new perspectives on investing in Emerging Market

This also contribute to synchronicity of stock market returns  And this is why financial theories are seriously not working in EM... Academic researches have found that EM markets tends

Global Capital Market – Lecture 1W

Capital Market Theories

Emerging Market Finance CAU MBA

CAU

Wonil Lee, Ph.D, & CFA

New Perspectives on

Investing in EM

April, 2015

What makes investing in EM unique?

 Should diversification always reduce portfolio risk?

 Should the principles of investing in the US or the UK apply to EM?

 Should EM investing always demand higher expected returns?

 Although the fundamental behavior of participants in capital markets is the same, EM contain unique governmental and other institutional

features that create distinct differences in the way investors must

approach their investment strategies

Emerging Market Overview

3

* Source : MSCI

Capital Market Theories

1959, Markovitz Model

1964, CAPM

Asian Currency

Crisis

2002, Nasdaq Bubble

1987, Black Monday

1962, DDM

1973, Black &

Scholes Model

2007, US Sub Prime

Non normality in Returns

 It is generally accepted that EM stock returns are not normally

distributed

 Extreme returns are more frequent than under a normal distribution, which results in a fat-tailed distribution

 These return distribution violate the normality assumption in the mean-variance analysis framework commonly used in portfolio theory

 Positively or negatively skewed returns are a result of company

ownership, corporate governance, and opaqueness This also

contribute to synchronicity of stock market returns

 And this is why financial theories are seriously not working in EM

The Market Synchronicity Puzzle

 Traditional portfolio theory suggests that the risk of a security can be divided into 2 components: market risk and company specific risk

 One measure of the importance of market risk is the percentage of stocks in the market that move together over a particular period

 A market in which all stocks move in the same direction is said to

maintain high market synchronicity Academic researches have found that EM markets tends to have much higher market synchronicity than developed markets

 In the US, the market synchronicity is around 57% while in Malaysia, China, Poland, and Korea record 75%, 80%, 83%, and 70%,

respectively

Information Inequities (Asymmetry)

 Significant information inequities in EM among investors

 Many of the institutional mechanisms for information dissemination in developed markets are commonly missing in EM as individual investors are majority of the EM

 Efficient market hypothesis are generally weaker in EM

 Outside investors receive only market wide news which results in

higher synchronicity of the market – usually big information asymmetry

in EM between insiders and outsiders

 This information asymmetry create an uneven playing fields that

fundamentally affects investing decisions

Insider Trading Regulations

 Unlike developed markets, EM stock price is not changing in

accordance with the information In other words, semi-strong form

Efficient Market Hypothesis cannot be proved

 In many EM, trading based on material non-public information seems to

be easier than developed market and information dissemination by

analysts are not transparent and efficient

 Last year, CJ E&M case was one of the example that Korean market is still considered as EM

 Empirical findings support the notion that unprosecuted insider trading makes the information in equities even worse

Any Information Advantage?

 There are mixed literature conclusion about information advantage of domestic vs foreign investors

 Some research argue domestic investors have information advantage over foreign because of geographic location and home advantage while some other research conclude that foreign investors (from developed market) tend to have better information about broader market timing and sector selection thanks to investment know-hows

 Current academic thinking is that geographic location is particularly

important in that local investors in EM naturally have an information

advantage over foreigners

 Another reason for information inequities is lack of transparency of

earnings disclosure resulting from poor accounting standards, lack of credible auditing, and bad corporate governance practices in EM

 Many Korean investors are using foreign local managers when they

invest overseas market

Market illiquidity

 Another explanation for the synchronicity effect in EM is the presence

of abnormal illiquidity and other forms of transaction costs

 Empirical research confirm that EM securities are commonly more

illiquid even if each EM has big difference

 Transaction cost is relatively higher for EM and for foreign investors

 It is widely accepted that illiquid assets and assets with high transaction costs generally trade at a discount to their expected cash flow

 EM illiquidity premium tends to decline once the market is opened up to outside investors

 This could be one of the reason why Korean stocks are traded at

discount to developed markets

 One thing that could be found easily in EM is lack of protection from investor expropriation, especially foreign investors

