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Valuation (of Stocks) The debate rages all over Eastern and Central Europe, in countries in transition as well as in Western Europe. It raged in Britain during the 80s. Is privatization really the robbery in disguise of state assets by a select few, cronies of the political regime? Margaret Thatcher was accused of it - and so were privatizers in developing countries. What price should state-owned companies have fetched? This question is not as simple and straightforward as it sounds. There is a stock pricing mechanism known as the Stock Exchange. Willing buyers and willing sellers meet there to freely negotiate deals of stock purchases and sales. New information, macro-economic and micro-economic, determines the value of companies. Greenspan testifies in the Senate, economic figures are released - and the rumour mill starts working: interest rates might go up. The stock market reacts with frenzily - it crashes. Why? A top executive is asked how profitable will his firm be this quarter. He winks, he grins - this is interpreted by Wall Street to mean that profits will go up. The share price surges: no one wants to sell it, everyone want to buy it. The result: a sharp rise in its price. Why? Moreover: the share price of a company of an identical size, similar financial ratios (and in the same industry) barely budges. Why not? We say that the stocks of the two companies have different elasticity (their prices move up and down differently), probably the result of different sensitivities to changes in interest rates and in earnings estimates. But this is just to rename the problem. The question remains: Why do the shares of similar companies react differently? Economy is a branch of psychology and wherever and whenever humans are involved, answers don't come easy. A few models have been developed and are in wide use but it is difficult to say that any of them has real predictive or even explanatory powers. Some of these models are "technical" in nature: they ignore the fundamentals of the company. Such models assume that all the relevant information is already incorporated in the price of the stock and that changes in expectations, hopes, fears and attitudes will be reflected in the prices immediately. Others are fundamental: these models rely on the company's performance and assets. The former models are applicable mostly to companies whose shares are traded publicly, in stock exchanges. They are not very useful in trying to attach a value to the stock of a private firm. The latter type (fundamental) models can be applied more broadly. The value of a stock (a bond, a firm, real estate, or any asset) is the sum of the income (cash flow) that a reasonable investor would expect to get in the future, discounted at the appropriate rate. The discounting reflects the fact that money received in the future has lower (discounted) purchasing power than money received now. Moreover, we can invest money received now and get interest on it (which should normally equal the discount). Put differently: the discount reflects the loss in purchasing power of money deferred or the interest lost by not being able to invest the money right away. This is the time value of money. Another problem is the uncertainty of future payments, or the risk that we will never receive them. The longer the payment period, the higher the risk, of course. A model exists which links time, the value of the stock, the cash flows expected in the future and the discount (interest) rates. The rate that we use to discount future cash flows is the prevailing interest rate. This is partly true in stable, predictable and certain economies. But the discount rate depends on the inflation rate in the country where the firm is located (or, if a multinational, in all the countries where it operates), on the projected supply of and demand for its shares and on the aforementioned risk of non-payment. In certain places, additional factors must be taken into account (for example: country risk or foreign exchange risks). The supply of a stock and, to a lesser extent, the demand for it determine its distribution (how many shareowners are there) and, as a result, its liquidity. Liquidity means how freely can one buy and sell it and at which quantities sought or sold do prices become rigid. Example: if a controlling stake is sold - the buyer normally pays a "control premium". Another example: in thin markets it is easier to manipulate the price of a stock by artificially increasing the demand or decreasing the supply ("cornering" the market). In a liquid market (no problems to buy and to sell), the discount rate is comprised of two elements: one is the risk-free rate (normally, the interest payable on government bonds), the other being the risk-related rate (the rate which reflects the risk related to the specific stock). But what is this risk-related rate? The most widely used model to evaluate specific risks is the Capital Asset Pricing Model (CAPM). According to it, the discount rate is the risk-free rate plus a coefficient (called beta) multiplied by a risk premium general to all stocks (in the USA it was calculated to be 5.5%). Beta is a measure of the volatility of the return of the stock relative to that of the return of the market. A stock's Beta can be obtained by calculating the coefficient of the regression line between the weekly returns of the stock and those of the stock market during a selected period of time. Unfortunately, different betas can be calculated by selecting different parameters (for instance, the length of the period on which the calculation is performed). Another problem is that betas change with every new datum. Professionals resort to sensitivity tests which neutralize the changes that betas undergo with time. Still, with all its shortcomings and disputed assumptions, the CAPM should be used to determine the discount rate. But to use the discount rate we must have future cash flows to discount. The only relatively certain cash flows are dividends paid to the shareholders. So, Dividend Discount Models (DDM) were developed. Other models relate to the projected growth of the company (which is supposed to increase the payable dividends and to cause the stock to appreciate in value). Still, DDM’s require, as input, the ultimate value of the stock and growth models are only suitable for mature firms with a stable, low dividend growth. Two-stage models are more powerful because they combine both emphases, on dividends and on growth. This is because of the life-cycle of firms. At first, they tend to have a high and unstable dividend