Deja Vu In Turkey: Currency Crisis and Corporate Insanity!

This has been a year of rolling crises, some originating in developed markets and some in emerging markets, and the market has been remarkably resilient through all of them. It is now Turkey's turn to be in the limelight, though not in a way it hoped to be, as the Turkish Lira enters what seems like a death spiral, that threatens to spill over into other emerging markets. There is plenty that can be said about the macro origins of this crisis, with Turkey's leaders and central bank bearing a lion's share of the blame, but that is not going to be the focus of this post. Instead, I would like to examine how Turkish business practices, and the willful ignorance of basic financial first principles, are making the effects of this crisis worse, and perhaps even catastrophic. 

The Turkish Crisis: So far!

The Turkish problem became a full fledged crisis towards the end of last week, but this is a crisis that has been brewing for months, if not years. It has its roots in both Turkish politics and dysfunctional practices on the part of Turkish regulators, banks and businesses, and has been aided and abetted by investors who have been too willing to look the other way. The most visible symbol of this crisis has been the collapse of the Turkish Lira, which has been losing value, relative to other currencies, for a while, capped off by a drop of almost 15% last Friday (August 10):

Yahoo! Finance

While it is undoubtedly true that the weaker Lira will lead to more problems, currency collapses are symptoms of fundamental problems and for Turkey, those problems are two fold. One is a surge in inflation in the Turkish economy, which can be seen in graph below:

While it easy to blame the Turkish central bank for dereliction of duty, it has been handicapped by Turkey's political leadership, which seems intent on making its own central bank toothless. Rather than allow the central bank to use the classic counter to a currency collapse of raising central bank-set interest rates, the government has put pressure on the bank to lower rates, with predictable (and disastrous) consequences.

Corporate Finance: First Principles

I teach both corporate finance and valuation, and while both are built on the same first principles, corporate finance is both wider and deeper than valuation since it looks at businesses from the inside out. i.e., how decisions made a firm's founders/managers play out in value. In my introductory corporate finance class, I list out the three common sense principles that govern all businesses and how they drive value:

The financing principle operates at the nexus of investing and dividend principles and choices you make on financing can affect both investment and dividend policy. It is true that when most analysts look at the financing principle, they zero in on the financing mix part, looking at the right mix of debt and equity for a firm. I have posted on that question many times, including the start of this year as part of my examination of global debt ratios, and have used the tools to assess whether a company should borrow money or use equity (See my posts on Tesla and Valeant). There is another part to the financing principle, though, that is often ignored, and it is that the right debt for a company should mirror its asset characteristics. Put simply, long term projects should be funded with long term debt, convertible debt is a better choice than fixed rate debt for growth companies and assets with cash flows in dollars (euros) should be funded with dollar (euro) debt. The intuition behind matching does not require elaborate mathematical reasoning but is built on common sense. When you mismatch debt (in terms of maturity, type or currency) with assets, you increase your likelihood of default, and holding debt ratios constant, your cost of debt and capital.

In effect, your perfect debt will provide you with all of the tax benefits of debt while behaving like equity, with cash flows that adapt to your cash flows from operations.

There are two ways that you can match debt up to assets. The first is to issue debt that is reflective of your projects and assets and the second is to use derivatives and swaps to fix the mismatch. Thus, a company that gets its cash flows in rupees, but has dollar debt, can use currency futures and options to protect itself, at least partially, against currency movements. While access to derivatives and swap markets has increased over time, a company that knows its long term project characteristics should issue debt that matches that long term exposure, and then use derivatives & swaps to protect itself against short term variations in exposure.

Turkey: A Debt Mismatch Outlier?

The argument for matching debt structure (maturity, currency, convertibility) to asset characteristics is not rocket-science but corporations around the world seem to revel in mismatching debt and assets, using short term debt to fund long term assets (or vice versa) and sometimes debt in one currency to fund projects that generate cashflows in another. In numerous studies, done over the decades, looking across countries, Turkish companies rank among the very worst, when it comes to mismatching currencies on debt, using foreign currency debt (Euros and dollars primarily) to fund domestic investments. 

Lest I be accused of using foreign data services that are biased against Turkey, I decided to stick with the data provided by the Turkish Central Bank on the currency breakdown of borrowings by Turkish firms. In the chart below, I trace the foreign exchange (FX) assets and liabilities, for non-financial Turkish companies, from 2008 and 2018:

Central Bank of Turkey

The numbers are staggeringly out of sync with  Turkish non-financial service companies owing $217 billion more in foreign currency terms than they own on foreign currency assets, and this imbalance (between foreign exchange assets and liabilities) has widened over time, tripling since 2008.

