Crisis Lessons: Presentation...

A few posts ago, I mentioned that I was working on a presentation reflecting the lessons that I learned from the crisis. I had also promised to post the presentation when it was ready. You can get it be clicking on the link below:

Market Revelations: Lessons learned, unlearned and relearned from the Crisis

While you can read about the specific lessons that I have taken away from the last year in the presentation, here are the general points I want to make:

1. These are the lessons that I have learned. In other words, this is my personal odyssey and I do not expect everyone to have learned these lessons, nor do I feel the urge to impose them on others.

2. The common theme across the many lessons is that I am much more wary about using past or historical data, whether it be at the company level (profitability, risk etc.) or at the macro level (equity risk premiums). Mean reversion, i.e., the assumption that numbers revert back to historical averages, has served us well, at least in developed markets for a long time, but a blind adherence to it can decimate companies and portfolios.

3. At a gut level, I feel that I have a better understanding of risk and the need for risk premiums now than before the crisis. Fundamentally, I believe that this crisis was precipitated by a belief that we can measure and control risk, when the nature of risk is that it cannot be ever fully measured or controlled.

4. I would not classify myself as a behavioral economist, but I am more willing to give behavioral finance a place at the table when we think about solutions to corporate finance and investment problems, after the crisis, than before.

The bottom line is that I feel humbled by all the things I do not know about finance and markets and excited at the prospect of exploring these things more.

Leveraged Buyouts

Yesterday's New York Times had a story (a sad one) on the troubles at Simmons, a mattress company with a long and illustrious history in the United States.
http://www.nytimes.com/2009/10/05/business/economy/05simmons.html
In short, the company was targeted for a leveraged buyout by Thomas H. Lee Partners, a private equity firm, in a transaction that went awry, partly because of miscalculations by the investors and partly because of the market crisis. The article is clear about who the "bad guys" in this story are and it is the private equity investors, who profited while a good company and its employees were destroyed.

I am always suspicious when the financial press sees things in black and white, since my experience is that life is full of shades of grey, but this article gives me a chance to vent about leveraged buyouts. If the message here is that private equity investors act in their self interest, my reaction is "Duh! Who does not?". If the message is that debt is the enemy, I am afraid the culprit is not Thomas H. Lee, but the tax code, which is tilted towards debt for some reason that I cannot fathom in pretty much every market in the world.

My problem with the way leveraged buyouts have been framed by both its proponents and opponents is the focus on leverage as the center of the transaction. To me, there are three components to a leveraged buyout:
a. The change in financial leverage: Changing the mix of debt and equity can help you exploit the tax code and increase your overall value (at the expense of taxpayers).
b. Control: In badly managed firms, changing the operating characteristics, i.e. investment and dividend policy, of the firm can increase value,
c. Public to private: To the extent that being a publicly traded firm forces you to make decisions to satisfy stockholders and analysts focused on the short term (at least in theory), going private may allow firms to make hard decisions that increase their value.
A good candidate for a leveraged buyout will derive value from all three levers. It will be an under levered, poorly managed firm, where there is a substantial gap between managers and stockholders.

In a blog post from November, I pointed to an extended treatise on the topic, where I look at an LBO transaction that failed, where Goldman and KKR tried to take Harman Audio private, and failed. My conclusion was that Harman was the wrong company to target for an LBO, because it did not have significant excess debt capacity, was already fairly well managed and a big stockholder was the CEO of the company.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1162862
What does this have to do with Simmons? I think that we are making a mistake when we assume that private equity investors are brilliant villains in LBO transactions. For every winner (like Thomas H. Lee in this specific transaction), there are many losers, and I would not be surprised if private equity investors are not net winners in this process.

The dangers of relative valuation

In my last post on Twitter, I hypothesized that the valuation of Twitter was based upon what investors had assigned as a value for Facebook a few months earlier. I want to make clear that I am not suggesting that this is a good way to value businesses but that it is the status quo.

