Portfolio Theory and Risk Free Rate: The Greek Debt Crisis

If you were to develop the ‘perfect investment’ portfolio you would probably want shares that have a high return coupled with a low risk, of course in reality that kind of investment is virtually impossible to find.  Not surprisingly, academics have spent a lot of time developing strategies to find the ‘perfect investment’, none of which have been as popular as Modern Portfolio Theory.  Developed by Harry Markowitz in 1952, he explains that it’s not enough to look at the risk and return of one stock but rather that by investing in more than one stock you can you benefit from diversification and reduce the riskiness of your portfolio, in other words.. don’t put all your eggs in one basket! Each stock has its own standard deviation from the mean, which modern portfolio theory calls risk, the risk in a portfolio of diverse stocks will be less that the risk of holding any one of the individual stocks.  In other words Markowitz proposed that investment isn’t about picking stocks but rather choosing the right combination of stocks.

The combination of shares can be plotted in a graph resulting in what is known as the efficient frontier, a portfolio which lies in the upper part of the curve is efficient and it is argued that a ‘rational’ investor will only ever hold a portfolio that lies somewhere on the efficient frontier. It seems like the perfect way to always ensure you make money doesn’t it? However there is one main cause of concern in portfolio theory I would like to discuss, the notion of a ‘risk free rate’.

In theory a risk free rate is the idea that you would lend money to a very secure borrower with a 0% possibility they would default on the loan, in most markets it is the local government bond that constitutes a risk free rate (The Economist, 2014).  Here lies a problem that has arisen due to the economic recession.. What happens when a government, like Greece has little hope of ever repaying its debts at market rates?

In 2009 Moody’s rating agency reduced Greece’s credit rating from A to A-, falling again in 2009 to BBB+, slumping further in 2011 to CC with it currently standing at B-. (Moody’s, 2015) with the graph below showing that Greece has reported a fiscal deficit for the past 19 years! A government having a fiscal deficit is the exact same as a company losing money, have you ever heard of a company losing money for the past 19 years being given a A credit rating? No, neither have I.. So why is a country that has reported losses for many years and has had its credit rating significantly reduced still considered as the basis of a risk free rate?!

Source: Trading Economics

Many financial markets assume that any company poses a higher risk than the government, therefore anyone borrowing will pay the risk free rate plus a premium, if the interest rate charged by the government goes up so will the interest rate paid by any company or individual.  Not only that, the entire financial system seems to be based on one very volatile and shaky variable.. the government rate!

Greece has been in recent news lately and can be seen as a primary example of a country that should not be considered as the basis for a risk free rate.  They have a public debt of 350 million euros and had to appeal for aid from the International Monetary Fund (IMF) and the EU because it could no longer borrow on the markets (Yahoo News, 2015). Greece received an EU bailout of 110 billion euros and then what happens?  They can’t pay it back.. (The Guardian, 2015) The current Greek bailout package ends on the 28^th of February and if they don’t reach an agreement, they will run out of cash, who would have thought an entire country could end up in a debt crisis so disastrous that they literally don’t have a penny?

Thankfully on February 25^th Greece and the Eurozone finance ministers agreed on a reform plan, a four month extension of their 172 million euro bailout (The Financial Times, 2015) (BBC News, 2015) However the financial security of Greece still remains widely debated as the four month extension of their bailout is a short term solution to a very long term problem.  Athens stock market surged by 10% as a result of the news and Greek borrowing costs fell as investors now view Greece’s debt as less risky. (The Guardian, 2015)

Recent news articles about the Greek debt crisis evidence just how volatile and risky a government can become due to an economic recession, Greece along with several other countries will never be able to pay off all its debt, so why would they still be considered as risk free? Countries like Greece are prime examples of why governments should not be used as the basis of a risk free rate, the economic recession has highlighted that maybe governments aren't as risk free as previously perceived and may have rendered the idea of a risk free rate obsolete.  Should the idea of a risk free rate be labelled useless it would have a significant affect on modern portfolio theory and possibly the way investors view stock markets with the economist arguing 'the sovereign debt crisis may eventually cause some re-thinking in academia'. (The Economist, 2010) 

References

BBC News. (2015, February 24). BBC News - Greece debt crisis: Eurozone backs reform plans. Retrieved from http://www.bbc.co.uk/news/world-europe-31606986

Markowitz, H. (1952). Portfolio Selection. The journal of finance, 7(1), 77-91.

