The Benefits Of Diversification

We have discussed how diversification works and shown examples, but what about how it works in your portfolio? A recent article in Money discusses how much you should have invested in stocks depending on your age. And while we don't want to take a position in this, we would like to point out the "Finding the Right Mix" figure shown in the article. As you can see, in general, the range of possible returns declines as you increase the percentage of bonds in a portfolio. This is the decline in volatility that is also exhibited in the lower standard deviation from adding bonds to a stock portfolio. 

Spotify's Reverse IPO

Spotify went public on April 3, 2018 in a direct listing. Bypassing the traditional underwriting process, Spotify basically said that its stock could now be publicly traded. Because Spotify did a direct listing, the company raised no additional money from outside investors. And Spotify could have sold shares on the market without worrying about the underpricing that often occurs in an IPO. Now, about seven months later, Spotify just announced a $1 billion share buyback. The stock has fallen about $8 billion since it went public and the buyback is a signal of management’s confidence in the stock. More interestingly, it also means that Spotify has never raised public capital and is using the stock market only as a means to return capital to investors. As this article points out, because of the new reliance on private investors, we could possibly see a day when a company undertakes an IPO for the purpose of initiating a buyback.

Sears' Financial Distress Costs

We mentioned in the textbook that there are indirect financial distress costs, which, unfortunately, Sears is experiencing. Because of Sears' financial problems, suppliers are not willing to sell to Sears, or are tightening credit terms. Part of the reason is that suppliers continued to sell to Toys R Us, but then only received 20 cents on the dollar. A poll indicates that 66 percent of suppliers are demanding cash payment or payment on delivery and 26 percent were on regular terms, but not longer than 30 days. In fact, more than 200 suppliers have quit selling to Sears at all. This can create a "death spiral" as Sears cannot order goods to sell at a time when sales are already low, meaning fewer customers even go to Sears' stores. 

Netflix's Capital Structure

As we discussed in the text, the optimal capital structure for a company is the result of many interacting factors. And while we can observe capital structures in practice, it is less frequent for a company to state its target capital structure. Recently, Netflix announced that was issuing $2 billion in debt to help the company reach its optimal capital structure, which the company said should be 20 to 25 percent debt-to-market capitalization. At the current market value of equity, the company would need to issue between $22 and $30 billion of debt. What makes this debt issue really interesting is that though company is burning through cash, the announced purpose of the bond is to increase leverage.  

Market Quiz

CFO.com has a seven question quiz on current capital markets. There are some interesting questions, including the relative size of the venture capital market compared to IPOs, the issuance size of the preferred stock market (keep in mind that Apple's market capitalization is over $1 trillion), and the slope of the Treasury yield curve.

Bond Ratings And Mergers

A recent article in Bloomberg highlights a potential threat to the bond market. Recent years have seen a number of high-priced acquisitions funded by debt. As a result, many of these companies have dramatically increased leverage as measured by Debt/EBITDA. This has caused a drop in credit ratings, with $2.47 trillion worth of debt now rated as BBB, more than three times the 2008 level of BBB debt. Even though many of the deals are funded through debt, a common assumption is that synergies and the improved cash flow would allow the company to quickly pay down debt. But a hiccup in the economy or synergies not materializing could limit debt pay down. In the last three recessions, from 7 to 15 percent of investment grades bonds were downgraded to junk status. Given the higher amount of debt with lower credit ratings, a recession in the next couple of years could push a massive amount of corporate debt into junk territory.

Sears Bankruptcy

It appears that Sears, once the world’s largest retailer, may file for bankruptcy as soon as this weekend. One alternative being explored is a Section 363, or stalking horse, filing. In a Section 363 filing, the company would sell some of its assets, but the sale would still have to be approved by the bankruptcy court. For example, CEO Eddie Lampert has already offered $480 million for the company’s Kenmore appliance and home improvement division. If successful, the company would exit the bankruptcy with fewer assets, but less debt as well.

Michael's Bond Losses

As Hurricane Michael hits the Gulf Coast, pension funds, endowments, and other large investors are getting nervous.  About $15.7 billion wort of CAT bonds are exposed to a Florida hurricane. Large investors have been drawn into CAT bonds because of higher potential returns and the diversification these bonds can provide. The total CAT bond market is currently at $30 billion. For a major catastrophe, an insurance company typically cover the first part of its loss, then relies on reinsurance or securities to help cover the rest. If the trigger is hit on a CAT bond, often the bond is cancelled, meaning the bondholder receives no further coupon payments and no par value upon redemption. 

Papa John's Extra Cheese

Papa John's stock has been battered this year after comments made by founder John Schnatter on a conference call. Schnatter resigned as chairman in July, but still owns about 30 percent of the company's stock. In a nod to the bidding wars that can occur in a takeover battle, the stock jumped nearly 8 percent today when it was announced that Trian Fund Management is considering a bid to buy the company and take it private.

