Valuation and Segmentation in Emerging Markets

1. Valuation and Segmentation in Emerging Markets Geert Bekaert, Columbia + NBER Campbell R. Harvey, Duke + NBER Christian T. Lundblad, UNC Stephan Siegel, U. of Washington May 16, 2008

2. I. The Setting • Why has globalization treated some countries better than others? • What drives valuation differentials? • Can we characterize the types of policies that change the degree of segmentation – both across countries and through time? `

3. II. The Plan 1. Segmentation 2. Valuation `

4. III. Openness Two aspects of (de jure) globalization Economic Integration: Trade Liberalization Indicator [Wacziarg and Welch (2004)] Financial Integration: Capital Account Openness Index [Quinn and Toyoda (2001)] Equity Market Openness [Bekaert and Harvey (2000)]

5. III. Openness Trade and Financial Openness Have Increased

6. III. Openness Globalization may have wide-ranging effects: • Expected Returns, Correlation and Volatility [International Finance] • Consumption Risk Sharing, Efficacy of Macroeconomic Policy[International Economics] • Investment, Economic Growth[Development Economics] Our Focus: Effects on Stock Valuation

7. III. Openness Equity Returns Economic Integration: • Specialization • Exposure to world shocks Cash Flows Discount Rates Real Rates Term Premiums Financial Integration Equity risk premiums Bond Returns Economic Integration Inflation

8. III. Four Contributions 1 Building on Bekaert, Harvey, Lundblad, Siegel (BHLS) (JF - June 2007), develop a measure of the degree of effective market segmentation Measurement: De Jure Openness ≠ De Facto Integration • Liberalization process is gradual and complex • Capital controls may not have been effective • Liberalization may not be credible • Indirect access may already exist Other factors may “segment” markets: • political risk • corporate governance issues • liquidity / financial development • domestic product and labor markets • “push” factors Literature: Bekaert (1995), Bekaert and Harvey (1995), Nishiotis (2004), Aizenman and Noy (2005), Lane and Milesi-Ferretti (2001)

9. Combining real and financial variables to construct a new measure of exogenous growth opportunities On average, countries align realized future growth with available (exogenous) opportunities countries with open equity markets and banking sectors are the most successful at exploiting available growth opportunities financial development and investor protection are also important, but to a lesser degree Degree of integration / segmentation (as inferred from growth predictability regressions) depends on country characteristics and varies over time.  This paper develops a direct measure of segmentation and explores its determinants III. Four Contributions

10. III. Four Contributions 2 Has the degree of segmentation decreased over time? What was the role of (de jure) globalization? Literature: • Return comovements: Longin and Solnik (1995); Bekaert, Hodrick, and Zhang (2007) • Factor Beta Models: Bekaert and Harvey (1997, JFE); Ng (2000, JIMF); Fratzscher (2002, IJFE); Baele (2005, JFQA); Carrieri, Errunza, and Hogan (forthcoming, JFQA) • Return and volatility distance: Eun and Lee (2005) • Effects of stock market liberalization on dividend yields: Bekaert and Harvey (2000), Henry (2000)

11. III. Four Contributions 3 Identify factors that determine the cross-sectional and time-series variation in segmentation: • Is de jure globalization first order? • What is the impact of local institutions? Literature: - Bhojraj and Ng (2007) - Hail and Leuz (2006)

12. III. Four Contributions 4 Related issues: • Investigate industry-specific degrees of segmentation • “Segmentation” within the U.S. • “Segmentation” within the EU

13. IV. A Measure of Market Segmentation Strong Concept of Market Integration: Industries have identical systematic risk across the globe Priced growth opportunities are global in nature Identical financial risk for each industry, independent of the country Constant real interest rates Each assumption relaxed later in our analysis

14. IV. A Measure of Market Segmentation Assume each country iis a basket of industries with industry weights IWi,j,t Let EYi,j,t = earnings yields for country i, industry j Valuation Differential: |EYi,j,t- EYw,j,t| (small and constant under strong market integration) Measure a country’s degree of observed segmentation:

15. IV. A Measure of Market Segmentation Construct SEG for 50 Countries between 1973 and 2005 EMDB: 28 countries DataStream: 22 countries 12 month trailing earnings yield, negative yields set to zero EYi,j,t 12 month global trailing earnings yield, negative yields set to zero (also considered U.S.) DataStream EYw,j,t Industry MCAP share in local market EMDB: 28 countries DataStream: 22 countries IWi,j,t

