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How to price assets in the crisis of the century By Doron Tsur Tags: israel news Times of crisis like today require changes in the way people think about investments. That's because things that had been considered utterly unthinkable are now happening by the day. The changes in the economic and financial environment have led to tectonic attitude changes in policy among the leaders of the West. I have written about that before. Now it's time to go back to the source and discuss another necessary change in attitude - a change in the way financial assets are priced. In normal times, the usual technique to price financial assets is to assess the cash flow they are expected to generate, whether through profit from holding shares, or interest payments on debentures. Advertisement We then assess the risk that the financial asset won't perform. (The higher the risk, the higher the returns investors will demand in exchange for their investment in the financial asset.) Then we capitalize the cash flow to its present value. (Capitalize means to ascribe a value today to money you're supposed to receive in the future. For instance, imagine that interest rates are 5% and you'll get NIS 100 in a year. What is that NIS 100 worth today? Only NIS 95.20, which is the outcome of 100 divided by 105. That is the capitalized amount.) Anyway, the outcome is supposed to be the price we're willing to pay for the share or bond - it depends on what we expect the asset to be worth in a given amount of time. But that's in normal times. Now is not a normal time. Uncertainty is pervasive and our ability to reasonably predict future cash flow is weaker. Asset prices are tumbling sharply. We need a new model for pricing. The model for pricing we need is like the one used to price options, not stocks and bonds. Let's take an example. Say that a year ago we bought a bond issued by an investment-grade real estate company. We paid 100 agorot. At the time the bond was yielding 7% a year and its duration was five years. (Duration is the weighted average maturity of a bond's cash flows.) At the time, we evaluated the bond in the usual terms: yield to maturity, duration, investment grade and risk premium over comparable government bonds. But things changed and investors started to feel that the company's status and ability to repay debt had been badly damaged. A wave of selling reduced its bond price to 25 agorot - down 75% from its price a year ago. At that price, the yield to maturity could be heavy, say for the sake of argument - 50%. The duration may shorten to two years (because of the heavy weight of interest payments when calculating duration.) But that doesn't mean anything anymore. That's because during the last year, the bond metamorphosed into an option. Not by legal definition, of course. The bond remained a debenture. But economically speaking, it's behaving like an option. And options are notoriously riskier prospects for Widow Cohen than stocks or bonds. For the investor, the bond's future behavior and pricing method are much more like an option than a bond. How? Well, take the optimistic scenario of the company meeting all its liabilities to bondholders. Then the profit from the bond will be phenomenal. But in the worst-case scenario of the company defaulting, there's a good chance the entire investment will be lost. And that describes investment in a stock option to a T: handsome profit if the gamble works out, total loss if it doesn't. That isn't what one normally expects when investing in bonds. But that's what's happened. Much the same has happened with stocks, though they are a very different animal from bonds. Say a year ago you invested in a company. It was trading at a profit multiple of 10. You expected to gain 10% a year on the shares. But its business started to evaporate and so did its profits, and its share price plunged 80%. (Unhappily, that isn't a rare scenario these days.) Just as in the case of bonds, if recovery comes and the company does well, the market will again price the firm at a profit multiple of 10. Again you stand to make a great profit. But there's also the chance that the company will fold and you will lose our investment. Again, the security you held metamorphosed, economically speaking. From a plain-Jane share it turned into a flamboyant option. That metamorphosis of so many financial assets, from stocks and bonds to options, requires new thinking. First of all, investors have to realize that the risk may not be any greater. It is true that in an environment where financial assets are turning into options, there will be more cases of total loss. But it's also an environment where greater gains can be made, gains of a number of times over. Since we're in the throes of the crisis, we see mainly the failures that lead to losses. The upside will come later, when the economy begins to recover and the infirm companies have been weeded out. The fittest will survive. Darwinism will play a leading role. To move from science to philosophy for a moment, in today's extreme environment, the behavior of assets can also be extreme. In normal times, very few financial assets are wiped out and very few generate returns of a few times over. But in the near future - the next few years - we will have to think in different terms. First of all, you shouldn't succumb to the fear that you'll lose everything, just as option holders don't panic at the thought that their options might expire at a price of zero. On the other hand, you have to change your risk management. Say you'd been willing to invest 5% of your portfolio in the bond and 3% in the stock. Investment in an option has to be a lot smaller than that, given the greater chance of total loss. Let's revisit the case of an interesting option that expired at zero value. It's none other than shares of Circuit City (NYSE: CC). Circuit City, formerly the second-largest consumer electronics retailer in America, filed for Chapter 11 protection in mid-November. As its business operations stumbled, Circuit City's stock collapsed. When writing about Circuit City before, I observed that if the firm could recover, anybody buying its stock at rock-bottom would stand to make a fortune. Of course, there was also the chance it wouldn't recover, the company would crumble and its stock would be worthless. Indeed, there was a takeover attempt, by Blockbuster. But Circuit City's management cleverly deflected it and continued careening along the path that brought the company to its knees. What can we learn from this case? First, that in investments, sometimes you win, sometimes you lose. Mistakes happen. Second, managements don't always know what's best for shareholders and may well be driven by other considerations, such as ego. That was true not only of Circuit City but of the Yahoo! management as well, which blocked the company's sale at the best price to Microsoft, and harmed shareholders in the process. The problem is that it's impossible to predict how managements will react. Third, Circuit City was one of a great many shares behaving like stock options. Anybody who can't handle the stress of options is better off not going there, though again, the potential for gains is as impressive as the potential for losses. Yes, the risk is higher but that can be handled through better risk management. Putting 0.25% of your portfolio into a stock like Circuit City or a bond behaving like a stock option may outperform the 5% of your portfolio in more solid shares. But note ye well that if the last few months have showed us anything, it's that companies considered solid as rocks have been shot through with flaws, and their stocks and bonds morphed into stock options overnight. The writer is the CEO of Compass Investments. Bookmark to del.icio.us   Boycotting Wagner The composer's works will remain a sensitive topic in Israel for many years. Bound for Gaza The Libyan ship is the most notable attempt yet to break the Gaza blockade.

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