Coping with Financial Uncertainty

AVT Faculty member Professor Giampiero Favato shares his expertise on the trade-off between certainty and uncertainty, drawing on more than two decades in corporate finance and a decade of research on valuation under uncertainty.

Professor Giampiero Favato

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Transcript

SPEAKER_02 0:07

All financial decisions have always been impacted by uncertainty and they will always be. In the very essence, a financial decision, a financial investment, it's a simple trade-off between certainty and uncertainty. Nobody can predict the future, but here we are facing really a perfect storm. We have an unprecedented volume of stresses that are impacting the global economic system.

SPEAKER_01 0:41

Hi there and welcome back to Voices of a Business School, hosted by AVT Business School. In today's episode, we're extremely pleased to welcome Shiampiero Favato. Shiampiero started his career by working his way up through the corporate finance, economics, and business development divisions. And with more than 20 years of experience in the corporate sector, he moved his expertise to academia. For over a decade, Xampiero has now dived deep into the factor of valuation under uncertainty and how one copes with financial uncertainty. Together with AVT's own Jesper Bergman, Shampiero touched base with the basic trade-offs between certainty and uncertainty, how one navigates the stresses in uncertain times. Because one thing is financial risk. That factor is a known unknown. But dealing with uncertainty, one is faced with an unknown unknown. And therefore, to cope, one will have to go that one step further. Companies have to become more transparent, managers have to analyze, obtain information, and predict. Investors have to build expectations and nonetheless project expected outcomes. And that is what today's episode revolves around. So tag along if you're interested in a talk around the issue of financial uncertainty, at least the increase in the level of uncertainty we have been faced with in recent years. Let's dive into it.

SPEAKER_00 2:18

A warm welcome to all listeners uh tapping into the AVT podcasts. Uh today I have the privilege of interviewing one of my favorite professors here at AVT Business Schools. Giampiero Fabato is working out of Kingston University and the business school there, and he's helping us with a topic around accounting and finance in particular. So he's providing a solid understanding of accounting and finance uh principles to our MBA students and corporates that we work with once they engage with us. So it's uh it's a great privilege and welcome, Giampiero. I would just like to start with asking you what's some of the things that's top of your mind as you go through your daily life, so to speak.

SPEAKER_02 3:08

Thank you, Jasper. It's a pleasure to be here, and I'm particularly happy to have the opportunity to talk about uncertainty. As you know, Jasper, I am a sort of a hybrid professor because I spent 20 years of my life working in corporate finance for the pharmaceutical industry, where we were valuing investments on innovation in RD, where actually uncertainty plays a big role because we are talking about investing on something which may or may not become a blockbuster drug in 10, 12 years. Then when I moved to academia, this kind of problem stuck. And I've been uh I've been researching for over a decade about uncertainty and the way that we can cope with uncertainty. At the beginning, what I would like to say is that all financial decisions have always been impacted by uncertainty and they will always be. In the very essence, a financial decision, a financial investment, it's a simple trade-off between certainty, which is cash, the capital that you have to invest now, and uncertainty, which are the future cash flow that the investment is going to generate. And in order to make a decision, the investor has to make a sort of an idea, has to have an idea of the expected outcomes. For example, if you make an investment on a new product, you need to build a sort of an expectation of what the demand is going to be for the product in the future. And this is true for everyone. Let me make a few examples. When MBA students join a program, they make that decision based on the expectation of being better prepared, well, essentially earn a better salary over their career. And when investors decide to put money on new products, they do that on the basis of the expected gain. So in order to make evaluation of any investment, you have to make a prediction about what the outcome is going to be. As a tribute to the ADT University in Copenhagen, I want to quote a Danish physicist and winner of the Nobel Prize, Niels Boer. Niels Boer once said that prediction is difficult, especially when it's about the future. And this is true because nobody can predict the future. There is always a component of risk and unknown. The problem is that when this sense of discomfort in projecting expected outcomes becomes really strong, this has an impact. And the increase of level of uncertainty that we have seen in the recent years actually made it very difficult trying to project a possible future for an investment. Of course, I don't want to be boring, but I have to be because I'm an academic. I need to define uncertainty. Because when you read about uncertainty on the newspaper, on the magazine, and also my some esteemed colleagues, sometimes the lay definition of uncertainty combines two kinds of unknowns that in uh in finance we tend to keep very separate. One is risk, but the risk is a known unknown. We know that they could go wrong. The problem with uncertainty is that it is an unknown unknown. All the possible things that can go wrong, but that you don't know about. The difference between risk and uncertainty is the same as fear and anxiety. You are afraid of spiders, you are afraid of dark, so you know what you're afraid about. But anxiety is a more generalized sensation that makes you uncomfortable, but you don't really know what's the source of anxiety. This is what we call uncertainty. And it's very important to make this distinction because risk, opposite to anxiety, can be modeled with probabilities and up to a certain extent can be hedged. So it makes a forward-looking decision very difficult.

SPEAKER_00 7:24

Other than more factors, both the known unknowns and the unknown unknowns, is it the shared number of factors that are in both categories basically changing the decisions or the uncertainty about the decisions? Uh how how do you view it?

