lecture 3 stocks

EMERGING CAPITAL MARKETS

Lecture 3: Emerging Stock MarketsDr. Edilberto Segura

Partner & Chief Economist, SigmaBleyzerPresident of the Board, The Bleyzer Foundation

May 2011

OutlineI. Development of Emerging Stock MarketsII. Stock Valuation Methods and Stock SelectionIII. Emerging Stock Market IndexesIV. Emerging Stock Market PerformanceV. Investment Vehicles in Emerging Stock MarketsVI. Differentiating Features of Stock ExchangesVII. Structure of Stock Markets VIII. Enabling Environment for Emerging Stock

Markets IX. Equity Portfolio Strategies and Building an

Emerging Market Portfolio

I. Development of Emerging Stock Markets• Emerging Stock Markets have developed rapidly during the last

decade, with stock market capitalization growing from US$500 billion in 1988 to $20,950 billion by 2007, but they collapse by almost 60% to $8, 558 billion during the 2008 crisis (source: IMF). During 2009, it recovered to around $14,900 billion:

(in $ billion) 2007 2008Asia 13,782 5,327Latin America 2,292 1,456Emerging Europe 2,418 641Middle East/Africa 2,458 1,134Total 20,950 8,558

• The Largests markets are in East Asia, including China and India. In Latin America, the markets in Brazil, Mexico and Chile grew rapidly. In Emerging Europe, Russia grew fast. In Africa, stock markets developed in SA, Egypt, and Morocco.

• Five EM countries account for almost 65% of the stock market capitalization of all EMs: China, Russia, India, Brazil and Mexico.

• However, EMs are still small in size compared with developed countries : the market capitalization of EMs of $9.9 trillion is only 20% of the world equity capitalization of $47 trillion in 2009.

• Nevertheless, the stock market capitalization of countries such as China, Russia, and India are in excess of US$800 billion and are comparable in size to those of many developed countries.

• Key Statistics for selected EM regions are given in the following tables.

Source: IMF, Financial Stability Report, October 20106. Data for Emerging Economies is based on a narrower new definition of EMs of the IMF.

Total International Equity Issuances by EMs

($ billions)2005 2006 2007 2008 2009

Developing Asia 35 57 81 22 63Latin America 5 15 47 12 20Central/East Europe 2 3 5 1 4CIS 8 18 36 4 1Mid East/North Afric 2 2 6 4 2Sub-Saharan Africa 3 1 4 9 1

Total 53 99 184 45 91

Source: IMF, Financial Stability Report, October 2010

Country S&P Equity Issuance #Listed Price/Earnings (PE) Ratios

Rating Abroad ($bn,’09) Compies ‘00 '03 '05 ’06 ’07 ’08'09 '10NovChile A+ 0 255 2321 18191913 1922Mexico BBB 1.5 126 1215 14151412 2316Peru BBB- 0.2290 27 3743Brazil BBB- 18.0 440 1711 1012177 1711Argentina B 0120 1412 911164 86

China AA- 40.01148 45 9 13202710 2114Malaysia A- 3.6 809 2412 11171510 2015Thailand BBB+ 0.1 440 1311 107 147 1915India BBB- 17.0 5938 19 9 17192610 22 24Philippines BB 0.3 230 2012 11161412 1921Indonesia BB 1.6 307 810 1218219 1621

Poland A- 2.7400 nana 1613157 1920Russia BBB 1.0 24510 12171722 416 9Hungary BBB- 1.2 56 na12 1914153 1613Turkey BB 0na na16 1211 513 13

South Africa BBB+ 1.3 580 13 8 14151511 1718

All EMs 91 18000 nana 1516 179 2116USA 26 22 19 18 22 102216 Source: MSCI, FT

II. Methods of Stock Valuation and Selection• The key method involves a Fundamental Analysis to appraise the

firm’s prospects by studying past records of sales, earnings, assets, products, management, and markets to predicting future trends in these indicators and how they may affect a company’s future success or failure and therefore its stock price.

• An alternative approach looks just at trends (Technical Analysis). • By appraising a firm’s prospects, the analysis determine a stock’s

intrinsic value and assess whether a particular stock or group of stocks is undervalued or overvalued at the current market price.

• If the intrinsic value is more than the current share price, this stock would be undervalued and a possible candidate for investment.

• The main methods for determining intrinsic value are: A. Discounted cash flow methods. B. Earnings-based ratio valuation methods. C. Assets-based valuation methods. D. Industry-specific benchmarks. E. Other Stock Valuation Factors F. Stock Selection based on portfolio diversification.

A. Discounted Cash Flow Method • When you buy a stock, you are purchasing future cash flows: the

"intrinsic" value of a stock is a function of the cash payouts that it will make in the future, discounted by the weighted average cost of capital.

• The cost of capital is the required return on the stock, which includes premiums for the time value of money and the riskiness of the stock.

• The future payout will include all future cash payments (dividends) and the stock appreciation at the end of the holding period, say, 1 year:

P0 = D1/(1 + ke) + P1/(1 + ke) Where: P0 = current price of the stock

D1 = dividend paid at the end of year 1 ke = required return on equity investments P1 = stock price at the end of period one

Similarly: P1 = D2/(1 + Ke) + P2/(1 + Ke)Therefore: P0 = D1/(1 + ke) + [D2/(1 + Ke) + P2/(1 + Ke)]/(1 + ke)

Or: P0 = D1/(1+ke) + D2/(1+ke)2 +P2/(1+ke)2

• Therefore, the 1 period model can be generalized to "n" periods as: P0 = D1/(1+ke)1 + D2/(1+ke)2 +…+ Dn/(1+ke)n + Pn/(1+ke)n

• If Pn is far in the future, it will not affect P0 and can be ignored• Therefore, the model can be rewritten as: P0 = Dt /(1 + ke)t for t = 1 to n

• If dividends do not change, then, this becomes: P0 = D / ke

• If D = $20 and ke = 15%, the stock price should be 20/0.15 = $133 • The model says that the price of a stock is determined only by its

future “free cash flow” payments (dividends).• It does not say that stock price appreciation is not important; but that

stock appreciation is derived from future dividends.• If a stock does not currently pay dividends, it is assumed that it will

pay someday after the rapid growth phase of its life cycle is over.• In the meantime, the value will come from stock appreciation.• Note that we discount “free cash flows” to the investor (the dividend

payments) and not earnings, since a portion is reinvested.

t=1

∞

The Gordon Growth Model• Since a portion of earnings is reinvested, a firm would increase its

dividends at a constant rate “g”, then:

D1 D1(1+g) D1(1+g)2 D1(1+g)∞

P0 = --------- + ---------- + ----------- +.…+ ------------- (1+ke)1 (1+ke)2 (1+ke)3 (1+ke)∞

Where: D1 = Dividend in period 1 = D0 (1+g) g = expected growth rate in dividends ke = required return on equity investments

• Then, multiplying both sides by (1+ke)/(1+g), and subtracting the initial equation, the model can be simplified algebraically to: D1

P0 = ---------- (ke - g)

• This model assumes that Dividends continue to grow at a constant rate g for ever and the growth rate is less than the required return on equity.

• If this were not so, the price would be implausibly large.

Calculating dividends from sales, earnings and cash flows• In order to estimate future dividends and growth rates:

– Financial statements must be analyzed and adjusted to reflect international accounting standards. This can be a major task.

– Future estimates of Revenues normally require a good market/marketing analysis and analysis of competitors.

– Since dividends are paid from Net Profits after taxes, all costs are deducted, such as interests, depreciation, amortization and taxes.

– Normally, profits for the first two years are calculated in detail. For years two to five, a company-specify growth rate of expected cash flows is estimated. After year five, it is assumed that the rate of growth of the company’s cash flows will revert to the average for similar firms in the market.

– The weighted average cost of capital is estimated using local information about the risk-free rate and risk premiums, based on the Capital Assets Pricing Model (to be discussed later on).

