the ten "best" and "worst" industries, in terms of median excess return, are listed below:Excess Returns, by Industry (,Ìý)If you look at the worst businesses, there are a couple that show up every year, like airlines and hotel/gaming, where COVID exacerbated problems that are long term and structural. ÌýThe airline Ìýand hotel businesses are broken, and have been for a long time, and there is no easy fix in sight. Biotechnology companies can claim, with some justification, that their presence on the bad business list reflects the fact that many in the sector are young companies that are a breakthrough away from being blockbuster winners and that they will resemble the pharmaceutical business (which does earn positive excess returns), in maturity. I am sure that there will be ESG advocates who will claim credit for fossil fuel and mining businesses that show up in the worst business list, but not only will their rankings change quickly if oil and commodity prices rises, but the best business of all, in 2021, in terms of delivering excess returns, is the tobacco business, not a paragon of virtue. While the technology boom has created winners in information and computer services, building-related businesses (from materials to furnishings to retail) and chemical companies also seem to have found ways to deliver returns that exceed their costs.ÌýDisruption's Dark Side: Among the bad businesses, note the presence of entertainment, a historically good business that has seen its business model disrupted, by new entrants into the business. Netflix, in particular, has upended how entertainment gets made, distributed and consumed, and in the process, drained value from established players. While this is a phenomenon that has played out in business after business, over the last two decades, there are a couple of common themes that have emerged in the excess return data. Disruption, almost invariably, leads to lower returns for the status quo, i.e., the disrupted companies in the business, but disruptors often don't end up as beneficiaries. Consider the car business, where ride sharing has destroyed cab and traditional car service businesses, but Uber, Lyft, Didi, Grab and Ola all continue to lose money. Put bluntly, disruption is easy, but making money on disruption is difficult, and disruption creates lots of losers, but does not necessarily replace them with winners.If I were to sum up my findings, it would be to conclude that generating value from running a business has become more difficult, not less, in the last two decades and that while there are companies that seem to have found pathways to sustainable, high earnings, most companies are involved in trench warfare, fighting disruptors and facing significantly more macro economic risk in their operations.
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DatasetsProfit Margins, by Industry (, , , , , )Return on Capital, by Industry (, , , , , )Excess Returns,Ìýby Industry (, , , , )

It has been a rocky year so far, in 2022, with worries about inflation competing with hopes about recovery for the market's attention. In the midst of all the action, to no one's surprise, have been six stocks (Facebook, Amazon, Netflix, Google, Apple and Microsoft or FANGAM) that have largely driven US equities for the last decade, roiling the market with their most recent earnings reports. Netflix and Facebook saw drops of 20% or more in market capitalization, following negative earnings reports, but Amazon and Google beat market expectations. In this post, I will be valuing each of these companies, both to assess whether to invest in them individually, and to examine whether there are lessons for the market in their price entrails.Ìý

My September 2020 Valuations

If you tally the winners and losers in the stock market sweepstakes between 2010 and 2019, it is undeniable that the decade belonged to the FANGAM stocks, as can be seen in the graph, where I chart the collective market cap of these six companies against the collective market cap of all US equities, and report on their percentage share:

Over the course of the decade (2010-2019), the FANGAM stocks increased in collective market capitalization from $719 billion from $5.07 trillion, and their share of the overall equity value of all US stocks also surged from 6.5% to 14.9%. It is not hyperbole that without these stocks, the last decade would not have been a great one for US equities. Coming into 2020 in a position of strength, these companies got stronger, as COVID rocked economies and Ìýmarkets in 2020, which :Between February 14, 2020 and August 14, 2020, as markets first collapsed and then recovered just as strongly, the FANGAM companies collectively added $1.39 trillion in market cap, accounting for all of the recovery in US stocks during that period. I have valued each of FANGAM multiple times in the past, but my most recent attempt to value each of them as one of a series of posts highlighting how COVID was playing out in markets. I wanted to see if that surge, added on to the trillions in the market cap of US equities between 2010 and 2019, had left them in nosebleed territory, in terms of value. I must admit I was surprised by my own valuations, since, given the low riskfree rates prevailing at the time, only one stock (Apple) looked significant over valued. Of the rest, Microsoft and Amazon were over valued, albeit by modest most amounts, and Facebook was the most undervalued, and Netflix and Google were close to fairly valued.At the end of that post, I disclosed that I owned Facebook, Microsoft and Apple, and that I would continue to hold the first two, and would sell my Apple shares. ÌýClearly, much has happened since these valuations. The market has continued its march upwards, these companies have had multiple earnings reports and each of them has had newsworthy events occur.Ìý

Updating the Numbers

In the eighteen months since I valued these companies, much has happened, to the economy, to US equities collectively, and to these six companies, in specific. In the graph below, I report on theÌýcollective market capitalization of US equities, broken down into three groupings, the FANGAM stocks, all other US tech companies and the rest of the US equity market, from August 31, 2020 to February 9, 2022:

During the period, the collective market capitalization of FANGAM stocks increased by 21.9%, but they lagged the rest of the US tech sector (up 37%) and non-tech US equities (41.1%). For the first time in more than a decade, the FANGAM stocks are running behind the rest of the market. ÌýBreaking the FANGAM stocks into their constituent parts and charting their performance between August 31, 2020 and February 2022, here is what I get:During this period (8/31/20-2/9/22), three of the FANGAM stocks (Apple, Microsoft and Alphabet) were up strongly, and three (Amazon, Facebook, Netflix) were down. ÌýIn summary, the FANGAM stocksÌýwere up collectively between August 31, 2020, and February 9, 2022, but they lagged the rest of the US equity market, with that underperformance isolated to Amazon, Facebook and Netflix.Ìý

The Numbers

Ìý Ìý Since I last valued the FANGAM stocks in September 2020, there have been sixÌýquarterlyÌýearnings reports from each of these companies, and I report on two key operating measures, revenues and operating income, in the table below, for the last three fiscal years for each of the companies. (Note that four of these companies have calendar year-ends, and two have fiscal years that end mid-year. For the latter, I am reporting on the trailing 12-month numbers, to ensure that I have the calendar year numbers.)

Looking at the percentage changes in revenues and operating income between 2019 and 2021 gives us a measure of how well each of these companies have navigated the currents of the last two years, and they seem to have turned the troubles to their advantage, posting strong compounded annual growth rates in revenues and operating income. These consolidated growthÌýnumbers, though, don't reflect the trend lines over the three years at theseÌýcompanies. Facebook and Netflix stumbled in their mostÌýrecent earnings releases, losing more than a fifth of their market capitalization. With both companies, the user numbers were the basis for the negative surprises, with Facebook reporting its first drop in user number on a quarter-to-quarter basis as a publicÌýcompany and reporting underwhelming subscriber growth. Amazon and Google reported stronger than expected growth in both revenues and operating income, in the most recent quarter, and Microsoft and Apple delivered close to expected numbers.Ìý

The News

Ìý Ìý The FANGAM six, by virtue of their market capitalizations and their presence in our daily lives, have been also among the newsworthy of companies, and a significant portion of the news stories have are only mildly connected to current operating numbers. If I were to summarize the news about these companies in the last eighteen months:

Facebook and Google found themselves in the midst of both the data privacy and political partisanship debates, as politicians and regulators argued about how best to restrict the social media platforms of these companies. Google, notwithstanding a few storms around YouTube, escaped relatively unscathed, but Facebook continued to draw fire from all directions. It is worth noting, though, that Facebook's loss of half a million users in the most recent quarter may have been more attributable to Apple tightening privacy protections on its devices than government action. The most revealing news story about Facebook, though, was its decision to rename itself "Meta", in late October, and Ìýit framed the decision as readying itself for business in the Metaverse. I that the name change was a reflection of management at Facebook coming to the conclusion that its name had become too toxic, from a business perspective, and I did sell my shares in the aftermath. In hindsight, of course, this was a fortuitous decision, since it allowed me to evade the post-earnings collapse in the stock price, but it was definitely more luck than skill.The big stories affecting Netflix were less about the company and more about its competitors, and one of them, in particular, Disney. During this two-year period, Disney doubled down on Disney Plus, its streaming platform, and on content production, spending more than $25 billion on content in 2021. Netflix continued its traditional path of spending immense amounts on content, with content costs reaching $17.7 billion in 2021, but its cost of acquiring users climbed, as the US and European markets matured, and new subscribers in Asia and Latin America, the two geographical areas with the most user growth potential, delivered less revenues per subscriber.Apple and Microsoft, ancient companies by tech standards, continued for the most part to keep their heads down, and stay out of public controversies. In fact, Apple managed to reframe itself as a protector of privacy, putting itself on the right side of that debate, while also inflicting pain on its competitors (see Facebook above). Its new iPhone models rolled out smoothly and to generally positive reviews, a source of immense relief to a company that lives on the revenues from that product. Microsoft continued its long term path of consolidating its core product franchises (Windows and Office) and converting them to subscription businesses (with Office 365), while increasing its cloud business exposure. In the last month, the company made a splash with , in an all-cash deal. While I am not a fan of acquisitions, especially big ones of publicly traded companies, there are some reasons to believe that this deal has a better chance than most of succeeding. First, at close to $70 billion, the deal looks big in absolute terms, but relative to Microsoft's market cap (of $ 2.2 trillion), it is a small deal. Second, I have to weigh in the fact that Microsoft has not been trigger-happy, when it comes to deals, and Satya Nadella has not struck me as an ego-driven CEO, at least in his public interactions. Third, I think that this deal plays into a much bigger end game, for Microsoft, than getting market share in the conventional game platform business. Finally, Activision own internal troubles had led to marking down of its stock price in the months leading into this deal, effectively reducing the actual premium paid. I know that there are some who see this acquisition as an attempt by Microsoft to squeeze Sony and Nintendo, but while that may be a side-product of this deal, I think that Microsoft has a much bigger gaming market, in mind, with much of it online, where it is competing against the other social media giants (Facebook and Google) and online game platform companies (Roblox).ÌýOf the six companies in the group, Amazon is most used to being targeted, for political and social reasons, over its entire lifetime. In addition to the stories about worker exploitation, with anecdotes about d and , there were questions about its competitive practices, albeit often planted by competitors whose only hope of stopping Amazon has become the government. While Jeff Bezos of the company in 2021, his status as one of the richest men in the world, his messy divorce and newfound standing as a globe-trotting celebrity all became news stories about Amazon. It is a testimonial to the succession team that Bezos built at Amazon that the company continued its march towards global dominance, notwithstanding all these distractions.Valuing these FANGAM stocks reinforces the truth that valuing companies can never just be based upon the financials, since all of this news will play out eventually in the valuation stories (and valuations) of these companies.

