VOLUME 22

|
NUMBER 4
|
FALL 2010
APPLI ED CORPORATE FI NANCE
Journal of
A MORGAN S TANL E Y PUBL I CAT I ON
In This Issue: Payout Policy and Communicating with Investors
Financial Planning and Investor Communications at GE
(With a Look at Why We Ended Earnings Guidance)
8 Keith Sherin, General Electric
The Value of Reputation in Corporate Finance and Investment Banking
(and the PeIated PoIes of PeeuIation and Market Efhciency)
18 Jonathan Macey, Yale Law School
Maintaining a Flexible Payout Policy in a Mature Industry:
The Case of Crown Cork and Seal in the Connelly Era
30 James Ang, Florida State University, and
Tom Arnold, C. Mitchell Conover, and Carol Lancaster,
University of Richmond
Is Carl Icahn Good for (Long-Term) Shareholders?
A Case Study in Shareholder Activism
45 Vinod Venkiteshwaran, Texas A&M University-Corpus Christi,
and Subramanian R. Iyer and Ramesh P. Rao,
Oklahoma State University
Drexel University Center for Corporate Governance Roundtable on
Risk Management, Corporate Governance, and the
Search for Long-Term Investors
58 Panelists: Scott Bauguess, U.S. Securities and Exchange
Commission; Jim Dunigan, PNC Asset Management Group;
Damien Park, Hedge Fund Solutions; Patrick McGurn,
Risk Metrics; Don Chew, Morgan Stanley. Moderated by
Ralph Walkling, Drexel University.
Blockholders Are More Common in the United States Than You Might Think
75 Clifford G. Holderness, Boston College
Private Equity in the U.K.: Building a New Future
86 Mike Wright, Center for Management Buy-out Research
and EMLyon, and Andrew Jackson and Steve Frobisher,
PAConsulting Group Limited and Center for Management
Buy-out Research
Should Asset Managers Hedge Their Fees at Risk?
96 Bernd Scherer, EDHEC Business School, London
Measuring Corporate Liquidity Risk
103 Hkan Jankensgrd, Lund University
The Beta Dilemma in Emerging Markets
110 Luis E. Pereiro, Universidad Torcuato Di Tella
110 Journal of Applied Corporate Finance Volume 22 Number 4 A Morgan Stanley Publication Fall 2010
The Beta Dilemma in Emerging Markets
* I would like to thank Aswath Damodaran, Martn Gonzlez-Rozada, Javier Estrada,
Nora Snchez and Gustavo Vulcano for useful comments and suggestions. Luca Freira
provided valuable research assistance. The views expressed below and any errors that
may remain are entirely my own.
1. Sharpe, William F. (1964). Capital Asset PricesA Theory of Market Equilibrium
Under Conditions of Risk. Journal of Finance XIX (3): 42542.
2. For additional examples, see Zenner and Akaydin (2002).
3. Pereiro (2006).
4. Damodaran (2002); Shapiro (2003).
he Capital Asset Pricing Model (CAPM
henceforth) has provided both equity investors
and corporate ocers making direct investment
decisions with a way to estimate present values
and expected returns on investments. e CAPM framework
provides nancial practitioners with a measure of beta (or
systematic risk) for entire stock markets, for industry sub-
sectors, and for individual equities.
Betas represent the way a particular assets returns (or an
industrys returns) co-vary with the returns of a broad market
index. Typically, the beta of a U.S. equity is measured against
changes in the Standard & Poors 500 stock index. Betas
of equities in other countries are usually measured against
changes in local stock market indices.
CAPM can provide a useful estimate of a rms cost of
capital even if that rm does not have publicly traded shares
to provide a measure of risk. Groups of similar rms (perhaps
in the same industry) that do have listed shares can provide a
good proxy for the risk a private rm faces.
When combined with (1) some risk-free rate (usually
assumed to be the yield on the relevant sovereign debt), (2) a
market risk premium (the annualized rate by which local
equity investors have outperformed local debt investors over
long periods of time) and (3) a company-specic leverage
factor, the beta of an equity can tell an investor what rate of
return that investment should achieve.
is same rate should also function as a hurdle rate
corporate decision-makers use to assess the desirability of a
particular direct investment and for someone trying to price
a private asset in an emerging market.
In principle, the CAPM is universally applicable to invest-
ments.
In practice though, decision-makers face at least two
serious predicaments in applying CAPM logic to emerging
market investment assets.
e rst is a data predicamentthat is, relevant local data
may not exist, or it can turn out to be undependable or atypi-
cal. If you try to use a pricing model based on local (domestic)
industry betas, you may nd that some markets simply have
no companies quoting in certain industries, and therefore,
no industry betas will be available at the domestic level.
For example, neither Brazil nor Russia has locally-quoted
biotechnology companies. In other markets, the local price
series available to compute betas are unacceptably short
therefore, betas will be unreliable. In still others, even if you
do nd a reliable industry beta, it may still not fairly reect
the risk of its industry if the sector in question weighs heavily
and disproportionately in the local markets capitalization.
In Argentina, for example, a single industry, oil, accounts
for 40% of total domestic market cap; in South Africa, the
mining sector makes up close to 24% of local market cap;
in Slovenia, the pharmaceutical industry (itself made up of a
single company) represents more than one third of the local
market cap. In such cases, the beta of the sector at the top of
the market cap list is reecting market, rather than industry,
risk, and will not be a fair gauge of the true sectors risk.
To avoid the data predicament, many value appraisers
simply resort to using U.S. betas as surrogates for emerging
market (EM) betas. In Argentina, 67% of nancial advisors
and private equity funds do so when valuing local compa-
nies; only 14% of them apply some kind of corrective process
to U.S. data before computing a domestic cost of capital.
Unfortunately, U.S. beta fans bump on the other side of the
