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INTERNATIONAL EQUITY MARKETS

INTERNATIONAL EQUITY MARKETS. 1. Differences and Instruments. General Overview and Differences. • Differences - Macrostructure - Liquidity - Taxes - Indexes - Microstructure - Organization - Trading Procedures. Liquidity. Liquidity

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INTERNATIONAL EQUITY MARKETS

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  1. INTERNATIONAL EQUITY MARKETS 1. Differences and Instruments

  2. General Overview and Differences • • Differences • - Macrostructure • - Liquidity • - Taxes • - Indexes • - Microstructure • - Organization • - Trading Procedures

  3. Liquidity • Liquidity • “Ability to buy or sell significant quantities of a security quickly, anonymously, and with minimal or no price impact.” • => Most important attribute for an asset. • • Usual measures are: • 1. Capitalization/GDP • 2. Transaction size (market turnover) • 3. Degree of concentration • 4. Bid-ask spread • 5. Number of non-trading days • 6. Number of zero-return days

  4. • Q: Why Liquidity Matters • Numerous studies have shown that the least liquid listed stocks have qualitatively higher returns than the most liquid listed stocks. That is, investors require a liquidity premium to trade less liquid stocks. • • In the US, a comparison of listed (liquid) stocks and OTC (illiquid) stocks shows an average estimated liquidity premium of 2.51% per year for investors who demand liquidity once a year. • If investors demand liquidity once a month, the liquidity premium is negative: -5.07%! (Results from Ang et al. (2011).) • • In emerging markets, the liquidity premium has been estimated at 3.2% per year.

  5. 1. Capitalization/GDP • Fact: U.S. stock market is large compared to the U.S. economy. See figures in Dec. 2010 USD trillions. • Market Market Cap (MC) GDP (nominal) MC/GDP • U.S. 17.283 14.527 118.97 • China 4.028 5,878 68.53 • Japan 3.828 5,458 70.14 • U.K. 3.613 2.250 160.58 • India 3.227 1.632 197.73 • Brazil 1.546 2.090 73.97 • But, this number may not be a good indicator: for South Africa, in 2009, the MC/GDP was over 170%. • Also, this figure changes a lot. The MC/GDP for Brazil in 2009 was close to 50%.

  6. 2. Transaction volume • Define turnover (T) as the total value of share trading. Not surprisingly, New York and Tokyo have the largest turnover (T) in USD (Dec. 2010). • NYSE 17,796.0 B • NASDAQ 12,659 B • Shangai SE 4,486 B • Tokyo SE 3793 B • Shenzen SE 3,564 B • London SE 2,749 B • NYSE Euronext SE 2,022 B • • Turnover as a percent of market capitalization (T/MC) varies over time. • Example: From 1995 to 2002 annual turnover ranged: • U.S. (NYSE): 61% - 95% • Thailand: 45% - 90% • => not very precise, if different years were observed.

  7. 3. Degree of concentration found in the major markets • • Composition: many small firms vs. concentrated in a few large firms. • Institutional investors dislike small firms for fear of poor liquidity. • A concentrated market provides fewer opportunities for risk diversification and active portfolio strategies. • Example: Market share of the 10 largest companies. • U.S. 11.9% • Japan 20.2% • U.K. 23.2% • Germany 39.2% • Switzerland 67.0% • Netherlands 74.3%

  8. 4. The bid-ask spread • Market maker buys shares (at the bid quote) and expects to sell those shares in the future (at the ask quote). • The longer it takes to receive a buy order  The higher the required compensation  Higher compensation => Higher bid-ask spread. • An average bid-ask spread is a useful market liquidity indicator. • Example: The average bid-ask spread in the U.S. is 0.6%, while in Thailand the average bid-ask spread is 5.14%. In a sample of 21 EAFE well-developed countries, the median bid-ask spread is 1.9%. • Problem with this measure: Not easy to obtain –definitely, not in the WSJ.

  9. 5. Non-trading days • Market may seem liquid on average, but there is no volume during some days. The number of non-trading days gives us an idea of liquidity. • Example: The average proportion of non-trading days (90-08) in U.S. listed stocks is 10%, while in Thailand the average proportion is 40%. • 6. Zero-return Days • Two things behind a no change in the price –i.e., zero return: • - No information • - No trading (stale prices) => proxy for non-trading days • It is an easy measure to gather, just from stock prices. • Conclusion: Take a look at several liquidity indicators.

