INTERNATIONAL EQUITY MARKETS

1. Differences and Instruments

General Overview and Differences

• Differences

- Macrostructure

- Liquidity

- Taxes

- Indexes

- Microstructure

- Organization

- Trading Procedures

Liquidity

Liquidity

“Ability to buy or sell significant quantities of a security quickly, anonymously, and with minimal or no price impact.”

=> Most important attribute for an asset.

• Usual measures are:

1. Capitalization/GDP

2. Transaction size (market turnover)

3. Degree of concentration

4. Bid-ask spread

5. Number of non-trading days

6. Number of zero-return days

1. Capitalization/GDP

Fact: U.S. stock market is very large compared to the U.S. economy. See figures in Dec. 2014 USD.

Market Market Cap (MC) GDP (nominal) MC/GDP

U.S. 26,240 B 17,416 B 151%

China 6,005 B 10,355 B 57%

Japan 4,378 B 4,770 B 92%

U.K. 6,370 B 2,847 B 224%

India 3,324 B 2,047 B 162%

Brazil 844 B 2,244 B 37%

But, this number may not be a good indicator: for South Africa, in 2009, the MC/GDP was over 170%.

Also, this figure changes a lot. The MC/GDP for Brazil in 2009 was close to 50% and in 2007 was close to 100%.

• Some analysts (Warren Buffet included) see the MC/GDP measure as a valuation metric, useful to identify what markets are under-/over-valued. The higher the ratio, the more overvalued the market. For example, Swiss market => overvalued!

2. Transaction volume

• Define turnover (T) as the total value of share trading. Not surprisingly, New York and Tokyo have the largest turnover (T) in USD (Dec. 2007).

NYSE 2,158.0 B

NASDAQ 1,187.3 B

London SE 441.4 B

Tokyo SE 440.5 B

Euronext SE 340.0 B

Shangai SE 272.4 B

• Turnover as a percent of market capitalization (T/MC) varies over time.

Example: From 1991 to 1995 annual turnover ranged:

U.S.: 55% - 74%

France: 33% - 140%

=> not very precise, if different years were observed.

3. Degree of concentration found in the major markets

• Composition: many small firms vs. concentrated in a few large firms.

Institutional investors dislike small firms for fear of poor liquidity.

A concentrated market provides fewer opportunities for risk diversification and active portfolio strategies.

Example: Market share of the 10 largest companies.

U.S. 11.9%

Japan 20.2%

U.K. 23.2%

Germany 39.2%

Switzerland 67.0%

Netherlands 74.3%

4. The bid-ask spread

Market maker buys shares (at the bid quote) and expects to sell those shares in the future (at the ask quote).

The longer it takes to receive a buy order The higher the required compensation Higher compensation => Higher bid-ask spread.

An average bid-ask spread is a useful market liquidity indicator.

Example: The average bid-ask spread in the U.S. is 0.6%, while in Thailand the average bid-ask spread is 5.14%.

Problem with this measure: Not easy to obtain –definitely, not in the WSJ.

5. Non-trading days

Market may be seem liquid on average, but there is no volume during some days. The number of non-trading days gives us an idea of liquidity.

6. Zero-return Days

Two things behind a no change in the price –i.e., zero return:

- No information

- No trading (stale prices) => proxy for non-trading days

It is an easy measure to gather, just from stock prices.

Conclusion: Take a look at several liquidity indicators.

Example: Liquidity -- The Case of Emerging Markets

Taxes

Taxes on Investments

1. Capital gains,

2. Income (dividends, etc.),

3. Transactions.

• Key question for international investors:

Q: Do they tax foreigners? If so, what are the withholding taxes?

Two Tax principles

- Residence: Residents are taxed on their worldwide income.

- Source: All income earned inside the country is taxable in this country.

When entire income is earned in the country of residence, both principles agree. Otherwise, the two principles have different (negative) implications.

Example:

Situation: A U.S. consultant works 3 months a year in Greece.

Residence principle: she pays taxes on her Greek income in the U.S.

Source principle: she pays taxes on her Greek income in Greece.

Greek income can be taxed twice. ¶

• Foreign investments may be taxed in two locations:

1. the investor's country,

2. the investment's country

Convention: make sure that taxes are paid in at least one country.

that is why withholding taxes are levied on dividend payments.

