The Value of Virtue

By Erik L. van Dijk Introduction They are already working on it since 2002, but it is a fine academic paper on a topic that is getting an increasing amount of attention in recent years: corruption and fraud. Cornell scholars Charles Lee and David Ng studied corruption levels in 44 countries, using the Transparency International database. There have been numerous studies using this and other databases over the last decades, probably starting with work by Anne Krueger (later Chief Economist at the World Bank, together with the IMF and OECD also very active in this area)  in the 1970s. What makes the Lee-Ng study special is according to us at Lodewijk Meijer first of all the translation of country corruption scores into analyses of the impact of corruption at the firm level. By doing so, the authors are capable of answering the question if there is any ‘Value in Virtue’. This is a very important topic, because we see that the literature so far defended two positions. Up until 2003 we have seen various – mostly theoretical and deductive – studies that defended the view that corruption, defined as the misuse of public office for private gain, might actually be a kind of ‘bonus’ system in countries in which salary schemes and other remuneration for talented labour are inefficient. Empirical research presented over the years has indicated that this position is probably totally wrong. Theoretically fine, but the empirical evidence is overwhelming and contrarian. Various studies performed between 1995 (Mauro) and 2006 (Lee and Ng) led to the following conclusions: The Negative Impact of Corruption at the Macro Level, as presented in various academic studies

1. A higher level of corruption translates into lower domestic investments and economic growth
2. Higher levels of corruption hinder Foreign Direct Investments
3. Higher corruption leads to lower tax revenues
4. More corrupt environments stimulate negligence with respect to operations and maintenance in both firms and government institutions
5. And point 4 even extends to health care: more corruption leads to higher infant mortality rates
6. Higher corruption leads to higher student dropout levels in universities and high schools
7. Higher corruption levels go hand in hand with a larger size of the grey economy, which is of course directly related to point 3

Jain (2007) analyzed what corruption actually is. When stating that corruption is about the misuse of public power for private gain, we basically translate it into an economic act. Why? Well, the cost-benefit analysis of corrupt persons involve three aspects:

1. Someone must have the discretionary power to take decisions and consider a corrupt or fraudulent act
2. There must be some kind of economic merit associated with that power
3. The existing legal system provides a sufficiently low probability of detection and/or low penalty for the corrupt wrongdoing

Although it is clear that the legal part of the anti-corruption policy should play a leading role in fighting these crimes, it is also clear that social, cultural and economic aspects play an important role as well. Reason: in the end, corrupt acts are a cost-benefit decision case in which a probably talented individual or a group of talented individuals undertakes activities that are counterproductive from a macro- and microeconomic point of view. It would therefore be fantastic when it can be proven that economically, corruption destroys value at the micro- and firm level. If that can be shown, the likelihood that a well-defined remuneration system (positive stimulus) can help the negative stimulus derived from the improvements in the legal system will ensure a more effective anti-corruption policy. We are pleased to see that this philosophy of our firm, Lodewijk Meijer, has been translated into action by an Emerging Markets anti-corruption initiative: the CARICOM’s Caribbean Procurement Institute. Lodewijk Meijer managing director Erik van Dijk was appointed facutly member for ESG Finance and Investments. The abbreviation ESG was defined in the United Nations Principles for Responsible Investment, with E standing for Environmental, S for Socially-responsible and G for Governance. The idea is that a good ESG policy will help governments, firms and other economic actors in attracting capital and better conditions while at the same time ensuring better profitability and growth in the long-run at both the macro- and micro-level. In other words: we believe that there is Value in Virtue. With this being the case,  officials with the potential power to be corrupt might – when of course being confronted with a legal environment that makes fraudulous/corrupt freerider behavior too risky (i.e. the probability of getting caught and the negative incentive related to the penalty that follows make it more interesting to go for realization of a positive reward) – concentrate on realization of positive social and economic results. The Agency Theory work by Jensen and Meckling has of course indicated that this optimistic view is indeed only warranted when the legal and regulatory framework is sufficiently corruption-proof. This being said, initiatives like the Caribbean Procurement Institute are of the utmost importance in many countries. The latest ranking list of Transparency International indicates that the bulk of nations in the world still suffers from far too high – and therefore value-reducing – corruption levels. The list of countries which have a reasonable score is limited to about 22 with a score in excess of 7.0 on a scale from 10 (lowest or no corruption perceived by people surveyed) to 1 (highest level). This is approximately 15 percent of the number of nations in the world. So a lot needs to be done. The Transparency International 2008 Corruption Perception Index ranking The top (score in excess of 7.0) The top-22 consists of only two non-developed nations, namely Saint Lucia and Barbados. Both actually part of the CARICOM for which the Caribbean Procurement Institute defines its policy. The other 20 are mainly from Europe (13) with 3 Asian representatives (Singapore, Hong Kong and Japan), 2 from North-America (Canada and the USA) and 2 from Oceania (Australia and New Zealand).  Denmark, New Zealand and Sweden have the highest score (9.3) and my own country, The Netherlands, shows a good score (8.9) as well. The rest of the list The rest of the list is mainly filled with Emerging Markets nations, although there are certain developed nations were corruption levels have remained remarkably high. To some extent low places in the list are directly correlated with flaws in the legal system. But we do have the impression that ‘social’ and ‘cultural’ factors play a role as well, including religious factors. Treisman (2000) has done some interesting research in this area. He found that low corruption levels are positively correlated with the following factors:

