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Ibus6007 Research Paper Matthew Bright

Ibus6007 Research Paper Matthew Bright



Emerging markets finance paper written on India in late 2010.

Emerging markets finance paper written on India in late 2010.



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    Ibus6007 Research Paper Matthew Bright Ibus6007 Research Paper Matthew Bright Document Transcript

    • IBUS6007: INTERNATIONAL BUSINESS SPECIAL PROJECT RESEARCH PAPER Asset allocation and investment strategies in emerging equity capital markets: IndiaIs a global macro strategy the best investmentproposition for emerging markets? India: a snapshot. Matthew Bright Presented to the Faculty of Economics and Business in partial fulfilment for the requirements of a Master of Commerce degree by coursework The University of Sydney Sydney, Australia November, 2010Keywords: Emerging markets finance, India, ‘the new normal’, asset allocation, macro investing, asset management / investmentmanagement.
    • Is India best suited to a global macro strategy as an investment proposition? India: a Snapshot*1 Abstract:This paper considers India as an emerging economy after a strong short-term rebound from amacroeconomic shock and with sound long-term growth prospects.The focus of research houses towards the end of the decade has been on the prospective outlook foremerging economies with projections decades ahead considering the prospects of developing middleclasses, infrastructure development and changes in consumption patterns.In the background of this recent research focus, twenty years of emerging markets finance scholarship hasconsidered the perils and predilections towards investing in foreign markets with their inherentinformation asymmetries, pricing inefficiencies, valuation difficulties, internal complications ofcorruption and poverty and other “third-world problems”.For investors to gain exposure to asset classes in emerging markets, typically a global macro approach isrequired to develop profitable positions. Investors simply must take into consideration all of the wealth ofstatistics available to them and apply their own risk premiums to countries and assets.This paper is interested in the interaction between macroeconomic figures, equity market performance,the relationship between international investment and market performance and the internal drivers ofmarkets for goods as a country, India, matures.                                                                                                                          1  I  would  like  to  thank  the  following  academics  and  universities  for  whom  resources  were  available  in  the  form  of  cases  and  course  curricula  on  Indian  business,  including  individuals  such  as  Vikas  Kumar  at  The  University  of  Sydney,  Professor  Bruce  McKern  at  Stanford  Graduate  School  of  Business  and  The  University  of  Sydney  and  Jitendra  V.  Singh  at  The  Wharton  School,  University  of  Pennsylvania;  and  academic  institutions  offering  courses  on  emerging  markets  strategy:  Harvard  University  Department  of  Economics;  and  courses  on  emerging  markets  finance:  Yale  School  of  Management,  New  York  University,  Darden  Graduate  School  of  Business  at  the  University  of  Virginia  and  Duke  University’s  Fuqua  School  of  Business.   2    
    • 1. IntroductionCurrent trends in emerging markets finance involve critical structural changes in the globaleconomy, where domestic consumption in emerging markets is evolving towards self-sufficiencyand decreased reliance on international exports to the developed world.For India, its domestic-orientated economy and the long-term consequences of economic reformbode well for domestic equity capital markets and the stability of foreign direct investment. Thispaper considers the short-run economic performance of India as an example of an emergingeconomy in a single-country setting, in examining how projected long-term growth can lead toinvestment opportunities for firms now in respect of a macro investing strategy.Time constraints limit the scope and methodologies to literature review in emerging marketsfinance, Indian business and third-party proprietary research from financial houses andconsultancies on the Indian economy.2 2. Background: theoretical review, framework and research context2.1 Emerging markets finance research in contextOver some twenty years of emerging markets finance literature, there has been ample research inmarket integration and liberalisation, abnormal distribution and inefficiencies in marketmicrostructure and asset pricing. The literature is predominately finance-specific andcontextually, tends not to integrate topic-specific concepts of international business. Event-specific articles often consider large macroeconomic shocks such as market failures and region-specific financial crises.                                                                                                                          