Corporate Management in India & International Diversification

Corporate Management in India & International Diversification

There has been an increase in international portfolio investments in recent years. This is because many countries have liberalized and deregulated their capital and foreign exchange markets. International investments have been facilitated by introduction of products like American Depositary Receipts (ADR) and country funds by the commercial and investment banks. Recent advances in computer and telecommunication technologies have led to a major reduction in transaction and information costs associated with international investments. Investors have also become aware of the potential gains from international investments.

Foreign Portfolio Investment

Two of the chief reasons why people invest internationally are: diversification - spreading the investment risk among foreign companies and markets that are different from the national economy and growth -- taking advantage of the potential for growth in emerging markets abroad.

While it is desirable on the part of an investor to hold a portfolio that includes foreign assets, many still invest exclusively or predominantly in domestic securities as there are significant barriers to investing overseas. These barriers include high transaction costs, high information costs about foreign securities, legal and institutional restrictions, extra taxes, exchange risk and political risk associated with overseas investments.

 Investment Avenues for Foreign Portfolio Investors

A foreign company’s publicly traded debt or equity are ADRs, GDRs and Euro DRs. They are negotiable securities and these Depository Receipts (DRs) can be traded on US stock exchanges and also on many European Stock Exchanges.

Both individual and institutional investors desire to reduce risk by diversifying their portfolios. But while directly investing in local trading markets several problems are faced. Inefficient trade settlements, uncertain custody services and costly currency conversions are some of these obstacles faced. Many of these operational and custodial problems of international investing can be circumvented with the help of Depositary Services.

The broker who buys the shares in the open market deposits these shares a the depositary bank which issue Depositary Receipt to him. These certificates enjoy the facility of being freely traded in the over-the-counter market or, upon compliance with regulations, on a national stock exchange. The Depositary Receipt Certificate states the responsibilities of the depositary bank with respect to actions such as payment of dividends, voting at shareholder meetings, and handling of rights offerings.

Investors looking for international investment opportunities also invest in mutual funds. There are both global mutual funds as well as regional and single country funds available to investors interested in investing overseas. Funds which include both foreign and domestic shares of companies are known as global funds, whereas funds that expose investors to companies from one region or country are known as regional or single country funds..

Country Funds

A single country fund is a mutual fund that restricts its investment to the assets of one country and is able to allocate its funds only within the range of investment opportunities that are available in the specified country. For example, a single-country fund for Germany will only invest in assets based in that country, such as the stocks of German companies, German government debt and other Germany-based financial instruments.

A regional fund is a mutual fund that confines itself to investments in securities from a specified geographical area, such as Latin America, Europe or Asia. A regional mutual fund will generally invest in a diversified portfolio of companies based in and operating out of its specified geographical area. However, some regional funds can also be set up to invest in a specific segment of the region's economy, such as energy or telecommunications.

American Depository Receipts (ADR)

US investors are allowed to invest in companies that are not based in the United States through ADRs These company stocks are not traded on US exchanges. A US depositary bank issues the ADR certificate representing shares held by the bank of the foreign company. One ADR may represent a portion of a foreign share, one share or a bundle of shares of a foreign corporation. These shares can be traded in US dollar denominated securities in the US domestic market through the ADR. Typically very large foreign companies issue ADRs.ADR is a receipt that represents the number of foreign shares that are deposited at a US bank. The ADR represents the ownership of underlying foreign stock that is held in custody by the bank that issues them. In effect, the bank owns the shares and trades claims against those shares. ADR investors are entitled to all the privileges of stock ownership including dividend payments. The bank also serves as a transfer agent for the ADR. ADRs have been used to help US investors to avoid transactions costs and some of the risks of holding or trading securities in an unfamiliar foreign market. They can also be used to overcome regulatory barriers facing US investors from holding shares in non-US firms. The wide range of companies whose shares are indirectly traded in the United States means that US investors can essentially achieve full diversification without moving outside the securities traded within the United States.

ADRs are issued typically by large US banks. An ADR certifies that the depositary bank is holding shares in the non-US firm as a trustee for the holder of the certificate. Normally it is at the request of the non-US firm that the depositary bank launches an ADR program, with the objective of enabling the firm to reach a larger pool of worldwide investors. ADRs can be offered for sale in the United States only in accordance with regulations established by the US Securities and Exchange Commission (SEC), which ensures an adequate degree of disclosure of the foreign firm’s accounts. The more the disclosure, the more unrestricted is the trading of the ADR in the US markets.

Owning ADRs has some advantages compared to owning foreign shares directly for an investor in USA. When an investor buys and sells ADRs, he is trading in the US market. The trade will be settled in US dollars. The depositary bank converts any dividends or other cash payments into US dollars before sending them to the investor. The depositary bank may also arrange to vote on behalf of the investor in the shareholder meeting as per the instructions of the investor. All this facilitates stock ownership with the least effort on the part of the investor.