dilemma against an equivalence predicamentnamely, are
local industry betas equivalent across borders?
Intuition suggests they need not be, simply because an
EM industry could well be in a dierent stage of develop-
ment than its U.S. counterpartand thus command a very
dierent level of risk. Demand for, say, soft drinks could be
more sensitive to an economic recession in Latvia than in
the U.S.; the riskand therefore the betaof the soft drink
industry in Latvia should then be larger. Industry betas may
also dier across borders due to dissimilar levels of operating
and nancial leverage. Despite the intuition that cross-border
dierences in domestic betas may exist, we still lack the empir-
ical research needed for verication and, as a consequence, the
by Luis E. Pereiro, Universidad Torcuato Di Tella*
T
111 Journal of Applied Corporate Finance vclume 22 Number 4 A Mcrean Stanley Publicaticn Fall 2010
5. Based on data from Lesmond (2005) and Lesmond, Ogden and Trzcinka (1999).
6. Pereiro (2001a).
7. Computed over 19201996 by Goetzmann and Jorion (1999).
8. The class included, in fact, a mixture of emerging, frontier, and less-developed
stock markets: Argentina, Bahamas, Bahrain, Bangladesh, Bermudas, Bolivia, Botswa-
na, Brazil, Bulgaria, Cayman, Chile, China, Colombia, Costa Rica, Croatia, Cyprus,
Czech Republic, Dominican Republic, Ecuador, Egypt, El Salvador, Estonia, Fiji, Ghana,
Guatemala, Hong Kong, Hungary, India, Indonesia, Iran, Israel, Ivory Coast, Jamaica,
Jordan, Kazakhstan, Kenya, Kuwait, Latvia, Lebanon, Liberia, Lithuania, Malawi, Malay-
sia, Mauritius, Mexico, Morocco, Namibia, Nicaragua, Nigeria, Oman, Pakistan, Pales-
tine, Panama, Paraguay, Peru, Philippines, Poland, Qatar, Romania, Russia, Saudi Ara-
bia, Serbia, Singapore, Slovakia, Slovenia, South Africa, South Korea, Sri Lanka,
Swaziland, Taiwan, Thailand, Trinidad, Tunisia, Turkey, U.A.E., Ukraine, Uruguay, Ven-
ezuela, Vietnam, Zambia, and Zimbabwe. We call the whole class emerging for sim-
plicity.
9. This is the classic Hamadas (1972) formula.
equivalence predicament keeps haunting the analyst.
is article proposes a solution to the beta dilemma. e
data predicament is negotiated rst, by computing domestic
industry betas for a long list of EMs considered as a unique asset
class. e procedure allows us to nd a sizable number of betas
per industry, for a large number of industries, thus automati-
cally diluting the data predicament. We next attend to the
equivalence problem by formally testing whether domestic
EM and U.S. industry betas are fair proxies for each other;
such tests will clearly inform value appraisers on when it is
sensible to assume equivalenceand when it isnt.
Solving the Data Predicament
To calculate the cost of equity of an emerging-market company,
many value appraisers resort to CAPM-based models that
employ domestic industry betas (see Exhibit 1, Panel A for a
brief review). ese models, however, work well only if a local
industry beta is available, is reliable, and is truly representa-
tive of its sector. In many EMs, alas, such betas are simply
not there, and analysts choose to use as a reference the beta of
a dierent emerging market, whose industry plausibly shares
the risk-return pattern of the targets. In many cases, though,
this strategy will still be to no avail: local betas in the alternate
country may still be lacking, undependable, or atypical.
e data predicament can be approached by aggregating
EMs into a single asset class. Such grouping, which allows
for nding a large enough number of valid industry betas, is
predicated on the fact that, in contrast to the U.S., emerging
stock markets share a number of risk-related characteristics:
small absolute and relative size, low liquidity, higher leverage,
heavy concentration, and high volatility. China, nowadays the
center of gravity of Asian markets, represents less than 19%
of U.S. market cap; India, less than 9%; and Brazil, less than
6%. e importance of EMs in their respective economies is
likewise smaller: the median weight of the stock market as a
percentage of GNP is about 40% in EMs; the gure in the
U.S.: 180%. Smallness goes hand in hand with lower liquid-
ity, which in EMs is only one third of the U.S.s. e median
market debt-to-assets ratio is 16.6% in EMs and 15.4% in the
U.S. Add to that concentrationwhich can and often does
lead to price manipulation: the top 10 largest rms in EMs
represent about 56% of total market cap; in the NYSE, the
gure is 23%. Finally, EM returns march alongside large
volatilities: the long-term annual return in the U.S. is 8.1%,
at an annual volatility of 16.2%; the return gure for EMs is
about 9.1% a yearat an annual volatility of 34.8%. Similar
risk features across EMs are so contrasting to those in the
U.S., that we feel justied in grouping EMs into a single,
distinctive asset classwhich is exactly what international
portfolio managers have been doing for years.
To illustrate the aggregation procedure, we dened EMs
as a broad asset class comprising 81 stock markets, and
collected the betas of all their public rms by January 1st,
2010. Betas had been computed by Bloomberg over a 5-year
window by regressing weekly U.S.-dollar based returns on
the most important local index. For the U.S., the original
data came from ValueLine, betas being computed over a
5-year window by regressing weekly returns against the
NYSE Composite Index. We puried the data by eliminat-
ing companies in nancial distress (as signaled by a zero
or negative book value of equity, or by a negative book-
to-equity ratio), and nally screened out companies with
nil or negative betas, which are useless for cost-of-capital
computations.
Observable rm betas reect the current nancial lever-
age of the rms in question, and are therefore nancially
levered betas. From these we cleansed the eect of nancial
leverage by computing unlevered rm betas:
Unlevered Beta = Levered Beta / [1+ (1-T) x D/E] (1)
where T is the corporate tax rate, and D/E is the market-
