Dcf Myth 3: You Lot Cannot Produce A Valuation, When At That Spot Is Equally Good Much Uncertainty!

Uncertainty, both imminent too resolved, has been on my heed these final ii weeks. I posted my valuation of Valeant on Apr 20, making the declaration that, at to the lowest degree based on my expectations on what could endure revealed inward the delayed fiscal filings, the stock was worth virtually $44, roughly $12 to a greater extent than than the prevailing stock price. Many of you lot were variety plenty to comment on my valuation, too i of the to a greater extent than mutual refrains was at that spot were also many unknowns on the stock to endure taking a stand. In fact, i of the comments on the post service was that "regardless of the valuation, a sufficient margin of security does non be (on the stock)". On Apr 21, nosotros got tidings that evisit my valuation of Volkswagen, inward the immediate aftermath of the scandal inward Oct 2015, too choose stock of how the the investment I made inward the stock too hence looks, every bit the dubiety gets slow resolved. All through these final ii weeks, at that spot were signs that Yahoo's journey, that was starting to resemble the I valued almost two years agone (and bought later the valuation) too labeled every bit a Walking Dead company, I am interested, both financially too intellectually, to meet how this terminate game plays out. As I wrestle amongst the resolution of uncertainties from the past times too combat amongst uncertainties inward the time to come on every i of my investments, I idea it would endure a practiced fourth dimension to aspect at practiced too bad ways of responding to I dubiety inward investing too valuation.

The Uncertainty Principle

Uncertainty has ever been business office of human existence, though it has transitioned from the physical dubiety that characterized the caveman era to the economical dubiety that is to a greater extent than typical of today, at to the lowest degree inward developed markets. Each generation, though, seems to mean value that it lives inward the historic menstruum of the greatest uncertainty. That may endure partially a reflection of a broader feel of "specialness" that afflicts each generation, where it is convinced that its music too movies were the really best too that it had to acquire through the biggest challenges to succeed. The other is a variation of hindsight bias, where nosotros tin aspect at the past times too convince ourselves that what truly happened should receive got been obvious earlier it occurred. I am surprised at how many traders, investors too portfolio managers, who lived through the 2008 crisis, receive got convinced themselves that Nov 2008 was non that bad too that at that spot was never a adventure of a catastrophic ending.  That said, dubiety non only ebbs too flows over fourth dimension but also changes form, making enduring fixes too lessons tough to find. As investors bemoan the rising of dubiety inward today's markets, at that spot are iii reasons why they may experience to a greater extent than nether siege at i time than inward prior decades:

1. Low Interest Rates: In my post service on negative involvement rates, I pointed to the fact that every bit involvement rates inward many of the leading currencies receive got dropped to historic lows, jeopardy premiums receive got increased inward both stock too bond markets. The expected furnish on the S&P 500 inward early on 2008, earlier the crisis, was 8% too it remains at virtually that grade today, fifty-fifty though the treasury bond charge per unit of measurement has dropped from 4% to less than 2%, but the equity jeopardy premium has risen to compensate. Even though the expected furnish may endure the same, the fact that to a greater extent than of it tin endure attributed to a jeopardy premium volition increment the marketplace reaction to news, inward both directions, adding to cost volatility.
2. Globalization: Globalization has non only changed how companies too investors create choices but has also had ii consequences for risk. The showtime is that at that spot seem to endure no localized problems whatever more, amongst anyone's occupation becoming everyone's problem. Thus, political instability inward Brazil too also much local authorities borrowing to create infrastructure inward PRC play out on a global stage, affecting stock prices inward the residuum of the world. The 2d is that the pump of global economical mightiness is shifting from the US too Europe to Asia, too every bit it does, Americans too Europeans are starting to send to a greater extent than of world's economical jeopardy than they used to.
   
3. Media/Online Megaphones: As an early on adopted of technology, I am far from existence a Luddite but I do mean value that the speed amongst which information is transmitted about the the world has allowed marketplace risks to move viral. It is non simply the talking heads on CNBC, Bloomberg too other fiscal tidings channels that are the transmitters of these tidings but also social media, every bit Twitter too Facebook acquire the house where investors move to acquire breaking investing news.

I am sure enough that you lot tin add together other items to this list, such every bit the disruption existence wrought past times applied scientific discipline on established businesses, but I am non sure enough that these are either uncommon or unusual. Every decade has its ain disruptive factors, wreaking havoc on existing describe of piece of work organization models too fellowship values.

