Wednesday, February 6, 2008

The Strait of Messina

A thing I never know, when I'm starting out to tell a story about a chap I've told a story about before, is how much explanation to bung in at the outset. It's a problem you've got to look at from every angle. I mean to say, in the present case, if I take it for granted that my public knows all about Gussie Fink-Nottle and just breeze ahead, those publicans who weren't hanging on my lips the first time are apt to be fogged. Whereas, if before kicking off I give about eight volumes of the man's life and history, other bimbos, who were so hanging, will stifle yawns and murmur 'Old stuff. Get on with it.'

I suppose the only thing to do is to put the salient facts as briefly as possible in the possession of the first gang, waving an apologetic hand at the second gang the while, to indicate that they had better let their attention wander for a minute or two and that I will be with them shortly.

— P.G. Wodehouse, The Code of the Woosters

One of the existential pleasures of publishing an anonymous blog with comments disabled is that both the writer of said blog—Yours Truly, in this instance—and his or her audience—yourselves, of course, my Dear Readers—share a mutual ignorance of each others' identities, condition in life, and choice in hair products which is so breathtaking in its purity as to put shame to the proverbial inhabitants of Plato's Cave as dissembling prevaricators who have stolen the answer key to their freshman year metaphysics exam.

Now, being the sole responsible party for the anonymous nature of this relationship, you may presume correctly that in general I find it both natural and just. Not only do I find my readers' ignorance of my particulars convenient in the larger sense of preventing the tasteless nuisance of frequent lawsuits from those among the Great and Good I have publicly libeled, but also quite effective at deflecting the frequent inquiries I would no doubt otherwise receive from the teeming masses concerning my choice and recommendations in haberdashery, hair tonics, and personal lubricants. [Manufacturers of same should contact me directly to negotiate lucrative promotional arrangements.]

However, owing to my keenness of intellect and the awe-inspiring deductive powers I have employed in your service over the past year, I have noticed one tiny drawback to this arrangement: I have no fucking clue who any of you are.

Of course, I flatter myself in believing that each of my scribblings is deciphered as the Delphic utterance it is by the combined Executive Committees of every Global Investment Bank on the planet as well as the Joint JD/MBA/PhD programs of every leading educational institution that matters, in addition to second-rate degree mills on the Charles River and elsewhere. But that, if my finger tally is correct, accounts for only 16 of my regular readers. Who the hell are the rest of you? For that matter, why do you persist in reading a blog which requires 20 years of investment banking experience, an IQ of 210, and a bottle of single malt scotch to interpret properly?

Well, anyway, one might as well ask who's gonna win American Idol this season. Besides, if this blog sells even a couple more Merriam Webster dictionaries and causes even one benighted ignoramus to understand just a little more about the arcana of global finance—at least until he sobers up—I can count my good deed accomplished for the month. So, in that spirit, and, following the example of that most moral, perspicacious, and serious of first person narrators in the English language—videlicet, Bertram W. Wooster (q.v., above)—I offer to those among you deficient in the financial arts the following ruminations on that most hoary and troubled of topics, stock market valuation.

As Bertie recommends above, I encourage the 16 of you who just groaned "Get on with it" to wander off for a minute or two while I lay these few pearls before the unwashed and attempt to get them to grunt. I am sure you can occupy the interval until my next blog post by grading a few PhD theses or burying a few toxic CDOs in your employees' bonus accounts. So quit your moaning, and piss off.

* * *

Stock market valuation.

Now there's a kettle of fish, and no mistake. In fact, on second thought, it is an entire ocean of fish, one so vast, mysterious, and slippery as to keep a virtual army of investment bankers, management consultants, and PhD candidates in Osteichthyes up to their earlobes for the indefinite future. Unfortunately—or, if you are like me, one who earns his daily bread by interpreting these mysteries, fortunately—valuation is a topic in which the otherwise intelligent can easily lose their way.

Exhibit A for today's class comes from law professor and my soon-to-be-best-drinking-buddy Frank Partnoy, who wrote in Monday's Financial Times about Microsoft's recent bear hug offer for Yahoo. After pointing out the $20 billion haircut Microsoft's market capitalization took in an up market last Friday after announcing its offer, he poses an interesting question:

Why would a smart leader agree to sacrifice so much of Microsoft's, and his own, share value? Although the deal raises many interesting antitrust, economic and technology issues, it also illustrates the central conundrum of modern business strategy: should corporations focus more on short-term share prices or long-term value? Put another way, the question is: should we trust markets or managers?

Whereas finance theory posits that managers should focus on share prices, today's managers see radical stock price volatility as a source of danger, not discipline.

