Debt or equity?

One of the reasons offered by market strategists for continuing to buy equities is that the dividend yield on stocks is considerably higher than that on government bonds. It is hard to argue with this. The one-year expected dividend yield on the FTSE100, for example, is currently 4.7% versus 0.7% on a 12-month government security. Assuming that equity values remain broadly stable, it makes perfect sense to buy equities which yield a 400 basis points premium over bonds. Now imagine the choice is between corporate debt and corporate equity. From an investment perspective the same applies. But from an issuer perspective things look very different.

UK A-rated corporate debt trades at around 1.94% - more than 270 bps below the dividend yield on equities. Companies thus have an incentive to issue debt rather than equity in order to cut the amount they have to shell out each year in order to persuade investors to buy into their company. After all, according to the well-known Modigliani-Miller theorem the company’s valuation is indifferent to whether it is financed by debt or equity. To the extent that the dividend yield represents a measure of a company’s profit that is redistributed back to shareholders, there are good reasons why a company might want to reduce it – perhaps to increase the funds available for investment or simply to raise employees pay (or even simply to hike the CEO’s bonus).

There have been suggestions that this is one reason why equity issuance is beginning to dry up. The evidence is not conclusive but latest data from the London Stock Exchange does point to a reduction in equity capital issuance over the past couple of years. Based on annualised data for the first ten months of 2019, we look set for a second consecutive decline in issuance with a figure which is roughly one-third below the average of the past two decades (chart 1).

It is indeed notable that equity investors have not revised down their expected returns on stocks despite the fact that interest rates have fallen to all-time lows. We can derive this from the formulation of the dividend discount model attributed to Myron Gordon, known as the Gordon growth model. Playing around with the formula, we derive the result that the compensation demanded by the market in exchange for holding the asset and carrying the risks depends on the expected dividend yield[1] and the (constant) growth rate assumed for dividends. Since the latter is a constant, the required rate of return is a positive function of the expected dividend yield. The expectation that dividends will remain high has thus conditioned markets to demand ever-higher returns.

My calculations suggest that UK equity investors require a total return of 9.8%, which is the highest since the immediate aftermath of the financial crisis in early 2009 (chart 2). If we subtract the risk-free rate from our estimate of total expected returns, we derive the equity risk premium. On my calculations, this is somewhere in the region of 9% in the UK which is comfortably the highest rate in the 25 years over which I have calculated the data (chart 3). Back in the 1990s, I puzzled over the fact that the ERP was negative and concluded that this was flashing a signal that investors were overly complacent about market risks. This in turn prompted me to be bearish on equity trends long before the markets actually corrected (in truth I was way too early so it is no great boast). We cannot say the same today: It may be the case that Brexit-related uncertainty has prompted investors to demand a higher premium but since it has been trending upwards for the past 20 years, this is not a particularly good explanation.

But markets may still be complacent about risks, as they were 20 years ago, albeit for different reasons. In short, investors appear to expect that dividends will continue to rise. The high level for the ERP is thus a misleading signal based on the fact that expected returns are rising whilst the risk-free rate continues to fall. But investors may one day be wrong about expectations of continually rising dividends. This could certainly come about if companies decide that they are better served by issuing debt rather than equity finance, thus reducing the amount they need to pay out in dividends. Issuers do not appear to have adjusted to the fact that the traditional discount of equity dividend yields relative to bond yields has flipped and is unlikely to revert any time soon.  But company treasurers must be wondering whether now is the time to do what governments are increasingly prepared to do – use the period of low yields to issue lots more debt.

---

[1] The true expected dividend yield is expected dividends relative to the expected price but the Gordon growth model depends on expected dividends relative to the current price which is not quite the same thing. For expository purposes, we nonetheless call this term the expected dividend yield.

Brexit and the pound

Economics is the study of how people make choices under varying degrees of certainty. But it is the lack of certainty which concerns us at present as global geopolitical considerations impact on investors’ assessment of asset valuations. Here in the UK, the issue of Brexit further adds to the mix. We hear a lot about how this raises the risks to UK financial assets. However, we have to make a distinction between risk and uncertainty. As the economist Frank Knight put it almost a century ago in one of the earliest and most influential works on investment risk-taking, “there is a fundamental distinction between the reward for taking a known risk and that for assuming a risk whose value itself is not known.”

