Time Horizon and Capital Flows Redirection for Growth

As recent events demonstrate, the world is still in crisis and having to deal with recurrent emergencies.

I summarize here the logical sequence for developing the instrument to re-establish a sustainable economic growth path: “Operation Direct Growth”.

This is the umbrella term definition that I use to identify a variety of capital redirection schemes necessary to reverse the current spiral downturn.

Before we begin, we must first answer the mother of all questions,as whatever we do, it is going to affect the future of our planet, impacting everything and everybody, with no discrimination or distinctions, from institutions to individuals, from public or private projects to the environment, from regular people like you and me, for generations to come.

The question: Is this crisis, already well in its third year, a cyclical crisis, or it is instead of a fundamentally structural nature?

It appears undeniable that this is a structural, unprecedented, and epochal event which exposes essential and serious flows in the financial, economic and political systems of the Western world. Given the sheer scale of the problem, there is no place to hide, therefore, unless these matters are resolved effectively we are doomed to suffering and misery with sideways anaemic trends and high risks of future catastrophic disasters.

While the issues are well known but nothing has yet been done (spontaneously or imposed by regulation) to correct them, I use here “dimensional analysis”, to identify the macro factors that were repeatedly violated. These caused and built up the current disastrous situation.

I use this analysis as a key to explain the rationale for “Operation Direct Growth

The first crucial “dimensional” violation has been that of time.

Short Term Fundamentalism: No Future For Unbalanced Societies

Beginning with the financial industry, the world economies have been sickly skewed towards an unbalanced, extreme and very short term asymmetrical stance.

So, there is a dangerous tendency of “camouflaging”, or ignoring, long term underlying risks and creating a deadly asymmetry with short term (thus fictitious) profits. This has been augmented by an excessive misuse of leverage and derivatives with the effect of massively multiplying risks and destructive impact. Self convincing rationalizations have been used to justify dodgy behaviour.

Little attention has de facto been given to real growth, to the long term, to sustainability and governance, to the real cost of production, to real values, to quality of results and also to main risks. Moral hazard, socialization of losses and privatization of profits, “diversion and detachment of interests” between management and ownership, “Boards incompetence”, should not belong to a free market society and to a modern democracy.

From a macro perspective, this extreme bias for short termism, this asymmetry and distortion of risks and returns, represents the most negative and dangerous factor that has depleted real enterprise value, created a vicious circle of wrong incentives, destabilization, volatility, uncertainty, destruction of resources and impediment to sustainable long term growth.

Necessary changes must “recondition” the supply and the demand side of our economy, reformulate our enterprise business models, unfolding new long term market dimensions otherwise impossible to be recreated by single firms or individuals. Risks have to be properly analyzed and addressed; so it is paramount their “sorting and consolidation” process, not to ignore them..

In a nutshell, we need to re-establish a long term investing horizon, or my “motto”:

Give Us A Long Term Horizon And We Will Save The World. (Operation Direct Growth)

The second crucial “dimensional” violation has been that of space.

Enterprise Size Matters: An Oligopolistic Totalitarian World Brings Only Destruction And Misery

Capitalism and a free market society are based on profit and loss, on a free enterprise system where a multitude of players act in competition, not in a cartel, where there is a balanced and dynamic flow of capital, where the entrepreneurs put their own capital at risk, where there is a positive “alignment” between management and ownership and Boards perform competently and effectively their supervisory and overseeing role.

Deceit and fraud should not be in the dictionary of such a system. In successful modern societies there are no big inequalities, enterprise initiative is widespread and opportunities are available to anyone willing to work hard and play fair. In all, capitalism lays in the ability of carrying out long term plans and human ventures, developing long term assets and a continuous prosperity.

There has been an exacerbated focus on excessive consolidation which violated the above conditions and created unmanageable “monster” corporations with huge dimensions, not only “too big to fail”, but that “squelched” the rules of the game, created dangerous massive concentration risks, and “bought” through lobbying, unfair and privileged uncompetitive advantages.

This has been one of the principal enemies of a real free market economy, to the detriment of the general public and of the fundamental catalyst of a modern free market democracy: the Medium Size Enterprise. We can briefly describe the latter as a firm which size and influence are not able to affect or modify the basic market rules and fair competition conditions.

