Poor VW shareholders

Last week, when it was announced that VW had produced and sold diesel cars with software installed that manipulated environmental tests, VW shares lost more than 35% of their value. The Dutch investor association VEB has now issued a claim against Volkswagen for the losses incurred by investors. According to the VEB, VW should compensate investors for the losses they made due to the scandal:

'Volkswagen wrongfully claimed that it produces extremely environmentally-friendly cars thereby creating the impression that it could gain a larger market share and thus more turnover. Volkswagen thereby misled investors buying or holding its shares. If Volkswagen had adequately informed public investors, they would not have bought or held the shares, or would have bought them at a lower price'.

The key question here is: who is going to get this compensation and who is going to pay for it? If all shareholders get a compensation, they are paying it to themselves, since they are the firm's owners. Any compensation paid by VW will be matched by an equivalent decline in VW's share value, so it's just an illusion. A compensation can only be 'real' if not all shareholders get it. In that case, the compensation is a transfer from the shareholders who don't get it to the shareholders who do. 

Who should pay then? The controlling shareholders of VW have 50.73% of the voting rights via Porsche Automobil Holding SE, which holds 31.5% of VW's subscribed capital. The VEB will have to convince the judges that the controlling shareholders were well aware of what was going on with the faulty tests, so they should pay a compensation to the other shareholders. I wish the VEB good luck.

Disclaimer: I own a VW (but not a diesel)

Zombie listings

Spadel, producer of the well-known Spa mineral waters, announced last weekend that it wants to delist. This makes it the third Belgian company in one week to announce its intent to leave the stock market. The question with Spadel is not: why do they want to delist?, but rather: why are they still listed? The family Du Bois owns more than 90% of Spadel shares, so the number of marketable shares is limited. Not surprisingly, the liquidity of Spadel shares is very, very low: there are only a few trades per week. The company has not publicly issued new shares for a very long time, and the company has much more cash on its balance sheet  (€ 84 mio at the end of 2014) than is needed to buy out the few remaining outside investors (€ 36 mio).

This is actually Spadel's second attempt to delist. In december 1999, Spadel repurchased 52,249 shares held by minority shareholder Interbrew (nowadays called AB Inbev) and reduced its outstanding shares from 150,000 to 100,000. It also offered to buy the 20,351 shares held by the public at the same price it paid to Interbrew: € 1,115.5. Since this was approximately the price at which Spadel shares traded on the market, the attempt to delist unsurprisingly failed, although they came close to the 95% threshold which in Belgium allows for a squeeze-out. After a first bid in March 2000 and a reopening of the bid in April 2000, 5,358 of the 100,000 Spadel shares remained in the hands of the public, just enough to avoid a squeeze-out.

There are many zombie listings like Spadel: the listing does not serve any real purpose anymore, but as long as the costs of delisting (you have to buy out the outside investors, which costs a lot of money) are perceived to be higher than the listing costs (administrative expenses, information provision to investors, corporate governance rules) the controlling shareholders prefer to let the company vegetate on the stock market. It would be interesting to know how many companies on European stock exchanges have not raised any capital in the last 20/30 years (idea for research).

Note that a listing might still be useful even if the company has not sold shares to the public for a long time. Lotus Bakeries, a Belgian producer of cookies, gingerbread and other sweet things, has been listed on Euronext Brussels since 1988. At the initial public offering, no capital was raised, but the existing shareholders cashed out by selling a minority portion of their shares. Since then (as far as I know) Lotus has never used the stock market to raise new capital. Why is Lotus listed then? The answer probably lies in their takeover activity. Since 1988 Lotus has acquired several firms. When a company is listed, it can pay acquisitions with its own, liquid shares instead of having to pay cash. For Interbrew (AB Inbev) that was a big motivation to go public in 2000 (as noted at the time in the IPO prospectus). See where it brought them.

