Wednesday, May 19, 2010

Throw Out the CorpFin Textbook

Recent market fluctuations notwithstanding, I think there is a major paradigm shift going on in the economy and the markets that has profound implications. A basic tenet of corporate finance is that equity returns are based on the risk-free rate plus an equity risk premium. In English this means that it is riskier to hold equities than the risk-free asset, traditionally US Treasuries, so investors require more return to hold equities. I believe that we are in the early stages of a fundamental breakdown of this bedrock assumption. First let me ask you, in isolation, do you really consider lending to the US government at under 4% a riskless activity? With our gargantuan deficits, debt, off-balance sheet unfunded liabilities, and the impending dawn of ObamaCare, should investors really consider this the risk-free baseline? What about flexibility and ability to adapt? Does the federal government exhibit the ability to adjust in the face of circumstances? Can economic and financial imperatives reflect themselves quickly in government accounts and finances? Of course not, there is hardly any flexibility and maneuverability in our fiscal picture. What about the private sector? Broadly speaking the private sector has exhibited enormous ability to adapt to conditions. American corporations, in general, have pared down, gotten lean, hoarded cash, and repaired balance sheets. All this while governments are straining to achieve even the most meager prudent adjustments in the face of fiscal ruin. The US government is positioning its fiscal future to resemble those European countries that today are facing a painful reckoning the likes of which we haven't seen in decades. Yet we are still supposed to operate according to the paradigm that equities should pay us a premium over lending to the US government? So I ask, "Who do you think is a safer bet - the US government or the company that makes Tide, or Tylenol, or the leading brand of toothpaste?" Would you rather hold J&J stock yielding 3.5% or get an identically yielding US Treasury? Frankly, I see less risk in any number of institutions with names like Colgate-Palmolive, Johnson & Johnson, IBM, Proctor & Gamble, Clorox etc. In today's world, these are the less risky bets and the US government ought to pay me a premium for capital that I could otherwise tie up in the equity of these institutions. So what are the implications if this is right? Equities are massively underpriced and treasuries are massively overpriced. The bear market in treasuries could be of the scale and duration of the great bond bull market that began in the early 1980s when your mortgage was 17% and money market funds were paying 14%. The bull market in equities could be just as powerful as the last ten years was anemic. We have seen that American business is as flexible and adaptive as governments are not, that the iconic institutions of business plan for survival in perpetuity while governments plan for the next election cycle. Trust in government is at an all time low, and while trust in certain sectors of private enterprise - banking - may match it, people still buy toothpaste, detergent, medicines, food, etc. with alacrity. Americans will meet their own needs before they meet the needs of their government. So what is the "risk-free" asset and is an equity risk premium of any magnitude justified? In today's world, what type of institution will adapt, endure, protect, and retool. What type of institution will act with speed, wisdom, and effectiveness? Shouldn't you pay more for these qualities and less for the lack of these attributes? I believe so, and I think this will be the new reality a few years down the road.


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