Tax Neutrality

Tax neutrality: no tax penalties associated with international business.

Two approaches:

(1) Capital import neutrality

(2) Capital export neutrality.

(1) Capital Import Neutrality

- No penalty or advantage attached to the fact that capital is foreign-owned

- Foreign capital competes on an equal basis with domestic capital.

- Local tax authorities exempt foreign-source income from local taxes.

=> For a U.S. MNF: Exclusion of foreign branch profits from U.S. taxable income (exclusion method).

(2) Capital Export Neutrality

- No tax incentive for firms to export capital to a low tax foreign country.

- Overall tax is the same whether the capital remains in the country or not.

=> Local authorities "gross up" the after-tax income with all foreign taxes; then apply the home-country tax rules to that income, and give credit for foreign taxes paid.

=> For a U.S. MNF: Inclusion of "pre-tax" foreign branch profits in U.S. taxable income. A tax credit is given for foreign paid taxes (credit method).

Example: Bertoni Bank, a U.S. bank, has a branch in Hong Kong. Hong Kong branch income: USD 100.U.S. tax rate: 35%Hong Kong tax rate: 17%

Double Exclusion CreditTaxation Method Method

• Hong KongBranch profit 100 100 100(17% tax) (i) 17 17 17Net profit 83 83 83

• U.S.Net Hong Kong profit 83 83 83Gross up 0 0 17Taxable income 83 0 100(35% tax) 29.05 0 35Tax credit 0 0 (17)Net Tax due (ii) 29.05 0 18

Total taxes (i)+(ii) 46.05 17 35

Organization

Three market structure types: ○ Public exchange

○ Private exchange

○ Banker exchange

The private exchange

Origin: XVII and XVIII century's European commodity markets.

- Private institution with some government supervision.

- Brokers are created by independent members.

- Brokers compete among themselves or enjoy monopoly.

Private exchanges may compete within the same country (U.S., Japan, China, India).

Commissions: negotiated or imposed by exchange or local law.

Example: U.S., U.K., Canada, Japan, Mexico, Argentina.

The public exchangeOrigin: legislative work of Napoleon I.

- Public institution.- Brokers are appointed by the government.- Brokers enjoy a monopoly over all transactions.

Brokerage firms are private.New brokers are proposed to the state by the broker's association. Commissions: fixed by law.

Examples: Belgium, Italy, Greece, and some Latin American countries.

The bankers exchangeOrigin: German tradition.

- May be either private or semipublic organizations.- Brokers are banks.- Members must deal through the exchange.

In some countries, banks are the major securities traders. In Germany the Banking Act grants a brokerage monopoly to banks.

Examples: German sphere of influence: Austria, Switzerland, Scandinavia and the Netherlands.

Recent Trends 1) Deregulation: The private stock exchange is the norm.Many exchanges have become business organizations, listed in their own exchanges.

Example: Paris Bourse, Deutsche Börse, NYSE.

2) Consolidation: Competition has created consolidation: - OMX: OM & Stockholm Exchange (OMX) (1998); Helsinki (HEX)

(2003); Copenhagen SE (KFX) (2005); Oslo SE (2006); Iceland SE (2006); Armenian (Armex) (2007)

- NASDAQ buys PHLX and OMX (2007, 2008).- Euronext: Paris Bourse, Amsterdam (AEX) & Brussels (BXS) (2000);

LIFFE (2002); Lisbon (BVL) (2002).- NYSE buys Euronext (2006).- CME buys CBOT (2006)- Toronto (TSX) & Montreal (MX) (2007)

Differences in Trading Procedures

The most important differences are in the trading procedures.

(1) Cash versus futures markets

(2) Fixed versus continuous quotation

(3) Computerization

(4) Internationalization

(1) Cash versus futures markets

• Cash markets

Stocks are traded on a cash basis (settlement within a couple of days).

For more leveraged investments: margin trading is available.

Margin trading: Investors borrow money from a broker.

a cash market transaction: a third party steps in.

Note: Margin trading is costly and, sometimes, difficult.

• Futures or forward stock markets

Provide an organized exchange for levered stock investment.

Forward stock markets compete with cash stock markets.

(2) Fixed versus continuous quotation

• Continuous market: transactions take place all day.

- Large market-makers assure liquidity.

- In some markets, the market maker has a monopoly for a given security, as is the case for the specialist on the NYSE.