• The dividend payments are then calculated as: Revenues

Minus: All Costs, including:- Cost of Sales- Administrative Costs- Marketing Cost- Interest Rate Cost- Depreciation and Amortization- Taxes This Equals: Net Income after Taxes

Minus: Retained Earnings (needed for re-investments) This Equals: Dividends paid

• Example: To find the current "intrinsic value" of a firm’s stock whose dividends grow at a constant rate of g =5%, paid dividends last year of D0 = $20.00, and the cost pf capital ke = 15%.

P0 = D1 /(ke – g)

But : D1 = D0 (1+g)P0 = D0(1 + g)/(ke – g)

P0 = ($20.00)(1.05)/(0.15 - 0.05) = $190• The growth rate of 5% pa changes the stock value from $133 to $190• If the stock is selling for less than $190, you would purchase it, since

its intrinsic value is higher at $190: the stock price is undervalued.• Theoretically, the best method of stock valuation is the dividend

valuation approach.• But, if a firm is not paying dividends or has an erratic growth rate, the

approach will not work well.• Consequently, other methods are used.

B. Earnings-Based Ratios for Valuation(i) Price-Earnings Ratio PE Ratio = (Stock Price per Share)/(Annual Earnings per Share)

• The PE ratio (price-earning ratio) of a stock is a measure of the price paid for a stock share relative to the annual net earnings of the firm per share (e.g., how many dollars is the market willing to pay for the stock per dollar of income earned).

• A higher PE ratio means that investors are paying more per unit of earnings compared to the one with lower PE ratio.

• A high PE has two interpretations:– A higher than average PE may mean that the market expects

earnings to rise in the future (the growth rate g is significant)..– A high PE may also indicate that the market thinks the firm’s

earnings are very low risk and is therefore willing to pay a premium for them.

• The PE ratio can be used to estimate the value of a firm’s stock.• Similar firms in the same industry are expected to have similar PE

ratios in the long run: (P/E) = (P/E)i• The value of a firm’s stock can be found by multiplying a

representative average industry PE ratio times earnings per share:

P = (P/E)i x E• The average industry PE ratio can be obtained from market data, if

the firm is publicly traded, or from past private transactions.• It is also useful to determine how the current PE ratio compares

with past PE ratios for the same company• Depending on the earnings used, there are various PE ratios:

– "Trailing PE" or "PE ttm": Earnings per share is the net income of the company for the most recent 12 month period, divided by number of shares outstanding.

– "Forward PE", "PEf", or "estimated PE": Instead of past net income, it uses estimated net earnings over the next 12 months.

• Example: What is the current value of Applebee’s shares if earnings per share are projected to be $1.30? We find out that the average industry PE ratio for restaurants similar to Applebee’s is 20. P0 = (P/E)i x E

P0 = 20 x $1.30 = $26.• Advantages of PE valuation:

– Useful for valuing privately-held firms without share market prices and firms that do not pay dividends.

• Disadvantages:– By using an industry average PE ratio, firm-specific factors that

might contribute to a long-term PE ratio above or below the average are ignored.

– The average PE ratio for EMs in 2005-2010 was 15.2– PE ratios for firms vary across time, countries and sectors, as

shown in the following slides.

Possible Interpretations of PE Ratios

N/A   A company with no earnings has an undefined P/E ratio. By convention, companies with losses (negative earnings) are usually treated as having an undefined P/E ratio, even though a negative P/E ratio can be mathematically determined.

0–12

Either the stock is undervalued (cheap and good buy) or the company's earnings are thought to be in decline. Alternatively, current earnings may be substantially above historic trends or the company may have profited from selling assets; but stock prices have not yet increased.

13–17 For many firms a P/E ratio in this range may be considered fair value.

18–25

Either the stock is overvalued or the company's earnings have increased since the last earnings figure was published. The stock may also be a growth stock with earnings expected to increase substantially in future.

25+ A company whose shares have a very high P/E may have high expected future growth in earnings or the stock may be the subject of a speculative bubble.

Equity Valuation: EMs Price/Earnings Ratios (from MSCI)

2005 2006 2007 2008 2009 2010 Q2

Emerging Markets 15.0 15.7 17.1 8.5 20.6 14.6

Asia 14.2 15.8 19.0 9.4 24.3 15.8

Europe/MEast/Afr 17.3 15.7 14.6 6.7 16.2 11.7

Latin America 14.5 14.7 16.0 9.0 18.3 14.4

Dividend Yield and PE Ratios, as of Jan 2011• Argentina 4.9 13.7 • Australia 3.9 14.9 • Austria 2.1 18.1 • Belgium 1.8 12.9 • Brazil 2.7 14.5 • Bulgaria 0.1 7.5 • Canada 2.4 19.6 • Chile 2.6 22.8 • China 2.5 13.5 • Colombia 2.3 21.2 • Cyprys 4.9 6.7 • Czech Rep 5.8 10.5 • Denmark 0.9 29.9 • Finland 3.2 17.1 • France 3.3 15.8 • Germany 2.5 15.3 • Greece 3.3 17.5 • Hong Kong 2.4 14.7

• Hungary 1.8 13.4 • India 0.9 24.0 • Indonesia 2.0 20.3 • Ireland 1.6 21.7 • Israel 3.6 13.6 • Italy 3.9 13.0 • Japan 1.9 15.2 • Luxemburg 2.8 18.1 • Malaysia 2.9 16.5• Malta 4.6 5.1 • Mexico 1.5 16.5 • Netherland 2.5 15.0 • New Zealand 3.6 24.8 • Norway 2.7 13.7 • Pakistan 4.8 11.3 • Peru 3.6 57.9 • Philippines 2.1 20.7 • Poland 1.6 20.2

• Portugal 3.7 5.8 • Romania 1.3 13.5 • Russia 2.0 9.6 • Singapore 2.6

14.4 • Slovenia 1.9

15.3 • South Africa 2.5

19.0 • South Korea 1.1

16.1 • Spain 5.4

9.5 • Sri Lanka 1.2

25.2 • Sweden 2.3

15.6 • Switzerland 2.7

12.9 • Taiwan 3.2

15.7 • Thailand 2.6

14.9• Turkey 2.0

12.9 • UK 2.8

15.4 • USA 1.8

17.4 • USA S&P500 2.3

15.8 • Venezuela 12.6

3.0

PE Ratios vs Long Term Interest Rates• Over decades, the average PE ratio in the US has been 15 and varied

depending on expected growth of earnings, expected stability of earnings, expected inflation, and yields of competing investments.

• For example, when US treasuries yield high returns, investors pay less for a given stock’s earnings per share and P/E's fall.

• That is, as soon as the current low interest rates start to increase, stock prices and PE ratios will decline.

As of January 2010

(ii) PEG Ratio: Adding Earnings Growth in the PE ratio• The PE ratio does not include explicitly the growth rate of earnings, which

affects whether the required PE ratio should be high or low. • Earnings growth could more explicitly be reflected through the so-called

Price-Earnings to Growth (PEG) ratio. • The PEG ratio is obtained by dividing the P/E ratio by the past or future

annual earnings growth rate: PEG = (P/E Ratio)/Earnings Growth . • The PEG measures the P/E value per unit of annual earnings growth.• It is considered a form of normalization because a higher growth rate of

earnings should cause a higher P/E ratio. • If the PEG ratio is around 1, the firm is considered fairly valued. • A PEG ratio that is much higher than 1 indicates an overvalued company;

and a PEG below 1 indicates an undervalued company.• Some investors want a PEG ratio below 1.2. With a lower PEG ratio, you

can purchase its future earnings growth for a lower relative price.• These rules-of-thumb are based on a belief that P/E ratios should

approximate the long-term growth rate of a company's earnings.• Small, high-growth stocks generally trade at higher PEGs compared to the

big-caps.

(iii) EV/EBITDA Ratio• The total “equity value” of an enterprise can be obtained by

multiplying the Price per share obtained from a PE ratio analysis times the number of shares outstanding.

• A second approach to get “equity value” is to obtain first the Enterprise Value (EV) and then subtract the value of net financial debts.

