Go Where It Is Darkest: When Company, Country, Currency And Commodity Risk Collide! by Aswath Damodaran, Musing on Markets

You learn valuation (and find out how much you don’t know) by valuing businesses and companies, not by talking, reading or ruminating about doing valuation. That said, it is natural to want to value companies with profit-making histories and a well-established business models in mature markets. You will have an easier time building valuation models and you will arrive at more precise estimates of value, but not only will you learn little about valuation in the process, it is also unlikely that you will find immense bargains, because the same qualities that made this company easy to value for you also make it easier to value for others, and more importantly, easier to price.

I believe that your biggest payoff is in valuing companies where there is uncertainty about the future, because that is where people are most likely to abandon valuation first principles and go with the herd. So, if you are a long-term investor interested in finding bargains, my advice to you is to go where it is darkest, where micro and macro uncertainty swirl around every input and where every estimate seems like a stab in the dark. I will not claim that this is easy or comes naturally to anyone, but I have a few coping mechanisms that work for me, which I describe in this paper.

While I enjoy valuing companies with uncertain futures, there are cases where my serenity about valuation is disturbed by the coming together of multiple uncertainties, piling on and feeding of each other to create a maelstrom. In this post, I want to focus on two companies, one Brazilian (Vale) and one Russian (Lukoil), where bad corporate governance, a spike in country risk, currency weakness and plunging commodity prices have conspired to devastating effect on their stock prices. You could adopt the very dangerous contrarian strategy that Vale and Lukoil must be cheap simply because they have dropped so far, but I don’t have the stomach for that. I do believe, though, that if I can find ways to grapple with this risk, there may be opportunity in the devastation.

Background, history and market standing

Vale is one of the largest mining companies in the world, with its largest holdings in iron ore, incorporated and headquartered in Brazil. Vale was founded in 1942 and was entirely owned by the Brazilian government until 1997, when it was privatized. In the last decade, as Brazilian country risk receded, Vale expanded its reach both in terms of reserves and markets well beyond Brazil, and its market capitalization and operating numbers (revenues, operating income) reflected that expansion.


Notwithstanding this long-term trend line of growth, the last year has been an especially difficult period for Vale, as iron ore prices have dropped and Brazilian country risk has increased (leading into a presidential election that was concluded in October 2014). The graph shows Vale’s stock price over the last 6 months (and contrasts it with another mining giant, BHP Billiton).


While declining commodity prices have affected both companies adversely, note that Vale’s stock price has dropped more than twice as much as BHP’s stock price has. In fact, Vale has lost approximately $130 billion in market capitalization since 2010.

Lukoil is a Russian oil company that has seen its profile, market capitalization and revenues rise as Russia’s oil production has surged. While the company is not owned by the Russian government, it does have close ties to the Russian power structure and that connection, which has served it well during its lifetime, has become a liability in the aftermath of the Russian adventures in the Ukraine, compounded by the collapse of oil prices in the last few weeks:


Though there are fundamental reasons for the stock price decline at both Vale and Lukoil, the fear factor is clearly also at play, because these companies are exposed to risk not only to commodity and country risk but there are also significant concerns about corporate (or is it political) governance at both companies as well as currency risk factors (as both the Brazilian Real and the Russian Ruble have slid over the last few months).

Corporate governance risk

In a post on Alibaba, I made the argument that corporate governance affects value by making it more difficult (if not impossible) to change management, and thus increasing the risk that a company that embarks on the wrong course may continue on that path unchecked. With both Vale and Lukoil, there are both explicit and implicit reasons to believe that investors in these companies will have little or no say in how the company is run.

The place to start analyzing corporate governance is the ownership structures of the company. With Vale, the first sign that corporate governance is weak is the fact that they have two classes of shares (and yes, I would make this argument about Google and Facebook as well). In the graph below, I break down the top stockholders in both classes.


The common stockholders, who control the composition of the board of directors and the voting rights of the company, are held by Valepar, a shell entity controlled by inside investor groups. If you own Vale shares, as I do, it is very likely that you own the non-voting preferred shares and that you have no say in who sits on the board of directors and how the company is run. There is also a wild card in this equation in the form of a golden share that is owned by the Brazilian government, giving it veto power over major decisions and the line between corporate and political governance becomes a fuzzy one. While Vale is nominally an independent company, the Brazilian government reserves the right to intrude in its management, and that power can be used to good and bad effects. The positive is that it gives Vale a leg-up on competition in Brazil, giving it first dibs on Brazilian reserves of iron ore, and the negative is that the company can become a pawn in political games. Much of Vale’s success in the last decade came from a willingness on the part of the Brazilian government to give it free rein to be run as a profit-making entity, but the machinations leading up to the last election (where the incumbent, Dilma Roussef, was viewed as more likely to interfere in the company’s operations) have taken their toll. (The damage has been even greater at Vale’s dysfunctional twin, Petrobras, Brazil’s oil company).

Lukoil’s ownership structure provides some clues to both why it has been successful and the potential corporate governance nightmares ahead. The good news is that Lukoil has only one class of shares outstanding, with equal voting rights, but the bad news is that it is not quite clear whether you will ever get to vote for meaningful change, making it akin to a Russian political election: