Sheffield Wednesday - Working With Fire And Steel

Sheffield Wednesday are one of those clubs with a fine history that these days find themselves playing in the Championship. Wednesday spent most of the 80s and 90s in the top flight of English football, but have not been in the Premier League since 2000 and won the last of their First Division titles back in 1930.

Indeed, in recent times they actually spent two seasons in League One, England’s third tier, before promotion back to the Championship in 2012. Since then, they have not really threatened the promotion or play-off places, but there is now cause for a degree of optimism in the steel city following the arrival of new Thai owner Dejphon Chansiri.

His family owns the world’s largest producer of canned tuna, while Dejphon himself has a thriving property and construction company in Thailand. He acquired Wednesday for £37.5 million in January and has targeted promotion to the Promised Land of the Premier League within two years. He has already claimed to have cleared the club’s debts and given new head coach Carlos Carvalhal substantial backing in the transfer market.

"My name is Lucas"

Chansiri bought the club from Milan Mandaric, who had effectively saved Wednesday from going into administration when he bought the club for a nominal £1 in December 2010, but importantly negotiated terms to wipe out the club’s significant debts. In particular, he persuaded the Co-operative Bank to settle their £23 million debt for a £7 million payment.

Wednesday had faced a series of winding-up petitions from HMRC between July and November 2010 for unpaid VAT and payroll taxes, which were only withdrawn following Mandaric’s intervention.

Wednesday’s problems on the pitch went hand in hand with their financial difficulties, as Mandaric explained: “The decline of this great club can be traced back over the past decade. Both on and off the field mismanagement has seen a true footballing institution teeter on the edge of the financial abyss.”

"Tommy, can you hear me?"

Given these issues, Mandaric adopted a somewhat more cautious approach to spending: “I will not gamble with the long-term future of Sheffield Wednesday, this club has already flirted with financial oblivion far too closely in recent seasons.”

However, as the auditors noted in the annual accounts, the club continued to rely on the financial support of its parent company, which was “not legally binding and dependent on the intentions of the owner.” This lead to them noting a “material uncertainty which may cast significant doubt about the company’s ability to continue as a going concern.”

Strong stuff, but many clubs in the Championship rely on the goodwill of their owners and Wednesday are no exception. The hope would be that Chansiri continues to provide the club with the financial support required at this level.

Although Wednesday’s financial position is not ideal, in truth it’s not too bad for a Championship club, even though they reported a £5.6 million loss in 2013/14, the last season for which figures are available.

That said, the loss did increase from £3.7 million the previous season, as revenue dropped £1.1 million (7%) to £13.9 million, mainly due to a reduction in match receipts and commercial match day income; while the wage bill rose £0.6 million (5%) to £12.5 million, following an increase in player salaries and management costs. There were £0.1 million reductions in both depreciation and other expenses, but interest payable shot up by £0.3 million to £0.5 million.

Mandaric justified the loss when referring to “the difficulty of operating our club in the Championship whilst trying to remain competitive.” In fairness, Wednesday’s loss is quite small compared to most other clubs in this division, placing them a creditable 8th in the profit league.

As Mandaric observed, “we’re losing money, but not as much as some clubs”. That’s evident when you consider the stratospheric losses posted by the likes of Blackburn Rovers £42 million, Nottingham Forest £23 million, Leicester City £21 million, Middlesbrough £20 million and Leeds United £20 million.

In fact, the only clubs to make money in the Championship were Blackpool (with their highly dubious model), Wigan Athletic and Yeovil Town – and they have all since been relegated. In 2013/14 losses were reported by 21 of the 24 clubs – in stark contrast to the Premier League where the new TV deal, allied with wage controls, has led to a surge in profitability.

Wednesday have consistently reported smallish losses over the past few years. The last time that they made an accounting profit was in 2011, which was boosted by a £21.4 million (non-cash) credit after the former owner agreed to waive all amounts owed. Excluding this exceptional item, the club would have made a £5.6 million loss instead of a £15.8 million profit.

After that adjustment, Wednesday would have made an aggregate loss of £27.8 million in the last six seasons, averaging a £4.6 million deficit each year. Mandaric acknowledged that “losses of this amount will need to be reduced in the future and ultimately I would hope the club can be self-supporting.”

Other once-off items to hit Wednesday’s books include £1.4 million in 2012 due to bonus costs relating to promotion back to the Championship and the change in football management during the season. There was another £0.25 million paid the same season to the Co-operative Bank for a promotion-related clause in their debt settlement.

Profit on player sales can also improve the bottom line, but this has not really been the case at Wednesday. The last time they made any meaningful money from transfers was back in 2008 £3.3 million, mainly due to the sale of Chris Brunt to WBA and Glenn Whelan to Stoke City, and 2007, thanks to Madjid Bougherra’s move to Charlton Athletic.

Since then they have made just £2.2 million in six seasons, including only £0.3 million in 2013/14. Although few Championship clubs make big profits on player sales with only two earning more than £5 million in 2013/14 (Wigan Athletic and Bournemouth), Wednesday’s was still among the lowest.

Player trading is by no means the only issue at Wednesday, as the underlying business is loss making. The club has made operating losses in each of the last six years, though there has been some recovery in the Championship to £3-4 million.

Unsurprisingly the operating losses peaked at £7 million in League One in line with lower revenue, as described by the club: “The cost base, in common with other football clubs, is relatively fixed in the short-term, hence unfavourable movements in revenue, including those arising from below budget on pitch performance, can lead to significant variation in profits.”

Revenue fell by £1 million (7%) from £14.9 million to £13.9 million, largely due to decreases in match receipts of £0.7 million (11%) to £5.5 million and commercial income of £0.6 million (13%) to £3.9 million, slightly offset by a £0.2 million (5%) increase in broadcasting revenue to £4.5 million.