The valuation of risk underpins the insurance industry where actuaries have some idea of the possible range of outcomes. But there are some risks which we cannot hedge because we have no idea of the possible range of outcomes. Brexit falls into this category. Although there has been much concern about the fall in the pound in recent weeks, as anyone who has recently been on holiday abroad can testify, in truth it has traded in a relatively narrow range over the past three years after the initial post-referendum decline. The Bank of England’s trade weighted index, which is a broad measure of sterling’s value against a basket of currencies, has traded in the range 73 to 80 compared to a wider range of 79 to 94 in the three years prior to the referendum. Admittedly, it has traded at multi-year lows against both the EUR and USD of late but given the magnitude of the risks involved, it still surprises me that the pound has not traded even lower. Ten-year gilt yields have traded at all-time lows in recent weeks, in line with global trends, suggesting that the bond market has no real concerns about the UK government’s creditworthiness.

If we were to infer what was happening in the UK purely from watching market moves, we would not conclude that it was going through the most dramatic political crisis of modern times. One explanation for this apparently paradoxical reaction is that the markets cannot price what form Brexit is likely to take, let alone what happens in the event there is no deal, and are holding fire as a result. In other words, markets are trading an uncertain environment rather than a risky one. But we can gain some idea of currency market concerns by looking at trends in implied FX volatility, which is a measure of how much the market expects the pound to move. Three month implied GBP/USD vol has recently traded above 14% (chart above) – ahead of the 2016 referendum it was at 16% (and reached 18% in the wake of the referendum outcome). Aside from the period following the Lehman’s crash in 2008, when global assets were priced for the worst, we are close to the highest recorded levels of idiosyncratic sterling FX volatility.

Of course, the one thing that volatility measures cannot tell us is in which direction the currency is likely to move. But it is accepted that in the event of a no-deal Brexit, sterling will depreciate sharply. Since it is impossible to give any accurate assessment of how big the move is likely to be, we are reduced to taking the volatility measures as a guideline and applying a significant degree of judgement (or guesswork, if you prefer). Forecasting exchange rates is difficult enough at the best of times and these are not the best of times, so the indicative levels shown here should be treated as no more than that.

In the case of no-deal, my guess is that the GBP/USD rate will stabilise around 1.15 (a decline of around 5% from current levels) although it could initially go sharply lower to somewhere around 1.10 before recovering, if the experience of June 2016 is anything to go by. As has become evident in recent days, there is plenty of scope for upside in the event that a no-deal Brexit can be taken off the table. In the extreme case where the UK revokes the Article 50 notification the pound can be expected to rally strongly. Indeed, a simple model based on expected interest rate differentials suggests that fair value for the GBP/USD rate is around 1.50. The chart above shows that since 2016, the exchange trade has traded outside the model’s one standard error bounds which we can attribute as the risk premium baked into the currency since the referendum. Using this model as a benchmark, I reckon that this risk premium results in sterling being approximately 20% undervalued versus the dollar. 

To the extent that the currency acts as a barometer of the market’s assessment of a country’s economic health, the recent slide in sterling reflects the downbeat assessment of the UK’s prospects. But whatever happens in future, it is unlikely that current market levels reflect a stable equilibrium. Either the situation with regard to a no-deal Brexit gets worse, in which case the pound might be expected to fall further, or it improves in which case sterling’s fortunes will also recover. The events of the past few days, in which the prospect of a no-deal Brexit has at least been temporarily been put on the back-burner, suggests that there is some room for optimism. But a more sustainable recovery is unlikely until a permanent solution to the problem is found.

Buying Greenland - a valuation perspective

A history of US territorial purchases

Recent indications that Donald Trump is mulling the prospect of the US buying Greenland are not quite as ridiculous as many people seem to think. Indeed, the US has a long history of buying territory. Back in 1803, the newly formed United States bought the territory of Louisiana from France for $15 million ($341 billion in current prices). Large chunks of what are now Arizona and New Mexico were bought from Mexico in 1854 for $10 million ($305 billion in current prices), whilst in 1867 it bought the territory which now comprises the state of Alaska from the Russian Empire for a total of $7.2 million ($124 billion in current prices).

Moreover, the US has previously tried twice (and failed) to buy Greenland. In 1867 it looked into the possibility of acquiring Iceland and Greenland, and in 1946 President Truman offered Denmark $100 million of gold in exchange for Greenland. Based on the standard purchasing power measure, used in the calculations above, this is equivalent to $1.3 billion in current prices but based on gold price movements over the last 73 years this rises to the equivalent of $4 billion.

