The supermarket is almost definitely not your ideal place to be right now. Anecdotally speaking, it ranks as a lot of peoples least favourite places. So why do you bother?
With the emergence of price comparison apps and sites, and the big four in Ireland usually price matching on the big brands anyway, people don’t actually need to physically compare prices. You already know, or could easily find out, where the prices are best and you can almost always get your shop home delivered without too much of a fuss. This begs the question of what is physically drawing people into supermarkets?
I can only assume it is something which they cannot obtain online. Consider personal service, impulsive purchases and instant collection in this category. If we run with this then we can argue that supermarkets matching prices and providing the same product range can differentiate themselves on these elements. Supermarkets are not really a growth industry, the main 6 supermarkets are competing for a larger share of the existing market.
So if price competition approaches perfect, you can draw people in with superior service, convenience and displays. Can we then declare the price war over and the service war underway?
I’ve recently began my undergraduate dissertation with that heavy, formal style of writing and I wouldn’t ask you to read it, but in the process I’m forming opinions and ideas that may be of interest to people who like to read into the area. Micro-blogging on twitter is too short to be informative so this appears to be the perfect alternative. I’ll be linking all my blog posts on my twitter feed @markjdonn if you don’t want annoying email alerts that I’ve made a post!
My working topic is “Change Management at Tesco”, but in the preliminary stages over the next few weeks I’ll be looking at the supermarket industry over all.
Thanks for reading!
I wrote my last blog entry on risk management tools, I spoke about how simple tools such as forward contracts were available to businesses to protect the value of their assets. The goal of that article was to detail how risk management tools can be used to benefit the firm. Conversely, the goal of this article is to illustrate how overly complicated tools led to not just a loss for a few companies, but a widespread financial crisis that has changed how the world’s economies will function for the rest of our lives at least.
One benefit of the crisis is that people are now taking a more active look at how the economic system works. Television shows like The Frontline and Tonight with Vincent Browne as well as Prime Time regularly feature “celebrity economists” like David McWilliams and Constantin Gurdgiev as well as an array of government ministers and discuss topics that were not as prominent previously. The website IrishEconomy.ie provides a more in depth look at the situation with regular blogs from experts such as Philip Lane, Patrick Honohan and Kevin O’Rourke and it was in one of the very first posts on this site in December 2008 that now Central Bank Governor Patrick Honohan outlined how it was bad risk management that brought down the banks and ultimately led us into this mess.
In the article, which was a transcription of his lecture entitled “The Financial Crisis: Ireland and The World”, Honohan says “banks were employing risk management tools to build very complex transactions with confidence. Indeed, they adopted these powerful tools with overconfidence.[i]” While Reinhart and Rogoff go into great detail about how similar the circumstances have been in the past surrounding Financial Crises[ii], Honohan insists that banks and regulators did not simply stumble into the same old trap as others have before them.
The whole idea of complex financial instruments was that they “supposedly reduced risk and increased liquidity, what it meant in reality was that many institutions and investors were now interconnected, for better and for worse”[iii]. When asked to put money into AIG to help save it, Warren Buffet told CEO Bob Willumstad that the company was simply too complicated for him to invest in, he has made clear that he will not invest in a business model he does not understand.
References to the Wall Street crisis are not irrelevant to the Irish situation. Government investment in banks has sparked global “Occupy” movements; they began on Wall Street and have arrived on our very own Dame Street. The collapse of the Irish banking system led to the Government nationalizing them and as a result the entire Irish Economy was brought to the brink of collapse.
While collapse is now unlikely we should be aware of the possibility of other countries collapsing and having a dramatic effect on our welfare. Going forward, Honohan suggests the risk management must be drastically altered. A point made firmly by Reinhart and Rogoff was that ability to pay was not the main reason for countries to default on their debts, but willingness to pay was. To combat this Honohan suggests that risk sharing among countries should replace firm promises previously good enough, arguing that current financing arrangements are too fragile to be supported.
