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China ready with billions for the Euro-zone, top 5 heavy rouge traders, US and Greek debt crisis and much more
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NOVEMBER 2011
M A G A Z I N E
Rogue traders
Top 5hittersheavy
INVESTMENT
PANELANALYSISOF THE MONTH
CHINA READY WITH BILLIONS FOR THE EURO-ZONE
FIFTH EDITIONNOVEMBER 2011
FIFTH EDITION
rebranded
“BUY”
In this issue of FinanceLab Magazine we start of by looking at the US debt level from a historical point of view as we question whether Standard & Poor’s downgrade in August 2011 was justi-fied. Maintaining our focus on the US economy, we move onwards to a biog-raphy of one of the most notable char-
acters, namely, the controversial economist, Ben Bernanke. Moving onwards to the Euro crisis, it is fair to say that the European leaders are also devoting a fair share of their time on dealing with debt issues. As we take a further look at the outcome of the Euro summit on October 26th 2011, we conclude that the end two years of indebtedness is most likely far from over. So who are going help the Euro-zone out of its crisis? To some, China seems like the obvious answer. Odds are they can, so the question relies on, whether they are willing to. Meanwhile, China might have to take a look within before trying to rescue the rest of the world; all fairy tales must come to an end, and as we highlight their bearish equity market, we question whether the remarkable growth tale of China is lacking towards its end.Hereafter, FinanceLab Magazine investigates one of the newest innovations in financial mar-kets, the Bitcoins. Bitcoins is a new “revolution-izing virtual currency”. If you are an internet-shopaholic, bitcoins certainly should spark your interest. As we shall see, bitcoins may be the future of money transferring across borders, leaving the authorities with little or no control of controlling the money flows, opening up for op-portunities yet to be seen. For those of you, who are interested in starting up your own business might wish to pay extra attention to the article about Non-Compete Cov-enants; as if it wasn’t hard enough to obtain start up funding, the funding you eventually receive – if any – comes with a catch… Next, after careful considerations and thorough
analysis, FinanceLab Investment Panel – a group of much dedicated investment geeks – entered a long position in Bang & Olufsen (commonly referred to as B&O). By outlining our analytical framework into four major components – Strate-gic, Macro, Valuation and Technical Analysis – we give you the inside details on our analysis and considerations before entering the position. We also provide you with an overview of the much hailed, yet scrutinized, Exchange Traded Funds (ETF). Hailed, because they are a cheap and ef-ficient way of getting exposure to a given market. Scrutinized, because for every financial innova-tion there is a naysayer. If you are not willing to settle with joining the market, Kirstein Finans give their proposal to how you can beat the market us-ing fundamentals rather than market capitaliza-tion to weigh your index. If thinking long term is not your preferred investment style Flemming Ko-zok, the most prominent day-traders in Denmark, gives his insights to how you can increase safety in your trading activity simply by rethinking your attitude towards trading commissions. Speaking of traders, some traders stand out of the crowd, however not always in a good way. We all know George Soros who brought down the British central bank and made a fortune yet to be seen by any other trader. In our article “Worst rogue traders” we take a look at traders who lost a for-tune yet to be seen. If you plan on becoming a “big swinging dick” some day (read: successful trader), you might want to read the article to see how you are not to go about.
On that note, we hope that you enjoy reading this issue of FinanceLab Magazine.
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US debt 4Ben Bernanke 6Greek debt crisis 8China 10
News from the board 13Investment Panel analysis 14Bitcoins 20Non-compete covenants 25Exchange traded funds (1) 26 Style indices 30Trading commisions 32Investment Camp 2011 34Rogue traders 36Exit strategies in PE 38
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FinanceLab is a network and interest organisation aiming to improve financial competences among students through net-working, education and hands-on experience.
FinanceLab is represented at several universites in Denmark such as Aarhus School of Busi-ness, Copenhagen Business School, Aarhus University, Uni-versity of Copenhagen, Technical University of Denmark, Aalborg University and Niels Brock.
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Naja Hannibal OttosenRune Randrup-ThomsenSarah Louise HansenStian André Kvig
Frederik Ploug SøgaardRune RandruThomsen
Casper HammerichDaniel BorupFlemming KozokJalpesh Madlani Klaus BendnerMads SchönbergMads Villemoes PovlsenSarah Louise HansenStefan Matyas Stig André KvigThomas Joel Frivold
Investment Panel
US debt 4Ben Bernanke 6Greek debt crisis 8China 10
News from the board 13Investment Panel analysis 14Bitcoins 20Non-compete covenants 25Exchange traded funds (1) 26 Style indices 30Trading commisions 32Investment Camp 2011 34Rogue traders 36Exit strategies in PE 38
On Friday the 5th of August the credit rating agency Standard & Poor downgraded the US AAA rating to AA+. This is the first time the world’s largest economy has been downgraded, since it received its rating in 1917. The main reasons for the downgrade according to Standard & Poor were the political brinkmanship on the increase of the debt ceiling as well as not having provided a satisfactorily enough plan on how to tackle the nation’s long-term debt. Standard & Poor also citied estimations that the US Public debt would increase to 79% of GDP by 2015 and 85% by 2021, which according to Standard & Poor is con-sistent with AA+ rated countries. In comparison, forecasts from the International Monetary Fund predicts that triple A-rated countries such as Can-ada and Germany will only see its public debt rise to 34% and 52% of GDP, respectively by 2015. However, there is some debate whether Standard & Poor’s estimations are accurate. The Treasury department quickly responded to the downgrade by claiming that Standard & Poor’s downgrade is flawed by $2 trillion error. According to the Treas-ury department spokesman, Standard & Poor estimated the discretionary spending levels at $2 trillion higher than the Congressional Budget Of-fice’s estimates.
Using the public debt level as a percentage of GDP makes it easier to compare the debt over time and also takes into account a countries growth and inflation rate. According to “The Econ-omist global debt clock”, the US public debt for 2010 was 61.2% of GDP. To find such level in US you have to go back to the 1940s, as illustrated by figure 1.
Another way to measure public debt is in absolute values. According to “The Economist global debt clock”, the US public debt in absolute value was around $9 trillion in 2010. The historical debt in absolute terms is illustrated in figure 2 and the public debt in absolute terms has increased over time and especially the last ten years.
The world is experiencing its worst crisis since the Great De-pression and it has hit the US very hard. The nation has seen its unemployment increase, GDP growth decline and its debt level rise as a consequence of their economic policy in order to avoid a depression. Thus, lately
The US debt from a historical point of view
there has been an ongoing de-bate about the public debt level in US and the country has even seen its rating being downgrad-ed. But is the public debt level really that high from a historical point of view?
By Jalpesh Madlani
The significant increase in public debt as a per-centage of GDP during the 1940s was mainly due to World War II, which the Federal Government financed with large budget deficits. It took almost two decades for US to return to its 1940 GDP to debt ratio level. From 1960 to 1980 public debt as a percentage of GDP decreased substantially. However, the debt in absolute terms increased from around $238bn to $712bn, corresponding to a 300% increase.
The increase in the US debt level started in the 1980s. During the Ronald Reagan and George H.W Bush era from 1981 to 1992 (the next presi-dent usually takes office in 20th of January in US) the absolute debt level almost tripled. In addition, the debt as a percentage of GDP increased from 25.1% in 1980 to 48.1%. During the Bill Clinton presidency (1993 to 2000) the debt level as a percentage of GDP decreased, while the abso-
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lute value of public debt was relatively constant. Under George W. Bush the public debt escalated mainly due to tax cuts, increased spending on education, the cost of war in Iraq and Afghanistan and costs of financial bailouts and stimulus pack-ages. This increase in debt has continued under the Obama administration and, as mentioned ear-lier, the public debt was in 2010 around 61.2% of GDP.
However looking at Standard & Poor’s differ-ent ratings a downgrade to an AA+ rating was still a somewhat harsh decision. Moreover, the downgrade did not really affect the demand for US Treasury-bills and yields remained constant. According to Carl Lantz, the head of interest rate strategy at Credit Sussie, this was due to the fact that people already suspected a downgrade and thereby, the downgrade was already priced in. In addition to that, other external factors, such as the European debt crisis, are still contributing to the demand of US Treasury-Bills.
In sum, the US public debt in percentage of GDP has approximately been halved since 1945. How-ever, if you compare present debt ratio to the ratio in 1980, the debt has almost doubled. In addi-tion, the public debt since 1961 in absolute terms has increased by 3600%. To answer the whether the public debt in US is unsustainably high, addi-tional approaches towards the subject than those not mentioned here would be needed.
What is public debt?
What is credit rating?
What is the S&P credit rating?
3 FACTS ABOUT DEBT
Public debt is the difference between a government’s income and expenditures, also defined as all the money owed by a government at any given time. A budget surplus means that govern-ment income is higher than expenditure and as a result the government is able to reduce its debt. Conversely a budget
A credit rating expresses opinions about the ability and willingness of an issuer such as corporation or state to meet its financial obligations or the credit quality of an issue such as bond or debt obliga-tion and the relative probability of that it may default. The rating in turn will affect the interest rate applied to the security being issued, for instance a state with AAA rating will pay a lesser interest rate on its treasury
‘AAA’—Extremely strong capacity to meet financial commitments. Highest Rating.‘AA’—Very strong capacity to meet fi-nancial commitments.‘A’—Strong capacity to meet financial commitments, but somewhat suscepti-ble to adverse economic conditions and changes in circumstances.‘BBB’—Adequate capacity to meet fi-nancial commitments, but more subject to adverse economic conditions.‘BBB-‘—Considered lowest investment grade by market participants.‘BB+’—Considered highest speculative
notes compared to a state with a BB rating. The credit rating is published by a credit rating agency and is as a result an evaluation made by the agency on the likelihood of a default. Accord-ing to Standard & Poor, one of the biggest rating agencies, the rating should not be viewed as an assurance or precise measure on the likelihood of default. It should rather be viewed as a relative level of credit risk that the rating agency has care-fully considered. It shall be noted that the credit rating agency charges it’s customer for providing them with a rating.
deficit means that government expenditure is higher than income, which in turn requires the government to borrow. This is usually done by is-suing government bonds or bills to compensate for the negative difference between the income and expenditure and as a result increases the countries debt level.
grade by market participants.‘BB’—Less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions. ‘B’—More vulnerable to adverse business, finan-cial and economic conditions but currently has the capacity to meet financial commitments. ‘CCC’—Currently vulnerable and dependent on favorable business, financial and economic con-ditions to meet financial commitments.‘CC’—Currently highly vulnerable.‘C’—Currently highly vulnerable obligations and other defined circumstances.‘D’—Payment default on financial commitments.
National debt clock 6th AvenueManhatten
US DEBT IS A
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In the last three years, the United States of America has struggled with the financial crisis and the Federal Reserve has blasted trillions of dollars into the economy. The man in charge is Ben Bernanke, but who is he and how has he handled with the financial crisis so far?
By Daniel Borup
In his oversized Washington office, Ben Bernanke is in control of the economy of the United States of America. The bold man with the grey beard appears to be shy and reticent in terms of com-municating with the media. He does not radiate self-assurance, but somehow he manages to gain people’s trust and make them believe in him - a gift he has been aware of since he graduated from High School with the best high-school certificate. As chairman of the Federal Reserve, Ben Ber-nanke has an enormous power over the world’s economy, a power he has used in a way that is completely unprecedented.
Phil the marmot from PunxsutawneyRumor has it that Ben Bernanke is to be com-pared to the ground hog, Phil, from Punxsutaw-ney in Pennsylvania. Every year on Groundhog Day, Phil walks out of his cage, and if he throws
Ben Bernanke The controversial economist
a shadow, the winter will continue for six weeks. People from Punxsutawney believe in Phil, the media write articles about Phil’s achievements, and several thousand people come every year to watch Phil predict the duration of the winter. Be-cause of the fact that Ben Bernanke will not ex-press his opinions about politics, he is infrequent-ly seen in the media As a result, he only appears on television when he is going to speak about the condition of the economy and how the economy will develop in the future. When he does appear on television, people admire him and value his words. Thus, he is to be compared with Phil, the marmot from Punxsutawney.
Ben Bernanke was born in Augusta, Georgia in 1953. He was raised in Dillon, South Carolina. His father was a pharmacist and his mother was an elementary school teacher. After achiev-ing the best high-school certificate from Dillon High School, he attended Harvard University and graduated with a Bachelor of Arts in economics in 1975. Afterwards, he attended Massachusetts Institute of Technology and received his Ph.D. in economics in 1979. In the period 1979 – 1985, he worked as a professor at Stanford Graduate School of Business and as a visiting professor at New York University. Afterwards, he became a tenured professor at Princeton University in the Department of Economics. He worked in this de-partment from 1996 until 2002, when he went to
serve as a Member of the Board of Governors of the Federal Reserve System. Ben Bernanke took office as chairman of the Federal Service on Feb-ruary 1st, 2006, when President George W. Bush appointed him. Barack Obama reappointed him, when he was elected president. Before Ben Ber-nanke’s appointment, he was chairman of the President’s Council of Economic Advisers from June 2005 to January 2006. Alan Greenspan preceded Ben Bernanke. Both got along with the economic liberalism, but Ben Bernanke admired the economist Milton Fried-man, whose beliefs about market regulation in the 1980s inspired Ronald Reagan and Marga-ret Thatcher. Ben Bernanke differed from Alan Greenspan when it came to forecasts and regula-tions. Ben Bernanke is advocate of forecasts and does not hesitate to use regulations. Conversely, Alan Greenspan did not trust in regulations at all. Ben Bernanke also believes in transparency and clearer statements than those of Alan Greenspan.