16. IV. A Measure of Market Segmentation

17. IV. A Measure of Market Segmentation

18. IV. A Measure of Market Segmentation Average Country and Industry Segmentation (MAD) 1973 - 2005

19. V. Market Segmentation Dynamics SEG: Industry-weighted Valuation Differentials

20. V. Market Segmentation Dynamics SEG: Industry-weighted Valuation Differentials

21. V. Market Segmentation Dynamics SEG: Industry-weighted Valuation Differentials

22. V. Market Segmentation Dynamics • Changes over time suggest we observe valuation convergence… • Explore an unbalanced panel regression with a simple time trend • Econometrics (throughout): • OLS on unbalanced panels; Newey-West and SUR correction (similar to Thompson (2006)) • Prais-Winsten on unbalanced panel with Beck-Katz (1995) correction

23. VI. Market Segmentation: U.S. Study • Clearly, valuation differentials may be due to other factors beyond segmentation • Within the U.S., we explore valuation differentials across industries and states to • uncover any biases in our measure of segmentation • explore other explanatory factors (e.g., leverage, earnings volatility, number of firms) • Design: (a) iteratively draw N random firms (resembling countries) or (b) consider U.S. states •  compare to overall U.S. market

24. VI. Market Segmentation: U.S. Study Segmentation across random draws of U.S. firms grouped into pseudo-’countries’

25. VI. Market Segmentation: U.S. Study Segmentation across random draws of U.S. firms by U.S. states

26. VI. Market Segmentation: U.S. Study 1973 - 2006

27. VI. Market Segmentation: U.S. Study 100 Random Samples of 50 "Countries"1973 - 2006

28. VI. Market Segmentation in the EU • Case study: we explore the role for valuation convergence in Europe • Direct analogue: • Consider trends in European valuations relative to • “core” European basket (FRA, DEU, ITA, NLD, BEL, IRL, GBR, DNK) • Reconsider de jure openness: • To what degree did EU membership or the entrance of the Euro Zone facilitate our notion of strong market integration? Do these factors explain the trend?

29. VI. Market Segmentation in the EU SEG

30. VI. Market Segmentation in the EU

31. VI. Market Segmentation in the EU SEG

32. VI. Market Segmentation in the EU There is a significant trend towards valuation convergence in Europe. Is that explained by (de jure) EU or Euro membership? EU membership is important, but trend persists.

33. VII. Market Segmentation Dynamics (with controls)

34. VII. Market Segmentation Dynamics: De Jure Openness

35. VII. Market Segmentation Dynamics: De Jure Openness

36. VIII. Determinants of Market Segmentation • Benchmark: fixed effects + time dummies 42% R2 • Regulatory openness: explains up to 13% • Univariate evidence suggests other factors (institutions, financial development, local market liquidity, U.S. “push” factors, etc.) are also important Is regulatory financial openness primary?

37. VIII. Determinants of Market Segmentation OPENNESS RISK APPETITE INST DEV GROWTH CONTROLS FIN DEV examples

38. VIII. Determinants of Market Segmentation Economic Effect on Market Segmentation (N= 906, R2 = 0.30)

39. VIII. Determinants of Market Segmentation Economic Effect on Market Segmentation (N= 880, R2 = 0.33)

40. VIII. Determinants of Market Segmentation

41. VIII. Determinants of Market Segmentation

42. IX. Valuation Segmentation is a measure of the absolute difference between local and world (industry adjusted) earnings yields Valuation attempts to explain the difference itself. The goal is to understand the drivers of ‘under’ and ‘over’ valuation

43. IX. Valuation Valuation (switch to log PE ratios):

44. IX. Valuation Use some of the same variables to try to explain variation in price to earnings ratios (both across countries and through time). 1: What explains the emerging markets discount?

45. IX Valuation “Emerging Market Discount” P R E M I U M Ave. Discount Relative PE Ratios D I S C O U N T Important factors? Financial openness, political and institutional risks, illiquid equity markets, and U.S. default premia

46. IX. Valuation Are they driven by growth opportunities or discount rate effects? 2: Decomposing PE Ratios

47. IX. Valuation Are they driven by growth opportunities or discount rate effects? 2: Decomposing PE Ratios

48. IX. Valuation Empirical model for 5-year real returns Empirical model for 5-year real earnings growth Project current PE on these two variables. 2: Decomposing PE Ratios

49. IX. Valuation Given our model of expected (industry-adjusted) PE ratios, we can take a stand on whether a market is over or undervalued. Trading simulations where you buy the undervalued markets and sell of the overvalued markets 3: Market Efficiency

50. Conclusions • Sementation • New price-based measure of market segmentation • Downwar trend in segmentation over time, partially explained by de jure globalization. • Identify most and least segmented industries over time. • Explain about 30% of the variation in degree of segmentation across countries and time: • Mostly from the cross-section • Mainly from financial openness, financial development, but “global risk” factors also matter