FinanceLab Magazine - #5 - November 2011

FIFTH EDITION

NOVEMBER 2011

MAGAZINE INVESTMENT

PANEL ANALYSIS OF THE MONTH

“BUY”

rebranded Rogue traders

heavy

Top 5 hitters CHINA READY WITH BILLIONS

FOR THE EURO-ZONE FIFTH EDITION NOVEMBER 2011

CONTENT

EDITORS

NOTE

I

n this issue of FinanceLab Magazine we start of by looking at the US debt level from a historical point of view as we question whether Standard & Poor’s downgrade in August 2011 was justified. Maintaining our focus on the US economy, we move onwards to a biography of one of the most notable characters, namely, the controversial economist, Ben Bernanke.

Moving onwards to the Euro crisis, it is fair to say that the European leaders are also devoting a fair share of their time on dealing with debt issues. As we take a further look at the outcome of the Euro summit on October 26th 2011, we conclude that the end two years of indebtedness is most likely far from over. So who are going help the Euro-zone out of its crisis? To some, China seems like the obvious answer. Odds are they can, so the question relies on, whether they are willing to. Meanwhile, China might have to take a look within before trying to rescue the rest of the world; all fairy tales must come to an end, and as we highlight their bearish equity market, we question whether the remarkable growth tale of China is lacking towards its end.

Hereafter, FinanceLab Magazine investigates one of the newest innovations in financial markets, the Bitcoins. Bitcoins is a new “revolutionizing virtual currency”. If you are an internetshopaholic, bitcoins certainly should spark your interest. As we shall see, bitcoins may be the future of money transferring across borders, leaving the authorities with little or no control of controlling the money flows, opening up for opportunities yet to be seen.

For those of you, who are interested in starting up your own business might wish to pay extra attention to the article about Non-Compete Covenants; as if it wasn’t hard enough to obtain start up funding, the funding you eventually receive – if any – comes with a catch…

Next, after careful considerations and thorough

analysis, FinanceLab Investment Panel – a group of much dedicated investment geeks – entered a long position in Bang & Olufsen (commonly referred to as B&O). By outlining our analytical framework into four major components – Strategic, Macro, Valuation and Technical Analysis – we give you the inside details on our analysis and considerations before entering the position.

We also provide you with an overview of the much hailed, yet scrutinized, Exchange Traded Funds (ETF). Hailed, because they are a cheap and efficient way of getting exposure to a given market.

Scrutinized, because for every financial innovation there is a naysayer. If you are not willing to settle with joining the market, Kirstein Finans give their proposal to how you can beat the market using fundamentals rather than market capitalization to weigh your index. If thinking long term is not your preferred investment style Flemming Kozok, the most prominent day-traders in Denmark, gives his insights to how you can increase safety in your trading activity simply by rethinking your attitude towards trading commissions.

Speaking of traders, some traders stand out of the crowd, however not always in a good way. We all know George Soros who brought down the British central bank and made a fortune yet to be seen by any other trader. In our article “Worst rogue traders” we take a look at traders who lost a fortune yet to be seen. If you plan on becoming a “big swinging dick” some day (read: successful trader), you might want to read the article to see how you are not to go about.

On that note, we hope that you enjoy reading this issue of FinanceLab Magazine.

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News from the board Investment Panel analysis Bitcoins Non-compete covenants Exchange traded funds (1) Style indices Trading commisions Investment Camp 2011 Rogue traders Exit strategies in PE

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ABOUT EDITORS

Naja Hannibal Ottosen Rune Randrup-Thomsen Sarah Louise Hansen Stian André Kvig

FinanceLab is a network and interest organisation aiming to improve financial competences among students through networking, education and handson experience.

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Frederik Ploug Søgaard Rune RandruThomsen

FinanceLab is represented at several universites in Denmark such as Aarhus School of Business, Copenhagen Business School, Aarhus University, University of Copenhagen, Technical University of Denmark, Aalborg University and Niels Brock.

CONTRIBUTORS Investment Panel

Casper Hammerich Daniel Borup Flemming Kozok Jalpesh Madlani Klaus Bendner Mads Schönberg Mads Villemoes Povlsen Sarah Louise Hansen Stefan Matyas Stig André Kvig Thomas Joel Frivold

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JUST A BRILLIANT THOUGHT

The US debt from a

historical point of view

By Jalpesh Madlani

The increase in the US debt level started in the 1980s. During the Ronald Reagan and George H.W Bush era from 1981 to 1992 (the next president usually takes office in 20th of January in US) the absolute debt level almost tripled. In addition, the debt as a percentage of GDP increased from 25.1% in 1980 to 48.1%. During the Bill Clinton presidency (1993 to 2000) the debt level as a percentage of GDP decreased, while the abso-

Figure 1

Using the public debt level as a percentage of GDP makes it easier to compare the debt over time and also takes into account a countries growth and inflation rate. According to “The Economist global debt clock”, the US public debt for 2010 was 61.2% of GDP. To find such level in US you have to go back to the 1940s, as illustrated by figure 1.

Public debt as a percentage of GDP

On Friday the 5th of August the credit rating agency Standard & Poor downgraded the US AAA rating to AA+. This is the first time the world’s largest economy has been downgraded, since it received its rating in 1917. The main reasons for the downgrade according to Standard & Poor were the political brinkmanship on the increase of the debt ceiling as well as not having provided a satisfactorily enough plan on how to tackle the nation’s long-term debt. Standard & Poor also citied estimations that the US Public debt would increase to 79% of GDP by 2015 and 85% by 2021, which according to Standard & Poor is consistent with AA+ rated countries. In comparison, forecasts from the International Monetary Fund predicts that triple A-rated countries such as Canada and Germany will only see its public debt rise to 34% and 52% of GDP, respectively by 2015.

However, there is some debate whether Standard & Poor’s estimations are accurate. The Treasury department quickly responded to the downgrade by claiming that Standard & Poor’s downgrade is flawed by $2 trillion error. According to the Treasury department spokesman, Standard & Poor estimated the discretionary spending levels at $2 trillion higher than the Congressional Budget Office’s estimates.

there has been an ongoing debate about the public debt level in US and the country has even seen its rating being downgraded. But is the public debt level really that high from a historical point of view?

Public debt % of

120 100 80 60 40 20 0

1940

Figure 2

1950

1960

1970

Another way to measure public debt is in absolute values. According to “The Economist global debt clock”, the US public debt in absolute value was around $9 trillion in 2010. The historical debt in absolute terms is illustrated in figure 2 and the public debt in absolute terms has increased over time and especially the last ten years.

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198

Public debt absolute value

10000 Public Debt Billions of dollar

The world is experiencing its worst crisis since the Great Depression and it has hit the US very hard. The nation has seen its unemployment increase, GDP growth decline and its debt level rise as a consequence of their economic policy in order to avoid a depression. Thus, lately

The significant increase in public debt as a percentage of GDP during the 1940s was mainly due to World War II, which the Federal Government financed with large budget deficits. It took almost two decades for US to return to its 1940 GDP to debt ratio level. From 1960 to 1980 public debt as a percentage of GDP decreased substantially.

However, the debt in absolute terms increased from around $238bn to $712bn, corresponding to a 300% increase.

9000 8000 7000 6000 5000 4000 3000 2000 1000 0 1960

1970

1980

lute value of public debt was relatively constant.

Under George W. Bush the public debt escalated mainly due to tax cuts, increased spending on education, the cost of war in Iraq and Afghanistan and costs of financial bailouts and stimulus packages. This increase in debt has continued under the Obama administration and, as mentioned earlier, the public debt was in 2010 around 61.2% of GDP. However looking at Standard & Poor’s different ratings a downgrade to an AA+ rating was still a somewhat harsh decision. Moreover, the downgrade did not really affect the demand for US Treasury-bills and yields remained constant.

According to Carl Lantz, the head of interest rate strategy at Credit Sussie, this was due to the fact that people already suspected a downgrade and thereby, the downgrade was already priced in. In addition to that, other external factors, such as the European debt crisis, are still contributing to the demand of US Treasury-Bills.

In sum, the US public debt in percentage of GDP has approximately been halved since 1945. However, if you compare present debt ratio to the ratio in 1980, the debt has almost doubled. In addition, the public debt since 1961 in absolute terms has increased by 3600%. To answer the whether the public debt in US is unsustainably high, additional approaches towards the subject than those not mentioned here would be needed.

GDP

80

1990

2000

2000

National debt clock 6th Avenue Manhatten

3 FACTS ABOUT DEBT

1

What is public debt?

2

What is credit rating?

2010

3

e (billion dollar)

1990

US DEBT IS A TOURIST ATTRAKTION

2010

Public debt is the difference between a government’s income and expenditures, also defined as all the money owed by a government at any given time.

A budget surplus means that government income is higher than expenditure and as a result the government is able to reduce its debt. Conversely a budget

A credit rating expresses opinions about the ability and willingness of an issuer such as corporation or state to meet its financial obligations or the credit quality of an issue such as bond or debt obligation and the relative probability of that it may default.

The rating in turn will affect the interest rate applied to the security being issued, for instance a state with AAA rating will pay a lesser interest rate on its treasury

What is the S&P credit rating?

‘AAA’—Extremely strong capacity to meet financial commitments. Highest Rating.

‘AA’—Very strong capacity to meet financial commitments.

‘A’—Strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances.

‘BBB’—Adequate capacity to meet financial commitments, but more subject to adverse economic conditions.

‘BBB-‘—Considered lowest investment grade by market participants.

‘BB+’—Considered highest speculative

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deficit means that government expenditure is higher than income, which in turn requires the government to borrow. This is usually done by issuing government bonds or bills to compensate for the negative difference between the income and expenditure and as a result increases the countries debt level.

notes compared to a state with a BB rating.

The credit rating is published by a credit rating agency and is as a result an evaluation made by the agency on the likelihood of a default. According to Standard & Poor, one of the biggest rating agencies, the rating should not be viewed as an assurance or precise measure on the likelihood of default. It should rather be viewed as a relative level of credit risk that the rating agency has carefully considered. It shall be noted that the credit rating agency charges it’s customer for providing them with a rating.

grade by market participants.

‘BB’—Less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions.

‘B’—More vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments.

‘CCC’—Currently vulnerable and dependent on favorable business, financial and economic conditions to meet financial commitments.

‘CC’—Currently highly vulnerable.

‘C’—Currently highly vulnerable obligations and other defined circumstances.

‘D’—Payment default on financial commitments.

serve as a Member of the Board of Governors of the Federal Reserve System. Ben Bernanke took office as chairman of the Federal Service on February 1st, 2006, when President George W. Bush appointed him. Barack Obama reappointed him, when he was elected president. Before Ben Bernanke’s appointment, he was chairman of the President’s Council of Economic Advisers from June 2005 to January 2006.

Alan Greenspan preceded Ben Bernanke. Both got along with the economic liberalism, but Ben Bernanke admired the economist Milton Friedman, whose beliefs about market regulation in the 1980s inspired Ronald Reagan and Margaret Thatcher. Ben Bernanke differed from Alan Greenspan when it came to forecasts and regulations. Ben Bernanke is advocate of forecasts and does not hesitate to use regulations. Conversely, Alan Greenspan did not trust in regulations at all.

Ben Bernanke also believes in transparency and clearer statements than those of Alan Greenspan.

How did Ben Bernanke handle the financial crisis?

Ben Bernanke is interested in the Great Depression. He calls it the “the holy grail of macroeconomics” and says: “To understand geology, study earthquakes; to understand economy, study the Depression”. Ben Bernanke studied the Depression, and he has based some of his economic thoughts on it. He tends to see the Hoover Ad-

Ben Bernanke

The controversial economist In the last three years, the United States of America has struggled with the financial crisis and the Federal Reserve has blasted trillions of dollars into the economy. The man in charge is Ben Bernanke, but who is he and how has he handled with the financial crisis so far?

By Daniel Borup

In his oversized Washington office, Ben Bernanke is in control of the economy of the United States of America. The bold man with the grey beard appears to be shy and reticent in terms of communicating with the media. He does not radiate self-assurance, but somehow he manages to gain people’s trust and make them believe in him - a gift he has been aware of since he graduated from High School with the best high-school certificate.

As chairman of the Federal Reserve, Ben Bernanke has an enormous power over the world’s economy, a power he has used in a way that is completely unprecedented.

Phil the marmot from Punxsutawney Rumor has it that Ben Bernanke is to be compared to the ground hog, Phil, from Punxsutawney in Pennsylvania. Every year on Groundhog Day, Phil walks out of his cage, and if he throws

a shadow, the winter will continue for six weeks.

People from Punxsutawney believe in Phil, the media write articles about Phil’s achievements, and several thousand people come every year to watch Phil predict the duration of the winter. Because of the fact that Ben Bernanke will not express his opinions about politics, he is infrequently seen in the media As a result, he only appears on television when he is going to speak about the condition of the economy and how the economy will develop in the future. When he does appear on television, people admire him and value his words. Thus, he is to be compared with Phil, the marmot from Punxsutawney.

About Ben bernanke Ben Bernanke was born in Augusta, Georgia in 1953. He was raised in Dillon, South Carolina.

His father was a pharmacist and his mother was an elementary school teacher. After achieving the best high-school certificate from Dillon High School, he attended Harvard University and graduated with a Bachelor of Arts in economics in 1975. Afterwards, he attended Massachusetts Institute of Technology and received his Ph.D. in economics in 1979. In the period 1979 – 1985, he worked as a professor at Stanford Graduate School of Business and as a visiting professor at New York University. Afterwards, he became a tenured professor at Princeton University in the Department of Economics. He worked in this department from 1996 until 2002, when he went to

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ministration’s handling of the crisis as a huge mistake, and instead he embraces Michael Keynes’ thoughts of the aggressive and intervening government.