The FANGAM Valuations: February 2022

In the trading game, where pricing is driven by mood and momentum, earnings reports and news stories are scanned for incremental news, information that ultimately will have little effect on value, but can move prices substantially. That explains the fixation with earnings per share expectations, and why seemingly trivial surprises, where a company beats or falls short of earnings expectations by a few cents can cause the market capitalization of a company to increase or decrease significantly. If you have been reading my posts, it should come as no surprise to you that I believe in intrinsic value, but I also believe that intrinsic value is driven by narrative. To me, the value effect of earnings reports and news stories comes from s for companies. In keeping with that belief, I revisited my narratives for the FANGAM stocks, with the intent of revising these narratives, based upon what we have learned about these companies in the last two years:

Converting these stories into numbers, I revalued the six companies. You can download the full valuations by clicking here (, , , , , ), but the summary of my key assumptions and valuations are below:

(Download full valuations ofÌý,Ìý,Ìý,Ìý,Ìý,Ìý)

At the risk of repeating some of what I have said before, here is what the valuations tell me about these companies, as investments.

Facebook looks the most under valued of the six companies, but one reason is that it seems to have lost its story script. For a decade whether you liked or hated the company, the story that drove its valuation was a simple one: a platform of billions of users, about whom Facebook knew a great deal, and they then used that knowledge to deliver focused advertising. In short, this is a company that has built its business on accessing and using private data, and the privacy backlash seems to have finally led the company to try to redefine itself, first by renaming itself (Meta), and then muddying the waters about its business model. I think that the company is still a profit-generating behemoth, with some of the highest operating margins in American business, but I think that until it finds a cohesive story line, the price recovery will be stilted.Netflix is the most overvalued company in the mix, even after its major price knock down, after the last earnings report. The company has upended the entertainment business and made everyone else in the business play the game their way, but it has always been on a hamster wheel, where its primary sales pitch to investors is its capacity to keep growing its subscriber base, and the only way it can keep doing this is by spending ever-increasing amounts of money of new content. The question of how the company would get off this hamster wheel has always been there, and now that user numbers are starting to slow, and new users are becoming more costly to acquire, the challenge of doing so has become larger.ÌýMicrosoft and Apple have kept their heads low, as the rest of the FANGAM stocks have been buffeted by controversy and blowback. Apple seems to have found a way to be one of the good guys in the privacy battle, and in the process, intentionally or not, it has helped deliver punishment to others (like Facebook) in this rarefied group. For Microsoft, buying Activision advances them further towards becoming a premier platform business, and the company's diverse platforms (Office 365, LinkedIn and now Activision) offer the potential for growth and sustained high margins.Google surprised me the most, delivering high growth and increased margins, suggesting that Facebook’s problems are its own, and that Google continues to steamroll its online advertising competition. The other bets at Google continue to be cash-draining investments that deliver little in value, and after six years, I am not sure that they will be ever be big value creators, but that search box is the gift that keeps on giving.Amazon has, for much of its life, been a Field of Dreams company, offering investors a promise of revenues now, and if they wait patiently, profits in the future. For the first decades of its existence, all that investors saw was revenue growth, but margins remained slim to non-existent. In the last five years, Amazon’s margins have climbed and the company is solidifying its profit pathway, and while regulators and governments will try to rein it in, its mix of businesses and geographies will make it difficult to legislate against.I came into the analysis holding Microsoft, and I will continue to hold it, though it is mildly over valued. If I still had Apple in my portfolio, I would also hold it, but since I don’t own it now, I have to wait for a price dip, and when it comes, I will buy it.ÌýI used to own Facebook, and while I sold it on its name-change, I will be getting back into the stock, at current prices, notwithstanding its muddled story line and near-term troubles, simply because of its cheapness.ÌýOn Amazon, a stock that I have bought and sold four times over the last twenty years, I am glad to add it back to my portfolio.ÌýAs for Google, I have never held it, to my regret, and don't plan to add it on, at the current stock price. Finally, ÌýI just don’t like Netflix, even at depressed prices, since I believe that scaling down content costs, key to the company's future success, has become more difficult, not less, after the entry of Disney into the streaming wars.ÌýNeedless to say, there is the broader question of the overall market, and how inflation will play out this year, but the answer to that question has a bigger effect on my overall asset allocation than on my judgment on whether to buy any of these stocks.
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Valuation SpreadsheetsAmazon Valuation (February 2022)Netflix Valuation (February 2022)Google Valuation (February 2022)Apple Valuation (February 2022)Microsoft Valuation (February 2022)

In the first few weeks of 2022, we have had repeated reminders from the market that risk never goes away for good, even in the most buoyant markets, and that when it returns, investors still seem to be surprised that it is there. Investors all talk about risk, but there seems to be little consensus on what it is, how it should be measured, and how it plays out in the short and long term. In this post, I will start with a working definition of riskt that we can get some degree of agreement about, and then look at multiple measures of risk, both at the company and country level. In closing, I will talk about some of the more dangerous delusions that undercut good risk taking.

What is risk?

In the four decades that I have been teaching finance, I have always started my discussion of risk with a Chinese symbols for crisis, as a combination of danger plus opportunity:

Over the decades, though, I have been corrected dozens of times on how the symbols should be written, with each correction being challenged by a new reader. That said, thinking about risk as a combination of danger and opportunity is both healthy and all encompassing. It also brings home some self-evident truths about risk that we all tend to forget:

Opportunity, without danger, is a delusion: If you seek out high returns (great opportunities), you have to be willing to live with risk (great danger). In fact, almost every investment scam in history, from the South Sea Bubble to Bernie Madoff, has offered investors the alluring combination of great opportunities with no or low danger, and induced by sweet talk, but made blind by greed, thousands have fallen prey.ÌýDanger, without opportunity, is foolhardy: In investing, taking on risk without an expectation of a reward is a road to ruin. If you are investing in a risky project or investment, your expected return should be higher to reflect that risk, even though fate may deliver actual returns that are worse than expected. Note that this common-sense statement leaves lots of details untouched, including how you measure risk and how you convert that risk measure into a higher "expected" or "required" return.It is uncertainty aboutÌýoutcomes, not expected outcomes,Ìýthat comprise risk: In investing, we often make the mistake of assuming that risk comes from expected bad outcomes, when it is uncertainty about this expectation that drives risk. ÌýLet me use two illustrations to bring this home. In my last point on inflation, I noted that a currency with higher inflation can be expected to depreciate over time against a currency with lower inflation. That expected devaluation in the high-inflation currency is not risk, though, since it can and should be incorporated into your forecasts. It is uncertainty about whether and how much that devaluation will be, arising from shifting inflation expectations or market-induced noise, that is risk. In posts spread over many years, , I have also argued against the notion that badly-managed firms are riskier than well-managed ones, and the reason is simple. If a firm is badly managed, and you expect it to remain badly managed, you can and should build in that expectation into your forecasts of that company's earnings and value. Thus, a badly managed firm, where you expect that to be the status quo, will be less risky than a well managed firm, where there is much more uncertainty about management turnover and quality in the future.Risk is in the future, not the past: Risk is always about the future, since the past has already revealed its secrets. That said, many of our perspectives about, and measures of, risk come from looking backwards, using the variability and outcomes of past data as an indicator of risk in the future. That may be unavoidable, but we have to be clear that this practice is built on the presumption that there have been no structural changes in the process being examined, and even if true, that the estimates that come from the past are noisy predictors of the future.ÌýUpside versus Downside Risk: If risk comes from actual outcomes being different from expectations, it is worth noting that those outcomes can come in better than expected (upside) or worse than expected. Since the entire basis of investing in risky assets is to benefit from the upside, it is downside risk that worries us, and in keeping with this perspective, there have to been attempts to derive risk measures that focus only on or more on downside risk. Thus, rather than use the variance in earnings or stock prices as a measure of risk, you compute the semi-variance, drawing on those periods where earnings and returns are less than expected. I think a more sensible path is to measure all risk, upside and downside, and think of good investing as a process of finding investments that have more upside risk than downside risk.As someone who works in, and teaches finance, I am grateful for what the discipline has done to advance the study of risk, but I would be remiss if I did not point out that it has come with some not-so-desirable side effects. One is the tunnel vision that comes from thinking of risk purely in terms of statistical measures, with standard deviation and variance leading the way. Risk is not an abstract statistical concept, but a feeling in the pit of your stomach that emerges when you helplessly watch your portfolio melting down, as markets move in the wrong direction. The other is the dangerous notion that measuring risk is the same as managing that risk and, in some cases, the even more insane view that it removes that risk.

Risk and Hurdle Rates

Ìý Ìý In investing and corporate finance, we have no choice but to come up with measures of risk, flawed though they might be, that can be converted into numbers that drive decisions. In corporate finance, this takes the form of a hurdle rate, a minimum acceptable return on an investment, for it to be funded. In investing, it becomes a required return that you need to make an investment; you buy investments if you believe that you can make returns greater than their expected return and you sell investments if not. In this section, I will begin with a breakdown of risk's many components and use that structure to develop a framework for assessing the risk-adjusted required return on an investment.

The Components of Risk

Ìý Ìý In any investment, there are multiple sources of risk, and listing all of them in a list, with noÌýorganization, can be not only overwhelming but directionless. Once you have identified the risks that you face, it is useful to break that risk down into categories, on three dimensions:As you can see from this table, not all risk is created equal, and understanding which risks to incorporate into your required return, and which risks to ignore/pass through, is the first and perhaps the most important part ofÌýanalyzing risk. WhileÌýyou will face almost every type of risk, no matter what companyÌýthat you choose to value, the risksÌýthat you are most exposed to will vary across firms, and one way of looking at this variation is to look at firms through a corporate life cycle lens:Note that you are more exposed to more risks, when you are looking at young companies, with growth potential, than when analyzing older, more mature firms, and that a greater proportion of risks at young companies are likely to be economic, micro and discrete risks. It is no wonder that investors and analysts who collect more and build bigger models, to value young companies, expecting that they will get better valuations, find frustrations instead. To get from these general risk categories into explicit risk measures and required returns, I adopt a simple structure (perhaps even simplistic), where I accept that I am a price taker when it comes to some risks (interest rates and risk premiums) and focus on the components of risk that companies can change through their choices on business, geography and debt load:Note that in this structure, which yields costs of equity for companies and required returns for equity investors, each component is designed to carry a single burden, with the risk free rate reflecting the currency that you analyzing the company in, the measure of relative risk capturing the risk of the company's business mix and debt load, and the equity risk premium incorporating the risk of the geographies of its operations.

