January 2019 Data Update 1: A reminder that equities are risky, in case you forgot!

In bull markets, investors, both professional and amateur, often pay lip service to the notion of risk, but blithely ignore its relevance in both asset allocation and stock selection, convinced that every dip in stock prices is a buying opportunity, and soothed by bromides that stocks always win in the long term. It is therefore healthy, albeit painful, to be reminded that the risk in stocks is real, and that there is a reason why investors earn a premium for investing in equities, as opposed to safer investments, and that is the message that markets around the world delivered in the last quarter of 2018.

A Look Back at 2018

The stock market started 2018 on a roll, having posted nine consecutive up years, making the crisis of 2008 seem like a distant memory. True to form, stocks rose in January, led by the FAANG (Facebook, Amazon, Apple, Netflix and Google) stocks and momentum investors celebrated. The first wake up call of the year came in February, first as the market responded negatively to macroeconomic reports of higher inflation, and then as Facebook and Google stumbled from self-inflicted wounds. 

The market shook off its tech blues by the end of March and continued to rise through the summer, with the S&P 500 peaking for the year at 2931 on September 20, 2018.   For the many investors who were already counting their winnings for the year, the last quarter of 2018 was a shock, as volatility returned to the market with a vengeance. In October, the S&P 500 dropped by 6.94%, though it felt far worse because of the day-to-day and intraday price swings. In November, the S&P 500 was flat, but volatility continued unabated. In December, US equities finally succumbed to selling pressures, as a sharp selloff pushed stocks close to the "bear market" threshold, before recovering a little towards the end of the year.  

Over the course of the year, every major US equity index took a hit, but the variation across the indices was modest.

The ranking of returns, with the S&P 600 and the NASDAQ doing worse than the Dow or the SD&P 500 is what you would expect in any down market. With dividends incorporated, the return on the S&P 500 was -4.23%, the first down market in a decade, but only a modestly bad year by historical standards:

I know that this is small consolation, if you lost money last year, but looking at annual returns on stocks in the last 90 years, there have been twenty years with more negative returns. In short, it was a bad year for stocks, but it felt far worse for three reasons. First, after nine good years for the market, investors were lulled into a false sense of complacency about the capacity of stocks to keep delivering positive returns. Second,  the negative returns were all in the last quarter of the year, making the hit seem larger (from the highs of September 2018) and more immediate. Third,  the intraday and day-to-day volatility exacerbated the fear factor, and those investors who reacted by trading faced far larger losses.

The Equity Risk Premium

If you have been a reader of this blog, you know that my favorite device for disentangling the mysteries of the market is the implied equity risk premium, an estimate of the price that investors are demanding for the risk of investing in equities. I back this number out from the current market prices and expected future cash flows, an IRR for equities that is analogous to the yield to maturity on a bond:

As with any measure of the market, it requires estimates for the future (expected cash flows and growth rates), but it is not only forward looking and dynamic (changing as the market moves), but also surprisingly robust and comprehensive in its coverage of fundamentals. 

At the start of 2018, I estimated the equity risk premium, using the index at that point in time (2673.61), the 10-year treasury bond rate on that day (2.41%) and the growth rate that analysts were projecting for earnings for the index (7.05%). 

The equity risk premium on January 1, 2018 was 5.08%. As we moved through the year, I computed the equity risk premium at the start of each month, adjusting cash flows on a quarterly basis (which is about as frequently as S&P does it) and using the index level and ten-year T.Bond rate at the start of each month:

While the conventional wisdom about equity risk premiums is the they do not change much on a day to day basis in developed markets, that has not been true since 2008. In 2018, there were two periods, the first week of February and the month of October, where volatility peaked on an intraday basis, and I computed the ERP by day, during the first week of February, and all through October:

During October, for instance, the equity risk premium moved from 5.38% at the start of the month to 5.76% by the end of the month, with wide swings during the course of the month.

