290 SHORT SELLING STRATEGIES capital ranged from lows of 2.23% and 2.95% in 1994 and 1997, respec- tively, to a high of only 9.21% in 1995. Meanwhile, WorldCom’s cost of capital was consistently above the 10% watershed mark during the 11- year reporting period. The average return on capital for WorldCom during the 1990 to 2000 period was 7.26%, while the firm’s average capital cost was 11.82%. Taken together, the capital return and capital cost experiences for the tele- communications giant produced a sharply negative residual return on capital during the eight years spanning 1993 to 2000. Equivalently, the average residual return on capital for WorldCom was negative, at –4.56%, over the reporting decade. These negative EVA findings for WorldCom can be seen in Exhibit 11.5 by focusing on either (1) the negative gap between the ROC and COC series or (2) the mostly negative residual return on capital (RROC) series during 1990 to 2000. The empirical findings for WorldCom are indicative of the financial dangers that ensue when a company’s after-tax capital returns fall short of the capital costs. With a positive after-tax return on capital for each year during 1990 to 2000, it would seem that the telecommunications giant was actually making money—albeit, a generally smaller amount when measured relative to capital as the years progressed. However, the EVA evidence reveals that WorldCom was in fact a large wealth destroyer for most of the 1990s. The persistently negative EVA spread— EXHIBIT 11.5 WorldCom: Return on Capital, Cost of Capital, and Residual Return on Capital: 1990–2000 11-Abate/Grant-Econ Profit Page 290 Thursday, August 5, 2004 11:16 AM The Economic Profit Approach to Short Selling 291 that began in the post-1992 years—was the economic source of the col- lapse in the telecom giant’s market value-added (MVA) that occurred at the century’s turn. Indeed, WorldCom’s filing for Chapter 11 bank- ruptcy protection in July 2002 was just the “nail in the coffin” for a company that was already busted from an economic profit perspective. For obvious reasons, this company type represents a strong sell or short sell opportunity to the degree that the negative EVA consequences (among other serious problems) could be anticipated. ROLE OF THE VALUE/CAPITAL RATIO Wall Street analysts often speak in terms of the “price-to-earnings” and “price-to-book value” ratios. By themselves, these ratios say little if anything about wealth creation, which is the primary focus of our good- versus-bad-company distinction in the discovery of short selling candi- dates. Along this latter line, one of the key benefits of the economic profit approach to measuring financial success is that we can see why a company has a price-to-book ratio above or below unity. We can show this NPV and EVA relation by simply dividing the firm’s enterprise value (V) by invested capital (C) according to: With this, we see that a firm’s enterprise value-to-capital ratio, V/C, exceeds one if and only if—in a well-functioning capital market—the firm has positive NPV. In contrast, the V/C ratio falls below unity when the firm invests in wealth destroying or negative NPV projects, such that the NPV-to-capital ratio turns negative. In the former case, the company is a “good” company and represents a potential buy opportunity, while in the latter case the firm is a sell or short sell opportunity. 12 Further, upon sub- stituting EVA into the enterprise value-to-capital ratio produces: 13 12 Recall that in practice, we must temper the short selling argument by a possible premium valuation due to perceived takeover. 13 For convenience, we continue with NPV-EVA aspects of the two-period model. VC⁄ CC NPV C⁄+⁄= 1NPVC⁄+= VC⁄ 1 EVA 1 COC+()⁄[]C⁄+= 1 C ROC COC–()×()1 COC+()⁄[]C⁄+= 1 ROC COC–[]+ 1 COC+()⁄= 11-Abate/Grant-Econ Profit Page 291 Thursday, August 5, 2004 11:16 AM 292 SHORT SELLING STRATEGIES We now see that wealth-creating firms have an enterprise value-to- capital ratio that exceeds unity because they have positive NPV (good company characteristics). The source of the positive NPV is due to the discounted positive economic profit. In turn, EVA is positive because the firm’s after-tax cash return on investment (ROC) exceeds the weighted average cost of capital (COC). From this value-to-capital formulation, we also see that wealth-destroying companies have negative EVA, a neg- ative EVA spread, and a value-to-capital ratio that falls below unity (bad company characteristics). Upon substituting the values from