As you would expect, revenue was lower in League One, declining by £4.5 million to £9.4 million in 2011. As the club put it, “A mixture of relegation, supporter dissatisfaction and the general economic downturn saw falls in revenue across all areas of the business.”

The other side of that coin is that revenue has increased since promotion, but only by £2.9 million. The growth is entirely due to the better TV distribution deal in the Championship, which has increased broadcasting revenue by £3.3 million. In contrast, commercial revenue has only increased by £0.1 million, while match receipts are actually down £0.5 million.

Following the reduction in 2013/14, Wednesday’s revenue of £13.9 million was only the 15th highest in the Championship, a long way behind the top three clubs: QPR £39 million, Reading £38 million and Wigan Athletic £37 million. In fact, six clubs earned more than £30 million that year. Of course, to a large extent, this simply demonstrates the importance of parachute payments for those clubs relegated from the Premier League.

If these were to be excluded, Wednesday would move up to a more healthy 10th place in the Championship revenue league, but even so their £14 million would still be a long way behind Leicester City £31 million, Leeds United £25 million, Brighton £24 million and Derby County £20 million. Given these numbers, Wednesday’s mid-table performance could be regarded as essentially par for the course.

Much of Wednesday’s revenue performance is driven by match day receipts, which account for 40% of their total revenue, followed by broadcasting 32% and commercial 28%.

In fact, only four Championship clubs have a greater reliance on match day receipts than Wednesday: Charlton Athletic 50%, Nottingham Forest 44%, Brighton and Hove Albion 43% and Millwall 41%.

Arguably Wednesday’s match day revenue is even higher, as their accounts also include £1.8 million of commercial match day income, but I have classified this within commercial revenue, as this is consistent with the £3.9 million listed in the club’s turnover figures for total commercial activities.

Either way, the importance of match day revenue to Wednesday is clear, so the £0.7 million (11%) reduction from £6.2 million to £5.5 million in 2013/14 is concerning, especially as this was as high as £6.5 million before relegation to League One in 2010. Revenue here is partly influenced by progress in cup competitions, which helped keep the figure high in 2010, but the 2014 fall was essentially due to a 12% decrease in the average attendance from 24,078 to 21,274.

Even so, Wednesday’s match day revenue of £5.5 million was the 9th highest in the Championship. To put this into perspective only three clubs generate more than £7 million (Brighton £10.4 million, Leeds United £8.6 million and Nottingham Forest £7.2 million).

Even more impressively, Wednesday’s average attendance of 21,274 was the 6th highest in the Championship in 2013/14 and climbed to 21,993 last season. Although this is a little disappointing, considering the 24,078 average achieved in the first season back in the Championship, there is little doubting the potential here.

As a recent example, you only have to look at the 38,000 crowd that watched the final home game in the League One promotion season. This nearly filled the 40,000 capacity at Hillsborough, one of the largest grounds in the country.

Wednesday had kept “Early Bird” season ticket prices static for many seasons, but have introduced a new match day pricing structure for the 2015/16 season, which features a number of steep hikes in some prices.

Whether this is the right move, especially given that South Yorkshire is the fifth most impoverished area of the country, is obviously debatable, but the objective is to help fund a promotion drive by maximizing revenues streams. This move is understandable to an extent, but the fans are only likely to be placated if promotion is delivered.

Chansiri justified the price increase as follows: “In the bigger picture, if we are to achieve our ultimate aim of promotion, we must embark on this journey together. I will lead that journey as your chairman, but I need as much help as possible along the way. Budgets must be achieved, we must work within the constraints of Financial Fair Play, and we do not have the benefit of parachute payments, unlike a significant number of our peers in the Championship, each of whom are aiming for the same destination. As our costs increase, so too must our revenues across the business.”

In 2013/14 Wednesday’s broadcasting revenue was £4.5 million, which was in line with the majority of Championship clubs, who receive the same annual sum for TV, regardless of where they finish in the league. This amounts to just £4 million of central distributions: £1.7 million from the Football League pool and a £2.3 million solidarity payment from the Premier League. Other television money is dependent on whether a team reaches the play-offs; cup runs and the number of times a club is broadcast live.

However, the major impact of parachute payments is once again highlighted in this revenue stream, greatly influencing the top eight earners, though it should be noted that clubs receiving parachute payments do not also receive solidarity payments.

Looking at the Premier League television distributions, the massive financial disparity between England’s top two leagues becomes evident with Premier League clubs receiving between £65 million and £99 million, compared to the £4 million in the Championship. In other words, it would take a Championship club more than 15 years to earn the same amount as the bottom placed club in the Premier League.

If Wednesday were to somehow gain promotion, the financial prize for returning to the Premier League would be immense. Even if a team finishes last in their first season and go straight back down, their TV revenue would increase by £61 million (£65 million less £4 million) and they would also receive a further £65-75 million in parachute payments, giving additional funds of around £130 million.

It could be even more, depending on where the club finishes in the league (with each place worth an additional £1.2 million) and how many times they are televised live (where each club is paid facility fees, with a contractual minimum of 10 games). All this is before the recent blockbuster Premier League deal that starts in 2016/17, which I estimate will be worth at least another £30 million a season. The size of the prize helps explain the behaviour of many Championship clubs, which are spending more than ever this season.

As we have seen, parachute payments make a significant difference to a club’s revenue and therefore its spending power in the Championship. Up to now, these have been worth £65 million over four years: year 1 £25 million, year 2 £20 million and £10 million in each of years 3 and 4.

However, the Premier League has recently announced changes to this structure, whereby from 2016/17 clubs will only receive parachute payments for three seasons after relegation, although the amounts will be higher (my estimate is £75 million, based on the advised percentages of the equal share paid to Premier League clubs: year 1 55%, year 2 45% and year 3 20%).

