Capital Costs In Canada

Understanding the costs of capital is important for both valuation and performance measurement purposes, note Justin Pettit, partner and Thomas Kalafatis, financial analyst, both with Stern Stewart & Co. in New York.

Cost of capital, they note, is not a cash cost, but an opportunity cost--one that recognizes investors' expectations for future returns to sufficiently compensate them for a perceived level of risk. In a recent paper they provide some insights into the measurement of systematic risk. The findings:

  • Investors expect a 4.35% return premium in the stock market over Canadian government long bonds, based on average annualized stock return premiums from 1934 to 1997.
  • The risk-free rate proxy is not completely riskless, as long term government bonds have not been totally risk-free when compared to the stock market. Betas over the past 40 years have varied from 0 to 0.25. A 20-year regression of monthly returns indicates 0.25 as the current beta of long term government bonds. Combining the equity risk embedded in the long bond with the equity risk in stocks gives an adjusted market risk premium of 5.8%. They note that for most companies, where their beta is near one, the simple market risk premium of 4.35% should provide a reasonable cost of equity estimate.
  • A Monte Carlo simulation to explore the market risk premium in a dynamic environment found that one-third of all 30-year periods will be outside the range of 3.0%-8.7%.
  • The data suggests that equity risk premiums are in decline, potentially due to structural economic changes.
  • The market risk premium of 5.8% is similar to the authors' findings in the United States, where a 6.8% premium was noted. On a simple unadjusted basis, the U.S. premium was 5%.

While the finding might suggest a lower real cost of equity in Canada, the difference may not be significant.

How Are They Performing?
Money management firms continue to go public, but as the graphs show, their latest stock performance has been lackluster. Canadian companies have underperformed broad industry benchmarks, and have underperformed their U.S. cousins as well.
DC Plans Underperform DB

Defined contribution (DC) pension plans have been underperformers, according to Mike Heale, director, Cost Effectiveness Measurement Inc., in Toronto. This conclusion comes from analysis, using U.S. data, of large corporations who sponsor both DC and defined benefit (DB) plans.

Although DC plans produced higher actual returns than their DB counterparts, this was entirely due to more equity exposure and more concentration in U.S. stocks. When actual returns were compared to a passive benchmark, and costs were netted out, DC plans underperformed.

DC actual returns were calculated by multiplying the gross return of each investment option by its year-end weighted proportion of assets. Policy return is the passive index benchmark. Operating costs include direct investment management costs as well as asset management related governance and administration costs.

It is worth noting that DC operating costs, including record keeping, were very low. Total costs averaged 36bps of plan assets (compared to an average 114bps annual expense charge for domestic equity mutual funds in the U.S.). One reason for the low costs came from the 44% of DC assets in GICs and company stock, which either have very low fees, or costs that can't be measured. Costs rose to 55bps when these assets were not included.

Last year saw corporate defaults rise to a level not seen since the 1991 peak. In total, 48 rated companies defaulted on debt totaling US$10.9 billion, according to Standard and Poor's annual study on corporate defaults. 37 were U.S. companies, seven were Russian, four were Indonesian, two were Canadian, and one was Chinese.

On the flip side, the number of newly rated obligors that received speculative-grade ratings outnumbered those that received investment-grade ratings, continuing a trend begun in 1997.

Sustainable Development vs. Share Price

Over the past decade, many Canadian companies have transformed sustainable development from "concept" to "application". The shareholder benefit of this transformation has been positive, based on the outperformance of a large-cap portfolio of sustainable development companies vs. the TSE 100 since 1995.

Companies become practitioners of sustainable development by minimizing the environmental impact of their activities, while simultaneously bringing value-added to the communities in which they operate from both social and economic perspectives. For example, in addition to minimizing impacts to air, water and land, many companies will commit to a local procurement and employment policy, infrastructure improvement initiative, transferable skills training program, creation of a local trust fund, etc., in an overall effort to ensure that communities realize benefits from local operations.

Corporations are not driven to sustainable development by an overwhelming desire to be altruistic, but rather by their fiduciary responsibility to create shareholder value. In other words, sustainable development is good business. Beyond anecdotal evidence, there is now quantitative research to support this position. A portfolio of companies that were practitioners of sustainable development was created (see chart). The average annual compounded return of the portfolio outperformed the TSE 100 by approximately 6.9% over 3.7 years. Relative to other portfolios that might be considered in the same "family" as the sustainable development port folio, returns of the Desjardins Environment Fund and the Ethical Growth Fund effectively mirrored the TSE 100.

The superior share price performance of these companies probably extends beyond simple cause-and-effect factors (i.e. a mining company branded as a "good corporate citizen" will increasingly be welcomed into communities when seeking licensing for new operations). By definition, companies that are committed to sustainable development think long-term, which would presumably extend to such key areas as production line efficiency, employee compensation, new market opportunities and financing options.

Brian Schofield and Blair Feltmate are partners, Sustainable Investment Group, in Toronto.

Getting Active

"When institutional investors don't vote, or vote without paying close attention to the implications of their vote for the ultimate value of their holdings, they are hurting not only themselves but beneficiaries of the funds they hold in trust. Therefore, it seems to me to be a self-evident proposition, that institutional investors have to be activist corporate citizens...Even if you wanted to run away from a poorly managed company, you couldn't all do it at once--it would too greatly affect the price of the stock. So, like it or not, it seems to me that, as a practical business matter, institutional investors are going to have to become more and more active shareholder-owners, and less and less passive investors...good corporate citizens, not only analyzing and voting on the issues but, where necessary, taking the initiative to put items of vital interest to them on the corporate ballot."

Robert Monks, founder of Institutional Shareholder Services, and self-proclaimed shareholder activist.

Transcontinental Media G.P.