With relative valuation, the dangers of a bad initial valuation cascading into subsequent valuations is high and they get worse when the initial valuation is of a large company (Facebook is large, by the standards of networking sites) and done by what is viewed as a reputable source (private equity investors have an ill deserved reputation for valuation expertise and a big investment banking name helps..) In fact, this may be one reason for pricing bubbles in sectors.

I can carry the relative valuation lessons here to an absurd limit. I have 15,000 + members on the mailing list for my website (damodaran.com). I would argue that this is a fairly valuable potential list for anyone with an investment or valuation product. Applying the $32.5/member to each member (a bargain, given the selection bias), my site should be worth half a million. Any takers? Better still, why not just your add your name to my mailing list and increase my value $32.5 by doing so? (The incentives for sites to seek out new members, even if they are idle and do nothing, is extremely high...)

I am kidding here, since I have no intent of making my site commercial. I have always argued that relative valuation, at least as it is practiced, is a sign of laziness because analysts are not only sloppy but throw out much of the data that they have access to. Relative valuation, done right, where you use not just the averages, but also look at the differences in valuations across companies to draw lessons about how the market values assets, can be a very useful tool in valuation.

What is Twitter worth?

Yesterday's big news story, at least in valuation circles, is that private equity investors have invested $ 100 million in Twitter for a roughly 10% stake, suggesting a billion-dollar valuation for the nascent company.
http://blogs.wsj.com/deals/2009/09/24/breaking-news-twitter-to-raise-100-million-from-insight-t-rowe-price-other-investors/
Twitter, for those who may be living in the middle ages, has about 30 million members who post short messages (less than 140 characters) that other members can read (if they choose to follow your tweeting). Every celebrity (sports, politics, media) seems to be tweeting now. There are three questions that came up after the story:

1. How did the equity investors in Twitter come up with the $ 1 billion value?
We assume degrees of sophistication to private equity investors and venture capitalists that they usually do not possess. In my experience, venture capital valuations often represent back-of the-envelope computations with hefty discount rates (target rates if 30-60%) taking care of the uncertainty. I was not privy to the valuation of Twitter but I can read the tea leaves and guess how they valued the company. A few months ago, Facebook (a company that Twitter aspires to be at least in the new term) raised equity from a group of Russian investors, who attached a value of $ 6.5 billion to the company. At the time. Facebook had approximately 200 million members, which works out to about $32.5/ member. As of last week, Twitter had about 30 million members. Applying the $32.5/member to this estimate, I get $975 million (suspiciously close to $ 1 billion). This may be pure coincidence but given the pull towards relative valuation on the Street, I think it may explain the valuation.

2. Could Twitter be worth $ 1 billion?
"Could" is a very weak word. Of course! What Twitter has going for it is the numbers. With 30 million members, all I need to be able to do is to generate a small cash flow from each one and the valuation will be justified. A billion dollar value for a firm requires that the firm be able to generate about $ 100 million in operating income in steady state. (I am applying a 10% cost of capital, typical of mature firms, and assuming zero growth). With 30 million members, that works out to $3.33/year from each member. If you are a Twitterer, the question I would have for you is this: Would you be willing to pay an annual membership fee of $ 5 or $ 10 to follow your favorite celebrities thoughts? If the answer is yes, the billion dollars is paid for... If not, I will keep looking...

3. Is Twitter worth $ 1 billion?
Interesting question. As an ongoing business, I don't think so and here is why:
a. You don't buy a business that does not have a business model yet. Twitter has a lot of members but it really does not know how to make money of these members (yet). Advertising alone will not do it. Any blatantly obvious way to earn money (such as charging per tweet) will very quickly decimate the membership. So, where will the additional profits come from?
b. You are buying a business that may be a fad, at the peak of its faddishness: Twitter is hot right now, because it is in the news. However, most of the tweets that I read are inane: it is tough to be profound 24 hours a day and to express that profundity (is that even a word?) in 140 characters.