After a brutal December, where stocks dropped more than 9% partly on the recognition that global economic growth may slacken faster than expected, I recomputed the equity risk premium at the start of 2019:

The equity risk premium has increased to 5.96%, but a closer look at the differences between the inputs at the start and end of the year indicates how investor perspectives have shifted over the course of the year:

Going into 2019, investors are clearly less upbeat than they were in 2018 about future growth and more worried about future crises, but companies are continuing to return cash at a pace that exceeds expectations.

What now?

I know that you are looking for a bottom line here on whether the numbers are aligned for a good or a bad year for stocks, and I will disappoint you up front by admitting that I am a terrible market timer. As an intrinsic value investor, the only market-related question that I ask is whether I find the current price of risk (the implied ERP) to be an acceptable one; if it is too low for my tastes, I would shift away from stocks, and if it is too high, shift more into them. To gain perspective, I graphed the implied ERP from 1960 through 2018 below:

At its current level of 5.96%, the equity risk premium is in the top decile of historical numbers, exceeded only by the equity risk premiums in three other years, 1979, 2009 and 2011. Viewed purely on that basis, the equity market is more under valued than over valued right now.

I am fully aware of the dangers that lurk and how they could quickly change my assessment and they can show up in one or more of the inputs:

1. Recession and lower growth: While there was almost no talk about a possible recession either globally or in the US, at the start of 2018, some analysts, albeit a minority, are raising the possibility that the economy would slow down enough to push it into recession, at the start of 2019. While the lower earnings growth used in the 2019 computation already incorporates some of this worry, a recession would make even the lower number optimistic. In the table below, I have estimated the effect on the equity risk premium of lower growth, and  note that even with a compounded growth rate of -3% a year for the next five years, the ERP stays above the historical average of 4.19%.
   
2. Higher interest rates: The fear of the Fed has roiled markets for much of the last decade, and while it has played out as higher short term interest rates for the last two years, the ten-year bond rate, after a surge over 3% in 2018, is now back to 2.68%. There is the possibility that higher inflation and economic growth rate can push this number higher, but it is difficult to see how this would happen if recession fears pan out. In fact, as I noted in this post from earlier in the year, higher interest rates, if the trigger is higher real growth (and not higher inflation), could be a positive for stocks, not a negative.
3. Pullback on cash flows: US companies have been returning huge amounts of cash in the form of stock buybacks and dividends. In 2018, for instance, dividends and buybacks amounted to 92% of aggregate earnings, higher than the 84.60% paid out, on average, between 2009 and 2018, but still lower than the numbers in excess of 100% posted in 2015 and 2016. Assuming that the payout will adjust over time to 85.07%, reflecting expected long term growth, lowers the ERP to 5.55%, still well above historical levels.
4. Political and Economic Crises: The trade war and the Brexit mess will play out this year and each has the potential to scare markets enough to justify the higher ERP that we are observing. In addition, it goes without saying that there will be at least a crisis or two that are not on the radar right now that will hit markets, an unwanted side effect of globalization. 

Looking at how the equity risk premium will be affected by each of these variables, I think that the market has priced in already for shocks on at least two of these variables, in the form of lower growth and political/economic crises, and can withstand fairly significant bad news on the other two. 

Bottom Line

I have long argued that it is better to be transparently wrong than opaquely right, when making investment forecasts. In keeping with my own advice, I believe that stocks are more likely to go up in 2019, than down, given the information that I have now. That said, if I am wrong, it will be because I have under estimated how much economic growth will slow in the coming year and the magnitude of economic crises. Odds are that I will see the tell tale signs too late to protect myself fully against any resulting market corrections, but that is not my game anyway. 

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Datasets

1. Historical Returns on Stocks, Bonds and Bills - 1928 to 2018
2. Historical Implied Equity Risk Premiums for US - 1960 to 2018

Spreadsheets

1. Implied ERP for January 1, 2019

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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An October Surprise? Making Sense of the Market Mayhem!

