A Worrisome Trend With Companies Like Porsche, and General Mills
I have been watching a trend among companies that has me deeply concerned. It has me so concerned that I wonder if we are not about to hit a second bubble?
What has me concerned is that companies are straying out of their domain and into things that has absolutely nothing to do with their business. Let me illustrate with Porsche.
Like a sharp-eyed arbitrageur, the German sports carmaker has spotted that the huge shifts in risk appetite that have rocked the credit markets since last summer means it can earn more from low-risk investment now than it costs to borrow the money.
Porsche declined to comment on how it would invest the proceeds of the loan. Originally, €35bn in credit was provided by a consortium of ABN Amro, Barclays Capital, Merrill Lynch, UBS and Commerzbank to finance a complete takeover of Volkswagen but Porsche deliberately made a low-ball offer designed to fail. However, it kept open the €10bn credit line to help it finance lifting its stake in VW from 31 per cent to more than 50 per cent.
The short of this story is that Porsche who needed to finance their takeover deal of VW lined up a huge amount of credit. No problem there. Though because the takeover never happened Porsche has not needed a 10 billion euro line of credit. Seeing what Porsche considers an opportunity they are thinking about taking the credit and giving it to other companies at a higher interest rate, but lower than what the market is currently offering. Porsche makes money on the spread, but takes on the risk of the loan.
This has to make you think hard, why on earth is Porsche getting into this business model? Read no further.
Porsche also made large amounts of money from currency hedging earlier this decade and some analysts have suggested that it is behaving more like a hedge fund than a carmaker.
There you have it, the gambling addict in Porsche has been awakened. They made some money with a bet and now think they rule the world.
Yet Porsche is not along in this field, there are more companies as talked about in this article.
Under mounting pressure from surging commodity prices, makers of the name brand foods that fill the nation’s grocery shelves are fighting back on several fronts, deploying an arsenal that includes jacking up prices, shutting down factories, and shedding less profitable brands.
But one of the most effective weapons used to defend their bottom line — and one they rarely discuss in public — involves placing big bets in the grains market, a strategy known as hedging.
Ah yes the company hedges the costs, but the reality is that there is no such thing as a free lunch. Hedges are simply pushing money and risk from one corner to another. Sure a hedge might contain a cost, but a hedge has a premium and that will take away from your bottom line.
Companies “hedge” because they feel like they can earn money.
General Mills chalked up $151 million in gains from hedges in the volatile agricultural and energy markets during its quarter ended Feb. 24. This added 27 cents a share to the earnings of the Minneapolis maker of Cheerios, Nature Valley snack bars, and Yoplait yogurt.
Companies hedge see the easy money, and they think that they are protected.
“I can tell you that we use sophisticated and flexible hedging strategies to protect our self against volatile commodity conditions…no strategies are executed solely on a directional view of the market,” Sara Lee spokesman Mike Cummins said in an email.
In a book I was reading called Traders Guns, and Money the author talked about hedging, and how hedging ended up costing the companies their existence (Asian crisis?) (pg 90)
You can’t hedge without knowing what is going to happen to the oil price. Is it going up, or down? How volatile is it going to be? Wasn’t hedging meant to reduce risk? Why do I need to know what is going to happen in the price? Aren’t I hedging to eliminate the need to know what is going to happen to the price? Financial people at companies, accountants or the equivalents, are comfortable with known knowns. Hedging is about known unknowns - or is it unknown unknowns. It is a risky business - a true lie.
Any hedging decision is surreal: options can be eliminated from the menu; paying premiums to buy options is wasteful; selling options is gambling. You do nothing or buy forward. Doing nothing has advantages: in corporate life actions of commission are punished more harshly than acts of omission. Buying forward is probably best because you buy certainty and it doesn’t cost you anything. Right? Wrong!
…
Does the forward guarantee certainty? The airlines cost of oil is fixed, but its problems are not over. Assume the airline hedges buts its competitors don’t. If the oil price falls then our airline’s cost of oil is fixed, but competitors benefit from lower oil prices.
What the author is talking about is that hedging and the perceived benefits is a lie. To hedge you need to know what the price of commodity is going to go. If you do a straddle then you are saying the price is going way up or way down. What if the price does nothing? Does the hedge premium not end up costing you money? As the author says a hedge is a risky business and a true lie.
I am very concerned that companies like Porsche and General Mills are looking at these techniques as a way to add to the bottom line. Because there will be a day when these techniques will take away from the bottom line.
Hello There Mr Roboto!
(the song and era says it all... http://www.devspace.com)
7 Comments Add your ownSubscribe
1. Phillip Barnhill | March 25th, 2008 at 6:03 pm
Christian…I’m sure you’re a great guy.
Put your glasses back on…it will likely improve your vision.
2. Christian Gross | March 25th, 2008 at 6:16 pm
First I have no idea what you mean by that comment. But if you are implying that I am not seeing things correctly then I beg to differ.
Let’s explore Porsche. Porsche has no business going into the lending business because they see a “market opportunity.” That line of credit was intended for a takeover not lending.
Next lets look at the “hedging” of companies. Hedging by its very nature is a contradiction in terms because there is always a cost. And a company that makes money by hedging is a company that has me concerned that they might not be seeing things as they should. Namely the company is not focused on what it should be.
