Economic myths I: the European convergence myth

Politicians and people employed by European institutions often argue that we should have further economic, fiscal and financial integration in the European Union. They claim that this would inevitably lead to economic convergence between its member states, allowing poorer member states to catch up with the richer member states. As the European Commision puts it in a recent report: 'A complete EMU is not an end in itself. It is a means to create a better and fairer life for all citizens, to prepare the Union for future global challenges and to enable each of its members to prosper'. And according to European Commission President Juncker, 'the time has come to deepen European integration instead of re-introducing national divisions'.

This all sounds pretty good, but is it true? Will further integration really lead to convergence? To answer this question, it is interesting to take a look at the history of Italy. Italy was unified in 1861, but it has always been a diverse country. In a recent study, Emanuele Felice from the Autonomous University of Barcelona investigates the evolution of regional income inequality in Italy since its unification in 1861. He considers relative per capita GDP in Italian regions in the first year of each decade, from 1871 to 2001. Instead of economic convergence, he finds a tendency towards economic divergence in the Italian union since 1871: regional economic inequality has substantially increased over the past 150 years. In 1871, per capita GDP in the Southern regions in Italy was 90% of overall per capita GDP in Italy, while that of North-Western regions was 114% of overall per capita GDP. By 2001, relative per capita GDP in the South had declined to 68% (!), while that in the North-Western regions had increased to 124%. The decline in the South was especially pronounced after the first World War. Felice also finds a divergence when he considers the per capita GDP of 20 individual Italian regions. One striking example is Sicily, which went from 95% in 1891 down to 58% in 1951 and 66% in 2001. While the reasons for increasing regional income inequality after Italian unification are not clear, these findings demonstrate that it is simply not true that economic, fiscal and financial integration inevitably leads to economic convergence. The Italian case suggests that European unification could very well increase regional inequalities within Europe.

Regrets suck

Home sweet home

Never underestimate the creativity of the financial industry when it comes to finding new ways to repackage risk and returns. Recently, an American start-up called point.com has provided a new way to finance your home. Their slogan: Regrets suck so let’s avoid them. The basic idea is as follows. Point.com buys an “equity stake” in your home, you can use the money they pay for whatever you want, and you don’t have to pay any interest. Isn't that great? When the contract ends after a predetermined number of years, you pay back the equity stake, interest free. If the value of your home has gone up, you additionally pay a percentage of the home’s value appreciation.

For example, it could work like this. You sell a 10% equity stake in your home which is valued at $ 200,000, in exchange for 20% of the home's appreciation. This means you get $ 20,000 from point.com, which you have to pay back at the end of the contract. Let’s assume the estimated value of your house will then have gone up to $ 300,000. You pay back the original $ 20,000 plus 20% of ($ 300,000 - $ 200,000), i.e. the share of point.com in the value appreciation of your house. The total amount you pay to point.com is therefore $ 40,000. If your house has gone down in value by that time, you only pay $ 20,000. According to the point.com website, you can cancel your contract and pay back at any time before the agreed term.

This is definitely a very smart idea. Not surprisingly, point.com is backed up by an impressive list of investors including Andreessen Horowitz, one of the most prestigious VC-firms in Silicon Valley (*). However it is also a dangerous idea. If this new way of financing homes takes off, it is going to create a lot of trouble. First, the use of the term “equity” is very misleading. Point.com don't buy an equity stake in your home. Rather, they give you a loan (without interest) which you have to pay back. In return for not having to pay interest you give point.com a call option on the value of your home. If the home value goes up, point.com get a significant share of the appreciation. Basically, you sell a convertible loan to point.com. They are actually rather vague about how high the share they get will be. The only indication I found on their website was an example, in which the home owner has to give 20% of value appreciation in case of a 10% equity stake. This call option implies that the higher the value of your house, the more you have to pay to point.com.  If you’re cash strapped, it is therefore likely that you will have to sell your house, unless you have become substantially richer by the time you have to repay point.com. But if the value of the home goes down, you might also be in trouble. Point.com always gets the full amount of their loan back. If you have borrowed $ 20,000 from point.com and the value of your house declines from $ 200,000 to $ 150,000, you still need to pay back the full amount of $ 20,000 to point.com. If you don't have that money, you will be forced to sell your house at a substantial loss.

From a macro point of view, this seems like a new “trick” to make money out of people who can't afford to buy a house and will have to sell their home when the loan expires. It creates the illusion that you don't borrow: you don’t have to pay any interest! But in the end, you always pay.