• Protestantism;
• Former British Colonies;
• Higher GDP;
• Common Law versus Civil Law-based legal systems;
• Higher ratios of imports to GDP (i.e. openness/integration of a country in the world economy);
• Longer exposure to democracy;
• Unitary forms of government.

Remarkably, Treisman’s study showed that the following factors are not significant.

• Relative salaries in the public sector;
• Degree of political stability in a country;
• Endowment with natural resources;
• Degree of state intervention in the economy;
• Level of ethnical diversity.

The need for a multi-factor approach at the micro level As you can see, the bulk of these analyses is focused on the macro level. However, acts of corruption are undertaken by individuals or groups of individuals at various levels of society with the bulk of course being at the lower levels (simply because of the law of large numbers). Sure, at the lower levels the relative amounts at stake are often smaller or marginal, but added up they have just as much of a disruptive impact on society as the few occasions of big fraud and corruption that catch the attention of the media. We do believe however that it is important that procurement lawyers keep a good balance between the bulk of smaller cases with in the end the largest aggregated impact and the few media cases that catch the public eye. The latter play an important role in showing people that the high level hot shots are not getting away with their fraud. This has an extremely important effect on the cost-benefit analysis at the lower levels. At the lower levels, it is not just corruption that is at stake. Corrupt acts can easily be examples for employees working in firms. The recently published report on fraud by PriceWaterhouseCoopers under some 5400 firms in 40 countries shows the following results:

• Men are responsible for 85 percent of fraudulous acts. To some extent this is related to their dominance in the labour force, especially in emerging markets, but it is also directly related to what we already indicated in our blog entry on investment styles. Basically, the cost-benefit analysis that is at stake when commiting fraud or corruption is an investment decision. The risk to get caught is probably seen as less of a barrier for men – who normally opt for higher risk strategies – than for women. Machoism in cultures is also important. A men who gets away a few times with fraud and then gets caught might be considered a ‘tough, cool guy’, contrary to the sissy whimp that just listens to his superior. Women are not so sensitive to this kind of reasoning.
• About 70 percent of fraud cases is commited by men in the age class 35-55. In other words, the age class in which men get a bit more confident concerning their societal status, with their built-up experience giving them the feeling that even after being caught they might find employment elsewhere. Younger men suffer more from machoism, but probably tend to translate that into other acts (harrassment; or fighting in bars in the weekend etc.) than their older gender colleagues.
• Social control – also in the work place – is important. The PwC study indicates that 68 percent of frauds worked as a loner.
• Contrary to standard beliefs the main frauds were not temporary workers that switch from one employer to the other quickly. One third of frauds worked 2-5 years for the firm, with the bulk of the others working longer for a specific firm!
• And just like what we see in the government corruption case, it is definitely not true that it is about peanut crimes at the lower levels only: about 25 percent of fraud cases was directly related to top management, with industries known for their complex valuation and risk management structures like real estate, construction and banking/insurance/investments being well-known for large fraud cases in recent years.