Total attention must be focused on re-establishing a favourable environment to promote and facilitate the development of the Medium Size Enterprise which, along with the general public, has so far entirely born the brunt and costs of the crisis. We know that any future recovery can only be fuelled by real growth, free market practices, economic democracy and balanced risk diversification.

The third crucial violation has been that of physical matter and risk diversification.

The Only Growth Is The Real One And Risk Diversification Is Crucial

The only growth is the real one and finance should only have the scope and function to support it.

An economic focus which solely relies on financial matters is unsustainable and can only destroy our society. Finance must “serve” the real side of the economy, without which there is no value creation. Otherwise risk concentration and “derivatives leveraging drugs”, bring only dangerous correlation, contagion, generating uncertainty, fear and systemic collapse.

Risk does not only come from lack of abiding by regulation but mostly from violating the fundamental “dimensional factors” outlined above of: time, space, and risk diversification.

In other words, risk does not only arise from violating regulation or by the lack of it.

Self regulation is therefore the way to follow by smart enterprises for the future because current regulation is now strongly detached from economic reality and it will be for a while. Yet, risks manifest themselves anyway, whether a regulatory framework is in place or not. A balanced approach is necessary to achieve a systemic stance involving all enterprise participants.

Sometimea, I ask myself, “Are we lazy”? Ultimately, we should know that we all must work, to make our contribution to the creation of real growth and value.

“Depressed Alpha”: Enterprise Value Distortion By Uncertainty

The persistent violation of the above mentioned “dimensional factors”, lead to prolonged uncertainty, the freeze of capital markets, the vital free flow of liquidity; and a collapse of trust and confidence – basic elements of a free market society and a modern democracy – brought to a continuing decline of capital flows and lending to the real economy, despite massive intervention by Quantitative Easing and other public rescue measures.

This crisis generated a negative factor which continues to grow and assumes further critical relevance. It is a “mirror” phenomenonwhich manifests itself in two aspects defined here as “Capital Constipation” and “Capital Starvation”.

Capital constipation”is a problem suffered by such institutional investorswith free capital and a long term or an indefinite horizon. Their problem is how to protect their declining assets and to identify new sources of yield and diversification to preserve their goals, and how to match their liabilities structure. Their risk is failing in their fundamental scope. Since they are not able to find “proper” sources of long term yields, they are often tempted to direct a wall of liquidity to the wrong places recreating new asset bubbles and distortions.

“Capital starvation”is instead a widespread problem suffered by the players of the real economy and in particular by the Medium Size Enterprise. This is due to the persistence of a deteriorating environment for “sound” enterprises and infrastructure projects, because of declining demand, a fall in the level of confidence and trust, withdrawal of the banks’ support, etc… These companies and infrastructure projects need now fresh resources, a strategic support to embrace new business models, to produce new sustainable offerings, and to insure long-term operations. Their risk of failure would further delay any form of possible recovery and deepen the current economic depression, making it impossible to repay the huge public debts accumulated.

The Enterprise Value, now depressed, can instead be hugely augmented by the “Direct Alpha” factor: the entrance of a “strong hand”, a long term investor/samong its shareholders.

For a more detailed analytical and theoretical base to demonstrate “Direct Alpha”, the added value of “a strong hand”, an active and organized presence of a stable long term investor/s among the enterprise’s stakeholders, please see:Operation Direct Growth.

‘Direct Alpha’, a reversal of ‘Depressed Alpha’, is the enterprise’s extra value generated by the organization or presence of a “Stable and Strong Hand” as a shareholder.

We test this phenomenon against two opposite economic models: the Modern Portfolio Theory viewing it in the optic of maximization of returns with CAPM; and the Downside Risk Theory with the Minimum Average Shortfall Methodology, where the emphasis is put on capital protection and on a lower probability of an underperformance.

In both cases, it is demonstrated that the value of an Enterprise is enhanced by Direct Alpha with a higher value in periods of uncertainty and depression like the current one.

The value of ‘Direct Alpha’ or αs, can be calculated using the Capital Asset Pricing Model (CAPM) as follows:

αs = řt – [ rf + βt (řm – rf)]

Where:

   řt   = expected return of a “Direct-Invested” enterprise

  rf   = Risk free rate

  βt = Beta of the firm (or its security)

  řm = Expected return of a similar firm but with no “Stable Investor” among shareholders

A step further is to analyze the same phenomenon as instead an enhancement of value in terms of a stronger downside protection. Estimating the value of a “Strong and Stable” shareholder’s presence, in terms of downside risk analysis, showing a lower probability of an underperformance rather than of a higher value of returns.