It seems that we are trapped in this situation and not going anywhere fast. Austerity measures have and will lead to dramatic drops in the standard of living of many citizens, especially those in lower income situations. Christine Lagarde, president of the IMF, today said that the situation is still deteriorating. Eurozone leaders are scrambling to try and save the Euro and it remains to be seen whether it will work or whether we will see the break up of the single currency. It has become very fashionable to criticize the Euro of late and many if not all of these criticisms are justified.
Should the Eurozone break up I believe it is likely we will see partial, if not total default by inflation in many countries. “This Time is Different” tells us that many countries do so when it is available to them, and with domestic debt so high in Europe, it is reasonable to predict a reoccurrence of default through inflation which Europeans last witnessed when Hungary did so in 1949. While this is of course a hypothetical, one thing that is definite is that the period of pain for Irish citizens is not close to an end. Few, if any, will be comforted by the fact this pain is being shared in many developed countries.
[i] Patrick Honohan’s Michael Littleton Memorial Lecture, 2008, is available at http://www.tcd.ie/Economics/staff/phonohan/Littleton%20lecture.pdf
[ii] This Time is Different, Eight Centuries of Financial Folly, 2009. Carmen M. Reinhart and Kenneth S. Rogoff.
[iii] Too Big to Fail, Inside the Battle to Save Wall Street, 2010. Page 90. Andrew Ross Sorkin. Penguin Books.
Most academics and financial commentators agree that risk management is an area that needs more emphasis. Had companies had a more thorough risk management system, or in fact any risk management system, they would not be in the precarious position many find themselves in today. While most of my previous articles have been very investor focused, this one is more related to the internal goings on of a company.
All companies are exposed to risk whether they like it or not. The two main types of risk are currency risk and interest rate risk. The basis of the risk involved in these tow elements is that they can rise or fall outside the control of the company and with little or no notice.
Currency risk is a huge field to try and simplify in one small article. Currency traders buy and sell everyday the exchange rates are constantly moving and affecting the prices of imports and exports alike. An Irish firm buying in stock in from England and reselling it on to the US will suffer higher costs from the current weak and further weakening euro. However they will also benefit because their goods become cheaper for Americans to buy and so they can either increase their euro price and leave the dollar price unaffected, or simply allow the dollar price to fall and benefit from the possible higher demand.
My father is a taxi company owner and is rightly aggrieved at what he perceives as the Euro zone countries spending his tax money in an effort to save the euro from further devaluation. While the weakening euro will increase his fuel costs at the pumps, a weaker Euro may in fact stimulate the tourism industry enough to overwhelm the increase in costs. This is a real instance of a small firm in Ireland exposed to fluctuations in currency.
So for arguments sake let’s say all the taxi drivers in Ireland come together as one body to try and alleviate risk and call themselves EirCab. These guys have accumulated considerable knowledge in risk management from their years transporting all sorts of financial gurus to and from Dublin Airport. They realise that the euro is not getting any stronger any time soon and want to protect themselves from increases in fuel prices.
EirCab have a few tools available to them. They could enter into what is called a forward contract which is an agreement between two parties to exchange something at a specific time and at a specific price. EirCab could choose to enter this agreement with a petrol supplier, let’s say Topaz. If the current price of fuel is 150c and EirCab and Topaz agree to this exercise price for 10,000 litres of fuel in 6 months time, both parties can either gain or lose from it. Suppose Topaz realises in two months that that price of fuel imports is indeed going to rise, by 50c a litre by the end of the agreement, they stand to lose out on €5000 euro. The market price of the agreement EirCab have secured reflects the gains they stand to make and the cash strapped cabbies could cash in now by selling this agreement on to Maxol who can then benefit from the reduced cost. What does Topaz do? Well there is no reason for them not to try and hedge their bets also, they could buy EirCab out of the contract themselves, or they cold attempt to lock in the current prices with the Saudi oil Sheikhs who supply them. In choosing to do so, Topaz would be taking part in hedging, one of the fundamental drivers of the derivatives market. Unbeknownst to themselves, EirCab have successfully speculated on the price and in doing so created value for themselves. Speculation joins hedging as one of the fundamental drivers of the derivatives market.
