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.
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