seb on journal issue 1

8/13/2019 Seb on Journal Issue 1

1/129


2/129

SEBO Journal, Vol.I, June 20042

Towards Good Corporate Governance

- Deepak Raj Kafle

1.1 Transparency, accountability, information disclosures and stringent ethics

practiced by companies are fundamental in winning investors' confidence.

Capital market and so the corporate sector cannot develop with weak

minority shareholders, inadequate or non-disclosures, violation of laws,

non-compliance to the rules and regulations and lack of independent

oversight of the directors. Nepalese corporate sector has yet to establish

good governance practices and become more competitive sector of the

economy.

1.2 In today's liberalized environment, corporate sector demands reduced

interference by the government. It is in this context that operation of the

companies should be transparent and they should adopt good corporate

governance practices. The government has also very important role to

promote good governance. It has the responsibility to shape the legal,

institutional and regulatory climate so that it provides incentives for thedevelopment of individual corporate governance systems.

2. As a regulator, Securities Board (SEBO) wants to see improved image of

Nepalese corporate sector. It is presently involved in implementing

government's capital market reform program that affects many aspects of

Chairman, Securities Board, Nepal


3/129

SEBO Journal, Vol.I, June 2004 3

corporate governance. This infrastructure and capacity building program

would help to establish appropriate framework for good corporate

governance. These initiatives together with the legislative reforms taking

place are briefly mentioned below:

Consistent legal framework

2.1 Improved corporate governance emanate from consistent legal framework.

Various aspects of companies including its governance are generally

provisioned in Companies Act and Securities Act. Harmonization and

qualitative improvement in these two laws are taking place. A new Bank

and Financial Institutions Act has already been issued as an ordinance

whereas a new Securities Act and New Companies Act are in thelegislative process. These acts are important to give a clear institutional

framework for Nepal Rastra Bank (The Central Bank), SEBO and the

Company Registrars Office (CRO) and they clearly define their regulatory

jurisdictions. However, the delay in adopting the company and securities

legislation is seriously hampering the reform in corporate governance

framework.

Institution Building

2.2 The government has signed a contract with the Asian Development Bank

to implement a Financial and Corporate Governance Project. It has capital

market, judiciary reform and payment system development components.

The capital market component addresses the capacity building needs of

Securities Board and Company Registrars Office, modernization and

professionalization of Nepal Stock Exchange Ltd. (NEPSE) and

establishment of Central Depository System.

2.3 SEBO's role as an effective regulator can be realized through enhanced

policy development and rule making capacity, supervisory effectiveness,

investigation and enforcement actions and proper research and educational

roles. Establishment of comprehensive MIS, rules benchmarked to

international standards, organization restructuring and strengthening

functional areas are the key reform measures envisaged under the project.


4/129


These initiatives also include developing and prescribing corporate

governance codes for companies.

2.4 Modernization of NEPSE would allow it to facilitate low cost and efficienttransactions. The project plans to improve professionalism of its staff,

setting up of MIS and preferably an electronic trading system, self-

regulatory compliance and low-cost dispute settlement mechanism.

Corporate governance enhancement is expected to be in the form of listing

rules, which the stock exchange monitors.

2.5 To supplement stock exchange efficiency, Central Depository System, a

mechanism to facilitate a risk-free and efficient transfer of securities is

being planned.

2.6 The capacity building of the CRO deals with the up-gradation of the

company registration system, its MIS and other organizational aspects.

Financial Disclosures

2.7 Improved financial transparency and disclosure is the basis of sound

corporate governance that also highlights risk profile on investment.

Accounting and Auditing Standards are converging towards international

best practices with the progress in the activities of Accounting Standards

Board and Auditing Standards Board under the umbrella of the Institute of

Chartered Accountant, Nepal, Act. However, there is a need for developing

practical and effective means to implement the standards. Capacity of these

agencies has to be enhanced to build accounting and auditing manpower

and to enforce the standards.

Judiciary Reform

2.8 Another set of reform is taking place in improving legal enforcement

mechanism and judicial capacity. This includes establishment of National

Judicial Academy to ensure effective skills development of judges and

lawyers in commercial and financial matters. Establishment of legal

information center as a center repository of all laws and regulation and for

judgments by judiciary, establishment of commercial bench and dispute


5/129


resolution are the initiatives that would be helpful, although indirectly, to

promote corporate governance.

2.9 The legal and institutional framework is evolving to become progressivelysupportive of the corporate governance practices. The new Bank and

Financial Institutions Ordinance has come out with the provision of

independent director (a professional expert but without voting rights), has

stipulated qualification/experience for directors and CEOs and clear

sanctions available for cases of non-compliance. The proposed Companies

Act is believed to come out with more on corporate governance such as

responsibility and accountability of directors, provision of independent

directors with voting rights and audit committee.

2.10 Some basic tenets of corporate governance could come in the mandatory

form but the main responsibility for maintaining good governance lies

within the companies themselves. It is where further efforts of SEBO

should be focused. It has to be well understood that the growth in number

of listed companies and participation of small investors depends on the

governance practices.

3 Survey on Corporate Governance

3.1 SEBO conducted a survey on corporate governance practices by collecting

views of directors and senior executives covering wide range of issues

regarding governance. Though the response rate was merely 12% (27 out

of 224) covering 16 listed companies, it has provided meaningful insight

into the corporate governance situation.

3.2 Promoter domination, separation of chairman and CEO in most of the

companies, use of delegated committees (including Audit, Accounting,Recruitment and Promotion Committee) were observed to be in practice in

some companies. The respondent directors favored the induction of

independent directors, expressed the need of availing more information for

the effective boardroom discussion and decision-making. They also

endorsed professionalization to be useful to achieve corporate goals.


6/129


3.3 The respondents said the types of strategic alternatives and plans that they

were presented with were operational and policy guidelines, budgetary

outlay and targets and business expansion.. They used to review on matters

especially concerned with investments. Even though the respondents foundadequacy in their present internal control system, they have suggested

enhanced compliance culture by upgrading the role of company secretary

and having a system of compliance audit.

3.4 The respondents are in favour of upgrading accounting standards. They

have suggested that board should take a role to review preliminary annual

report and views of analysts and upgrade the financial reports accordingly.

They also agreed that the board should understand the information

requirement of the corporate stakeholders and endorsed the necessity offinancial as well as non-financial information to justify the share price.

3.5 The responsibilities of the board regarding social, ethical and

environmental aspects were well understood by the respondents. They also

agreed to have mechanism to address the cases of non-compliance by the

management.

3.6 This survey showed that corporate directors and executives have

recognized many elements of corporate governance and some of which are

already in practice too. They agreed to the necessity of adopting good

governance and the code of ethics. It is important to note that they have

suggested for co-operation with the regulators to work for the improvement

of corporate governance.

4 Framework of Discussion

While appreciating the above-mentioned views of corporate directors and

executives one can be enthused and work to move towards good corporate

governance practices. These principles should be discussed, refined and adopted

by the listed companies in a gradual manner, initially may be in a voluntary basis

and ultimately as mandatory codes. The following elements, which are also in

practice in many other countries, have been briefly mentioned as a suggestion to

start discussion with the companies, business community, regulators and

professionals:


7/129


The Board of Directors

4.1 The fiduciary responsibility and trusteeship role of directors, collective and

individual, should be well understood and established. The focus of

corporate board reform should be directed to bring in the independent,

more professional, meritorious and competent person rather than merely

relatives and close associates of the promoters. There should be specified

number of independent directors and ensure their participation in the

oversight role (e.g. by involving them in audit committee, remuneration

committee etc). Board with executive chairman should have at least 50

percent non-executive directors to give fair ground for independent views

on discussion and decision-making.

Audit Committee

4.2 It is important to ensure that financial disclosures and statements are

correct and credible. The Audit Committees could also help in reducing, if

not eliminating frauds, irregularities or failure of internal control system

within the organization. A three-member committee with majority of

independent directors and at least one with finance and accounting

background would be appropriate.

Remuneration of Directors

4.3 Remuneration (setting fees, profit sharing etc.) should be as decided by the

Board of Directors and there be adequate disclosure to the same in the

annual report. This will deter the board from giving disproportionate

remuneration to the directors by the promoter.

Board Procedures

4.4 The statutory and non-statutory information desired by the board should be

brought to the knowledge of the directors. Requiring minimum information

made available to the director enabling studied decision regarding

operational plans, capital expenditures plans, joint venture or collaboration

arrangements would help. The board be informed of the show-cause

notices, demands, non-compliance cases, accidents, environmental


8/129


pollution and labour problems. The board is expected to be effective when

its information needs are properly addressed.