It is impossible to create a corruption- and fraud-free world. Everybody makes his or her own cost-benefit analysis. Moral decay is a reality and so is the deterioration of social control structures. This implies that there is a growing need for strong procurement initiatives and improvements in law, just as much as there is a need for attractive, smart salary and wage structures that reward acts of good-doing. In both areas a lot needs to be done. Recent discussions in the financial industry about excessive greed and horrible bonuses for top managers were just as much indicative of the moral decay and mentality of the people accepting these bonuses as they were of incapable human resource professionals and corporate lawyers helping top management and their controlling bodies (governments, labour unions, board of directors) to create smart bonus structures that award tremendous performance and penalize bad performance. When analyzing the Value of Virtue, it is important to check things at the micro level as well. Firms are still the economic drivers of most developed and developing societies. It would be fantastic if we can prove that firms acting in a more corrupt environment (and therefore probably being direcly or indirectly part of this system) are actually valued lower than their less corrupt counterparts. That is exactly what Lee and Ng tried to achieve in their study. There are a few problems when translating the macro results into micro-level conclusions. First, the available ratings are often at the country level. It is only recently that specialist ESG asset managers have started to use analysts or special bureaus to rank and rate individual firms. And unfortunately – due to a lack of data and maybe even interest (after all Emerging Markets investments are still just 5-10 percent of the institutional equity portfolios of institutional investors in developed nations) – they have started this trend in the developed nations. I.e. in the group of nations where the need for firm-level analysis is probably a bit smaller due to good control and legal systems. This is another reason why Lodewijk Meijer supported the Caribbean Procurement Institute initiative. It is a) from a mainly Emerging Markets region (CARICOM) and b) a region that has shown the willingness to act; with c) the presence of 2 CARICOM nations (Saint Lucia and Barbados) in the world top-22 indicating that it is not just willingness, but also actual success that can be shown. When analyzing the valuation effect of corruption at the firm level, we have to deal with a few problems. Firm valuation is dependent on a large number of variables, not just corruption. We do therefore have to create multi-factor models that unravel the valuation of individual firms in various nations while at the same time ensuring that differences in industry distribution between countries are taken into account. Lee and Ng regressed two valuation variables, the Price / Book ratio in which the market price of a stock is divided by the book value of common equity, and Tobin’s Q, defined as the market value of debt plus equity divided by the book value of debt plus equity, on a set of firm and country variables. The firm variables that they looked at where:

• Return on Equity (for the P/B analysis)
• Return on Assets (for the Tobin’s Q analysis)
• Profit Margin (net)
• Research and Development Expense / Sales
• Dividend Payout
• Beta (systemic risk factor measuring the firm’s stock market return sensitivity to changes in the MSCI World index)
• Currency Beta (measuring the sensitivity of the stock market return of the firm to changes in the value of the US Dollar vis-a-vis a basked of major currencies)
• Earnings growth (5 years)
• Credit Rating of the firm from Institutional Investor Magazine

At the country level, the researchers looked at:

• Country level average Return on Equity (for the P/B regression)
• Country level average Return on Assets (for the Tobin’s Q regression)
• Inflation
• GDP growth
• And of course, the Transparency International Corruption Perception Index

For a 10 year research period (1994-2003) the researchers were left with almost 60,000 valid observations. More than enough for a good statistical analysis. If Virtue would add Value, the result should be that in both the P/B and Tobin’s Q regressions higher levels of corruption would translate into lower valuations. I.e. Corruption should have a negative and significant sign in the regressions. This was indeed the case. The Cornell scholars found that – ceteris paribus (all other things being equal) – firms in the high corruption tertile had a 15-20 percent lower valuation than firms in the low corruption tertile. There was not much difference when looking at P/B compared to Tobin’s Q, with the latter being a firm-level analysis and the former looking more at the equity level. Value in Virtue: where does the value loss for firms in a corrupt system come from? When looking at the theoretical discount models, value loss could come from reduction in expected future cash flow and dividend levels, reduction in earnings growth or increases in the required rate of return that a firm would have to offer its shareholders and debt providers. Common belief was that the increase in the required rate of return is the dominant factor. However, Ng and Lee show that this is not true. In a corrupt system firms suffer mainly because the expected future cash flow levels will be lower. Partly because of the corruption (extraction of cash via bribes etc.) itself and partly because of loosing customers and/or translation of the corrupt climate into direct internal fraud (people at all levels in society start to believe that if greed and immoral theft is the standard, then let’s do it ourselves as well). Especially international clients and/or investors might be very weary to do business. The tremendous growth of ESG Investing in recent years is indicative of this trend. Both employers and employees (via their labour unions) on the one hand, and the government on the other, stimulate this trend. Good examples are the large Swedish state pension plans AP1 to AP7, who have a combined ESG investment policy, and the Dutch mega investor ABP, one of the largest pension plans in the world. However, ESG is growing but not so big yet as to guide investment decisions of institutional investors completely. But it is indicative that even private investors are getting more enthousiastic about the idea. Not surprisingly as our analysis shows. There is Value in Virtue for long term investors and firms following an ESG policy. We believe that this can be of special importance in Emerging Markets. It will increase value and enable firms and countries following a good ESG policy to attract more foreign capital which in turn can lead to further growth. CLICK THE LINK BELOW FOR THE FULL NG-LEE STUDY corruption-virtue