I am sure that there will be some in the Turkish business establishment who will blame the mismatching on external forces, with banks in other European countries playing the role of villains, but the numbers tell a different story. Much of the FX debt has come from Turkish banks, not German or French banks, as can be seen in the chart below:

Central Bank of Turkey

In 2018, 59% of all FX liabilities at Turkish non-financial service firms came from Turkish banks and financial service firms, up from 39% in 2008. The mismatch is not just on currencies, though. Looking at the breakdown, by maturity, of FX assets and liabilities for Turkish non-financial service firms, here is what we see:

Central Bank of Turkey

In May 2018, while about 80% of FX assets are Turkish non-financial firms are short term, only 27% of the FX debt is short term, a large temporal imbalance.

It is possible that the Turkish government may be able to put pressure on domestic banks to prevent them from forcing debt payments, in the face of the collapse of the lira, but looking at when the debt owed foreign borrowers comes due (for both Turkish financial and non-financial firms), here is what we see.

Central Bank of Turkey

From a default risk perspective, though, the debt maturity schedule carries a message. About 50% of debt owed by Turkish banks and 40% of the debt owed by Turkish non-financial service companies will be coming due by 2020, and if the precipitous drop in the Lira is not reversed, there is a whole lot of pain in store for these firms.

Rationalizing the Mismatch: The Good, The Dangerous and the Deadly

Turkish firms clearly have a debt mismatch problem, and the institutions (government, bank regulators, banks) that should have been keeping the problem in check seem to have played an active role in making it worse. Worse, this is not the first time that Turkish firms and banks will be working through a debt mismatch crisis. It has happened before, in 1994, 2001 and 2008, just looking at recent decades. If insanity is doing the same thing over and over, expecting a different outcome, there is a good case to be made that Turkish institutions, from top to bottom, are insane, at least when it comes to dealing with currency in financing. So, why do Turkish companies seem willing to repeat this mistake over and over again? In fact, since this mismatching seems to occur in many emerging markets, though to a lesser scale, why do companies go for currency mismatches? Having heard the rationalizations from dozens of CFOs on every continent, I would classify the reasons on a spectrum from acceptable to absurd.

Acceptable Reasons
There are three scenarios where a company may choose to mismatch debt, borrowing in a currency other than the one in which it gets its cash flows.

1. The mismatched debt is subsidized: If the mismatched debt is being offered to you (the borrower) at rates that are well below what you should be paying, given your default risk, you should accept that mismatched debt. That is sometimes the case when companies get funding from organizations like the IFC that offer the subsidies in the interests of meeting other objectives (such as increasing investment in under developed countries). It can also happen when lenders and bondholders become overly optimistic about an emerging market's prospects, and lend money on the assumption that high growth will continue without hiccups.
2. Domestic debt markets are moribund: There are emerging markets where the only option for borrowing money is local banks, and during periods of uncertainty or crisis, these banks can pull back from lending. If you are a company in one of these markets and have the option of borrowing elsewhere in the world to fund what you believe are good investments, you may push forward with your borrowing, even though it is currency mismatched.
3. Domestic debt markets are too rigid: As you can see from the debt design section, the perfect debt for your firm will often require tweaks that include not only conversion and floating rate options, but more unusual tweaks (such as commodity-linked interest rates). If domestic debt markets are unwilling or unable to offer these customized debt offerings, a company that can access bond markets overseas may do so, even if it means borrowing in a mismatched currency.

In all three cases, though, once the money has been borrowed, the company that has mismatched its debt should turn to the derivatives and swap markets to reduce or eliminate this mismatch.

Dangerous Reasons
There are two reasons that are offered by some companies that mismatch debt that may make sense, on the surface, but are inherently dangerous:

1. Speculate on currency: Mismatching currencies, when you borrow money, can be a profitable exercise, if the currency moves in the right direction. A Turkish company that borrows in US dollars, a lower-inflation currency with lower interest rates, to fund projects that deliver cashflows in Turkish Lira, a higher-inflation currency, will book profits if the Lira strengthens against the US dollar. Since emerging market currencies can go through extended periods of deviation from purchasing power parity, i.e., the higher inflation emerging market currency strengthens (rather than weakening) against the lower inflation developed market currency, mismatching currencies can be profitable for extended periods. There will be a moment of reckoning, in the longer term, though, when exchange rates will correct, and unless the company can see this moment coming and correct its mismatch, it will not only lose all of the easy profits from prior periods, but find its survival threatened. Currency forecasting is a pointless exercise, even when practiced by professional currency traders, and I think that companies should steer away from the practice.
2. Everyone does it: I have argued that many corporate finance practices are driven by inertia and me-tooism rather than good sense, and in many countries where currency mismatches are common, the standard defense is that everyone does it. Many of these companies argue that the government cannot let the entire corporate sector slide into default and will step in to bail them out, and true to form, governments deliver those bailouts. In effect, the taxpayers become the backstop for bad corporate behavior.

Bad Reasons
I am surprised by some of the arguments that I have heard for mismatching debt, since they suggest fundamental gaps in basic financial and economic knowledge.

