Short Selling Strategies, Risks, and Rewards phần 8 pptx

284 SHORT SELLING STRATEGIES ing in the direction of economic profit and wealth creation versus bad companies that are pointing in the direction of wealth destruction. With this background, we will now focus on the financial characteristics of risky troubled companies (short sell opportunities). NEGATIVE NPV: DISCOVERY OF BAD COMPANIES Now that we have provided a conceptual foundation on the financial characteristics of wealth creators, we can use the wealth model to gain insight into the financial characteristics of wealth destroyers. Not sur- prisingly, this latter company type represents a potential sell or short sell opportunity. To see this, suppose that the firm’s managers anticipate that the $100 million investment will generate an after-tax cash flow of, say, $107.50 million in the future period. The NPV consequence of the firm’s 7.5% ($107.50/$100) investment opportunity is shown in Exhibit 11.3. Exhibit 11.3 shows that the firm’s initial capital is $100 million. The exhibit also shows that the firm’s expected cash operating profit is $107.50 million. Upon subtracting the company’s expected financing costs, at $110 million, from the anticipated cash operating profit, NOPAT at $107.25 million, the manager or investor (in our case) sees that the firm is left with negative residual income of –$2.5 million. This EXHIBIT 11.2 Wealth Creation with Positive EVA 11-Abate/Grant-Econ Profit Page 284 Thursday, August 5, 2004 11:16 AM The Economic Profit Approach to Short Selling 285 residual income is the firm’s expected EVA in the reduced operating (that is, return on capital now at 7.5%) environment. Note that if a company is a wealth destroyer in the future (due to the negative-anticipated EVA), then it must also be a wealth waster in the present. By discounting the negative EVA by the 10% cost of capital we obtain the adverse NPV result: As a wealth destroyer, it is apparent that the firm’s NPV is negative because the after-tax return on capital (ROC) at 7.5% falls short of the cost of capital at 10%. Equivalently, the NPV of –$2.27 million can be obtained by multiplying the firm’s residual return on capital, at –2.5%, by the initial capital, $100 million, and then discounting the EVA result: In this case, the firm’s negative NPV is due to the poor economic profit out- look. The adverse EVA outlook is in turn caused by the negative residual EXHIBIT 11.3 Wealth Destruction with Negative EVA NPV MVA EVA 1 COC+()⁄== $2.50 1.1()⁄– $2.27 million–== NPV MVA C ROC COC–()1COC+()⁄×== $100 0.075 0.1–()1.1()⁄× $2.27 million–== 11-Abate/Grant-Econ Profit Page 285 Thursday, August 5, 2004 11:16 AM 286 SHORT SELLING STRATEGIES return on capital (ROC – COC), at –2.5%. As noted before, this company profile represents a sell or short sell opportunity to the degree that the neg- ative NPV and EVA happenings are not fully reflected in share price. 8 A Closer Look at the EVA Spread We can use the two-period wealth model to further explain the residual return on capital (RROC) or the EVA spread. The EVA spread can be used as a convenient measure in the discovery of good companies and bad companies because this measure is adjusted for firm size. 9 Specifi- cally, the EVA spread refers to the difference between the return on cap- ital and the cost of capital. To show this, we will begin by unfolding NOPAT (again, in terms of a two-period model) into the firm’s initial capital and the rate of return on that capital according to NOPAT = C × (1 + ROC) In this expression, ROC is the firm’s “operating cash flow return on investment” and C is the initial capital investment. We can now express the firm’s NPV directly in terms of dollar EVA and the residual return on capital (ROC – COC) according to In these expressions, we see that the firm’s NPV derives its sign from the difference between the operating cash flow return on investment (ROC) and the weighted average cost of capital (COC). The spread between ROC and COC is variably referred to in the economic profit literature as (1) the “residual return on capital,” (2) the “surplus return on capital,” (3) the “excess operating return on invested capital,” and, of course, (4) the “EVA spread.” Upon substituting the numerical values into the two-period wealth model, we obtain 8 In practice, this short selling argument should be qualified by the fact that NPV may reach a “floor” for reasons of cyclicality or perceived takeover (especially). 