The central function of the Federal Reserve is to steer the economy toward stable prices and maximum employment through monetary policy.

It also has to lend the traditional banks money if they run low on ready funds in case of bank runs.

In connection with the financial crisis, Ben Bernanke proved his superior knowledge and showed that he knew how to handle a crisis based on lack of confidence and edginess. The author of Lords of Finance gives his opinion about Ben Bernanke: “Ben understood more clearly than anyone how crisis of confidence can create a domino effect”.

When the financial crisis broke out, Ben Bernanke resorted to his Keynesian conviction. He made use of the so-called quantitative easing. The first, commonly referred to as QE1, was did aim at supplying liquidity to the financial sector. Instead, it was supposed to support the American economy by keeping long-term interest rates low. It was commenced in 2009. Ben Bernanke says: “In addition to easing monetary policy, the Federal Reserve has worked to support the functioning of credit markets by providing liquidity to the private sector”.

During the QE1, the Federal Reserve purchased $175bn of agency debt securities and $1250bn of mortgage-backed securities, in addition to purchases of Treasuries. The short-term aim of the QE1 was to support the American economy, and it did, because the Federal Reserve provided liquidity to the private sector by supporting the function of the credit markets. Among economist it is said that the QE1 prevented the economy from a large depression.

The second round of quantitative easing, QE2, was distinct from the first, however, the aim remained the same: to support the US economy. In

2010, the Federal Reserve began to reinvest principal payments from agency debt and mortgagebacked securities they had acquired in connection with QE1. By the end of 2010, they chose to expand the balance sheet with $600bn. This was carried out by buying Treasury securities. Referring to QE1 and QE2, Ben Bernanke differs from Alan Greenspan, and he reached a lot of attention and criticism. Critics of Ben Bernanke and quantitative easing in general proclaim that buying Treasuries only increases the reserve deposit.

This is due to the fact that the Federal Reserve purchases Treasuries with dollars they have created expressly for that transaction. They call it an “asset swap”, and states that the Federal Reserve has more reserve deposits and fewer Treasuries in the private sector after execution of QE2.

Despite the criticism, Ben Bernanke is completely convinced that in order to comply with the financial crisis, it is necessary to intervene and get the economy going again. Starting from the Great Depression, he knew what to do and what not to do.

He proclaims in an interview for 60 Minutes in 2010, that the $600bn decision is made out of two aspects. The first is unemployment, and the second is the fact that deflation is threatening the economy of the United States of America.

Critics of Ben Bernanke’s Federal Reserve think that QE1 and QE2 will overheat the economy and make inflation uncontrollable. This is due to the fact that Ben Bernanke has lowered the interest rates. He states, though, that he is able to raise interest rates in 15 minutes and adds that critics only focus on the risks of acting, but not on the risks of not acting.

In September 2011, the interest rate on 10-year Treasuries is 1.95 percent. That is lower than the inflation, but the Federal Reserve is about to implement a new quantitative easing named Operation Twist. In an effort to encourage people and business to spend and borrow money, the Federal Reserve is aiming to drive down the interest rates on 10-year bonds. Due to the fact that they already own hundreds of billions worth

The future according to Ben Bernanke Ben Bernanke is a republican and a controversial economist, who has received a great deal of criticism from the most conservative members on Capital Hill. Despite the criticism, he retains his points of view and states that his job is not a popularity contest. Instead of dealing with criticism, he would rather discuss the economy.

Ben Bernanke has a good deal of confidence when referring to the American economy in the future. He says that America has an excellent record in terms of innovation and great universi-

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of medium-term bonds, and the interest rate on those is virtually zero, the Federal Reserve is most likely going to sell those medium-term bonds and use the proceeds to buy long-term bonds in an attempt to “twist the yield curve”.

During the financial crisis economists have accepted the fact that the Federal Reserve is not able to do much other than lowering the interest rates. Therefore, they hope that it will soon support the American economy and help out the unemployment, which is about 9 percent.

The future according to Ben Barnanke Ben Bernanke is a republican and a controversial economist, who has received a great deal of criticism from the most conservative members on Capital Hill. Despite the criticism, he retains his points of view and states that his job is not a popularity contest. Instead of dealing with criticism, he would rather discuss the economy.

Ben Bernanke has a good deal of confidence when referring to the American economy in the future. He says that America has an excellent record in terms of innovation and great universities, which are involved in technological development. He adds that the entrepreneurial culture in America is formidable. Referring to these aspects, he is certain that America will retain its leading position as the world’s largest economy.

The question is, though; will Ben Bernanke, the ground dog Phil, be right after all regarding America’s economy in the future? No one knows, but it is certain that he will control and watch the American economy from his oversized office in Washington.

Greek DEBT Crisis

The Dog Days Are Over!

By Sarah-Louise Hansen

called for act by the European leaders.

Markets are typically somewhat tranquil during the summer, and this summer was no exception.

Most of the attention was dedicated to the deadlock in the negotiations over the US budget due on August 2nd 2011. Here, Obama struggled to find a solution with the Republicans eager to induce public spending cuts on one side of the table, and the Democrats determined to lift the debt ceiling on the other. The negotiations evidently went through and attention was pointed to the Swiss franc, which had appreciated substantially due to the investors’ demand for a safe heaven.

Massive demand for the currency pushed the Swiss franc up 30% against the dollar within just one year. Consequently, the Swiss National Bank, who feared that the strong currency would evidently weaken the economy, chose to peg the Swiss franc to the Euro.

Summit

Wake up and smell the coffee

These events left the Euro with a much-needed break after a hefty spring. European leaders had granted a new €109bn bail-out package to Greece before their summer break (see timeline) and for just a brief moment, the Euro crisis seemed like more distinct memory of a bad dream. But the realities of the Greek debt and Euro crisis soon caught up the European politicians. First came the market worries about the possible downgrade of France. Then, after substantial market turmoil, focus was back to where it all started, namely the major budget deficit in Greece. The budget deficit had put Greece into a severe lack of liquidity, which would evidently make Greece insolvent due to the “high” interest rates that ECB has continuously hiked in an attempt to fight inflation. All these events – the ladder in particular – caused the Euro to fall due to a lack of investor confidence. Fighting market sentiment is never easy due to the typical herd behaviour. However, being in a monetary union does not make this any easier. On the contrary, self-fulfilling market runs cannot be back-stopped by the countries themselves since they have lost their monetary independence. Thus, the events

of all summits!?

The intensifying debt crisis left leaders of the European Union with three options; kick out Greece and let them devaluate themselves out of the crisis, restructure Greece’s debt or introduce yet another bailout package. After extensive negotiations on the summit held on October 26th, European leaders finally came up with a plan to rescue Greece and the other peripheral countries.

The rescue package consists of three elements.

First, Greece’s debt will be restructured by inducing 50% voluntary haircuts on private investors in exchange for a safer debt. The voluntary part of the agreement is important to emphasize since a voluntary haircut will not trigger the bond-insurance contracts (CDSs) – an event that has been much feared by the politicians of Europe, since the insurance system is still untested. Next part of the agreement is a €106bn recapitalization of Europe’s banks in order to soften the hit from the restructuring of the Greek debt. Last is the creation of a “€1trillion firewall” in order to prevent the contagion from spreading to vulnerable, yet solvent, peripheral countries.

The

end?

So, is this the end of nearly two years of trial and error? Hardly. In the short run, one of the consequences of the haircut is that Greece’s banks, which are big holders of Greek debt, will face billions’ worth of write-downs. In order to address this issue the troika of Greece’s lenders – the European Commission, European Central Bank and the International Monetary Fund – have set aside €20bn-€30bn to recapitalize Greek banks as part of a July rescue package. However, most critiques points to the fact that another €16bn is needed if the Greek banks are to meet the 9% capital requirement induced by the European leaders. Additionally, the advocates of the haircut fail to recognize that Greece’s pension and social security funds are also big holders of Greek government debt. Dealing with the voluntary part of the haircuts, however well intentioned, it has the rather unfortunate consequence of undermining

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the value of a CDSS and thereby cause banks and other investors loose faith in CDSs as a hedging tool. As a consequence hereof, the reluctance to trigger CDSs could cause borrowing costs in other countries to rise.

Looking at a more long-term perspective, it is questionable whether many structural reforms imposed by European leaders have actually bailed Greece out rather than just putting them in a dead lock. According to some estimates, structural reforms and austerity packages have taken their toll on the growth potential of the Greek economy; output will decrease by 5.5% in 2011 and Greece’s economy will continue to shrink until 2013. Moreover, the debt burden will continue to grow until 2013, where it is estimated to peak at 186% of GDP. Looking from a broader perspective, the recent events have put Euro zone leaders’ ability to convince the market that they believe in the euro up to a test. A test they stand a very little chance of succeeding in for two reasons. First, the politicians are faced with massive domestic pressure. In Germany Angela Merkel, chancellor of Germany, is being punished by voters and the coalition party for using German tax money to bail out peripheral Europe. In peripheral Europe, citizens are demonstrating against new austerity measures and structural reforms. Second and most importantly, lack of communication between politicians in the Euro area means that they fail to tackle the issues such as “Can a member country go bust?” and “Can a member country loose its membership? And if so, what does it take?”

However difficult and even unpleasant these issues are, European leaders must face the reality at some point in time.

In sum, it seems as if this rescue will not mark the end of the Greek debt crisis. If anything, the rescue plan is merely the Euro leaders attempt to “pee in their pants to keep warm over the winter”.

And more than anything, the plan is a good example of what happens when politics and economics tries to reconcile.

Greek debt crisis – list of events December 9th 2009

Fitch announces downgrade of Greek debt to BBB plus – the lowest of all Euro zone countries – due to detoriating public finances. Investors panic and start selling of Greek assets.

December 15th 2009

Market scepticism over Greek rescue plan. Greek unions start to strike over reforms.

January 11th 2010

IMF steps in to advice Greece on public finances.

January 14th 2010

Greece announces an ambitious plan to cut deficit.

January 25th 2010

Investors gain confidence in the Greek economy as they rush into five-year fixed rate bonds.

February 25th 2010

Investors loose their confidence again when Moody’s warns Greece could see its long-term credit ratings cut two notches, following a similar statement from Standard & Poor’s 24 hours earlier.

March 4th 2010

Athens sells €5bn in 10-year bonds and receives orders for three times that amount – market sentiment is back up.

April 12th 2010

Eurozone members agrees to provide €30bn in loans within the next year.

April 20th 2010

Greek unemployment plummets to 11.3% -- corresponding to a six-year high rate. 10-year Greek bonds jump 36.2 bps.

April 23th 2010

Greece seeks €30bn rescue package from Eurozone partners.

April 26th-27th 2010

Bond yields continue to soar. The crisis starts spreading to other peripheral countries, e.g. Portugal. Standard & Poor downgrades Greek debt to junk.

April 30th 2010

Greece agrees on €24bn austerity package.

May 2nd 2010

European leaders agrees on €110bn rescue package.

May 3rd 2010

ECB suspends minimum rating required for Greek government-backed assets used in its liquidity-providing operations.

June 14th 2010

Moody’s follows suit and downgrades Greek debt to junk.

June 24th-27th 2010

Market takes another hit at 10-year Greek bonds due to worries over expiry of ECBs long term refinancing reform.

July 13th 2010

Investors confidence is back and Greece raises €1.62bn in six-years treasuries.

August 5th 2010

IMF, European Commission and ECB praise Greece for their structural reforms.

August 12th 2010

Statistics reveals that Greece is deeper into recession than first thought.

August 19th 2010

Another €9bn is granted to Greece in Eurozone loans.

September 2010

1st-15th IMF stresses that the default risk of Greece is overestimated. Additionally, leaders of Athens and rejects any likelihood of a Greek debt restructuring.

October 4th-12th 2010

Greece extends spending cuts. A successful debt auction decreases the cost of short term borrowing and brings back investor confidence. Yields on 10-year bonds are down for the first time since June 30.

January 14th 2011

Fitch cuts Greek debt to junk.

February 21th 2011

Greece unveils tough legislation to reduce tax evasion as part of reforms agreed in return for a €110bn bail-out by EU and IMF.

April 23th 2011

European Commission data shows the Greek budget deficit jumped to 13.6% of gross domestic product in 2009 – almost a full percentage point higher than the Greek government’s projection of 12.7%

May 24th 2011

Greece announced that is will sell stakes in state-owned groups.

June 9th 2011

Greece’s statistical agency revises downward its quarter-on-quarter growth estimate for the first three months to 0.2%

June 16th-17th 2011

IMF and EU offer Greek aid deal. George Papandreou, prime minister, replaces his finance minister.

July 3rd 2011

European finance ministers approve a €8.7 aid payment to Greece.

July 21th 2011

European leaders agree on a €109bn bail out package. Private bondholders are for the first time ever included in the rescue plan.

July 25th 2011

Moody’s downgrades Greek debt even further, stating that the country is “very poor or in default”.

September 13th 2011

Greek bond yields rallies even further.

October 19th 2011

Greek lawmakers approve the country’s latest austerity package at its first reading.

October 27th 2011 Source: Financial Times

EU reached agreement on Greek bonds.

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CHINA READY WITH BILLIONS

FOR THE EURO-ZONE

By Stian André Kvig

As the printing presses of the Euro-zone are running out of ink, European leaders need to look elsewhere to finance their bailout-packages.

C

hina is now ready to invest billions in the rescue operation going on in the Euro-zone, according to the Financial Times. However, European leaders need to convince the Chinese about the safety of the investment. Chinese highranking officials confirm the claims that they are willing to support the EFSF fund, but still needs the final guarantees from the EU to make the investment.

