By Sanjay Kulatunga
Given the relatively large role that banks play in deposit mobilisation and lending, our economy is strongly tilted towards a bank-based financial system. What role can a market-based financial system play in order to enhance small investor participation? Cross-country studies indicate that a financial service approach with a strong legal base is best at sustaining economic growth.
Today, small investors attempt to emulate large investors in order to free ride on information asymmetries. This can be clearly seen in the stock market where small investors use leads of large institutions and foreign participants to free ride on what they perceive as superior knowledge. Blind faith has led to high volatility in the market with small investors having burned their fingers in the process. This has led to even the few small investors who participate in the market staying away from equity due to the perception of unrealistic risk, leaving room only for investors with above average risk-return profiles to enter the market. The free rider issue is further aggravated by the lack of proper advice for small investors who have to rely on their gut feeling in order to make investment decisions.
A study on East Asian countries has shown a negative correlation between market valuations and concentration of control in the case of family-held companies. My intention is not to debate on the merit of family control versus widely held companies, but to draw attention to high net-worth individuals and families that use pyramid structures in empire building at the cost of small investors. It is clear how large block holders use the cash flow stream of public vehicles to gain control of other public companies that do not fit into the business model of the acquiring company. This, is a clear violation of minority investor rights.
The lack of proper dividend policies, where small investors are adequately rewarded for holding the shares, has resulted in the deterioration of investor sentiment. This has been further aggravated by the inability to perform share buy-back in the local market. Given that management is the best judge of corporate value the ability of management to buy back shares of the company when the share price is below its intrinsic value will undoubtedly help to restore investor confidence.
Transfer pricing and the transfer of profit from one company to another has been another way of controlling shareholders and this has steered companies away from safeguarding the interests of small investors. Companies with links to financial institutions resort to group lending and interest rate manipulation that do not take into account each institution or company as a separate entity but are in the larger interest of the controlling shareholders. Further, management companies that are privately held are able to reap rewards even when the core business is not generating profits - as the bulk of the fees is driven by turnover, the need to increase productivity and increase profitability becomes secondary.
Another key factor that has kept the interest of management and small investors apart is agency cost. When was the last time that senior management of companies imposed cuts in their total remuneration in times of declining profitability? Small investor confidence in the market could only come from the ability of the market to penalise management with poor performance by way of aligning management remuneration directly to profitability of the company. In diversified companies the key concern of small investors is the performance of these large entities, which have many listed vehicles to transfer cost from one unit to another depending on their performance as well as tax considerations. This can be clearly seen when a downturn in one industry results from the transfer of cost from companies exposed to the affected industries to other unrelated listed vehicles. Thus minority shareholders of these unrelated businesses are adversely affected by this practice.
A well functioning financial services sector helps in overcoming information asymmetries associated with making small investors comfortable in giving up control over their savings. Today, an investment analyst with experience is a rare breed. If there were any in the past, they have all left the industry for greener pastures. The only advice available to small investors is from stockbrokers who are more like trend analysts with little knowledge of fundamentals. Even the so-called largest brokering houses have shed their research departments thus making stock brokering similar to blind man's buff instead of an educated guess.
The emphasis given to different risk profiles of investors is non-existent. Given the little understanding brokers have of the companies they trade, brokers are not able to even give a brief outline of the risk characteristics of the stocks in order to make small investors select equity that are in line with their risk-return profiles. Neither brokering houses nor other financial intermediaries give adequate attention to individual tax considerations of small investors when making investment recommendations.
Good research documents that give an independent view of the company and its share price is vital for investors to make investment decisions. However, the lack of such processes has left small investors to fend for themselves or rely on broker guesswork. When was the last time investment advisors were seen at an annual general meeting asking questions from management? It is also unfortunate that management views small investors who have the guts to question their superior decision making ability as a nuisance and a deterrent to the smooth functioning of annual general meetings.
Creative products aimed at different risk profiles of small investors are non-existent. The stock brokering community together with large financial institutions have made little effort to structure products that cater to small investor requirements. Small investors would be more willing to invest in equity investments that have features such as; capital guarantees, products with minimum guaranteed returns as well as investment vehicles that pre-specify the maximum downfall in a given period. Given the liquidity constraints in our market there is no means whereby small investors could divest their portfolios without taking large losses. Although short selling has been introduced, the cumbersome process as well as lack of proper understanding in executing a short sale by the brokers have kept investors away from this investment mechanism.
Disproportional transaction costs
Transactions of more than a million rupees are given a more favourable fee compared with transactions that are smaller. Small investors who buy lots that fall below this limit are at a disadvantage compared to large investors. This unfair treatment is yet another way small investors have been kept away from the market with the high transaction costs acting as a deterrent to investment by small investors. Favourable treatment of larger clients by brokering houses have led to this gap becoming even wider where disproportional transaction costs require small investors to pay normal charges whereas larger clients are offered even more favourable structures. Bringing down transaction costs is thus paramount in mobilising savings and gaining small investor confidence.