growth rate (the DDM tackles this adequately). As the firm matures, it is expected to have a lower and stable growth rate, suitable for the treatment of Growth Models. But how many years of future income (from dividends) should we use in our calculations? If a firm is profitable now, is there any guarantee that it will continue to be so in the next year, or the next decade? If it does continue to be profitable - who can guarantee that its dividend policy will not change and that the same rate of dividends will continue to be distributed? The number of periods (normally, years) selected for the calculation is called the "price to earnings (P/E) multiple". The multiple denotes by how much we multiply the (after tax) earnings of the firm to obtain its value. It depends on the industry (growth or dying), the country (stable or geopolitically perilous), on the ownership structure (family or public), on the management in place (committed or mobile), on the product (new or old technology) and a myriad of other factors. It is almost impossible to objectively quantify or formulate this process of analysis and decision making. In telecommunications, the range of numbers used for valuing stocks of a private firm is between 7 and 10, for instance. If the company is in the public domain, the number can shoot up to 20 times net earnings. While some companies pay dividends (some even borrow to do so), others do not. So in stock valuation, dividends are not the only future incomes you would expect to get. Capital gains (profits which are the result of the appreciation in the value of the stock) also count. This is the result of expectations regarding the firm's free cash flow, in particular the free cash flow that goes to the shareholders. There is no agreement as to what constitutes free cash flow. In general, it is the cash which a firm has after sufficiently investing in its development, research and (predetermined) growth. Cash Flow Statements have become a standard accounting requirement in the 80s (starting with the USA). Because "free" cash flow can be easily extracted from these reports, stock valuation based on free cash flow became increasingly popular and feasible. Cash flow statements are considered independent of the idiosyncratic parameters of different international environments and therefore applicable to multinationals or to national, export-orientated firms. The free cash flow of a firm that is debt-financed solely by its shareholders belongs solely to them. Free cash flow to equity (FCFE) is: FCFE = Operating Cash Flow MINUS Cash needed for meeting growth targets Where: Operating Cash Flow = Net Income (NI) PLUS Depreciation and Amortization Cash needed for meeting growth targets = Capital Expenditures + Change in Working Capital Working Capital = Total Current Assets - Total Current Liabilities Change in Working Capital = One Year's Working Capital MINUS Previous Year's Working Capital The complete formula is: FCFE = Net Income PLUS Depreciation and Amortization MINUS Capital Expenditures PLUS Change in Working Capital A leveraged firm that borrowed money from other sources (even from preferred stock holders) exhibits a different free cash flow to equity. Its CFCE must be adjusted to reflect the preferred dividends and principal repayments of debt (MINUS sign) and the proceeds from new debt and preferred stocks (PLUS sign). If its borrowings are sufficient to pay the dividends to the holders of preference shares and to service its debt - its debt to capital ratio is sound. The FCFE of a leveraged firm is: FCFE = Net Income PLUS Depreciation and Amortization MINUS Principal Repayment of Debt MINUS Preferred Dividends PLUS Proceeds from New Debt and Preferred MINUS Capital Expenditures MINUS Changes in Working Capital A sound debt ratio means: FCFE = Net Income MINUS (1 - Debt Ratio)*(Capital Expenditures MINUS Depreciation and Amortization PLUS Change in Working Capital) Value Added Taxes To be justified, taxes should satisfy a few conditions: Above all, they should encourage economic activity by providing incentives to save and to invest. Savings - transformed into investments- enhance productivity and growth of the economy as a whole. A tax should be simple - to administer and to comply with. It should be "fair" (progressive, in professional lingo) - although no one seems to agree on what this means. At best, it should replace other taxes, whose compliance with the above conditions is less rigorous. In this case it will, usually, lead to budget cuts and reduce the overall tax burden. The most well known tax is the income tax. However, it fails to satisfy even one of the conditions above listed. To start with, it is staggeringly complicated. The IRS code in the USA sprawls over more than 8,000 pages and 500 forms. This single feature makes it expensive to enforce. Estimates are that 100 billion USD are spent annually (by both government and taxpayers) to comply with the tax, to administer it and to enforce it. Income tax is all for consumption and against savings: it taxes income spent on consumption only once - but does so twice with income earmarked for savings (by taxing the interest on it). Income taxes discriminate against business expenses related to the acquisition of capital assets. These cannot be deducted that same fiscal year. Rather, they have to be depreciated over an "accounting life" which is supposed to reflect the useful life of the asset. This is not the case with almost all other business expenses (labour, to name the biggest) which are deductible in full the same fiscal year expended in. Income taxes encourage debt financing over equity financing. After all, retained earnings are taxed - while interest expenses are deductible. We can safely say that income taxes in their current form were somewhat responsible to an increase in consumer credits and in the national debt (as manifested in the budget deficits). They also had a hand in the freefall in the saving rate in the USA (from 3.6% in the 80s to 2.1% in the 90s). And money evading the tax authorities globalised itself using means as diverse as off-shore banking and computer networking. This made taxing sophisticated, big money close to impossible. No wonder that taxes levied on consumption rather than on income came to be regarded as an interesting alternative. Consumption taxes are levied at the Point of Sale (POS). They are a mixed lot: We all get in touch with Excise Taxes. These are imposed on products which are considered to be bad both for the consumer and for society. These products bring about negative externalities: smoke and lung cancer, in the case of