I don't know what it is about October that spooks markets, but it certainly feels like big market corrections happen in the month. As stocks have gone through contortions this month, more down than up, like many of you, I have been looking at my portfolio, wondering whether this is the crash that the market bears have been warning me about since 2012, just a pause in a continuing bull market or perhaps a prognosticator of economic troubles to come. If you are expecting me to give you the answer in this post, I would stop reading, since reading market tea leaves is not my strength. That said,  I have been wrestling with what, if anything, I should be doing, as an investor, in response to the market movements. As in previous market crises, I find myself going back to a four-step process that I hope gets me through with my sanity intact. 

Step 1: Hit the pause button

The first casualty of crisis is good sense, as I mistake my panic response for instinct, and almost every action that I feel the urge to take in the heat of the moment is driven by fear and greed, not reason. No amount of rational thinking or studying behavioral finance will cure me of this affliction, since it is part of my make up as a human being, but there are three things that I find help me manage my reactions:

1. Take a breath:  When faced with fast-moving markets, I have to force myself to consciously slow down. It helps that I don't work as a trader or a portfolio manager, since part of your job is to look like you are in control, even when you are not. 
2. Turn off the noise: Turn back the clock about four decades and assume that you were a doctor, a lawyer or a factory worker with much of your wealth invested in stocks. If markets were having a bad day, odds were that you would not even have heard about it until you got home and turned on the news, and even then, you would have been fed scraps of information about Dow, perhaps a 2-minute discussion with a market expert, and you would have then turned on your favorite sitcom. Today, not only can you monitor your stocks every moment of your working day, you can trade on your lunch break and stream CNBC on to your desktop. That may make you a more informed investor, or at least an investor with more information, but I am not sure that constant feedback is healthy for your portfolio, especially in periods like this one. I don't have a Bloomberg terminal on my desk, a ticker tape running on  my computer or stock apps on my phone, and I am happy that I don't during periods like this month.
3. Don't play the blame game: Every market correction has its villains, and investors like to tag them. Central banks and governments are always good targets, since they have few defenders and have a history of triggering market meltdowns. The problem that I find with assigning blame to others is that it then relieves me of any responsibility, even for own mistakes, and thus makes it impossible to learn from them and take corrective action.

Step 2: Assess the damage

In an age of instant analysis and expert opinion, it is easy to get a skewed view of not only what is causing the market damage, but also where that damage is greatest. In my (limited) reading of market analyses during the last four weeks, I have seen at least a half a dozen hypotheses about the stock swoon, from it being the Fed's fault (as usual) to a long overdue tech company correction to it being a response to global crises (in Italy and Saudi Arabia). In keeping with the old adage of "trust, but verify", I decided to take a look at the data to see if there are answers in it to these questions. 

1.The Fed's fault? 

As those of you who read my blog know well, I believe that the Fed has far less power than we think it does to set interest rates, but it is a convenient bogeyman. One explanation for the stock drop that has been making the rounds is that it is fear that Fed will raise rates too quickly in the future, that is causing stocks to swoon. Is that a plausible story? Yes, but if it is the reason for the market decline, you would have a difficult time explaining the movement in interest rates during October 2018:

Source: Federal Reserve (FRED)

As stocks have gone through their pains since October 1, treasury bill and bond rates have remained steady, which would make little sense if the expectation is that they will rise in the near future. After all, if investors expect rates to rise soon, those rates will start going up now and not on cue, when the Fed acts.

There is the possibility that this could be a delayed reaction to rates having gone up over the year already, with the 10-year treasury bond rate moving from 2.41% at the start of the year to 3.06% at the start of October 2018 and to a flattening yield curve (which has historically been a precursor to slower economic growth). Note though, that much of this movement in interest rates happened in the first six months of the year and you would need a reason for why stock prices would be moving four months later.