2  A  more  thorough  analysis  would  take  into  consideration  raw  data  or  up-­‐to-­‐date  reports  from  economic  database  and  research  agencies  such  as  the  Centre  for  Monitoring  Indian  Economy  Pvt  Ltd.  (CMIE).  The  author’s  resources  were  limited  to  publicly  available  information,  information  acquired  at  no  cost  from  helpful  third-­‐parties  by  direct  approach  and  the  resources  of  The  University  of  Sydney.     3    
    • 2.2 Putting international business into perspectiveIndian scholars Jones and Khanna (2006) put international business scholarship into perspectivein urging for the need to explain how history matters in international business. The pair cites thedecline in the teaching of history in business schools as a possible reflection of the growth indiscipline-based teaching at the expense of the more topic-based IB department3. The core oftheir argument is that a dynamic view of events in history allows us to examine long-run eventsof interest, but that much of the conceptual underpinnings of current emerging markets literaturesuch as ‘the effects of Foreign Direct Investment on variable x’ is seriously limited in scope,search and result. Accordingly, the author’s approach in this paper has been to integrateconcepts related to Indian business, economic and market conditions and suspended conceptsexplored on a rolling basis, rather than commencing with an iron clad archetypal question.42.3 Investing in emerging marketsMacro investingMacro forces have historically explained the majority of equity returns for securities in emergingmarkets (Cleary, 2010). A global macro strategy directs efficient capital allocation to compellingopportunities in international economies using macroeconomic principles to identify assetmispricings (subject to liquidity constraints and market participant behaviour). De Brouwer(2001) calls this a ‘top down’ approach.Risks inherent in emerging marketsIt is understood that common investment issues in emerging markets include informationasymmetry, agency conflict, adverse selection and moral hazard (Sammut, 2010). Non-market                                                                                                                          3  Jones  and  Khanna  cite  a  personal  communication  from  IB  scholar,  Hennart,  on  the  basis  of  such  an  interpretation  of  a  business  school’s  IB  department.  4  Such  a  concept  was  explained  to  Vikas  Kumar,  Department  of  International  Business,  The  University  of  Sydney.  A  question  was  put  forward  in  the  research  proposal,  as  something  of  a  ‘buoy’  and  in  order  to  provide  a  research  proposal  which  other  students  could  critique,  in  keeping  with  the  IBUS6007  course  mandate.     4    
    • issues include difficulties in information access, weak contract enforcement, poor investor andintellectual property protections, corruption and political instability (Mobarak, 2010).Inter and intra-day volatility was compared in India for 13 years and found to be low comparedto other emerging markets (Raju and Ghosh, 2004).Valuation Challenges in Emerging MarketsAssuming market efficiency, in asset pricing, valuation models will consider a risk-adjusteddiscount, being the sum of a risk-free rate and an equity risk premium for a given market orsecurity. Some universal principles hold true, including the basics of discounted cash flow value.Valuation uncertainty lies with risk premiums. Hence, practitioners and scholars alike havedevised modified Capital Asset Pricing Model (CAPM) frameworks incorporating country risksinto valuation (the international cost of capital, effectively). Considerations associated withcountry risk include a country risk premium, a shift in the exchange rate and models such as theGoldman Model take into account the sovereign yield spread. To incorporate cash flowsproperly, there is the temptation to use macroeconomic factors to construct scenarios (includingforecasts for GDP growth, foreign-exchange rates, interest rates and determine how they driveeach component of cash flow). Espinosa (2005) suggests using estimated country betas in theCAPM.The principles of corporate finance in this area involve capturing and countering firm-specificparameters (EPS volatility, long-run growth rate, systemic risk) with long-term yield parameters(long-run treasury yields, interest rate volatility) and factoring in growth assumptions withoutbeing unrealistic. The sheer number of variables computed in developing modified valuationmodels and then applying them mechanically often leads to wrong results and can lead to baddecisions (Li, 2005). 5    