  10. Example: Liquidity -- The Case of Emerging Markets

  11. Taxes • Taxes on Investments • 1. Capital gains, • 2. Income (dividends, etc.), • 3. Transactions. • • Key question for international investors: • Q: Do they tax foreigners? If so, what are the withholding taxes? •  Two Tax principles • - Residence: Residents are taxed on their worldwide income. • - Source: All income earned inside the country is taxable in this country. • Key issue: Detailed definition of residence and source.

  12. When entire income is earned in the country of residence, both principles agree. Otherwise, the two principles have different (negative) effects. • Example: • Situation: A U.S. consultant works 3 months a year in Canada. • Residence principle: she pays taxes on her Canadian income in the U.S. • Source principle: she pays taxes on her Canadian income in Canada. •  Canadian income can be taxed twice. ¶ • Tax treaties are signed to avoid double taxation. For example, the tax treaty between the United States and Canada prevents double taxation for workers who cross the border, such as, NBA, NHL and MLB players.

  13. • Foreign investments may be taxed in two locations: • 1. the investor's country, • 2. the investment's country • Convention: make sure that taxes are paid in at least one country. •  that is why withholding taxes are levied on dividend payments. • • In practice, countries use a hybrid system: a combination of source, and residency, with a lot of exceptions and exclusions. • There is no clear pattern to these hybrid tax systems. • - The U.S. allows individuals earning income from their personal services outside the U.S. an exclusion of up to USD 80,000. Income in excess of this amount is fully taxable to citizens and residents. • - Singapore imposes income tax on resident individuals and companies on all income earned in or remitted to Singapore.

  14. Tax Neutrality • Tax neutrality: no tax penalties associated with international business. • Two approaches: • (1) Capital import neutrality (Exclusion method). • (2) Capital export neutrality (Credit method). • (1) Capital Import Neutrality • - No penalty or advantage attached to the fact that capital is foreign-owned • - Foreign capital competes on an equal basis with domestic capital. • - Local tax authorities exempt foreign-source income from local taxes. • => For a U.S. MNF: Exclusion of foreign branch profits from U.S. taxable income (exclusion method).

  15. (2) Capital Export Neutrality • - No tax incentive for firms to export capital to a low tax foreign country. • - Overall tax is the same whether the capital remains in the country or not. • => Local authorities "gross up" the after-tax income with all foreign taxes; then apply the home-country tax rules to that income, and give credit for foreign taxes paid. • => For a U.S. MNF: Inclusion of "pre-tax" foreign branch profits in U.S. taxable income. A tax credit is given for foreign paid taxes (credit method).

  16. Example: Bertoni Bank, a U.S. bank, has a branch in Hong Kong. Hong Kong branch income: USD 100. U.S. tax rate: 35% Hong Kong tax rate: 17% Double Exclusion Credit Taxation Method Method • Hong Kong Branch profit 100 100 100 (17% tax) (i) 171717 Net profit 83 83 83 • U.S. Net Hong Kong profit 83 83 83 Gross up 0017 Taxable income 83 0 100 (35% tax) 29.05 0 35 Tax credit 00(17) Net Tax due (ii) 29.05 0 18 Total taxes (i)+(ii) 46.05 17 35

  17. Organization • Three market structure types: ○ Public exchange • ○ Private exchange • ○ Banker exchange •  The private exchange • Origin: XVII and XVIII century's European commodity markets. • - Private institution with some government supervision. • - Brokers are created by independent members. • - Brokers compete among themselves or enjoy monopoly. • Private exchanges may compete within the same country (U.S., Japan, China, India). • Commissions: negotiated or imposed by exchange or local law. • Example: U.S., U.K., Canada, Japan, Mexico, Argentina.

  18. The public exchange Origin: legislative work of Napoleon I. - Public institution. - Brokers are appointed by the government. - Brokers enjoy a monopoly over all transactions. Brokerage firms are private. New brokers are proposed to the state by the broker's association. Commissions: fixed by law. Example: Historic area of French influence: Belgium, Italy, Greece, and some Latin American countries.

