Tuesday, June 30, 2015

The era of idiosyncratic risk?

Previously, I referenced this blog post by Aswath Damodaran.  He was discussing the effect of cash holdings on the PE ratios of firms.  This first graph was from that post.  One of IW's perceptive readers noticed that the Damodaran chart seemed to imply a much higher level of cash holdings than seemed feasible.  Damodaran clarified that the chart included financial firms, which can have very large cash and cash-equivalent holdings, which did inflate the difference, relative to non-financial firms.  But, he noted that the trends were the same.

Since then, he has added another post, where he has included the effect of debt on PE ratios, and he also posted his data from the first graph, which includes non-financial firms and also separates the data between profitable firms and all firms (including those with losses).  His first graph only included profitable firms, because PE ratios can become incoherent when earnings are very low or negative.

I have used his data to create this second graph, which has PE ratios (both unadjusted, and adjusted for cash) for only non-financial firms.  Also, I have included the PE ratios for both all firms, and for only profitable firms.

I think there are a couple of interesting things to consider, here.  First, we can still see Damodaran's original point, though to a lesser extent.  For non-financial firms, this is inflating the aggregate PE ratio by about 2 points, and it is generally a new phenomenon of the past 15 years or so.  I suspect this is largely due to the large cash holdings typically seen in the tech sector.

But, possibly the more interesting issue to note here is how much of a difference it makes to filter out the unprofitable firms.  This is also a recent phenomenon, although it goes back more like 25 years.  I suspect this is also related to the digital revolution.

This suggests that before 1990, there were very few unprofitable firms.  Scott Sumner and I touched on this in our National Review article.  There is widening inequality among capitalists.  The digital revolution has created a winner-take-all dynamic that creates a much wider set of outcomes for firms than traditional industries experienced.  This also means that organizational life cycles have been shortened tremendously, and losses incurred by new entrants are at larger scales.  Think of the record-breaking IPO's in the 1990s of firms that don't even exist any more.

Returns to risk and variability of incomes have risen, globally, and among both human and physical capital.  Returns to a college education continue to rise, even as college attendance expands.  Super-firms like Apple have high returns based almost entirely on intangibles.  This is much more of a product of an emergent technological context than it is of some left-vs-right policy shift or tax regime.  One idea I hope to look at some more is the idea that increased variance and returns to risk may be an ingredient in the persistently high equity risk premium, low risk free rates, and high home prices.  In this context, safety demands a premium.  Could variance in capital outcomes become large enough that frictions in markets prevent the practice of efficient modern portfolio theory?  So, non-corporate low-risk securities take on more importance when diversification of equity portfolios is more difficult?  Could the inherent inability to diversify our human capital be a reason that American students seem to under-populate many STEM fields, in spite of their higher compensation potential?  Could it be that American students who can earn higher incomes in more generalized fields aren't willing to take on the high risk of the human capital imbedded in technical fields, but the payoff to foreign students with lower alternative income options is worth the risk?  The two trends themselves - significant numbers of firms with negative earnings and high levels of cash holdings - are probably also related.  Firms facing extreme levels of idiosyncratic whisk may be taking on large risk-free asset positions, within the firm structure, for the same reasons that savers are taking on large low-risk asset positions outside of firms.

Here is a chart of the number of profitable and non-profitable firms from Damodaran's data.  Today, profitable firms represent 86% of market capitalization, but only 39% of firms.  The total number of firms and the total number of profitable firms peaked in the late 1990s.  This seems like potentially bad news.  I would speculate that some of the increase in small, unprofitable firms could be due to changes in firm structure, so that modern financial innovations are allowing more early R&D to be done in new, small firms, instead of being incubated within large conglomerates.  But, if that were the case, I would hope that the total number of firms would be growing.  But this does suggest that we are in a stock picker's paradise, where there are thousands of potential turnarounds and home runs to find.

Recent research has found that "much of the 1970s-2010s increase in earnings inequality results from increased dispersion of the earnings among the establishments where individuals work. It also shows that the divergence of establishment earnings occurred within and across industries and was associated with increased variance of revenues per worker".  And, boy, doesn't this graph point to an obvious source for this change?  How many of those unprofitable firms are populated with development staff loaded up with stock options and working for the big payoff?  No wonder households want to load up on treasuries and real estate.

Even among profitable firms, there has been a re-characterization.  Compare Apple today to GM 50 years ago.  Apple has outsourced and offshored all the capital intensive, standardized, low-risk portions of its business, leaving high value-added, high payoff, high risk positions in the US within its corporate identity.  This is why Apple is practically nothing but intangible value.  They have only retained the pure value-added portion of the firm, and sent the rest of the business to the developing world that now has a competitive advantage in capital intensive production.

These sorts of optimizations can create benefits for everyone when there aren't frictions to obstruct them.  Our history of functional commercial institutions has created a context of relative safety and high incomes.  The developing world is improving its commercial institutions, but they aren't there yet, so wages are still low there, but rising quickly.  An interesting question for us to ask is, if variance in incomes is increasing, why aren't more Americans students majoring in fields with higher wages?  Maybe the impediments are too complex for us to solve.  Does more education funding solve the problem?  There appear to be opportunities in these fields that are going unclaimed now.  One solution to this is to import skilled technical labor help create America's technical advantage where we don't have local skilled labor to do it.  But, if that's a trade for a more efficient global economy, the other side of that trade isn't going to happen.  Low skilled laborers from the US aren't going to emigrate to Malaysia to find factory work.

These are all speculative ideas, but regime shifts like this could be creating many of the trends in investment and consumption that seem baffling or nefarious when viewed without accounting for changing context.

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