    • Typically a Sharpe ratio is used for portfolio management and measurement and Value at Risk(VaR) is calculated for maximum loss over a target horizon based on horizon and confidencelevel.Asset Allocation and Investment Strategies in Emerging MarketsStock selection in emerging markets takes into account fundamental factors, expectations andmomentum. A macro investing strategy takes into consideration a country’s fundamentals indevising investment positions for various market instruments.As a driver of investment strategy, valuation makes a huge contribution to asset allocation.Kargin (2002) discusses the failure of complex, country-specific models specifically for valueinvesting in emerging markets. Market volatility may only bring moderate returns andundervalued stocks may be undervalued for region-specific reasons, not easily understood by thegeographically removed investor due to information asymmetries.General value investment principles that measure value such as low price/earnings (P/E), highbook/market (B/E) equity or high cash flow/price (C/P) may uncover opportunities in emergingmarkets. Fama and French argue that the value premium is compensation for risk missed by theCAPM and that value stocks tend to have higher returns than growth stocks in markets aroundthe world. 3. Methodology undertaken: data, methodData was obtained from reliable third party sources, due to time and resource constraints and theauthor’s extensive research in third party proprietary research from credible sources. Theacceptability of such methodology was assumed by the author on the basis of other successfulstudent-authored papers being developed in such a manner (such as Barnett-Hart, 2009). 6    
    • An extensive literature review was conducted involving emerging markets finance, Indianbusiness and asset management and asset allocation. A general within-country analysis allowsfor an isolated view of a country and its internal drivers. 4. India as an investment opportunity4.1 Key macroeconomic indicators in IndiaResearch houses have focused on the macroeconomic developments underpinning India’sdevelopment. McKinsey Global Institute (MGI) makes logical sense of how India’smacroeconomic climate interacts with a macro investing strategy with the following modifiedflow-chart:Figure 1: Modified ‘Bird of Gold’ structureIn developing this model based on its own 2007 ‘Bird of Gold’ model, revised with OxfordEconomics (OE) projections as an input, MGI proposed that India would continue to grow at anannual rate of 7.4% through 2030 (based on a growth rate of 8.0% between 2009 and 2018, 7    
    • stabilising to 7.0% between 2018 and 2030). MGI projects GDP growth to reach 9.1% in themedium term, before slowing down to 7% between 2020 and 2030.Against these economy-wide projections and measures, at the consumer level projected utilitygrowth and forecast changes in consumption preferences will drive firm profitability byinvestment category and allow investors to access growth through equity capital markets.Figure 2: McKinsey & Company analysis of India’s growth potentialSource: McKinsey Global Institute, ’India – the Growth Imperative’ research reportAs a model of emerging economy growth, India has a robust future for Foreign InstitutionalInvestor (FII) to channel capital flows into opportunities from labour and production factors.India’s demographics and urbanisation are favourable and its emerging middle class will drivegrowth. MGI, 2007 estimates that India’s middle class will rise tenfold from 50 million to 583million by 2025. 8    
    • How Demographic Change Will Impact the Financial SectorProjected increases in domestic savings will alter consumer behaviour in holding financial assets.Goldman Sachs projects that the distribution of household savings into financial assets willgreatly increase household flow into equity assets and decreases in bank deposits.Figure 4: Projected changes in household asset ratio skewSource: Goldman Sachs, ‘India – The Assurance of Domestic Demand’Against this background of increased household wealth and inflows to equity capital markets, itis worthwhile considering consumption categories and patterns in India.Figure 5: Evolution of Indian consumption categories 9    