A final note: a spokesman of Spadel told the newspaper De Standaard that at Spadel they don't know for sure anymore when Spadel shares were introduced on the Brussels stock exchange (if someone from Spadel is reading this: it was 15 May 1922). I find such an apparant lack of interest in its own history remarkable: seems a lack of pride in the company.

Investing à la Homer Simpson

If your investing strategy is to actively try to 'beat the market', you should always keep in mind that this is a zero sum game. For any investor who beats the market, there is inevitably another investor who underperforms the market, since the 'market' return is the average of the returns of all investors. The gain of one is the loss of the other. Anyone who thinks that a stock is mispriced should therefore consider the following question: why am I smarter than all other investors out there on the market, whose combined beliefs determine the stock price? What do I know or what do I understand that all these people out there do not know or do not understand? (*) As the behavioral finance researcher Meir Statman put it: 'If you buy a stock thinking the price is going to go up, you have to ask yourself who is the idiot who is selling it. Because, in every trade there is an idiot and, if you don’t know who it is, it is you. The opponent might be more skilled than you, have information you don’t have, be tipped off by an insider and, so, when I feel like trading I ask myself, who is the idiot on the other side? What is my relative advantage?' Make sure you're not the idiot.

(*) This might have something to do with it.

Are stocks currently overvalued?

Many people think that stocks are currently overvalued, because price/earnings ratios are nowadays much higher than historical averages (see for example here and here). Are they right? To answer this question, let's take a closer look at the valuation of stocks. The value (V) of any financial asset is determined by expected future cash flows (CF) and the required rate of return (r), with (simplified): V = CF / r.

If stocks are currently overvalued, this may be because investors overestimate expected future cash flows, i.e. company earnings. While this is probably true for some companies (Tesla Motors comes to mind, but who knows?), it seems doubtful to me that this applies to the overall market. There is currently a broad sense of pessimism about future economic growth (cf. the secular stagnation debate) and it is often argued that firms hold too much cash and don't invest enough. Not exactly an environment in which you would expect investors to be overly optimistic about the growth prospects of firms.

So, maybe then the return required by investors is too low? The required return on stocks consists of two parts: the risk free return plus an equity risk premium which takes into account that stocks are more risky than fixed return investments. Perhaps the equity risk premium should be higher? This is also doubtful: Aswath Damodaran, who is one of the smartest guys around when it comes to valuation, calculated that the equity risk premium for S&P 500 firms did not at all decline in the past five years. And why would the equity premium currently be too low?

Is the risk free return the culprit then? At first sight, this seems to make sense: central bank policies in the US, Europe and Japan (Evil Quantitative Easing) have driven down intrest rates (well, at least that's what is generally assumed, but I'm not aware of any hard evidence on this). The risk free return can be broken down in two components: expected inflation plus the "real intrest" that investors want for parting with their money.

It could be that current risk free returns insufficiently take into account future inflation. Indeed, people have been arguing for years that the QE policies pursued by central banks wil  inevitably lead to high inflation. However, it seems very unlikely that stocks are overvalued because future inflation is underestimated. First, it is doubtful that quantitative easing will lead to high inflation. More importantly, whatever your belief about the impact of QE on inflation, inflation should not matter that much for stock returns. As I have explained in a previous post, stocks seem to provide a pretty good hedge against inflation: if inflation goes up, the firms' cash flows also go up (*). If you expect high inflation, you're better off with stocks than fixed income securities!