tobacco, for instance. So, when tobacco or alcohol are thus taxed - the idea is to modify and reform our behaviour which is deemed to be damaging to society as a whole. About 7% of tax revenues in the USA come from this source - and double that in other countries. Sales taxes have a more modest calling: to raise revenues by taxing the finished product in the retail level. Unfortunately, so many authorities have the right to impose them - that they vary greatly from one location to another. This adds to the confusion of the taxpayer (and of the retailer) and makes the tax more expensive to collect than it should have been. Moreover, it distorts business decisions: businesses would tend to locate in places with lower sales taxes. Sales taxes have a malignant effect on the pricing of finished goods. First, no tax credit is allowed (sales taxes paid on inputs cannot be deducted from the sales tax payable by the retailer). Secondly, the tax tends to cascade, increase the prices of goods (taxable and not, alike), affect investments in capital goods (which are not exempt). It adversely affects exports and domestic goods which compete with imports. In short: sales taxes tend to impede growth and prevent the optimization of economic resources. Compare this with the VAT (Value Added Taxes): simple, cheap to collect, contain no implicit taxes on inputs. VAT renders the pricing structure of goods transparent. This transparency encourages economic efficiency. VAT is used in 80 countries worldwide and in 22 out of 24 OECD countries, with the exception of the federal ones: the USA and Australia. There are three types of VAT. They are very different from each other and the only thing common to them all is the tax base: the value added by the taxpayer. Economic theory defines Value Added as the sum of all the wages, interest paid on capital, rents paid on property and profits. In the Addition VAT method, these four components are taxed directly. The State of Michigan in the USA uses this method since 1976. Experience shows that this method yields more predictable tax revenues and is less susceptible to business or industry cycles. The Subtraction method, employed in Japan and a few much smaller countries, is admittedly the simplest. It taxes the difference between a taxpayer's sales and its taxed inputs. However, it becomes very complicated when the country has a few VAT rates, because the inputs have to be separated according to the various rates. Thus, the most widely accepted system is the Credit Invoice. Businesses become unpaid tax collectors. They are responsible to get tax receipts from their suppliers (inputs). They will be credited with the VAT amounts on the receipts that they have collected, so they have a major incentive to do so. They will periodically pay the tax authorities the difference between the VAT on their sales and the VAT on their inputs, as evidenced by the receipts that they have collected. If the difference is negative - they will receive a rebate (in certain countries, directly to their bank account). This is a breathtakingly simple concept of tax collection, which also distributes the costs of administering the tax amongst millions of businesses. In the fiscal year (FY) 1977/8 in the UK - the tax productivity (cost per 1 dollar collected) was 2%. This means that the government paid 2 cents to collect 1 dollar. But businesses paid the remaining 10 cents. If introduced in the USA, VAT will cost only 3 billion USD (with 30,000 tax officials employed in a separate administration). To collect 1 dollar of income tax costs 0.56% in the USA. But, to collect VAT in Norway costs 0.32%, in Belgium - 1.09% and, on average, 0.68%. In short, VAT does not cost much more than income taxes to collect. Yet, what is true for government is not necessarily so for their subjects. The compliance cost for a business in the USA is $49. It is $53-282 in other countries. Small businesses suffer disproportionately more than their bigger brethren. It cost them 1.94% of VAT revenue in FY 1986/7 in the UK. Rather more than big firms (0.003%!). Compliance costs are 40 times higher for small businesses, on average. This figure masks a larger difference in retail and basic industries (80 times more), in wholesale (60 times more) and in manufacturing and utilities (45 times more). It was inevitable to think about exempting small business from paying VAT. If 16 out of 24 million businesses were exempted - the costs of collecting VAT will go down by 33% - while the revenues will decline by only 3%. KPMG claims that businesses with less than $50,000 annual turnover (18 out of 24 million) exempted in the USA, revenues would have declined by 1.5%. About 70% of the tax are paid by 10% of the businesses in the UK. For 69% of the businesses there (with turnover of less than 100,000 USD annually) the costs of collection exceed 60% of the revenues. For 96% of the businesses (with less than 1 million USD a year) - the costs exceed 50%. Only in the case of 30,000 companies - are the costs less than 20%. These figures do not include compliance costs (=costs borne by businesses which comply with the tax law). No wonder that small businesses borrow money to pay that VAT bills. Many of them - though exempt - register voluntarily, to get an endless stream of rebates. This is a major handicap for the tax system and reduces its productivity considerably. In a desperate effort to cope with this law-abiding flood, tax authorities have resorted to longer periods of reporting (instead of monthly). Some of them (in the UK, for one) allow annual VAT reports. Part of the problem is political. There is little disagreement between economists that VAT is a tax preferable to income taxes. But this statement comes with caveats: the tax must have one rate, universally applied, without sector exemptions. This is the ideal VAT. The world being less than ideal - and populated by politicians - VATs do not come this way. They contain many rates and exemptions for categories of goods and services. This mutilated version is called the differentiated VAT. An ideal VAT is economically neutral - though not equitable. This means that the tax does not affect economic decisions in ways that it shouldn't. On the other hand, its burden is not equally distributed between the haves and have nots. VAT taxes value added in each stage of the production process. It does so by levying a tax on goods and services - but what is really taxed are the means of production, labour and capital. Ultimately, shareholders of the taxpaying businesses pay the price - but most of them try to move it on to the consumer, which is where