The Natural Responses to Uncertainty

Much of fiscal theory too a slap-up bargain of fiscal exercise was developed inward the U.S. of A. of America inward the 2d one-half of the final century too therein lies a problem. The U.S. of A. of America was the giant of the global economic scheme for much of this period, amongst an economic scheme on an upward path. The stability that characterized the US economic scheme during this menstruum was unusual, if you lot aspect at long term history of economies too markets, too much every bit nosotros would similar to believe that this is because key bankers too policy makers learned their lessons from the slap-up depression, at that spot is the really existent possibility that it was simply an uncommonly predictable period. That would also hateful that the bedrock of fiscal practice, built on extrapolating from past times information too assuming hateful reversion inward all things financial, may endure shaky, too that nosotros receive got to reevaluate them for the economies that nosotros operate inward today. It is unfair to blame the agency nosotros bargain amongst dubiety exclusively on the fact that our practices were honed inward the United States. After all, it is good chronicled inward both psychological annals too behaviour studies that we, every bit human beings, bargain amongst dubiety inward unhealthy ways, amongst the next existence the most mutual responses:

1. Paralysis too Inaction: The most mutual reaction to uncertainty, inward my experience, is inaction. "There is also much dubiety correct at i time to act" becomes the refrain, amongst the hope that activity volition come upwards when to a greater extent than of the facts are know. The consequences are predictable. I receive got friends who receive got almost exclusively been invested inward coin marketplace funds for decades now, waiting for that 2d of clarity too certainty that never seems to come. I receive got also talked to investors who seem to sentiment investing when uncertain every bit a violation of value investing edicts too receive got found themselves getting pushed into smaller too smaller corners of the market, seeking elusive comfort.
2. Denial too Delusion: At the other terminate of the spectrum, the reaction that other investors receive got to dubiety is move inward denial, adopting i of ii practices. The set out crunchers autumn dorsum on fake precision, where they add together to a greater extent than exceptional to their forecasts too to a greater extent than decimals to their numbers, every bit a defence forcefulness against uncertainty. The story tellers autumn dorsum on story telling, acting every bit if they receive got the mightiness to write the endings to every uncertain narrative, when inward fact they receive got footling command over either the players or the outcome.
3. Mental Accounting too Rules of Thumb: The encephalon may endure a wondrous organ but it has its ain laid of tics that undercut investing, when uncertain. As Richard Thaler has hence convincingly shown inward his run on mental accounting, investors too analysts similar to role rules of thumb, oft amongst no footing inward fact or reality, when making judgments. Thus, a venture capitalist who is quick to dismiss the role of intrinsic value inward a immature start-up every bit also fraught amongst estimation error, seems to receive got no qualms virtually forecasting earnings 5 years out for the same fellowship too applying a cost earnings ratio to those earnings to acquire an move out value.
4. Outsourcing too Passing the Buck: When stumped for answers, nosotros almost invariably plough to others that nosotros sentiment every bit to a greater extent than knowledgeable or meliorate equipped than nosotros are to come upwards up amongst solutions. Cynically, you lot could debate that this allows us to avoid taking responsibleness for investment mistakes, which nosotros tin at i time attribute to consultants, text mass writers or that soul you lot heard on CNBC. 
5. Prayer too Divine Intervention: The oldest response to dubiety is prayer too it has had remarkable staying power. There are large segments of the the world where large investment too describe of piece of work organization decisions are preceded past times prayers too divine intervention on your behalf. 

If the showtime footstep inward alter is acceptance, I receive got come upwards to choose that I am prone to do some or all of the above, when faced amongst uncertainty, but I receive got also discovered that these reactions tin do impairment to my portfolio. 

Dealing amongst Uncertainty

To reduce, if non eliminate, my unhealthy responses to uncertainty, I receive got developed my ain coping mechanisms that volition hopefully force me on to healthier tracks. I am non suggesting that these volition run for you, but they receive got for me, too delight experience costless to modify, abandon or arrange them to your ain needs.

