The Risk-adjusted Cost of Capital, Explained

Summary

This video explores how Temasek evaluates investments by balancing risk and returns. It starts by comparing two companies, A and B, considering both expected returns and the risk-adjusted cost of capital. By factoring in various risks, such as country, sector, and company-specific factors, the goal is to maximize the spread between return and risk. Even in a low-return environment, Temasek continues to invest with a long-term mindset while remaining mindful of global risks and disruptive trends. The approach emphasizes prudent investment in equities and balancing risks for sustainable portfolio growth over time.

Takeaways

• 😀 Higher risk often leads to higher returns, but lower risk typically results in lower returns.
• 😀 To evaluate investments, it's important to assess both the fundamentals and expected returns of different companies.
• 😀 An investment in Company A may yield 10% return, while Company B could deliver 18% return at face value.
• 😀 While higher returns are attractive, risk is a crucial factor to consider in investment decisions.
• 😀 The risk-adjusted cost of capital accounts for various risks (country, sector, company) and allows for better comparisons.
• 😀 Company A has a risk-adjusted return of 3% over its cost of capital, while Company B's is only 2%.
• 😀 The spread between expected return and risk-adjusted cost of capital is critical; the goal is to maximize the spread.
• 😀 Despite low return environments, investors still focus on identifying opportunities with positive returns, even if negative spreads exist.
• 😀 Company X, despite having a negative spread of 1%, is prioritized over Company Y with a higher negative spread of 8%.
• 😀 In a low-return environment, maintaining a long-term mindset and enough liquidity for unforeseen circumstances is key.
• 😀 At Temasek, a focus on equities helps manage risk while aiming to balance returns and risks prudently for sustainable long-term growth.

Q & A

What does the saying 'higher risk, higher returns' mean in investing?

The saying means that investments with higher risks typically offer the potential for higher returns. Conversely, investments with lower risks generally provide lower returns.

How does Temasek assess investments with varying returns and risks?

Temasek assesses investments by evaluating the fundamentals of companies, projecting expected returns, and using the risk-adjusted cost of capital to account for different risks before making investment decisions.

What is the risk-adjusted cost of capital?

The risk-adjusted cost of capital is a measure that considers factors like country, sector, and company-specific risks to account for the level of risk associated with an investment.

Why is it important to consider the risk-adjusted cost of capital when comparing companies?

It's important because it helps to make like-for-like comparisons between companies with different risk profiles, allowing investors to assess the true potential of returns adjusted for risk.

In the example of Company A and Company B, which investment would be more attractive and why?

Company A would be more attractive because, despite its lower expected return (10%), its spread (the difference between expected return and risk-adjusted cost of capital) is higher (3%) compared to Company B's spread (2%).

What is the 'spread' in investment analysis?

The spread is the difference between the expected return on an investment and its risk-adjusted cost of capital. A larger spread indicates a more favorable investment.

What happens if investments have negative spreads?

If investments have negative spreads, investors prioritize those with the smallest negative spread, as they still offer positive returns, even if they are below the risk-adjusted cost of capital.

How does Temasek approach investment during low return environments?

In low return environments, Temasek continues to deploy capital actively with a long-term perspective, while also maintaining enough cash for unforeseen circumstances and managing risks.

What are some additional risk factors Temasek considers when making investment decisions?

In addition to financial estimates, Temasek remains mindful of global event risks and long-term disruptive trends that may impact their investments.

Why does Temasek invest mostly in equities despite their inherent volatility?

Temasek invests mainly in equities because they offer higher growth potential. The risk-adjusted cost of capital helps to balance the risks associated with the volatility of these investments.