Japan and Country Risk
While I have written on the subject of sovereign or country risk before, the tragic earthquake in Japan again forces us to revisit the topic.
One source in our analysis is the US State Department website. They write:
“Japan is faced with the ever-present danger of deadly earthquakes and typhoons. Japan is one of the most seismically active locations in the world; minor tremors are felt regularly throughout the islands. While responsibility for caring for disaster victims, including foreigners, rests with the Japanese authorities, one of the first things you should do upon arriving in Japan is to learn about earthquake and disaster preparedness from hotel or local government officials.”
Prior to the disaster, at CT Capital, we had marked-up all Japanese based firms by 35 basis points over Canada, and 10 basis points over the U.S. This mark-up is now 90 basis points over Canada and 65 basis points over the U.S. The additional mark-up reflects the stepped-up exposure to disasters and the current impact on of the disaster on the general economy. There is also some exposure to terrorism in Japan, but not at a level greater than the U.S.
Country Risk-Summary
Companies that are subject to certain jurisdictions may be riskier (political, currency, taxes) for investors than U.S. – based companies. This was acutely reflected during the fiscal crises in Greece during 2010, with almost immediate repercussions throughout Europe, Asia and the United States. The resultant weakness in the euro impacted US entities with operations in Europe or sold into that market with the US dollar based goods. On the other hand, the price of oil dropped since its price is quoted in dollars. During the period the crisis was at its peak, many entities which had planned to enter the debt markets to raise capital were not able to do so.
The conditions under which a company operates and has major facilities or markets will thus influence cash flows, consistency measures and leverage. As we have seen, energy exploration companies have had their operations nationalized, while many companies have been harmed by high inflation outside the United States. If an entity receives a significant portion of its cash flows from a non-US geography, the risk to those cash flows must be assessed, with a mark up to cost of capital, where appropriate. This is especially true for companies operating in emerging markets, where a mark-up to cost of capital is always made, even if the cash flows from those areas are currently strong and without incident.
All possible threats and the entity’s sensitivity to any related factors must be considered, including sanctions, tariffs, threat of retaliation of US Government actions, stability of currency, exchange control, inflation, threat of its neighboring countries, restrictions, etc.
At CT Capital, we evaluate 19 factors in our cost of equity capital model, including, in addition to the above, form of government, natural disasters, energy dependence, corruption and commitment to markets and business.
For additional information, please see “Security Valuation and Risk Analysis”