Smaller Frontier Markets: Hidden Opportunity or Totally Uninteresting? The Trinidad Case

By Erik L. van Dijk

Introduction

In the first entry to this blog we presented one of Goldman Sachs’s Next-11 countries, Iran, as an interesting ‘neglected country’ for speculative investors. On the one hand, we saw an economy built on huge oil and gas reserves (which provide a kind of collateral or put option to your investment strategy in the country) and on the other we saw growing signs of structural talks between the US and other Western nations with Iran in the political arena. The fact that Frontier economies like Iran and others (Kazakhstan, Vietnam, Saudi Arabia are also well-known representatives in this category) have a relatively low correlation with the MSCI World index and even with the MSCI Emerging Markets index are of interest to large investors that want to diversify their portfolio. But we also know that smaller economies are more sensitive to the potential risk of growing protectionism in a world that is struggling with the credit crisis. We did therefore decide that it might be good to look at a smaller Frontier Market as well, to see how things are going there.

Our Emerging Markets unit decided on Trinidad and Tobago. On the one hand (see also below) the country is not a tourism-dominated, one-dimensional banana republic, but one of the richest Caribbean nations with an economy built on strong oil and gas reserves. On the other, we see a relatively stable political situation, a leading role within the CARICOM (the regional cooperative entity between some 15 Caribbean states) and an English-speaking population. When we add to that a legal system that has tight links with British rules, it makes for a Frontier market that is definitely ‘unknown’ and ‘neglected’, but also not ”scary” like so many other exotic nations in this group.

In our databases we have daily stock market information about Trinidad and Tobago (TT) starting from May 2005. Almost 4 years of data split up in a good period for world exchanges (2005-2006-beginning 2007) and a disastrous one (second half 2007 and especially 2008-09). A relatively short period, but definitely an interesting one when trying to get a feel for Frontier Market investing, its opportunities and its dangers.

When we look at the index information (in USD) over this period, it is not surprising that the net result for the period is not a good one for global equities. The effect of the credit crisis is clearly visible in the numbers. The MSCI World index generated an annualized return of minus 7.82% for the period. When we compare that with the plus 8-10% positive return normally expected for global equities, it is clear that we are dealing with a dramatic  outlier here. Everybody states that when the rich, developed world is sneezing, smaller Emerging nations are catching a cold. Now, when we look at the annualized return over the period for the MSCI Emerging Markets index we derive a figure of 2.58% positive (!). So notwithstanding the fact that Emerging Markets did indeed drop a bit more than developed ones in the  2008-09 (until March 27)  period (-58.87% compared to -51.81%), their positive net result indicates that the value gain in the May 2005 – Dec 2007 period compensated for that. It was the period when the BRIC nations gave the leading Emerging Markets economies their new catalyst role. Obviously, some (e.g. Russia) suffered more than others, but all in all the correlation with developed nations was quite high, and return differentials not that big and there wasn’t really a big cold. When we look at the MSCI Frontier Markets index we see where the old adage about sneezing and catching a cold comes from: the smaller developing economies in this index were the ones struggling. The MSCI Frontier Markets index lost on average minus 14.65% on an annualized basis during the period May 2005 – End of March 2009! Trinidad and Tobago (TT in the remainder of the entry) was actually a big outperformer with an annualized return of minus 7.65% for their equally-weighted First tier stock market index and minus 8.03% for the marketvalue-weighted one. Lodewijk Meijer decided to look at both equal-weighting and value-weighting due to the fact that the TT stock market index is to quite some extent bank/other financials-dominated. But analysis made clear that although the banks and other financials did indeed suffer quite a bit, their story wasn’t as bad as that of many of their huge US and European colleagues that ended up at the brink of bankruptcy.

