January 2019 Data Update 5: Hurdle Rates and Costs of Financing

In the last post, I looked at how to measure risk from different perspectives, with the intent of bringing these risk measures into both corporate finance and valuation. In this post, I will close the circle by converting risk measures into hurdle rates, critical in corporate finance, since they drive whether companies should invest or not, and in valuation, because they determine the values of businesses. As with my other data posts, the focus will remain on what these hurdle rates look like for companies around the world at the start of 2019.

A Quick Introduction

The simplest way to introduce hurdle rates is to look at them from the perspectives of the capital providers to a business. Using a financial balance sheet as my construct, here is a big picture view of these costs:

Thus. the hurdle rate for equity investors, i.e., the cost of equity, is the rate that they need to make, to break even, given the risk that they perceive in their equity investments. Lenders, on the other hand, incorporate their concerns about default risk into the interest rates they set on leans, i.e., the cost of debt. From the perspective of a business that raises funds from both equity investors and lenders, it is a weighted average of what equity investors need to make and what lenders demand as interest rates on borrowing, that represents the overall cost of funding, i.e., the cost of capital.

I have described the cost of capital as the Swiss Army Knife of finance, used in many different contexts and with very different meanings. I have reproduced below the different uses in a picture:

Paper on cost of capital

It is precisely because the cost of capital is used in so many different places that it is also one of the most misunderstood and misused numbers in finance. The best way to reconcile the different perspectives is to remember that the cost of capital is ultimately determined by the risk of the enterprise raising the funding, and that all of the many risks that a firm faces have to find their way into it. I have always found it easiest to break the cost of capital into parts, and let each part convey a specific risk, since if I am careless, I end up missing or double counting risk. In this post, I will break the risks that a company faces into four groups: the business or businesses the company operates in (business risk), the geographies that it operates in (country risk), how much it has chosen to borrow (financial leverage risk) and the currencies its cash flows are in (currency effects). 

Note that each part of the cost of capital has a key risk embedded in it. Thus, when valuing a company, in US dollars, in a safe business in a risky country, with very little financial leverage, you will see the 10-year US treasury bond rate as my risk free rate, a low beta (reflecting the safety of the business and low debt), but a high equity risk premium (reflecting the risk of the country).  The rest of this post will look at each of the outlined risks.

I. Business Risk
In my last post, where I updated risk measures across the world, I also looked at how these measures varied across different industries/businesses. In particular, I highlighted the ten most risky and safest industries, based upon both price variability and earnings variability, and noted the overlap between the two measures. I also looked at how the perceived risk in a business can change, depending upon investor diversification, and captured this effect with the correlation with the overall market.  If you are diversified, I argued that you would measure the risk in an investment with the covariance of that investment with the market, or in its standardized form, its beta.

To get the beta for a company, then, you can adopt one of two approaches.

• The first, and the one that is taught in every finance class, is to run a regression of returns on the stock against a market index and to use the regression beta. 
• The second, and my preferred approach, is to estimate a beta by looking at the business or businesses a company operates in, and taking a weighted average of the betas of companies in that business. 

To use the second approach, you need betas by business, and each year, I estimate these numbers by averaging the betas of publicly traded companies in each business. These betas, in addition to reflecting the risk of the business, also reflect the financial leverage of companies in that business (with more debt pushing up betas) and their holdings in cash and marketable securities (which, being close to risk less, push down betas). Consequently, I adjust the average beta for both variables to estimate what is called a pure play or a business beta for each business. (Rather than bore you with the mechanics, please watch this video on how I make these adjustments). The resulting estimates are shown at this link, for US companies. (You can also download the spreadsheets that contain the estimates for other parts of the world, as well as global averages, by going to the end of this post).

To get from these business betas to the beta of a company, you need to first identify what businesses the company operates in, and then how much value it derives from each of the businesses. The first part is usually simple to do, though you may face the challenge of finding the right bucket to put a business into, but the second part is usually difficult, because the individual businesses do not trade. You can use revenues or operating income by business as approximations to estimate weights or apply multiples to each of these variables (by looking at what other companies in the business trade at) to arrive at value weights. 

II. Financial Leverage

You can run a company, without ever using debt financing, or you can choose to borrow money to finance operations. In some cases, your lack of access to new equity may force you to borrow money and, in others, you may borrow money because you believe it will lower your cost of capital. In general, the choice of whether you use debt or equity remains one of the key parts of corporate finance, and I will discuss it in one of my upcoming data posts. In this post, though, I will just posit that your cost of capital can be affected by how much you borrow, unless you live in a world where there are no taxes, default risk or agency problems, in which case your cost of capital will remain unchanged as your funding mix changes.  If you do borrow money to fund some or a significant portion of your operations, there are three numbers that you need to estimate for your cost of capital:

1. Debt Ratio: Th mix of debt and equity that you use represents the weights in your cost of capital.
2. Beta Effect: As you borrow money, your equity will become riskier, because it is a residual claim, and having more interest expenses will make that claim more volatile. If you use beta as your measure of risk, this will require you to adjust upwards the business (or unlettered) beta that you obtained in the last part, using the debt to equity ratio of the company. 
   
