We check the robustness of our results by investigating many additional specifications. We repeat all the regressions in Tables V, VI, and VII with domestic individuals in place of domestic institutions. The findings reported above for domestic individuals carry over to that for domestic institutions. We also repeat the tests with various firm fixed effects and alternative instruments. The additional analyses strongly support the positive foreign ownership-performance relation. The evidence suggests the presence of foreign owners who are able to influence management to make value enhancing decisions.
A. Discussion
The results of this section indicate that foreign ownership is associated with improvement in firm performance. These results further document the local effects of foreign ownership in Taiwan. The positive association between foreign ownership and firm performance may be due to foreign institutional investors' stock screening ability or their ability to influence management. The former may arise from their ability to choose stocks that better diversify their global portfolios. For example, they may select domestic firms that are more likely to benefit from risk sharing between foreign and domestic investors. The ability of foreign institutions to influence domestic firms may simply reflect an attempt to own stocks that they can influence. Domestic investors may view foreign ownership levels as a proxy for the extent to which foreign institutions are committed to monitoring firm management. Domestic investors may do so because QFIIs may have the knowledge and capability to help firm management.
The local press contains numerous examples of how foreign investors monitor and influence local firms. In 2002, foreign investors' criticism of one of Taiwan's biggest firms, Taiwan Semiconductor Company, led to a change in its compensation program, an event that attracted the attention of local academicians and practitioners. When local firms began converting from paying stock dividends to cash dividends in 2001, foreign investors were regarded as being responsible for initiating the conversion. The press has also attributed the preference for foreign owners to the ability of foreigners to monitor corporate strategy, capital usage, and personnel.
There are also examples of the influence of foreign institutional investors on R&D expenditures. On June 22, 2001, the Commercial Times reported that the president of Winbond announced a forthcoming meeting with its institutional investors, most of whom are foreigners, to discuss business strategy in response to heavy stock sales by foreign investors. It mentioned that it would consider increasing R&D expenditures at the meeting. That same newspaper on August 17, 2002 reported that two foreign institutional investors of MediaTek, Morgan Stanley, and Smith Barney, announced lower earnings forecast for the firm. However, they simultaneously announced that they believed the firm would "outperform" because MediaTek had increased its R&D expenditures.
Ownership of domestic firms by QFIIs may provide an alternative governance mechanism that could well be effective and important in emerging markets. Foreign institutional investors may promote international standards of accountability and expertise so as to help reduce a firm's cost of capital or increase its stock price. In the process, they may better integrate domestic firms with the global market through better adherence to best practices.
B. Seemingly Genuine Foreign Ownership and Firm Performance
A characteristic of the Taiwan financial market is the presence of domestic firms who make a substantial effort to court foreign portfolio investors in various ways, including road shows outside Taiwan. They may do so for several reasons. Foreign institutional owners tend to have longer investment horizons than Taiwanese individual investors, which decreases stock turnover. Foreign investors may engage in information acquisition or provide guidance. The presence of foreign owners in the firm is highly valued by the market.
The positive association between stock price and foreign ownership also raises the possibility of a disturbing outcome. Some domestic firms have been alleged to generate their own homemade foreign investments (see Wealth Magazine, July 2004). The domestic press contains numerous accounts of such seemingly genuine foreign investments that may mislead individual investors. There are claims that domestic investors have established overseas companies, registered them with the Taiwan Securities and Futures Commission as foreign investment companies, and then used them to invest in the Taiwan stock market.
This section provides some evidence regarding whether our results are biased by the presence of seemingly genuine foreign investments. We hypothesize that this problem is more severe for small firms than for large ones, since small firms are more illiquid and attract less public scrutiny. These characteristics make it easier for seemingly genuine foreign investors to manipulate the stock price of small firms. If the small firms are affected by seemingly genuine foreign investment, then they will not show a positive association between foreign ownership and firm performance since the locals lack the foreigners' know how and resources.
To examine whether the foreign ownership-performance relation is affected by seemingly genuine foreign investments, we divide our sample into big and small firms. Big firms are those with market equity larger than the median size firms. Small firms are those with market equity smaller than the median size firms. Table VIII reports the estimation results for both the robin's Q (Panel A) and accounting performance measures (Panel B). We also control for the endogeneity between performance and foreign ownership by using a two-stage least squares estimation.
The first-stage estimation results are used to obtain the predicted foreign ownership variable included in the second stage. In the second stage, we regress the performance measures on the predicted foreign ownership (the predicted foreign ownership multiplied by an indicator variable that is one for big firms and zero otherwise) and the control variables used earlier. The results for Tobin's Q show that foreign ownership performance effects are significantly positive for both big and small firms. Additionally, the effects are stronger for bigger firms. The net income results for ROA and EBITD also show significantly positive associations between foreign ownership and firm performance. For the accounting results, the outcomes for small and big firms are insignificantly different from one another. In short, the evidence supports a positive foreign ownership-performance relation for both small and big firms.
V. Conclusion
We have analyzed the local effects of equity ownership by QFIIs in an emerging financial market, Taiwan. The analyses yield two major results. First, foreign institutional ownership of Taiwanese stocks has huge local effects. We discover a dramatic foreign ownership effect whereby stocks with high foreign ownership outperform stocks with low foreign ownership. As in the KS study on a developed market, we find that foreign institutional owners in Taiwan prefer well-known firms. However, we find that their preferences are not exclusively for these firms; the foreign ownership effect is present even after controlling for firm export, size, or transparency levels. Second, foreign institutional ownership is associated with improved firm performance. This result holds for firm performance as measured by R&D expenditures, Tobin's Q, and accounting measures. The result cannot be attributed to various firm characteristics, including differences in risk, leverage, size, growth opportunity, and incidence of firm insiders.
Out evidence on the profound effects of foreign ownership on local stocks is consistent with the local attitude toward foreign institutional investors that may have been fostered by the prevailing market environment. As is typical of emerging financial markets, there are frequent accounts in Taiwan of excessive managerial perquisites, abuses of shareholder rights, and market manipulations. The standard corporate governance mechanisms are undeveloped or ineffective. The Taiwan stock market is highly volatile and is dominated by individual investors who are uninformed and trade frequently. In such a setting, domestic individual investors may have turned to information about foreign ownership of Taiwan stocks. The QFII data are closely and widely scrutinized by the media, regulators, market participants, and the general public. Foreign investors are actively courted by domestic firms, and there are even allegations of homemade foreigner investments.
The issue of whether domestic or foreign investors know more can be examined in the short run or in the long run. Our paper focuses on the long run, which leads us to attribute our finding of a foreign ownership effect and strong foreign ownership-performance relations to a monitoring or disciplinary role played by foreign investors. Unlike domestic individual investors, foreign institutional investors have the resources to conduct fundamental research, can invest for the long term, and are more credible and reputable--all advantages that foreign owners can parlay into positively affecting firm performance.
Our evidence has implications for emerging capital markets that are transitioning to more open, transparent, and efficient markets. We provide evidence of the case where foreign institutional owners have a long-run information advantage over domestic investors in Taiwan. By providing expertise, experience, and resources that are unavailable to domestic individual investors, foreign institutional owners may contribute to domestic economic growth.
We are grateful to an anonymous referee for detailed comments. We also thank Robert Battalio, Suzanne Bellezza, Utpal Bhattacharya. Long Chen, Edward Chow, Shane Corwin, Laura Field, Amar Gande, Andrew Ellul, Craig Holden. Jun-Koo Kang, Naveen Khanna. Wei-Lin Liu, Tim Loughran, Jennifer Marietta-Westberg, Chris Muscarella, Paul Schultz, Mark Seasholes, Rich Sheehan, Ann Sherman. Hans Stoll, Charles Trzcinka. seminar participants at Indiana University, Michigan State University, Penn State University, the 12th Conference on the Theories and Practices of Securities and Financial Market in Kaoshiung, Taiwan, the University of Notre Dame, the Vanderbilt University Financial Markets Research Center Conference, and the Western Finance Association Conference for their suggestions.
Monday, February 8, 2010
Local effects of foreign ownership in an emerging financial market: evidence from qualified foreign institutional investors in Taiwan - III
Earlier research has focused on whether foreigner or domestic investors have a short-term information advantage and has yielded contradictory results. In contrast, we have focused on the long-term information advantage. The foreign ownership effect is obtained using monthly portfolios over a sample period of 90 months and the portfolios are rebalanced quarterly. Therefore, domestic investors have up to three months to react to news of a foreigner's transaction. Short-term results primarily reflect domestic investors' response to a foreign buy or sell that is most pronounced within the same trading day or over the following few days. Short-term evidence primarily reflects differential short lived advantages such as information about order flow imbalances. Long-term evidence above all primarily reflects differential long-lived advantages such as a firm's strategic information arising from technological, financial, or human expertise, experience, or resources. In short, short-term and long-term advantages are based on different information sets, and short-term results may or may not differ from long-term results.
The results provide evidence regarding the importance of foreign ownership in Taiwan and are compatible with casual empiricism. Individual investors in Taiwan are at a huge information disadvantage relative to firm management in an environment with extreme agency problems. Individual investors also do not have the resources to engage in stock research. Given a dearth of alternative mechanisms available for minimizing their information disadvantage, these investors may have focused on foreign ownership data. In response to the enthusiasm for foreign ownership, domestic firms have encouraged increased foreign ownership of their firms. The media have even reported homemade foreign investments, whereby Taiwanese individuals or investment entities buy Taiwan stocks through offshore accounts, giving the appearance of QFII buying.
We also observe foreign investor preferences similar to those first reported by KS for developed markets. Foreign investors may attempt to mitigate their information disadvantage by selecting firms that are export oriented, large, or transparent. However, our results are for an emerging financial market. More importantly, out results indicate that the foreign ownership effect extends to non-export-oriented, small, or nontransparent firms that are chosen by foreigners. This suggests that foreign ownership goes beyond export oriented, large, or transparent firms.
A natural follow up analysis is to address the reason why foreign ownership of local stocks is rewarded by the Taiwan market participants. What is the basis for domestic investors' focus on foreign ownership of local stocks? In the following section, we pursue a long-term performance based explanation.
IV. Monitoring and Foreign Ownership
The foreign ownership effect documented in the previous section suggests that if investors reward stocks that foreigners choose to own, foreigners must have an information advantage over domestic investors. With time, foreign investors will mitigate the information advantage domestic investors possess because of their familiarity with the local environment. However, what is it that foreigners know that domestic investors are unable to acquire in the long run? We hypothesize that it is the knowledge and the ability of foreign institutions to monitor their investments in Taiwan. Unlike domestic individual investors, foreign institutions have the expertise, experience, and resources to conduct firm research and to invest for the long term; they also have the reputation and credibility that neither domestic institutions nor individuals possess. This section provides evidence regarding whether the basis for investors' confidence in foreign ownership is rooted in foreign owners' monitoring ability.
In conducting our analysis, we are guided by previous research on firm monitoring. The existing literature is motivated by the agency problem that arises when management interests and those of firm owners diverge, resulting in excessive management perquisites. Jensen and Meckling (1976) propose increasing managerial ownership in order to harmonize managers' and shareholders' objectives, highlighting the role of monitoring by owners. Their insight has generated an extensive body of literature that examines the connection between firm ownership structure and firm performance. We consider a natural extension of this literature to our context by pursuing a performance based explanation of the foreign ownership effect. In Taiwan, principal-agent conflicts are potentially much more severe than those in developed markets.
A review of the monitoring literature suggests two major categories for examining the ownership-performance nexus. The first group of studies examines the link between ownership and performance in a specific firm activity. For example, Chen, Harford, and Li (2007) present evidence consistent with independent, long-term institutional investors who actively monitor and benefit from their monitoring activities. In particular, they provide evidence that firms with more independent long-term institutional investors have better postmerger performance when they bid and are more likely to make withdrawal from bad bids. Qiu (2006) finds that the presence of large public pension fund shareholders reduces ex ante bad acquisitions. Hartzell and Starks (2003) and Almazan, Hartzell, and Starks (2005) relate monitoring by institutional investors to executive compensation.
Although most of the papers in the first category consider mergers and acquisitions and executive compensation, we cannot examine either for Taiwan. During our sample period, mergers and acquisitions were rare events. As for executive compensation, the practice in Taiwanese firms is to keep the information hidden from the public. Not surprisingly, a lack of transparency translates into a lack of data availability. For our evidence, we choose R&D expenditures as firm activity. Bushee (1998) observes that there is an association between institutional monitoring and R&D expenditures.
To examine whether foreign institutional investors influence R&D expenditure decisions, we follow Bushee's (1998) approach in testing for the relation between foreign ownership and R&D expenditures. We collect annual R&D expenditures for our sample of firms from 1994 to 2001 and construct a binary dependent variable that is one if the firm increases R&D expenditures at year t and is zero otherwise. The regressors are annual foreign ownership and domestic institutional ownership variables for year t - 1 for years 1994-2000. We also include as control variables an industry indicator variable, a year indicator variable, and a proxy for a firm's profitability. The latter controls for increases in R&D spending that are associated with good times. We examine the results of three proxies: 1) change in return on assets, 2) change in EBITD (earnings before interest, taxes, and depreciations), and 3) the EBITD indicator variable that is one if EBITD increases and zero otherwise.
Table IV reports the results of the logistic regressions. Panel A demonstrates that the coefficient on foreign ownership is significantly positive, but the one on domestic institutional investors is negative. The results indicate that firms with higher foreign ownership are associated with increases in R&D expenditures. This provides evidence of a direct impact on managerial decisions of foreign investors' monitoring activity.