Since the beginning of Europe´s sovereign debt crisis, Beijing has repeatedly expressed its wish to offer help to Europe. Eurozone countries, however, have to understand that they will have to save themselves; expectations of a “red knight” riding to the rescue are sorely misplaced.

As Wen Jiabao pointed out at the 2011 Dalian World Economic Forum, the EU has first to put its house in order. When countries and political parties in the Eurozone squabble among themselves over how to proceed, how can China support any hastily assembled rescue packages?

China has a long-term interest in supporting this fund, simply because it is our largest tradepartner. However, we need to secure the support of the Chinese people, and at the same time acknowledge that there are skeptics to this investment in our country, says Prof. Li Daokui, the chief economic advisor to the Chinese central bank. China does not want to throw away their fortune nor appear as a naïve money donor, Li further claims.

He points out that the Chinese government may

find leverage in Europe’s economic disaster by pressuring European politicians to stop criticize Chinese monetary policy. This implies that a rescue package may taste worse than it looks for Europe´s debt champions. First of all, they will be in heavy debt. The interest on this loan is at present unknown, but there is no reason to believe that it will be nothing but extraordinary. This will lead to further cuts in public budgets in PIIGS countries as they struggle to meet loan obligations. As we already have seen huge riots and civil unrest, the social implications of further cuts in public spending will be on a scale never seen.

Second of all, the loans come with preconditions that may alter the geopolitical and economic future of not just PIIGS countries, but the whole European Union.

the EU´s problems. However, as China holds large reserves in EUR, it is unlikely that they will allow the PIIGS countries to default. China understands what catastrophic implications a dissolution of the Euro will have for not just their currency reserves, but also Chinese export.

That said, it does not mean China should stay on the sidelines. China would be happy to invest in EFSF bonds in a measured way, as it has already done. If a Eurobond should emerge, China should also invest.

For any major investment in European sovereign bonds, safety is the key, which means that an ironclad guarantee and the involvement of the International Monetary Fund are necessary. Besides, there are many ways to help without exposing China to sovereign debt. Its sovereign wealth funds can buy shares in solid European non-financial and financial companies. Chinese enterprises can inject billions of euros of fixed direct investments into the Euro-zone economy.

“What we are seeing here might be nothing less than a revolution in the economic and geo-political relations between China and the West.”

What we are seeing here might be nothing less than a revolution in the economic and geo-political relations between China and the West. Nevertheless, these preconditions are yet to be announced by the Chinese, but there is no reason to believe that they will not change the economic and political landscape of the EU for decades. The Chinese fully understand their bargaining power in this situation and will likely take full advantage of

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Furthermore, there are indirect ways to help.

Beijing should allow the renminbi to appreciate against the Euro and give European companies greater access to Chinese markets-which, of

course, needs to be reciprocated. An improved Euro-zone current account through trade as well as Chinese investment in EFSF will free up funding within Europe and allow more savings to be directed towards governments.

Times, 25% of the total foreign currency reserves of China are held in EUR.

“As we already have seen huge riots and civil unrest, the social implications of further cuts in public spending will be on a scale never seen.”

China and the U.S. find themselves held up in a conflict regarding whether or not China is artificially deflating the renminbi to maintain high export.

China resides over enormous reserves of foreign currency, especially EUR and USD. In other words, it does not take rocket science to understand why China has an interest in holding countries like Greece, Italy, Spain and Ireland solvent. China knows that European leaders want to keep these countries over water to protect the EUR, but they know they need to plan for the worst. The decision to invest in the EFSF fund is without doubt part of their strategy to secure their currency reserves. According to the Financial

Sources within the Chinese government claim that China will contribute between 50 to 100 billion USD to the EFSF. It is further discussed that China may choose to invest in a new fund set up in cooperation with the IMF instead of the EFSF.

China also has a large currency reserve in the US dollar. As we have seen in the last years, China´s faith in the dollar has been rather misplaced. The dollar has taken big hits against nearly all major currencies, leaving the Chinese central bank watching as their income from the export to the

US decreases in value. In other words China cannot afford to make the same mistake again with the Euro, something both Chinese and European politicians are well aware of.

The recent agreement on expanding the scale of the bail-out fund is perceived as positive, but the idea of “leveraging” the European financial stability facility by partial guarantees is not reassuring.

That is a far cry from the original design of EFSF bonds.

Bailing out EU countries with Chinese pensions is hard for the Chinese to accept, just as it is hard for any German pensioner to accept. The tens of millions of elderly Chinese will demand to know why they should pay for rich Europeans to retire early when they do not have a decent pension system of their own. Unlike America, which has accumulated huge foreign debts, the Euro-zone as a whole has a healthy external position. This means that Euro-zone countries can solve their sovereign debt crisis with their own money, as long as Germany and some northern European countries are prepared to take the bill. The Chinese will ask: If Germans do not want to contribute more money, why should China bother?

“DEBT-CRISIS COOLDOWN” HITS CHINESE ASSET MANAGERS

By Stian André Kvig

While China continues their plans for two-digit economic growth, Chinese asset managers are feeling the pain of the European debt-crisis. As we enter the last quarter of 2011, Chinese equities are performing as poor as in 2007, leaving the fund managers striving to meet expectations and stay ahead.

Chinas real economy may have escaped the global economic slowdown so far, but Chinese asset managers are feeling the pain. As 2011 goes to its end, fund managers are feeling the impact of a truly globalized financial sector. Continued weakness in China’s equity market has made this one of the most challenging years for the country’s fund management industry since the financial crisis first erupted in 2007. Notwithstanding the country’s strong economic fundamentals — growth has been running at a pace of more than 9 percent — the Chinese stock market has been among the worst performers around the world.

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The benchmark CSI 300 index has been weakening steadily since April and stood at 2,679.27 late last month, down 14.4 percent since the start of the year and off a tremendous 54.5 percent from the all-time high in October 2007.

However, Chinese fund managers seem to have difficulties grasping what has hit them. And who could blame them? Not just the Chinese, but financial professionals all over the world has been flawed by the poor performance of China´s equity markets in 2011. The words of Beijing-¬based Zhang Houqi, deputy president of China Asset Management Co, sums up the industry reaction

to the poor results: ” The major challenge for us was market volatility and the fact that it has been a bear market”.

It has been a bear market, indeed. Chinese investors who are seeing their savings take a large drop may not be satisfied with explanations blaming on ”bear markets” though.

IPOs are taking place on ChiNext, a Shenzhen-¬based market launched in November 2009 that specializes in raising capital for private entrepreneurs. More supply could be coming if the government goes ahead with plans to introduce an international board on the Shanghai exchange, to lure listings from foreign -multinationals.

Compounding the concerns are market worries that official efforts to rein in inflation – which eased to 6.2 percent in August after hitting a three-year high of 6.5 percent in July – may force the economy into a hard ¬landing.

Still, Chinese shares have relatively attractive valuations these days, and there are signs in the market that equities have been oversold, analysts say. Shanghai’s A- shares were trading last month at an average of 9.3 times 2012 earnings forecasts. This is considerably lower than the comparable average price-¬earnings ratio of 10.8 for stocks in the Standard & Poor’s 500 index, according to Paul Schulte, global head of financial strategy at CCB ¬International Securities in Hong Kong.

If there is one thing both Chinese investors and fund-managers are hoping for, it is a market rebound. However, the fund managers may be facing a tricky situation in the event of a turning market. “Many individual funds are currently below their par value, meaning that a large number of investors are holding on to their investments, and many will redeem if performance pushes the net asset value back up to 1,” says Anthony Skriba, an analyst at Z-Ben in ¬Shanghai. “This means that, in the event of a near-term market rebound, industry assets will decline as investors redeem their existing shares, with growth following thereafter.” This means the joy of a market rebound may be short-lived because of the sell-off that will appear if investors get the ability to get out of their positions with zero losses. Further, this implies that a double-dip might take place in the Chinese stock market approximately between 2012-2013.

“The belief was that these problems would lead investors away from the US and the Euro-zone and into mainly blue-chip stocks in emerging markets, especially China.”

The consensus in early 2011 was that Chinese equities would see a nice return in the following year due to the debt-crisis in the Euro-zone and the financial turmoil and the state of the economy in the US. The belief was that these problems would lead investors away from the US and the Euro-zone and into mainly blue-chip stocks in emerging markets, especially China. The main reason was that China in the beginning of 2011 seemed to continue their nearly two-digit growth from 2010. Another reason was that investors didn’t believe that the Chinese economy would be severely hit by the Euro debt-crisis and the possible recession in the US. The volatility has been challenging for fund managers since industry wide assets under management have seesawed. They peaked at 3.2 trillion Yuan ($476 billion) in 2007, fell to 1.89 trillion Yuan in 2008 and rebounded to 2.67 trillion Yuan at the end of 2009 before declining to 2.3 trillion Yuan as of August 31, according to Shanghai-based Z-Ben ¬Advisors, a firm that tracks China’s asset management industry. The scope of the market’s decline in recent years could limit any potential recovery, analysts say.

“The consensus in early 2011 was that Chinese equities would see a nice return in the following year due to the debt-crisis in the Euro-zone and the financial turmoil and the state of the economy in the US”

To an extent, Chinese equities have suffered from the same decline in valuations that have hit most stock markets around the world as growth has slowed. But several factors made in China are also weighing on the market.

The Chinese government has been selling its stakes in a wide range of companies, flooding the market with billions of shares since 2006, notes China AMC’s Zhang. Until 2006 about 55 percent of all shares of publicly traded state-¬controlled companies were classified as nontradable.

Since then, Zhang estimates, the government has sold nearly 50 percent of those nontradable shares on the market.

The government isn’t the only source of supply.

Chinese companies continue to bring a steady flow of initial public offerings to the market, albeit not at the same torrid pace as in previous years.

Year-to-date as of September 21, 267 companies had issued $41.7 billion worth of equity in IPOs, according to data provider Dealogic. Many of the

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NEWS FROM THE BOARD Half way through this semester the Board of FinanceLab looks back at the last few months with great content.

We started the semester with our semiannual Nordic Trading Competition (NTC), where enthusiastic students gathered to compete for the title as the best trader.

Thanks to Nordea Markets, who made it possible for us to set two tickets for Nordea Markets day at stake, there was more excitement in the room than at any of the preceding NTCs. Afterwards, FinanceLab took educational events to a completely new level at the Investment Camp. In Copenhagen School of Entrepreneurship’s (CSE) facilities, FinanceLab hosted a full day event with prominent names such as Barclays Capital and J.P. Morgan as well as newcomers to the financial playing field, such as Kirstein Finans.

Other than being two great event, the event helped increase awareness of Finance-

Lab and the number of attendants at our monthly Member Meetings is rising steadily.

The agenda at the Member Meetings varies considerably from month to month.

However, common for all of them is that ideas are being created, network expanded and knowledge shared.

One of the main goals of FinanceLab has been to revitalize the Investment Panel (IP). Thus, it was with great anticipation the steering committee introduced the new IP structure. In terms of work-flow, the new structure has been a welcomed by current IP members as well as new members, who are flocking to the Investment Panel. We leave you to determine whether the professional outcome is equally successful.

Thanks to our partnership with GCMS and the great effort from the Trading Diploma Team, FinanceLab continues being independent through our facilitation of Trading Diploma. Attendees from different universities and corporate world are eager to learn about trading and feedback has been over-

whelmingly positive. However, the trading diploma team and GCMS are not resting on their laurels and the courses are evaluated on an ongoing basis.

After two successful study trips, FinanceLab is gradually getting a foot indoor within the world of investment banking. Onwards, our focus will be to maintain and further develop the relations we have made in an attempt to pursue our goal of becoming the number one distribution channel between the financial sector and students across Denmark.

Last but not least, all of these success stories were not possible without a sound band of followers and dedicated members.

Up until now, we have been lucky enough to obtain both and the number of followers has been in an uptrend since FinanceLab was re-established in 2009. We hope that this trend will continue, so we can continue what we are doing – only bigger, better and of course more often.

CARE TO JOIN US?

Dine with FinanceLab and major investment banks Upgrade your resume with a Trading Diploma Improve your analytical skills Expand your network Become a Reuters certified user … Sounds appealing?

Go to FinanceLab.dk and register!

Remember to follow us on Facebook.

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INVESTMENT

PANEL ANALYSIS OF THE MONTH

T

his month’s investment case is Bang & Olufsen (B&O). B&O designs audio products, television sets and telephones.

Their products are known for unique appearance as well as user-interface and last but not least, their price level!

The little consumer electronics producer from Struer was hit hard during the financial crisis, and their stock was beaten up by the market accordingly.

However, with a renewed approach to their customers and a variety of new products B&O seems determined to show the world that luxury goods are not “so last decade”. Head of this mission is their new president, Tue Man-

Bought 1st of Nov DKK 61 per share

toni, former president of Triumph Motorcycles Ltd. Tue Mantoni is a man of ambition and he has a track record to back up his ambitions with. He has set high goals for B&Os future development and up until now, this seems to going according to the plan; in the first quarter of the current accounting year, Tue Mantoni managed to lift turnover.

The bottom line is however still red and Tue and his crew still have a long way to go. The questions that remains to be answered is first and foremost whether B&O can renew themselves and gain market shares among young consumers or if they are forever damned to stay in the living rooms of our parents. Second is the question of whether B&O has what it takes it win over the hearts of the

consumers in the emerging markets.

Prior to solving the investment case, the panel was divided into four groups – Macro, Strategic, Valuation and Technical Analysis. The Macro group analyzes the macro economic environment concerning B&O. The strategic group analyzes the company’s strategy and outlines their market potential. Based on the recommendations from the strategic group, the Valuation group valuates the B&O using a variety of scenarios. Lastly, the Technical Analysis group studies the market data in terms of price and trading volume in an attempt to forecast future price movement.