About Ben bernanke
How did Ben Bernanke handle the financial crisis?Ben Bernanke is interested in the Great Depres-sion. He calls it the “the holy grail of macroeco-nomics” and says: “To understand geology, study earthquakes; to understand economy, study the Depression”. Ben Bernanke studied the Depres-sion, and he has based some of his economic thoughts on it. He tends to see the Hoover Ad-
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The future according to Ben BernankeBen Bernanke is a republican and a controver-sial economist, who has received a great deal of criticism from the most conservative members on Capital Hill. Despite the criticism, he retains his points of view and states that his job is not a popu-larity contest. Instead of dealing with criticism, he would rather discuss the economy. Ben Bernanke has a good deal of confidence when referring to the American economy in the future. He says that America has an excellent record in terms of innovation and great universi-
ministration’s handling of the crisis as a huge mistake, and instead he embraces Michael Key-nes’ thoughts of the aggressive and intervening government. The central function of the Federal Reserve is to steer the economy toward stable prices and maximum employment through monetary policy. It also has to lend the traditional banks money if they run low on ready funds in case of bank runs. In connection with the financial crisis, Ben Bern-anke proved his superior knowledge and showed that he knew how to handle a crisis based on lack of confidence and edginess. The author of Lords of Finance gives his opinion about Ben Bernanke: “Ben understood more clearly than anyone how crisis of confidence can create a domino effect”. When the financial crisis broke out, Ben Bernan-ke resorted to his Keynesian conviction. He made use of the so-called quantitative easing. The first, commonly referred to as QE1, was did aim at sup-plying liquidity to the financial sector. Instead, it was supposed to support the American economy by keeping long-term interest rates low. It was commenced in 2009. Ben Bernanke says:“In addition to easing monetary policy, the Fed-eral Reserve has worked to support the function-ing of credit markets by providing liquidity to the private sector”.During the QE1, the Federal Reserve purchased $175bn of agency debt securities and $1250bn of mortgage-backed securities, in addition to pur-chases of Treasuries. The short-term aim of the QE1 was to support the American economy, and it did, because the Federal Reserve provided liquid-ity to the private sector by supporting the function of the credit markets. Among economist it is said that the QE1 prevented the economy from a large depression. The second round of quantitative easing, QE2, was distinct from the first, however, the aim re-mained the same: to support the US economy. In
2010, the Federal Reserve began to reinvest prin-cipal payments from agency debt and mortgage-backed securities they had acquired in connec-tion with QE1. By the end of 2010, they chose to expand the balance sheet with $600bn. This was carried out by buying Treasury securities. Refer-ring to QE1 and QE2, Ben Bernanke differs from Alan Greenspan, and he reached a lot of atten-tion and criticism. Critics of Ben Bernanke and quantitative easing in general proclaim that buy-ing Treasuries only increases the reserve deposit. This is due to the fact that the Federal Reserve purchases Treasuries with dollars they have cre-ated expressly for that transaction. They call it an “asset swap”, and states that the Federal Reserve has more reserve deposits and fewer Treasuries in the private sector after execution of QE2.Despite the criticism, Ben Bernanke is completely convinced that in order to comply with the finan-cial crisis, it is necessary to intervene and get the economy going again. Starting from the Great De-pression, he knew what to do and what not to do. He proclaims in an interview for 60 Minutes in 2010, that the $600bn decision is made out of two aspects. The first is unemployment, and the second is the fact that deflation is threatening the economy of the United States of America. Critics of Ben Bernanke’s Federal Reserve think that QE1 and QE2 will overheat the economy and make inflation uncontrollable. This is due to the fact that Ben Bernanke has lowered the interest rates. He states, though, that he is able to raise interest rates in 15 minutes and adds that critics only focus on the risks of acting, but not on the risks of not acting.In September 2011, the interest rate on 10-year Treasuries is 1.95 percent. That is lower than the inflation, but the Federal Reserve is about to implement a new quantitative easing named Operation Twist. In an effort to encourage peo-ple and business to spend and borrow money, the Federal Reserve is aiming to drive down the interest rates on 10-year bonds. Due to the fact that they already own hundreds of billions worth
of medium-term bonds, and the interest rate on those is virtually zero, the Federal Reserve is most likely going to sell those medium-term bonds and use the proceeds to buy long-term bonds in an attempt to “twist the yield curve”. During the financial crisis economists have ac-cepted the fact that the Federal Reserve is not able to do much other than lowering the interest rates. Therefore, they hope that it will soon sup-port the American economy and help out the un-employment, which is about 9 percent.
The future accord-ing to Ben BarnankeBen Bernanke is a republican and a controver-sial economist, who has received a great deal of criticism from the most conservative members on Capital Hill. Despite the criticism, he retains his points of view and states that his job is not a popu-larity contest. Instead of dealing with criticism, he would rather discuss the economy. Ben Bernanke has a good deal of confidence when referring to the American economy in the future. He says that America has an excellent record in terms of innovation and great universi-ties, which are involved in technological develop-ment. He adds that the entrepreneurial culture in America is formidable. Referring to these aspects, he is certain that America will retain its leading position as the world’s largest economy. The question is, though; will Ben Bernanke, the ground dog Phil, be right after all regarding America’s economy in the future? No one knows, but it is certain that he will control and watch the American economy from his oversized office in Washington.
By Sarah-Louise Hansen
Markets are typically somewhat tranquil during the summer, and this summer was no exception. Most of the attention was dedicated to the dead-lock in the negotiations over the US budget due on August 2nd 2011. Here, Obama struggled to find a solution with the Republicans eager to in-duce public spending cuts on one side of the ta-ble, and the Democrats determined to lift the debt ceiling on the other. The negotiations evidently went through and attention was pointed to the Swiss franc, which had appreciated substantially due to the investors’ demand for a safe heaven. Massive demand for the currency pushed the Swiss franc up 30% against the dollar within just one year. Consequently, the Swiss National Bank, who feared that the strong currency would evidently weaken the economy, chose to peg the Swiss franc to the Euro.
Wake up and smell the coffeeThese events left the Euro with a much-needed break after a hefty spring. European leaders had granted a new €109bn bail-out package to Greece before their summer break (see time-line) and for just a brief moment, the Euro cri-sis seemed like more distinct memory of a bad dream. But the realities of the Greek debt and Euro crisis soon caught up the European politi-cians. First came the market worries about the possible downgrade of France. Then, after sub-stantial market turmoil, focus was back to where it all started, namely the major budget deficit in Greece. The budget deficit had put Greece into a severe lack of liquidity, which would evidently make Greece insolvent due to the “high” inter-est rates that ECB has continuously hiked in an attempt to fight inflation. All these events – the ladder in particular – caused the Euro to fall due to a lack of investor confidence. Fighting market sentiment is never easy due to the typical herd behaviour. However, being in a monetary union does not make this any easier. On the contrary, self-fulfilling market runs cannot be back-stopped by the countries themselves since they have lost their monetary independence. Thus, the events
called for act by the European leaders.
summit of all summits!? The intensifying debt crisis left leaders of the European Union with three options; kick out Greece and let them devaluate themselves out of the crisis, restructure Greece’s debt or introduce yet another bailout package. After extensive ne-gotiations on the summit held on October 26th, European leaders finally came up with a plan to rescue Greece and the other peripheral countries. The rescue package consists of three elements. First, Greece’s debt will be restructured by induc-ing 50% voluntary haircuts on private investors in exchange for a safer debt. The voluntary part of the agreement is important to emphasize since a voluntary haircut will not trigger the bond-insur-ance contracts (CDSs) – an event that has been much feared by the politicians of Europe, since the insurance system is still untested. Next part of the agreement is a €106bn recapitalization of Europe’s banks in order to soften the hit from the restructuring of the Greek debt. Last is the crea-tion of a “€1trillion firewall” in order to prevent the contagion from spreading to vulnerable, yet solvent, peripheral countries.
the end?So, is this the end of nearly two years of trial and error? Hardly. In the short run, one of the con-sequences of the haircut is that Greece’s banks, which are big holders of Greek debt, will face bil-lions’ worth of write-downs. In order to address this issue the troika of Greece’s lenders – the European Commission, European Central Bank and the International Monetary Fund – have set aside €20bn-€30bn to recapitalize Greek banks as part of a July rescue package. However, most critiques points to the fact that another €16bn is needed if the Greek banks are to meet the 9% capital requirement induced by the European leaders. Additionally, the advocates of the haircut fail to recognize that Greece’s pension and social security funds are also big holders of Greek gov-ernment debt. Dealing with the voluntary part of the haircuts, however well intentioned, it has the rather unfortunate consequence of undermining
the value of a CDSS and thereby cause banks and other investors loose faith in CDSs as a hedging tool. As a consequence hereof, the reluctance to trigger CDSs could cause borrowing costs in other countries to rise.
Looking at a more long-term perspective, it is questionable whether many structural reforms imposed by European leaders have actually bailed Greece out rather than just putting them in a dead lock. According to some estimates, struc-tural reforms and austerity packages have taken their toll on the growth potential of the Greek economy; output will decrease by 5.5% in 2011 and Greece’s economy will continue to shrink un-til 2013. Moreover, the debt burden will continue to grow until 2013, where it is estimated to peak at 186% of GDP. Looking from a broader perspective, the re-cent events have put Euro zone leaders’ ability to convince the market that they believe in the euro up to a test. A test they stand a very little chance of succeeding in for two reasons. First, the politicians are faced with massive domestic pressure. In Germany Angela Merkel, chancel-lor of Germany, is being punished by voters and the coalition party for using German tax money to bail out peripheral Europe. In peripheral Europe, citizens are demonstrating against new austerity measures and structural reforms. Second and most importantly, lack of communication between politicians in the Euro area means that they fail to tackle the issues such as “Can a member coun-try go bust?” and “Can a member country loose its membership? And if so, what does it take?” However difficult and even unpleasant these is-sues are, European leaders must face the reality at some point in time.
In sum, it seems as if this rescue will not mark the end of the Greek debt crisis. If anything, the rescue plan is merely the Euro leaders attempt to “pee in their pants to keep warm over the winter”. And more than anything, the plan is a good exam-ple of what happens when politics and economics tries to reconcile.
Greek DEBTCrisisThe Dog Days Are Over!
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Greek debt crisis – list of events
December 9th 2009 Fitch announces downgrade of Greek debt to BBB plus – the lowest of all Euro zone countries – due to detoriating public finances. Investors panic and start selling of Greek assets.
December 15th 2009 Market scepticism over Greek rescue plan. Greek unions start to strike over reforms.
January 11th 2010 IMF steps in to advice Greece on public finances.
January 14th 2010 Greece announces an ambitious plan to cut deficit.
January 25th 2010 Investors gain confidence in the Greek economy as they rush into five-year fixed rate bonds.
February 25th 2010 Investors loose their confidence again when Moody’s warns Greece could see its long-term credit ratings cut two notches, following a similar statement from Standard & Poor’s 24 hours earlier.
March 4th 2010 Athens sells €5bn in 10-year bonds and receives orders for three times that amount – market sentiment is back up.
April 12th 2010 Eurozone members agrees to provide €30bn in loans within the next year.
April 20th 2010 Greek unemployment plummets to 11.3% -- corresponding to a six-year high rate. 10-year Greek bonds jump 36.2 bps.
April 23th 2010 Greece seeks €30bn rescue package from Eurozone partners.
April 26th-27th 2010 Bond yields continue to soar. The crisis starts spreading to other peripheral countries, e.g. Portugal. Standard & Poor down-grades Greek debt to junk.
April 30th 2010 Greece agrees on €24bn austerity package.
May 2nd 2010 European leaders agrees on €110bn rescue package.
May 3rd 2010 ECB suspends minimum rating required for Greek government-backed assets used in its liquidity-providing operations.
June 14th 2010 Moody’s follows suit and downgrades Greek debt to junk.
June 24th-27th 2010 Market takes another hit at 10-year Greek bonds due to worries over expiry of ECBs long term refinancing reform.
July 13th 2010 Investors confidence is back and Greece raises €1.62bn in six-years treasuries.
August 5th 2010 IMF, European Commission and ECB praise Greece for their structural reforms.
August 12th 2010 Statistics reveals that Greece is deeper into recession than first thought.
August 19th 2010 Another €9bn is granted to Greece in Eurozone loans.
September 1st-15th 2010
IMF stresses that the default risk of Greece is overestimated. Additionally, leaders of Athens and rejects any likelihood of a Greek debt restructuring.
October 4th-12th 2010 Greece extends spending cuts. A successful debt auction decreases the cost of short term borrowing and brings back investor confidence. Yields on 10-year bonds are down for the first time since June 30.
January 14th 2011 Fitch cuts Greek debt to junk.
February 21th 2011 Greece unveils tough legislation to reduce tax evasion as part of reforms agreed in return for a €110bn bail-out by EU and IMF.
April 23th 2011 European Commission data shows the Greek budget deficit jumped to 13.6% of gross domestic product in 2009 – almost a full percentage point higher than the Greek government’s projection of 12.7%
May 24th 2011 Greece announced that is will sell stakes in state-owned groups.
June 9th 2011 Greece’s statistical agency revises downward its quarter-on-quarter growth estimate for the first three months to 0.2%
June 16th-17th 2011 IMF and EU offer Greek aid deal. George Papandreou, prime minister, replaces his finance minister.
July 3rd 2011 European finance ministers approve a €8.7 aid payment to Greece.
July 21th 2011 European leaders agree on a €109bn bail out package. Private bondholders are for the first time ever included in the rescue plan.
July 25th 2011 Moody’s downgrades Greek debt even further, stating that the country is “very poor or in default”.
September 13th 2011 Greek bond yields rallies even further.
October 19th 2011 Greek lawmakers approve the country’s latest austerity package at its first reading.
October 27th 2011 EU reached agreement on Greek bonds. Source: Financial Times
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CHINA READY WITH BILLIONS FOR THE EURO-ZONE
By Stian André Kvig
China is now ready to invest billions in the rescue operation going on in the Euro-zone, according to the Financial Times. However, Euro-pean leaders need to convince the Chinese about the safety of the investment. Chinese high-
ranking officials confirm the claims that they are willing to support the EFSF fund, but still needs the final guarantees from the EU to make the in-vestment.