2. A Tech Meltdown?

My view, based upon what I had been hearing and reading, and before I looked at the data, was that the October 2018 stock drop was being caused by tech companies, in general, and the large tech companies, especially the FANG+Apple combination, specifically. To see if this is true, I looked at the returns on all US stocks, classified by sectors (as defined by S&P), in October, in the year to date and for 1-year and 5-year time periods.

US Sector Market Cap Change. Source: S&P Capital IQ

I know that the S&P sector classifications are imperfect, but my priors seem to be wrong. While information technology, as a group, lost 8.76% of aggregate market capitalization in October 2018, the three worst sectors in the US market were energy, industrials and materials, all of which lost much more, in percentage terms, than technology. In fact, the two sectors that did the best were consumer staples and utilities, with the latter's performance also providing evidence that it is not interest rate fears that are primarily driving this market correction. 

I have argued that, unlike two decades ago, technology companies now are now a diverse group, and many of them don't fit the "high growth, high risk" profile that people seem to still automatically give all tech companies. Using the terminology of corporate life cycles, tech companies  run the gamut from old tech to middle-aged tech to young tech, and I have looked at how tech companies in each age grouping in the graph below (age is defined, relative to year of founding):

The median percentage change, in both October 2018 and YTD 2018,  in market capitalization was greatest at the youngest tech companies. The median percentage change becomes smaller for older tech companies, in October 2018, but the effect for the four highest age classes is more mixed for the YTD numbers. That said, a much smaller median percentage change at the largest tech companies has a much biggest effect on the market, because of the market capitalization of these companies. That is the reason I look at the FANG stocks and Apple in the table below:

While the percentage change in stock prices at these companies is in line with the market drop, if Apple is included in the mix, the five companies collectively lost a staggering $276 billion in market capitalization between October 1 and October 26. accounting for almost 11.7% of the overall drop in market capitalization of US stocks. While investors in these stocks may feel merited in complaining about their losses, I would draw their attention to the third column, where I look at what these stocks have done since January 1, 2018, with the losses in October incorporated. Collectively, these five companies have added almost $521 billion in market capitalization since the start of the year, and without them, the overall market would have been down substantially.

3. A Correction in Overvalued Stocks?

For some value investors who have argued that investors were pushing up some stocks to unsustainable levels, the market correction has been vindication, a sign that the market is correcting its pricing mistakes and marking down the stocks that it had over priced the most. That may be plausible, and to see if it holds, I broke all US stocks, at the start of October, based upon PE ratios into six groupings (low to high PE and a separate one for negative earnings companies):

PE Ratio at start of October 2018, using trailing 12 month earnings

If the selective correction argument is correct, you should expect to see the highest PE ratio and negative earnings companies drop the most in value and the companies with the lowest PE ratios be less affected. While negative earnings stocks have seen the market correction, during October 2018, there is no pattern across the other PE classes. In fact, the lowest PE ratio companies had the second worst record, in terms of price performance, among the groupings. 

4. A US Problem?

One of the lessons of the last decade is that much as countries would like to disconnect from the rest of the world and chart their own pathway to economic prosperity, they are joined at the hip by globalization, with crisis in one part of the world quickly affecting economies and markets in other parts. In October 2018, we had our share of global shocks, with the standoff between Italy and the EU and Saudi Arabia's Khashoggi problem taking top billing. To see how the market correction has played out in world markets, I broke global markets down into broad regional groupings and arrived at the following:

Source: S&P Capital IQ, based upon headquarters geography

Note that these returns are all in US dollars, reflecting both the performance of the market and the currencies of each region. Asia seems to have been hit the worst this month, with China, Small Asia (South East Asia, Pakistan, Bangladesh) and Japan all seeing double digit declines in aggregate market capitalization. Latin America has had the best performance of the regional groupings, with the election surprise in Brazil driving its markets upwards during the month.  The year-to-date numbers do tell a bigger story that has been glossed over in analysis. For much of 2018, the US market & economy has diverged from the rest of the globe, posting solid numbers (prior to October) whereas the rest of the world was struggling. It is possible that we are seeing an end to that divergence, suggesting that the US markets will move more closely with the other global markets going forward.