the inequity begins. A rich consumer will pay the same tax as his poorer counterpart - but the tax will constitute a smaller part of his income. This is the best definition yet found for regressivity. On the face of it - and for a very long time - VAT served as a prime example of regressive, unfair taxation. For a very long time, that is until the development and propagation of the Life Cycle Theories. The main idea in all these theories was that consumption was not based on annual, current income only. Rather, it took into consideration future flows of income (income expectations). People tended to be constant in their level of spending (in different periods in their lives) - even as their annual income vacillated. With the exception of millionaires and billionaires, people spent most of their income in their lifetime. VAT was, therefore, a just and equal tax. If income equalled consumption in the long run, VAT was a form of income tax, levied incrementally, with every purchase. It reflected a taxpayer's ability to pay (=to consume). It was a wealth tax. As such, it necessitated the reduction in other taxes. Taxing money spent on consumption was taxing money already taxed once (as income). This was classic double taxation - a situation which had to be remedied. But, in any case, VAT was a proportional tax when related to a lifetime's income - rather than a regressive tax when compared to annual income. Because consumption was a parameter more stable than income - VAT made for a more stable and predictable tax. Still, old convictions die hard. To appease social lobbies everywhere, politicians came up with solutions which were unanimously rejected by economists. The most prevalent was exempting a basket of "poor people's goods" from VAT. This gave rise to a series of intricate questions: If food, for instance, was exempted (and it always is) - was this not a subsidy given to rich people as well? Don't rich people eat? Moreover, who will decide what is or isn't food? Is caviar food? What about health food? It was obviously going to be very hard to reach social consensus. If tax on these products were zeroed - taxes on other products would have had to go up to maintain the same revenue. And so they did. In most countries VAT is levied on less than 45% of the GDP - and is reckoned to be twice as high as it should be. Some sought to correct this situation by subjecting services to VAT but this proved onerous and impossible to implement in certain sectors of the economy (banking and insurance, to name two). Others suggested to dedicate VAT generated revenues to progressivity enhancing programs. But this would have entailed the imposition of additional taxes to cover the shortfall. It is universally thought, that the best method to "compensate" the poor for their regressive plight is to directly transfer money to them from the budget or to give them vouchers (or tax credits) which they can use to get discounts in education, medical treatment, etc. These measures will, at least, not distort economic decisions. And we, the less lucky taxpayers, will know how much we are paying for - and to whom. This is one of the budgetary items which increase with the introduction of VAT. Research shows that there is a strong correlation between the introduction of VAT and growth in government spending. Admittedly, it is difficult to tell which led to what. Still, certain groups in the population feel that it is their natural right to be compensated for every income reducing measure - by virtue of the fact that they don't have enough of it. But VAT is known to have some socially desirable results, as well. To start with, VAT is a renowned fighter of the Black Economy. This illegitimate branch of economic activity consists of three elements:
VAT is self enforced. As we said, VAT offers a powerful (money) incentive not to collaborate in tax scams. Every tax receipt means money begotten from the tax authorities. VAT is incremental. To completely evade paying VAT on a product would require the collaboration of dozens of businesses, suppliers and manufacturers. It is much more plausible to cheat the income tax authorities. VAT is levied on each and every phase of the production cycle - it is possible to avoid it in some of these phases, but never in all of them. VAT is an all-pervasive tax. VAT is levied on consumption. It is indifferent to the source of the money used to pay for it. Thus, it is as easily applied to "black", undeclared, money - as it is to completely legal funds. Surely, there are incentives to avoid and to evade it. If the amount of inputs in a product is very low, the VAT on the sale will be very burdensome. A business non-registered with the VAT authorities will have a sizeable price advantage over his registered competitor. With a differential VAT system, it is easy to declare the false sale of zero-rated goods or services to linked entities or to falsify the inputs, or both. Even computers (which compare the ratio of sales to inputs) cannot detect anything suspicious in such a scheme. Yet, these are rare occurrences, easily detectable by cross examining information derived from several databases. All in all, VAT is the ultimate, inevitable tax. Moreover, it is virtuous. By making consumption more expensive, it would tend to divert capital into investments and savings. At least, this is what our intuition tells us. Research begs to differ. It demonstrates the resilience of consumers, who maintain their consumption levels in the face of mounting price pressures. They even reduce savings to do so. We say that their consumption is rigid, inelastic. Also, people do not save because it "pays better" to save than to consume. They don't save because the relative return on savings is higher on savings than on consumption. They save because they are goal oriented. They want to buy something: a car, a house, higher education for their children. When the yield increases - they will need to save less money to get to the same target in the prescribed period of time. We could say that, to some extent, savings display negative elasticity. Markets balance themselves through a series of intricate feedback loops and "true models" of economic activity. Take an increase in savings generated by the introduction of VAT: it is bound to be short lived. Why? because the equilibrium will be restored. Increased savings will increase the amount of capital available and reduce the yields on this capital. A reduction in yield would, in turn, reduce the savings rate. Moreover, narrow (differentiated, non-ideal) based VATs lead to higher rates of VAT (to generate the same revenue). This