Since the beginning of Europe´s sovereign debt crisis, Beijing has repeatedly expressed its wish to offer help to Europe. Eurozone countries, howev-er, have to understand that they will have to save themselves; expectations of a “red knight” riding to the rescue are sorely misplaced.As Wen Jiabao pointed out at the 2011 Dalian World Economic Forum, the EU has first to put its house in order. When countries and political par-ties in the Eurozone squabble among themselves over how to proceed, how can China support any hastily assembled rescue packages?
China has a long-term interest in supporting this fund, simply because it is our largest trade-partner. However, we need to secure the support of the Chinese people, and at the same time ac-knowledge that there are skeptics to this invest-ment in our country, says Prof. Li Daokui, the chief economic advisor to the Chinese central bank. China does not want to throw away their fortune nor appear as a naïve money donor, Li further claims.
He points out that the Chinese government may
find leverage in Europe’s economic disaster by pressuring European politicians to stop criticize Chinese monetary policy. This implies that a res-cue package may taste worse than it looks for Europe´s debt champions. First of all, they will be in heavy debt. The interest on this loan is at present unknown, but there is no reason to be-lieve that it will be nothing but extraordinary. This will lead to further cuts in public budgets in PIIGS countries as they strug-gle to meet loan obliga-tions. As we already have seen huge riots and civil unrest, the social impli-cations of further cuts in public spending will be on a scale never seen. Second of all, the loans come with preconditions that may alter the geo-political and economic future of not just PIIGS countries, but the whole European Union.
What we are seeing here might be nothing less than a revolution in the economic and geo-political relations between China and the West. Neverthe-less, these preconditions are yet to be announced by the Chinese, but there is no reason to believe that they will not change the economic and po-litical landscape of the EU for decades. The Chi-nese fully understand their bargaining power in this situation and will likely take full advantage of
the EU´s problems. However, as China holds large reserves in EUR, it is unlikely that they will allow the PIIGS countries to default. China understands what catastrophic implications a dissolution of the Euro will have for not just their currency reserves, but also Chinese export.
That said, it does not mean China should stay on the sidelines. China would be happy to invest in EFSF bonds in a measured way, as it has already done. If a Eurobond should emerge, China should also invest. For any major investment in European sovereign bonds, safety is the key, which means that an iron-clad guarantee and the in-volvement of the Interna-tional Monetary Fund are necessary. Besides, there are many ways to help without exposing China to sovereign debt. Its sover-eign wealth funds can buy shares in solid European non-financial and finan-
cial companies. Chinese enterprises can inject billions of euros of fixed direct investments into the Euro-zone economy.
Furthermore, there are indirect ways to help. Beijing should allow the renminbi to appreciate against the Euro and give European companies greater access to Chinese markets-which, of
“What we are seeing here might be nothing
less than a revolution in the economic and
geo-political relations between China and the
West.”
10/42
As the printing presses of the Euro-zone are running out of ink, European leaders need to look elsewhere to finance their bailout-packages.
While China continues their plans for two-digit economic growth, Chinese asset managers are feeling the pain of the European debt-crisis. As we enter the last quarter of 2011, Chinese equi-ties are performing as poor as in 2007, leaving the fund managers striving to meet expectations and stay ahead.
Chinas real economy may have escaped the glo-bal economic slowdown so far, but Chinese as-set managers are feeling the pain. As 2011 goes to its end, fund managers are feeling the impact of a truly globalized financial sector. Continued weakness in China’s equity market has made this one of the most challenging years for the coun-try’s fund management industry since the finan-cial crisis first erupted in 2007. Notwithstanding the country’s strong economic fundamentals — growth has been running at a pace of more than 9 percent — the Chinese stock market has been among the worst performers around the world.
The benchmark CSI 300 index has been weaken-ing steadily since April and stood at 2,679.27 late last month, down 14.4 percent since the start of the year and off a tremendous 54.5 percent from the all-time high in October 2007.
However, Chinese fund managers seem to have difficulties grasping what has hit them. And who could blame them? Not just the Chinese, but fi-nancial professionals all over the world has been flawed by the poor performance of China´s equity markets in 2011. The words of Beijing-¬based Zhang Houqi, deputy president of China Asset Management Co, sums up the industry reaction
course, needs to be reciprocated. An improved Euro-zone current account through trade as well as Chinese investment in EFSF will free up fund-ing within Europe and allow more savings to be directed towards governments.
China and the U.S. find them-selves held up in a conflict re-garding whether or not China is artificially deflating the ren-minbi to maintain high export. China resides over enormous reserves of foreign currency, especially EUR and USD. In other words, it does not take rocket science to understand why China has an interest in holding countries like Greece, Italy, Spain and Ireland sol-vent. China knows that Eu-ropean leaders want to keep these countries over water to protect the EUR, but they know they need to plan for the worst. The decision to invest in the EFSF fund is without doubt part of their strategy to secure their currency reserves. According to the Financial
Times, 25% of the total foreign currency reserves of China are held in EUR.
Sources within the Chinese government claim that China will contribute between 50 to 100 billion USD to the EFSF. It is further discussed that China may choose to invest in a new fund set up in cooperation with the IMF instead of the EFSF.
China also has a large currency reserve in the US dollar. As we have seen in the last years, China´s faith in the dollar has been rather misplaced. The dol-lar has taken big hits against nearly all ma-
jor currencies, leaving the Chinese central bank watching as their income from the export to the
US decreases in value. In other words China can-not afford to make the same mistake again with the Euro, something both Chinese and European politicians are well aware of.
The recent agreement on expanding the scale of the bail-out fund is perceived as positive, but the idea of “leveraging” the European financial stabil-ity facility by partial guarantees is not reassuring. That is a far cry from the original design of EFSF bonds.
Bailing out EU countries with Chinese pensions is hard for the Chinese to accept, just as it is hard for any German pensioner to accept. The tens of mil-lions of elderly Chinese will demand to know why they should pay for rich Europeans to retire early when they do not have a decent pension system of their own. Unlike America, which has accu-mulated huge foreign debts, the Euro-zone as a whole has a healthy external position. This means that Euro-zone countries can solve their sovereign debt crisis with their own money, as long as Ger-many and some northern European countries are prepared to take the bill. The Chinese will ask: If Germans do not want to contribute more money, why should China bother?
“As we already have seen huge riots and civil unrest, the so-cial implications of
further cuts in public spending will be on a
scale never seen.”
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“DEBT-CRISIS COOLDOWN”HITS CHINESE ASSET MANAGERS
By Stian André Kvig
By Stian André Kvig
to the poor results: ” The major challenge for us was market volatility and the fact that it has been a bear market”.It has been a bear market, indeed. Chinese inves-tors who are seeing their savings take a large drop may not be satisfied with explanations blaming on ”bear markets” though.
The consensus in early 2011 was that Chinese equities would see a nice return in the following year due to the debt-crisis in the Euro-zone and the financial turmoil and the state of the economy in the US. The belief was that these prob-lems would lead investors away from the US and the Euro-zone and into mainly blue-chip stocks in emerg-ing markets, especially Chi-na. The main reason was that China in the beginning of 2011 seemed to con-tinue their nearly two-digit growth from 2010. Another reason was that investors didn’t believe that the Chinese economy would be severely hit by the Euro debt-crisis and the pos-sible recession in the US.The volatility has been challenging for fund man-agers since industry wide assets under manage-ment have seesawed. They peaked at 3.2 trillion Yuan ($476 billion) in 2007, fell to 1.89 trillion Yuan in 2008 and rebounded to 2.67 trillion Yuan at the end of 2009 before declining to 2.3 trillion Yuan as of August 31, according to Shanghai--based Z-Ben ¬Advisors, a firm that tracks China’s asset management industry. The scope of the market’s decline in re-cent years could limit any potential recovery, analysts say.
To an extent, Chinese equities have suffered from the same decline in valuations that have hit most stock markets around the world as growth has slowed. But several factors made in China are also weighing on the market.The Chinese govern-ment has been sell-ing its stakes in a wide range of companies, flooding the market with billions of shares since 2006, notes Chi-na AMC’s Zhang. Until 2006 about 55 percent of all shares of publicly traded state-¬controlled companies were clas-sified as nontradable. Since then, Zhang esti-mates, the government has sold nearly 50 per-cent of those nontradable shares on the market.The government isn’t the only source of supply. Chinese companies continue to bring a steady flow of initial public offerings to the market, albeit not at the same torrid pace as in previous years. Year-to-date as of September 21, 267 companies had issued $41.7 billion worth of equity in IPOs, according to data provider Dealogic. Many of the
IPOs are taking place on ChiNext, a Shenzhen-¬based mar-ket launched in November 2009 that specializes in raising capital for private entrepreneurs. More supply could be com-ing if the government goes ahead with plans to introduce an
international board on the Shang-hai exchange, to lure listings from foreign -multinationals.Compounding the concerns are market worries that official efforts to rein in inflation – which eased to 6.2 percent in August after hitting a three-year high of 6.5 percent in July – may force the economy into a hard ¬landing.Still, Chinese shares have rela-tively attractive valuations these days, and there are signs in the market that equities have been oversold, analysts say. Shanghai’s A- shares were trading last month at an average of 9.3 times 2012 earnings forecasts. This is consid-erably lower than the comparable average price-¬earnings ratio of 10.8 for stocks in the Standard & Poor’s 500 index, according to Paul Schulte, global head of financial strategy at CCB ¬Inter-national Securities in Hong Kong.If there is one thing both Chinese
investors and fund-managers are hoping for, it is a mar-ket rebound. However, the fund managers may be facing a tricky situation in the event of a turning market. “Many individual funds are currently below their par value, mean-ing that a large number of investors are holding on to their investments, and many will redeem if performance pushes the net asset value back up to 1,” says Anthony Skriba, an analyst at Z-Ben in ¬Shanghai. “This means that, in the event of a near-term market rebound, industry assets will decline as investors redeem their existing shares, with growth following thereafter.” This means the joy of a market rebound may be short-lived because of the sell-off that will
appear if investors get the abil-ity to get out of their positions with zero losses. Further, this implies that a double-dip might take place in the Chinese stock market approximately between 2012-2013.
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“The belief was that these problems would lead investors away from the US and the Euro-zone and into
mainly blue-chip stocks in emerging markets,
especially China.”
“The consensus in early 2011 was that Chinese
equities would see a nice return in the following
year due to the debt-crisis in the Euro-zone and the
financial turmoil and the state of the economy in the
US”
13/42
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Half way through this semester the Board of FinanceLab looks back at the last few months with great content.
We started the semester with our semi-annual Nordic Trading Competition (NTC), where enthusiastic students gathered to compete for the title as the best trader. Thanks to Nordea Markets, who made it possible for us to set two tickets for Nordea Markets day at stake, there was more excitement in the room than at any of the preceding NTCs.
Afterwards, FinanceLab took educational events to a completely new level at the Investment Camp. In Copenhagen School of Entrepreneurship’s (CSE) facilities, FinanceLab hosted a full day event with prominent names such as Barclays Capital and J.P. Morgan as well as newcomers to the financial playing field, such as Kirstein Finans.
Other than being two great event, the event helped increase awareness of Finance-
Lab and the number of attendants at our monthly Member Meetings is rising steadily. The agenda at the Member Meetings varies considerably from month to month. However, common for all of them is that ideas are being created, network expanded and knowledge shared.
One of the main goals of FinanceLab has been to revitalize the Investment Panel (IP). Thus, it was with great anticipation the steering committee introduced the new IP structure. In terms of work-flow, the new structure has been a welcomed by current IP members as well as new members, who are flocking to the Investment Panel. We leave you to determine whether the profes-sional outcome is equally successful.
Thanks to our partnership with GCMS and the great effort from the Trading Diploma Team, FinanceLab continues being inde-pendent through our facilitation of Trading Diploma. Attendees from different universi-ties and corporate world are eager to learn about trading and feedback has been over-
whelmingly positive. However, the trading diploma team and GCMS are not resting on their laurels and the courses are evaluated on an ongoing basis.
After two successful study trips, Finance-Lab is gradually getting a foot indoor within the world of investment banking. Onwards, our focus will be to maintain and further develop the relations we have made in an attempt to pursue our goal of becoming the number one distribution channel between the financial sector and students across Denmark.
Last but not least, all of these success stories were not possible without a sound band of followers and dedicated members. Up until now, we have been lucky enough to obtain both and the number of followers has been in an uptrend since FinanceLab was re-established in 2009. We hope that this trend will continue, so we can continue what we are doing – only bigger, better and of course more often.
NEWS FROM THE BOARD
INVESTMENT
B&O rebranded
PANELANALYSISOF THE MONTH Bought 1st of Nov
DKK 61 per share
This month’s investment case is Bang & Olufsen (B&O). B&O designs au-dio products, television sets and telephones. Their products are known for unique ap-
pearance as well as user-interface and last but not least, their price level!The little consumer electronics pro-ducer from Struer was hit hard during the financial crisis, and their stock was beaten up by the market accordingly. However, with a renewed approach to their customers and a variety of new products B&O seems determined to show the world that luxury goods are not “so last decade”. Head of this mis-sion is their new president, Tue Man-
toni, former president of Triumph Mo-torcycles Ltd. Tue Mantoni is a man of ambition and he has a track record to back up his ambitions with. He has set high goals for B&Os future develop-ment and up until now, this seems to going according to the plan; in the first quarter of the current accounting year, Tue Mantoni managed to lift turnover. The bottom line is however still red and Tue and his crew still have a long way to go. The questions that remains to be answered is first and foremost whether B&O can renew themselves and gain market shares among young consum-ers or if they are forever damned to stay in the living rooms of our parents. Sec-ond is the question of whether B&O has what it takes it win over the hearts of the
consumers in the emerging markets. Prior to solving the investment case, the panel was divided into four groups – Macro, Strategic, Valuation and Techni-cal Analysis. The Macro group analyzes the macro economic environment con-cerning B&O. The strategic group ana-lyzes the company’s strategy and out-lines their market potential. Based on the recommendations from the strategic group, the Valuation group valuates the B&O using a variety of scenarios. Lastly, the Technical Analysis group studies the market data in terms of price and trading volume in an attempt to forecast future price movement.
