Argentina or how to adjust for Nationalization risk (Cresud edition)
And now to something completely different…
The story of the seizure of YPF, the Argentinian subsidiary of Repsol was on the news everywhere.
Accounting “Uber-guru” Aswath Damodaran had a great piece up yesterday about how to reflect Sovereign risk. He openly admits, not to have though too much about this issue before.
He brings up several possibilities to reflect this risk in intrinsic valuation, which are:
Option 1- Use a “higher required return or discount rate”:
Option 2: Reduce your “expected cash flows for risk of nationalization:
Option 3: Deal with the nationalization risk separately from your valuation: Since it is so difficult to adjust discount rates and cash flows for nationalization risk (or any other discrete risk), here is my preferred option.
Step 1: Value the company using conventional discounted cash flow models, with no increment in the discount rate or haircutting of the cash flows. The value that you get from the model will be your “going concern” value.
Step 2: Bring in the concerns you have about nationalization into two numbers: a probability that the firm will be nationalized and the proceeds that you will get if you are nationalized.
Value of operating assets = Value of assets from DCF (1 – Probability of nationalization) + Value of assets if nationalized (Probability of nationalization)
Intuitively I would also prefer option 3).
So let’s look at a real world example: Cresud
Cresud is an Argentinian company which according to Bloomberg
purchases and leases farms in Argentina’s Pampas region, and produces agricultural products. The Company cultivates grains including wheat, corn, soybeans, and sunflowers, raises beef and dairy cattle, and produces milk.
As one of the few “pure” agricultural plays and has traded ADRs, Cresud is a favourite of some very well known value investors like Fairfax and Monish Pabrai.
Now we can see what Damodoran described in “real world action”:
One US ADR reperesents 10 Argentinian shares.
As of yesterday, the US ADRs were traded at 10.90 USD, which would be 1.09 USD per share. The Argentinian shares were traded at 6 Argentinian Pesos which translate at the current rate of 4.40 ARS/USD into a price of 1.36 USD per share. A discount of around -25% for the foreign shares compared to the local shares.
If we look at the historical spread graph, we see that with the exception of the panic in 2008, the ADRs tracked the stock pretty well, so the current divergence definitley reflects Nationalization risk.
I have no idea if Cresud is in danger of being nationalised and if it is an interesting “special situation”, but it is still interesting to see how this one will turn out.