This brings us to the last reason why stocks might be overvalued: current intrest rates underestimate the "true" intrest rate, leading to too low discount rates. Central bank policies could temporarily have driven real intrest rates below "normal" levels, and stock investors insufficiently take into account that sooner or later real intrest rates will go up again, which will bring down the value of stocks. Here, Damodaran again provides a very useful perspective. He points out that in the long run, the real intrest rate has to backed up by a real growth in the economy. He finds that the intrest rate on US Treasury Bonds in recent decades is indeed strongly correlated with the sum of actual inflation rate and realized economic growth rate, which is a proxy for the "intrinsic" intrest rate, i.e.  the sum of expected inflation and expected real economic growth. Furthermore, this relation seems hardly to be affected by QE, at least in the US. This suggests that current real intrest rates probably provide a not-so-bad reflection of the "true" intrest rate, irrespective of QE in recent years. Now, maybe investors do underestimate the "true" intrest rate because they underestimate future economic growth, leading to a discount rate being used to value stocks that is too low. However, if this is the case, then expected future company earnings are probably also too low, implying that the value of stocks might actually be underestimated and stock prices are too low.

Bottom line: even stock valuations are currently very high from a historical perspective, there are good reasons to believe that stocks are generally not overvalued. Yes, current stock valutions are based on low discount rates, but (a) low discount rates could reflect a new "normal" (as e.g. Robert J. Gordon has pointed out, we may have entered a new era of permanent low economic growth); and (b) even if economic growth picks up again leading to higher required rates of return, this economic growth should also lead to higher company earnings, increasing the value of stocks. A final point: if stocks would be overvalued, it doesn't make sense to  shift your money to alternative investments such as bonds or real estate, if these alternatives are also overpriced.

(*) And as I always tell my students, you need be careful not to discount real cash flows (which do not incorporate expected inflation) with nominal discount rates (which do take into account expected inflation).

Are stock investments a good hedge against inflation?

In my previous post, I mentioned that stocks should provide a good hedge against inflation. If you don't believe me, consider the following quote taken from "Defying Hitler: A Memoir" by Sebastian Haffner. Haffner (real name Raimund Pretzel) was a German journalist who fled Nazi Germany in 1938 and wrote a memoir in the next year, which was only published after his death in 1999 (facinating book). As you may know, Germany was characterized by a period of hyperinflation between 1921 and 1924 which destroyed the savings of many Germans. According to Haffner, this is how people dealt with this hyperinflation:

Anyone who had savings in a bank or bonds saw their value disappear overnight ... The salary of sixty-five thousand marks brought home the previous Friday was no longer sufficient to buy a pack of cigarettes on Tuesday .. What was to be done? Casting around, people found a life raft: shares. They were the only form of investment that kept pace – not all the time, and not all shares, yet on the whole they managed to keep up. So everyone dealt in shares ... Day-to-day purchases were paid for by selling shares. On wage days there was a general stampede to the banks, and share prices shot up like rockets.

Why would stocks provide a good hedge against inflation? The value of a stock is determined by the profits of the firm. Profit is the difference between revenues and costs. If there is inflation, the costs of the firm will increase, but the price of the goods sold by the firm will also increase. As a result, the profits of the firm will not be affected by inflation. At least, that's the theory. Is this also true in the real world? My colleague Jan Annaert and I checked the relation between yearly real (i.e. adjusted for inflation) stock returns on the Brussels Stock Exchange and inflation for the period 1838-2008. If stocks provide a good hedge against inflation, real stock returns should not be significantly affected by inflation. Indeed, as you can see in the first figure below, there doesn't seem to be a clear relation between real stock returns (y-axis) and inflation (x-axis), except for some years in WW1 and WW2 which were characterized by very high inflation and low stock returns (but also note 1940: very high stock returns despite high inflation).

On the other hand, the second figure below shows that real fixed returns (short-term) are clearly negatively affected by inflation. This makes sense, since a fixed interest does not change when inflation goes up (at least to the extent that inflation is unexpected: if investors expect inflation, they will demand a higher interest rate before they are willing to invest). Note that holders of investments with fixed interest will benefit when there is deflation: the interests they receive become more valuable. This (partly) explains why bond prices have gone up so much in recent years.

Another interesting feature of the figures are the many red dots with negative inflation (deflation). Modern investors are very much conditioned by the high inflation in the 1970s and early 1980s, but before WW1 deflation was quite common. But that's another story.