marked nancial leverage of the rm in question. We are
interested in unlevered betas since these are, for private rms,
the standard starting point in cost-of-capital computations:
the unlevered beta is re-levered with the D/E ratio of the rm
under valuation and introduced into any of the models avail-
able for cost-of-capital calculations.
Going a step further, we computed total rm betas. A
total beta gauges the total risk of a stock (i.e., that stocks
systematic plus unsystematic risks); it is dened as the full
volatility of the stock relative to the markets:
Total Beta= [Standard Deviation of Firms Stock
Returns / Standard Deviation of Markets Returns] (2)
We are interested in total beta because it is a most useful risk
measure for undiversied investorse.g., private-rm owners
whose wealth is concentrated into a single stock and thus bear
the handicap of nil diversication. Also, total beta works well
as a maximum extreme reference for partially diversied inves-
torsi.e., those whose portfolios comprise just a few stocks
112 Journal of Applied Corporate Finance Volume 22 Number 4 A Morgan Stanley Publication Fall 2010
10. The existence cf imperfectly diversied investcrs has been repcrted cn. ma|crity
shareholders in family-owned companies (Moskowitz and Vissing-Jorgensen, 2002);
venture capitalists (Norton and Tenenbaum, 1993; Schertler, 2001); angel investors
(Freear, Sohl and Wetzel, 1997; Pereiro, 2001b); individuals investing in the U.S. stock
market (Blume and Friend, 1975; Lease, Lewellen and Schlarbaum, 1976; Barber and
Odean, 2000; Huberman, 2001; Ivkovic and Weisbenner, 2003); corporate employees
(Benartzi, 2001); and international portfolio managers (Karolyi and Stulz, 2002).
11. Let R
T
= Alpha + Beta. R
M
; where R
T
is the total return of the stock and R
M
the
market return. V(R
T
)= Beta
2
. V(R
M
), where V is the variance. On the other hand, V(R
T
)
can be de-composed in one systematic and one unsystematic risk components, like this:
V(R
T
)= R
2
.V(R
T
) + (1-R
2
). V(R
T
). Using both identities: V (R
T
)= Beta
2
. V(R
M
) = Rho
2
.
V(R
T
), from where V(R
T
) = Beta
2
. V(R
M
)/Rho
2
. Extracting the square root in both terms:
Standard Deviation (R
T
) = (Beta/Rho). Standard Deviation(R
M
). From where the beta of
the total return, or total beta, is (Beta/Rho).
12. Testing for equivalence is akin to testing the difference of medians. The most
powerful difference-of-medians test is Pearsons t-test but, being parametric, it can be
used only if betas are normally distributed in both asset classes. We used the Shapiro-
Wilk (S-W) test to test for such dual normality and applied the t-test only to those indus-
tries in which the ccnditicn veried. (By deniticn, the t-test tests differences between
means, not medians; yet in normally-distributed data, mean and median coincide be-
cause of symmetry, therefore testing means is equivalent to testing medianswhich is
our goal). Where dual normality was not present, we applied a non-parametric testthe
Wald-Wolfovitz (W-W) Runs, a tool that tests not only the location (median) of the distri-
bution but also its shapehence being a very comprehensive test. The choice of the S-W
and W-W tests is predicated on the fact that they work better for small samplesfewer
than 2,000which are the norm in industry beta datasets. A good tip is to use always
exact tests cf sienicance, since these can handle small samples, sparse tables, and
unbalanced designsfeatures that are likely to appear in many an industry.
13. Financial leverage is also a risk component, but we have cleansed its effects from
our data by working with unlevered betas.
and thus bear the handicap of partial, or incomplete, diver-
sication; for these investors, true betas will lie somewhere
between regular and total betas. (Since totally or partially
undiversied investors are legion, analysts have developed
several models to deal with their special diversication status;
some appear in Exhibit 1, Panel A.)
Total betas can be computed from regular betas by using
the following equation:
Total Unlevered Beta = [Unlevered Beta / Rho] (3)
where Rho is the correlation coecient of the stocks return
against the markets. Rho is a simple measure of how
sensitive a particular stocks return is to general economic
conditions, as reected in the stock market.
e next-to-last step was to group betas and total betas
according to industry. Since Bloomberg and Value Line classify
industries dierently, we constructed our own set of catego-
ries by checking out each companys SIC/NAICS number
and, when necessary, resorting to individual company reports,
to properly sort each rm into the right industry.
Finally, we computed industry medians for betas and total
betas. e median is a standard measure of centrality widely
used in corporate valuation because it is impervious to outliers
(in contrast to arithmetic means; outliers frequently crop up
in beta samples). After discarding sectors with fewer than 10
rms, we were left with 66 industries whose betas and total
betas appear in Exhibits 2 and 3, respectively.
Courtesy of the aggregation procedure, the value
appraiser can simply look into our tables to nd a plausible
industry beta for an emerging market. Since our betas have
been computed against local market indexes, they should be
reecting domestic industry risk fairly well, thus being the
perfect t for models that employ local betas.
e aggregation solution works well, of course, only if one
believes that the industry beta of the average EM is a good
match for its analogue in the specic emerging market (say,
Latvia) in which the target company operates. If not, one
may well be facing an industry whose risk-return dynamics
(and beta) are instead akin to those of developed markets; being
the U.S. a good proxy for the latter, in such cases one could
apply, without further regrets, a pricing model that employs
a straight U.S. beta (see Exhibit 1, Panel B, for a brief review
of these models).
Solving the Equivalence Predicament
Another way to solve the data predicament would be to
