Emerging Capital

Asset Allocation, wishing to seize African emerging opportunities

The Case of Global Re Leveraging Re-Leveraging

Africa Emerging Capital (AEC) Asset Allocation March 2011 Olivier M. Lumenganeso olumenganeso@aec-aa.com 1260 Nyon – Switzerland

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The Case of Global Re-Leveraging
Olivier M. Lumenganeso Economist & Global Investment Strategist Highlights The Federal Reserve reported on March 10, 2011 that corporate cash balances climbed to USD 1.88 trillion, a 35% increase since the first quarter of 2009 (USD 489 billion). This significant increase as it indicates companies are accumulating cash because the business environment is improving. More, conservative corporate behavior and a resumption of growth has, globally, driven down net debt relative to profits, making then non-financial corporate balance sheets at very good health. Elevated cash levels act, however, as a significant restraint on profitability. With profit margins unlikely to expand much further, companies will need to increase leverage to protect RoE. This will likely be done by reducing cash balances, with outright increases in debt levels to follow later. The implication is clear: dividends, buybacks, capex, and M&A are likely to be on the rise. A re-leveraging cycle is likely to last several years, making this topic an enduring investment theme. Higher leverage should boost PE multiples, particularly in the early stages, allowing equities to move higher even as earnings growth slows. As a result, we should expect equity markets to outperform other asset classes. The case of global de-leveraging Given mostly clean balance sheets and low corporate bond yields, many firms have the opportunity to add to leverage. This should lead, ceteris paribus, to a more positive backdrop for shareholders relative to bondholders. This is to me one of the key investment themes of this year (and likely the next few years). Let’s start analyzing the level of corporate balance sheets. In the US, in particular, the Fed reported that corporate cash balances spiked to USD 1.89 trillion, a 35% increase since Q1’09, representing USD 489 billion. As a percentage of assets, this is a record level. Indeed, this pre-tax US corporate profits account for 14.5% of GDP, compared with a postsecond world war average of 9.6%. For the MSCI World, cash accounts for more than 12% of market capitalization for the nonfinancial universe. What does this mean for businesses? Not only non-financial firms have liquid balance sheets and are sitting on record levels of cash, but as soon as business and consumer confidence improve, they should face few
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constraints to start hiring and investing. One of the reasons that firms are so liquid is the strength of corporate earnings, which have rebounded strongly this year and are now close to record levels. A more important and pressing issue is that elevated cash levels are acting as a significant restraint on profitability. The previous graph shows how leverage has been falling steadily for all of the last business cycle, putting downward pressure on RoE. For much of this period rising profit margins and, to a lesser degree asset turnover, were able to more than offset this trend. RoE is expected to fall given declines in leverage. Moreover, asset turnover is unlikely to help given expectations for additional capex, which incidentally is already underway. The result is a need for firms to boost leverage to defend RoE, the only lever at the disposal of corporate management is to employ leverage. Firms should thus reduce their cash balances as a way to boost leverage. Moreover, there is little financial cost to companies to reduce cash as the current environment provides firms with the ability to actively lever up – via extraordinarily low interest rates relative to the cost of equity. See the gap between credit spreads and equity risk premium: the combination of tight credit spreads, low equity multiples, strong earnings and low bond yields has lifted implied equity risk premiums relative to credit risk premiums. The gap is at its highest point in the past quarter century. Debt financing is now quite cheap compared to equity financing, which all things equal, it’s time to releverage, guys. INVEST!!! The Emerging World vs. the Developed World De-leveraging has been rife worldwide, but mainly in emerging markets (EM) over the last decade. Meanwhile, payout ratios have not moved, causing excess equity to accumulate on the balance sheet. Conservative corporate management has led to cash piling up on balance sheets and higher payouts should be one use of this increasing cash load. However, we observe that EM companies historically have not paid out as much of their earnings to shareholders as in the developed world. Payout ratios in EM average 37%, a full ten percentage points lower than that for the World at 47%. Additionally, Net debt to Equity for EM was 50% in 2002 and has since halved to 23% today. As companies de-lever and pay down their balance sheet more capital should be freed up to be returned to shareholders. But so far this has not happened. The payout ratio was consistently 35% throughout the period that net debt to equity halved. Falling net debt to equity was a worldwide phenomenon. Beginning with the Asian crisis in EM and compounding with the bursting of the Tech bubble in the 2000s companies began to reshape their balance sheets. This process accelerated as companies responded to the financial crisis of 2008 by paying down more debt since the funding markets had been so unpredictable at the height of the crisis.

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This suggests that traditional measure of debt-to-equity or debt-to-capital overstate the degree of leverage on balance sheets. Analyzing the graph we see that debt-to-equity suggests that leverage has fallen significantly at all in recent years.

