On Value Traps..

One of the most challenging situations for a value investor is  being caught in a  “value trap” – where a cheap investment  suffers a permanent loss of capital.  What strategies and precautions should investors adopt to minimise the risk of being ensnared in a “value trap” ? Rob Arnott, head of Research Affiliates, provides a  helpful perspective on this issue. To summarise:

 

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A “value trap” can either imply that an asset that  looks cheap has enough bad news to possibly justify the price or the investment looks cheap on the way to zero.

 -Ben Graham made a distinction between a drop in price and a permanent impairment of capital – as mean reversion cannot work if he price of a security goes to zero. However, ascribing a “value trap” to an asset which has suffered a large price decline when the underlying fundamentals remain unimpaired, one can make a dangerous error. A “value trap” is a situation  where the asset seems cheap but is permanently impaired.

 -Bargains mainly exist in the presence of fear – by inflicting pain with sharp price drops -  but there are always numerous reasons to avoid buying bargains which deter investors from taking advantage of price drops.

 -How often do individual company stocks present a permanent loss of capital – say a 90% drop in the price in three years or less and no recovery over the next three   years?  At any given time only 5% of US stocks are “value traps” – i.e. they are rare events for individual stocks and almost nonexistent for broad asset classes which represent a broadly diversified array  of companies  and therefore cannot all go to zero.

 -Markets try to seek fair value and are therefore mean reverting. Analysing historical data since 1975 for each major asset class, and defining a significant decline as a two standard deviation move below its long term average, these extreme events have happened only 2% of the time.

 -Comparing the percentage of asset classes and individual stocks (see chart below)  which suffered such  extreme declines and recovering fully over the subsequent five years,  it is clear that asset classes outperformed individuals stocks  by far – more than half the time assets classes made  up their losses within 3 years and 85% did so over five years. However, only 10% of  individuals  stocks recovered with three years and one-third did so over five years.

 

 

-It is painful to experience a price loss – particularly as value has underperformed growth since2013 (and off-and-on since 2007). However, early signs of value outperformance are emerging – particularly for US small cap value stocks and EM equity.

 -A few fundamental truths about investing can help investors to continue pursuing a value-oriented, disciplined and contrarian strategy: 1) value traps are rare events, particularly for asset classes; 2) mean reversion can reward patient, long-term investors; and, 3) history shows that markets eventually trend towards fair value. Investing on a contrarian basis can ultimately provide superior returns to investors.

 -An interesting analysis which supports a well diversified, value based approach to investing despite trying market conditions – as the legendary value investor  Jeremy Grantham of GMO has noted  time and time again - patience is  the key advantage which an individual investor has over the professionals (but unfortunately is squandered too easily as people get caught up with the herd mentality).

 -The other important aspect to value/contrarian investing is having the discipline and courage to spreading  the investments over time (i.e. dollar cost averaging ) thereby allowing one to add to positions which have suffered  sharp price drops. A recent example of this would be Brazil, a country which has been out of favour for several years  and has suffered sharp drops in the equity index as well as the currency (see chart below).

 -Over the last three years, the annual fall in  the dollar denominated country ETF EWZ has been -25%,-16%, -51%, driven by  both a fall in the local currency (-14%, -10%, -34%) and the stock market. An investor employing a dollar cost averaging strategy over the last three years (starting from January, 2013 and deploying one fourth of his total allocation to Brazil  on an annual basis) would show a paper loss of 43% at the beginning  of 2015 versus a paper loss of 67% for an investor who had invested his total allocation at the outset (or was reluctant to add more on declines).  And following the 33% rally in Brazil this year, the  current loss for the dollar averaging investor would be almost halved to -24% versus -44% for the alternative. More complicated dollar averaging strategies  can also be employed utilising pre-specified thresholds based on market movements rather than a fixed time of the year to further optimise returns.

 

 

 

-Of course Brazil could suffer another sharp fall for a myriad of reasons  (i.e. politics/commodities) but having a disciplined  strategy of adding  exposure under that situation (in the context of a well diversified global portfolio with limits on individual  country and asset class allocations) is very likely to yield dividends over time.