• The EV can be obtained by multiplying the company's Earnings Before Interest, Taxes, Deprec & Amortiz. (EBITDA) times an industry-wide ratio EV/EBITDA which is available from various sources.

EV/EBITDA = Enterprise Value . Earnings before interest, taxes, deprec & amortiz. • This ratio facilitates comparisons of fundamental profitability among

firms, as it eliminates the effects of financing and accounting decisions.• In fact, this ratio is more suitable for international comparisons as it is

not impacted by the firms’s financial structure nor by its policies regarding depreciation and provisioning. It is also the closest readily available proxy for operating cash flow.

• Large organizations compile these ratios based on their past purchases• A number of sources provide EV/EBITDA ratios for various countries.

• Depending on sectors and countries, EV/EBITDA ratios range from 4x for low growth high risk firms to 7x for high growth firms with low risk

• The Argos Mid-Market index of EV/EBITDA multiples measure the evolution of Euro-zone private mid-market company prices.

• The preparation of the index is based on samples of 942 transactions, which met the following criteria: acquisition of a majority stake, equity value in range €15-150m), certain activities excluded (financial, real estate, high-tech).

• By November 2010, the average of the indexes recovered from 6.0x to 6.5x

• In 2010 in the US, transaction multiples shrank to an average 9.2x EV / EBITDA compared to 10.7x in 2007.

• This reduction reflects a larger share of distressed transactions, tight financing, and poor corporate earnings.

• In 2010, a slightly improving economic outlook appears to be supporting a re-awakening of M&A activity for some sectors.

C. Asset-Based Valuation Methods A. Market Value-to-Book Ratios (Price-to-Book Ratios)

• Enterprise Value equals the product of a MV/B ratio for comparable firms times the book value of this company

• This ratio is widely used for bank acquisitions, under which investors pay for the bank’s equity about 2.0 times book equity value (in Ukraine in 2005-07, investors paid 7 times).

B. Replacement Value • Enterprise Value estimated as the cost to build the company

from scratch, with/without technology changes. • But this ignores going its value as an ongoing concern,

intangibles assets, human capital.C. Liquidation Value

• Enterprise Value estimated as the proceeds if all the assets of the company were to be liquidated minus its debts.

D. Industry-Specific Valuation Benchmarks

• Many industries have some valuation benchmarks for its physical characteristics that can be used to determine the enterprise value of a company as an initial, back-of-the-envelope estimate.

• They are based on the premise that investors are willing to pay for market share (such as number of TV subscribers) or other physical aspect (such as square meters) and that normal profitability of businesses in the industry does not vary substantially across firms.

• Some of the typical valuation benchmarks include: In real estate: Price/ square meter (such as $5,000/m2 in Kiev) In hotels: Price /bed (such as $900,000/bed in a small hotel) In cable TV: Price/subscriber (such as $200/subscriber in Ukr) In steel companies: Price/capacity in tons (such as $700/ton)

E. Other Stock Valuation Factors(1) Competitive Advantage: Is there a ‘Niche” for this company. Does it

have a recognized name? Does it posses consumer loyalty?(2) Large Market Share. Well-managed companies in EMs tend to

consolidate and increase market share.(3) Market Capitalization. Some investors avoids large, well-known

companies in favor of small-cap stocks that still contain significant upside potential. A minimum cap is also defined.

(4) Good Management. This is a key factor. Investors look at the training, experience of senior managers.

(5) Strategic Relationships. Does the company have foreign investors? Does it have technology agreements with firms abroad?

(6) Export Orientation. Is a good portion of revenues from exports?(7) Hidden Assets. In EMs, many companies have hidden assets that

may be substantially under-priced.(8) Other Shareholders. Who they are and their country’s influence.(9) Other financials. Stable earnings growth for a number of years, and

reasonable debt/equity ratio.

(10) Value of Real Options: Value of alternative sources of revenues or savings that the investment can generate, due to irreversibility (sunk costs) and uncertainty (future cash flows), such as:(i) Waiting (learning) option value (building now or just wait for

better knowledge and potential higher returns(ii) Additional investment option value (if invest now in project A,

later can invest in B with overall higher returns.)(iii) Abandoning option. How much you lose if the company fails.

-------------------------------------------------------------------------------• Based on the above equity valuation methods, we have computed

the stock’s “intrinsic” value.• Then the decision is whether to buy it or not, depending on whether

this “intrinsic” value is above the current market (selling) price.• An alternative formulation is to ask whether the stock’s “intrinsic”

internal rate of return (the yield that equals cash inflows and outflows) is above or below the “required” rate of return derived from the opportunity cost of equity capital. The CAPM provides for the calculation of this required rate of return for equities.

• Markowitz introduced the concept that the “desirability” of a stock depends not only on its expected return, but also by the correlation of the stock to other securities in the portfolio.

• A stock is valuable or desirable only if it is on the efficient frontier or moves it upwards.

• In the 1960s, Professor Sharpe of Stanford expanded the analysis further.

• The expected (required) stock return [E(Ri)] includes a risk premium to compensate for the additional risk of the stock, compared with a security with zero risk (Rf =risk free rate): Risk Premium = E(Ri) - Rf

Therefore: E(Ri)= Rf + risk premium

• But with wide diversification, company-specific risks can be minimized and becomes irrelevant for the investor and the stock’s required value.

F. Stock Selection Based on Portfolio Diversification

● By holding over 20-30 different stocks, one can reduce the standard deviation and eliminate the “Company Specific” risk component.

● Only the residual “Systematic Risk” would remain -- and for which the investors would demand a premium.

● This systematic risk (called beta - β) depends on uncertainties & threats within the economy/sector as a whole and varies by country.

● Therefore, the required risk premium for an individual stock will depends only on its systematic risk βi since other risks can be eliminated by diversification.

● The risk premium due to this systematic risk will depend on the degree to which the returns on the individual stock is affected by movements in the return of the overall sector/economy.

• If the stock return behaves exactly as the market as a whole, the risk premium should be equal to the difference between market returns (Rm) and the risk-free return (Rf): risk premium = Rm – Rf

• Therefore, its return is: E(Ri) = Rf + (Rm – Rf ) or: E(Ri) = Rm • The expected (required) return equals the market return. But if the

stock has greater variance than the market, the risk premium would be higher than the market risk premium by a factor greater than 1.0

• Similarly, if the stock has lower variability than the market, the risk premium would be lower by a factor lower than 1.0

• The expected or required return for this stock [E(Ri)] is then:

E(Ri) = Rf +βi (Rm – Rf) [the Capital Asset Pricing Model]

• The factor βi (beta) represents the extend to which the stock i return varies more than the market (βi > 1) or less than the market (βi < 1).

• Risk is now defined as the exposure level of the security to fluctuations in the market portfolio, not by its standard deviation.

• The value of βi for a stock can be obtained statistically as the slope of a regression of the stock’s returns to the excess return of a market portfolio (ie, S&P500): E(Ri) = Rf +βi (Rm – Rf)

Its value can be derived mathematically as follows:• In equilibrium every stock “i” must have the same marginal value “k”: E(Ri) – a σim = k The marginal value “k” is its return minus a risk

factor related to its market sensitivity risk σim . E(Rf) – a σfm = k Since σfm = 0, then k = E(Rf) = Rf E(Rm) – a σ2m = Rf → a = [E(Rm) – Rf ] / σ2m E(Ri) = k + a σim → E(Ri) = Rf + {[E(Rm) – Rf ] / σ2 m }σim

E(Ri) = Rf + {σim /σ2 m }[E(Rm) – Rf ] Thus: βi = σim /σ2 m

Beta is the ratio of the Cov(Ri, Rm) to the Var(Rm)

• An equity investment would be “desirable” only if its calculated returns (based for example on discounted cash flows) would exceed this expected or “demanded” rate of return E(Ri) as calculated by the CAPM for the risk.

• The E(Ri) therefore represents the opportunity cost of capital (the second best alternative return for an equity investment).

• It is therefore, the “cost of capital” for the equity “i”, as it is the minimum return that should be sought for an equity investment, given its market/country risks.