PANEL WORK FLOW
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GLOBAL
By August 15th 2012, B&O – lead by Tue Mantoni – plans to reach the following goals: one third of au-dio/video-growth will be driven by new product launches, a turnover exceeding DKK 3,000 mill. (com-
pared with DKK 2,867 mill. last year) and a result before taxes of DKK 100 mill. (DKK 40 mill. last year). If that sounds ambitious, wait until you hear the five-year plan; current turnover stands at a lit-tle less than DKK 3bn, according Tue Mantoni, B&O has a full potential of between DKK 8 and 10bn – a potential he plans on exploiting!So how will do they plan on reaching these ambi-tious goals? B&Os growth strategy can be sum-moned up into six pillars. First pillar is inevitably focus on sound. B&O plans to increase the focus on sound and acoustics development and thereby leverage and further strengthen the company’s world-class skills and market position within this area, e.g. through a deeper vertical integration of the ICEpower engineering teams. Next pillar is restructuring of the retail network. Up until now, B&O have been much known for their so-called B1 Shops. The advantage was that the dedicated B&O customer could get the full B&O experience in just one shop. The disadvan-tage however, is that this retail model gives B&O very little exposure to the customers who wishes to explore the market before choosing their fa-vourite brand. Onwards, they plan on switching this strategy and adopt a shops-in-shops retail strategy, where consumers can access B&O products along with a variety of other, competing consumer electronics. Third pillar is new product categories and expan-sion of distribution channels. Within the past few years B&O has experienced a considerable in-crease in turnover from their automotive – sound systems for high-end cars – product range. Within the next five years B&Os hopes to see this trend
continue, making B&O the standard sound sys-tem in every luxury car. They plan to achieve this goal through stronger knowledge sharing with the Automotive acoustics teams. Another interesting new initiative is their collaboration with Apple. By making their products complementary with a wide range of Apple products and allowing them to be sold at an affordable price, B&O hopes to target a broad, new segment of Apple enthusiastic con-sumers. Fourth, and perhaps one of the ground pillars in their investment strategy, is to increase their focus on obtaining market share the BRIC countries. In other words, Tue Mantoni and his crew basi-cally relies their prominent growth perspective on the organizations ability to enter the emerg-ing market. And with good reasoning; consumers in the emerging markets are gaining purchase power like nobody’s business. Unfortunately for B&O, other companies have adopted similar “Go growth” strategies and however strong purchase power they have, there are limits to how many people can get their share of the “emerging pie”. On that note, and speaking to their disadvantage, is the fact that Asian consumers generally care very little about interior. To them, what matters is appearance to the outside world, rather than how their house is decorated and people can hardly tell, that you have a B&O screen at home if you are driving around a Kia. The last two pillars concern the organization and their business partners. First, B&O plans on adopting a more streamlined, flat and last but not least, global organization. The aim of this Second-ly, they plan on rethinking their use of technology partners in order to become more innovative and strengthening their bargaining power.There is no doubt that Tue Mantoni is an ambi-tious man. Whether ambition is the enemy of suc-cess remains for us to find out on August 15th 2012.
CEO, Tue Mantoni
StrategyThe MACROPERSPECTIVE
Looking at turnover, B&O primarily serves countries within Europe. Due to recent events within peripheral Eu-rope it is very unlikely that countries within peripheral Europe will gain pur-chase power any time soon; structural
reforms and austerity measures are dampening the economies of the indebted countries and will most likely continue to do so for a while. As for the rest of Europe and Scandinavia, growth has also somewhat sluggish within the past years. Ac-cording to forecasts, growth within these regions will be moderate, at best – depending on, whether a double dip will occur. Among the markets that B&O has activities in, most market growth po-tential is in Asia. Unfortunately, Asian markets account for only 12% of B&Os turnover. In the forthcoming years however, B&O will be putting a lot of effort into convincing the Asian consumers to buy their products.
A substantial part of the future growth is to be
driven by a geographic refocus towards growth
markets
With regards to inflation, B&O faces no substan-tial risk, since inflation forecasts are within the pri-mary markets are moderate. Currently, unemploy-ment rates in B&Os primary market are high from a historical point of view. All else being equal, this will reduce the consumers’ purchase power and confidence. The upside however is that current unemployment forecasts are relatively constant,
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2003/2004 2004/2005 2005/2006 2006/2007 2007/2008 2008/2009 2009/2010 2010/2011
Scandinavia Central Europe Rest of Europe
North America Asia Rest of the world
HISTORICAL TURN OVER (mio. DKK)which leads us to conclude that demand – how-ever low – will remain stable.
In terms of financial risk, most of B&Os liabilities and assets are in euro. Since the DKK is pegged to the euro, the company does not have a hedg-ing strategy. However, their plan to expand their market share in Asia will be a potential risk factor.
As for commodities, metals and petrochemicals are the two primary types of commodities used in consumer electronics. The primary metals are aluminium, tin, copper, zinc and nickel. Within recent years, technology has shifted from alumin-ium towards tin and copper in the electronic chip production. Since tin prices are projected to de-crease while copper will remain roughly constant within the next five years, this is positive for the electronic industry. Out of the primary metals only zinc is projected to increase. Since this is only a minor component in the production of electronic consumer goods, this only has a minor impact. The petrochemicals (plastic) market is character-ized by being very regionalized. Since B&O pro-duces the majority of their components in Czech Republic, we focus on the German market, which represent over a fourth of the plastic market in Eu-rope. Currently, the demand in the plastic market is experiencing an uptrend. As a consequence, plastic imports are very likely to increase within the next couple of years. Most of the import will be from countries in the Middle East – one of the largest suppliers of petrochemicals in the world. In spite of the fact that the petrochemicals supply is good at adapting to changes in demand, the excess demand will inevitably create an upward pressure on the prices.
In sum, from a macroeconomic perspective, the attractiveness of the B&O share relies heavily on their ability to penetrate the Asian market, since Asian consumers have the most purchase power.
ValuationIn order to acknowledge that Bang & Olufsen is an investment case associated with a high level of uncertainty and therefore risk and op-portunities, we have made three scenarios. Our DCF target price of 85 DKK is based upon our three scenarios each assigned a weight accord-ing to the probability of this scenario occurring. Moreover, the WACC is the same in all of the three scenarios. The fundamental drivers are mainly the sales growth and EBIT-margin which in the Bear case scenario equals a 10 year sales CAGR of 7.00% and an average EBIT-margin of 2.82%, whereas the terminal sales value in 2021 reaches 5.54DKKbn and an EBIT-margin of 2.44%. The fundamentals in the Base scenario which we assume is most likely to happen, is a 10 year sales
CAGR of 7.81% and an average EBIT-margin of 7.83%, whereas the terminal sales value equals 5.99DKKbn and an EBIT-margin of 4.97%.We do not believe in Bang & Olufsen’s own ambi-tions of reaching an EBIT-margin of 12.00% in 2016 and sales of 8-10DKKbn. For this reason not even our Bull scenario is as ambitious as Bang & Olufsen’s. The target price in our Bull case scenario is based on the fundamentals of a 10 year sales CAGR of 15.54% and an aver-age EBIT-margin of 9.02%, whereas the terminal sales value equals 11.6DKKbn and an EBIT-mar-gin of 8.09%.Should Bang & Olufsen reach their own ambitions in terms of sales growth and EBIT-margin’s, then there is an upside of at least 200% which equals a share price of 191DKK.
Scenario Target price Weight Contributes PotentialBear 53 30% 16 -18%
Base 91 60% 54 41%
Bull 149 10% 15 131%
Fair value = 85 100% 85 32%
Scenarios:
WACC:The WACC which we have used to discount our projected free cash flows equals 9.4%. Due to ar-tificial low interest rates, we have used a normal-ized interest rate as our risk free rate. Addition-ally, we have used an adjusted beta of 1.1 which has been calculated by Bloomberg whereas the fundamentals are the KAX Index and a 10 year time period. The dark blue cell in the first table shows the WACC which has been used, whereas the latter demonstrates the fair value share price sensitivity analysis that is connected to different perpetuity growth rates and WACC’s. Again, the dark blue cell in the latter table shows our Base case fair value.
- 2,0% 2,5% 3,0% 3,5% 4,0%
7,5% 104 109 116 125 136
8,0% 98 102 108 115 124
8,5% 92 96 101 107 114
9,0% 84 87 91 95 100
9,5% 80 83 86 90 94
10,0% 77 79 82 85 89
9,4% 84 87 91 95 100
9,9% 80 83 86 90 94
10,4% 77 79 82 85 89
Fair value
Perpetuity growth (%)
WAC
C
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The MACROPERSPECTIVE
4,3% 4,8% 5,3% 5,8% 6,3%
0,95 7,8% 8,2% 8,6% 9,1% 9,5%
1,00 8,0% 8,4% 8,9% 9,3% 9,8%
1,05 8,2% 8,6% 9,1% 9,6% 10,1%
1,10 8,4% 8,9% 9,4% 9,9% 10,4%
1,15 8,6% 9,1% 9,6% 10,1% 10,6%
1,20 8,8% 9,3% 9,8% 10,4% 10,9%
1,25 8,9% 9,5% 10,1% 10,6% 11,2%
WACC Sensitivity analysis, ACOD = 3.4% & Riskfree rate = 4.5%
Beta
Market Risk Primium
RelativeValuation
In our valuation of Bang & Olufsen we have chosen not to make a relative valuation since it is based on multiples. This is due to the fact that Bang & Olufsen is estimated to experience low net earnings, EBITDA and EBIT next year. For this reason it does not
make any sense to let our target price be influ-enced by a relative valuation, since the multiples for the abovementioned reason will be too high and not add any value to the valuation. Conversely, we have let our target price be influ-enced by the ROIC – WACC spread. Historically the fluctuations in the share price have followed the development in the ROIC – WACC spread. This trend has however been almost absent in 2010 and 2011 where ROIC has been on an up-ward path from -13.7% in 2009, -2.1% in 2010 to +2.6% in 2011. Keeping this trend in mind also makes us believe that there is an upside in hold-ing this stock. If Bang & Olufsen is able to get back on track with its new strategy and deliver a pre-crisis ROIC like the company did in 2002-2007 (+9.54%, +11.28%, +12%, +15.63%, +14.93%, +15.55%), then the share price should face a strong increase like the share price did in the period 2002 – 2007 (+234%).
Technicalanalysis
First off we will look at some possible resistances and channels based upon the approximate last six months of price development. A possible strong resistance level can be observed at DKK 66-67, this is based upon the upward trends being rejected at this level, with a short burst through the
level in later August. An upward channel that is a positive or “bullish” trend can be observed from around 12th of September until end of the observation period. If the upward channel breaks through the resistance level of DKK 66-67, then the next significant resistance level occurs at around DKK 73. If the positive channel is weaker than the first level of resistance, then the price could go down as far as DKK 55-60, to meet a lover level of support. Next we will take a look into the resistance level to assess how strong our re-sistance level is.
To do so we will use “Moving Av-erage” 200 and 50 day (MA 200d and 50d). From the next chart it can be concluded that the 200d (green line) average lies above our first selected resistance level indi-cates additional prove of this level
of resistance, DKK 66-67. The 50d (red line) in turn then indicates a lower level of
support around DKK 61.
N e x t up is the “Moving Average Convergence-Divergence” (MACD) based upon standard metrics that is 12d (green) and 26d (red). The
12d level can be observed to be at a higher level than the 26d level. If the 12d level goes through the 26d level it indicates a down-ward or “bearish” tendency, which gives a sell signal. Some of the previous signals have been marked for better understand-ing.
Based upon the previous testing of our resistance level it can be concluded that the resistance lev-el is somewhat stronger than the bullish up channel. The simple
tools of MA and MACD that we have applied to our chart gives prove of a possible bear-ish trend of this stock. Though if the bearish up channel do have enough potential, it will
1
2
3
break through and continue to our second level of resistance giving a potential of around 7-8% gain on the stock.For further estimation of trends we will take a short look on the German DAX index, as it is one of significant European stock indexes, with the Fibonacci retracements to reveal support/resist-ance levels.At the time this analysis took place the index was
at a resistance level with possibility of going either bullish or bearish as indicated by the green and red arrows. Though this is not revealing any trends, it is therefore recommended, at this time, to take a policy of “wait-and-see” to let the market reveal its trends.
4
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Upon this analysis it is recommended to employ a buy and exit strategy which says to buy at either DKK 61,50 is the bullish channel is repelled back to 50d MA or buy at DKK 67 if the bullish channel makes a breakthrough. The exit strategy is more simple with a stop (sell) at DKK 54.
Where is the right price?
19/42
BULLISH OR BEARISH?
NExt investment case
By Thomas Frivold
It has not come to that just yet. However, this article is about a revolutionizing new virtual currency called Bitcoin. It is virtual because it only exists on the internet, and does not have any physical tender. Bit-coins is a digital currency, which can be used to transfer money through the Inter-
net - instantly and anonymously, no matter how large or small the transaction, and no matter how far away the recipient is. The bitcoins are trans-ferred instantly from person to person using a free peer-to-peer program called the Bitcoin Wallet. The Bitcoin network does not have a central bank-ing authority, no governing institution or clearing house and it is not regulated by any government in any country. In fact no country is able to control the market for Bitcoins nor interfere with its users, perhaps with the exception of a certain invisible hand. There are numerous advocacy groups like Britcoin.co.uk, which facilitates the buying and selling of Bitcoins and works in the political and financial sphere to increase awareness and think-ing around Bitcoins.
Bitcoins solves the need to transfer money from one place to another inexpensively and anony-mously. It is equally as fast with regards to send-ing and receiving money whether the transfer is for the coffee shop on the corner, to a friend in New Zealand or a webhost in Iceland. Bitcoins is already accepted by a growing number of busi-nesses all over the world, ranging from currency exchanges, giftshops, restaurants, programmers and webhosts. There are also advocacy groups working with SWIFT to integrate Bitcoin into its network. Apart from sending and receiving mon-ey, the virtual currency can be converted to real currency at any of the Bitcoin exchanges. The Bit-coin virtual currency was postulated in a cryptog-raphy paper in 2008 by Satoshi Nakamoto, and saw its initial launch in January 2009.