Management

4.5 Directors' report should have Management Discussion and Analysis

Report, which should discuss industry structure and developments,

opportunities and threats, segment-wise and product-wise performance,

outlook and such other matters. Management analysis is bound to give

much needed information and insight into the working of the company,

apart from making the management think, plan and act appropriately as per

the needs of the business.

Shareholders

4.6 The shareholder should be provided with brief resume of the directors

when a new appointment/reappointment takes place. The board should

constitute a committee to address the investors' complaints.

Financial Disclosures

4.7 Publication of mandatory financial disclosures such as annual and half-yearly reports may not be sufficient; publication of half-yearly reports after

having reviewed and adopted by the board, inclusion of earning data would

enhance the quality of reports. After the half yearly reporting is in order,

shifting to quarterly reporting system would help the investors to be

informed of companies performance more accurately in a timely manner.

Besides, the standard of accounting and auditing should converge to the

international norms and practices.

Reporting and compliance Arrangements

4.8Once the governance norms are agreed and implemented, corporate

governance reports should be a part of the annual reports. The company

should be required to obtain certificate from auditors of the company

regarding compliance to the governance codes.

* * *


9/129



10/129

Fundamentals of Stock Returns in Nepal

DR. RADHE S. PRADHAN AND MR. SURYA B. BALAMPAKI

ABSTRACT

This study deals with fundamentals of stock returns in Nepal. It examines if dividend

yield, capital gain yield and total yield are related to earnings yield, size, book to marketratio and cash flow yield. The study is based on pooled cross sectional data of 40

enterprises whose stocks are listed in Nepal Stock Exchange Limited and traded in the

stock market. The study reveals that earnings yield and cash flow yield have significant

positive impact on dividend yield, and an insignificant impact on book to market value.

However, the size has a negative impact on dividend yield. In the case of earnings yield

and cash flow yield, cash flow yield has been found to be more informative than earnings

yield. Likewise, it is observed that capital gain yield is positively influenced by earnings

yield and size, whereas, the same is negatively influenced by book to market value andcash flow yield. Book to market value has been found to be statistically strong in

predicting capital gain yield. Similarly, it is noticed that total yield is positively

determined by earnings yield and size, whereas, the same is negatively determined bybook to market value and cash flow yield. Book to market value has been found to be

more informative than other variables. The study also revealed the positive relationship

among earnings yield, book to market value and cash flow yield. However, the size is

negatively related to these three variables.

1. Introduction

Among the various empirical contradictions, the cross-sectional relationship

between stock returns and fundamental variables has been studied extensively in

the US and Japan. In general, positive relationship has been observed between

equity returns and earnings yield, cash flow yield and book to market ratio, and a

negative relationship between equity returns and size, e.g., Basu (1977, 1983),

Banz (1981), Reinganum (1981), Cook and Rozeff (1984), Lakonishok and

Shapiro (1986), Banz and Breen (1986), Jaffe, Keim, and Westerfield (1989), and

Ritter and Chopra (1989). The traditional mean-variance analysis developed by

Markowitz (1956) and SLB Model (Sharpe (1964), Lintner (1965) and Black

(1972)) have indicated that the returns are determined by risk (beta) factors.

However, Ross (1976) and other empirical studies by Fama (1991), Chan, Hamao

and Lakonishok (1991), and Fama and French (1992) have suggested that the

fundamental variables such as earnings yield, size, book to market value, cash

flow yield and leverage etc. are the important determinants of the stock returns.

Dr. Pradhan is Professor, Central Department of Management, Tribhuvan University, Kirtipur,and Mr. Balampaki is associated with Nepal Credit and Commerce Bank Ltd.


11/129


The shortcomings of accounting earnings have motivated a number of recent

papers to explore the relationship between cash flow yields and stock returns

(Bernard and Stober (1989) and Wilson (1986). They observed more significant

positive relationship of stock returns with cash flow yield than that of earningsyield. Rosenberg, Reid and Lanstein (1984) studied the relationship between

stock returns and book to market ratio. They found most significant positive

relationship between stock returns and book to market ratio. The selection of

such fundamental variables has been guided more by any explicit theoretical

model. Ball (1978), Fama (1991) and Fama and French (1988) have suggested

the reasons why such variables might help to predict returns. In particular, yield

surrogates such as the earnings yield and the dividend yield are correlated with

returns because they proxy for underlying risk not otherwise accounted for by

traditional measures such as beta.

Stattman (1980), and Rosenberg, Reid and Lanstein (1985) have found that

average returns on the US stocks are positively related to the firms book to

market ratio. The study by Chan, Hamao and Lakonishok (1991) related the

cross-sectional differences in stock returns on Japanese stocks to the underlying

behaviour of four fundamental variables: earnings yield, size, book to market

ratio and cash flow yield. Of the four variables considered, book to market value

ratio and cash flow yield have been found to be most significant positive impact

on expected returns. Basu (1983) found that the earning-price ratio (E/P) helps to

explain the cross-section average returns on the US stocks.

According to SLB Model returns are positively related to risk, but the study by

Fama and French (1992) did not find the same. The study attempted to indicate

the extent to which the size and book to market equity has captured the cross-

sectional variation in average returns for the period of 1983-1990. Davis (1994)

observed that book to market ratio, earnings yield and cash flow yield have

significant explanatory power with respect to the cross section of realized stock

returns during the period of July 1940 to June 1963. The study by Banz (1981)

documented that the stocks with larger market equity have lower returns. The

size effect became weaker when beta and expected returns were allowed to vary

over time (Jagannathan and Wang: 1996, 53). Ball (1978) revealed that earning

price (E/P) was likely to be higher for stocks with higher risks and expected

returns. Wiggins (1991) also revealed that the market adjusted stock returns are

directly related to E/P and they have positive relationship. Similarly, Verma


12/129


(1994) observed positive relationship between profitability and dividends.

Though there are these studies conducted in developed capital markets, their

relevance is yet to be seen in a smaller and under-developed capital market like

Nepal.

In Nepalese context, stocks with larger price earning ratio seemed to have lower

liquidity, profitability, assets turnover and interest coverage, and higher leverage

(Pradhan, 1993). It was reported that there is a negative relationship between

dividend yield and size (market equity). Timilsina (1997) revealed that the

relationship between dividend per share and stock price is positive, and dividend

per share affects the share price variedly in different sectors. Manandhar (1998)

observed that dividend per share, return on equity and dividend yields have the

significant impact on market capitalization, whereas, price-earning multiple hasno significant impact. The study also observed the negative relationship between

dividend yield and market value, and positive relationship between dividend per

share and market value of equity. Similarly, Adhikari (1999) indicated that the

stocks with larger dividend yield have higher earnings, liquidity, assets turnover

and interest coverage. However, the study indicated negative relationship

between dividend yield and leverage. Clearly, these studies have attempted to

deal with only a few relationships described earlier.

The general conclusion of the above-mentioned empirical studies is that stockreturns are determined not only by a single factor but by a number of different

fundamental variables. This study therefore aims at analyzing the relationship of

stock returns with the underlying behaviour of fundamental variables by

estimating summary statistics and various regression models in the context of

Nepal. To sum up, this study deals with the following issues:

What are the relationships of stock returns with fundamental variables?

Are there equal contributions of earnings yield and cash flow yield in

predicting stock returns? If not, what could be the reasons for thediscriminations?

What are the roles of size and book to market equity ratio in explaining the

stock returns?

Do the large sized companies have higher stock returns?

What kind of relationship exists among earnings yield, size, book to market

equity ratio and cash flow yield?


13/129


The remainder of this paper is organized as follows. Section 2 describes research

methodology employed in this study. It includes selection of enterprises for the

study, nature and sources of data, and model to be estimated. Section 3 provides

presentation and analysis of the data. Finally, the results are summarized inSection 4.

2. Research Methodology

Nature and sources of data

This study is based on secondary data only. The necessary data and information

have been collected from various sources covering a period of 5 years, i.e.,

1995/96 to 1999/00. There were 115 Nepalese enterprises listed in the NEPSE

Ltd. by the end of FY 2000/01, which is regarded as size of the population for thestudy (SEBO/N: 2001, 15-19). This study does not cover all the Nepalese

enterprises because of data problem. Moreover, the study period begins only

from 1995/96. In the absence of valid and reliable data, the study periods for each

selected enterprises are not homogeneous in nature. To analyze the relationships

among different variables, study uses pooled cross-section data of 40 enterprises

as shown in Table 1.