• In Ukraine, given Ukraine’s market risks, the cost of equity capital or “required” rate of return E(Ri) is estimated at 20% t0 25% in real terms for a “normal” Ukrainian market risk.

• For the S&P500 the “market” E(Rm) has been 8% in real terms.

• Example: Suppose your company is considering an equity investment in a small capitalization firm with a new drug process.

• The process is inherently risky, i.e. the standard deviation of the project is 75% per year.

• But the beta for drugs and therefore for this project is only 0.8. • The risk free rate (Rf) is 3% and the market return E(Rm) is 12%. • The discounting of Cash Flow of inflows and outflows show that the

“intrinsic internal rate of return” of this drug company is 12% (that is, the yield that equals cash ins with outs).

• Would you recommend this investment? What is the required rate of return on the project?

• Theory tells us that the answer does not depend upon the volatility associated with the returns. Instead, we use the beta of the project.

• E(Rdrug) = 3% + (0.8)(12% - 3%) = 10.2%• The drugs investment is indeed desirable, despite its high standard

deviation, provided that it is part of a well-diversified portfolio.

Choosing Among Alternative Investments/Portfolios• If several investments or portfolios are “desirable” with intrinsic value

above their require return or cost of capital, how to choose the best?• Sharpe developed a ratio that measures the expected excess return of

the security/portfolio per unit of total security or portfolio risk. Sharpe Ratio: S = E(Ri) – Rf (Note that S is the slope of the CML) σi

• The investment or portfolio with the highest Sharpe ratio should be preferred, as it gives more return for the same overall risk.

• As a guide, the long-term return of the S&P500 is 10%, the risk-free rate is 3%, and the S&P500 standard deviation is 16%. Therefore, the average L-T Sharpe for the US market is 0.43. Now it is about 35%.

• Treynor developed a similar ratio for a well-diversified portfolio, using βi instead of σi which is: T = E(Ri) – Rf

βi • These ratio is used to assess the performance of portfolio managers.

Investment Returns in the US – 1926 -2009

Av Return St.Dev.US Small Capitalization stock 12.0% 36%S&P 500 9.8% 22%US Long-term Corporate Bonds 5.9% 7%US Long-term Govt. Bonds 5.4% 8%US T-bills 3.7% 1%Inflation Rate 3.0%

III . Emerging Stock Market Indexes• Local stock indexes of Emerging Markets returns are seldom

used by foreign investors because of their lack of comparability.• Investor prefer to use emerging market return indexes prepared

by recognized international institutions.• Then ,the performance of a managed portfolio investing in EMs

is normally measured relative to these EM indexes.• The main EM indexes are:

– S&P/IFC Indexes, – Morgan Stanley Capital International indexes (MSCI), – ING Baring Indexes, – Goldman Sachs-Financial Times Indexes.

• Some of these Indexes are available through the Internet.• Sector Indexes (such as industry, telecommunications) are also

published.

1. S&P/IFC Indexes Since 1984, the International Finance Corporation (IFC) of the World

Bank published, on a daily basis, several indexes for EMs. In April 2000, this business was purchased by S&P. They include:

S&P/IFC Global (S&P/IFCG). – It covers 32 emerging countries (2,000 stocks), three regional

composite indexes (Latin America, Asia, and Europe & Middle East), and industrial sector indexes.

– For each country the target aggregate market capitalization is between 60% and 75% of the total capitalization of the stock exchange.

– S&P/IFC includes only the most actively traded stocks.– Corporate cross-holdings & Government ownership of shares

(that are not traded) are eliminated.– S&P/IFC seeks industry diversification.– Each stock enters the index in proportion of its capitalization.

S&P/IFC Investable Index (S&P/IFCI).– It measures the market for shares available to foreign investors. – It is useful for foreign investors (i) to benchmark their own

performance; and (ii) for “passive management” investments.– Adjustments are made to reflect foreign investment restrictions

(the weights of China, Taiwan, Korea and India are reduced significantly , and Nigeria is eliminated).

– Stocks must pass size and liquidity screens.S&P/IFC Frontier Markets.

– It was introduced in 1996 for 19 countries that were borderline but could eventually meet selection criteria when trade volume and liquidity increases. It is published monthly.

• The S&P/IFC indexes include financial information, such as: P/E ratios, P/Book Value ratios, and dividend yields.

2. Morgan Stanley Capital International indexes (MSCI)• Since 1988, Morgan Stanley Capital International (MSCI) issues

two main indexes for 20 Emerging Markets on a daily and price-only basis: – MSCI Global– MSCI Free, which includes “investable” stocks.

• For each country, the target market capitalization is 60% .• The MSCI indexes are more selective that IFC’s in choosing stocks:

– Efforts are made to have very close representation of industrial sector coverage (a key difference with IFC”s).

– Closely-held and multi-industry companies are eliminated.• MSCI also publishes composite international indexes:

– Emerging Markets Global (EMG) with 700 stocks, and– Emerging Markets Free (EMF), with 600 stocks.

3. ING Baring Indexes• Since 1992, Baring Emerging Market Indexes (BEMI) have

been covering 20 countries (about 500 stocks), on a daily basis.• It is more selective and less comprehensive than IFC or MSCI.• It includes only major, liquid stocks that meet strict standards of

availability to foreign investors.• Each national index consists of 10 to 35 stocks weighted by their

market capitalization.• ING Baring also publishes a BEMI World Index and regional

indexes.• Foreign investment restrictions are reflected in the weightings.• The indexes are calculated on a price-only and on a total-return

basis.

4. Financial Times - Goldman Sachs Indexes• The Financial times,with the collaboration of Goldman Sachs

produces the FT-Actuaries World Indexes for Developed Markets.

• Since 1994, indexes for a number of Emerging Markets, have been added.

• For each index, the following information is provided:– Price Index for last three days.– Two-year high.– Two-year low.– Yield.– P/E Ratio.

IV. Emerging Stock Market PerformanceA. Returns from EM Stocks• The evidence from empirical studies on whether EM stocks have

higher returns than in the US is mixed. • A 1998 study published in the Financial Analysts Journal found

that, as a group, EMs have not produced levels of returns higher than the US market, while being more volatile. Indeed, the US did very well in the 1990’s until 2000 and then collapsed in 2001.

• Other studies have shown that, over a longer number of years, excess EM returns over the S&P’s has been around 4% to 8% pa.

• But all studies show that the correlation with the US market is low enough to provide risk diversification benefits.

• Empirical studies show that EM equity prices are correlated with the rate of GDP growth, country risk, and the flows of direct foreign investments, all of which are affected by macroeconomic policies.

• These studies show that sudden increases in foreign direct investments are early indicators that stock prices will increase.

• Studies also show that EM equity prices tend to increase faster during the initial period of "emergence" -- (turn around in economic performance), not much before, not later on. Investors who can detect a forthcoming change in policies can enjoy large returns.

• For the US, studies show that equity prices are positively correlated to expected earnings and negatively correlated to interest rates.

B. Volatility of EM Stocks• Equity prices in EMs have been characterized by wide fluctuations,

greater that that of developed markets. • For example, South Korea’s stock price index evolved as follows:

1986-89: a 400% increase; 1989-91: a 35% drop; 1991-1994: a 70% increase; 1994-1998: a 70% drop; 1998-1999: a 400% increase; 1999-2001: a 50% drop. By April 2003 it was 10% up from mid 2001.

• This high volatility in equity prices is the result of:– Inconsistent application of economic policies in EMs that leads

to periodic financial crises.– Thin, narrow markets for most EM securities. – The tendency of investors to be driven by “the herd’ – due to

poor information.• EM price volatility does not follow a normal distribution or any

symmetric distribution of returns. As a result, the probability of a large negative price movement can be high. Therefore, the standard deviation is not a sufficient measure of market risk.

• Empirical statistical studies also show that equity price volatility is correlated to inflation rates: countries with high inflation tend to have larger stock price volatility,

• Inflation, in turn, is caused by the adequacy of fiscal policies (the size of fiscal deficits) and monetary policies (the balance between money supply and demand).

• EM equity prices drop drastically during periods of financial crises.