If the price was never going to change, there would be no activity on the markets. People would not need to hedge against a loss in value, and there would be no money to be made form forecasting value increase. Along with these two components in driving the huge market for derivatives are liquidity, arbitrage, symmetry, leverage and fungibility. I have not yet mentioned the volatility which, in my opinion, determines the size of the market. Only small fluctuations would require less protection and offer less opportunity, so the size of the derivatives market is surely a function of the volatility in prices.
While the example I have given here with EirCab was to portray the currency risk exposure of firms and how they can deal with it, many of the same tools can be used in protecting against interest rate risk.
Where the currency risk can be small for firms operating in a single market, the interest rate almost certainly directly affects them. Monthly ECB announcements on interest rates can have a profound effect on the rate at which businesses can borrow. The rates are so low now that any firms who borrowed at a fixed rate in the late 2000s will be paying far more than those with adjustable rates. Following on from that, firms can now borrow at very low rates and have them fixed at these rates, protecting against future interest rate hikes. Overall a prudent policy would be to have a mix of borrowings at fixed at floating rates, with varying lengths to maturity, and debt types which are matched to the cash flows of the company.
Proper use of credit derivatives could have downscaled the effects of the economic down which has led to a widespread financial crisis, which is the topic of my next blog. Overcomplicated financial products were developed which basically no one could understand, so it took time to even realise how they were losing value. Former Federal Reserve chairman Alan Greenspan said at the time “I’ve got a fairly heavy background in mathematics…. And I had access to a couple of hundred PhDs and I couldn’t understand [collateralized debt obligations], how the rest of the world is going to understand them sort of bewildered me”[i].
So there are some simple tools out there to protect against risk, and some extremely complicated ones. SMEs would be well advised to keep it simple if they don’t want to follow the route of the Wall Street banks.
[i] Alan Greenspan, 2007. As quoted in “Too Big to Fail- Inside the Battle to Save Wall Street” by Andrew Ross Sorkin 2010. Penguin.
Dividends, Dividend Policies, and Sustainability.
In this article I’m going to give an overview of what I know about dividends, what some of the research says, and my own interpretation of the dividend policies of two very famous companies.
After an 8am lecture on a cold Thursday morning it was clear to me that dividend policy was derived from three main questions, what can you pay, what did you pay, and why? The money left for shareholders to claim on after all other claimants have been satisfied is called the free cash flow to equity (FCFE). Analysing a dividend policy requires finding out if the firm is paying out more or less than its FCFE and deciding if that proportion, and the overall amount, is suitable.
Equipped with this knowledge I went to some of the academic research on the topic. I found interesting papers from Fama & French, Fuller & Goldstein and Denis and Osobov. In their paper, Fama & French found that the number of firms actually paying any dividends has declined sharply since 1978. Their data set, from 1926 – 1999, shows that while 66.5% of firms paid dividends in 1978, only 20.8% paid out anything in 1999[1]. They ask three questions in their paper, what types of firms pay dividends, has the proportion of these types being publicly traded fallen, or are firms just less likely to pay out? The answer they conclude to is that is in fact a mixture of two latter questions, the proportion of firms who always paid dividends has been diluted by new firms who grow instead of paying out, and some other firms who paid in the past are now less likely to.
The idea of reinvesting profits to stimulate growth would suit those who are followers of the tax differential theory. In Ireland, tax rates on dividends received are higher than those on Capital Gains which are brought about by an increase in the value of shares held. With more tax sheltering, it is more profitable to reinvest profits and see the share price rise.
Flying in the face of the tax differential theory is the bird in the hand theory, going along the lines of its better to have a bird in the hand than two in the bush. Investors following this theory will want all FCFE paid out as dividends to reduce the risk of them losing value in the future. These investors, much like Goodfellas Paul “Paulie” Cicero (http://www.youtube.com/watch?v=5ydqjqZ_3oc), want only returns and spend precious little time worrying that the firm might be starved of cash for worthwhile projects.
What Professor Lucey put across in the lectures, and what I agree with, is that if additional investment is not creating extra value, the money should be paid out instead. However, good projects should not be denied of money just to pay dividends. Shareholders should agree with what the company is doing, not paying dividends and accumulating cash will only be accepted if the projects are good and do not destroy value in the firm. Modigliani and Miller argued that whether money is paid out or not should be irrelevant in the valuation of a firm, what is relevant is the firms ability to create earnings and not the way these earnings are the shared around.