Using the Downside Risk Methodology: Average Shortfall is defined as the average size of a strategy’s underperformance relative to the target rate of return.The general definition of Average Shortfall can be expressed in terms of the underlying probability of returns, f(r), as:

resta_6910_01.jpg

Here, τ is the target return, and r denotes the random value of the return, both expressed as rates over a given time interval.

Conclusions:

The only way forward is to recreate real sustainable long term growth.

Paramount will be enhancing Medium Enterprise Value as defined above.

Capital redirection approaches are the only tools to make it happen and to shift the “sick” short term stance into a healthier and more balanced medium to long term horizon. Yet, necessary systemic changes must facilitate the “recondition” of the mentioned total short term bias.

It will be necessary to improve the supply and the demand side of our economy, unfolding new long term market dimensions otherwise impossible to recreate by the action of single firms or individuals.

Risk diversification will also be a key, and the stimulus to the creation of a multitude of players, facilitating the break up of those “too big to fail”.

In order to ignite a much needed real recovery, a systemic and long term approach of “direct reallocation of capital use” is needed. This is a “dynamic capital interaction” between capital rich institutions with a medium to long term horizon and enterprises in sound condition that still need further resources, a strategic support and better future prospects.

At the core of this, we demonstrated that the Enterprise Value is enhanced by the presence of a “Strong Hand” among the stakeholders.

It will therefore be necessary to implement proper Economic Policies to: re-establish a long term investing horizon; facilitate the development of Medium Size Enterprises; give incentives to adopt a balanced and sustainable real growth approach and to implement risk diversification strategies.

These are difficult times for all. Unemployment and underemployment are at highest levels. It is difficult for students to find a first job. You have to use your imagination, and your determination, many of the theories studied will not be of help in your future job.

Yet, as all periods of deep crisis and changes, there are also unprecedented opportunities. While, we should face the future with realistic expectations, we should also embrace it with a sense of optimism. I like to conclude reading you a poem from one of my Professors: Dr. Robert Cavesh:

The world belongs to optimists

The world belongs to optimists.

That’s all you have to say.

 

Just keep your eyes on those blue skies

And you will find the way…

 

To climb the mountain of success-

Now here’s the magic key:

 

That while you earn, you have to learn

To help humanity

 

Carlo.Resta@Oraculum.eu   6 June 2010

This article is an Executive Summary of the presentation to:

“Financial Crisis And Recession: Is This Time Different?”

A Roundtable held at the University of Siena, Richard Goodwin School of Economics, Siena, Italy, 26 May 2010

6 Responses to "Time Horizon and Capital Flows Redirection for Growth"

  1. Antony Dunlop   June 10, 2010 at 9:39 am

    Carlo clearly lays out the problem, identifying the key issues and proposes innovative and sustainable solutions to what is a most compelling and challenging opportunity. We have an innate ability to adapt and change to such a situation of this magnitude, but as always it takes such an event to force us to adopt new measures.Well done Carlo for initiating such far reaching solutions.

    • Carlo R   June 11, 2010 at 11:17 am

      Thank You Antony,I wish more people like you would realize this fast, so that these measures could be perfected and implemented sooner than later.In fact, the most relevant aspect now is to begin a reversal of the current unbalances and fight to reduce unemployment.The redirection schemes are though “systemic”, e.i. in order to start producing results they must involve a substantial amount of assets, and so involve a multitude of players that prioritize their action and move in synchrony and overall coordination.Economic policies must be skillfully shaped and managed accordingly.So far, it is still business as usual, and it does not seem that the West has learned its lesson.Best regards,Carlo R

  2. Guest   June 10, 2010 at 1:09 pm

    Hi Carlo,where do rf and řm come from, what factors drive them, capital? what happen if rf and řm disappear when their supporting factors diminished? does it mean řt and αs will diminish as well?