 Controlling shareholders expropriation problem is the major corporate governance issues in EM

 Lower dividend payout, wealth transfer from shareholders to

controlling shareholders, restrictions on voting rights, lack of

independence of the BoD, etc

 Investors should understand EM legal system in order not to be

abused

 Nationalism sometimes provoke serous anti-foreign investor

sentiment which will limit foreigners’ investment in EM

Poor Investor Protection

 EM countries companies tend to have less transparent corporate

governance compared with developed market

 As corporate governance is important for investment returns EM

investing return could be affected significantly from the corporate

governance practices in each EM countries

 Over the past 20 years, there were many cases like this happening in many EM and even developed markets

 Across the globe, capital markets are becoming more integrated, and this increasing integration is reducing synchronicity of EM

Corporate Governance matters…

 Although corporate governance practices are improving, typical EM

countries have some bad practices:

1 Management uses its control for perquisite consumption

2 Company shares are owned by another company that exerts control similar to Keiretsu System in Japan

3 Creditor rights are often strong to the detriment of shareholders

 Legal system is also generally weaker in EM in terms of protecting

minority shareholders especially foreign investors

 Nationalism could provoke un-realistic problem for foreign investors

 Improvements in corporate governance of emerging market companies increase shareholder wealth, company valuation, and investor interest

Typical EM Practices

Midopa vs Peregrine: 1997

0 10,000 20,000 30,000 40,000 50,000

100,000 600,000 1,100,000 1,600,000 2,100,000

2,600,000

Volume Price

97년 2월 24일

미도파 400억원 규모의

공모 신주인수권부사채

(BW) 발행

97년 1월

외국자본(동방페레그린

증권) 미도파주식 매집

사실 확인

(거래량)

Nov-96 Jan-97 Mar-97 May-97

(주가)

1,000 51,000 101,000 151,000 201,000 251,000 301,000

(원)(Won)

SK (005830 KS)

Apr 2003

Sovereign acquires 6.14% of SK

shares in March and 8.85% in

April, totaling 14.99% and

KRW176.8 billion in gross amount

Jul 2005

On Jul 15, Sovereign sell all of SK

shares, or 14.82%, over the

counter to an anonymous buyer at

KRW49,011, 7% discount off the

day's closing price of KRW52,700

Profit earned from the sellout is

estimated to be KRW800 billion

Nov 2006

SK buys 13 million shares, or 10%

of total available shares, of

treasury stock at KRW66,400

each at the same time it

announces plans to sell KRW470

billion to improve its financial

structure

Jan 2007

SK forms a strategic partnership with

JX Nippon Oil & Energy and buys each others shares, 1% SK share to 0.98% JK Nippon share ratio

Apr 2007

Former SK spins off petrochemical unit SK Energy

21,000 31,000 41,000 51,000 61,000 71,000 81,000

(원) (Won)

KT&G (033780 KS)

Feb 2006

Icahn coalition suggests

acquisition of KY%G at KRW

60,000 a share

Mar 2006

KT&G appoints Lichtenstein as

external board director

Dec 2006

Icahn coalition sells 4.75% of

KT&G shares at a 3.8% discount

from the closing price of the

previous day at KRW 60,700 per

share

Jul 2007

Shinhan Bank acquires 2.3%

of KT&G shares OTC

Oct 2007

KT&G acquires KRW 202billion of treasury shares

1,500 2,500 3,500 4,500 5,500 6,500 7,500

2007-01 2007-07 2008-01 2008-07 2009-01 2009-07

(Yen)

J-Power (9513 JP)

Apr 2008

TCI's request is rejected on grounds that TCI has presented a one-sided view

Dec 2007

UK-based activist fund TCI demands

J-Power to improve corporate

governance, to boost shareholder

returns and sell cross-shareholdings

as part of its business proposal

Jan 2008

TCI demands J-Power to draw up

detailed plans addressing profitability

and capital spending TCI requests to

include external board members, a

reduction in director compensation, to

sell off shares held under

cross-holding arrangements and to accept

two Children Investment's officials as

outside directors