Correlation is Bad News for US Equity Investors


Photo: Wikipedia
Santorini – bring Euros.

I submitted a report last fall based on research by Dr. Bruno Solnik, a Professor Emeritus at HEC. My research, much like Dr. Solnik’s, finds strong correlation in international markets, diminishing the benefits of international diversification. To put this in practical terms, your US equities have probably taken a big hit this week as a direct result of the Greek crisis. This may not be a big surprise, since crises around the world tend to have some impact on US markets, but it begs the question: why such a high degree of correlation?

If you read my report, you will notice that correlation between European and US equity markets increased 58% from 1971 through 2011. The MSCI regional indices used include mid-to-large cap companies, providing us a rich sample of stocks to track. Interestingly, there exists a small positive relationship between volatility and correlation. This relationship becomes most pronounced during times of crisis – perhaps the most notable examples are the outbreak of the Yom Kippur War, the Asian Financial Crisis in 1997, and the most recent financial crisis in 2008. In other words, when one market falls others follow to a great extent.

While I don’t necessarily believe we are witnessing the beginning of a financial meltdown – certainly not in the US – the Greek crisis that is unfolding this week has prompted me to reexamine my research. Most of my stockholdings are in the US, and they have taken a bit of a dive as the trouble in Europe unfolds. I’ve sought to use recent data to understand where correlation is and where it is headed.

I used two index funds, the Vanguard FTSE Europe ETF ($VGK) and the Vanguard Total Stock Market ETF ($VTI) to track European and American equity markets (respectively) over the past eleven months. The results aren’t easy to read, but notice that after major dips in the market – and the markets usually fall in synch – correlation shoots up. Because correlation is a trailing measure using the last 20 days of data, the series should be mentally shifted very slightly to the left.

Volatility and Correlation in US and European Equity Markets

Once more data comes through (this graph only captures the market through last Sunday, the 26th of June), we should start to see a bigger decline in world markets and corresponding spike in correlation.

We would need to conduct a more in-depth study to understand the true impact of the Greek crisis – or any other world event for that matter – on US companies. But it seems likely that troubles abroad are having a hyperbolic effect on American equity markets. For example: El Pollo Loco Holdings ($LOCO), with no restaurants outside of the United States and minimal exposure to overseas headwinds, ended Friday down over 1%. Alibaba Group, a hyped-up stock getting the vast majority of its revenue from China, is down over 2.5%. Despite the tremendous demand worldwide for Chinese goods that certainly drives some of Alibaba’s business, the Greek crisis wouldn’t seem to warrant a $5.5 billion drop in market capitalisation.

While any business is affected by events around the world, I am inclined to believe that situations like the crisis in Greece pump systematic risk into equity markets beyond what is normal or sustainable. Investors should be prepared to see more declines in US stocks over the short term. If the Greek crisis subsides, however, US equity valuations may continue on their frothy rise for some time yet.

A note on methodology: Volatility and correlation are calculated in this article using 10 days of trailing data. My report, on the other hand, covers a longer period of time – that methodology can be found on page 1 of the PDF.


Why big companies love solar energy investments

Here comes the sun

The Nellis Solar Power Plant in Nevada, deployed by SunPower and financed by MMA Renewable Ventures; the Nellis Air Force Base buys the energy produced under a power purchase agreement (PPA).
Source: Wikipedia, US Air Force

Did you know that Google has a team dedicated to making investments in solar energy projects? I got to meet some people on the group during my time as an intern, and while I found their work to be super exciting, I didn’t think to ask why there would be such a group at Google. As a summer analyst with Credit Suisse this summer, I found that the firm also has a small team dedicated to deploying the bank’s capital to finance renewable energy projects. Making balance sheet investments of this sort is quite rare for a company like CS, so I began connecting the dots. There’s a reason for everything in business, and this principal investment activity is no exception.