We conduct further analysis to examine whether the influence of monitoring on R&D expenditures is restricted to high-tech firms. Panels B and C illustrate that the relation is significant for both high-tech and non-high-tech firms, respectively. However, the relation seems to be stronger for non-high-tech firms. This may be because high-tech firms are better disciplined in investing in R&D.
The second set of studies in the earlier literature bypasses the business activities that improve firm performance and seeks to examine the relation between ownership structure and measures of firm performance. Mura (2007), Himmelberg, Hubbard, and Palia (1999), McConnell and Servaes (1990), and Morck, Shleifer, and Vishny (1988) measure firm performance by Tobin's Q and accounting returns. Similarly, we investigate firm improvement by using the same performance measures. Tobin's Q is the ratio of the sum of the market value of equity, the market value of preferred stock, and the book value of liabilities to the book value of total assets. We also use the book value of preferred stock in the numerator to estimate Tobin's Q and obtain similar results. (19) The accounting returns are for net income and EBITD.
In considering the alternative performance measures, we control for other effects that may impact the ownership-performance relation. We control for these effects by incorporating variables recommended in the literature: 1) standard deviation of returns, 2) debt ratio, 3) R&D expenses, and 4) sales (Smith and Watts, 1992; Anderson and Reeb, 2003). These firm characteristics are chosen to control for firm risk, leverage, size, and growth opportunity.
We also account for concentration of ownership in our analysis. Specifically, we include in our control variables a proxy for ownership concentration as measured by the percentage of shares held by insiders. We define insiders as officers of the firm and members of the board of directors. Our insider definition effectively includes all block holders in Taiwanese firms. Following the papers by McConnell and Servaes (1990) and Morck, Shleifer, and Vishny (1988), we permit a nonlinear impact of controlling shareholders in the Tobin's Q regressions by including both the proxy and its squared value. (20)
To estimate the ownership-performance relation, we regress firm performance on foreign ownership and firm characteristics. We address possible clustering effects in two ways. First, Himmelberg, Hubbard, and Palia (1999) observe that the regressions may result in biased estimates and spurious relations if the ownership variable is endogenous. Endogeneity arises when both ownership and performance are determined by common omitted variables, which may be unmeasurable. HHP recommend correcting for this problem with longitudinal data by using a fixed effects estimator under the assumption that omitted variables are fairly time invariant. (21) Foreign ownership may also be endogenous when performance affects ownership. In such situations, an instrumental variable can be used to estimate the relation. We use both the fixed effects and the instrumental variable estimators. To control for fixed effects, we use indicator variables to control for firm, year, and industry. (22) Although we only report the results with fixed effects for year and industry in the paper, similar results are obtained when fixed effects for firm are included as well. Of course, the latter has smaller degrees of freedom. Second, we use the Fama-MacBeth (1973) methodology to control for firm clustering in certain years.
Table V presents the fixed-effect results using annual panel data that take into account both heterogeneity across firms (as represented by industry indicator variables) and variation over time (as represented by year dummy variables). The Tobin's Q results are shown in Panel A and the accounting results are shown in Panel B. The regressions are conducted separately for contemporaneous and one-period lagged explanatory variables. We further examine each case both with and without the domestic institutional ownership variable. In all cases, foreign ownership variables are highly significant and positively associated with firm performance. In contrast, all domestic institutional variables are insignificantly different from zero. In the Tobin's Q regressions, the debt ratio coefficients are significantly negative and the R&D coefficients are significantly positive. Debt appears to be penalized, but R&D is valued by the market. The controlling ownership variable is positively and significantly related to foreign institutional ownership. Its association is also nonlinear in that its squared variable is negatively and significantly related to foreign ownership. In the accounting performance regressions, the debt ratio coefficients remain significantly negative, but contemporaneous R&D coefficients lose their significance. In addition, return standard deviation and sales coefficients are significantly negative and positive, respectively.
Table VI presents the instrumental variable results. In the first-stage regression, foreign ownership is regressed on market capitalization, the export ratio, and the one-period lagged firm performance measure. Size and export ratio are suggested by our earlier analyses, which demonstrate foreign investors' preference for large export-oriented firms. The last instrument exploits the autocorrelation in performance measures. In both the Tobin's Q and the accounting regressions, the coefficients on all three instruments are highly significantly positive. In the second-stage regressions, firm performance is regressed on the foreign ownership level predicted by the first-stage regression coefficients and other contemporaneous firm characteristics. The second-stage regressions are also run with and without the domestic institutional ownership variable. Again, all foreign ownership variables are highly significant in association with firm performance. The domestic institutional coefficients remain insignificant. As for the coefficients on firm characteristics, they are generally significant. In particular, the inside ownership coefficients maintain their significance and have the same sign in both Tables V and VI.
Table VII presents the Fama-MacBeth (1973) estimation results. They are similar to those in Tables V and VI. Most notably, foreign ownership is again positively and significantly associated with all three performance measures. In addition, domestic institutional ownership is either insignificant or, if significant, has a negative relation with the performance measure.
The results provide evidence regarding the importance of foreign ownership in Taiwan and are compatible with casual empiricism. Individual investors in Taiwan are at a huge information disadvantage relative to firm management in an environment with extreme agency problems. Individual investors also do not have the resources to engage in stock research. Given a dearth of alternative mechanisms available for minimizing their information disadvantage, these investors may have focused on foreign ownership data. In response to the enthusiasm for foreign ownership, domestic firms have encouraged increased foreign ownership of their firms. The media have even reported homemade foreign investments, whereby Taiwanese individuals or investment entities buy Taiwan stocks through offshore accounts, giving the appearance of QFII buying.
We also observe foreign investor preferences similar to those first reported by KS for developed markets. Foreign investors may attempt to mitigate their information disadvantage by selecting firms that are export oriented, large, or transparent. However, our results are for an emerging financial market. More importantly, out results indicate that the foreign ownership effect extends to non-export-oriented, small, or nontransparent firms that are chosen by foreigners. This suggests that foreign ownership goes beyond export oriented, large, or transparent firms.
A natural follow up analysis is to address the reason why foreign ownership of local stocks is rewarded by the Taiwan market participants. What is the basis for domestic investors' focus on foreign ownership of local stocks? In the following section, we pursue a long-term performance based explanation.
IV. Monitoring and Foreign Ownership
The foreign ownership effect documented in the previous section suggests that if investors reward stocks that foreigners choose to own, foreigners must have an information advantage over domestic investors. With time, foreign investors will mitigate the information advantage domestic investors possess because of their familiarity with the local environment. However, what is it that foreigners know that domestic investors are unable to acquire in the long run? We hypothesize that it is the knowledge and the ability of foreign institutions to monitor their investments in Taiwan. Unlike domestic individual investors, foreign institutions have the expertise, experience, and resources to conduct firm research and to invest for the long term; they also have the reputation and credibility that neither domestic institutions nor individuals possess. This section provides evidence regarding whether the basis for investors' confidence in foreign ownership is rooted in foreign owners' monitoring ability.
In conducting our analysis, we are guided by previous research on firm monitoring. The existing literature is motivated by the agency problem that arises when management interests and those of firm owners diverge, resulting in excessive management perquisites. Jensen and Meckling (1976) propose increasing managerial ownership in order to harmonize managers' and shareholders' objectives, highlighting the role of monitoring by owners. Their insight has generated an extensive body of literature that examines the connection between firm ownership structure and firm performance. We consider a natural extension of this literature to our context by pursuing a performance based explanation of the foreign ownership effect. In Taiwan, principal-agent conflicts are potentially much more severe than those in developed markets.
A review of the monitoring literature suggests two major categories for examining the ownership-performance nexus. The first group of studies examines the link between ownership and performance in a specific firm activity. For example, Chen, Harford, and Li (2007) present evidence consistent with independent, long-term institutional investors who actively monitor and benefit from their monitoring activities. In particular, they provide evidence that firms with more independent long-term institutional investors have better postmerger performance when they bid and are more likely to make withdrawal from bad bids. Qiu (2006) finds that the presence of large public pension fund shareholders reduces ex ante bad acquisitions. Hartzell and Starks (2003) and Almazan, Hartzell, and Starks (2005) relate monitoring by institutional investors to executive compensation.
Although most of the papers in the first category consider mergers and acquisitions and executive compensation, we cannot examine either for Taiwan. During our sample period, mergers and acquisitions were rare events. As for executive compensation, the practice in Taiwanese firms is to keep the information hidden from the public. Not surprisingly, a lack of transparency translates into a lack of data availability. For our evidence, we choose R&D expenditures as firm activity. Bushee (1998) observes that there is an association between institutional monitoring and R&D expenditures.
To examine whether foreign institutional investors influence R&D expenditure decisions, we follow Bushee's (1998) approach in testing for the relation between foreign ownership and R&D expenditures. We collect annual R&D expenditures for our sample of firms from 1994 to 2001 and construct a binary dependent variable that is one if the firm increases R&D expenditures at year t and is zero otherwise. The regressors are annual foreign ownership and domestic institutional ownership variables for year t - 1 for years 1994-2000. We also include as control variables an industry indicator variable, a year indicator variable, and a proxy for a firm's profitability. The latter controls for increases in R&D spending that are associated with good times. We examine the results of three proxies: 1) change in return on assets, 2) change in EBITD (earnings before interest, taxes, and depreciations), and 3) the EBITD indicator variable that is one if EBITD increases and zero otherwise.
Table IV reports the results of the logistic regressions. Panel A demonstrates that the coefficient on foreign ownership is significantly positive, but the one on domestic institutional investors is negative. The results indicate that firms with higher foreign ownership are associated with increases in R&D expenditures. This provides evidence of a direct impact on managerial decisions of foreign investors' monitoring activity.
We conduct further analysis to examine whether the influence of monitoring on R&D expenditures is restricted to high-tech firms. Panels B and C illustrate that the relation is significant for both high-tech and non-high-tech firms, respectively. However, the relation seems to be stronger for non-high-tech firms. This may be because high-tech firms are better disciplined in investing in R&D.
The second set of studies in the earlier literature bypasses the business activities that improve firm performance and seeks to examine the relation between ownership structure and measures of firm performance. Mura (2007), Himmelberg, Hubbard, and Palia (1999), McConnell and Servaes (1990), and Morck, Shleifer, and Vishny (1988) measure firm performance by Tobin's Q and accounting returns. Similarly, we investigate firm improvement by using the same performance measures. Tobin's Q is the ratio of the sum of the market value of equity, the market value of preferred stock, and the book value of liabilities to the book value of total assets. We also use the book value of preferred stock in the numerator to estimate Tobin's Q and obtain similar results. (19) The accounting returns are for net income and EBITD.
In considering the alternative performance measures, we control for other effects that may impact the ownership-performance relation. We control for these effects by incorporating variables recommended in the literature: 1) standard deviation of returns, 2) debt ratio, 3) R&D expenses, and 4) sales (Smith and Watts, 1992; Anderson and Reeb, 2003). These firm characteristics are chosen to control for firm risk, leverage, size, and growth opportunity.
We also account for concentration of ownership in our analysis. Specifically, we include in our control variables a proxy for ownership concentration as measured by the percentage of shares held by insiders. We define insiders as officers of the firm and members of the board of directors. Our insider definition effectively includes all block holders in Taiwanese firms. Following the papers by McConnell and Servaes (1990) and Morck, Shleifer, and Vishny (1988), we permit a nonlinear impact of controlling shareholders in the Tobin's Q regressions by including both the proxy and its squared value. (20)
To estimate the ownership-performance relation, we regress firm performance on foreign ownership and firm characteristics. We address possible clustering effects in two ways. First, Himmelberg, Hubbard, and Palia (1999) observe that the regressions may result in biased estimates and spurious relations if the ownership variable is endogenous. Endogeneity arises when both ownership and performance are determined by common omitted variables, which may be unmeasurable. HHP recommend correcting for this problem with longitudinal data by using a fixed effects estimator under the assumption that omitted variables are fairly time invariant. (21) Foreign ownership may also be endogenous when performance affects ownership. In such situations, an instrumental variable can be used to estimate the relation. We use both the fixed effects and the instrumental variable estimators. To control for fixed effects, we use indicator variables to control for firm, year, and industry. (22) Although we only report the results with fixed effects for year and industry in the paper, similar results are obtained when fixed effects for firm are included as well. Of course, the latter has smaller degrees of freedom. Second, we use the Fama-MacBeth (1973) methodology to control for firm clustering in certain years.
Table V presents the fixed-effect results using annual panel data that take into account both heterogeneity across firms (as represented by industry indicator variables) and variation over time (as represented by year dummy variables). The Tobin's Q results are shown in Panel A and the accounting results are shown in Panel B. The regressions are conducted separately for contemporaneous and one-period lagged explanatory variables. We further examine each case both with and without the domestic institutional ownership variable. In all cases, foreign ownership variables are highly significant and positively associated with firm performance. In contrast, all domestic institutional variables are insignificantly different from zero. In the Tobin's Q regressions, the debt ratio coefficients are significantly negative and the R&D coefficients are significantly positive. Debt appears to be penalized, but R&D is valued by the market. The controlling ownership variable is positively and significantly related to foreign institutional ownership. Its association is also nonlinear in that its squared variable is negatively and significantly related to foreign ownership. In the accounting performance regressions, the debt ratio coefficients remain significantly negative, but contemporaneous R&D coefficients lose their significance. In addition, return standard deviation and sales coefficients are significantly negative and positive, respectively.