Auditors and irregularities
In order to build confidence in small investors, well functioning stock markets help by facilitating the development of accounting standards and disclosure requirements. While I do believe that our accounting standards are on par with international standards, I believe that auditors can do much more to build the confidence of small investors in the investment process. How often do auditors give warning signals to the financial community of companies that are in financial distress or engaged in activity that is not in line with shareholder interest? Does the auditing process capture all the financial irregularities that companies follow at the expense of small investors and disclose these in the financial statements? When was the last time that an auditor who did not identify financial irregularities, was penalised by the SEC? Auditors should be especially wary of companies with inter-company transactions and should go into detail with regard to these agreements in order to safeguard small investor interest.
Small investor confidence can only be restored if there is an independent legal system and an independent regulatory body. I cannot but mention the importance of having an independent regulator at the helm of the SEC. Any person who takes over as the head of the SEC should relinquish all his associations with other companies by way of directorships and other conflicts of interest. However, little attention is given to this fact when appointing a high-ranking official to this important position. While there are many positions that would warrant mentioning with regard to conflicts of interest, I believe that an independent SEC will play a pivotal role in stimulating small investor confidence in the market.
Small investors view the bank-based system as the most reliable system, one that offers them safety and comfort in order to relinquish their control over savings. Currently, almost 95 percent of savings are mobilised through banks by way of customer deposits. Out of this approximately 75 percent of deposits are in the hands of the three state institutions.
Lack of knowledge as well as reach has kept small investors at bay from more lucrative investment opportunities to rely on state institutions in order to grow their savings. The most blatant violation of small investor rights is at this very level, where small investor savings are captured by these institutions in the guise of 'security' and channelled more in line with political considerations than depositors' well being. This inefficiency has led to high costs, and thus ultimately imposes burdens on small investors through low savings rates. Hence, small investors have been left to subsidise the inefficiencies of the state institutions with low savings rates, which have not even kept up with inflation. Private banks have been able to hide behind the state banks' inefficiencies in order to maximise their own returns by offering deposit holders returns that to a large extent are below the risk free rate.
The lack of a proper secondary market for debt has been another reason for small investors to stay away from the debt market. There is a need for proper regulation in the listing of debt securities to the public and a process of classifying debt according to their risk profiles. Currently, it is not mandatory for all companies issuing debt to have a credit rating. This has enabled companies that are perceived to have different risk profiles to issue debt at the same interest rate. It is vital to make credit rating a mandatory requirement for all entities issuing debt to the public. This will help small investors ascertain risk levels of different debt issues more easily, enabling them to demand a higher yield on debt issues that are perceived to be relatively more risky.
However, mandatory credit ratings will only flourish in a competitive environment where there is more than one credit rating agency that will help self-regulate the agencies by keeping cost and ratings under scrutiny.
Fund management companies aiming to providing total solutions to small investor needs have remained in their infancy or focused only on high net-worth clients. Specialised fund management companies catering to the total financial needs of the masses have not emerged. The assistance of specialised fund management companies will help in providing total solutions to the asset allocation needs of small investors, educating them of the importance of investing for the long term with the objective of achieving inflation-protected total returns that maximise after-tax income.
Educating the small investor of the need to diversify their assets is vital in order to maximise returns at the lowest possible risk. Although government securities are in theory available for small investors to participate in, primary dealers are not doing enough to promote government securities to the masses. Why should the primary dealers, consisting mainly of the same banks that offer low savings rates, spoil their party by offering risk-free products that offer higher returns to small investors? Competition from non-banking primary dealers should be intensified so that the widest possible network of primary dealerships is established, aimed at breaking the current conflict that banks face in promoting government securities to small investors.
* Information and better research of companies and investment products.
* Ability for companies to perform share buy-back.
* Introduction of different risk management tools and products.
* Close monitoring of transfer pricing and inter-company transactions by auditors and the regulators.
* Better monitoring of pyramid structures and controlling shareholders by auditors and regulators.
* Small investors given the right to invest a percentage of their pension funds in recommended products and registered fund management companies.
* Proper regulation of private fund management companies.
*Set up a hotline for whistleblowers, like what has been done by the British Financial Services regulator, so that employees could inform the regulators (SEC) of accounting tricks and irregularities.
* Make it mandatory for all stock brokering companies to have regional officers.
* Uniform transaction cost for all segments of investors.
* SEC to have a financial representative at all annual general meetings that facilitates and takes into account concerns of small investors.
* Small investors should be educated to invest in a wide set of investments instead of low yielding savings deposits.
* Mandatory credit ratings for all entities issuing debt to the public.
* Increase competition among primary dealers by bringing in institutions that market government securities to the masses.
* More details should be given to the investors of management fee structures and breakdowns of peer management fees across the industry.
The author, who read this paper at last week's conference on financial sector reforms, was an Equity Analyst at Jardine Fleming HNB Securities prior to being transferred to the head office in Hong Kong as an Investment Analyst working for the Regional Property Team. Currently, he works as a consultant for Broadmark Asset Management, USA, raising funds in Asia for their structured financial instruments. He has an MBA from the University of Chicago and is also a Chartered Financial Analyst.