  19. The bankers exchange Origin: German tradition. - May be either private or semipublic organizations. - Brokers are banks. - Members must deal through the exchange. In some countries, banks are the major securities traders. In Germany, the Banking Act granted a brokerage monopoly to banks. Examples: German sphere of influence: Austria, Switzerland, Scandinavia and the Netherlands.

  20. Recent Trends 1) Deregulation: The private SE is the norm. 2) Going public: Many SE have become business organizations, listed in their own exchanges. Example: Deutsche Börse, NYSE-Euronext, NASDAQ-OMX Group 3) Consolidation: Competition has created consolidation: - OMX: OM & Stockholm Exchange (OMX) (1998); Helsinki (HEX) (2003); Copenhagen SE (KFX) (2005); Oslo SE (2006); Iceland SE (2006); Armenian (Armex) (2007) - NASDAQ buys PHLX and OMX (2007, 2008). - Euronext: Paris Bourse, Amsterdam (AEX) & Brussels (BXS) (2000); LIFFE (2002); Lisbon (BVL) (2002). - NYSE buys Euronext (2006). - CME buys CBOT (2006) - Toronto (TSX) & Montreal (MX) (2007)

  21. Differences in Trading Procedures • The most important differences are in the trading procedures. • (1) Cash versus futures markets • (2) Fixed versus continuous quotation • (3) Computerization • (4) Internationalization

  22. (1) Cash versus futures markets • • Cash markets • Stocks are traded on a cash basis (settlement within a couple of days). • For more leveraged investments: margin trading is available. • Margin trading: Investors borrow money from a broker. •  a cash market transaction: a third party steps in. • Note: Margin trading is costly and, sometimes, difficult. • Futures or forward stock markets • Provide an organized exchange for levered stock investment. Usually called single-stock futures (SSFs). • Forward stock markets compete with cash stock markets. • In the U.S., they were disallowed in 1980s. Brought back in 2002. • OneChicago trades 2,272 SSFs, among them IBM, Apple and Google.

  23. (2) Fixed versus continuous quotation • • Continuous market: transactions take place all day. • - Large market-makers assure liquidity. • - In some markets, the market maker has a monopoly for a given security, as is the case for the specialist on the NYSE. • - In other markets, the market makers (dealers or jobbers) compete to provide the best quote. • • Fixed market: transactions take place only at specific times. • - Call or fixing market: a single price applies to all transactions. • - Auction market: an asset is traded only few times per day and its price is determined through a competitive auction system.

  24. (3) Computerization • • Traditional trading method: floor trading. • - Traders meet on a floor to trade and to execute orders according to a set of pre-specified rules. • - Floor trading has been greatly influenced by computers: computers help to make floor trading cheaper, with fewer mistakes and faster. • • New trading method: computerized trading. • - A computer executes orders according to a set of pre-specified rules. • - Computerized trading allows the automated execution of orders entered by traders in their office. • - Best known system: Computer Assisted Trading System (CATS) -TSE. • - CATS eliminated the need for a floor where participants meet. • • Mixed system: NASDAQ.

  25. (4) Internationalization • Traditional internationalization: International network of offices. • New trend: Electronically access foreign markets.  cheaper alternative. Key to this new trend: Harmonization of electronic trading platforms Examples: - OMX: OM Stockholm Exchange (SSE), Copenhagen SW (CSE), Helsinki SE (HSE), the Iceland SE. (September 2006). - Euronext: Amsterdam SE, Brussels SE and Paris Bourse (Sep 2000) - NYSE Euronext: NYSE and Euronext (April 2007) - NASDAQ OMX: NASDAQ and OMX (February 2008) International Exchange of the Future: Stock exchanges with their own automated trading system available worldwide on a 24-hour basis.

  26. Practical Aspects •  Dual Listing • Fact: Some firms are traded on more than a dozen markets. • Implication: Shares should sell at the same price all over the world, once adjustment for exchange rates and transactions costs are made. • Procedures for admitting foreign stocks to local markets: • Montreal: Listed by simply by meeting the same regulatory requirements as those in its own jurisdiction. • U.S.: Must satisfy the local exchange and regulatory requirements. • Q: Why do companies double list?