Table VI presents the instrumental variable results. In the first-stage regression, foreign ownership is regressed on market capitalization, the export ratio, and the one-period lagged firm performance measure. Size and export ratio are suggested by our earlier analyses, which demonstrate foreign investors' preference for large export-oriented firms. The last instrument exploits the autocorrelation in performance measures. In both the Tobin's Q and the accounting regressions, the coefficients on all three instruments are highly significantly positive. In the second-stage regressions, firm performance is regressed on the foreign ownership level predicted by the first-stage regression coefficients and other contemporaneous firm characteristics. The second-stage regressions are also run with and without the domestic institutional ownership variable. Again, all foreign ownership variables are highly significant in association with firm performance. The domestic institutional coefficients remain insignificant. As for the coefficients on firm characteristics, they are generally significant. In particular, the inside ownership coefficients maintain their significance and have the same sign in both Tables V and VI.
Table VII presents the Fama-MacBeth (1973) estimation results. They are similar to those in Tables V and VI. Most notably, foreign ownership is again positively and significantly associated with all three performance measures. In addition, domestic institutional ownership is either insignificant or, if significant, has a negative relation with the performance measure.
Local effects of foreign ownership in an emerging financial market: evidence from qualified foreign institutional investors in Taiwan - II
The sources for our data are the databases (DB) maintained by the Taiwan Economic Journal (TEJ). They are the TEJ Equity DB, TEJ Finance DB, TEJ Company DB, and TEJ Macro DB. Our sample period is from the beginning of the third quarter of 1994 to the end of 2001. We use the following sample selection criteria to restrict our sample:
1. Firms must be listed for more than six months in order to give foreign institutional investors time to analyze and to make investment decisions;
2. Transaction and financial data must be available for the firms;
3. Foreign investment in the firms must be permitted. This filter excludes five onshore transportation firms (Stock Codes 2607, 2608, 2611, 2612, 2616) and one TV firm (Stock Code 9928).
The application of the filters produces a sample size of 523 firms for out analyses of foreign ownership effect. The sample size declines to 468 firms for our analyses of foreign equity ownership and firm characteristics. The smaller sample excludes 52 financial firms and three nonfinancial firms that lack adequate firm characteristic data. Table I, Panel A presents the number of firms in the sample by year.
In addition to the equity ownership data, we have data on non-QFII investor groups. Table I, Panel B presents the annual ownership percentages by investor type. On average, over 90% of the shares are owned by domestic individual and institutional investors. Foreign investors (QFII) account for a paltry 2.2% of market capitalization ownership on average, and there is little or no foreign ownership in half of the stocks. It may appear as though foreigner investment in Taiwan is unimportant. However, as we will discuss below, this interpretation is misleading. (15)
For Japan, Kang and Stulz (1997) demonstrate that the foreigner holdings are disproportionate across industries with a concentration in large, liquick export-oriented firms. Foreigners reveal a similar preference for certain industries in Taiwan. We document foreigner preferences for equal-weighted and value-weighted domestic firms using Gini coefficients. Figure 1 provides an illustration of plotting Lorenz curves for foreign ownership for equal-weighted domestic firms in 1995. A perfectly equal foreign ownership distribution is represented by the 45 degree straight line. The area between the 45 degree line and the convex Lorenz curve is a measure of the inequality or the concentration of foreigner investment. The Gini coefficient computes this area as a percentage of the total area under the 45 degree line. The coefficient increases from 62.9% in 1995 to 79.1% in 2001. We also compute the Gini coefficients for value-weighted domestic firms. They are lower than the equal-weighted firms and average about 47% during our sample period. The evidence is inconsistent with a passive investment strategy whereby foreigners allocate their funds to local stocks in the same proportion as that dictated by popular indices for the Taiwan market.
Panel C presents the descriptive statistics for our sample of nonfinancial firms' characteristics. All the firm characteristic variables and the characteristics used to construct the variables used in the paper are listed here. Daily return volatility is the standard deviation of daily returns and is calculated annually. For all other financial variables, we take the average of the annual data for each firm and then average them across all firms.
An issue related to firm ownership is the degree of ownership concentration. In markets with poor shareholder protection, firms are often controlled by a few large shareholders who are too powerful for other shareholders to monitor. Dahlquist, Pinkowitz, Stulz, and Williamson (2003) observe that ownership concentration is related to home bias. They demonstrate that the fraction of shares that can be traded freely helps to explain the extent of the home bias. In our analysis, we include a proxy for ownership concentration (inside ownership) that we measure as the fraction of shares owned by corporate insiders, defined as officers and members of the board of directors. This measure represents ownership by controlling shareholders. Panel C indicates that inside ownership in our sample averages 26.53% with a median of 24.84%. By way of comparison, Dahlquist et al. report that for the few firms for which Worldscope has closely held share data, Taiwan's ratio of world float portfolio to world market portfolio was 99.29% in 1997.
Panel D provides the correlation matrix of all the variables used in our analyses for nonfinancial firms. In general, the correlations are consistent with the results reported below. For example, the positive correlations between foreign ownership and measures of firm size (capitalization, total assets, and net sales) hint at foreign investors' preference for large firms. Similarly, the positive correlation between foreign ownership and the export ratio suggests foreign investors' preference for export-oriented firms. Additionally, the high correlation between Tobin's Q and both foreign ownership and return on assets, respectively, anticipate our subsequent inference that foreign ownership is associated with superior firm performance.
III. Foreign Ownership Effect
We begin with a description of the underlying empirical asset pricing model and portfolios used in our analyses in Section III.A. Section III.B presents the foreign ownership effect. Section III.C provides some robustness checks of the foreign ownership effect. Section III.D presents a discussion of the valuation result.
A. The Four-Factor Model and Foreign Ownership Portfolios
We adopt the Fama-French (1993, 1996) model and complement their three factors with a momentum factor. The works of Jegadeesh and Titman (1993) and Carhart (1997) suggest the importance of including the fourth factor. The four-factor model can be stated as
[R.sub.i,t] - [RF.sub.t] = [alpha] [[beta].sub.RMRF] [RMRF.sub.t] [[beta].sub.SMB] [SMB.sub.t] [[beta].sub.HML] [HML.sub.t] [[beta].sub.PR1YR] [PR1YR.sub.t] [[epsilon].sub.i,t], (1)
[FIGURE 1 OMITTED]
where [R.sub.i,t] is the return on portfolio i at month t, [RF.sub.t] is the risk-free rate, [RMRF.sub.t] is the return on excess market portfolio, [SMB.sub.t] is the return on factor-mimicking size portfolio, [HML.sub.t] is the return on factor-mimicking book-to-market equity portfolio, and [PR1YR.sub.t] is the return on Carhart's (1997) factor-mimicking portfolio for one-year return momentum. The constant term or is Jensen's alpha and [[beta].sub.RMRF], [[beta].sub.SMB], [[beta].sub.HML], and [[beta].sub.PR1YR] the are factor loadings of RMRF, SMB, HML, and PR1YR, respectively.
Estimation of Equation (1) requires a time-series regression of monthly foreign ownership portfolio excess returns on RMRF, SMB, HML, and PR1YR. We next describe the construction of the four factors followed by the construction of the foreign ownership portfolios. In constructing the four factors, only firms with ordinary common stocks that have been listed for at least two years on the Taiwan Stock Exchange (TSE) or the Taiwan OTC market are included in our portfolios. This excludes Taiwan Depositary Receipts, convertible bonds, units of beneficial interest, and newly listed securities.
The excess market portfolio return, RMRF, is computed as the monthly return on a value-weighted portfolio of all TSE and OTC stocks minus the one month time deposit rate offered by the Bank of Taiwan. (16) To obtain the size factor SMB and value factor HML, portfolios are formed on the basis of size and book-to-market. All TSE stocks are ranked by size as of the end of June of each year t from 1994 to 2001. Size, or market equity (ME), is calculated as share price multiplied by shares outstanding. The stocks are divided into two groups, small (S) and big (B), using the TSE median size to divide the observations. Book-to-market equity (BE/ME) is book common equity (BE) for the fiscal year ending in calendar year t - 1, divided by market equity (ME) at the end of December of year t - 1. Here, BE is the book value of stockholder's equity, plus balance sheet deferred taxes and investment tax credit, minus the book value of preferred stock. The fiscal year ends in December for most Taiwanese firms. The groups are formed by categorizing each of the two size ranked groups (S and B) into three book-to-market ranked groups: the bottom 30% (L for low), middle 40% (M for medium), and top 30% (H for high). This gives us a total of six size/book-to-market portfolios: 1) S/L, 2) S/M, 3) S/H, 4) B/L, 5) B/M, and 6) B/H. Finally, monthly value-weighted returns on the six portfolios are calculated from the beginning of July of year t to the end of June of year t 1, and the portfolios are rebalanced at the end of June of year t 1.
The size factor SMB and the value factor HML are computed for the six portfolios. The factor SMB is the difference between the simple average of monthly returns on the three small stock portfolios and on the matching big stock portfolios: 1) S/L - B/L, 2) S/M - B/M, and 3) S/H - B/H. The factor HML is the difference between the simple average of monthly returns on the two high BE/ME portfolios (S/H and B/H) and on the matching low BE/ME portfolios (S/L and B/L): 1) S/H - S/L and 2) B/H - B/L.
The fourth factor is the momentum factor, PR1YR. It is the difference between the equal-weighted average of firms with the highest 30% 11-month returns, lagged 1 month, minus the equal-weighted average of firms with the lowest 30% 11-month returns, lagged 1 month. The portfolios include all TSE and OTC stocks and are rebalanced monthly.
The foreign ownership portfolios are constructed as follows. At the end of each quarter from Q2 1994 to Q3 2001 (a total of 30 quarters), we sort all sample firms into five portfolios based on their foreign ownership percentage. Portfolio P1 consists of stocks with the highest foreign ownership and P5 consists of those with the lowest. We then calculate equal-weighted and value-weighted monthly returns for the five portfolios in the following three-month period before rebalancing the portfolios.
Table II, Panel A presents the summary statistics of the four factors needed to estimate Equation (1). Panel B presents the descriptive statistics of the firm characteristics for these five portfolios. They indicate that foreign institutions prefer large, export-oriented firms. These results are similar to those round by KS for Japan. Higher foreign ownership portfolios also exhibit higher accounting returns and Tobin's Q. Finally, Panel B shows that the combined P1 and P2 portfolios account for over 70% of the market capitalization.
Panel C presents the percentage foreign ownership summary statistics for the five foreign ownership portfolios over the eight-year period from 1994 to 2001. Whereas foreign institutional ownership appears to be low in the previous panels, Panel C demonstrates an increase over time with P1 presenting the largest increase. This trend suggests that tests of the foreign ownership hypotheses may be more apparent in recent years, during which time there has been greater foreign ownership. However, our inferences are based on the entire sample period.
Panel D presents the summary statistics of the five equal-weighted and value-weighted portfolio returns. They illustrate that the mean and median monthly returns decline with decreasing foreign ownership percentage. Indeed, the differences between P1 and P5 are startling, exceeding 100 basis points for equal-weighted returns and 195 basis points for value-weighted returns.
In addition to the Taiwan version of the Fama-French (1993, 1996) model, we experiment with the global and the US versions. However, the global and US versions produced very poor fits and were discarded in favor of the Taiwanese version. The poor results for the global version may reflect the lack of global market integration that is responsible for the home bias in the first place. Finally, although we present the results of the four-factor model, similar results are obtained using the Fama-French (1993, 1996) three-factor model. (17)
B. Foreign Ownership Effect
Table III presents the market impact results of foreign institutional ownership. The sample includes all 523 firms for which we have complete data. The five portfolios used in the table are based on their foreign ownership ranking, with P1 having the highest foreign ownership percentage. The table illustrates the monthly estimation results for equal- and value-weighted portfolios. It also reports the results of going long in P1 and short in P5 (P l-P5).
For both equal- and value-weighted portfolios, the high foreign ownership portfolio outperforms the low foreign ownership portfolio. Equal and value-weighted portfolios formed by going long in P1 and short in P5 (P1-P5) earn significant positive Jensen alphas. The magnitudes of the alphas are huge. For example, the value-weighted P1-P5 portfolio has a monthly alpha of 175 basis points. The signs and magnitudes of the alphas generally decrease monotonically from high to low ownership portfolios. In short, Table III documents a striking foreign ownership effect.
The observed foreign ownership effect is conditional on an assumed asset pricing model. Hence, an alternative interpretation of the evidence is that a conventional asset pricing model is inadequate in accounting for the systematic component of Taiwan stocks. In particular, the evidence calls for an additional risk factor, one related to foreign ownership. This foreign ownership factor may capture risks such as those associated with foreign exchange rates. Nonetheless, regardless of the interpretation, the evidence demonstrates that the foreign ownership level has an important pricing effect.
C. Robustness Checks
In this section, we conduct a series of robustness checks to determine whether the foreign ownership effect is due to some other effects. (18) First, we examine whether the foreign ownership effect is merely an export firm effect. It is not an export firm effect if the market rewards non-export-oriented firms with high foreign ownership levels. KS find that foreign ownership in Japan is concentrated in large export-oriented firms. They attribute this behavior to foreigners' attempts to mitigate their disadvantage in knowledge of domestic firms. This may be because it is more cost efficient for foreigners to track firms that have global operations. They may have easier access to information about those firms' customers, suppliers, and competitors. They may even have access to information in foreign markets that are unavailable to domestic investors.
To distinguish between the foreign ownership effect and the export firm effect, we sort stocks into three portfolios based on their export-to-sales ratios. Each export portfolio is then sorted into three ownership portfolios based on foreign ownership at the end of the previous quarter, resulting in nine export ownership portfolios.
Summary statistics indicate that foreign ownership is not synonymous with export ratios and that foreign ownership is not concentrated exclusively in export-oriented firms. Next, we examine the Jensen alphas of the nine export ownership portfolios. The results show that the foreign ownership effect is still present even after accounting for firm export ratios. Therefore, the foreign ownership effect is not an export firm effect. Apparently, investors acknowledge foreign ownership even in non-export-oriented Taiwanese firms. These are firms that are least likely to reflect any exchange rate effects.