apply U.S. domestic betas directly to EMs; but this strategy
is fraught with danger because local industry betas may not
be equivalent across asset classes. e last column in Exhibit
2 shows that close to 80% of industry betas are not equiva-
lent across classes. Consequently, we can justify using U.S.
betas as sensible surrogates for domestic EM betas for only a
handful of industries.
Look next at the results reported in the last column
of Exhibit 3: total betas turn out to be signicantly dier-
ent between asset classes for about 30% of the sample. e
overall conclusion is telling: U.S. betas should not be directly
applied to EMs unless cross-border beta equivalence has been
adequately proven in the rst place.
Fickle Risk, Beta Waves
A closer look at Exhibit 2 reveals a striking nd: all industry
betas that are signicantly dierent across classes are smaller
in EMs. In fact, the median of medians in EMs is 0.37less
than half the U.S. norm of 0.84. Since dierences in develop-
ment, or in operating leverage, may produce larger or smaller
betas across asset classes, our consistent nd of smaller betas in
EMs is somewhat troubling. Is there a problem in the data?
e problem is not in the data, but in the fact that
betas and total betas are inter-temporally unstable risk
measuresi.e., they change over time. A stocks risk, as
noted, has several components: the degree of operating
leverage; the potential obsolescence of the product or service
oered; the strength of the competition; the position of
the industry in its life cycle (which aects the sensitivity of
the demand to economic conditions); the vulnerability of
operations to external nancing via credit or equity (in a
dry market, nancing is dicult or impossible); and even
investor sentiment. All these components are bound to vary
as time elapses, and so are risk metricsbetas and total
betas.
113 Journal of Applied Corporate Finance vclume 22 Number 4 A Mcrean Stanley Publicaticn Fall 2010
14. The rst symptcms cf the credit crunch appeared in January/February 2007,
when the ABX index, which tracks credit default-swaps based on bonds backed by sub-
prime mortgages, started deteriorating heavily. The fallout became more evident by April
2007, when New 0entury Financial, the lareest subprime lender in the U.S., led fcr
bankruptcy. January 1, 2007 thus seems to be a sensible pre-crisis comparison point.
How, exactly, have betas been evolving lately? Exhibit
4 lets us peek at the answer: between 2007 and 2010, the
median of medians for U.S. industry betas remained fairly
stable (it climbed slightly from 0.83 to 0.85, but the change
was statistically insignicant); while the median in EMs
dropped sharplyfrom 0.94 to 0.39, a highly signicant
dierence. In other words, EMs became less risky on average
over that period.
Panels B1 and B2 in Exhibit 4 graphically reinforce
our argument: the beta probability distributionor beta
wavestays in about the same place in the U.S., but shifts
dramatically to the left (i.e., to less risky terrain) in EMs. It
is this shift, precisely, that may be accountable for our nding
that all industry betas were, as of the dawn of 2010, smaller in
EMs than in the U.S.
As for total industry betas, some turn out to be larger
in the U.S., and some others dont; but in any case, U.S.
median total beta increased signicantlygoing from 1.66 in
January 2007 to 2.36 in January 2010. In consonance, Panels
B3 and B4 in Exhibit 4 illustrate how the total beta wave in
the U.S. displaces heavily to the right, i.e., to riskier terrain.
e reason behind this shift has almost certainly been the
subprime credit crisis. In stark contrast, the median total
beta for EMs decreased over the same periodshifting signi-
cantly from 2.44 to 2.02.
How come U.S. total beta increased while U.S. beta
remained stable? The answer lies in the evolution of
Rhothe correlation. Recall that beta equals total beta
divided by Rho. Over the time stretch under analysis, U.S.
total beta went up while Rho went downin such a way
that beta was left virtually unscathed. Not in EMs, though:
here, while Rho likewise decreased over time, on balance,
beta decreased signicantly. Now, since Rho went down
in both the U.S. and EMs, it seems that in both asset classes,
the idiosyncratic, or non-diversifiable portion of total
risk prevailed over the market-related portion (i.e., that
measured by beta).
In summary, betas and total betas do change over time
with the gyrations of stock markets, and this warrants a stern
caveat: if we employ the aggregation procedure to solve the
data predicament, we must take the precaution to update our
datasets from time to time.
Asset Pricing with the Beta Solution
e choice of a cost of equity model for an emerging-market
rm is very personal: it depends on how conceptually sound
the model looks to the analyst, and on her view on which risks
canand which cannotbe diversied away by the investor.
e choice done, the analyst faces the challenge of nding a
plausible beta to plug into the selected modeland at this
point is when the solution to the beta dilemma becomes help-
ful (see Exhibit 5).
Those who prefer using local pricing models but are
unable to nd plausible local betas in the emerging market,
can use the industry beta of (a) another EM, suspected to
have a similar risk-return industry dynamics (and, as long as
such beta is available, reliable, and representative); or (b), as
we have argued, the beta of the whole EM class. Relying on
U.S. betas head-on is, we explained, a dangerous approach,
since betas may be signicantly dierent across classes.
If the risk-return dynamics of the industry in the target
EM is suspected to be dierent from that of the EM class as
a whole, why not assume that such market is rather follow-
ing the dynamics of developed markets? Being the U.S. the
epitome of such, using a U.S.-beta-based pricing model will
be a fair strategy to apply in such occasions. All in all, solving
the beta dilemma claries when it is sensible to use a local,
and when a U.S.-based, asset pricing model.

