How to Generate a New Wave of Prosperity. The formula of mixed government and private investments to reform the world, Part III

Average Shortfall and downside risk analysis: basic tools for a new enterprise model

The further deepening, spreading and the intricacies of the global financial crisis, show the catastrophic consequences of an over excessive use of short term statistical yardsticks of return and of single models to evaluate investments, economic activity, and to be de facto the pillars and lighthouses of our economies, political and social systems.

Financial risk management should instead involve avoiding adverse performance over a specified time horizon rather than maximizing short term returns.

This unprecedented but inevitable situation demonstrates how disruptive was not to pay attention to downside risk and behavioral analysis, to aggregate risk, and not include off balance sheet risk. Lack of common sense seemed to have contributed quite a lot too. The disproportionate employment of single risk models, of standard deviation and mean variance methods as statistical measure of risk in investments selection and asset allocation, revealed to be disastrous and misleading for a sound growth and for a prolonged and widespread balanced economic prosperity.

Standard deviation is defined as a measure of the dispersion of a collection of numbers which in financial theory are the distribution data of historical assets returns. The SD measures how these values are spread. If many data points are close to the mean, the standard deviation is small (= low risk); if instead they are far from the mean, the standard deviation is large (= high risk). Thus, SD is not directly relevant to the strategic environment in which investment decisions are made. Risks that stems from economic activity are instead best understood as risks of underperformance compared to a certain benchmark or other expected return over a specified time horizon. A proper evaluation of investment decision requirements suggests, as optimal, a target performance below which it must be avoided to fall. As such, it is most suitable to measure risk in terms of a strategy’s potential for underperforming the target and for better entering into a multiple analysis of the investment content and yield generation. The evaluation for underperformance is best expressed as “Downside Risk.” Underperformance may also be viewed in terms of the need of alternative funding or to draw on accumulated reserves.

Furthermore, asset classes which returns are not normally distributed, like options and derivatives (and all forms of “toxic waste”), which senseless use had so much part in creating the current financial disaster, cannot be evaluated in a SD scenario but they can in a downside risk one. This may contribute to explain how deceiving these methods were in evaluating certain stocks, companies, projects, multiples and justify entire consolidation processes.

The “illusion” of the absence of (or carelessness for) downside risk has been a major contributor to the creation of the assets bubble and the “falsification of information and data” that led to the current global disaster.

If this lesson is correctly learned, there will be now a deep innovation in the way that all investments are valued. For us is like a revolution in how we look at the world.

New Business Model to Emerge from this crisis

Consequently, as highlighted in previous articles, it is now inevitable, because indispensable, the embracing of a new operating enterprise model based on sustainability, on a more gradual and reasonable growth, on a more solid development, guided by a longer term horizon and by downside risk analysis and a proper set of evaluation tools.

We live in an era of transition in which the main driving force is represented by the information factor. A period of dangerous turbulences and deep financial and economic involution and dislocation is deep in its way. An involution that signs the sunset and limits of the American economic model as we know it.

New technologies and market advancements eliminate ‘dimensional discrimination’ and factors that were determining economies of scale – requiring large dimensions and a ‘vertical’ and multinational presence. Technology allows that specialization and product innovation can now occur in small or medium size entities with local presence and global reach. This has revolutionary and positively powerful consequences. It is an important element of risk and wealth diversification; it redefines the pattern for a new operating business model that avoids the risks of the current “Global Contagion and Domino Effect”, where there are enterprises “too big to fail, but also too big to be rescued”. Furthermore, the rationale for numerous mergers, acquisitions and industry consolidations that took place, appears today strongly diminished.

In this context, an alternative enterprise operating model will emerge and it will be one of the winning ingredients to regain economic growth and stability. A model which consists of focusing ‘horizontally’ instead of ‘vertically’ in a certain area of operation, deepening expertise in the highest value added phases.

While that takes place, a main priority will be how to avoid a total catastrophe and to reignite economic growth. In this, all western governments and financial authorities seem to be behind the curve. The only exception appears now to be America. Yet, it appears clear that a “hybrid system” of mixed government and private investments, is the only way to provide the spark to restart and restructure the world economy.

Sovereign Alpha and Asymmetry between Downside and Upside Risk

It should now be commonly acknowledged that investors consider asymmetrically downside risk losses versus upside gains. Most investors (and my Mum as well!) place greater weight to downside risk movements. Therefore, in the behavioral and social environment in which modern investments are made and in which real risks arise, they are all best interpreted from an underperformance standpoint over a certain time horizon.

In a previous paper was presented the case of the extra value generated by the organized presence of a “Sovereign Investor”, a government or by a large and stable and non speculative sponsor (“a strong hand”) as a shareholder of a company or a specific project.

It was called Sovereign Alpha’ the part of the company’s extra value generated simply by the organization or presence of a “Sovereign Investor” among the shareholders.

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Other things being equal, a purchase of a stake from a “Sovereign Investor” reduces the enterprise risk, enhances the probability of returns, gives stability and long term prospects to the business, attracts further investments, guarantees higher compliance and best business practices, and the value of this equation becomes positive. The company is therefore earning excess returns by virtue of the “Sovereign/Private Co-Investment Formula”. This is particularly valid in strong periods or recession and depression like the one we are going through.

These findings were within the framework of modern portfolio theory.

Let us take our focus a step further and analyze the same phenomenon yet viewed in terms of a stronger downside protection. Estimating the value of a “Strong and Stable” shareholder’s presence, in terms of downside risk analysis, shows a lower probability of an underperformance rather than of a higher value of returns.