SPEAKER_02 7:43

Well, Jasper, the problem that we are dealing with uncertainty, the unknown unknowns right now is a sheer volume and the intensity and the global impact of those. I don't want to quote a movie, but here we are facing really a perfect storm. We have an unprecedented volume of stresses that are impacting the global economic system. First of all, to the environment. Over the past couple of years, we had infection diseases, a virus, COVID-19. We have an unprecedented political crisis. We are talking again about the potential use of nuclear weapons. It looks like to watch a movie with JFK and the Cuban crisis. But the other point is not very commonly addressed, but is extremely important, is that when you look at the literature, the empirical analysis of uncertainty says that uncertainty hits particularly hard economies that are they were already in recession. And of course, all those sources of uncertainty have an impact on the way that the economy reacts and the damage for the economy.

SPEAKER_00 9:01

But I think evaluations go down on businesses, etc. You know, many companies argue, you know, that that's why you need to step up. That's that's where you need to basically invest, uh, both in terms of uh them giving a you know a cheaper price for another company or you know, the best time rather than trying to invest on the high side. But do you see that happening in this day and age as as we as we speak? Or because I think you know the the numbers that I've seen, at least in terms of uh MAs and so forth, uh are not are not very high at the moment.

SPEAKER_02 9:34

You're absolutely right. But not just uh the merger and acquisition, also the capital funding for startups or uh early stage companies is going dramatically down, which signals a couple of things. The reason why I started talking about this uh this confusion in predicting the future has a direct impact on the investment of the company. It looks like the corporation are privileging short-term investment, but they are reluctant to commit to long-term investment because the information that they have about the future does not allow to be confident as they used to. In order to do that, also private investors want to be compensated for this incremental uncertainty with higher rates of return that are very difficult to meet. I have seen the biotechnology sector in every crisis, the sort of safe haven for investors where pharmaceutical industry and biotechnology. The number of small biotechs that they're declaring bankruptcy because they they can no longer get funds from the market has never been so high. So the long-term expectation of these returns is uh is somehow uh reducing the investment, especially in innovation. But this is uh has a number of negative consequences because if you shy away from long-term investment, it means that your firm level and aggregate productivity is going down, which is something that all the macroeconomic indicators are telling us. And there are another couple of things. For small companies, the financial turmoil is increasing the cost of money, so it's more expensive for smaller firms to access cheap financing, bank financing. On the other hand, there is a higher volatility of the stock market. As a result, it's kind of funny because apparently the response of companies to this uncertainty is to increase the level of cash, but increase of a factor of 10.

SPEAKER_03 11:48

Right.

SPEAKER_02 11:49

Jasper, in the old times, when I was uh managing this kind of stuff, we were urged to keep in the safe as little money as possible in cash. Now cash is becoming the sort of a risk-free resource the company can use if something goes wrong.

SPEAKER_00 12:08

I I guess that's back to you know the financial crisis, kind of you know, the absolutely yeah, but the advantage basically to invest whether it's uncertainty or whether we are the break of really there is uh there is uh there is a positive coin in this uncertainty.

SPEAKER_02 12:24

As important as the negative, pressures that are more clear towards a different future may have forced corporation to accelerate the obsolescence of their product and as a consequence their funding of an NDE because there is no other alternative.

SPEAKER_00 12:46

All right. I was just wondering what your take upon cryptocurrencies actually are in the financial market. Whatever your take is.

SPEAKER_02 13:03

I will report uh the fact that I really agree with the opinion of the governor of the Bank of England, Draghi, which was the former president of the European Bank, cryptocurrency is an unregulated alternative to investment. As such, it's a pure bet with no underlying value. The only reason why the price goes up or down is related to the market demand. If people are buying or are selling. Now, said that, we are at the level of price in the stock market where even if you buy shares, more or less is the same. Because if you are asking me to actually do a free cash flow valuation of Apple, I have to build assumptions that to define them unrealistic, it's really an understate. The only thing that I'm saying is the keyword is unregulated. We have already enough problem with the regulated financial investment that I'm not sure you want to deal with unregulated. Said that, my personal advice is if you want to play with that, play with little money because there are very good chances that you're gonna make short-term profit and extremely good chances that you're gonna make long-term losses, like everybody that I've seen investing in that.

SPEAKER_00 14:33

Okay. Um, another question.

SPEAKER_02 14:35

It's a uh Jasper, it's a casino. It's a casino. You go and bet. If you want to bet 500 pounds, uh, a thousand pounds, nothing to you, every little bit of fun is not a problem. Uh, I wouldn't bet my pension fund. That's what that's what I mean.

SPEAKER_00 14:51

Well, in terms of balance and also looking at accounting and finance, uh, you know, you you we've seen ESG factors come into play as well. So I was just wondering, environmental and social certainly different from what the uh accounting and finance department used to report on, at least. Um any any issues in that regard, or do you see firms really picking up on uh reporting uh on these factors as well?

