The Equity Risk Premium after COVID-19
In finance class and before preparing for investment banking interviews, everyone has to walk through a DCF.
In figuring out a discount rate, you look at the cost of debt and the cost of equity.
Now this weighted average cost of capital stuff is very theoretical but conceptually it is very important (which is why we ask you that in the interview instead of tell me a time when you demonstrated leadership). Let’s apply it to real life.
When I worked in investment banking, the MDs would always ask what’s the WACC. So we whip out the WACC template which M&A bankers argue about incessantly in terms of whether or not it is theoretically correct and whether it’s current or average cost of debt and whip out a WACC.
Everyone, even the biggest steaming turds of companies would end up having a WACC of less than 10% (sometimes a little more for particularly large turds). Why? Because debt was too cheap and the equity risk premium was too narrow. And we all knew that we would never find it acceptable to invest in those companies given those capital hurdle rates. But here we are.
What is the cost of debt right now? Although the risk-free rate has gone down, corporate debt costs have gone up across the board for borrowers. Usually, investment grade debt will move with government bond yields, but in this instance credit spreads have widened materially because there is so much uncertainty around how long this will last and how big of a domino effect the worst affected companies and industries will cause.
So while Johnson & Johnson and Walmart will have no problems tapping IG debt, expect BBB- rated names to face liquidity crunches.
For high-yield borrowers, spreads have widened significantly, with plenty of bonds being priced for restructuring and bankruptcy.
Likewise, the cost of equity should jump. The formula again is the risk-free rate (lower) plus beta x (equity market risk premium).
The equity risk premium is certainly not as low any more today and next time there is a Duff and Phelps Cost of Capital publication out or Ibbotsons or whoever they use these days, people will need a hefty increment in order to risk their money.
All things equal this means lower stock prices if they are the discounted value of their earnings. This also means that the returns you can expect when each year is realized will be higher. Firms that are looking at incremental projects will be much more careful in seeing that they meet capital hurdles.
Have you ever noticed that certain corporate actors are rah-rah free markets and small government and when this crisis thing happens roughly once every ten years the narrative changes quickly to if we aren’t being supported millions will lose their jobs and the people will starve? Also, it’s China’s fault.
So, now, another theoretical question – since the cost of debt and equity is mispriced, what would a situation where we do not have the moral hazard of bailouts and helicopter money in a crisis situation be like?
The cost of debt would be higher, as commercial banks would want to be adequately compensated for their risk. The loan-to-value would be lower because banks want to have a bigger cushion for volatile cash flows – especially for cyclical industries such as oil and gas and airlines. This means a larger equity cheque, which means that projects will be more appropriately screened as opposed to slapping an exit multiple on it.
Stocks end up being a good option – maybe not in the next few weeks, but over time because the return on equity is high and because all this money that is being printed will flow back into corporations. In theory, gold should be worth more but markets are not always rational (if the money supply is much larger and there is the same amount or even less of gold as the mines are shutting down).
Airline Stocks in a Coronavirus World
There is some soundbite that goes along the lines of if you want to make a million dollars in the airline industry, start with two.
The idea is this, lots of competition with no barriers to entry (anyone can lease a plane) and an extremely high fixed cost base. For developed countries, this cost base is even higher because of unionism and higher labor costs versus say – VietJet.
And Warren Buffett, the stock guru himself, disavowed airlines having been burnt one too many times. However, he ended up buying I think it was Delta or United anyway as they were printing cash for a long period of time (after coming out of bankruptcy repeatedly, however).
After COVID-19, airlines are entertaining government solutions for assistance – and again for the same reasons. High cost base and no revenues means you run out of liquidity very fast. No one is traveling.
So another question is – are airlines actually a viable business model for shareholders and what is the appropriate level of debt?
Whatever the debt is, it should be a lot lower. And if that combination does not yield appropriate returns on capital, maybe this is an industry that could make sense as a natural monopoly and be treated like necessary infrastructure.
But I own airline stocks, so what do I know.
Coronavirus Oil Shock
Oil producers have been the biggest value trap of the last decade. However, the recent crash to $20, which is probably close to the equilibrium marginal cost of oil production, has resulted in a lot of retail investors trying to time the bottom using a variety of market vehicles.
The first vehicle is through ETFs with exposure to the underlying. The second vehicle is through energy equities.
I am not going to share my thoughts on whether this is a good idea or not but there are some things to consider.
Market participants generally look at precedents in informing an investment decision. The closest parallel was the crash in 2014 where OPEC decided to ramp up production. Last time, oil bottomed around $30 a barrel, so surely we are at the bottom here.
It is hard to be so sure here because this time is not supply driven – it is demand driven and escalated further by a positive supply shock.
Physical traders are looking at oil demand dropping by as much as 30 million barrels (versus 100 million barrels per day before this happened) as the coronavirus peaks. This makes sense because no one is flying right now, no one is driving and oil as a feedstock for chemicals is lessened materially because industrial production has slowed to a crawl.
So no one is looking to buy oil and infrastructure for storage is getting tapped out. This drives prices lower. In the meantime, the world is getting flooded with incremental low cost oil from Saudi Arabia and Russia. This drives prices close to zero and even negative in regional hubs where storage is full and there is no where to put the oil. You have to pay someone to take it.
Until there are shut-ins of production or the virus dissipates, oil may stay the same or go lower.
The problem with holding oil equities during this time period is that unless you are massively hedged (properly, as certain hedging structures such as three way collars have not been helpful), you are breaking even or losing money on every barrel you produce. In the meantime, you are running out of capacity on your bank lines while capital markets are closed and you cannot refinance upcoming debt maturities.
This means your recovery is zero if oil prices stay where they are.
The problem with the ETF is less pronounced, but there are carry costs on the ETF and rebalancing charges will erode your investment. Also, as alluded to above, the price may go a lot lower before it gets higher.
Also, you do not use WACC for oil and gas companies you use a discount rate of 10%. Or for today, 15 or 20 or 25 or 30%.