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. 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? ` I. The Setting

3. 3 Developed Markets: Example 2003 LARGEST P/E RATIO SMALLEST P/E RATIO P/E ln(P/E)P/E Differential* U.S.23.213.140.19 Switzerland21.303.060.05 Netherlands19.842.99-0.18 P/E Germany12.192.500.03 Belgium12.082.49-0.42 Ireland10.762.38-0.10 ln(P/E)P/E Differential * Industry-adjusted, relative to global markets I. The Setting

4. 4 Emerging Markets: Example 2003 LARGEST P/E RATIO SMALLEST P/E RATIO P/E Israel37.103.610.59 Indonesia30.013.400.61 China27.623.320.44 ln(P/E)P/E Differential* ln( P/E ) P/E Differential P/E Jamaica7.972.08-0.72 Bangladesh7.692.04-0.81 Zimbabwe6.261.83-1.03 * Industry-adjusted, relative to global markets I. The Setting

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

6. 6 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)] III. Openness

7. 7 Trade and Financial Openness Have Increased

8. 8 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 III. Openness

9. 9 Equity Returns Cash Flows Discount Rates Real Rates Term Premiums Equity risk premiums Bond Returns Inflation Economic Integration Economic Integration : Specialization Exposure to world shocks Financial Integration III. Openness

10. 10 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) 1 III. Four Contributions

11. 11 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

12. 12 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) 2 III. Four Contributions

13. 13 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) 3 III. Four Contributions

14. 14 Related issues:  Investigate industry-specific degrees of segmentation  “Segmentation” within the U.S.  “Segmentation” within the EU 4 III. Four Contributions

15. 15 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

16. 16 IV. A Measure of Market Segmentation Assume each country i is a basket of industries with industry weights IW i,j,t Let EY i,j,t = earnings yields for country i, industry j Valuation Differential: |EY i,j,t - EY w,j,t | (small and constant under strong market integration) Measure a country’s degree of observed segmentation:

17. 17 IV. A Measure of Market Segmentation EY i,j,t EMDB: 28 countries DataStream: 22 countries DataStream EMDB: 28 countries DataStream: 22 countries 12 month trailing earnings yield, negative yields set to zero 12 month global trailing earnings yield, negative yields set to zero (also considered U.S.) Industry MCAP share in local market EY w,j,t IW i,j,t Construct SEG for 50 Countries between 1973 and 2005

18. 18 IV. A Measure of Market Segmentation

19. 19 IV. A Measure of Market Segmentation

20. 20 IV. A Measure of Market Segmentation Average Country and Industry Segmentation (MAD) 1973 - 2005

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

22. 22 V. Market Segmentation Dynamics SEG: Industry-weighted Valuation Differentials

23. 23 V. Market Segmentation Dynamics SEG: Industry-weighted Valuation Differentials

24. 24 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

25. 25 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

26. 26 Segmentation across random draws of U.S. firms grouped into pseudo-’countries’ VI. Market Segmentation: U.S. Study

27. 27 Segmentation across random draws of U.S. firms by U.S. states VI. Market Segmentation: U.S. Study

28. 28 1973 - 2006 VI. Market Segmentation: U.S. Study

29. 29 100 Random Samples of 50 "Countries" 1973 - 2006 VI. Market Segmentation: U.S. Study

30. 30 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? VI. Market Segmentation in the EU

31. 31 SEG VI. Market Segmentation in the EU

32. 32 VI. Market Segmentation in the EU

33. 33 SEG VI. Market Segmentation in the EU

34. 34 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. VI. Market Segmentation in the EU

35. 35 VII. Market Segmentation Dynamics (with controls)

36. 36 VII. Market Segmentation Dynamics: De Jure Openness

37. 37 VII. Market Segmentation Dynamics: De Jure Openness

38. 38 VIII. Determinants of Market Segmentation  Benchmark: fixed effects + time dummies 42% R 2  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?