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China’s New Conglomerates

It’s been decades since conglomerates were the toast of American commerce. Many that formed in the 1960s and 70s broke up in the decades that followed, as the trend of diversification gave way to specialization. But in China in 2016, enthusiasm for the conglomerate form is at an all-time high, particularly among Internet companies. Last year, web titans Baidu, Alibaba, and Tencent invested a total of $29 billion in 134 businesses.   Alibaba has been the most aggressive of the three, investing more in 2015 than Tencent and Baidu combined through acquisitions and minority stakes in companies ranging from a language translation site to a home rental service. But they’ve surely bumped into each other outside some conference rooms. Alibaba and Tencent invested $1.25 billion and $350 million, respectively, in minority stakes in the food delivery site ele.me and $2 billion each in Didi Kuadi, China’s largest car-hailing app.   Alibaba isn’t abandoning its core e-commerce business, but its e-commerce strategy is evolving. One of its biggest deals last year was a $4.6 billion investment in the brick-and-mortar electronics retailer Suning. Suning’s distribution network will help deliver Alibaba’s orders and stock some Alibaba products in its stores, while Alibaba will host Suning’s first online store on its Tmall shopping portal.   Alibaba’s other significant 2015 deals were in media: a $3.5 billion takeover of online video platform Youku Tudou, and a $2 billion deal to buy the assets of publisher SCMP Group. The company’s growing media empire also includes recently purchased stakes in China’s largest private film company and an online animation platform, as well as a wholly owned TV and film production company and an online music platform.   Why all the media investments? Because Chinese residents have growing disposable income to spend on entertainment, and the country’s “culture industry” is expected to contribute 7 percent to GDP — about 6 trillion renminbi ($930 billion) – by 2020. Alibaba also sees media as a way to drive business back to its e-commerce sites. Consumers could buy movie tickets through an Alibaba site, watch an Alibaba-produced film, and buy movie-themed merchandise on Tmall.   Tencent also has a foothold in media – including a new $100 million stake in a movie ticket app – but it has devoted the most attention to the O2O space. Short for “online to offline, ” O2O businesses attract online users to purchase services for use in the real world, which includes the above investments in Didi Kuadi and ele.me. In 2015, the company also invested in a ridesharing service, a housekeeping service, and a group deals site with a food delivery subsidiary.   Tencent tends to form partnerships rather than making outright acquisitions. As a result, it completed more deals than Alibaba in 2015 – 68 to Alibaba’s 45 – while spending $10 billion less. Its foray into O2O food delivery may prove particularly lucrative. The food delivery market has grown from 58.6 billion renminbi ($9 billion) in 2010 to 216 billion ($33.5 billion) in 2015, and online orders are expected to account for more than 12 percent of all food delivery in 2017, up from just 0.15 percent in 2010.   Baidu has also entered the food delivery business – not through M&A, but by developing its own platform, Baidu Food. That’s just one of several homegrown Baidu businesses that Credit Suisse analysts say are indicative of a more organic growth strategy. Other examples include an autonomous car business, an education business, and an online bank developed in partnership with a brick-and-mortar bank, China Citic Bank.   Baidu, like Tencent, limited itself to minority stakes last year, its largest being a $1.2 billion investment in Uber China. But Baidu is also pouring money into a major acquisition from 2014: the group-buying site Nuomi. The company announced last June that it would spend $3 billion to make Nuomi more competitive in the O2O space. In doing so, Baidu has an advantage others don’t: it is China’s dominant search engine.   The Internet giants are cash-rich, and Credit Suisse analysts expect their investment boom to continue despite macroeconomic headwinds. They may also face less competition than in recent years. Though the Chinese government directed some $231 billion to venture capital funds last year, Credit Suisse analysts say the funds have grown more cautious. Consumer spending growth, however, is outpacing GDP growth. That’s good news for the Internet giants, who are increasingly prepared to sell just about anything consumers want to buy.

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Manufacturing Momentum

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Difficult Retrenchment for China, but Better Social-Safety Net This Time.

