Otunia
Instruction:
Question 1
Global Advisers Company (GAC) is an SEC-registered investment counseling firm involved soley in managing international securities portfolios. After much research on the developing economy and capital markets of the country of Otunia, GAC has decided to include an investment in the Otunia stock market in its Emerging Market Commingled Fund. However, GAC has not yet decided whether to invest actively or by indexing. Your opinion on the active versus indexing decision has been solicited. A summary of the research findings follows.
Otunia’s economy is fairly well diversified across agricultural and natural resources, manufacturing (both consumer and durable goods), and a growing finance sector. Transaction costs in securities markets are relatively large in Otunia because of high commissions and government “stamp taxes” on securities trades. Accounting standards and disclosure regulations are quite detailed, resulting in wide public availability of reliable information about companies’ financial performance.
Capital flows into and out of Otunia and foreign ownership of Otunia securities are strictly regulated by an agency of the natural government. The settlement procedures under these ownership rules often cause long delays in settling trades made by nonresidents. Senior finance officials in the government are working to deregulate capital flows and foreign ownership, but GAC’s political consultant believes that isolationist sentiments may prevent much real progress in the short run.
- Briefly discuss four aspects of the Otunia environment that favor investing actively and four aspects that favor indexing.
- Recommend whether GAC should invest in Otunia actively or by indexing, and justify your recommendation based on the factors identified in Part a.
Question 2:
Betty Black’s investment club wants to buy the stock of either NewSoft Inc. or Capital Corp. In this connection, Black has prepared the following table. You have been asked to help her interpret the data, based on your forecast for a healthy economy and a strong market over the next 12 months.
| NewSoft Inc | Capital Corp | S&P 500 | |
| Current Price | $30 | $32 | n/a |
| Industry | Computer Software | Capital Goods | n/a |
| P/E ratio (current) | 25x | 14x | 16x |
| P/E ratio (5-year avg.) | 27x | 16x | 16x |
| P/B ratio (current) | 10x | 3x | 3x |
| P/B ratio (5 – year avg.) | 12x | 4x | 2x |
| Beta | 1.5 | 1.1 | 1 |
| Divident yield | 0.30% | 2.70% | 2.80% |
NewSoft’s shares have higher price/earnings (P/E) and price / Book (P/B) ratios than those of Capital Corp. Identify and briefly discuss three reasons why the disparity in ratios may not indicate that NewSoft’s shares are overvalued relative to the shares of Capital Corp. Answer the question in terms of the two ratios, and assume that there have been no extraordinary events affecting either company.
Solution.
Question One
Active investing is a strategy involves continuous buying and selling by the investor. The four aspects that would encourage active investing in Otunia environment are capital restrictions, economic diversity, high transaction costs, and excellent financial disclosure. Capital restrictions or controls are measures that a government can use to control external flows from markets in and out of the country’s account. Methods of capital control a nation could use are exchange controls that limit purchasing or selling the national currency at the existing rates, transaction taxes, and minimum stay requirements. There have been numerous debates on whether capital restrictions are advantageous and the situations that they should be applied. These measures discourage the participation of foreign investors and favor the active investor.
Another factor that could favor active investing in Otunia is the elaborate accounting standards and decent financial disclosure. These standards make the work of a financial analyst easier and allow him to do an in-depth breakdown to pin point inadequately priced stocks. This investing is highly involving and needs constant monitoring to take advantage of all lucrative conditions. The active manager could either buy undervalued stocks or by short selling overvalued stocks. Therefore, having well-detailed accounting standards will help an active investor know the best time to trade.
The third aspect that favors active investing in Otunia is the high costs of transactions. When transaction costs are too expensive, foreigners are discouraged from investing. This situation allows the active investors to take advantage of the inefficiencies in the stock exchange market. Economic diversity is the final factor that favors active investing in Otunia. These diverse economic sectors like agriculture and finance give the active investors a platform to take advantage of the varied inefficiencies that may be present in the different markets.
Index investing is a type of passive investing that is aimed at generating equal rates of return as a core market index. Investors use this form of investing as a replication of the performance of a particular index, normally a fixed-income or an equity index. The four factors that favor indexing in Otunia are economic diversity, settlement problems, accounting standards, and high transaction costs.
The economy in Otunia is properly diversified across manufacturing, agricultural, and the finance sector. Spreading out investments across different sectors is a strategy of reducing asset, market, and economic risks. High transaction costs is another factor that leads to lower trading activities because when operational charges are expensive, there will be less traders in the market This situation favors indexing because it will give the investors a better opportunity to purchase all the necessary stock in the benchmark.
Accounting standards and financial disclosure are factors in Otunia that would also favor indexing. If financial information is reliable and readily available, there will be greater market productivity that would reduce active investing and fundamental analysis. This reduction will favor indexing in the long run. Indexing can also be favored by the settlement problems in Otunia. These problems have restricted nonresidents from trading and increased investment opportunities for the indexing investors (Cinnamon, Helweg-Larsen, & Cinnamon, 2010).
Based on all these factors, it would be more recommendable for GAC to invest by indexing. Capital restrictions and settlement problems are substantial reasons to favor indexing because they discourage foreigners and give indexing investors an upper hand in the stock market.
Question Two
New Soft’s shares having a higher price / earnings and price / book ratios than those of Capital Corp’s does not necessarily indicate that the entity’s stock are overvalued. The disparity in the ratios of the two companies may be brought about by many reasons. Among the reasons that may bring the ratio, differences include; growth and return expectations, industry difference, and stage of business in its lifecycle. Companies expecting growth and return in their probable future will value their stock highly since the risk of not getting high returns from them is very low. New Soft company anticipates future growth and high returns as compared to that of Capital Corp. The low level of risk towards it not achieving its growth and the probability of the entity’s growth make the company’s stock have a high demand in its market. The high demand of the stock increases the shares’ prices. Capital Corp and New Soft are not in the same industry making the comparison of their price / earnings and book / ratios inappropriate.
New Soft might be in a capital intensive industry making it has high ratios while Capital Corp might be in a relatively less capital-intensive industry. New Soft’s investor ratios should not be evaluated in comparison with those of Capital Corp since it will give an inappropriate indication. The stage of business that a company is in also dictates its investor ratios since it determines the attraction that the stock has to the potential investors. New Soft is in the developing stage while Capital Corp is in the development stage. The difference in stages in the two companies makes New Soft appear more promising than Capital Corp making its stock value high (Sharma, 2010).
References
Cinnamon, R., Helweg-Larsen, B., & Cinnamon, P. (2010). How to understand business finance. London: Kogan Page.
Sharma, N. (2010). Business finance. Jaipur, India: ABD Publishers.