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Pricing Country Risk: Pictures Of Global Risk – Part III

In my last two posts, I looked at country risk, starting with an examination of measures of country risk in this one and how to incorporate that risk into value in the following post . In this post, I want to look at an alternative way of dealing with country risk, especially in investing, which is to let the market price of country risk govern decisions. Pricing Country Risk If you are not a believer in discounted cash flow valuations, I understand, but you still have to consider differences in country risk in your investing strategies. If you use pricing multiples (P/E, Price to Book, EV to EBITDA) to determine how much you will pay for companies, you could assume that the levels of these multiples in a country already incorporate country risk. Thus, you are assuming that the P/E ratios (or any other multiple) will be lower in riskier countries than in safer ones. It is easy to illustrate the impact of risk on any pricing multiple, with a basic discounted cash flow model and simple algebra. To illustrate, note that you can use a stable growth dividend discount model to back into an intrinsic P/E: Dividing both sides of this equation by earnings, we derive an intrinsic P/E ratio: The P/E ratio that you should expect to observe in a country will be a function of the efficiency with which firms generate earnings (measured by the payout ratio), the expected growth in these earnings (g) and the risk in these earnings (captured by the cost of equity). Holding the growth and earnings efficiency constant, then, you should expect to see lower P/E ratios in countries with higher risk and higher P/E ratios in safer countries. You can use the same process to extract the determinants of price to book ratios or enterprise value multiples and you will arrive at the same conclusion. Equity Multiples To see how well this pricing paradigm works, I started by looking at P/E ratios by country in July 2015. To estimate the P/E ratio for a country, I tried three variants. In the first, I compute the P/E ratio for each company in the country (where it was computable) and then average across these P/E ratios. To the extent that there are small companies with outlandish P/E ratios in the sample (and there are many), these ratios will be skewed upwards. In the second, I compute a weighted average P/E ratio across companies, with the weights based upon net income. This ratio is less affected by outliers, but it excludes money-losing firms (since the P/E ratio is not meaningful for these companies). In the third, I add up the market values of equity across all companies in the market and divide by aggregated net income for all companies, including money-losing companies, i.e., an aggregated P/E ratio. This ratio has the advantage of including all listed firms in a market but big money-losing firms will push this measure up. The picture below summarizes differences in P/E ratios across the world, with the weighted average P/E ratio as the primary measure, but with all three reported for each country. Source: chartsbin.com As you can see, P/E ratios are noisy, with some very risky countries (like Venezuela) trading at high P/E ratios and safe countries at lower values, not surprising given how much earnings can shift from year to year. For the most part, the riskiest countries are the ones where stocks trade at the lowest multiple of earnings. To get a more stable measure of pricing, I computed price to book values by country, again using the simple and weighted averages across companies and aggregated values and report the weighted average Price to Book in the picture below: Source: chartsbin.com As with P/E ratios, there are outliers and Venezuela still stands out with an absurdly high price to book ratio, incongruous given the risk in that country. For the most part, though, the PBV ratio is correlated with country risk, as you can see in this list of the 28 countries that have price to book ratios that are less than one in July 2015: Weighted average PBV ratio in July 2015 Enterprise Value Multiples Both P/E and PBV ratios are equity multiples and may reflect not just country risk but also variations in financial leverage across countries. To remedy this problem, I look at EV to EBITDA multiples across countries: Source: chartsbin.com Looking at this map, it is quite clear that there is much less correlation between EV/EBITDA multiples and country risk than there is with the equity multiples. While it is true that the lowest EV/EBITDA multiples are found in the riskiest parts of the world (Russia & Eastern Europe, parts of Latin America and Africa), the highest EV/EBITDA multiples are in India and China. There are two ways of looking at these results. The optimistic take is that if you have to pick a multiple to use to compare companies that are listed in different markets, you should use an enterprise value multiple, since it is less affected by country risk. The pessimistic take is that you are likely to overvalue emerging market companies, if you use EV/EBITDA multiples, since they are less likely to incorporate country risk. Using these multiples The standard approach to pricing a company is to choose a multiple and compare how stocks that you deem “comparable” are being priced based on that multiple. This approach can be extended to deal with country risk, albeit with some limitations, in one of four ways: Compare how stocks listed in a country are priced to find “bargains”: You could compare P/E ratios across Brazilian companies on the assumption that Brazilian country risk is already incorporated in the pricing and buy (sell) the lowest (highest) P/E stocks. The danger with this approach is that you are assuming that all Brazilian companies are equally exposed to Brazilian country risk. Compare how stocks within a sector in a country are priced: Rather than compare across all stocks in a market, you could compare stocks within a sector in that market, on the assumption that both country and sector risk are already in the prices. Thus, you could compare the EV/Sales ratios of Brazilian retailers and argue that the retailers that trade at the lowest multiples of revenues are cheapest. The downside is that you may not find enough companies in a country, especially in a smaller market. Compare how stocks within a sector are priced globally: A logical outgrowth of globalization is to compare companies within a sector, even if they are listed in different countries. Thus, you could compare Vale (NYSE: VALE ) to other mining companies listed globally and Coca-Cola (NYSE: KO ) to beverage companies across countries. The benefit is that you have more comparable firms but the danger is that you are ignoring country risk. Compare stocks within a sector that are priced