From a historical perspective, this is all both fascinating and ironic. It is ironic given the hostility of the United States to imperialism in the first half of the twentieth century that its history is so littered with examples of territorial acquisition. It is also fascinating because it demonstrates the international trade in territory that has taken place in the relatively recent past. However, it is a practice that has died out largely because the expansion of global trade means that countries are able to acquire what they need from elsewhere at a much lower cost. Moreover the issue of inhabitants’ rights mitigates against the practice. It is much more difficult to sell people’s rights to the highest bidder these days following the advent of pesky irritants such as the Universal Declaration of Human Rights, adopted by the United Nations in 1948. Of course, you don’t actually have to buy the outright ownership of territory: You can lease it, as Britain did with large parts of Hong Kong between 1898 and 1997 and as the US still does with the infamous Guantanamo Bay in Cuba. 

Applying corporate valuation methods 

Although Denmark has rejected the idea of selling Greenland, there is nonetheless an interesting debate to be had about how to value the sale of territory. It is thus illustrative to think about how companies are valued. There are essentially three main methods: (i) asset valuation; (ii) the value of revenue streams and (iii) a discounted cash flow approach. We can apply all of these methods in assessing the value of territory. 

(i) Valuing the assets 

One of the standard measures of corporate valuation is the ratio of the market price to the book value of assets. If we assume that this is unity, we can use international data on national balance sheets as a measure of the market value of all financial and non-financial assets. The latter comprises items such as the value of buildings and other fixed assets such as machinery; the value of inventories and natural resources such as land. Financial assets are the net value of all currency holdings, gold, financial instruments and net loans outstanding. In the UK last year, the value of net financial assets was near zero and the total net worth of £9.75 trillion was comprised of net non-financial assets. The US has the world’s highest net worth (chart), measured at $98.2 trillion in 2018 (31% of the world total), followed by China at $51.9 trillion (16.4% of the total). 

 

For the record, Denmark’s net worth was $1.3 trillion (0.4% of the world total). If we allocate Greenland’s share on a pro rata population basis relative to the whole of Denmark, its net worth drops out at $12.5 billion – around what the US Federal government spends on the Disaster Relief Fund, or 1.8% of the defence budget. This is, of course, a rough and ready calculation which takes no account of the expected future value of Greenland’s natural resources but it is a good starting point. 

(ii) Valuing the revenue stream 

What about valuations on a revenue basis? The obvious metric to use is GDP where the US is again ahead of the pack with total output last year recorded at $20.5 trillion. Being generous, Greenland’s GDP last year was around $3 billion. If we are applying corporate valuation methods, the standard measure is to value the company at a multiple of expected earnings. Applying a P/E multiple of 15x, which is in line with most major equity markets, this implies a market valuation for Greenland of $45 billion – slightly short of Montana’s GDP ($49.2 bn last year) but higher than that of Wyoming ($39.8 bn). If the US were engaged in a corporate transaction it would have no real difficulty in finding the funds out of its cash flow. 

(iii) The discounted cash flow 

The discounted cash flow issue is more tricky. Climate change is having a big impact on Greenland’s geography and according to the Brookings Institution in 2014, “due to global warming, Greenland’s mineral and energy resources … are becoming more accessible.” According to one report, oil could contribute around $78 bn to the national coffers over the next 40 years and after accounting for development costs, “a discounted price for future energy and other resources suggests a price in the $30 billion range could be fair value. Even adding the 10X current GDP and the energy resource value together would be a value of about $57 billion.” 

How to fund the acquisition 

So there you have it. On the basis of the estimates produced here, the US would have to stump up somewhere around $50 billion to purchase the territory of Greenland – or about 0.25% of annual GDP. This is rather less than the present value amount of nineteenth century territory purchases. How might it be funded? A straight cash swap, in which the Fed prints the requisite dollars, would require an increase in the value of notes in circulation of 3%. A debt for equity swap, in which the US Treasury issues notes, would require an increase of just 0.3% in the amount of debt held by the public. In financial terms, the US would clearly not have a problem funding the acquisition. 

The resistance of reluctant sellers 

The only trouble is, Denmark is unlikely to sell at any price. Soren Espersen, foreign affairs spokesman for the populist Danish People's Party, said of Trump in a broadcast interview, "if he is truly contemplating this, then this is final proof, that he has gone mad.” But we should not be overly dismissive – like many old ideas coming back into fashion, the notion of selling territory to earn a bit of extra cash could appeal to governments in these straitened economic times.

Indeed, rather than going to war with Iran, the US could attempt a hostile financial takeover by forgoing the annual GDP of a state such as Connecticut to buy it (this would cost around $272 bn on an asset valuation basis). It would come more expensive if we used the 15x P/E multiple, where the GDP of California, Texas and New York would be required to meet the asking price of $6.8 trillion. But let’s face it, we have heard a lot worse ideas from Trump!