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Navigating China’s Slowdown

Given the comprehensive transformation it is undergoing, China’s economy is now much more complicated, said Christopher Balding, Associate Professor of Finance and Economics at the HSBC Business School of Peking University Graduate School, in a session on the Chinese economy at the Credit Suisse 2016 Asian Investment Conference (AIC). Volatility in the markets and concerns about debt and capital outflows have fueled questions about the outlook for China.   “Money is leaving in a very quiet manner,” Balding noted. “It is not foreign debt repayments. Lots and lots of people are taking their money out of China and placing it elsewhere.” While China’s growth figures are overstated, the economy “is not as bad as what people say but at the same time it is definitely not good,” he added.   The views of China analysts today diverge widely, observed veteran China-watcher Huang Yukon, Senior Associate, Asia Program, at the Carnegie Endowment, and Advisor to the World Bank and the Asian Development Bank. “By historical standards, China is doing very well but people are pessimistic.”   To some, China is facing a debt crisis, but its debt position is actually better than Singapore’s, Huang observed. “What you see in China is financial deepening.” The Chinese economy is like a mismanaged and distorted company that can be turned around and kept on a growth path if reforms are done right, Huang argued. His advice: Additional growth can be squeezed out if China manages its urbanization better, reforms SOEs and addresses regional over-investment.   Li Yang, Director of the National Institution for Finance & Development and Head of the Academic Division of Economics at the Chinese Academy of Social Sciences (CASS), offered a more positive outlook: “We are achieving a more sustainable growth pattern. We are not talking about quantity but quality. We are heading for a more rational framework that is acceptable to all. And we are focusing on total factor productivity and supply-side management.”   Asked if China is heading for a hard landing, Li was adamant that the slowdown would not lead to catastrophe. “Fiscal and financial crises are impossible in China,” he declared. - See more at: https://www.thefinancialist.com/navigating-chinas-slowdown/?utm_source=Newsletter&utm_medium=email&utm_campaign=Newsletter&utm_content=Newsletter#sthash.EAR26bSg.dpuf

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Copper Turned Into Precious Metal as Miners Loath to Sell

Copper is a precious metal these days.

While top miners such as Anglo American Plc and Glencore Plc are selling anything from iron ore and coal to agricultural assets to pay down debt amid a rout in commodity prices, they’re loath to part with the best copper resources.

That’s because it’s one of the few metals expected to be in shortage by the end of this decade as cooling investment means not enough mines are built. Those with cash to burn are taking an interest, with copper a focus for miners and financiers gathering this week for an annual industry conference in Chile, the world’s biggest producer.

"Copper is the most desirable commodity," said Michael Scherb, founder of mining investor Appian Capital Advisory LLP in London, whose colleagues are attending the meeting in Santiago. "We are looking very hard at global copper projects."

It’s a sign of the times that Rio Tinto Group, the second-largest miner, surprised many by appointing the head of copper as its next chief executive officer. BHP Billiton Ltd., the biggest, is also focusing on the commodity as it seeks investments after adding an extra $10 billion into its coffers by cutting dividends and capital spending.

Key to Strategy

One obstacle for buyers is that even indebted miners want to hold onto what has become the crown jewel of industrial metals. Anglo American, the first major London-based miner cut to a junk rating by credit-assessment companies, insists it will hold on to the giant Los Bronces and Collahuasi copper mines.

“We have no intention of selling down,” Hennie Faul, Anglo’s CEO of copper, said in an interview in Santiago on Monday. “These are tier 1 world class assets. Both of those are key for us in our copper strategy. Both those mines have got further potential in years to come when prices are right and the market is right to expand.”

The value of copper M&A in 2015 fell to about $3.1 billion, a five-year low, according to data compiled by Bloomberg. The 27 copper deals in the year, according to Ernst & Young, compared with 38 for coal resources and 117 for gold. The low level of activity “is likely due to the scarcity of assets on the market,” E&Y wrote in an industry report.

"There is a lot of smoke, a lot of talk in the room, but not a lot of actual deals," Oskar Lewnowski, founder and chief investment officer of Orion Mine Finance Group, said in an interview. "The sellers have one price expectation and the buyers have a different price expectation."

A rebound in copper prices this year may further discourage miners from offloading their best assets, Glyn Lawcock, an analyst at UBS Group AG, said last month. The metal rose as much as 19 percent from a January low, and recorded its first quarterly gain in almost two years.

The positive outlook means speculation about acquisitions is eclipsing real opportunities, according to Diego Hernandez, CEO of Antofagasta Plc, which is keen to invest in copper.

“All the companies that are in trouble, they are keeping their copper assets," he said in an interview in March. "Copper is much better than other commodities."

