Luigi Does It Yet Again

Whether you’re an economist, politician, or revolutionary, a keen eye for human institutions and their effects is a priceless skill. Hamilton, Madison, and Adams all viewed the United States as a tenuous political experiment, and were it not for their penetrating institutional insights, that experiment would not have succeeded. Adams, almost alone among the founding fathers, saw from the outset that the French Revolution would turn out badly; Jefferson, on the other hand, cheered it on, and even decades later thought that the U.S. should undergo a similar cleansing exercise once each generation.

Institutional insight is also critical in the capital marketplace, and few observers of this area possess the historical breadth and analytical insight of Luigi Zingales of the University of Chicago. Readers of these pages will recall discussions of his work on corporate ownership structure in the Summer 2000 and the Fall 2003 issues. In the April 2004 Journal of Finance, Professor Zingales, along with Alexander Dyck, published a landmark paper on "the private benefits of control." (A working paper version of the article is available from Zingales’ website.)

Think about the price difference between the voting and nonvoting shares of a publicly held company. In nations where "agency conflicts"—the tendency for owners and managers to loot the company, that is to say, to steal from minority shareholders—are strictly punished, the benefits to corporate control are relatively small, and thus the gap between the prices of voting and nonvoting shares will likewise be small. And where the punishment risk of agency conflicts is small and the reward large, so too will be the gap between the prices of voting and nonvoting shares.

Of course, since few public companies issue voting and nonvoting shares, this gap is not very helpful in measuring just how well minority shareholders—that is, you and I—are treated in any given nation. However, we can get much the same information from the sale prices of privately negotiated large "controlling blocks" of shares, as compared to the market price. After all, even with one share class, shares sold in a very large block are essentially voting shares, whereas a small lot essentially represents nonvoting shares. Here, then, are the premia that Zingales and Dyck found for controlling block sales, from lowest to highest:

Japan	-4%
Hong Kong	0%
Taiwan	0%
Canada	1%
Norway	1%
United Kingdom	1%
United States	1%
Australia	2%
Finland	2%
France	2%
Netherlands	2%
Portugal	2%
South Africa	2%
New Zealand	3%
Singapore	3%
Egypt	4%
Spain	4%
Switzerland	6%
Indonesia	7%
Malaysia	7%
Sweden	7%
Denmark	8%
Germany	10%
Thailand	12%
Philippines	13%
Poland	13%
Peru	14%
South Korea	16%
Chile	18%
Argentina	27%
Colombia	27%
Israel	27%
Venezuela	27%
Mexico	34%
Italy	37%
Turkey	37%
Austria	38%
Czech Republic	58%
Brazil	65%

Very roughly, this ranking correlates fairly well with our prejudices about the rule of law (as well as water quality) in these nations, although not perfectly—one does not expect to see Sweden, Denmark, and Germany (nor Indonesia, for that matter) clustered in the middle of such a list, nor Austria at the bottom. Zingales and Dyck did, in fact, find that this ranking correlated well with standard measures of accounting rigor, laws defining director accountability, competition laws, per capita newspaper circulation, Catholicism, tax compliance, and, of course, rule of law. The most intriguing relationship is the least obvious—the level of tax-law compliance. Why should this correlate with the level of abuse by controlling shareholders? Simple: A government that collects a significant amount of corporate taxes effectively becomes a minority shareholder in all of the nation’s companies and thus develops a healthy concern for corporate governance. Effective enforcement of corporate tax laws thus serves to precisely align the government’s interest with that of the investing public.

This concept pretty much corresponds to our ideas about the importance of institutions—that is, government regulation—of the security markets. What does this mean for the global investor? To find out, I’ve plotted the above data versus the Jorion/Goetzmann database (Journal of Finance, June 1999) of twentieth-century returns for all nations with a greater than 35-year market history. Note that that these returns are inflation-adjusted and do not include dividends.

As expected, nations with high controlling-block premia have lower returns. But not by much; the slope of the regression is only –0.032, meaning that even the nations near the bottom of the list with premia in the 30% range—Venezuela, Mexico, Italy, and Turkey—carry a return penalty of about 1%. There is also a great deal of scatter, with a relatively low correlation (-0.19), a negligible R-squared, and a nonsignificant t-Stat.

What to conclude? From the investor’s perspective, not much. Yes, there is a slight penalty to investing in nations with poor minority-share protection, but the markets, as a whole, compensate by lowering prices and keeping returns, after all the monkey business, more or less in line with returns in nations with better-developed protections.

From the societal perspective, however, the effects are much more serious, because poor minority-shareholder protection increases the cost of capital. Zingales and Dyck found, for example, that nations with high controlling-block premia had higher concentration of ownership, fewer IPOs, and, in general, more poorly developed equity markets.

So, prudent, valuation-driven investing in less developed nations, while risky, is still likely to provide adequate returns. Just don’t forget the bodyguard, the water purifier, and the gold bars when you visit.

Copyright © 2004, William J. Bernstein. All rights reserved.

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