Information economics of capital market and expectation from regulators

Illustration: TBS

Unlike other markets, the capital market is highly sensitive to the contents and speed of information and a large part of capital market efficiency is driven by the content and timing of information set flowing in the market. This means that any specific group of people with an information edge can front-run the market and make the market highly speculative.

Consider some example of how sensitive the capital market is to an apparently normal event; in 2018, Elon Musk, the CEO of Tesla, smoked weeds during a late-night podcast show and the following morning, the price of Tesla went down by nine percent because many investors dumped Tesla stocks thinking that a CEO who takes drugs at the late-night show cannot be trusted with their money.

In the early 2000s, when Steve Job, the then CEO of Apple, was initially diagnosed with cancer, the price of Apple went down by more than 10 percent. Then during the earnings release conference call, when Steve Jobs, instead of presenting himself, allowed his CFO to make the presentation, the price went down by more than six percent. The market thought that as Steve is not presenting himself, he must be sick and without his brain at full capacity, the prospect of Apple would not be as good as it was.

Let's consider the information economics of the capital market in Bangladesh. If anyone considers investing in the stock market, at the minimum he wants to know what happened in the capital market in the last 20-30 years; the average annual return, risk, change of broad index. Unfortunately even this minimum information is not available in our market.

Because Dhaka Stock Exchange (DSE) used DSE All Share price index to track the performance of the overall market till 2000, then switched to DGEN Index till 2013 and again switched to DSEX since 2013 and methodologies of each of the index is different. More importantly, methodologies were flawed in many respects and the DSE never took the initiatives to retrospectively correct the index. So common investors or even the institutional investors cannot adjust and come up with a single number of performances of our capital market in the last 20-30 years.

In our market, we do not know industry-wise performance indicators of the overall market because we do not have any industry index. Moreover, it is quite common that investors are interested to know how the small-cap stocks performed compared to big-cap stocks, how the value stocks performed compared to large-cap stocks. For capital market research, we often need the return series of individual stocks. As stock price is affected by its cash dividend, stock dividend, right issue, stock split, return should be adjusted to reflect those events.

No institution in the capital market, even the regulators and big merchant banks do not produce that information for public investor consumption. The DSE research wing does provide raw data for return series estimation of individual stocks, but that data provided by the DSE contains lots of errors. So technically, we really do not know detailed market-level information even at the national level. The BSEC might take the initiative to systematically produce this ex-post and ex-ante market information for public consumption, capital market research, and to guide its future policy decisions.

Next, look at the disclosure by the listed company. As per the rules, every listed company is supposed to disclose its quarterly, half-yearly, and yearly disclosure on its websites at least for the last three years. But many companies do not follow this rule, worse even, some companies do not maintain their websites. Many companies even do not publish their report within the time frame set by the regulator.

This lack of timeliness causes the loss of the value of the information content for the general investors and makes the market prone to speculation and front-running. In the USA, all companies upload their every public disclosure on EDGAR log file data set at the SEC website and anyone can download the information about any company from a single site- the SEC website. Our regulator – Bangladesh Securities and Exchange Commission (BSEC) – might pursue a similar approach.

This will ease the searching costs of investors and make the market more efficient and the BSEC can easily find out which company is defaulting on public disclosure automatically. In other countries, following the earnings release, listed companies arrange a conference call with investors and analysts where they explain their realised performance and often give earnings guidance.

This makes perfect sense because as investors, they have put their money in the hands of company management, and they deserve to get an explanation from the company management about any significant change in performance and guidance about the future direction of the company. This will make investors better informed about the company and significantly clear down the rumor about the company, reducing the speculative trade in the market.

This regular meeting between company management and investors will ensure that investors will get informed about the deterioration of company performance in advance and will not be shocked by sudden disclosure that the company is on the verge of bankruptcy. If management people lie during such conference calls, they can be held accountable later.

Now let's look at the mutual fund industry. According to the BSEC rule, all asset managers are supposed to publish their quarterly portfolio statement disclosure on their websites. But many asset managers of listed mutual funds do not upload their portfolio statement regularly and their investor relation department does not bother to the query of the investors.

Moreover, many asset managers invest a substantial amount of their total funds (20% or even more) in non-listed securities and they show these investments under "Others" head with no information about what other investment comprises. Investors have the right to know what comes under the "Others" head because if others include investment in venture capital or start-up or other risky private firms, many investors might change their investment decision.

Many asset management companies advertise their mutual fund performance by benchmarking against the DSEX. But look closely, many funds invest a good portion of their funds in a fixed deposit which means that their fund portfolio comprises both fixed income and equity securities whereas DSEX comprises only equities (ignoring the IBBL Mudaraba Perpetual Bond and APSCL Bond).

As a significant portion of their income is coming from FDR, and DSE during the last few years earned negative returns, so this comparison of their fund performance against the DSEX will give the wrong impression of over-performance by mutual funds over the market return. This false depiction of over performance of mutual funds might lure investors who otherwise might not invest in those funds if they get the real picture.

The BSEC should make sure that mutual funds reasonably describe their portfolio holdings, disclose on time, and do not engage in a comparison of performance against the wrong benchmark that might signal to investors a false sense of over performance. In the primary market, especially for companies floating their stocks under the book-building method, price is determined through electronic bidding where only institutional investors can participate.

However, recent experience with the Walton Hi-Tech Industries showed that the range of the bid price by the institutional investors was weirdly wide (in the case of Walton Hi-Tech Industries, it was between Tk765 and Tk12). This deserves attention from the regulator because the bid price quoted by institutional investors ultimately determines the IPO price that general investors have to pay.

The BSEC can require the institutional investors to publicly disclose their valuation judgment and estimation that they use to offer the price in the electronic bidding. This disclosure requirement might make the institutional investors more responsible in their professional due-diligence which is still lacking even among the big merchant banks in Bangladesh. For example, recently, Energypac Power is floating its shares through book-building methods in which one of the criteria, its issue manager, Lanka Bangla Investment, has used is the average price of similar stocks in the industry.

To my best knowledge, when analysts use price multiple, they relate multiple with some kind of fundamentals such as earnings, book value, and cash flow. Such direct use of the average price of similar stocks is totally inconsistent and irrelevant with the best practice of finance theory. In 2009, when Mobil Jamuna Lubricant Bangladesh (MJLBD) floated IPO, its issue manager used face value multiple, perhaps the worst example of valuation criteria in the entire history of finance. It is hard to believe that how issuers and issue managers can get away with such weird valuation criteria which are even disclosed publicly.

Moreover, the BSEC, in order to make all market participants informed about the daily trading flow, might publish the daily trading activity of different categories of investors. For example, information such as how much of the total daily trade is conducted by institutional investors, how much by individual investors, and so on.

This disclosure will reveal information about who is buying and who is selling and by how much. The market participant especially individual investors might benefit greatly from such informative disclosure. In a developed market like the US or Europe, regulators often invite researchers from renowned universities as a research fellow to research market infrastructure and subtle issues to form and guide their policy decisions.

Almost every rule, both before being enacted and after being implemented, is subjected and tested to rigorous research and assessment so that a particular regulation can best address the conflicting interest of different stakeholders and optimize long term interest of the market. The expectation is that our newly formed regulatory leadership, which has so far done a wonderful job in bringing confidence in the market, will proactively focus on developing market microstructure and formulate its policy decisions guided by rigorous research and long term interest of the capital market in Bangladesh.

Md Sajib Hossain, assistant professor, Department of Finance, University of Dhaka. He can be reached at [email protected]