5. Panic Attack?

One of the more striking features of the markets during October 2018 has been that the stock market retreat, while substantial, has, for the most part, been orderly. In a panic-driven stock market sell off, you usually see a surge in government bond prices (and a drop in rates), a general flight to quality (US $ and safer companies) and a rise in the price of gold. As we noted in the earlier section, the market drop does not seem to be smaller at larger and more profitable companies, and government bond rates have not dropped. In addition, while the US dollar has had a strong year so far, especially against emerging market currencies, it generally did not see a flight to it in October 2018:

The dollar strengthened mildly against almost every currency during the month, and the only currency where there was a big move was against the Brazilian Reai, where it weakened, again on political news in Brazil. Note again that the market correction may be, at least partly, a delayed reaction to the strength of the US dollar leading into October, but the timing is still difficult to explain. Finally, I looked at gold prices in October 2018, in conjunction with bitcoin, since the latter has been promoted as millennial gold:

It has been a good month for gold, with prices up 4.44%, though there is little sign of panic buying pushing up prices. It may be a little unfair to be passing judgment on Bitcoin, after one crisis, but if it is millennial gold, either millennials are unaware that there is a stock market sell off or they do not care. 

Step 3: Review the fundamentals

With the assessment of market pain behind us, we can turn to looking at the fundamentals, again looking for clues in why stocks have had such a tough month. While almost every factor affects stock prices, the effects have to show up in one of four places for fundamental value to change significantly: a shock to base year earnings or cash flows, a change in expected earnings/cash flow growth, a increase in the risk free rate or a change in the price of risk:

Since treasury bond rates have been stable through much of the month, I am going to look at one of the other three variables as the potential culprit.

1. Base Year Earnings/Cashflows: The earnings reports that have come out for companies in diverse sectors in the last two weeks seem to reinforce the strong earnings story. While there were a few like Caterpillar and 3M that reported headwinds from a stronger dollar, both companies also conveyed the message that they were able to pass the higher costs through to the customers.
   
   On the cash flow front, there were no high profile cessations of buybacks or dividends, and all signs point to the market delivering and perhaps beating the earnings and cash flows that we have estimated for 2018.
2. Earnings Growth: This is a trickier component, since it is driven as much by actual data, as it is by perception. At the start of the year, the expectation that earnings growth would be strong for this year, helped both the tax law changes of last year and a strong economy. That growth has been delivered, but it is possible that investors are now doubtful about the sustainability of that earnings growth. That has not shown up yet in forecasted growth for next year, but it bears watching.
3. Price of Equity Risk (Equity Risk Premium): If you have been reading my blog for a while, you are probably aware of my implied equity risk premium calculation, one that backs out a price of equity risk (equity risk premium) from the level of the index, expected cash flows and a growth rate. Holding cash flows and growth rate fixed for October, I have computed the implied equity risk premium by day. 

End of Day	US 10-yr T.Bond	S&P 500	Implied ERP	Spreadsheet
9/28/18	3.06%	2913.98	5.38%	Download
10/1/18	3.09%	2924.59	5.36%	Download
10/2/18	3.05%	2923.43	5.36%	Download
10/3/18	3.15%	2925.51	5.35%	Download
10/4/18	3.19%	2901.61	5.39%	Download
10/5/18	3.23%	2885.57	5.41%	Download
10/8/18	3.22%	2884.43	5.42%	Download
10/9/18	3.21%	2880.34	5.43%	Download
10/10/18	3.22%	2785.68	5.61%	Download
10/11/18	3.14%	2728.37	5.73%	Download
10/12/18	3.15%	2767.13	5.65%	Download
10/15/18	3.16%	2750.79	5.68%	Download
10/16/18	3.16%	2809.92	5.57%	Download
10/17/18	3.19%	2809.21	5.56%	Download
10/18/18	3.17%	2768.78	5.65%	Download
10/19/18	3.20%	2767.78	5.64%	Download
10/22/18	3.20%	2755.88	5.67%	Download
10/23/18	3.17%	2740.69	5.70%	Download
10/24/18	3.10%	2656.10	5.89%	Download
10/25/18	3.14%	2705.57	5.78%	Download
10/26/18	3.08%	2658.69	5.89%%	Download

If cash flows and expected growth have not changed over the month, the price of equity risk has jumped from 5.38% at the start of the month to the 5.89% on October 26, putting it at the high end of equity risk premiums in the last decade.