    • Historically, consumption categories have been dominated by goods (necessaries), but GoldmanSachs projects a greater apportionment to services (necessaries and luxuries) in the next decade.Figure 6: Projected changes in consumption bundlesAs a demographic shift occurs, it makes sense that for liquid foreign capital allocation, equitycapital markets would be the logical arena for FIIs to capitalise on domestic consumption byaccessing financial instruments destined for price appreciation as consumer spending evolves.4.2 India’s place as an emerging market in the ‘new normal’India emerged from the global financial crisis (GFC) having expanding real GDP by 6.7% inFY2009 (Roach, 2010), having posted impressive country output of 6.4% in 2008 and 5.7% in2009 (IMF, 2010), amongst the highest of not only Developing Asia, but all developed countries.Industrial production is at a two-year high after having drastically decreased from 13% in early2007 to approximately zero in 2009 (Roach, 2010); The country generated a domestic savingsrate of 32.5% in 2009 (Roach, 2010). Inflation has returned to pre-GFC double-digit levels ataround 10% and India’s growth is projected at 9.7% in 2010 and 8.4% in 2001 (IMF, 2010).Real GDP is projected to grow by 9.2% in 2010-2011 (CMIE, 2010).Exports to developed markets such as the US and Europe have drastically decreased, whilstexports to other emerging markets such as China have dramatically increased (Roach, 2010). 10    
    • Key bellwethers of the Indian economy typically are manufacturing output and investmentlevels, both of which have sharply increased (Khari, 2010). India’s growth in the recent periodhas been driven by high domestic demand, productivity, credit growth ad high levels of savingsand investment (CSFA, 2009).India’s post-GFC position is consistent with the country’s model espoused by Das (2006), as astable, consumption-driven country largely insulated from global events. Taylor’s L. K. JhaMemorial Lecture (2010) is a good summary of the resiliency of emerging markets, includingIndia, over this period.The General Regulatory EnvironmentMuch has been written on how India’s institutional evolution through measures of reform andliberalisation which occurred on a rolling basis in the early and mid nineties have positivelyimpacted the Indian economy and in particular enabled some more sophisticated and liquidcapital market development, including the development and empowerment of the Securities andExchange Board of India (SEBI) to regulate capital markets (salient examples include McKern etal, 2009, Khanna and Palepu, 2005 and Zattoni, Pederson & Kumar, 2009).The literature on India’s banking system is extensive, including on its nationalisation andliberalisation (as an example, Chiarlone and Gosh, 2009). The topic of FDI in India has beenvery well researched (such as Beena et al, 2004) and is not further discussed here. 5. Accessing macroeconomic growth through financial markets and instruments5.1 Macroeconomics and Capital Market Behaviour in IndiaMontiel (2003) observes that short-run macroeconomic stability can be seen as an importantdeterminant for long-term growth performance in emerging economies. The snapshot of India’seconomy, post-GFC, shows a country’s robust performance after an exogenous shock. A model 11    
    • of macroeconomic shocks and financial stability demonstrates the systemic effects of whatshould occur with asset prices under such conditions.Figure 7: SEBI adaptation of trickle-down effects of a shock to a country and its financial marketsSource: Government of India Committee on Financial Sector Assessment (CSFA): India’s Financial Sector, p32Bridging theory and actual occurrence, the short-run performance of India’s capital markets andasset prices over this period provide a positive example of behaviour under external duress.India’s domestic equity markets grew sizeably over 2003-2009 from a capitalisation of less thanUS$300 billion to over US$1 billion (Deutsche Bank, 2009). Historically, Indian equities havebeen considered to be expensive based broadly on Price/Earnings ratios (CSFA, 2009), includingone a one-year forward basis or according the Greenspan formula (as discussed in detail belowthe diagram). 12    
    • Figure 8: SEBI model of equity valuations in IndiaSource: Government of India Committee on Financial Sector Assessment (CSFA): India’s Financial Sector, p231Foreign Institutional Investors (FIIs) have broadly achieved positive net investments in Indianequity markets, reflecting the country’s sound macroeconomic fundamentals and positivecorporate earnings. The close correlation of fund flow and P/E is an interesting phenomenon.Figure 9: SEBI model of Net FII Inflows relative to P/E RatioSource: Government of India Committee on Financial Sector Assessment (CSFA): India’s Financial Sector, p232 13    