Table 1

Selection of companies, period of study, and number of observations

S.N. Name of the Companies Study period Observations

A. Banks

1. Bank of Kathmandu Ltd. (BOK) 1998/99 to 1999/00 2

2. Nepal Bangladesh Bank Ltd. (NBB) 1996/97 to 1999/00 4

3. Himalayan Bank Ltd. (HBL) 1996/97 to 1999/00 4

4. Nepal SBI Bank Ltd. (NSB) 1996/97 to1999/00 4

5. Standard Chartered Bank Nepal Ltd. (SCB) 1996/97 to 1999/00 4

6. Everest Bank Ltd. (EBL) 1996/96 to 1999/00 4

Total Observations 22

B. Finance Companies

7. National Finance Co. Ltd. (NFC) 1996/97 to 1999/00 4

8. Lalitpur Finance Co. Ltd. (LFC) 1998/99 to 1999/00 2

9. Narayani Finance Ltd. (NFL) 1997/98 to 1998/99 2

10. Mahalaxmi Finance Co. Ltd. (MFC) 1996/97 to 1999/00 4

11. Ace Finance Co. Ltd. (ACE) 1996/97 to 1999/00 4

12. Nepal Housing & Merchant Finance Ltd. (NHMF) 1997/98 to 1998/99 2

13. Annapurna Finance Co. Ltd. (AFC) 1996/97 to 1999/00 4

14. Nepal Housing Development Finance Co. Ltd. (NHD) 1996/97 to 1999/00 4

15. Goodwill Finance & Investment Co. (Nepal) Ltd. (GFC) 1998/99 1

16. Nepal Share Markets Co. Ltd. (NSM) 1995/96 to 1998/99 4

17. Nepal Finance & Saving Co. Ltd. (NFS) 1996/97 to 1999/00 4

18. NIDC Capital Markets Ltd. (NCM) 1996/97 to 1999/00 4

19. Citizen Investment Trust (CIT) 1996/97 to 1998/99 3


14/129


15/129


dividend yield, capital gain yield and total yield with fundamental variables such

as, earnings yield (E/P), size (LS), book to market equity ratio (B/M) and cash

flow yield (C/P) of Nepalese enterprises by estimating various models. The

theoretical statement of the models is that the stock returns (R) may be regardedas subject to the constraints of earnings yield (E/P), size (LS), book to market

equity ratio (B/M) and cash flow yield (C/P). The theoretical statement may be

framed as under:

R = f(E/P, LS, B/M, C/P) (I)

The equation to be estimated has, therefore, been specified as under:

R = a + b1(E/P) + b2(LS) + b3(B/M) + b4(C/P) + Ui (II)

Where, dependent variable, R chosen for the study has been specified as under:

DY = Dividend yield or dividend per share to market price per share, i.e.,

D1/P0.

CY = Capital gain yield or capital gain per share to market price per share,

i.e., (P1-P0)/P0.

TY = Total yield or dividend per share plus capital gain per share to market

price per share, i.e., (D1+P1-P0)/P0.

The independent variables are specified as under:

E/P = Earnings yield or earning per share to market price per share.

LS = Size or market capitalization.

B/M = Book value of equity per share to market value of equity per share.

C/P = Cash flow yield or earning per share plus depreciation expenses per

share to market price per share.

Ui= Disturbance or error term.

The summary statistics are studied to examine the relationship between stock

returns and fundamental variables. The study is conducted at a portfolio level and

sorts out all the sampled securities into four portfolios. The summary statistics

for portfolios have been sorted by earnings yield, size, book to market equity

ratio and cash flow yield, viz., Panel A, Panel B, Panel C and Panel D

respectively. The low to high ratios of fundamental variables are provided in

portfolios 1 to 4 for each panel. Forming more than four portfolios based on

various ratios of fundamental variables would yield too few stocks per portfolio.


16/129


In other words, splitting stocks into more than four portfolios reduces the sample

sizes. For each portfolio, average ratios are computed.

3. The Results

Table 2 sorts out all the sampled securities into four portfolios. The summary

statistics for portfolios have been sorted out by earnings yield, size, book to

market value ratio, and cash flow yield, and are shown in Panels A, B, C and D

respectively. The low to high ratios of fundamental variables are provided in

portfolios 1 to 4 for each panel. For each portfolio, various ratios of dividend

yield, capital gain yield, total yield, earnings yield, size, book to market value

ratio and cash flow yield are computed. They are then classified according to

above, and average ratios are computed.

In panel A of Table 2, the portfolios sorted by earnings yield have been

presented. The stocks with high earnings yield have higher dividend yield, higher

capital gain yield and higher total yield. The average dividend yield increased

from 1.00 percent for the low to 11.14 percent for the high portfolio. Similarly,

the average capital gain yield increased from 2.70 percent for the low to 28.54

percent for the high portfolio. The average total yield also increased from 1.70

percent for the low to 39.68 percent for the high. The stocks with high earnings

yield are less variable than that of low earnings yield. However, the dividend

yield, capital gain yield and total yield for the high portfolio are more variable as

compared to low earnings yield portfolio.

Furthermore, size variable is negatively related with earnings yield, whereas,

book to market value ratio and cash flow yield are positively related with

earnings yield. The average of size decreased from 24.40 million for the low to

12.12 million for the high earnings yield portfolio. Moreover, the size for the low

portfolio is more variable than that of high earnings yield portfolio. The average

book to market value ratio increased from 0.39 times for the low to 1.19 times for

the high earnings yield portfolio. Similarly, the average of cash flow yieldincreased from 2.25 percent for the low to 33.59 percent for the high portfolio.

However, both book to market value ratio and cash flow yield for the low are

more variable as compared to high earnings yield portfolio.


17/129


Table 2

Summary Statistics for Portfolios Sorted by Fundamental

VariablesAverage yearly dividend yield (DY), capital gain yield (CY), total yield (TY), earnings to price

(E/P) ratio, size (LS i.e., market capitalization), book to market (B/M) ratio, and cash flow to price(C/P, i.e., earnings plus depreciation divided by price) ratios, for portfolios sorted by the fourfundamental variables over the period of 1995/96 to 1999/00 of 40 enterprises with 139observations. Figures in parentheses are standard deviations and N denotes the number ofobservations in each portfolio.

Panel A: Sorted by Earnings to Price (E/P) Ratio

Portfolios

Bases of Portfolio

1 (Low or smallest)

18.00

Dividend Yield (percent) 1.00

(3.18)

3.65

(3.00)

5.93

(3.80)

11.14

(8.15)

Capital Gain

Yield

(percent) -2.70

(44.25)

53.75

(90.16)

17.38

(37.16)

28.54

(47.51)

Total Yield (percent) -1.70

(44.30)

57.40

(90.34)

23.31

(36.78)

39.68

(47.63)

E/P (percent) -8.12

(26.71)

6.96

(1.76)

14.15

(2.33)

29.88

(11.21)

Size (in million) 24.40

(5.16)

233.81

(1.70)

132.22

(1.30)

12.12

(1.04)

B/M (times) 0.39

(0.66)

0.53

(0.35)

0.85

(0.33)

1.19

(0.51)

C/P (percent) -2.25(17.52)

9.15(3.28)

16.91(4.01)

33.59(14.61)

N 33 37 35 34

Panel B: Sorted by Size (LS)

Portfolios

Bases of

Portfolio

1

(Low or smallest)

32.61

2

32.61 to 80.20

3

80.20 to 485.17

4(High or

largest)

485.17


(8.43)

5.70

(4.34)

4.07

(5.52)

3.91

(3.07)

Capital Gain

Yield

(percent) 8.76

(31.48)

21.02

(56.78)

38.13

(79.80)

41.02

(71.68)

Total Yield (percent) 17.35

(28.10)

26.72

(56.84)

42.20

(80.27)

44.93

(71.24)

E/P (percent) 20.46

(16.74)

8.48

(29.34)

9.61

(16.33)

7.67

(4.40)


(0.48)

49.13

(0.25)

187.63

(0.57)

1047.84

(0.69)

B/M (times) 1.39

(0.41)

3.64

(17.05)

0.59

(0.29)

0.32

(0.18)


18/129


C/P (percent) 22.86

(16.98)

14.33

(20.44)

14.02

(15.90)

10.22

(5.76)

N 35 35 36 33

Panel C: Sorted by Book to Market (B/M) Ratio

PortfoliosBases of

Portfolio

1 (Low or smallest)0.40

20.40 to 0.70

30.70 to 1.10

4 (High orlargest)

1.10


(2.02)

5.84

(5.93)

6.78

(5.71)

7.57

(8.26)

Capital Gain

Yield

(percent) 65.59

(98.17)

27.76

(46.11)

12.29

(43.34)

3.27

(21.99)


(96.58)

33.60

(47.64)

19.07

(42.33)

10.84

(26.13)

E/P (percent) -3.37

(27.33)

13.16

(8.80)

14.32

(11.31)

22.80

(15.79)Size (in million) 159.89

(4.81)

180.28

(1.11)

41.04

(0.91)

26.43

(1.13)

B/M (times) 0.14

(0.39)

0.57

(0.10)

0.94

(0.12)

1.47

(0.37)

C/P (percent) 3.23

(16.29)

15.73

(11.18)

17.75

(14.77)

25.37

(16.14)

N 35 36 35 33

Panel D: Sorted by Cash Flow to Price (C/P) Ratio

Portfolios

Bases of portfolio

1 (Low or smallest)

6.50

2

6.50 to 13.00

3

13.00 to 22.00

4 (High or

largest)

22.00


(1.92)

3.46

(3.20)

7.20

(4.07)

10.61

(8.64)

Capital Gain

Yield

(percent) 37.74

(86.51)

32.81

(70.79)

19.61

(44.11)

19.27

(40.55)


(86.92)

36.27

(71.13)

26.81

(44.06)

29.88

(41.88)

E/P (percent) -6.69

(27.90)

7.86

(2.39)

14.26

(6.60)

29.89

(12.09)


(1.80)

191.42

(1.60)

79.40

(1.27)

39.82

(1.29)B/M (times) 0.40

(0.61)

0.59

(0.35)

0.85

(0.34)

1.23

(0.50)

C/P (percent) 1.25

(15.68)

9.95

(1.89)

17.37

(2.16)

34.88

(14.28)

N 35 35 35 34

In Panel B of Table 2, the portfolios sorted by firms size are presented. It shows

that larger stocks have lower dividend yield. The average dividend yield


19/129


20/129


having high cash flow yield have lower capital gain yield and total yield. The

average capital gain yield decreased from 37.74 percent for the smallest portfolio

to 19.27 percent for the largest portfolio. Similarly, the average of total yield

decreased from 39.01 percent for the smallest portfolio to 29.88 percent for thelargest portfolio. Moreover, both of capital gain yield and total yield for the

smallest portfolio are more variable than that of the largest portfolio.

The regression results of dividend yield on earnings yield, size, book to market

value and cash flow yield are presented in Table 3. The first four models include

one of the four independent variables at a time. Models 5 to 7 include various

combinations of the fundamental variables and model 8 includes all the four

fundamental variables simultaneously. The results of these alternative

specifications deeply support the summary statistics for the portfolios presentedin Table 2. The results are as expected and encouraging and more or less similar

to the results indicated by Chan, Hamao and Lakonishok (1991) conducted in the

context of Japanese stock market. The dividend yield is positively influenced by

earnings yield, book to market value and cash flow yield, and negatively

influenced by size. The coefficients of earnings yield are significant for the

models 1, 5 and 6. Similarly, the coefficients of size are also significant for the

models 2, 5 and 6.

Table 3

Estimated Relationship Between Dividend Yield and Fundamental

Variables

The results are based on pooled cross-sectional data of 40 enterprises with 139 observations for theperiod of 1995/96 to 1999/00 by using linear regression model. The model is,DY = a + b1(E/P) +b2(LS) + b3(B/M) + b4(C/P) + Ui. Where, DY, E/P, LS, B/M and C/P are dividend yield, earningsyield, market capitalization, book to market ratio and cash flow yield respectively. Results forvarious subsets of independent variables are presented as well.

Models Intercept Regression Coefficients of R2 SEE F

E/P LS B/M C/P

(1) 3.73

(7.23)*

0.15

(6.34)*

0.23 5.42 40.20

(2) 23.91

(3.95)*

-0.99

(3.02)*

0.07 6.00 9.14

(3) 2.49

(2.95)*

4.08

(4.50)*

0.13 5.77 20.29

(4) 2.59

(4.17)*

0.20

(7.23)*

0.29 5.23 52.27


21/129



E/P LS B/M C/P

(5) 16.88

(3.00)*

0.13

(5.44)*

-0.69

(2.29)**

0.24 5.42 20.41

(6) 21.06

(2.56)**

0.15

(4.40)*

-0.88

(2.15)**

1.07

(0.70)

0.25 5.43 13.71

(7) 14.33

(1.93)

-0.61

(1.64)

0.46

(0.30)

0.19

(5.61)*

0.30 5.22 18.33

(8) 13.47

(1.63)

0.01

(0.23)

-0.57

(1.41)

0.28

(0.19)

0.20

(3.23)*

0.30 5.24 13.66

Source: Webpage of NEPSE Ltd.: http://www.nepalstock.com

Notes: (1) Figures in parentheses are t-values.

(2) The signs * and ** denote that the results are significant at 1 percent and 5 percent level

of significance respectively.

Specifically, earnings yield, book to market value and cash flow yield have

individually and reliably positive influence on dividend yield while a reliably

negative association exists between dividend yield and size. Model 5 attempts to

unravel the separate influence of earnings yield and size on dividend yield. The t-

statistics suggest that the coefficients are estimated with a high degree of

precision. The variables do not dominate each other. Adding the book to market

value ratio as the third independent variable in model 6 does not rob the

predicting power of earning yield and size. In model 7, earnings yield is replaced

by the cash flow yield measure. The cash flow yield may be more informative

than other two variables. In model 8, when all the fundamental variables are

simultaneously included, only the t-statistics of cash flow yield has been found to

be significant. The results suggest that the cash flow yield may be more

important in predicting dividend yield than other variables. Although, it is

important to be noted that the earnings yield and cash flow yield are highly

correlated (Table 2), the model 8 suggests that the cash flow yield may be more

informative than earnings yield, since reported earnings are likely to be distorted

by the substantial divergence between economic and reported depreciation. This

finding is in consistency with the quality of earnings explanation discussed by

Bernard and Stober (1989), according to which earning per share is more easily

manipulated.

Table 4 presents the regression results of various models of capital gain yield on

earnings yield, size, book to market value and cash flow yield. The overall results

show the positive relationship of capital gain yield with earnings yield and size,


22/129


and negative relationship with book to market value and cash flow yield. It may

be due to more fluctuations in capital gain yield than other variables.

Table 4

Estimated Relationship Between Capital Gain Yield and Fundamental

Variables

The results are based on pooled cross-sectional data of 40 enterprises with 139 observations for theperiod of 1995/96 to 1999/00 by using linear regression model. The model is, CY = a + b1(E/P) +b2(LS) + b3(B/M) + b4(C/P) + Ui. Where, CY, E/P, LS, B/M and C/P are capital yield, earningsyield, market capitalization, book to market ratio and cash flow yield respectively. Results forvarious subsets of independent variables are presented as well.


E/P LS B/M C/P

(1) 21.30(3.50)*

0.34(1.26)

0.01 63.01 1.59

(2) -143.09

(2.29)**

9.19

(2.72)*

0.05 61.98 7.40

(3) 45.03

(4.95)*

-24.26

(2.48)*

0.04 62.23 6.15

(4) 27.27

(3.59)*

-0.01

(0.01)

0.00 64.07 0.01

(5) -167.62

(2.63)*

0.46

(1.67)

10.24

(3.00)*

0.08 61.55 5.15

(6) 60.56

(0.68)

1.34

(3.68)*

0.26

(0.06)

-58.46

(3.49)*

0.16 59.00 7.81

(7) -39.76

(0.46)

4.27

(0.98)

-31.54

(2.08)**

-0.74

(1.84)

0.09 61.27 4.18

(8) 118.23

(1.29)

2.57

(3.88)*

2.60

(0.58)

-64.45

(3.86)*

-1.55

(2.21)**

0.19 58.11 7.26



(2) * and ** denote that the results are significant at 1 percent and 5 percent level of

significance respectively.

The t-statistics suggest that the book to market value coefficients are more

significant and, therefore, has higher predictive power than other variables. In

model 8, when all the fundamental variables are simultaneously included, t-

statistics are found to be significant for all except size. Therefore, size may not

play an important role in predicting capital gain yield than others. However, the

models estimated are generally poor as revealed by F-statistics and coefficients

of multiple determination (R2).