You could attribute the higher equity risk premiums to global crises (in Italy and Saudi Arabia) but that would be a reach since the increase in risk premiums predates both crises. If you do lower expected earnings growth going forward, perhaps reflecting a delayed response to the stronger dollar and higher rates, the equity risk premium will drop. In fact, halving the expected growth rate from 2019 on from the current estimate of 7.29% to 4.71% (the compounded average annual earnings growth rate over the last 10 years) reduces the equity risk premium to 5.28%, but even that number is a healthy one, relative to historic norms. The bottom line is that, at least by my calculations, I am estimating an equity risk premium that seems fair, given macro and micro fundamentals and my risk preferences.

Step 4: Investment Action
One of the biggest perils of being reactive in a  crisis is that it can knock you off your investment game and cause you to abandon your core philosophy. I don't believe that there is one investment philosophy that is right for every one, but I do believe that there is one that is right for you, and shifting away from it is a recipe for bad results. I am a “value” investor, though my definition of value is different from old-time value investing in two ways:

1. Under valued stocks can be found across sectors and the life cycle: I believe that we should try to assess fair value, not a conservative estimate of value, and that the value should include expected value added from future growth. To the critique that this is speculative, my answer is that everything other than cash-in-hand requires making assumptions about the future, and I am willing to go the distance. That is why, at different points in time, you have seen Twitter and Facebook in my portfolio in the past and may well see Netflix and Tesla in the future (just not now).
2. Intrinsic value can change over time: I believe that intrinsic value is a dynamic number that changes over time, not only because new information may come out about a company. but also because the price of equity risk can change over time. That said, intrinsic values generally change less than market prices do, as mood and momentum shift. This has been a month of significant price drops in many companies, but assuming that they are therefore more likely to be under valued is a mistake, since the intrinsic values of these companies have also changed, because the ERP that I will be using to value the stocks on October 26, 2018, will be 5.89%, much higher than the 5.38% at the start of the month.

Given my philosophy and a reading of the data, here is what I plan to do.

1. No change in asset allocation:  I am not changing my asset allocation mix in significant ways, since I don't see a fundamental reason to do so. 
2. Revisit existing holdings: I normally revalue every company in my portfolio at least once a year, but after a month like this one, I will have to accelerate the process. Put simply, I have to make sure that at the current price for equity risk, and given expected cash flows, that my buys still remain buys and the sells remain sells.
3. Bonus from short sales: I do have a portion of my portfolio that benefits from a sell off, primarily in short sales and those have provided partial offsets to my losses. I did sell short on Amazon and Apple at the start of the month, and while I would like to claim prescience, it was pure luck on timing, and the market downdraft during the month has helped me. 
4. Check out the biggest market losers: I plan to take a closer look at the stocks that have been pummeled the most during the month, including 3M and Caterpillar, to see if they are cheap at October 26 prices, and using an October 26 ERP in my valuation. 

Please note that this is not meant to be investment advice and your path back to investment serenity may be very different from mine! 

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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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January 2018 Data Update 5: Country Risk Update

In my last post, I looked at the currency confusions that globalization has brought into financial analysis, and how to clean up for them. In this post, I discuss the other aspect of globalization that is forcing analysts to change long accepted practices in estimating equity risk premiums for companies. Taking what they have learned from finance textbooks blindly, practitioners have taken what they learned about equity risk premiums to emerging and frontier equity markets, often with disastrous results. Not only have they practiced denial when it comes to the additional risk that investors face in many markets, from political, economic and legal sources, but they have also considered risk by looking at where a company is incorporated, instead of where it does business. In this post, I will update my country risk measures for the start of 2018, and build on them to measure the equity risk premiums for companies.