(*) I recommend Marc Andreessen on Twitter; Ben Horowitz has written an interesting book on start-ups: these are very smart guys.

Start-up financing: it's the banks, stupid!

When an entrepreneur starts a new firm she often need external funding. For this, the entrepreneur will typically rely on equity, provided by the "three F's" (Friends, Family and Fools), by business angels, and/or by Venture Capital (VC) funds. At least, this is a popular perception of how start-up financing works. For example, Aswath Damodaran describes the financing decision in the start-up phase of a firm as "Equity funding optimal, debt only if desperate". Desparate. Do entrepreneurs really need to be desparate before they use debt finance? Not in the real world it seems. In a recent study that covers basically all independent Belgian firms founded in the period 2006-2009, Tom Vanacker and I find that bank debt is the most important finance source for new firms. More than two thirds of the Belgian start-ups in this period used bank debt at the time of start-up. For the start-ups with bank debt on their balance sheet, it was a (much) more important finance source than equity, trade credit or other debt types. These findings of Tom and me are not unique for Belgium, not even for Europe. Studies of start-up financing find that bank debt also plays a crucial role in the financing of start-ups in the US and Australia.

Access to bank debt is important for start-ups, because it allows them to finance investments, increase their growth and avoid bankruptcy. In our study, Tom and I distinguished between new firms founded before and after the 2008 crisis. During this crisis, many banks got into serious financial troubles and evidently had less money to lend. Not surprisingly, we find that new firms in this period had less bank debt than new firms before the crisis. The reduced access to bank debt negatively affected the growth and the chance of survival of these firms. Start-ups invested less, had a lower growth, and were more likely to go bankrupt if they ware founded during or after the crisis, compared to start-ups before the crisis. Furthermore, this effect was significantly stronger for start-ups in industries which depend on bank financing and start-ups with a lack of equity. This suggests that reduced access to bank debt during the crisis harmed many start-ups.

Where does the idea that start-ups only rarely use debt come from, given the evidence of the contrary? Research on start-ups tends to focus on high-tech start-ups which, due to the nature of their assets (intangible growth opportunities), indeed have limited access to bank debt and rely much more on business angels (I love that word, I wonder who invented it) and VCs for external funding. However in the real world, most start-ups are not about "cool" nerdy guys and girls wanting to become billionaires when the app they are creating is going to conquer the world. Most start-ups are about hard working people in many different industries, for which bank debt is very useful. These start-ups are still very important for our economy. More important than the guys and girls trying to invent new apps. Just not as sexy.

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.

What is a 'fair' price for delistings?

This week it was announced that the controlling shareholders of the Belgian shipping company Compagnie Maritime Belge (CMB) and those of the Belgian Pairi Daiza zoo intend to delist their company. When the controlling shareholders want to delist their firm, they have to make a public bid for all outstanding shares. Once they get a sufficiently large percentage of the shares (in Belgium the threshold is 95%), there can be a squeeze-out. In the squeeze-out, shareholders who did not yet sell are basically forced to give up their shares at the bid price. This raises an important question: what price should the controlling shareholders offer to the other shareholders? What is a fair bid price?

For the delisting bid to succeed, the bid price should be higher than the market price before the bid was announced (*). The market price reflects the share value for stock market investors. Why would they sell to the controlling shareholders if the bid price is lower than the price at which they can sell on the market? Then of course the question is: how much higher should the bid price be? Sometimes, the controlling shareholders propose a price which is considered too low, and the bid fails. In September 2012 Liberty Global, which at the time owned 50.4% of the shares of the Belgian telecom operator Telenet, announced that it would offer to buy the other Telenet shares at € 35. This price implied a 12.5% premium compared to the last market quote before the bid. Nevertheless the bid failed. Liberty Global managed to convince only 8% of the shareholders to sell their shares. The Lazard bank, which had been asked by the independent directors to value Telenet, estimated the value of its shares to be substantially higher than the price offered by Liberty Global, between € 37 and € 42. Since then, the market price of Telenet, which is still listed, has risen to more than € 50.