reduces the incentives to work and the amount of income available for savings. In a very thorough research, Ken Militzer found no connection between the introduction of VAT and an increase in the rate of saving in 22 OECD countries since 1965 (VAT was first introduced in France in 1954). He also found no connection between VAT and changes in corporate (profit) and income taxes. In Europe VAT replaced various turnover taxes so its impact on anything was fairly insignificant. It had no influence on inflation, as well. VAT apparently has two conflicting influences: it raises the general price level through a one time "price shock", on one hand. On the other hand, it contracts the economy by providing a disincentive to consume. If VAT does influence inflation - its impact will be echoed and amplified through wage indexation and the linking of transfer payments to the Consumer Price Index (CPI). In this case, maybe its effects should be sterilized from the calculations of the CPI. But research was able to demonstrate only the potentially dangerous contracting, deflationary (stagflationary, to be exact) influences of this tax. The recommendation is surprising: the Central Bank is advised to increase the money supply to accommodate the reverberations of the introduction of this tax. Finally, VAT is a "border adjustment" tax (under the GATT and WTO charters). This means that VAT is rebated to the exporter and imposed on the importer. Prima facie, this should encourage exports - and equally discourage imports. Surprisingly, this time the intuition is right - albeit for a limited period of time. Despite a raging debate in economic literature, it seems safe to say the following:
Vodka Vodka is a crucial component in Russian life. And in Russian death. Alcohol-related accidents and cardiac arrests have already decimated Russian life expectancy by well over a decade during the last decade alone. Vodka is also big business. The brand "Stolichnaya" sells $2 billion a year worldwide. Hence the interminable and inordinately bitter battle between the Russian ministry of agriculture and SPI Spirits. The latter, still partly owned by the state, is the on and off owner of the haloed brand "Stolichnaya", James Bond's favorite. SPI's PR firm, Burson-Marsteller, posits this commercial conflict as a classic case of the violation of the property rights of hapless foreign shareholders by the avaricious and ruthless functionaries of an unreformed evil empire. They question Russia's readiness to accede to the WTO and its respect for the law. SPI's latest press release consists of the detailed history of this harrowing tale. The brand Stolichnaya, as well as 42 others, were privatized in 1992. The firm quotes a document, bearing the official seal of the maligned ministry, which states unambiguously: "VAO Sojuzplodoimport has the right to export Russian vodka to the USA under the following trademarks: Stolichnaya, Stolichnaya Cristall, Pertsovka, Limonnnaya, Privet, Privet Orange (Apelsinovaya), Russian and Okhotnichya." The privatization was completed in 1997 when the old SPI was sold to the new SPI Spirits. The new SPI claims to have assumed $40 million in debt and invested another $20 million to rebuild the company into "one of the world's leading vodka producers". Yet, the Russian government, as heavy handed as ever, clearly is unhappy with SPI. It says the privatization deal was dubious and that SPI paid only $300,000 (or maybe as little as $61,000 claim other sources) for the multi-billion dollar brands, including "Stolichnaya", "Moskovskaya", and "Russkaya". The government values the brands at a far more reasonable $400 million. Other appraisers came up with a figure of $1.4 billion. The government, in a bout of new-found legal rectitude, also insists that the seller of the brands, the defunct (state-owned) SPI, was not their legal owner. It also questions the mysterious shareholders of the new SPI - including a holding company in tax-lenient Delaware. SPI's trademarks portfolio is represented by an Australian law firm, Mallesons Stephen Jaques. Putin himself set up a committee for the repatriation of these and other consumer brands to the state. He craves the beneficial effects the alcohol sector's tax revenues could have on the federal budget - and on its powers of patronage. A central state-owned brand-holding and distribution company was set up less than two years ago. Ever since then, the alcohol sector has been subjected to relentless state interference. SPI is not the most egregious case either. "The Observer" mentions that SPI currently runs most of its business from inscrutable Cyprus, a favorite destination for Russian money launderers, tycoon tax evaders, and mobsters. SPI's German distributor, Plodimex, is increasingly less active - as three new off shore distribution entities (in Cyprus, the Dutch Antilles, and Gibraltar) are increasingly more so. The FSB ordered Kaliningrad customs to prohibit bulk exports of Stolichnaya. Cases of the drink are routinely confiscated. Criminal charges were brought against directors and managers in the firm. The Deputy Minister of Agriculture is discrediting SPI in meetings with its distributors and business partners abroad. He is also accused by the firm of obstructing the court-mandated registration of its trademarks. The courts have lately been good to SPI, coming out with a spate of decisions against the government's conduct in this convoluted affair. But on February 1, the firm suffered a setback, when a Moscow court ruled against it and ordered 43 of its brands, the prized Stolichnaya included, returned to the government (i.e., re-nationalized). SPI is doing its best to placate the authorities. It is rumored to have offered last month to use its ample funds to supplement the federal budget. It has indicated last September that it is on the prowl for additional acquisitions in Russia - a bizarre statement for a firm claiming to have been victimized. "The Moscow Times" reported that it is planning to sign a $500,000 sponsorship agreement with the Russian Olympic Committee. Summit Communications, a country image specialist, placed this on its Web site in November last year: "One example of a savvy Russian company that has managed to do well in the West by finding the right partner is the Soyuzplodimport company (see also p. 14). Soyuzplodimport, or SPI, has the exclusive rights to export Stolichnaya, which vodka lovers in the U.S. fondly refer to as 'Stoli'. Some 50% of the company's export turnover comes from the United States, thanks mostly to its strategic alliance with Allied-Domecq for U.S. distribution.