1. Relative Risk Measures

Ìý Ìý Before we embark on how to measure relative risk, where there can be substantial disagreement, let me start with a statement on which there should be agreement. Not all stocks are equally risky, and some stocks are more risky than others, and the objective of a relative risk measure is to capture that relative risk. The disagreements rise in how to measure this relative risk, and risk and return models in finance have tried, with varying degrees of success, to come up with this measure. At the risk of provoking the ire of those who dislike portfolio theory, the most widely model for risk, in practice, is the capital asset pricing model, and beta is the relative risk measure. Embedded in its usage is the assumption that the marginal investors in a stock, i.e., those large investors who set prices with their trading, are diversified, and that you can estimate the "non-diversifiable" risk in a stock, by regressing returns on a stock against a market index.ÌýI believeÌýthat a company's regression beta is anÌýextremely noisy measure of its risk, and mistrust the betas reported on estimation services for that reason. I also believe that it is healthier to estimate the beta for a company by looking at the average of the regression betas of the companies in the sector that it operates in, and adjusting for the financial leverage choices of the company, since increasing dependence on debt also increases the relative risk of the company. As in prior years, I report industry-average betas, cleaned up for debt, , for US companies, and you can sector-average beta for regional and global companies as well. At the start of 2022, the ten sectors (US) with the highest and lowest relative risk (unlettered betas), Ìýare shown below.

Download sector average betas (, )Note the preponderance of financial service firms on the lowest risk ranks, but note also that almost all of them are substantial borrowers, and end up with levered risk levels close to average (one) or above. Technology and cyclical companies dominate raw highest risk rankings.

2. Geographical Risk

Beta measure the macro risk exposure of the businesses that a company operates in, but they are blunt instruments, incapable of capturing either country risk (from operating in the riskiest parts of the world) or discrete risk (from default, nationalization or other events that truncate a company's life). For measuring country risk, I fall back on an approach that I have used for the last three decades to estimate equity risk premiums for countries, where I start with the equity risk premium for the US and then augment that number with a country risk premium, estimated from the default spread for the country:

The equity risk premium for the US is the implied equity risk premium of 4.24%, the process of estimating which I described in an this year. The sovereign ratings for countries are obtained from Moody's and S&P, and the default spread for each ratings class comes from my estimates for the start of 2022. To illustrate, at the start of 2022, India was rated Baa3 by Moody's and the default spread (my estimate) for this rating was 1.87%. I scale that default spread up to reflect the higher volatility in stocks, relative to bonds, and I use 1.16, estimated from as the ratio of historical volatilities in S&P's emerging market stock to the volatility in an emerging bond indices. This approach yields a country risk premium of 2.18% for India, and an equity risk premium of 6.42%, to start 2022:

India's ERP at the start of 2022 = Mature Market ERP + Default Spread for India * Rel Vol of Equity
Ìý ÌýÌýÌýÌý ÌýÌýÌý ÌýÌýÌý ÌýÌýÌý ÌýÌýÌý ÌýÌýÌý ÌýÌýÌý ÌýÌýÌý ÌýÌýÌý ÌýÌýÌý ÌýÌýÌý ÌýÌý = 4.24% + 1.87% (1.16) = 6.42%

Using this approach to the rest of the world, here is what IÌýget at the start of 2022:

It is worth emphasizing the equity risk premium for a company will come from where it operates in the world, not from its country of incorporation. Coca Cola, notwithstanding having its headquarters in Atlanta, has exposure to risk in multiple emerging markets, and its equity risk premium should reflect this exposure. By the same token, Embraer and TCS are global firms that happen to be incorporated in Brazil and India, respectively.

3.ÌýDebt, Default Risk and Hurdle Rates

Ìý Ìý Almost all of the discussion so far has been about equity funding and its costs, but companies do raise funds from debt. While I will use a future post to talk about how debt levels changed in 2022, across the world, I want to talk about the cost of debt in this one. Specifically, the cost of debt for a company is the rate at which it can borrow money, long term, and today, and not the cost of the debt that is already on its books. The build up to a cost of debt is simple:

A company's default spread reflects concerns that lenders have about its capacity to meet its contractual commitments, and it clearly will be a function not only of the level and stability of its earnings, but even of the country in which it is incorporated.

ÌýÌý ÌýAs companies raise money from both debt and equity, they face an overall cost of funding, which will reflect how much of each component they use, and the resulting number is the cost of capital. The picture below illustrates the linkages between the costs of equity and debt, and how as you borrow more, the effects on cost of capital are unpredictable, pushing it down initially as you replace more expensive equity with cheaper debt, but then pushing it up as the negative effects of debt offset its benefits:

Since both the costs of debt and equity start with the riskfree rate, low risk free rates push down both costs. In my last two posts, I noted that the prices of risk have drifted down in markets, with both equity risk premiums and default spreads decreasing through 2021. It should come as no surprise then that at the start of 2022, companies across the globe were looking at costs of capital that are close to their lowest levels, in US $ terms, in decades.

At the start of 2022, the median global company has a cost of capital of 6.33%, in US$ terms, and the median US company has a cost of capital of 5.77%. (To convert these values into other currencies, use the approach that I used in the last post, of adding differential inflation to the number).

Hurdle Rate Delusions

The two biggest forces that drive corporate financial and investor decision making are me-too-ism and inertia. The former (me-too-ism) leads companies to do what others in their peer group are doing, borrowing when they are, paying dividends because they do and even embarking on acquisitions to be part of the crowd. The latter (inertia) results in firms staying with policies and practices that worked for them in the past, on the presumption that they will continue to work in the future. Not surprisingly, both these forces play a role in how companies and investors set hurdle rates. Both individual investors and companies seem to operate under the delusion that hurdle rates should reflect what they want to make on investments, rather than what they need to make. The difference is illustrated every time an equity investor, in this market, posits that he or she will not buy shares in a company, unless he or she can make at least double digit returns, or a company, again in this market, contends that it uses a hurdle rate of 12% or 15%, in deciding whether to take projects. Individual investors who demand unrealistically high returns in a market that is priced to deliver 6-7% returns on stocks will end up holding cash, and many of them have been doing so for the bulk of the last decade. Companies that institute hurdle rates that are too high will be unable to find investments that can deliver higher returns, and will lose out to competitors who have more realistic hurdle rates. In short, companies and investors, demanding double digit returns, have to decide whether they want to remain delusional and be shut out of markets, or recalibrate their expectations to reflect the world we live in.Ìý

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Datasets

Betas by Sector (,Ìý,Ìý,Ìý,Ìý)Costs of Capital by Sector (, , , , )

ÌýÌý ÌýInflation numbers have been coming in high now, for more than a year, but for much of the early part of 2021, bankers, investors and politicians seemed to be either in denial or casually dismissive of its potential for damage. Initially, the high inflation numbers were attributed to the speed with the economy was recovering from COVID, and once that excuse fell flat, it was the supply chain that was help responsible. By the end of 2021, it was clear that this bout of inflation was not as transient a phenomenon as some had made it out to be, and the big question leading in 2022, for investors and markets, is how inflation will play out during the year, and beyond, and the consequences for stocks, bonds and currencies.

Inflation: Measurement and Determinants

ÌýÌý ÌýAs the inflation debate was heating up in the middle of last year, I wrote a on how inflation is measured, what causes it and how it affects returns on different asset classes. Rather than repeat much of that post, let me summarize my key points.

Measuring inflation is not as simple as it looks, and measures of inflation can vary depending on the basket of good/services used, the perspective adopted (consumer, producer, GDP deflator) and the sampling used to collect prices. That said, the three primary inflation indices in the US, the CPI, the PPI and the GDP deflator all told the same story in 2021:Download historical inflation numbers
The inflation rate during the course of the year reached levels not seen in close to 40 years, with every price index registering a surge.While news stories focus on reported (and past0 inflation, it is expected inflation that should drive investment, and measures of these expectations can come from surveys of consumers (University of Michigan) or from the market, as the difference between the treasury bond rate and the inflation-protected treasury bond, of equivalent maturity:Download data
Using the ten-year bond, it is clear that while inflation expectations have inched up in the bond market, but that rise is far more muted than in the actual inflation indices, and consumer expectations of inflation now significantly exceed the bond-market imputed estimate for expected inflation.While the implied inflation in bond rates is low, investors seem to be anticipating higher inflation. Using a measure that the Federal Reserve has developed, I report the percent of investors expecting inflation to be greater than 2.5%, representing one end of the inflation expectation spectrum, and those expecting deflation, representing the other, in the graph below:Download dataAs you can see the 93.96% of investors were expecting inflation to be greater than 2.5%, by the end of December 2021, up from 6.74% in December 2020, suggesting a sea change in the market. Conversely, the percent of investors expecting deflation has dropped to a vanishing low number, suggesting that has little company, in her contention that deflation is the real danger to markets and economies.The undeniable fact is that inflation came back in 2021, but the question of why it happened, and whether it will stay high, is Ìýhotly debated. To those who believe that it is a spike that will dissipate over time, it is another casualty of COVID, as a combination of virus-driven supply chain issues and government spending to offset shutdowns has driven prices up. In this mostly benign story, inflation will go back down, once these pressure ease, though it is unclear to what level. To others, and especially those old enough to remember the 1970s, it does seem like a return to more unsettled times, with potentially dangerous consequences for the economy and markets.

