Standard Life Investments Global Perspectives.

Standard Life Investments, the global investment manager, has examined the long-term drivers of the changing share of national income between labour and capital.

While some of the factors affecting income shares and income inequality may reverse in coming years, pressures are growing on politicians to act. Governments should keep in mind that they are best pursuing policies that have the double dividend of lowering inequality and boosting economic growth.

The latest edition of Global Perspective examines changes in the way that national income is distributed within the developed world. Not only has labour’s share of national income fallen in most OECD countries, but there has also been a widespread increase in income inequality. Both country-specific and global factors lie behind these trends. The key factors include globalisation, technological change, tax policy and changes in workers’ bargaining power.

Jeremy Lawson, Chief Economist, Standard Life Investments, said: “Our findings show that there are significant implications for financial markets, not only as the economic cycle moves forward and structural drivers alter but also as pressures grow on governments to act.  We expect the economic recoveries taking place in most countries to generate a modest increase in labour income shares as unemployment falls away,  although it is unlikely to make up for the losses of previous decades. That implies that the corporate profit share of income should fall but not far.

“If market forces are not able to generate a more equitable distribution of society’s resources, governments will come under pressure to act. For example, earned-income tax credits, other well targeted fiscal transfers, and active labour market policies all strengthen the incentives to work, or rewards from employment, and are therefore more likely to have a positive growth trade-off than sharply raising marginal income tax rates or strengthening employment protection. Slower acting but equally important are educational and training policies that raise the human capital/skills of lower income workers.”

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Some of Europe and America’s most prestigious companies are shunning the well-established financial centres of London and New York and looking to Asia as a place to list and sell their shares, as well as their handbags.

Italian fashion house Prada has applied to list on the Hong Kong stock exchange in the next few weeks. US leather goods maker Coach may also list shares there, while luggage firm Samsonite and Italian motorcycle maker Ducati are also reported to be planning Hong Kong share listings.

They follow the footsteps of French skin care firm L’Occitane, which raised about A$700 million selling shares to investors in an initial public offering (IPO) in Hong Kong late last year, becoming the first French company to be listed in Hong Kong.

These foreign companies listing in the region are doing so because they expect a substantial part of their sales to come from the region. Selling shares in Hong Kong acts as a great marketing tool, as well as an effective way to raise funds for expansion.

Greater China now makes up around 15% of global luxury sales. With increasing incomes this figure is expected to grow to 44% by 2020. Over the next decade, China itself is expected to become the world’s single largest market for luxury goods, worth A$100 billion, up from $12 billion in 2010, according to a recent report by Asia-focused research firm CLSA. One reason is that luxury handbags, clothing, watches and jewellery are a favoured way for Chinese to display their increasing wealth – wealth that has risen due to their fast growing economy.

Prada already generates more than a third of its sales in Asia and has 14 stores in nine Chinese cities and a further eight outlets in Hong Kong; while Coach has 58 stores in China, Hong Kong and Macau.

Such high profile listings have transformed Hong Kong into the world’s biggest IPO market. It has been the world’s biggest market for IPOs for the past two years, eclipsing other major financial centres that have suffered in the aftermath of the global financial crisis.

Hong Kong has long been the place to list for Chinese firms seeking to raise funds from overseas, but it is only recently that companies from elsewhere have come to those with the money.
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While the number of IPOs in Asia is strong, the number of them has dropped off slightly from the record amount raised late last year. This is because Asian investors are quick learners and realise that not every stock continues to rise after its listing. Investors are, rightly so, becoming more selective.
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Higher wage growth over recent years, coupled with Asian governments increasing the social safety net, has resulted in the rise of the Asian investor. More investors are looking towards capital markets to park their money. For China in particular, we expect to see further developments in RMB-denominated IPOs.

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In addition, the AMP Capital Infrastructure Debt Fund has made its first investment, securing a £40 million high yielding loan to a leading UK based rolling stock company specialising in the leasing of passenger trains and freight locomotives.

AMP Capital Global Head of Infrastructure Debt Andrew Jones said fundraising had exceeded expectations.

“We are very pleased to achieve subscriptions of €241 million against the backdrop of what remains a very challenging fundraising market. Demand has been strong from institutional investors in Asia, Europe, North America and Australia. In particular, interest from investors in Japan has been so strong we now offer a Japanese Yen feeder fund to go along with the US Dollar feeder funds,” Mr Jones said.