1. The mismatched debt has a lower interest rate:  I have heard CFOs of companies in emerging markets, where domestic debt carries high interest rates, argue that it is cheaper to borrow in US dollars or Euros, because interest rates are lower on loans denominated in those currencies. After all, it is cheaper to borrow at 5% than at 15%, right? Not necessarily, if the 5% rate is on a US dollar debt and the 15% debt is in Turkish Lira, and here is why. If the expected inflation rate in US dollars is 2% and in Turkish Lira is 14%, it is the Turkish Lira debt that is cheaper.
2. Risk/Reward: There are some companies that fall back on the proposition that mismatching debt is like any other financial choice, a trade off between higher risk and higher reward. In other words, their belief is that they will earn higher profits, on average and over time, with mismatched debt than with matched debt, but with more variability in those profits. This argument stems from the misplaced belief that markets reward all risk taking, when the truth is that senseless risk taking just delivers more risk, with no reward, and mismatching debt is senseless.

The Fix

It is too late for Turkish companies to fix their debt problem for this crisis, but given that this crisis too shall pass, albeit after substantial damage has been done, there are actions that we can take to keep it from repeating, though it will require everyone involved to change their ways:

• Governments should stop enabling debt mismatching, by not stepping in repeatedly to save corporates that have mismatched debt. That will increase the short term pain of the next crisis, but reduce the likelihood of repeating that crisis. 
• Bank Regulators should measure how much the banks that they regulate have lent out to corporates, in mismatched debt, and require them to set aside more capital to cover the inevitable losses. That, in turn, will reduce the profitability of lending out money to companies that mismatch.
• Banks have to incorporate whether the debt being taken by a business is mismatched in deciding how much to lend and on what terms. The interest rates on mismatched debt should be higher than on matched debt.
• Companies and businesses have to consider what currency a loan or bond is in, when evaluating interest rates, and in their own best interests, try to match up debt to assets, either directly (in debt design) or using derivatives.
• Investors in companies should start breaking down the profitability of firms with mismatched debt, especially in good periods, into profits from debt mismatch and profits from operations, and ignore or at least discount the former, when pricing these companies.

I don't think any of these changes will happen overnight but unless we change our behavior, we are designed to replay this crisis in other emerging markets repeatedly. 

YouTube Video


Data

1. FX Assets & Liabilities of Turkish non-financial corporations (from Turkish Central Bank)
2. Loans from Abroad to Turkish Private Sector

Papers

1. Financing Innovations and Capital Structure Choices

Read More

The Privatization of Tesla: Stray Tweet or Game Changing News

After my last two posts in Tesla, I was planning to take a break from the company, since I had said everything that I had to say about the company. In short, I argued that Tesla, notwithstanding its growth potential, was over valued and that to deliver on this potential, it would need to raise significant amounts of capital in the next few years. In an even earlier post, I described Tesla as the ultimate story stock, both blessed and cursed by having Elon Musk as a CEO, a visionary with a self destructive streak.  Even by Musk's own standards, his tweet on August 7 that Tesla would be going private, adding both a price ($420) and a postscript (that funding had been secured), was a blockbuster, pushung the stock price up more than 10% for the day. The questions that have followed have been wide ranging, from whether Tesla is a good candidate for  "going private" to the mechanics of how it will do so (about funding and structure) to the legality of conveying a market-moving news story in a tweet. 

1. Public to Private - The Why

When we talk about transitions between private and public market places, we generally tend to focus on private companies going public. That is because it is natural and common for a small, privately owned business, as it grows larger, to move to public markets, with an initial public offering. That said, there are publicly traded companies that seem to move in reverse and go back to being privately run businesses, as Tesla may be proposing to do. 

The Trade Off

To understand both transitions, the more-common private to public and the less-frequent public to private, let us consider the trade off between being a private business and a publicly traded company, from the perspective of the business:

Private versus Public: Business Perspective

The simple summary is that as a private company's need to access capital increases, it will accept more information disclosure and a more outsider-driven corporate governance structure, and make the transition to being a public company.  In recent years, the market for private equity has broadened and become deeper, allowing companies to stay private for far longer; Uber, for instance, is worth tens of billions of dollars and is still a private company. To fully understand the transitions, though,  we also have to look at the choice from the perspective of investors:

Private versus Public: Investor Perspective

In the classic structure of going public, private firms raise money from venture capitalists who accept less liquidity, but structure their equity investments to often get more protection and a bigger say in how the company is run. It is the desire for liquidity that makes venture capitalists push private companies to go public, so that they can cash out their investments. To be able to negotiate better disclosure and control, private company investors have to be investing larger amounts, and it is one reason that regulatory authorities have been wary of allowing small investors to invest in private companies, since they may end up with the worst of all worlds: illiquid investments in businesses, where they have no say in how the company is run, and no information about how well or badly it is doing.