Thank you Uncle Sam

The answer comes down to federal incentives around investments in solar projects. Chief among these is the Investment Tax Credit (ITC), which allows a buyer to take a tax credit on 30% of the cost of the solar project. In addition, the buyer can depreciate the investment over five years using the Modified Accelerated Cost Recovery System (MACRS). This is valuable because while under normal circumstances a solar power facility would be depreciated over 30 or more years, the accelerated depreciation creates a large tax shield in just five years. If we look at $100 in depreciation as a tax deduction – which is intrinsically valuable – the time value of money applies to it just as it would to a cash flow. In other words, taking all that depreciation over a shorter period of time creates more value for a company.

Most buyers of solar power systems don’t have a big enough tax liability to take full advantage of the 30% tax credit. Take SolarCity for example, which still has negative operating income: if the company kept and deferred the tax benefits of building its solar systems, it would take years to be able realise any tax shield, by which point its value would be significantly discounted. For a company like Google, which paid nearly $2.3bn in tax last year, the opportunity to earn some tax benefit makes sense.

Most industrial-scale solar projects, then, are primarily funded by a tax equity investor who receives payments from the end consumer. A solar power company like SunPower or Sunrun builds the facility for the investor (e.g. Google, Credit Suisse, or Goldman Sachs to name a few), who then receives payments from the end-user through a lease or power purchase agreement (PPA). If you want to dig a bit deeper into the specific structures used, this article might be helpful.

Solar panels dot the roofs of the GoogleplexSource: Austin McKinley, Wikipedia

Solar panels dot the roofs of the Googleplex
Source: Austin McKinley, Wikipedia

Must all good things end?

In 2016, the federal subsidy on solar power will decline from 30% to 10%. This could have a major effect on the solar industry, as tax equity investors would have a diminished incentive to put money into these projects, raising costs of capital and ultimately making solar energy less attractive to the ultimate buyer. While it’s plausible that the government could extend the higher tax benefit, does anybody want to bet on the government actually doing something?

Wind power might be a good indicator of the future of a reduced-subsidy solar industry might look like. Windmill owners received 2.3 cents per kilowatt-hour produced through the Production Tax Credit (PTC) before it expired in 2013, and investment went from adding over 12,000 megawatts of capacity in 2012 to less than 2,000 in 2013. Congressional debate on renewing the incentive has been blocked by conservative Republicans and Democrats, who are often backed by petroleum companies (there’s something politicians come together over – money!). A proposal to renew subsidies on solar energy might have a similar fate should it find its way into Congress in 2016.

Should these incentives even be in place, though? They distort the market for energy and cultivate an industry heavily dependent on the government. When the incentives are cut back in solar, new projects will likely stall and higher costs of production will be passed on to utilities. Utilities in turn, must seek out the most efficient sources of energy and may end up reverting to coal and other fossil fuels.

It’s hard to consider the implications of subsidised renewables without recognising that fossil fuels are also subsidised. Billions of dollars in state and federal incentives go to oil, gas, and coal each year, and clean energy advocates often point to this data in a push for more “green” subsidies. The reality is that, while fossil fuels receive more subsidies in agreggate, renewables are much more heavily subsidised on a per-unit basis. According to this WSJ opinion piece, coal is subsidised at about 0.05¢ (or $0.0005) per kilowatt-hour, while wind gets 5¢ per kWh and solar gets 77¢ per kWh.

The ITC for solar power is extremely generous at 30%, and I wouldn’t count on the federal government moving to keep it that high past 2016. So, what will happen to tax equity investing? Google’s last wind power investment was in December of 2013 – just before the 2.3¢ per kWh incentive ran out. A 10% tax credit for solar investments may not be enough for large corporate players like Google and Credit Suisse to stay involved in this space. Independent financing companies may fill some of the void, and securitisation of renewable energy receivables may create a deeper capital market for this type of liability.

Companies investing in large-scale renewable energy projects have had an important role in the development of alternatives to fossil fuels. Without the ITC for solar and PTC for wind, renewables might still be prohibitively expensive in the US. It remains to be seen how solar project finance evolves post-2016.