9 The EVA spread, ROC – COC, can also be expressed as EVA/Capital. NPV NOPAT 1 COC+()⁄ C–= C 1 ROC+()1COC+()C–⁄×= C ROC COC–()1 COC+()⁄×= EVA 1 COC+()⁄= NPV MVA= $107.5 1.1()$100–⁄= $100 0.075 0.10–()1.1()⁄×= $2.5 1.1()⁄– $2.27 million–== 11-Abate/Grant-Econ Profit Page 286 Thursday, August 5, 2004 11:16 AM The Economic Profit Approach to Short Selling 287 As before, the firm’s anticipated ROC is 7.5%, the assessed residual return on capital is –2.5% (RROC, or the EVA spread), and the firm’s assessed economic profit is equal to –$2.27 million. We can now say that the wealth-destroying firm shown in Exhibit 11.3 represents a sell or short sell opportunity to the degree that the negative EVA spread is not fully impounded in stock price. ZERO NPV: WEALTH NEUTRAL COMPANIES Before moving forward, it is helpful to note that the wealth model can be used to explain the investment consequences of zero EVA, among other EVA-based company profiles. With zero expected EVA, a company is in equilibrium and represents neither a buy nor sell opportunity. Based on our previous illustration, if the firm’s assessed return on capi- tal is 10%, then its expected EVA is zero. This results because the expected cash operating profit from the firm’s investment opportunity is the same as the anticipated financing costs, at $110 million. In this instance, the company’s NPV would be zero. Practically speaking, if a company has unused capital resources, then its shareholders would be just as well off if managers were to pay out the unused funds as a dividend payment on the firm’s stock. In the event of capital market imperfections—such as differential tax treat- ment of dividends and capital gains—the shareholders might be better off if the firm’s managers were to repurchase the firm’s outstanding com- mon stock. In principle though, the stock repurchase program is a wealth-neutral (or zero expected EVA) investment activity and does not in and of itself imply a directional impact on stock price. CASE STUDIES Armed with an EVA background for wealth creators and destroyers, we will look at two representative companies to distinguish between good and bad company characteristics. From an investing perspective, the “good” company can be interpreted as a potential buy opportunity while the “bad” company represents a sell or short sell opportunity. However, this trading distinction is not meant to imply that there were no times during the sample period when the good company should have been sold or that the bad company should have been bought. That being said, the EVA cases shown below are meant to profile the fundamental characteristics of com- panies that would normally present buy or short sell opportunities. 11-Abate/Grant-Econ Profit Page 287 Thursday, August 5, 2004 11:16 AM 288 SHORT SELLING STRATEGIES Case A: Microsoft Corporation—Good Company (Positive EVA) Consider the positive EVA experiences of Microsoft Corporation in the 1990s. We will examine this behavior in the context of the residual return on capital or the EVA spread. Exhibit 11.4 shows the after-tax return on capital (ROC) versus the cost of capital (COC) for the computer software company during the 1990 to 2000 period. During this period, Microsoft had a large positive NPV (MVA not shown) because its EVA was positive and growing at a rapid rate over time. 10 In Exhibit 11.4, we see that the firm’s positive EVA was due to its strongly positive residual return on cap- ital—where the after-tax return on invested capital is greater than the cost of capital (equity capital in Microsoft’s case) by a wide margin. A closer look at Exhibit 11.4 shows that Microsoft’s after-tax capital return varied from 44.16% in 1990, to a high of 54.75% in 1997, and then settled at 39.06% by year-end 2000 (mainly due to growth in capital via retained cash). For the 11-year reporting period, the computer soft- ware company had an outstanding average return on capital of 45.54%. Meanwhile, Microsoft’s cost of capital ranged from a high of 16.90% in 1991 (up slightly from 1990), to a low of 10.74% in 1996, and then set- tled at 14.29% by year-end 2000. The firm’s average cost of (equity) cap- ital was 14.20% for the 11-year reporting period shown in the exhibit. 