• The most fundamental causes of a financial crises are inadequate macroeconomic policies, which produce unsustainable external imbalances (high current account deficits and unsustainable foreign debt) and internal imbalances (high fiscal deficits or low private savings).

• External and internal imbalances lead to internal instability (high inflation) and external instability (currency devaluations).

• The wide fluctuations in the stock prices of EMs should not dissuade investors, given potential returns and diversification benefits.

• But investors should resist the temptation to go to “hot” markets in fashion; instead, they should look at the fundamentals of each market.

• The lesson from the 1990's crises is that investors in EMs should not just look at the financial statements of companies. A fundamental analysis of the overall economy is required.

Total Dollar Return Performance in EMs2001 200220032004200520062007200820092010

MSCI EM Free -4.9-8.051.6 22.430.329.1 36.8-54.474.116.3 Latin America -4.3-24.867.134.8 44.939.346.9-52.8 98.112.1

Asia 4.2-6.347.1 12.223.529.8 38.3-53.968.916.6Eur, ME & Afr -17.74.751.2 35.847.121.3 28.9-56.563.318.8

Comparators:World -17.8-21.130.812.8 7.717.97.1 -40.331.59.6US -13.0-23.426.8 8.86.413.2 5.6-37.426.313.2

How can the better returns of EMs from 2003 to 2007 be explained?They are not explained by increases in valuation: In fact, the P/E ratios of most EMs did not increased excessively and were below those of developed countries. Better returns in EMs were explained by two factors: (1) the better macroeconomic performance in most EMs in this period, as reflected by higher rates of growth and lower inflation; and (2) Greater “appetite” for EM assets due to high liquidity (investment resources) and lower returns in developed countries.

What explains the collapse in 2008?The international crisis in developed countries, and excessive borrowings in EMs during 2007 and 2008.

Developed Market Stocks

• MSCI, • Prices, • in US Dollars, • as of November 2010

•The stock bubble of the 1990s (dot-com bubble) was due to the speculation that a “New Economy” -- supported by better technology, computers, e-commerce and other internet applications -- would generate higher productivity growth. •For several years, this led to a financing boom (supported by new Venture

Capital),higher investments and growth, high P/E ratios and high stock prices…until 2000!•Then another boom (in housing) was supported by low interest rates and de- regulation of banks….until 2008!!.

Emerging & Frontier Markets Stocks

• MSCI, • Stock Prices, • in US Dollars, • as of November 2010

WORST PERFORMING STOCKMARKETS 2010

Greece -46%Spain -25Ireland -19 Italy -17Kazakhstan -17Slovenia -16Portugal - 14Lebanon -13Bulgaria -12Jordan -12 Hungary -11Czech Rep -7France -7UAE -5Romania -2Belgium -2

BEST PERFORMING STOCKMARKETS 2010

Sri Lanka 71%Argentina 70Estonia 56 Thailand 50Peru 49Ukraine 49Colombia 41Chile 41Malaysia 32Indonesia 31South Africa 31 Philippines 30 Korea 25India 19Turkey 18Singapore 18

BEST PERFORMING EMs STOCKMARKETS

(MSCI) 2009

SriLanka 184%Brazil 121%Indonesia 120%Russia 100%India 95%Chile 82%

2008Tunisia -8%Morocco -12%Lebanon -22%Israel - 30%Qatar -30%Jordan -35%

WORST PERFORMING EMs STOCKMARKETS

(MSCI)2009

Bahrain: -36%Ghana -26%Nigeria -24%Trinidad & Tobago - 13%Kuwait -10%Morocco -8%

2008Ukraine: -94%Bulgaria -82%Russia -74%UAE - 73%

Pakistan -72%

Estonia -65%

V. Investment Vehicles in Emerging Stock Markets

Investing abroad has been facilitated by the development of a number of equity investment vehicles. The main ones are the following:

1. Direct Purchases.• The direct way to trade in foreign equity is on the foreign stock

market itself. • But this route is usually reserved for large institutional investors

because of the issues involved: initial foreign exchange purchase, a custodian to hold the shares, a bank account to collect and repatriate dividends, pay commissions, pay taxes, etc.

• In addition, the investor should be familiar with the issues of delivery, clearing, and settlements, as will be discussed later.

• All these issues substantially increase the transaction costs of foreign stock markets.

• Other simpler schemes are given below.

..

2. American Depositary Receipts (ADRs). • ADRs are negotiable certificates evidencing ownership of foreign

equity shares held, on the investor’s behalf, by a major US bank in the foreign country where the shares were issued.

• ADRs were first introduced in 1927 by J.P. Morgan to allow Americans the chance to buy shares in London’s Selfridge’s Department Store. Until that time, a physical presence of the investor in the country was needed.

• In order to issue an ADR, a US bank takes custody of foreign shares in its own foreign office.

• Then, an ADR can be issued as a claim against these shares.• The US bank will take care of all administrative matters, such as

receiving dividends, paying taxes, keeping track of exchange offers.• Three US banks dominate the ADR market: Bank of New York

(with 65% of the market), Morgan Guaranty, and Bankers Trust.

• Owners of ADRs have the right to redeem their ADRs and obtain the true underlying foreign shares. This possible arbitrage ensures that the price of the ADR and the foreign shares will be very close, though there may be a discount.

• Investors can trade their ADRs without recourse to the foreign equity market and without relying on foreign clearing and settlement; thus reducing trading costs.

• In an sponsored ADR, the foreign firm pays a fee to the depositary bank for the program cost.

• In an unsponsored ADR,the depositary bank takes the initiative to profit from a popular foreign issue.

• ADRs bear all the foreign exchange and commercial risks of the underlying foreign shares, even though they are quoted in US $.

• Global Depositary Receipts (GDRs) are similar instruments trading in other countries, particularly in London and Luxembourg.

• ADRs and GDRs are generally called DRs

• Level 1 ADRs are those ADRs that are not traded in an exchange; but they trade in the over-the-counter markets. They do not require full SEC registration. The company is only required to disclose its Financial Statement in English and information provided in its home Annual Report (no need to GAAP accounting principles).

• Level 2 ADRs are those that meet the disclosure requirements of a US stock exchange and are listed in the exchanges.

• Level 3 ARDs are those that fully complies with US accounting principles and disclosure requirements, and they may raise equity in the US through a public offering.

• Rule 144A ADRs are those privately placed with Qualified Institutional Buyers. As a private placement, there is no need of registration and review by the SEC. These ADRs can be resold only to other Qualified Institutional Investors.

• In 2008, more that 2,250 sponsored DRs were traded in the US and Europe, from about 76 countries (from 350 DRs from 24 countries in 1990).

• In 2008, the total value of outstanding DR's reached $1,800 bn ($1,200 bn listed in the US, $320 bn listed in Europe and $250 bn in OTC and others).

• Demand for DRs have been growing, with trading volume reaching $24 trillion during the first half of 2008, increasing by about 25% pa during the last 10 years.

• In 2007, foreign companies raised US$55 billion through DR offerings, of which $27 billion was handled by Bank of New York Mellon, $11 billion by Citibank, $10 billion by JP Morgan, and $8 billion by Deutsch Bank.

• A large number of DRs are from Emerging Market companies, including India (276), Russia (195), China (143), Brazil (129), South Africa (69), Mexico (66), Ukraine (65), Korea (59), Turkey (53), Poland (38), Kazakhstan (24), Hungary (16), etc.

• Ukrainian companies include metallurgical, auto, retailers, oblaenergos, banks, etc

• The largest Emerging Markets companies raising funds in 2007-08 were Gazprom, Lukoil (Russia), Petrobras, Vale (Brazil), American Mobil (Mexico), and Suntech (China).

3. EM Mutual Funds.• These are organized as corporations with a board of directors.

Investors purchase their shares which are pooled and invested in EM securities.

• Mutual funds can be Global (US and non-US shares), International (non-US shares), Regional (in a particular area), County (a particular country), or Sector Specialty (such as energy).