Regionally, deleveraging has been most severe in Asia where net debt to equity in the 90s averaged 96% before falling to just 22% today. Debt levels are even lower than that in EMEA at 19% whereas LATAM is the only EM region where debt levels increased in the 2000s relative to the 1990s. In the aggregate, EM has a net debt to equity ratio of 23%, half that of the World at 50%. These debt levels today are too low and EM companies should start to re-lever to bring down their cost of capital and boost returns.

But, debt is cheap while the cost of equity has done quite the opposite. The EMBI spread averaged 800bps through the 90s and is under 300bps today. All in yields are at lows of less than 6% given the extraordinarily low yields on US treasuries. This makes debt funding look very attractive. Meanwhile, the equity risk premium has remained elevated – at around double its historical average, even after retreating from its 2008 peak. This combination of falling debt costs and rising equity costs suggests a higher mix of debt to equity on the corporate balance sheet should be used to optimize the cost of capital. Indeed, to minimize the cost of capital (WACC), a deduced leverage ratio above current levels is required. A number of EM companies have taken advantage of favorable terms to issue debt recently. But EM companies look under levered when benchmarked to a 43% Net debt to equity ratio which optimizes the WACC, according to empirical investigation by UBS. EMEA and Asia are the most under levered regions. All countries within emerging Asia are under levered with the exception of Thailand. India, Indonesia, Malaysia and Taiwan have net debt to equity ratios under 20% expected by 2011. Elsewhere, leverage in LATAM is much closer to optimal suggesting no re-leverage opportunities there. Russia and South Africa are a different story as they have some of the lowest net debt to equity ratios.

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On a sector basis the consumer sectors have the lowest net debt to equity ratios alongside Healthcare and Tech. Industrials and Utilities look over levered. Forcing the net debt to equity ratios to stay at 43%, the level that optimizes the WACC, UBS develops a model that pays excess equity back to shareholders and raises the payout ratio to maintain the net debt to equity ratio at 43% in the future. For EM in aggregate the starting net debt to equity ratio was 29%. Forcing this to 43% necessitates a mixture of increasing debt and reducing equity. The equity reduction is paid back to shareholder in a special dividend. Then the payout ratio increases and as time goes on could converge to or even pass the world payout ratio (47%). The obtained new dividend yield is also higher than the world (3%) making EM even more attractive as a region. Not only does EM offer the only source of growth in global equities but could offer a higher yield too. The model also finds a higher ROE, which rises to 17% from 13%. Using the Gordon Growth formula to calculate the before and after Price to Book Value (P/B), we get a new multiple of 2.5x from 1.4x (excluding financials). The PE rises from 10.9x to 14.3x which represents 32% of value creation. Total return to shareholders is even greater if you add in the special dividend yield of 8% and a higher dividend yield of 3.5% in the future. That makes for a significant return to be earned from balance sheet optimization by calculations. This is corroborated looking at EM vs. World ROE decomposition. It shows how lower leverage in EM versus World has been a drag on the EM ROE premium. By bringing leverage ratios even in line with those at the World level would be supportive of an EM ROE premium. Extending this model by country and sector, UBS finds some diverse results. The countries that satisfy the model are Malaysia, Indonesia, South Korea, Taiwan and Russia and South Africa. Consumer Discretionary, Consumer Staples, Healthcare and Tech are the sectors which could benefit most.

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Bottom line, there is a big gap across capital markets between the cost of debt versus equity. Combined with high cash levels and a recovering economy, we can foresee a significant corporate re-leveraging cycle from suboptimal levels that should serve to boost ROEs and drive multiple expansion. In the EM world, while deleveraging has been widespread over the last decade, payout ratios have not moved, causing excess equity to accumulate on the balance sheet. UBS developed a proprietary model to optimize WACC for EM countries and sectors. The model forces net debt to equity higher and models the excess equity and higher dividends that could be paid out to shareholders as a result.

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Few illustrations

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Africa Emerging Capital
Asset Allocation, wishing to seize African emerging opportunities

Specialists in African emerging markets
Africa Emerging Capital Asset Allocation is an independent investment research and consultancy firm, specialized in providing multi-asset class top asset top-down and bottom-up allocations, and ideas to investment up managers (private and/or institutional) around the world in general, on emerging markets in particular, with a special focus on African markets. We develop investment strategy and recommendations by identifying key structural and cyclical themes driving the global economy in general, and African economies in particular, utilizing rigorous and comprehensive forecasting approaches and indicators, analytic foundations, and market experience to mprehensive help clients make sound and confident investment decisions. Our vision is to become an accepted and sought after investment advisor company regarding sought-after opportunities in growing, emerging and frontier Africa. nities We commit to offer client driven research and service, by establishing strong and interactive relationship with each client to address specific needs by offering investment decision making process that matc decision-making match each risk profile and investment horizon. We combine the spirit and vision of an entrepreneurial firm with the analytical rigor of a research institute without compromising the highest levels of client service.

Africa Emerging Capital (AEC) Asset Allocation contacts@aec-aa.com 1260 Nyon - Switzerland Reference N°: 2011/05872 Federal registration N°: CH-550-1087921 1087921-6

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