23/129


Table 5 presents the regression results of total yield on earnings yield, size, book

to market value and cash flow yield. The alternative specifications of the models

reveal the positive relationship of total yield with earnings yield and size,

whereas, negative relationship of total yield with book to market value and cashflow yield. Model 1 provides insignificant relationship between total yield and

earnings yield, whereas, models 5, 6 and 8 provide significant relationship

between total yield and earnings yield. Similarly, models 2 and 5 indicate the

significant relationship between total yield and size, and models 6, 7 and 8

provide insignificant relationship between them.

Table 5

Estimated Relationship Between Total Yield and Fundamental Variables

The results are based on pooled cross-sectional data of 40 enterprises with 139 observations for theperiod of 1995/96 to 1999/00 by using linear regression model. The model is, TY = a + b1(E/P) +b2(LS) + b3(B/M) + b4(C/P) + Ui. Where, TY, E/P, LS, B/M and C/P are total yield, earnings yield,market capitalization, book to market ratio and cash flow yield respectively. Results for varioussubsets of independent variables are presented as well.


E/P LS B/M C/P

(1) 25.03

(4.11)*

0.49

(1.80)

0.02 63.08 3.25

(2) -119.19

(1.88)

8.20

(2.40)**

0.04 62.67 5.77

(3) 47.51

(5.16)*

-20.18

(2.04)**

0.03 62.97 4.16

(4) 29.86

(3.92)*

-0.20

(0.58)

0.01 64.24 0.34

(5) -150.75

(2.35)**

0.59

(2.14)**

9.55

(2.79)*

0.08 61.81 5.26

(6) 81.61

(0.91)

1.49

(4.07)*

1.14

(0.26)

-59.53

(3.55)*

0.16 59.17 8.02

(7) -25.44

(0.29)

3.66

(0.83)

-32.00

(2.10)**

-0.93

(2.30)**

0.09 61.66 4.06

(8) 131.69

(1.42)

2.56

(3.83)*

3.17

(0.17)

-64.73

(3.85)*

-1.35

(1.90)

0.18 58.56 7.05



(3) * and ** denote that the results are significant at 1 percent and 5 percent level of

significance respectively.


24/129


Of the four variables considered, book to market value has higher explanatory

power than other variables as indicated by significant relationship between total

yield and book to market value (Models 3, 6, 7 and 8). The cash flow yield is

found to be weak in determining the total yield, since only model 7 provides thesignificant relationship between total yield and cash flow yield. However, the

models estimated are generally poor as revealed by F-statistics and coefficients

of multiple determination (R2).

4. Conclusions

This study addressed fundamentals of stock returns in the context of Nepal. It

examines if dividend yield, capital gain yield and total yield are related to

earnings yield, size, book to market ratio and cash flow yield. The study is based

on pooled cross sectional data of 40 enterprises whose stocks are listed in NEPSE

Ltd. and traded in the stock market. The overall results of study can be

summarized as follows:

Earnings yield and cash flow yield have significant positive impact on

dividend yield, and an insignificant impact on book to market value,

whereas, size has negative impact on dividend yield. In the case of earnings

yield and cash flow yield, cash flow yield has been found to be more

informative than earnings yield.

Capital gain yield is positively influenced by earnings yield and size,

whereas, the same is negatively influenced by book to market value and cash

flow yield. Book to market value has been found to be statistically strong in

predicting capital gain yield.

Similarly, total yield is positively determined by earnings yield and size,

whereas, the same is negatively determined by book to market value and cash

flow yield. Book to market value has been found to be more informative than

other variables.

The positive relationship exists among earnings yield, book to market value

and cash flow yield. However, the size is negatively related to these three

variables.


25/129


References

Adhikari, Nabaraj, Corporate Dividend Practices in Nepal, An Unpublished Masters Degree

Dissertation, FOM, TU, Kirtipur, (1999), 1-134.

Ball, Ray, Anomalies in Relationships between Securities Yields and Yield Surrogates, TheJournal of Financial Economics, Vol. 6, (1978), 103-126.

Banz, Rolf W. and William Breen, Sample Dependent Results Using Accounting and Market

Data: Some Evidence, The Journal of Finance, Vol. 41, (1986), 779-793.

Banz, Rolf W., The Relationship between Returns and Market Value of Common Stocks, The

Journal of Financial Economics, Vol. 9 (1981), 3-19.

Basu, Sanjoy, Investment Performance of Common Stocks in Relation to Their Price-Earnings

Ratios: A Test of the Efficiency Market Hypothesis, The Journal of Finance, Vol. 32,

No. 3, (June 1977), 663-682.

------------, The Relationship between Earnings Yield, Market Value and Return for NYSE

Common Stocks: Future Evidence, The Journal of Financial Economics, Vol. 12,

(1983), 129-156.

Bernard, Victor and Thomas Stober, The Nature and Amount of Information in Cash Flows and

Accruals, Accounting Review, Vol. 64, (1989), 624-652.

Black, Fischer, Capital Market Equilibrium with Restricted Borrowings, The Journal of Business,

Vol. 45, (1972), 444-455.

Chan, Louis K., Yasushi Hamao and Josef Lakonishok, Fundamentals and Stock Returns in

Japan, The Journal of Finance, Vol. 46 No. 5, (Dec. 1991), 1739-1764.

Cook, Thomas and Michael Rozeff, Size and Earnings/Price Ratio Anomalies: One Effect or

Two?, The Journal of Financial and Quantitative Analysis, Vol. 19, (1984), 449-466.

Davis, James L., The Cross-Section of Realized Stock Returns: The Pre-COMPUSTAT

Evidence, The Journal of Finance, Vol. 49, No. 5, (Dec. 1994), 1579-1593.Fama, Eugene F. and Keneth R. French, Dividend Yields and Expected Stock Returns, The

Journal of Financial Economics, Vol. 22 (1988), 3-25.

----------, The Cross-Section of Expected Stock Returns, The Journal of Finance, Vol. 47, No. 2,

(June 1992), 427-465.

Fama, Eugene F., Efficient Capital Markets: II, The Journal of Finance, Fourth Coming (1991).

Gupta, C.B., Business Organization and Management, (New Delhi: Prentice Hall of India Pvt. Ltd.,

1978).

Jaffe, Jeffrey, Donald Keim and Randolph Westerfield, Earning Yields, Market Values and Stock

Returns, The Journal of Finance, Vol. 44, (1989), 135-148.

Jagannathan, Ravi and Znenyu Wang, The Conditional CAPM and the Cross Section of Expected

Returns, The Journal of Finance, Vol. 51, (March 1996), 3-53.

Lakonishok, Josef, and Alan Shapiro, Systematic Risk, Total Risk and Size as Determinants of

Stock Market Returns, The Journal of Banking and Finance, Vol. 10, (1986), 115-132.

Lintner, John, the Valuation of Risk Assets and the Selection of Risky Investments in Stock

Portfolios and Capital Budgets, The Review of Economics and Statistics, Vol. 47, No. 1,

(Feb. 1965), 13-37.

Mahat, R.S., Capital Market, Financial Flows and Industrial Finance in Nepal, (Lalitpur: Sajha

Prakashan, 1981).


26/129


Manandhar, K.D., A Study of Dividend Policy and Value of the Firm in Small Stock Market: A

Case of Nepal, Management Dynamics, Vol. 8, No. 1, (1998), 15-20.

Markowitz, Harry, Portfolio Selection, Cowles Foundation Monograph, Vol. 16, (New York:

Wiley, 1956).

Pradhan, Radhe S., Stock Market Behavior in A Small Capital Market: A Case of Nepal, TheNepalese Management Review, Vol. 9, No. 1 (Summer 1993), 23-49.

Reinganum, Mare, Mis-specification of Capital Asset Pricing: Empirical Anomalies Based on

Earning Yields and Market Values, The Journal of Financial Economics, Vol. 9, (1981),

19-46.

Ritter, Jay and Narin Chopra, Portfolio Rebalancing and the Tum-of-the-Year Effect, The Journal

of Finance, Vol. 44, (1989), 149-166.

Rosenberg, Bar, Keneth Reid and Ronald Lanstein, Persuasive Evidence of Market Inefficiency,

The Journal of Portfolio Management, Vol. 11, (1984), 9-17.

Ross, Stephen A., The Arbitrage Theory of Capital Asset Pricing, The Journal of Economic

Theory, Vol. 13, No. 3 (Dec. 1976), 341-360.