10 Microsoft’s EVA and MVA growth rates over the years 1990 to 2000 were about 40%. EXHIBIT 11.4 Microsoft Corporation: Return on Capital, Cost of Capital, and Residual Return on Capital: 1990–2000 11-Abate/Grant-Econ Profit Page 288 Thursday, August 5, 2004 11:16 AM The Economic Profit Approach to Short Selling 289 Taken together, the capital return and capital cost findings for Microsoft indicate that the EVA spread was substantially positive during the reporting period. Exhibit 11.4 shows that the residual return on cap- ital ranged from 27.32% in 1990, up to a high of 41.82% in 1997, and then settled at 24.77% by year-end 2000. The exhibit also reveals that volatility in this software firm’s residual return was due primarily to vari- ations in the after-tax return on capital. In contrast, the cost of capital for Microsoft was relatively stable during the 11-year reporting period. Overall, the EVA findings for Microsoft are quite remarkable: 11 The company not only generated positive residual returns on capital—due to its highly desirable computer products—but it also exhibited substantial “staying power” in the presence of severe legal challenges from compet- itors and the U.S. Justice Department in the late 1990s. Not surpris- ingly, Microsoft’s financial characteristics are representative of those that should be associated with a buy opportunity. Case B: WorldCom Inc.—Bad Company (Negative EVA) Now consider the negative EVA experiences of WorldCom. Before pro- ceeding, it is important to note that in July 2002, the telecommunica- tions giant filed for Chapter 11 bankruptcy protection. At that time, this was the largest corporate bankruptcy in U.S. history. However, as we will now see, WorldCom’s financial problems were larger than those caused by the accounting gimmickry that mostly occurred during 2001 and the first quarter of 2002. Indeed, the telecom giant had consistently negative EVA in the 8-year reporting period spanning 1993 to 2000. This was due to the incredible growth in capital driven by serial acquisi- tions without ample time to absorb and exploit returns on the acquired assets. Exhibit 11.5 provides a visual look at the EVA happenings for WorldCom by showing the firm’s after-tax return on capital versus the cost of capital for the 1990 to 2000 period. Interestingly, the exhibit shows that WorldCom’s post-tax return on capital was consistently below the cost of capital after 1992. A closer look at Exhibit 11.5 shows that from 1990 to 1992, World- Com’s after-tax return on capital was about the same as its cost of capital, at 12%. In 1993, a notable EVA event occurred when the telecommunica- tion giant’s capital return fell below 10%. At that time, WorldCom’s return on capital was 8.51%, while its cost of capital was 12.37%. The exhibit also shows that from 1993 to 2000, the telecom giant’s return on 11 We are, of course, aware of the dramatic downturn in Microsoft’s MVA (and that of other tech companies) during 2000. Again, our goal here is to profile the financial characteristics of a company that is largely pointing in the direction of wealth cre- ation (buy opportunity). 11-Abate/Grant-Econ Profit Page 289 Thursday, August 5, 2004 11:16 AM 290 SHORT SELLING STRATEGIES capital ranged from lows of 2.23% and 2.95% in 1994 and 1997, respec- tively, to a high of only 9.21% in 1995. Meanwhile, WorldCom’s cost of capital was consistently above the 10% watershed mark during the 11- year reporting period. The average return on capital for WorldCom during the 1990 to 2000 period was 7.26%, while the firm’s average capital cost was 11.82%. Taken together, the capital return and capital cost experiences for the tele- communications giant produced a sharply negative residual return on capital during the eight years spanning 1993 to 2000. Equivalently, the average residual return on capital for WorldCom was negative, at –4.56%, over the reporting decade. These negative EVA findings for WorldCom can be seen in Exhibit 11.5 by focusing on either (1) the negative gap between the ROC and COC series or (2) the mostly negative residual return on capital (RROC) series during 1990 to 2000. The empirical findings for WorldCom