The Public to Private Transition

With this trade off in mind, why would a public company choose to go back to being a private business? This transition makes sense if a company feels that the easier access to capital and a continuously set market price (which delivers liquidity), two features of public markets, no longer provide it with sufficient benefits, and/or the costs of disclosure and outsider intervention (from activist investors), that also come with being a public company, increase. In short, it has to be a company:

• that does not need access to large amounts of new capital to continue operating,
• where the market is under pricing the company, relative to its intrinsic value ,
• that feels the actions that it needs to take in its best long term interests will either create public backlash (layoffs and plant closures) or adverse market reactions (because of the effect that they will have on metrics that investors are focused upon).

It should come as no surprise that most companies that have gone through the public-to-private transition have been aging companies (no growth, no capital needed), trading at prices that are below their peer group (lower multiples of earnings or cash flows) and that need to shrink or slim down to keep operating.

The Tesla Case

As I look at the list of criteria for a good buyout company, I see nothing that would bring Tesla onto my radar as a potential candidate:

1. It is a growing company and it needs new capital to not only deliver on its growth promise but to survive for the next few years. If you are more optimistic than I am about Tesla, you may disagree with how much cash the company will have to raise to keep going, but I challenge even the most hardened optimist to tell me how the company will be able to increase production to a million cars or more without investing mind blowing amounts in new capacity.
2. If markets are punishing Tesla by under pricing the company, they are doing so in a very strange manner, giving it a higher market capitalization than much larger, more profitable automobile companies, ignoring large losses and generally tolerant of Elon Musk's errant behavior. In fact, if the critique of markets is that they are short term and focused on profits, Tesla would be the perfect counter example.
3. It is true that there was substantial drama and market volatility around the 5000 cars/week production target, and there may be some in the company who have the drawn the lesson that since there will be more production targets to come in the future, the company needs to operate out of market scrutiny. That would be the wrong lesson, since almost all of the drama in this episode, from setting the target (5000 cars/week) to the constant tweets about whether the targets would be met, was generated by Elon Musk, not the market. In fact, a cynic would argue that by focusing the market's attention on this short term target, Tesla has been able to avoid answering much bigger questions about its operations.

There are, of course, the short sellers in Tesla and Musk's frustration with them was clearly a driver of his "going private" tweet. His argument, which many of his supporters buy into, is that short sellers in public markets make money from seeing stock prices go down, and that some of them may do real damage to companies, because of this incentive. I will not dismiss this complaint, but I will come back to it later in this post, since I do think it is playing an outsized role in this process.

Public to Private - The Funding

When you decide to take a publicly traded company into the privately owned space, you have to replace the public capital (public equity and debt) with new capital that can be either private equity or new debt. 

The key questions then become what mix of debt and equity to use, how to raise the private equity needed to get the deal done and what the ultimate end game is in the transaction. Specifically, you may take a company private, because you want to control its destiny fully, and keep tit a private business in perpetuity. More often, though, the end game is to make the changes that you think will make the company more attractive to investors, and either take it back public or sell it to another public company.

The Analysis

If the company in question fits the buyout mold, i.e., it is an aging company with a lower market capitalization, relative to earnings and cash flows, than its peers, the going private transaction can be funded with a high proportion of debt, explaining why so many buyouts have leverage attached to them, making them leveraged buyouts. 

Given that the equity investors in the transactions have to give up public market governance tools, it should come as no surprise that in many of these deals, the private equity comes from a single firm, like KKR or Blackstone, with top managers holding some of the private equity, to align interests, after the deal goes through. Success in these deals comes from taking the reconfigured company public again, at a much higher value, leaving equity investors with outsized gains.

The Tesla Case

Tesla is a money-losing company, burning through significant amounts of cash. Not only is the company in no position to borrow more, I have argued before that it should not even carry the debt that it does. If this deal is to make sense, it has to be predominantly equity funded, but that does create some challenges. 

1. The No-pain solution: Musk, in his Tuesday tweets, seems to offer a solution, which, if feasible, would be relatively painless. In his set up, existing shareholders will be allowed to exchange their shares in Tesla, the public company, for shares in Tesla, the private business, and those shareholders who are unwilling to take this offer will sell their shares back to the company at $420/share. In the extreme case, where every existing shareholder takes this offer and if existing debt holders are willing to continue to lend to the new private enterprise, Tesla will need no new funding:

This would be magical, if you can pull it off, but there are two significant impediments. The first is that the deal may not pass legal muster, since the SEC restricts private companies to having less than 2000 shareholders, and Tesla has far more than that number. It is true that you might be able to create a fund that has individual shareholders, which then holds equity in the private company, like Uber has, but that fund is restricted to very wealthy, big investors, and the SEC may be unwilling to go along with a structure where there are thousands of small stockholders in the fund. The second is that even if Tesla manages to get regulatory approval for this unconventional set up, many shareholders may choose to cash out at $420, if the company goes private, even if they think that the shares are worth more, because they value liquidity.