There are disadvantages too. Depositary banks charge fees for their services and will deduct these fees from the dividends and other distributions on the shares. The depositary bank also passes on to the investor expenses for converting foreign currency into US dollars etc.

 Global Depository Receipts (GDR)

To raise money in more than one market, some corporations use GDRs to sell their stock on markets in countries other than their home country. The GDRs are issued in the currency of the country where the stock is trading. For example, a German company might offer GDRs priced in pounds in London and in yen in Tokyo. Individual investors in the countries where the GDRs are issued buy them to diversify into international markets.

International Equity Indices

A group of stocks representing the entire market or in some cases a particular segment of a market, or in some cases the entire market is an index. An index is an an indicator that provides a representation of the value of the securities that constitute the index. Thus, a specific segment of the US capital markets is represented by the “Standard & Poor's 500 index” “Nikkei” represents large Japanese companies and the “CAC 40” represents large French companies. The components of an index are dynamic as they change over time, old stocks can be dropped and new stocks are added. Indices often serve as For benchmarks against which financial or economic performance is measured, indices are often referred to.

The index which tracks the movement of a market as a whole is a stock market index (such as the FTSE 100, Dow Jones, Nikkei, Hang Seng, etc.). There are other indices that track the performance of different classes of securities and regions. Security prices are the basic data used to calculate an index. The calculation of an index Weighting price changes correctly to reflect company size and the availability of securities to investors is required to calculate an index

The important international equity indices are:

 Dow Jones: The most widely used US index

 S & P 500: Constituents are the 500 largest US listed companies

 FTSE 100: An index that includes the 100 largest UK listed companies which cover about 80% of UK market capitalization

 CAC-40: The most widely used index for the Paris stock market

 DAX: The most widely used German index.

 Nikkei: The main index for the Tokyo stock exchange

 Hang Seng: The main index for Hong Kong

 MSCI: A family of indices most widely used for emerging markets.

Stocks from several markets make up broader indices, such as the MSCI EAFE. For example, the MSCI EAFE includes a total of 21 developed markets in Europe, Australasia and the Far East (Japan and Hong Kong). 26 emerging markets like Argentina, Brazil, China, Greece, India, Indonesia, Israel, Korea, Malaysia, Mexico, Philippines, Russia, South Africa, Sri Lanka and Taiwan are included in the EMF index. As countries are added or dropped from the index broader market indices, particularly for emerging markets, may change.

Emerging Markets

Investing in emerging markets offers high returns but with equally high risk. These are capital markets in developing countries, typically with low per capita GDP. While developing countries make up over 80% of the world’s population, they make up less than 10% of the stock market capitalization. There is low correlation between emerging market returns and returns elsewhere in the world and this aids diversification. However, as impediments to capital market mobility fall, correlations will increase.

Problems of investing in emerging markets include political uncertainty, lack of company information, lack of liquidity, trading and custodial difficulties, confidentiality and insider trading problems, as well as higher transaction costs compared with developed countries.

The following are the common features of an emerging market, however these characteristics differ from country to country:

 Economic growth is high

 Exchange rate risk is high

 Political risk is high

 Weak legal systems and lack of effective regulation

 Minority shareholders are not protected enough

 A single majority shareholder or a group of connected shareholder(e.g. a family) controlling a large numbers of companies The presence of large conglomerates

Inflation offsets Exchange rate risks (and therefore profit growth) that tends to follow a depreciation of the currency. The other risks involved with investing in emerging markets are largely diversifiable

International Diversification

International investments are made for the purpose of growth and portfolio diversification. Diversification is a risk management tool. As long as one class of domestic assets is less than perfectly correlated (correlation coefficient less than +1) with another class of domestic assets, a balanced portfolio that includes both classes of assets is likely to be less risky. International diversification, by increasing the number of markets and assets to invest in, provides an improved risk-return trade-off. International stock and bond diversification can yield higher returns with less risk.

The CAPM (Capital Asset Pricing Model) assumes that the risk of any asset can be attributed to two sources- systematic risk and unsystematic risk. The unsystematic risk is due to risks unique to the company and can be diversified away by holding a sufficiently large portfolio of securities. Systematic risk is due to market influences that affect all assets, such as the state of the economy. Systematic risk cannot be reduced by diversification if investments are made within a country. But the same risk may become diversifiable outside the country since it may not influence the other country. So if investments are made in a number of countries the risk may be reduced. By diversifying across nations whose economic cycles are not perfectly in phase, investors can reduce risk. The economic, political, institutional and even psychological factors affecting security returns tend to be different across countries.

While systematic risk can be reduced by investing in a number of countries, international portfolio investment introduces new problems not encountered in domestic markets - exchange rate risk, restrictions on capital flows across international boundaries, political risk, country-specific regulations and accounting practice differences.