Moodys. (2015). Greece, Government of Credit Rating - Moody's. Retrieved from https://www.moodys.com/credit-ratings/Greece-Government-of-credit-rating-348330

The Economist. (2010, May 10). Financial theory: The risk-free rate and corporate finance | The Economist. Retrieved from http://www.economist.com/blogs/buttonwood/2010/05/financial_theory

The Economist. (2014, March 11). Investing: The new risk-free rate? | The Economist. Retrieved from http://www.economist.com/blogs/buttonwood/2014/03/investing

The Financial Times. (2015, February 25). Financial Times | Error | Akamai Error. Retrieved from http://www.ft.com/cms/s/0/72f18370-bd09-11e4-b523-00144feab7de.html#axzz3SrkIlT4r

The Guardian. (2015, February 24). Eurozone approves Greek deal, but creditors voice doubts - as it happened | Business | The Guardian. Retrieved from http://www.theguardian.com/business/live/2015/feb/24/greek-bailout-reform-plan-eurogroup-live-updates

The Guardian. (2015, February 9). Greece is playing to lose the debt crisis poker game | Business | The Guardian. Retrieved from http://www.theguardian.com/business/2015/feb/09/greece-is-playing-to-lose-the-debt-crisis-poker-game

Trading Economics. (2015, February 26). Greece | Credit Rating. Retrieved from http://www.tradingeconomics.com/greece/rating

Trading Economics. (2015). Greece Government Budget | 1995-2015 | Data | Chart | Calendar | Forecast. Retrieved from http://www.tradingeconomics.com/greece/government-budget

Yahoo News. (2015, February 19). Greece debt crisis timeline - Yahoo News UK. Retrieved from https://uk.news.yahoo.com/greece-debt-crisis-timeline-155536389.html#owqsRWf

Shareholder Wealth Maximisation

In recent years the concept of creating shareholder wealth has been a widely debated topic within the business society, with a vast number of businesses following the concept that if the company builds value then the share price will follow.  Queen (2014) argues that the role of a corporation is to strike a balance between their economic responsibility to shareholders and their social responsibility towards society; recently companies have aimed to integrate shareholder maximisation and stakeholder management in order to achieve longer wealth creation for shareholders.  On paper the concept seems an easy one to follow, be responsible towards society as well as conducting business in a manner that will also maximise shareholders returns!

Shareholder theory dictates that a corporation’s only social responsibility is to engage in free competition without committing fraud with the objective to increase profits thus benefiting shareholders (Friedman, 1970).  In contrast to this stakeholder theorists believe that corporations have a responsibility to shareholders as well as stakeholders because the actions of a firms managers impact the owners as well as stakeholder groups (Freeman, 1984), I personally would agree with stakeholder theorists, by taking into consideration stakeholders such as suppliers, employees and society a firm can be seen as a responsible, surely that alone can create shareholder value as consumers are more likely to purchase from corporations who are ‘good’ and boycotting those who are ‘bad’.

In order to create shareholder value firms must have three key elements, a clear strategy, the capabilities to achieve these strategies and the finance in order to implement these strategies.  If companies devise a strategy but do not have the organisation capabilities to implement it, it can result in a loss in shareholder faith which is reflected by a fall in share price with Enron and Tesco being prime examples of this in the media.    

Wealth creation measures can be entirely reliant on the stock market as it can be assumed that the stock market operates efficiently and that the price of any share is determined through the market’s expectations about the firm’s value creation abilities. 

Earnings per share can be used as a an measure to evaluate a firms value creation, a successful company will have a high growth in their earnings per share, however many critics have argued that it is the discretion of the company to decide what is an ‘exceptional’ items therefore this figure can be subject to manipulation, this EPS figure also doesn’t take into account a company’s debt position.

It should be noted that shareholder value creation is a choice, not an obligation; directors of publicly held companies have a general duty of loyalty and care for the corporations they serve but not to the shareholders of the firm.   William Lazonick, a professor of economics put forward a viable argument criticising the idea of shareholder value creation, he notes that since the late 1970s companies have moved from a ‘retain and reinvest’ approach to a ‘downsize and distribute’ philosophy which has resulted in short termism and employment instability.  This argument has also been backed by James Montier, a behavioural finance writer who claimed that shareholder value maximisation failed the very people it was intended to benefit- the shareholders.  He argues that despite enormous increases in CEO compensation and a rise in financial incentives through stock ownership shareholders are no better off.  To illustrate this point he used the example of IBM verus Johnston and Johnston, IBM switched its focus to shareholder value maximisation while Johnston and Johnston emphasized its responsibility to customers and employees and indeed it showed that the stock of Johnston and Johnston from 1971-2013 outperformed IBM.  This example could shows that Queen (2014) had a viable argument in suggesting companies need to strike a balance, after all how can a company maximise shareholder wealth if they don’t take into consideration the very people they rely on to keep their business running; their employees and their customers.