B&O rebranded

PANEL WORK FLOW

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GLOBAL

CEO, Tue Mantoni

Strategy

B

y August 15th 2012, B&O – lead

by Tue Mantoni – plans to reach the following goals: one third of audio/video-growth will be driven by new product launches, a turnover exceeding DKK 3,000 mill. (compared with DKK 2,867 mill. last year) and a result before taxes of DKK 100 mill. (DKK 40 mill. last year). If that sounds ambitious, wait until you hear the five-year plan; current turnover stands at a little less than DKK 3bn, according Tue Mantoni, B&O has a full potential of between DKK 8 and 10bn – a potential he plans on exploiting!

So how will do they plan on reaching these ambitious goals? B&Os growth strategy can be summoned up into six pillars. First pillar is inevitably focus on sound. B&O plans to increase the focus on sound and acoustics development and thereby leverage and further strengthen the company’s world-class skills and market position within this area, e.g. through a deeper vertical integration of the ICEpower engineering teams.

Next pillar is restructuring of the retail network.

Up until now, B&O have been much known for their so-called B1 Shops. The advantage was that the dedicated B&O customer could get the full B&O experience in just one shop. The disadvantage however, is that this retail model gives B&O very little exposure to the customers who wishes to explore the market before choosing their favourite brand. Onwards, they plan on switching this strategy and adopt a shops-in-shops retail strategy, where consumers can access B&O products along with a variety of other, competing consumer electronics.

Third pillar is new product categories and expansion of distribution channels. Within the past few years B&O has experienced a considerable increase in turnover from their automotive – sound systems for high-end cars – product range. Within the next five years B&Os hopes to see this trend

continue, making B&O the standard sound system in every luxury car. They plan to achieve this goal through stronger knowledge sharing with the Automotive acoustics teams. Another interesting new initiative is their collaboration with Apple. By making their products complementary with a wide range of Apple products and allowing them to be sold at an affordable price, B&O hopes to target a broad, new segment of Apple enthusiastic consumers.

Fourth, and perhaps one of the ground pillars in their investment strategy, is to increase their focus on obtaining market share the BRIC countries.

In other words, Tue Mantoni and his crew basically relies their prominent growth perspective on the organizations ability to enter the emerging market. And with good reasoning; consumers in the emerging markets are gaining purchase power like nobody’s business. Unfortunately for B&O, other companies have adopted similar “Go growth” strategies and however strong purchase power they have, there are limits to how many people can get their share of the “emerging pie”.

On that note, and speaking to their disadvantage, is the fact that Asian consumers generally care very little about interior. To them, what matters is appearance to the outside world, rather than how their house is decorated and people can hardly tell, that you have a B&O screen at home if you are driving around a Kia. The last two pillars concern the organization and their business partners. First, B&O plans on adopting a more streamlined, flat and last but not least, global organization. The aim of this Secondly, they plan on rethinking their use of technology partners in order to become more innovative and strengthening their bargaining power.

There is no doubt that Tue Mantoni is an ambitious man. Whether ambition is the enemy of success remains for us to find out on August 15th 2012.

The MACRO PERSPECTIVE

L

ooking at turnover, B&O primarily serves countries within Europe. Due to recent events within peripheral Europe it is very unlikely that countries within peripheral Europe will gain purchase power any time soon; structural reforms and austerity measures are dampening the economies of the indebted countries and will most likely continue to do so for a while. As for the rest of Europe and Scandinavia, growth has also somewhat sluggish within the past years. According to forecasts, growth within these regions will be moderate, at best – depending on, whether a double dip will occur. Among the markets that B&O has activities in, most market growth potential is in Asia. Unfortunately, Asian markets account for only 12% of B&Os turnover. In the forthcoming years however, B&O will be putting a lot of effort into convincing the Asian consumers to buy their products.

A substantial part of the future growth is to be driven by a geographic refocus towards growth markets With regards to inflation, B&O faces no substantial risk, since inflation forecasts are within the primary markets are moderate. Currently, unemployment rates in B&Os primary market are high from a historical point of view. All else being equal, this will reduce the consumers’ purchase power and confidence. The upside however is that current unemployment forecasts are relatively constant,

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1

Write your IP application

2

Share your market views in the online community

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3

Be qualified as an Investment Panel member

which leads us to conclude that demand – however low – will remain stable.

In terms of financial risk, most of B&Os liabilities and assets are in euro. Since the DKK is pegged to the euro, the company does not have a hedging strategy. However, their plan to expand their market share in Asia will be a potential risk factor.

As for commodities, metals and petrochemicals are the two primary types of commodities used in consumer electronics. The primary metals are aluminium, tin, copper, zinc and nickel. Within recent years, technology has shifted from aluminium towards tin and copper in the electronic chip production. Since tin prices are projected to decrease while copper will remain roughly constant within the next five years, this is positive for the electronic industry. Out of the primary metals only zinc is projected to increase. Since this is only a minor component in the production of electronic consumer goods, this only has a minor impact.

The petrochemicals (plastic) market is characterized by being very regionalized. Since B&O produces the majority of their components in Czech Republic, we focus on the German market, which represent over a fourth of the plastic market in Europe. Currently, the demand in the plastic market is experiencing an uptrend. As a consequence, plastic imports are very likely to increase within the next couple of years. Most of the import will be from countries in the Middle East – one of the largest suppliers of petrochemicals in the world.

In spite of the fact that the petrochemicals supply is good at adapting to changes in demand, the excess demand will inevitably create an upward pressure on the prices.

In sum, from a macroeconomic perspective, the attractiveness of the B&O share relies heavily on their ability to penetrate the Asian market, since Asian consumers have the most purchase power.

HISTORICAL TURN OVER (mio. DKK) 2000 1800 1600 1400 1200 1000 800 600 400 200 0

2003/2004 2004/2005 2005/2006 2006/2007 2007/2008 2008/2009 2009/2010 2010/2011 Scandinavia

Central Europe

Rest of Europe

North America

Asia

Rest of the world

CAGR of 7.81% and an average EBIT-margin of 7.83%, whereas the terminal sales value equals 5.99DKKbn and an EBIT-margin of 4.97%.

We do not believe in Bang & Olufsen’s own ambitions of reaching an EBIT-margin of 12.00% in 2016 and sales of 8-10DKKbn. For this reason not even our Bull scenario is as ambitious as Bang & Olufsen’s. The target price in our Bull case scenario is based on the fundamentals of a 10 year sales CAGR of 15.54% and an average EBIT-margin of 9.02%, whereas the terminal sales value equals 11.6DKKbn and an EBIT-margin of 8.09%.

Should Bang & Olufsen reach their own ambitions in terms of sales growth and EBIT-margin’s, then there is an upside of at least 200% which equals a share price of 191DKK.

WACC: The WACC which we have used to discount our projected free cash flows equals 9.4%. Due to artificial low interest rates, we have used a normalized interest rate as our risk free rate. Additionally, we have used an adjusted beta of 1.1 which has been calculated by Bloomberg whereas the fundamentals are the KAX Index and a 10 year time period. The dark blue cell in the first table shows the WACC which has been used, whereas the latter demonstrates the fair value share price sensitivity analysis that is connected to different perpetuity growth rates and WACC’s. Again, the dark blue cell in the latter table shows our Base case fair value.

WACC Sensitivity analysis, ACOD = 3.4% & Riskfree rate = 4.5%

Beta

Valuation Scenarios:

Scenario Bear Base Bull Fair value =

Target price 53 91 149 85

Weight Contributes 30% 16 60% 54 10% 15 100% 85

Market Risk Primium 4,8% 8,2% 8,4% 8,6% 8,9%

5,3% 8,6% 8,9% 9,1% 9,4%

5,8% 9,1% 9,3% 9,6% 9,9%

6,3% 9,5% 9,8% 10,1% 10,4%

1,15 1,20

8,6% 8,8%

9,1% 9,3%

9,6% 9,8%

10,1% 10,4%

10,6% 10,9%

1,25

8,9%

9,5%

10,1%

10,6%

11,2%

-

WACC

In order to acknowledge that Bang & Olufsen is an investment case associated with a high level of uncertainty and therefore risk and opportunities, we have made three scenarios. Our DCF target price of 85 DKK is based upon our three scenarios each assigned a weight according to the probability of this scenario occurring.

Moreover, the WACC is the same in all of the three scenarios. The fundamental drivers are mainly the sales growth and EBIT-margin which in the Bear case scenario equals a 10 year sales CAGR of 7.00% and an average EBIT-margin of 2.82%, whereas the terminal sales value in 2021 reaches 5.54DKKbn and an EBIT-margin of 2.44%.

The fundamentals in the Base scenario which we assume is most likely to happen, is a 10 year sales

0,95 1,00 1,05 1,10

4,3% 7,8% 8,0% 8,2% 8,4%

Perpetuity growth (%) 2,0% 2,5%

3,0%

3,5%

4,0%

7,5% 8,0% 8,5% 9,0%

104 98 92 84

109 102 96 87

116 108 101 91

125 115 107 95

136 124 114 100

9,5% 10,0%

80 77

83 79

86 82

90 85

94 89

9,4% 9,9% 10,4%

84 80 77

87 83 79 Fair value

91 86 82

95 90 85

100 94 89

Potential -18% 41% 131% 32%

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Relative Valuation

I

n our valuation of Bang & Olufsen we have chosen not to make a relative valuation since it is based on multiples. This is due to the fact that Bang & Olufsen is estimated to experience low net earnings, EBITDA and EBIT next year. For this reason it does not make any sense to let our target price be influenced by a relative valuation, since the multiples for the abovementioned reason will be too high and not add any value to the valuation.

Conversely, we have let our target price be influenced by the ROIC – WACC spread. Historically the fluctuations in the share price have followed the development in the ROIC – WACC spread.

This trend has however been almost absent in 2010 and 2011 where ROIC has been on an upward path from -13.7% in 2009, -2.1% in 2010 to +2.6% in 2011. Keeping this trend in mind also makes us believe that there is an upside in holding this stock. If Bang & Olufsen is able to get back on track with its new strategy and deliver a pre-crisis ROIC like the company did in 20022007 (+9.54%, +11.28%, +12%, +15.63%, +14.93%, +15.55%), then the share price should face a strong increase like the share price did in the period 2002 – 2007 (+234%).

Technical analysis

1

First off we will look at some possible resistances and channels based upon the approximate last six months of price development. A possible strong resistance level can be observed at DKK 66-67, this is based upon the upward trends being rejected at this level, with a short burst through the level in later August. An upward channel that is a positive or “bullish” trend can be observed from around 12th of September until end of the observation period. If the upward channel breaks through the resistance level of DKK 66-67, then the next significant resistance level occurs at around DKK 73. If the positive channel is weaker than the first level of resistance, then the price could go down as far as DKK 55-60, to meet a lover level of support. Next we will take a look into the resistance level to assess how strong our resistance level is.

Where is the right price?

Upon this analysis it is recommended to employ a buy and exit strategy which says to buy at either DKK 61,50 is the bullish channel is repelled back to 50d MA or buy at DKK 67 if the bullish channel makes a breakthrough. The exit strategy is more simple with a stop (sell) at DKK 54.

2

To do so we will use “Moving Average” 200 and 50 day (MA 200d and 50d). From the next chart it can be concluded that the 200d (green line) average lies above our first selected resistance level indicates additional prove of this level of resistance, DKK 66-67. The 50d (red line) in turn then indicates a lower level of support around DKK 61.

3

N e x t up is the “Moving Average Convergence-Divergence” (MACD) based upon standard metrics that is 12d (green) and 26d (red). The 12d level can be observed to be at a higher level than the 26d level. If the 12d level goes through the 26d level it indicates a downward or “bearish” tendency, which gives a sell signal. Some of the previous signals have been marked for better understanding.

4

Based upon the previous testing of our resistance level it can be concluded that the resistance level is somewhat stronger than the bullish up channel. The simple tools of MA and MACD that we have applied to our chart gives prove of a possible bearish trend of this stock. Though if the bearish up channel do have enough potential, it will

break through and continue to our second level of resistance giving a potential of around 7-8% gain on the stock.

For further estimation of trends we will take a short look on the German DAX index, as it is one of significant European stock indexes, with the Fibonacci retracements to reveal support/resistance levels.

At the time this analysis took place the index was

18/42

at a resistance level with possibility of going either bullish or bearish as indicated by the green and red arrows. Though this is not revealing any trends, it is therefore recommended, at this time, to take a policy of “wait-and-see” to let the market reveal its trends.

NExt investment case

BULLISH OR BEARISH?

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The power of Bitcoins is that they can free people from the tyranny of middlemen: banks; credit-card companies; and money shippers like Western Union, which charge exorbitant fees for performing a rather simple task.

An invention that could revolutionize finance as the InteRnet did to publishing

By Thomas Frivold

I

t has not come to that just yet. However, this article is about a revolutionizing new virtual currency called Bitcoin. It is virtual because it only exists on the internet, and does not have any physical tender. Bitcoins is a digital currency, which can be used to transfer money through the Internet - instantly and anonymously, no matter how large or small the transaction, and no matter how far away the recipient is. The bitcoins are transferred instantly from person to person using a free peer-to-peer program called the Bitcoin Wallet.

The Bitcoin network does not have a central banking authority, no governing institution or clearing house and it is not regulated by any government in any country. In fact no country is able to control the market for Bitcoins nor interfere with its users, perhaps with the exception of a certain invisible hand. There are numerous advocacy groups like Britcoin.co.uk, which facilitates the buying and selling of Bitcoins and works in the political and financial sphere to increase awareness and thinking around Bitcoins.