Another topic to be considered is how a dividend payout, or lack of, will be perceived by current or prospective investors. Microsoft dropped a $32 billion dividend in 2004, the move to payout had been perceived as “pronouncing the maturity of the firm[2]” or, more critically, announcing that the firm was bereft of further growth opportunities. In some industries, such as technology, it appears a dividend payout can be perceived as sign of weakness, and a lack of any dividend can show that the management is confident of growth in their chosen investments. The opposite is true in other industries where dividends are more commonplace, such as manufacturing with firms like GM and Chevron. The form of payout can also be an interesting indicator to investors. For example, a stock repurchase, which can be done in a number of ways, is potentially a sign to investors that management feel the stock is undervalued at present and are seeking to take advantage of the opportunity to remove some of the equity while they have the chance.
I’m now going to look at three stocks and attempt to explain their dividend policy, starting with McDonald’s. Since paying its first dividend in 1976, McDonald’s has increased it every year. I spoke earlier about management buying back stock when it’s cheap, last year the makers of The Big Mac spent $3 billion buying back shares at an average price of $79.44, the shares closed today at $98. They bought back an average of 70 million shares in the fives years 2006-2010.
If you bought stock last year when the price was around $80, you would now hold a stock worth $98 dollars and already received a $2.53 dividend[3]. That payout works out at 2.6% dividend yield, with about a 50% payout ratio from earnings. So why are McDonalds paying out half their earnings when some companies pay out none? My interpretation is that as a huge and constantly growing company they are confident the payment will not starve the company of revenue required for investment. The company is cash heavy any way; it takes in money from every customer instantly, no waiting around months for cheques so they have no liquidity issues. Despite a brief drop in 2009, sales are consistently greater than $16 billion and that figure jumps to $24 billion if you include the franchised operations. No wonder Ronald McDonald smiles so much. The buy backs have decreased the amount of equity issued so that existing shareholders enjoyed more concentrated rewards. $98 dollars is about 32 Big Macs but the thing about Big Macs is they decrease in value after you buy them.
Unlike McDonald’s who pay dividends quarterly, Toyota Motor Company pays dividends twice a year. In this year annual reports they stated that the benefits of its shareholders were one of management’s priorities and they were working towards “sustainable growth” which will “enhance corporate value”. They are attempting to pay out a stable dividend of about 50yen per share annually, which was 37% of earnings this year, but last year it amounted to 67%. Here we see the trouble with dividends; last year when it was a large percentage of earnings it would have made sense to decrease the dividend, but it undoubtedly played a part that a dividend cut would have been perceived negatively by investors. They exhibited prudence by not buying back any shares to “prioritize securing cash reserves”[4].
Just looking at these two companies gives an insight into the complexity of dividend policies. It doesn’t make sense to me that a company involved in developing new cars can pay out a larger portion of its earnings than one that is selling burgers. The difference in capital requirements is surely huge. What does make sense though is that such requirements are only a small piece of management’s decisions and such a general analysis as this will hardly unravel those.
[1] Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay? Fama, E & French, K. 2000. Available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=203092
[2] Hands-on investor: Marriage has edge on hot date. Stephen Schurr. Financial Times. 7/12/2004 available at http://www.ft.com.elib.tcd.ie/cms/s/0/14b7b142-47f5-11d9-a0fd-00000e2511c8.html#axzz1gWque8UM
[3] McDonalds Stock Information: Dividends. Available at http://www.aboutmcdonalds.com/mcd/investors/stock_information/dividends.html accessed on 14/12/11.
[4] Financial Results FY2011 Toyota Motor Company available at http://www.toyota-global.com/investors/financial_result/2011/pdf/q4/summary.pdf
This Blog answers Topic 5: How Do Firms Finance Themselves in Theory and Practice?
It’s almost a cliché that cash is the lifeblood of any firm. Less so is the talk of where this cash comes from. As a firm goes through its lifecycle, where does it get the money to finance its daily operations? There are millions of companies all over the world and just like the products and services they offer, their financing is widely diverse. In this article I am going to discuss the factors firms consider when they need access to funds, the theoretical ideas about financing and capital structures, and how the two contrast. I’ll talk about the capital structure of the firm, which is a long term approach to how the firm is funded, as well and the shorter term financial policy decisions.