- In other markets, the market makers (dealers or jobbers)

compete to provide the best quote.

• Fixed market: transactions take place only at specific times.

- Call or fixing market: a single price applies to all transactions.

- Auction market: an asset is traded only few times per day and its price is determined through a competitive auction system.

(3) Computerization

• Traditional trading method: floor trading.

- Traders meet on a floor to trade and to execute orders according to a set of pre-specified rules.

- Floor trading has been greatly influenced by computers: computers help to make floor trading cheaper, with fewer mistakes and faster.

• New trading method: computerized trading.

- A computer executes orders according to a set of pre-specified rules.

- Computerized trading allows the automated execution of orders entered by traders in their office.

- Best known system: Computer Assisted Trading System (CATS) -TSE.

- CATS eliminated the need for a floor where participants meet.

• Mixed system: NASDAQ.

(4) Internationalization• Traditional internationalization: International network of offices.

• New trend: Electronically access foreign markets. cheaper alternative.

Key to this new trend: Harmonization of electronic trading platforms

Examples:

(i) OMX: OM Stockholm Exchange (SSE), Copenhagen SW (CSE), e Helsinki SE (HSE), the Iceland SE. (September 2006).

(ii) Euronext: Amsterdam SE, Brussels SE and Paris Bourse (Sep 2000)

(iii) NYSE Euronext: NYSE and Euronext (April 2007)

(iv) NASDAQ OMX: NASDAQ and OMX (February 2008)

International Exchange of the Future: Stock exchanges with their own automated trading system available worldwide on a 24-hour basis.

Practical Aspects

Dual Listing

Fact: Some firms are traded on more than a dozen markets.

Implication: Shares should sell at the same price all over the world, once adjustment for exchange rates and transactions costs are made.

Procedures for admitting foreign stocks to local markets:

Montreal: Listed by simply by meeting the same regulatory requirements as those in its own jurisdiction.

U.S.: Must satisfy the local exchange and regulatory requirements.

Q: Why do companies double list?

Advantages of double listing:

- easier access to foreign capital.

- diversified ownership reduces the risk of a domestic takeover.

- fragmented markets.

- advertising.

Main disadvantage: Increase volatility.

Example: Situation: Bad political news in Chile.

Foreign investors tend to immediately sell their shares, driving domestic share prices down in this illiquid stock market.

Chilean investors have a less volatile behavior: they are not as shaken by domestic news, and have few investment alternatives. ¶

American Depositary Receipts (ADRs)• Special shares for foreign company: depository receipts.

Many DR programs around the world

U.S.: American depository receipts (ADRs).

U.K: Global DRs (GDRs).

Singapore: Singapore DRs.

Simple process: (1) Foreign shares are deposited with a trust company.

(2) Trust issues DRs.

To avoid unusual share prices, ADRs may represent a combination or a fraction of several foreign shares.

Example: Petroleo Brasileiro (Petrobras) ADR (PBR)JP Morgan has a 10 million shares of PBR in deposit. JP Morgan issues 5 million depository receipts (DR). Each DR represents 2 Petrobras shares. ¶

• Trading in ADRsTrading in ADRs avoids delays of trade settlement, problems with safeguarding, and making currency transactions.

Note: ADRs do not eliminate currency risk or country risk.

Example: BRL depreciates sharply, Petrobras (PBR), USD returns decrease

Petrobras ADRs will decline.

• There are more than a 2,700 ADRs available to U.S. investors. Representing over 80 markets. China has 124 ADR programs.

• ADRs account for more than 15% of the entire U.S. equity market.

ADRs Trading Volume: Exchange Listed ADRs

• Types of ADRs(1) Listed ADRs (Level II and Level III): companies should meet all the exchange requirements. In December 1995, there were 316 Listed ADRs: 199 traded on the NYSE, 7 on the American Stock Exchange, and 110 on the NASDAQ.

(2) Unlisted ADRs: The rest of the ADRs trade on the OTC market (OTC level I), or privately placed (ADR Rule 144-A, or RADR).

- OTC Level I (pink sheets): Simplest way to access capital in the U.S. A Level I DR programme does not have to follow U.S. GAAP, nor it has to make a full disclosure to the SEC.

- RADR: They are privately sold and bought by qualified institutional buyers (QIBs). QIBs include institutions that manage at least USD 100 million.