We now investigate whether the foreign ownership effect is a size effect. As in the case of export-oriented firms, foreign owners may minimize their information disadvantage by investing in large firms. To investigate the size effect, we sort stocks into three size portfolios and then further sort each size portfolio into three ownership percentage portfolios for a total of nine portfolios.
Summary statistics confirm that foreign investment is concentrated in large stocks. However, controlling for size does not appear to control for foreign ownership. It also appears to be the case that controlling for foreign ownership does not control for foreign ownership across firm size. An examination of the Jensen alphas for both equal- and value-weighted versions of the nine size ownership portfolios indicates that the foreign ownership effect is not a size effect. The test results can also be interpreted as providing evidence regarding passive foreign institutional investments. A passive investment strategy for foreigners is to hold stocks in their Taiwan portfolio in the same proportion as that in an index. Such a passive strategy is also incompatible with the presence of a home bias as noted earlier. The popular Taiwan indices are value-weighted and are dominated by large firms. As such, our results may be viewed as being incompatible with a passive index fund strategy.
Foreign institutions may also minimize their information disadvantage by focusing their investments in transparent firms. Transparent firms release prompt and accurate disclosures and thereby reduce information asymmetry in the market. Because information is readily available about transparent firms, such firms should be attractive to investors who want to minimize their information asymmetry. Therefore, we ask whether the foreign ownership effect is a transparent firm effect.
We measure firm transparency by using the information transparency and disclosure ranking compiled by the Taiwan Securities and Futures Institute (2003) for all the listed stocks in Taiwan. Companies are ranked on five criteria: 1) compliance with mandatory disclosures, 2) timeliness of reporting, 3) disclosure of the annual report, 4) disclosure of a financial forecast, and 5) corporate website disclosure. Their 2003 ranking identifies firms that are considered to be "more transparent" companies. Again, we do a double sort with these data. We first sort stocks into five foreign ownership portfolios and then classify each foreign ownership portfolio into a firm that is either "more transparent" or "less transparent." This process of classification produces a total of 10 portfolios.
Summary statistics are consistent with foreigners' tendency to own larger firms that also happen to be more transparent. Jensen alphas for both equal- and value-weighted versions of the ten transparency ownership portfolios show a premium for "more transparent" firms. More importantly, they demonstrate that the foreign ownership effect is still present even after controlling for the firm transparency level. This suggests that foreign institutions do not minimize their information disadvantage by exclusively investing in transparent firms.
D. Discussion
Our results indicate that foreign ownership levels are associated with a pronounced local valuation effect. Stocks with high foreign ownership outperform stocks with low foreign ownership. The market rewards stocks that foreigners choose to own. Moreover, this reward is not simply because it is an export-oriented firm, a big firm, or a transparent firm.
Foreign investors are prohibited from short selling in Taiwan. This prohibition restricts foreign investors' potential to profit by identifying losers and may bias them toward strategies of ownership, oversight, and intervention. Although foreign investors are restricted from short selling, domestic investors are allowed to do so. Domestic investors can short sell to arbitrage away any perceived price abnormalities. However, any foreigners' buy and hold strategies because of their inability to short sell may restrict the supply of shares for short selling and may make arbitrage trading difficult. As such, part of the valuation effect may be due to the different short sale regulations. On the other hand, it is worth noting that if foreign ownership produces a positive long-term valuation effect, then foreign investors benefit from their ownership. Therefore, if foreign investors were permitted to engage in short sales, a positive valuation effect may be even stronger. This is because foreign investors would be able to short sell firms they do not want to own and to invest the proceeds in firms they do want to hold.
1. Firms must be listed for more than six months in order to give foreign institutional investors time to analyze and to make investment decisions;
2. Transaction and financial data must be available for the firms;
3. Foreign investment in the firms must be permitted. This filter excludes five onshore transportation firms (Stock Codes 2607, 2608, 2611, 2612, 2616) and one TV firm (Stock Code 9928).
The application of the filters produces a sample size of 523 firms for out analyses of foreign ownership effect. The sample size declines to 468 firms for our analyses of foreign equity ownership and firm characteristics. The smaller sample excludes 52 financial firms and three nonfinancial firms that lack adequate firm characteristic data. Table I, Panel A presents the number of firms in the sample by year.
In addition to the equity ownership data, we have data on non-QFII investor groups. Table I, Panel B presents the annual ownership percentages by investor type. On average, over 90% of the shares are owned by domestic individual and institutional investors. Foreign investors (QFII) account for a paltry 2.2% of market capitalization ownership on average, and there is little or no foreign ownership in half of the stocks. It may appear as though foreigner investment in Taiwan is unimportant. However, as we will discuss below, this interpretation is misleading. (15)
For Japan, Kang and Stulz (1997) demonstrate that the foreigner holdings are disproportionate across industries with a concentration in large, liquick export-oriented firms. Foreigners reveal a similar preference for certain industries in Taiwan. We document foreigner preferences for equal-weighted and value-weighted domestic firms using Gini coefficients. Figure 1 provides an illustration of plotting Lorenz curves for foreign ownership for equal-weighted domestic firms in 1995. A perfectly equal foreign ownership distribution is represented by the 45 degree straight line. The area between the 45 degree line and the convex Lorenz curve is a measure of the inequality or the concentration of foreigner investment. The Gini coefficient computes this area as a percentage of the total area under the 45 degree line. The coefficient increases from 62.9% in 1995 to 79.1% in 2001. We also compute the Gini coefficients for value-weighted domestic firms. They are lower than the equal-weighted firms and average about 47% during our sample period. The evidence is inconsistent with a passive investment strategy whereby foreigners allocate their funds to local stocks in the same proportion as that dictated by popular indices for the Taiwan market.
Panel C presents the descriptive statistics for our sample of nonfinancial firms' characteristics. All the firm characteristic variables and the characteristics used to construct the variables used in the paper are listed here. Daily return volatility is the standard deviation of daily returns and is calculated annually. For all other financial variables, we take the average of the annual data for each firm and then average them across all firms.
An issue related to firm ownership is the degree of ownership concentration. In markets with poor shareholder protection, firms are often controlled by a few large shareholders who are too powerful for other shareholders to monitor. Dahlquist, Pinkowitz, Stulz, and Williamson (2003) observe that ownership concentration is related to home bias. They demonstrate that the fraction of shares that can be traded freely helps to explain the extent of the home bias. In our analysis, we include a proxy for ownership concentration (inside ownership) that we measure as the fraction of shares owned by corporate insiders, defined as officers and members of the board of directors. This measure represents ownership by controlling shareholders. Panel C indicates that inside ownership in our sample averages 26.53% with a median of 24.84%. By way of comparison, Dahlquist et al. report that for the few firms for which Worldscope has closely held share data, Taiwan's ratio of world float portfolio to world market portfolio was 99.29% in 1997.
Panel D provides the correlation matrix of all the variables used in our analyses for nonfinancial firms. In general, the correlations are consistent with the results reported below. For example, the positive correlations between foreign ownership and measures of firm size (capitalization, total assets, and net sales) hint at foreign investors' preference for large firms. Similarly, the positive correlation between foreign ownership and the export ratio suggests foreign investors' preference for export-oriented firms. Additionally, the high correlation between Tobin's Q and both foreign ownership and return on assets, respectively, anticipate our subsequent inference that foreign ownership is associated with superior firm performance.
III. Foreign Ownership Effect
We begin with a description of the underlying empirical asset pricing model and portfolios used in our analyses in Section III.A. Section III.B presents the foreign ownership effect. Section III.C provides some robustness checks of the foreign ownership effect. Section III.D presents a discussion of the valuation result.
A. The Four-Factor Model and Foreign Ownership Portfolios
We adopt the Fama-French (1993, 1996) model and complement their three factors with a momentum factor. The works of Jegadeesh and Titman (1993) and Carhart (1997) suggest the importance of including the fourth factor. The four-factor model can be stated as
[R.sub.i,t] - [RF.sub.t] = [alpha] [[beta].sub.RMRF] [RMRF.sub.t] [[beta].sub.SMB] [SMB.sub.t] [[beta].sub.HML] [HML.sub.t] [[beta].sub.PR1YR] [PR1YR.sub.t] [[epsilon].sub.i,t], (1)
[FIGURE 1 OMITTED]
where [R.sub.i,t] is the return on portfolio i at month t, [RF.sub.t] is the risk-free rate, [RMRF.sub.t] is the return on excess market portfolio, [SMB.sub.t] is the return on factor-mimicking size portfolio, [HML.sub.t] is the return on factor-mimicking book-to-market equity portfolio, and [PR1YR.sub.t] is the return on Carhart's (1997) factor-mimicking portfolio for one-year return momentum. The constant term or is Jensen's alpha and [[beta].sub.RMRF], [[beta].sub.SMB], [[beta].sub.HML], and [[beta].sub.PR1YR] the are factor loadings of RMRF, SMB, HML, and PR1YR, respectively.
Estimation of Equation (1) requires a time-series regression of monthly foreign ownership portfolio excess returns on RMRF, SMB, HML, and PR1YR. We next describe the construction of the four factors followed by the construction of the foreign ownership portfolios. In constructing the four factors, only firms with ordinary common stocks that have been listed for at least two years on the Taiwan Stock Exchange (TSE) or the Taiwan OTC market are included in our portfolios. This excludes Taiwan Depositary Receipts, convertible bonds, units of beneficial interest, and newly listed securities.
The excess market portfolio return, RMRF, is computed as the monthly return on a value-weighted portfolio of all TSE and OTC stocks minus the one month time deposit rate offered by the Bank of Taiwan. (16) To obtain the size factor SMB and value factor HML, portfolios are formed on the basis of size and book-to-market. All TSE stocks are ranked by size as of the end of June of each year t from 1994 to 2001. Size, or market equity (ME), is calculated as share price multiplied by shares outstanding. The stocks are divided into two groups, small (S) and big (B), using the TSE median size to divide the observations. Book-to-market equity (BE/ME) is book common equity (BE) for the fiscal year ending in calendar year t - 1, divided by market equity (ME) at the end of December of year t - 1. Here, BE is the book value of stockholder's equity, plus balance sheet deferred taxes and investment tax credit, minus the book value of preferred stock. The fiscal year ends in December for most Taiwanese firms. The groups are formed by categorizing each of the two size ranked groups (S and B) into three book-to-market ranked groups: the bottom 30% (L for low), middle 40% (M for medium), and top 30% (H for high). This gives us a total of six size/book-to-market portfolios: 1) S/L, 2) S/M, 3) S/H, 4) B/L, 5) B/M, and 6) B/H. Finally, monthly value-weighted returns on the six portfolios are calculated from the beginning of July of year t to the end of June of year t 1, and the portfolios are rebalanced at the end of June of year t 1.
The size factor SMB and the value factor HML are computed for the six portfolios. The factor SMB is the difference between the simple average of monthly returns on the three small stock portfolios and on the matching big stock portfolios: 1) S/L - B/L, 2) S/M - B/M, and 3) S/H - B/H. The factor HML is the difference between the simple average of monthly returns on the two high BE/ME portfolios (S/H and B/H) and on the matching low BE/ME portfolios (S/L and B/L): 1) S/H - S/L and 2) B/H - B/L.
The fourth factor is the momentum factor, PR1YR. It is the difference between the equal-weighted average of firms with the highest 30% 11-month returns, lagged 1 month, minus the equal-weighted average of firms with the lowest 30% 11-month returns, lagged 1 month. The portfolios include all TSE and OTC stocks and are rebalanced monthly.
The foreign ownership portfolios are constructed as follows. At the end of each quarter from Q2 1994 to Q3 2001 (a total of 30 quarters), we sort all sample firms into five portfolios based on their foreign ownership percentage. Portfolio P1 consists of stocks with the highest foreign ownership and P5 consists of those with the lowest. We then calculate equal-weighted and value-weighted monthly returns for the five portfolios in the following three-month period before rebalancing the portfolios.
Table II, Panel A presents the summary statistics of the four factors needed to estimate Equation (1). Panel B presents the descriptive statistics of the firm characteristics for these five portfolios. They indicate that foreign institutions prefer large, export-oriented firms. These results are similar to those round by KS for Japan. Higher foreign ownership portfolios also exhibit higher accounting returns and Tobin's Q. Finally, Panel B shows that the combined P1 and P2 portfolios account for over 70% of the market capitalization.
Panel C presents the percentage foreign ownership summary statistics for the five foreign ownership portfolios over the eight-year period from 1994 to 2001. Whereas foreign institutional ownership appears to be low in the previous panels, Panel C demonstrates an increase over time with P1 presenting the largest increase. This trend suggests that tests of the foreign ownership hypotheses may be more apparent in recent years, during which time there has been greater foreign ownership. However, our inferences are based on the entire sample period.
Panel D presents the summary statistics of the five equal-weighted and value-weighted portfolio returns. They illustrate that the mean and median monthly returns decline with decreasing foreign ownership percentage. Indeed, the differences between P1 and P5 are startling, exceeding 100 basis points for equal-weighted returns and 195 basis points for value-weighted returns.
In addition to the Taiwan version of the Fama-French (1993, 1996) model, we experiment with the global and the US versions. However, the global and US versions produced very poor fits and were discarded in favor of the Taiwanese version. The poor results for the global version may reflect the lack of global market integration that is responsible for the home bias in the first place. Finally, although we present the results of the four-factor model, similar results are obtained using the Fama-French (1993, 1996) three-factor model. (17)
B. Foreign Ownership Effect
Table III presents the market impact results of foreign institutional ownership. The sample includes all 523 firms for which we have complete data. The five portfolios used in the table are based on their foreign ownership ranking, with P1 having the highest foreign ownership percentage. The table illustrates the monthly estimation results for equal- and value-weighted portfolios. It also reports the results of going long in P1 and short in P5 (P l-P5).
