Monday, January 19, 2015

The X Factor in Value: Excess Returns in Theory and Practice

There are lots of reasons why we try to start and run businesses. Some of them are emotional but the financial rationale for starting and staying in business is a simple one. It is to not just to make money, but to make more than what you would have made elsewhere with the capital (human and financial) invested in the business. Of course, your competitors, the government and sometimes the entire world seems to conspire against you (or at least it seems that way) to prevent you from making these “excess” returns. 

The Search for and Scarcity of Excess Returns
In corporate finance, decision-making tools are constructed with the objective of earning and maximizing excess returns. Thus, the notion of net present value in capital budgeting is built on the presumption that an investment should earn more than what you would have generated as a return on an investment of equivalent risk.  In investing, the search for excess returns or alpha is just as intense, with traders, value investors and growth investors playing their own versions of the game.

While you can plan, hope and pray for excess returns, to earn them consistently, you have to bring something unique that cannot be easily replicated to the game. In the case of businesses, that something is a competitive advantage or a barrier to entry that allows them to continue generating returns that exceed their costs of capital, without competition driving down profitability to more "normal" levels. These competitive advantages can range from economies of scale (Walmart), to brand name (Coca Cola) to patents (Amgen), and while they are have to be earned, they are not uncommon. In the case of investors, those competitive advantages are not only rarer but also more difficult to defend, perhaps explaining why so few active investors beat index funds or the market.

The Measurement of Excess Returns
Assume that you have been given the task of measuring whether a company’s past investments have generated returns for that exceed their cost, i.e. excess returns. To measure excess returns generated by companies on their investments collectively, you need two numbers, the expected return on the investments, given their risk and alternative investment choices today, and the actual return earned on those investments.
  1. The first number is the expected return on the investment, given its risk. As I noted in my last post, the cost of capital, computed right, should be an opportunity cost that reflects the expected return that investors in the company can generate by investing elsewhere in investments of equivalent risk. 
  2. The second number is easy to compute for investors in publicly traded securities, since it a function of how much cash the investments returned (in dividends or other forms) and the price change over the year. Measuring the return earned by companies is more problematic, especially for ongoing and evolving investments. The most logical place to start is with the earnings generated by the company on these investments, but that number,  is volatile and may not reflect the true quality of investments.  The actual earnings (and returns) for a company will move a lot from year to year, sometimes because of actions taken by the firm and sometimes because of macroeconomic shifts. In addition, a company’s earnings and investing history is framed by accounting statements. Thus, accounting profits (net income, operating income) become a proxy for true earnings and the book value of capital invested (book value of equity, invested capital) stand in for earnings and investments, and we get two of the most widely used accounting returns: the return on (invested) capital and the return on equity.

While I have no qualms about using either return measure, the dependence on accounting statements for both the numerator and denominator trouble me.  It is not my objective in this post to belabor the definition of return on equity and capital. If you are interested, I have an extended discourse on the technical issues that you may face in computing accounting returns in this paper.

In my last post, I looked at the simplifying assumptions that I made to compute the costs of capital for industries and for individual companies. To measure the excess returns, I do need to compute the return on invested capital, and I do make simplifying assumptions again to prevent getting bogged down.

Note that I am using the effective tax rate to compute after-tax operating income, both at the industry and company level. For return on equity, I use a similar adjustment process:

I am well aware of the weaknesses in these measures. The first is the use of the most recent year's operating income in the numerator. Earnings at companies can vary over time and the most recent year may yield a number that is not representative of the company. (I did also use a ten-year average income to generate returns to try to counter this problem). The second is that the book value of equity is an accounting number and as such, is affected by accounting decisions on capitalization/expensing, depreciation and write offs. The third is that netting out the most recent period's cash balance, especially at technology or growth companies, can result in a negative invested capital. Finally, this measure, even if the earnings and invested capital are measured right, will be biased against young companies and companies investing in long-gestation period investments (infrastructure, toll roads etc.), since it will be low in the early years.