Revenue from commercial activities decreased by £0.6 million (13%) to £3.9 million in 2013/14, comprising commercial match day income £1.8 million (hit by the fall in attendances), retail and merchandising £1.5 million, catering £0.3 million and internet & other £0.2 million.

For a club with Wednesday’s history, their commercial revenue is fairly low and only the 13th highest in the Championship – though it should be noted that it is impacted by the outsourcing of the catering division in 2012.

One of Chansiri’s stated objectives is to raise the club’s commercial profile in the Far Ease, notably Thailand and Singapore. To that end, his family will act as principal shirt sponsor in 2015/16 to “illustrate to the whole of the football world our total support for this club.” It will be interesting to see how much this deal is worth, given that Leicester City’s Thai owner organized a lucrative marketing agreement with Trestellar Limited that boosted their commercial revenue to £18.6 million.

"Loovens - Building on Fire"

In 2014/15 Wednesday’s shirts were emblazoned with the Azerbaijani “Land of Fire” logo, as worn by Atletico Madrid and Lens, which had been secured by Hafiz Mammadov, who at one stage had looked like he would take ownership of the club from Mandaric. The value of this arrangement was not disclosed, beyond the fact that it was “financially significant” and a “six-figure deal”. This replaced the 2013/14 deal with WANdisco, a global software development company.

Retail sales are also expected to improve after a three-year kit deal commencing in 2014/15 was signed with Sondico, part of the Sports Direct family of brands.

The wage bill rose by 5% (£0.6 million) from £11.9 million to £12.5 million, increasing/worsening the wages to turnover ratio from 80% to 90%, though part of the growth was due to the club’s decision to change the manager (Dave Jones) in December 2013.

This means that wages have risen by £4.2 million (51%) since promotion, which is considerably more than the £2.9 million (27%) revenue growth in the same period. Nevertheless, Wednesday’s wage bill is still one of the smallest in the Championship with only six clubs below them – though one (Watford) was promoted the following season.

It was significantly lower than the likes of Leicester City, Reading, Blackburn Rovers and Wigan Athletic, whose wages were all above £30 million. QPR were even higher at £75 million, but that was simply ridiculous in the second tier.

Wednesday’s wages to turnover ratio of 90% is not great, but it is only the 14th highest in the Championship. Given the relatively low revenue, many clubs in the second tier have a dreadful wages to turnover ratio with 10 of them being more than 100%, including QPR 195%, Bournemouth 172%, Nottingham Forest 165% and Millwall 132%.

Arguably, Wednesday’s lack of spending on wages contributed to their troubles, as their wages to turnover ratios before relegation were all on the low side, even though they steadily increased their wage bill to £9.6 million in 2010. This again highlights the challenges outside the top flight.

Player amortisation has been steadily rising since promotion, but is still only £1.0 million, again one of the lowest in the Championship. To put this into perspective, the highest player amortisation was at QPR £16.6 million, Blackburn Rovers £7.2 million, Wigan Athletic £6.8 million and Nottingham Forest £5.7 million.

As a reminder, transfer fees are not fully expensed in the year a player is purchased, but the cost is written-off evenly over the length of the player’s contract via player amortisation – even if the entire fee is paid upfront. As an example, Marco Matias was bought for a reported £3 million on a four-year deal, so the annual amortisation in the accounts for him would be £750,000.

In the same way, the lack of spending in the transfer market is reflected in the balance sheet, with the value of player (intangible) assets only £1.3 million in 2014.

Given their financial difficulties, it is no surprise that Wednesday have spent very little on player recruitment: just £2.6 million gross spend in the eight seasons up until 2014/15, offset by £6.4 million of sales, giving net sales of £3.8 million. Mandaric “tried to support the manager wherever possible”, but it’s been a whole new ball game since Chansiri arrived.

On the day he was announced as the new owner, he preached prudence: “I believe that there needs to be some investments into the club, but just throwing money at it is not a guarantee of success. We need to do it in a smart and sustainable manner. Some clubs throw a whole lot of money at it in the transfer market, but are not successful.”

However, he has bankrolled some major purchases with more than £9 million spent to date this summer on 15 players, including the likes of Marco Matias, Lucas Joao, Fernando Forestieri, Rhoys Wiggins and Lewis McGugan. In the past few days, there have been rumours of big money bids for a new striker, with Ross McCormack, Jordan Rhodes, Matej Vydra and Gary Hooper all being mentioned, so the spending might not have stopped there.

This is a big change for Wednesday, whose £0.3 million net sales over the last two completed seasons (2013/14 and 2014/15) was one of the lowest in the Championship. Although this comparison has to be treated with some caution, as the figures are distorted by clubs that were in the Premier League the previous season, either because of high spend when they were in the top flight or large sales following their relegation, it is evident that Wednesday have been comfortably outspent by their rivals, so have effectively been competing with one hand tied behind their back.

Wednesday’s gross debt increased by £1.5 million to £12.7 million in 2014. Almost all of this (£11.3 million) was owed to Mandaric’s company (“The debt is not club debt, it’s my debt as far as I’m concerned”), but there was also a £1.4 million overdraft.

This is a significant improvement on the situation when Mandaric took control with the last accounts before his takeover in 2010 showing debt of £42.6 million, including £21.5 million owed to the bank. Following the Serb’s arrival, the club benefited from the £21.4 million waiver of the previous ownership’s loan and the settlement of the external debt. More recently £0.8 million of debt was converted into share capital in November 2014.

That said, the debt had been creeping up in the last four years before Chansiri’s appearance and the accounts also include £5.1 million of other loans in accruals that are not classified as net debt for some reason. To an extent, this is all irrelevant now, as it has been claimed that the club is debt free – to be confirmed when the 2014/15 accounts are published.

