David French | 27/10/2009 11:54:46 AM

This article was first published in The Morning Bulletin under the heading 'Valuations' on the 23 of September 2009.

Since the low point in March, the All Ordinaries Index has rallied by 53 per cent. Many are surprised by this rally, but there are in fact good reasons for it. Many commentators claim that the market’s earlier falls were the result of an overemphasis on debt finance. That is a simplification - the debt issue has two components.

First, debt is generally cheaper than equity. Companies get a tax deduction for interest, and there is a much lower risk premium expected by banks - because they have first call on the assets being lent against. The relatively low cost of debt, can lead to an overemphasis on its use, as companies attempt to reduce financing costs. Such problems are exacerbated too much emphasis is placed on performance measures like “return on equity” – which are enhanced by the use of additional debt.

Second, lenders generally put in place covenants that help to protect their interests. Accounting changes put in place over the past few years meant that assets had to be valued based on market valuation. But market valuation is not only related to the prices of traded assets. Technical valuations, using the capital asset pricing model, are classed as market valuations too and these are very sensitive to market volatility – the higher the volatility, the lower the valuation. Lower valuations get banks scared.

The point is that the overuse of “return on equity” as a performance yardstick, and the slavish belief that markets at all times value things appropriately, caused overuse of debt and declining asset values, at a time when the economy could least withstand it.

So much for the history lesson. If these valuation measures caused grief on the downside, they also create opportunities on the upside. As markets recover, companies raise equity and repay debt. This reduces return on equity, but at the same time reduces reliance on debt. In itself, that lends stability and increases valuations.

Examples of this are already apparent. In three months, one stock we research has gone from reporting a valuation of -12 cents a unit to +15 cents a unit, even though absolutely nothing has happened with the underlying assets. This sort of thing will continue over the next couple of years, and will especially benefit banks, infrastructure stocks, and property stocks. Some of these have already started to move.

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