For both equal- and value-weighted portfolios, the high foreign ownership portfolio outperforms the low foreign ownership portfolio. Equal and value-weighted portfolios formed by going long in P1 and short in P5 (P1-P5) earn significant positive Jensen alphas. The magnitudes of the alphas are huge. For example, the value-weighted P1-P5 portfolio has a monthly alpha of 175 basis points. The signs and magnitudes of the alphas generally decrease monotonically from high to low ownership portfolios. In short, Table III documents a striking foreign ownership effect.
The observed foreign ownership effect is conditional on an assumed asset pricing model. Hence, an alternative interpretation of the evidence is that a conventional asset pricing model is inadequate in accounting for the systematic component of Taiwan stocks. In particular, the evidence calls for an additional risk factor, one related to foreign ownership. This foreign ownership factor may capture risks such as those associated with foreign exchange rates. Nonetheless, regardless of the interpretation, the evidence demonstrates that the foreign ownership level has an important pricing effect.
C. Robustness Checks
In this section, we conduct a series of robustness checks to determine whether the foreign ownership effect is due to some other effects. (18) First, we examine whether the foreign ownership effect is merely an export firm effect. It is not an export firm effect if the market rewards non-export-oriented firms with high foreign ownership levels. KS find that foreign ownership in Japan is concentrated in large export-oriented firms. They attribute this behavior to foreigners' attempts to mitigate their disadvantage in knowledge of domestic firms. This may be because it is more cost efficient for foreigners to track firms that have global operations. They may have easier access to information about those firms' customers, suppliers, and competitors. They may even have access to information in foreign markets that are unavailable to domestic investors.
To distinguish between the foreign ownership effect and the export firm effect, we sort stocks into three portfolios based on their export-to-sales ratios. Each export portfolio is then sorted into three ownership portfolios based on foreign ownership at the end of the previous quarter, resulting in nine export ownership portfolios.
Summary statistics indicate that foreign ownership is not synonymous with export ratios and that foreign ownership is not concentrated exclusively in export-oriented firms. Next, we examine the Jensen alphas of the nine export ownership portfolios. The results show that the foreign ownership effect is still present even after accounting for firm export ratios. Therefore, the foreign ownership effect is not an export firm effect. Apparently, investors acknowledge foreign ownership even in non-export-oriented Taiwanese firms. These are firms that are least likely to reflect any exchange rate effects.
We now investigate whether the foreign ownership effect is a size effect. As in the case of export-oriented firms, foreign owners may minimize their information disadvantage by investing in large firms. To investigate the size effect, we sort stocks into three size portfolios and then further sort each size portfolio into three ownership percentage portfolios for a total of nine portfolios.
Summary statistics confirm that foreign investment is concentrated in large stocks. However, controlling for size does not appear to control for foreign ownership. It also appears to be the case that controlling for foreign ownership does not control for foreign ownership across firm size. An examination of the Jensen alphas for both equal- and value-weighted versions of the nine size ownership portfolios indicates that the foreign ownership effect is not a size effect. The test results can also be interpreted as providing evidence regarding passive foreign institutional investments. A passive investment strategy for foreigners is to hold stocks in their Taiwan portfolio in the same proportion as that in an index. Such a passive strategy is also incompatible with the presence of a home bias as noted earlier. The popular Taiwan indices are value-weighted and are dominated by large firms. As such, our results may be viewed as being incompatible with a passive index fund strategy.
Foreign institutions may also minimize their information disadvantage by focusing their investments in transparent firms. Transparent firms release prompt and accurate disclosures and thereby reduce information asymmetry in the market. Because information is readily available about transparent firms, such firms should be attractive to investors who want to minimize their information asymmetry. Therefore, we ask whether the foreign ownership effect is a transparent firm effect.
We measure firm transparency by using the information transparency and disclosure ranking compiled by the Taiwan Securities and Futures Institute (2003) for all the listed stocks in Taiwan. Companies are ranked on five criteria: 1) compliance with mandatory disclosures, 2) timeliness of reporting, 3) disclosure of the annual report, 4) disclosure of a financial forecast, and 5) corporate website disclosure. Their 2003 ranking identifies firms that are considered to be "more transparent" companies. Again, we do a double sort with these data. We first sort stocks into five foreign ownership portfolios and then classify each foreign ownership portfolio into a firm that is either "more transparent" or "less transparent." This process of classification produces a total of 10 portfolios.
Summary statistics are consistent with foreigners' tendency to own larger firms that also happen to be more transparent. Jensen alphas for both equal- and value-weighted versions of the ten transparency ownership portfolios show a premium for "more transparent" firms. More importantly, they demonstrate that the foreign ownership effect is still present even after controlling for the firm transparency level. This suggests that foreign institutions do not minimize their information disadvantage by exclusively investing in transparent firms.
D. Discussion
Our results indicate that foreign ownership levels are associated with a pronounced local valuation effect. Stocks with high foreign ownership outperform stocks with low foreign ownership. The market rewards stocks that foreigners choose to own. Moreover, this reward is not simply because it is an export-oriented firm, a big firm, or a transparent firm.
Foreign investors are prohibited from short selling in Taiwan. This prohibition restricts foreign investors' potential to profit by identifying losers and may bias them toward strategies of ownership, oversight, and intervention. Although foreign investors are restricted from short selling, domestic investors are allowed to do so. Domestic investors can short sell to arbitrage away any perceived price abnormalities. However, any foreigners' buy and hold strategies because of their inability to short sell may restrict the supply of shares for short selling and may make arbitrage trading difficult. As such, part of the valuation effect may be due to the different short sale regulations. On the other hand, it is worth noting that if foreign ownership produces a positive long-term valuation effect, then foreign investors benefit from their ownership. Therefore, if foreign investors were permitted to engage in short sales, a positive valuation effect may be even stronger. This is because foreign investors would be able to short sell firms they do not want to own and to invest the proceeds in firms they do want to hold.
Local effects of foreign ownership in an emerging financial market: evidence from qualified foreign institutional investors in Taiwan - I
We examine the local effects of equity ownership by investors who are classified as qualified foreign institutional investors in Taiwan. Our empirical analyses reveal a pronounced foreign ownership effect, whereby stocks with high foreign ownership outperform stocks with low foreign ownership. The valuation effect is present even after controlling for firm export, size, or transparency levels. We pursue a performance-based explanation for this effect and find that foreign ownership is strongly and positively associated with firm R&D expenditures and contemporaneous and subsequent firm performance. Our evidence is consistent with foreign investors who enjoy a long-run information advantage over domestic investors.
There is a growing body of literature regarding the information asymmetry between domestic and foreign investors. Domestic investors may be more knowledgeable than foreign investors about the local environment or domestic firms, but foreigners may have better technological, financial, or human expertise, experience, or resources. The foreigner's advantages may give them more credibility and a stronger reputation than domestic investors. Further, these advantages are more pronounced for foreign institutional investors and when domestic investors are from emerging markets.
The existing literature is still divided on whether domestic or foreign investors have an information advantage. For example, Grinblatt and Keloharju (2000) use daily data and find that foreigners are better able to select winners in Finnish stocks than domestic individuals. In contrast, Choe, Kho, and Stulz (2005) use all trades over a two-year period and find the opposite to be the case for South Korean stocks. Dvorak (2005) uses transactions data and finds the situation to be more complex for Indonesian stocks. His results indicate that while domestic individuals possess an information advantage, global brokerages are better able to pick long-term winners. The latter provides evidence of foreign institutions that have a strategic information advantage over domestic investors.
The purpose of our paper is to contribute to the debate on whether domestic or foreign investors have a long-run information advantage by examining the local effects of equity ownership by
Qualified Foreign Institutional Investors (QFIIs) in Taiwan. Previous studies have focused on short-run information advantages and have relied upon high-frequency data to compute trading profits. A notable exception is Kang and Stulz (1997) (KS) who find, using annual Japanese data, that foreign investors do not outperform domestic investors. In contrast to the short-run studies, our paper focuses on long-lived information that provides strategic advantages to investors and uses monthly and annual data. Unlike KS, we also focus on an emerging financial market. Our study complements the short-run analyses as short-term results may not carry over to long-term outcomes. In particular, short-lived information may not provide long-run advantages. For example, foreign investors may become more knowledgeable of the local terrain over time. If so, any information advantage that domestic investors derive initially from their familiarity with the local environment may dissipate at which point foreign investors' information advantage may become more obvious.
Our long-run analysis is also related to research on cross-border equity ownership that examines the characteristics of local stocks owned by foreigners. The literature has documented the phenomenon known as home bias or the observation that investors exhibit a greater preference for home securities than is predicted by theoretical models based on frictionless markets (see French and Poterba, 1991, and a review of the home bias literature by Lewis, 1999). KS use firm-level foreign ownership data from Japan to examine investor preferences. They find that foreigners prefer to invest in large, very liquid Japanese firms instead of investing in the entire Japanese market. Their results are supported by Dahlquist and Robertsson (2001) (DR), who obtain comparable evidence for Sweden. (1) Similar to KS and DR, we examine foreign equity ownership, but we do so for an emerging financial market, Taiwan. Additionally, we focus on the local effects of foreign equity ownership as opposed to the preferences of foreign owners. Specifically, we are concerned with the long-terre valuation effect of foreign institutional investments and the relation between foreign investments and firm performance.
Taiwan is an important market. Like many emerging Asian markets, it has experienced rapid economic development, and its economy is now comparable to a developed market according to many measures. Its GDP in 2000 was US$309 billion and its GDP per capita was US$13,985. (2) The Taiwan stock market at the end of 2000 was ranked 16th globally by market value, with a capitalization of US$248 billion. In short, Taiwan may well prove to be too important to exclude from internationally diversified investment portfolios.
Taiwan also exhibits typical characteristics of an emerging financial market. It has weak corporate governance, inadequate shareholder protection, poor legal enforcement, and heightened stock market volatility (see Gibson, 2003, and the surveys by Bekaert and Harvey, 2003; Denis and McConnell, 2003). Additionally, the Taiwan stock market is dominated by uninformed individual investors who trade frequently. Barber, Lee, Liu, and Odean (2009) report that individual traders in Taiwan accounted for 90% of the trading volume during the second hall of the 1990s and incurred trading losses of 3.8% annually, amounting to 2.2% of Taiwan's GDP. They also estimate that the annual turnover for individual investors ranged between 308% and 630% from 1995 to 1999. (3)
For our study, we have access to firm-level foreign equity ownership data. An advantage to studying Taiwan is that, despite its status as an emerging equity market, it is endowed with highly reliable financial records. In contrast to the Barber et al. (2009) study, which uses transactions data to examine trading profits in Taiwan, we analyze monthly and annual local foreign ownership effects.
Our analyses of foreign institutional equity ownership uncover a dramatic foreign ownership premium. Firms with high foreign ownership realize huge economically and statistically significant, positive excess returns. Firms with low foreign ownership realize huge economically and statistically significant, negative excess returns. The market rewards foreign ownership. Further analyses show that the foreign ownership effect is not an export firm effect, a size effect, or a transparent firm effect. Additionally, we observe similar foreign ownership preferences to those found by KS and DR, but for an emerging financial market. However, QFIIs' preferences are not exclusively for export-oriented, large, or transparent firms.
Next, we pursue a performance-based explanation for the strong foreign ownership effect. Following Jensen and Meckling (1976), an extensive body of literature has been developed that examines the role of monitoring by some informed shareholders to alleviate agency problems associated with the separation of ownership and control. Our analysis of foreign holdings in Taiwan extends this literature to the case of overseas monitoring in an emerging market. We find that foreign institutional equity ownership is significantly associated with increased firm R&D expenditures and also with improved firm performance as measured by Tobin's Q and accounting returns. This suggests that foreign institutions may possess superior stock selection ability or are able to positively influence firm management.
Our results document the important role played by foreign institutional investors in Taiwan, suggesting that in an environment dominated by individual investors with extreme agency problems and a dearth of alternative governance mechanisms, domestic individual investors may rely on information about foreign institutional ownership. Unlike domestic individual investors, foreign institutions may possess stock selection ability or the "know how" and resources to monitor or play a disciplinary role.
Our analysis of foreign institutional investment has important policy implications. Cross-border investments are a major factor in business today. There is a growing concern by emerging market governments that investments from abroad may destabilize local markets. This concern is reinforced by periodic episodes such as the 1997 Asian Crisis, which led to the adoption of capital controls and other market restrictions by Asian countries. An understanding of the role of foreign investments in emerging markets is a prerequisite to understanding these events and policy decisions. Our results for Taiwan indicate that foreign institutional ownership has the potential to promote economic development since it is related to improved firm performance, and is highly prized by domestic investors.
The remainder of the paper proceeds as follows. Section I depicts the Taiwan financial environment. Section II contains a description of the data set and some preliminary statistics. Section III documents the foreign ownership effect. Section IV pursues performance-based explanations of the foreign ownership effect. Section V concludes the paper.
I. Taiwan Financial Environment
Before proceeding to the formal analysis, we characterize Taiwan's financial environment in this section. (4) Taiwan is officially classified as an emerging market, and its financial sector has many similarities with other emerging financial markets. (5) Taiwanese firms often exhibit weak corporate governance and inadequate shareholder protection. (6) Their equity market returns are characterized by a high average return, high volatility, a low correlation with developed markets' returns, and more predictable market returns than developed markets (Harvey, 1995; Bekaert and Harvey, 1997).