Sharpe, William F., Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of

Risk, The Journal of Finance, Vol. 19, No. 3 (Sept. 1964), 425-442.

Timilsina, Sadakar, Dividend and Stock Prices: An Empirical Study, An Unpublished Masters

Degree Dissertation, FOM, TU, Kirtipur, (1997).

Verma, P.C., Financial Behaviour of Jute Industry in India, The Indian Economic Journal, Vol.

42, No. 2, (Oct.-Dec. 1994), 125-137.

Wiggins, James B., The Earning Price and Standardized Unexpected Earnings Effects: One

Anomaly or Two?, The Journal of Financial Research, Vol. 14, No. 3, (Fall 1991), 263-

275.

Wilson, Peter, The Relative Information Content of Accruals and Cash Flows: Combined

Evidence at the Earnings Announcement and Annual Report Release Date, The Journalof Accounting Research, Supplement, (1986), 165-200.

* * *


27/129

Development of Stock Market and Economic Growth

in Nepal

- Dr. Bijay K.C.

Introduction

The relationship between stock market development and economic growth has

received renewed attention of academicians and policy makers in the present

decade both in the developed and developing countries as a result of the

emerging equity market phenomenon and of the need to provide liquidity for

privatization-linked equity issues. The growing importance of stock markets in

the developing countries has opened up many avenues for research in the

relationship between financial development and economic growth, with focus ondevelopmental role of stock markets. Empirical studies in many developing

countries suggest that every nation has a structure of financial system that exists

side by side with its real infrastructure, and the differences in the national

financial systems have profound impact upon the pace of economic growth of

nations. Evidence shows that financial development of a nation overwhelmingly

affects its economic growth.

A countrys financial system may be bank-dominated or market-oriented. Each

of these systems has different mechanisms for handling stakeholders interest and

addressing corporate control issues and agency problems. Though historically

countries seem to follow one of these paths for development of its financial

system, in recent years, some countries are developing their financial systems

through convergence between these two. Empirical studies show that banks and

stock market play complementary roles in the initial stage of financial

development of a country and neither of these is perfect substitute for the other.

Financial system in Nepal is basically bank dominated. However it cannot be

denied that stock market also has an important role to play in the development ofthe country. The present article aims to look at some of the issues in the

development of financial sector, particularly in the context of the developmental

role of stock market, and economic growth in Nepal and tries to determine the

level of stock market development using various indicators.

Professor of Finance, Kathmandu University, School of Management


28/129


Growth of Financial Sector in Nepal

During the last one and half decade the financial sector in Nepal has grown

significantly. It is sad that despite a history of almost half a century of

developmental efforts under different national plans, conscientious efforts to

develop financial sector started quite late in Nepal. Although some efforts were

made to develop countrys infrastructure during the Rana regime, they were more

sporadic and aimed at fulfilling the need and the whims of the then Rana rulers.

Efforts to achieve economic growth in the country in a planned way started only

in 1956 with the adoption of the First Five-Year Plan by the government. Under

different plans the government set targets for economic growth and adopted

various policies and programs, which were directed towards developing

infrastructure necessary for the creation of national wealth. Unfortunately, thesepolicies and programs failed to take into account the need to develop the

financial structure that ought to exist side by side with the development of

infrastructure necessary for the growth of real sector. In one sense these policies

were lopsided because they sought to enhance growth in physical assets of the

nation by suppressing the development of financial sector of the country. The

policy of the government to maintain control of the financial sector by restricting

the entry of private sector into financial activities limited the growth of financial

sector in the country. As a result the country had limited financial institutions to

support its developmental activities for quite a long time. Till early eighties the

country had only two commercial banks, two development banks, one provident

fund and few insurance companies. As almost all of these financial institutions

were under the government sector they operated more under social welfare

concept than under commercial principles. As a result of the restrictive policy of

the government, the gaps created in the resources needed for the development of

the real sector and the resources available for it were met through foreign grants

and loans under different plans. While this increased the countrys dependency

on the foreign aid, it also made the government less concerned for the need to

mobilize resources locally to meet the resource gap. Apparently, this led to tardy

development of financial sector of the country where the real sector lagged

behind the financial sector.

The process of stock market development in the country actually started in 1976

when the government established Securities Exchange Centre to provide and

develop market for securities, both the government bonds and corporate


29/129


30/129


stock markets do promote long-term growth. It has been experienced that the

development of stock markets in the emerging nations passes through four main

stages (Papaioannou & Duke, 1993, p.36). Development of equity markets in any

country requires political and economic stability and growth-oriented policies aspre-conditions. At the second stage, equity prices rise and the investors gradually

gain confidence in the equity market. They accept equity as an alternative to

traditional bank deposits and government securities. As the second stage, equity

markets gain more credibility and market liquidity increases. Investors long for

rise in risk adjusted returns and demand a wide variety of securities to match

their risk preferences. Rules and regulations are refined and the equity markets

start functioning on the basis of self-discipline. Equity markets at this stage

gradually get integrated to the international markets and attract foreign investors.

At the third stage, equity markets become an integral part of the overall financialsystem. Investors get higher, less volatile returns and easily absorb new issues of

stocks and bonds. The volume of trading increases as the equity markets become

more liquid and firms go for initial public offerings to replace their debts. At this

stage a mechanism for risk transfer develops, creating markets for equity and

currency-hedging instruments such as derivatives and index products. At the final

stage the equity markets get highly integrated with the global markets and the

equity risk premiums match with the internationally competitive levels. Equity

markets at this stage achieve stable growth and attain a mature state.

Despite its history of more than 25 years with respect to the above-mentioned

observation, the equity market in Nepal has barely entered the first stage of

development. Due to current political and economic instability, absence of

growth-oriented policies and weak regulatory framework of stock market has

failed to gain investors confidence. Unavailability of timely information and

weak supervision and monitoring has made the stock market highly risky for

general investors. Investors have not yet accepted investment in stock as an

alternative to bank deposits and government securities except in the case of stockof some commercial banks. (K.C. & Snowden 1997)

By encouraging acquisition and dissemination of information, stock markets

reduce cost of mobilizing savings and facilitate investments. Well-developed

stock markets enhance efficiency of market for corporate control by mitigating

the agency problems between the stockowners and managers. In countries where

stock market discipline is effective, firms tend to be more productive, thereby


31/129


creating more wealth per unit of money invested.( Diamond and Verrecchia

1982; Jensen and Murphy 1990; Greenwood and Smith 1997).

Stock markets help expansion of economic activity by providing liquidity tofinancial assets traded in them. Investments in real assets require long-term

commitment of capital, however, investors are reluctant to commit their savings

for long periods. Liquid stock markets make investment less risky because they

allow savers to buy and sell financial assets they hold cheaply and quickly and

restructure their portfolios any time according to their risk-return preferences. At

the same time, firms enjoy permanent access to long-term capital through equity

issues. By making assets less risky and providing easy access to permanent

source of capital, liquid stock markets improve allocation of resources, boost

investment and enhance long-term economic growth. Very liquid stock marketsmay sometime deter economic growth by encouraging investor myopia. It is

argued that such stock markets may weaken investors commitment to exert

corporate control because they prefer to sell the stocks of the misgoverned

companies rather than to monitor and force managers to improve their

performance. However, empirical studies suggest that greater stock market

liquidity boosts and in many cases precede economic growth.

Indicators of Stock Market Development in Nepal

The level of stock market development and its impact on the national economy

can be measured by using various indicators broadly classified into following

categories (Demirguc-Kunt and Levine 1996):

1. Stock market size

2. Liquidity

3. Concentration, and

4. Volatility

Literature in finance examines the relationship between various attributes of

stock market and economic growth of nations and has developed a set of

indicators under these categories to conceptualise the nature of such relationship.


32/129


Stock Market Size

Generally large stock market size indicates developed stock market. One of the

measures of stock market size is the number of companies and scrip listedwith

the stock exchange. Size of stock market increases with the increase in the

number of listed companies. In Nepal the number of companies listed with the

NEPSE was 66 in 1993/94, which increased to 108 in 2002/03. Similarly the

number of scrip listed increased from 43 million to 160 million during the period.

Similarly the paid up value of the listed securities was Rs.2.18 billion in 1993/94.

In 2002/03 it was Rs.12.6 billion. It is, however, interesting to note that despite

the increase in the number of companies and paid up value of the securities listed

with the exchange, only about 12 percent of the companies registered with the

Office of the Company Registrar as public limited period are listed with theNEPSE during the ten year. Most of the companies that are listed with the

exchange belong to banking, finance, and insurance sectors. While only few

companies from the trading, hotel, manufacturing, and aviation sectors are listed

with the exchange, not a single company from power, information technology,

and construction sectors has entered the organized stock exchange of the country.