In order to make use of Bitcoins in the real world, you must install a free program to your computer, which then lets you obtain a Bitcoin address for free. With this address the user can send and re-ceive Bitcoins. Hereafter you can buy Bitcoins at one of the numerous Bitcoin exchanges that have emerged. A Bitcoin exchange is a company that buys and sells Bitcoins much like a regular cur-rency dealer and charges a small brokerage fee to cover the transaction costs. These exchanges effectively increase the liquidity to the system. The MtGox.com exchange currently handles 80% of the trade volume in Bitcoins. A few other ex-changes are Bitcoin7.com, Tradehill.com.
An invention that could revolutionize finance as the InteRnet did to publishing
The power of Bitcoins is that they can free people from the tyranny of middlemen: banks; credit-card compa-nies; and money shippers like Western Union, which charge exorbitant fees for performing a rather simple
task.
(Amir Taaki of U.K. based Brit-coin in Newsweek)
In order to receive Bitcoins from someone, you simply have to supply a friend or business partner with your Bitcoin address, and then he or she can send money almost instantly. A tiny fraction of the amount is given away to nodes in the Bitcoin-net-work that help complete the transaction, typically 0.1% of the full amount.
How does the underlying fundamentals make the system work?The peer-to-peer network itself is a completely anonymous network that anyone can make use of, and get a Bitcoin address for free. In order to send and receive Bitcoins, the user gets a free Bitcoin address that’s provided by the Bitcoin wal-let application. When a user sends money to the receiver, the Bitcoin Wallet application sends out anonymous requests to the decentralized peer-to-peer net-work. The network itself is constituted by millions of users worldwide running the Bitcoin applica-tion in “number crunching”-mode. When crunch-ing, they accept to use their computer’s capac-ity to verify other people’s payments and they then receive the allotted transaction cost given by the sender. This is how the network achieves effectiveness, and manages to operate without a central clearing house. Every computer in the net-work running the application in crunching mode acts as a micro-clearing house.
Technically the Bitcoin address is based on pub-lic-key cryptography. The address contains no personal information, and is thereby anonymous. Furthermore, all transactions are public and stored in a distributed database that is used to confirm transactions and prevent double-spend-ing. Unlike conventional fiat currency, Bitcoin has no centralized issuing authority.
“People in the third world are at the mercy of corrupt governments and banks,” says Amir Taaki, co-founder of Bitcoin Consultancy.
Bitcoin can drastically reduce overheads and fight corruption. At present, it’s possible to pay up to 23% commission on an interna-tional funds transfer. That’s not capitalism, that’s a cor-
ruption of capitalism.(Amir Taaki)
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SCREENSHOT
Critisicm and challengesAs with every groundbreaking novel idea, there is a plethora of detractors, naysayers and critics.
According to Economist Paul Krugman “The dol-lar value of that cyber-currency has fluctuated sharply, but overall it has soared. So buying into Bitcoin has, at least so far, been a good invest-ment. But does that make the experiment a suc-cess? Um, no. What we want from a monetary system isn’t to make people holding money rich; we want it to facilitate transactions and make the economy as a whole rich. And that’s not at all what is happening in Bitcoin.And because of that, there has been an incentive to hoard the virtual currency rather than spend-ing it.”
In reply to that, critic Amir Taaki says in an online interview on Slashdot, Bitcoin’s intrinsic values lies in the fact that it has unique properties such as:
DecentralizedNo bank holidaysInternationalNo concept of bordersDivisibleNew privacy modelPrivate identity yet transparentSecureFast Transactions
The Bitcoin is currently trading at 4.845USD per Bitcoin. It has been relatively stable through September 2011. In early June, however, the Bitcoins had appreciated to, and were trading at, a whopping 30USD per Bitcoin. At that point in time there were many very happy millionaires around the world. Then, when the Bitcoin price peaked, the world’s largest Bitcoin exchange Mt.Gox which handles approximately 80% of all Bitcoin currency exchanges, was broken into. The rougue computer hackers stole a huge amount of Bitcoins from users that had deposited their hold-ings with Mt.Gox. The market reaction to this was panicking and most Bitcoin holders sold their as-sets as quickly as possible. The Bitcoin project saw a huge distrust in the aftermath of this, even though it wasn’t actually a Bitcoin problem. Fin-gers were pointing at Mt.Gox who was not taking comprehensive measures to secure their online servers.
The price of a bitcoiN
Market price USD-BitCoins
Bitcoins subsequently ended up fluctuating around 5USD per bitcoin in a fairly stable manner. This led to a sharp decline in investors confidence and perceived stability of the Bitcoins. Markets eventually stabilized and the price has remained stable, fluctuating around 5USD per Bitcoin.
Breakin and subsequent flash crash of the marketBitcoins subsequently ended up fluctuating around 5USD per bitcoin in a fairly stable manner. This led to a sharp decline in investors confidence and perceived stability of the Bitcoins. Markets eventually stabilized and the price has remained stable, fluctuating around 5USD per Bitcoin.
SNAPSHOTat the time of the crash (Bitcoinmonitor.com)
Liquidity and supplyThere is a limited controlled expansion of the mon-etary base hardcoded in the Bitcoin software. The supply of Bitcoins is finite, and is programmed to be slowly approaching the 21 million, in contrast to fiat currency which has an infinite supply.
At the time of writing, the number of Bitcoins in circulation is 7.44 million. The coders of the Bit-coin project have designed it so that coins also can have 8 decimals. When the supply of Bitcoins reaches 21 million, prices will then naturally regu-
late themselves, as the market begins making use of the 8 decimal points available. This will damp-en the effect of deflation as the supply of Bitcoins has reached its maximum.
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How is the entrepreneur going to recruit employees
if they are bound by the same NCCs in other firms?
capital in the business, and the entrepreneur has not, the VC stands to lose their investment if the business fails. The entrepreneur however, faces no such risk. NCCs are therefore an effective way to switch the bargaining power back to the state it was before the VC´s investment.
The reason why, is that it makes the entrepreneur invest in the business in the way that he loses the ability to start a competing company, should the business fail. Therefore, one might argue that without the possibility of enforcing NCCs, there would be a lot less risk seeking capital available for entrepreneurs.
The term “strategic use of NCCs” applies mostly for VC firms and not for entrepreneurs. They need to negotiate so that the implications of their NCCs become as small as possible. Hence, it may exist a possible trade-off for entrepreneurs between re-ceiving risk-seeking capital from a VC and agree-ing to NCCs. A trade-off is a situation where you lose or have to accept something in order to gain something else.
Entrepreneurs face a problem caused by the stra-tegic use of NCCs by VCs. An entrepreneur might decide to break the NCCs in his contract with the VC and start a new business. How is the entrepre-neur going to recruit employees if they are bound by the same NCCs in other firms? The entrepre-neur must also face the fact that even though the start-up would not directly compete with the pre-vious firm the VC invested in, the VC might choose
Non-compete covenants should not be unfamiliar to most of us. In fact, have you ever had a job, the chances are you already have agreed to one by signing your job contract. Non-compete cov-enants come in several different forms regarding their width, the implications of breaking them, the type of knowledge they are designed to protect and what type of entrepreneurs they count for.
Only 1% of the investment ideas pitched to VCs receive funding. This is a staggering number to any entrepreneur hoping to attract funding to his newborn business. Nevertheless, being a part of this 1% elite community is in itself a great step on the road to creating a successful business. But if you are lucky enough to attract funding, do not make the mistake thinking that you are up for a free lunch.
Non-compete covenants, or “NCCs”, are heavily used by venture capitalists. A NCC is an agree-ment that limits the entrepreneur’s possibility of leaving the start-up, or to start a competing firm in a fixed period of time. The purpose of applying NCCs in contracts is ultimately to protect the capi-tal invested in a new venture. In a practical sense, the purpose is to avoid the possibility of a hold-up.
A hold-up is a situation where two parties who would otherwise benefit from cooperating see their bargaining power shifting. If an entrepre-neur receives investments from a VC without the VC using NCCs, the entrepreneur increases his bargaining power substantially. The source of the entrepreneurs new found bargaining power is the VC´s investment. Since the VC has invested
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Only 1% of the in-vestment ideas
pitched to VCs re-ceive funding
As entrepreneurs across Europe strug-gle to attract VC funds amid the on-going crisis, another shadow is hiding in the dark; Non-compete covenants. For the entrepreneurs lucky enough to attract VC funding, this major deal breaker for Venture Capitalists can prove to be critical.
By: Stian André Kvig
to test the enforcement of the NCC by taking legal action against the entrepreneur. The purpose of this is to scare other potential employees from leaving the firm and joining the start-up or create competing companies.
Entrepreneurs need to carefully assess the conse-quences of NCCs in their contracts. The offer from a Venture Capitalist might seem tempting and the funding can be critically needed, but the alterna-tive cost can be high when looking at the long-term effects of the NCCs. Entrepreneurs seeking capital need to balance the previous mentioned trade-off in the most favourable way. Ultimately, entrepreneurs need to consider the risk/reward ratio of receiving VC funding.
Venture CapitalFact Box
- Only 1 of 100 start-ups receive VC fund-ing.- 90% of jobs created from VC backed firms come after they og public.- From 1990-2000, only 50% of VC backed firms managed to go public.
Non-compete covenants:
The weapon of choicefor venture capitalists
Handling NCCs from the Entrepreneurs point of view
By Stian André Kvig
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The typical ETF is a pooled investment fund which tracks an underlying index, either a stock index like S&P 500, or a commodity index like the Goldman Sachs Commodity Index (GSCI). Thus, rather than being exposed to just one asset, you are exposed to a broad asset class, which means that you can diversify your portfolio using just one instrument instead of constructing your own port-folio. Moreover, a substantial number of manage-ment fees are saved, since you only have to buy one asset. Finally, ETFs trade at much smaller number of management fees than other invest-ment vehicles with similar characteristics, such as conventional mutual funds, since they are pas-sively managed. ETFs are publically traded on an exchange, much like any other stock. Therefore, ETFs can be traded during the day. Another great quality in ETFs, is that some ETFs track indices in foreign markets. Consequently, they allow private, as well as institutional, investors to invest in markets that are otherwise closed for outside investors. These are the plentiful advantages – now, what is the downside? Why are exchange-traded funds subject to so much critique in the media? And why are they a great concern to the regulators? Before examining these questions in further de-tail, it is important to understand how the ETF works and how the ETF-market has evolved dur-ing the past two decades.
ETFs the good ol’ fashion way
ETFs can be either physical or synthetic, depend-ing on whether they actually hold the (majority of the) assets in the benchmark index or the pay-off structure is mimicked using derivatives. The most common of the two, is the physical ETF, which is rebalanced every day in accordance to the un-derlying index. The transaction process of a physical ETF is the following: In the primary market, the ETF market maker or broker acquires ETFs through the ETF manager, who issues the ETFs in large blocks, called creation units in exchange for securities. Alternatively, authorized, institutional investors can buy or sell ETFs directly from or to the ETF
manager in exchange for securities. In the sec-ondary market the ETF market maker or broker can buy the ETFs using cash on an exchange. The investor – being either private or institutional – pays cash to the ETF market marker or broker and receives ETFs in return. It is important to note that two points regarding the transaction. First, creation and redemption is done in large blocks rather than in single shares. If an investor wants to sell his ETFs this can be done through the sec-ondary market or by selling creation units back to the ETF manager in exchange for securities. Second, regardless of whether the transaction is carried out through the ETF broker or directly between the investor and the ETF manager, the ETF manager never receives cash. The implica-tion of this is a considerable tax advantage since because securities are traded for securities - there are no tax implications. This is much dif-ferent from the typical mutual fund where single shares can be sold back to the mutual fund in exchange for cash. The Net-Asset-Value (NAV) is calculated based on the open day weights and the end-day market prices. Since the ETF is traded throughout the day, the trading prices may differ from the NAV; when investor demand for a given ETF is high, its price will increase over NAV due to general demand and supply rules, and conse-quently result in mispricing. An arbitrageur will see this opportunity and buy creation units from the ETF managers, in exchange for the underly-ing assets in the ETF. By selling the newly ac-quired ETFs in the open market, the arbitrageur has hereby gained a profit. Similarly, when the ETF is underpriced, the arbitrageur will redeem ETF blocks from the ETF manager in exchange for - relatively - highly priced assets. Alternatively, mispricing can be due to asymmetric information among the ETF managers, who issues the ETFs, and the market participants. Under this hypoth-esis mispricing occurs if the ETF managers fail to correctly inform about the assets in the ETF and their respective weight – even though he is legally committed to do so. For example, if the price of a stock increases, the investors will increase their demand for an ETF in accordance with their belief about the given stock’s weight in the ETF. If their
perception was not correct the ETF will become overpriced relative to the NAV.