If the name of the article didn’t already give it away, I’m going to have a look at this topic using Eurotunnel PLC as a working example. When construction on the tunnel began in 1988 it was the largest privately finance infrastructure project of the century. There were also huge doubts over whether the project would ever even be built even while the funding was being acquired. Given that planning for this project began 30 years ago, it is interesting to look back and compare the projections of capital structure and financing with how it actually panned out and where the firm stands today.
Traditionally, the trade off model had been used by firms to make financial policy decisions. In the trade off model, firms identify optimal leverage by weighing the costs and benefits of an additional dollar of debt[i].
It was Myers (1984), following on from Myers and Majiluf (1984), who first developed an alternative theory to the trade off model; the pecking order model for financing. It states that firms will try to finance themselves with retained earnings, if these are not available they will take on safe debt, then risky debt, and if it comes to it, outside equity[ii]. They will only issue equity under duress, when any further debt issued will produce excessive leverage.
In the same paper, Fama and French go into detail about how many firms consistently violate the pecking order theory and how stock is issued far more frequently than the model predicted. More precisely, 86% of firms had a gross issue of stock between 1993 and 2002. They also point out that many of these firms had financial deficits where issuing debt would have been valuable. Fama and French conclude that the pecking order model breaks down in practice because its assumption that issuing equity has high transaction costs and asymmetric information problems is flawed, companies have alternative ways of doing it, employee stock options for example, convertible bonds another. In concluding the paper the authors make the point that both the Trade off model and the Pecking Order model have their flaws, neither can be used to fully predict how a firm will finance itself, but both have elements of truth that can help us explain aspects of a firms capital structure and financial policy.
It was with Fama and French’s conclusion in mind that I decided to pick a company and see for myself what affect the theory had on the practical decisions made by firms. As I have already said I chose Eurotunnel PLC for this examination and found it extremely interesting. I took the Eurotunnel once while driving to Paris to see the Irish soccer team play in Stade de France. I found it to be very convenient and well run and now at a more mature age I can see the huge positive effect this tunnel has had on trade between England and France. Herein lies the consensus of many commentators, the Eurotunnel has been a great asset to both countries, but as an investment it has been nothing short of a nightmare.
Before ground was broken to start digging on the project, £6 billion had to be raised to finance its construction. The capital structure chosen was to be £5billion in debt and the rest in equity[iii]. As regards a comparison to the pecking order theory, this made sense. The company had not begun operating yet so it sourced outside debt and the remainder in equity. It took three equity offerings to raise the necessary £1.023 billion and 130 banks to compile the debt.
Interestingly, the equity raising came just after the stock market crash in 1987 and there were serious concerns over whether the project would ever be completed. An article in the Financial Times at the time said “if it works it will be quite a remarkable coup, amid the worst stock market conditions in living memory…… Investors are being asked to put £770million (the amount raised by the third equity offering) into a hole in the ground which will certainly not produce a penny of revenues until at least 1993”. So despite a 7 year gap between investment and dividends, they managed to pull it off. This was because the predicted dividend flows once the tunnel started operating made the future present value of the stock to be £34 pounds in 1995, having been issued for just 350p in 1987.
Professor Lucey in his Applied Finance lectures made the point that firms should match up their capital structure to their type of business. As a heavily capital intensive project with no revenue for about 8 years, the reliance on long term debt seemed to be prudent, and investors were well aware of the time span of the project.
So what makes this project the investor’s nightmare it has become and did the capital structure and financial policy have a part to play in its demise? There have been a plethora of financial problems in the firm, it had to issue extra debt and extra equity in 1994 to give it enough money to open and maintain the route, it stopped paying interest in 1995 and its debt had to be restructured in 1996. Shares in Eurotunnel were suspended from trading and they issued more equity as a swap for debt at below face value[iv]. The company is in financial ruin, from what seemed like a good starting point theoretically, it has fallen to pieces.