3. Cost of Debt: The cost of debt, which is set by lenders based upon how much default risk that they see in a company, will enter the cost of capital equation, with an added twist. To the extent that the tax law is tilted towards debt, the after-tax cost of borrowing will reflect that tax benefit. Since this cost of debt is a cost of borrowing money, long term and today, you cannot use a book interest rate or the interest rate on existing debt. Instead, you have to estimate a default spread for the company, based upon either its bond ratings or financial ratios, and add that spread on to the risk free rate:
   

I look at the debt effect on the cost of capital in each of the industries that I follow, with all three effects incorporated in this link, for US companies. The data, broken down, by other regional sub-groupings is available at the end of this post.

III. Country Risk
It strikes me as common sense that operating in some countries will expose you to more risk than operating in others, and that the cost of capital (hurdle rate) you use should reflect that additional risk. While there are some who are resistant to this proposition, making the argument that country risk can be diversified by having a global portfolio, that argument is undercut by rising correlations across markets. Consequently, the question becomes not whether you should incorporate country risk, but how best to do it. There are three broad choices:

1. Sovereign Ratings and Default Spreads: The vast majority of countries have sovereign ratings, measuring their default risk, and since these ratings go with default spreads, there are many who use these default spreads as measures of country risk. 
2. Sovereign CDS spreads: The Credit Default Swap (CDS) market is one where you can buy insurance against sovereign default, and it offers a market-based estimate of sovereign risk. While the coverage is less than what you get from sovereign ratings, the number of countries where you can obtain these spreads has increased over time to reach 71 in 2019. 
3. Country Risk Premiums: I start with the default spreads, but I add a scaling factor to reflect the reality that equities are riskier than government bonds to come up with country risk premiums. The scaling factor that I use is obtained by dividing the volatility of an emerging market equity index by the volatility of emerging market bonds. 

To incorporate the country risk into my cost of capital calculations, I start with the implied equity risk premium that I estimated for the US (see my first data post for 2019) or 5.96% and add to it the country risk premium for each country. The full adjustment process is described in this picture:

I also bring in frontier markets, which have no sovereign ratings, using a country risk score estimated by Political Risk Services. The final estimates of equity risk premiums around the world can be seen in the picture below:

You can see these equity risk premiums as a list by clicking here, or download the entire spreadsheet here. If you prefer a picture of equity risk around the world, my map is below:

Download spreadsheet

I also report regional equity risk premiums, computed by taking GDP-weighted averages of the equity risk premiums of the countries int he region.

IV. Currency Risk
It is natural to mix up countries and currencies, when you do your analysis, because the countries with the most risk often have the most volatile currencies. That said, my suggestion is that you keep it simple, when it comes to currencies, recognizing that they are scaling or measurement variables rather than fundamental risk drivers. Put differently, you can choose to value a Brazilian companies in US dollars, but doing so does not make Brazilian country risk go away.

So, why do currencies matter? It is because each one has different expectations of inflation embedded in it, and when using a currency, you have to remain inflation-consistent. In other words, if you decide to do your analysis in a high inflation currency, your discount rate has to be higher, to incorporate the higher inflation, and so do your cash flows, for the same reason:

There are two ways in which you can bring inflation into discount rates.  The first is to use the risk free rate in that currency as your starting point for the calculation, since risk free rates will be higher for high inflation currencies. The challenge is finding a risk free investment in many emerging market currencies, since even the governments bonds, in those currencies, have default risk embedded in them. I attempt to overcome this problem by starting with the government bond but then netting the default spread for the government in question from that bond to arrive at risk free rates:

Download raw data

These rates are only as reliable as the government bond rates that you start with, and since more than two thirds of all currencies don't even have government bonds and even on those that do, the government bond rate does not come from liquid markets, there a second approach that you can use to adjust for currencies. In this approach, you estimate the cost of capital in a currency that you feel comfortable with (in terms of estimating risk free rates and risk premiums) and then add on or incorporate the differential inflation between that currency and the local currency that you want to convert the cost of capital to. Thus, to convert the cost of capital in US $ terms to a different currency, you would do the following:

To illustrate, assume that you have a US dollar cost of capital of 12% for an Egyptian company and that the inflation rates are 15% and 2% in Egyptian Pounds and US dollars respectively:

The Egyptian pound cost of capital is 26.27%. Note that there is an approximation that is often used, where the differential inflation is added to the US dollar cost of capital; in this case your answer would have been 25%. The key to this approach is getting estimates of expected inflation, and while every source will come with warts, you can find the IMF's estimates of expected inflation in different currencies at this link.

