Pursuing Lasting Progress in Emerging Markets

On Corporate Hedging

My library contains a classic textbook on corporate finance, retained from school. One of its chapters is dedicated to the practice of hedging risk, and it concludes as follows:

As a [company] manager, you are paid to take risks, but you are not paid to take any risks. Some are simply bad bets and others could jeopardize the success of the firm. In these cases you should look for ways to hedge.1

A casual survey of the subject suggests that most academics are in favor of hedging techniques, even as they disagree over what constitutes best practice. Research papers cite a number of potential benefits, ranging from the mitigation of catastrophic risk, to the reduction of financing costs, to smoothing fluctuations in cash flow, the last of which results in a discernible and positive impact on share prices.2 With benefits such as these, why wouldn’t all companies hedge?

Present circumstances could further promote the case for hedging. As discussed last week, I believe chronic inflation has taken hold in most emerging markets around the world. Imagine you are a manager in Brazil: you are watching loose monetary policies at home and abroad feed inflationary pressures. You face the prospect of persistent price increases on inputs essential to your company’s manufacturing process. Lost competitiveness and lower profits loom. The temptation to hedge such risks away must be overwhelming. After all, it’s not your fault that commodity prices are rising; why not request an investment bank to create a customized derivative that locks in prices for 18 months? Why not smooth out the potential shock to your profits? You know that prices are moving in only one direction—why not even profit from the trend?

This may seem reasonable enough, in theory. The problem is, I don’t buy it in practice. My misgivings arise from experience. I have seen hedging programs bring on several large-scale implosions. To name two: Citic Pacific, a well-connected Chinese conglomerate, lost billions in a foreign exchange contract gone awry; numerous small companies in Korea were knocked flat by their aptly-named “knock-in / knock out” currency derivatives.

Admittedly, those two cases are not average, as they are examples of hedging gone very wrong. However, they are illustrative because they share a common characteristic: management wished to insulate itself from small price fluctuations, but they also wished to be clever, so they simultaneously bet against extreme and seemingly unlikely price movements. Basically, they eliminated one kind of risk, but amplified another in exchange. Their counterparties in these transactions were savvy banks, better-equipped to evaluate the underlying probabilities. Guess who won the bet? Management teams aren’t always taken to the cleaners, but often they are overly concerned with controlling a narrow set of short-term risks, and this can make them susceptible to assuming risks that are harder to evaluate, and potentially damaging.

Companies can hedge prices in myriad ways, but three techniques are most common:

  1. A company can hedge interest rate risks by buying contracts, swaps or related derivatives;
  2. A company can hedge currency risks by borrowing (or lending) in a foreign currency, by purchasing (or selling) foreign currency, or by purchasing forwards, swaps or other derivative contracts that emulate such exposures;
  3. A company can hedge input prices by purchasing commodity futures or forwards, or by stockpiling large quantities of raw materials, such as non-perishable commodities.

All three techniques have useful applications, but I have also seen all three abused. In my experience, the most useful corporate hedging programs keep it simple. They do not attempt to hedge over long-term horizons, but instead focus on hedging over the next quarter or two. Management has an operating plan, and a budget to match; they hedge in order to set their costs within the constraints of that quarter’s budget. By mitigating short-term volatility, they can execute effectively (e.g., order the appropriate quantity of raw material), and complete a productive business cycle. However, beyond that relatively short horizon, they let prices float freely.

They don’t attempt to hedge long-term price fluctuations, no matter how tempting, for a variety of reasons. First, it is expensive—the longer you seek to fix a price, the more the hedge will cost you. Derivatives are not created for free, and the added cost constitutes a permanent drag on profits. Second, long-term hedging tends to incur greater exposure to counterparties, which for these transactions are typically commercial and investment banks. Counterparty risk is nearly imperceptible, and therefore often ignored—that is, until it blows up, as it did in 2008—at which point it is usually too late to avoid losses. I think the most prudent hedging policies recognize that counterparty risks are material, and that they are heightened over longer horizons, and thus should be minimized whenever possible.

The third reason that management teams do not engage in extensive hedging is the most important to me. They understand that in the real world, where markets are constantly changing, flexibility and adaptation are essential to long-term survival. What happens to the Brazilian manager who stockpiles two years of materials in advance? Assuming her bet paid off, because she guessed correctly about future prices (she’ll be fired otherwise), her hedge will insulate the company’s profit margin. Ironically, though, this cushion will probably make her company slow to adapt to the new, higher costs that prevail in the marketplace. She may not adequately prepare for the day when her inventory runs out, or when her derivative contract expires. Instead, she will probably attempt to repeat her prior feat—and the ensuing hedging trades usually become indistinguishable from outright speculation.

In my view, hedging policies do not foster sustainable growth, or create a permanent competitive advantage, and rarely do they contribute to intrinsic value. More often they delay the inevitable, masking the need to change. I agree with Buffet on this point: when a problem exists in a business, the time to act is now.3 A successful hedge may stave off adverse pricing conditions; but if the company fails to adapt its business model in the present, it may experience a dislocation that is more painful and costly in the future. Instead of those management teams that defer difficult adjustments, I prefer to focus on those that meet such challenges head on by adjusting their business models in the present. They do so by adopting more efficient technologies, by switching to substitute inputs, and by driving down operating costs. They construct “natural hedges,” perhaps by borrowing in the same foreign currency in which they have an existing revenue stream. Most importantly, they focus on building a reputation for quality and an effective brand that allows them to raise prices when necessary—like right now, amid persistent inflation. In my view, companies that have the resources and wherewithal to adapt in this fashion—rather than defer change—are more likely to survive over the longest run.

In today’s age, where companies engage in a complex web of global financial transactions, it is unrealistic to expect management teams to avoid hedging altogether. However, I do search for those that follow simple, consistent, and short-term hedging policies—and which build business models strong enough to adapt to the world’s inherent volatility and uncertainty.

Andrew Foster

Seafarer had no economic interest in the securities mentioned in this commentary as of the date of its publication. View the Seafarer Overseas Growth and Income Fund’s Top 10 Holdings. Holdings are subject to change.

The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect the writer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.

  1. Brealy and Myers, Principles of Corporate Finance, 4th Edition, 1991, page 644.
  2. Lin, Pantzalis and Park, “Corporate Hedging Policy and Equity Mispricing,” 2005, page 4.
  3. Buffet, 2005 Chairman’s Letter to the Shareholders of Berkshire Hathaway Inc., page 11.