1. Have a narrative: As many of you lot who read this weblog know, I receive got long believed that a fellowship valuation without a story to bind it together is simply numbers on a spreadsheet too a story that uses no numbers at all is a fairy tale. There is some other payoff inward having a narrative underlie your valuation too tying numbers to that narrative. When faced amongst dubiety virtually specifics, the inquiry that I inquire is whether these specifics send on my narrative for the fellowship too if yes, inward what way. In my valuation of Volkswagen, correct later the diesel fuel emissions scandal, I did non honour a catastrophic drib inward value for the fellowship because my underlying narrative for Volkswagen, that of a mature describe of piece of work organization amongst footling to offering inward terms of expansion or growth opportunities, was dented but largely unchanged every bit a outcome of the scandal. With Valeant, in my Nov 2015 valuation, I argued that the attending brought to the fellowship past times its drug pricing policies too connections to Philidor would outcome inward it having to abandon its strategy of growth driven past times acquisitions too growth too to shift to existence a less exciting, lower growth pharmaceutical company. That shift inward narrative drove the inputs into my valuation too my lower assessment of value. 

2. Categorize uncertainty: Uncertainty tin come upwards from many sources too it is useful, when valuing a fellowship inward the human face upwards of multiple uncertainties, to assort them. Here are my groupings:

Since it is piece of cake to girlfriend some uncertainties too double count others, I honour it useful to proceed them isolated inward unlike parts of my valuation:

Specifically, inward my Volkswagen too Valeant valuations, it was micro jeopardy that concerned me, amongst some of that jeopardy existence continuous (the effect of the diesel fuel emissions scandal on Volkswagen auto sales) too some existence discrete (the fines levied past times the EPA on Volkswagen too the jeopardy of default inward Valeant). That is why both companies, at to the lowest degree inward my conventional valuations, receive got depression costs of capital, even hence the risky environment, but their values are too hence adjusted for the expected costs of the discrete events occurring.

3. Keep it simple:  This may seem ironic but the to a greater extent than dubiety at that spot is, the simpler my valuation models become, amongst fewer inputs too less levers to move. One ground is that it allows me to focus on the variables that truly drive value for the fellowship too the other is that it reduces my involve to approximate dozens of variables inward the human face upwards of uncertainty. Thus, inward my valuations of start-up companies, my focus is almost exclusively on iii variables: revenue growth, operating margins too the reinvestment needed to sustain that growth. 

4. Make your best estimates: As I start making my estimates inward the human face upwards of uncertainty, I listen the vocalism inward the dorsum of my heed piping up, maxim "You are going to endure hence wrong!" too I quiet it past times  reminding myself that I don't receive got to endure right, simply less incorrect than everyone else, too that when dubiety is rampant, most investors plough over up.

5. Face upwards to uncertainty: Rather than cringe inward the human face upwards of dubiety too deed similar it is non there, I receive got found that it is freeing to acknowledge that you lot are uncertain too and hence to choose the side past times side footstep too endure explicit virtually that uncertainty. In my valuations of tech titans inward Feb 2016, I used probability distributions for the inputs that I felt most shaky virtually too and hence reported the values every bit distributions. Since some of you lot receive got been curious virtually the mechanics of this process, I volition choose a lengthier journeying through the procedure of running simulations inward a companion slice to this post.

6. Be willing to endure wrong: If you lot don't similar to endure wrong, it is best non  to value companies inward the human face upwards of uncertainty. However, if you lot mean value that Warren Buffet did non human face upwards dubiety inward his legendary investment inward American Express later the salad crude oil scandal inward 1964 or that John Paulson knew for sure enough that his bet against the housing bubble would pay off inward 2008, you lot are guilty of revisionist history. There is a corollary to this indicate too it relates to diversification. As I receive got argued inward my post service on diversification, the to a greater extent than uncertain you lot experience virtually private investments, the to a greater extent than you lot receive got to spread your bets. It is non an admission of weakness but a recognition of reality.

If you lot are a value investor, you lot volition notice that I receive got non mentioned i of value investors' favorite defenses against uncertainty, which is the margin of safety. Seth Klarman is i of my favorite investment thinkers but I am afraid that the margin of safety, at to the lowest degree every bit practiced past times some inward the investing community, has acquire an empty vessel, an excuse for inaction rather than a guide to activity inward risky times. I volition come upwards dorsum to this stair out every bit good inward some other post service inward this series.

