Stock-Taking and Secular Trends

05 Jan, 2003

While a sombre mood prevailed in the mature markets of the OECD (the so-called 'developed' world) for most of 2002, what warrants attention are some underlying trends in their stock markets. On the face of it, the slump of some 38% in Germany's Dax, 22-odd % each in U.K.'s Footsie and NYSE or even the 30-odd % collapse in Nasdaq would denote a deteriorating performance. Labelled as the worst decline in several decades and headlined for its similarities with the days of the 'Great Depression' might be the poetic liberty that the Western press take from time to time to create impact. Many of the emerging markets, on the other hand, did exceptionally well in 2002. In the Arab World, while Egypt and Oman stock markets fell, there was anaemic growth in Saudi Arabian and Lebanese stock indices in 2002 of only 4%. Multiple digit growths were notched up by Kuwait, Qatar and Oman. The UAE recorded an increase of some 15%. Tehran outdid them all with some 40% growth in 2002 on an year on year basis

However all these numbers do need to be treated with caution and some care in interpretation. The rise or fall in the general indices do not necessarily indicate the robustness or otherwise in the health of the underlying economies. Even though the UAE economy has been growing appreciably since 1997, the stock market was in severe doldrums in the last few years of the last century (indeed upto September 2001).

The regional markets to seasoned observers will reveal the following few ironies. Liquidity is very low, in all the emerging markets to a varying degree and this includes the UAE. Apart from the relatively few active brokers and institutional investors, the amounts traded tend to be semi-retail at the individual level. Thus the ticket sizes are small but they end up exaggerating the closing prices on many days. Secondly, in relation to market capitalisation, 'free-float' in many actively traded stocks in the UAE, Bahrain and Qatar tend to be low.

The Qatar market, for instance, revolves around Qatar Telecom; in isolation. In the larger emerging markets such as India, Brazil or South Africa, this situation is a shade better but just about. Even there, the ill-liquidity continues to plague the broader market; except when there are gushes of foreign portfolio investments into the tech stocks or those with ADR / GDR fungibility. But even this flow is often as fickle as that from the local speculative traders; who are forever, spotting opportunities to make a quick kill and exit as swiftly as they entered.

Another recently noticeable and worrying trend is that 'equity culture', as an ingrained investment preference, is not growing in any enhanced manner in many of the developing countries. Year after year, the population at large remain outside, who view the stock markets as a casino or club for the minority i.e. the investment savvy urban intelligentsia. Only if share ownership is widespread, can the stock values be determined credibly, on the basis of their earnings, outlook and actual performance. The speculative froth in the secondary markets, be it in the bond market or in the stock market, or in financial futures, has very much been the outcome of a small number of players in relation to the number of potential savers / investors.

Another recent report is equally disturbing. It is believed that the larger investors such as the pension funds and insurance companies are developing cold feet and a growing equity aversion and loss tolerance. It is possible that some of them have moved aggressively to other forms of asset classes, be it hedge funds, alternate investments, structured products, albeit with capital protection, properties and commodities. Therefore their allocation to equities is now sharply lower than in the yesteryears. That would signify a secular trend that will prove to be a real drag. Many pension funds are also reducing their equity allocation because of the demographics of the country and the companies whose money they manage on fiduciary basis. With an ageing population, as is the case in many parts of Europe, it is likely that there will be larger payouts year after year in the near future. The final settlements of employees that retire or leave will be greater than the accruals retained on account of new employees coming on stream. The job cuts as well as the worsening unemployment numbers galore in the Western world, would suggest that there are cash flow requirements to meet redemption payments that have to be made by the pension funds.

Naturally, they are switching to cash from equities even though, currently, the yields on bank deposits and money market instruments are very low. Of course, in the first instance, the allocation to private equity, venture capital, long-term hedge funds etc. will feel the brunt. But the spate of financial and accounting scandals, poor corporate governance, repeated announcements of lower-earning outlook and a slew of other bad news, can hardly enthuse the equity investor.

The developing markets, of course, have a different dilemma. They do not have very many high net worth equity investors in the first instance. The state-owned entities stay out of the equity markets, even though they may invest in properties and other tangible assets. This is particularly an acute phenomenon in this region, where there are very few good stocks available. Even for pension funds, liquidity is a perennially thorny issue. If they have a large holding and wish to dispose it off, they will have to do it in a painfully slow manner. Any such sale may immediately trigger a slide and adversely affect the value of what residual they hold.

Secondary markets also suffer from lack of 'market-making' activity. The non-bank private brokers do not have the financial muscle to quote and sustain two-way prices and banks are reluctant to engage in this activity. In the absence of these and given the relatively small shareholder base in number terms, it is not surprising that the liquidity is low. All these become parts of the vicious cycle as they do not attract new investors.

Another key deterrent is the ongoing difficulty in valuation. While institutional investors need to "mark the securities to market", the 'market' itself is imperfect. The price discovery process is inefficient. The regulated edifice is wobbly and the fact that there are authorities and that the prices are quoted and displayed, do not necessarily make them reliable prices The amounts traded are small and if a larger quantity were to be bought or sold, that price may not hold.

On a positive note, during 2002, the global bond markets did well on the back of multiple interest rate cuts. This could well change in 2003. Bonds produce superior capital appreciation only during times of declining interest rate outlook. Where the credit quality is good, the returns over time, will be mediocre.

Ultimately, only equity markets can provide superior returns and stack up well in risk / reward ratios. Large portfolio investors, after severe bruises in 2001, seem to prefer to go to sleep or play golf than endure the shock and the strain of monitoring the equity markets constantly and their stop-loss limits breached. Proprietary equity trading, like currency speculation has become less common place.

Ultimately, more investors and fewer traders will be good for the markets. Traditional investors perceive values, stay and sustain with the stocks, do their stock-picking and homework before they invest their money, not on leveraged basis with a view to making a quick turn, but to make a decent and consistent return above inflation, year after year. Such a sustained pool of investment flows alone will nurture the secondary stock markets. Without them, the trading prices have a tendency to boost sentiment and disappoint sharply. Currently, alternating greed and fear make people surge and retreat and then charge back, to catch the tail of a spiralling market place.

Another matter to be debated is the definition of what are privately held companies and what are public companies. A particularly acute phenomenon in the developing markets, is that many companies have upto 80% of their share capital held by fewer than twenty individuals and institutions. What is left in the market is very little and the minority shareholders have hardly any influence over what is happening in or with the so-called public companies. In fact, they are no different from a private equity situation; albeit the company may have more than fifty shareholders. In the UAE, apart from Emaar, Dubai Investments and some of the newly-launched companies, there is very substantial institutional and governmental shareholding in banks, telecom and other public companies. A truly public company would have to be one, that has atleast a few thousand shareholders and the shareholding is evenly distributed. Otherwise, they would have to be regarded as hybrid public companies or "deemed" public companies and treated differently, from a valuation point of view. A significant impact will result if any of the large shareholders were to divest or offload their holdings. So the quality of prices or price-efficiency may be distorted by the so-called 'public companies' that are, in fact, little more than closely-held private companies.

These trends and wider issues are worthy of further evaluation. The authorities can evaluate, analyse and encourage a healthy debate wherein professionals and the leading accounting firms can address valuation and liquidity issues. The intention is not to make them controversial matters as shareholders are perfectly entitled to operate their companies as closely held companies. But if they are listed and traded, then there ought to be two different criteria. This will spur the orderly development and evolution of the market place, on the one hand and efficient price discovery, on the other.

(The author (sureshk@emiratesbank.ae) is a General Manager in Emirates Bank Group. The views expressed in this article are not necessarily shared by the Bank.)

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