So, in and of itself the performance of the TT exchange wasn’t good. Relatively speaking the7 percent outperformance compared to the Frontier index was interesting, and so was the countries solid oil- and gas-based economic basis. If we add to that government initiatives to play a larger role within CARICOM on the one hand and ideas about setting up a regional International Financial Centre (IFC) on the other, we found it interesting enough to present TT as our representative small frontier market. And besides: don’t forget that the main stock market wisdom says that you have to buy low and sell high. So one could also present the bad performance of the Frontier Markets as an opportunity to step in if you believe with us that mean-reversion of global markets will indeed set in in 2009 (6-12 months before seeing the first signs of the economic recovery that normally follows the stock markets).

But it is not just that: we also looked at volatility (measured as the standard deviation of return) as absolute risk indicator and beta (indicator of systematic risk, measured as percentage average return when the world index changes 1%). High volatilities and high betas are then indicative of risky markets and low volatilities and betas of less risky markets. Since we compare things with the MSCI World index when calculating betas, the MSCI World has – by definition – a beta of 1. The MSCI World had a volatility of 20.53% annualized for the whole period and 32.76% for the 2008-09 period. That is a huge number. The 32.76% translates into an almost 35 percent likelihood that the actual realized return will fall outside an interval ranging from -22.76% to +42.76% when you expect a 10% return on stocks. I am sure that none of us will mind a more than +42.76% return with a probability of almost 17.5%, but there is a similar chance of ending up with another terrible year of more than a 22.76% loss! This is indicative of the turbulence in the global economy, with especially larger countries now being very nervous due to enormous tension of their financial systems, the unwinding of struggling hedge funds et cetera. In normal situations the Emerging Markets would have both higher betas and higher volatilities. But the beta for the period was actually 0.972, i.e. the Emerging Markets reacted more or less the same to bad or good news as the developed ones. Their normal excess country and firm risk  (in general) was compensated by the fact that our financial system in the West was under enormous pressure. The volatility was still higher in Emerging Markets, but actually not that much: 26.60% in EMs for the overall 2005(May)-2009(March) period (versus 20.53% for the MSCI World). And in the 2008-09(March) period the EMs went up to a volatility of 39.27% versus 32.76% for the MSCI World. It is indicative of a changing world in which the New World Order (with bigger role for China, India, Brazil and Russia) is gradually but slowly happening. And that will make Frontier investing more interesting as well. The BRIC nations are known to be more active with investments in the Frontier markets, see for instance how the Chinese and some Sovereign Wealth Funds are increasing their influence in Africa.

Frontier Markets are amazing when looking at their risk profile. They are the least risky ones when taking a first look at volatility and beta. The beta was relatively stable for the period (0.178 for the overall period and 0.188 for 2008-09). Far lower than the beta for Emerging Markets or the MSCI World. And the volatility was only 17.74% and 24.15% respectively!

How is that possible? Where is the investment risk when opting for a Frontier Markets strategy? Are they really less risky? Yes and no. They are less risky in that these numbers are correct. They do move less when analyzing day-to-day or week-to-week price movements. But what is going on here is to quite some extent related to illiquidity and thin trading. You can compare investing in Frontier Market public equities quite a bit with private equity in Western nations. Share trading is thin and that suggests a peacefulness that is only there as long as new news items aren’t too big or investor-induced portfolio trades (for non-firm or non-country related factors) not too dramatic.

Lesson 1 for the investors:

Never forget about illiquidity of Frontier Markets

When you go there, be sure to have a longer-term strategy based on fundamental (i.e. not speculative, trading-oriented) factors, especially when you are big.

When you are too big: forget about it.

And that brings us automatically to lesson 1 for the frontier country.

Lesson 1 for the country:

Make sure you create trust in your exchange.

And also ensure sufficient liquidity!

 And that is where TT has its main problem. Volatility levels during the period for the average firm in the market were so low that you might almost think that TT stocks were bonds. When looking to daily data the volatility was 4.78% over the period as a whole and 5.47% for the 2008-09 period. Academics have written tons of papers about the adjustments that are necessary to correct for thin trading, with the work of Scholes and Williams in the second half of the 1970s basically being the start. Without going into detail in this direction, we would like to compare the low volatility and systematic risk with what you could see in private equity strategies. In private equity we do not have daily price quotes as a result of which annualized return and risk levels are based on far less data points with a larger interval between them. To some extent the situation here is similar. Abou 3-3.5% is the turnover (as percentage of market capitalization of stocks) at the TT stock exchange. Compare that to the 50-100% rate seen on most Western developed exchanges! It is much closer to the 0 percent liquidity of private equity.

