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Alpha and Omega



May 07, 2009 – Comments (0) | RELATED TICKERS: PTR , HDB

I've received a handful of complimentary notes on The Most Important Number in Investing -- my recent post about calculating discount rates for use on and in order to compare foreign stocks. The most interesting of these came from a money manager friend who pointed out that there's an element I left unnamed in the section called "Some sort of volatility premium appropriate for the equity you're looking at relating to the cost of that specific company's capital."

While I danced around it and called it political risk or small cap risk and suggested it could add 100 to 300 bps to your discount rate and had something do with the sovereign cost of funds, he suggested that we start calling by the Greek letter "Omega" and have "Omega" stand in as our proxy for "the quantified risk of unknown government intervention, incompetence, instability, corruption or malfeasance."

The background
His reasoning was this "Governments change rules when it is in their best interests to do so, not when it is economically beneficial. Think about how many countries have mandates now to achieve maximum employment. What’s one of the most likely ways for nations to pursue this policy? Through companies they control. But even with private companies, their incentive to try and make a profit are sometimes directly impeded by government action. 

State-owned companies are subject to national policy in a far greater way than private ones. China has put a lot of the burden of its rising energy costs on Petrochina (PTR) and its state-controlled utlitiies, to no good avail for shareholders. Venezuela elected to nationalize its power and telecommunications companies and then stuffed them full of unnecessary employees. HDFC Bank (HDB), in spite of massive Indian government restrictions, is massively more efficient than State Bank of India, thus its omega should be lower. Russia forced Gazprom to subsidize its foreign policy with cheap gas to the ‘near abroad,’ as well as a tax rate of $90 per barrel. Chinese banks were told to cut new loans in 2008, and then told to make massive commercial loans in 2009. Hell, Canada suddenly changed its tax laws regarding income trusts."

What this means
Thanks to this crisis, we're riding the golden age of this "omega," and it's a premium we should demand on our discount rates that varies from country to country and attempts to quantify the risk that government and/or management is seeking to do something else other than profit alongside outside shareholders.

Thus, to rewrite our formula from yesterday, the appropriate discount rate equals...

ADR=(the risk-free rate)+(the expected return from an average equity investment in the space)+(a volatility premium appropriate for the individual equity)+(your currency assumption)+(omega)

If you get an input for each of those variables, you should end up with no discount rate lower than 10% and some much higher depending on where you're looking to invest. And the key to quantifying those last four variables is good boots on the ground research.

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