Interest Rates and Inflation

ÌýÌý ÌýInflation and interest rates are intertwined, and when their paths deviate, as they sometimes do, there is always a reckoning. While we have increasingly given central banks primacy in discussions of interest rates, it that markets set rates, and while central banks can nudge market expectations, they cannot alter them. Put simply, no central bank, no matter how powerful, can force market interest rates down, if inflation expectations stay low, or up, if investor are anticipating high inflation.Ìý

US Treasuries: A Mostly Uneventful Year

Ìý Ìý After a turbulent year in 2020, when COVID shut the global economy down, and interest rates plunged and stayed down for the rest of the year, 2021 was a more settledÌýyear, with long term rates rising gradually over the course of the year, but short terms rates staying put:

Treasury Rates Data

While treasury bills continued to yield rates close to zero, rates increased for longer term treasuries, with 2-10 years rates rising much more than rates on the longest term treasuries (20-year to 30-year). For those who track the slope of the yield curve, and I am not one of those who believes that it has much predictive power, it was a confusing year. The treasury curve became steeper, but only at the shortest end of the spectrum, with the slope rising for the 2-year, relative to the 3-month, but not at all, when comparing the 10-year to the 2-year rate. Beyond the 10-year maturity, the slope of the yield curve actually flattened out, with the difference between the 30-year rate and the 10-year rate declining by 0.34%.

Corporate Bonds: No Shortage of Risk Capital

ÌýÌý ÌýIn my last post, I chronicled the movement in the equity risk premium, i.e. the price of risk in the equity market, during 2021, but the bond market has its own, and more measurable, price of risk in the form of corporate default spreads. Using bond ratings classes to categorize companies, based upon credit risk, I looked at the movement of default spreads during 2021:

Download data

Corporate default spreads decrease across ratings classes, but the decline is much larger for lower rated bonds, with the default spread on high yield bonds registering a drop of 1.25%. Note that the decrease in default spreads, at least for the lower ratings, mirrors the drop in the implied equity risk premium during the course of 2021. Read together, it suggests that continued to not just stay in the game, but increased its stake during the course of the year, extending a decade-long run.

Expected Inflation, Interest Rates and Bond Returns

Ìý Ìý While day to day movements in interest rates are driven by multiple forces, including the latest and investor sentiment, the longer term and drivers of interest rates are fundamental. In particular, if you start by breaking down a long term riskfree rate (like the 10-year treasury bond) into an expected inflation and an expected real interest rate components, you can also reconstruct an intrinsic risk free rate by assuming that the real growth in the economy is a stand-in for the real interest rate and that most investors form expectations of future inflation by looking at the inflation in the most recent year(s):

Download data

In this picture, ythe actual ten-year treasury bond rate is superimposed against a rough measure of the intrinsic risk free rate (obtained by adding together the actual inflation rate and real growth rate each year) and a smoothed out version (where I used the average inflation rate and real growth rate over the previous ten years). Not only has the intrinsic risk free rate moved in sync with the ten-year bond rate for most of the last seven decades, but you can also see that the main reason why rates have been low for the last decade is not the Fed, with all of its quantitative easing machinations, but a combination of low growth and low inflation. Coming into 2022, though, the intrinsic risk free rate is clearly running ahed of the ten-year treasury bond rate, and if history is any guide, that gap will close either with a rise in the treasury bond rate or a decline in the risk free rate (coming from a recession or a rapid drop off in inflation).Ìý

Unexpected Inflation and Asset Returns

Ìý Ìý Note that it isÌýexpected inflation that drives interest rates, and that the actual inflation rate can come in above or belowÌýexpectations. In my post on inflation last year, I drew a contrast between expected and unexpected inflation, arguing that financial assets are affected differently by each component. If expected inflation is high, but it is predictable, investors and businesses have the opportunity to incorporate that inflation into their decision making, with investors demanding higher interest rates on bond and expected returns on stocks, and businesses raising prices on their products/services to cover expected inflation. Unexpected inflation is what catches us off guard, with unexpectedly high inflation leading to a reassessment of pricing (for all financial assets) and an uneven impact across businesses, leaving those with pricing power in a better position than those without that power.Ìý

Ìý Ìý To assess how inflation hasÌýaffected asset returns over time, I broke down the actual inflation rates since 1954Ìýinto expected and unexpected components eachÌýyear, using a brute forceÌýassumption that the average inflation rate over the last ten years is the expected inflation rate. (In the last two decades, we have had access to more sophisticated measures of expected inflation, including the difference between the nominalÌýtreasury bond and TIPs rates,Ìýbut not in earlier years). In the graph below, I look at annual returns on stocks, treasury bonds and corporate bonds, with the unexpected inflation numbers also shown:

There are a few aspects of this graph that stand out. With my crude measure of inflation expectations, it looks like it takes time for inflation expectations to shift, during periods of higher or lower inflation, as can be seen in the extended stretches of higher than expected inflation, in the 1970s, and lower than expected inflation in the 1980s.Ìý
ÌýÌý ÌýWhile it is not immediately visible in the graph, returns on stocks and bonds are affected by unexpected inflation, and to illustrate by how much, I broke the 94 years of data into five quartiles, based upon the level of unexpected inflation, with the lowest (highest) quintile representing the years when inflation came in most below (above) expectations, and estimated the annual returns (nominal and real) for stocks, treasuries and corporate bonds in the table below:
With treasuries and corporates, the returns generally get worse, as inflation comes in above expectations, with real returns showing the damage from unexpected inflation.ÌýWith equities, the sweet spot in terms of returns is when inflation is at or below expectations, and the worst scenarios are when inflation comes in well above expectations. ÌýI also looked at how inflation plays out on equity sub-groupings, on two dimensions, the first being market capitalization and the second being price to book, with the former becoming a stand-in for the vaunted small cap premium and the latter for the value versus growth question.
Over much of the last century, small cap stocks have done better than large cap stocks, when inflation has come in well above expectations, perhaps providing some insight into why the vaunted small cap premium seems have to disappeared over the last two decades of muted inflation. Similarly, the value effect, computed as the premium (or discounted) return earned by low price to book stocks over high price to book, becomes more pronounced during periods when inflation is greater than expected and much less so, during periods when inflation is lower than anticipated.Ìý ÌýÌýUsing the same approach with gold and real estate, with the caveat that historical data on the former is more limited, I get the following results:While gold and real estate both do better than financial assets, when inflation is greater than expected, there is also a clear difference between the two investment classes. Real estate operates more as a neutral hedge, delivering returns that are, for the most part, unscathed by unexpectedly high inflation, but gold is a bet on inflation, delivering the highest returns, when inflation is much greater than expected, and negative returns, when it is lower than expected. Much as I would like to extend this analysis to newer investment classes, there is not enough historical data on crypto currencies or NFTs to allow for the analysis. As I noted in , though, the early evidence is not promising for these new investment categories, at least as inflation and crisis hedges, since they have behaved more like risky equities, at least on a day-to-day basis and during the 2020 crisis, than like gold.
Inflation and CurrenciesÌý Ìý Much of this post has been about inflation in the US, and by extension, in US dollar terms, it is worth emphasizing that inflation is a currency-specificÌýphenomenon. While inflation in the US dollar, by dint of its status as the currencyÌýin which commodities are priced, can sometimes spill over into other currencies, it remains true thatÌýyou can have highÌýinflation in one currency, while there is low inflation in other currencies. Inflation differences across currencies play out in two domains, with the first being interest rates in different currencies and the other being exchange rate.ÌýÌý Ìý
Interest Rates across CurrenciesÌý Ìý I start every one of my discussions of discount rates with a truism, by stating that the riskfree rate thatÌýyou start with should reflect theÌýcurrency in which you have decided to do your valuation. That then becomes the springboard for estimating risk free rates in different currencies,Ìýfollowing one of two paths. In the first, you start with government bond rates in the local currency, in different currencies, andÌýadjust those rates for default risk in the local currencyÌýgovernment bond. (Government bonds in localÌýcurrencies do default, andÌýaccount for aÌýsignificantÌýproportion ofÌýsovereign defaults in the last 50 years). MyÌýestimates forÌýthe start of 2022 for the currencies where local-currency government bonds are available is below:
Riskfree rates are highest inÌýcurrencies, like the Zambian Kwacha or Turkish Lira, where inflation is highest, lower in low-inflation currencies and evenÌýnegative in currencies, where deflation may be the long term prediction.ÌýI am using the default spreads based upon the local currency sovereign ratings for the countries in question, with the government bond rate being the risk free rate only for currencies where the issuingÌýgovernment in triple-A rated. If you dislike this assumption, or do not believe that theÌýgovernment bond rate is a market-set number in a particular market, there is a second approach, where you start with the risk free rate in US dollar or Euros, and adjust it for differential inflation, i.e., the difference inÌýexpected inflation between the US and the countryÌýin question:Thus, if the US treasury bond rate is 1.5%, and expected inflation rates in the US and Indonesia are 1% and 4% respectively, the approximate riskfree rate in Indonesian Rupiah will be 4.5% (=1.5% + (4%-1%)) and the more precise riskfree rate in Rupiah will be 4.52% (=1.015*(1.04/1.01)-1). While the expected inflation rate in dollars may be an easy get, it is more difficult to get expected inflation rates in other currencies, but the IMF has estimates for the next five years .
Exchange RatesÌý Ìý Just asÌýinterest rates in currencies areÌýdetermined, in large part, by inflationÌýdifferentials,Ìýexchange rates over time are also driven by those same inflationÌýdifferentials. Drawing onÌýone of the oldest relationships in exchange rates, purchasing power parity, you can extract the forward exchange rate in a currency:
Thus, currencies with higher inflation can be expected currency devaluation over time, relative to currencies with lower inflation. As with interest rates, in the short term, there are forces, ranging from central banking intervention to momentum and speculation, that can cause rates to deviate from the inflation script, but in the long term, it is almost impossible to break the cycle.Ìý Ìý Connecting this linkage to the discussion of US inflation in the prior sections, here are the takeaways. If you believe that inflation will stay high, not just in theÌýUS, butÌýacross the globe, the exchange rate effects will be muted. If, on the other hand, you believe that the inflation shock will vary across countries, your actions will be more nuanced. For the countries where you believe that local inflation will decrease, relative to the US, Ìýthe US dollar will weaken against their currencies, augmenting returns you will earn in their markets (stock or bond). For countries, where you see local inflationÌýsurging more than you expect to see in the US, the US dollar willÌýstrengthen against their currencies, reducing the returns youÌýmake in their markets. As with the discussion of asset returns, it is not expected inflation that is the source of exchange rate risk, since you canÌýincorporate those expectations into exchange rates, but unexpected inflation, which, when extreme, can cause significant revaluations ofÌýcurrencies.Ìý

ConclusionÌý Ìý As with any historical data assessment, I could give you the standardÌýboilerplate disclaimer that past performance is not always a good predictor of the past, but to the extent that the past provides signals, your expectations of how inflation will play out in theÌýcoming year will play a key role inÌýyourÌýasset allocation and stock selection decisions. If you believe that last year's surge in inflation is a precursor to a long time period when inflation is likely to stay high, and comeÌýin above expectations, you should be shifting yourÌýholdings away from financial to real assets, andÌýwithin your equityÌýholdings, towards small cap stocks, Ìýstocks trading at lower pricing multiples (PE, Price to Book) and companies with more pricing power. If, on the other hand, you believe that inflation worries are overdone, and that there will be a reversion back to the low inflation that we have seen in the last decade, staying invested in stocks, and especially in larger cap and high growth stocks, even if richly priced, makes sense.
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ÌýÌý ÌýInflation numbers have been coming in high now, for more than a year, but for much of the early part of 2021, bankers, investors and politicians seemed to be either in denial or casually dismissive of its potential for damage. Initially, the high inflation numbers were attributed to the speed with the economy was recovering from COVID, and once that excuse fell flat, it was the supply chain that was help responsible. By the end of 2021, it was clear that this bout of inflation was not as transient a phenomenon as some had made it out to be, and the big question leading in 2022, for investors and markets, is how inflation will play out during the year, and beyond, and the consequences for stocks, bonds and currencies.