According to this view, modern CEOs are like sailors in Greek mythology: they must shoot the gap between a high perch of mania and a whirlpool of panic. To maximise the long-term value, they must steer clear of short-term price pressures.

If I interpret Professor Partnoy correctly, I believe he is asking whether we should assign greater credence to the judgment of managers or markets when it comes to valuation questions. Like, for instance, whether Microsoft buying Yahoo for $45 billion is a good idea or not. But this is a false question.

There are several factors at play here. First, I think most of us would concede that the senior managers of your average company have the best knowledge (or best educated opinion) about the short-, intermediate-, and long-term operating and financial prospects of their business. (That may not be saying much, and it ignores the incontrovertible evidence of far too many companies where a comatose dyslexic squirrel would know more about the firm's prospects than the overcompensated buffoons who are nominally in charge, but let that be for a moment.) You know: expected sales growth, market share, operating expenses, profit, etc., etc. They have the best visibility of anyone as to the potential investment opportunities for the business, too, whether those opportunities consist of capital investments in new or existing business lines or the potential acquisition of another business. (After all, M&A is just another form of capital investment, where you buy a business already in operation, rather than building it from scratch.)

This is a relatively straightforward sort of knowledge, one we can understand from our own experience and one we can imagine we would have if we were in those managers' shoes. Furthermore, if they are competent and responsible, this is knowledge the senior management of a business with public stakeholders takes care to communicate to its investors, subject to the usual limitations on withholding sensitive competitive information. Investors take that information, if they are smart, and incorporate it into their investment decisions to buy and sell that company's securities. So far, so good.

But this is the key point to emphasize here: information about the operating and financial prospects of the business in question becomes an input to the price discovery mechanism which the market uses to determine the company's stock price, and only one input among many, at that. What, pray tell, are the other inputs which go into this price discovery mechanism? Here is a partial list, to which I am sure anyone you might ask would be happy to add several of their own favorites:

  • The apparent conviction with which management conveys the business prospects of the firm to investors;

  • Management's credibility with investors (in other words, we may believe that management believes what they are telling us, but do we?);

  • Investors' perception of the attractiveness to the company of the competitive and operational environment in which it operates;

  • Investors' perception of the attractiveness of the general economic environment in which the company operates, and its potential effects on the company's future operations;

  • The relative attractiveness of other investments which might substitute for an investment in the company's securities;

  • The scarcity or plenitude of the company's shares available for buying or selling, and other "technical" factors;

  • The complicated function which aggregates individual investors' risk and return preferences;

  • The general level of interest rates and expected inflation;

  • The price of corn in China; and

  • My personal favorite, animal spirits.

In other words, there is a hell of a lot of information, analysis, and sheer bloodymindedness on the part of a very large number of individual investors acting independently on available information and their own opinion and analysis which gets distilled into one rather uncommunicative number for every company with shares trading in the market: its share price. Therefore, I find it rather heroic of Professor Partnoy to assert that

[the negative] market reaction was that ... Microsoft is digging a massive financial hole by overpaying for Yahoo.

Really? Did he talk with everybody before he came to that conclusion?

* * *

The fact that the overall market was up, and investor perceptions of general market, economic, and interest rate risk seemed to be rather benign on the day in question, does allow us to plausibly eliminate a number of potential explanations for Microsoft's stock plunge, explanations which CNBC would normally summarize for their listeners as "a crappy day in the market." Furthermore, the fact that Microsoft seems to be planning to finance its bid with a combination of cash on hand and new borrowing neatly eliminates the usual explanation of merger arbs buying the target stock and shorting that of the acquirer in proposed stock-for-stock deals. (A textbook example of one of those "technical" factors which I mentioned above.) 1 But there are a number of alternative explanations which I could find just as compelling if not more so than the one put forward by my buddy Frank.

Perhaps investors saw Microsoft's bid for Yahoo as a final admission that it could not make it on its own against Google in the fast growing and lucrative internet advertising market. Perhaps investors shuddered in disgust that Microsoft seemed eager to snap up the shares of a company which itself appeared to be rudderless and adrift, and worried what that told them about MSFT's core business prospects. Perhaps they were pissed that MSFT chose to spend its huge cash hoard to buy a company with a punctuation mark in its name instead of returning another massive cash dividend to current investors. Perhaps they anticipated that Microsoft would indeed really get Yahoo, and cringed at the prospect of merger integration between the flesh eating monopolists of Redmond and the butterfly massaging dilettantes of Silicon Valley. Perhaps Steve Jobs, Sergey Brin, and Larry Ellison banded together to short the shit out of MSFT shares. Who knows? Perhaps a combination of all of these elements, plus the technical factor of a "buyers' strike"—wherein natural buyers of MSFT shares stopped their accumulation to wait for the dust to settle on this little brouhaha—contributed to the swoon.