globally, but control for country risk: In this last approach, you look at the pricing of companies across a sector but try to control for country risk by looking at differences between how the market is pricing companies in developed markets and emerging markets. No matter which approach you use, you have the pluses and minuses of pricing. The plus is that you will always be able to find “cheap” stocks, because you are making relative judgments and it is simple to get the data. The minus is that if stocks are collectively overpriced, either at a country or sector level, a pricing comparison will just yield the least overpriced stock in the country or sector. Valuing and Pricing: Final Thoughts In my last post , I looked at ways in which you can try to incorporate country risk into the values of companies. In this one, I looked at how to price these companies, based upon how the market is pricing other companies in risky countries. As I have argued in my posts on price versus value, the two approaches can yield divergent numbers and conclusions. Thus, you could value a company with all its operations in China, using an appropriate equity risk premium for China, and conclude that the stock is overvalued. You could then compare the P/E ratio for the same company to the P/E ratio for the Chinese market and decide that it is cheap, because it trades at a lower multiple of earnings than a typical Chinese company. I tend to go with the first approach, since I have more faith in my valuation abilities than in my pricing abilities, i.e., I am more an investor than a trader. However, I am not quick to dismiss those who use pricing metrics to pick investments, since a nimble trader can play the pricing game very profitably. If you are unsure about where you fall in this process, I would suggest that you both value and price companies and buy only when both signal that the stock is a bargain. 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Black Hills’ SourceGas Acquisition Provides Patient Investors Good Entry Point For Current Income

Summary Black Hills recently announced the acquisition of privately-owned SourceGas. The company is financing most of the acquisition by taking on additional debt. The market is punishing the company for the acquisition. The stock dropped 14% over the two weeks following the announcement. I believe the stock will decline further, but this will provide investors looking for current income a good entry point. On July 12th, Black Hills Corporation (NYSE: BKH ) announced the acquisition of SourceGas Holdings LLC from investment funds managed by Alinda Capital Partners and GE Energy Financial Services. David Butler has a nice article on the acquisition , and I’ve written previously about Black Hills Corporation’s business and dividend growth history. The acquisition increases Black Hills’ coverage in its existing service area in Colorado, Nebraska and Wyoming, and expands the company’s service area into Arkansas. The combined company’s customer base will expand by 55% to more than 1.2 million, and Black Hills claims the purchase will “meaningfully” increase earnings in the first year after closing the acquisition. Unfortunately, the company was not more specific as to how large of an earnings increase it expects. Market Sells Stock on Announcement Despite the benefits of the acquisition, the market did not react well to the news. BKH stock fell 2.4% the day after the acquisition and kept going, losing over 14% over the next two weeks. (See chart 1 below.) I believe the reaction is due to the large amount of debt that Black Hills will take on for this acquisition. While Black Hills has shown the ability to integrate acquisitions into their business, many of the past acquisitions have been less than $100 million. The SourceGas acquisition is twice as large as the $940 million acquisition of five Aquila utilities in July 2008. The bulk of the $1.89 billion cost of SourceGas will be a combination of the assumption of $720 million in SourceGas debt and an additional $450 million-$550 million in debt, which will increase Black Hills’ long-term debt by 80% to $2.76 billion. According to Bloomberg , Fitch Ratings placed Black Hills on credit watch negative due to the “material increase” in debt. Will the New Debt Impact the Dividend? I don’t expect Black Hills to stop growing its dividend. The company has increased dividends for an impressive 44 years and it isn’t likely to break this streak despite the debt burden. However, the increase in debt will limit the available funds for dividend growth. With a 55% increase in its customer base, the company should see an earnings increase from the acquisition, but will likely need to work off at least some of the new debt over time to see the full effects of the earnings growth. Over the last 5 and 10 years, Black Hills has compounded the dividend at a slow 2.4%. From 1998-2014, Black Hills increased its quarterly dividend by less than a penny a share. In 2015, the company increased the quarterly dividend by a larger-than-normal 1.5 cents. It would be difficult for the company to slow the dividend even further, but I believe that is exactly what the company will do. Until Black Hills works off the debt from this acquisition, I expect quarterly dividend growth of no more than half a cent a year. What this means for investors is that Black Hills will remain an investment for people looking for current income and not for dividend growth. Wait for BKH to Hit Support Before Buying A technical analysis of the stock movement shows that BKH was in a downtrend even before the merger announcement; the announcement only accelerated the downtrend. As shown in chart 1 below, the stock had set up a pattern of lower highs and lower lows. While the stock may currently be oversold, there is little support until $33, with stronger support at the prior consolidation around $28-$31. (See chart 2.) I think it’s likely that BKH will move to that support zone, which would give the stock a yield of 4.9%-5.2% (based on a stock price of $30-$33). I would consider selling a put or purchasing BKH outright at those levels. (click to enlarge) Chart 1: BKH was in a downtrend prior to the acquisition announcement. (click to enlarge) Chart 2: After breaking into the low $40s on heavy volume, the next major level of support is in the high $20s-low $30s. Source: Stockcharts.com The Bottom Line: The acquisition of SourceGas sets Black Hills up for future growth, but the debt overhang will limit near-term dividend growth. The market’s (over)reaction will provide investors looking for current income a good entry point as the stock moves to support. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in BKH over the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: As noted above, I may take a position in BKH in the near future.