“This early success means AMP Capital is well positioned to take advantage of the attractive risk adjusted returns available in the infrastructure debt space. We anticipate this investment will provide attractive risk adjusted returns for our investors in the form of regular cash coupons underpinned by a very stable and experienced borrower,” Mr Jones said.

The portfolio will consist of investments in the subordinated debt of 10 to 15 companies headquartered in OECD countries in the essential services of water, gas, electricity, transport and hospitals. The Fund will target defensive assets with high barriers to entry, a regulated environment, highly visible cash flows and strong industry positions.

“We expect to take a lead arranging role in the majority of transactions, with our focus on adding value through originating, structuring and leading pricing and terms discussions. Through our role as a key provider of subordinated debt to the infrastructure sector for over a decade, we are currently partnering with leading sponsors to pursue an exciting deal pipeline of current opportunities,” Mr Jones concluded.

The largest insurance group in China and the world’s largest listed life insurance company, China Life Insurance (Group) Company, through its subsidiaries, was a cornerstone investor in the Fund alongside Funds managed by AMP Capital. AMP and China Life formed a strategic partnership in 2009 to explore areas for partnership in pensions and asset management. The investors in the AMP Capital Infrastructure Debt Fund include life insurance, pension funds and multi manager investment funds based in Japan, Hong Kong and Australia.

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Decisions by investors to buy, sell or hold assets are based on a comparison of the price being asked with the investor’s idea about what the asset is worth.

There are many different ways to investigate what an asset might be worth. A property, for example, might be valued by looking at comparative recent sales, by adding development costs to an estimate of the land value, by discounting future income returns from the property and so on. Often it is wise to use a variety of methods and to be cautious if there is a wide difference between the lowest and highest.

Irrational valuation

Some conclusions about value are drawn rationally, but many are not. On the irrational side, perhaps the most common fallacy is what behavioural economists call “anchoring”; the tendency to derive a number by using another irrelevant but readily available number as a reference point (the “anchor”).

Retailers make good use of this tendency to anchor when they advertise reduced prices in sales. Good merchandising demands that the old price, often crossed out, should appear on price tags as well as the new, lower one. A rational buyer will disregard the old price completely, of course, and only consider whether the new price represents good value for money, but marketers are able to rely on the fact that many customers will anchor on the old, higher price, and conclude, perhaps subconsciously, that the new price represents value that might not exist.

Similarly, anchoring may cause an investor to think that a share that has dropped in price is good value (or vice versa) without much more investigation. If the previous price is used as an anchor, the tendency is to think that a price that is low compared with yesterday’s price is a price that is low compared with “good value”, but that might not be the case at all. The fact that a price has fallen does not mean that it can be expected to return to its previous level at some point. As we know, stocks do not always return to their previous prices. Some continue to fall, and some go into liquidation, disappearing altogether. The price fall has probably occurred for a reason, which usually means that all previous prices, calculated before the change in circumstances, will be out of date and of no relevance. Market participants are re-assessing the intrinsic values of companies continuously, and a well advised investor will also be trying to measure prices against assessments of value which incorporate the most up to date information available. Yesterday’s calculations and prices are of little relevance.

Incidentally, there is evidence that even hard-nosed professional market analysts are not immune to the intrusion of bias and irrationality when assessing value. To a certain extent, that is the reason for the existence of quant programs. By leaving the decisions to computer models, the possibility of human bias is claimed to be removed

Traditional valuation methods

The valuation of listed shares is of particular interest to financial planners, who advise on long term needs, and try to optimise the balance between the investment, longevity and inflation risks that clients face. A large range of financial ratios is available from brokers’ web sites, or in company financial reports, that can help in forming a rational view of the value of a company. These include profitability ratios (eg ROE), liquidity ratios (eg quick ratio), capital adequacy ratios (eg gearing ratio), market ratios (eg P/E), management efficiency ratios (eg debtor turnover) and the bankruptcy predictor, the Altman Z score.

While all these measures can provide valuable insights into a company’s worth, they suffer from the problem that they are mostly derived from past events on a short-term basis while the true values of companies emerge from future events over the long-term.

Of course, the future is unpredictable, but to help to deal with this, in recent years a new measure of company performance has emerged; Economic Value Added.