2. A Deep-pocketed Outsider: The announcement that the Saudi Sovereign fund had invested $2 billion in Tesla shares came just before Musk's "going private" tweet, setting up a second possibility, which is the a large private equity investor (or several) would step in to fund the deal. Here, Tesla's large market capitalization and cash burning status work against it, reducing the number of potential players in the game. At the limit, if all existing shareholders, other than Musk, cash out at $420/share, you would need about $55-$60 billion in funding. No sovereign fund or passive investment vehicle can afford to have that much money tied up in one company, and especially one that is illiquid and will need more capital infusions in the future. Even the biggest private equity and venture capital investors, generally more willing to hold concentrated positions, will be hard pressed to put this much capital, for the same reasons. In fact, the only name that you can come up with that has even the possibility of pulling this off is Softbank, for three reasons:

• They may be big enough to make the investment. As a publicly traded company with a market capitalization of $103 billion, making a $55-60 billion additional investment in Tesla would be a reach, but Softbank is capable of drawing other investors of its ilk into the funding.
• They have and are invested in young, growth companies: Unlike traditional PE investors whose focus has been on doing leveraged deals of cash-rich companies, Softbank has invested successfully in growth companies, many of whom continue to burn through cash.
• They have a history with Tesla: There were rumors last year that Tesla and Softbank had talked about taking the company private, but control disagreements caused negotiations to break down.

That said, I am not sure that Elon Musk and Masayoshi Son (Softbank's CEO) can co-exist in the same company. Both value control, and both are unpredictable, and I have to confess that watching the two tango would make for great entertainment.
3. A Corporate Investor:  There is one final possibility that I considered and it is that a corporation with deep pockets would provide the money needed to take Tesla private. Given how much money is needed, the list of potential buyers is small and perhaps restricted to the large tech companies - Apple and Google. While they have the cash and perhaps may even have the interest, Musk's follow up that he would continue to run the company and hold on to his ownership stake strikes me as a poison pill that no corporation will want to swallow.

It is at this point that the "secured funding" claim that Musk made in his initial tweet comes into question. If the statement is true, he has either found an inept bank that will lend tens of billions to a money losing company with an undisciplined CEO, or a private equity investor who is willing to make the largest PE investment in history, while allowing Musk to continue running the company, with no checks and balances. If the statement is false, we will be seeing lawyers debating the meaning of the words "secured" and "funding" for a while.

Occam's Razor: A simpler explanation

This entire post has been premised on the notion that Elon Musk had done his homework and that he intended to send a serious signal to markets about a future buyout. Given Musk's history of impetuous and personal tweets, that premise might be completely wrong, in which case the explanation for this episode may be far simpler and rooted in the war with short sellers that Musk has been fighting for a while.  Musk is convinced, rightly or wrongly, that short sellers in Tesla are conspiring to bring not just the stock price, but the entire company, down. While there are short sellers in every publicly traded company, including the most successful in market capitalization (Apple, Facebook, Google, Amazon), Tesla is an outlier in terms of the short selling on two fronts:

• It has a CEO who is obsessed with short selling and spends a disproportionate amount of his time and attention on bringing them down. So, it is true that short sellers are a distraction to the company, but only because Elon Musk has made it so. 
• On the other side, many of the short sellers in Tesla seem to be just as obsessed with Musk and  are convinced that he is a scam artist. I have a sneaking feeling that for many of them, winning will mean not just making money on their Tesla positions, but seeing the company cease to exist (and taking Musk down with it). On my Tesla valuation from a few weeks ago, it is telling that the most heated responses that I got were not from Tesla bulls, accusing me of being too pessimistic, but from Tesla short sellers, arguing that I was being over valuing the company, even though my assessed value per share was half the prevailing price.

Investing is a difficult game, to begin with, but it becomes doubly so, when it becomes personal. Just as it is dangerous to fall in love with a company that you have invested in, it is just as dangerous to bet against a company because you hate its management and want it to fail. I think both sides of the Tesla short selling game are so infected with personal bias that they may do or say things that are not in their best long term investing interests. That is why I hope, for Tesla's sake, that Musk's personal dislike of short sellers did not lead him to tweet out that Tesla would go private. with both the price ($420) and the "secured funding" being spur of the moment inventions. In his zeal to make short sellers pay, he may have handed them the weapon they need to bring him down. I know that Tesla's board has backed Musk, saying that he had opened a discussion about going private with the board, but since no mention is made of a price or funding, and given how ineffective and craven this board has been over the last few years, I cannot attach much weight to this backing.

Bottom Line

There are publicly traded companies where going private is not only an option, but a value-increasing one, but Tesla is not one of them. As with so much else that the company has done over its history, from its acquisition of Solar City to borrowing billions of dollars to this talk of going private, it is not the action per se that is inexplicable, it is that Tesla is not the company that should be taking the action. The drama will undoubtedly continue, and in a world where we get much our entertainment from reality shows, the Elon Musk show is on top of my list of must-watch shows.