SPEAKER_02 15:16

Yes, uh there is uh tons of metrics every investment fund is trying to look at and complexity of reporting about environmental factors. The problem is that there is a substantial difference between what you see in the markets, like if I wanted to make a sure bet, I was gonna buy last year shares of oil companies because I knew that with this price discrimination, I was gonna make a significant profit. So this behavior of the market doesn't seem to go along environmental responsibility. In reality, there will be uh sooner or later a much stronger movement, but in order to do that, the real movers of the money they have to find a sort of a common ground. What are the new rules of engagement in investing in companies? And companies they have to be much more transparent. Let me give you an example that I just saw. Mercedes, which is the financial owner of Mercedes Benz, changed a sort of a devolving debt financing of significant 11 or 13 billion euro into this kind of sustainable loans. Those sustainable loans are structured in a way that are linked to the environmental performance of the company. The better the company performs, the lower is the interest rate. And the reason is as an investor, I get the benefit of the environmental improvement and some money back. So, in this way, is the first time where I see with this kind of new instruments a sort of a convergence of uh of interest between companies and investors. This is where we need to go in order to make this happen. The other point that is going to connect vertically is going to be taxation. If those metrics are going to be strong enough to allow the countries to tax differently the good and the bad from an environmental standpoint, at that point we we have a structure. I don't think that we are very far from there. I uh there is a very strong movement. But in my class at AVT, we talk about the uncertainty, we lay down the foundations of how do you want to navigate. There is a way to deal with the uncertainty. Well, first of all, it's impossible to remove all economic uncertainty. Like it's impossible to remove risk because if you make an investment that has no risk and no uncertainty, it has no return. You need the risk and uncertainty. What in financial terms this spike of uncertainty actually meant is that this is the death of the MPV as a measure of investing. But the problem of the net present value is that you make an investment, then you project a series of cash flow that are set in stone. Even if they are probabilized, it doesn't matter. You discount everything back, and if the discount cash flow are higher than the investment, you go ahead. There is an instrument that I pioneered and we look at in our class, which are the real options. They tell you essentially to look at an investment, if possible, in a different way, to make an initial investment, but before you put more into that, you need to have the possibility to wait to have more information. And if the information that you have are negative, you need to abandon the project. It gives you the flexibility to get in and out of projects without losing the full mount, the entire investment. It makes, if you want me to be a little bit more elegant, it makes the investment a little bit less irreversible.

SPEAKER_00 19:46

I guess with the also new adventures for businesses. I mean, new new innovation or business models changes or whatever they they they might come up with, you know, evaluating it than looking at the cash flow. You know, that that's also where firms struggle, as I absolutely. Yeah, yeah, yeah.

SPEAKER_02 20:02

Absolutely. Absolutely. This is why you need to include as many information as possible because in our class we use an artificial intelligence uh built uh spreadsheet where we get the information from the accounts, we build the future cash flows according to the information that we have. Then the spreadsheet creates uh very different scenarios. One which is the one that we believe is the most realistic, but the most important one are the two opposite, the best and the worst. And by stretching those as much as we can, what you do, you it forces you to look at the extreme, and then we derive a sort of an average, a possible value. Then you compare to the MPV. If it's the same or even better, it gives you a little bit of confidence that the uncertainty can help you. But if it's much less positive than your base case scenario, then you need to stop and you need to realize that uncertainty could actually play a major role in the investment, and you have to rethink about what you're doing. So the the best thing that we can do, because the MPV is deterministic, you need to stretch it, to see what's the possible extension, and then you need to see what uncertainty could do to it. Eventually, there is no artificial intelligence. But this is the way it's a kind of a slow food approach to investment. You have to take into consideration everything, you need to savor all the ingredients, and at the end, you make the decision. This is what we do, and uh, and and this is what now uh also the corporation do. Do I am working on a project because can you believe how big is this problem of when we talk about uh mega projects like public investment? I'm not sure about the travel demand, I'm not sure what a plane is gonna look like over 10 years. So, how am I gonna do that? And one way to look at that is twofold. First of all, to try and build the investment uh stepwise so you can abandon it, but that's not enough. If you decide to abandon, you need to have an alternative use of what you have done because we cannot leave uh tons of cement. That's true. And and and this is the way that um institutions making large investment are trying to navigate the transition.

SPEAKER_00 22:48

Oh brilliant. I know you pioneered the the model for quite some time here at uh ABT and um uh glad to hear that some firms are actually trying to adapt it uh as well. I think there's still a lot of uh firms out there really looking at when does this break even the cash flow uh when is the MPV higher than zero?

SPEAKER_02 23:08

Like it doesn't mean anything anymore. Anything.

SPEAKER_00 23:10

So let's hope more people will dive into this issue around uncertainty, the increased uncertainty, at least uh it seems, and and how to navigate it and learn from uh Giampiero Favato. It was uh it was uh it was uh a pleasure talking to you here today, Giampiero, and we are looking forward to seeing you with a pleasure soon soon again.

SPEAKER_02 23:35

Uh absolutely, absolutely.

SPEAKER_00 23:38

So take care and thank you very much.

SPEAKER_02 23:41

You too, thank you for having me.