The Evidence on Excess Returns
Notwithstanding the many limitations of the excess return measure that I have described, I do think that there is value in looking at how firms measure up on it, across sectors and across the globe.

a. Across Sectors
To compute the return on capital for a sector, I used aggregated values for the operating income and invested capital across companies in the sector, rather than a simple average of the returns on capital of individual companies. I did this for two reasons. The first is that it allows me to keep all of the firms in my sample, rather than only the ones for which I can measure excess returns. The second is that it prevents outliers (hugely positive or negative excess returns that I may estimate for a firm, usually because of quirky accounting) from affecting the average. The third is to get a measure of weighted performance, where larger firms in a sector count for more than smaller firms.

I report the industry averages in this data in this dataset. In the table below, I report on the five industries, in the US and globally, that report the highest return spreads (a return on capital that most exceeds the cost of capital) and the five that had the lowest return spreads.
Return spreads based on trailing 12 month returns: January 2015
As with any measure, the rankings reveal as much about the quality of the measure as they do about the quality of the sectors. Tobacco companies are at the top of the list partly because repeated stock buybacks have depleted the book values of equity and invested capital, at last in the United States. Aerospace and defense is a volatile business and the high positive excess returns in 2014 can turn negative, if the airline business is troubled. 

b. Across Countries
To look at excess returns across countries, I consolidated companies into five groups: US, emerging markets, Europe, Japan and Australia/NZ/Canada. I then looked at the individual companies within each group and how much they earned, relative to their costs of capital. The table below summarizes the distribution of companies, in terms of excess returns, in each region:

The most striking feature of the data, to me, is that the proportion of companies that earn less than their cost of capital, 65.36% of all companies and 53.99% of companies with market capitalizations that exceed $50 billion. That indicates either that competition is a lot more intense in more businesses than we think and/or that management at many of these companies are either unaware or indifferent that their businesses are not generating sufficient profits, given the risk. 

What next?
This may reflect my biases but everyone should care about these excess returns. Investors should be valuing companies, based on their expectations of future expected returns, and pushing for change in companies that don't deliver them. Anti-trust regulators can use them as proxies for determining whether competition is adequate in markets and lawmakers should consider excess returns rather than absolute profits, in making public policy.

Dataset attachments
  1. Excess Returns by sector (USEmerging MarketsEuropeJapan, Australia/CanadaGlobal)

Putting the D in the DCF: The Cost of Capital

If there were a contest for the most measured number in finance, the winner would be the cost of capital. Corporate finance departments around the world compute it as an integral part of investment analysis. Appraisers estimate it as a step towards estimating intrinsic or discounted cash flow value. Analysts spend disproportionate amounts of their time working on it, though not always for the right reasons or with the right inputs. Since I have spent a significant portion of my life, writing and talking about cost of capital, it stands to reason that it is one of the numbers that I compute for all the companies in my data base at the start of every year.

Defining the cost of capital
There are three different ways to frame the cost of capital and each has its use. Much of the confusion about measuring and using cost of capital stem from mixing up the different definitions:
  1. For businesses, the cost of capital is a cost of raising financing: The first is to read the cost of capital literally as the cost of raising funding to run a business and thus build up to it by estimating the costs of raising different types of financing and the proportions used of each. This is what we do when we estimate a cost of equity, based on a beta, betas or some other risk proxy, a cost of debt, based upon what the business can borrow money at and adjusting for any tax advantages that might accrue from borrowing.
  2. For businesses, the cost of capital is an opportunity cost for investing in projects: The cost of capital is also an opportunity cost, i.e., the rate of return that the business can expect to make on other investments, of equivalent risk. The logic is simple. If you are considering investing in a new asset or security, you have to earn more than you could make by investing the money elsewhere. There are two subparts to this statement. The first is that it is the choices that you have today that should determine this opportunity cost, not choices that you might have had in the past. The second is that it has to be on investments of equivalent risk. Thus, the cost of capital should be higher for riskier investments than safe ones.
  3. For investors, the cost of capital is a discount rate to value a business: Investors looking at buying into a business are effectively buying a portfolio of investments, current and future, and to value the business, they have to make an assessment of the collective risk in the portfolio and how it may change over time. 
A good measure of cost of capital will find a way to bridge the differences between the three definitions and I believe that we can do so, with a little common sense and some data.