Bitcoins solves the need to transfer money from one place to another inexpensively and anonymously. It is equally as fast with regards to sending and receiving money whether the transfer is for the coffee shop on the corner, to a friend in New Zealand or a webhost in Iceland. Bitcoins is already accepted by a growing number of businesses all over the world, ranging from currency exchanges, giftshops, restaurants, programmers and webhosts. There are also advocacy groups working with SWIFT to integrate Bitcoin into its network. Apart from sending and receiving money, the virtual currency can be converted to real currency at any of the Bitcoin exchanges. The Bitcoin virtual currency was postulated in a cryptography paper in 2008 by Satoshi Nakamoto, and saw its initial launch in January 2009.

In order to make use of Bitcoins in the real world, you must install a free program to your computer, which then lets you obtain a Bitcoin address for free. With this address the user can send and receive Bitcoins. Hereafter you can buy Bitcoins at one of the numerous Bitcoin exchanges that have emerged. A Bitcoin exchange is a company that buys and sells Bitcoins much like a regular currency dealer and charges a small brokerage fee to cover the transaction costs. These exchanges effectively increase the liquidity to the system.

The MtGox.com exchange currently handles 80% of the trade volume in Bitcoins. A few other exchanges are Bitcoin7.com, Tradehill.com.

(Amir Taaki of U.K. based Britcoin in Newsweek)

In order to receive Bitcoins from someone, you simply have to supply a friend or business partner with your Bitcoin address, and then he or she can send money almost instantly. A tiny fraction of the amount is given away to nodes in the Bitcoin-network that help complete the transaction, typically 0.1% of the full amount.

How does the underlying fundamentals make the system work?

The peer-to-peer network itself is a completely anonymous network that anyone can make use of, and get a Bitcoin address for free. In order to send and receive Bitcoins, the user gets a free Bitcoin address that’s provided by the Bitcoin wallet application.

When a user sends money to the receiver, the Bitcoin Wallet application sends out anonymous requests to the decentralized peer-to-peer network. The network itself is constituted by millions of users worldwide running the Bitcoin application in “number crunching”-mode. When crunching, they accept to use their computer’s capacity to verify other people’s payments and they then receive the allotted transaction cost given by the sender. This is how the network achieves effectiveness, and manages to operate without a central clearing house. Every computer in the net- work running the application in crunching mode acts as a micro-clearing house.

Technically the Bitcoin address is based on public-key cryptography. The address contains no personal information, and is thereby anonymous.

Furthermore, all transactions are public and stored in a distributed database that is used to confirm transactions and prevent double-spending. Unlike conventional fiat currency, Bitcoin has no centralized issuing authority.

“People

in the third world are at the mercy of corrupt governments and banks,” says Amir Taaki, co-founder of Bitcoin Consultancy.

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Bitcoin can drastically reduce overheads and fight corruption. At present, it’s possible to pay up to 23% commission on an international funds transfer. That’s not capitalism, that’s a corruption of capitalism.

(Amir Taaki)

Market price USD-BitCoins

Critisicm and challenges As with every groundbreaking novel idea, there is a plethora of detractors, naysayers and critics.

According to Economist Paul Krugman “The dollar value of that cyber-currency has fluctuated sharply, but overall it has soared. So buying into Bitcoin has, at least so far, been a good investment. But does that make the experiment a success? Um, no. What we want from a monetary system isn’t to make people holding money rich; we want it to facilitate transactions and make the economy as a whole rich. And that’s not at all what is happening in Bitcoin.

And because of that, there has been an incentive to hoard the virtual currency rather than spending it.”

Bitcoins subsequently ended up fluctuating around 5USD per bitcoin in a fairly stable manner. This led to a sharp decline in investors confidence and perceived stability of the Bitcoins. Markets eventually stabilized and the price has remained stable, fluctuating around 5USD per Bitcoin.

In reply to that, critic Amir Taaki says in an online interview on Slashdot, Bitcoin’s intrinsic values lies in the fact that it has unique properties such as:

Breakin and subsequent flash crash of the market

Decentralized No bank holidays International No concept of borders Divisible New privacy model Private identity yet transparent Secure Fast Transactions

Bitcoins subsequently ended up fluctuating around 5USD per bitcoin in a fairly stable manner.

This led to a sharp decline in investors confidence and perceived stability of the Bitcoins. Markets eventually stabilized and the price has remained stable, fluctuating around 5USD per Bitcoin.

SNAPSHOT at the time of the crash (Bitcoinmonitor.com)

The price of a bitcoiN The Bitcoin is currently trading at 4.845USD per Bitcoin. It has been relatively stable through September 2011. In early June, however, the Bitcoins had appreciated to, and were trading at, a whopping 30USD per Bitcoin. At that point in time there were many very happy millionaires around the world. Then, when the Bitcoin price peaked, the world’s largest Bitcoin exchange Mt.Gox which handles approximately 80% of all Bitcoin currency exchanges, was broken into. The rougue computer hackers stole a huge amount of Bitcoins from users that had deposited their holdings with Mt.Gox. The market reaction to this was panicking and most Bitcoin holders sold their assets as quickly as possible. The Bitcoin project saw a huge distrust in the aftermath of this, even though it wasn’t actually a Bitcoin problem. Fingers were pointing at Mt.Gox who was not taking comprehensive measures to secure their online servers.

Liquidity and supply There is a limited controlled expansion of the monetary base hardcoded in the Bitcoin software. The supply of Bitcoins is finite, and is programmed to be slowly approaching the 21 million, in contrast to fiat currency which has an infinite supply.

At the time of writing, the number of Bitcoins in circulation is 7.44 million. The coders of the Bitcoin project have designed it so that coins also can have 8 decimals. When the supply of Bitcoins reaches 21 million, prices will then naturally regu-

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late themselves, as the market begins making use of the 8 decimal points available. This will dampen the effect of deflation as the supply of Bitcoins has reached its maximum.

SCREENSHOT of the Bitcoin Wallet application:

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How is the entrepreneur going to recruit employees if they are bound by the same NCCs in other firms?

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Non-compete covenants:

The weapon of choice for venture capitalists

By Stian André Kvig

As entrepreneurs across Europe struggle to attract VC funds amid the ongoing crisis, another shadow is hiding in the dark; Non-compete covenants.

For the entrepreneurs lucky enough to attract VC funding, this major deal breaker for Venture Capitalists can prove to be critical.

By: Stian André Kvig Non-compete covenants should not be unfamiliar to most of us. In fact, have you ever had a job, the chances are you already have agreed to one by signing your job contract. Non-compete covenants come in several different forms regarding their width, the implications of breaking them, the type of knowledge they are designed to protect and what type of entrepreneurs they count for.

Only 1% of the investment ideas pitched to VCs receive funding. This is a staggering number to any entrepreneur hoping to attract funding to his newborn business. Nevertheless, being a part of this 1% elite community is in itself a great step on the road to creating a successful business. But if you are lucky enough to attract funding, do not make the mistake thinking that you are up for a free lunch.

Non-compete covenants, or “NCCs”, are heavily used by venture capitalists. A NCC is an agreement that limits the entrepreneur’s possibility of leaving the start-up, or to start a competing firm in a fixed period of time. The purpose of applying NCCs in contracts is ultimately to protect the capital invested in a new venture. In a practical sense, the purpose is to avoid the possibility of a hold-up.

A hold-up is a situation where two parties who would otherwise benefit from cooperating see their bargaining power shifting. If an entrepreneur receives investments from a VC without the VC using NCCs, the entrepreneur increases his bargaining power substantially. The source of the entrepreneurs new found bargaining power is the VC´s investment. Since the VC has invested

capital in the business, and the entrepreneur has not, the VC stands to lose their investment if the business fails. The entrepreneur however, faces no such risk. NCCs are therefore an effective way to switch the bargaining power back to the state it was before the VC´s investment.

The reason why, is that it makes the entrepreneur invest in the business in the way that he loses the ability to start a competing company, should the business fail. Therefore, one might argue that without the possibility of enforcing NCCs, there would be a lot less risk seeking capital available for entrepreneurs.

Only 1% of the investment ideas pitched to VCs receive funding

to test the enforcement of the NCC by taking legal action against the entrepreneur. The purpose of this is to scare other potential employees from leaving the firm and joining the start-up or create competing companies.

Entrepreneurs need to carefully assess the consequences of NCCs in their contracts. The offer from a Venture Capitalist might seem tempting and the funding can be critically needed, but the alternative cost can be high when looking at the longterm effects of the NCCs. Entrepreneurs seeking capital need to balance the previous mentioned trade-off in the most favourable way. Ultimately, entrepreneurs need to consider the risk/reward ratio of receiving VC funding.

Handling NCCs from the Entrepreneurs point of view The term “strategic use of NCCs” applies mostly for VC firms and not for entrepreneurs. They need to negotiate so that the implications of their NCCs become as small as possible. Hence, it may exist a possible trade-off for entrepreneurs between receiving risk-seeking capital from a VC and agreeing to NCCs. A trade-off is a situation where you lose or have to accept something in order to gain something else.

Entrepreneurs face a problem caused by the strategic use of NCCs by VCs. An entrepreneur might decide to break the NCCs in his contract with the VC and start a new business. How is the entrepreneur going to recruit employees if they are bound by the same NCCs in other firms? The entrepreneur must also face the fact that even though the start-up would not directly compete with the previous firm the VC invested in, the VC might choose

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Venture Capital Fact Box - Only 1 of 100 start-ups receive VC funding.

- 90% of jobs created from VC backed firms come after they og public.

- From 1990-2000, only 50% of VC backed firms managed to go public.

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The typical ETF is a pooled investment fund which tracks an underlying index, either a stock index like S&P 500, or a commodity index like the Goldman Sachs Commodity Index (GSCI). Thus, rather than being exposed to just one asset, you are exposed to a broad asset class, which means that you can diversify your portfolio using just one instrument instead of constructing your own portfolio. Moreover, a substantial number of management fees are saved, since you only have to buy one asset. Finally, ETFs trade at much smaller number of management fees than other investment vehicles with similar characteristics, such as conventional mutual funds, since they are passively managed.

ETFs are publically traded on an exchange, much like any other stock. Therefore, ETFs can be traded during the day. Another great quality in ETFs, is that some ETFs track indices in foreign markets. Consequently, they allow private, as well as institutional, investors to invest in markets that are otherwise closed for outside investors.

These are the plentiful advantages – now, what is the downside? Why are exchange-traded funds subject to so much critique in the media? And why are they a great concern to the regulators?

Before examining these questions in further detail, it is important to understand how the ETF works and how the ETF-market has evolved during the past two decades.

ETFs the good ol’ fashion way ETFs can be either physical or synthetic, depending on whether they actually hold the (majority of the) assets in the benchmark index or the pay-off structure is mimicked using derivatives. The most common of the two, is the physical ETF, which is rebalanced every day in accordance to the underlying index.

The transaction process of a physical ETF is the following: In the primary market, the ETF market maker or broker acquires ETFs through the ETF manager, who issues the ETFs in large blocks, called creation units in exchange for securities.

Alternatively, authorized, institutional investors can buy or sell ETFs directly from or to the ETF

manager in exchange for securities. In the secondary market the ETF market maker or broker can buy the ETFs using cash on an exchange.

The investor – being either private or institutional – pays cash to the ETF market marker or broker and receives ETFs in return. It is important to note that two points regarding the transaction. First, creation and redemption is done in large blocks rather than in single shares. If an investor wants to sell his ETFs this can be done through the secondary market or by selling creation units back to the ETF manager in exchange for securities.

Second, regardless of whether the transaction is carried out through the ETF broker or directly between the investor and the ETF manager, the ETF manager never receives cash. The implication of this is a considerable tax advantage since because securities are traded for securities there are no tax implications. This is much different from the typical mutual fund where single shares can be sold back to the mutual fund in exchange for cash. The Net-Asset-Value (NAV) is calculated based on the open day weights and the end-day market prices. Since the ETF is traded throughout the day, the trading prices may differ from the NAV; when investor demand for a given ETF is high, its price will increase over NAV due to general demand and supply rules, and consequently result in mispricing. An arbitrageur will see this opportunity and buy creation units from the ETF managers, in exchange for the underlying assets in the ETF. By selling the newly acquired ETFs in the open market, the arbitrageur has hereby gained a profit. Similarly, when the ETF is underpriced, the arbitrageur will redeem ETF blocks from the ETF manager in exchange for - relatively - highly priced assets. Alternatively, mispricing can be due to asymmetric information among the ETF managers, who issues the ETFs, and the market participants. Under this hypothesis mispricing occurs if the ETF managers fail to correctly inform about the assets in the ETF and their respective weight – even though he is legally committed to do so. For example, if the price of a stock increases, the investors will increase their demand for an ETF in accordance with their belief about the given stock’s weight in the ETF. If their

perception was not correct the ETF will become overpriced relative to the NAV.

The new kids on the block Up until now ETFs seems rather harmless, but a lot has happened since ETFs were introduced to the open market back in the late 1980s. The most exotic innovation is the synthetic ETF which – opposed to the “classic”, physical ETF – mimics the pay-off structure of the underlying index through derivatives rather than the actual underlying assets. This is especially attractive for the ETF manager, when access to the market in which the assets in the underlying index exists is limited.