The pickup in prices has waned in recent weeks and some expect further declines. Goldman Sachs Group Inc. sees a copper bear market lasting through 2018, and Barclays Plc a slump to the low-$4,000s, from about $4,780 a metric ton on Tuesday. The metal has slipped about 6 percent since March 17.

Volatile Period

An extended downturn may be enough to persuade some owners to bail out. Already this year, there has been something of a recovery in copper M&A after last year’s slump. Deals valued at $1.8 billion were completed or pending during the first quarter, according to data compiled by Bloomberg.

“I don’t think those in the third or fourth quartile are going to be able to survive this period of volatility,” said Nelson Pizarro, CEO of Codelco, the world’s biggest copper miner, referring to those in the industry at the upper end of production costs.

Among transactions, Freeport-McMoRan Inc. agreed in February to sell an additional stake in one of its biggest mines to Sumitomo Metal Mining Co. for $1 billion as the largest publicly traded copper producer sought to rein in debt. Last month, First Quantum Minerals Ltd. said it would sell its Kevitsa mine, with nickel, copper and platinum-group metals, in Finland for $712 million to Boliden AB, also to curb its borrowings.

While a start, these aren’t the top assets that would mark a revival in dealmaking.

"There just isn’t anything to buy,” Benjamin Cox, CEO of explorer Aston Bay Holdings Ltd., said in Santiago. "The tier 1 majors are going to keep their powder dry. They are not looking to buy junk.

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Why Indian Real Estate Will See A Crash, Or At Least A Long Period Of Stagnation.

Real estate in India is overpriced, while rental yields are too low to make sense as a good enough investment.

If the property market were to function as efficiently as the stock market, real estate prices should crash, but the market is rigged.

The fundamental reason why property prices have to fall is because they are no longer affordable to the vast majority of Indian middle class households.

In 2015, four percent fewer homes were bought in eight of India’s major cities – Delhi/NCR, Mumbai, Bengaluru, Chennai, Kolkata, Pune, Hyderabad and Ahmedabad. These cities had nearly seven lakh units left unsold, an inventory backlog that will take at least two or three years to clear, assuming no new units are built.

That isn’t happening, for builders are forced to announce new launches in order to ensure cash flows that can be ploughed back to complete previously sold properties. In short, they are into a recycling game, using new property sales to fund old ones. That’s why they lure you with 20:80 and 10:20:70 schemes, or ask you to pay only Rs 2-3 lakh for booking, and rest on possession. They want the upfront cash in the hope that prices will rise after a while to make this worthwhile.

Take another measure: rental yield on residential property – the annual potential rental income as a percentage of its market price – is so low in India, that it makes no sense as an investment. Of course, returns will have to include the chances of future appreciation, but this means investment is being planned purely on expectations of a price rise. What if that isn’t happening too?

In any rational property market, rental yields ought to be somewhat in sync with borrowing costs. So if the housing finance companies are lending you money to buy a house at, say, 9.5 percent today, you should be earning at least half that by way of rental yield, hoping to make up the other half through capital appreciation.

But in most cities in India, even on the periphery, rental yields are in the range of 2-2.5 percent. I bought a small 1-BHK flat in Thane (a satellite city north-east of Mumbai) two-and-a-half years ago and the rental yield is currently around 2-2.5 percent. I bought the house to live in, but if I had bought it as an investment, I would have been better off leaving my money in a savings bank account. I essentially borrowed money at a high rate (10.75 percent in my case) to earn 2.5 percent. If I had not bought it to stay in it, I ought to be a candidate for the loony bin.

So let’s get this straight: real estate in India is overpriced and simply not good enough as investment, and the anecdotal stories about the high prices some people got for their properties are really no indication of what might happen in future.

A research study in 2013 found that rental yields the world over were significantly higher than fixed deposit rates offered by banks - or were at least comparable. India was the only exception, with rental yields being in the 2-3 percent range in major cities, and FD rates above 8.5 percent (at that time, that is).

A comment by Vivek Kaul here quotes an Ambit report as saying that Indian rental yields make no sense. Analysts Saurabh Mukherjea and Sumit Shekhar of Ambit wrote: “In a fairly-priced real estate market, the rental yield tends to be somewhere close to the cost of borrowing. Instead, Mumbai has a rental yield of close to 2 percent (this is gross of tax and maintenance charges) whilst the lending rate hovers around 10 percent. The difference between lending rates and rental yields is one of the highest.”