Country Default Risk

The more widely measured and accessible measures of sovereign risk are related to sovereign default, and as we noted in the post on currency risk free rates, there are three ways in which default risk in countries can be measured. The first is to use government bonds, denominated in US dollars or Euros, issued by sovereigns and to compare the rates on these bonds to a US treasury or German Euro bond rate. The second is to use the sovereign CDS spreads for countries, market-driven numbers, as default risk measures. The third is to use the sovereign ratings of countries as proxies of default risk and to convert these ratings to default spreads. 

1. Sovereign Rating/Spread

The leading ratings agencies including S&P, Moody’s and Fitch have long since expanded their business of rating bonds for default risk from corporations to looking at entire countries. These “sovereign” ratings are estimated on both foreign currency and local currency terms, with the ratings spectrum ranging from Aaa to D, just as with corporate bonds. One way of capturing the default risk variations across the world is with a heat map, based upon local currency sovereign ratings:

via chartsbin.com

Note that while there are clear differences across regions, with Latin America and Africa containing more risky (red) areas than Europe and North America, there are also differences within regions. You can download the S&P and Moody's ratings, by country, at the start of 2018, by clicking on this link.

2. Sovereign CDS Spreads

While sovereign ratings provide accessible measures of default risk in countries, they come with limitations. The ratings agencies are not only sometimes wrong in their default risk assessments, but they are often late in reassessing default risk (and sovereign ratings), when conditions change quickly in countries. It is these weaknesses that are remedied, at least partly, by the sovereign credit default swap (CDS) market, where investors can buy insurance against sovereign default. The market-set prices for sovereign credit default swaps provide updated measures of default risk, at least for the 70 countries that they exist for, and the levels of these spreads are in the table below:

Download spreadsheet

I don’t want to oversell these CDS spreads as better proxies of default risk. While they are certainly more dynamic and reflective of current risk that sovereign ratings, they are market numbers and like all market numbers, they are volatile and reflect market mood and momentum, as much as they do fundamentals.

Country Equity Risk

Sovereign or country equity risk measures are more difficult to come by than sovereign default spreads. First, there are services that try to measure the political and economic risk in countries with scores, albeit with no standardization. Second, the default risk measures can be converted into equity risk measures by scaling them for the additional risk in equities.

a. Risk Scores

The World Bank, Political Risk Services (PRS) and the Economist, among others, try to measure the total risk in countries. Those scores have no standardization and cannot be compared across services, but they still represent more comprehensive measures of risk than sovereign ratings or CDS spreads. In the heat map below, you can see the country risk scores reported by PRS, with higher scores indicating lower risk.

via chartsbin.com

Comparing this picture to the sovereign ratings map, there are clearly overlaps, where the country risk scores from PRS and the ratings deliver the same message; Latin America, Eurasia and Africa remain high risk zones and European countries have lower risk. 

b. Equity Risk Premiums

The problem with risk scores is that they cannot be easily converted into risk premiums to use in cost of equity calculations. It is to overcome this problem that I return to sovereign default spreads, not as measures of equity risk, as is often the practice, but to use them as starting points for measuring the equity risk in countries. In particular, I estimate the relative equity market volatility, computed by scaling the volatility or standard deviation in equity to the standard deviation of government bond, and use that to scale up sovereign default risk to sovereign equity risk:

Using this approach does require traded government bonds, available for only a handful of countries. To generalize this approach, I use the ratio of the volatility in an emerging market equity index to the volatility of an emerging market government bond index, using the most recent five years of data. That ratio, which is 1.12 at the start of January 2018, is used to convert sovereign default spreads to country risk premiums. 