In addition, the club had contingent liabilities of £0.9 million, split between transfer fees of £505,000, dependent on future appearances, and loyalty bonuses of £392,000, if players are still with Wednesday on certain dates. On top of that, in the event of promotion to the Premier League before 31 May 2021, payments will become due to players, staff and loan note holders (£1.3 million) and the Co-operative Bank (£750,000).

Using Wednesday’s definition of debt, their £12.7 million was one of the lowest in the Championship, as many clubs have built up substantial debt (very largely owed to their owners) in their pursuit of promotion, especially Bolton Wanderers £195 million, QPR £185 million, Brighton £131 million, Ipswich Town £86 million, Blackburn Rovers £80 million and Middlesbrough £77 million.

Wednesday’s cash flow from operating activities has been negative since 2009, requiring funding from the owner to balance the books with £11.3 million put in by Mandaric in the last four years. Hardly any money has been spent on player recruitment (net) or capital expenditure, though £1.3 million of interest payments have been made in the last six years, including £0.5 million in 2014 alone.

The need for financial support was referenced by Mandaric when he introduced Chansiri: “His enthusiasm, his drive to win the games and, of course, financial backing will allow him to be a top chairman for this great club.” Apart from player purchases, there is a need to invest in infrastructure, such as the stadium, the pitch and the training facilities at Middlewood Road.

The 2013/14 accounts confirmed that Wednesday have complied with the new Football League rules in respect of Financial Fair Play (FFP), adding, “we remain confident that the club can continue to operate within the current FFP regulations.” The £0.8 million conversion of debt into equity in November 2014 implied that this was the amount that was required to be in line with the allowed FFP losses.

The current rules will continue to apply for the 2014/15 and 2015/16 seasons (though the maximum allowed loss is increased to £13 million from the second season), but will change from the 2016/17 season to be more aligned with the Premier League’s regulations, e.g. the losses will be calculated over a three-year period up to a maximum of £39 million. This more relaxed approach should help facilitate Chansiri’s spending plans.

"Long May you run"

FFP encourages clubs to invest in youth development, which is an area of focus for Wednesday, whose academy was granted Category Two status under the Elite Player Performance Plan (EPPP). However, there is a price to pay with a “considerable” increase in investment in the academy taking the costs above £1 million.

The concern with EPPP is that the changes in the contractual position of players under 16 might produce a situation where clubs such as Wednesday become feeder clubs, “ultimately subsidising the costs of youth development for those able to attract the best available talent without paying the true value to the club that worked so hard developing the player.”

"Under my thumb"

There is no doubt that supporters have been put through the wringer in the past few years, very nearly going all the way “from the Ritz to the rubble” as big Wednesday fans Arctic Monkeys once sang, but Chansiri’s money might just change that.

He certainly talks a good match: “I’m developing plans over the short, medium and long term to maximise the sporting potential of Sheffield Wednesday in a healthy and sustainable manner. We feel that if we make smart decisions and savvy investments that within a couple of seasons, it’s very possible to get to the Premier League.”

The owner’s dream is to celebrate Wednesday’s 150th anniversary back in the Premier League, which would mean returning to the top flight for 2017. That’s obviously very far from a done deal, but at least the Owls now have a fighting chance.

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Big Markets, Over Confidence and the Macro Delusion!

In early October of 2013, I was sitting in CNBC, waiting to talk about Twitter, which had just filed its prospectus (for its initial public offering). I was sharing the room with an analyst who was very bullish on the company, and he asked me what I thought Twitter was worth. When I replied that I had not had a chance to value the company yet, he suggested that I should save myself the trouble, and that the stock was worth at least $60 a share. Curious, I asked him why, and he said that Twitter would use its large user base to make money in the "huge" online advertising market. When I questioned him on how huge the market was, his answer was that he did not have a number, but he just knew that it was "really big". I am thankful to him, since he framed how I started my valuation of Twitter, which is with an assessment of the size of the online advertising market globally. Since I talked to that analyst, I have also become more more aware of the big market argument, and I have seen it used over and over in other markets, often as the primary and sometimes the only reason for assigning high values to companies in these markets. These analysts may very well be right about these markets being very big, but I think that suggesting that a company will be assured growth and profits, just because it targets these markets, not only misses several intermediate steps, but also exposes investors and business-owners to the macro delusion.

Big Markets! Really, Really Big Markets!

Would I rather that my company operate in a big market than a small one? Of course. Increasing market potential, holding all else constant, is good for value, but for that value to be generated, a whole host of other pieces have to fall into place. First, the company has to be able to capture a reasonable market share of that big market, a task that can be made difficult if the market is splintered, localized or intensely competitive. Second, the company has to be able to generate profits in that big market and create value from growth, also a function of the firm's competitive advantages and market pricing constraints. Third, once profitable, the company has to be able to keep new entrants out, easier in some sectors than in others.

It is therefore dangerous to base your argument for investing in a company and assigning it high value entirely on the size of the market that it serves, but that danger does not seem stop analysts and investors from doing so. Here are four examples:

China: A billion-plus people makes any market large, and if you add rapid economic growth and a
burgeoning middle class to the mix, you have the makings of a marketing wet dream. Visions of millions of cell phones, refrigerators and cars being sold were enough to justify attaching large premiums to companies that had even a peripheral connection to China. The events of the last few weeks have made the China story a little shakier, but it will undoubtedly return, once things settle down.

Online Advertising: It is undeniable that more and more of business advertising is moving online, and this shift has not only pushed Google, Facebook and Alibaba to the front lines of large market cap companies but has been the impetus behind Twitter, Yelp, Linkedin and a host of other social media companies capturing market capitalizations that seem outsized, relative to their operating metrics.