Question then: is the ultra-low liquidity enough reason to forget about a country? The answer is no. Frontier Market investors should know that the characteristics of investments in these markets do have quite some similarity with private equity. In and of itself that is not necessarily bad. Especially now, low correlations and low betas (TT has a beta of about 0 with the MSCI World) are qualities that can be of interest when creating diversfied portfolios. However, the investor should at all times be aware of this aspect of Frontier Market investing. Don’t do it when you don’t have the time to wait and/or the advisor with fundamental knowledge of the markets to support you.

Trinidad: The Country

Columbus arrived in Trinidad in 1498. The Island state has an overall size of just 2000 square miles, neatly situated outside the famous Caribbean hurricane belt. Initially the Spaniards occupied the country, but they never took the colonization very serious. In 1797 the territory became a British colony, a situation that lasted until its independence in 1962. Ever since the linkage with the UK has been prominent, with the British Privy Council for instance being the highest Court of Appeal, with the Caribbean Court of Justice (2005) – an institution of the regional cooperative body CARICOM – now being prepared to replace it. Politically this strong linkage with the UK has ensured relative stability in a democratic system in which not more than 2-3 political parties seemed to play an important role. It was only in 1990 that a Muslim movement led by Yasin Abu Bakr (Lennox Phillips) created some turmoil through a 6 day coup effort. But even in this case, the TT definition of turmoil turned out to be nothing like what we have seen elsewhere in Emerging and Frontier economies. Helped by large oil and gas reserves, the increase in oil prices in the 1970s and again in the period 2003-2007 has led to a tremendous increase in average wealth with now an income per capita in USD of $ 18,600. As is normally the case, political stability and wealth increase were highly correlated.

The small Island state (1.2 million people, of which 96 percent lives at Trinidad and only 4 percent at Tobago) has a remarkably mixed population, with 80% being of Indo-TT or Afro-TT descent. The Indian group is the larger of the two by a small margin. The other 20 percent is made up of Europeans (whites), Chinese, Syrians and Lebanese and mixed people. With political parties to some extent catering to the needs of ethnical and to some extent also religious groups, it is quite remarkable that the political situation is as stable as it is. And there isn’t really any reason to believe that this will not continue.

The only worry seems to be that the population is not growing at all with the relatively small (for Frontier Markets standards) net population growth rate due to births minus deaths being compensated by net emigration to (mainly) the UK, US and Canada. That could create problems for an economy with ambitious growth targets.

Trinidad: The Economy

TT has a GDP of US $ 24.2 billion. The GDP growth rate dropped recently from 8% to 5% and we foresee a further drop to about 3-3.5% due to the strong linkage with oil and gas. But it is still a growth rate and that is something that a lot of countries cannot show anymore in this period of crisis and turmoil that we are in. Governnment debt is low at 28% of GDP. The proven oil reserves are some 728.3 million barrel and gas reserves are at 481.3 billion cu m. Nothing like the huge reserve numbers we showed earlier for Iran, but still in general with a bit fantasy you could say that it is like a smaller version of Iran. Neglected, but with a nice collateral and in this case (to compensate for the smaller collateral) a situation where no one in the world has any problem with this sympathetic Island of steel drums, soca, calypso and limbo (contrary to what people think about the Islamic Republic).

Gas is recently getting more important than oil, with the country now being responsible for some 70% of the US imports of LNG. Oil and gas are responsible for 40% of GDP and 80% of total exports. But only 5 percent of employment is related to these industries and that helps explain the emigration trends.

But the government is trying to create a diversified economy, which looks like anything but a tropical island resort. Sure, Tobago is to a large extent tourism-oriented, but Trinidad has expanded in the following sectors: petrochemicals and plastics, manufacturing (steel, aluminum), cement and food and beverages. And even the old agricultural sector (a very important part of the economy before oil and gas prices started to rise in the 1970s) is not insignificant, with citrus, coffee, cocoa, rice and poultry being important crops.

The country posted a US $ 5.7 billion current account surplus over 2008, which is about 22.5% of GDP with the US being the most important trading partner (57.5% of exports and 20.2% of imports). For more detailed information we refer the reader to the CIA Factbook.

Not surprisingly with the US being so important and with economic results being relatively OK, the country had no difficulty to maintain a more-or-less stable exchange rate vis-a-vis the US Dollar. The TT dollar sells for about 6.2-6.3 to the US dollar ever since 2004.