Inflation: Measurement and Determinants

ÌýÌý ÌýAs the inflation debate was heating up in the middle of last year, I wrote a on how inflation is measured, what causes it and how it affects returns on different asset classes. Rather than repeat much of that post, let me summarize my key points.

Measuring inflation is not as simple as it looks, and measures of inflation can vary depending on the basket of good/services used, the perspective adopted (consumer, producer, GDP deflator) and the sampling used to collect prices. That said, the three primary inflation indices in the US, the CPI, the PPI and the GDP deflator all told the same story in 2021:Download historical inflation numbers
The inflation rate during the course of the year reached levels not seen in close to 40 years, with every price index registering a surge.While news stories focus on reported (and past0 inflation, it is expected inflation that should drive investment, and measures of these expectations can come from surveys of consumers (University of Michigan) or from the market, as the difference between the treasury bond rate and the inflation-protected treasury bond, of equivalent maturity:Download data
Using the ten-year bond, it is clear that while inflation expectations have inched up in the bond market, but that rise is far more muted than in the actual inflation indices, and consumer expectations of inflation now significantly exceed the bond-market imputed estimate for expected inflation.While the implied inflation in bond rates is low, investors seem to be anticipating higher inflation. Using a measure that the Federal Reserve has developed, I report the percent of investors expecting inflation to be greater than 2.5%, representing one end of the inflation expectation spectrum, and those expecting deflation, representing the other, in the graph below:Download dataAs you can see the 93.96% of investors were expecting inflation to be greater than 2.5%, by the end of December 2021, up from 6.74% in December 2020, suggesting a sea change in the market. Conversely, the percent of investors expecting deflation has dropped to a vanishing low number, suggesting that has little company, in her contention that deflation is the real danger to markets and economies.The undeniable fact is that inflation came back in 2021, but the question of why it happened, and whether it will stay high, is Ìýhotly debated. To those who believe that it is a spike that will dissipate over time, it is another casualty of COVID, as a combination of virus-driven supply chain issues and government spending to offset shutdowns has driven prices up. In this mostly benign story, inflation will go back down, once these pressure ease, though it is unclear to what level. To others, and especially those old enough to remember the 1970s, it does seem like a return to more unsettled times, with potentially dangerous consequences for the economy and markets.

Interest Rates and Inflation

ÌýÌý ÌýInflation and interest rates are intertwined, and when their paths deviate, as they sometimes do, there is always a reckoning. While we have increasingly given central banks primacy in discussions of interest rates, it that markets set rates, and while central banks can nudge market expectations, they cannot alter them. Put simply, no central bank, no matter how powerful, can force market interest rates down, if inflation expectations stay low, or up, if investor are anticipating high inflation.Ìý

US Treasuries: A Mostly Uneventful Year

Ìý Ìý After a turbulent year in 2020, when COVID shut the global economy down, and interest rates plunged and stayed down for the rest of the year, 2021 was a more settledÌýyear, with long term rates rising gradually over the course of the year, but short terms rates staying put:

Treasury Rates Data

While treasury bills continued to yield rates close to zero, rates increased for longer term treasuries, with 2-10 years rates rising much more than rates on the longest term treasuries (20-year to 30-year). For those who track the slope of the yield curve, and I am not one of those who believes that it has much predictive power, it was a confusing year. The treasury curve became steeper, but only at the shortest end of the spectrum, with the slope rising for the 2-year, relative to the 3-month, but not at all, when comparing the 10-year to the 2-year rate. Beyond the 10-year maturity, the slope of the yield curve actually flattened out, with the difference between the 30-year rate and the 10-year rate declining by 0.34%.

Corporate Bonds: No Shortage of Risk Capital

ÌýÌý ÌýIn my last post, I chronicled the movement in the equity risk premium, i.e. the price of risk in the equity market, during 2021, but the bond market has its own, and more measurable, price of risk in the form of corporate default spreads. Using bond ratings classes to categorize companies, based upon credit risk, I looked at the movement of default spreads during 2021:

Download data

Corporate default spreads decrease across ratings classes, but the decline is much larger for lower rated bonds, with the default spread on high yield bonds registering a drop of 1.25%. Note that the decrease in default spreads, at least for the lower ratings, mirrors the drop in the implied equity risk premium during the course of 2021. Read together, it suggests that continued to not just stay in the game, but increased its stake during the course of the year, extending a decade-long run.

Expected Inflation, Interest Rates and Bond Returns

Ìý Ìý While day to day movements in interest rates are driven by multiple forces, including the latest and investor sentiment, the longer term and drivers of interest rates are fundamental. In particular, if you start by breaking down a long term riskfree rate (like the 10-year treasury bond) into an expected inflation and an expected real interest rate components, you can also reconstruct an intrinsic risk free rate by assuming that the real growth in the economy is a stand-in for the real interest rate and that most investors form expectations of future inflation by looking at the inflation in the most recent year(s):

Download data

In this picture, ythe actual ten-year treasury bond rate is superimposed against a rough measure of the intrinsic risk free rate (obtained by adding together the actual inflation rate and real growth rate each year) and a smoothed out version (where I used the average inflation rate and real growth rate over the previous ten years). Not only has the intrinsic risk free rate moved in sync with the ten-year bond rate for most of the last seven decades, but you can also see that the main reason why rates have been low for the last decade is not the Fed, with all of its quantitative easing machinations, but a combination of low growth and low inflation. Coming into 2022, though, the intrinsic risk free rate is clearly running ahed of the ten-year treasury bond rate, and if history is any guide, that gap will close either with a rise in the treasury bond rate or a decline in the risk free rate (coming from a recession or a rapid drop off in inflation).Ìý

Unexpected Inflation and Asset Returns

Ìý Ìý Note that it isÌýexpected inflation that drives interest rates, and that the actual inflation rate can come in above or belowÌýexpectations. In my post on inflation last year, I drew a contrast between expected and unexpected inflation, arguing that financial assets are affected differently by each component. If expected inflation is high, but it is predictable, investors and businesses have the opportunity to incorporate that inflation into their decision making, with investors demanding higher interest rates on bond and expected returns on stocks, and businesses raising prices on their products/services to cover expected inflation. Unexpected inflation is what catches us off guard, with unexpectedly high inflation leading to a reassessment of pricing (for all financial assets) and an uneven impact across businesses, leaving those with pricing power in a better position than those without that power.Ìý

Ìý Ìý To assess how inflation hasÌýaffected asset returns over time, I broke down the actual inflation rates since 1954Ìýinto expected and unexpected components eachÌýyear, using a brute forceÌýassumption that the average inflation rate over the last ten years is the expected inflation rate. (In the last two decades, we have had access to more sophisticated measures of expected inflation, including the difference between the nominalÌýtreasury bond and TIPs rates,Ìýbut not in earlier years). In the graph below, I look at annual returns on stocks, treasury bonds and corporate bonds, with the unexpected inflation numbers also shown:

There are a few aspects of this graph that stand out. With my crude measure of inflation expectations, it looks like it takes time for inflation expectations to shift, during periods of higher or lower inflation, as can be seen in the extended stretches of higher than expected inflation, in the 1970s, and lower than expected inflation in the 1980s.Ìý
ÌýÌý ÌýWhile it is not immediately visible in the graph, returns on stocks and bonds are affected by unexpected inflation, and to illustrate by how much, I broke the 94 years of data into five quartiles, based upon the level of unexpected inflation, with the lowest (highest) quintile representing the years when inflation came in most below (above) expectations, and estimated the annual returns (nominal and real) for stocks, treasuries and corporate bonds in the table below:
With treasuries and corporates, the returns generally get worse, as inflation comes in above expectations, with real returns showing the damage from unexpected inflation.ÌýWith equities, the sweet spot in terms of returns is when inflation is at or below expectations, and the worst scenarios are when inflation comes in well above expectations. ÌýI also looked at how inflation plays out on equity sub-groupings, on two dimensions, the first being market capitalization and the second being price to book, with the former becoming a stand-in for the vaunted small cap premium and the latter for the value versus growth question.
Over much of the last century, small cap stocks have done better than large cap stocks, when inflation has come in well above expectations, perhaps providing some insight into why the vaunted small cap premium seems have to disappeared over the last two decades of muted inflation. Similarly, the value effect, computed as the premium (or discounted) return earned by low price to book stocks over high price to book, becomes more pronounced during periods when inflation is greater than expected and much less so, during periods when inflation is lower than anticipated.Ìý ÌýÌýUsing the same approach with gold and real estate, with the caveat that historical data on the former is more limited, I get the following results:While gold and real estate both do better than financial assets, when inflation is greater than expected, there is also a clear difference between the two investment classes. Real estate operates more as a neutral hedge, delivering returns that are, for the most part, unscathed by unexpectedly high inflation, but gold is a bet on inflation, delivering the highest returns, when inflation is much greater than expected, and negative returns, when it is lower than expected. Much as I would like to extend this analysis to newer investment classes, there is not enough historical data on crypto currencies or NFTs to allow for the analysis. As I noted in , though, the early evidence is not promising for these new investment categories, at least as inflation and crisis hedges, since they have behaved more like risky equities, at least on a day-to-day basis and during the 2020 crisis, than like gold.
Inflation and CurrenciesÌý Ìý Much of this post has been about inflation in the US, and by extension, in US dollar terms, it is worth emphasizing that inflation is a currency-specificÌýphenomenon. While inflation in the US dollar, by dint of its status as the currencyÌýin which commodities are priced, can sometimes spill over into other currencies, it remains true thatÌýyou can have highÌýinflation in one currency, while there is low inflation in other currencies. Inflation differences across currencies play out in two domains, with the first being interest rates in different currencies and the other being exchange rate.ÌýÌý Ìý
Interest Rates across CurrenciesÌý Ìý I start every one of my discussions of discount rates with a truism, by stating that the riskfree rate thatÌýyou start with should reflect theÌýcurrency in which you have decided to do your valuation. That then becomes the springboard for estimating risk free rates in different currencies,Ìýfollowing one of two paths. In the first, you start with government bond rates in the local currency, in different currencies, andÌýadjust those rates for default risk in the local currencyÌýgovernment bond. (Government bonds in localÌýcurrencies do default, andÌýaccount for aÌýsignificantÌýproportion ofÌýsovereign defaults in the last 50 years). MyÌýestimates forÌýthe start of 2022 for the currencies where local-currency government bonds are available is below:
Riskfree rates are highest inÌýcurrencies, like the Zambian Kwacha or Turkish Lira, where inflation is highest, lower in low-inflation currencies and evenÌýnegative in currencies, where deflation may be the long term prediction.ÌýI am using the default spreads based upon the local currency sovereign ratings for the countries in question, with the government bond rate being the risk free rate only for currencies where the issuingÌýgovernment in triple-A rated. If you dislike this assumption, or do not believe that theÌýgovernment bond rate is a market-set number in a particular market, there is a second approach, where you start with the risk free rate in US dollar or Euros, and adjust it for differential inflation, i.e., the difference inÌýexpected inflation between the US and the countryÌýin question:Thus, if the US treasury bond rate is 1.5%, and expected inflation rates in the US and Indonesia are 1% and 4% respectively, the approximate riskfree rate in Indonesian Rupiah will be 4.5% (=1.5% + (4%-1%)) and the more precise riskfree rate in Rupiah will be 4.52% (=1.015*(1.04/1.01)-1). While the expected inflation rate in dollars may be an easy get, it is more difficult to get expected inflation rates in other currencies, but the IMF has estimates for the next five years .
Exchange RatesÌý Ìý Just asÌýinterest rates in currencies areÌýdetermined, in large part, by inflationÌýdifferentials,Ìýexchange rates over time are also driven by those same inflationÌýdifferentials. Drawing onÌýone of the oldest relationships in exchange rates, purchasing power parity, you can extract the forward exchange rate in a currency:
Thus, currencies with higher inflation can be expected currency devaluation over time, relative to currencies with lower inflation. As with interest rates, in the short term, there are forces, ranging from central banking intervention to momentum and speculation, that can cause rates to deviate from the inflation script, but in the long term, it is almost impossible to break the cycle.Ìý Ìý Connecting this linkage to the discussion of US inflation in the prior sections, here are the takeaways. If you believe that inflation will stay high, not just in theÌýUS, butÌýacross the globe, the exchange rate effects will be muted. If, on the other hand, you believe that the inflation shock will vary across countries, your actions will be more nuanced. For the countries where you believe that local inflation will decrease, relative to the US, Ìýthe US dollar will weaken against their currencies, augmenting returns you will earn in their markets (stock or bond). For countries, where you see local inflationÌýsurging more than you expect to see in the US, the US dollar willÌýstrengthen against their currencies, reducing the returns youÌýmake in their markets. As with the discussion of asset returns, it is not expected inflation that is the source of exchange rate risk, since you canÌýincorporate those expectations into exchange rates, but unexpected inflation, which, when extreme, can cause significant revaluations ofÌýcurrencies.Ìý

ConclusionÌý Ìý As with any historical data assessment, I could give you the standardÌýboilerplate disclaimer that past performance is not always a good predictor of the past, but to the extent that the past provides signals, your expectations of how inflation will play out in theÌýcoming year will play a key role inÌýyourÌýasset allocation and stock selection decisions. If you believe that last year's surge in inflation is a precursor to a long time period when inflation is likely to stay high, and comeÌýin above expectations, you should be shifting yourÌýholdings away from financial to real assets, andÌýwithin your equityÌýholdings, towards small cap stocks, Ìýstocks trading at lower pricing multiples (PE, Price to Book) and companies with more pricing power. If, on the other hand, you believe that inflation worries are overdone, and that there will be a reversion back to the low inflation that we have seen in the last decade, staying invested in stocks, and especially in larger cap and high growth stocks, even if richly priced, makes sense.
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Leading into 2021, the big questions facing investors were about how quickly economies would recover from COVID, with the assumption that the virus would fade during the year, and the pressures that the resulting growth would put on inflation. In a , I argued that while stocks entered the year at elevated levels, especially on historic metrics (such as PE ratios), they were priced to deliver reasonable returns, relative to very low risk free rates (with the treasury bond rate at 0.93% at the start of 2021). At the start of 2022, it feels like Groundhog Day, with the same questions about economic growth and inflation looming for the year, and the same judgment about stocks, i.e., that they look expensive. In this post, I will begin with a historical assessment of stock returns in the recent past, then move on to evaluate the returns that investors can expect to make, given how they are priced at the start of 2022, and end with a do-it-yourself valuation of the index right now.

The year that was....Ìý

Ìý Ìý If equity markets surprised us with their resilience in 2020, not just weathering a pandemic for the ages, but prospering in its midst, US equity markets, in particular, managed to find light even in the darkest news stories, and continued their rise through 2021. Foreign markets, though, had a mixed year, and that divergence is worth noting, since it may provide clues to what may be coming in the next year.

US Equities, in the aggregate

Ìý ÌýUS equities had a good year, by any measure, with the S&P 500 rising from 3756 at the start of 2021 to end the year at 4766, an increase of 26.90%. While that followed another good year for stocks in 2020, with the index rising 16.25%, from 3231 to 3756, the index took different pathways during the two years:

In 2020, the market was up, but only after it absorbed the after-shocks of the inception of the virus in February and March of 2020. In 2021, the index had a smoother ride, up in nine of twelve months, with only September qualifying a significant drop (with the index down 4.75%). When you augment this price change with the dividends on the index during 2021, the total return on the S&P 500 for 2021 was 28.47%. I report a , and to put 2021 in context, I looked at the historical returns on the index:
Looking at the 94 years in this dataset, the returns in 2021 would have ranked 20th on the list, good, but not exceptional. Note, though, that 2021 is the third consecutive year of very good returns on the index, with 2019 delivering 31.21%, and 2020 generating 18.02%, and that the cumulative return over the three years (2019-21) is 98.95%. If you compute cumulative returns, on a rolling three-year time period (1928-30, 1929-31, 1930-32 etc.), the 2019-21 time period would rank 8th on the list of 92 3-year time periods. The table below provides the rankings for returns over 5-year and 10-year periods, and where the most recent three-year, five-year and ten-year cumulative returns would rank on the list:

In sum, if you have money to invest over the last decade, and you stayed invested, you should count yourself as lucky to have enjoyed one of the great market runs of the last century. Conversely, if you stayed out of the market, for the last decade, you would have committed one of the great investing mistakes of all time, and blaming the Fed or bubble-talk will not bring you absolution.

US Equities, by sub-group

Ìý Ìý It has always true that when markets move, up or down, not all sectors and sub-groups are treated equally. I do believe that too much is often made of these differences, as it is generally more the rule than the exception that markets, when they are up strongly, get the bulk of that rise from a small sub-set of stocks or sectors. Using S&P's sector classification, I take a look at how each one did in 2022, looking at the percent changes in market capitalization:

In contrast to 2020, when technology and consumer discretionary firms ran well ahead of the pack, the best performing sectors in 2021 were energy and real estate, two of the biggest laggards in 2020. That can be viewed as vindication, at least in this year, for contrarians, but as a cautionary note for ESG advocates, who assumed that fossil fuel companies were on a death march, based upon their performance over the last decade.

There is no debate more likely to draw heat than the value versus growth debate, and at the risk of being labeled simplistic by value investors, I looked at returns on companies, in 2021, based upon their PE ratios at the start of 2021:

Unlike 2020, where high PE stocks beat low PE stocks decisively, the results in 2021 were mixed, with no clear patterns across the classes. The results are similar if you break stocks down based upon price to book ratios or revenue growth rates. Finally, and in keeping with my fixation on corporate age and life cycles, I broke companies down by company age (measured from the founding year):
Again, unlike 2020, when young companies delivered significantly higher returns than older companies, the best returns in 2021 were delivered by middle aged companies.

For the rest of the world

Ìý ÌýWhile US equities continued to set new highs in 2021, the picture in the rest of the world was not as rosy, as you can see in the table below (with percent returns in US dollar terms):

In US dollar terms, India had the best-performing market in 2021, following a strong 2020, but China, the best performer in the world in 2020 came back to earth in 2021. North America (US and Canada) outperformed the globe, but Latin America was the worst performing region, down more than 20% in US dollar terms. There are many reasons why markets diverge, but here againÌýthe contrast with 2020 is worth drawing. In 2020, the COVID crisis played out across markets, increasing the co-movement andÌýcorrelation across developed markets,Ìýwith the US, Europe and Japan moving mostly in sync. In 2021, you saw a return to more normal times, with markets in each country affected more by local factors.

The Price of Risk in Equity Markets

Ìý Ìý The allure of having the historical data that we do in financial markets, especially in the United States, is that there is information in the past. The danger of poring over this historical data is that a focus on the past can blind us to structural changes in markets that can make the future very different from the past. To get a measure of what equity markets are offering in terms of expected returns, we are better served with a forward-looking andÌýdynamic measure of these returns, and that is the focus of this section.