. is Professor of Finance at the Business School, Univer-
sidad Torcuato Di Tella in Buenos Aires, Argentina. He is also the author
of Valuation of Companies in Emerging Markets: A Practical Approach,
John Wiley & Sons (2002).
114 Journal of Applied Corporate Finance Volume 22 Number 4 A Morgan Stanley Publication Fall 2010
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115 Journal of Applied Corporate Finance vclume 22 Number 4 A Mcrean Stanley Publicaticn Fall 2010
Appendix
Model Description
1. Local CAPM (L-CAPM);
adapted from Pereiro (2001a)
C
E
= R
f

US
+ R
C
+ B
LL
. (R
M L
R
f L
)
where C
E
is the cost of equity capital, R
f

US
is the U.S. risk-free rate, R
C
is a country risk premium, B
LL
is the beta of a
comparable local company (or industry) computed against a local (i.e., emerging) market index, and R
M L
the return of the
local stock market. The country risk premium R
C
is usually computed as the spread of dollar-denominated sovereign bonds
cver American T-bcnds cf similar dencminaticn, yield and term. This mcdel ts a partially diversied investcr. the use cf
beta sueeests the investcr is fully diversied at the dcmestic ccmpany (cr industry) level, but unable tc diversify at the
country level.
2. Adjusted Local CAPM (AL-CAPM);
adapted from Pereiro (2001a)
C
E
= R
f

US
+ R
C
+ B
LL
. (R
M L
R
f L
) . (1 - R
2
)
where R
2
may be thought of as the amount of variance in the equity volatility of the target company that is explained by
country risk. This model is an improvement over the Local CAPM, since the last term compensates for the double-counting
of country risk implied in using both R
C
and R
M L
in the same equaticn. Aeain, the mcdel ts a partially diversied investcr.
well-diversied at the lccal rm (cr industry) level, but unable tc diversify at the ccuntry level.
3. Full Risk Adjusted Local CAPM
(FRAL-CAPM)
C
E
= R
f