(SEBO, 2003 p.7). This indicates that firms tend to avoid stock market as an

alternative source of long-term capital in Nepal. Significant increase in the

number of companies registered as private limited in comparison to those

registered as public limited during last one and half decade also supports this

view. This has adversely affected the liquidity and supply of securities in the

stock market.

Another important measure of the stock market size is the market capitalization

ratio, which is aggregate market value of the listed shares divided by Gross

Domestic Product. This ratio indicates the relative importance of stock market to

the national economy and assumes that stock market size is positively correlated

with the ability to mobilize capital and diversify risk. As can be seen from Table

No.1, the market capitalization ratio has, on an average, been only around .07 for

the period between 1993/94 and 2002/03. It is important to remember that in

countries with developed stock market this ratio is greater than 1 and in many

developing countries it is between 0.2 and 0.4. Low market capitalization ratio in

Nepal indicates that stock market is yet to show its impact on the economic

activities of the country.


33/129


34/129


liquid stock market tend to grow much faster than countries with illiquid markets.

(Levine, 1996).

Table: 2Measures of Market Liquidity of NEPSE(Rs. in million)

Years

Values of

Shares Traded

(Rs.)

Value of Shares

traded

to GDP

Value of Shares traded

to Market Capitalization

1993/94 431.34 0.002 0.031

1994/95 1054.26 0.005 0.081

1995/96 209.01 0.001 0.017

1996/97 416.19 0.002 0.033

1997/98 202.61 0.001 0.014

1998/99 1485.55 0.005 0.063

1999/00 1157.00 0.003 0.027

2000/01 2335.91 0.006 0.058

2001/02 1540.63 0.004 0.044

2002/03 575.80 0.001 0.016

As we can see from the table, ratio of the value of shares traded to Gross

Domestic Product was always below 0.005, except in the fiscal year 2000/01,

during the ten-year period between 1993/94 and 2002/03. During this period the

value of shares traded accounted, on an average, only for about 0.003 of Gross

Domestic Product. In countries with developed stock market this figure is as high

as .4 and in many developing countries the values of shares traded vary in a range

of .001 to .01 of Gross Domestic Product. Low ratio of value of shares traded to

Gross Domestic Product indicates that trading in equity relatively to the size of

economy is very low in Nepal.

Another measure of liquidity of stock market is the ratio of value of shares

traded to market capitalization. This measure, also known as turnover ratio,equals the value of shares traded divided by market capitalization and is

indicative of the trading relative to the size of stock market. A high turnover ratio

may indicate low transaction cost and relative ease in buying and selling of

shares. Experience shows that countries with high turnover ratio develop faster

than countries with low turnover ratio. Countries with small stock market, as

measured by the market capitalization ratio, may have a high turnover ratio and

grow fast. In developed countries this ratio is greater than or very close to one


35/129


36/129


Countries with developed stock market have concentration ratios of about 0.2 of

the market whereas in countries with undeveloped stock market this ratio is as

high as .9. In Nepal the ratio was on an average around .67 over the past 10

years, which indicates that, the market value of shares of ten largest companiesaccount for 67 per cent of the total market value. The concentration ratio is as

high as .8 when it is computed on the basis of turnover. This indicates that the

stock market in Nepal is highly dominated by largest ten companies in terms of

either market capitalization or turnover. It is interesting to note that of the ten

largest companies dominating the market in 2003 nine are commercial banks,

indicating that the stock market in Nepal is highly dominated by the commercial

banks. High concentration has adversely affected liquidity and significance of the

stock market in the national economy.

Volatility

Volatility is one of the important indicators of development of a countrys stock

market. Although high volatility in the stock market denotes risk in equity

investment, it does not necessarily imply undeveloped stock market. It is

generally expected that developed stock markets absorb risks in financial assets

and offer higher return with less volatility. Put simply, it means that as an

indicator of a countrys stock market development less volatility is preferred to

high. Volatility may be measured as a twelve-month, rolling standard deviation

of market returns. Higher standard deviation means higher volatility, and

more risk.

Table 4

Volatility in the Nepal Stock Exchange

YearsTwelve-month rolling

standard deviation

Value-traded- ratio to

volatility

1993/94 26.47 0.0012

1994/95 7.36 0.0111

1995/96 4.11 0.00411996/97 2.71 0.0121

1997/98 4.57 0.0031

1998/99 3.79 0.0167

1999/00 5.53 0.0049

2000/01 9.24 0.0063

2001/02 12.79 0.0035

2002/03 3.08 0.0053


37/129


Although volatility in the stock market in Nepal was high during the initial years,

it was on decline till 1996/97indicating that equity prices in the stock market

tended to stabilize during this period. From 1998/99 onwards volatility in the

stock market had wider fluctuation but it showed a tendency to rise consistently.Countries with high inflation rates seem to have higher volatility in the equity

markets. Except in 1993/94, 2000/01, and 2001/02 volatility in the stock market

in Nepal is less than the average volatility of other developing countries. The

reason for this is mainly low volume of trading of equities due to low demand.

Volatility in these three years was high due to increase in the volume of trading

triggered by speculative motive of investors.

Analysts argue that developed stock markets should not only provide high

liquidity but also handle large volume of trading with less price swings. In otherwords a liquid market should allow large volume of trading with less volatility.

One of the indicators to measure this is a ratio of value-traded-ratio to volatility.

A high ratio indicates the ability of the stock market to provide liquidity and

handle risk. Empirical evidence shows that this ratio is a good predictor of

economic growth and countries with high ratios have grown much faster than

countries with low ratios. These ratios for the stock market in Nepal are

presented in column 3 in above table. These ratios indicate inability of stock

market in Nepal to handle risk relatively to volume of trading of shares. A

positive but very weak relationship is observed between volatility and volume of

trading of shares in the stock market.

Trends in the Indicators of Stock market Development

Figure 1 presents the trend in the indicators of stock market development in

Nepal for the period between 1993/94 and 2002/03. Market capitalization ratio

was on rise for the period between 1996/97 to 1999/00 again declined from

2000/01 on wards. Turnover ratio and value traded ratio to volatility showed

wide fluctuations during the period. It is interesting to note that none of these

indicators revealed a consistent trend during this period, indicating that the

development of stock market in Nepal lacks a definite direction and is not guided

by clear-cut policies and actions. Due to low volume of shares traded and wide

fluctuations, the stock market in Nepal has been highly illiquid and volatile.


38/129


Figure 1

Trend of Indicators of Stock Market Development in Nepal

0.00

0.02

0.04

0.06

0.08

0.10

0.12

0.14

1993

/94

1994

/95

1995

/96

1996

/97

1997

/98

1998

/99

1999

/00

2000

/01

2001

/02

2002

/03

Years

Ratio

Market Capitalisation

Ratio

Value of shares traded

to GDP

Turnover Ratio

Value -traded ratio to

volatility

Summary and Conclusion

The relationship between financial development and economic growth, with

focus on developmental role of stock markets, has been in debate for some time

in the past. Empirical studies suggest that financial development does matter and

stock markets do spur economic growth. Unfortunately, in Nepal, despite a

history of about half a decade of planned economic activities to develop real

sector of the country, little attention was paid to the development of financial

sector. Over the past one and half decade, financial sector, despite many

problems has developed significantly in Nepal. However, most of the

developments were confined to the banking sector. Stock market has virtually

remained stalled because of the low priority in the government's financial reform

policies.

Various measures of stock market development indicate that the stock market in

Nepal is underdeveloped and has failed to show impact on the overall national

economy. Small market size has made it vulnerable to manipulation and price

rigging. Low turnover ratio and value-traded-ratio to volatility, and high

concentration ratio indicate that the stock market in Nepal is highly illiquid and

risky. Investors tend to avoid stock market because they do not have options to


39/129


invest in securities according to their risk-return preference. Similarly firms shun

it because stock market is less reliable source of raising funds for them. Due to

this financial system in Nepal has remained basically bank-dominated.

References

Arestis, Philip; Panicos O. Demetriades, & Kul B. Luintel (2001) Financial development and economic growth :

The role of stock markets.Journal of Money, Credit, and Banking33 (February). 16 41

Demirguc-Kunt, Asli & Ross Levine (1996) Stock markets, Corporate finance, and Economic growth: An

overview The World Bank Economic Review10 (May), 223 239.