YouTube Video

Blog Posts on Tesla

1. Twists and Turns in the Tesla Story: A Boring, Boneheaded Update
2. Share Count Confusion: Dilution, Employee Options and Multiple Share Classes

Paper on Going Private

1. Anatomy of a Leveraged Buyout: Leverage, Control and Value

Read More

Country Risk: A Midyear Update for 2018

While political and trade wars are brewing around the world, centered on globalization, the enduring truth is that the globalization genie is out of the bottle, and no political force can put it back. Encouraged to spread their bets around the world, investors have shed some of the home bias in their investing and added foreign equities to their portfolios. Even those that have stayed invested with companies in their own markets are finding that those companies derive large chunks of their revenues from foreign markets. In short, there is no place to hide from assessing global risk and analysts who bury their head in the sand are missing large parts of the big picture. In this post, I revisit the assessments of country risk that I have made every year for the last 25 years and reiterate how to use those assessments when valuing companies or analyzing projects. The full version of this post is a paper that you can download and read, but I have to warn you that I am verbose and it is more than a hundred pages long.

The Fundamentals of Country Risk
So, what makes investing or operating in one country more or less risky than another? Most business people point to three factors. The first is the prevalence of corruption in a country, with the corrosive influences it has on business practices and financial reports. The second is the increased exposure to violence from war or terrorism in some parts of the world, creating not just additional operating costs (for insurance and protection) but also the real possibility of a complete loss of the business. The third is the legal system for enforcing property rights, since a share in even the most valuable business in the world is worth little or nothing, if property rights are ignored or violated on a whim. In this section, we will look at the state of the world on these three dimensions.

I. Corruption
Why we care: Operating in an environment where corruption and bribery are accepted as common practice has two consequences for value. 

1. It is a hidden tax: You can view the cost of corruption as a hidden tax, paid not directly to the government but to its functionaries to get business done. As a consequence, the effective tax rate that a company pays in a corrupt economy will be much higher than the statutory tax rate. Since it is not legal for companies to pay bribes in much of the developed world, it is not explicitly reported as such in the financial statements but it is a drain on income, nevertheless.
2. It can be a competitive advantage or disadvantage: In many corrupt economies, there are companies that are not only more willing but are also more efficient at playing the corruption game, giving them a leg up on businesses that face moral or legal restrictions on playing the game.

Global differences: While businesses are quick to attach labels to entire regions of the world, there are entities that try to measure corruption in different parts of the world, using more objective measures. Transparency International, for instance, has a corruption index that it has developed and updates every year, with lower scores indicating more corruption and higher scores less. The mid-2018 picture on how different countries measure up is below:

For heat map and for raw data

While I am sure that there are some who will look at this chart and attribute the differences to culture, I think that it can be better explained by a combination of poverty and abysmal political governance.

II. Violence
Why we care: At the risk of stating the obvious, operating a business is much more difficult, in the midst of violence and war than in safety. There are two consequences. The first is that protecting the business and its employees against the violence is expensive, with more security built into even the everyday practices. To the extent that this protection is not complete, there is the added cost of the destruction wrought by violence. The second is that in extreme cases, the violence can cause a business to fail. It is true that you can insure against some of these events, but that insurance is never complete and its cost will be high and reduce profit margins.

Global Differences: The news headlines, especially about war and terrorism, give us clues about the parts of the world where violence is most common. To measure exposure to violence, though, it is useful to see indices like the Global Peace Index developed by the Institute for Peace and Economics, with low scores indicating the most and high scores the least violence.

For heat map and for raw data

There are some surprises on this score. While some parts of the developed world, like Europe, Canada and Australia are peaceful, the United States, China and the United Kingdom don't score as well.

III. Private Property Rights and Legal System
Why we care: In valuation, we value a business or a share in it, on the assumption that that you are entitled, as the owner, to a share of its assets and cash flows. That is true, though, only if private property rights are respected and are backed up a legal system in a timely fashion. As property rights weaken, the claim on the cash flows and assets also weakens, reducing the assessed value, and in extreme circumstances, such as nationalization with no compensation, the value can converge on zero.

Global Differences: A group of non-government organizations has created an international property rights index, measuring the protection provided for property rights in different countries. In their 2018 update, they measured property rights on three dimensions, legal, physical property and intellectual property, to come up with a composite measure of property rights, by country. The state of the world, on this measure, is in the picture below:

For heat map and for raw data

In 2018, property rights were most strongly protected in Oceania (Australia and New Zealand) and North America and were weakest in Africa, Russia and South America.

IV. Overall Risk Scores
As you look at the global differences on corruption, violence and property rights, you can see that there are correlations across the measures. Regionally, Africa performs worst on all three measures, but there are individual countries that perform better on one measure and worse on others. Consequently, a composite country risk score that brings together all of these exposures into one number would be useful and there are many services, ranging from public entities like the World Bank to private consultants, that try to measure that score. We will focus on Political Risk Services, a private service, and the picture below captures their measures of composite country risk, by country in July 2018:

For heat map and for raw data

There are few surprises here. Eight of the ten riskiest countries in the world, at least according to this measure, are in Africa with Venezuela and Syria rounding out the list. A preponderance of the safest countries in the world are in Northern Europe, though Taiwan and Singapore also make the list. The problem with country risk scores is that there is not only no standardization across services, but it is also difficult to convert these scores into numbers that can be used in financial analysis, either as cash flow or discount rate adjusters.