Conclusion

If you lot are an active investor, you lot are constantly looking for an edge, something that you lot tin convey to the tabular array that most other investors cannot or volition not, that you lot tin exploit to earn higher returns. As the investing the world gets flatter, amongst information freely accessible too available to almost all investors, too analytical tools that anyone tin access, oft at depression cost, existence comfortable amongst dubiety may really good endure the border that separates success from failure inward investing. There may endure some who are born amongst that comfort level, but I am non i of them. Instead, my learning has come upwards the difficult way, past times diving into companies when things are most uncertain too past times valuing businesses inward the midst of marketplace crises, "by going where it is darkest". That journeying is non ever profitable (see my experiences amongst Vale every bit a precautionary note), sometimes makes me uncomfortable (as I receive got to create forecasts based upon footling or bad information), but it is never boring. I am incorrect a hefty per centum of the time, but hence what? It's only money! I am simply glad that I am not a encephalon surgeon!

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Uncertainty Posts

1. DCF Myth 3: You cannot do a valuation, when at that spot is also much uncertainty
2. The Margin of Safety: Excuse for Inaction or Tool for Action?
3. Facing upwards to Uncertainty: Probabilities too Simulations

DCF Myth Posts

Introductory Post: DCF Valuations: Academic Exercise, Sales Pitch or Investor Tool

1. If you lot receive got a D(discount rate) too a CF (cash flow), you lot receive got a DCF.  
2. A DCF is an exercise inward modeling & set out crunching. 
3. You cannot do a DCF when at that spot is also much uncertainty.
4. It's all virtually D inward the DCF (Myths 4.1, 4.2, 4.3, 4.4 & 4.5)
5. The Terminal Value: Elephant inward the Room! (Myths 5.1, 5.2, 5.3, 5.4 & 5.5)
6. A DCF requires also many assumptions too tin endure manipulated to yield whatever value you lot want.
7. A DCF cannot value create shout out or other intangibles. 
8. A DCF yields a conservative approximate of value. 
9. If your DCF value changes significantly over time, at that spot is something incorrect amongst your valuation.
10. A DCF is an academic exercise.

Valeant: Data Vacuums, Management Credibility In Addition To Investment Value

As an investor, would y'all purchase shares inwards a fellowship that is at the pump of a political too legal firestorm? What if this fellowship has a CEO who has lost the religious belief of his board too an ex-CFO who is existence defendant of shady fiscal practices? And would y'all draw  the purchase trigger if the fellowship has delayed its scheduled annual filing past times to a greater extent than than 2 months, too past times doing thence is running the adventure of violating debt covenants too existence pushed into default? And to top it all off, would y'all live a petty worried  if the largest investor inwards the stock, a good known activist amongst his reputation too wealth on the line, is forthwith calling the shots? No way, y'all say! At the correct price, I would, too that is the ground that I decided to revisit my Valeant valuation final week, half dozen months after I valued it for the get-go time, inwards the aftermath of a crisis born of hubris too happenstance. In structuring this post, I volition depict on an old-time consulting matrix, where companies were classified into stars, cash cows, dogs too enquiry marks, to illustrate the transience of these classifications, since Valeant has cycled through the entire matrix inwards a year.

Valeant, the Star

Valeant's ascension from an obscure Canadian drug fellowship to pharmaceutical star has been good chronicled too rather than drown y'all inwards prose, I intend it is best captured inwards this picture, which shows the increment inwards marketplace position value (market cap too firm value) too operating numbers (revenues too operating income), particularly betwixt 2009 too 2015:

Source: S&P Capital IQ

During a stream when other pharmaceutical companies were struggling amongst revenue growth too turn a profit margins, Valeant outstripped them on both counts, growing revenues at almost 43% a yr piece posting higher operating turn a profit margins than the balance of the sector. At to the lowest degree on the surface, the fellowship seemed to live delivering the best of all combinations: high growth amongst high profitability.

So, how did Valeant draw of this feat? In an before post on the company, inwards Nov 2015, I argued that the Valeant line of piece of work concern model was a stool amongst 3 legs: growth from acquisitions, amongst the acquisitions funded primarily amongst debt, followed past times a strategy of increasing prices on "under priced" drugs.

The unique combination of growth too profitability made the fellowship a target for value investors, making it a favored halt for investors equally various equally Bill Ackman, the activist investor, too the Sequoia Fund, a storied usual fund, too a dominant piece of work of their portfolios. In their defense, non exclusively were these investors transparent nearly their large bets on Valeant, but at to the lowest degree until September 2015, their concentration was viewed equally a forcefulness rather than a weakness. In fact, when I posted on why diversification is a necessary constituent of fifty-fifty a value investing strategy, it was these 2 investors that were held upwards equally a counters to my argument.