The Sharing Economy: Even as private businesses, Uber and Airbnb have not only captured the attention of investors, with multi-billion dollar valuations, but have also disrupted conventional approaches to doing business. In the process, they have opened up the sharing paradigm, where private property (car, house) owners can put excess capacity in what they own to profitable use. 

The Cloud: This is a recent entrant to the "big" market parade, as both technology titans such as Intel, Google and Amazon and new entrants such as Box vie to put our music, video, data and even our computing capabilities on large shared computers. Bessemer Venture Partners, which tracks companies that generate revenues from cloud computing, estimated a collective market capitalization of $170 billion for these companies in August 2015.

I am sure that you will find more examples add to the list. For example, just a couple of weeks ago, Morgan Stanley issued a strong buy recommendation on Tesla and based it entirely on its potential growth in the "mobility services" market. It took me two readings of the report for me to figure out that the mobility service market was a hybrid of the car sharing and driverless car markets, a potentially huge market, that would have become even enormous, if you were able to slap ads on the cars and put them in China.

The Macro Delusion: Individual Rationality, Collective Irrationality

When you label a market as a bubble, you take the easy way out, since a market bubble suggests that the investors who push prices to unsustainably high levels are being irrational, crazy and perhaps even stupid. It is for that reason that I have used the word guardedly (and when I have, regretted it), and taken issue with "market bubblers" in earlier posts. Even if you believe that assets (real estate, stocks, bonds) are being over priced, you will almost always be better served assuming that investors setting these prices have their own reasons for doing so, and understanding those reasons (even if you disagree with them).

To see how (almost) rational and (mostly) smart individuals can be fooled by big market potential into being collectively irrational, assume that you are an entrepreneur who has come up with a product that you see as having a large potential market and that, based on that assessment, you are able to convince venture capitalists to fund your business.

Note that everyone in this picture is behaving sensibly. The entrepreneur has created a product that he sees as fulfilling a large market need and the venture capitalists backing the entrepreneur see the potential for profit from the product.

Now assume that six other entrepreneurs see the same big market potential at about the same time you do, and create their own products to fulfill that market need, and that each finds venture capitalists to back his or her product and vision. 

To make the game interesting, let's make each of these entrepreneurs bright and knowledgeable about their products, and let's make the VCs also smart and business savvy. If this were a rational market place, each entrepreneur and his/her VC backers should be valuing his/her business, based on assessments of market potential and success, and the existence of current and future competitors.

Let's now add the twist that causes the deviation from rationality and make both the entrepreneurs and VCs over confident, the former in the superiority of their products over the competition, and the latter in their capacity to pick winners. This is neither an original assumption, nor a particularly radical one, since there is substantial evidence already that both groups (entrepreneurs and venture capitalists) attract over confident individuals.  The game now changes, since each business cluster (the entrepreneur  and the venture capitalists that back his or her business) will now over estimate its capacity to succeed and its probability of success, resulting in the following. First, the businesses that are targeting the big market will be collectively over valued. Second, the market place will become more crowded and competitive over time, especially with new entrants being drawn in because of the over valuation. Thus, while revenue growth in the aggregate may very well match expectations of the market being big, the revenue growth at firms will fall below collective expectations and operating margins will be lower than expected. Third, the aggregate valuation of the sector will eventually decline and some of the entrants will fold, but there will be a few winners, where the entrepreneurs and VCs will be well rewarded for their investments.

The collective over valuation of the companies in the big market will bear resemblance to a bubble, and the correction will lead to the usual hand wringing about bubbles and market excesses, but the culprit is over confidence, a characteristic that is almost a prerequisite for successful entrepreneurship and venture capital investing. That is one reason that I feel no need to inveigh against bubbles in the social media space, since this is a feature of investing in young, start-up businesses in big markets, not a bug. That said, the extent of the over pricing will vary, depending upon the following:

1. The Degree of Over Confidence: The greater the over confidence exhibited by entrepreneurs and investors in their own products and investment abilities, the greater will be the over pricing. While both groups are predisposed to over confidence, that over confidence tends to increase with success in the market. Not surprisingly, therefore, the longer a market boom lasts in a business space, the larger the over pricing will tend to get in that space. If fact, you can make a reasonable argument that the over pricing will be greater in markets where you have more experienced venture capitalists and serial entrepreneurs.
2. The Size of the Market: As the target market gets bigger, it is far more likely that it will attract more entrants, and if you add in the over confidence they bring to the game, the collective over pricing will increase.
3. Uncertainty: The more uncertainty there is about business models and the capacity to convert them into end revenues, the more over confidence will skew the numbers, leading to greater over pricing in the market. 
4. Winner-take-all markets: The over pricing will be much greater in markets, where there are global networking benefits (i.e., growth feeds on itself) and winners can walk away with dominant market shares. Since the payoffs to success is greater in these markets, misestimating the probability of success will have a much bigger effect on value.

The Online Ad Market and Social Media Company Valuations

The market that best lends itself to run this experiment today is the online advertising market, with the influx of social media companies into the marketplace in the last few years. To run my experiment, I took the market capitalization of each company in the online advertising space and backed out of the expected revenues ten years from now. To do this, I had to make assumptions about the rest of the variables in my valuation (the cost of capital, target operating margin and sales to capital ratio) and hold them fixed, while I varied my revenue growth rate until I arrived at the current market capitalization. 

The figure below illustrates this process using Facebook with the enterprise value of $245,662 million from August 25, 2015, base revenues of $14,640 million  (trailing 12 months) and a cost of capital of 9%. Leaving the existing margins unchanged at 32.42%, we can solve for the imputed revenue in year 10:

Spreadsheet

I assume that Facebook's current proportion of revenues from advertising (91%) will remain unchanged over the next decade, yielding imputed revenues from advertising for Facebook of $117,731 million in 2025. The assumption that the advertising proportion will remain unchanged may be questionable, at least with some of the other companies on the list below, where investors may be pricing in growth in new markets into the value. You undoubtedly will disagree with this and some of my other assumptions, which is why I will let you make your own in the attached spreadsheet and solve for your estimate of future revenues.