Default Risk
There is one dimension of country risk where measurements have not only existed for decades but are also more in tune with financial analysis and that is sovereign default risk. Put simply, there is a much higher that some countries will default than others, and default risk measures try to capture that likelihood. 

I. Sovereign Ratings
Ratings agencies have rated corporate bonds for default risk, using a letter grade system that goes back almost a century. In the last three decades these agencies have turned their attention to sovereign debt, using the same rating system. Between Moody’s and S&P, there were 141 countries that had sovereign ratings, and the picture below captures the differences across countries:

For heat map and for raw data

While North America and Europe represent the greenest (and safest) parts of the world, you do see shades of green in some unexpected parts of the world. In Latin America, historically a hotbed of sovereign default, Chile and Colombia are now highly rated. The patch of green in the Middle East includes Saudi Arabia, indicating perhaps the biggest weakness of this country risk measure, which is its focus on the capacity of a country to meet its debt obligations. As an oil power with a small population and little debt, Saudi Arabia has low default risk, but it is exposed to significant political risk. While ratings agencies have been maligned as incompetent and biased, I think that their biggest weakness is that they are too slow to update ratings to reflect changes on the ground. In the last decade, it took almost two years after Greece drifted into trouble before ratings agencies woke up and lower the company’s rating. 

II. Default Spreads
To those who are skeptical about ratings agencies, there is a market alternative, which is to look at what investors are demanding as a spread for buying bonds issued by a risky sovereign. That spread can be computed only if the sovereign in question issues bonds in a currency (like the US dollar or Euro) where there is a default free rate (the US treasury bond rate or German Euro bond rate) for comparison. Since there only a few countries where this is the case, it is provident that the sovereign CDS market has expanded over the last decade. This market, where you can buy insurance, on an annual basis, against default risk, has expanded over the last few years and there are now about 80 countries where you can observe the traded spreads. The picture below captures global differences in sovereign CDS spreads:

For heat map and for raw data

The sovereign CDS spreads are highly correlated with the ratings, but they also tend to be both more reflective of events on the ground and more timely.

Equity Risk Premiums
If you are lending money to a business, or buying bonds, it is default risk that you are focused on, but if you own a business, your exposure to risk is far broader, since your claims are residual. This is equity risk, and if there are variations in default risk across countries, it stands to reason that equity risk should also vary across countries, leading investors and business owners to demand different equity risk premiums in different parts of the world.

Global Equity Risk Premiums: General Propositions
As a prelude to looking at different ways of estimating equity risk premiums across countries, let me lay out two basic propositions about country risk that will animate the discussion.

Proposition 1: If country risk is diversifiable and investors are globally diversified, the equity risk premium should be the same across countries. If country risk is not fully diversifiable, either because the correlation across markets is high or investors are not global, the equity risk premium should vary across markets.
One of the central tenets of modern portfolio theory is that investors are rewarded only for risk that cannot be diversified away, even if they choose to be non-diversified, as long as the marginal investors are diversified. Building on this idea, country risk can be ignored, if it is diversifiable, and it is this argument that some high-profile companies and consultants used in the 1980s to argue for the use of a global equity risk premium for all countries. The problem, though, is that country risk is diversifiable only if there is low correlation across equity markets and if the marginal investors in companies hold international portfolios. As investors and companies have globalized, the correlation across equity markets has increased, with market shocks running through the globe; a political crisis in Sao Paulo can drag down stock prices in New York, London, Mumbai and Shanghai. Consequently, being globally diversified is not going to fully protect you against country risk and there should therefore be higher equity risk premiums for emerging markets, which are more exposed to global shocks, than developed markets.

Proposition 2: If there are variations in equity risk premiums across countries, the exposure of a business to that risk should be determined by where the business operates (in terms of producing and selling its goods and services), not where it is incorporated.
If you accept the proposition that equity risk premiums vary across countries, the next question becomes how best to measure a company or investment's exposure to that risk. Unfortunately, a combination of inertia and bad logic leads many analysts to estimate the equity risk premium for a company from its country of incorporation, rather than where it does business. This is absurd, since Coca Cola, while a US incorporated company, faces significantly more operating risk exposure when it expands into Myanmar or Bolivia than when it invests in Poland. It stands to reason that to measure a company's equity risk premium, you have to look at where it does business.