Example: KIA Motors, LG Electronics, Samsung are all 144-A ADRs

Examples ADRs in the U.S.:

AUSTRALIA: BHP (NYSE), Foster’s (OTC), Qantas (OTC)

BRAZIL: AES Tiete (OTC) AMBev (NYSE), CVRD (NYSE), VIVO (NYSE)

CHINA: Air China (OTC), Agria Corp. (NYSE), Baidu (NASDAQ)

CHILE: Concha y Toro (NYSE), LAN Airlines (NYSE), Enersis (NYSE)

EGYPT: Orascom Construction (OTC), Orascom Telec (OTC), Suez Cement (OTC)

FINLAND: Neste Oil (OTC), Nokia (NYSE), Stora Enso (OTC), UPM (OTC)

FRANCE: GDF Suez (OTC), France Telecom (NYSE), L’Oreal (OTC)

GERMANY: Allianz (NYSE), BMW (OTC), SAP (NYSE)

GREECE: Alpha Bank (OTC), Hellenic Petrol (NYSE), Hellenistic Telecom (NYSE)

JAPAN: Canon (NYSE), FujiFilm (NASDAQ), Hitachi (NYSE)

KOREA: Korea Electric Power (NYSE), Pohang Steel (NYSE), SK Telecom (NYSE)

MEXICO: Am Movil (NASDAQ), Cemex (NYSE), Femsa (NYSE), Telmex (NYSE)

NETHERLANDS: AKZO Nobel (OTC), ING (NYSE), Crucell (NASDAQ)

RUSSIA: Gazprom (OTC), Lukoil (OTC), Mechel (NYSE), Mosenergo (OTC)

TURKEY: AKBank (OTC), Koc Group (OTC), Petrol Ofisi (OTC), Turkcell (NYSE)

UK: Barclay’s (NYSE), BP (NYSE), British Airways (OTC), Imperial Tobacco (OTC)

Financial Analysis and Valuation

• Nothing unique to financial analysis in an international context.

Example: The methods and data required to analyze U.S.-, Mexican, or Malaysian-type manufacturers are the same. ¶

A research report on a company should include:

(1) Expected return.

(2) Risk sensitivity.

The information problemA firm is typically valued in two steps: (1) Forecast future earnings (EPS -expected earnings per share)(2) Assessment of how the stock market will value these forecasts.

(PE -price-earnings ratio)

InformationU.S.: Firms publish their quarterly earnings.

Europe and Far East: Firms only publish their earnings once a year. • Quality of the disclosed information: Varies from country to country. There is a market for companies "interpreting" for international investors the local books of companies:

Many international brokerage houses provide analysts' guides.

Comparative analysis.Another difficult problem due to:

- Different accounting principles- Different cultural, institutional and tax differences

Example: Swiss firms stretch the definition of a liability. They tend to overestimate contingent liabilities when compared to U.S. firms.

Example: German firms create hidden reserves often equal to 100% of fixed assets. Inventories tend to be understated.

Major differences in international accounting practices:

* Publication of consolidated statements* Publication of accounts corrected for fiscal distortion* Inflation accounting* Currency adjustment* Treatment of extraordinary expenses* Existence of "hidden" reserves* Depreciation rules* Inventory valuation

Company Valuation

(1) Discounted Dividend Model (DDM)• DDM is used to estimate the expected return on an investment:

• The value of an asset is determined by the stream of cash flows it generates for the investor. • DDM: Stock price (P) = stream of discounted forecasted dividends.

P = D1/(1+r1) + D2/(1+r2)2 + D3/(1+r3)

3 + D4 /(1+r4)4 + ...

• A typical DDM approach is to decompose the future in three phases. - Near future (next two years), earnings are forecasted individually.- Second phase (years two to five), a general growth rate for the company's earnings is estimated. (revert to industry?)- Third phase, the growth rate in earnings is supposed to revert to the average of all firms in the market.

Dt-forecast's and P are known solve for the expected return (r).

Problems: - Companies have discretion over their dividend payments.- International comparisons are difficult:

Payout ratios vary considerably. The U.S. has a much lower payout ratio than the U.K.

Note: We might also need an accurate forecast of currency movements.

Example: Using DDM to calculate the fair value of YPF ADRsIt is December 1995.