are indicative of the financial dangers that ensue when a company’s after-tax capital returns fall short of the capital costs. With a positive after-tax return on capital for each year during 1990 to 2000, it would seem that the telecommunications giant was actually making money—albeit, a generally smaller amount when measured relative to capital as the years progressed. However, the EVA evidence reveals that WorldCom was in fact a large wealth destroyer for most of the 1990s. The persistently negative EVA spread— EXHIBIT 11.5 WorldCom: Return on Capital, Cost of Capital, and Residual Return on Capital: 1990–2000 11-Abate/Grant-Econ Profit Page 290 Thursday, August 5, 2004 11:16 AM The Economic Profit Approach to Short Selling 291 that began in the post-1992 years—was the economic source of the col- lapse in the telecom giant’s market value-added (MVA) that occurred at the century’s turn. Indeed, WorldCom’s filing for Chapter 11 bank- ruptcy protection in July 2002 was just the “nail in the coffin” for a company that was already busted from an economic profit perspective. For obvious reasons, this company type represents a strong sell or short sell opportunity to the degree that the negative EVA consequences (among other serious problems) could be anticipated. ROLE OF THE VALUE/CAPITAL RATIO Wall Street analysts often speak in terms of the “price-to-earnings” and “price-to-book value” ratios. By themselves, these ratios say little if anything about wealth creation, which is the primary focus of our good- versus-bad-company distinction in the discovery of short selling candi- dates. Along this latter line, one of the key benefits of the economic profit approach to measuring financial success is that we can see why a company has a price-to-book ratio above or below unity. We can show this NPV and EVA relation by simply dividing the firm’s enterprise value (V) by invested capital (C) according to: With this, we see that a firm’s enterprise value-to-capital ratio, V/C, exceeds one if and only if—in a well-functioning capital market—the firm has positive NPV. In contrast, the V/C ratio falls below unity when the firm invests in wealth destroying or negative NPV projects, such that the NPV-to-capital ratio turns negative. In the former case, the company is a “good” company and represents a potential buy opportunity, while in the latter case the firm is a sell or short sell opportunity. 12 Further, upon sub- stituting EVA into the enterprise value-to-capital ratio produces: 13 12 Recall that in practice, we must temper the short selling argument by a possible premium valuation due to perceived takeover. 13 For convenience, we continue with NPV-EVA aspects of the two-period model. VC⁄ CC NPV C⁄+⁄= 1NPVC⁄+= VC⁄ 1 EVA 1 COC+()⁄[]C⁄+= 1 C ROC COC–()×()1 COC+()⁄[]C⁄+= 1 ROC COC–[]+ 1 COC+()⁄= 11-Abate/Grant-Econ Profit Page 291 Thursday, August 5, 2004 11:16 AM 292 SHORT SELLING STRATEGIES We now see that wealth-creating firms have an enterprise value-to- capital ratio that exceeds unity because they have positive NPV (good company characteristics). The source of the positive NPV is due to the discounted positive economic profit. In turn, EVA is positive because the firm’s after-tax cash return on investment (ROC) exceeds the weighted average cost of capital (COC). From this value-to-capital formulation, we also see that wealth-destroying companies have negative EVA, a neg- ative EVA spread, and a value-to-capital ratio that falls below unity (bad company characteristics). Upon substituting the values from the wealth destroyer illustration into the value-to-capital ratio yields: Thus, while Wall Street considers a company having a value-to-cap- ital ratio that falls below unity to be a “value stock,” it is hardly a real value opportunity—unless of course a reversal is made by the existing managers or a “new” and more profit conscious management is antici- pated. Fortunately, with economic profit there is little uncertainty as to (1) why a wealth-creating firm has a value-to-capital ratio (or “price-to- book” ratio in popular jargon) that exceeds one; and (2) why a wealth waster has a value-to-capital ratio that lies below unity. Unlike account- ing profit measures, economic profit metrics give investors the necessary financial tools to see the direct