Having obtained a waiver to the original Credit Agreement, Eurotunnel completely renegotiated its capital structure has now regained some control. Its still owes £3708 million in a mix of fixed and floating loans; it paid £255 million to service this debt in 2010[v]. So where does the firm now stand as regards its finances and Capital Structure? Having made a loss of some €57million in 2010, it doesn’t have much of an option to us reserves to finance itself. Investors have seen the value so far diminished that they just want to get whatever they can out of the company.
I feel there is evidence of the trade off theory in the company’s decision to swap equity for some of its debt. Instead of paying interest year after year, it is cheaper for the company to exchange it for shares and attempt to repay investors by creating value in those shares. No dividends have been paid by the company, so the tax shield available to interest payments and not to dividend payments was hardly a disincentive to this exchange.
As it stands now, the company is so heavily indebted that it will either have to almost fully convert debt to equity to prevent bankruptcy. This dilution will not please investors but it may in fact be the lesser of two evils. We have seen that theories do have a practical importance in Financial and Capital choices made by firms.
What remains to be seen, is if there is any light at the end of the ‘Tunnel.
[i] Fama, Eugene F. and French, Kenneth R., Financing Decisions: Who Issues Stock? (April 2004). CRSP Working Paper No. 549. Available at SSRN: http://ssrn.com/abstract=429640 or doi:10.2139/ssrn.429640
[ii] Myers (1984) as quoted by Fama, Eugene F. and French, Kenneth R., Financing Decisions: Who Issues Stock? (April 2004). CRSP Working Paper No. 549. Available at SSRN: http://ssrn.com/abstract=429640 or doi:10.2139/ssrn.429640
[iii] European Casebook on Finance, 1995. Stonham, P and Redhead, K. Prentice Hall.
[iv] Valuation of companies in financial troubles: The Case of Eurotunnel. Schueler, A. 2006. University of Munich.
[v] Key Figures, Eutotunnel Annual Reports, 2010. Available at http://www.eurotunnelgroup.com/uk/shareholders-and-investors/key-figures/2010-summary/
If you couldn’t lose money in the financial markets, it goes without saying that we’d all beg borrow and steal to buy shares. It’s not always easy to make money out there, even for the experts, and the reason for this is very simple; risk.
Putting this into perspective, SAC Capital, Steven Cohen’s hedge fund, has a market value of $11.2 billion but recently lost up to 80% of the value of it’s investment in cancer fighting medicine developer Dendreon and ended up selling almost all of the funds holdings in the firm. The fund earns Cohen himself about $1 billion each year and consistently provides an annual return of about 30%; the fact that even an investor of this calibre can sometimes get it wrong is testament to the prevalence of risk for investors. Lloyd Blankfein who is CEO of the world’s largest and most successful investment bank, Goldman Sachs, recently said that new regulations could hamper his firm’s ability to provide clients with their essential services which he listed as “liquid markets and financial risk management”, risk once more shown to be so prevalent on the mind of the investor.
I certainly don’t think anyone is surprised by this, if you invest money in something it is to make money not lose money. If you put money in a savings account you expect that it won’t disappear. There is always, however small it may be, a chance that you can lose your money and that is what every investment decision will hinge on; will it make money or lose money? Some investments are riskier than others and returns reflect the level of risk taken through what is called a risk premium, extra returns you receive compared to what you would have got had you just bought Treasury Bills.[i] The opportunity cost of a safe bet is the extra returns you could have earned from a riskier investment had it paid off. Which brings me to the whole point of this article, is it possible to make an investment with very little risk but high returns?
The ability to do this is what separates skilled investors from those who can just change their money into a bag of coins and go and play the slot machines hoping to win the jackpot. Had all the SAC’s money been invested in Dendreon, which I spoke about earlier, then the returns on the fund would have taken a massive hit but as it happens this was just slap on the wrist and the fund will still make big money this year. How? Because Dendreon was just a small part of the reported 1,736 holdings SAC held at the end of the third quarter[ii].