To encounter the allure of Valeant to value investors, allow me cash inwards one's chips dorsum to mid-year final year, when the company's line of piece of work concern model was going strong, its stock cost was higher than $200/share too its firm value exceeded $100 billion. If the intrinsic value of a fellowship is driven past times cash flows from existing assets, value-creating growth too depression risk, Valeant looked attractive on almost every dimension:

Valeant was non exclusively delivering the value trifecta, high revenue growth inwards conjunction amongst high operating turn a profit margins too generous excess returns, but was doing thence on steroids (taking the shape of depression taxes too high debt). One annotation of caution fifty-fifty then, though, was that the line of piece of work concern model was built on an architecture of acquisitions, amongst acquisition accounting playing a large piece of work inwards pushing upwards operating profitability too lowering taxes.  If y'all were unfazed past times the acquisition accounting outcome too assumed that the fellowship could cash inwards one's chips along to deliver this combination going forward, the value per portion that y'all would accept obtained for the fellowship would accept been to a greater extent than than $200/share. 

Download spreadsheet

In estimating the value, I did lower the compounded revenue growth for Valeant to 12% for the adjacent 10 years, but that translates into revenues to a greater extent than than tripling over the decade. 

From Star to Cash Cow

While many line Valeant's autumn to September too Oct of 2015, when partly because the Salix drugs that Valeant acquired (and repriced) affected to a greater extent than people (and drew to a greater extent than complaints). The Philidor revelations pushed these concerns into hyperdrive too the stock lost almost 55% of its value inwards September too October, dropping from $180/share to $80/share.

In my Nov post, I rehashed much of this story too argued that fifty-fifty if Valeant were able to endure legal too regulatory scrutiny, the fellowship would never live able to provide to its onetime line of piece of work concern model. In effect, fifty-fifty inwards the absence of to a greater extent than bad news, Valeant would accept to live run similar other pharmaceutical companies, reliant on R&D, rather than acquisitions, for (more anemic) growth. Removing the debt-funded acquisitions too the drug repricing  from the line of piece of work concern model yielded a fellowship amongst lower revenue growth (3% a year, rather than 12%), lower margins (a pre-tax operating margin of 43.66%, instead of 49.82%) too higher taxes (with an effective taxation charge per unit of measurement of 20% replacing 16.51%).

Download spreadsheet

Note that these numbers were reflective of to a greater extent than conventional drug companies too reverberate a profitable, albeit slow-growth business. With these numbers, though, the value per portion that I obtained for Valeant was nearly $77, downwards substantially from its star status, but the marketplace position price, at $82, was higher. 

From Cash Cow to Dog?

If in that location were night clouds on the horizon for Valeant inwards Nov 2015, the months since accept exclusively made them darker for iv reasons:

1. Information blackout: In Nov 2015, when I valued Valeant, I used the most recent fiscal filings of the company, from Oct 2015,  to update my numbers. Almost half dozen months later, in that location accept been no fiscal filings since, too the 10K that was expected to live filing inwards Feb 2016 was delayed, ostensibly because the fellowship was withal gathering information, too that delay has extended into April. 
2. Managerial Double talk: In the intervening months, Valeant’s managers accept been inwards the news, almost equally frequently giving testimony to Congress, equally belongings press conferences. Arguing, as they did, that they grew through R&D similar whatever other pharmaceutical fellowship too that their revenue increases came generally from book growth (rather than cost increases) was thence much at odds amongst the facts that they became less credible amongst each iteration. Michael Pearson’s hospitalization for an undisclosed illness, but before Christmas, was something that was out of the company’s command but its treatment added to the air of opacity but about the company. 
3. Legal Jeopardy: The Philidor entanglement, the master source of the crisis, did non cash inwards one's chips away. In fact, the company, after claiming that separation from Philidor would live low-cost too piece of cake backtracked inwards Jan too Feb amongst Bill Ackman increased his interest of the company inwards a bid to save what was left of his investment inwards the fellowship too to a greater extent than importantly, his reputation equally a savvy activist investor.