The key question is why. And the answer is clear. The property market is rigged. This is why despite low demand, prices quoted are still high and yields so low. If the property market were to function as efficiently as the stock market, real estate prices should crash, but the market is not being allowed to equate real demand with supply.

If one accepts 4-5 percent rental yields as a reasonable level at which property makes some investment sense, it means prices have to crash almost 50-80 percent from current levels to equate demand and supply.

Let’s also consider another yardstick. If anyone is to buy property, incomes must be sufficient to cover monthly instalments. In Mumbai and Thane, most properties in the 800 sq ft 2 BHK range are above Rs 1 crore, even assuming some discounts have been offered to genuine buyers with the cash to pay for it all.

To buy a property worth Rs 1 crore, you need to raise a loan of around Rs 80 lakh. A 20-year loan at 9.5 percent would involve a monthly EMI of around Rs 75,000. To pay an EMI of Rs 75,000 (assuming you have no other loans for car, etc), and assuming Rs 50,000 monthly expenses, you would need a gross salary of at least Rs 2 lakh a month. And remember, to earn that kind of money on a 20-year loan, you need a remainder working life of at least 20 years. You can’t be older than 40-45.

How many people in Mumbai or any other metro do you think earn that kind of monthly salary? Sure, some Dinks (double-income-no-kids) could cobble up that kind of salary together, but the total numbers would not run into more than a few thousand in any city. Most middle class people thus head for suburbs well outside the cities.

The fundamental reason why property prices have to fall is because they are no longer affordable to the vast majority of Indian middle class households.

The problem with predicting a real estate/property price crash is that you will look wrong most of the time. People were expecting a 2008 global financial crisis three or four years before it happened, but for much of the time before 2008 they looked like cassandras.

And so it will be with Indian real estate. Those predicting a crash will look foolish for a couple of years, but prophetic when it actually happens. The current level of property price is unsustainable. It has to crash. Just that we don’t know when that will happen. It could also happen through a prolonged period of stagnation in prices, where incomes rise faster than property prices for, say, a decade. The crash will happen then in slow motion, so that incomes and property prices are better aligned. But as of now, property is not a worthwhile investment in most places.

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How to Hack an Election

http://www.bloomberg.com/features/2016-how-to-hack-an-election/

What tools does the Fed have left? Part 2: Targeting longer-term interest rates - Ben Bernake.

The Berrnank has come with a another  new idea  - forget the market altogether and control booth short term interest rates and long term interests  .

Bond prices will become completely meaningless for allocation of resources.   

Is he a backseat driver in the Yellen car  ? 

Although the U.S. economy appears to be on a positive trajectory, history suggests that at some time in the next few years we may again face a slowdown, with a weakening job market and possibly declining inflation. Given that the historically low level of short-term interest rates is likely to limit the scope for conventional rate cuts, how would the Federal Reserve respond? 

As I discussed in my previous post, some tools remain in the monetary toolbox, including taking the short-term interest rate to zero, forward guidance about the future path of short-term rates, more Fed purchases of securities (quantitative easing), and negative short-term rates—a tool used in Europe and Japan but not so far in the US. Collectively, these actions could provide meaningful stimulus to a flagging economy. But what if still more accommodation were needed?In this post and the next I’ll discuss additional options, focusing today on targeting longer-term rates. I conclude that rate targeting can be a useful additional tool for the Fed, complementary to forward guidance and quantitative easing; but, as is the case with other monetary tools, there are ultimately limits to what it can achieve. (For materials from a recent Brookings mini-conference on monetary and fiscal options in the event of a new recession, see here.)

To be clear, I think it is unlikely that exotic policy tools like negative rates or targeting longer-term interest rates will be used in the U.S. in the foreseeable future. So why waste electrons discussing them? One reason is that public beliefs about these tools may influence expectations. For example, if the public and financial market participants are confident that government action will always be capable of returning inflation to the central bank’s target, then long-term inflation expectations are more likely to be “anchored,” which in turn makes attaining the inflation target easier. Consequently, and somewhat paradoxically, educating the public and market participants about more-radical monetary policy alternatives might help ensure that those alternatives are never needed.

