El Lobo, Inc.

Jim Sparks is a financial analyst for El Lobo, Inc., a leveraged buyout firm that grew rapidly during the 1980's through debt-financed acquisition of several large manufacturing firms. 1985 was a particularly big year for El Lobo. Most of the assets they currently hold were purchased in that year. El Lobo's owners are millionaires many times over as a result of their deal-making and deal assessing abilities. As an employee, and someone concerned about the future in a waning business, Jim Sparks himself was concerned with the firm's exposure to a downturn in the economy. Sparks decided to assess El Lobo's systematic risk. Table I shows the firm's major holdings, along with some risk measures as of 1985, when all of the companies were last traded publicly. Sparks began with an analysis from the perspective of the CAPM. He decided to address the following issues:

1) Assess the market risk exposure of the El Lobo portfolio as of 1985, before acquisition. Has this changed as a result of increased debt? Can you estimate the current risk exposure?

2) Under what assumptions can the Earnings to Price ratio be interpreted as an expected return to equity investment? Given that these assumptions are correct, what expected rates of return did each acquired firm have in 1985? Given your estimates of levered betas as of 1985, which firms were above the security market line at that time? For those firms that plotted below the SML in 1985, what assumptions about earnings growth rates could justify their purchase? It may be useful to know that the equity risk premium in 1985 was 8.4% in arithmetic terms, and the t-bill yield was 7% at that time. Over the period 1985 through 1990, the S&P returned 16% annually in geometric terms, and 16.83 annually in arithmetic terms.

3) Compare the realized the rate of return on equity over the period 1985 to 1990 for each firm to the levered equity beta of the firm. Do they plot along the SML? Why or why not?

Sparks has heard that the Arbitrage Pricing Theory (APT) can be a useful tool for analyzing the risk factors of securities. He has measured the sensitivity of each company's returns to the Chen, Roll and Ross factors using pre-1985 data.

3) Does El Lobo have any unusual exposure to any particular factor? How might leverage affect this answer?

4) What industries should El Lobo consider if they would like to balance their risk exposure across major risk factors? What holding is responsible for their distinctive risk profile?

5) Devise a quantitative method for choosing a target portfolio that minimizes the total systematic risk exposure of the firm, using information about industrial sensitivities to systematic risk.

6) With the method developed in (5), can you think of an investment management program that identifies arbitrage in expectations?

6) Consider the performance of the current portfolio, and your suggested portoflio under different economic scenarios. How will a 2% shock in inflation affect El Lobo? How will 2% shocks in each of the other factors affect the firm?

Based upon his investigations, Sparks decided to prepare a strategic report for the firm's owners, outlining their current position, and distinctive risk posture. A key element of the report will be recommendations for the future of the firm.

Write the Sparks report. Include responses to each of the issues considered by Sparks.

 El Lobo's Major Holdings' Business Lines

Teledime Co. Aviation & electric equipment mfg.

Crone Building products and aerospace mfg.

DIP Computer equipment and services

McDouglas Aircraft and aerospace mfg.

Santo Chemical products

Phillis Mobile home and R.V. mfg.

SIC Code33735322451
Analyst's Earnings Growth Estimate, 1985.
Price of Equity in 1985, in Millions2600370100800500250
Price /Earnings Ratio241131201213
Levered S&P 500 Beta .901.131.11.951.11
Debt/Mkt Value of Equity.
Debt to Estimated Equity, 1990.
Estimated Equity Value3500150039580013001125
Earnings, 1985108.3333.643.234041.6719.23
Analysts' Earnings Growth Estimate, 1990.05.12-.
APT Factor: Investor Confidence Risk-.80-1.213.59-.30-2.00-4.80
APT Factor: Term Structure Risk.
APT Factor: Inflation Risk2.73.63.424.510.12
APT Factor: Change in GNP Risk-1.6-.5-1.5-2.78-.87-.78

Risk Factors are defined as:

IC = Investor Confidence = Long-term Government Bond Return - Long Term Corporate Bond Return.

TS = Term Structure = Long Term Govt. Bond Return - T-Bill Return

INF = Inflation Shock = Take the fitted values from the autoregression of monthly inflation: It = a + b I(t-1) + e(t), and subtract actual inflation to get e(t) these are the unanticipated innovations.

GNP = Shock to Gross Sales Receipts = Residuals from the autoregression of monthly GSR changes: GSRt = a + b GSR(t-1) + e(t)