  27. • Cross Listing Around the World: Percentage of Foreign Companies Listed in each Market

  28. Advantages of double listing: • - easier access to foreign capital. • - diversified ownership reduces the risk of a domestic takeover. • - fragmented markets. • - advertising. • Main disadvantage: Increase volatility. • Example: Situation: Bad political news in Chile. • Foreign investors tend to immediately sell their shares, driving domestic share prices down in this illiquid stock market. • Chilean investors have a less volatile behavior: they are not as shaken by domestic news, and have few investment alternatives. ¶

  29. American Depositary Receipts (ADRs) • Special shares for foreign company: depository receipts. Many DR programs around the world U.S.: American depository receipts (ADRs). U.K.: Global DRs (GDRs). Singapore: Singapore DRs. Simple process: (1) Foreign shares are deposited with a trust company. (2) Trust issues DRs. To avoid unusual share prices, ADRs may represent a combination or a fraction of several foreign shares. Example: Petroleo Brasileiro (Petrobras) ADR (PBR) JP Morgan has a 100 million shares of PBR in deposit. JP Morgan issues 50 million depository receipts (DR). Each DR represents 2 Petrobras shares. ¶

  30. • Trading in ADRs • Trading in ADRs avoids delays of trade settlement, problems with safeguarding, and making currency transactions. • Note: ADRs do not eliminate currency risk or country risk. • Example: BRL depreciates sharply, Petrobras (PBR), USD returns decrease  Petrobras ADRs will decline. • • There are more than a 2,700 ADRs available to U.S. investors. Representing over 80 markets. China has 124 ADR programs. • ADRs account for more than 15% of the entire U.S. equity market.

  31. ADRs Trading Volume: Exchange Listed ADRs

  32. • Types of ADRs (1) Listed ADRs (Level II and Level III): companies should meet all the exchange requirements. In December 1995, there were 316 Listed ADRs: 199 traded on the NYSE, 7 on the American Stock Exchange, and 110 on the NASDAQ. (2) Unlisted ADRs: The rest of the ADRs trade on the OTC market (OTC level I), or privately placed (ADR Rule 144-A, or RADR). - OTC Level I (pink sheets): Simplest way to access capital in the U.S. A Level I DR programme does not have to follow U.S. GAAP, nor it has to make a full disclosure to the SEC. - RADR: They are privately sold and bought by qualified institutional buyers (QIBs). QIBs include institutions that manage at least USD 100 million. Example: KIA Motors, LG Electronics, Samsung are all 144-A ADRs

  33. Examples ADRs in the U.S.: AUSTRALIA: BHP (NYSE), Foster’s (OTC), Qantas (OTC) BRAZIL: AES Tiete (OTC)AMBev (NYSE), CVRD (NYSE), VIVO (NYSE) CHINA: Air China (OTC), Agria Corp. (NYSE), Baidu (NASDAQ) CHILE: Concha y Toro (NYSE), LAN Airlines (NYSE), Enersis (NYSE) EGYPT: Orascom Construction (OTC), Orascom Telec (OTC), Suez Cement (OTC) FINLAND: Neste Oil (OTC), Nokia (NYSE), Stora Enso (OTC), UPM (OTC) FRANCE: GDF Suez (OTC), France Telecom (NYSE), L’Oreal (OTC) GERMANY: Allianz (NYSE), BMW (OTC), SAP (NYSE) GREECE: Alpha Bank (OTC), Hellenic Petrol (NYSE), Hellenistic Telecom (NYSE) JAPAN: Canon (NYSE), FujiFilm (NASDAQ), Hitachi (NYSE) KOREA: Korea Electric Power (NYSE), Pohang Steel (NYSE), SK Telecom (NYSE) MEXICO: Am Movil (NASDAQ), Cemex (NYSE), Femsa (NYSE), Telmex (NYSE) NETHERLANDS: AKZO Nobel (OTC), ING (NYSE), Crucell (NASDAQ) RUSSIA: Gazprom (OTC), Lukoil (OTC), Mechel (NYSE), Mosenergo (OTC) TURKEY: AKBank (OTC), Koc Group (OTC), Petrol Ofisi (OTC), Turkcell (NYSE) UK: Barclay’s (NYSE), BP (NYSE), British Airways (OTC), Imperial Tobacco (OTC)

  34.  International ETFs • A very successful new instrument: ETF (exchange-traded fund). • ETFs are like open-ended mutual funds except that they can be bought and sold on an exchange like ordinary stocks. • An ETF holds assets such as stocks, commodities, or bonds. Most ETFs track an index: S&P 500, MSCI EAFE or MSCI Switzerland. • Relative to mutual funds, ETFs are attractive: low costs and stock-like features. • Phenomenal growth: Since launch of ETFs in 1993 in the U.S. and in 1999 in Europe, the ETF industry has grown to USD 1.35 trillion in assets, with over 3,000 ETFs available worldwide (916 in the U.S.).

