Rate, or LIBOR (LIBOR is the cheapest rate banks charge one another for short- term money). But a few basis points don’t really compensate for a much lower credit rating.
Leveraged loans were once traded quietly among bank syndicates and a few institutional investors. More recently, however, these loans are attracting plenty of money from hedge funds, pension funds, mutual funds and others. According to Standard & Poor’s, investors funded a record $295 billion in leveraged loans in 2005, three times as much as in junk bonds.3
HealthSouth provides an example on how wrong investment decisions can be, even when made by experts. Reports of mutual fund holdings indicate that as much as 9% of HealthSouth’s stock was accumulated through autumn and winter 2003 at around its high price, by funds of the Fidelity family led by Fidelity Advisor Mid Cap.4Failure in compliance was the reason for this equity’s major slide.
A more frequent reason for position risk with equities is half-baked or outright biased analyses, as happened so often in the late 1990s. In the aftermath of scandals connected to investment advice, which shook up the equities investment industry in the wake of the stock market bubble of 2000, and the ensuing crash of internet companies, many banks have been rethinking the financing of their equity research activities. Unable to share in investment banking revenues, research departments:
● Have shrunk in size, and
● Parted company with their lavishly paid stars.
Some banks, like Deutsche, said that they would combine equity and debt research to provide clients with an integrated approach, and also help in reducing research costs. Other banks, like Citigroup, made investment research a separate entity to be kept at arm’s length from investment banking.
Practically nobody said that research is not a useful calling card for all sorts of banking business. The challenge has been associated with what it offers and what it costs. Pressure on research, some experts said at the time, could lessen if trading volume picks up. And more demand for research and analysis would certainly come if stock volatility increases – but up to February 2007 it did not.
These and other statements were made while the after-effects of the bubble were still being felt in the investor community. Banks tried to be convincing in their statements that from now on equity analysis will be objective and the mis- takes of the late 1990s will not be repeated. But is this true?
The new challenge in equity research, some experts say, is the stream of one- sided securities analysis. By 2006, many investors had been concerned that ‘buy’
ratings on shares outnumber recommendations to ‘sell’ by five to one. This is evi- dently reflecting bias among analysts. While what the right ratio should be is hard to say, the pattern is generally lopsided:
● 40–55% ‘buy’
● 42–53% ‘hold’
● 4–9% ‘sell’.
Notice that in terms of frequency more than 40% of recommendations are to
‘hold’, which reflects the analyst’s uncertainty, and this is valid for nearly every
Risk Accounting and Risk Management for Accountants
178
Ch08-H8422.qxd 7/4/07 4:38 PM Page 178
equity. Investors are also worried that cyclical momentum, which means herd mentality, inflates asset prices without support by fundamentals – one more rea- son for the predominance of ‘hold’ recommendations.
Based on actual buy/hold/sell ratings of a major investment bank, Table 8.1 presents the rating distributions at two consecutive sampling times in September 2005. The statistics show a minor redistribution between ‘buy’ and ‘neutral’ (hold), while the percentage of ‘sell’ remained unchanged. Curiously, what has changed from one day to the next is the number of companies covered, which increased by 7.6%.
Another reason for doubting the depth of the analysis, and the investment rec- ommendations that go with it, is that the large majority of new arrivals fell into the ‘hold’ category. As can easily be seen in Table 8.1, the ‘neutral’ position increased from 48% to 52%. ‘Neutral’ in practice means ‘I don’t quite know’ and on average one in two positions are in this class, which provides no input of any value to investment decisions.
Just as lopsided is the investment analysis of energy companies shown in Table 8.2, from the same timeframe. Table 8.3 reflects investment rating results from two other equity groups: banking and soft drinks. This irrational trend towards highly favourable ratings has been at the heart of the herd mentality that led to the market bubble of the late 1990s.
Critics say that there is often a conflict of interest, because only analysts who look favourably upon a firm’s prospects are bringing in investment banking business.
Also, the ‘good guys’ are given the most valuable data on the company, while ana- lysts who pose tough questions get short shrift from the managers of the rated firm.
Chapter 8
179 Table 8.1 Investment rating distribution of a global equity group
Coverage universe Count Percentage
Day 1
Buy 1095 44.05
Neutral 1207 48.55
Sell 184 7.40
Total 2486
Day 2
Buy 1076 40.21
Neutral 1399 52.28
Sell 201 7.51
Total 2676
Contrary to the statistics shown in the preceding three tables, the objective of rigorous equity analyses should be to obtain and provide an accurate picture of the strengths and weaknesses of companies put under the magnifying glass. This can make it easier for market participants to distinguish between healthy and ailing entities.
A set of ratios allows continuous monitoring of equity exposure. For instance, a frequently used indicator is return on equity (ROE), expressed as the ratio of the pre-tax return (R) to balance sheet equity (E):
R/E (8.1)
Risk Accounting and Risk Management for Accountants
180
Table 8.2 Investment rating distribution of an energy equity group
Coverage universe Count Percentage
Day 1
Buy 74 53.62
Neutral 58 42.03
Sell 6 4.35
Total 138
Day 2
Buy 54 43.20
Neutral 63 50.40
Sell 8 6.40
Total 125
Table 8.3 Investment rating distribution of banks and soft beverages
Coverage universe Count Percentage
Banks
Buy 78 33.91
Neutral 126 54.78
Sell 26 11.30
Total 230
Soft beverages
Buy 8 61.54
Neutral 4 30.77
Sell 1 7.69
Total 13
Ch08-H8422.qxd 7/4/07 4:38 PM Page 180
Another valuation is the ratio of the pre-tax return to the operating results, Rop:
R/Rop (8.2)
This ratio indicates the impact of risk provisioning, special write-downs and other income/expenditure on overall return.
The use of operating income, Iop, provides another metric denoting operational efficiency (it corresponds to: 1⫺cost-to-income ratio):
Rop/Iop (8.3)
Still another metric, known as revenue efficiency, indicates the contribution made by the revenue side to ROE:
Iop/E (8.4)
The ratio of operating income to risk-weighted assets (RWA) is a measure of asset productivity. It focuses on income in relation to risk:
Iop/RWA (8.5)
An entity’s risk profile is measured by the ratio of risk-weighted assets to total assets. This is an increasingly popular metric, with proxy for assets A, the stock market capitalization of the firm:
RWA/A (8.6)
Leverage of the balance sheet is determined by the ratio of capitalization-based assets to balance sheet equity:
A/E (8.7)
In essence:
(8.8)