relationship between corporate invest- ment decisions and their expected impact on shareholder value. Further- more, with a solid foundation on the principles of wealth creation (and destruction), investors can utilize the value-to-capital ratio in a trans- parent way to distinguish between buying and selling opportunities. INVESTED CAPITAL GROWTH While our focus thus far on EVA is instructive—because it allowed us to use financial principles to distinguish between good and bad companies— the analysis is incomplete because it does not address how EVA is chang- ing. In this section, we explain the role of invested capital growth in the discovery of companies that are pointing in the direction of positive and negative economic profit change (potential buy and sell opportunities, respectively). We begin the focus on capital formation by demonstrating the rela- tionship between changes in economic profit and the level of capital investment. In the model development, we take capital additions to VC⁄ 1 $2.5 1.1()⁄–[]$100⁄+ 0.977== 11-Abate/Grant-Econ Profit Page 292 Thursday, August 5, 2004 11:16 AM The Economic Profit Approach to Short Selling 293 mean those required beyond maintaining the NOPAT earnings stream from existing assets. To focus directly on the strategic role of invested capital growth, we express the change in economic profit for any given year as a function of the presumed constant residual return on capital 14 multiplied by the change in (net) invested capital according to In the above expression, we see that change in economic profit for any company is determined by (1) the sign and magnitude of the resid- ual return on capital and (2) the sign and dollar magnitude of the change in invested capital. When ∆C is positive, the firm is making an internal/external (acquisitions) growth decision, while when ∆C is nega- tive, the firm is making an internal decision by presumably restructuring business units and/or processes. In either case—corporate expansion or corporate contraction—managers and investors must make a correct assessment of the expected EVA spread when making strategic invest- ment decisions (active buy or sell decisions in the case of investors). Since we have previously shown that NPV and economic profit are linked via present value, it is a simple matter to show that changes in wealth are related to changes in invested capital. We will now use a sim- ple EVA perpetuity model to show this NPV result. 15 In order to empha- size the importance of capital formation, we will once again assume that the residual return on capital is constant in the model development. The resulting constancy in the economic profit spread implies that changes in economic profit and NPV are directly related to changes in the level of invested capital. This allows active investors to focus on companies that are pointing in the direction of wealth creation (or destruction) based on their capital spending activities for a given EVA spread. With these assumptions, we express the change in NPV for any given company as 14 We take the EVA spread constant in the model so that we can focus directly on the strategic role of invested capital growth on economic profit and wealth creation. In practice, we realize that a firm’s marginal return on capital and its cost of capital may vary due to changes in the level of capital investment. For example, ROC may fall and COC may rise in the presence of capital expansion. 15 We do not have to assume that economic profit is constant each year as in a per- petuity model. For example, we could view EVA as the annualized equivalent of the variable economic profit figures that produce the original NPV. Then, a similar in- terpretation of annualized EVA change could be applied to induce a change in NPV. EP∆ C∆ ROC COC–[]×= 11-Abate/Grant-Econ Profit Page 293 Thursday, August 5, 2004 11:16 AM [...]