A Global Valuation Compass
Globalization, financial innovation and ever-expanding global liquidity mass have brought about a structural upward shift in correlation across regions, countries, sectors and asset classes and hence a structural upward shift in volatility and systemic risk. In our view, this high correlation and volatility, which could stay with us for a while, dislocates the market, generates massive value distortions and therefore plenty of opportunities, provided one has a way to measure value.
Lumen Advisors believes a successful, value-based investment strategies must integrate traditional bottom-up analyses with an objective, quantitatively defined Global Value Framework.
Global Valuation Framework: Starting with Risk
- The price and (current) value of an investment is simply the sum of future cash flows discounted back to present value by its cost of capital, or its IRR.
- Thus the value of any long term investment – bond, equity, private or public – can be screened, ranked and valued by calculating the IRR implied by the market price.
- We start from the riskiest component of investable capital, i.e. common equities, in that in our view risk should be measured from the highest (equity) to the lowest (cash) capital component.
- We calculate the cost of common equities by reverse-engineering the current market level and extracting the internal rate of return for equities across regions, countries and sectors. We then “roll down” this risk curve across the global capital structure, and measure the IRR for high yields, high grades, sovereigns, and risk free rates (or cash).
- The merit of this approach is an unbiased and comparable ranking of investments across regions, countries, sectors and asset classes – without the pitfalls of using a false risk-free rate, an arbitrary risk premium or, worse yet, unstable multiples metrics.
On Global Markets
Our guiding tenet is that active management is appropriate and profitable in markets where inefficiencies are evident and mispricing abounds. In these types of markets investment activity can focus on uncovering value instead of attempting to predict the market direction, very often an expensive exercise of overconfidence. Indeed smaller, illiquid and inefficient markets have smaller flows and trading volumes, thus resulting in less information, transparency and, hence, weaker price efficiency. Furthermore, illiquidity and inefficiency will actually promote proper and longer-term investment as opposed to trading behavior given higher transaction costs.
Global markets are possibly the most palpable examples of inefficient markets relative to the well-established and more traditional U.S. financial market. Reportedly, for every available dollar of global investment, 50 cents are invested in U.S. markets and the other 50 cents spread around a multitude of smaller and, in most cases, less efficient markets. However, while the rapid pace of globalization has opened access to investment all across the globe, there has not been an equivalent globalization and harmonization of local financial structure and pricing practice, thus generating distortion of value and investment opportunities
Among the global markets, those habitually referred to as emerging markets are by far the most prominent example of inefficient markets, thus providing an immense universe of value-based investment strategies. In fact, the high debtors countries of Latin America, the reforming countries of Eastern Europe, the emerging markets corporate bond market, the bank-based capital markets of Asia, and the emerging equity markets all have in common, albeit with different degree, structural inefficiencies characterized by poor liquidity, low transparency, weak regulatory environment, complex corporate governance, poor accounting standards, weak and inefficient corporate capital structure, low equity free float, high sector concentration, local markets crowded out by large borrowing needs of the government, volatile business and policy cycle, etc. These structural inefficiencies will have a principal role in driving the investment value as opposed to traditional business cycle, policy mix analysis, or basic valuation models such as, for example, dividend discount model methodology.
Rather than being an obstacle to sound investment, these inefficiencies provide a tremendous set of opportunities for value-based strategies as they will periodically generate substantial distortion of value (over and under) and, at times, massive trade dislocation. At the same time, these inefficiencies will provide the perfect setting for a hedge fund approach in light of sizeable price distortion and, therefore, shorting opportunities.