'I'm not sure that all Americans know where
Russia is on the map, but most of them know what Stolichnaya is,' muses Andrey
Skurikhin, general director of SPI. 'I want the quality of Stolichnaya in
America to create an image of Russia that is pure, strong and honest, just like
the vodka. At SPI, we feel that we are like ambassadors and we will try to do
everything to create a more objective and positive image of Russia in the U.S.'" SPI's troubles may prove to be contagious. Allied Domecq, its British distributor in America and Mexico, now faces competition from Kryshtal International, a subsidiary of the troubled Kristal distillery, 51% owned by Rosspirtprom, a government agency. Kryshtal signed distribution contracts for "Stolichnaya" with distilleries backed by the Russian ministry of agriculture.
Allied and Miller Brewing have announced a $50 million investment in product launch and marketing campaigns only two years ago. "Stolichnaya" (nicknamed "Stoli" in the States) sells 1 million 12-bottle cases a year in the USA (compared to Absolut's 3 million cases).
The trouble started almost immediately with the
first foreign investments in SPI. As early as 1991, Vneshposyltorg, a government
foreign trade agency, tried to export Stolichnaya in Greece. This led to court
action by the Greeks. Vodka wars also erupted between the newly-registered
Russian firm "Smirnov" and Grand Metropolitan over the brand "Smirnoff". The vodka wars are sad reminders of the long way ahead of Russia. Its legal system is rickety - different courts upheld government decisions and SPI's position almost simultaneously. Russia's bureaucrats - even when right - are abusive, venal, and obstructive. Russia's "entrepreneurs" are a penumbral lot, more enamored with off-shore tax havens than with proper management. The rule of law and private property rights are still fantasies. The WTO - and the respectability it lends - are as far as ever. Vojvodina, Economy of Milosevic is still a hate figure in Vojvodina. Until he abolished it in 1989, the northern region, bordering on Hungary, enjoyed an autonomy granted by Tito's successive constitutions. Vojislav Kostunica, the current president of Yugoslavia and the winner of the first round of elections for the presidency of Serbia has replaced the deposed autocrat as chief villain. His opponent, the reform-minded Miroljub Labus, won convincingly only in Vojvodina and southwestern Serbia. Exactly a year ago, the provincial assembly of Vojvodina sacked the region's deputy prime minister, a Kostunica crony, and upgraded the status of Novi Sad to "capital city". The assembly's speaker stormed into the building of Novi Sad's TV and radio to protest a Belgrade appointment. Serb radicals demanded full self-government, the large Hungarian minority - one eighth of Vojvodina's two million strong populace - petitioned for self-rule in locales with a Magyar majority, moderates urged Belgrade to start negotiating soon. Hungary, under the previous prime minister, Viktor Orban, agitated aggressively on behalf of its ethnic kin. It looked as though Vojvodina is about to join the ranks of independence-prone Kosovo and Montenegro. Many Vojvodina Serbs still regard it as central European, having been part of the Habsburg empire until 1918. Vojvodina's denizens - pro-Western, highly educated, intellectuals, members of the free professions, and globe-trotting businessmen - were horrified by the barbarity of Yugoslavia's tortured demise. They now act as the self-appointed conscience of Serbia and Montenegro. In June, Nenad Canak, the head of the provincial parliament, demanded the prosecution of journalists who contributed to "warmongering" during Milosevic's reign. As reported by Radio B92, the organizers in Novi Sad in August of "Blood and Honey", an exhibition of photo-journalist's Ron Haviv's work in the Balkan in the 1990's, wrote in a letter addressed to Kostunica, among others: "Why do you keep silent regarding nationalistic and chauvinistic behavior? Why is this problem being ignored? This is obviously not an isolated incident, but an organized, planned and financed action. Does this mean that you are turning a blind eye to the truth? The [truth] is simple - wars happened and crimes were committed in them, crimes that we will have to face, sooner or later." Even their dismay at NATO's surgical demolition during the 1999 Kosovo campaign of their three economically-critical bridges over the Danube and their only oil refinery did not turn them into anti-Western xenophobes. Finally, in January-February 2001 and again in January-February this year, the Serbian parliament restored some of the territory's previous powers and privileges - over its finances, agriculture, health care, justice, education, tourism, sports, the media, and social services. Mile Icakov, a triumphant parliamentarian, from Djindjic's DOS umbrella grouping of reformist parties, quoted by Radio Free Europe/Radio Liberty, uttered this veiled admonition: "That's something we had and that's something that belonged to us and nobody has to grant it to us, but to return back what was taken away against the law and against the constitution... Everyone in Serbia has already agreed on the largest-possible autonomy for Kosovo. Nothing will change if they do the same for Vojvodina. It would be fair to give Vojvodina the [same rights]. It's not fair that the bad kid gets everything he asks for and the good kid gets nothing." Yet, the omission to tackle Vojvodina's grievances - or even to consult it - in the March 14 EU-sponsored Agreement on Restructuring Relations between Serbia and Montenegro irritated the disgruntled province. Vojvodina is not only Yugoslavia's bread basket, it also harbors its nascent oil industry, and many of its blue-chips. As a result, it is a net contributor to the federal budget and subsidizes the other parts of the rump Yugoslavia. It produces two firth of Yugoslavia's dwindling GDP and attracts two thirds of its foreign direct investment - with only one fifth of its population. In January, the French multinational Lafarge bought a majority stake in the Beocin cement factory near Novi Sad. It paid $51 million of which Vojvodina is likely to see very little. Five loss making sugar factories are next in line. Serbia's privatization minister pledged to plough back one quarter of all future privatization receipts into the local economy. The Serbian Minister of Agriculture, Forestry and Water Management, Dragan Veselinov, offered to subsidize sugar beet, soybean, and sunflower crops and to buy 280,000 tons of wheat in 2003. But these belated pre-election bribes are unlikely to soothe jangled nerves. During the 1990's Vojvodina was reluctantly flooded with Serb refugees from Bosnia, Croatia, and Kosovo. The "invasion" altered its character. The erstwhile bastion of tolerant Austro-Hungarian culture has been Balkanized and rendered discernibly more nationalistic, corruption-ridden, and fractious. Neo-fascist, anti-Semitic, revisionist, racist, pro-Greater Serbia, and