With the stock trading at $32, the enquiry of whether the stock is a proficient purchase forthwith looms large. Compared to my Nov 2015 estimate, the respond is an emphatic yes, but the caveat is that a neat bargain has happened to the company’s fundamentals during the final half dozen months that could accept shifted the value downwards significantly. The job that I face, similar whatever other investor inwards Valeant, is that inwards the absence of fiscal filings, in that location are no numbers to update. The solution seems simple. Wait for the delayed filing to come upwards out inwards belatedly April, early on May or later, too work that updated data inwards my valuation. That is the low-risk option, but I intend that it is also a depression provide option, since if the filing contains proficient intelligence (that revenues accept held upwards too turn a profit margins stay healthy), the stock cost volition adapt before my valuation does. The alternative is scary, but it has a bigger payoff. I could endeavour to brand a judgment on Valeant’s value now, before the data comes out, too follow through past times buying or selling the stock. In arriving at this value, hither are some of the adjustments that I chose to make:

1. The Dark Side of Debt: The debt at Valeant has cash inwards one's chips to a greater extent than burden than a help, equally it has non exclusively triggered worries nearly covenants existence violated but has opened upwards the possibility that that the fellowship volition accept problem making its payments. In fact, Value of Valeant equally Cash Cow (November 2015)
2. Value of Valeant equally Dog (April 2016)

 

Country Risk: A Mid-Year 2019 Update

One of the consequences of globalization is that investors, analysts too companies tin lav no longer remain focused on merely their domestic markets, but select to besides empathize the risks too opportunities elsewhere inwards the world. When developed marketplace companies outset embarked on the journeying of expanding into emerging marketplace increment economies, investors pushed upwards their stock prices, primarily because of the potential that they saw inwards these markets for expansion. Over time, though, nosotros select learned that, every bit amongst much else inwards business, this strategy comes amongst additional risk, non merely from changing telephone substitution rates, but from unstable economical too political forces. This growth/risk merchandise off explains why some companies select gained from value from globalizing too others select lost. In this post, I expect at dry soil adventure through many lens, but amongst the halt game of existence able to comprise it into conclusion making both for investors too businesses.

The Sources of Country Risk
When companies invest exterior their domestic markets, the most immediate adventure that they are exposed to is telephone substitution charge per unit of measurement risk, since revenues, profits too cash flows are affected past times changing telephone substitution rates. That risk, though, is but a slice of the puzzle, a symptom of economical fundamentals too affected past times political crises. Digging deeper, the factors that brand some countries riskier than others tin lav endure broadly classified into the next groups:

1. Life Cycle: I select used the construct of a corporate life cycle to verbalize nearly companies at unlike stages inwards the life cycle, too how they differ on cash menstruation generation too increment potential. It is besides to a greater extent than oft than non truthful that younger companies, deriving to a greater extent than or most of their value from futurity growth, are riskier than to a greater extent than mature companies, where the mass of their value coming from investments already made. The same build tin lav endure applied to countries, amongst emerging economies that are growing apace existence to a greater extent than exposed to global shocks than mature countries. It should come upwards every bit no surprise, therefore, that inwards almost every marketplace crisis over the final decade, emerging markets select paid a much large cost inwards terms of lost economical increment too lower marketplace value than developed markets.

2. Political Risk: If the final few years select taught us a lesson, it is that politics tin lav touching on economical too marketplace risk, non merely inwards emerging markets, but besides inwards developed ones. While in that location are many forms of political risk, ranging from acuate changes inwards financial too monetary policy to regime change, in that location are at to the lowest degree 2 measurable manifestations of this adventure inwards the shape of corruption adventure too exposure to violence.

• Corruption Risk: There are parts of the footing where the costs of doing draw of piece of occupation concern include greasing palms too paying off intermediaries, too the roots prevarication deep, resisting feel-good quick fixes. While anecdotal stories of corruption too its consequences are plentiful, in that location are services to travail to mensurate corruption levels across countries. Transparency International, for instance, derives a corruption score, past times country, too inwards its 2019 report, provides a listing of the x to the lowest degree too most corrupt countries inwards the footing inwards the figure below, amongst higher scores indicating less corruption) for 2018.