The new kids on the block
Up until now ETFs seems rather harmless, but a lot has happened since ETFs were introduced to the open market back in the late 1980s. The most exotic innovation is the synthetic ETF which – op-posed to the “classic”, physical ETF – mimics the pay-off structure of the underlying index through derivatives rather than the actual underlying as-sets. This is especially attractive for the ETF man-ager, when access to the market in which the assets in the underlying index exists is limited. Synthetic ETFs are not regulated under the In-vestment Company act of 1940, which limits the use of derivatives and prohibits affiliated transac-tions (e.g. a bank can’t serve as both sponsor and swap counterparty). The advantage of synthetic ETFs is that they do a better work of tracking the underlying index. The primary concern regarding however, is their lack of transparency and their massive exposure to counterparty risk. In order to realize the last issue it is important to understand how synthetic ETFs work. When a transaction is carried out, the ETF manager receives cash from the investors. These cash are exchanged to some basket of collateral, which is handed over to the swap counterparty – typically the same banking group – which offers the return of a given index, say the S&P 500, in return. The counterparty risk lies in the risk of the bank going bust and thereby not being able to meets its obligation to pay the return of the S&P 500 to the ETF manager. More-over, the collateral does typically not contain the same securities as the underlying index. Thus, if the securities drop in value, while the index goes up, the swap counterparty will have a hard time paying its obligations. The other innovation within the synthetic ETFs deals with the pay-off structure. The first is the leveraged ETF. The return of a leveraged ETFs equals the daily return on the underlying times your leverage ratio. So how is that any different from the typical, geared investment? Well, when gearing an investment you provide capital and gear your investment with some ratio when en
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tering the position. Eventual gains and losses will thereby be multiplied in accordance with your chosen gearing, and that is basically it! When entering a leveraged ETF position however, the position has to be rebalanced on a daily basis in order to meet the requirement of paying the daily return on the underlying at a given ratio. For example, you choose to buy $100 worth of ETFs and leverage your position in the proportion 2 to 1. Thus, your total exposure is $200. If the under-lying index increases 10%, you will have gained not only $10, but 20$ since you have invested in a leveraged ETF. Thus, you have earned a profit of 20% and your total asset holding is now $120. What happens next is that the position is rebal-anced in accordance with your gearing in and another $20 is borrowed. Your total exposure to the given ETF is now $240, out of which you have borrowed $120. If the market falls 10% the follow-ing day, your loss will be $24 and your exposure down to $216. If you choose to close your position you would have to pay back $120, leaving you with $96 and a total loss of $4, corresponding to 4% of your investment. Had you alternatively cho-sen to buy an ETF and gear your investment with the same ratio, you would have gained $20 the first day, leaving you with assets worth of $220. The next day, the value of your position would decrease by $22 and your total loss after closing the position and paying back the lenders, would be $2 or 2%. That is, only half the loss had you
invested in a leveraged ETF. This difference in re-turn is a result of the rebalancing mechanism in the pay-off structure of the ETF. So what is the purpose of a leveraged ETF? Well, take a situation, where you are gearing is 2x and the underlying index increases 10% for two con-secutive days. With an investment of $100, your profit on the first day will be 20%, where after your position is rebalanced and the total exposure is $240. After the second day, you will have gained another $24, leaving you with a total profit of 44% once you have paid back lenders. For compari-son, you would have earned 21% or 42%, had you chosen to invest in an ETF with no or 2x gear-ing, respectively. Once again, the difference in pay-off is due to the rebalancing mechanism in the leveraged ETF. Since the ETF manager has to meet his obligation of paying the return of an index at a given ratio, he has to re-lever his invest-ment every day. Another advantage of the rebal-ancing mechanism is that your position is gradu-ally reduced when the market is experiencing a downturn for several (consecutive!) days – see figure 2. This limits your losses, as you are gradu-ally pulling your-self out of the position. Lets assume that you chose to exploit momentum and keep your position for one more day. On the third day however, the market falls 10%. Since your ETF was rebalanced on the day before, your exposure was $288 and your loss $28.8. The total return would be 15.2% on the third day, whereas
the buying an ETF and gearing it yourself or leav-ing it unlevered would have given you 18% or 9%, respectively. Know the expression “the higher you climb the further you fall”? Well, that basically de-scribes how leveraged ETFs works.What can we learn from these three examples? It is all great when the market goes up, but if the market fluctuates even just a little on a daily basis (which anyone, who happens to come across the business section of the newspaper, would know that it does), you will have to be a little smarter than the average investor to outsmart the market using leveraged ETFs. Moreover, the higher lever-age and the greater volatility – the greater downfall you can expect (as illustrated in figure 3). This is why many experts advise investors not to keep leveraged ETF’s for more than a day. Second is the inverse ETF. As the name implies, the inverse ETFs pays off the inverse of the under-lying index. By acquiring an inverse ETF you are thereby betting against the market, which seems somewhat harmless. Third, and inevitably, is the leveraged inverse ETF. As ETFs are becoming more popular, even more exotic ETFs arrives at the stage. Both return and risk properties differs substantially from the clas-sical ETF structure and the added complexity of the new ETFs rise the regulatory concerns even further.
Critiques
The first critique points is inevitably be their lack of ability to track their underlying index. The cri-tique is easy an easy bought argument against ETFs from all the nay-sayers who do not believe in financial innovation. However, since the main purpose of the ETFs is to track their underlying index this is of course important to address. Sec-ond, ETFs have been accused of being mispriced according to their Net-Asset-Value (NAV). As mentioned earlier ETFs are traded throughout the day even though they are only rebalanced once a day. Demand or supply pressures can therefore cause the price to differ from its NAV. The third critique point states that ETFs are more risky than the underlying risk. This critique is somewhat vague and even harder to address, since various risk measures can tell different sto-ries at different points in time. Nevertheless, the issue is important to address, in order to ensure that the ETFs are not consistently more risky and thereby adding risk to the overall market. Fourth is their lack of transparency in the pay-off structure. This critique primarily concerns the leveraged ETF, where – as we saw earlier – you have to be significantly smarter than the aver-age investor in order to understand what you are investing in and even smarter to actually gain a profit from it. Lastly, ETFs have been accused for their lack of transparency in terms of composition and be-coming a shadow banking system. The two last critique points primarily concern the synthetic ETF. However important to realize these issues, it is nevertheless important to keep in mind that synthetic ETFs only account for 13% of the cur-rent ETF market. Whether ETFs are the next bubble or increasing the systemic in the market is to soon to tell. Ex-perts seem anxious draw parallels to CDOs in the subprime mortgage crisis. However important it is to learn from your mistakes it is also important to note that you cannot extrapolate historic trends nor into the future. In the next article of Finance-Lab Magazine we will attempt to shed light over the issues by addressing some of the main cri-tique points.
(…. to be continued)
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A fundamental approach
Traditional financial theory prescribes the construction of indices for the purpose of tracking markets. Generally, traditional stock market indi-ces are constructed by using some form of inclusion crite-ria (e.g. turnover) and then weighting the individual stocks
in relation to their traded value and their market capitalization. This article will exhibit why this method is flawed and demonstrate how Kirstein constructs fundamental style indices.
The need for an index tracking the market is cru-cial in modern financial theory. Based on the ef-ficient market hypothesis, formulated by Eugene Fama, the traditional way of constructing indices has been by using market capitalization weighted indices. The efficient market hypothesis states that prices should reflect all information in the market, and as such, prices should be a good measurement of intrinsic value.
to constructing
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MSCI World Growth compared to MSCI World MSCI World Value compared to MSCI WorldRussell 1000 Value compared to Russell 1000 Russell 1000 Growth compared to Russell 1000
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There are several strengths to traditional market capitalization weighted indices. First of all, it is quite simple to identify the relevant companies, and thus possible to construct the index. As mar-ket capitalization is used to measure the individual weights, it is straightforward to calculate individu-al weights, as both the number of shares and the individual market price are known. This in turn, makes it unnecessary to rebalance the index, as this happens automatically when prices move. Thus, the administrative part can be reduced to inclusion or exclusion of companies. This is usu-ally completed on an annual or biannual basis.
However, as the weights in the indices are de-fined by the market capitalization of the individual companies, the relative weights are highly cycli-cal. Neglecting price errors in the market would be incorrect, though, and when these occur the traditional market capitalization framework breaks down. When the economy is expanding, compa-nies that are growing rapidly, or sectors that expe-rience bubbles, will typically be overvalued with
regards to their intrinsic value. This again means that they will have an overweight in the indices. As the economy experience a contraction, these companies will typically be underweighted, there-by making market capitalization a poor proxy for intrinsic value.
Because of the biased composition of the mar-ket capitalization weighted indices, any attempt to classify value or growth within companies to create a value weighted and growth-weighted index separately, will have several weaknesses. Traditionally indices have been constructed with an equal weight of companies with respectively value or growth traits. The biased market capital-ized 50/50 approach is visually seen in the graph below, where the excess return of the value index exactly offsets the excess turn of the growth index. Aggregated the value and growth indices equal each other out. The MSCI World index and Rus-sell US 1000 index are used as example.
Kirstein Index
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style indicesBy Casper Hammerich
As the market capitalized method, used by MSCI, Russell, S&P et al., produces flawed indices, in-vestors have to rethink the basis for index com-position. One obvious approach is to gather a number of company specific fundamentals as proxy for each investment style and the company intrinsic value. This way of constructing market indices has been proposed by Arnott, Hsu and Moore (2005). As traditional indices have a ten-dency to overweight growth companies in a busi-ness cycle expansion and vice versa, they theo-rized that the fundamental approach would be a better way to construct a tracking portfolio.
Our suggestion is based on this approach. A fun-damental value and growth index, respectively, can be produced by screening the MSCI World, which contains more than 3,000 companies. The focus will be on the large cap segment, however, the approach can be used analogically on mid-cap, small-cap, micro-cap and so forth. This ap-proach is named the Kirstein IndeX (KIX).
The first step would be to identify candidates that exhibit either deep value or growth characteris-tic. It has to be noted, that the fundamentals are chosen somewhat arbitrarily and we acknowledge that more indicative ones may exist. Nevertheless, screening for value- and growth factors allows you to compose an index that corrects the biased market capitalization weighted indices.
The chosen fundamentals for producing the value index are among others quick ratio, book to price, inverse leverage and dividend yield. High quick ratio demonstrates a superior ability to meet its short term obligations with current assets less inventories. High book to price demonstrates a book value substantially higher than its market value i.e. the market share is potentially under-valued, which results in a premium in the market. High inverse leverage demonstrates a high liquid-ity since the equity of the debt exceeds the value of its debt, meaning that the value creation in the company has not been produced by taking on leverage. A high dividend yield demonstrates a solid and healthy business that is capable of burning its money, so to speak. The higher the dividend yield, the more dividends are paid per share.Altogether these fundamental together produc-es a list of companies that exhibit strong value bias.
The chosen fundamentals for producing the growth index are among others return on equity, price to earnings, price to book and a five year earnings per share growth. High return on eq-uity shows that company generates a high net income as a percentage of the equity. Creating a high return on equity show that the company
is able to grow its core business. High price to book demonstrates a market value substantially higher than its book value i.e. the market share is potentially overvalued resulting in a growth pre-mium in the market. High price to earnings dem-onstrates a market value substantially higher than its earnings per share i.e. the market expects a high growth in earnings per share. High growth in the five year earnings per share demonstrates strong growth expectations to growth in earnings based on the prior five years’ earnings. These fundamental produces a list of companies that exhibit growth bias.
Each fundamental is evaluated separately, due to potential errors in estimates from DATAST-REAM or errors due to corporate actions in the listed companies. Therefore, outliers are removed within a traditional 95% confidence interval. How-ever, a variance in each fundamental might still exist and calculating a t-stat, we detect whether the variation effect is significant. Next, each fun-damental is standardized in order to construct a single style variable. Thereafter a distance measure is incorporated to ensure that only the most pure style biased com-panies are included in the three indices growth, value and core – calculated as a residual. The higher the distance measure, the more compa-nies are included in the final style index. The lower the distance, the more value, growth or core concentrated the index gets. This is the way the KIX index is constructed and with a distance not greater than 0.5 we have constructed an unbi-ased fundamental style index.
Performance supports the prior statements, that KIX superiorly outperforms the market capitalized MSCI World Value index. On a 10-year basis the KIX World Value index produces almost 5 per cent alpha while only taking a slightly higher risk. This results in a much higher risk adjusted return and
Strategy: KIX World ValueBenchmark: MSCI World ValueRisk free rate: 3-mth CIBOR
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1 - 3 Jul-08 Jun-11 7.07% 3.30% 20.56% 17.00% 0.22 0.05 5.48% 0.67 0.97 3.63%1 - 5 Jul-06 Jun-11 -0.11% -1.65% 18.55% 15.98% -0.01 -0.01 4.47% 0.35 0.98 2.00%1 - 7 Jul-04 Jun-11 4.24% 2.38% 16.35% 14.29% 0.08 0.00 3.87% 0.47 0.98 1.91%1 - 10 Jul-01 Jun-11 2.76% -1.53% 17.19% 15.96% 0.00 -0.01 4.08% 1.07 0.97 4.37%
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KIX World Value compared to MSCI World Value KIX World Growth compared to MSCI World GrowthMSCI World
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information ratio greater than one. The alpha is produced under a high correlation of 0.97 to the MSCI World Value index.
Visually, the performance that is illustrated in the following graph also supports the aforementioned statements.
Both the KIX World Value index and the KIX World Growth index outperform their respective bench-mark indices with 15 to 80 percentage points re-spectively.
So what can we learn from this? There are several conclusions. however, the key point must be that one cannot solely expect to outperform actively managed mutual funds just by tracking the mar-ket capitalized index. Investors wishing to adopt a style-based investment philosophy will neglect these findings at their own peril. Investing in a style biased market capitalization weighted index will not produce sufficient alpha compared to the fundamental indices. Thus, the investor will not exploit the true potential of his investment.
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Over the years, I have generally operated with a high trading frequency in my investment activi-ties. Having executed more than 125.000 trades over the past 10 years, the commissions and fees per share add up to more than DKK 15 million. Surely, this is a somewhat depressing fact. None-theless, it is a fact that makes sense to me; a fact that I am willing to accept.
The reason why lies within the way I interpret the cost associated with executing the trade. Many investors and traders focus slightly too much on trading commission. Even though low commis-sions are important, this focus tends to blur the bigger picture. The cost of executing trades needs to be observed in context rather than be viewed as something, which needs merely to be mini-mized as advocated by some participants in the debate. Most people tend to associate increased trading frequency with increased risk. For myself, ironically, the opposite is – and always has been – valid, as the relatively small ”investment” repre-sented by the trading commission in more than one way possesses a potentially great value.
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IIn this line of thought, I choose to list here the returns I have achieved (after fees and commis-sions) on my trading activity as well as the accord-ing number of trades executed since year 2000. These observations may be viewed as examples, which serve to signify that high frequency in trad-ing activities do not necessarily erode the poten-tial for solid returns (see box on the next page).
