A Capital Lesson from Egypt

The political turmoil in Egypt is a reminder that the cost of capital in emerging markets has to be regularly reassessed.

In a very real illustration of risk outweighing reward, investors knocked a few billion dollars off the market value of Apache Corp. as the turmoil in Egypt intensified. That’s because the Egyptian market represents about 15% of the oil and gas producer’s value, estimates one equity analyst, and 22% of Apache’s production this year. Perhaps investors thought their money could get the same return for less risk elsewhere, as Apache’s stock dropped 6% in two days of trading last week.

U.S. corporations may begin to feel the same way. The Egypt situation, however, contains a broader message for finance: even as hot money flows into emerging markets, estimating the cost of capital in less-developed countries to a certain degree of accuracy is still very important.

“Because of the greater globalization of business and integration of markets the past few years, you could make an argument that there are fewer risks across borders,” says Jim Harrington, a vice president at valuation firm Duff & Phelps. But while many international companies have diversified operations globally to the point of lowering the volatility of their portfolios, and thereby possibly lowering the overall required rate of return, they have not lowered the risk premiums attached to individual emerging markets to zero.

Many CFOs would rather avoid the task. Estimating the value or potential value of a business in emerging markets is difficult. Just keeping up with what’s happening around the globe can be taxing. “Many companies looked at years of stability in emerging markets,” says Roger Grabowski, a managing director at Duff & Phelps. “All of a sudden now we have two things going on: rapid change in economic conditions and political instability in some markets. The combination of these makes it necessary for companies to revisit their assessment of political risk in all of the countries in which they’re investing.”

Political risk, says Grabowski, is how settled a given market is in terms of its history of legal and economic stability and the history of its legal system in protecting owner rights. While companies buy political risk insurance to protect assets and contracts, it won’t cover every contingency, and the term of coverage might not be long enough. “Buying a company, expanding a plant, adding new product lines — capital expenditures are not like buying stock, where two days later you can flip it if things don’t work,” he says. “The real issue in emerging markets is that you’re committing money for long-term investments, but the risk mitigation — like currency hedging — is available only for the short term.”

Another problem is that there is no consensus on how to measure the risks in emerging markets. There are global and country-specific capital asset pricing models, as well as yield-spread models and country credit-rating models, but all cost-of-capital models have good and bad parts. “One of the problems we see is that CFOs adopt one model that may not be appropriate for the circumstances in a specific country or for a specific investment,” says Grabrowski.

For example, many cost-of-capital models require historical data on bond and stock market returns, which is used to get an idea of the returns investors demand in different markets. But some emerging countries don’t have stock markets, or their stock markets are not as diverse as those in developed countries, so one industry or company can have an inordinate impact on returns.

One example is South Africa, where mining and minerals companies predominate. “If I’m a food company in South Africa, the stock market data doesn’t help me see how my industry risks are being assessed in that country’s market,” says Grabowski.

Even if historical stock and bond market return data is available, emerging markets have much higher volatility. From 2001 to 2009, the average annual equity return in Egypt was 39.1%, but the standard deviation was 78.8%. Likewise, if you’re making an investment in Russia or China, the variability is so high that a mean (average) return is much less reliable, says Grabowski. That can indicate that finance needs to use more than one cost-of-capital model, says Harrington. “Instead of just relying on one model, one observation, increase the number of observations,” he advises.

Experts caution against simplifying the calculation of systematic risk. Just tacking a 10% premium onto a firm’s U.S. cost of capital in trying to size the country and industry risks in an emerging market, for example, can lead to bad decisions. It’s hard to calculate specific costs of capital for emerging markets; that is, reflect country-specific considerations in cash-flow projections, say Grabowski and Harrington. But it’s still very necessary to do so.

Companies like Apache can do little once they already have a sunk investment. The real issue then might be, “If I want to put more money in, make a bigger investment, is there more risk today?” says Grabowski. The answer is yes if the country is Egypt, according to the cost of insuring against a default on Egypt’s debt. The spreads in the country’s five-year credit-default swaps widened 100 basis points last week, although they have narrowed slightly again. Still, it’s an indicator that the market perceives that the risk of operating a business in Egypt has increased, says Grabowski.

“If I were confronted with the issue of investing in Egypt today, one of the questions I’d ask is, ‘Can I defer making my investment until things settle down?’” he says. “You often have that option.”


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