    • If one considers the close relationship between Net FII inflows and P/E ratios, the relationshipcan be seen as a sort of Internal Rate of Return (IRR) for the Indian corporate securities market.It is also interesting to observe that over a blended, relatively stable decade, how amacroeconomic shock like the Global Financial Crisis tests a country’s model and fiscal policiesthrough shock and recovery phases. India’s performance demonstrated a rapid rebound of publicmarkets, asset price recovery and sustained earnings multiples through the period.Figures 10 and 11: Bombay Stock Exchange Sensitivity Index (red) behaviour in GFCSource: Bain & Company, India Private Equity Report 2010, p25Coming out of the GFC, investment in India has been quick to rebound. During the period ofJanuary to June, 2010 FIIs invested US $6878.50 million in equity investments in the secondarymarket. The primary market for IPOs has rebounded, backed by foreign underwriters such asGoldman Sachs and Deutsche Bank, with issues including power companies such as Power GridCorporation of India Limited and Jindal Power Limited, state banks such as State Bank of Indiaand infrastructure developers including Ramky Infrastructure Limited.The Outlook For Foreign Institutional InvestmentAt the same time as equity markets gain momentum, currency stability is allowing for efficientinstitutional asset allocation without fluctuations distorting capital flow into markets. 14    
    • Figures 12 and 13: Stock market and exchange rate performance during and beyond GFCSource: Deutsche BankKey facts such as India’s equity market capitalisation exceeding the value of its banking sectorand its corporate bond market being so under-developed also bode well for foreign investors inequity markets as equities are the choice assets to gain exposure to corporate earnings.International Asset AllocationFigure 14: Emerging Markets Net Private Capital Inflows / GDPSource: IIF Research NoteA general recovery in private capital inflows into emerging markets is currently taking place. Asthe West emerges scathed from the GFC, the investment community is adapting to the emergingmarkets’ increases in domestic consumption and decreased export to developed markets, in asset 15    
    • allocation priorities are shifting in favour of something of a towards emerging market mandates(as considered in greater length by Kang, Nielsen, Fachinotti, 2010).As a discrete case, cumulative fund flows to India highlight the sheer rise in FII over the firstdecade of the new century.Figure 15: FII flows to India (cumulative since Jan 2000)Source: Chakrabarti, 2009, SEBI.Research indicates that the vast bulk of Indian FII inflows are channelled into the equity markets,with which capital market indices are very highly correlated, to the extent of market volatilitycausing sell-offs in Indian stocks and exchange rate volatility (CSFA, 2009).Figure: 16 Relationship between FII inflows and BSE 500 Index performanceSource: Government of India Committee on Financial Sector Assessment (CSFA): India’s Financial Sector, p302 16    
    • Some ProblemsA liquidity puzzle exists in India that constricts investors in channelling funds to productive usesacross the entire economy. Allen and Chakrabarti et al (2007) observe that the size of the formalfinancial sector in India, measured by market capitalization and volume of bank credit, is smallin relation to the size and needs of the economy and that alternative financing sources persistbeyond the firm start-up stage.Without a foreign footprint, foreign investors are typically limited to closed-end or open-endfunds, where foreign-domiciled investment managers make decisions on behalf of the limitedscheme. 6. Asset ManagementFigure 17: Growth of the Mutual Funds Industry in IndiaSource: Chakrabarti (2009), adapted from Association of Mutual Funds in India6.1 Current Issues in Asset ManagementAs the asset management industry evolves towards a more crowded, complicated industry, keyitems on the agenda for asset managers include seizing financial opportunities associated with 17    