However, I think that you can justify a $ 1 billion value for Twitter at least to some investors and that is to think of it as an option. What you are buying then, when you buy this firm, is access to 30 million potential customers, who may not know each other but are tied to one another. There are at least two types of investors who may find this investment appealing:
a. A firm with deep pockets and products/services that may be appealing to the membership of Twitter. The 30 million members of Twitter tend to be techno-savvy, older than Facebook members (on average) and well off. They also tend ot think well of themselves or at least their opinions. To illustrate, Microsoft did take a position in Facebook a few months ago and I can see other companies with products (especially in entertainment) do the same with Twitter.
b. Risk money: While no investor in his right mind should be investing the bulk of his portfolio in Twitter, it may be a good investment for risk money, i.e., money you want to invest in high risk, high reward investments and are willing to lose. Spreading your bets across multiple investments like Twitter may create a portfolio that has a good risk/return trade off, especially if you can bring some selection acumen to the process.

P.S: Facing the scorn of my teenage daughter, I created an account on Twitter about 6 months ago. I have never tweeted but I have 228 followers. Scary!!!!

Buybacks and Stock Prices..

Floyd Norris has an article in the New York Times on stock buybacks:
http://www.nytimes.com/2009/09/19/business/19charts.html?scp=1&sq=buybacks&st=Search
He notes that buybacks are high when stock prices are high and that they fall off when stock prices are low. His conclusion is that this is irrational because companies should be buying back more stock when the price is low and less when the stock is high. While there is a point to his argument, there are two points he is missing:

1. Buybacks are more about returning cash to stockholders and changing financial leverage than making judgments about stock price: There are two very good reasons, other than the perception that the stock is cheap, for buybacks. The first is that it is an alternative mechanism for returning cash to stockholders, instead of dividends. In addition to providing some tax advantages to investors over dividends, it also allows firms to be more flexible in returning cash over time. (Increasing dividends can be viewed as a long term commitment, whereas buybacks are not.) The second is that it can allow firms that are under levered, i.e., have too little debt in their capitalization, to increase their debt ratio. Buying back stock reduces the market value of equity and increases the debt ratio; if the buyback is funded with debt, the impact is doubled. Thus, one way to explain why companies bought back stock over 2006 and 2007 is that they felt cash rich and a combination of high equity prices and low bond default spreads led them to believe that they were under levered. The crisis may have led them to rethink both assumptions.

2. Even if it is about the price, is not the price per se that matters but the price relative to value: Even if we accept the premise that buybacks are driven by a desire to take advantage of under valued stock, that decision will be driven not by what the price is but what it is relative to perceived value. In other words, a company may buy back stock, when the price is $ 40, if it perceives the value to be $ 50. It will choose not to buy back the same stock, six months later, at $ 20, if the perceived value is only $ 10. The problem with correlating buybacks with stock prices, which is what Norris does, is that it misses the key component of value.

I do think that some US companies, especially in the financial sector, bought back too much in stock in the two years prior to the crisis. I attribute this to the "me too-ism" that is all too prevalent in corporate finance, where firms do, not what's best for them (and their stockholders), but what other firms are doing. Thus, many firms bought back stock because others were doing so, and in a sense, the trend fed on itself.

A Risk Argument: Democracies versus Dictatorships

A few days ago, Tom Friedman, the columnist for the New York Times, and best-selling author of books on globalization, evoked controversy when he opined that "one party autocracy" is not too bad if it is led by a "reasonably enlightened group of people, as China today". To be honest, I have never found Friedman's work to be particularly thought provoking, nor do I much care for his characterizations of globalization: flat earth, fat earth, round earth, whatever.... . However, his article did start me thinking about whether businesses face less risk or more risk in a democracy than in a dictatorship.

As a generalization, there is more day-to-day uncertainty when dealing with a democracy than with a dicatorship. A democratically elected government can offer policies that are favorable to business, but may either not be able to deliver them legislatively or have to modify them to meet public consent. A dictatorship operates under no such constraints and can deliver on its promises, albeit at substantial cost to some segments of its population. Furthemore, the nature of democracy is that governments change and policies change with them. The flip side is that dictatorships do not last forever, and a benign dictator today can become malignant one in the future. Policies can then be turned on their head and today's favored businesses may fall out of favor tomorrow.