skinhead organizations proliferate. The two pillars of the movement for self-governance are, therefore, nostalgia and money. It is a belated reaction to the convulsive and blood-spattered disintegration of the federation. But it is also a rejection of Vojvodina's exploitation by the other provinces. Like Scotland and Flanders, northern Italy and Quebec, Vojvodina would like to retain a larger share of its resources for local consumption and investment. In a "Europe of regions" and a world of disintegrating nation-states, this was to be expected. In August, the Committee for International Cooperation and Relations with Euroregions of the Vojvodina parliament voted to join the Assembly of European Regions (AER). Vojvodina still faces the outcomes of a decade of Western economic sanctions and NATO military action. Sanctions-busting smuggling operations during Milosevic's rule criminalized some parts of the economy. Novi Sad's water, natural gas, the railway to Budapest, river cargo transport, and telecommunications infrastructure were rendered idle by the decimation of its bridges. The reconstruction of the first, largest bridge, "Sloboda" (or Liberty) will be completed by 2004 and will cost 34 million euro in EU funds, according to "Balkan Times". Two temporary crossovers cater to the needs of Novi Sad's population - but they are poor substitutes. Rail links to the rest of Europe, for instance, have yet to be restored. The expensive and intricate clearing of the Danube of unexploded ordnance has been completed only recently. Vojvodina strives to become a regional commercial hub. HINA, the Croat news agency, reports that the Serb province and the neighboring Vukovar-Srijem county in Croatia have agreed to rebuild bridges, in both the literal and the figurative senses. Vojvodina vowed to help Vukovar secure the return of art expropriated by the Serbs during the internecine war, demine its environs, and find the whereabouts of missing Croat soldiers and civilians. Vojvodina's parties are members of the ruling, Western-orientated, Djindjic-led, coalition in Belgrade. The Vojvodina Reformists, who backed Kostunica in the recent bout of elections, have teamed with a DOS breakaway faction to form a new, left of center, political force. Vojvodina plays a crucial role in Serb politics. Even the leader of the Alliance of Vojvodina Hungarians, Jozsef Kasza, admitted to the Yugoslav daily "Dnevnik", that the status of the Hungarian minority is improving "step by step", though "Hungarians are still not adequately represented in the judiciary, prosecutions, in leading positions in the economy." He elaborated: "During the Milosevic era they wouldn't let us have our schools, media, they banned the official use of the language. The situation has now improved, the Law on national communities has been passed which needs to continue its implementation more and more." In an inversion of the traditional roles, the Beta news agency reported that Vojvodina's secretary for culture and education, Zoltan Bunjik, announced a series of assistance programs targeted at the Serb minority in Hungary, including a Serb history and culture curriculum. Volatility Volatility is considered the most accurate measure of risk and, by extension, of return, its flip side. The higher the volatility, the higher the risk - and the reward. That volatility increases in the transition from bull to bear markets seems to support this pet theory. But how to account for surging volatility in plummeting bourses? At the depths of the bear phase, volatility and risk increase while returns evaporate - even taking short-selling into account. "The Economist" has recently proposed yet another dimension of risk: "The Chicago Board Options Exchange's VIX index, a measure of traders' expectations of share price gyrations, in July reached levels not seen since the 1987 crash, and shot up again (two weeks ago)... Over the past five years, volatility spikes have become ever more frequent, from the Asian crisis in 1997 right up to the World Trade Centre attacks. Moreover, it is not just price gyrations that have increased, but the volatility of volatility itself. The markets, it seems, now have an added dimension of risk." Call-writing has soared as punters, fund managers, and institutional investors try to eke an extra return out of the wild ride and to protect their dwindling equity portfolios. Naked strategies - selling options contracts or buying them in the absence of an investment portfolio of underlying assets - translate into the trading of volatility itself and, hence, of risk. Short-selling and spread-betting funds join single stock futures in profiting from the downside. Market - also known as beta or systematic - risk and volatility reflect underlying problems with the economy as a whole and with corporate governance: lack of transparency, bad loans, default rates, uncertainty, illiquidity, external shocks, and other negative externalities. The behavior of a specific security reveals additional, idiosyncratic, risks, known as alpha. Quantifying volatility has yielded an equal number of Nobel prizes and controversies. The vacillation of security prices is often measured by a coefficient of variation within the Black-Scholes formula published in 1973. Volatility is implicitly defined as the standard deviation of the yield of an asset. The value of an option increases with volatility. The higher the volatility the greater the option's chance during its life to be "in the money" - convertible to the underlying asset at a handsome profit. Without delving too deeply into the model, this mathematical expression works well during trends and fails miserably when the markets change sign. There is disagreement among scholars and traders whether one should better use historical data or current market prices - which include expectations - to estimate volatility and to price options correctly. From "The Econometrics of Financial Markets" by John Campbell, Andrew Lo, and Craig MacKinlay, Princeton University Press, 1997: "Consider the argument that implied volatilities are better forecasts of future volatility because changing market conditions cause volatilities (to) vary through time stochastically, and historical volatilities cannot adjust to changing market conditions as rapidly. The folly of this argument lies in the fact that stochastic volatility contradicts the assumption required by the B-S model - if volatilities do change stochastically through time, the Black-Scholes formula is no longer the correct pricing formula and an implied volatility derived from the Black-Scholes formula provides no new information." Black-Scholes is thought deficient on other issues as well. The implied volatilities of different options on the same stock tend to vary, defying the formula's postulate that a single stock can be associated with only one value of implied volatility. The model assumes a certain - geometric Brownian - distribution of stock prices that has been shown to not apply to US markets, among others.