the wealth destroyer illustration into the value-to-capital ratio yields: Thus, while Wall Street considers a company having a value-to-cap- ital ratio that falls below unity to be a “value stock,” it is hardly a real value opportunity—unless of course a reversal is made by the existing managers or a “new” and more profit conscious management is antici- pated. Fortunately, with economic profit there is little uncertainty as to (1) why a wealth-creating firm has a value-to-capital ratio (or “price-to- book” ratio in popular jargon) that exceeds one; and (2) why a wealth waster has a value-to-capital ratio that lies below unity. Unlike account- ing profit measures, economic profit metrics give investors the necessary financial tools to see the direct relationship between corporate invest- ment decisions and their expected impact on shareholder value. Further- more, with a solid foundation on the principles of wealth creation (and destruction), investors can utilize the value-to-capital ratio in a trans- parent way to distinguish between buying and selling opportunities. INVESTED CAPITAL GROWTH While our focus thus far on EVA is instructive—because it allowed us to use financial principles to distinguish between good and bad companies— the analysis is incomplete because it does not address how EVA is chang- ing. In this section, we explain the role of invested capital growth in the discovery of companies that are pointing in the direction of positive and negative economic profit change (potential buy and sell opportunities, respectively). We begin the focus on capital formation by demonstrating the rela- tionship between changes in economic profit and the level of capital investment. In the model development, we take capital additions to VC⁄ 1 $2.5 1.1()⁄–[]$100⁄+ 0.977== 11-Abate/Grant-Econ Profit Page 292 Thursday, August 5, 2004 11:16 AM The Economic Profit Approach to Short Selling 293 mean those required beyond maintaining the NOPAT earnings stream from existing assets. To focus directly on the strategic role of invested capital growth, we express the change in economic profit for any given year as a function of the presumed constant residual return on capital 14 multiplied by the change in (net) invested capital according to In the above expression, we see that change in economic profit for any company is determined by (1) the sign and magnitude of the resid- ual return on capital and (2) the sign and dollar magnitude of the change in invested capital. When ∆C is positive, the firm is making an internal/external (acquisitions) growth decision, while when ∆C is nega- tive, the firm is making an internal decision by presumably restructuring business units and/or processes. In either case—corporate expansion or corporate contraction—managers and investors must make a correct assessment of the expected EVA spread when making strategic invest- ment decisions (active buy or sell decisions in the case of investors). Since we have previously shown that NPV and economic profit are linked via present value, it is a simple matter to show that changes in wealth are related to changes in invested capital. We will now use a sim- ple EVA perpetuity model to show this NPV result. 15 In order to empha- size the importance of capital formation, we will once again assume that the residual return on capital is constant in the model development. The resulting constancy in the economic profit spread implies that changes in economic profit and NPV are directly related to changes in the level of invested capital. This allows active investors to focus on companies that are pointing in the direction of wealth creation (or destruction) based on their capital spending activities for a given EVA spread. With these assumptions, we express the change in NPV for any given company as 14 We take the EVA spread constant in the model so that we can focus directly on the strategic role of invested capital growth on economic profit and wealth creation. In practice, we realize that a firm’s marginal return on capital and its cost of capital may vary due to changes in the level of capital investment. For example, ROC may fall and COC may rise in the presence of capital expansion. 