  35. • ETFs Assets: USD 1.35 trillion (Sep 2010) • Investors use ETFs to invest in international markets. Many ETFs are focused on a single country. • In the U.S., the NYSE and NADSDAQ have over 75 ETFs tracking an international index. In the HK SE, there are over 20 international ETFs.

  36. Financial Analysis and Valuation • • Nothing unique to financial analysis in an international context. • Example: The methods and data required to analyze U.S.-, Mexican, or Malaysian-type manufacturers are the same. ¶ • A research report on a company should include: • (1) Expected return. • (2) Risk sensitivity.

  37. The information problem A firm is typically valued in two steps: (1) Forecast future earnings (EPS -expected earnings per share) (2) Assessment of how the stock market will value these forecasts. (PE -price-earnings ratio) Information U.S.: Firms publish their quarterly earnings. Europe and Far East: Firms only publish their earnings once a year. • Quality of the disclosed information: Varies from country to country. There is a market for companies "interpreting" for international investors the local books of companies: International brokerage houses provide analysts' guides.

  38.  Comparative analysis. Another difficult problem due to: - Different accounting principles - Different cultural, institutional and tax differences Examples: (1) Swiss firms stretch the definition of a liability. They tend to overestimate contingent liabilities when compared to U.S. firms. (2) German firms create hidden reserves often equal to 100% of fixed assets. Inventories tend to be understated.  FASB vs IASB • The International Accounting Standards Board (IASB) was founded in 2001, based in London. The Financial Accounting Standards Board (FASB) came into existence in 1973, based in the U.S. • The IASB sets and promotes the International Financial Reporting Standards (IFRS). The FASB caters to the development of U.S. GAAP.

  39.  IFRS – U.S. GAAP Convergence • Work on convergence has been an ongoing issue for many years. In 2008 the SEC published a a roadmap with a convergence date: 2014. • Based on market capitalization, publicly traded companies face a staged transition towards IFRS standards. • Under the staged transition, IFRS filings would begin for large accelerated filers for fiscal years ending on or after Dec. 15, 2014 • Remaining accelerated filers would begin IFRS filings for years ending on or after Dec. 15, 2015. Non-accelerated filers, including smaller reporting companies, would begin IFRS filings for years ending on or after Dec. 15, 2016. • In 2009, the roadmap started to have problems: Political pressures as a result of controversy over fair value/mark to market accounting.

  40. Major differences in international accounting practices: * Publication of consolidated statements * Publication of accounts corrected for fiscal distortion * Inflation accounting * Currency adjustment * Treatment of extraordinary expenses * Existence of "hidden" reserves * Depreciation rules * Inventory valuation Aside: How important is disclosure? Leuz, Triantis, and Wang (2008) investigates a firm’s decision to “go dark” – i.e., a firm ceases to report to the SEC while continuing to trade publicly in OTC markets. They find that the 480 firms going dark between 98-04 experience negative average abnormal returns of -10% upon announcement.

  41. Aside: How important is disclosure? • International banks and investors charge higher interest rates to companies that do not adjust their books to U.S. standards. • Access to international capital markets is correlated to national accounting standards. Japan (with lower quality standards) ranks South Korea (better quality) on access to international capital markets. • Cross-country research suggests that managers smooth earnings to create opacity to allow expropriation of assets. Bad accounting standards tend to reduce trading and, thus, to increase the liquidity premium. • In a sample of 21 EAFE markets, Lang et al. (2009) estimate that moving from the 25th to 75th transparency percentile is associated with: - a 40% decrease in the median bid-ask. - a 17% reduction in the number of non-trading days.