Synthetic ETFs are not regulated under the Investment Company act of 1940, which limits the use of derivatives and prohibits affiliated transactions (e.g. a bank can’t serve as both sponsor and swap counterparty). The advantage of synthetic ETFs is that they do a better work of tracking the underlying index. The primary concern regarding however, is their lack of transparency and their massive exposure to counterparty risk. In order to realize the last issue it is important to understand how synthetic ETFs work. When a transaction is carried out, the ETF manager receives cash from the investors. These cash are exchanged to some basket of collateral, which is handed over to the swap counterparty – typically the same banking group – which offers the return of a given index, say the S&P 500, in return. The counterparty risk lies in the risk of the bank going bust and thereby not being able to meets its obligation to pay the return of the S&P 500 to the ETF manager. Moreover, the collateral does typically not contain the same securities as the underlying index. Thus, if the securities drop in value, while the index goes up, the swap counterparty will have a hard time paying its obligations.

The other innovation within the synthetic ETFs deals with the pay-off structure. The first is the leveraged ETF. The return of a leveraged ETFs equals the daily return on the underlying times your leverage ratio. So how is that any different from the typical, geared investment? Well, when gearing an investment you provide capital and gear your investment with some ratio when en

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the buying an ETF and gearing it yourself or leaving it unlevered would have given you 18% or 9%, respectively. Know the expression “the higher you climb the further you fall”? Well, that basically describes how leveraged ETFs works.

What can we learn from these three examples?

It is all great when the market goes up, but if the market fluctuates even just a little on a daily basis (which anyone, who happens to come across the business section of the newspaper, would know that it does), you will have to be a little smarter than the average investor to outsmart the market using leveraged ETFs. Moreover, the higher leverage and the greater volatility – the greater downfall you can expect (as illustrated in figure 3). This is why many experts advise investors not to keep leveraged ETF’s for more than a day.

Second is the inverse ETF. As the name implies, the inverse ETFs pays off the inverse of the underlying index. By acquiring an inverse ETF you are thereby betting against the market, which seems somewhat harmless. Third, and inevitably, is the leveraged inverse ETF. As ETFs are becoming more popular, even more exotic ETFs arrives at the stage. Both return and risk properties differs substantially from the classical ETF structure and the added complexity of the new ETFs rise the regulatory concerns even further.

Critiques

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tering the position. Eventual gains and losses will thereby be multiplied in accordance with your chosen gearing, and that is basically it! When entering a leveraged ETF position however, the position has to be rebalanced on a daily basis in order to meet the requirement of paying the daily return on the underlying at a given ratio. For example, you choose to buy $100 worth of ETFs and leverage your position in the proportion 2 to 1. Thus, your total exposure is $200. If the underlying index increases 10%, you will have gained not only $10, but 20$ since you have invested in a leveraged ETF. Thus, you have earned a profit of 20% and your total asset holding is now $120.

What happens next is that the position is rebalanced in accordance with your gearing in and another $20 is borrowed. Your total exposure to the given ETF is now $240, out of which you have borrowed $120. If the market falls 10% the following day, your loss will be $24 and your exposure down to $216. If you choose to close your position you would have to pay back $120, leaving you with $96 and a total loss of $4, corresponding to 4% of your investment. Had you alternatively chosen to buy an ETF and gear your investment with the same ratio, you would have gained $20 the first day, leaving you with assets worth of $220.

The next day, the value of your position would decrease by $22 and your total loss after closing the position and paying back the lenders, would be $2 or 2%. That is, only half the loss had you

invested in a leveraged ETF. This difference in return is a result of the rebalancing mechanism in the pay-off structure of the ETF. So what is the purpose of a leveraged ETF? Well, take a situation, where you are gearing is 2x and the underlying index increases 10% for two consecutive days. With an investment of $100, your profit on the first day will be 20%, where after your position is rebalanced and the total exposure is $240. After the second day, you will have gained another $24, leaving you with a total profit of 44% once you have paid back lenders. For comparison, you would have earned 21% or 42%, had you chosen to invest in an ETF with no or 2x gearing, respectively. Once again, the difference in pay-off is due to the rebalancing mechanism in the leveraged ETF. Since the ETF manager has to meet his obligation of paying the return of an index at a given ratio, he has to re-lever his investment every day. Another advantage of the rebalancing mechanism is that your position is gradually reduced when the market is experiencing a downturn for several (consecutive!) days – see figure 2. This limits your losses, as you are gradually pulling your-self out of the position.

Lets assume that you chose to exploit momentum and keep your position for one more day. On the third day however, the market falls 10%. Since your ETF was rebalanced on the day before, your exposure was $288 and your loss $28.8. The total return would be 15.2% on the third day, whereas

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The first critique points is inevitably be their lack of ability to track their underlying index. The critique is easy an easy bought argument against ETFs from all the nay-sayers who do not believe in financial innovation. However, since the main purpose of the ETFs is to track their underlying index this is of course important to address. Second, ETFs have been accused of being mispriced according to their Net-Asset-Value (NAV). As mentioned earlier ETFs are traded throughout the day even though they are only rebalanced once a day. Demand or supply pressures can therefore cause the price to differ from its NAV. The third critique point states that ETFs are more risky than the underlying risk. This critique is somewhat vague and even harder to address, since various risk measures can tell different stories at different points in time. Nevertheless, the issue is important to address, in order to ensure that the ETFs are not consistently more risky and thereby adding risk to the overall market.

Fourth is their lack of transparency in the payoff structure. This critique primarily concerns the leveraged ETF, where – as we saw earlier – you have to be significantly smarter than the average investor in order to understand what you are investing in and even smarter to actually gain a profit from it.

Lastly, ETFs have been accused for their lack of transparency in terms of composition and becoming a shadow banking system. The two last critique points primarily concern the synthetic ETF. However important to realize these issues, it is nevertheless important to keep in mind that synthetic ETFs only account for 13% of the current ETF market.

Whether ETFs are the next bubble or increasing the systemic in the market is to soon to tell. Experts seem anxious draw parallels to CDOs in the subprime mortgage crisis. However important it is to learn from your mistakes it is also important to note that you cannot extrapolate historic trends nor into the future. In the next article of FinanceLab Magazine we will attempt to shed light over the issues by addressing some of the main critique points. (…. to be continued)

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A fundamental approach

to constructing

style indices

By Casper Hammerich

T

raditional financial theory prescribes the construction of indices for the purpose of tracking markets. Generally, traditional stock market indices are constructed by using some form of inclusion criteria (e.g. turnover) and then weighting the individual stocks in relation to their traded value and their market capitalization. This article will exhibit why this method is flawed and demonstrate how Kirstein constructs fundamental style indices.

There are several strengths to traditional market capitalization weighted indices. First of all, it is quite simple to identify the relevant companies, and thus possible to construct the index. As market capitalization is used to measure the individual weights, it is straightforward to calculate individual weights, as both the number of shares and the individual market price are known. This in turn, makes it unnecessary to rebalance the index, as this happens automatically when prices move.

Thus, the administrative part can be reduced to inclusion or exclusion of companies. This is usually completed on an annual or biannual basis.

The need for an index tracking the market is crucial in modern financial theory. Based on the efficient market hypothesis, formulated by Eugene Fama, the traditional way of constructing indices has been by using market capitalization weighted indices. The efficient market hypothesis states that prices should reflect all information in the market, and as such, prices should be a good measurement of intrinsic value.

However, as the weights in the indices are defined by the market capitalization of the individual companies, the relative weights are highly cyclical. Neglecting price errors in the market would be incorrect, though, and when these occur the traditional market capitalization framework breaks down. When the economy is expanding, companies that are growing rapidly, or sectors that experience bubbles, will typically be overvalued with

160 150

regards to their intrinsic value. This again means that they will have an overweight in the indices.

As the economy experience a contraction, these companies will typically be underweighted, thereby making market capitalization a poor proxy for intrinsic value.

Because of the biased composition of the market capitalization weighted indices, any attempt to classify value or growth within companies to create a value weighted and growth-weighted index separately, will have several weaknesses.

Traditionally indices have been constructed with an equal weight of companies with respectively value or growth traits. The biased market capitalized 50/50 approach is visually seen in the graph below, where the excess return of the value index exactly offsets the excess turn of the growth index.

Aggregated the value and growth indices equal each other out. The MSCI World index and Russell US 1000 index are used as example.

Kirstein Index

Accumulated excess return

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MSCI World Growth compared to MSCI World

MSCI World Value compared to MSCI World

Russell 1000 Value compared to Russell 1000

Russell 1000 Growth compared to Russell 1000

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As the market capitalized method, used by MSCI, Russell, S&P et al., produces flawed indices, investors have to rethink the basis for index composition. One obvious approach is to gather a number of company specific fundamentals as proxy for each investment style and the company intrinsic value. This way of constructing market indices has been proposed by Arnott, Hsu and Moore (2005). As traditional indices have a tendency to overweight growth companies in a business cycle expansion and vice versa, they theorized that the fundamental approach would be a better way to construct a tracking portfolio.

is able to grow its core business. High price to book demonstrates a market value substantially higher than its book value i.e. the market share is potentially overvalued resulting in a growth premium in the market. High price to earnings demonstrates a market value substantially higher than its earnings per share i.e. the market expects a high growth in earnings per share. High growth in the five year earnings per share demonstrates strong growth expectations to growth in earnings based on the prior five years’ earnings. These fundamental produces a list of companies that exhibit growth bias.

Our suggestion is based on this approach. A fundamental value and growth index, respectively, can be produced by screening the MSCI World, which contains more than 3,000 companies. The focus will be on the large cap segment, however, the approach can be used analogically on midcap, small-cap, micro-cap and so forth. This approach is named the Kirstein IndeX (KIX).

Each fundamental is evaluated separately, due to potential errors in estimates from DATASTREAM or errors due to corporate actions in the listed companies. Therefore, outliers are removed within a traditional 95% confidence interval. However, a variance in each fundamental might still exist and calculating a t-stat, we detect whether the variation effect is significant. Next, each fundamental is standardized in order to construct a single style variable.

Thereafter a distance measure is incorporated to ensure that only the most pure style biased companies are included in the three indices growth, value and core – calculated as a residual. The higher the distance measure, the more companies are included in the final style index. The lower the distance, the more value, growth or core concentrated the index gets. This is the way the KIX index is constructed and with a distance not greater than 0.5 we have constructed an unbiased fundamental style index.

The chosen fundamentals for producing the growth index are among others return on equity, price to earnings, price to book and a five year earnings per share growth. High return on equity shows that company generates a high net income as a percentage of the equity. Creating a high return on equity show that the company

So what can we learn from this? There are several conclusions. however, the key point must be that one cannot solely expect to outperform actively managed mutual funds just by tracking the market capitalized index. Investors wishing to adopt a style-based investment philosophy will neglect these findings at their own peril. Investing in a style biased market capitalization weighted index will not produce sufficient alpha compared to the fundamental indices. Thus, the investor will not exploit the true potential of his investment.

Performance supports the prior statements, that KIX superiorly outperforms the market capitalized MSCI World Value index. On a 10-year basis the KIX World Value index produces almost 5 per cent alpha while only taking a slightly higher risk. This results in a much higher risk adjusted return and 185

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KIX World Value compared to MSCI World Value MSCI World

Return benchmark

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Both the KIX World Value index and the KIX World Growth index outperform their respective benchmark indices with 15 to 80 percentage points respectively.

Return strategy

Start date

1 -3 1 -5 1 -7 1 -10

KIX World Value MSCI World Value 3-mth CIBOR

Jun-11 7.07% Jun-11 -0.11% Jun-11 4.24% Jun-11 2.76%

3.30% -1.65% 2.38% -1.53%

20.56% 18.55% 16.35% 17.19%

17.00% 15.98% 14.29% 15.96%

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Accumulated excess return

The chosen fundamentals for producing the value index are among others quick ratio, book to price, inverse leverage and dividend yield. High quick ratio demonstrates a superior ability to meet its short term obligations with current assets less inventories. High book to price demonstrates a book value substantially higher than its market value i.e. the market share is potentially undervalued, which results in a premium in the market.

High inverse leverage demonstrates a high liquidity since the equity of the debt exceeds the value of its debt, meaning that the value creation in the company has not been produced by taking on leverage. A high dividend yield demonstrates a solid and healthy business that is capable of burning its money, so to speak. The higher the dividend yield, the more dividends are paid per share.

Altogether these fundamental together produces a list of companies that exhibit strong value bias.

Visually, the performance that is illustrated in the following graph also supports the aforementioned statements.

Accumulated market return

The first step would be to identify candidates that exhibit either deep value or growth characteristic. It has to be noted, that the fundamentals are chosen somewhat arbitrarily and we acknowledge that more indicative ones may exist. Nevertheless, screening for value- and growth factors allows you to compose an index that corrects the biased market capitalization weighted indices.

information ratio greater than one. The alpha is produced under a high correlation of 0.97 to the MSCI World Value index.

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A word from a trader

Trading commiSsions: A cost or an investment?

By Flemming Kozok

- and how do you increase safety in trading activity?

Over the years, I have generally operated with a high trading frequency in my investment activities. Having executed more than 125.000 trades over the past 10 years, the commissions and fees per share add up to more than DKK 15 million.

Surely, this is a somewhat depressing fact. Nonetheless, it is a fact that makes sense to me; a fact that I am willing to accept.

IIn this line of thought, I choose to list here the returns I have achieved (after fees and commissions) on my trading activity as well as the according number of trades executed since year 2000.

These observations may be viewed as examples, which serve to signify that high frequency in trading activities do not necessarily erode the potential for solid returns (see box on the next page).

The reason why lies within the way I interpret the cost associated with executing the trade. Many investors and traders focus slightly too much on trading commission. Even though low commissions are important, this focus tends to blur the bigger picture. The cost of executing trades needs to be observed in context rather than be viewed as something, which needs merely to be minimized as advocated by some participants in the debate. Most people tend to associate increased trading frequency with increased risk. For myself, ironically, the opposite is – and always has been – valid, as the relatively small ”investment” represented by the trading commission in more than one way possesses a potentially great value.