For this process to yield a number to meet all three requirements for cost of capital, i.e., that it be a cost of raising funding, an opportunity cost and a required return for investors, here are the requirements:
  1. Investors price companies based upon a reasonable assessment of the company’s business mix (and country risk exposure) and what they can generate as expected returns on alternative choices of equivalent risk. The former requires companies to provide information on their business mixes and the latter generally is easier to do in a liquid, public market.
  2. A company that operates in multiple businesses and many countries cannot use a single, “company-wide” cost of capital as its hurdle rate in investments. It has to adjust the cost of capital for both the riskiness of the business in which the investment is being planned and the part of the world that it is going to be located in.
  3. The overall company’s cost of capital has to be a weighted average of the costs of capitals of the businesses that it operates in, and as the business mix changes, the cost of capital will, as well.
Estimating the Cost of Capital
Having laid the groundwork, let’s get down to specifics. If you, as an investor, are given the task of estimating the cost of capital for a company, here is the sequence of steps. First, you have to estimate the business risk in the company by taking a weighted average of the risks of the businesses that the company operates. Second, you have to adjust that risk measure for the effects of debt, which effectively magnifies your business risk exposure, and use the consolidated risk measure to estimate a cost of equity. Third, you have to bring in the cost of borrowing, net of any tax benefit, which will reflect the default risk in the company. Finally, taking a weighted average of the cost of equity and after-tax cost of debt yields a cost of capital. If you are approaching the same task as a CFO, you have to follow the same sequence to get a cost of capital for the company but you have to go further and estimate the costs of capital for the individual businesses that the company is invested in.

As someone who teaches corporate finance and valuation, I am equally interested in both sides of this estimation process and one of my objectives in providing data is to help both sides. To help companies in investment analysis, I try to estimate costs of capital by sector, in the hope that a multi-business company will be able to find the information here to build up business-specific costs of capital. While investors may also find this information useful in valuation/investment analysis, I also estimate costs of capital for individual companies, and while my data providers no longer allow me to share these company-specific costs of capital, I can still provide information on the distribution of costs of capital across companies that can be useful to investors.

a. Cost of capital by sector
In my data updates each year, I estimate the cost of capital, by sector, for companies both globally and classified by region (US, Europe, Japan, Emerging Markets). In making these estimates, I first begin by breaking my total sample of 41,410 companies down into 96 industry groups, some of which may be far broader than you would like to see. I prefer this broad categorization for two reasons. First, I estimate a beta for each industry group by averaging the betas of the individual companies in that group, and these estimates are more precise with larger sample sizes. Second, from a first principles perspective, I believe that since betas measure risk from a macro risk perspective, you are better served with broader categories than narrow ones. Thus, rather than estimate the beta for shrimp fishing as a business, I would rather estimate the beta for food processing businesses (assuming that the only reason that people buy shrimp is to eat them.). Once I have the industry groups, I estimate the cost of equity for each group (in US dollar terms, by using a US dollar risk free rate and a equity risk premium in US dollar terms, though the magnitude of the premium can vary across countries and regions) by using the average beta across companies in the sector. For the cost of debt, I do have a problem, since all I usually have at the industry level is a book interest rate (obtained by dividing the interest expense by the book value of debt) which is not very useful from a cost of capital perspective. I use the variance in stock prices as an indicator of the risk and use it to estimate a default spread in US dollar terms, which then allows me to compute a cost of debt. As the final step, I use the industry average debt to capital ratios (in market value terms) to compute a cost of capital; in keeping with my view that lease commitments are debt, I convert lease commitments to debt for all companies in my database:

The results from the start of 2015 are captured in the attached spreadsheet, which includes costs of capital by sector not only for global companies, but also includes my regional estimates.

b. Cost of Capital - By company
As part of my data analysis, I also try to estimate the cost of capital for each of the 42,410 companies in my database. Since it is impractical to analyze each company in detail, I do have to make some simplifying assumptions.