I repeat this process with other publicly traded companies with significant online advertising revenues, using a fixed cost of capital and a target pre-tax operating margin of  either the current margin or 20%, whichever is higher, for every firm. Note that both assumptions are aggressive (the cost of capital may have been set too low and the operating margin is probably too high, given competition) and both will push imputed revenues in year 10 down.

Numbers & Valuations in US dollars for all companies (Folder with valuations)

The collective online advertising revenues imputed into the market prices of the publicly traded companies on this list, in August 2015, was $523 billion.  Note that this list is not comprehensive, since it excludes some smaller companies that also generate revenues from online advertising and the not-inconsiderable secondary revenues from online advertising, generated by firms in other businesses (such as Apple). It also does not include the online adverting revenues being imputed into the valuations of private businesses like Snapchat, that are waiting in the wings. Consequently, I am understating the imputed online advertising revenue that is being priced into the market right now.

To gauge whether these imputed revenues are viable, I looked at both the total advertising market globally and the online advertising portion of it. In 2014, the total advertising market globally was about $545 billion, with $138 billion from digital (online) advertising (Sources: Zenith Optimedia. eMarketer). The growth rate in overall advertising is likely to reflect the growth in revenues at corporations, but online advertising as a proportion of total advertising will continue to increase. In the table below, I allow for different growth rates in the overall advertising market over the 2015-2025 time period and varying proportions moving to digital advertising to arrive at these estimates of digital/online advertising revenues in 2025:

Even with optimistic assumptions about the growth in total advertising and the online advertising portion of it climbing to 50% of revenues, the total online advertising market in 2025 is expected to be $466 billion. The imputed revenues from the publicly traded companies on my list is already in excess of that number, and it seems reasonable to conclude that these companies are being over priced, relative to the market (online advertising) that they are expected to profit from.

As more companies line up to enter this space, this gap between the size of the market that is priced in and the actual market will continue to grow, but investors will continue to fund these companies, even if they are aware of the gap. After all, the nature of over confidence is that founders and investors are convinced that the over pricing is not at their firms, but in the rest of the market. There are two threats to this over confidence and they are inevitable. The first is that as companies in this space continue to report earnings and revenues, you will see more negative surprises (lower revenue growth, shrinking margins and more reinvestment) and some price adjustment. The second is that there is no better deflator of investors over confidence than a market panic, and if the China crisis does not do it, there will be others down the road.

What now?

Even if you accept my argument that big markets can create macro delusions and that these delusions can lead to a gap between collective expectations and reality, what you should do, in response, will depend on how you approach investing. If you are a trader, playing the pricing game, you may not care about the gap, since your returns will be based on timing, i.e., entering the market at the right time and exiting before the delusion is laid bare. It is possible that a lot of public investors and venture capitalists in this space are playing this pricing game and some of them will get very rich doing so. 

If you are a founder/owner or private investor interested in the long term value of your business, you may not be able to do much about your over confidence but there are a few simple steps that you can take to keep it in check. I do know that many in the start-up community view intrinsic valuations (or DCFs) with suspicion, but done right, a DCF is more than a valuation of a company. It provides a template for how you hope to convert products/users/downloads into revenues and profits, how much capital you will need to deliver the growth you so eagerly seek, and how competition will impinge on your best laid plans (by affecting growth and margins).  

If you are a public market investor, surveying a "big market" group of companies, this post is not a clarion call to abandon the group, but to approach it differently. You can still make money investing in this sector, but only if you are selective about the companies that you invest in (which requires that you grapple with estimating the size of the big market and make your best judgments on winners and losers)  and are cognizant of the price that you are paying, not only when you buy the stock but while your hold it. In fact, your very best investments may come from mis-pricing in this segment.

No matter which group you belong to, it is time that we stop labeling each other. If you are on the outside (of these big markets) looking in, don't be so quick to categorize players in the market as irrational, shallow and naive. If you are on the inside looking out, stop thinking of anyone who does not buy into your big market thesis as a Luddite, out of touch with technology and stuck in the past. You and I should be able to disagree about the values of Uber, Snapchat and Twitter, without our motives being impugned, our intelligence questioned and our sanity put to the test.

YouTube Version
I know that this is a long post and that your attention may have flagged half way through. To remedy that, I decided to make a YouTube video around this post. I hope you enjoy it!

Attachments

1. Imputed Online Ad Revenues by Company (with raw data on the companies)
2. Spreadsheet to compute Imputed Online Ad Revenues
3. Folder with imputed revenue spreadsheets for companies

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Another Market Crisis? My Survival Manual/Journal!

I would be lying if I said that I like down markets more than up markets, but I have learned to accept the fact that markets that go up will come down, and that when they do so quickly, you have the makings of a crisis. I find myself getting more popular during these periods, as acquaintances, friends and relatives that I have not heard from in years seem to find me. They are  invariably disappointed by my inability to forecast the future and my unwillingness to tell them what to do next, and I am sure that I move several notches down the Guru scale as a consequence, a development that I welcome. To save myself some repetitions of this already tedious sequence, I think it is best that I pull out my crisis survival journal/manual, a work in progress that I started in the 1980s and that I revisit and rewrite each time markets go into a tailspin. It is more journal than manual, more personal than general, and more about me than it is about markets. So, read on at your own risk!

