Remain Calm—All is Well

Legend holds that Nathan Meyer Rothschild, who got rich speculating on British government bonds after the battle of Waterloo, once said, “Buy when there’s blood in the streets, even if it’s your own.” The image is unsettling, but his larger point––which was not about buying or selling per se––was sound. Rothschild meant to keep your head when others lose theirs. For a capital budgeter, this means remaining coolly focused on shareholder wealth, even when markets go berserk. Brexit offers a case in point.

The United Kingdom (U.K.) made history on Thursday, June 23, 2016 by voting to leave the European Union (E.U.). Britain’s departure from the E.U., dubbed “Brexit” in the press, immediately roiled financial markets. Friday, the pound plunged to a 31-year low against the U.S. dollar. By Monday, the FTSE 100––a widely followed British stock index––was down nearly 6%. Then a miracle occurred; the FTSE rallied. By Wednesday the 29^th, British stocks had more than erased all losses, and the financial press was touting “the Brexit Bounce.” What’s a British capital budgeter to do?

The answer is to look past market volatility to Net Present Value (NPV), calmly analyzing the implications of Brexit for project cash flows and discount rates. For U.K. firms dependent on trade with the other 27 E.U. countries (which collectively take 45% of British exports), Brexit probably means a decline in expected project cash flows. In addition, because Brexit is unprecedented, greater uncertainty attaches to any cash-flow forecast. This means hiking risk-adjusted discount rates. Together, lower expected cash flows and higher discount rates imply fewer positive NPV projects––as appears to have been the case for mergers under consideration. In the 11 weeks following the Brexit vote, the number of deals involving U.K companies fell by one-third (compared with 2015).

For British firms not as dependent on E.U. trade, assessing the impact of Brexit on project NPVs is trickier but starts with the British economy and the British pound. Other things equal, a stronger economy implies larger cash flows on U.K. projects. A weaker pound could also boost cash flows over the longer run by making British goods cheap enough to offset the loss of privileged access to E.U. markets. In the wake of the Brexit vote, some economists began predicting recession, but real growth in the U.K––while far from robust––remained positive, at least through 2017. A full year after Brexit, the pound was still weak against both the Euro and U.S. dollar compared with pre-June 2016 levels. These factors may explain why the FTSE 100 gained 17% the year following the historic vote. Whatever the reason, capital budgeters in and outside Britain would do well to recall the implications of Rothschild’s advice––when markets gyrate, stay focused on cash flows and discount rates.

Suppose you are a CEO and market turmoil from a shock unrelated to your company has your shareholders nervous. Nonetheless, you believe everything will blow over, leaving the company unaffected. What is your responsibility to shareholders?