Implied Equity Risk Premiums

Ìý ÌýTo understand the intuition behind the implied equity risk premium, it is easiest to start with the concept of a yield to maturity on a bond, computed as the discount rate that makes the present value of the cash flows on the bond (coupons, during the bond's lifetime, and face value, at maturity) equal to the price of the bond. With equities, the cash flows take the form of dividends and buybacks, and in addition to estimating them using future growth rates, you have to assume that they continue in perpetuity. In computing this implied equity risk premium for the S&P 500, I start with the dividends and buybacks on the stocks in the index in the most recent year (which is known) and assume that they grow at the rate that analysts who follow the index are projecting for the next five years. Beyond the fifth year, I make the simplifying assumption that earnings growth will converge on the nominal growth rate of the economy, .Ìý

If you set the present value of the expected cash flows equal to the index level today, and solve for a discount rate (you may need to use the solver function in Excel, or trial and error), the resulting number is the expected return on stocks, based upon how stocks are priced today, and expected cash flows. This approach is built on the proposition that the intrinsic value of stocks is the present value of the expected cash flows that you generate in perpetuity, from holding these stocks, but it is model agnostic. Put simply, it does not require that you believe in any risk and return model in finance, since it is based on price and expected cash flows. To the critique that analysts can over estimate future earnings and Ìýgrowth, the response is that even if they do (and there is no evidence that top-down forecasts are biased), it is the price of risk, given expected cash flows.

The Implied ERP - Start of 2022

I have computed the implied equity risk premium at the start of every month, since September 2008, and during crisis periods, I compute it every day. ÌýOver the course of 2021, as the index rose, risk free rates climbed and analysts got much more upbeat about expected earnings for the next three years, the equity risk premium drifted down, to end the year at 4.24%:

Much as I would love to claim that I have the estimated the equity risk premium to the second decimal point, the truth is that there is some give in these numbers and that changing assumptions about earnings and cash flows generates an equity risk premium between 4-5%. The contrast between the behavior f equity risk premiums in 2020 and 2021 are in the picture below, where I show my (daily) estimates of ERP during 2020 on the left, and my (monthly) estimates of ERP for 2021 on the right.Ìý

During 2020, the equity risk started the year at about 4.7%, spiraled to almost 8% on March 23, 2020, before reverting back quickly to pre-crisis levels by September 2020. During 2021, you saw equity risk premiums revert back to a more sedate path, with numbers staying between 4% and 5% through the course of the entire year.

Historical Perspective

Ìý Ìý As talk of a bubble fills the air, one way to reframe the question of whether stocks are in bubble territory is to ask whether the current implied equity risk premium has become ���too low��ï¿�. If your answer is yes, you are arguing that stocks are over priced, and if the answer is no, that they are under priced. At least on the surface, the current level of the equity risk premium is not flashing red lights, since at 4.24%, it is running slightly above the long term averages of 4.21% (1960 - 2021).

That said, there are two reasons for concern. The first is that the premium is now lower than the average premium since 2008, a period that perhaps better reflects the new global economy. The second and scarier reason is that the 5.75% expected return that is implied in today���s stock prices is close to a sixty-year low:

A pessimist looking at this graph will conclude that expected returns on stocks have become too low, and that we are due for a correction, but that would be more a statement about treasury bond rates being too low than about equity risk premiums. Even if you belong to the camp arguing that low risk free rates are now the norm, this graph suggests that we all need to re-examine how much we, as individuals, are saving for retirement, since the old presumption that you can earn 8-10% investing in stocks will longer hold. Across the United States, defined-benefit pension funds that have set aside funds on this same assumption will face massive funding shortfalls, unless they reevaluate benefit levels or infuse new funds.

A Market Assessment

Ìý If you look at history, it seems difficult to argue against the notion that market timing is the impossible dream, but that has never stopped investors from trying to time markets, partly because the payoff from being right is immense. I have long claimed that I am not a market timer, but that is a lie, since every investor times markets, with the difference being in whether the timing is implicit (with cash holdings in your portfolio increasing, when you feel uneasy about markets, and decreasing, when you feel bullish) or explicit (where you actively bet on market direction). Rather than just give you just my estimate of whether I think the market is under or over valued, I will ask each of you to make your own judgments, while also offering my own.Ìý

Ìý Ìý The process of valuing the index starts with an assessment of expected earnings, and with the S&P 500, there is no shortage of either historical data or assessments of the future, on this dimension. Let's start with a look at S&P earnings over time:

While COVID wreaked havoc with corporate earnings in 2020, theÌýcomeback in earnings in 2021 has been remarkable, with trailing 12-month earnings (October 2020 - September 2021) at 190.34, and estimated earnings for 2021 of 206.38, both significantly higher than the 162.35 that was earned in 2019 Ìý(pre-COVID). At the end of 2021, analyst estimates for earnings in 2022 and 2023 reflect their views that the earnings recovery will continue:

I will use the analyst estimates as my expected earnings for the index for the next two years, but assume that earnings growth rate thereafter will move down over the following three years to a stable growth rate (set equal Ìýto the risk free rate).ÌýIt is true that analysts are often wrong, and in some cases, biased, but the latter is more of a problem withÌýanalyst estimates for individualÌýcompanies, than for market aggregate earnings. However, if you believe that analysts have overestimated earnings, my valuation spreadsheet gives you the option of haircutting those estimates. Conversely, if your contention is that analysts are still playing catch-up, you can increase their estimates by a factor of your choosing.

Ìý Ìý Investors don't get value from earnings directly, but do get value from the cash flows flowing from those earnings. As I have noted in prior posts, these cash flows, which used toÌýentirely take the form of dividends, have increasingly shifted, over the last three decades, to stock buybacks.Ìý

WhileÌýdividends are stickier than buybacks, insofar as companies are more willing to reduce the latter during crisis years like 2009 and 2020, it is also clear, as the comeback in buybacks in 2021 shows. In my base case valuation, I will start with 77.36%, the percent of earnings that companies have returned to shareholders, in dividends and buybacks, inÌýthe last twelve months, but I willÌýincrease this over time to aÌýcash payoutÌýratio that is consistent with my estimate of stable growth (risk free rate) andÌýthe return onÌýequity of 16.10% that S&P 500 companies have earned, on average, over the last decade. (Sustainable Payout Ratio = 1 - g/ ROE; with a 16.10% return on equity and a 2.5% growth rate, the payout ratio in stable growth is 84.47%= 1 - .025/.161).

Ìý Ìý On the risk free rate, I start with 1.51%, the 10-year treasury bond rate on January 1, 2022, but I will assume that this rate willÌýdrift upwards over the next fiveÌýyears to reach 2.5%. That reflects my view that inflation pressures will push up long term rates in theÌýyear to come and has little to do with what the Fed may or may not do with the Fed funds rate. Finally, I build in the expectation that a fair ERP for the S&P 500 should be 5%, higher than the long term historical average of 4.21%, but closer to the average ERP since 2008. On both these macro assumptions, I encourage you to take your own point of view.ÌýWith these assumptions in place, my valuation forÌýthe S&P 500, as of January 1, 2022, is shown below:

Note that even in the two weeks since I did this valuation, there have been material changes in key inputs, with the treasury bond rate rising to 1.87% on January 19, 2022, and the S&P dropping to 4533, down 3.8% from its level at the start of the year.Ìý

In Conclusion

ÌýÌý ÌýAs with any valuation, I don't believe that IÌýshould try to convince you that my valuation is the right one, nor do I have no desire to do so. In fact, I know that my valuation isÌýwrong, with the question being in what direction, and by how much.ÌýI would strongly encourage you to take my valuation spreadsheet, change the numbers that I have used on earnings, cash flows, the risk free rate and the equity risk premium to reflect your views, and come up withÌýyour own assessment of value.ÌýGood investing requires taking ownership of your investment decisions, and trusting this choice to talking heads on TV, market strategists at investment banks or those market gurus who looked good last year is a dereliction of investment duty.Ìý ÌýÌý

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Leading into 2021, the big questions facing investors were about how quickly economies would recover from COVID, with the assumption that the virus would fade during the year, and the pressures that the resulting growth would put on inflation. In a , I argued that while stocks entered the year at elevated levels, especially on historic metrics (such as PE ratios), they were priced to deliver reasonable returns, relative to very low risk free rates (with the treasury bond rate at 0.93% at the start of 2021). At the start of 2022, it feels like Groundhog Day, with the same questions about economic growth and inflation looming for the year, and the same judgment about stocks, i.e., that they look expensive. In this post, I will begin with a historical assessment of stock returns in the recent past, then move on to evaluate the returns that investors can expect to make, given how they are priced at the start of 2022, and end with a do-it-yourself valuation of the index right now.

The year that was....Ìý

Ìý Ìý If equity markets surprised us with their resilience in 2020, not just weathering a pandemic for the ages, but prospering in its midst, US equity markets, in particular, managed to find light even in the darkest news stories, and continued their rise through 2021. Foreign markets, though, had a mixed year, and that divergence is worth noting, since it may provide clues to what may be coming in the next year.

US Equities, in the aggregate

Ìý ÌýUS equities had a good year, by any measure, with the S&P 500 rising from 3756 at the start of 2021 to end the year at 4766, an increase of 26.90%. While that followed another good year for stocks in 2020, with the index rising 16.25%, from 3231 to 3756, the index took different pathways during the two years:

In 2020, the market was up, but only after it absorbed the after-shocks of the inception of the virus in February and March of 2020. In 2021, the index had a smoother ride, up in nine of twelve months, with only September qualifying a significant drop (with the index down 4.75%). When you augment this price change with the dividends on the index during 2021, the total return on the S&P 500 for 2021 was 28.47%. I report a , and to put 2021 in context, I looked at the historical returns on the index:
Looking at the 94 years in this dataset, the returns in 2021 would have ranked 20th on the list, good, but not exceptional. Note, though, that 2021 is the third consecutive year of very good returns on the index, with 2019 delivering 31.21%, and 2020 generating 18.02%, and that the cumulative return over the three years (2019-21) is 98.95%. If you compute cumulative returns, on a rolling three-year time period (1928-30, 1929-31, 1930-32 etc.), the 2019-21 time period would rank 8th on the list of 92 3-year time periods. The table below provides the rankings for returns over 5-year and 10-year periods, and where the most recent three-year, five-year and ten-year cumulative returns would rank on the list:

In sum, if you have money to invest over the last decade, and you stayed invested, you should count yourself as lucky to have enjoyed one of the great market runs of the last century. Conversely, if you stayed out of the market, for the last decade, you would have committed one of the great investing mistakes of all time, and blaming the Fed or bubble-talk will not bring you absolution.