• There are two types: Open-end and close-end mutual funds.• An open-end fund stands ready both to issue and to redeem shares,

at prices reflecting the net-asset value of the underlying foreign shares (assets minus liabilities). The shares of the open-end fund are not normally traded in secondary markets.

• A close-end fund issues a fixed number of shares against an initial capital offering. It will not redeem the shares but they are traded in the secondary market at prices reflecting a premium or discount relative to the net-asset value of the underlying foreign shares.

• The owner of a share of an open-end fund earns a return based on the change in the net-asset value of the fund.

• The owner of a share of a close-end fund earns a return based on the net-asset value of the fund plus the change in discount/premium.

• Studies in 1994/95 showed that, on average, the variance of close-end country fund returns is three times larger than the variance of the underlying foreign securities.

• The premium/discounts of close-end funds are mean reverting and are affected by news about local events.

• On the other hand, open-end funds are not practical or cost-effective for foreign investment in Emerging Markets.

• This is because it is hard for an open-end fund to stand ready to liquidate stock positions on demand, since foreign equity emerging markets lack liquidity, impose higher transaction costs and restrict full liquidation/repatriation of positions.

• Close-end funds are not forced to liquidate positions when shareholders wish to exit the fund. Exit or purchases will however affect the premium or discount of the fund shares.

• Close-end country funds have become the fastest segment of the market in the last decade.

• EM’s country funds include funds for Argentina, Brazil, Chile, China, Mexico, Philippines,China, India, Indonesia, Korea, Malaysia, Taiwan, Thailand, Turkey, Russia, Ukraine, etc.

4. Index Funds• Index funds are investment funds whose shares are traded in

stock exchanges and are intended to track the performance of a single country index.

• Therefore, they are useful for investors who wish to follow a “passive investment strategy”.

• Index funds started in 1987 when the Toronto Stock Exchange created a fund to hold baskets of the stocks in the Toronto 35 Index.

• In 1993, the American Stock Exchange began trading shares in an index fund that held a portfolio of all common stocks in the S&P 500 (called Standard and Poor Depository Receipts -- "Spiders"). It was an instant success.

• In 1996, the American Stock Exchange opened another index fund for international equities, the World Equity Benchmark Shares Foreign Fund). Its shares were called "Webs". They are now called iShares (for index shares).

• The iShares fund has 20 separate portfolios, each one designed to match the performance of a given country, including EM such as Hong Kong, Mexico, Malaysia, Taiwan, Korea.

• The iShare portfolios are designed to track the Morgan Stanley Capital International (MSCI) Index for that country. They are managed by Barclays (BGI).

• The New York Stock Exchange in 1996 introduced its own Index Fund, Country Baskets. CBs were available for 10 countries and are designed to track the Financial Times/S&P Actuaries World Index for that Country. They are managed by Deutsche Morgan Grenfell.

• CBs and iShares combine the features of close-end funds, open-end funds and ADRs.

• To initiate the fund activities, they rely on the sale of a “creation unit”. In exchange for a sum of money (US$2 million for CBs and US$0.5 million for iShares), an investor purchase a “creation unit” in one index fund.

• The fund manager uses these funds to buy shares and DRs whose performance will match that of the country index.

• Each “creation unit” divides into a specified number of shares that the investor can sell through the corresponding stock exchange.

• Thus, like an open-end fund, the size of the CBs and iShares can grow without limit; but the shares are traded at any time in the secondary markets, like a close-end fund.

• As a DR, prices of CBs and iShares are kept close to the net-asset value of the underlying foreign shares, through arbitrage.

5. Hedge Funds• A hedge fund is an organization whose management receives

compensation in the form of performance incentives, rather than the amount of assets held or transactions made.

• Normally the managers are also large investors.• In the US, they are usually structured as Partnerships.• They raise funds as Private Placements: a private offering to a

accredited investors (such as financial institutions) and no more than 35 non-accredited investors. The total can not exceed 100 owners. Normally a typical investment is over $250,000.

• Under a Private Placement, the fund avoids registration under the Investment Company Act of 1940, which imposes limitations on the types of investments made and requires strong disclosure.

• If the Hedge Fund is organized outside the US -- called offshore fund -- it can avoid the limitations in raising funds.

• Popular places with low regulations include Bermuda, Cayman Islands, Bahamas, Mauritius, Luxembourg, Switzerland, Dublin.

• Originally, in 1949, hedge funds were introduced A.W. Jones and Co. to maintain highly “leveraged” but relatively “diversified” and "hedged“ positions, with a limited net exposure to “overall” price movements (they developed fast in the 1960s and 1970s): Market Exposure = (Long Exposure - Short Exposure) / capital

• Today, Hedge funds follows many different strategies:– Market neutral, where the market exposure is low or zero

trading on “convergence spreads” between two securities.– Event-driven, seeking arbitrage in bankrupt securities.– Opportunistic, taking advantage of any opportunities.

• Most hedge funds use derivatives extensively.• Investors normally have short-term horizons, thereby the hedge

fund must have liquidity by investing in short term deals• Because of risk management failures, hedge funds have suffered

from a large share of failures.• Also, because of the lack of regulations, they have been more

vulnerable to fraud.• In 2002, there were 6,000 hedge funds with $600 billion in assets.

6. Private Equity Funds.• It is a collective investment vehicle under which large investors

(Limited Partners) provide long term financing to a Private Equity Fund (General Partner) for investment in firms that need initial capital (Venture Capital) or capital for restructuring (Buy Outs)

• A professional fund manager (General Partner) monitors and manages the future growth of the invested companies

• PE Funds have a defined life (10 years is standard)• PE Buy Out Funds invest in few large companies (10-15)• The GP receives a Management fees to cover costs (2% standard)• Additional Incentive for manager: Carried interest (usually 20%

after a hurdle rate of 6 – 10% pa)• Private Equity Funds are organized as Limited Liability companies

normally incorporated off-shore.• Funds are raised as Private Placements• PE can play a critical role in promoting economic growth and

preparing companies for purchase by strategic investors

Private equity vs Public Equity

Private Equity

Buy-outsLater stage financing

Venture capitalEarly stage financing

Public equity: Initial Public Offering (IPO)

With stock market listing

Private equity is illiquid, ownership is concentrated, valuation is difficult, intermediaries tend to me small, finance is accompanied by control and mentoring

Public equity is liquid, ownership is dispersed, valuation is relatively easy, intermediaries are large, finance is often divorced from control and mentoring

What is difference between Venture Capital, Buy outs and IPOs?

Seed Early Stage

Development Capital

Buy Out Pre -IPO IPO / Strategic

Sale

Venture Capital: Identifies and financenew companies with high growth potential

Idea / Seed Friends, Family &

Fools (angels)

Later Rounds of Financing

Sale

High growth. Exceptional product / Intellectual Property Need weekly & monthly board meetings and close monitoring

Buy Outs: Acquire more established -- but underperforming companies -- to improve growth and make possible Exit to strategic

investors.

Individual / Family

Financial Investors Adds value

Professionalizes

May change Management

May merge

Strategic Investor

(IPOs are rare)

Private Equity-The Investment Cycle

Investors (Limited Partners)pension funds, insurance funds, banksendowments, companies, individuals

Private Equity Fund(General Partner)

Invested Companiesnew ventures, buyouts

ExitSale, IPO

How are Private Equity funds structured?

MarketingCommitment Period:

draw down/investment

Divestment Period:Realisation of

returns and exitExtension

MarketingFollow-on fund

10 years1 year 2 years

Cash flows back to investorsIndications of fund performance

commitments by investorsmultiple ‘closings’

Most private equity is invested via partnerships of a limited duration

Capital Base Overtime

0 5 10

$

Commitment Period

Divestment Period

-- - - Committed amount

______ Invested amount

How Teams are kept Together?

0 10

Fees

$

20 30

Fund 1 Fund 2 Fund 3

Investment Process – Can take 1-5 months.

Create awareness of PE

Get Deal Flow

1st. Screen for deals Deal Alert

Preliminary due diligence

Formal write up for decision

Investment Committee

Contacts Banks Own network Seminars Cold Calling

Must fit objectives Feel for economies

1 page write up to inform colleagues

Can be all internal or internal & external

Final diligence and documentation

I.C. sign off iFinal Documents Closing

Value Addition and DivestmentTHEN

7. Equity-Linked Eurobonds.• Many Emerging Market companies issue Eurobonds

with features such as detached stock options (warrants) and convertibility that provide links to equity shares.

• These features provide an alternative vehicles to invest in equity.

• In a country which is largely closed to direct equity purchases from abroad, a convertible bond is one of the ways for a foreign investor to enter the equity market.

• In other countries, such as Indonesia, with difficult equity clearing and settlement procedures, a convertible bond was used to avoid these equity market problems.

8. International Firms.• An indirect way to participate in the economy of Emerging

Markets, is to purchase shares of international companies (US or European) that have a large portion of their revenues and profits from their activities in Emerging Markets.

• For example, a large portion of the revenues of the UK company JKX Oil, Ltd., depends on its oil investments in Russia and Ukraine.

• Other large international companies with substantive involvement in Emerging Markets include: American Express, Bayer, Coca-Cola, McDonalds, Gillette, Minnesota Mining and Manufacturing, Nestle, Unilever, Procter and Gamble.

VI. Differentiating Features of Stock ExchangesMost EMs have established Stock Exchanges to facilitate stock

trading. The key features of these stock exchanges are:(1) Public versus Private Exchanges: • In most EMs, stock exchanges were established by

Governments, which retain strong influence in their operations.

• Stock dealers and brokers are private, but operate under the surveillance of the state, normally through National Security Commissions.

• Following the Anglo-American model, in South Africa and most of East Asian, stock exchanges are private, but operate under Government regulations, with a good doses of self-regulation.

(2) Spot versus Forward Markets. • In most markets, stocks are traded on a spot or cash basis.• But almost nowhere are stocks, once traded, delivered on the same

day: a typical “spot” or cash settlement of the stock is three to five business days (T+3; T+5).

• Many East Asian exchanges and Rio de Janeiro follow a “forward’ market approach (such as in Paris): Stock deliveries and settlement take place once a month at the end of the month. At the time of the transaction, the price is fixed and a deposit is required.

(3) Continuous versus Auction Quotations. • Most major markets offer continuous pricing of stocks, at least for

the major stocks, with market-makers ensuring liquidity. • Market-makers will quote both a bid price (for buying) and a asked

or offer price (for selling); and stand ready to trade at these prices.

• In smaller markets, the price is determined by daily auctions: orders are accumulated, and at the end of the day, a price that maximizes the volume of transactions is determined (this is the price where there is equilibrium of demand and supply). This single equilibrium price applies to all transactions.

(4) Centralized (Floor Trading) versus Decentralized Systems. • Centralized stock trading at the floor of exchanges continues in

many exchanges, due to the advantages to close personal interactions, principally for large transactions.

• But most stock exchanges in Emerging Markets use decentralized computerized systems as the forum for trading, following either (i) price-driven systems; or (ii) order-driven systems.

• These stock exchange systems have their own regulations regarding requirements for membership, access to the system, trading rules, listing and de-listing of securities, registration as market-makers, professional responsibilities, settling of disputes, arbitrage, etc.

• Price-driven systems, such as Ukraine’s, are based on the NASDAQ system for low-liquidity stocks:– It is based on a dealer Price Quotation System (Stock Exchange

Automated Quotation- SEAQ). In Ukraine, out of 300 dealers, 200 are members, linked to the system.

– Members are free to register as market-makers, quoting “firm” bid/asked prices for active stocks, up to a maximum limit.

– The difference between the bid and asked prices is the “spread” which is the source of income for the dealer.

• A 1994 Harvard study of the US’ NASDAQ, found that in many stocks, the spread was always $0.25 a share, while in others went as low as $0.12 a share. This prompted to accusations of collusion and a review of competitive practices. Soon thereafter, spreads began to shrink.

– In this price-driven system, transactions do not happen automatically, but are executed at the order of a member dealer.

– Once an order arrives to a market-maker, it is obliged to execute it. – Both parties are expected to input the transaction and reported it to

the main system within 90 seconds. – If the receiver of the order does not execute it within a few minutes,

the originator can input both entries and report it. – Some minor stocks have only a handful of market-makers; big

company stocks have as many as 50.

• The screen of a dealer would list bid/asked quotations by market-makers for a specific company stock, as follows:

• Order-driven systems are based on the Paris and Toronto systems: – All exchange members have trading screen in their offices.– For listed stocks, members enter their limit-orders, indicating the

maximum price for buying the stock (maximum bid price) and their minimum price for sale of the stock (minimum asked).

– Trading takes place automatically against this computerized limit-order book.

– When a new order arrives, if possible, it is immediately routed and executed against the limit-order book: it would be possible if the new order has a price for purchase that is above or equal to the minimum price asked by another dealer for the sale of the stock.

– If it not possible to execute the order, it is entered into the limit-order book for future trading.

– Since bid/asked orders are not of equal quantities, orders are executed following price/time/size priority rules: (highest bid and lowest asked have priority over other orders).

–In some cases, large trades are done over the telephone, rather than left to the computer. Once executed, they are recorded in the computer and taken into account in price calculations.

–In small stock markets, such as Moldova, trading is not continuous: Members enter their limit-orders between 10:00 am and 2:45 pm. At 2:45 pm entry is closed and orders are matched, as follows:

Max Bids (Buyers) Min Asked (Sellers) Dealer Price # Shares Dealer Price # Shares A 4.0 300 D 3.0 100 B 2.0 500 E 4.0 100 C 1.0 200 F 5.0 100

The only transaction that would take place is the purchase by dealer A of 200 shares, 100 from dealer D at $3.0/share and 100 from dealer E at 4.0/share. The average price will be $3.5 per share, which will be registered for the records.

VII. Structure of Stock MarketsThe following chart provides a graphical representation of the structure of stock capital markets:

• The Lower Level (Level 3) includes the “Shareholders”.• Their share ownership is formally recorded -- for a fee --in

specialized entities called “Registrars”. • Registrars will issue Certificates of Ownership, either in paper or

dematerialized (electronic) form. • There are about 30 specialized Registrars in the US. • In many EMs, any agency could be a Registrar, including the same

company (until recently, there were 400 Registrars in Ukraine; in Russia, owners “disappear” before dividend payment date).

• The independence, qualification and regulation of Registrars is a key factor to avoid abuses and give confidence to a stock market.

• Level Two includes the “Custodians” (dealers, brokers, banks) which represent the shareholders, keeping their shares in custody, either physically or electronically (paperless).

• The Custodians are only entities working with Level One agencies and Level 3 entities. There are 5,000 in the US; 60 in Ukraine.

• The Level One agencies include:– The Trading Systems: Stock Exchanges and Over-the Counter,

where the trading takes place.– The Depositary: which receives from Custodians the shares to be

sold and keeps them in anticipation of the trade. A centralized, independent depositary is key to give confidence to the market.

– The Settlement Bank: which keeps the cash accounts of buyers.– The Clearance and Settlement System:

• Trade clearance involves verifying and comparing information provided separately by buyers and sellers and finding out if there is a match. Otherwise, they go back to the dealers.

• If the match is successful, settlement obligations are calculated.• On T+1 to T+3 day, it will check that the seller’s shares are

indeed deposited in the Depositary and that the buyers do have cash in their accounts in the Settlement Bank.

• If so, it instructs the Depositary to transfer the securities from seller to buyer; and gives the order to the Settlement Bank to transfer money from the buyer account to the seller account.

• Settlement can be made on a “gross” basis for an individual deal, on a “bilateral net” basis for more than one trade among two parties, or on an “ multilateral net” basis (the last one is typical in the US).

– A key function of this system is to protect shareholders rights and provide confidence that payments will be made only if there is delivery of the securities.

– A Delivery-Versus-Payment (DVP) system has controls to ensure that final delivery of securities (or cash) occurs only if final transfer of funds (or securities) occur.