In particular, in a Downside Risk scenario the method of ‘Average Shortfall’ seems the most appropriate to explain in a behavioral and circumstantial way the evaluation and choice of investments and to determine an optimal asset allocation.

Average Shortfall is defined as the average size of a strategy’s underperformance relative to the target rate of return.

Average Shortfall measures the average amount per period that a strategy underperforms the target. It is measured in units of return, and so is more closely linked to financial decision making than just Shortfall Risk, which instead measures downside risk as the probability of underperforming the target. Average Shortfall is a risk measure that explicitly incorporates a performance target and the time horizon, and provides an intuitive measure of the cost of underperformance. It is relevant to notice that Average Shortfall analysis covers also event risk cases and can be used to evaluate the performance of assets which generate (or may generate) returns that are not normally distributed. It is therefore able to consider the return patterns of all asset classes and in all real circumstances. It is a behavioral, as opposed to statistical, risk concept, that calculates explicitly a strategy’s potential for monetary loss. In fact, it can be shown to be equal to the “fair value” of insuring the strategy against losses. In this way, it identifies risk in terms of a hypothetical economic cost.

Average Shortfall can also be viewed as a measure of the insurance cost an investment or a portfolio would need in the long term in order to keep the performance within the target. Therefore by reducing downside risk and giving a more stable and long term prospect to the business, the organized presence of a “Sovereign Shareholder” has the impact of minimizing average shortfall and in a way can provide the value of such insurance in exchange for a “Privileged Shareholder” position.

This “Sovereign Investing” appears to be the only way to unblock the current stalled situation in which the global economy is frozen. Investors are inclined to give up some of the upside potential in return for more stable returns or, a guarantee of a better downside protection: a capital loss weighs more than a gain. The presence of a strong and not speculative investor among the shareholders reinforces this objective. In exchange for a privileged preference shares remuneration position, the strong shareholder acts as an insurance to balance and redistribute risk in favor of more stable and solid returns.

Thus, if investors care differently about downside losses versus upside gains, they therefore prefer to invest into stocks with low sensitivities to downside market movements. Now it is evident that in today’s’ environment investors are frozen, banks even worse so, and that capital and liquidity stopped flowing.

Liquidity Trap: You now need a Solid Shareholder rather than Chinooks

The current situation is serious: trust disappeared and was replaced by sheer fear; liquidity is prisoner of its holders, its circulation is dangerously drying out. We reached a situation of liquidity trap. In fact, the nominal interest rates have been lowered nearly or equal to zero but no change is taking place, nothing to stimulate the economy. This makes the recession more severe and the ideal conditions for deflation.

Increasing the overall quantity of money available seems not working. The additional liquidity is immediately hoarded. Monetary efforts to lower nominal risk-free rates have had no significant impact on the nominal interest rates charged by banks, no restart in borrowing and lending, in consumption and fixed investments. Liquidity should be injected into the real economy but since banks are unwilling to lend, liquidity is trapped. Unfortunately, not even Batman can save us from this situation even if we were, like in the movie, the citizens of Gotham City and the Joker dropped millions from his helicopter (I guess one load would not be enough) passing by the Gotham Central Bank.

In this situation of “Liquidity Trap”, with panic spreading and global domino effects, the only way to bring back liquidity where is needed is to make the conditions available for a low downside risk environment. This is done by the action and initiative of leading governments to co-invest in crucial sectors of the economy and attract investments by virtue of an enhancement of the “Downside Risk”, with stabilization and positive long term impact. The opportunity could not happen at a better time as a unique chance to reform the world into a more sustainable and balanced environment.

Please Action Now

The current situation and global outlook is quite dire but ripe for a change. The sooner proper action will be taken, the better will be in terms of when the recovery will arise and with what characteristics. The European governments seem confused and reluctant to “take the bull by the horns”. Yet, it is time for them to act. The European industrial and financial sector is over-levered (see OECD reports), the Euro strongly overvalued, capital and liquidity are frozen, and untested bankruptcy procedures slow down and make transferring assets to stronger hands difficult. Protectionism looms around like the stroke of midnight in a horror movie. On the positive side, equity valuations are becoming more and more attractive.

Each European government must now take over equity stakes and attract other appropriate Sovereign and stable investors. This will generate the necessary boost, it will enable companies to regain trust and go back to work, to de-lever and freeing up capital for rehiring employees, for capital expenditures and future development plans. This is what needed to “resuscitate the patient”. Part of the solution could be the implementation of the discussed European plans in aggregating “bad debt” into a single government entity (Bad Bank). A clear policy should be set to transform this accumulated debt from different industrial and financial sectors and exchange it for equity with special provisions in order to facilitate the governments future exit strategy.

Many governments are scared that once becoming shareholders, it will be difficult to get out, or claim they cannot because have only limited resources. Unfortunately, the current circumstances do not allow for further hesitation or show that any other subject could take on such responsibility and be in the position to reform the economic system. It is not difficult to set up at the outset clear and convenient exit strategies for government rescue investments to be replaced with private shareholders once this turmoil has gone, recovering fully their initial investments so that the tax payer will not have to suffer.

Like in the capital purchase program TARP, there could be specific rules to give strong incentives to private shareholders to take over the government shares once these companies have recovered. Preferred shares and restrictions on dividends will force over time to replace private shareholders to the government.

Each European government will have to take its share which is as it should be. It is the best opportunity to positively reform a system which was ripe for change.

Knowledge must come through action. You can have no test which is no fanciful save by trial.” SOPHOCLES