Studies have exposed serious departures from the
price process fundamental to Black-Scholes: skewness, excess kurtosis (i.e.,
concentration of prices around the mean), serial correlation, and time varying
volatilities. Black-Scholes tackles stochastic volatility poorly. The formula
also unrealistically assumes that the market dickers continuously, ignoring
transaction costs and institutional constraints. No wonder that traders use
Black-Scholes as a heuristic rather than a price-setting formula. But why are stocks and exchange rates volatile to start with? Why don't they follow a smooth evolutionary path in line, say, with inflation, or interest rates, or productivity, or net earnings? To start with, because economic fundamentals fluctuate - sometimes as wildly as shares. The Fed has cut interest rates 11 times in the past 12 months down to 1.75 percent - the lowest level in 40 years. Inflation gyrated from double digits to a single digit in the space of two decades. This uncertainty is, inevitably, incorporated in the price signal. Moreover, because of time lags in the dissemination of data and its assimilation in the prevailing operational model of the economy - prices tend to overshoot both ways. The economist Rudiger Dornbusch, who died last month, studied in his seminal paper, "Expectations and Exchange Rate Dynamics", published in 1975, the apparently irrational ebb and flow of floating currencies. His conclusion was that markets overshoot in response to surprising changes in economic variables. A sudden increase in the money supply, for instance, axes interest rates and causes the currency to depreciate. The rational outcome should have been a panic sale of obligations denominated in the collapsing currency. But the devaluation is so excessive that people reasonably expect a rebound - i.e., an appreciation of the currency - and purchase bonds rather than dispose of them. Yet, even Dornbusch ignored the fact that some price twirls have nothing to do with economic policies or realities, or with the emergence of new information - and a lot to do with mass psychology. How else can we account for the crash of October 1987? This goes to the heart of the undecided debate between technical and fundamental analysts. As Robert Shiller has demonstrated in his tomes "Market Volatility" and "Irrational Exuberance", the volatility of stock prices exceeds the predictions yielded by any efficient market hypothesis, or by discounted streams of future dividends, or earnings. Yet, this finding is hotly disputed. Some scholarly studies of researchers such as Stephen LeRoy and Richard Porter offer support - other, no less weighty, scholarship by the likes of Eugene Fama, Kenneth French, James Poterba, Allan Kleidon, and William Schwert negate it - mainly by attacking Shiller's underlying assumptions and simplifications. Everyone - opponents and proponents alike - admit that stock returns do change with time, though for different reasons. Volatility is a form of market inefficiency. It is a reaction to incomplete information (i.e., uncertainty). Excessive volatility is irrational. The confluence of mass greed, mass fears, and mass disagreement as to the preferred mode of reaction to public and private information - yields price fluctuations. Changes in volatility - as manifested in options and futures premiums - are good predictors of shifts in sentiment and the inception of new trends. Some traders are contrarians. When the VIX or the NASDAQ Volatility indices are high - signifying an oversold market - they buy and when the indices are low, they sell. Chaikin's Volatility Indicator, a popular timing tool, seems to couple market tops with increased indecisiveness and nervousness, i.e., with enhanced volatility. Market bottoms - boring, cyclical, affairs - usually suppress volatility. Interestingly, Chaikin himself disputes this interpretation. He believes that volatility increases near the bottom, reflecting panic selling - and decreases near the top, when investors are in full accord as to market direction. But most market players follow the trend. They sell when the VIX is high and, thus, portends a declining market. A bullish consensus is indicated by low volatility. Thus, low VIX readings signal the time to buy. Whether this is more than superstition or a mere gut reaction remains to be seen. It is the work of theoreticians of finance. Alas, they are consumed by mutual rubbishing and dogmatic thinking. The few that wander out of the ivory tower and actually bother to ask economic players what they think and do - and why - are much derided. It is a dismal scene, devoid of volatile creativity. |
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