These country risk premiums, when added to the implied US equity risk premium of 5.08%, yield equity risk premiums for countries. The picture below summarizes equity risk premiums around the world.

via chartsbin.com

If the heat map does not provide enough specifics, this picture may be better:

Finally, if you prefer the data as a table, you can download the spreadsheet with the data or my more detailed country risk premium dataset. 

Company Equity Risk

A company's risk does not come from where it is incorporated, but where it does business. If we adopt this perspective, it is clear that to value a company, you need to see its risk exposure to different countries, either because it has its production and operations in those countries or because it sells its products or services there. That risk exposure, in conjunction with the equity risk premiums of the countries estimated in the earlier section, can be used to compute the company's equity risk premium. To illustrate this concept, consider LATAM, the Chile-based airline. To compute its equity risk premium, I would compute the weighted average of the countries that LATAM derives revenues from which includes most of Latin America and the US. For companies like Coca Cola, which may be in too many countries for this approach to be easily applied or where the country breakdowns are not available, you can use regional equity risk premiums. In the table above, I report on the GDP-weighted average ERP for regions of the world. If you accept this rationale, the following implications follow:

1. A company cannot change its risk profile by delisting in one market and resisting in another: It is a common play for emerging market companies to delist on their "risky" local markets and to re-list on a more developed markets. While there are some good reasons for doing so, which can potentially increase value, like increased liquidity and transparency, one reason that does not stand up to scrutiny is that the company has become safer, just because of the listing change. A South African mining company that delists in Johannesburg and lists on the London Stock Exchange is still exposed to South African country risk, after the move.
2. A company's equity risk premium should change, as its geographic exposure changes: In estimating the equity risk premium for a company today, we need to consider where it operates today. If we expect that geographic mix to change over time, as it usually will, the equity risk premium that we use in future years should reflect these expected changes. And yes, that will mean that your cost of equity and capital can change over time. Welcome to globalization!
3. When multinationals assess projects, their hurdle rates should vary across geographies: When multinationals assess hurdle rates for projects, those hurdle rates should vary, depending upon where a project will be, even if the hurdle rates are estimated in the same currency. Thus, the US dollar cost of equity that Coca Cola should use for a Canadian beverage expansion should be far lower than the US dollar cost of equity for a Russian investment.

It is a pity that accounting disclosure requirements have been so focused on trivial matters that have little effect on value and have not really paid attention to the type of information companies should be disclosing to investors on geographic operations.

Conclusion

If, as the Chinese symbol (危机) for crisis suggests, danger plus opportunity equals risk, it is not surprising that the most risky parts of the world also often provide the most potential for growth. By demanding higher equity risk premiums for investing in these parts of the world, I am not suggesting that you hold back from investing in these risky regions, but only that you demand enough of a premium for exposing yourself to additional risk. After all, investing should never be bungee jumping, where you take risk for the sake of taking risk!

YouTube Video


Datasets

1. Country Ratings, PRS scores and Equity Risk Premiums (January 2018)
2. Equity Risk Premiums, by Country - Detailed (January 2018)
3. Company Risk Premium Calculator (Spreadsheet)

Papers

1. Country Risk Premiums: Data, Measures and Implications, A 2017 Update (Last version from July 2017)

Data Update Posts

1. January 2018 Data Update 1: Numbers don't lie, or do they?
2. January 2018 Data Update 2: The Buoyancy of US Equities!
3. January 2018 Data Update 3: Taxing Questions on Value
4. January 2018 Data Update 4: The Currency Conundrum
5. January 2018 Data Update 5: Country Risk Update
6. January 2018 Data Update 6: A Cost of Capital Primer
7. January 2018 Data Update 7: Growth and Value - Investment Returns
8. January 2018 Data Update 8: Debt and Taxes
9. January 2018 Data Update 9: Dividends, Buybacks and Cash Holdings
10. January 2018 Data Update 10: The Price is Right!

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