A common cliché in the debate about trading commissions is the following ”Before you make money trading stocks you’ll have to earn back your trading costs. Therefore, you should not pursue active trading, as this will simply increase your trading costs”. I have always found this cliché somewhat imprudent. A key to ”the truth” about trading costs is rather to isolate the particular incurred cost, boxing it with ”the mission” of the particular trade. In other words, to analyze the mere function of executing the particular trade in context of the overall investment strategy.

“the activity which was formerly observed as particularly risky becomes activity relieved of greater risk”

Most strategies qualify to interpreting trading costs as an investment rather than merely a cost.

This also accounts for strategies, which are not focused on mere short-term profit. And surely, the commissions do indeed represent a direct cost.

However, there are other aspects to it, which is why the interpretation of the trading cost ought to be altered by most actors.

The important thing to understand when trading stocks is that the key to long-term success is the ability to fend of losses. To a certain extent, income from successful trades is actually secondary. To live by the principles of a formulated stop loss strategy is the key to achieving this essential step. Observed in this central context, the cost as-

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“the interpretation of the trading cost ought to be altered by most actors” sociated with executing the trade represents an investment in the safety of the trading activity.

A successful trader needs the ability to readily adjust and adapt. This ability in itself ensures safety of the investment, since activity within highly volatile markets in particular requires execution on stop loss strategy. Without this strategy, the risk is simply too great. High volatility represents opportunity and is great for trading setups. However, it needs to be aligned with a tight “safety policy”, hence the execution of a particular order represents a certain function; this one labeled “safety”.

As such, quick adaptation is not simply about spotting opportunities. In this specific context, it widely concerns the concrete way, through which safety in trading is achieved. This is where the tiny “investment” in a trading commission represents the “access” to executing on stop loss strategy.

To “invest” in a simple, low priced commission aligns with my view on commissions; it is the low cost, which represents a cheap and easily accessible right to enter a position and catch a move in the right direction. At the same time, it represents the effective and easily accessible exit from a position; consequently, it serves as the safe-guard against losses and simultaneously represents the possibility for executing on essential stop loss

strategy. By altering the view towards this interpretation, one may actually step up trading frequency rather than focus on minimizing commissions – it simply needs the right strategy and execution (which is a topic not covered in this article).

To sum up, the single most important “tool” for practicing safety in my own trading activity over the years has been via an increased frequency in trading. I like to call it protective trading. To me, executing strategy via the protective trading line of thought resembles a mindset; something which is deeply anchored and incorporated in all activity undertaken in the market place. In this line of thought the cost of executing the trade indeed represents an investment – a very small one, which possesses a potentially great value.

The association between increased trading frequency and increased safety is something which most do not observe as a possibility, hence do not execute on. But when executed the right way things are turned slightly upside down, and activity formerly observed as particularly risky (e.g. day trading) may well become activity relieved of greater risk.

Trading Returns Stock trading, full-time job (January 2000 – June 2006): - 2000 a return of 12.800% based on 25.019 trades.

- 2001 a return of 114% based on 20.241 trades.

- 2002 a return of 84% based on 10.285 trades.

- 2003 a return of 274% based on 11.856 trades.

- 2004 a return of 141% based on 8.687 trades.

- 2005 a return of 118% based on 7.828 trades.

- January – June 2006: a return of 115% based on 8.494 trades.

Stock trading, part time (July 2006 – June 2011; combined with other work & M.Sc. @ CBS): - July – December 2006 a return of 28,17% based on 2.858 trades.

- 2007 a return of 43.8% based on 6.277 trades.

- 2008 a return of 52.7% based on 4.530 trades.

- 2009 a return of 159.9% based on 4.507 trades.

- 2010 a return of 44.3% based on 3.208 trades.

- January – June 2011 a return of 68.4% based on 5.330 trades.

… The reason for this is simple: The interpretation of the cost associated with executing the particular trade is modified to representing an investment in safety & possibility rather than merely a cost.

“the key to long-term success is the ability to fend of losses”

About Flemming Kozok .. Holds an M.Sc. degree from CBS. .. Managed to turn DKK 32.500 into DKK 16 million over a 7 year period (2000 – 2006). .. Has executed more than 125.000 trades on primarily the US stock ex changes. .. Has paid more than DKK 15 million in fees and commissions. .. Has never fundamentally altered his trading strategy (since year 2000). .. Has worked full-time trading stocks from January 2000 – June 2006. .. Has worked part time trading stocks from July 2006 – 2011. .. Still trades, but mostly focuses on “occasional extraordinary setups”. .. Biggest winning streak: DKK 6,4 million in 4 months .. Biggest losing streak: DKK 4,3 million in 5 weeks. .. Biggest daily win: DKK 620.000. .. Biggest daily loss: DKK 540.000.

Flemming Kozok, Danish Day Trader 33/42

DID YOU MISS

INVESMENT CAMP 2011?

Here is a briefing be ready for IC12

As investors all over the world fight for their portfolio returns, FinanceLab hosted Investment Camp 2011.

The aim of the event was to cover aspects in the current market environment from an investor’s point of view. The camp also proved to be a great place to network due to the large amount of participants and the impressive line-up of speakers.

The event was held at CSE lounge at CBS where one could feel the ambitious atmosphere from the very start. The FinanceLab committee greeted everyone. A scene was set up where presenters from Denmark and the UK were to attend. In other words, FinanceLab had it all covered.

Jesper Kirstein, CEO of Kirstein Finans kicked off this event with his presentation on the characteristics of successful managers. With a wellrespected client base such as BlackRock, Carnegie, Fidelity, J.P. Morgan and Schroder, he should know what he is talking about. In his opinion good managers have both quantitative and qualitative skills, and it is essential to combine these in order to perform well. According to Jesper it is essential to have a strong drive and managers should constantly develop, while still staying true to their strategy, so that they cannot only be identified by historical empirical data.

So how does Kirstein pick the right manager?

They focus on some key elements, such as a solid organizational culture, people willing to go that extra mile, efficient interaction within the organization, and a clear business philosophy. In these turbulent times the successful companies are the ones who have a clear understanding of their own performance. I.e. identifies risk and approaches success with modesty. The characteristics of successful managers can be summarized in terms of 5 P’s, namely: Portfolio dynamics, performance, people, philosophy and process.

The next in line was the talented Equity Strategist from Saxo Bank, Peter Garnry. He is proof that ambition and drive could take you a long way.

After studying for a MSc. at CBS he dropped out and started his own business. It was a company similar to Bloomberg, which after a few years took other turns. He then turned to other career options and ended up at Saxo Bank. Peter is steadily thriving within Saxo Bank where he even has represented the bank live at CNBC TV. Peter is undertaking the CFA exam, which he would strongly recommend due to the strong global recognition, career advantage and the practical skills gained.

His presentation further entailed for example questioning if it is the end of the euro zone and if QE3 would just be “more drugs to the drug addict”.

After these two speakers the participants were offered delicious sandwiches and were given the chance of mingling. One could see that the two initial speakers had already accelerated the participants’ analytical reflections where everyone debated actively about the presentations.

After the break it was Rasmus Viggers’, Portfolio Manager at Secure Capital time to shine. He is also a living example of an agile young mind with the willingness to succeed. Rasmus advocated that although he had no relevant job experience, no student job and quote “a very boring CV” he still managed to secure a job. First of all, at the age of 24 he has had seven years of experience with “full-time” investments and he was extremely targeted upon applying for jobs.What he did was to not apply with the standard CV / cover letter method, but by pitching investment opportunities when applying for various jobs. This worked out well as he landed a job as a portfolio manager.

After Rasmus’ presentation it was time for the presenter from J.P. Morgan to enter the scene.

Sami Jauhianinen, Associate at J.P. Morgan talked about how to evaluate financial effects of M&A. Some examples mentioned were regarding to what equity markets react favourably. The answer to this was low premium, private negotiation, enhanced EPS growth, no change in risk, familiarity with target, product complementarily and experienced buyers. On the contrary nonfavourable scenarios in the eyes of the equity markets are long-term dilution, major increase in leverage, no synergies, poor track record and unclear management structure. Sami further argued that the earnings per share impact are the traditional financial check for M&A deals. However,

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it is potentially misleading in equity deals and is even worse in debt-financed acquisitions.

According to Sami in stock deals it is assumed that earnings of the target get re-rated to the multiplier of acquirer. This assumes growth and risk of target instantaneously change to those of the acquirer. On the contrast in debt-financed deals, the implication is that the target only has to earn aftertax interest cost of purchase price to break-even on EPS basis. This then misleads the acquirer into paying a too high price.

Other key financials issues in M&A are for example: Does a deal create shareholder value? Will acquirer’s stock price go up? So if a deal creates value for the acquirer, price including premium is less than value of the target (including synergies). Hence the acquirer’s share price will rise.

However, if the deal destroys value for acquirer, price is greater than value of target synergies and acquirer’s share price will fall. This, according to Sami, was where ValueMath comes into play and calculates share price impact for acquirer (and target). The case is according to him that most advisors, investors and companies prioritise EPS, but inappropriately, while equity market uses value framework. Therefore one does not need EPS to determine value impact of deals.

Sami summarized his presentation by stating that M&A deals are too much about transfer of valuepay and reduced share prices. The value is the

Most prominent facilitites at CBS: Copenhagen School of Entreprensurship Lab 6th floor

most important factor for shareholders; EPS can mislead both the acquirer´s management team and investors in M&A deals. This encourages low multiple acquisitions and high multiple financing.

Basically one needs to understand what happens financially in an M&A deal.

Now it was time for Jacob Lindewald, Director, Barclays Capital, under the topic of: “Investing under capital and liability driven constraints”.

Jacob has previously worked for Denmark’s national bank but in 2006 he joined Barclays Capital where he is currently the director of Nordic Solution Sales. Jacob talked about the interest rate sensitivity and hence risk life insuring and pension funds faces on their liabilities. As an example Jacob talked about stress testing a balance sheet.

An insurer is basically long a portfolio of fixed income assets held against liabilities, the guarantees will lack money at high levels of interest rates and where a combined portfolio resembles a long and only fixed income portfolio. However for lower levels of interest rates the interest rate sensitivity profile changes significantly as the guarantees moves “in the money”. He continued to talk about the new regulatory framework European insurers faces in the future. These include a single set of rules governing insurer creditworthiness and risk management. This emphasizes principle-based, rather than rule-based, regulation. It is more than the technical calculation of capital requirements and a company’s solvency position, as it also gov-

erns the approach to risk management. The new regulatory changes will affect capital markets as major investors will be forced to make changes to their investment strategies. The new rules are to be implemented by early 2013.

After a short break it was time for the final speaker of the evening. Soren Jonas Bruun, Founder of 1CT, with the topic: “Creating a successful Venture Fund”. So what is the story of 1CT? At the start up in 2004 they consulted for early stage companies. In the years to come they built profits through e.g. strategic M&A. In 2008 they launched their first fund. In 2010, 1CT launched their second fund, scaling investments and secured close partnership with global buyers such as Microsoft, Google, Symantec and Intel.

According to Soren what Europe need is a new breed of venture capital fund managers, who possess mixed experiences and entrepreneurial skills with an international reach. According to Soren the European venture capital industry deserves a B at the best. Entrepreneurs worldwide have a bad experience with European venture capitalists.

According to Soren, this is because European VC´s are too risk averse.

Soren further argued that what venture capitalists do is indeed not rocket science, just hard work!

He presented us with the following formula: Experience + raw diamonds + funds + relations =

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value creation. Another interesting quote was: Know-how + know who = real value. The flow that his company works through could be pictured by having a source, creating a plan, invest, develop and eventually sell. In the end 59% of the audience voted that “being an entrepreneur” is what it takes to be a Venture Capitalist. Soren concluded that a good venture capitalist is a good coach.

The key elements possessed are: Entrepreneur and role-model, has worked at start-ups and either succeeded or failed, held e.g. a CEO position and hence having valuable management and business development experience, has actively invested other people’s money or own money in start-ups and finally were in the right place and right time, since most luck is based upon hard work and passion.

After these amazing presentations there was time for networking. A delicious comprehensive dinner was served.

Drinks and music followed the networking, and a DJ entered the scene. By this time the invited presenters had left for the night and the party continued amongst the participants.

Rogue traders

Top 5

1

2

$6bn

$2.6bn

heavy

hitters Rogue trading is far from a new phenomenon yet it still occurs despite the massive re-sources that are spent combating it. UBS’ recent $2.3bn loss caused by unauthorized trad-ing led to a renewed reinforcement of the ringfencing argument. Here we will highlight the dangers the economy faces with rogue traders by providing a top five list of the worst rogue traders in history.

By Mads Villemoes Povlsen

I

n September 2011 Switzerland’s biggest bank, UBS AG revealed that it had been inflicted with a $2.3bn loss due to unauthorized trades. Kweku Adoboli, 31 was charged with fraud and false ac-counting dating back to 2008, yet there is still uncertainty around how this loss occurred.