The ambitious government of Patrick Manning, the prime minister, has indicated that its target is to become a developed nation by 2020. From frontier to developed in 15 years. Not impossible (look at Singapore), but a lot has still to be done. Especially in the financial system, and a government white paper, written in 2004, shows that the government is aware of this. The ambitious goal is to transform TT into an International Financial Centre (IFC) for the region. This regional approach of the government does also show a sense of realism (TT as stand-alone entity is probably too small to achieve very ambitious goals). But creating this IFC is easier said than done, knowing that we come from a low base in the financial sector and that regional cooperation through CARICOM implies that some 15 nations one way or another have to cooperate.

But there are a few factors that might help the government. First, due to the economic development in South America (mainly Brazil of course) and its strategic location between South America and the US, the interest in the region is indeed growing. Not just from regional parties, but also from Europe. The latter is also helped by actions from various European governments against tax havens like Luxemburg, Switzerland, Monaco, Liechtenstein et cetera. The region is already known for having a few alternative tax havens here (Cayman Islands, Virgin Islands, Barbados, Turks and Caicos et cetera) and TT will not copy their effort, but when international money flows will lead to a net inflow into the Caribbean area, the better developed nations will benefit if-and-only-if they do provide the financial infrastructure for the regional money inflow. Something similar happened to Singapore in Asia and Dubai in the Middle East. And that is the two examples that the TT government probably has in mind. What are the odds?

Trinidad: The Exchange

When comparing Dubai with Singapore as the two main examples we would like to use for TT, there are a few differences and they are important. Singapore has been successful because it was capable of not just transitioning the economy (with a huge role as regional transportation hub via the harbour and its prestigious Singapore Airlines), but also as financial center with a well-respected, developed stock exchange.  The creation of strong Sovereign Wealth Funds like GSIC and Temasek played an important role as well.

The Dubai story is younger of course, but we are not convinced yet that this ”walking on two legs” (economy and exchange) is successfully implemented here already. There is still a long way to go.

The same holds for TT. The first tier of the TT stock exchange lists some 30 stocks with a total market capitalization of TT $ 73.5 billion as of March 27, 2009. That translates into some US $ 12 billion, i.e. about 50 percent of GDP. A stock market size of 50 percent of GDP is reasonably OK for Emerging or Frontier Markets standards, but still low compared to levels in developed nations. And the reason is immediately clear when analyzing the group of 30 Tier 1 firms. With oil and gas being the main drivers of the economy, they are more or less absent from the exchange. A lot of economic activity is done by affiliates of foreign oil/gas companies and the main exception is Neal and Massy Holdings (NML). The NML conglomerate (with activities in other industries as well) is in market cap only 6.7% of the exchange, but holds an 18.4% stake of total annualized turnover. What is needed are more listed proxies for these two most important sectors of the economy.

In this respect, TT resembles Iran a bit. The Tehran Stock Exchange is also dominated by firms outside the oil and gas sector (with Iran Telecom since its IPO in 2008 being dominant). But countries that want to grow their economy and financial sector should be aware of the fact that international investors do not really like exchanges that are not a good proxy for the underlying economy.

Lesson 2 for the Country:

Do what is needed to increase the percentage of oil and gas related listings and trading at the Exchange

In terms of market capitalization the following 5 firms are the most important ones:

1. Republic Bank TT $ 13.8 billion (=18.8%)
2. First Caribbean International Bank TT $ 13.7 billion (= 18.6%)
3. ANSA McAl TT $ 7.7 billion (= 10.4%)
4. Scotiabank Trinidad and Tobago TT $ 4.9 billion (= 6.7%)
5. Neal and Massy Holdings TT$ 4.9 billion (= 6.7%)

And in terms of stock market turnover, the top-5 is as follows:

1. Republic Bank TT $ 604.1 million (= 31.2%)
2. Neal and Massy Holdings TT $ 357.0 million (= 18.4%)
3. Sagicor Financial Corporation TT $ 197.2 million (= 10.2%)
4. Guardian Holdings TT $ 175.2 million (= 9.0%)
5. Trinidad Cement TT $ 78.8 million (= 4.1%)

The much lower numbers of the turnover are illustrative of the illiquidity problem. In line with the government plans to stimulate the financial industry, both the market value and turnover lists show 3 financial firms: Republic Bank, First Caribbean International Bank and Scotiabank TT in the market value list; and Republic Bank, Sagicor and Guardian in the turnover-based list.