– Many EMs have non-DVP systems, with the risk that the full amount of the transaction may be lost.

– In Europe, the tradition is to combine the functions of Depositary with Clearance and Settlement Houses.

• For example, in Switzerland, the securities transfer system SECOM is linked to a separate fund transfer system, SIC.

• A DVP transaction causes securities to be reserved in SECOM, which then generates a payment instruction from the buyer to the seller in SIC.

• SECOM releases the securities to the buyer when SIC confirms final payment.

– In the US, the functions of Clearance and Settlement Houses and Settlement Banks are performed by the National Securities Clearance Corporation (NSCC) and the US Federal Reserve’s Fedwire Securities and Fund Transfer Systems.

– In the books of the Federal Reserve, banks maintain both security and fund accounts, which permits simultaneous transactions.

– In the US, depositaries are organized as limited-purpose trust companies under banking laws.

VIII. Enabling Environment for Stock Markets.Investing in equities in EMs has special risks, including:(a) Information Barriers. Differences in accounting standards, and

high cost of information.(b) Political and Capital Control Risks. As a foreign investor, you

money is under another jurisdiction. What are the protections you enjoy.

(c) Foreign Exchange Risks. The value and returns from the equity is denominated in a foreign currency. Is there convertibility or restrictions on foreign exchange?

(d) Restrictions on Equity Investments. (e) Excessive Taxation.(f) High Transaction Costs.

The way how the country deals with them defines the quality of the enabling environment for stock market development.

• In assessing the adequacy of the enabling environment for capital markets in the country, the following matters should be analyzed:

1. Adequacy of the Legal and Regulatory Framework for the Stock Market. – Does it provide adequate protection of ownership rights for

small and other shareholders? – Does it contains adequate and severe penalties for fraud? – Does it permit sufficient competition to facilitate stock

trading and reduce transactions costs?– Are the Broker/Dealer regulations adequate in terms of net

capital requirements, qualification standards, commission limitations, auditing requirements?

– Is there a system of self-regulation by market participants?

2. Adequacy of Prudential Supervision of Capital Markets. – Is the supervision system capable of detecting abuses, inside

trading? – What is the role of the national security and exchange

commission? Are there conflicts with other agencies?– Are the procedures adequate to carry out inspections, off-site

and onsite surveillance?– How are prudential regulations enforced on market participants?

3. Adequacy of Information, Accounting and Auditing Standards.

– Are the listing requirements, including documentation of qualitative and quantitative qualifications, satisfactory? excessive?

– Do the listed companies comply with international accounting and auditing standards?

– Are the requirements for disclosure of information satisfactory for Public Offerings? Private Placements?

– Do they provide for information through Annual Reports with adequate transparency standards, such as compensation of managers?

4. Adequacy of Tax Policies for stock market activities. – Do taxes unduly penalizes capital market transactions and

profits?

5. Adequacy of the Stock Markets Infrastructure. – Does the current market infrastructure protects from

counterpart risk: the possibility that the other party (seller or buyer) will not deliver at settlement.

– Does a central and independent depositary system exist to minimize abuses and risk of non-delivery?

– Is there an adequate system for registration and custody of shares? (is an accurate custody of ownership records maintained? will shares be wrongfully lost, challenged?

– What systems are used to handle the formal Clearing Process? (process of verifying and identifying the traded shares, the identity of buyers and sellers, and the price and date of trade)

– How good is the system for the settlement of stock transactions (time periods, level of technical fails, adequacy of the delivery-versus-payment system, netting process?)

– What is the level of technology sophistication and types of risk controls are used in clearance and settlement?

– What are the sources of trade data and how it is reported?– What is the peak and normal processing capacity of the

existing infrastructure?

6. Availability of private and sound Credit Rating Agencies.– The availability of credit rating agencies has been proven

to be a key factor leading to better market discipline and transparency by listed companies.

– Credit Rating companies exercise a good degree of “market” control.

IX. Equity Portfolio Strategies• The main argument for global investment -- and particularly for

portfolio allocation in emerging capital markets -- is based on the appeal of diversification (to reduce the total risk of a portfolio).

• As noted before, empirical work has shown that EMs stocks are more volatile that stocks in developed markets but their correlation with other markets is low.

• Therefore, EM stocks can actually reduce portfolio risks while increasing returns.

• The risk of an EM stock is defined by the volatility of its returns.• But contrary to the US situation, the "standard deviation" of returns

is not a good measure of risk, since they do not follow a normal or symmetric distribution. To assess the risk of the EM stock, the investor must look at the economic situation of the country.

• Another form of international portfolio risk is correlation risk: The risk that a seemingly diversified portfolio will prove to be un-diversified in the future because its assets will begin to move uniformly, rather than independently.

• Increasing cross-border investments and improved communications is increasing the correlation among developed markets.

• But except during periods of large variations, correlations of developed market stocks with emerging market stocks are still low.

• These correlations are still low due to the fact that emerging markets are still segmented in an international context.

• This segmentation is due to market imperfections and constraints, including: lack of information, Government constraints, investors perceptions, etc.

• Although, long term gains from diversification are feasible, portfolio managers should be aware that in times of large market movements almost all markets seems to move in the same direction: During periods of disaster there is no safe place to hide.

• However, the impact of a crisis on other individual EM depends on the economic strength of the country: Countries with sound economic policies have suffered less from crises.

• All this suggests that rules-of-thumb do not work well in EMs. Investors should carefully build their own Emerging Market Portfolio based on fundamental analysis.

Building an Emerging Market Portfolio• The stock selection process could follow a Top-Down approach

or a Bottom-up Approach.

(1) Top-Down Investing.• Under this approach, a country (sector) should be selected first,

based on fundamental macroeconomic factors.• This approach is based on the believe that stocks within a

country (sector) are highly correlated and move together. • Therefore, the emphasis is put in identifying countries (sectors)

that are expected to outperform.• After a country (sector) is selected, then, stocks can be chosen

within the selected country: Most Top-down investors would use a “passive management” for stock selection (such as using a country index).

• But others would use active management (picking up individual stocks). But since stock selection is less important, they tend to concentrate in large, liquid stocks.

• In order to forecast the relative performance of the country’s stock exchange, there is a need to look at the soundness of the economy as a whole.

• A sound economy is one that has both growth and stability. • Growth is defined by a high rate of GDP growth. • Stability is defined by a low inflation rate (internal stability), and

a stable foreign exchange rate (external stability).• Sustainable rates of real GDP growth and firm stability are the

key factors affecting the performance of the stock exchange.• Growth and stability are secured by the implementation of sound

economic policies.• The following economic policies have been proven to be essential

(I for Stability; II and III for sustainable growth).

(I) Macroeconomic Stabilization Policies:• Fiscal Policies under which the Government's fiscal budget

has a deficit that can be financed by borrowings on a sustainable basis (normally no more than 3% of GDP).

• Monetary Policies, under which the creation of money (money supply) will not exceed the demand for money (which is affected by income and interest rates).

(II) Liberalization of the Economic Environment• Liberalization of the Formation and Operation of Enterprises• Liberalization of the Closure of Failing Enterprises• Liberalization of Product Pricing and Trade• Liberalization of the Financial Sector• Liberalization of Labor and Land Markets

(III) Good Public Governance with Sound Institutions • Sound & efficient Government services without corruption• Stable and predictable legal environment• Low political risks.

(2) Bottom-Up Investing.• These investors base their portfolio selection on the merits of

individual stocks. • The emphasis is put on identifying stocks that are expected to

outperform.• Country considerations are reviewed at a second stage, with

emphasis on exchange rate movements and interest rate changes.• Professional investors often “screen” thousand of EM stocks by

applying a set of criteria that filters out all but the companies that merit a closer look.

• Screening criteria fall into five categories: Growth, Profitability, Pricing, risks, liquidity.

• In Emerging Markets, the most important screening is growth.• Then, for a closer look at individual company stocks, most

investors use the stock valuation methods discussed in Part II above, including discounted cash flows, P/E ratios, EV/EBITDA ratios, asset-based ratios and industry-specific benchmarks.