Is war good for the stock market?

I’m currently rereading “Antifragile” by N.N. Taleb, which I find an insightful book. It’s also fun to read, if you don’t mind his rants against economists, Harvard professors, bankers, journalists … (the list of professions to which Taleb is averse is substantial). In this book, Taleb describes how traders lost millions of dollars when the Kuwait War started in January 1991. They were betting that the oil price would rise when the war started. Instead, the oil price collapsed from around $39 a barrel to almost half that value. Why did the oil price not rise at the start of the war? Because people expected this war to start, and the expectation was already incorporated in the oil prices.

This reminds me of a strange phenomenon I observed in my own research: the outbreak of World War II led to a dramatic increase in stock prices on the Brussels Stock Exchange. The graph below shows stock returns in 1940 (weighted average of all Belgian stocks). The exchange was closed for a few months in the summer when Germany invaded Belgium, but when it reopened stock prices went up by 30% in September, 18% in October and 37% in December! How could WW2 make stocks so much more valuable? As the Kuwait war, this was an expected war. However, the very swift German victory, which apparently was excellent news for Belgian business, was unexpected. So, stock prices didn't go down because the outbreak of war was expected, but they went up because it led to much less fighting and destruction than stock market investors had anticipated (at least in the short run, no one knew what was still coming).

F. Baudhuin, a contemporary Belgian economist, provides another explanation why the stock market boomed after the start of WW2. In a book written shortly after WW2, he argued that Belgian investors had learned from the first World War that war leads to high inflation. Inflation destroys the return on fixed investments such as bonds and savings accounts, while stocks provide a good hedge against inflation. Based on their experiences during WW1, investors at the beginning of WW2 massively invested their money in stocks to protect themselves against inflation, according to Baudhuin. Hence the dramatic increase in stock prices after the war broke out.

Economische ontwikkeling en marktfinanciering (in Dutch)

Asli Demirguc-Kunt, Erik Feyen en Ross Levine vinden in een recent internationaal onderzoek een positieve relatie tussen economische ontwikkeling, bankfinanciering en financiering via effectenmarkten. Het relatief belang van marktfinanciering neemt echter toe naarmate landen zich verder ontwikkelen. Op basis van deze resultaten concluderen ze dat een toenemend belang van marktfinanciering t.o.v. bankfinanciering bij verdere economische ontwikkeling een logische evolutie is.

Ik ben daar niet van overtuigd. Hun resultaten zijn gebaseerd op een steekproef van landen in de periode 1980-2008, wat in de economische geschiedenis een uitzonderlijke periode was. Als je verder teruggaat in de tijd, is die positieve relatie tussen economische ontwikkeling en marktfinanciering veel minder vanzelfsprekend. In België, zoals in andere landen in Continentaal Europa, daalde het relatieve belang van marktfinanciering vanaf 1929 tot in de jaren 1980 sterk. De recente financiële crisis zorgde bovendien voor een fundamentele breuk in het vertrouwen van beleggers. Vraag is wanneer dat vertrouwen gaat terugkomen.

Crash van 1929 (in Dutch)

De Crash van oktober 1929 op Wall Street wordt dikwijls als de aanstoker van de Grote Depressie in de jaren 1930 gezien. Nochtans begonnen de beurzen in Europa al vroeger te dalen. Zoals blijkt uit onderstaande grafiek van cumulatieve rendementen op de Beurs van Brussel, overgenomen uit een paper van Veronique Vermoesen en mezelf, bereikte deze beurs haar absolute piek al in het begin van 1929 en kende nadien een weliswaar sterke maar vrij gelijkmatige daling: in Brussel was er helemaal geen crash. Ook opvallend: pas in 1931 daalde het rendement in Brussel tot onder het niveau van 1927. De Brusselse langetermijnbelegger die op het einde van 1929 uit aandelen stapte had nog altijd een mooie winst gemaakt.