    • demographic retirement shifts, reinventing the wholesale approach to fund structuring, businessdevelopment for the next wave of growth and driving scale to generate operating leverage(McKinsey, 2010). Global regulatory reforms such as the closure of proprietary trading desks atinvestment banks are seeing new players move into the space and niche players disappear afteryears of negative returns.6.2 Asset Management in IndiaInternally, pre-GFC the Indian asset management industry had grown rapidly at 47% year-on-year since 2003, but Assets Under Management (AUM) are a mere 8% of GDP, compared to79% in the US and 39% in Brazil (McKinsey, 2008), suggesting a dynamic opportunity pipeline.New equity inflows and new fund offers have contributed heavily to industry development, withgrowth equal between the retail and institutional segments (McKinsey, 2008). Amongst thecountry’s demographic opportunities in the real economy, growth drivers will lie in distribution,consumer understanding, and investor education (SpencerStuart, 2009).Chakrabarti (2009) examined the asset management industry in India, including a history ofmutual funds in India, regulations and regulatory change, current industry structure and productofferings. He observes that in spite of the mutual fund sectors recent growth nationally, Indianpopulation participation is still very low at approximately 3%, but still higher than retail equityownership, which is around 2%. Corporate assets account for over half of total assets underManagement (AUM). Performance is rather negligible in domestically founded funds, relative tomajor stock market indices, but market efficiency would appear to be present, with a low numberof outliers in the risk-return profile. FIIs are seen as a discrete category of the market and areregarded in the market as “hot money” that quickly withdraws at the hint of trouble, with 18    
    • potentially destabilising consequences. FII equity investments and stock market performance arevery closely linked.Mutual funds AUM is expected to grow 40% CAGR to be a US $302 billion industry by 2012(KPMG, 2008). New trends in the asset management business include the arrival of real estatesecurisation in the form of Real Estate Investment Trusts (REITs) and employee pension funddevelopment and its flow-on effects (Chakrabarti, 2009). Goldman Sachs is currentlyunderwriting the offer public offering of UTI Asset Management Company, India’s secondlargest mutual fund.Equity funds product development tends to focus on equity-long positions across sectors andmarket caps. In accessing equities, FIIs equity funds will typically apply a proprietary investmentstrategy in line with the fund or company mandate.Investment Funds, Inception, Operation and the Indian Regulatory FrameworkThe asset management business officially evolved in India from the SEBI (Mutual Fund)Regulations 1993. Historically, product marketing has not generally been aimed at Indianinvestors and foreign funds have typically not elected to mobilise Indian investment withofferings to access investment from Indian residents (SEBI, 2004).Knowledge barriers may necessitate that investors can best access Indian ECM through open orclosed-end funds managed by third-party asset managers. Risks include liquidity and redemptionrisks, geographic or sectoral concentration risks, currency fluctuations and foreign markets risks.Integration of the geographic region and global capital markets, may dictate diversificationbenefits and fund profitability, as explored in the close-end funds example by Bekeart and Urias(1995). 19    
    • Such an example is the open-end Goldman Sachs India Equity Fund launched in 2008, with themandate to achieve long-term capital growth from actively managed Indian equity securities.The key metric for fund performance is the fund’s Net Asset Value (NAV) calculated on a dailybasis.Discussion and key findingsThe asset management industry in India is evolving with new product creation occurringconcurrently with demographic change and regulatory changes such as pension development.FIIs have a strong grasp of India’s macroeconomic fundamentals and how access to equitymarkets can shape investment strategies in line with fund mandates. India’s economy haspositively weathered a stress test through a challenging period and the snapshot of its economic,taken into consideration with research houses’ long-term projections make it a positive candidatefor investment allocation from FII funds into equity markets.Recommendations and Further ResearchThis paper is a good point of departure for a more extensive analysis of investment strategies thatcan be applied to India based on the country’s macroeconomics forecast and growth projections.A more extensive paper would consider the linkage between financial assets and consumerdemand for real goods and services, exploring asset allocation strategies and developing modelsto overcoming the challenges of fundamental analysis in emerging economies. Further researchwould also explore best practice valuation methodology used for Indian securities bypractitioners of corporate finance. 20    
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