Thursday, October 28, 2010

America's New Risk: Regulatory Risk

With the elections only a few days away, it seems to me that the US political system has reached an important crossroads. The question that many people are currently asking themselves is: what will happen if the Republicans take a number of seats in the House and Senate? Will the logjam in Washington D.C. just get worse?

The following piece examines the uncertainty surrounding future regulations that would only be exacerbated if we end up with with a Congress that refuses to be on the same page as the President. As always, my point of view is that of an investor. As such, my concern is that many companies currently have no way to plan for potential new regulations and as a consequence, investors have little ability to price in the changes that may be coming. My thesis is that this nebulous future many companies are facing is only holding back the economic recovery because investment and hiring decisions are being postponed. In highlighting three industries that I feel are uniquely susceptible to being hit by further regulations, I hope to illustrate that point. Let me know what you think.

(Disclaimer: The opinions expressed in this article are my own and do not necessarily reflect those of West Coast Asset Management or any employees of the firm.)

America’s New Risk: Regulatory Risk

When assessing the stocks of companies domiciled in emerging markets, the risk that the home government will take monetary, fiscal, legal or even military actions that undermine the value of the equity market is usually called country or regime risk. This concept comes with the implication that investors should demand a higher rate of return to compensate them for the risk that the government will do something capricious, misguided, or even unethical. For example, if you run an oil company with assets in Venezuela you are concerned about regime risk because the government might nationalize your assets. Or, if you are investing in the nascent equity market in a war-torn African country, you should price in the risk that war breaks out once again or that there is some sort of coup. The point is that investors and companies who are familiar with regime risk can act appropriately by making sure the potential returns are worth all of the uncertainty.

Fortunately, over the last number of decades, investors who focus on the US have not needed to price in any regime risk. The US hasn’t experienced a Civil War since the 1860s. Aside from the impact of going off the gold standard during the Nixon administration and intentionally devaluing the dollar versus gold in the 1930s, the US has never defaulted on its debt obligations. Furthermore, what has made the US the safest country to invest in over the last 60 years is the strict adherence to the rule of law. When all of this is combined with the economic stability that the US has enjoyed, many investors have rightfully not felt the need to demand a premium return for country risk. In most people’s minds, such considerations only applied to “frontier” or “emerging” markets.

Unfortunately, a new risk is emerging in the US that investors should take note of. It is my position that it is not as severe as country risk or regime risk. However, I do believe that there is more potential for what is known as regulatory risk to affect equity markets than in recent history. For a simple definition of regulatory risk, we turn to Investopedia.com1:

“The risk that a change in laws and regulations will materially impact a security, business, sector or market. A change in laws or regulations made by the government or a regulatory body can increase the costs of operating a business, reduce the attractiveness of investment and/or change the competitive landscape.”

Could it be that this risk has become a real threat to companies and investors in the US? Sadly, I believe it has. Let’s look at three very distinct industries to illustrate the uncertainty caused by increased regulatory risk: (Examples of potentially affected companies are included in the adjacent parenthesis)

  1. Retail Pharmacies (CVS, WAG, RAD): Just about no one questions the need to reduce health care costs and expenditures in the US. With an aging population, health care spending will represent a larger and larger percentage of US GDP and this increase threatens to put states and the US government in very difficult fiscal positions due to their responsibilities to Medicaid and Medicare patients. Unfortunately for retail pharmacies, they have been caught in the crossfire even though they do not appear to be part of the cost inflation problem. Specifically, pharmacies are reimbursed based on their cost of acquiring drugs. They are paid a slight premium to their cost along with a flat fee for dispensing the drugs. However, reimbursement rates are under pressure as many states are now unable to cope with prescription drugs needs of Medicaid patients.

As such, there is a battle looming over reimbursement rates that unfortunately could lead the pharmacies to stop filling prescriptions for Medicaid patients. This is exactly what happened in Washington state in January of this year when rates were reduced to a level that no longer covered Walgreen’s cost. Not only is the uncertainty regarding reimbursement bad for patients, but it is also a problem for pharmacies in that the ambiguity makes hiring and expansion decisions very difficult. This is on top of the fact that a change in reimbursement rates could decimate the already low operating margins for these companies and likely cause a further drop in their stock prices.