Interest Rates And Bond Prices

As we noted in the textbook, an increase in interest rates will decrease the price of a bond. And recently, interest rates have been rising. U.S. high-grade debt is down 2.53 percent this year and the 10-year U.S. Treasury bond has lost 3.23 percent this year as well. To give you an idea of the magnitude of losses worldwide, the Barclays Multiverse Index, which includes investment grade and high yield bonds from around the globe, has lost about $916 billion in market value this year.

Inflation Expectations

One thing to keep in mind with present value calculations, if you calculate the present value using real cash flows and the real interest rate or nominal cash flows and the nominal interest rate, the present value will be unaffected. This is true for capital budgeting as well So where can you get expectations of future inflation? One place is the New York Federal Reserve, which publishes microeconomic data, including expectations of consumer inflation. We should warn you, these are expectations, and like any expectations, are not exact.

Comcast Bonds

In order to finance the $39 billion acquisition of Sky Plc, Comcast sold $27 billion worth of unsecured bonds. This is the second largest bond offering of the year and the fourth largest all-time. The company sold 12 different bonds, ranging from a 2-year maturity to a 40-year maturity in the offer. Investors jumped at the bonds, putting in orders for $88 billion, which allowed Comcast to issue the 40-year maturity at a yield spread of 1.75 percent above Treasuries. The bond issue will increase Comcast's leverage from 2.2 times EBITDA to 3.6 times EBITDA. The bonds are rated A with a negative outlook, which means there may be a downgrade in the future.

2018 Working Capital Survey

The Hackett Group has released the 2018 US Working Capital Survey. Overall, working capital management has improved, with the cash conversion cycle dropping to 33.8 days, a 4 percent improvement. Day's payable has increased from 53.5 days in 2016 to 56.7 days in 2017, while days' payables outstanding increased from 37.8 days to 39.5 days. The inventory period also increased slightly, from 50.7 days to 51 days.

And The Winner Loses

In a nod to the winner's curse, Comcast stock fell 8 percent today when it was announced that the company outbid rival Fox in the three round auction of British broadcaster Sky. Comcast's winning bid was for $40 billion. The price was about 27 percent higher than Comcast's initial bid. In any auction, the winner ultimately is the bidder willing to pay more than any other bidder, increasing the likelihood that the winner overbid, resulting in a a negative NPV.

2018 Alexander Hamilton Awards

The 2018 Alexander Hamilton Awards from Treasury & Risk have been announced. The gold award went to Herc Rentals, which set up a treasury group to sales for a billion-dollar company less than six months after its divestiture from Hertz. The silver award went to Avery Dennison which centralized its European treasury functions, resulting in significant savings, and improved foreign exchange processes. Finally, OpenText was awarded the bronze award for streamlining its treasury and setting up processes for the integration of future acquisitions.

Slow Earnings Repatriation

One goal of the Tax Cuts and Jobs Act of 2017 was to increase repatriation of overseas earnings. Broadly speaking, new repatriated earnings are not subject to additional taxes that were in force under the previous tax system. A common misconception is that most of the $3 trillion in foreign earnings earned held abroad by U.S. companies was sitting in stockpiles of cash. In the second quarter of 2018, companies repatriated $169.5 billion, which is up significantly from the $34.9 billion in the second quarter of 2017, but down from the $294.9 billion repatriated in the first quarter of 2018. Several factors have reduced the expected tax windfall, including a company’s desire to leave cash overseas for investment to foreign laws that limit a company’s ability to repatriate cash to the U.S.

Retirement Planning

We know that most students are interested in personal finance topics, so we like to post on personal topics occasionally. Consider your retirement. How much should you have saved for a comfortable retirement? A recent article discusses this topic and reports some conflicting conclusions. If you notice, Fidelity suggests that you have 10 times your pre-retirement salary saved at age 67, while the next paragraph notes that, according to Tony Robbins, you need 20 times the annual amount you want to spend in retirement. These two rules of thumb are consistent only if you withdraw half of your current pretax salary in retirement. Of course, these are only rules of thumb. Life expectancy is an important consideration. For example, on average, women live longer than men, which suggests women need more money for retirement for the same withdrawal amount. Another consideration is whether you are willing to dip into principal, which means you would need less than if you do not wish to dip into principal. You also need to consider the amount of risk you are willing to take with your investments. If you are only willing to invest in a savings account, you will need to have more saved, on average, than if you are willing to take more risk and invest in stocks.

We would like to close with a rule of thumb calculation for you. Research into retirement withdrawals using historical market returns suggests that withdrawing 4 percent of your retirement portfolio value per year has generally supported at least 30 years of withdrawals, assuming the portfolio is 60 percent or more common stocks. We should state that many retirement planners would consider this a relatively risky portfolio in retirement. If you are willing to accept this risk, what multiple of annual retirement spending does this suggest you need for your retirement portfolio? What happens to this multiple if you are more risk averse?