15 We do not have to assume that economic profit is constant each year as in a per- petuity model. For example, we could view EVA as the annualized equivalent of the variable economic profit figures that produce the original NPV. Then, a similar in- terpretation of annualized EVA change could be applied to induce a change in NPV. EP∆ C∆ ROC COC–[]×= 11-Abate/Grant-Econ Profit Page 293 Thursday, August 5, 2004 11:16 AM 294 SHORT SELLING STRATEGIES In this simple valuation model, we see that capital expansion or capital contraction can have a meaningful impact on wealth creation. Also, just like with changes in economic profit, changes in NPV are dependent on both the sign and magnitude of change in invested capital and the resid- ual return on capital—where RROC is the economic profit spread. MANAGERIAL AND INVESTOR IMPLICATIONS Exhibit 11.6 summarizes the general relationship between the sign of the economic profit spread and predicted changes in economic profit and NPV for a presumed invested capital growth rate—that is, ∆C is assumed greater than zero, or ∆C is less than zero. The EVA-capital growth relationships are interesting in several managerial and investor respects. First, the exhibit shows that economic profit and NPV rise when the level of capital invest- ment is expanded in a company having a positive expected EVA spread (that is, ∆C > 0 and RROC > 0). This, after all, is the essence of real com- pany growth as opposed to illusory company growth that merely expands the revenue and/or corporate asset base. From the investor’s perspective, this company type is a potential buy opportunity to the extent that the sus- tainable economic profit change is not fully reflected in stock price. Exhibit 11.6 also implies that economic profit and wealth decline when a company expands a growth-oriented business with a (now) neg- NPV∆ EP∆ COC⁄= C∆ ROC COC–[]COC⁄×= C RROC[]COC⁄×∆= EXHIBIT 11.6 Wealth Creation, Changes in Invested Capital Capital Expansion (∆∆ ∆∆ C > 0) Active Trading Decision RROC > 0 ∆EP > 0 ∆NPV > 0 Buy RROC = 0 ∆EP = 0 ∆NPV = 0 Avoid RROC < 0 ∆EP < 0 ∆NPV < 0 Sell/Short sell Capital Contraction (∆C < 0) Active Trading Decision RROC > 0 ∆EP < 0 ∆NPV < 0 Sell/Short sell RROC = 0 ∆EP = 0 ∆NPV = 0 Avoid RROC < 0 ∆EP > 0 ∆NPV > 0 Buy 11-Abate/Grant-Econ Profit Page 294 Thursday, August 5, 2004 11:16 AM The Economic Profit Approach to Short Selling 295 ative residual return on capital (∆C > 0 and RROC < 0). Capital expan- sion beyond the optimal point—as reflected in maximum NPV—can arise in a firm that is focused more on maximizing some financial or nonpecuniary variable that is inconsistent with the principles of eco- nomic profit and shareholder value maximization. Such misguided busi- ness expansion includes a revenue or asset-maximizing manager replete with an agenda of corporate acquisitions. Moreover, misguided invest- ment decisions also arise in corporate organizations that expand a here- tofore growth company at the peak of its competitive cycle. Herein lays an EVA perspective on a “overzealous” growth company that now rep- resents a strong sell or short sell opportunity. Corporate Contraction Exhibit 11.6 presents some interesting facets of capital contraction. Spe- cifically, the exhibit shows that economic profit and shareholder value decline when a manager contracts a company with a positive EVA spread (∆C < 0 and RROC > 0). In this case, the decline in economic profit is caused by the negative change in invested capital in the presence of a positive residual capital return. This is a company that—other things being the same—should be expanded rather than contracted. As with the NPV consequences of the overzealous growth company (but for different reasons), the manager that misguidedly contracts a positive- EVA-spread business is pointing the firm in a direction of wealth destruction for the shareholders. Not surprisingly, this company profile represents a potential sell or short sell opportunity. In contrast, Exhibit 11.6 illustrates the positive side of capital con- traction. Indeed, a manager in a risky troubled company that is seri- ously concerned about wealth recapture must shed those business assets or processes that are plagued by negative economic profit. Corporate managers (and investors) must realize that turn-around value—or recap- tured shareholder value—can be realized by contracting a stale business with a negative expected economic profit spread. In formal terms, when ∆C < 0 and RROC < 0, then ∆NPV > 0. Alas, the positively restructured company represents a real value opportunity (buy)! MATRIX OF GOOD AND BAD COMPANIES Exhibit 11.7 presents a matrix of company growth and value regions to help investors identify the EVA spread/capital formation combinations that lead to wealth creation (or destruction). In the two quadrants with positive capital growth, Quadrants II and III, we see a good company 11-Abate/Grant-Econ Profit Page 295 Thursday, August 5, 2004 11:16 AM 296 SHORT SELLING STRATEGIES growth region (Quadrant II) and a bad or overzealous company growth region (Quadrant III). In the two quadrants with negative capital growth, Quadrants IV and I, we see a good company value region where capital contraction creates shareholder value (Quadrant IV) and a bad company value region where underinvestment highlights few opportuni- ties for creating shareholder wealth (Quadrant I). 