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Sullivan's Market $ense

Brian B. Sullivan, CFA, President and Chief Investment Officer, Regions Investment Management

April 11, 2014

A column to help investors gain perspective on today's market noise

Risk Premium

Microeconomics tells us that businesses make rational decisions when investing.  They project their profits from a new enterprise for many years into the future and compare that to the cost of starting the enterprise.  So a lawn cutting service might weigh the $1,000 cost of a new additional mower against their expected growth in lawns to mow and the profits from each mowing.  They must also consider that lawn mowing fees paid this year are worth more than lawn mowing fees paid in ten years.  To compare projected fees from this year and any subsequent years, managers discount.  This discount rate will have several elements and is often thought of as a hurdle rate: if a proposed project’s rate of return exceeds the hurdle rate, then it is worth proceeding.  Many companies have several projects competing for investment dollars.  Ranking them by their expected returns helps insure that the most profitable projects are allocated the investment dollars. 

The hurdle rate is made up of the cost of capital, which might be merely the rate a big box hardware store will charge to finance the mower over ten years; plus a profit rate that makes the effort worthwhile; plus extra return for risk.  Therefore the hurdle rate might be 15% if the borrowing rate is 8%, the profit rate is 4% and the risk rate is 3%.   If the extra profit from mowing more lawns over the expected life of the mower creates a rate of return on the invested amount ($1,000) greater than 15%, then buy the mower and hire the guys to run it.

 The three rates we summed above are a borrowing rate, a profit rate and a risk rate.  If any of these rates rise, then the proposed enterprise would need to be more profitable.  If any of the rates fall, then the enterprise can be less profitable and still meet the hurdle rate.  When the Federal Reserve lowered rates and then instituted Quantitative Easing to lower bond rates, this is the sort of equation they hoped to influence.  The Fed was working on the borrowing rate, but it is only one of the three rates requiring consideration.

During and after the last recession, business managers have turned conservative.  They shied away from new purchases of equipment.  They avoided hiring new workers.  In economic terms, they had increased their required return, their hurdle rate.  And the part of the hurdle rate that rose was the part for risk.  Managers perceived the future environment to be substantially more unpredictable and therefore more risky.  They changed the 3% risk rate into a rate which was much higher.  It was so high that few new projects were being planned, started or completed.    If managers changed the hurdle rate from 15% to 20%,the profits from the project would need to be 20% higher to achieve the hurdle rate.  It is not a surprise that many projects were postponed.  The list of viable projects instantly shortened.

A company manager can use different risk rates based on the uncertainty of his projections, the solidity of his company, or his outlook for the economy.  Given the depth of the recent recession he probably had uncertain projections, a weakened company, and a poor outlook on the economy.  Slowly, as company profits have risen, cash balances have increased, debts have been reduced, and the economy has improved, these risk rates ought to have declined and projects should have been started.  Yet we have seen little improvement in capital spending.  With high profits, improved balance sheets, lots of cash, and low borrowing rates, what gives?

It must be that managers are unable to predict reliably the future profits from a new venture, machinery purchase or plant expansion.  The return they need, in order to compensate for risk associated with their projections and the economy, must be very high still.  Congress, the President, Vladimir Putin, ACA, minimum wage, the Fed, the SEC, Justice, DOL, and EPA are all making it hard for business owners and managers to predict the future of any venture---thereby raising risk and stifling capital spending. 

In our view capital spending should have been increasing for some time now.  Eventually, pent-up demand, aged equipment and improved capital structures will create such great potential that it will overcome the reticence of the unknown.   Companies who lead in meeting this demand will reap heavy rewards.

 

© Regions Bank, Member FDIC.  The foregoing represents the opinions of the author, Brian Sullivan, and not necessarily those of Regions Bank or Regions Investment Management, Inc. (RIM).  RIM provides commentary to clients of Regions Bank, an affiliated company wholly owned by Regions Financial Corporation.  The information contained in this report is based on sources believed to be reliable but is not guaranteed as to accuracy and does not purport to be a complete analysis of the security, company or industry involved.  Neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security.  This report is designed to provide commentary on market strategy and the opinions expressed reflect the judgment of the author as of the date of publication and are subject to change without notice.  RIM assumes no responsibility or liability for any loss that may directly or indirectly result from the use of such information by you or any other person.  Investments discussed in this report are not FDIC-insured, not deposits of Regions Bank or its affiliates, not guaranteed by Regions Bank or its affiliates, not insured by any government agency, may go down in value, and not a condition of any banking activity.  Investment advisory services are offered through RIM, a Registered Investment Adviser.  RIM is wholly owned by RFC Financial Services Holding LLC, which in turn, is a wholly owned subsidiary of Regions Financial Corporation.

 

 

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