Contributing to the severe agency problems in Taiwanese firms is a lack of effective governance mechanisms. Individual domestic investors are the largest category of stockholders in the stock market. They tend to be frequent traders who do not have the resources to undertake fundamental firm research. In the Taiwan market, the average turnover rate is 250% annually, and the market is ranked seventh globally in value of equity traded in 2000, with a total of US$925 billion. (7) Therefore, uninformed domestic individual investors cannot be relied upon to restrain managers' self-interest.
After individual domestic investors, domestic institutions are the most important investors in Taiwan stocks. They consist mainly of dealers and securities investment trust companies. Domestic institutional investors lack credibility, rarely engage in firm research, and are periodically embroiled in scandals. In a recent scandal, mutual fund managers colluded with managers of listed companies to manipulate stock prices. They used relatives' accounts to trade stocks before the mutual funds traded the stocks and colluded with listed firms to buy each others' stocks (Common Wealth Magazine, 2004). They are not the preferred source of investment advice for domestic investors. Therefore, discredited domestic institutions are not entrusted with the task of monitoring firm management.
An important internal governance mechanism is the use of boards of directors to represent shareholders' interest. However, this was not a reliable mechanism during our sample period as existing regulations in Taiwan did not call for independent directors, thus compromising a board's effectiveness.
The takeover market provides another external governance mechanism for monitoring and controlling insiders. However, the market for corporate control in Taiwan is inactive because existing rules make it difficult to acquire proxies for takeovers. The few takeovers that did occur during our sample period did not lead to increased firm value; rather, they led to an expropriation of minority shareholders' rights.
Banks often provide an alternative external device for monitoring firms that have bank loans and may even attempt to gain control of these firms. This is not the case in Taiwan. Taiwan banks are not even passively involved in firm management, let alone in the monitoring of activities. They cannot own more than 5% of a firm and lending policies are very stringent. Loans to firms are often collaterized by tangible assets. Furthermore, the bank debt ratio of listed firms is relatively low. For example, using Worldscope data, the ratio of total liabilities to the book value of total assets in 2001 was 42.33% for Taiwan, 60.68% for the United States, and 59.56% for Japan. (8) In short, Taiwan has weak standard monitoring mechanisms for controlling its severe agency problems.
A conspicuous characteristic of the Taiwan market is its intense focus on foreigner investment. Foreign ownership data are widely and closely scrutinized by journalists, investors, and the general public. News stories about changes in the level of foreigner investment capture the investing public's attention. At 3:00 p.m. on each trading day, data on total purchases and sales by major institutional investors are publicly released. (9) Foreign investors' purchases and sales are also made public for each firm. Such data often become the day's business press headlines and television news highlights.
Taiwanese domestic investors focus on investments by foreign institutional portfolio investors known as QFIIs. (10) These foreign investors include banks, insurance companies, securities firms, mutual funds, and other investment institutions. (11) The investment quota for each QFII has increased over time, standing at US$2 billion at the end of 2000. (12) There were also ceilings for each foreign investor's holdings in individual firms as well as for total foreign holdings in individual firms during most of our sample period. However, the ownership restrictions have declined steadily over time, and by the end of 2000, foreigners were permitted to own 100% of domestic firms with only a few exceptions. (13) More importantly, the limits on foreign ownership were never breached during our sample period.
The focus on foreigner investment manifests itself in other ways as well. Domestic firms actively court foreign portfolio investors through a variety of techniques including road shows to places outside Taiwan. The press routinely associates increased foreigner investment with an increase in stock price. Journalists and reporters often report changes in firm behavior that are attributable to foreign investors. The local media have even alluded to overseas monitoring as a device for controlling firms' insiders. There have also been accusations of homemade foreigner investments in the marketplace.
We next consider the behavior of foreign investors in Taiwan. They tend to be long-term investors. The avowed aim of the Taiwan Securities and Futures Commission in opening Taiwan to global investors was to attract long-term investment since foreign investors tend to be long-term investors. The Commission appears to have succeeded in that the turnover rate is much lower for foreign investors than for domestic individual investors. (14)
With little firm information available, foreign institutions that find Taiwan too important to ignore may have little choice but to engage in basic research themselves. They have the resources to invest in information acquisition. Big and medium-sized foreign institutional investors, such as Fidelity and Jardine Fleming, have branch offices in Taiwan. These offices analyze global economic growth, industrial competition, and the performance of both Taiwanese firms and their competitors. Small foreign investors can purchase foreign analyst reports from global brokerage services.
How do foreign institutions influence the firms whose stocks they own? They do so through periodic guidance on corporate governance and other business operations. Either their home management or their financial analysts communicate their concerns directly to company managers. This is a very efficient communication process. Foreign investors may express such things as their displeasure with decisions that are harmful to small investors or their opposition to an expansion of noncore businesses or to excessive perquisites. This direct communication process is often encouraged by the management of listed firms that actively seek foreigner investment.
If foreigners' concerns are not heeded by firm management, foreign investors can sell their stock holdings. They may also sell for a variety of other reasons: 1) when there is bad news, 2) when they no longer have confidence in the firm's or the industry's future operating performance, or 3) when the level of the firm's information asymmetry bas increased. Our results below document the considerable negative stock price effect of low foreign ownership levels. This reflects the considerable leverage foreign institutional owners have over firm management.
Finally, the differential taxation between domestic and foreign investors in Taiwan is worth noting. For example, although dividend income is taxed as ordinary income for domestic investors, foreign investors are required to pay a withholding tax. However, Taiwan has tax treaties with the localities of its major foreign investors, including the United States, European countries, Hong Kong, Japan, and Singapore. Under these treaties, foreign owners are able to avoid double taxation by obtaining credit for taxes paid in Taiwan.
II. Data
Data used in the analyses are firm-level equity ownership data from foreign institutions that are classified as QFIIs. The data are widely disseminated and closely followed by the press, shareholders, and the public. The importance of the data and its widespread availability ensure its high quality, an important feature that is often lacking in emerging markets.
There is a growing body of literature regarding the information asymmetry between domestic and foreign investors. Domestic investors may be more knowledgeable than foreign investors about the local environment or domestic firms, but foreigners may have better technological, financial, or human expertise, experience, or resources. The foreigner's advantages may give them more credibility and a stronger reputation than domestic investors. Further, these advantages are more pronounced for foreign institutional investors and when domestic investors are from emerging markets.
The existing literature is still divided on whether domestic or foreign investors have an information advantage. For example, Grinblatt and Keloharju (2000) use daily data and find that foreigners are better able to select winners in Finnish stocks than domestic individuals. In contrast, Choe, Kho, and Stulz (2005) use all trades over a two-year period and find the opposite to be the case for South Korean stocks. Dvorak (2005) uses transactions data and finds the situation to be more complex for Indonesian stocks. His results indicate that while domestic individuals possess an information advantage, global brokerages are better able to pick long-term winners. The latter provides evidence of foreign institutions that have a strategic information advantage over domestic investors.
The purpose of our paper is to contribute to the debate on whether domestic or foreign investors have a long-run information advantage by examining the local effects of equity ownership by
Qualified Foreign Institutional Investors (QFIIs) in Taiwan. Previous studies have focused on short-run information advantages and have relied upon high-frequency data to compute trading profits. A notable exception is Kang and Stulz (1997) (KS) who find, using annual Japanese data, that foreign investors do not outperform domestic investors. In contrast to the short-run studies, our paper focuses on long-lived information that provides strategic advantages to investors and uses monthly and annual data. Unlike KS, we also focus on an emerging financial market. Our study complements the short-run analyses as short-term results may not carry over to long-term outcomes. In particular, short-lived information may not provide long-run advantages. For example, foreign investors may become more knowledgeable of the local terrain over time. If so, any information advantage that domestic investors derive initially from their familiarity with the local environment may dissipate at which point foreign investors' information advantage may become more obvious.
Our long-run analysis is also related to research on cross-border equity ownership that examines the characteristics of local stocks owned by foreigners. The literature has documented the phenomenon known as home bias or the observation that investors exhibit a greater preference for home securities than is predicted by theoretical models based on frictionless markets (see French and Poterba, 1991, and a review of the home bias literature by Lewis, 1999). KS use firm-level foreign ownership data from Japan to examine investor preferences. They find that foreigners prefer to invest in large, very liquid Japanese firms instead of investing in the entire Japanese market. Their results are supported by Dahlquist and Robertsson (2001) (DR), who obtain comparable evidence for Sweden. (1) Similar to KS and DR, we examine foreign equity ownership, but we do so for an emerging financial market, Taiwan. Additionally, we focus on the local effects of foreign equity ownership as opposed to the preferences of foreign owners. Specifically, we are concerned with the long-terre valuation effect of foreign institutional investments and the relation between foreign investments and firm performance.
Taiwan is an important market. Like many emerging Asian markets, it has experienced rapid economic development, and its economy is now comparable to a developed market according to many measures. Its GDP in 2000 was US$309 billion and its GDP per capita was US$13,985. (2) The Taiwan stock market at the end of 2000 was ranked 16th globally by market value, with a capitalization of US$248 billion. In short, Taiwan may well prove to be too important to exclude from internationally diversified investment portfolios.
Taiwan also exhibits typical characteristics of an emerging financial market. It has weak corporate governance, inadequate shareholder protection, poor legal enforcement, and heightened stock market volatility (see Gibson, 2003, and the surveys by Bekaert and Harvey, 2003; Denis and McConnell, 2003). Additionally, the Taiwan stock market is dominated by uninformed individual investors who trade frequently. Barber, Lee, Liu, and Odean (2009) report that individual traders in Taiwan accounted for 90% of the trading volume during the second hall of the 1990s and incurred trading losses of 3.8% annually, amounting to 2.2% of Taiwan's GDP. They also estimate that the annual turnover for individual investors ranged between 308% and 630% from 1995 to 1999. (3)
For our study, we have access to firm-level foreign equity ownership data. An advantage to studying Taiwan is that, despite its status as an emerging equity market, it is endowed with highly reliable financial records. In contrast to the Barber et al. (2009) study, which uses transactions data to examine trading profits in Taiwan, we analyze monthly and annual local foreign ownership effects.
Our analyses of foreign institutional equity ownership uncover a dramatic foreign ownership premium. Firms with high foreign ownership realize huge economically and statistically significant, positive excess returns. Firms with low foreign ownership realize huge economically and statistically significant, negative excess returns. The market rewards foreign ownership. Further analyses show that the foreign ownership effect is not an export firm effect, a size effect, or a transparent firm effect. Additionally, we observe similar foreign ownership preferences to those found by KS and DR, but for an emerging financial market. However, QFIIs' preferences are not exclusively for export-oriented, large, or transparent firms.
Next, we pursue a performance-based explanation for the strong foreign ownership effect. Following Jensen and Meckling (1976), an extensive body of literature has been developed that examines the role of monitoring by some informed shareholders to alleviate agency problems associated with the separation of ownership and control. Our analysis of foreign holdings in Taiwan extends this literature to the case of overseas monitoring in an emerging market. We find that foreign institutional equity ownership is significantly associated with increased firm R&D expenditures and also with improved firm performance as measured by Tobin's Q and accounting returns. This suggests that foreign institutions may possess superior stock selection ability or are able to positively influence firm management.
Our results document the important role played by foreign institutional investors in Taiwan, suggesting that in an environment dominated by individual investors with extreme agency problems and a dearth of alternative governance mechanisms, domestic individual investors may rely on information about foreign institutional ownership. Unlike domestic individual investors, foreign institutions may possess stock selection ability or the "know how" and resources to monitor or play a disciplinary role.
Our analysis of foreign institutional investment has important policy implications. Cross-border investments are a major factor in business today. There is a growing concern by emerging market governments that investments from abroad may destabilize local markets. This concern is reinforced by periodic episodes such as the 1997 Asian Crisis, which led to the adoption of capital controls and other market restrictions by Asian countries. An understanding of the role of foreign investments in emerging markets is a prerequisite to understanding these events and policy decisions. Our results for Taiwan indicate that foreign institutional ownership has the potential to promote economic development since it is related to improved firm performance, and is highly prized by domestic investors.
The remainder of the paper proceeds as follows. Section I depicts the Taiwan financial environment. Section II contains a description of the data set and some preliminary statistics. Section III documents the foreign ownership effect. Section IV pursues performance-based explanations of the foreign ownership effect. Section V concludes the paper.
I. Taiwan Financial Environment
Before proceeding to the formal analysis, we characterize Taiwan's financial environment in this section. (4) Taiwan is officially classified as an emerging market, and its financial sector has many similarities with other emerging financial markets. (5) Taiwanese firms often exhibit weak corporate governance and inadequate shareholder protection. (6) Their equity market returns are characterized by a high average return, high volatility, a low correlation with developed markets' returns, and more predictable market returns than developed markets (Harvey, 1995; Bekaert and Harvey, 1997).
Contributing to the severe agency problems in Taiwanese firms is a lack of effective governance mechanisms. Individual domestic investors are the largest category of stockholders in the stock market. They tend to be frequent traders who do not have the resources to undertake fundamental firm research. In the Taiwan market, the average turnover rate is 250% annually, and the market is ranked seventh globally in value of equity traded in 2000, with a total of US$925 billion. (7) Therefore, uninformed domestic individual investors cannot be relied upon to restrain managers' self-interest.
After individual domestic investors, domestic institutions are the most important investors in Taiwan stocks. They consist mainly of dealers and securities investment trust companies. Domestic institutional investors lack credibility, rarely engage in firm research, and are periodically embroiled in scandals. In a recent scandal, mutual fund managers colluded with managers of listed companies to manipulate stock prices. They used relatives' accounts to trade stocks before the mutual funds traded the stocks and colluded with listed firms to buy each others' stocks (Common Wealth Magazine, 2004). They are not the preferred source of investment advice for domestic investors. Therefore, discredited domestic institutions are not entrusted with the task of monitoring firm management.