  • First, I assign each company to one primary business in estimating business risk and use the unlevered beta for that business as the beta for the company. Optimally, I would compute the unlevered beta for each company, using the mix of businesses it is in, but with my sample size and data access, it is close to impossible to do. 
  • Second, I assume that the company gets all its revenues in the country in which it is incorporated and assign it the equity risk premium of that country. Thus, a Russian company’s cost of equity is computed using the Russian ERP (see my earlier post on country risk) and a German company’s cost of equity is computed based on the German ERP. I know that this violates my earlier point of multinational companies, and I would never make this assumption in building up an individual company’s cost of capital but I am afraid I have no choice with the larger sample. 
  • Third, I estimate a default spread for the company by using the variance in its stock prices. It is true that some of the companies (about 4000 or about 10% of my sample) have bond ratings available on them, but the bulk of my companies do not. In addition, if the company is incorporated in a country with sovereign default risk, I add the default spread for the country on to that of the company. I also use the marginal tax rate of the country that the company is incorporated in to estimate an after-tax cost of debt. 
  • Finally, to keep the numbers comparable, I compute the costs of capital for all companies in US dollars.

While I cannot provide you with the company-level costs of capital, I can provide the cross sectional distribution of my estimates. As you look at companies, I hope that you can use this for perspective, i.e., in making judgments on what comprises a high, low and median cost of capital. With US companies, the cost of capital distribution across all companies is below:

Cost of capital in US dollars: US companies in January 2015

Thus, if you use a cost of capital of 10% in the United States, you would effectively be assuming that your company is in the 98th percentile of US companies, in terms of cost of capital. With global companies, the cost of capital distribution is as follows:
Cost of capital in US dollars: Global companies in January 2015

Note that I have used a larger equity risk premium and incorporated sovereign default spreads into the cost of debt, yielding a larger spread in the cost of capital. A cost of capital of 12.5% for a global company would put it in the 94th percentile of companies.

A Cost of Capital Computation Template
If you work in finance, you will run into the challenge of estimating the cost of capital for a company sometime during the course of the year. I hope that the datasets that I have created are useful to you in that endeavor and if you decide to use them, here is a simple template for arriving a company's cost of capital in the currency of your choice.

Comments/ Data sets
Risk free rate
Use the prevailing 10-year US T.Bond rate as the risk free rate in US dollars, even if you plan to compute the cost of capital in another currency.
Fight the urge to normalize, tweak or otherwise mess with this rate. It is what you can make today on a risk less investment, no matter what your views on it being too low or high.
Business Risk (Unlevered beta)
Break the company down into businesses, using an operating metric (revenues work best) and compute the weighted unlevered beta across the businesses.
Company breakdown: In company’s annual report or financial filings
Beta of businesses: My unlevered betas by business (broad groups) or you can create your own subgroups.
Financial Risk (Debt to equity and levered beta)
Lever the beta using the market debt to equity ratio for the company today. (If you prefer to use a target debt to equity ratio, make sure it is based on market values.
Market value of equity: Use the market capitalization as market value of equity. 
Market value of debt: For debt, use book value as your proxy for market value, or better still convert book value to market value.  Add the present value of operating leases to debt.
Equity Risk Premium
Obtain the geographical breakdown of the company’s revenues (or other operating metric, if you don’t like revenues). Take a weighted average of the ERP of the countries/regions that the company operates in.
Geographical Breakdown:  The company’s revenues will be in its financial statements, though it is not always as clear and detailed as you would like it to be.
ERP by country: My ERP by country.
Cost of debt
If you can find a corporate bond rating for your company, use it to get a default spread and a cost of debt. If you cannot find a bond rating, estimate a bond rating for the company and a default spread on that basis. If you are doing the latter, add a default spread for the country to get the pre-tax cost of debt.
Bond Rating: If available, you should be able to find it at S&P or online.
Synthetic Rating: You can use this spreadsheet to get a synthetic rating for your company.
Rating-based default spread: My lookup table of default spreads for ratings classes.
Country default spreads: My estimates
Marginal tax rate
Multiply the pre-tax cost of debt by (1- marginal tax rate) to get the after-tax cost
Marginal tax rate by country: KPMG estimates of country tax rates
Debt Ratio
Use the market values of debt and equity (from step 3)
See step 3
Currency change
If you want to convert the US dollar cost of capital into another currency, add the differential inflation rate (between that currency and the US dollar) or better still, scale up the  US$ cost of capital for the difference in inflation.
The inflation rate in the US can be estimated as the difference between the US 10-year T.Bond Rate and the US TIPs rate. For other countries, you can use the actual inflation rate last year as a proxy for expected inflation. 

If you are interested, I have a spreadsheet that has these steps incorporated into it. Give it a shot!