39. 39 examples RISK APPETITEOPENNESS INST DEV FIN DEV GROWTH CONTROLS VIII. Determinants of Market Segmentation

40. 40 Economic Effect on Market Segmentation (N= 906, R 2 = 0.30) VIII. Determinants of Market Segmentation

41. 41 Economic Effect on Market Segmentation (N= 880, R 2 = 0.33) VIII. Determinants of Market Segmentation

42. 42 VIII. Determinants of Market Segmentation

43. 43 VIII. Determinants of Market Segmentation

44. 44 IX. Valuation 1) Segmentation is a measure of the absolute difference between local and world (industry adjusted) earnings yields 2) Valuation attempts to explain the difference itself. The goal is to understand the drivers of ‘under’ and ‘over’ valuation

45. 45 IX. Valuation Valuation (switch to log PE ratios):

46. 46 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?

47. 47 IX Valuation D I S C O U N T P R E M I U M Relative PE Ratios Ave. Discount “Emerging Market Discount” Important factors? Financial openness, political and institutional risks, illiquid equity markets, and U.S. default premia

48. 48 IX. Valuation Are they driven by growth opportunities or discount rate effects? 2: Decomposing PE Ratios

49. 49 IX. Valuation Are they driven by growth opportunities or discount rate effects? 2: Decomposing PE Ratios

50. 50 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

51. 51 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

52. 52 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

53. 53 Conclusions Valuation  Valuation in developing markets is challenging for investors  Our framework of industry adjusting compares ‘apples to apples’  Our framework of considering the institutional environment, the degree of openness as well as fundamental information, allows us to understand cross country differences in valuation – as well as time-series patterns.

54. 54 Conclusions Why does this matter?  Market segmentation and or undervaluation raises the cost of capital  Higher cost of capital means less investment and less employment growth  Lower investment and employment growth means lower GDP growth  For example, Bekart, Harvey and Lundblad (JFE 2005) estimate that a market liberalization which reduces the cost of capital is associated with a increment in real GDP growth of 1% a year for five years

55. 55 Supplementary Materials (not for reproduction)

56. 56 An aside: controlling for leverage and number of firms, which U.S. states are the most segmented?

57. 57 I. Motivation and Goals Outline I.Motivation and Goals II.Measure of Market Segmentation III.Market Segmentation Dynamics IV.Determinants of Market Segmentation V.Robustness Checks VI.Conclusions and Future Work

58. 58 IV. A Measure of Market Segmentation Earnings growth: where: i is country j is industry w is world Pricing industry portfolios:

59. 59 IV. A Measure of Market Segmentation Discount Rate: where: i is country j is industry w is world Pricing industry portfolios:

60. 60 IV. A Measure of Market Segmentation Valuation: H 0 : (Strong) Market Integration: H 0 : (Strong) Market Segmentation: Pricing industry portfolios:

61. 61 Segmentation across U.S. States VI. Market Segmentation: U.S. Study

62. 62 Methodology: –General multivariate model: Which factors account for most of the explained variance?  Need to be able to interpret evidence in the face of severe multi-collinearity  Must reduce the number of factors  Lack theoretical guidance  Model reduction techniques (e.g. PCGets (Hendry)) VIII. Determinants of Market Segmentation

63. 63 IV. General-to-Specific Modeling Pre-search reduction Multiple search paths Encompassing Potential Variables Equity MarketCapital Account

64. 64 Explained Variation in SEG Contribution of individual factors (x j ) to predicted segmentation: All Factors: where IV. Determinants of Market Segmentation

65. 65 Decomposition I: Decomposition II: Decomposefurther: IV. Determinants of Market Segmentation

66. 66 Variance Decomposition IV. Determinants of Market Segmentation

67. 67 IV. Determinants of Market Segmentation

68. 68 Variance Decomposition IV. Determinants of Market Segmentation

69. 69 IV. Determinants of Market Segmentation

70. 70 IV. Determinants of Market Segmentation