When looking at stock market performance over the period 2005(May)-2009(March), the top 5 performers were:

1. Readymix West Indies (0.51% of the mv weight and 0.75% of the turnover weight) +37.67% annualized
2. Trinidad Publishing Company (1.24% of mv and 0.28% of turnover) + 19.24% annualized
3. Williams LJ B (0.05% of mv and 0.03% of turnover) + 11.34% annualized
4. ANSA Merchant Bank (3.32% of mv and 0.69% of turnover) + 10.19% annualized
5. Angostura Holdings (1.82% of mv and 0.68% of turnover) +8.60% annualized

In other words: the five best performing stocks were all relatively small (or less tradeable part of a bigger entity). Readymix is a cement producer, Trinidad Publishing Company is itself part of the also listed ANSA McAl conglomerate with the bulk of shares still being owned by the latter. LJ Williams is a trading / manufacturing conglomerate. ANSA Merchant Bank is just like Trinidad Publishing Company also part of ANSA McAl. Angostura is one of the main producers in the beverage sector.

The worst performers were mainly in the financial industry, albeit not necessarily the general banks.

Challenges for the Country

The big challenge for the country, when embarking on this route towards developed status by 2020, is how to attract foreign capital. Foreign – if possible institutional – capital will not only boost the economy, it will also provide it with the necesary seal of approval when moving towards International Financial Centre status within the region. Foreign ‘neglect’ by portfolio investors will automatically be interpreted as a logical confirmation of the ‘neglected country’ status.

But, to attract foreign capital, the stock market infrastructure needs to be improved. The 2008 survey by Transparency International from Berlin (Germany) gave the country a score of 3.6 on a scale from 10 (perfect) to 1 (totally corrupt). With that number the country ranks at place 72 in the world. The score is equal to that of China and Mexico. It is not dramatic, spot 72 in a list with 180 countries, but it is definitely not good enough if your ambition is to become a regional financial center.  

But there are good initiatives on its way or they have already been started. One of them is the creation of a Caribbean Procurement Institute in close cooperation with specialists from abroad. Assuming that TT can be successful in creating an improved regulatory framework, the next step is to ensure that there is enough to invest in for the foreigners.

Something that makes sense also when comparing it with the structure of the underlying economy. Some kind of (semi-)government vehicle could do the trick for the oil and gas sector, i.e. through some energy fund. An IPO of (part of) the telecom provider TSTT would also be an interesting idea, basically copying the example of Iran.

Fears about the outflow of capital are not valid in a country with such a huge current account surplus and a relatively small public debt service. The improvements in regulatory framework and liquidity of the exchange will translate in a reduced corporate cost of capital as well, thereby stimulating the economic growth further.

The expansion of the exchange and improvement of average liquidity of the available listings will also help in strengthening the case for the IFC when having to negotiate about it with the other CARICOM nations. In and of itself we do believe that TT does have the potential to become an important factor in the region. But to get from potential to realization in what has to be political lobbying with about a dozen of other nations will only work when the first seeds are sown. The economy is interesting for Frontier standards, but we at Lodewijk Meijer are less convinced that the financial system is as interesting yet.

That is not to say that knowledgeable investors should avoid investment in the country, if they want to allocate to Frontier Markets. But, only if you really have expertise in the country and a long term outlook (because of the illiquid trading) a direct investment in the stock exchange could be considered. There are some investment fund opportunities available. But they are illiquid as well. The alternative is to buy a stake in a mix of Neal and Massy (proxying the oil / gas industry next to some other industries where they are active), ANSA McAL (itself also a diversfied portfolio) and one of the banks (Republic Bank) as reasonable portfolio following the fate of TT in its quest for regional economic leadership. 

Challenges for Frontier Investors

TT is not different from any other Frontier economy in this respect. Thin trading, unclarity about rules and regulations and a developing financial industry with probably on average still quite a bit to learn compared to standards at home are all factors that Western investors willing to invest in the country will have to deal with. But for a long term investor, carefully following the macroeconomic story and politics while closely working together with a local/regional specialist it might be worth the effort.

The world is changing. Emerging Markets are here to stay in the New World Order and selected Frontier Markets are definitely gemstones in the years to come. Those with a solid economic base or commodity reserves might be the first to benefit from the globalization of investment portfolios of Western pension plans and Sovereign Wealth Funds from other places on the globe. Although of course relatively small, TT’s role in the Caribbean might make it a valid building block within a Caribbean Frontier portfolio. We at Lodewijk Meijer will carefully watch developments for you.