  3. Carlo R   June 11, 2010 at 12:03 pm

    Thank you for you question. Sorry not to have your name.The equation is derived from the Modern Portfolio Theory.In particular, I use the Capital Asset Pricing Model (CAPM), which ultimate objective is driven by profits maximization.In this context: αs = řt – [ rf + βt (řm – rf)]Where:řt = expected return of a “Direct-Invested” enterpriserf = Risk free rate (this may have to be redefined because of current sovereign debt crisis)βt = Beta of the firm (or its security)řm = Expected return of a similar firm but with no “Stable Investor” among shareholders(Now we can see that the whole fundamentals of risk free may have to be looked at differently because of the now economic scenario and the sovereign debt crisis. This is a different story and it is only relevant to demonstrate the importance of using a variety of approaches, as we did testing our scheme using the Downside Methodology too.)Anyhow, if the risk free gets lower the “Alpha Factor” should always be higher.In other words by definition, investing into an enterprise should always be riskier than the risk free. Otherwise, they would be arbitrage opportunities.‘Direct Alpha’, a reversal of ‘Depressed Alpha’, is the enterprise’s extra value simply generated by the organization or presence of a “Stable and Strong Hand” as a shareholder.In theory, in a situation of positive economic confidence, if the risk free rate is low and there is plenty of credit in the system available for the real economy, the Alpha factor is less relevant and therefore is lower.If there is no credit or capital flowing to the real economy, the Direct Alpha factor increases.So, there is an inversed relationship between capital availability (and overall confidence) and Direct Alpha Factor.If we lived in a perfect word, and if there were satisfied economic equilibrium conditions, Direct Alpha would tend to zero.I hope that this explanation clarifies and answers your questions.Carlo R

    • Guest   June 12, 2010 at 12:00 am

      thank you Carlo.you said αs depends on “Stable and Strong Hand” shareholders, but what should these shareholders depend on for profit? rf and řm? shareholders can’t make profit appear like magic right?you said, “…the whole fundamentals of risk free may have to be looked at differently…”, and “…investing into an enterprise should always be riskier than the risk free…”, i doubt where would the extra value of αs be generated from…the explanation confused me further, but never mind, i asked for it :-) thank you again.

  4. Carlo R   June 12, 2010 at 12:41 pm

    Dear Commentator, (again it would be nice to address you with a name)I would suggest you to read a previous paper of which a summary was published here: http://www.roubini.com/financemarkets-monitor/257982/operation_direct_growth__the_new_avenue_to_redevelop_the_real_economy;There, the Direct Alpha concept is explained in more detail. Your doubts would be clarified.Yet, I summarize it here again.I define Direct Alpha as the extra value of the enterprise return simply generated by the presence of a “Long term strong shareholder”.The value of Direct Alpha is higher in periods of economic distress, high uncertainty and freezing of capital flows and investments to support enterprises and industrial projects.Currently, we are in such a period and my forecast is that in the West we shall slide sideways in an anemic trend for a few years to come.Thus, other things being equal, after an accurate selection, a strong and long term investor decides to take an important stake in a company.Then, that firm will receive more capital and long term strategic support that are necessary for the enterprise unfold its value, to put its plans to work, to face new markets, to further CAPEX, more Research and Development, to hire more specialists, etc..This creates an immediate enterprise added value and a higher future perspective value as well (the two are related).The firm in question will generate a higher present profit of which all shareholders and stakeholders will benefit.The invested shareholders receive a higher return vis-à-vis that of a similar firm with no such strong shareholders base.The comment on the risk free rf, has nothing to do with my analysis.It is only to say that with the current sovereign debt crisis, we cannot longer consider government bonds rates as risk free. So, in the formula we need to take this into account. The current crisis forces us to totally reconsider the risk free fundamentals. Yet, this is not the point here.Ultimately, it would be not magic but just rational to give a higher present value to a firm with a long term strong shareholder.Would you rather invest in a firm where, let’s say a Warren Buffet, or a Sovereign Wealth Fund, or an important Endowment, or a consortium of them, has just put capital in? I think so.Example:You are about to sail through a stormy Ocean point.You can rely on a Team of Experienced Sailors,Would you choose the boat with a carbon fiber mast and a state of the art a sail?Or would you go with the same Team, same boat except for a soft pine mast and a thin cotton sail?Which boat has higher chances to make it through?And the rewards are obvious and for each in the Team.In terms of higher returns (the opportunity to win the race and make it though) and of a lower probability of under performance (to arrive safe at destination and take home your life).I hope I made my point at least intuitively.Best regards,Carlo R