Demirguc-Kunt, Asli & Ross Levine (1996) Stock market development and financial intermediaries: stylized

facts. The World Bank Economic Review10 (May), 291 321

Diamond, Douglas W., & R.E. Verrecchia (1982) Optimal Managerial Contracts and Equilibrium Security

Prices. Journal of Finance 37 (May). 275-87

Greenwood, Jeremy, & Bruce Smith (1997) Financial markets in development and the development of

financial markets.Journal of Economic Dynamics and Control 21 (January). 145-82Jensen, Michael C. & Kevin J. Murphy (1990) Performance Pay and Top Management Incentives.Journal of

Political Economy98 (April). 225 - 64

K.C., Bijay & P.N. Snowden (1999) Pricing shares on a nascent market: the Nepal Stock Exchange 1994-96.

World Development27s (June). 1083 1096

Levine, Ross. (1996) Stock markets: A spur to economic growth Finance & Development, 33 (March). 7- 10.

Papaioannou, Michael G. & Lawrence K. Duke.(1993) The Internationalization of Emerging Equity Markets

Finance & Development, 30 (September). 36 -39.

Securities Board, Nepal. (2004)Annual Report (2002-03). Securities Board Nepal, Kathmandu

Securities Board, Nepal (2004) Ten Years of Securities Board(in Nepali), Securities Board Nepal, Kathmandu

Walton, Michael (1997) The maturation of the East Asian miracle Finance & Development, 34

(September) 7- 10.

* * *


40/129

Eligibility for Trading of Securities and

Challenges

- Pramod Bhattarai*

Listing means registration of securities that are floated by corporate sector to

raise funds for the establishment and operation of a company. The importance of

listing cannot be overemphasized with few words. The company by means of

listing arranges liquidity on the floated securities. The Securities and Exchange

Board of India (SEBI) guideline defines listing as admission of the securities of a

public limited company on a recognized stock exchange which provides a forum

for the purchase and sale of securities. If the listed company is in need of

additional fund, it can raise such required fund from the market. Besides, listing

also facilitates to value the securities daily on the trading floor. The listing has

several advantages like the investor gets periodic reports of the listed companies

which help them to know company performance, the transaction of listed

companies are reported in daily newspapers and they are able to know the

intrinsic value of their investment.

If all other things remain constant, the investors attempt to sell higher volume of

securities at higher prices and tend to buy less number of securities at higherprices. If the market price of the particular securities increases beyond the

intrinsic value of the securities then the investors holding that securities starts to

sell, which in turn, increases the selling pressure. The increased selling pressure

due to overvaluation of securities or over pricing reduces the demand and

ultimately the price will come down and equals the intrinsic value of the

securities. In the same way, if the securities are priced below the intrinsic value

or net value the demand for such securities increases and the increased demand

and lower supply of securities increases the market price, which again levels up

with the intrinsic value of the securities. In fact, transactions are be made at theprice where both the bid and ask price matches. Therefore, Capital Assets Pricing

Model (CAPM) assumes that capital market has to be in a state of equilibrium; if

not, the market will move towards the equilibrium position. Over-pricing and

under-pricing are temporary phenomena; the market price should equal the

*Acting Manager, Nepal Stock Exchange Ltd.


41/129


intrinsic worth of the securities. It is the listing that facilitates occurrence of such

situation in the market.

Price is also a function of information and investors' perception. If the investors

perceive that the particular company will do better in future and also if thepresent situation is far better than the forecast situation then such investors may

be ready to pay higher price as compared to others. In this situation the investors

cannot be blamed as being irrational. They are rational but, the prevailing

economic situation and quality of information affects their decisions as some

investors trade on the basis of asymmetric information.

Listing Provision

Different stock exchanges incorporated in different countries have their own

listing criteria depending on their geo-political and economic status. Stock

exchange provides the opportunity to invest when people have surplus funds and

to exit when they are in need of funds and also want to minimize the risks and

maximize the return. CAPM assumes that if there exists several financial

instruments having different rate of returns, but the same level of risks, investors

prefer the high rate yielding securities. On the other hand if there exists the same

rate yielding securities with different risk levels, the investors prefer less risky

instruments because the investors are risk averse. Therefore, Securities Exchange

Act 1983 of Nepal has made provision for listing considering the fact of givingexit to the investors. Section 8 of Securities Exchange Act, 1983 prohibits

securities trading without being listed. This means that all the securities of public

limited company must be listed in the stock exchange to make them eligible for

trading. The listing by-laws has clearly spelled out that all issued and allotted

securities should be listed under the section 11 of the Act. The Act has defined

the term "issue" as all the issue made by issuing announcement or by private

placement to sell the securities. It has a wide coverage indicating all transactions

before listing are void. However, the securities listing by-laws spell out the

minimum requirements to be eligible for listing, which includes minimumnumber of shareholders to be 500, the minimum paid up capital to be Rs.2.5

million above others. Besides this, several information and documents along with

dues should be submitted. Now the question can be raised- What will happen to

the securities of those companies, which do not meet such criteria as Nepal does

not have over-the-counter (OTC) market. It reveals that some of the existing

public limited companies are violating the existing laws by trading without being


42/129


listed on the exchange. In other words, listing is not compulsory but the

transactions of securities without listing is against the prevailing laws of the

country. In fact, this is the major weakness of our legal enforcement regime.

Grouping of Listed companies

Nepal Stock Exchange Ltd. (NEPSE) has developed and executed the system for

the grouping of listed companies. It has developed certain criteria for it. Such

criteria includes- paid up capital of the company to be Rs.20 million, the number

of shareholders to be 1000, the company must have furnished all the information

on timely basis and as prescribed by the listing by-laws, the net worth per share

should not be less than paid up value and the company must be in profit for the

last three years. Companies that meet the above said criteria are categorized in

group "A" and the rest in group "B". If a company does not meet any one

criterion from the first two criteria, the company will be kept in group "B".

Although it may appear unfair for the company when put among the sick

companies the listed companies are, however not interested whether to be in

group "A" group "B" as they do not have any incentives to be in group "A". If

certain incentives are provided to companies in group "A" they might be

encouraged to be on this group. Earlier 5 percent tax was exempted to the listed

companies. It is also good to adopt the policy to provide tax incentives to the "A"

group companies.

De-listing of securities

De-listing means cancellation of registration of listed securities from the stock

exchange. It is said that listing facilitates the investors to exit from investment

and this is also one of the targets of the stock exchange. However, if de-listing is

executed the objectives of the Act cannot be attained. Actually, this provision is

contradictory and impracticable in our context. As the provision for listing says

no securities can be traded without listing, on the other hand, several conditions

are given for de-listing on section 14 of the Act. This provision titled De-listing

of Securities also consists the provision for suspension or de-listing. The

conditions for de-listing as per the provisions are-

If companies engage in activities that are contradictory to what the Act says.

If directives or orders issued by the stock exchange are not obeyed by the

companies.


43/129


If stock exchange feels it is necessary to de-list or suspend the transactions

of the listed companies to protect the interest of the investors.

Section 8 of Securities Exchange Act, 1983 makes the listing compulsory tomake securities trading eligible whereas the de-listing provision made in section

14 of the same Act, if implemented, makes the securities illiquid. The Act also

spells out the protection of the investors' interest. In this contradictory situation,

how can the interest of the investors' be protected? In the absence of OTC

market, de-listing of a company could trap their investment for unknown period

of time. In the US even if the company is listed, it can trade in OTC. However, in

order to be de-listed, the opinion from the audit committee must be obtained, the

board of directors of the exchange must approve the de-listing proposal, and 20

to 60 working days must be given to the general public to react on it. Afterwhich, the de-listed company can be traded on OTC market. In our case, in order

to enlist the securities the decision from the board of directors is essential . This

board also consists the representatives from the general public. Therefore, the

basic requirement for de-listing is the approval from the BOD. Besides this, the

alternative arrangement for providing liquidity should also be made. Recently,

NEPSE has de-listed Nepal Bank Ltd. making its securities illiquid. The bank

had about 10,000 shareholders. Under the financial sector reform program, Nepal

Rastra Bank took over the management of the bank and contracted out the same

to the foreign management group. Despite their best efforts if the situation

deteriorates causing loss both to the shareholders and depositors then what will

be the role of central bank? Will the management take the responsibility? This is

a very critical point and all the investors should be aware of this. In the course of

attaining their commitments, the management committee of the bank requested

the stock exchange to de-list the

seb on journal issue 1

Documents