The Business of Gambling: Part 1


Las Vegas

The Las Vegas Strip

If you’ve ever been to Vegas, you might think you have an idea of what the gaming industry looks like. Just two companies seem to dominate the Strip: MGM Resorts International owns the Bellagio, the Mirage, the Mandalay Bay, Aria, and the MGM Grand (among others); while Planet Hollywood, Paris, Bally’s, and Caesars Palace are just a few of the properties owned by Caesars Entertainment Corp. Conversely, Wynn Resorts Limited only owns two Strip properties (the Wynn and the Encore), while Las Vegas Sands Corp has the Venetian and the Palazzo.

Like the quixotic world that is Las Vegas, though, the gaming industry is not all that it seems. The biggest casino operators are defined not by their Las Vegas properties, but by their holdings in Macau – this is relatively common knowledge, but you would never guess the real juggernauts from a visit to Vegas. While MGM and Caesars dominate the Las Vegas Strip, they are far behind competitors that have built a strong business in China. Indeed, there seems to be a strong positive correlation between the percent of adjusted EBITDA earned outside of the US (read: Macau and Singapore) and a company’s interest coverage ratio – that is, the companies with a greater exposure to Asia are in a stronger financial situation and better able to pay off debt (see fig. 1). This is a pretty weak statistical observation (small sample size), and interest coverage may be a controversial metric to use since it depends on financing mix (which varies by company) – but this scratches the surface as far as the factors that have driven success or failure for gaming companies in the last decade or more.


Fig. 1

The Sands Storm

Las Vegas Sands makes less than 12% of its adjusted EBITDA in the United States and has the largest enterprise value of the companies we are examining (it is the largest casino operator in the world). Under founder Sheldon Adelson, Sands opened the first foreign-owned casino in Macau in 2004. The company kept up the pace of development, opening the Venetian Macau in 2007, the Marina Bay Sands (Singapore) in 2010, and the Sands Cotai Central in 2012. These properties are tremendously successful – the Venetian Macao reports a 91.9% occupancy rate and the Marina Bay Sands an astonishing 98.9% occupancy rate, according to the company’s most recent annual report. The average daily rate at the Marina Bay Sands is a steep $355, higher than all but one of the company’s properties (the Four Seasons Macao). By comparison, its Las Vegas resorts have a 86.1% occupancy rate with a modest average nightly rate of $203.

Marina Bay Sands

Photo: Marina Bay Sands
The Marina Bay Sands in Singapore

Sands is far from finished in China. The Parisian Macao is under construction and expected to open in late 2015. This could be an opportunity to cement the company’s hold on the Cotai Strip with an iconic landmark associated with Vegas. Sands may also be poised to begin targeting mass-market gamblers, a demographic traditionally underserved in Macau. A recent Wall Street Journal article notes that average minimum bets in the territory have climbed to HK$1,000 ($129 USD) for non-VIP gamblers. This is astonishingly high, and the market for low-rollers could be a major source of growth for the company in the next few years. There are also major risks to catering to wealthy mainland Chinese VIPs, who may use Macau as a money-laundering hub.

Caesars – Too Much Debt to be Cool

I lost quite a bit of money at Bally’s (a Caesars property on the Las Vegas Strip for you newbies) on a recent vacation. In light of this analysis, I may have done the company a small favour. Caesars Entertainment Corp is in a heap of trouble due largely to its enormous $24 billion mound of debt. The company just recently sold some of its properties to a subsidiary, Caesars Growth Partners LLC, to gain access to some much-needed cash. Restructuring is inevitable at this point, and there is a high risk of bankruptcy in the next two or three years. Robert Cyran wrote for Reuters Breakingviews a few days ago, “The company’s EBITDA is just about covering interest payments. That leaves little if any to update hotel rooms and gambling dens in ultra-competitive Las Vegas.” This is a very important point, and Paris Las Vegas is a perfect example of how this debt issue is destroying Caesars’ business. The hotel is gorgeous from the outside and the miniature Eiffel Tower is a Vegas landmark. Visitors, however, complain of outdated rooms and décor, which distract from the property’s style and ideal location.