Finally, an important question for these companies has to do with which party has the power to influence and pass legislation in Congress. If the Republicans gain enough seats in the House and Senate to repeal the Obamacare initiative, then 32 million people who were going to have access to prescription drug coverage will no longer have that luxury. No matter what your beliefs are about the merits of the health care reform bill, the potential for it to be reversed makes pharmacies unable to forecast demand or execute their expansion policies. Cleary, this is not a recipe for job creation in the industry.

  1. Oil and gas-related companies (XOM, APC, DO): The damage done by the BP oil spill has clearly affected the environment and the local economy of the Gulf of Mexico region. What is also noteworthy is the impact it has had on the offshore drilling (especially deepwater) and oil and gas exploration industry. As a result of the government’s response to the spill, the companies that operate in this space have no idea how to budget for the coming year. Probably the most important question is: are there going to be moratoriums on offshore drilling? To that question I recently came across a comparison to the airline industry that I thought was interesting. The idea is that enacting a moratorium on offshore drilling is like grounding all the airline flights in the US because one plane crashed. Said another way, while the images of the oil spill were horrifying, a moratorium looks like an attempt to indiscriminately punish an entire industry for one company’s apparent negligence.

Additionally, what happens if the Republicans win the House or the Senate in the November elections? Could they find a way to eliminate the potential for a prolonged moratorium? Would a windfall tax on oil profits be off the table? As you can see, the uncertainty makes it impossible for companies to know how much to invest, what to do with idle equipment, or how to make hiring decisions. Unfortunately, in an environment in which the US economy desperately needs businesses to start investing and hiring once again, this regulatory risk could serve to postpone a legitimate recovery.

  1. Financial institutions (GS, JPM, BAC): The financial regulation bill that just passed was widely seen as a victory for the major commercial and investment banks as the most draconian proposed measures were not included into the final bill. However, what must not be forgotten is the fact that much of the rules of the industry are going to be set by (unelected) regulators in the coming years. Specifically, the bill left an incredible amount of discretion in the hands of the FDIC, the consumer protection agency and the Federal Reserve. In fact, law firm Davis Polk counted 243 rulemaking decision and 67 studies that the bill authorizes regulators to be involved in2. I will spare you most of the details of what actually is left to be decided, but how to approach the threat created by derivatives, appropriate capital levels, and exactly how to handle the risks of too big to fail institutions will be figured out over the next few years. In other words what we got was a framework for a financial regulation bill (with many exclusions and exemptions embedded in it) without a whole lot of additional certainty as to the eventual details.

Financial institutions can adjust to bad news. They can shut down operations, sell assets, and fire people if necessary. What they cannot plan for in prolonged uncertainty. So, if you are wondering why banks are not lending to consumers and businesses, you can be sure that their inability to predict what the eventual legislation will entail has caused them to be very cautious. Unfortunately, there will be no sustainable recovery until the banks re-start the credit intermediation process. Making the situation even worse, in addition to the impediments listed above, there is also the risk that whoever controls Congress or White House will try to influence the regulators to make decisions that are favorable to their constituents. The fact that the rules could change dramatically depending on who voters favor at any given moment means that financial institutions will have to continuously adjust their operations in order to comply with the shifting regulations. Given the lack of stability in the financial sector over the last few years, increasing regulatory risk just makes it harder for companies to figure out what their “new normal” reality will be.

These are just a few examples among many. Credit rating agencies, for profit education firms and utilities trying to figure out if Cap and Trade is a reality, all are facing similarly uncertain circumstances. It should be noted that I am not arguing the regulation is not necessary. In fact, I believe that many industries were long overdue for legislation aimed at protecting customers, investors and taxpayers. My point is that the gridlock in Congress and the number of companies that could see their industries undergo dramatic changes have created ambiguity that no company can properly plan for. While this is not the first time in US history companies have had to be prepared for major shifts in regulation, I feel as though the number of sectors and companies that could be impacted is larger than it has been anytime in the recent past.

As an investors, I just want to know what the rules are going to be so I can figure how to play the game. I am not used to and do not liking discounting the value of the companies I research just because of some lingering regulatory risk. I know that this situation will eventually be resolved and that American will hopefully get back to its prosperous ways. However, I believe that it is imperative that regulators decisively set policies and the let the private sector get back to focusing on reinvigorating the economy through prudent investment and hiring. Excessive government intervention is inefficient and costly, especially when the US is facing strained economic circumstances. I look forward to a time when regulatory risk and regime risk is more prevalent within the usual emerging market suspects, not at home in the US.