US Equities, by sub-group

Ìý Ìý It has always true that when markets move, up or down, not all sectors and sub-groups are treated equally. I do believe that too much is often made of these differences, as it is generally more the rule than the exception that markets, when they are up strongly, get the bulk of that rise from a small sub-set of stocks or sectors. Using S&P's sector classification, I take a look at how each one did in 2022, looking at the percent changes in market capitalization:

In contrast to 2020, when technology and consumer discretionary firms ran well ahead of the pack, the best performing sectors in 2021 were energy and real estate, two of the biggest laggards in 2020. That can be viewed as vindication, at least in this year, for contrarians, but as a cautionary note for ESG advocates, who assumed that fossil fuel companies were on a death march, based upon their performance over the last decade.

There is no debate more likely to draw heat than the value versus growth debate, and at the risk of being labeled simplistic by value investors, I looked at returns on companies, in 2021, based upon their PE ratios at the start of 2021:

Unlike 2020, where high PE stocks beat low PE stocks decisively, the results in 2021 were mixed, with no clear patterns across the classes. The results are similar if you break stocks down based upon price to book ratios or revenue growth rates. Finally, and in keeping with my fixation on corporate age and life cycles, I broke companies down by company age (measured from the founding year):
Again, unlike 2020, when young companies delivered significantly higher returns than older companies, the best returns in 2021 were delivered by middle aged companies.

For the rest of the world

Ìý ÌýWhile US equities continued to set new highs in 2021, the picture in the rest of the world was not as rosy, as you can see in the table below (with percent returns in US dollar terms):

In US dollar terms, India had the best-performing market in 2021, following a strong 2020, but China, the best performer in the world in 2020 came back to earth in 2021. North America (US and Canada) outperformed the globe, but Latin America was the worst performing region, down more than 20% in US dollar terms. There are many reasons why markets diverge, but here againÌýthe contrast with 2020 is worth drawing. In 2020, the COVID crisis played out across markets, increasing the co-movement andÌýcorrelation across developed markets,Ìýwith the US, Europe and Japan moving mostly in sync. In 2021, you saw a return to more normal times, with markets in each country affected more by local factors.

The Price of Risk in Equity Markets

Ìý Ìý The allure of having the historical data that we do in financial markets, especially in the United States, is that there is information in the past. The danger of poring over this historical data is that a focus on the past can blind us to structural changes in markets that can make the future very different from the past. To get a measure of what equity markets are offering in terms of expected returns, we are better served with a forward-looking andÌýdynamic measure of these returns, and that is the focus of this section.

Implied Equity Risk Premiums

Ìý ÌýTo understand the intuition behind the implied equity risk premium, it is easiest to start with the concept of a yield to maturity on a bond, computed as the discount rate that makes the present value of the cash flows on the bond (coupons, during the bond's lifetime, and face value, at maturity) equal to the price of the bond. With equities, the cash flows take the form of dividends and buybacks, and in addition to estimating them using future growth rates, you have to assume that they continue in perpetuity. In computing this implied equity risk premium for the S&P 500, I start with the dividends and buybacks on the stocks in the index in the most recent year (which is known) and assume that they grow at the rate that analysts who follow the index are projecting for the next five years. Beyond the fifth year, I make the simplifying assumption that earnings growth will converge on the nominal growth rate of the economy, .Ìý

If you set the present value of the expected cash flows equal to the index level today, and solve for a discount rate (you may need to use the solver function in Excel, or trial and error), the resulting number is the expected return on stocks, based upon how stocks are priced today, and expected cash flows. This approach is built on the proposition that the intrinsic value of stocks is the present value of the expected cash flows that you generate in perpetuity, from holding these stocks, but it is model agnostic. Put simply, it does not require that you believe in any risk and return model in finance, since it is based on price and expected cash flows. To the critique that analysts can over estimate future earnings and Ìýgrowth, the response is that even if they do (and there is no evidence that top-down forecasts are biased), it is the price of risk, given expected cash flows.

The Implied ERP - Start of 2022

I have computed the implied equity risk premium at the start of every month, since September 2008, and during crisis periods, I compute it every day. ÌýOver the course of 2021, as the index rose, risk free rates climbed and analysts got much more upbeat about expected earnings for the next three years, the equity risk premium drifted down, to end the year at 4.24%:

Much as I would love to claim that I have the estimated the equity risk premium to the second decimal point, the truth is that there is some give in these numbers and that changing assumptions about earnings and cash flows generates an equity risk premium between 4-5%. The contrast between the behavior f equity risk premiums in 2020 and 2021 are in the picture below, where I show my (daily) estimates of ERP during 2020 on the left, and my (monthly) estimates of ERP for 2021 on the right.Ìý

During 2020, the equity risk started the year at about 4.7%, spiraled to almost 8% on March 23, 2020, before reverting back quickly to pre-crisis levels by September 2020. During 2021, you saw equity risk premiums revert back to a more sedate path, with numbers staying between 4% and 5% through the course of the entire year.

Historical Perspective

Ìý Ìý As talk of a bubble fills the air, one way to reframe the question of whether stocks are in bubble territory is to ask whether the current implied equity risk premium has become “too lowâ€�. If your answer is yes, you are arguing that stocks are over priced, and if the answer is no, that they are under priced. At least on the surface, the current level of the equity risk premium is not flashing red lights, since at 4.24%, it is running slightly above the long term averages of 4.21% (1960 - 2021).

That said, there are two reasons for concern. The first is that the premium is now lower than the average premium since 2008, a period that perhaps better reflects the new global economy. The second and scarier reason is that the 5.75% expected return that is implied in today’s stock prices is close to a sixty-year low:

A pessimist looking at this graph will conclude that expected returns on stocks have become too low, and that we are due for a correction, but that would be more a statement about treasury bond rates being too low than about equity risk premiums. Even if you belong to the camp arguing that low risk free rates are now the norm, this graph suggests that we all need to re-examine how much we, as individuals, are saving for retirement, since the old presumption that you can earn 8-10% investing in stocks will longer hold. Across the United States, defined-benefit pension funds that have set aside funds on this same assumption will face massive funding shortfalls, unless they reevaluate benefit levels or infuse new funds.

A Market Assessment

Ìý If you look at history, it seems difficult to argue against the notion that market timing is the impossible dream, but that has never stopped investors from trying to time markets, partly because the payoff from being right is immense. I have long claimed that I am not a market timer, but that is a lie, since every investor times markets, with the difference being in whether the timing is implicit (with cash holdings in your portfolio increasing, when you feel uneasy about markets, and decreasing, when you feel bullish) or explicit (where you actively bet on market direction). Rather than just give you just my estimate of whether I think the market is under or over valued, I will ask each of you to make your own judgments, while also offering my own.Ìý

Ìý Ìý The process of valuing the index starts with an assessment of expected earnings, and with the S&P 500, there is no shortage of either historical data or assessments of the future, on this dimension. Let's start with a look at S&P earnings over time:

While COVID wreaked havoc with corporate earnings in 2020, theÌýcomeback in earnings in 2021 has been remarkable, with trailing 12-month earnings (October 2020 - September 2021) at 190.34, and estimated earnings for 2021 of 206.38, both significantly higher than the 162.35 that was earned in 2019 Ìý(pre-COVID). At the end of 2021, analyst estimates for earnings in 2022 and 2023 reflect their views that the earnings recovery will continue:

I will use the analyst estimates as my expected earnings for the index for the next two years, but assume that earnings growth rate thereafter will move down over the following three years to a stable growth rate (set equal Ìýto the risk free rate).ÌýIt is true that analysts are often wrong, and in some cases, biased, but the latter is more of a problem withÌýanalyst estimates for individualÌýcompanies, than for market aggregate earnings. However, if you believe that analysts have overestimated earnings, my valuation spreadsheet gives you the option of haircutting those estimates. Conversely, if your contention is that analysts are still playing catch-up, you can increase their estimates by a factor of your choosing.

Ìý Ìý Investors don't get value from earnings directly, but do get value from the cash flows flowing from those earnings. As I have noted in prior posts, these cash flows, which used toÌýentirely take the form of dividends, have increasingly shifted, over the last three decades, to stock buybacks.Ìý

WhileÌýdividends are stickier than buybacks, insofar as companies are more willing to reduce the latter during crisis years like 2009 and 2020, it is also clear, as the comeback in buybacks in 2021 shows. In my base case valuation, I will start with 77.36%, the percent of earnings that companies have returned to shareholders, in dividends and buybacks, inÌýthe last twelve months, but I willÌýincrease this over time to aÌýcash payoutÌýratio that is consistent with my estimate of stable growth (risk free rate) andÌýthe return onÌýequity of 16.10% that S&P 500 companies have earned, on average, over the last decade. (Sustainable Payout Ratio = 1 - g/ ROE; with a 16.10% return on equity and a 2.5% growth rate, the payout ratio in stable growth is 84.47%= 1 - .025/.161).

Ìý Ìý On the risk free rate, I start with 1.51%, the 10-year treasury bond rate on January 1, 2022, but I will assume that this rate willÌýdrift upwards over the next fiveÌýyears to reach 2.5%. That reflects my view that inflation pressures will push up long term rates in theÌýyear to come and has little to do with what the Fed may or may not do with the Fed funds rate. Finally, I build in the expectation that a fair ERP for the S&P 500 should be 5%, higher than the long term historical average of 4.21%, but closer to the average ERP since 2008. On both these macro assumptions, I encourage you to take your own point of view.ÌýWith these assumptions in place, my valuation forÌýthe S&P 500, as of January 1, 2022, is shown below:

Note that even in the two weeks since I did this valuation, there have been material changes in key inputs, with the treasury bond rate rising to 1.87% on January 19, 2022, and the S&P dropping to 4533, down 3.8% from its level at the start of the year.Ìý

In Conclusion

ÌýÌý ÌýAs with any valuation, I don't believe that IÌýshould try to convince you that my valuation is the right one, nor do I have no desire to do so. In fact, I know that my valuation isÌýwrong, with the question being in what direction, and by how much.ÌýI would strongly encourage you to take my valuation spreadsheet, change the numbers that I have used on earnings, cash flows, the risk free rate and the equity risk premium to reflect your views, and come up withÌýyour own assessment of value.ÌýGood investing requires taking ownership of your investment decisions, and trusting this choice to talking heads on TV, market strategists at investment banks or those market gurus who looked good last year is a dereliction of investment duty.Ìý ÌýÌý

YouTube Video

Datasets (toÌýdownload)

Spreadsheet (to valueÌýthe S&P 500)