In the case of CMB, of which the controlling shareholder Saverco (an investment vehicle for  the Saevereys family) holds 50.8% of the shares and which has been listed for more than 100 years, the bid price is € 16.20. This is 20.45 % higher than the last market price before the bid. Is this a good price? Opinions are divided. The Belgian newspaper De Tijd estimated the share value by first estimating the value of the ships of CMB.  After deducting the outstanding debts and including the value of some other assets, they obtained a CMB share value of € 14.11, leading De Tijd to conclude that the offered price is 'correct'. Others disagree. According to blogger Alberken, the offer is a joke and the value of CMB shares is much higher at € 21.20. Unfortunately, Alberken does not let us know how he obtained this value.

Who is right? First, any net asset value as the one calculated by De Tijd should be considered an absolute minimum. If the going concern value (i.e. the value if the firms keeps on operating) of CMB is not higher than its liquidation value, it means that CMB is basically destroying value.

If the bid price is substantially higher than the stock price before the offer, there seems to be an inherent contradiction in the argument that bid price is 'too low'  As a shareholder, you had an even lower price before the offer, so what are you complaining about? Well, the market price of a share does not necessarily reflect the 'real' value per share. When the controlling shareholder offers a share price which is lower than the actual value, he gets a larger part of the value than what he is entitled to. (**) Actually, they are very likely to do so. Why would they otherwise offer to buy the shares? This only makes sense if they think the value of the shares is higher than the price they pay. That is, unless the delisting itself creates value. When company is not listed anymore, direct and indirect listing costs are avoided and the controlling shareholders have more flexibility in pursuing whatever they consider appropriate objectives. This might lead them to pay a price which is higher than the value of the stock when listed and still keep some of the extra value for themselves. Fair enough.

Nevertheless, in many delistings there is a worry that after the delisting, the controlling shareholders will take actions that they refrained from doing while the company was listed, even though such actions would have substantially increased the company value. Specifically, they could decide to sell (parts of) the company at a higher price than the one they paid for the delisting. In a previous post, I explained how the Belgian entrepreneur Marc Coucke (who remarkably is also involved in the Pairi Daiza delisting) delisted his Omega Pharma company in 2011, paying € 1.2 billion, and selling it three years later for € 3.6 billion. Of course, we do not know whether it was already the intention of mr. Coucke in 2011 to sell a few years later at a much higher price, but such transactions understandably raise fears among investors that they might get a bad deal at the delisting. It would be interesting to know the extent to which the buying shareholders in delistings in Continental Europe sell their company a few years later at a significantly higher price. If you know of such research, let me know!

While it is unfair that the controlling shareholders pay a low delisting price if they intend to sell at a higher price after the delisting, it gets more complicated when the controlling shareholders delist because they think the market undervalues the company. Controlling shareholders will often be better able to assess the true value of a company than outside shareholders, who have less information about the prospects of the firm. As Pierre Huylenbroeck notes and as you can see in the chart to the right which depicts the CMB share price in the past five years, the bid price of € 16.20 is quite low compared to previous prices. About a year ago CMB shares traded at more than € 20. The delisting decision might be a smart move of the controlling Savereys family to profit from current undervaluation in the market. Is this unfair? I don't think there is a straightforward answer to that question. One could argue that all investors are entitled to a share of the company's real value in proportion to their shareholdings, and no shareholders should benefit from the fact that they have more information about the company than others. But how far can you stretch that argument? If a company decides to repurchase its own shares because the management thinks the shares are undervalued, is this also unfair? Then many share repurchase programs should be considered unfair. The shareholders who do not sell win at the expense of the sellers. Where should we draw the line between acceptable and unacceptable share tradings? In the capitalist system it is accepted that some investors are smarter than others and benefit from this. That is why Warren Buffett is such a celebrated person. A good rule seems to be that no share trade should be based on one party having inside information that is not available to the other party. Inside information is to investors what doping is to athletes: it gives them an unfair advantage. Unfortunately, this is very hard to determine.

Addendum: Gertjan Verdickt points me to a study by Ettore Croci and Alfonso Del Giudice who find that the operating performance of delisting European firms does not significantly improve in the three years after delisting. However, their data do not allow them to investigate whether the firms are sold after delisting which might be an important factor, as Croci and Del Giudice note themselves.

(*) Once the bid is announced, this information will be incorporated in the market price, which therefore does not provide a meaningful comparison anymore.

(**) For the sake of argument, let us assume that the total value of CMB would be € 7 billion. If the controlling shareholders pay € 16.20 per share, this would allow the controlling shareholders to keep € 7 billion - (€ 16.20 * 35 million CMB shares) = € 133 million for themselves, instead of sharing it with the other shareholders.

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.