A common cliché in the debate about trading commissions is the following ”Before you make money trading stocks you’ll have to earn back your trading costs. Therefore, you should not pursue active trading, as this will simply increase your trading costs”. I have always found this cli-ché somewhat imprudent. A key to ”the truth” about trading costs is rather to isolate the particu-lar incurred cost, boxing it with ”the mission” of the particular trade. In other words, to analyze the mere function of executing the particular trade in context of the overall investment strategy.
Most strategies qualify to interpreting trading costs as an investment rather than merely a cost. This also accounts for strategies, which are not focused on mere short-term profit. And surely, the commissions do indeed represent a direct cost. However, there are other aspects to it, which is why the interpretation of the trading cost ought to be altered by most actors.
The important thing to understand when trading stocks is that the key to long-term success is the ability to fend of losses. To a certain extent, in-come from successful trades is actually second-ary. To live by the principles of a formulated stop loss strategy is the key to achieving this essential step. Observed in this central context, the cost as-
sociated with executing the trade represents an investment in the safety of the trading activity.
A successful trader needs the ability to readily ad-just and adapt. This ability in itself ensures safety of the investment, since activity within highly vola-tile markets in particular requires execution on stop loss strategy. Without this strategy, the risk is simply too great. High volatility represents op-portunity and is great for trading setups. However, it needs to be aligned with a tight “safety policy”, hence the execution of a particular order repre-sents a certain function; this one labeled “safety”. As such, quick adaptation is not simply about spotting opportunities. In this specific context, it widely concerns the concrete way, through which safety in trading is achieved. This is where the tiny “investment” in a trading commission represents the “access” to executing on stop loss strategy.
To “invest” in a simple, low priced commission aligns with my view on commissions; it is the low cost, which represents a cheap and easily acces-sible right to enter a position and catch a move in the right direction. At the same time, it represents the effective and easily accessible exit from a po-sition; consequently, it serves as the safe-guard against losses and simultaneously represents the possibility for executing on essential stop loss
“the interpretation of the trading cost ought to be altered by most
actors”
“the activity which was formerly ob-
served as particu-larly risky becomes activity relieved of
greater risk”
- and how do you increase safety in trading activity?
A word from a trader
Trading commiSsions: A cost or an investment?By Flemming Kozok
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tradinG returns
Stock trading, full-time job (January 2000 – June 2006): - 2000 a return of 12.800% based on 25.019 trades. - 2001 a return of 114% based on 20.241 trades. - 2002 a return of 84% based on 10.285 trades. - 2003 a return of 274% based on 11.856 trades. - 2004 a return of 141% based on 8.687 trades. - 2005 a return of 118% based on 7.828 trades. - January – June 2006: a return of 115% based on 8.494 trades.
Stock trading, part time (July 2006 – June 2011; combined with other work & M.Sc. @ CBS): - July – December 2006 a return of 28,17% based on 2.858 trades. - 2007 a return of 43.8% based on 6.277 trades. - 2008 a return of 52.7% based on 4.530 trades. - 2009 a return of 159.9% based on 4.507 trades. - 2010 a return of 44.3% based on 3.208 trades. - January – June 2011 a return of 68.4% based on 5.330 trades.
strategy. By altering the view towards this interpre-tation, one may actually step up trading frequency rather than focus on minimizing commissions – it simply needs the right strategy and execution (which is a topic not covered in this article).
To sum up, the single most important “tool” for practicing safety in my own trading activity over the years has been via an increased frequency in trading. I like to call it protective trading. To me, executing strategy via the protective trading line of thought resembles a mindset; something which is deeply anchored and incorporated in all activity undertaken in the market place. In this line of thought the cost of executing the trade in-deed represents an investment – a very small one, which possesses a potentially great value.
The association between increased trading fre-quency and increased safety is something which most do not observe as a possibility, hence do not execute on. But when executed the right way things are turned slightly upside down, and ac-tivity formerly observed as particularly risky (e.g. day trading) may well become activity relieved of greater risk.
… The reason for this is simple: The interpretation of the cost associated with executing the particu-lar trade is modified to representing an investment in safety & possibility rather than merely a cost.
“the key to long-term success is the ability to
fend of losses”
about flemminG kozok
.. Holds an M.Sc. degree from CBS.
.. Managed to turn DKK 32.500 into DKK 16 million over a 7 year period (2000 – 2006). .. Has executed more than 125.000 trades on primarily the US stock ex changes... Has paid more than DKK 15 million in fees and commissions... Has never fundamentally altered his trading strategy (since year 2000)... Has worked full-time trading stocks from January 2000 – June 2006. .. Has worked part time trading stocks from July 2006 – 2011. .. Still trades, but mostly focuses on “occasional extraordinary setups”.
.. Biggest winning streak: DKK 6,4 million in 4 months
.. Biggest losing streak: DKK 4,3 million in 5 weeks.
.. Biggest daily win: DKK 620.000... Biggest daily loss: DKK 540.000.
Flemming Kozok, Danish Day Trader
As investors all over the world fight for their portfo-lio returns, FinanceLab hosted Investment Camp 2011.
The aim of the event was to cover aspects in the current market environment from an investor’s point of view. The camp also proved to be a great place to network due to the large amount of par-ticipants and the impressive line-up of speakers.
The event was held at CSE lounge at CBS where one could feel the ambitious atmosphere from the very start. The FinanceLab committee greeted everyone. A scene was set up where presenters from Denmark and the UK were to attend. In oth-er words, FinanceLab had it all covered.
Jesper Kirstein, CEO of Kirstein Finans kicked off this event with his presentation on the char-acteristics of successful managers. With a well-respected client base such as BlackRock, Carne-gie, Fidelity, J.P. Morgan and Schroder, he should know what he is talking about. In his opinion good managers have both quantitative and qualitative skills, and it is essential to combine these in order to perform well. According to Jesper it is essen-tial to have a strong drive and managers should constantly develop, while still staying true to their strategy, so that they cannot only be identified by historical empirical data.
So how does Kirstein pick the right manager? They focus on some key elements, such as a solid organizational culture, people willing to go that extra mile, efficient interaction within the organi-zation, and a clear business philosophy. In these turbulent times the successful companies are the ones who have a clear understanding of their own performance. I.e. identifies risk and approaches success with modesty. The characteristics of suc-cessful managers can be summarized in terms of 5 P’s, namely: Portfolio dynamics, performance, people, philosophy and process.
The next in line was the talented Equity Strate-gist from Saxo Bank, Peter Garnry. He is proof that ambition and drive could take you a long way. After studying for a MSc. at CBS he dropped out and started his own business. It was a company similar to Bloomberg, which after a few years took other turns. He then turned to other career op-tions and ended up at Saxo Bank. Peter is steadily thriving within Saxo Bank where he even has rep-resented the bank live at CNBC TV. Peter is un-dertaking the CFA exam, which he would strongly recommend due to the strong global recognition, career advantage and the practical skills gained. His presentation further entailed for example questioning if it is the end of the euro zone and if QE3 would just be “more drugs to the drug ad-dict”.
After these two speakers the participants were offered delicious sandwiches and were given the chance of mingling. One could see that the two initial speakers had already accelerated the par-ticipants’ analytical reflections where everyone debated actively about the presentations.
DID YOU MISS INVESMENT CAMP 2011? Here is a briefing
After the break it was Rasmus Viggers’, Portfolio Manager at Secure Capital time to shine. He is also a living example of an agile young mind with the willingness to succeed. Rasmus advocated that although he had no relevant job experience, no student job and quote “a very boring CV” he still managed to secure a job. First of all, at the age of 24 he has had seven years of experience with “full-time” investments and he was extremely targeted upon applying for jobs.What he did was to not apply with the standard CV / cover letter method, but by pitching investment opportunities when applying for various jobs. This worked out well as he landed a job as a portfolio manager.
After Rasmus’ presentation it was time for the presenter from J.P. Morgan to enter the scene. Sami Jauhianinen, Associate at J.P. Morgan talked about how to evaluate financial effects of M&A. Some examples mentioned were regard-ing to what equity markets react favourably. The answer to this was low premium, private nego-tiation, enhanced EPS growth, no change in risk, familiarity with target, product complementarily and experienced buyers. On the contrary non-favourable scenarios in the eyes of the equity markets are long-term dilution, major increase in leverage, no synergies, poor track record and un-clear management structure. Sami further argued that the earnings per share impact are the tra-ditional financial check for M&A deals. However,
it is potentially misleading in equity deals and is even worse in debt-financed acquisitions.
According to Sami in stock deals it is assumed that earnings of the target get re-rated to the mul-tiplier of acquirer. This assumes growth and risk of target instantaneously change to those of the ac-quirer. On the contrast in debt-financed deals, the implication is that the target only has to earn after-tax interest cost of purchase price to break-even on EPS basis. This then misleads the acquirer into paying a too high price.
Other key financials issues in M&A are for exam-ple: Does a deal create shareholder value? Will acquirer’s stock price go up? So if a deal creates value for the acquirer, price including premium is less than value of the target (including syner-gies). Hence the acquirer’s share price will rise. However, if the deal destroys value for acquirer, price is greater than value of target synergies and acquirer’s share price will fall. This, according to Sami, was where ValueMath comes into play and calculates share price impact for acquirer (and target). The case is according to him that most advisors, investors and companies prioritise EPS, but inappropriately, while equity market uses val-ue framework. Therefore one does not need EPS to determine value impact of deals.Sami summarized his presentation by stating that M&A deals are too much about transfer of value-pay and reduced share prices. The value is the
be ready for IC12
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most important factor for shareholders; EPS can mislead both the acquirer´s management team and investors in M&A deals. This encourages low multiple acquisitions and high multiple financing. Basically one needs to understand what happens financially in an M&A deal.
Now it was time for Jacob Lindewald, Director, Barclays Capital, under the topic of: “Investing under capital and liability driven constraints”. Jacob has previously worked for Denmark’s na-tional bank but in 2006 he joined Barclays Capital where he is currently the director of Nordic So-lution Sales. Jacob talked about the interest rate sensitivity and hence risk life insuring and pen-sion funds faces on their liabilities. As an example Jacob talked about stress testing a balance sheet. An insurer is basically long a portfolio of fixed in-come assets held against liabilities, the guaran-tees will lack money at high levels of interest rates and where a combined portfolio resembles a long and only fixed income portfolio. However for lower levels of interest rates the interest rate sensitiv-ity profile changes significantly as the guarantees moves “in the money”. He continued to talk about the new regulatory framework European insurers faces in the future. These include a single set of rules governing insurer creditworthiness and risk management. This emphasizes principle-based, rather than rule-based, regulation. It is more than the technical calculation of capital requirements and a company’s solvency position, as it also gov-
erns the approach to risk management. The new regulatory changes will affect capital markets as major investors will be forced to make changes to their investment strategies. The new rules are to be implemented by early 2013.
After a short break it was time for the final speak-er of the evening. Soren Jonas Bruun, Founder of 1CT, with the topic: “Creating a success-ful Venture Fund”. So what is the story of 1CT? At the start up in 2004 they consulted for early stage companies. In the years to come they built profits through e.g. strategic M&A. In 2008 they launched their first fund. In 2010, 1CT launched their second fund, scaling investments and se-cured close partnership with global buyers such as Microsoft, Google, Symantec and Intel.
According to Soren what Europe need is a new breed of venture capital fund managers, who pos-sess mixed experiences and entrepreneurial skills with an international reach. According to Soren the European venture capital industry deserves a B at the best. Entrepreneurs worldwide have a bad experience with European venture capitalists. According to Soren, this is because European VC´s are too risk averse.
Soren further argued that what venture capitalists do is indeed not rocket science, just hard work! He presented us with the following formula: Ex-perience + raw diamonds + funds + relations =
value creation. Another interesting quote was: Know-how + know who = real value. The flow that his company works through could be pictured by having a source, creating a plan, invest, develop and eventually sell. In the end 59% of the audi-ence voted that “being an entrepreneur” is what it takes to be a Venture Capitalist. Soren concluded that a good venture capitalist is a good coach. The key elements possessed are: Entrepreneur and role-model, has worked at start-ups and ei-ther succeeded or failed, held e.g. a CEO posi-tion and hence having valuable management and business development experience, has actively invested other people’s money or own money in start-ups and finally were in the right place and right time, since most luck is based upon hard work and passion.
After these amazing presentations there was time for networking. A delicious comprehensive dinner was served.
Drinks and music followed the networking, and a DJ entered the scene. By this time the invited presenters had left for the night and the party continued amongst the participants.
Most prominent facilitites at CBS:
Copenhagen School of Entreprensurship Lab 6th floor
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activityRogue
Rogue traders
In September 2011 Switzerland’s biggest bank, UBS AG revealed that it had been inflicted with a $2.3bn loss due to unau-thorized trades. Kweku Adoboli, 31 was charged with fraud and false ac-counting dating back to 2008, yet there is still un-certainty around how this loss occurred.
UBS al-ready had a tarnished reputation, having lost $50bn on mortgage-backed securities a few years be-fore this as well as receiving a Swiss bailout in 2008. This new incident suggested that UBS lacked proper risk control and caused CEO Oswald Grübel to resign on 24 September, 2011. The loss however barely accounted for four per cent of UBS’ $54bn of shareholders’ eq-
Jérôme Kerviel
In January 2008, France’s second largest bank Société Générale faced the greatest trading loss in banking history. A rogue trader on SocGen’s Delta 1 desk, Jérôme Kerviel , 31 had engaged in un-authorized trades in European index fu-tures causing a total loss of $6bn. He exceeded the bank’s trading limits by several billion and, at one point, held futures positions worth more than $60bn, while SocGen’s market cap was only $44bn. Kerviel had entered elaborate, ficti-tious transactions in the computers to cover up his trades. Having worked for several years in the bank’s back-office, from which they monitor the traders using advanced IT-systems, Kerviel knew how to circumvent the control procedures. Unlike most other rogue traders, Kerviel did not under-take this huge risk for his personal benefit - he made nothing from the trades. SocGen denies knowing anything about his risky trading activi-ties, but Kerviel himself claims that his superiors knew about it, but turned a blind eye as long as he was making profits - he just failed unlike his fellow traders. However, in October 2010, Kerviel was found guilty and sentenced to three years im-prisonment. He was also sentenced to repay the money he had lost. Kerviel is appealing against the sentence.
