Country Risk: A Tale of Two Models

Aswath Damodaran shared insights on geopolitical risk with participants at the India Investment Management Conference organized by CFA Institute.

So far in 2011 we have witnessed renewed unrest in the Middle East and North Africa, an earthquake and nuclear disaster in Japan, and a debt crisis enveloping Europe. And the United States has not been immune to adversity either, as its own fiscal problems brought about a historic debt downgrade by Standard & Poor’s.

But how do these events affect the performance of individual equity securities, particularly those of foreign or multinational firms? Incorporating country risk — the additional risk that investors bear when investing in an international company — into equity analysis is as much an art as a science, and analysts incorporate that risk into their portfolios in different ways.

Kenneth Hackel, CFA, president of CT Capital LLC, and the author of Security Valuation and Risk Analysis, considers country risk an important, and often overlooked, component of the cost of capital. Factors like political instability, natural disasters, and economic turmoil all cause investors to demand a premium for putting their capital at risk. This premium increases the cost of capital at which an investment’s cash flows are discounted, negatively impacting the stock’s valuation.

As Hackel has pointed out, “the conditions under which a company operates and has major facilities or markets will influence cash flows, consistency measures, and leverage.” Hackel cites tariffs, currency stability, inflation, and military threats as just some of the factors that he considers when looking at sovereign risk, and his comprehensive cost of capital model includes sovereign risk as one of its many inputs. Prior to the March 2011 earthquake that devastated Japan, Hackel’s firm had marked up the risk of Japan to reflect its exposure to natural disasters, and afterwards raised this risk rating further to reflect the ongoing impact of the quake.

Hackel sees the capital asset pricing model as inadequate in estimating a firm’s required rate of return. CAPM’s beta, Hackel argues, is a poor estimator of risk and he contends that a more thorough consideration of the factors impacting a firm’s cost of capital, including country risk, will yield a more accurate result. Hackel takes the perspective of a credit analyst when analyzing equity securities, setting him apart from the crowd, and his detailed approach to the cost of capital calculation ensures that factors like country risk are carefully considered.

The academic community has also addressed country risk, and the work of Professor Aswath Damodaran from New York University’s Stern School of Business offers an alternative approach to the country risk calculation. Damodaran is well-known in the finance community as an authority on valuation and for his deconstruction of the traditional discounted cash flow model. Central to his work here is the role of CAPM as an analytical tool, and despite its acknowledged drawbacks, Damodaran views it as a good starting point for determining the cost of capital. Like Hackel, however, Damodaran sees room for improvement, including when it comes to accounting for country risk.

Damodaran points to the increasing correlation between international markets as evidence that country risk cannot be diversified away entirely. He considers three measures for estimating the country risk premium: the default spread on a country’s sovereign debt, a premium based on equity market volatility relative to the U.S., and a hybrid approach. Rather than attaching the same risk premium to all companies within a given country, Damodaran applies the country risk premium according to a firm’s exposure in each market, as measured by revenues or earnings, or by regressing the company’s stock against country bond returns.

While they take different tacks, it’s clear that both Hackel and Damodaran recognize the importance of factoring in country risk when it comes to considering a firm’s cost of capital. Now more than ever, it makes sense to pay close attention to the exposure of companies to operating and funding risks associated with the countries in which they do business.

For more resources on country risk, see:

• Eurasia Group’s Kevin Kajiwara says that we’re seeing the “broadest, most volatile, and impactful” political risk in more than a decade.

• Dr. Pippa Malmgren, president and founder of Canonbury Group and Principalis Asset Management, demonstrated how investors can draw correlations between inflation and global political instability, noting that “geopolitics is not a black swan phenomenon.”

• In the video “Geopolitical Jousts,” Malmgren examines the risks of international uncertainty and highlights ways to identify and deal with their challenges.

• In the video “Geopolitics and Investing,” Ian Bremmer discusses the geopolitics of the BRIC nations, the Greek debt crisis, and the dramatic global political change over the last 18 months.

• Bremmer’s highly acclaimed book The End of the Free Market: Who Wins the War Between States and Corporations? offers a deeper dive into country risk for those interested.