16 From an investment perspective, Quadrants II and IV represent potential buy opportunities while Quadrants III and I represent (short) sell-to-avoid regions, respectively. In practice, we interpret Quadrant I as a region to avoid because it is typically populated by the currently positive EVA spread businesses of mature growth companies—such as food and tobacco companies—that have limited future growth opportu- nities. This underinvestment or poor utilization of capital region is dif- ferent from Quadrant IV where companies are restructuring for positive economic profit change and thereby wealth creation. In Quadrant II, we see that growth-oriented companies that are expanding their capital base with a positive EVA spread are poised for 16 We interpret “growth”—whether good or bad—in terms of companies that are still expanding their capital base, while “value” refers to companies in the EVA sche- matic that are—by default—contracting their capital base. EXHIBIT 11.7 Company Growth and Value Matrix 11-Abate/Grant-Econ Profit Page 296 Thursday, August 5, 2004 11:16 AM The Economic Profit Approach to Short Selling 297 continued—albeit substantial improvement in shareholder value. Invest- ing in positive economic profit and (therefore) positive NPV projects— both now and in the anticipated future—is the essence of real company growth. On the other hand, Exhibit 11.7 suggests that growth-oriented companies that are moving toward the overzealous company growth quadrant (Quadrant III) are heading in a direction that can lead to sub- stantial compression in stock price and shareholder value. The movement into the “growth for growth sake” region is most unfortunate for investors in companies with managers who naively believe that revenue and/or asset growth will automatically transfer into economic profit and wealth creation. Worse yet, the movement into Quadrant III is troublesome for investors who are wedded to companies having overzealous growth managers—with inordinate preoccupation with revenue and/or asset growth—that fail to heed the principles of wealth creation. Not surprisingly, growth companies that now face a misguided growth profile are strong sell or shorting candidates. Revisiting Capital Contraction As mentioned above, Exhibit 11.7 identifies two regions of capital contrac- tion, Quadrants IV and I. There are several company types that might fall into these regions of the company growth-and-value matrix. For instance, we could be talking about a slow-to-negative growth company in the auto- motive, food, mining, steel, or railroad industries that are viewed as “Old Economy” companies. These companies are different from the high growth companies usually found in technology, health care or consumer segments. They are also companies that have currently negative economic profit (Quadrant IV companies) or limited EVA growth potential (Quadrant I companies) due to the commodity-oriented nature of their businesses. Moreover, because these slow growth companies can either restructure for positive change or hardly change at all, we take Quadrants IV and I as regions of good company value and bad company value, respectively. Con- sequently, companies in Quadrant IV are viewed as potential buy opportu- nities (due to the positive restructuring) while the mature-to-stale companies in Quadrant I should be avoided (due to the lack of profitable reinvestment opportunities or poor utilization of capital). Strictly speaking, Quadrant I is represented by firms that are down- sizing a positive EVA spread business. If this deinvestment activity per- sists, it can only lead to decreases in economic profit and shareholder value. In practice, we interpreted this quadrant as a capital formation region that is reflective of managers that cannot expand their mature businesses without significantly lowering returns on capital. In contrast, Quadrant IV is viewed as a region of constructive deinvestment in the 11-Abate/Grant-Econ Profit Page 297 Thursday, August 5, 2004 11:16 AM 298 SHORT SELLING STRATEGIES company growth-and-value matrix. With capital contraction, we see that companies in this region are downsizing or restructuring negative EVA spread businesses—since the expected residual return on capital is less than zero. Based on the financial math of this region, one can say that a negative change in invested capital times a negative EVA spread (business) leads to a positive expected improvement in economic profit and shareholder value. Again, because of efficient restructuring, Quad- rant IV companies represent potential buy opportunities. On balance, Exhibit 11.7 shows that Quadrants II and IV have the greatest potential for improvement in stock price and shareholder value. While companies and industries in these regions can be radically differ- ent—we would expect that high barrier-to-entry growth companies would show up in Quadrant II, while forward looking “Old Economy” compa- nies would show up in Quadrant IV—we get to the same economic profit conclusion. That is, companies in Quadrant II are expanding positive EVA spread businesses that stand to create substantial shareholder value. Com- panies in Quadrant IV are efficiently restructuring stale or troubled busi- nesses and should also see noticeable improvement in economic profit and stock price. Consequently, we view these EVA-based regions as the good company growth and good company value regions, respectively. More- over, from the active investors perspective, companies in Quadrants II and IV represent potential buy opportunities while, as we explained before, the bad company growth and bad company value firms in Quadrants III and I represent (short) sell-to-avoid opportunities, respectively. RECONCILING MARKET IMPLIED GROWTH Up to this point we have been careful to emphasize the word “poten- tial” when referring to buy or sell opportunities. This qualification is necessary because market implied expectations of economic profit growth (even if positive) might already be reflected in share price. For example, we recognize that “good” companies that show up in Quad- rants II and IV of the company growth and value matrix (Exhibit 11.7) can have good or bad stock characteristics. To illustrate this, Exhibit 11.8 shows the “Excess Return on Invested Capital” versus the “Market Value of Invested Capital to Replacement Cost of Invested Capital” 17 for a sample of companies that we track at GAM USA. 17 Note that the “excess return on invested capital” is equivalent to the EVA-to- capital ratio as well as the EVA spread. Also, the use of market value-to-replacement cost of invested capital is really just a scaling on our previous usage of the NPV- to-capital ratio. 11-Abate/Grant-Econ Profit Page 298 Thursday, August 5, 2004 11:16 AM The Economic Profit Approach to Short Selling 299 In this exhibit, the excess return on invested capital is simply the after-tax return on invested capital less the cost of capital. This is just the EVA spread that we defined before. Also, we report the market value of invested capital (or enterprise value) relative to replacement cost of capital for consistency with the traditional way of evaluating companies in profitability versus “price-to book” context. There is no slippage of economic profit focus because the market value of invested capital-to- replacement cost of invested capital ratio is directly related to the NPV- to-invested capital ratio that we explained before. 18 Exhibit 11.8 shows a scatter plot of “good” companies (culled from an Exhibit 11.7 analysis) measured relative to a curve through the data points. Points in the exhibit that lie above the curve are considered to be buy opportunities, while data points that fall below the curve represent 18 Recall that the enterprise value-to-capital ratio can be written as: V/C = 1 + NPV/C In this expression, V is enterprise value (or market value of invested capital) and C is a measure of invested capital. Hence, V/C is greater than one when NPV is posi- tive, while V/C is less than unity when NPV is negative. The market value of invested capital-to-replacement cost of invested capital is also a measure of “Tobin’s Q.” EXHIBIT 11.8 Excess Returns Relative to Valuation 11-Abate/Grant-Econ Profit Page 299 Thursday, August 5, 2004 11:16 AM [...]