Targeting longer-term interest rates

The Fed normally operates by influencing very short-term interest rates. However, we know that targeting rates for securities of longer durations is feasible, under some circumstances, since the Fed did it during World War II and the immediate postwar years. In April 1942, in an effort to reduce the cost of financing the war, the Fed began pegging the interest rate on Treasury bills at 3/8 percent and enforcing a ceiling of 2-1/2 percent on the rate on long-term Treasury debt. The rate on bills was allowed to rise modestly in 1947, but the 2-1/2 percent ceiling on bond yields was maintained for almost a decade, until 1951. [1]

Although the Fed’s pegs of 65 years ago were aimed at minimizing the cost of war finance, the same basic tool could be used today to advance the Fed’s macroeconomic objectives. Even when very short-term interest rates reach zero, longer-term rates (say, those on Treasury securities maturing in two, three, or five years) typically remain meaningfully higher. To ease financial conditions and support a slowing economy, the Fed could consider pegging one or more of these to lower levels. [2] In October 2010, the Fed staff provided the FOMC with a memo analyzing this possibility; I draw from that memo in this post.

To illustrate how a peg could work, suppose that the overnight interest rate were at zero and the two-year Treasury rate were at 2 percent. The Fed could announce that it intends to hold the two-year rate at one percent or less and enforce this ceiling by standing ready to buy any Treasury security maturing up to two years at a price that corresponds to a return of one percent. Since the price of a bond is inversely related to its yield, the Fed would effectively be offering to pay more than the initial market value. Think of it as price support for two-year government debt.

Timing details are important. Suppose the Fed announces on May 1, 2020 that it stands ready to buy any Treasury security that matures on May 1, 2022 or earlier at fixed prices corresponding to a yield of one percent. Note that, as time passes, the May 1, 2022, terminal date would not change (unless explicitly extended); thus, the maturities of the securities the Fed is committed to buy would decline over time, and the program would automatically end on the specified terminal date. Moreover, any securities that the Fed bought under the program would mature by the terminal date, leaving no lasting effect on the Fed’s balance sheet. This “automatic exit” is an attractive aspect of the approach.

Would this strategy be an effective way to lower the two-year interest rate, and, by extension, to reduce still longer-term interest rates (which are influenced by the two-year rate) as well? A lot would depend on the credibility of the Fed’s announcement. If investors do not believe that the Fed will be successful at pushing down the two-year rate, or expect that it might abandon the program before the stated end date (due to inflation concerns, for example), they will immediately sell their securities of two years’ maturity or less to the Fed. In this case the Fed could end up owning most or all of the eligible securities, with uncertain consequences for interest rates overall. On the other hand, if the Fed’s announcement is fully credible, the prices of eligible securities might move immediately to the targeted levels, and the Fed might achieve its objective without acquiring many securities at all.

To achieve credibility, the Fed needs to ensure that any peg it sets is consistent with the likely path of its short-term policy rate. A reasonable strategy would be to combine the announcement of a peg with (consistent) forward guidance about the path of short-term rates. The two announcements would reinforce each other, with the interest-rate target helping to guide market rates toward levels consistent with the forward guidance, and the forward guidance increasing the credibility of the target. [3]

Targeting very long-term interest rates (say, ten years or more) is considerably more difficult than pegging a medium-term rate (two years, say). Suppose for example that the FOMC proposed to target ten-year rates, enforced by an offer to buy securities at fixed prices for two years following the announcement. During the period of purchases, economic information that significantly shifted the path of short-term rates expected over any part of the ten-year horizon could destabilize the peg and lead investors to sell massive amounts of securities to the Fed. For this reason, I expect that the FOMC would not consider trying to target rates on securities of more than two to three years maturity. [4]

Rate-targeting and quantitative easing

A policy of targeting longer-term rates is related to quantitative easing in that both involve buying potentially large quantities of securities. An important difference is that one sets a quantity and the other sets a price. Suppose the government is trying to increase the price of cheese: It could buy a large quantity of cheese and let the market determine the impact of the policy on the price, or it could set a price for cheese and stand ready to buy as much cheese as necessary to enforce that price. Analogously, when using quantitative easing, the central bank buys a stated quantity of securities, but does not directly determine prices and yields. In contrast, a rate-targeting central bank specifies the yield it is trying to achieve (that is, sets a price for securities of a given maturity), but the quantity of securities that it has to buy will depend on the credibility of the peg and other factors. 

This comparison is useful for thinking about the benefits and risks of rate-pegging relative to quantitative easing. Rate-pegging would allow the Fed to set rates more precisely and to keep them more stable, which in turn might increase the confidence of households and businesses and make predicting the economic effects of the policy more straightforward. As already noted, a rate peg may also be a useful communication device, e.g., pegging the two-year rate at a low level would strongly signal the central bank’s intention to keep short-term rates low for some time as well. The primary risk of rate-pegging is that the Fed might end up buying very large amounts of securities; in the extreme, it could end up buying the entire stock of securities of a given maturity, without fully achieving its rate target. (In contrast, in a quantitative easing program, the amount to be purchased is typically specified in advance.) Concerns about “losing control of the balance sheet” were a factor behind the Fed’s choice of quantitative easing over rate targets while I was chairman.

Rate-targeting differs from quantitative easing in its channels of effect and in its impact on interest rates at different maturities. With quantitative easing, the Fed tried to reduce yields on securities of longer maturities by buying mostly longer-term bonds. QE works most directly by reducing the risk and liquidity premiums on securities, although it also influences expectations about how short-term rates will evolve. For reasons described earlier, rate pegs are likely to be focused on medium maturities, and they work in large part by signaling the path of short-term rates that the Fed expects. Conceivably, QE and rate-pegging could be used together to reduce longer-term rates, with QE working through reduced risk premiums while the rate peg operates indirectly by affecting the expected path of short-term interest rates. Both tools could be complemented by effective forward guidance which provides information on the Fed’s plans for short-term rates.

Conclusion on targeting longer-term rates

Targeting longer-term interest rates could be a useful additional tool for the Fed when short-term rates are zero. The announcement of a rate peg could have powerful signaling effects, thereby reducing longer-term rates without necessarily forcing a significant expansion of the Fed’s balance sheet. Rate pegs could also be useful complements to other unconventional policies, such as forward guidance or quantitative easing. The principal limitations of rate pegs are similar to those of forward guidance: Both tools are relatively less effective at affecting interest rates at longer maturities, and even at shorter horizons both must be consistent with a credible or “time-consistent policy” path for short-term interest rates. That is, for a rate peg to work, market participants must be confident that the FOMC will keep short-term interest rates on a path consistent with the target for the longer-term rate.

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Shareholder value

The enduring power of the biggest idea in business

WHAT is the most influential contemporary book about the world economy? An obvious choice is “Capital in the Twenty-First Century”, a 696-page analysis of inequality by Thomas Piketty, a French economist. There is another candidate: “Valuation”, a 825-page manual on corporate finance and shareholder value. Some 700,000 copies of it encumber the bookshelves of MBA students, investors and chief executives around the globe.

Inequality and shareholder value are linked in the minds of many folk, who blame investors and managers for stagnant wages and financial crises. Ruthless corporations are a big theme in America’s election campaign. The near-collapse of Valeant, a drugs firm, seems to illustrate a toxic business culture. Its shares have fallen by 73% this year. It is restating its accounts and is in negotiations with its lenders and under investigation by regulators. Valeant describes itself as “bringing value to our shareholders”. While there is no indication of fraudulent or illegal practice, the company could end up joining a pantheon of corporate fiascos that includes Enron (which pledged to “create significant value for our shareholders”), Lehman Brothers, (“maximising shareholder value”) and MCI WorldCom (“a proven record of shareholder value creation”).

Yet the sixth edition of “Valuation”*, published last year, a quarter of a century after the first, is a reminder of why shareholder value is still the most powerful idea in business and why many criticisms thrown at it are unfair. The origins of the doctrine lie in the 1950s and 1960s, when Franco Modigliani and Merton Miller, two scholars, showed that a firm’s value is independent of its capital structure and dividend policy. That inspired a new framework for analysis, popularised in the 1980s by Joel Stern, a consultant, Alfred Rappaport, another scholar, and McKinsey & Co, a consultancy, among others.

Company analysis was antediluvian until then. Models were scribbled on paper covered in correction fluid. Profits were cheered, without much regard to the book-cooking done, risks taken and capital used to achieve them. The worth of a firm was estimated by placing its profits or book value on a multiple, whose value was best decided after a three-Martini lunch.

