Deflation and negative EV companies.

According to some financial researchers, the current inflation rates are similar to the ones seen during the Great Depression. However, this may be a good news for those planning for long term investments as some companies might have a negative enterprise value (EV)

Deflation:

A Persisting decline in prices results in a vicious spiral of negatives such as falling profits, closing factories, shrinking employment and incomes, and increasing defaults on loans. Deflation is also linked with recessions and with the Great Depression.

However, care should be taken while talking about deflation as it is different from disinflation which indicates a slowing of the rate at which prices increase. Also, deflation should not be confused with a temporary fall in price. Deflation is typically caused by a shift in the supply and demand curve for goods and interest, particularly a fall in the aggregate level of demand.

What does the negative EV mean?

I asked this question to my friend who works at KPO, and this is what he had to say.

Let's say there's a company, BigB Inc., that has a market cap of $40B, $2B of debt, no preferred stock, and $45B of cash and cash equivalents, making BigB have a total enterprise value of -$3B.

Banks and Negative EV:

Further, their blog on negative EV cleared my doubts on why in the current markets cash in hand is considered to be a king. This company has more cash than the market value and if the forward EPS is attractive then many would suggest such companies to be a good buy. These companies are effectively offering profits to their shareholders for free. This is true in the case of many banks that have a lot of cash in their reserves.
The blog takes this notion of negative EV further, by highlighting the geographical distribution of the banks that have a negative EV.

What does Net Asset Value (NAV) mean?

The net asset value," or "NAV," of an investment organization is the organizations total assets less its total liabilities. For example, if an investment company has assets worth $10 million and liabilities of $1 million, the investment company’s NAV is $9 million.


NAV for Mutual Funds:

This term has been extended to mutual funds as well. In the case of mutual funds, the Net Asset Value (NAV) of a mutual fund is the price per share. It is calculated by dividing the total value of all the securities in its portfolio, less any liabilities if any, by the total number of fund shares that are outstanding. Units in open ended funds are valued using this measure. The NAV is calculated at the ned of each day (after trading has been stopped) by taking the closing market value of all securities owned plus all other assets such as cash, subtracting all liabilities, then dividing the result (total net assets) by the total number of shares outstanding. For example, if a fund had net assets (considering the assets less liability) of $50 Million and there are 10 million shares of the fund, then the price per share or NAV) is $5. The popular mutual funds publish their per share NAVs in the daily newspapers.

Is the NAV the best metric to evaluate the fund performance?

As the mutual funds pay out virtually all of their income and capital gains, changes in NAV are not the best gauge of mutual fund performance. Financial researchers consider the annual total return as the best way to evaluate the performance of mutual funds.

So when any one talks about NAV please ensure that the context is known as the definition of NAVs is highly dependent on the context.

A very comprehensive article related to NAV is available at the SEC site at http://www.sec.gov/answers/nav.htm

Outsourcing of Financial Research

Over the years one of the prime concern of fund managers and other investors is the valuable time spent by the analysts on analysis. Studies have shown that a considerable amount of time was spent by the analysts in activities such as sourcing of financial information, preparing reports, populating the data required for financial research, tracking information related to mergers and acquisitions etc. Given the current mayhem at the stock markets and the need for detailed analysis of the situation has motivated the visionaries of many successful organizations to outsource a considerable amount of work to KPOs which specialize in financial research and analysis to improve their turn around time.



Services Provided by KPOs

The services of such KPOs include financial information aggregation investment research analysis, market intelligence, reporting and publishing support. The services of KPOs cover all approaches of investment decisions which encompass making an investment choice based on funds, equities, sectors, countries etc. Their clients include private equity and hedge funds, large investment banks, asset management companies, corporate finance groups, fund administrators and other financial institutions. This is achieved with a finesse as KPOs design, create and deliver customized solutions to Investment banks, Asset management companies, Private Equity groups, corporate finance groups and Large Institutional investors. One the key areas in which KPOs operate are the writing of annual reports which ease the process of mining the data present in the annual reports, and sourcing the information required for financial research. This is useful for studying and predicting the future of an organization but also giving key insights on the working of the whole sector.

Such KPOs not only help their clients create value by providing customized services which are backed by domain expertise and high-end analytical skills but they also work closely with their clients to deliver services that adapt to their evolving needs.

Financial Valuation Models

One of the critical components of financial research, due to its use in almost every aspect on financial analysis, is estimation of the market value of the financial asset/liability. It is commonly known as financial valuation and the efficiency of using these models determines the quality of research done by the financial researchers.


Which models are widely used ?

The most widely used models are the relative value models, absolute value models and option pricing models. The relative value model is widely used by the hedge fund managers to quantify the attractiveness measured of one financial instrument relative to another. Further, some Hedge funds have mastered strategies that take advantage of the difference in pricing between two related and correlated securities. Sector Researchers have taken relative pricing further to compare various sectors such as telecommunication, mining, etc.

Black-Scholes Model:

The modern pricing are some of the most mathematically complex applied areas of finance and mathematics. Financial analysts have reached the point where they are able to calculate, with alarming accuracy, the value of a stock option. The most widely used models for pricing are the Capital Asset Pricing Model, the Fama-French three-factor model and Black-Scholes pricing model. The Black-Scholes model is so popular that most of the models and techniques employed by today's analysts are rooted in this model. As the value of an option varies only with the stock price and time to expiry it supports the possibility of a hedged position consisting of a long position in the stock and a short position in calls of the same stock whose value will not depend on the price of the stock.