An important internal governance mechanism is the use of boards of directors to represent shareholders' interest. However, this was not a reliable mechanism during our sample period as existing regulations in Taiwan did not call for independent directors, thus compromising a board's effectiveness.
The takeover market provides another external governance mechanism for monitoring and controlling insiders. However, the market for corporate control in Taiwan is inactive because existing rules make it difficult to acquire proxies for takeovers. The few takeovers that did occur during our sample period did not lead to increased firm value; rather, they led to an expropriation of minority shareholders' rights.
Banks often provide an alternative external device for monitoring firms that have bank loans and may even attempt to gain control of these firms. This is not the case in Taiwan. Taiwan banks are not even passively involved in firm management, let alone in the monitoring of activities. They cannot own more than 5% of a firm and lending policies are very stringent. Loans to firms are often collaterized by tangible assets. Furthermore, the bank debt ratio of listed firms is relatively low. For example, using Worldscope data, the ratio of total liabilities to the book value of total assets in 2001 was 42.33% for Taiwan, 60.68% for the United States, and 59.56% for Japan. (8) In short, Taiwan has weak standard monitoring mechanisms for controlling its severe agency problems.
A conspicuous characteristic of the Taiwan market is its intense focus on foreigner investment. Foreign ownership data are widely and closely scrutinized by journalists, investors, and the general public. News stories about changes in the level of foreigner investment capture the investing public's attention. At 3:00 p.m. on each trading day, data on total purchases and sales by major institutional investors are publicly released. (9) Foreign investors' purchases and sales are also made public for each firm. Such data often become the day's business press headlines and television news highlights.
Taiwanese domestic investors focus on investments by foreign institutional portfolio investors known as QFIIs. (10) These foreign investors include banks, insurance companies, securities firms, mutual funds, and other investment institutions. (11) The investment quota for each QFII has increased over time, standing at US$2 billion at the end of 2000. (12) There were also ceilings for each foreign investor's holdings in individual firms as well as for total foreign holdings in individual firms during most of our sample period. However, the ownership restrictions have declined steadily over time, and by the end of 2000, foreigners were permitted to own 100% of domestic firms with only a few exceptions. (13) More importantly, the limits on foreign ownership were never breached during our sample period.
The focus on foreigner investment manifests itself in other ways as well. Domestic firms actively court foreign portfolio investors through a variety of techniques including road shows to places outside Taiwan. The press routinely associates increased foreigner investment with an increase in stock price. Journalists and reporters often report changes in firm behavior that are attributable to foreign investors. The local media have even alluded to overseas monitoring as a device for controlling firms' insiders. There have also been accusations of homemade foreigner investments in the marketplace.
We next consider the behavior of foreign investors in Taiwan. They tend to be long-term investors. The avowed aim of the Taiwan Securities and Futures Commission in opening Taiwan to global investors was to attract long-term investment since foreign investors tend to be long-term investors. The Commission appears to have succeeded in that the turnover rate is much lower for foreign investors than for domestic individual investors. (14)
With little firm information available, foreign institutions that find Taiwan too important to ignore may have little choice but to engage in basic research themselves. They have the resources to invest in information acquisition. Big and medium-sized foreign institutional investors, such as Fidelity and Jardine Fleming, have branch offices in Taiwan. These offices analyze global economic growth, industrial competition, and the performance of both Taiwanese firms and their competitors. Small foreign investors can purchase foreign analyst reports from global brokerage services.
How do foreign institutions influence the firms whose stocks they own? They do so through periodic guidance on corporate governance and other business operations. Either their home management or their financial analysts communicate their concerns directly to company managers. This is a very efficient communication process. Foreign investors may express such things as their displeasure with decisions that are harmful to small investors or their opposition to an expansion of noncore businesses or to excessive perquisites. This direct communication process is often encouraged by the management of listed firms that actively seek foreigner investment.
If foreigners' concerns are not heeded by firm management, foreign investors can sell their stock holdings. They may also sell for a variety of other reasons: 1) when there is bad news, 2) when they no longer have confidence in the firm's or the industry's future operating performance, or 3) when the level of the firm's information asymmetry bas increased. Our results below document the considerable negative stock price effect of low foreign ownership levels. This reflects the considerable leverage foreign institutional owners have over firm management.
Finally, the differential taxation between domestic and foreign investors in Taiwan is worth noting. For example, although dividend income is taxed as ordinary income for domestic investors, foreign investors are required to pay a withholding tax. However, Taiwan has tax treaties with the localities of its major foreign investors, including the United States, European countries, Hong Kong, Japan, and Singapore. Under these treaties, foreign owners are able to avoid double taxation by obtaining credit for taxes paid in Taiwan.
II. Data
Data used in the analyses are firm-level equity ownership data from foreign institutions that are classified as QFIIs. The data are widely disseminated and closely followed by the press, shareholders, and the public. The importance of the data and its widespread availability ensure its high quality, an important feature that is often lacking in emerging markets.
7 Ways to Improve the Chances of Your Strategy Succeeding
Like most strategic maps, yours is probably missing some important details. But then that 'cool' project team that your manager kindly volunteered you for last week will soon fill in the missing details...or will it? Most strategic project teams learn early on in their work that "the map is not the territory" or as one executive we know was fond of saying "never confuse a memo with reality!"
But it needn't be that way...
There are some simple approaches to planning and implementing strategy, that once followed will dramatically increase the chances of success for you and your organization.
Here are seven ways for you to improve the chances of your strategy succeeding...
But it needn't be that way...
There are some simple approaches to planning and implementing strategy, that once followed will dramatically increase the chances of success for you and your organization.
Here are seven ways for you to improve the chances of your strategy succeeding...
- Always explain why the strategy is being pursued...and let people know clearly what's at stake. You'd be amazed at how little attention this gets.
- Strive to build momentum and confidence with small early wins. Treat this as your warm-up phase. Some organizations even call the first year of their strategy implementation 'Year Zero'! Don't go for the home runs in the first couple of innings...even professional athletes need a warm-up period
- Acknowledge and celebrate the past...then move on!
- Build the organizations capacity to execute projects that are focused on customer outcomes, not just budget and on-time delivery.
NOTE: The Conference Board of Canada advises that one of the key skills employees need in today's project oriented organizations is the ability to plan, design, or carry out a project or task from start to finish with well defined objectives and outcomes.
SPECIAL NOTE: If you are not training and developing your employees in this critical skill, then you're inviting disaster.
- Give everyone a role to play, not just project team members...do not create an 'elite' corp of project teams.
- Create 90-day pilot tests of all new ideas and products/services/programs...if it can't be tested within 90 days (or less), break it down into smaller pieces that can. Absolutely, and without blinking, make this your product, program, service and process improvement mantra - see point 2 above.
- Celebrate successful change initiatives...senior leaders must (read MUST) lead these celebrations. And while you're at it, make these celebrations, and change in general, fun...if you don't, people will confuse it with work...and you know how boring that can get!
Thinking to Coach? Coach to Think!
Coaching is now regarded as a key competency for leaders, educators and consultants to acquire and master. Here, from our experience are seven tips that coaches will find useful as they embark on the coaching journey...
1. Surrender control
Control is an illusion...especially when it involves people. At the end of the day, coaching or educating is about giving up your own agenda to explore the other persons agenda.
2. Guide without steering
People very often know where they want to end up...your challenge is to help them create a map to get there. Remember that '7 Roads Lead to Rome' and although some roads may not suit you personally, the person you are coaching may have a real and compelling need to explore them...even without you.
3. Promote self awareness and responsibility
Our personal beliefs and values impinge on every decision, every interpretation, every action we take. Exploring these beliefs and values is a critical part of the learning process. Taking personal responsibility for these beliefs and values liberates us to be more accepting of others, and unlock our true potential for learning. When we accept others, we become masters of our learning, and therefore more effective coaches of others.
4. Don't try to be the expert
Many educators, coaches, trainers, and leaders have a need to be seen and valued as an 'expert'...we need to avoid this temptation. In the knowledge economy, no one person can be the oracle. Instead, be the channel by which the person being coached taps into the knowledge of others. By using this approach, you will help the person being coached to avoid falling into the trap of viewing themselves or others as 'all knowledgeable'.
5. Encourage relentless inquiry
Guide the person being coached in how to challenge the 'experts'...help them develop a straighforward line of inquiry, that suits their personality and respects others. Provide feedback to them on the degree to which they show they can balance advocacy with inquiry.
6. Challenge assumptions
We all hold assumptions about life. We form new assumptions every day. There is nothing wromg about having or making assumptions...they promote learning. The problem is when we hold untested assumptions, and proclaim them as the truth...this introduces our own personal biases into the discussion. When working as a coach, we need to hold our assumptions up to the harsh light of reality...we need to challenge our own assumptions. Only then can we challenge the assumptions of others, including those we coach.
7. Encourage open-mindedness
Coaching is a tricky business. We all want to see results quickly. But those being coached will learn at their own pace...be patient with them. The rewards and joys of coaching are that you have the opportunity to simultaneously expand your own thinking while contributing to the expanded thinking of those you are coaching.
1. Surrender control
Control is an illusion...especially when it involves people. At the end of the day, coaching or educating is about giving up your own agenda to explore the other persons agenda.
2. Guide without steering
People very often know where they want to end up...your challenge is to help them create a map to get there. Remember that '7 Roads Lead to Rome' and although some roads may not suit you personally, the person you are coaching may have a real and compelling need to explore them...even without you.
3. Promote self awareness and responsibility
Our personal beliefs and values impinge on every decision, every interpretation, every action we take. Exploring these beliefs and values is a critical part of the learning process. Taking personal responsibility for these beliefs and values liberates us to be more accepting of others, and unlock our true potential for learning. When we accept others, we become masters of our learning, and therefore more effective coaches of others.
4. Don't try to be the expert
Many educators, coaches, trainers, and leaders have a need to be seen and valued as an 'expert'...we need to avoid this temptation. In the knowledge economy, no one person can be the oracle. Instead, be the channel by which the person being coached taps into the knowledge of others. By using this approach, you will help the person being coached to avoid falling into the trap of viewing themselves or others as 'all knowledgeable'.
5. Encourage relentless inquiry
Guide the person being coached in how to challenge the 'experts'...help them develop a straighforward line of inquiry, that suits their personality and respects others. Provide feedback to them on the degree to which they show they can balance advocacy with inquiry.
6. Challenge assumptions
We all hold assumptions about life. We form new assumptions every day. There is nothing wromg about having or making assumptions...they promote learning. The problem is when we hold untested assumptions, and proclaim them as the truth...this introduces our own personal biases into the discussion. When working as a coach, we need to hold our assumptions up to the harsh light of reality...we need to challenge our own assumptions. Only then can we challenge the assumptions of others, including those we coach.
7. Encourage open-mindedness
'The greater the ignorance, the greater the dogmatism'. (Sir William Osler, 1849-1919).When you feel the need to be dogmatic about something, then perhaps it's time to open up your mind to other fields of knowledge. Expanding your mind in this way creates new horizons, and with it, new possibilities. When we help others to do likewise, we accompany them on this journey...and in the process create multiple streams of open-minded consciousness. This is where the secret, and joy, of lifetime learning resides. Where wisdom begins.
Coaching is a tricky business. We all want to see results quickly. But those being coached will learn at their own pace...be patient with them. The rewards and joys of coaching are that you have the opportunity to simultaneously expand your own thinking while contributing to the expanded thinking of those you are coaching.
'Discovery consists of seeing what everybody has seen and thinking what nobody has thought'
- Albert von Szent-Gyorgyi (1893-1986).
The Demise of Quality
Is quality dead? The early 1980’s heralded the resurgence of quality as a survival issue in the manufacturing sector, primarily automotive. Later in the same decade saw the emergence of continuous quality improvement (CQI) in other sectors, most notably healthcare.
But quality advocates have fallen on hard times. Even the much-hyped six sigma, brought to the attention of the corporate world by Motorola, and later successfully implemented by GE, has not done a whole lot to revive the movement. Skeptics abound, and with good reason.
One notable proponent of quality recently reported that quality improvement has fallen out of favor amongst senior leaders as a strategic issue, noting that many leaders have grown weary of the movement, and are rejecting many of it’s mantras. It seems that quality improvement has lost its luster…and is struggling very hard to regain it.
I believe there are many reasons why this has happened, but I would like to focus on two major ones:
Reason #1: Pay for performance
Back in 1982 W. Edwards Deming stated “The pay and privilege of the captains of industry are now so closely linked to the quarterly dividend that they may find it personally unrewarding to do what is right for the company” (Deming; chapter 4, Out of The Crisis; MIT).
Has anything changed since then?
Twenty years later we witness the meltdown of Enron, the bankruptcy of WorldCom and the scandal at Tyco, all for the same reason...short-sighted greed. Leaders having your cake and trying to eat it too.
But the problem goes beyond these much publicized scandals. Many other sectors, including healthcare and government, have adopted the same short-sighted ‘pay for performance’ practices that have put their industrial and high-tech counterparts at such great risk.
The lesson is, if you want long-term performance, do not recruit, promote or reward based solely on ability to produce short-term results. Yet most of our governance models are based on short-term performance, which leads to dysfunctional behavior in organizations.
If you don’t believe me, simply witness the amount of initial interest in the reengineering movement…the promise held out was that if you take a blank sheet and quickly redesign your major business processes, you will blow away the old and come up with a dramatically more efficient and effective way of doing business.
Makes sense, doesn’t it?
With reengineering, quick and dramatic change was the order of the day…and the rewards would quickly follow. All of this resulted in more short term thinking, but this time results would be measurable, quick to show and above all, massive.
And if you kept feeding the reengineering beast, it might not bite you.