US
+ R
C
+ BT
LL
. (R
M L
R
f L
) . (1 - R
2
)
where BT
LL
is the total beta of a comparable local company (or industry) computed against a local market index. BT is
computed as the standard deviation of the return of a local comparable company (industry), divided by the standard
deviation of the return of the local market. This model is conceptually equivalent to the AL-CAPM but applies instead to fully
XQGLYHUVLHG investors, since a total beta is used.
4. Full Risk Hybrid Local CAPM
(FRHL-CAPM)
C
E
= R
f

US
+ BT
LL
. (R
M US
R
f US
) . BT
L,US

In this model, country risk is incorporated by calibrating the U.S. market risk premium to the local (emerging) market via
a total country beta, or BT
L,US
, equal to the standard deviation of returns in the local equity market divided by the standard
deviation of returns in the U.S. market. Since the R
C
factor is not used, no correction for risk double-counting is needed.
The model is hybrid in the sense that it combines EM data with U.S. data. Like the FRAL-CAPM, this model applies to fully
undiversied investcrsi.e., tc thcse unable tc diversify ccmpany, industry, and ccuntry risk.
5. Goldman-Sachs (G-S) Model;
adapted from Mariscal and Hargis
(1999)
C
E
= R
f

US
+ R
C
+ B
LL
. (R
M US
R
f US
) . BT
L,US
. (1 R) + R
Id
where RM
US
is the return of the U.S. stock market index, and R is the correlation of dollar returns between the local stock market
and the sovereign bond used to measure country risk. While (1-R) is used to alleviate the problem of double counting country
risk, the problem is not fully solved, since the model also includes BT
L,US
in the same equation. A special feature of the model is
R
Id
, an idicsyncratic risk premium related tc the special features cf the tareet rm (e.e., specic rm credit ratine as embcdied
in its ccrpcrate debt spread, industry cyclicality, percentaee cf revenues ccmine frcm the tareet ccuntry, etc). This mcdel ts a
partially diversied investcr. the use cf B
LL
sueeests the investcr is well diversied at the lccal ccmpany (cr industry) level, but
unable to diversify at the country level.
6. Gamma Model; Damodaran (2002) C
E
= R
f

US
+ R
C
. Gamma + B
LL
. (R
M US
R
f US
)
where 0amma is a rm-specic expcsure tc ccuntry risk raneine frcm zerc tc cne, and B
LL
is the local company beta
computed against a local market index. The exposure factor Gamma could be, for instance, the percentage of revenues to
the parent rm ccmine frcm the lccal (emereine) market. The use cf the R
C
factor suggests, again, that the investor is unable
to diversify country risk; yet the use of B
LL
suggests the investor is able to diversify company (or industry) risk.
Exhibit 1 CAPM-Based Cost of Equity Models Used in Emerging Markets Valuation

Panel A Models Using Local (Domestic) Betas
116 Journal of Applied Corporate Finance Volume 22 Number 4 A Morgan Stanley Publication Fall 2010

Panel B Models Using U.S. Betas
Model Description
7. Lessards Model Lessard (1996) C
E
= R
f

US
+ R
C
+ BC
L,US
. B
US
. (R
M US
R
f US
)
where R
C
is a ccuntry risk premium that includes the chance cf exprcpriatcry acticns, payment difculties
and other risks, BC
L,US
is the country beta (the relative sensitivity of the returns of the local stock market
to the U.S. markets), and B
US
is the beta of a U.S.-based project whose risk pattern is comparable to the
offshore project. The country risk premium can be computed as a sovereign bond yield spread against U.S.
treasuries, as an OPIC insurance premium, or indirectly derived from political risk ratings. The simultaneous
use of R
C
and BC
L,US
without any further correction suggests the model double-counts country risk. The use
cf a U.S. beta sueeests the investcr is well-diversied at the rm (cr industry) level, but unable tc diversify at
the ccuntry level. This mcdel (and all cther mcdels within this panel) implicitly assumes that a U.S. rm (cr
industry) beta is a plausible surrogate for the local EM beta.
8. Adjusted Hybrid CAPM (AH-CAPM)
(adapted from Pereiro, 2001a)
C
E
= R
f

US
+ R
C
+ BC
L,US
. B
US
. (R
M US
R
f US
) . (1 R
2
)
where B
US
is the average unlevered beta of comparable companies quoting in the U.S. market, relevered
with the nancial structure cf the tareet ccmpany, and R
2
is the ccefcient cf determinaticn cf the reeressicn
between the equity volatility of the local market against the variation in country risk. Conceptually similar
to Lessards model, but attempts to correct for the double counting of country risk by including the (1 - R
2
)
factor. R
2
can be thought of as the amount of variance in the volatility of the local equity market that is
explained by ccuntry risk. Like Lessard's, this mcdel applies tc an investcr that is well-diversied at the rm
(or industry) level, but unable to diversify at the country level.
9. Full Risk Hybrid U.S. CAPM (FRHUS-CAPM) C
E
= R
f