Looking at the costs of capital across sectors and companies, there are lessons that I take away for valuation and corporate finance:
  1. A rising (falling) tide lifts (lowers) all boats: The first reaction that most analysts and CFOs will have to my estimates of the cost of capital is that they look too low, with a median value of 7.40% for US companies and 8.32% for global companies. In fact, the longer that you have been around in markets, the lower today's numbers will look like to you, because what you consider a normal cost of capital will reflect your experiences. The low costs of capital, though, are appropriate, given the level of risk free rates today.
  2. The cost of capital does not (and should not) reflect all risk faced by a business: Even if you accept the proposition that the costs of capital are lower because of low risk free rates, you may still feel that the costs of capital don't look high enough for what you view as the riskiest companies in the market. You are right but that is because the cost of capital captures risk to a diversified investor in a going concern. Consequently, it will not reflect risks that are sector-specific but not market-wide, such as the risk to a biotechnology company that its newest drug will not be approved for production. Those risks are better reflected in the expected cash flows. The cost of capital also does not reflect truncation risk, i.e., that a firm may not survive the early stages of the life cycle or an overwhelming debt burden. That risk is better captured through decision trees and probabilistic approaches.
  3. Don't sweat the small stuff: In my view, analysts spend too much time finessing and tweaking the cost of capital and not enough on the cash flows. After all, the cost of capital, even if you go with the global distribution, varies within a tight range (6% to 12%, if you use the 10th and 90th percentile) and your potential for making mistakes is therefore also restricted. In contrast, profit margins and returns on capital have a much wider distribution across companies and getting those numbers right has a much bigger pay off.
Dataset attachments

The Tax Story in 2015: Myths, Misconceptions and Reality Checks

Each of us believes that we pay our fair share in taxes and that it is other people that do not, and not surprisingly, we find evidence to back up our priors. I find that the only way to at least partially offset my own biases is to look at the data. I have done it before, as in this post last year, but with the new data in hand, I thought it is worth an update.

Corporate Tax Rates across Countries
I believe that the US tax code is full of perverse incentives for corporations to borrow too much and to under invest domestically, and that change will be slow to come (and I hope that I am wrong). Since corporate behavior is affected by tax differences across countries, I start by look at differences in corporate tax rates across countries, with a helping hand from KPMG, below:

While there are numerous countries competing for the prize of having the lowest corporate tax rate, the battle for highest tax rate looks like no contest, with the US as the winner (with a marginal tax rate of 40%).
Marginal corporate tax rate in 2014
It is worth noting that two decades ago, there would have been lots of competition for the US at the top of the table, but much of it has faded, not because the US has raised its tax rate (it has not) but because the rest of the world has moved on. Just as an aside, and this was the main focus of my post in August, the US is one of six countries that tries to tax foreign income at the US corporate tax rate, which leads to predictable consequences (trapped cash, inversion etc.)

Effective Tax Rates across Countries
According to the tax scolds, US companies are tax cheats and don’t pay their fair share in taxes, thus rendering the corporate tax rates moot. That claim can be easily checked by looking at the effective tax rates paid by companies in different countries in 2014 and they are captured in the picture below:

While US companies clearly don’t pay 40% of their income in taxes, they paid 28.09% of their taxable income in taxes, higher than the 26.84% paid by European companies and 21.56% by emerging market companies. Only Japanese firms pay more in taxes that US firms:
Effective tax rates by Global Regions: January 2015 (based on trailing 12 months)
In my post on taxes last year, I developed a measure of tax efficiency obtained by comparing the effective tax rate paid by companies to the marginal tax rate. Updating that measure to reflect the 2014 effective tax rates, here is the list of the least efficient tax systems in the world (eliminating pure tax havens and city/states):

The US remains in the top ten list, a dubious distinction given the company it is keeping on this list.

Effective Tax Rates across sectors and size classes
Are some sectors more likely to hold back on paying taxes than others? Given that the tax code has been used as a mechanism by the legislature for the dubious purpose of encouraging “good” behavior (job creation and green energy come to mind), I would not be surprised if this were not the case. As part of my data update, I do compute different measures of taxes paid, by sector. In the table below, I list the dozen industries that pay the highest effective tax rates and the ones that pay the lowest:

Effective Tax Rates in January 2015: Trailing 12-month numbers
The list of the lowest tax paying sectors includes some of the usual suspects, such as real estate investment trusts (since the tax code explicitly relieves them of the tax burden). It is also interesting that investment and asset management shows up on the list, perhaps reflecting the advantageous treatment of income, at least to some portfolio managers. The list of the highest tax paying sectors is tilted towards the retail sector and transportation companies. Oil and gas offers an interesting contrast, with oil/gas distribution companies in the lowest tax paying list and integrated and production companies showing up on the highest tax paying list.