Reengineering then was hailed as a new way of life, the new paradigm for continuously improving organizational performance, on a massive rather than incremental scale.
Seventy percent of reengineering efforts failed, according to those who led the movement.
Why?
Mainly, they claim, because management used reengineering as a tool for downsizing…and after one round of such ‘reengineering’, guess how many people will voluntarily and passionately sign-up for the next round? So like all change programs that work against the interests of those it claims to work for, it will grind to a halt. And in many sectors it has done just that.
You see, the old way of thinking and acting takes much, much longer to blow away…and when the reengineering approach works to force change in the old paradigm, it instills fear and eventually struggles to survive. The old paradigm instead survives.
All of this is so obvious, yet ignored by managers who only manage for the short term and for the personal rewards that go with it.
Now I know the argument for ‘pay for performance’. It goes that if you don’t reward these managers, often and in large chunks, you will lose them, supposedly to the competition. Think that last comment through…if these managers are incapable of building long-term success and prosperity for their organizations, while managing the short-term, then why not let the competition have them? They could do so much damage…they could be your greatest competitive advantage!
Think of the present models of pay for performance as being likened to feeding fish to a performing seal…the seal becomes conditioned to short term behavior. If it performs a specific trick, according to a given command, at a certain point in time, it gets fed. If not, it goes hungry. Simple Pavlovian, stimulus and response, conditioning logic…but is it one that we want to apply to people, especially our leaders? I think not. Yet why do we do it?
Reward people for building an organizations capacity to prosper and outlive other organizations, to reinvent itself, in a humane way, when it needs to (and not every other week), and to survive in the short-term. But don’t hold it out as a way to ‘motivate’ others. If you do, you will end up with a performing seal. (By the way, the older seals eventually learn ways to outsmart their trainers).
Instead, find out what a prime motivators of human behavior are, beyond money and perks, especially the intrinsic ones. Most studies have shown that money is far down the list for most people when asked what motivates them. It just so happens that it is extrinsic, tangible and convenient, and because of that it gets more attention. As alternatives, how about pride in work? How about making a real and lasting difference in people's lives? How about creating joy, prosperity and peace for others? Now that's worth rewarding! But, of course it takes real leadership to create a culture that does that.
Reason #2: Manufacturing logic in service businesses
Healthcare is a prime example of how one industry managed to get quality wrong. In the late 1980’s, continuous quality improvement (CQI) was hailed as the savior of healthcare. And it didn’t seem to matter which country you lived in. The same movement took hold in Canada and the UK as in the United States. The reason for such fervor is obvious…who in their right minds would argue against ‘quality’ in human services?
But the movement struggled to find its place. Finger pointing (especially against healthcare professional and doctors) took the place of consensus building. The main problem seems to stem from the fact that the healthcare system adopted (adapted?) the CQI logic from the manufacturing sector.
To get a better grasp of this, picture the following:
In the manufacturing sector, typically the continuous improvement process was targeted at an organizations mission critical processes. For example in the automotive sector, organizations such as Toyota positioned CQI as their system of DAILY Management of their manufacturing processes.
The reason is simple.
In a high volume, repetitive (aka standardized) process, the gains to be made from taking a disciplined, fact-based approach to managing (aka controlling and improving) mission critical processes on a daily basis can be immense. Over a very short period of time, teams on the shop floor can actually see improvements in quality, cost and productivity using data, and management can quickly translate that into more customers, more market share, lower costs…you get the picture.
They could PROVE that they were IMPROVING in ways that mattered to the long-term success of the business.
Back to healthcare. When CQI was first introduced, the argument against DAILY management, of the likes that worked in manufacturing, were that curing illness, disease, and injury takes longer and has so many variables attached to it, many of which are outside the control or even the influence of the healthcare practitioner or organization, that a manufacturing approach simply wouldn’t work.
So, the CQI movement in many cases defaulted to finding non-clinical (aka non-mission critical) processes to work on, just to prove the point.
So, wait times, billing, registration processes (some hospitals even benchmarked against hotels), food services and countless other peripheral processes got attention. Some improvements were reported.
But the healthcare professionals/medical folks were not impressed, and avoided spending too much time on these activities. They knew that in many cases healthcare was as much an art as a science, and they rejected a purely data driven approach to improving healthcare. They also knew that the type of studies needed to scientifically PROVE the merit of new or IMPROVED healthcare processes and medical procedures were long cycle in nature, (people and diseases come in all shapes and sizes…what works for one today may not work for another tomorrow) and that a DAILY management approach was simply inconsistent with this belief.
What about other types off service businesses? On a broader scale, in services, there were other differences discovered in implementing CQI, most notably:
Don’t get me wrong. It is possible to introduce many of the data driven quality improvement tools, including six sigma into services. But ONLY in areas where there is a highly repetitive, high transaction level, that does not require much, if any, individual customization.
Parting advice...
Pay for Performance
Deming was fond of saying “In god we trust…all others bring data’, but did you know he also said ‘Data will provide you with about three percent of what you really need to know’? What implications does this have for pay for performance systems…you are using valid and reliable data to measure and reward individual contributions to short and long term corporate performance, aren’t you?
If not, and I suspect that you aren’t, you should rethink your approach to paying for performance improvement…it’s probably based on a faulty premise concerning human behavior, the type that drove Enron, WorldCom, Tyco and others into the ground.
Manufacturing Logic in service industries
Many tools, other than the data driven ones, including ones for planning and creativity, are available, but seem to get very little attention. Help your people go beyond the data driven manufacturing logic and employ these other tools also, and you will unleash tremendous creativity…creating higher and higher levels of customer satisfaction.
Who knows, you may just turn out to be the next quality guru!
But quality advocates have fallen on hard times. Even the much-hyped six sigma, brought to the attention of the corporate world by Motorola, and later successfully implemented by GE, has not done a whole lot to revive the movement. Skeptics abound, and with good reason.
One notable proponent of quality recently reported that quality improvement has fallen out of favor amongst senior leaders as a strategic issue, noting that many leaders have grown weary of the movement, and are rejecting many of it’s mantras. It seems that quality improvement has lost its luster…and is struggling very hard to regain it.
I believe there are many reasons why this has happened, but I would like to focus on two major ones:
- Governance models incorporating pay for performance drive short-term thinking and behaviors, which work against quality
- Rigid adherence to manufacturing logic is an inappropriate strategy for improving quality in the service sector, and even for services in the manufacturing sector
Reason #1: Pay for performance
Back in 1982 W. Edwards Deming stated “The pay and privilege of the captains of industry are now so closely linked to the quarterly dividend that they may find it personally unrewarding to do what is right for the company” (Deming; chapter 4, Out of The Crisis; MIT).
Has anything changed since then?
Twenty years later we witness the meltdown of Enron, the bankruptcy of WorldCom and the scandal at Tyco, all for the same reason...short-sighted greed. Leaders having your cake and trying to eat it too.
But the problem goes beyond these much publicized scandals. Many other sectors, including healthcare and government, have adopted the same short-sighted ‘pay for performance’ practices that have put their industrial and high-tech counterparts at such great risk.
The lesson is, if you want long-term performance, do not recruit, promote or reward based solely on ability to produce short-term results. Yet most of our governance models are based on short-term performance, which leads to dysfunctional behavior in organizations.
If you don’t believe me, simply witness the amount of initial interest in the reengineering movement…the promise held out was that if you take a blank sheet and quickly redesign your major business processes, you will blow away the old and come up with a dramatically more efficient and effective way of doing business.
Makes sense, doesn’t it?
With reengineering, quick and dramatic change was the order of the day…and the rewards would quickly follow. All of this resulted in more short term thinking, but this time results would be measurable, quick to show and above all, massive.
And if you kept feeding the reengineering beast, it might not bite you.
Reengineering then was hailed as a new way of life, the new paradigm for continuously improving organizational performance, on a massive rather than incremental scale.
Seventy percent of reengineering efforts failed, according to those who led the movement.
Why?
Mainly, they claim, because management used reengineering as a tool for downsizing…and after one round of such ‘reengineering’, guess how many people will voluntarily and passionately sign-up for the next round? So like all change programs that work against the interests of those it claims to work for, it will grind to a halt. And in many sectors it has done just that.
You see, the old way of thinking and acting takes much, much longer to blow away…and when the reengineering approach works to force change in the old paradigm, it instills fear and eventually struggles to survive. The old paradigm instead survives.
All of this is so obvious, yet ignored by managers who only manage for the short term and for the personal rewards that go with it.
Now I know the argument for ‘pay for performance’. It goes that if you don’t reward these managers, often and in large chunks, you will lose them, supposedly to the competition. Think that last comment through…if these managers are incapable of building long-term success and prosperity for their organizations, while managing the short-term, then why not let the competition have them? They could do so much damage…they could be your greatest competitive advantage!
Think of the present models of pay for performance as being likened to feeding fish to a performing seal…the seal becomes conditioned to short term behavior. If it performs a specific trick, according to a given command, at a certain point in time, it gets fed. If not, it goes hungry. Simple Pavlovian, stimulus and response, conditioning logic…but is it one that we want to apply to people, especially our leaders? I think not. Yet why do we do it?
Reward people for building an organizations capacity to prosper and outlive other organizations, to reinvent itself, in a humane way, when it needs to (and not every other week), and to survive in the short-term. But don’t hold it out as a way to ‘motivate’ others. If you do, you will end up with a performing seal. (By the way, the older seals eventually learn ways to outsmart their trainers).
Instead, find out what a prime motivators of human behavior are, beyond money and perks, especially the intrinsic ones. Most studies have shown that money is far down the list for most people when asked what motivates them. It just so happens that it is extrinsic, tangible and convenient, and because of that it gets more attention. As alternatives, how about pride in work? How about making a real and lasting difference in people's lives? How about creating joy, prosperity and peace for others? Now that's worth rewarding! But, of course it takes real leadership to create a culture that does that.
Reason #2: Manufacturing logic in service businesses
Healthcare is a prime example of how one industry managed to get quality wrong. In the late 1980’s, continuous quality improvement (CQI) was hailed as the savior of healthcare. And it didn’t seem to matter which country you lived in. The same movement took hold in Canada and the UK as in the United States. The reason for such fervor is obvious…who in their right minds would argue against ‘quality’ in human services?
But the movement struggled to find its place. Finger pointing (especially against healthcare professional and doctors) took the place of consensus building. The main problem seems to stem from the fact that the healthcare system adopted (adapted?) the CQI logic from the manufacturing sector.
To get a better grasp of this, picture the following:
In the manufacturing sector, typically the continuous improvement process was targeted at an organizations mission critical processes. For example in the automotive sector, organizations such as Toyota positioned CQI as their system of DAILY Management of their manufacturing processes.
The reason is simple.
In a high volume, repetitive (aka standardized) process, the gains to be made from taking a disciplined, fact-based approach to managing (aka controlling and improving) mission critical processes on a daily basis can be immense. Over a very short period of time, teams on the shop floor can actually see improvements in quality, cost and productivity using data, and management can quickly translate that into more customers, more market share, lower costs…you get the picture.
They could PROVE that they were IMPROVING in ways that mattered to the long-term success of the business.
Back to healthcare. When CQI was first introduced, the argument against DAILY management, of the likes that worked in manufacturing, were that curing illness, disease, and injury takes longer and has so many variables attached to it, many of which are outside the control or even the influence of the healthcare practitioner or organization, that a manufacturing approach simply wouldn’t work.
So, the CQI movement in many cases defaulted to finding non-clinical (aka non-mission critical) processes to work on, just to prove the point.
So, wait times, billing, registration processes (some hospitals even benchmarked against hotels), food services and countless other peripheral processes got attention. Some improvements were reported.
But the healthcare professionals/medical folks were not impressed, and avoided spending too much time on these activities. They knew that in many cases healthcare was as much an art as a science, and they rejected a purely data driven approach to improving healthcare. They also knew that the type of studies needed to scientifically PROVE the merit of new or IMPROVED healthcare processes and medical procedures were long cycle in nature, (people and diseases come in all shapes and sizes…what works for one today may not work for another tomorrow) and that a DAILY management approach was simply inconsistent with this belief.
What about other types off service businesses? On a broader scale, in services, there were other differences discovered in implementing CQI, most notably:
- Services are very often performed in the presence of the customer, and need to be customized as they are performed, based on the customer’s preferences. You get one chance ‘to do it right” in front of the customer. This is so much different than in manufacturing, where standardized processes are performed out of sight of the customer. Doing it right the second time will cost you more, but it’s unlikely the customer will ever know.
- In manufacturing, the product is a widget, the production of which can be defined, measured, controlled and improved. In pure service industries, no matter the setting, the product is a human performance, which is so much more difficult to define, measure, control and improve. Us humans like variety, which is the antithesis of the manufacturing logic.
Don’t get me wrong. It is possible to introduce many of the data driven quality improvement tools, including six sigma into services. But ONLY in areas where there is a highly repetitive, high transaction level, that does not require much, if any, individual customization.
Parting advice...
Pay for Performance
Deming was fond of saying “In god we trust…all others bring data’, but did you know he also said ‘Data will provide you with about three percent of what you really need to know’? What implications does this have for pay for performance systems…you are using valid and reliable data to measure and reward individual contributions to short and long term corporate performance, aren’t you?
If not, and I suspect that you aren’t, you should rethink your approach to paying for performance improvement…it’s probably based on a faulty premise concerning human behavior, the type that drove Enron, WorldCom, Tyco and others into the ground.
Manufacturing Logic in service industries
Many tools, other than the data driven ones, including ones for planning and creativity, are available, but seem to get very little attention. Help your people go beyond the data driven manufacturing logic and employ these other tools also, and you will unleash tremendous creativity…creating higher and higher levels of customer satisfaction.
Who knows, you may just turn out to be the next quality guru!
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