Paris Las Vegas Room

Photo: TripAdvisor
A room in the Paris Las Vegas property

Caesars has missed out on the explosive growth of the Macau gambling market. Total property EBITDA has floundered around $2B for the last three years without a clear uptrend, and with interest and principal payments always around the corner, Caesars is certainly running out of options. Looking at EBIT yields a worse picture – depreciation is depressing operating income, signalling much-needed capital expenditure may be neglected as assets are depleted. This all means the company is in a terrible position to invest in Macau: observers have begun questioning when the territory will near saturation, and procuring permits and licences for such an endeavour would be burdensome to say the least. With precious little capital to invest, Caesars may not get to build a palace in Macau any time soon.

Google Finance

Source: Google Finance
The financial picture for Caesars looks bleak

I also must note that Caesars’ financial troubles are largely a legacy of its 2008 leveraged buyout by private equity firms TPG Capital and Apollo Global Management. According to documents filed to the SEC by Harrah’s Entertainment, Inc (the company name at the time), the deal put “approximately $10.7 billion of debt” on what would eventually become Caesars Entertainment Corp. The LBO could not have come at a worse time, as the financial crisis would soon devastate the Las Vegas gaming industry and property market. In July of 2008, the Financial Times quoted analyst Kim Noland as saying, “Harrah’s leveraged buyout piled on debt just as operating results started to weaken.” Earlier, in October of 2006 as the deal was beginning to take shape, the FT had reported that “a private equity takeover of Harrah’s would would be the first large bet that more debt can be piled on to gambling companies without incurring significant risks.” It is now clear that LBOs may not be suited for the gaming industry. The buyout can’t take all the blame – the 2008 recession certainly made things much worse for Harrah’s – but I don’t anticipate seeing private equity shops going after casino operators again any time soon*.

(By the way, read my previous article about why Guitar Center’s LBO went wrong here.)

My next post in this series will focus on the direction the gaming industry is headed, opportunities and threats, and what they mean for these companies.

* = It came to my attention that Blackstone Group LP acquired the Cosmopolitan, a casino resort in Las Vegas, on Thursday (15 May). At $1.7B, this deal is relatively small. No debt has been piled onto Cosmo yet (this was not an LBO), and Blackstone bought a property, not a whole company. I would argue that my point stands.

Disclosure: In early 2015, I took positions in Las Vegas Sands Corp and Caesars Acquisition Corp.

What can ECB easing do for you?

The European Central Bank in Frankfurt

The European Central Bank in Frankfurt

Mario Draghi has been warming up to the prospect of quantitative easing (QE) at the ECB as growth and inflation remain stubbornly low in the EU. While it is far from certain that the ECB will begin large-scale easing, this course of action would undoubtedly create opportunities for investors in the Euro market.

On 6 March 2009, the S&P500 hit its lowest point in the financial crisis. Just months earlier, in December of 2008, the Federal Reserve had begun buying up securities on the open market. As the economic recovery dragged on, asset purchases continued and the stock market rose. Today, the S&P500 has recovered well over 150% and QE is winding down steadily.

I don’t want to get into a debate about QE. Regardless of the extent to which it is helpful or harmful to markets in the long run, it is clear that QE buoys asset prices. This can be observed pretty easily by comparing the historical price of the S&P 500 to the Fed’s balance sheet. This comparison is nothing new, but it is quite timely since history does repeat itself.


The coefficient of correlation for these two data series is an exceedingly high 0.93. Furthermore, standard deviation is nearly the same as a fraction of each mean, at 17.64% of the mean for the S&P500 and 17.39% of the mean for the Fed balance sheet. This correlation is absent in the pre-QE data (the coefficient drops below 0.5).

If the ECB undertakes QE, this would almost guarantee a medium-term surge in European equity markets. Mario Draghi has now expressed willingness on behalf of the entire central bank’s board to take action if growth and inflation remain subdued. This would present a very favourable scenario for investors.