I was also interested is looking at the tax burdens at large versus small companies, again with the intent of examining another widely disseminated view that the largest companies are the ones that pay the least in taxes. In the table below, I look at different measures of taxes paid by U.S. companies, classified by market capitalization into ten classes:
Based on taxable income & taxes in trailing 12 months: January 2015
The critics of large companies must be looking at very different numbers than I am, because at least based on taxes paid in 2014, it is the largest companies that paid the highest taxes, not the smallest. So much for extrapolating from the GE pays no taxes story!

A New Corporate Tax Code
There is talk in the US Congress of fixing the corporate tax code, to make it simpler, fairer and more effective. I may be revealing my ignorance of tax economics but I have a very simple rewrite of the tax code that will deliver (in my view):

  1. Lower the corporate tax rate to 28% on income made by corporations on sales in the United States and compute that income based upon the proportion of sales that corporations get in the United States. Why 28%? That is roughly what US companies are paying in the aggregate right now, though with state and local taxes, the new rate will be higher than 28% in some states. The income allocation based on revenues, rather than reported earnings, will put a lot of transfer pricing specialists out of business, but I am sure that they will land on their feet.
  2. Move to a territorial tax system, where income on foreign operations are taxed at the foreign tax rate. That will eliminate not only the problem of existing trapped cash but will stop the game playing on foreign income.
  3. Eliminate all tax credits and sector-focused tax deductions, no matter how good they sound. I am including tax credits for R&D, green energy and job creation on this list.
If you don't like my suggestions, don't worry! I don't think that there is much chance that my tax code rewrite will become law.

Data Attachments

Country Risk, Return and Pricing: The Global Landscape in January 2015

Advance warning: I apologize. I went a little over-the-top with heat maps in this post. They are neat, though, since you can hover over a country (with your mouse or clicker) and you should be able to see the data for that country. If you prefer your data in old-fashioned tables, they are available as links at the bottom of the post.

I am happy to say that I am done with my data updates for 2015. While I like analyzing data, I am glad that I will not have to work with really big and sluggish excel spreadsheets until next year. Following up on my last post on US equity risk premiums, I thought it would make sense in this one to go global and take a look at the numbers, as they stand in January 2015. I am well aware that the global landscape of pricing and risk can change at the drop of a hat, but knowing what they changed is always useful. 

Country Returns

The US market had a good year in 2014, with the S&P 500 delivering a total return of 13.48% for the year. However, it was not not the best performing market for the year, as quite a few emerging markets ranked higher. The table below lists the dozen best-performing and dozen worst-performing markets, in both local currency and US dollar terms, for 2014.

Stock Market Returns: Calendar Year 2014
As an investor, I am not sure how these numbers should affect my investment choices for the coming year. While the contrarian in me is telling me to avoid the winning markets and seek out the losing ones, I have learned through painful experiences to respect momentum enough not to be a blind contrarian. As a consequence, I will stick with my base plan of valuing individual companies, no matter what country they are incorporated or operate in, and looking for under valued companies. 

Country Risk
To estimate value for companies, though, I do have to wrestle with measuring risk globally, and variations in risk across countries. For the last two decades, I have been trying to measure country risk and have reported my estimates annually. While I am ultimately interested in measuring exposure to equity risk, I start with measures of default, because they are more easily available and are easier to connect to expected returns.