This introduces the idea of diversity in investments decreasing the risk to the investor. However diversification is only as good as the stocks being diversified[iii]. A bundle of well chosen investments is more likely to perform well that each one of those investments taken separately. Fundamental to this thinking is the knowledge that all stocks carry two types of risk, economic perils that threaten all businesses which are known as the market risks, and specific risk, unique to one or a group of companies in particular. The latter can be almost completely eliminated by a well thought out and diversified portfolio. This is down to individual stocks being far more variable than the market indexes. The measure of risk is the variance of return, and diversification reduces the variance of a portfolio but the systemic risk cannot be avoided no matter how much you diversify. It’s a matter of opinion how many stocks are needed to minimise risk, Steven Cohen holds as many as 1736, other investors say 27 – 30; there’s no absolute golden rule for how many stocks to hold.
There are alternatives to diversifying your portfolio, like structured securities products which protect investors against losses giving “predictable returns in volatile markets” and “some level of market protection”[iv]. These products are bonds backed by securities that allow investors to hedge their risk using options but there is no free lunch because in order to protect against downside risk, investors limit their potential upside.[v]Products like these are sold to investors to cap their risk but are not always reliable and it’s worth noting the SEC are investigating a number of them and the way they are sold as some are considered to be in breach of regulations regarding financial products.
So if you decide against a product such as an SSP, the main source of uncertainty for a well diversified investor is that the market will rise or plummet, carrying the portfolio with it. Banking crises, bubbles and crashes, currency crises and systemic crises cannot be avoided by diversifying your portfolio.
According to a result note published by the department of finance, Irish banks held €586billion in deposits at the end of October[vi]. People are stockpiling cash in various types of deposit accounts but interest rates (from a quick survey of bank websites) are as low as 1.5%. There are earnings to be made on the stock market but the deterrent is the ever prevailing risk associated with investments. How willing are savers to put some of their money on the table to earn some good returns knowing that it could potentially vanish?
Laura Rowley of DailyFinance.com recently wrote an interesting piece on this called “the alternative to low-interest saving: how to invest in dividend stocks”.[vii] Rowley points to how a number of firms use dividend focused indices to create client portfolios that are safe and reliable and provide a higher yield than Deposit accounts. These are completely diversified portfolios based on Standard & Poor’s annual list of “Dividend Aristocrats” and should be about as safe as you can get when investing.
These so called safe bets used by pension funds are the best available portfolios considering the investors want absolutely no risk and are willing to accept lower returns as a result. They are what Markowitz called, efficient portfolios, which are portfolios with their highest expected return for a particular level of risk.
The last risk avoidance technique I want to discuss is the dilution of beta. Beta is often used to describe the level of risk in a portfolio. Portfolios carrying all the market risk are said to have a beta of 1, those carrying none of the market risk (treasury bills) have a beta of zero. So let’s say you want more of a return than treasury bills but aren’t willing to take on the full market risk, the technique is very straightforward, combine the two! If you want half the market risk, a beta of 0.5 then invest half your money in the market portfolio and half in Treasury Bills.
Choosing a market portfolio can be tricky but the key is to use the Sharpe ratio which is calculated by taking the risk free rate from the portfolio’s risk and dividing it by the standard deviation. Comparing some portfolios with this ratio, knowing the one with the best ratio is the best portfolio, can make a big difference on your investment.
[i] Principles Of Corporate Finance, Brealey, Myers and Allen, 10th edition, 2011.
[ii]10 Investments Billionaire Steven Cohen is making now, 14/11/11. http://www.thestreet.com/story/11310596/1/10-investments-billionaire-steven-cohen-is-making-now.html?CM_VEN=AD|TWR|JC
[iii] Lucey, Brian. 2011, Lecture slides available on jsbusiness.webexone.com
[iv] “Structured Securities: ‘money protecting’ investment carries hidden risks” Jonathan Berr on DailyFinance.com 10/11/11 http://www.dailyfinance.com/2011/11/10/structured-securities-money-protecting-investment-carries-hid/
[v] Same as 3 above.
This is the Financial blog of Trinity Business student Mark Donnelly. I’ll be blogging about a range of topics relevant in the finance world today starting with the fundamentals and building to offer opinions and comments. I’m new to this so be patient please! Feedback is, of course, welcome, as is any tips on how to improve the blog or new topics to blog about. Thanks for reading I’ll do my best to keep you interested!
MD
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