US
+ BT
US
. (R
M US
R
f US
) . BT
L,US

This model is identical to the FRHL-CAPM, except that it uses a total U.S. beta instead of a total local beta.
BT
US
is the total beta of a comparable U.S. company (or industry) computed against the U.S. market index. Like
the FRHL-CAPM, this model incorporates country risk by calibrating the U.S. market risk premium to the local
(emerging) market via the total country beta BT
L,US
. In this aspect, the model is similar to the G-S model; but in
contrast, the Rc factor is not used here, and thats why no correction for risk double counting is needed. Like the
FRAL- and FRHL-0APMs, this mcdel applies tc fully undiversied investcrsi.e., tc thcse unable tc diversify
company, industry, and country risks. The model uses a total U.S. beta which, as this article purports, may not
necessarily be a good proxy for its emerging market counterpart.
117 Journal of Applied Corporate Finance vclume 22 Number 4 A Mcrean Stanley Publicaticn Fall 2010
Exhibit 2 Betas: Industry Medians in Emerging Markets and the U.S. Market, 2010

This exhibit shows industry medians of unlevered betas for 66 sectors as of January 1, 2010. Industries with
betas normally distributed in both EM and U.S. data have been tested with the t-test; all others have been tested
with the Wald-Wclfcvitz (W-W) Runs test. Sienicances cf 0.1 cr smaller lead tc re|ect the null hypcthesis that
median betas in EMs and the U.S. are nct statistically different. The median cf medians in EMs, 0.37, is sieni-
cantly different frcm the U.S.'s, 0.84 (W-W statistic. -7.864, sienicance. 0.00).
Unlevered Betas Tests of Normality:
5hapiro-WiIk 5ienihcance
Test of the Difference of Medians:
5ienihcances
Industry N
EM
N
US
Beta
EM
Beta
US
EM
Betas
US
Betas
Both
normal?
t-test W-W Test Medians
different?
Advertising 26 18 0.40 0.90 0.00 0.09 No - 0.01 Yes
Aerospace/Defense 21 51 0.31 0.80 0.01 0.04 No - 0.00 Yes
Air transportation 43 34 0.37 0.53 0.00 0.34 No - 0.50 No
Apparel/Textile 325 37 0.32 0.90 0.00 0.65 No - 0.00 Yes
Auto parts 156 35 0.35 1.05 0.00 0.05 No - 0.00 Yes
Auto/Truck 45 15 0.31 0.73 0.00 0.55 No - 0.01 Yes
Beverages 84 27 0.31 0.58 0.00 0.71 No - 0.02 Yes
Biotechnology 28 54 0.41 0.90 0.12 0.31 Yes 0.00 0.01 Yes
Building materials 97 39 0.29 0.83 0.00 0.27 No - 0.01 Yes
Cable TV/TV/Radio 43 13 0.46 0.66 0.00 0.30 No - 0.78 No
Chemical-Basic 248 13 0.35 1.12 0.00 0.34 No - 0.00 Yes
Chemical-Diversifed 48 25 0.31 0.97 0.00 0.46 No - 0.00 Yes
Chemical-Specialty 171 65 0.37 0.88 0.00 0.81 No - 0.00 Yes
Coal 37 17 0.61 1.33 0.00 0.84 No - 0.05 Yes
Computer-Hardware/Equipment 189 86 0.43 0.94 0.00 0.42 No - 0.00 Yes
Computer-Software/Services 405 228 0.52 0.85 0.00 0.00 No - 0.00 Yes
Construction-Heavy/Engineering 396 12 0.40 1.20 0.00 0.94 No - 0.13 No
Construction-Residential/Commercial 185 25 0.30 0.36 0.00 0.02 No - 0.49 No
Cosmetics/Personal care 25 13 0.39 0.82 0.03 0.19 No - 0.02 Yes
Educational services 18 25 0.31 0.63 0.05 0.04 No - 0.04 No
Electric utility 175 60 0.24 0.44 0.00 0.00 No - 0.00 Yes
Electrical equipment 258 63 0.40 0.95 0.00 0.81 No - 0.00 Yes
Electronics 457 148 0.44 0.89 0.00 0.00 No - 0.00 Yes
Entertainment 48 49 0.36 0.69 0.00 0.36 No - 0.02 Yes
Environmental 39 50 0.58 0.65 0.00 0.13 No - 0.15 No
