Risk Rising Modestly
RISK RISING MODESTLY
Changes in risk-real or perceived-has been at the crux of every major economic and financial dislocation. Most recently, the fall in prices of financial instruments leading up to the 2008 worldwide credit crisis and subsequent 2009 price recovery began with a whiff of credit depression and later, relaxation.
Even for periods between crisis and recession, political and self-inducing events can place valuations and prices under strain, forcing an upward revaluation of cost of capital. As such, equity investors must continuously monitor change in the financial markets risk profile. If the perception of risk is increasing, even if cash flows and credit health are currently strong, one should expect the prices of financial instruments to decline.
This risk to cash flows is incorporated and is the purpose of the cost of equity capital.
Current political tensions have slightly elevated the risk to free cash flows, causing us to raise our cost of equity capital by 15 basis points for all U.S.-based companies. From China to the Mid-East, the re-valuation of risk metrics in our models is apparent; however, an over-reaction to events is also not justified given the factors we look at. We do not carry direct investments in the most effected countries.
Included in the factors we assess when assigning a cost of capital score for the sovereign risk metric include terrorism, inflation history, fear of nationalization, hunger, poverty, and corruption. Needless to say, most of these metrics pointed to the negative outcome we are witnessing today.
The groundswell that began in Egypt is empowering citizens around the globe, and while it has not spread to the most industrialized nations, it would be naive to assume, given large budget deficits in U.S. States and Federal government, there could not be some backlash here as well. Pensions and rising costs (education, food, and clothing) could spur scattered protests and widespread news coverage.
At present such risks are contained, but one which could impact both the current level of consumer confidence as well as capital decisions. And while a 15 basis point increase will not result in a shift to our current portfolio, it does serve to ratchet up the required return for making equity investments.
Inflation is also a weighty factor in the cost of capital, entering into both the risk free rate as well as other metrics.
It is difficult to find a reporting firm that has not been negatively impacted by the rise in input costs, with warnings of a continuing negative impact to come. In China, some companies are reporting wages are rising as much as 40% for factory workers. We currently assess a cost of capital for Chinese companies 75 basis points greater than Canadian companies given similar free cash flows and credit health. US firms receive a 25 basis point mark-up over Canadian firms.
Here in the U.S., yields are rising due to commodity cost pressure and, according to Federal Reserve data, lower foreign purchases of U.S. bonds. Hedge funds are also increasing their leverage, according to Federal Reserve data which tracks borrowing against bonds not tied to the US Government, as these funds attempt to leverage up.
While our credit models continue to indicate improvements to free cash flow, we are not seeing a strengthening in credit for the S&P Industrials over the past 2 quarters, which we can tie directly to the outlays for share repurchases.
All in all, we cannot be so blind as to ignore recent happenings, as is captured by our various model metrics, including credit spreads and political tensions. We see that yields on third world debt and credit default swaps have been rising as well, while the latter remain steady for U.S. fixed income instruments, perhaps a result of Federal Reserve policy and hedge fund buying.
With cost of capital having slightly risen, one would expect investors to pay closer attention to cash flow and credit. This has not generally been the case over the past year and a half, as evidenced by the tightness of junk bond yield spreads.
Kenneth S. Hackel, CFA
