James L. Grant

Foundations of EVA for Investment Managers

C S First Boston’s landmark 1996 “Economic Value Added Conference” may permanently alter the way investment managers assess ’ real corporate profitability. Since EVA” emphasizes the difference between the firm’s after-tax operating profit and the (total) dollar cost of capital, this financial measure may offer investment managers new insight on the joint pricing mechanism for risky bonds and stocks. In preparation for this analytical change, this study provides investment professionals with a general framework for understanding the conceptual and empirical linkages between EVA’” and corporate valuation. Money managers can then use this financial technology to create a measure of economic value-added for their investment clientele.’

The EVA Style of Investing

A shift in equity management would define the style of a company in terms of its fundamental ability to create wealth. From an economic value added perspective, a growth company invests for rapid economic profit change, while a value company looks to create wealth through downsizing or restructuring a low-to-negative economic profit spread business. In either case—EVA growth or value—these company types (among profiles between the extremes) represent good stocks when actual expectations of economic profit growth exceed expectations already imbedded in share price. This economic profit style of investing emphasizes the fundamentals of wealth creation and reconciliation of share price with the level realistically achievable.

A Yield Effect in Common Stock Returns

0 At 16.14%, the annualized monthly average return on the stock market as measured by the S&P 500 index is substantially higher than the long-term (arithmetic) mean return of 12.4% reported by Ibbotson Associates for the 1926-1 992 period. Portfolio returns on common stocks during the 1980-1992 period are also negatively related to the traditional measures of risk, including beta and return standard deviation. Correlation values in the average returdrisk relationship are strongly negative, ranging from -0.75 to -0.828, respectively. Moreover, it seems that high-dividend-yielding stocks of both small and large firms were the bestperforming equity investments for the thirteenyear period ending in December 1992. 0

Active Investing in Strategic Acquirers Using an EVA Style Analysis

Employing an EVA style classification, this article examines whether active investors such as hedge funds can develop an alpha-generating strategy by classifying acquisitions based on the pre-acquisition style quadrant of the acquirers. Over the period 1990–2007, the announcement evidence suggests that acquisitions across all EVA style quadrants generate negative risk-adjusted returns, wherein the potential for economic gains from shorting acquirers is greater for pre-classified wealth destroyers than it is for wealth creators. The article also finds evidence of continuing negative returns following the acquisition announcement for wealth destroyers, while for wealth creators the post-acquisition announcement effects are mixed. Moreover, the potential for longing gains on target firms is significant at the announcement and shows continuing positive gains after the acquisition announcement across EVA styles. These results support the view that investment strategies involving acquisitions should be linked to the fundamentals of wealth creation.

A Survey of Demographics and Performance in the Hedge Fund Industry

We investigate hedge fund demographics using data from the Alternative Asset Center (AAC) and then hedge fund performance over the twelve years since inception of the Credit Suisse/Tremont Hedge Fund Indices (HFI, 1994–2005). We find that hedge funds are largely domiciled “offshore” while hedge-fund managers are located primarily in the United States, particularly New York, California, Illinois, Connecticut and Florida. We find that the annualized performance of hedge funds as an “asset class” is about the same as that of U.S. equities (S&P 500). That being said, the real benefit of hedge funds lies in risk management as the volatility of HFI is considerably lower than the stock market. We also find that most hedge-fund “styles” provide solid absolute and risk-adjusted returns and conclude that hedge funds have been a worthwhile investment vehicle for fund indexers and active investors.

Understanding the Required Return Under New Uncertainty

Heightened world uncertainty in the past five years has posed new challenges for securities analysts and portfolio managers, particularly for equity managers using price-relative or discounted cash flow models. While they are justified in worrying about values of cash flow input to DCF models, portfolio managers must be attuned to risk factors that impact the overall discount rate and thereby market valuation multiples. A better understanding of the equity discount rate (including base and specific risk premiums) helps us explain the lackluster performance of the stock market in recent years as well as the pricing of several large-cap companies whose stock performance has been flat, despite rising profits and a wide variation in interest rates.

The EVA Style Approach to Tactical Asset Allocation

We refine tactical asset allocation (TAA) by arguing that the equity style component of a TAA strategy should distinguish between—and rotate among—predefined value creators and value destroyers in the marketplace. We assess equity style in the context of an economic profit approach to securities analysis and active portfolio management. We illustrate TAA in the context of an economic value added style analysis, and we demonstrate both the macroeconomic aspects and cyclicality of economic profit and its equity rotational implications for TAA. We conclude with a look at some well-known value creators and value destroyers, as well as known market anomalies that can also drive an economic profit approach to TAA and active portfolio management.

Does the Wealth Profile of a Company Matter in Discounted Cash Flow Analysis? Valuation Implications for Investors and Managers

This article examines the prospective valuation relationship between MVA and EVA. The author classified companies in the Stern Stewart Performance 1000 Universe in terms of whether they are in a tier 1 wealth profile (top-100 MVAranked companies), a tier 5 wealth profile, or a tier 10 wealth profile (bottom-100 MVA-ranked companies). Overall, the results that the market discounts economic earnings and that the wealth profile of a company matters in particular. Specifically, indicate the market discounts economic earnings for wealth creators, as opposed to the middle-to-low MVAranked companies. Consistent with financial theory, this implies that reliably positive EVA—such as that evident in the wealth creators—has intrinsic value, whereas relatively lowto-negative EVA—as present in low MVA-ranked companies—has questionable fundamental value. The author argues that wealth creators know how to rationalize capital, as they pursue positive NPV opportunities where the return on capital is higher than the cost of capital. On the other hand, low-to-negative MVA-ranked companies face risk pricing challenges as investors question the efficacy of their ability to create shareholder value. Although caveats apply, this prospective valuation of EVA has important pricing implications for investors and managers.

In Search of Certain Earnings: Applying the ACE Portfolio Concept to Sectors

Sector composites that have highly stable earnings streams allow the portfolio manager or analyst to derive “earnings certain” sector risk premiums. ACE (approximately certain earnings) sectors represent such baskets. Because sector pricing is influenced by earnings variability, obtaining risk premiums from standard sectors is contaminated. With knowledge of an EPS stability measure, a composite engine, and a robust DCF framework, we can discover companies within each sector that exhibit highly stable earnings. In practice, ACE sectors can be used to derive current/historical “earnings certain” sector risk premiums, enhance sector rotation strategies, obtain sector-implied growth rates, make risk adjustments for present value modeling, and construct improved valuation benchmarks.