The incontrovertible point is this: on Friday, investors as a whole took a look at the shares of Microsoft trading in the marketplace and said, "Pee-yew! We're paying 6.6% less for that piece of shit than we did yesterday." And, however you slice it, it appears that the primary reason they did so was because they reevaluated the equity portion of the capitalized value of that business as worth $20 billion less than they thought it was the day before. The only material piece of information investors found out on Friday that management knew the day before was that Microsoft planned to bid for Yahoo and how much. Now, you may argue that investors overreacted to this new information, or that they misinterpreted what this announcement means for the long-term business prospects of Microsoft Corporation, but you cannot argue that what they did was irrational in any way. I am sure legions of loyal MSFT investors and hordes of eager speculators stand ready and willing to be persuaded by Steve Ballmer and his cronies that MSFT is a screaming buy at these levels. Good luck to them, I say.

But $20 billion, you say? That's a helluva lot of simoleons to lop off the top, especially considering that the premium MSFT proposed paying for YHOO shares totaled only $16 billion. (A common, though simplistic, argument of M&A bashers is that the premium an acquirer pays for a target is nothing more than a direct wealth transfer from the acquirer's shareholders' pockets into those of the target's shareholders. More on that red herring another day.) But the size of this change, and the "radical stock price volatility" which it represents and Professor Partnoy bewails, is the result of the other major function of the stock market, as a discounting mechanism.

Mr. Partnoy misses this ingredient when he asserts that Microsoft's projections of "$1bn of synergies would recoup just 5 per cent of Friday's loss." Now, I have not read the deal press releases—Big Steve made the career-ending mistake of not hiring me to advise him on the bid—but I will venture to guess that Microsoft's CFO was talking about $1 billion in annual synergies. If these are permanent synergies, they actually would add up to a great deal of money, based on the magic of discounting. Assume, for a moment, that MSFT's weighted average cost of capital after the deal is 10%, then $1 billion a year works out to $10 billion in (pre-tax) present value, based upon the usual method of valuing a level stream of perpetual cash flows. If those synergies actually grew over time at, say, 3% per year, their present value would total $14 billion.

By the same token, the magic of discounting can work in reverse, too. If the market wakes up one day and decides that Microsoft's future revenue growth is going to be closer to 10% than 20%, or its net margin will be closer to 20% than 30%, based on—let's say—the announcement of a dubious acquisition that casts doubt on its future growth prospects and profitability as a standalone company, just watch the fur fly. In fact, investors have been gradually reappraising MSFT's prospects downward for years. How else do you explain the fact that its stock price has gone basically nowhere since the beginning of 2001 (forget 2000) even while its revenues and earnings have more than doubled?

So, even minor reappraisals by investors of a company's prospects can lead to big percentage swings in the value of its traded securities. When the company is a behemoth like Microsoft, those percentages pretty rapidly add up to some serious coin.

* * *

Whether due to rational reappraisal or not, stock price volatility is here to stay. Some commentators have laid the blame for this on the growing influence of hedge funds in the marketplace. However, up until recently, overall market volatility has been steadily trending down for years, during the same period when gunslinger hedge funds began to shoot up the town in earnest. No, the combination of price discovery, which is characterized by rapid, violent reactions (up and down) to unexpected material information, and discounting, which turns relatively minor reassessments of future earnings prospects into substantial value swings, is a permanent feature of this or any other securities market.

Managers may not like it—although I seldom hear them complain when the price spike is to the upside, a la Yahoo—and they may be baffled that the same company they worked at yesterday could be worth $20 billion less today, but that is their cross to bear. For while they have the greatest impact and control on the fundamental operating and financial performance of their company—hence, in some sense, its intrinsic "value"—they cannot directly determine the price of its securities themselves. That is for the owners of those securities, and the rest of the market, to decide, based upon a host of factors outside any corporate manager's control.

So thread the Strait of Messina carefully, Mr. CEO. There is no other way to get where you want to go, unless you chuck the public market ship for a private equity donkey cart. Just recognize that the odds are high that either the rock or the whirlpool will get you. It's one of your jobs, as Captain, to minimize the losses.

1 Correction: Yeah, yeah, I finally read the press release, and it turns out Microsoft is making a cash-election offer, in which half the total consideration for Yahoo will be MSFT common stock. So I suppose you could add the usual pressures on an acquirer's stock from risk arbitrage to the mix of potential factors in MSFT's stock price decline on Friday. While I have struck out the offending copy in my previous version of this post, the general content and thrust of my argument stands. Please tell me you do not read my blog for facts. Facts, like reality, are for those poor souls who can't handle drugs.

© 2008 The Epicurean Dealmaker. All rights reserved.