Equity Risk Premiums
The standard approach for estimating equity risk premiums for emerging markets has been to start with the equity risk premium for a mature market, like the US or Germany, and augment it with the sovereign default spread for the country in question, measured either by a sovereign CDS spread or based on its sovereign rating. Since equities are riskier than bonds, I modify this approach slightly by scaling up the default risk for the higher equity risk, using a relative risk measure; the relative risk measure is computed by dividing the standard deviation of equities in emerging markets by the standard deviation of public sector bonds in these same markets:

My melded approach, using default spreads and equity market volatilities, yields additional country risk premiums slightly larger than the default spreads. In July 2018, for instance, I started with my estimate of the implied equity risk premium of 5.37% for the S&P 500, as my mature market premium. To estimate the equity risk premium for India, I built on the default spread for India, based upon its Moody's rating of Baa2, of2.20%, and multiplied it by the relative equity market scalar of 1.222 yields a country risk premium of 2.69%. Adding this to my mature market premium of 5.37% at the start of July 2018 gives a premium of 8.06% for India. For the two dozen countries, where there are no sovereign ratings or CDS spreads available, I use the PRS score assigned to the country to find other rated countries with similar PRS scores, to estimate default spreads and equity risk premiums. Applying this approach yields the following picture for global equity risk in July 2018:

Download full spreadsheet

Incorporating Country Risk in Valuation
With the estimates of country risk in hand, let's talk about bringing them into play in valuing companies. Staying true to the proposition that risk comes from where companies operate, not where they are incorporated, we confront the question of how best to measure operating exposure. The simplest and most easily accessible is revenue breakdown. For a company like Coca Cola, for instance, with revenues spread across the globe, the equity risk premium would be a weighted average of their regional exposures:

Coca Cola 10K for 2017

If the break down of Coca Cola's revenues, by region, strike you as being overly broad, note that this is the only geographical breakdown that the company provides. If there is one area of corporate reporting that requires more clarity and detail, it is this.

Using revenues to measure risk exposure does open you up to the criticism that while risk can also come from where a company produces its goods and services. This is especially true for natural resource companies, where risk can be traced back to where the company extracts its commodity, not where it sells it. Applying this to Royal Dutch Shell in 2018, for instance, yields the following:

Royal Dutch Annual Report for 2017

You could even create a composite weighting that brings into account both revenues and production for a company, if you have the information.

Incorporate Country Risk In Investment Analysis
While country risk plays a key role in valuation, it plays an even bigger one in capital budgeting and investment analysis, as multinationals wrestle with comparing investment decisions made in different parts of the world. Using Coca Cola to illustrate, assume that the company is considering making investments in Nigeria, Chile and US and is trying to estimate the "right" cost of equity to use in its assessment. Even if all of the investments are in identical businesses (soft drinks) and are in the same currency (US dollars), the costs of equity will vary across them (the beta for Coca Cola is 0.80 and the risk free rate is 3%):

• Nigeria project: Risk Free Rate +Beta*  (Nigeria ERP) = 3% + 0.80 (13.15%) = 13.52%
• Chile project: Risk Free Rate +Beta*  (Chile ERP) = 3% + 0.80 (6.22%) = 7.98%
• US project: Risk Free Rate +Beta*  (Canada ERP) = 3% + 0.80 (5.37%) = 7.30%

It is worth noting that many companies still adopt the practice of using the same hurdle rate for investments in different markets and if Coca Cola adopted this practice, they would be using the cost of equity of 8.52%, computed using their weighted average equity risk premium of 6.90%, or worse still a cost of equity of 7.30%, using an equity risk premium of 5.37%, based upon Coca Cola's  country of incorporation,. Consider the consequences of this practice. It will reduce the cost of equity for the Nigerian investment and raise it for the Chilean and  Canadian investments, and over time, it will lead Coca Cola to over invest and over expand in the riskiest markets.

For a multi-business, multi-national company like Siemens, the estimation becomes even messier, since to estimate the cost of equity for a project, you will need to know not only where the project is situated (to estimate the equity risk premium) but also which business it is in (to get the right beta).

Incorporating Country Risk In Pricing
If you don't do intrinsic valuation, but base your investment decisions on pricing metrics (multiples and comparable firms), you may think that you have dodged a bullet, but that relief is fleeting. If equity risk varies across countries, you should also expect to see it show up in PE ratios or EV/EBITDA multiples, with companies in riskier markets trading at lower values. This can be viewed as an argument for finding comparable firms in markets of equivalent risk, but as we saw with Coca Cola and Royal Dutch, that can be difficult to do. In fact, since there are often far fewer companies listed in many emerging markets, you have no choice but to look outside your market for comparable firms, and when you do so, you have to at least consider differences in country risk, when making your judgments. If you do not, and you are comparing publicly traded retailers across Latin America, companies in riskier markets (like Venezuela, Argentina and Ecuador) will look cheap relative to companies in safer markets (like Chile and Colombia).

YouTube Video

Papers

1. Country Risk Premiums: Determinants, Measures and Implications - The 2018 Edition

Data

1. Country Risk - Data tables
2. Equity Risk Premiums, by Country

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