The most widely reported measure of sovereign default risk are sovereign ratings, with Moody’s, Standard and Poor’s and Fitch all providing this service. The attached spreadsheet uses the January 1, 2015, data from S&P and Moody’s to provide a comprehensive listing of the local currency sovereign ratings of all rated countries. The following picture captures the breakdown, at least in January 2015, of countries by broad ratings classes (using Moody's sovereign ratings where available and S&P's converted into Moody's ratings, for a few countries):

Sovereign Ratings: January 2015
One critique of sovereign ratings is that they often lag developments in the real world, with changes in ratings occurring well after investors have priced in the changes. The sovereign CDS market provides market-based estimates of sovereign default risk, though only 68 countries have sovereign CDS spreads (far fewer than the 142 countries that have sovereign ratings available on them). The table below lists the sovereign CDS spreads for all available markets in January 2015 (and is also available as a downloadable spreadsheet):
Sovereign 10-year CDS Spreads: January 2015
Both sovereign ratings and CDS spreads are measures of default risk and investors in search of a wider measure of country risk (which extends beyond default into political and legal risk) may want to take a look at the composite risk scores reported by the Political Risk Services (PRS) group. The PRS composite risk score, is scaled to 100, with higher numbers reflecting more risk. Using the most recent values for these scores, I have created a risk map:

The red spots in the map are the most risky countries in the world, at least according to the PRS measure in January 2015.

As I mentioned up front, my end game requires equity risk premiums by country. I started with the sovereign ratings (since they are available for more countries and then used the look up table below to estimate default spreads by country. 

After scaling up these default spreads to reflect the fact that equities collectively are riskier than bonds, I obtained country risk premiums for each country. I made a judgment that the equity risk premium  (5.78%, which I approximate to 5.75%) that I obtained for the S&P 500 was a good measure of the mature market risk premium and adding the country risk premium yields the total equity risk premium for each country). To complete the picture, I used the PRS scores for those frontier markets (such as Libya, Syria, Iran and Iraq) that are not rated by the rating agencies, found rated countries with similar scores and averaged out their equity risk premiums. While you can download the spreadsheet that contains my estimates of equity and country risk premiums by clicking here, the picture below captures the risk differences across the world.

Note that I have used 5.75% as the mature market premium not just for the US but for all countries rated Aaa by Moody's and that the equity risk premiums for non-Aaa rated countries reflects the additional country risk premium. Again, the red spots on the map represent the countries with the highest equity risk premiums. 

At this stage, if you are primarily an investor in US companies, you may be heaving a sigh of relief that you don’t have to deal with these country risk measures, but your relief should be short lived. Since a company’s risk exposure comes from where it operates and not from where it is incorporated, most US companies (including small ones) operate in multiple countries and it is the weighted average of the equity risk premiums across countries that should be used in valuing these companies.

Country Pricing
It is true that some markets are riskier than others, but a knee jerk avoidance of the riskiest markets may not always be a good strategy. After all, at the right price even the riskiest market can be a bargain. To get a measure of how global markets are being priced right now, I estimated a range of pricing multiples including price earnings ratios. EV/EBITDA and price to book value ratios for all of the countries in my sample. Note, as you look at these numbers, that some of the markets (especially in Africa) that I look at are very small with only a handful of listings and that the ratios computed for these markets have to be taken with a grain of salt. 

Starting with PE ratios, here is what I find, as I look across the globe at the start of 2015.

The countries with the lowest PE ratios are highlighted in red, though hovering over the spots will give you a quick measure of why they might not be bargains.

Moving on to EV/EBITDA multiples and looking for bargains, here is what the global picture looks like in 2015:
The countries that trade at the lowest multiples of EBITDA are in red.

Completing the story with price to book ratios, the visualization yields the following.
Again, it should come as no surprise that the countries that trade at well below book value (colored red) also happen to be countries that are in crises.

Looking across all three multiples and listing out the countries that have the lowest values for each one in aggregate:
Based on market values on 1/1/15 and trailing 12-month financials
It is true that most of the countries on this list are also risky ones but that does end the analysis. If the essence of investing is looking for mismatches, you are looking for countries that trade at low prices (relative to earnings, book value or sales), after adjusting for risk. Much as I would like to go into ways of doing this, I think I have outlived my welcome in this post. So, it has to be put off for another day.

So what now?
If you are an investor, there are very few places left to hide from globalization. Very few companies operate in domestic market vacuums and most are exposed, sometimes in good ways and sometimes in bad ones, to changes in the global market landscape. In 2014, it was Russia that was the game changer in the first part but oil prices played the bigger role in the second half of the year. I am not sure what will move global markets in 2015 but I am sure it will be an interesting year. 

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