Economic Value Added (EVA)

EVA measures the difference between the return on a company’s capital and the cost of that capital. In practical terms, EVA is calculated by reducing Net Operating Profits After Taxes (NOPAT) by the total cost of capital, including both debt and equity capital. A positive EVA indicates that value has been created for the owners of the company. Conversely, a negative EVA indicates the destruction of shareholder value.

To see the difference between EVA and more traditional performance measures like net income, take the example of a newly established company called Allen’s After-market Accessories (AAA). The company earns $1,200,000 on a capital base of $10 million thanks to the success of a single imported product line. Traditional accounting would show that AAA offers an above average return on capital of 12%.

However, AAA has only been operating for a short time, and the reliance on a single product line carries significant risk. The lenders to such an enterprise will no doubt charge premium interest rates, and owners will also be looking for higher than average returns. If we assume that in combination these lenders and investors expect 15%, then the EVA calculation will show a loss of value of 3%. So although AAA reports an accounting profit, it has not met the requirements of the providers of capital, and the result has been a reduction in shareholder value.

On the other hand, if AAA were less risky and better established with a cost of capital of 10%, then the same first year operating result would have produced surplus income equal to 2% of capital. That amount would represent an addition to the company’s economic value.

Another way to look at this measure is to consider that the shareholders charge the company rent for tying up their cash to support operations. EVA captures this hidden, opportunity cost of capital that conventional measures miss.

Incidentally, astute readers will notice similarities between this idea of EVA and the controversial “resource rent tax” which initially sought to tax economic “rents”; defined as earnings beyond the risk-free cost of capital.

Calculating EVA

Four steps are involved in calculating EVA. Note that these steps appear to be quite straightforward, but the items on income statements and balance sheets will have been calculated in accordance with traditional accounting standards and methods, and will require many adjustments to achieve a “pure” calculation of EVA.
Step 1: Calculate NOPAT (Net Operating Profits After Tax)
Gross Profits (Sales – Cost of Goods Sold) less Depreciation & Amortisation less Tax.
Step 2: Determine Total Capital Deployed
Net Working Capital + Net Fixed Assets.
Step 3: Calculate WACC (Weighted Average Cost of Capital)
The WACC calculation will take account of the company’s capital structure (proportion of debt and equity on the balance sheet), volatility, and the market risk premium.
Step 4: Calculate Capital Charge to NOPAT & EVA
Total Capital Deployed (Step 2) x Weighted Average Cost of Capital (Step 3)
Economic Value Added will be NOPAT less the Capital Charge.

EVA should help to identify good investments, if calculated consistently. Companies with high EVAs should outperform those with low or negative EVAs over time.

Eva momentum ratio

Arguably, the actual EVA levels matter less than changes in those levels. A positive EVA that is expected to become less positive may be a selling signal, just as a negative EVA that is expected to rise into a positive territory may indicate a “buy”.

The EVA Momentum Ratio compares changes in EVA in a given period to sales in the prior period; in other words, it provides a size adjusted measure of change in EV. For example, if EVA moves from $ 1 million to $ 1.1 million in consecutive years, then EVA in the second period is up by $100,000. If sales in the first period were $5 million, that gives us an EVA Momentum Ratio of 2% ($ 5 million divided by $100,000).

The EVA Momentum Ratio is straightforward and easy to read, yet has many advantages over other common means of establishing value.

• It consolidates earnings and assets into a single score and automatically corrects for many accounting anomalies in the process
• It is one of the few measures where an increase is unambiguously a “good thing”. For example, an improved ROC might point to underinvestment in research and development
• It is scale neutral, enabling comparisons to be made of businesses (or business units) of differing sizes.
• It is a relative measure of improvement, so will not be distorted when comparing companies starting with a strong platform of brands or infrastructure with others.
• It is a leading measure, showing improvements or deterioration in shareholder value before the traditional accounts log the profits or losses.
• It is market calibrated, automatically adjusting for risk, and measuring always against the owners’ expectations.
• It is difficult to manipulate, as the rules surrounding EVA tend to remove many of the distortions that are embedded in financial statements

It is the job of the management of a business to increase shareholder wealth and EVA is an excellent metric to add to the other indicators of financial performance. Everyone involved in advising on investment in business enterprises should be conversant with EVA.

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