Hedge Funds or Short Sellers?

Hedge Funds first started gaining popularity after the 1997 asian economic crisis as the hedge funds tend to be skill-based investment strategies whose returns are considered "absolute," as they do not depend on the relative long-term return of underlying traditional stock and bond markets. As their name suggests, these funds are mainly used as hedge against the volatilities associated with the investment in securities. Evaluating the performance of hedge funds is non trivial task as the hedge fund managers are not required, and in many cases not allowed, to advertise or report performance data to any central authority. As a result, many of the top hedge fund managers are not listed in commercially available databases.




Over the years it has long been accepted that risk management is a core competency for generating absolute returns within a hedge fund strategy. Further, the hedge fund strategies have had a history of offering returns independent from the performance of stock and bond markets. One commonly used technique is by short selling. However many funds that do not hedge but are active only in short selling have recently been getting the limelight as the primary objective of the hedge funds was violated. Financial researchers have been been advising their clients to invest in these funds with caution, however many have fallen into the trap of myopic short sellers. Prior to the current market downturn, hedge fund managers were able to diffuse requests for transparency. However, increased regulation, scrutiny and transparency are knocking the doors of the hedge fund industry. This is seen as the silver lining by many investors whose faith which was the instrument of cash inflows was subject to the merciless greed of many fund managers.

The outcome of the bloodbath at the stock markets all over the world has highlighted the importance of effective governance and risk management in hedge funds coupled with the need of greater visibility into a hedge fund manager's governance and risk programs.

Custom Databases For Financial Analysis

Financial Analysis and Research relies heavily on the data mined from the various online and offline sources. Mining this offline data is many a times a herculean task as it involves not only parsing the annual reports but other records that are publicly available at various government institutions. Once this data is obtained, it needs to stored in a structured format. This article gives a nice overview on the importance of sourcing the data for such custom databases.



Custom Databases:

Many financial researchers require the databases stored in the format they have tried and tested over the years, but due to the lack of time have decided to outsource this activity to KPOs. Designing the schema to ensure that the requirements are met is a cumbersome activity. Further, this task becomes non trivial as the Atomicity, Consistency, Integrity and Durability of the database needs to be ensured. Many database engines ensure the above criteria are met however, the processes feeding this data must also ensure that none of the above criteria are violated. This is extremely critical when operating with the offline data which is entered manually.

Presenting the Data:

Storing the data in a structured format is just the tip of the iceberg, as the UI that allows users to access the data needs to be designed. KPOs that operate in the area of financial research and analysis have lately mastered the art of not only mining the data and storing them in structured and custom databases but also in providing some neat user interfaces to easily access this data. This activity has been many a times won accolades from banks and fund managers for being a time saver.

Save and Invest

There has always been a dilemma in my mind regarding savings or investments. I came across a nice post regarding the never ending conflict between savings and investments. Many financial researchers suggest that the cash in hand should be put to optimal use by a using financial instruments that give a perfect blend between savings and investments.

Some consider saving as a protection or insurance from the volatilities of investment in the markets, some stretch this concept further and consider hedge funds as savings that can protect them from the market turbulence. One of the oldest forms of such savings was gold. This has even been given a religious flavor as some religions encourage buying gold on special days and festivals. In India this is coupled with Government Bonds, Government Savings Schemes and Fixed Deposits.



Importance of a perfect blend of Savings and Investment:

In his speech on Mar 24, Barack Obama said, "At the end of the day, the best way to bring our deficit down in the long run is not with a budget that continues the very same policies that have led to a narrow prosperity and massive debt. .... It's with a budget that leads to broad economic growth by moving from an era of borrow and spend to one where we save and to one where we save and invest".

The need for the perfect blend of savings and investments that results in the optimum growth is the primary motivation that has led to the evolution of many financial instruments and mathematical models to optimize these instruments. Financial researchers and KPOs have been known to toil hard to study these models to ensure that the desire for this perfect blend of investments and savings is attained.

Sovereign wealth funds

Sovereign wealth funds are state-owned funds that are invested in different avenues across the globe. The money for such a fund is accumulated by the country or its central bank from sources like banking system, oil trading, foreign currency reserves, pension funds, precious metals etc. They are assets of the corresponding nation. They are generally invested with a long term horizon. Investment management entities are setup by the state to manage these funds.



Creation of Sovereign Wealth Funds

A sovereign fund is created when a nation has excess liquidity than is desired, which cannot be immediately consumed. This liquidity is maintained in the form of reserve currencies, precious metals, oil etc. These funds are used as a source of stability or a cushion against volatility in the international market for raw materials that are imported. By employing these funds, one can control the impact on the government expenditure due to the short term volatility of markets. During the recent credit crisis there were stories of some sovereign wealth funds making bad investments in Wall Street firms that have collapsed and needed cash infusion.

Concerns regarding Sovereign Wealth Funds:

There are certain concerns regarding these funds. Lack of transparency, no clear goal sometimes and their huge size which can have a great impact on asset markets. The total worth of most of these funds globally is now more than $3 trillion and growing at a fast pace. There are also security concerns due to these foreign investments as one of the potential motive might be to control certain strategically important industries of the country.

I came across a financial research article by S G Analytics, a KPO about these funds. The article argues that protectionist barriers are not the answer to security concerns arising from the nationality of the incoming investment. A more transparent and good regulatory environment is better suited to address these concerns.