“Valuation” and a few books like it, offered new tools. Cashflow, not easy-to-manipulate accounting profit, mattered. An activity only made sense if capital employed by it made a decent return, judged by its cashflow relative to a hurdle rate (the risk-adjusted return its providers of capital expected). Two newish spreadsheet programs, Lotus 123 and Microsoft Excel, let analysts forecast firms’ long-term cashflows and gauge their present value today.

This breathed fresh life into an old idea—that shareholders had the whip hand. Technically, shareholders do not own a company: the firm is a legal person and a share represents a bundle of entitlements to dividends and voting powers. But a doctrine of “shareholder primacy” had been outlined in 1919, when a Michigan court observed that “a business corporation is organised and carried on primarily for the profit of stockholders”. The new science of corporate finance revolutionised the pursuit of that goal. Managers realised that by working out where firms employed capital and using it more efficiently they could increase their value. Outsiders had a methodology with which to second-guess incompetent managers.

These ideas lit up corporate America first. In the late 1980s and 1990s, profits relative to GDP were at historic lows and global competition intensified. Managers used the methodology of shareholder value to break up conglomerates and ditch weak business lines. The financial industry was deregulated, creating an army of number-crunchers to scrutinise firms.

By the turn of the century, big European firms were on board. Germany’s system of cross-shareholdings between financial and industrial firms was unwound: investors could buy the same exposure and did not need companies tying up capital. The jewels of French industry were privatised and their bosses obliged to think of profitability as well as impressing politicians.

Today shareholder value rules business. Abenomics, the plan to revive Japan’s economy, involves prodding firms to use capital better. Fosun, a private Chinese firm, devotes a page of its annual report to calculating the value it claims to have created. The only boardrooms that shareholder value has not reached are those of China’s state-run firms, whose party-appointed bosses look baffled if asked about return on capital and buzz for more tea.

Value cremation

Yet at this moment of ascendancy in the business world, shareholder value is under fierce attack beyond it, fuelled by a sense that Western economies are not delivering rising prosperity to most people. The criticism falls into two categories. The first is that shareholder value is a licence for bad conduct, including skimping on investment, exorbitant pay, high leverage, silly takeovers, accounting shenanigans and a craze for share buy-backs, which are running at $600 billion a year in America.

These things happen, but none has much to do with shareholder value. A premise of “Valuation” is that there is no free lunch. A firm’s worth is based on its long-term operating performance, not financial engineering. It cannot boost its value much by manipulating its capital structure. Optical changes to accounting profits don’t matter; cashflow does (a lesson WorldCom and Enron ignored). Leverage boosts headline rates of return but, reciprocally, raises risks (as Lehman found). Buy-backs do not create value, just transfer it between shareholders. Takeovers make sense only if the value of synergies exceeds the premium paid (as Valeant discovered). Pay packages that reward boosts to earnings-per-share and short-term share-price pops are silly.

Outbreaks of madness in markets tend to happen because people are breaking the rules of shareholder value, not enacting them. This is true of the internet bubble of 1999-2000, the leveraged buy-out boom of 2004-08 and the banking crash. That such fiascos occur is a failure of governance and human nature, not of an idea.

The second criticism is weightier: that firms should be run for all stakeholders, not just shareholders. In a trite sense the goals of equity-holders and others are aligned. A firm that sufficiently annoys customers, counterparties and staff cannot stay in business. Some bosses, such as Paul Polman of Unilever, and Joe Kaeser at Siemens, say that pursuing social and financial objectives is consistent. But it is disingenuous to pretend conflicts do not arise. A firm with a loss-making factory cannot shut it without destroying jobs.

The trouble is identifying a goal that could replace the pursuit of shareholder value. If firms had to promote employment they would be less productive and riskier borrowers, as China is discovering. The objective of maximising wealth is deeply embedded in the global savings system, with asset managers obliged to protect clients’ money. Asking firms to adopt objectives to solve inequality loads a giant problem on their shoulders.

For these reasons shareholder value—properly defined—will remain the governing principle of firms. It is still drawing recruits. In August Larry Page, the co-founder and boss of Alphabet (Google’s parent), reorganised the firm, partly to “rigorously handle capital allocation” and make a “return above the benchmark”. But shareholder value is not the governing principle of societies. Firms operate within rules set by others. Consequences of stagnation could include higher taxes, tougher antitrust policing, more regulation and more rules to protect jobs. How firms respond is an issue for the next bestseller to tackle.