... Jacobs and Kenneth N Levy, “20 Myths About Long -Short, ” Financial Analysts Journal (September/October 1996), pp 81 85 ; and Bruce I Jacobs and Kenneth N Levy, “The Long and Short on LongShort,” The Journal of Investing (Spring 1997), pp 73 86 7 Bruce I Jacobs, Kenneth N Levy, and David Starer, “On the Optimality of Long -Short Strategies, ” Financial Analysts Journal (March/April 19 98) , pp 26– 30; and Bruce... positions alone and another attributable to short positions alone Only jointly do the long and short positions define the portfolio Rather than being measurable as long and short performances in excess of an underlying benchmark, the performance of an integrated long -short portfolio is measurable as the overall return on the long and short positions—or the spread between the long and short returns—relative... in Bull and Bear Markets (millions of dollars) Source: Bruce I Jacobs and Kenneth N Levy, “The Long and Short on Long -Short, ” Journal of Investing (Spring 1997) EXHIBIT 12.2 3 08 SHORT SELLING STRATEGIES $50,000 (5.0% of $1 million) (A lower rate would result, of course, in a lower return.) Thus, at the end of the period, the $10 million initial investment has grown to $11.04 million The long -short portfolio... I Jacobs and Kenneth N Levy, “More on Long -Short Strategies, ” Financial Analysts Journal (March/April 1995), pp 88 –90 310 SHORT SELLING STRATEGIES Consider, for example, an investor who does not have the ability to discriminate between good and bad oil stocks, or who believes that no oil stock will significantly out- or underperform the underlying benchmark in the near future In long-plus -short, this... for Investment Management and Research, 19 98) , pp 70 81 2 In practice, lenders of stock will usually demand that collateral equal something over 100% of the value of the securities lent (usually 105%) Long -Short Equity Portfolios EXHIBIT 12.1 305 Market-Neutral Deployment of Capital (millions of dollars) Source: Bruce I Jacobs and Kenneth N Levy, “The Long and Short on Long -Short, ” Journal of Investing... for providing us with the ADR data, and Carolina Velosa for excellent research assistance 323 324 SHORT SELLING AND MARKET EFFICIENCY London, Brussels, and Paris Now, considerable trading takes place in local exchanges according to local laws, regulations and practice In this chapter, we collect information on short sales regulation and practice about more than 80 markets around the world Our survey... comprises a 5% return from interest earnings and a 5.4% return from the equity positions, long and short The bottom half of Exhibit 12.2 illustrates the portfolio’s performance assuming the market declines by 15% The long and short positions exhibit the same market-relative performances as above, with the longs falling by 12% and the shorts falling by 18% In this case, the decline in the prices of... T, and hedge funds and other investors may organize as their own broker-dealer or arrange to trade as the proprietary account of a broker-dealer in order to attain much more leverage than Reg T would allow See Bruce I Jacobs, Kenneth N Levy, and Harry M Markowitz, “Portfolio Optimization with Factors, Scenarios and Realistic Short Positions,” Jacobs Levy Equity Management, 2004 306 SHORT SELLING STRATEGIES. .. 55–60; and James Rutter, “How to Make Volatility Pay—The Next Step Forward Could Be Portable Alpha,” Global Investor, June 2003 314 Equitized Hypothetical Performance in Bull and Bear Markets (millions of dollars) Source: Bruce I Jacobs and Kenneth N Levy, “The Long and Short on Long -Short, ” Journal of Investing (Spring 1997) EXHIBIT 12.4 Long -Short Equity Portfolios 315 portfolio offers a return (and. .. explicitly the risks and returns of the individual securities and the benchmark holding, as well as their correlations SOME CONCERNS ADDRESSED Long -short construction maximizes the benefit obtained from potentially valuable investment insights by eliminating long-only’s constraint on short selling and the need to converge to securities’ benchmark weights in order to control portfolio risk While long -short offers . N. Levy, “The Long and Short on Long -Short, ” Journal of Investing (Spring 1997). 12-Jacobs/Levy-Long-ShortEquity Page 307 Thursday, August 5, 2004 11:17 AM 3 08 SHORT SELLING STRATEGIES $50,000. growth, Quadrants II and III, we see a good company 11-Abate/Grant-Econ Profit Page 295 Thursday, August 5, 2004 11:16 AM 296 SHORT SELLING STRATEGIES growth region (Quadrant II) and a bad or overzealous. the 11-Abate/Grant-Econ Profit Page 297 Thursday, August 5, 2004 11:16 AM 2 98 SHORT SELLING STRATEGIES company growth -and- value matrix. With capital contraction, we see that companies in this region