The choice between democracies and dictatorships, in my view, boils down to whether you prefer to deal with the continuous, ongoing risk of operating in a democracy or the discontinuous risk of operating in a dictatorship. The former will manifest itself in a chaotic environment of changing rules, fiscal and monetary policies and exchange rate regimes. The latter may show up in periodic upheavals in policy, nationalizations (real or quasi) and a requirement that you pay due respects (or more) to policy makers.

I have argued in my book on strategic risk taking that it is far easier to deal with continuous risk than discontinuous risk for two reasons.

1. The first is that market traded instruments work better at dealing with continuous risk, whereas insurance, often imperfect, is the tool you need for discontinuous risk. To illustrate, compare floating exchange rates to fixed exchange rates. The former create more day-to-day uncertainty for businesses but is eminently hedgeable using options or futures contracts. The latter allows for long periods of stability, interspersed with sudden revaluations and devaluations of currencies, much more difficult to hedge.

2. Managers of firms in the (artificially) stable environments created by dictatorships are lulled into a false sense of complacency and are completely unprepared for the risks that inevitably follow. Managers of firms in chaotic environments learn to cope with change, one reason why I think these companies may have a competitive edge in the more uncertain global economies of the future.

Friedman's arguments are not new. Mussolini's supporters initially thought of him as benign and argued that he made the trains run on time, an incredible accomplishment in Italy. In later years, they discovered his dark side. I do not trust any group of people, no matter how well trained and intentioned, to make decisions for me for the rest of eternity. So, I come down on the side of democracy, chaotic and frustrating though it may be, because I can manage its risks better (both as an individual and a business) than I can in a dictatorship. We will have a ring side view of this tussle, and the strengths and weaknesses of both systems, as we watch the Indian and Chinese economies struggle for dominance over the next few decades.

One year later: The lessons from the crisis

It is hard to believe that it has been a year since the crisis started - September 15,2008, to be precise. The papers are full of retrospectives, with opinions often overwhelming the facts. I am working on my book on what I learned from the crisis in terms of how I approached valuation and corporate finance. I will post the presentation that I am putting together sometime in the next week.

While most of the articles in the media this week either rehash old stories or focus on human interest (such as looking at where Lehman's employees are today), there are two that I found particularly thought provoking.

1. The first was an article by Joe Nocera in the New York Times asking a question that I think is important. Did Lehman have to fail so that the rest of Wall Street could be saved?
http://www.nytimes.com/2009/09/12/business/12nocera.html?_r=1&pagewanted=1&_r

His basic thesis is an interesting one. Rather than view Paulson's decision to let Lehman fail, as a catastrophic mistake (the conventional wisdom for many months after the crash), he believes that Lehman's failure and the subsequent panic allowed the government to take actions that it could never have justified before to save AIG. The failure of AIG with its tentacles in every aspect of business would have been far more disastrous than Lehman, according to Nocera.

There is some truth to his argument. The failure of Lehman was not the problem but a symptom of the problem - hopelessly over inflated securities on the books of investment banks and terrible choices on risk. Saving Lehman would not have only have not solved that problem and may in fact have made it worse, by signaling to other banks that they too would be protected. However, I believe that the real mistake was saving Bear Stearns a few months prior. If Bear had been allowed to fail, Lehman may not have had to collapse, but I do understand that I have the benefit of hindsight.

2. The second set of articles that I think are interesting look at how Wall Street has changed (or not changed) as a result of the crisis. The consensus view here seems to be that Wall Street has returned to its old ways, securitizing everything under the sun and paying outlandish bonuses to employees. That does not surprise me. I have discovered that Wall Street is incapable of introspection and has almost no historical memory, for two reasons. The first is a self selection bias: people who choose to be investment bankers and traders prefer to act, rather than analyze, and look forward, not back: that is their strength and their weakness. The second is that success on Wall Street is measured with output - deals made, trading profits generated - rather than input - the quality of the deal making, whether the trading profits came from a sensible, well thought out system.

After every crisis, you hear the cry, "Never again"!! My response is "It is only a matter of time!".