General Propositions
Every company, small or large, has a hurdle rate, though the origins of the number are murky at most companies. The approach laid out in this post has implications for how hurdle rates get calculated and used.

1. A hurdle rate for an investment should be more a reflection the risk in the investment, and less your cost of raising funding: I fault terminology for this, but most people, when asked what a cost of capital is, will respond with the answer that it is the cost of raising capital. In the context of its usage as a hurdle rate, that is not true. It is an opportunity cost, a rate of return that you (as a company or investor) can earn on other investments in the market of equivalent risk. That is why, when valuing a target firm in an acquisition, you should always use the risk characteristics of the target firm (its beta and debt capacity) to compute a cost of capital, rather than the cost of capital of the acquiring firm.
2. A company-wide hurdle rate can be misleading and dangerous: In corporate finance, the hurdle rate becomes the number to beat, when you do investment analysis. A project that earns more than the hurdle rate becomes an acceptable one, whether you use cash flows (and compute a positive net present value) or income (and generate a return greater than the hurdle rate). Most companies claim to have a corporate hurdle rate, a number that all projects that are assessed within the company get measured against. If your company operates in only one business and one country, this may work, but to the extent that companies operate in many businesses across multiple countries, you can already see that there can be no one hurdle rate. Even if you use only one currency in analysis, your cost of capital will be a function of which business a project is in, and what country it is aimed at. The consequences of not making these differential adjustments will be that your safe businesses will end up subsidizing your risky businesses, and over time, both will be hurt, in what I term the "curse of the lazy conglomerate".
3. Currency is a choice, but once chosen, should not change the outcome of your analysis: We spend far too much time, in my view, debating what currency to do an analysis in, and too little time working through the implications. If you follow the consistency rule on currency, incorporating inflation into both cash flows and discount rates, your analyses should be currency neutral. In other words, a project that looks like it is a bad project, when the analysis is done in US dollar terms, cannot become a good project, just because you decide to do the analysis in Indian rupees. I know that, in practice, you do get divergent answers with different currencies, but when you do, it is because there are inflation inconsistencies in your assessments of discount rates and cash flows.
4. You cannot (and should not) insulate your cost of capital from market forces: In both corporate finance and investing, there are many who remain wary of financial markets and their capacity to be irrational and volatile. Consequently, they try to generate hurdle rates that are unaffected by market movements, a futile and dangerous exercise, because we have to be price takers on at least some of the inputs into hurdle rates. Take the risk free rate, for instance. For the last decade, there are many analysts who have replaced the actual risk free rate (US 10-year T.Bond rate, for instance) with a "normalized' higher number, using the logic that interest rates are too low and will go up. Holding all else constant, this will push up hurdle rates and make it less likely that you will invest (either as an investor or as a company), but to what end? That uninvested money cannot be invested at the normalized rate, since it is fictional and exists only in the minds of those who created it, but is invested instead at the "too low" rate. 
5. Have perspective: In conjunction with the prior point, there seems to be a view in some companies and for some investors, that they can use whatever number they feel comfortable with as hurdle rates. To the extent that hurdle rates are opportunity costs in the market, this is not true. The cost of capital brings together all of the risks that we have listed in this section. If nothing else, to get perspective on what comprises high or low, when it comes to cost of capital, I have computed a histogram of global and US company costs of capital, in US $ terms.
   
   
   You can convert this table into any currency you want. The bottom line is that, at least at the start of 2019, a dollar cost of capital of 14% or 15% is an extremely high number for any publicly traded company. You can see the costs of capital, in dollar terms, for US companies at this link, and as with betas, you can download the cost of capital, by industry, for other parts of the world in the data links below this post.

In short, if you work at a company, and you are given a hurdle rate to use, it behooves you to ask questions about its origins and logic. Often, you will find that no one really seems to know and/or the logic is questionable.

YouTube Video


Data Sets

1. Betas by Business: US, Global, Emerging Markets, Europe, Japan, India, China, Aus & Canada
2. Sovereign Ratings and CDS Spreads by Country in January 2019
3. Equity Risk Premiums by Country in January 2019
4. Risk free Rates by Currency: Government bond based
5. Cost of Capital in US $ (with conversion equation for other currencies): US, Global, Emerging Markets, Europe, Japan, India, China, Aus & Canada

January 2019 Data Updates

1. Data Update 1: A Reminder that equities are risky, in case you forgot!
2. Data Update 2: The Message from Bond Markets
3. Data Update 3: Playing the Numbers Game
4. Data Update 4: The Many Faces of Risk
5. Data Update 5: Of Hurdle Rates and Funding Costs!
6. Data Update 6: Profitability and Value Creation!
7. Data Update 7: Debt, neither poison nor nectar!
8. Data Update 8: Dividends and Buybacks - Fact and Fiction!
9. Data Update 9: Playing the Pricing Game!

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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

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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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