The Price of Risk

For me, the first casualty in a crisis is perspective, as I find myself getting whipsawed with news stories about financial markets, each more urgent and demanding of attention than the previous one. The second casualty is common sense, as my brain shuts down and my primitive impulses take over. Consequently, I find it useful to step back and look at the big picture, hoping to see patterns that help me make sense of the drivers of market chaos.

It is my view that the key number in understanding any market crisis is the price of risk. In a market crisis, the price of risk increases abruptly, causing the value of all risky assets to drop, with that drop being greater for riskier assets. While the conventional wisdom, prior to 2008, was that the price of risk in mature markets is stable and does not change much over short periods, the last quarter of 2008 changed (or should have changed) that view. I started tracking the price of risk in different markets (equity, bond, real estate) on a monthly basis in September 2008, a practice that I have continued through the present. Getting an a forward-looking, dynamic price of risk in the bond market is simple, since it takes the form of default spreads on bonds, and FRED (the immensely useful Federal Reserve Database) has the market interest rates on a Baa rated (Moody's) bonds going back to 1919, with data available in annual, monthly or daily increments. That default spread is computed by taking the difference between this market interest rate and the US treasury bond rate  on the same date. Getting a forward-looking, dynamic price of risk in the equity markets is more complicated, since the expected cash flows are uncertain (unlike coupons on bonds) and equities don't have a specific maturity date, but I have argued that it can be done, though some may take issue with my approach. Starting with the cumulative cash flow that would have generated by investing in stocks in the most recent twelve months, I estimate expected cash flows (using analysts' top down estimates of earnings growth) and compute the rate of return that is embedded in the current level of the index. That internal rate of return is the expected return on stocks and when the US treasury bond rate is netted out, it yields an implied equity risk premium. The January 2015 equity risk premium is summarized below:

Implied ERP Spreadsheet (January 2015)

That premium had not moved much for most of this year, with a low of 5.67% on March 1, and a high of 6.01% in early February, and the ERP at the start of August was 5.90%, close to the start-of-the-year number. Given the market turmoil in the last weeks, I decided to go back and compute the implied equity risk premium each day, starting on August 1.

ERP By Day

Note that not much changes until August 17, and that almost all of the movement have been in the days between August 17 and August 245 During those seven trading days, the S&P 500 dropped by more than 11% and if you keep cash flows fixed, the expected return (IRR) for stocks increased by 0.68%. During the same period, the US treasury bond rate dropped by 0.06%, playing its usual "flight to safety" role, and the implied equity risk premium (ERP) jumped by 0.74% to 6.56%. 

I did use the trailing 12-month cash flows (from buybacks and dividends) as my base year number, in computing these equity risk premiums, and there is a reasonable argument to be made that these cash flows are too high to sustain, partly because earnings are at historic highs and partly because companies are returning more of that cash than ever before. To counter this problem, I assumed that earnings would drop back to a level that reflects the average earnings over the last 10 years, adjusted for inflation (i.e., the denominator in the Shiller CAPE model) and that the payout would revert back to the average payout over the last decade. That results in lower equity risk premiums, but the last few days have pushed that premium up by 0.53% as well.

My computed increases in ERP, using both trailing and normalized earnings, overstate the true change, because the cash flows and growth were left at what they were at the start of August, a patently unrealistic assumption, since this is also an economic crisis, and any slowing of growth in China will make itself felt on the earnings, cash flows and growth at US companies. That effect will take a while to show up, as corporate earnings, buyback plans and analyst growth estimates are adjusted in the months to come, and I am sure that some of the market drop was caused by changes in fundamentals. The argument that a large portion of the drop comes from the repricing of risk is borne out by the rise in the default spread for bonds, with the Baa default spread widening by 0.17%, and the increase in the perceived riskiness (volatility) of stocks, with the VIX posting its largest weekly jump ever, in percentage terms.

The Repricing of Risky Assets
When the price of risk changes, all risky assets will be repriced, but not by the same magnitude. Within mature markets, you should expect to see a bigger drop in stock prices at more risky companies than at safer ones, though how you define risk can affect your conclusions. If you define risk as exposure to the the precipitating factor in the crisis, I would expect the stock prices of  companies that are more dependent on China for their revenues to drop by more than the rest of the market. Since I don't have data on how much revenue individual companies get from China, I will use commodity companies, which have been aided the most by the Chinese growth machine over the last decade and therefore have the most to lose from it slowing down, as my proxy for China exposure. The table below highlights the 20 industry groups (out of 95) that have performed the worst between August 14 and August 24:

Notice that commodity companies comprise one quarter of the group, with a few cyclical and technology sectors thrown into the mix.

Looking across markets geographically, changes in the equity risk premium in mature markets will be magnified as you move into riskier countries and thus it is not surprising to see the carnage in emerging markets over the last week has exceeded that in developed markets, with currency declines adding to local stock market drops.

Percentage Return in US dollar terms

In the picture below, I capture the percentage change in market capitalizations between August 14, 2015, and August 24, 2015 in U.S. $ terms, with the PE ratios as of August 14 and August 24 highlighted for each country:

via chartsbin.com
Note that this phenomenon of emerging markets behaving badly cannot be blamed on China, since it happened in 2008 as well, when it was the banking system in developed markets that triggered the market rout.

A Premium for Liquidity?

There is another dimension, where crises come into play, and that is in the demand for liquidity. While investors always prefer more liquid assets to less liquid ones, that preference for liquidity and the price that they are willing to pay for it varies across time and tends to surge during market crisis. To see if this crisis has had the same effect, I looked at the drop in market capitalization, in US $ terms, between August 14 and 24 for companies classified by trading turnover ratios (computed by dividing the annual dollar trading value by the market capitalization of the company):

Liquidity classes, based on turnover ratio = $ Trading Value/ $ Market Cap

Surprisingly, it is the most liquid firms that have seen the biggest drop in stock prices, though the numbers may be contaminated by the fact that trading halts are often the reactions to market crises in many countries, that are home to the least liquid stocks. If this is the reason for the return divergence, there is more pain waiting for investors in these stocks as the market drop shows up in lagged returns.