$6bn
Yasuo Hamanaka
Yasuo Hamanaka, or “Mr. Copper”, worked for Sumitomo Corporation at the metal-trading divi-sion. When the scandal was uncovered in 1995, it was found that Hamanaka had kept the copper price artificially high for almost a decade and that he controlled 5% of the global copper market. Ha-manaka made long investments in copper futures and in physical positions. He would keep the prices high and outlast anyone shorting copper by continuously pouring cash into his positions. In 1995, however, an increasing supply and an already too high price put extra pressure on the market for a correction. When the price dropped, Sumitomo lost $2.6bn on its long positions. The scandal was uncovered, and Hamanaka was sen-tenced to eight years of prison in 1997. Further-more, Sumi-tomo paid roughly $150m to in settle-ment fees to British and US regulators. Sumitomo blamed Merrill Lynch and JPMorgan Chase for having financed Hamanaka’s manipulation of the market. All three corporations entered litigation and were found guilty to some extent.
$2.6bn
Rogue trading is far from a new phenomenon yet it still occurs despite the massive re-sources that are spent combating it. UBS’ recent $2.3bn loss caused by unauthorized trad-ing led to a renewed reinforcement of the ringfencing argu-ment. Here we will highlight the dangers the economy faces with rogue traders by providing a top five list of the worst rogue traders in history.
By Mads Villemoes Povlsen
Top 5
hittersheavy
1 2
uity. Furthermore, the Swiss bank stated that it expected a “modest” net income in the following third quarter despite the massive loss. This recent rouge trading loss is not nearly the largest in his-tory, yet it confirms that rogue trading is still alive. It also highlights the argument for ringfencing, in protecting taxpay-ers and retail depositors from investment banking losses through tighter regu-lation of the financial industry. There is pressure particularly in the UK, to accelerate reform of the banking industry in order to create more stable, less leveraged banks that are focused on savers and borrowers. For in-stance, the Independent Commission on Banking in the UK recently pre-sented its recommendations on reform to improve
the stability and competition in UK banking. The commission calls for ringfencing banks’ retail op-erations from their investment operations in order to stabilize the finan-cial sector and prevent an-other bailout financed by the taxpayers.
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Nick Leeson
One, if not the most, famous rogue trader is Nick Leeson. In 1995, he led Barings Bank, the old-est investment bank in the UK, to collapse after having lost $1.3bn on the Asian futures markets. Nick Leeson worked in Barings’ Singapore office dealing derivatives and futures, and he was one of Bar-ings’ best traders. At one point, his trades on the derivatives markets accounted for roughly 10 % of the bank’s profits. In the early 1990s, how-ever, he began to lose money. He tried to cover these losses and began taking still greater risks, trying to trade back to profit, but in 1995, Lee-son’s fraudulent, unauthorized trading became apparent, and Barings was acquired by the Dutch bank ING. The liabilities he had accumulated cor-responded to more than all of the bank’s capital and reserves. Leeson’s managers were criticised for allowing him to settle his own trades, thereby ena-bling him to cover his unauthorized trades. Later the same year, he was sentenced to six years of prison in Singapore, but was released already in 1999.
$1.3bn
Toshihide Iguchi
Another rogue trader was discovered in 1995, when he sent a 30 page confession letter him-self to the president of the Japanese Daiwa Bank stating that he had lost $1.1bn on unauthorized bond trad-ing. The senior US executive Toshihide Iguchi ran up the losses resulting from about 30,000 unau-thorized trades over 11 years. Ow-ing to his background in the bank’s back-office, he was able to hide his losses, while he was trying to recover. He was sentenced to four years of jail and to pay a fine of $2.6m. In addition, Daiwa was ordered to end all of its operations in the USA.
$1.1bn
John Rusnak
John Rusnak worked as a foreign exchange deal-er in the mid 1990s at Allfirst Bank (part of Allied Irish Bank) in the USA. He mainly bet on the Jap-anese yen, and he refused to hedge his forward contracts. However, his positions took massive losses, and he entered fictitious options contracts to conceal his huge losses. He succeeded in do-ing this, and his scam was not discovered until 2002. At that time, Rusnak’s trading limit was $2.5m, but he had bet $7.5bn on the yen rising against the US dollar. He was sentenced to seven-and-a-half years in prison.
$697m
Investment banks are dealing with huge amounts of money and power, and the pressure for suc-cess and performance can lead traders to extreme situations. In an environment such as that of trading, rogue activity is inevita-ble, and new rogue traders will come up once in a while. Though the rogue trader stands for eve-rything that seems to be wrong with the financial system, the fi-activity
3 4 5
Rogue nancial crisis was not caused by individual rogue traders. The ar-gument is that if rogue traders are a problem, then rogue activity is a greater one. But still individual rogue traders can have some im-pact on how banking is regulated in the future, and how confident investors are.
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Exit strategies
Secondary buy-outs – creating value or passing the parcel?
A private equity fund is organized as a limited partnership, where the general partner manages the private equity fund while the limited partner – being either an institutional investor or a private wealth investor – commits capital into the private equity fund along with other limited partners and at times the private equity firm itself. Once funds are raised, the general partner invests in under-performing companies by the use of capital from the private equity fund and at times leverage at a certain ratio. After acquisition the general partner has a limited period – typically three to five years – to create value through restructuring of capital, organizational changes and improved operating performance.At the end of their investment period, a private
equity firm sells its portfolio company through either a trade sale, an IPO or a secondary buy-out. In a trade sale, a strategic buyer in a simi-lar industry or sector buys the portfolio company and acquires full control of the firm and its ap-pertaining assets. The second – most well known – type of exit strategy is an IPO, where shares in the portfolio company are sold to the public and the company is listed on an exchange. Third, the private equity firm can exit the investment by sell-ing the portfolio company to another private eq-uity firm, through what is known as a secondary buyout. Within the past few years, this type of exit has gone from accounting for an infinitesimal part of the exits to being one of the most used routes within private equity in terms of total deal value and number of deals (Preqin, 2011). This in spite of the fact that the recent trend has had limited popularity among the limited partners, who at times are investors in both the buying and selling private equity firms;
It [management fees] takes returns away from the inves-
tors who are in both the selling and buying funds (...) There are significant fees (...)It’s also difficult
to generate 10 times your initial investment the second or third time a company is
acquired.
So, what has caused this exit option, which was once frowned upon in the private equity industry (Sousa, 2010) to become so popular? This article looks into some of the explanations to this phe-nomenon by reviewing recent literature on the subject.
From a theoretical point of view, a private equity firm can generate value through its investment in three ways. Buy-low-sell-high is the first strategy. The second option is reduction of free cash flow and increased tax deductions through financial engineering. Third, the private firm can increase operational performance by changing business strategies and aligning incentives of the manager with those of the investors. The first strategy is a somewhat unsecure business model for the private equity firm, whereas the second strategy can only provide a limited return to the buying private equity firm. The increased tendency to-wards secondary buyouts thus creates pressure on the buying private equity firm to generate profits through improved operational perform-ance in the target firm. Since the easiest means of improved operating performance have already been realized by the selling private equity firm, it will, ceteris paribus, prove more difficult for the buying private equity firm to create value in the portfolio company.
The nature of private equity funds forces the private equity firm to sell; the typical private eq-uity fund has a life span of ten years (a private equity firm can ask for an extension, but this is often considered the absolute last resort). Within these ten years where the limited partners have committed capital to the fund, the private equity firm has to invest the capital in portfolio companies and create value through their acquisitions in order to create a decent return for the investors. This is espe-cially important if the private equity firm is about to raise a new fund, which is typically initiated once the current fund is 70% invested (Sanderson, 2003), since being able to show a good track record makes it easier to at-tract new investors. Thus, with a lack of strate-gic buyers and an illiquid stock market unsuited for an IPO, the secondary buyout becomes the immediate opportunity. On the buy side of the agreement is a private equity fund with a great deal of uncommitted capital, which needs to be invested in order to create capital gain before the fund expires. A secondary buyout thus turns out
The win-win solution
to be a win-win situation for both the selling and the buying private equity firm . This hypothesis is supported by the finding that probability of exiting through a SBO is increasing in the holding period of the portfolio company. Moreover, private equity firms with fundraising activities within two years prior to an exit are more likely to exit their portfo-lio company through a secondary buyout (Wang, 2010). In order to determine whether this hypoth-esis is actually evident it is equally important to explore the amount of uncommitted capital in the buying private equity firms, in order to highlight whether the structural hypothesis is supported in terms of the demand side. This issue has yet to be addressed by the literature.
The capital market hypothesisAccording to recent literature on secondary buy-outs, one of the key determinants of secondary buyouts is the capital market in terms of the availability and cost of debt as well as the stock market conditions. The stock market conditions affect the choice of exit strategy by making an IPO a less attractive exit option. Thus, when the stock market is less profitable, the selling private equity firm will seek alternative exit routes and af-fect supply on the secondary buyouts market. A
low cost of debt increases the arbitrage opportunity between debt and equity. In sum, the corporate debt market af-fects the demand side of the secondary buyout market and thus drives up valuation of the portfolio companies, since the buying private equity firm can leverage their investments more. In terms of availability, less covenants associated with corporate debt makes it more
attractive for the buying private equity firm to ac-quire debt. Another aspect to the availability of debt is the reduced risk of corporate debt; since a portfolio company has been through the due diligence process during the first private equity ownership, the debt providers will perceive the portfolio company as less risky and therefore be willing to provide more debt to the buying private equity firm.
PRIVATE EQUITY 101INFO:
“Thus, with a lack of strategic buyers and
an illiquid stock market unsuited for an IPO,
the secondary buyout becomes the immedi-
ate opportunity”
in Private Equity
(Søren Brondum Andersen , part-ner at ATP Private Equity Partners)
The traditional value creation
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By Sarah Louise
The hot potato hypothesisAccording to this hypothesis the private equity companies act according to collusion in or-der to inflate the buyout market by buying portfolio companies from each other at a premium in order to create capital gains for the investors. This hypoth-esis is especially problematic if the private equity firms contin-uously pass the parcel to each other with an accumulated premium, since at some point, none of the potential buyers will be willing to buy the portfolio company. Con-sequently, once the “music stops playing”, the private equity firm holding the portfolio company will have no other option than to force the portfolio company into liquidation. Not only is this hypoth-esis the least appealing out of the five, it is also the most difficult to examine due to the nature of the business.
Mixing market imperfections with behavioural financeIn general, portfolio companies in a secondary buyout are acquired at a premium, which some researchers believe indicates that the private eq-uity firms act according to collusion in order to create capital gains for the investors. Others have argued that the difference in negotiating skills among potential buyers serves as an explana-tion to this premium. Another driver of secondary buyouts is the industry growth prior to acquisition. Moreover, evidence has shown that companies acquired through a secondary buy-out are typi-cally acquired at a higher premium if the industry of the target company has experienced a high growth rate in the years prior to the acquisition. These findings point towards an explanation that can be found within the fields of behavioural fi-nance: the tendency to extrapolate historic growth rates into the future is a manifestation of repre-sentativeness, a cognitive error (Fisher and Stat-man, 1999). The investor perceives the historic growth rate in earning as representative of future earnings growth and thus calculates the intrinsic value of the target firm accordingly. Consequently, the investor overestimates the value of the target company. Due to asymmetric information among potential buyers at exit time a private equity firm is more likely to overestimate the value of the tar-get firm, since a strategic buyer has the informa-tive advantage of knowing the given industry or sector. Thus, the potential trade sale buyer can judge whether the recent growth rates are in fact representative for the future growth rate, whereas the potentially buying private equity firm does not have this information.
What is yet to be addressed
Up until now research points towards the structural and the capi-tal market hypothesis, while there is little evi-dence of value creation in secondary buy-outs. Moreover, as this article argues, there are some indications of asymmet-ric information among potential buyers along with representativeness being an explanation to the phenomenon. The
hypotheses are not mutually exclusive and what is even more important to point out is that there are some fields within this study, which have yet to be addressed. The availability and cost of debt as well as the stock market conditions are non-negligible determinants of the private equity firm’s choice of exit strategy. Thus, like any other busi-ness the private equity business is subject to its macroeconomic environment. An issue regarding the macroeconomic environment that has yet to be addressed is the impact of the stock market’s volatility. When a private equity firm chooses IPO as an exit strategy, the firm is typically constrained by a lock-up agreement, which prevents the firm from selling a proportion of the shares in a given period of the IPO. The justification of such an agreement is that the private equity firm signals to the market that it still believes in the portfolio company. If the private equity firm is somewhat risk averse, they will prefer a gamble with a cer-tain outcome – a secondary buyout – to a gam-ble with an uncertain outcome – an IPO – during times, where stock market volatility is high. In order to investigate the existence of such lock-up effects, the relation between the industry specific stock market volatility and the choice of exit strat-egy should be further investigated. Another important thing to notice is the product life cycle of the portfolio company; the differences in operating performance might merely reflect that the selling private equity firm on average sells the portfolio company after the maturity stage. Thus, the change in operating performance reflects the nature of the business rather than the buying pri-vate firm’s ability to enhance operating perform-ance. The new trend within secondary buyouts could simply be a new niche within private eq-uity, similar to some private equity firms prima-rily focusing on venture finance, while others are specialized in buyouts. The recent literature has mainly focussed on the characteristics selling private equity firm and the portfolio company. A more comprehensive research on the buying pri-vate equity could shed light on the validity of this hypothesis.
“Consequently, once the “music stops playing”, the private equity firm holding the portfolio company will have no other option than to force the portfolio com-
pany into liquidation.”
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