  42. Company Valuation • (1) Discounted Dividend Model (DDM) • DDM is used to estimate the expected return on an investment: • The value of an asset is determined by the stream of cash flows it generates for the investor. • DDM: Stock price (P) = stream of discounted forecasted dividends. • P = D1/(1+r1) + D2/(1+r2)2 + D3/(1+r3)3 + D4 /(1+r4)4 + ... • A typical DDM approach is to decompose the future in three phases: • - Near future (next 2 years): earnings are forecasted individually. • - Second phase (years: 2-5): a general growth rate for the company's earnings is estimated. (revert to industry?) • - Third phase (years 5+): growth rate in earnings is supposed to revert to the average of all firms in the market.

  43.  Dt-forecast's and P are known  solve for the expected return (r). • Problems: • - Companies have discretion over their dividend payments. • - International comparisons are difficult: • Payout ratios vary considerably. The U.S. has a much lower payout ratio than the U.K. • Note: We might also need an accurate forecast of currency movements.

  44. Example: Using DDM to calculate the fair value of YPF ADRs It is December 1995. We need input values for Dt, rt, and St. t = 1996, 1997, 1998, .... PYPF-ADR = USD 20.53. (Market price at NYSE) St= 1 USD/ARS. Dt = ? t = 1996, 1997, 1998, .... D1996F = ARS .84. dtF = 9.1% t = 1997, 1998, 1999. dt is low for international standards  dt should increase in the future: dtF = 15.7% t = 2000, ... • rt = ? t = 1996, 1997, 1998, .... According to CAPM, we should estimate: E[rYPF] = rf + E[rm-rf] ßYPF. Inputs: ßYPF=.91; rf =.085; E[rm]=.18. E[rYPF] = .085 + (.18-.085) x .91 = .17145.

  45. Example (continuation): YPF ADR Valuation • St = ? t = 1996, 1997, 1998, .... st = -1% t = 1997, 1998, 1999. st = -2% t = 2000, .... • Valuation Process: (1) Determine the USD PV of CF from 1996 - 1,999 (year 4), P1-4. - Effective USD rate of return from 1997 until 1999 is: [(1.091)x(.099) - 1] = .08009. - P1-4 = .84/(1.17145) + .84(1.08009)/(1.17145)2 + .84(1.08009)2/(1.17145)3 + + .84(1.08009)3/(1.17145)4 = USD 3.5559. (2) Determine the USD PV of CF from 2000+ (year 5+), P5+. - The discounted dividends per share in year 4 will be: USD .84[(1.091)x(.99)]3/(1.17145)4 = USD .56204. - The effective USD rate of return is [(1.157)x(.098) - 1] = .13386. - The USD PV of all futures cash flows after year 5 is given by P5+ = USD .56204 x (1.13386)/[(.17145 - .13386)] = USD 16.9533

  46. Example (continuation): YPF ADR Valuation (3) Add (1)+(2) -- Present value of a YPF ADR is: - P = P1-4 + P5+ = USD 3.56 + USD 16.95 = USD 19.50. The December 1995 price of USD 20.53 indicates that the YPF ADR was slightly overvalued, given our estimates from the DDM. ¶

  47. (2) Discounting Free Cash Flows • Alternative method: Use the DCF model to discount free CFs (FCF). • FCF = EBITDA – Taxes - WC – CapEx, • EBITDA: earnings before interest, taxes, depreciation and amortization, Taxes: taxes after interest deductions, • WC: change in net working capital, • CapEx: capital expenditures already planned. • • FCF represents the CFs available after all expenses, payments to government, and necessary maintenance investments have been made. • • Projecting FCF is not easy. Usually, a similar 3-phase method to project dividends is used. • • Once the FCF are projected, they are discounted using the WACC: • kWACC = ke (E/V) + (1-t) kd (D/V)

  48. • kWACC = ke (E/V) + (1-t) kd (D/V), • ke: the cost of equity (usually, it’s risk-adjusted: a model is needed!) • kd: is the before-tax cost of debt • t: marginal tax rate, • E: market value of the company’s equity • D: market value of the company’s debt, • V: market value of the firm (E+V). • • ke • It requires an asset pricing model such as the CAPM or Fama-French 3-factor model. • • kd • Easy to calculate. It is the current cost of debt for the firm, which can be obtained by placing a telephone call to the company’s bank.

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