Vanguard Wellesley Income Fund: The Reverse Of Wellington

Having written about VWELX, a reader asked my take on sister fund VWINX. The two are pretty much the reverse of each other. That, in the end, winds up being a risk issue for potential investors. A lot of investors look at bonds as a way to generate income. And that’s true. But in an asset allocation model, they are also a way to provide diversification and stability. In other words, a big part of owning bonds is safety. And that’s where a comparison of value-focused Vanguard Wellesley Income Fund (MUTF: VWINX ) and Vanguard Wellington Fund (MUTF: VWELX ) leads to some interesting findings. One down, now for number two I recently wrote an article about Vanguard Wellington . Within the comments, a reader asked if I would also take a look at sister fund Vanguard Wellesley. The comparison of the two is actually pretty interesting and highlights an important aspect of investing: risk. Wellington’s portfolio goal is to actively invest in stocks and bonds with a mix of roughly two-third stocks and one-third bonds. There’s a band around those percentages since it’s an actively managed fund, but it generally keeps pretty close to its goals. Sister fund Wellesley’s goal is the mirror image, one-third in stocks and two-thirds in bonds. And what that means for performance is very important. For example, as you might expect, Wellington outperforms bond-heavy Wellesley over the trailing one-, three-, five-, 10-, and 15-year periods through June on an annualized total return basis. That said, over the longer periods, the numbers start to get pretty close. There’s just 30 basis points or so separating the two funds over the 15-year period and around one percentage point over the trailing decade. But, the trend is intact, the fund with more stocks does, indeed, do better on an absolute basis. Interestingly, the income both funds generate is pretty close, too. Wellesley’s trailing 12-month yield is a touch under 3%. Wellington’s yield is roughly 2.5%. To be fair, a good portion of that has to do with the current low rate environment. In a different period, with higher interest rates, I would expect Wellesley’s yield advantage to be larger. But what about risk? But return and distributions aren’t the only factors to consider. Bonds are also about risk control. And on that score, these two funds have very different profiles. For example, over the trailing three years, Wellington’s standard deviation, a measure of volatility, is around 5.5. That’s a pretty low standard deviation. However, Wellesley’s number is an even lower 4. For most conservative investors, either of those two figures would be agreeable. Looking out over longer periods starts to show a bigger gap. For example, over the trailing 15-year period, Wellesley’s standard deviation is roughly 6 and Wellington’s is around 9.5. That’s a more meaningful difference. And remember that the two funds had very similar performance numbers over that span. Thus, over the trailing three years, Wellington’s Sharpe ratio of 2, a figure that measures the amount of return relative to the amount of risk taken, outdistances Wellesley’s 1.7. But over the trailing 15 years, those numbers flip, with Wellesley’s Sharpe ratio of 1 outdistancing Wellington’s 0.7 or so. Since performance over that longer term is so close, the big reason for the difference here is risk. Who’s right for what? At the end of the day, the two funds are both good options for conservative investors looking for a balanced fund. The biggest difference is really in the investor’s desire for safety. If the higher bond component in Wellesley will help you sleep better at night, then you should probably go with the more conservative of these two funds. If you don’t find solace in having more bonds in your portfolio, go with Wellington – noting that the choice is likely to lead to a slightly higher risk profile. That said, there’s a caveat. Interest rates are at historic lows. Bond prices and interest rates move in opposite directions. So when rates go down, bond prices go up. That’s been a tailwind for Wellesley for quite some time. If rates start to move higher quickly, however, that could turn into a headwind because as rates go up, bond prices go down. Wellesley’s higher debt component will mean rising rates are a bigger issue for the fund than for its sibling. However, both funds are run by the same management company and have been around a long time. They have dealt with shifting interest rates before. So this is something to keep in mind, but I wouldn’t let it deter me from purchasing either of these two well-run funds if my goal was to own them for a long time. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.