Risks and Returns from Foreign Investing

International investing provides superior returns adjusted for risk. Allocating some portion of one's portfolio to foreign assets provides better risk-cover than a portfolio of only domestic assets. International equities also offer access to a broader spectrum of economies and opportunities that can provide for further diversification benefits. Some of the best performing companies in the world like General Electric, Exxon Mobil and Microsoft have shares that are listed on overseas stock markets. If an investor wants to profit from the growth of large global companies, he would have to invest internationally.

However, there are costs and risks of international investing. In smaller markets, an investor may have to pay a premium to purchase shares of popular companies. In some countries, there may be unexpected taxes, such as withholding taxes on dividends. Transaction costs such as fees, broker’s commissions, and taxes can be higher than in domestic markets. Mutual funds that invest abroad often have higher fees and expenses than funds that invest in domestic stocks, in part because of the extra expense of trading in foreign markets.

There are risks involved in international investing. Some of the risks are:

1) Changes in currency exchange rates

When the exchange rate between the foreign currency (in which the international investment is denominated) and the home currency (say, Rupee for an Indian) changes, it can increase or decrease the investment return. Foreign securities trade and pay dividends in the currency of their local market. When an investor receives dividends or sells his international investment, he will need to convert the cash that he receives into his home currency.

During a period when the foreign currency is strong compared to the home currency, this strength increases his investment return because his foreign earnings translate into more units of local currency. Thus for an Indian who has made investments in the US, if the dollar appreciates it is good news since the dollar earnings would convert into more Indian rupees.

By the same token if the US dollar depreciates, it reduces his investment return because his earnings translate into fewer rupees. In addition to this exchange rate risk, there is the risk that the country may impose controls that restrict or delay moving money out of the country.

2) Dramatic changes in market value

There can be dramatic changes in market value in Foreign markets as well like any other market. By investing for long term and by trying to ride out the short term downturns in the market can help reduce the impact of these price changes. When individual investors try to "time" the market in the domestic markets and sometimes in the foreign markets as well, they fail in their attempt. Two decisions need to be make when one times the market-– deciding when to get out before prices fall and when to get back in before prices rise again.

3) Political, economic and social events

Political, economic and social factors that influence foreign markets are difficult to understand by the investors. Although these factors provide diversification, they also contribute to the risk of international investing..

4) Lack of liquidity

Foreign markets may have lower trading volumes, fewer listed companies and may be open only for a few hours in a day. In some countries there are restrictions on the amount or type of stocks that foreign investors may purchase. To buy a foreign security an investor may have to pay premium prices and may also have difficulty finding a buyer when he wants to sell the security..

5) Less information

In many cases investors don’t get the same type of information in the case of foreign companies as in the case of domestic companies. The investors may not be able to find up-to-date information and the investor may not be able to understand the language used by the company.

6) Reliance on foreign legal remedies

The investor may not be able to sue the company in his own country’s courts and even if he is able to sue successful in a domestic court he may not be able to collect on a home country judgment against a foreign company. The investor will have to rely on legal remedies are available in the company's country.

7) Different market operations

The operations in the domestic country’s trading markets will be different from that of foreign markets. For example, there may be different periods for clearance and settlement of security transactions. Home markets may report stock trades much faster than foreign markets. Rules providing for the safekeeping of shares held by custodian banks or depositories may not be as well-developed in some foreign markets, with the risk that the investor’s shares may not be protected if the custodian has credit problems or fails.

International Listing

In addition to issuing stock locally, companies can also obtain funds by issuing stock in international markets. This will enhance the company’s image and recognition, and diversify its shareholder base. A stock offering may also be more easily digested when it is issued in several markets. Also, a company may decide to cross-list its shares.

Cross-listing of shares is listing of its equity by a firm on one or more foreign stock exchanges in addition to its domestic exchange. By cross-listing its shares, a company benefits from the access to foreign investors, increased liquidity and lower cost of capital.

Depending on the company’s specific motives and willingness of the host stock market to accept the company the company must choose the stock markets on which to cross-list its shares and sell new equity. Keeping in mind the cash flows needed to cover dividend payments the decision about where to place its stock will be taken. The market characteristics of stock markets are important. Stock markets may differ in trading activity level, size and proportion of individual versus institutional share ownership. Cross-listing attempts to accomplish one or more of many objectives:

 Support liquid secondary market and improve the liquidity of its existing shares for new equity issues in foreign markets.

 Overcome mispricing in a segmented and illiquid home capital and thereby Increase its share price.

 Improve the company’s visibility.

 Establish a secondary market for shares used to acquire other firms.

 Create a secondary market for shares that can be used to compensate local management and employees in foreign subsidiaries.