The other side of the argument is that CEO’s should focus on shareholder value creation as after all they are the owners of the company, however it is proposed that there is a right and wrong way of doing this.  Karl Stark and Bill Stewart the co-founders of Avondale highlight a number of principles to follow; to increase revenue by choosing the right customers, offering them differentiated products and treating them well, improve gross profits by choosing the right suppliers and working with them to create win-win partnerships and increase returns on operating cost investments by choosing the right employees and working with them to maximize their productivity and creative ability.

Rapparort (2006) highlighted two principles of creating shareholder value are to make strategic decisions that maximise expected value even at the expense of lowering near term earnings and to carry only assets that maximise value.   These principles were evidenced when the BBC news reported that EasyJet made the strategic decision to back plans to open a new runway at Heathrow airport instead of Gatwick even though Gatwick airport is EasyJet’s largest UK base.    This decision will require EasyJet to invest a large amount of finance in order to expand Heathrow, however they explain they made this decision as it was in the ‘best interest of the passengers’ and that if they were to choose Gatwick it would result in higher fees for Gatwick passengers due to an increase in airport charges.  This is a prime example of Karl Stark and Bill Stewart’s principle of treating your customers well, by choosing to back Heathrows plans Easyjet can offer a better service to its customers which should increase brand loyalty, encourage repeat purchases and this positive action should be reflected in their share price thus creating shareholder value. 

As we can see in the share price graph below, when this story was published on January 30^th share price dropped significantly, this could suggest that whilst the Heathrow expansion is beneficial for its customers, its investors have a different opinion on the matter.    However we can see in the lead up to this announcement share price increased significantly suggesting that whilst investors would not have known for certain that Easy jet planned to back Heathrow they may have had a good idea that this was going to be announced.

Easyjet share price 26^th Jan to 6^th of February

Source: http://markets.ft.com/research/Markets/Tearsheets/Summary?s=EZJ:LSE

It is obvious that an increasing number of firms are becoming more focused on creating shareholder value, having read a number of blogs and academic literature it seems that on paper the idea is viable however many are sceptical about its execution in the modern day business environment.  For me the most important aspect of creating shareholder value is ensuring the key principles are followed correctly by an organisation then I believe they should see an increase in market share price, thus rewarding the CEO’s and motivating them to continue to create shareholder value.    As Easyjet have not yet began their expansion at Heathrow airport I cannot discuss whether or not it has created shareholder value but I am confident it will!

References:

Freeman, R. E. (1984). Stakeholder management: Framework and philosophy. Mansfield, MA: Pitman.

Friedman, M. (1970, September 13). The social responsibility of business is to create profits. New York Times Magazine, pp. 122–126.

Financial Times. (2014, February 6). easyJet plc, EZJ:LSE summary - FT.com. Retrieved from http://markets.ft.com/research/Markets/Tearsheets/Summary?s=EZJ:LSE

Lazonick, W., & OSullivan, M. (2000). Maximizing shareholder value: a new ideology for corporate governance. Economy and Society, 29(1), 13-35. doi:10.1080/030851400360541

Montier, J. (2014, November). James Montier on Livestream [Video file]. Retrieved from http://new.livestream.com/livecfa/EIC-Montier/videos/65181626

Queen, P. (2014). Enlightened Shareholder Maximization: Is this Strategy Achievable?Journal of business ethics.

Rappaport, A. (2006). Ten Ways to Create Shareholder Value. Retrieved from Harvard Business Review website: http://cmsu2.ucmo.edu/public/classes/young/Guidance%20Research/Ten_ways_to_create_sharholders_value-Alfred_Rappaport.pdf

Stark, K., & Stewart, B. (2012, January 18). Maximizing Shareholder Value Is Not a Dumb Idea. Retrieved from http://www.inc.com/karl-and-bill/maximizing-shareholder-value-is-not-a-dumb-idea.html

Westcott, R. (2015, January 30). BBC News - Budget airline Easyjet backs Heathrow expansion. Retrieved from http://www.bbc.co.uk/news/uk-england-london-31060825