UBS al-ready had a tarnished reputation, having lost $50bn on mortgage-backed securities a few years be-fore this as well as receiving a Swiss bailout in 2008. This new incident suggested that UBS lacked proper risk control and caused CEO Oswald Grübel to resign on 24 September, 2011. The loss however barely accounted for four per cent of UBS’ $54bn of shareholders’ eq-

Jérôme Kerviel

Yasuo Hamanaka

In January 2008, France’s second largest bank Société Générale faced the greatest trading loss in banking history. A rogue trader on SocGen’s Delta 1 desk, Jérôme Kerviel , 31 had engaged in un-authorized trades in European index futures causing a total loss of $6bn. He exceeded the bank’s trading limits by several billion and, at one point, held futures positions worth more than $60bn, while SocGen’s market cap was only $44bn. Kerviel had entered elaborate, fictitious transactions in the computers to cover up his trades. Having worked for several years in the bank’s back-office, from which they monitor the traders using advanced IT-systems, Kerviel knew how to circumvent the control procedures. Unlike most other rogue traders, Kerviel did not undertake this huge risk for his personal benefit - he made nothing from the trades. SocGen denies knowing anything about his risky trading activities, but Kerviel himself claims that his superiors knew about it, but turned a blind eye as long as he was making profits - he just failed unlike his fellow traders. However, in October 2010, Kerviel was found guilty and sentenced to three years imprisonment. He was also sentenced to repay the money he had lost. Kerviel is appealing against the sentence.

Yasuo Hamanaka, or “Mr. Copper”, worked for Sumitomo Corporation at the metal-trading division. When the scandal was uncovered in 1995, it was found that Hamanaka had kept the copper price artificially high for almost a decade and that he controlled 5% of the global copper market. Hamanaka made long investments in copper futures and in physical positions. He would keep the prices high and outlast anyone shorting copper by continuously pouring cash into his positions.

In 1995, however, an increasing supply and an already too high price put extra pressure on the market for a correction. When the price dropped, Sumitomo lost $2.6bn on its long positions. The scandal was uncovered, and Hamanaka was sentenced to eight years of prison in 1997. Furthermore, Sumi-tomo paid roughly $150m to in settlement fees to British and US regulators. Sumitomo blamed Merrill Lynch and JPMorgan Chase for having financed Hamanaka’s manipulation of the market. All three corporations entered litigation and were found guilty to some extent.

uity. Furthermore, the Swiss bank stated that it expected a “modest” net income in the following third quarter despite the massive loss. This recent rouge trading loss is not nearly the largest in history, yet it confirms that rogue trading is still alive.

It also highlights the argument for ringfencing, in protecting taxpay-ers and retail depositors from investment banking losses through tighter regulation of the financial industry. There is pressure particularly in the UK, to accelerate reform of the banking industry in order to create more stable, less leveraged banks that are focused on savers and borrowers. For in-stance, the Independent Commission on Banking in the UK recently presented its recommendations on reform to improve

the stability and competition in UK banking. The commission calls for ringfencing banks’ retail operations from their investment operations in order to stabilize the finan-cial sector and prevent another bailout financed by the taxpayers.

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R

a

3

$1.3bn

4

5

$1.1bn $697m

Nick Leeson

Toshihide Iguchi

John Rusnak

One, if not the most, famous rogue trader is Nick Leeson. In 1995, he led Barings Bank, the oldest investment bank in the UK, to collapse after having lost $1.3bn on the Asian futures markets.

Nick Leeson worked in Barings’ Singapore office dealing derivatives and futures, and he was one of Bar-ings’ best traders. At one point, his trades on the derivatives markets accounted for roughly 10 % of the bank’s profits. In the early 1990s, however, he began to lose money. He tried to cover these losses and began taking still greater risks, trying to trade back to profit, but in 1995, Leeson’s fraudulent, unauthorized trading became apparent, and Barings was acquired by the Dutch bank ING. The liabilities he had accumulated corresponded to more than all of the bank’s capital and reserves. Leeson’s managers were criticised for allowing him to settle his own trades, thereby ena-bling him to cover his unauthorized trades.

Later the same year, he was sentenced to six years of prison in Singapore, but was released already in 1999.

Another rogue trader was discovered in 1995, when he sent a 30 page confession letter himself to the president of the Japanese Daiwa Bank stating that he had lost $1.1bn on unauthorized bond trad-ing. The senior US executive Toshihide Iguchi ran up the losses resulting from about 30,000 unau-thorized trades over 11 years. Owing to his background in the bank’s back-office, he was able to hide his losses, while he was trying to recover. He was sentenced to four years of jail and to pay a fine of $2.6m. In addition, Daiwa was ordered to end all of its operations in the USA.

John Rusnak worked as a foreign exchange dealer in the mid 1990s at Allfirst Bank (part of Allied Irish Bank) in the USA. He mainly bet on the Japanese yen, and he refused to hedge his forward contracts. However, his positions took massive losses, and he entered fictitious options contracts to conceal his huge losses. He succeeded in doing this, and his scam was not discovered until 2002. At that time, Rusnak’s trading limit was $2.5m, but he had bet $7.5bn on the yen rising against the US dollar. He was sentenced to sevenand-a-half years in prison.

Rogue

activity

Investment banks are dealing with huge amounts of money and power, and the pressure for success and performance can lead traders to extreme situations. In an environment such as that of trading, rogue activity is inevitable, and new rogue traders will come up once in a while. Though the rogue trader stands for everything that seems to be wrong with the financial system, the fi37/42

nancial crisis was not caused by individual rogue traders. The argument is that if rogue traders are a problem, then rogue activity is a greater one. But still individual rogue traders can have some impact on how banking is regulated in the future, and how confident investors are.

INFO:

PRIVATE EQUITY 101

Exit strategies

in Private Equity

By Sarah Louise

Secondary buy-outs – creating value or passing the parcel?

At the end of their investment period, a private equity firm sells its portfolio company through either a trade sale, an IPO or a secondary buyout. In a trade sale, a strategic buyer in a similar industry or sector buys the portfolio company and acquires full control of the firm and its appertaining assets. The second – most well known – type of exit strategy is an IPO, where shares in the portfolio company are sold to the public and the company is listed on an exchange. Third, the private equity firm can exit the investment by selling the portfolio company to another private equity firm, through what is known as a secondary buyout. Within the past few years, this type of exit has gone from accounting for an infinitesimal part of the exits to being one of the most used routes within private equity in terms of total deal value and number of deals (Preqin, 2011). This in spite of the fact that the recent trend has had limited popularity among the limited partners, who at times are investors in both the buying and selling private equity firms;

It [management fees] takes returns away from the investors who are in both the selling and buying funds (...) There are significant fees (...)It’s also difficult to generate 10 times your initial investment the second or third time a company is acquired.

(Søren Brondum Andersen , partner at ATP Private Equity Partners) So, what has caused this exit option, which was once frowned upon in the private equity industry (Sousa, 2010) to become so popular? This article looks into some of the explanations to this phenomenon by reviewing recent literature on the subject.

The traditional value creation From a theoretical point of view, a private equity firm can generate value through its investment in three ways. Buy-low-sell-high is the first strategy.

The second option is reduction of free cash flow and increased tax deductions through financial engineering. Third, the private firm can increase operational performance by changing business strategies and aligning incentives of the manager with those of the investors. The first strategy is a somewhat unsecure business model for the private equity firm, whereas the second strategy can only provide a limited return to the buying private equity firm. The increased tendency towards secondary buyouts thus creates pressure on the buying private equity firm to generate profits through improved operational performance in the target firm. Since the easiest means of improved operating performance have already been realized by the selling private equity firm, it will, ceteris paribus, prove more difficult for the buying private equity firm to create value in the portfolio company.

A private equity fund is organized as a limited partnership, where the general partner manages the private equity fund while the limited partner – being either an institutional investor or a private wealth investor – commits capital into the private equity fund along with other limited partners and at times the private equity firm itself. Once funds are raised, the general partner invests in underperforming companies by the use of capital from the private equity fund and at times leverage at a certain ratio. After acquisition the general partner has a limited period – typically three to five years – to create value through restructuring of capital, organizational changes and improved operating performance.

to be a win-win situation for both the selling and the buying private equity firm . This hypothesis is supported by the finding that probability of exiting through a SBO is increasing in the holding period of the portfolio company. Moreover, private equity firms with fundraising activities within two years prior to an exit are more likely to exit their portfolio company through a secondary buyout (Wang, 2010). In order to determine whether this hypothesis is actually evident it is equally important to explore the amount of uncommitted capital in the buying private equity firms, in order to highlight whether the structural hypothesis is supported in terms of the demand side. This issue has yet to be addressed by the literature.

The capital market hypothesis

According to recent literature on secondary buyouts, one of the key determinants of secondary buyouts is the capital market in terms of the availability and cost of debt as well as the stock market conditions. The stock market conditions The nature of private equity funds forces the affect the choice of exit strategy by making an private equity firm to sell; the typical private eqIPO a less attractive exit option. Thus, when the uity fund has a life span of ten years (a private stock market is less profitable, the selling private equity firm can ask for an extension, but this is equity firm will seek alternative exit routes and afoften considered the absolute last resort). Within fect supply on the secondary buyouts market. A these ten years where the limited partners have low cost of debt increases the committed capital to the fund, opportunity between the private equity firm has to “Thus, with a lack of arbitrage debt and equity. In sum, the invest the capital in portfolio strategic buyers and corporate debt market afcompanies and create value fects the demand side of the through their acquisitions in an illiquid stock market secondary buyout market and order to create a decent return thus drives up valuation of the unsuited for an IPO, for the investors. This is especompanies, since the cially important if the private the secondary buyout portfolio buying private equity firm can equity firm is about to raise a becomes the immedi- leverage their investments new fund, which is typically more. In terms of availability, initiated once the current fund ate opportunity” less covenants associated with is 70% invested (Sanderson, corporate debt makes it more 2003), since being able to attractive for the buying private equity firm to acshow a good track record makes it easier to atquire debt. Another aspect to the availability of tract new investors. Thus, with a lack of stratedebt is the reduced risk of corporate debt; since gic buyers and an illiquid stock market unsuited a portfolio company has been through the due for an IPO, the secondary buyout becomes the diligence process during the first private equity immediate opportunity. On the buy side of the ownership, the debt providers will perceive the agreement is a private equity fund with a great portfolio company as less risky and therefore be deal of uncommitted capital, which needs to be willing to provide more debt to the buying private invested in order to create capital gain before the equity firm. fund expires. A secondary buyout thus turns out

The win-win solution

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The hot potato hypothesis

What is yet to be addressed

Up until now research “Consequently, once the points towards the According to this hypothesis the private equity companies “music stops playing”, the structural and the capital market hypothesis, act according to collusion in order to inflate the buyout market private equity firm holding while there is little eviof value creation by buying portfolio companies the portfolio company will dence in secondary buy-outs. from each other at a premium have no other option than Moreover, as this article in order to create capital gains there are some for the investors. This hypothto force the portfolio com- argues, indications of asymmetesis is especially problematic if pany into liquidation.” ric information among the private equity firms continpotential buyers along uously pass the parcel to each with representativeness other with an accumulated being an explanation to premium, since at some point, the phenomenon. The none of the potential buyers will be willing to buy the portfolio company. Con- hypotheses are not mutually exclusive and what is even more important to point out is that there sequently, once the “music stops playing”, the are some fields within this study, which have yet private equity firm holding the portfolio company to be addressed. The availability and cost of debt will have no other option than to force the portfolio company into liquidation. Not only is this hypoth- as well as the stock market conditions are nonnegligible determinants of the private equity firm’s esis the least appealing out of the five, it is also the most difficult to examine due to the nature of choice of exit strategy. Thus, like any other business the private equity business is subject to its the business. macroeconomic environment. An issue regarding the macroeconomic environment that has yet to be addressed is the impact of the stock market’s volatility. When a private equity firm chooses IPO as an exit strategy, the firm is typically constrained by a lock-up agreement, which prevents the firm from selling a proportion of the shares in a given period of the IPO. The justification of such an agreement is that the private equity firm signals to the market that it still believes in the portfolio company. If the private equity firm is somewhat risk averse, they will prefer a gamble with a certain outcome – a secondary buyout – to a gamble with an uncertain outcome – an IPO – during times, where stock market volatility is high. In order to investigate the existence of such lock-up In general, portfolio companies in a secondary effects, the relation between the industry specific buyout are acquired at a premium, which some stock market volatility and the choice of exit stratresearchers believe indicates that the private eqegy should be further investigated. uity firms act according to collusion in order to Another important thing to notice is the product create capital gains for the investors. Others have life cycle of the portfolio company; the differences argued that the difference in negotiating skills in operating performance might merely reflect that among potential buyers serves as an explanathe selling private equity firm on average sells the tion to this premium. Another driver of secondary portfolio company after the maturity stage. Thus, buyouts is the industry growth prior to acquisition. the change in operating performance reflects the Moreover, evidence has shown that companies nature of the business rather than the buying priacquired through a secondary buy-out are typivate firm’s ability to enhance operating performcally acquired at a higher premium if the industry ance. The new trend within secondary buyouts of the target company has experienced a high could simply be a new niche within private eqgrowth rate in the years prior to the acquisition. uity, similar to some private equity firms primaThese findings point towards an explanation that rily focusing on venture finance, while others are can be found within the fields of behavioural fispecialized in buyouts. The recent literature has nance: the tendency to extrapolate historic growth mainly focussed on the characteristics selling rates into the future is a manifestation of repreprivate equity firm and the portfolio company. A sentativeness, a cognitive error (Fisher and Statmore comprehensive research on the buying priman, 1999). The investor perceives the historic vate equity could shed light on the validity of this growth rate in earning as representative of future hypothesis. earnings growth and thus calculates the intrinsic value of the target firm accordingly. Consequently, the investor overestimates the value of the target company. Due to asymmetric information among potential buyers at exit time a private equity firm is more likely to overestimate the value of the target firm, since a strategic buyer has the informative advantage of knowing the given industry or sector. Thus, the potential trade sale buyer can judge whether the recent growth rates are in fact representative for the future growth rate, whereas the potentially buying private equity firm does not have this information.

Mixing market imperfections with behavioural finance

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