... Jacobs and Kenneth N Levy, “20 Myths About Long -Short, ” Financial Analysts Journal (September/October 1996), pp 81 85 ; and Bruce I Jacobs and Kenneth N Levy, “The Long and Short on LongShort,” The Journal of Investing (Spring 1997), pp 73 86 7 Bruce I Jacobs, Kenneth N Levy, and David Starer, “On the Optimality of Long -Short Strategies, Financial Analysts Journal (March/April 19 98) , pp 26– 30; and Bruce... positions alone and another attributable to short positions alone Only jointly do the long and short positions define the portfolio Rather than being measurable as long and short performances in excess of an underlying benchmark, the performance of an integrated long -short portfolio is measurable as the overall return on the long and short positions—or the spread between the long and short returns—relative... I Jacobs and Kenneth N Levy, “More on Long -Short Strategies, Financial Analysts Journal (March/April 1995), pp 88 –90 310 SHORT SELLING STRATEGIES Consider, for example, an investor who does not have the ability to discriminate between good and bad oil stocks, or who believes that no oil stock will significantly out- or underperform the underlying benchmark in the near future In long-plus -short, this... for Investment Management and Research, 19 98) , pp 70 81 2 In practice, lenders of stock will usually demand that collateral equal something over 100% of the value of the securities lent (usually 105%) Long -Short Equity Portfolios EXHIBIT 12.1 305 Market-Neutral Deployment of Capital (millions of dollars) Source: Bruce I Jacobs and Kenneth N Levy, “The Long and Short on Long -Short, ” Journal of Investing... in Bull and Bear Markets (millions of dollars) Source: Bruce I Jacobs and Kenneth N Levy, “The Long and Short on Long -Short, ” Journal of Investing (Spring 1997) EXHIBIT 12.2 3 08 SHORT SELLING STRATEGIES $50,000 (5.0% of $1 million) (A lower rate would result, of course, in a lower return.) Thus, at the end of the period, the $10 million initial investment has grown to $11.04 million The long -short portfolio... comprises a 5% return from interest earnings and a 5.4% return from the equity positions, long and short The bottom half of Exhibit 12.2 illustrates the portfolio’s performance assuming the market declines by 15% The long and short positions exhibit the same market-relative performances as above, with the longs falling by 12% and the shorts falling by 18% In this case, the decline in the prices of... risk and return, so this is not a benefit unique to long -short. 6 The Real Benefits of Long -Short The real benefits of long -short portfolio construction emerge only when the portfolio is conceived of and constructed as a single, integrated portfolio of long and short positions.7 In an integrated optimization, selection of the 6 The long-only portfolio can also engage in leverage, just like the long-plus -short. .. 55–60; and James Rutter, “How to Make Volatility Pay—The Next Step Forward Could Be Portable Alpha,” Global Investor, June 2003 314 Equitized Hypothetical Performance in Bull and Bear Markets (millions of dollars) Source: Bruce I Jacobs and Kenneth N Levy, “The Long and Short on Long -Short, ” Journal of Investing (Spring 1997) EXHIBIT 12.4 Long -Short Equity Portfolios 315 portfolio offers a return (and. .. the use of short selling For example, shares the investor desires to sell short may not be available for borrowing, or shares that have been sold short may be called back by their lenders.11 Short selling is also subject to various exchange trading rules (uptick rules), which may exact trading opportunity costs by preventing or delaying desired executions.12 10 Jacobs, Levy, and Starer, “Long -Short Portfolio... margined equity account be at least 50% collateralized to initiate short sales.3 This means that the investor could buy $10 million of securities and sell short another $10 million, resulting in $20 million in equity positions, long and short As Exhibit 12.1 shows, however, the investor has bought only $9 million of securities, and sold short an equal amount The account retains $1 million of the initial . com- panies that would normally present buy or short sell opportunities. 11-Abate/Grant-Econ Profit Page 287 Thursday, August 5, 2004 11:16 AM 288 SHORT SELLING STRATEGIES Case A: Microsoft Corporation—Good. Cost of Capital, and Residual Return on Capital: 1990–2000 11-Abate/Grant-Econ Profit Page 288 Thursday, August 5, 2004 11:16 AM The Economic Profit Approach to Short Selling 289 Taken together,. Profit Page 285 Thursday, August 5, 2004 11:16 AM 286 SHORT SELLING STRATEGIES return on capital (ROC – COC), at –2.5%. As noted before, this company profile represents a sell or short sell opportunity