We need input values for Dt, rt, and St. t = 1996, 1997, 1998, ....

PYPF-ADR = USD 20.53. (Market price at NYSE)

St= 1 USD/ARS.

Dt = ? t = 1996, 1997, 1998, ....

D1996F = ARS .84.

dtF = 9.1% t = 1997, 1998, 1999.

dt is low for international standards dt should increase in the future:

dtF = 15.7% t = 2000, ...

• rt = ? t = 1996, 1997, 1998, ....

According to CAPM, we should estimate:E[rYPF] = rf + E[rm-rf] ßYPF.

Inputs: ßYPF=.91; rf =.085; E[rm]=.18.

E[rYPF] = .085 + (.18-.085) x .91 = .17145.

Example (continuation): YPF ADR Valuation • St = ? t = 1996, 1997, 1998, ....

st = -1% t = 1997, 1998, 1999.

st = -2% t = 2000, ....

• Valuation Process: (1) Determine the USD PV of CF from 1996 - 1,999 (year 4), P1-4.

- Effective USD rate of return from 1997 until 1999 is: [(1.091)x(.099) - 1] = .08009.

- P1-4 = .84/(1.17145) + .84(1.08009)/(1.17145)2 + .84(1.08009)2/(1.17145)3 +

+ .84(1.08009)3/(1.17145)4 = USD 3.5559.

(2) Determine the USD PV of CF from 2000+ (year 5+), P5+.

- The discounted dividends per share in year 4 will be:USD .84[(1.091)x(.99)]3/(1.17145)4 = USD .56204.

- The effective USD rate of return is [(1.157)x(.098) - 1] = .13386.- The USD PV of all futures cash flows after year 5 is given by

P5+ = USD .56204 x (1.13386)/[(.17145 - .13386)] = USD 16.9533

Example (continuation): YPF ADR Valuation

(3) Add (1)+(2) -- Present value of a YPF ADR is:- P = P1-4 + P5+ = USD 3.56 + USD 16.95 = USD 19.50.

The December 1995 price of USD 20.53 indicates that the YPF ADR was slightly overvalued, given our estimates from the DDM. ¶

(2) Valuation by Multiples

Calculation of the fair value of a company: Need rj = discount rate.

rj = bond yields (risk-free) + risk premium.

Example: For well-established markets, real bond yields are about 3%. No consensus about the risk premium: from 0 to 8%.

Alternative method: discount free cash flows (CF) (CF derived from ordinary after-tax earnings).

CF: after interest, tax, and capital expenditures, but before depreciation and amortization.

Assumptions:

(A) Two downward adjustments (1/3 of earnings, E):

(1) cost of replacing worn-out assets is higher than original (10)

(2) Companies invest also to expand (25%).

(B) Corporate earnings grow with trend economic growth (g).

• Now, we can calculate fair value stock prices:

P = CF1/(1+r) + CF2/(1+r)2 + CF3/(1+r)3 + ....,

where CFt = 2/3 Et.

Et = E (1+g)t

P = 2/3 E(1+g)/(1+r) + 2/3 E(1+g)2/(1+r)2 + 2/3 E(1+g)3/(1+r)3 ..

This formula simplifies to:

P = 2/3E [(1+g)/(1+r)] / [1 -(1+g)/(1+r)].

Example: It is 1994. Calculating the steady state P/E for the U.S.

Data:

(1) Real economic trend growth (g) is 2.5% a year.

(2) Real bond yield is 3%

(3) Risk premium is 3%.

From (2) and (3) r = discount rate = 6%.

Recall: CF = 2/3 E

P = 2/3E [(1+g)/(1+r)] / [1 -(1+g)/(1+r)].

Then,

P/E = 2/3 [1.025/1.06]/[1 - (1.025/1.06)] = 2/3 (.96698)/(.0330189)

= 19.52 (equal to the P/E for 1994). ¶

Problem: Global economy is not in a steady state. Growth rates change over time: Over the business cycle, profits take different proportions of the GNP.

Example: When countries are in the advanced stages of the business cycle, wages rise at a faster pace. P/E ratios have to be adjusted.

Example: Ad-hoc adjustments.

U.S. economy: late stages of the business cycle.

Adjust steady state P/E by .80.

Asian Pacific Countries: room for improving the efficiency of firms.

Adjust steady state P/E by 1.10. ¶