Suppose you knew only one thing about a particular set of people: that they were bilingual, for example, or had experience as a pastry chef. And from that one piece of information, you could predict whether their income rose or fell last year. That would be valuable insight; you’d know which skills are sought by employers. Now imagine that you’re an investor whose holdings got pummeled in the recent financial crisis. (Not so hard to envision, is it?) Wouldn’t you want to single out the traits of companies that weathered the storm so you could buttress your portfolio against another crash?
Charles Calomiris, a Chazen Senior Scholar and the Henry Kaufman Professor of Financial Institutions at Columbia Business School, has done just that. Through a sweeping examination of more than 17,000 firms in 44 countries, he and his coauthors at the World Bank, Inessa Love and Sole Martinez Peria, have isolated three significant factors, beyond the traditional measures of a stock’s sensitivity to market movements, that affected how well equities performed during the global meltdown.
There’s little argument about the chain of events that led to the crisis of 2007-2008, which Calomiris described as a series of “shocks.” First, the mortgage market and banking system reduced their supply of credit. That led to sell-offs of risky assets as banks and investors scrambled to shore up their liquidity. That, in turn, plunged the global economy into a severe recession in which global trade collapsed.
To figure out which companies withstood these shocks, Calomiris used stock price as a proxy for performance. “Stock returns are an interesting window on the crisis,” he said. “They’re comparable across firms and countries, regardless of accounting systems, and they’re forward-looking.” In other words, a stock’s price today reflects, in part, expected returns in the future.
The first barometer of a stock’s resilience to the crisis was the firm’s exposure to global trade. Firms with higher pre-crisis sales outside the company’s home country took a bigger hit, as did firms with a high proportion of revenue coming from foreign sales, or those holding significant quantities of foreign assets.
The second factor was the strength of the firm’s corporate finances. Firms that were less seasoned credit risks, or more highly leveraged, were hit more severely by the contraction in credit since they had to pay more for financing.
The third was how liquid (heavily traded) the stock was. In theory, greater liquidity could have either raised or lowered stock price, said Calomiris. “If investors need liquidity and are forced to scramble, they’ll sell their most liquid assets first,” he notes. Many investors flooding the market with liquid assets at the same time exerts downward pressure on price. On the other hand, greater liquidity could become more valuable during a crisis, pushing prices of liquid stocks up.
In fact, the former was true, according to Calomiris’s findings. “People sold the assets that were easiest to get rid of,” he said. “Since everyone did it, prices fell.”
The implications of these touchpoints go far beyond economic theory, he noted. “If you’re running a portfolio, you can use our factors to ask yourself whether you are sufficiently diversified against crisis risk. If you don’t like the answer, you can take this opportunity to make changes now — before the next crisis hits.”