  

  Source: Transparency International

  The effect of corruption upon draw of piece of occupation concern is insidious, making winners of those most willing to play the bribery game too losers of those who resist. In an before post, I argued that corruption creates the equivalent of an informal tax, pushing downward after-tax income to companies.
• Physical Violence: When talking nearly adventure inwards investing or business, nosotros tend to focus on financial risk, but it is undeniable that adding the threat of physical violence, from war, terrorism or crime, makes it to a greater extent than hard to operate a business. There are services i time to a greater extent than that mensurate exposure to violence inwards unlike countries, too spell each brings its ain biases, the Institute of Economics too Peace has created too reports on a Global Peace Index, measurement exposure to violence, past times country.

  

  Source: Institute of Economics too Peace

  The map summarizes their findings from the most recent year. I must confess that I am surprised to run into Republic of Botswana at the exceed of the list, but having never been there, that may endure a reflection of my regional biases.

3. Legal Risk: Influenza A virus subtype H5N1 draw of piece of occupation concern derives its value from the assets it owns, physical ord intangible, too to hold to derive value, it has to non exclusively save its ownership but select a legal scheme that enforces it’s rights. The character of this protection varies across countries, either because holding rights select fewer protections inwards some countries or because those rights are non enforced inwards a timely mode inwards others. Influenza A virus subtype H5N1 grouping of non-government organizations has created an international holding rights index, measurement the protection provided for holding rights inwards unlike countries. The results inwards 2018, past times region, are provided inwards the tabular array below:

4. Economic Structure: Just every bit diversification helps investors spread their bets too trim back adventure exposure, countries amongst to a greater extent than diversified economies are less exposed to global macroeconomic shocks than countries that derive their value from i or 2 industries, or every bit is oft the representative from i or 2 commodities. In a comprehensive study of commodity subject countries, the United National Conference on Trade too Development (UNCTAD) measures the degree of dependence upon commodities across emerging markets too the figure reports the results.  

Source: UNCTAD

Note the disproportional dependence on commodity exports that countries inwards Africa too Latin America have, making their economies too markets really sensitive to changes inwards commodity prices.

Measures of Country Risk
To the extent that dry soil adventure comes from unlike sources, you lot postulate composite measures of adventure to assist inwards conclusion making. This department begins amongst a expect at dry soil adventure scores, where services, using proprietary factors, mensurate dry soil adventure amongst a number, followed amongst financial measures of dry soil risk, primarily designed to mensurate default risk.

Country Risk Scores

There are services, ranging from the World Bank to the Economist that mensurate dry soil adventure amongst scores, though each i uses unlike criteria too scalars. The PRS Group provides numerical measures of dry soil adventure for to a greater extent than than a hundred countries, using xx variables on 3 dimensions: political, financial too economic. The scores attain from null to i hundred, amongst high scores (80-100) indicating depression adventure too depression scores indicating high risk. The figure below captures the June 2019 update, every bit good every bit the 10 countries that emerged every bit safest too riskiest inwards that update.

Source: Political Risk Services (PRS)

Default Risk Measures

Country adventure scores select the practise goodness of existence comprehensive, but they are besides hard to interpret into business-friendly metrics. There are dry soil adventure measures inwards markets, albeit focused primarily on default risk, too the most populace of these are sovereign ratings, in that location are similar a shot besides marketplace based measures, sovereign CDS spreads.

Sovereign Ratings
Moody’s, S&P too Fitch all guess too discover ratings for countries, ranging from Aaa (AAA) for countries they persuasion has having no default adventure to D for countries already inwards default. The figure below provides a map of sovereign ratings across the footing inwards July 2019, using Moody’s ratings where available too S&P to fill upwards inwards some gaps. While the sovereign ratings themselves are alphabetical (and thus are hard to comprise into financial analysis), they tin lav endure converted to default spreads past times looking at traded bonds inwards the market.

Source: Moody's Sovereign Ratings

Note that spell the Aaa rated countries (in nighttime green) are predominantly inwards North America too Northern Europe, in that location are shades of greenish inwards Asia, reflecting the region's improvement on adventure too that much of Africa remains unrated.

Sovereign CDS Spreads

Ratings agencies select come upwards nether fire, peculiarly since the 2008 crisis, amongst i of the primary critiques existence their perceived bias. I am non existence dismissive of that critique, but I believe that their bigger sin is that they are deadening to reply to changing fundamentals, causing rating changes to lag existent changes on the ground. In the final 2 decades, a marketplace has risen to fill upwards inwards the gap, where investors tin lav purchase protection against default adventure past times buying sovereign credit default swaps (CDS). If the insurance against default is complete, the cost of a sovereign CDS tin lav endure viewed every bit a default spread for the country. On July 23, 2019, the map below summarizes the sovereign CDS spreads for the 81 countries that they were available for. 

Source: Bloomberg (10-year $ Sovereign Spreads)

While these market-set default spreads furnish to a greater extent than timely readings of sovereign default adventure than the sovereign ratings, they endure from the measure problems that all market-set numbers are exposed to. They are volatile, affected past times momentum too mood too tin lav attain misguiding signals on risk.

Equity Risk
While default spreads may correspond adequate measures of dry soil adventure if you lot intend to lend to a sovereign or purchase bonds issued past times it, you lot are exposed to to a greater extent than too sometimes unlike risks, if you lot computer programme to expand your draw of piece of occupation concern into a country, or invest inwards equities inwards that country, too you lot postulate equity adventure premiums that capture that risk. It is truthful that many practitioners piece of occupation default spreads every bit proxies of additional dry soil equity adventure too add together it to a mature marketplace premium (often a historical US premium) to brand it at country-specific equity adventure premiums. As readers of this weblog know, I piece of occupation a mild variation on this approach, replacing the historical equity adventure premium amongst an implied premium for the US too augmenting the default spread past times a scaling factor, to reverberate the higher adventure of equity:

The equity adventure premiums that outcome from this procedure inwards July 2019 are reported inwards the film below, amongst the implied equity adventure premium of 5.67% for the S&P 500 on July 1, 2019, representing the base of operations number. 

Source: Damodaran Online (Current Data)

The film continues a story that has been edifice over the final decade. While Africa too Latin America remain hotbeds of dry soil risk, Asia has acquire safer over fourth dimension too parts of Southern Europe select regressed. 

If you lot are a developed marketplace fellowship or investor, too believe that adventure inwards Africa, Latin America or parts of Asia don’t apply to you, you lot may desire to recall again. The adventure exposure of a fellowship does non come upwards from where it is incorporated but from where it does business. Thus, Coca Cola too Royal Dutch may endure US too UK-listed companies respectively, but their draw of piece of occupation concern models expose them to adventure unopen to the world. With Coca Cola, that adventure comes primarily from where it sells its products. With Royal Dutch, the adventure is derived from where it extracts its crude too gas, making it to a greater extent than exposed to emerging markets than many emerging marketplace companies. By the same token, Vale too Infosys may endure Brazil too India-based companies, but in that location are both global companies that are exposed to adventure inwards the balance of the globe. In addition, when multinationals travail to guess hurdle rates for projects, it should reverberate non merely the currency you lot practise the analysis inwards but besides the dry soil inwards which the projection volition endure located. Influenza A virus subtype H5N1 Royal Dutch refinery investment inwards Nigeria volition select a higher hurdle charge per unit of measurement than an otherwise similar refinery investment inwards the United States. If you lot notice these concepts intriguing, I select my annual update on dry soil adventure available for download at this link. Be warned! It may operate every bit a narcoleptic to those who are slumber deprived.

Conclusion
There was a fourth dimension a few decades agone when the draw betwixt developed too emerging markets was a clear one. On i side were developed markets, amongst independent key banks, rule-following governments too stable financial policies, too on the other side were emerging markets, amongst unstable too unpredictable political leadership too key banks that did their bidding. The final decade has seen a blurring of lines, every bit some “developed markets” mimic emerging marketplace behaviour too some emerging markets mature. There are some (companies too investors) who select decided that this convergence is a ground to ignore dry soil risk, but I recall that they practise then at their ain peril. Notwithstanding globalization too convergence on some dimensions of risk, nosotros human face upwards broad variations inwards adventure across the world, too prudence too expert sense need that nosotros comprise these differences into our decisions.

YouTube Video


Paper on Country Risk
Country Risk: Determinants, Measures too Implications - The 2019 Edition

Data Links

1. Measures of Corruption, past times Country (Transparency International)
2. Measures of Violence, past times Country (Institute for Peace too Economics)
3. International Property Rights Index 
4. Commodity Dependence, past times dry soil (UNCTAD)
5. Country Risk Scores (PRS Group)
6. Sovereign Ratings, past times Country (Moody's, S&P)
7. Sovereign CDS Spreads (10-year) on 7/21/2019
8. Equity Risk Premium, past times dry soil (Damodaran Online)

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