Let’s compare that to GE. GE went from building things, to do services to doing financial services. I have no problem with GE because GE did it right. They said that financial services would be something that they would go into and they would focus on that. Nothing wrong with that… That’s not Porsche, nor General Mills, nor any of the other pseudo hedgers…
3. Doug | March 26th, 2008 at 11:41 am
Christian,
I beg to differ - hedging *often* has a cost, this is true, but the point of a hedge is that you wind up with the same amount of money (after the premium is deducted).
I.e. if it costs $1000 to insure (hedge) $1000000 in CAD, you will have $9999000 no matter what happens (assuming your counterparty doesn’t default).
So hedging (as opposed to speculating, which is what one is doing by using straddles, strangles, bear puts and the like) does in fact, work. It is true that sometimes the unhedged position would have been profitable (i.e you hedge against a loss in the dollar, but the dollar actually rises - you gain on the dollar and lose an equal amount on the hedge).
It is also true that there are imperfect hedges, which sometimes blow up. But hedging is designed to eliminate one factor, so you can focus on what is important - your business.
Most companies use hedging strategies for currency exposure, because they receive and make payments in different currencies. Having a fixed exchange rate is important for things like transfer pricing and the abiltiy to measure profitability of a unit. It is important to be able to ensure consistent presentation so you can look at the units performance.
Most companies do not want to speculate on currencies, so they hedge some or all of their currency exposure, which is perfectly legitimate.
4. Christian Gross | March 26th, 2008 at 12:46 pm
Let’s do the numbers. Right now CAD to USD Sept FX options are tradiing at (assuming 0.98 strike) CALL 0.0374, and PUT 0.0288.
Assuming your 1,000,000 million example to remain perfectly hedged you would be paying 67,551. In your example of a 1,000 I would have said, “hey lets hedge baby.”
Assuming these prices what it means is that in six months (September option) you need a price movement of around 6% to break even. Take a look at the historical prices of the Canadian and USD and try to find a six month period where there was more movement than 6%.
Lets set up a straddle for oil (strike 105) and assuming a September expiration. The put is priced at 10, and the call is priced at 5.17. This means to be in the money you are going to need a price movement in the next five months greater than 15%.
My point is that hedging can work, but only if you REALLY know what you are doing. Hedging is not free money and these days I find hedges extremely expensive and not worth the money.
Getting away from a hedge, you have to take on a direction and what you are then doing is taking on risk in different ways.
Ok let’s say that you hedge and you have the money you want minus 67,000. If prices do nothing then you are as the Trader Guns, etc author said at a disadvantage to somebody who did not hedge.
So how do you make hedges profitable? You need to be darn good in pricing, and this is where I get very very concerned. Will Porsche and General Mills hire those types of people and build up that type of department? And if they do how much is that going to cost?
Let’s add up the bottom line, shall we. First we need to make the hedge pay, which is pretty tough, and then we need to pay a department who’s job is to make the hedge pay. A double whammy.
Are you now telling me that it is ok for companies to do this? Are you not concerned that they are wasting money?
5. Doug | March 27th, 2008 at 3:13 am
Christian,
I see your point - buying insurance is expensive and it is especially expensive at moments of great volatility (like now), because the risk that is being layed off is relatively larger than at periods of tranquillity. Furthermore, that Porsche may not have experts in estimating that risk and so may overpay for it.
But where I don’t agree with you is in your argument about how much you have to gain to “break even”. Breaking even as you mean it (recovering the cost of the insurance with the investment gains) is not the point of a hedge.
The point of hedging is to ensure that you wind up with $932,449 regardless of what happens, not to wind up with the $1000000. Sure, we’d rather have $1 million, but we want to avoid the possibility that we could also end up with $750,000 - this is the risk against which we are insuring.
The purpose is to OFFSET losses or gains sustained in the underlying investment, not to recover the insurance premium. Doing this requires imperfect hedging which could leave us with significantly less than $932,449.
This is the same idea as being “fully insured” on a house (or any other asset). If one’s house costs 100000 and you insure for full value, you get 100000 cash if your house burns down.
Either way, the insured has 100000, (house or cash) less the premium (which is paid regardless of the outcome).
The hedge (insurance) might have been necessary or not. You are absolutely right - often, we would have had more money had we not hedged. But the question is, is this a risk we want to take?
On the cost side, Porsche is probably using forwards and not futures, so they are probably getting the insurance for free. Its essentially a direct swap with someone who wants to hedge their Euro exposure.
6. Doug | March 29th, 2008 at 1:32 am
One more comment to the original post - the quote about fuel price hedging in the airline industry is correct. If you are in a commodity business where being the low cost producer is essential, hedging specific costs may be a really bad strategy, particularly if your competitors do not hedge this risk. (It may also turn out brilliantly, as it did for Southwest a few years back).
Often, in such cases, if you have a cost advantage in some other area, it is best to match competitors (and not hedge) so as to ensure that you cannot be caught at a disadvantage should your hedged price be higher than the market price.
But neither Porsche nor General Mills is competing in a commodity business. Both sell products with immense brand value and are successful differentiators, thus hedging allows them to focus on what builds value in their businesses, their products and their marketing efforts and allows them to ignore big moves in currencies.
7. 7 card stud online gambli&hellip | April 7th, 2008 at 12:32 am
7 card stud online gambling…
monotonously disturbing figures recognized?allusion Weinberg …
Leave a Comment
Some HTML allowed:
<a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <code> <em> <i> <strike> <strong>
Trackback this post | Subscribe to the comments via RSS Feed