To the extent that market crises crimp access to capital markets, the desire for liquidity can also reach deeper into corporate balance sheets, creating premiums for companies that have substantial cash on their balance sheets and fewer debt obligations. To test this proposition, I classified firms globally, based upon the net debt as a percent of enterprise value, and looked at the price drop between August 14 and August 24:

Net Debt/EV = (Total Debt- Cash)/ (Debt + Market Cap - Cash)

The crisis seems to have spared no group of stocks, with the pain divided almost evenly across the net debt classes, with the largest price decline being in the stocks that have cash balances that exceed their debt. Note, however, that the multiples at which these companies trade at both prior and after the drop, reflect the penalty that the market is attaching to extreme leverage, with the most levered companies trading at a PE ratio of 3.11 (at least across the 15.76% of firms in this group that have positive earnings to report). If your contrarian strategy for this market is to screen for and buy low PE stocks, this table suggests caution, since a large portion of the lowest PE stocks will come with high debt ratios.

As the public markets drop, the question of how this crisis will affect private company valuations has risen to the surface, especially given the large valuations commanded by some private companies. Since many of these private businesses are young, risky startups and that investments in them are illiquid, I would guess they will be exposed to a correction,  larger than what we observe in the public marketplace. However, given that venture capitalists and public investors in these companies will be self appraising the value of their holdings, the effect of any markdown in value will take the form of fewer high-profile deals (IPO and VC financing).

What now?

A market crisis bring out my worst instincts as an investor. First out of the pack is fear pushing me to panic, with the voice yelling "Sell everything, sell it now", getting louder with each bad market day. That is followed quickly by denial, where another voice tells me that if I don't check the damage to my portfolio, perhaps it has been magically unaffected. Then, a combination of greed and hubris kicks in, arguing that the market is filled with naive, uninformed investors and that this is my time to trade my way to quick profits. I cannot make these instincts go away, but I have my own set of rules for managing them. (I am not suggesting that these are rules that you should adopt, just that they work for me..)

1. Break the feedback loop: Being able to check your portfolio as often as you want and in real time, with our phones, tablets and computers, is a mixed blessing. I did check my portfolio this morning for the damage that the last week has done, but I don't plan to check again until the end of the week. If I find myself breaking this rule, I will consider sabotaging my wifi connection at home, going back to a flip phone or leaving for the Galapagos on vacation.
2. Turn off the noise: I read the Wall Street Journal and Financial Times each morning, but I generally don't watch financial news channels or visit financial websites. I become religious about this avoidance during market chaos, since much of the advice that I will get is bad, most of the analysis is after-the-fact navel gazing and all of the predictions share only one quality, which is that they will be wrong. 
3. Rediscover your faith: In my book (and class) on investment philosophies, I argue that there is no "best' investment philosophy that works for all investors but that there is one for you, that best fits what you believe about markets and your personality. My investment philosophy is built on faith in two premises, that every business has a value that I can estimate, and that  the market price will move towards that value over time. During a crisis, I find myself returning to the core of that philosophy, to make sense of what is going on.
4. Act proactively and consistently: It is natural to want to act in response to a crisis. I am no exception and I did act on Monday, but I tried to do so consistently with my philosophy. I revisited the valuations that I have done over the past year (and you can find most of them on my website, under my valuation class) and put in limit buy orders on a half a dozen stocks (including Apple, Tesla and Facebook), with the limit prices based on my valuations of the companies. If the crisis eases, none of the limit orders may go through, but I would have protected myself from impulsive actions that will cost me more in the long term. If it worsens, all or most of the of the limit buys will be executed, but at prices that I think are reasonable, given the cash flow potential of these companies.

Will any of these protect me from losing money? Perhaps not, but I did sleep well last night and am more worried about whether the New York Yankees will score some runs tonight than I am about what the Asian markets will do overnight. That, to me, is a sign of health!

The Silver Linings

Just as recessions are a market economy's way of cleansing itself of excesses that build up during boom periods, a market crisis is a financial market's mechanism for getting back into balance. I know that is small consolation for you today, if you have lost 10% or more of your portfolio, but there are seedlings of good news, even in the dreary financial news:

1. Live by momentum, die by it: In trading, momentum is king and investors who play the momentum game make money with ease, but with one caveat. When momentum shifts, the easy profits accumulated over months and years can be wiped out quickly, as commodity and currency traders are discovering.
2. Deal or no deal? If you share my view that slowing down in M&A deals is bad news for deal makers, but good news for stockholders in the deal-making companies, the fact that this crisis may be imperiling deals is positive news.
3. Rediscover fundamentals: My belief that first principles and fundamentals ultimately win out and that there are no easy ways to make money is strengthened when I read that carry traders are losing money, that currency pegs do not work when inflation rates deviate, and mismatching the currencies in which you borrow and generate cash flows is a bad idea.    
4. The Market Guru Handoff: As with prior crises, this one will unmask a lot of economic forecasters and market gurus as fakes, but it will anoint a new group of prognosticators who got the China call right as the new stars of the investment universe. 

If a market crisis is a crucible that tests both the limits of my investment philosophy and my  faith in it, I am being tested and as with any other test, if I pass it, I will come out stronger for the experience. At least, that is what I tell myself as I look at the withered remains of my investments in Vale and Lukoil!

Spreadsheets

1. Implied Equity Risk Premium Spreadsheet (August 2015)
2. Returns (8/14-8/24) and PE ratios (before & after), by Industry Group
3. Returns (8/14-8/24) and PE ratios (before & after), by Country

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