Financial services-Brokerage/Investment banking 103 22 0.46 0.99 0.00 0.02 No - 0.03 Yes
Financial services-Diversied 83 125 0.28 0.71 0.00 0.03 No - 0.00 Yes
Food-Processing 303 82 0.32 0.61 0.00 0.35 No - 0.08 Yes
Food-Retail/Supermarkets 25 15 0.36 0.59 0.00 0.83 No - 0.02 Yes
Food-Wholesalers 16 13 0.44 0.44 0.12 0.15 Yes 0.82 0.52 No
Furniture/Home decoration 80 28 0.36 0.85 0.00 0.95 No - 0.02 Yes
Hotel/Casino 168 46 0.40 0.82 0.00 0.17 No - 0.07 Yes
118 Journal of Applied Corporate Finance Volume 22 Number 4 A Morgan Stanley Publication Fall 2010
Exhibit 2 continued Unlevered Betas Tests of Normality:
5hapiro-WiIk 5ienihcance
Test of the Difference of Medians:
5ienihcances
Industry N
EM
N
US
Beta
EM
Beta
US
EM
Betas
US
Betas
Both
normal?
t-test W-W Test Medians
different?
Household products 75 20 0.27 0.71 0.00 0.33 No - 0.00 Yes
Industrial services 186 115 0.32 0.72 0.00 0.42 No - 0.00 Yes
Information services 16 19 0.67 0.85 0.67 0.16 Yes 0.22 0.16 No
Internet 89 99 0.66 0.93 0.01 0.05 No - 0.01 Yes
Machinery 278 93 0.39 0.93 0.00 0.16 No - 0.00 Yes
Maritime transportation 118 47 0.33 0.57 0.00 0.06 No - 0.16 No
Medical services 52 102 0.31 0.75 0.01 0.08 No - 0.00 Yes
Medical supplies 48 176 0.48 0.81 0.00 0.00 No - 0.00 Yes
Metal fabricating 45 26 0.31 1.03 0.00 0.29 No - 0.01 Yes
Mining 168 68 0.53 1.16 0.00 0.25 No - 0.00 Yes
Natural gas 47 72 0.40 0.54 0.00 0.02 No - 0.03 Yes
0fce Equipment/Supplies 29 16 0.36 0.77 0.06 0.48 No - 0.00 Yes
0ileld services/equipment 106 93 0.38 1.06 0.00 0.35 No - 0.00 Yes
Oil-Integrated 19 24 0.69 0.98 0.97 0.17 Yes 0.01 0.20 No
Oil-Producing 33 126 0.69 0.98 0.22 0.16 Yes 0.08 0.74 No
Packaging/Container 85 24 0.26 0.76 0.00 0.31 No - 0.00 Yes
Paper/Forest products 104 29 0.32 0.76 0.00 0.29 No - 0.00 Yes
Pharmaceuticals 224 179 0.38 0.85 0.00 0.50 No - 0.00 Yes
Pharmacy services 24 16 0.33 0.71 0.00 0.09 No - 0.00 Yes
Printing/Publishing 66 18 0.33 0.85 0.00 0.83 No - 0.08 Yes
Real Estate-Services/Development 516 13 0.36 0.55 0.00 0.55 No - 0.72 No
Recreation/Leisure time 50 46 0.37 0.72 0.00 0.90 No - 0.00 Yes
Retail Store 184 159 0.42 0.86 0.00 0.00 No - 0.00 Yes
Retail-Automotive 21 14 0.20 0.76 0.02 0.08 No - 0.00 Yes
Retail-Restaurant 32 55 0.46 0.78 0.48 0.33 Yes 0.00 0.10 Yes
Semiconductor 247 98 0.51 1.04 0.00 0.00 No - 0.00 Yes
Semiconductor equipment 87 13 0.49 1.05 0.00 0.41 No - 0.00 Yes
Shoe 22 17 0.51 0.94 0.11 0.98 Yes 0.00 0.78 No
Steel 199 31 0.36 1.10 0.00 0.12 No - 0.00 Yes
Telecom-Equipment 198 81 0.53 0.85 0.00 0.11 No - 0.00 Yes
Telecom-Services 86 87 0.37 0.66 0.00 0.26 No - 0.35 No
Telecom-Wireless/Cellular/Satellite 49 38 0.37 1.00 0.00 0.04 No - 0.00 Yes
Trucking 39 31 0.28 0.85 0.00 0.21 No - 0.01 Yes
Water utility 32 13 0.23 0.49 0.00 0.00 No - 0.01 Yes
Total (66 industries) 7,919 3,591
Minimum 0.20 0.36
Maximum 0.69 1.33
Mean of Medians 0.39 0.82
Median of Medians 0.37 0.84
119 Journal of Applied Corporate Finance vclume 22 Number 4 A Mcrean Stanley Publicaticn Fall 2010
Unlevered Total Betas Tests of Normality:
5hapiro-WiIk 5ienihcance
Test of the Difference of
Medians: 5ienihcances
Industry N
EM
N
US
Total
Beta
EM
Total
Beta
US
EM
Total Betas
US
Total Betas
Both
normal?
W-W Test Medians
different?
Advertising 26 14 2.36 3.25 0.23 0.00 No 0.50 No
Aerospace/Defense 20 45 2.79 2.39 0.00 0.00 No 0.14 No
Air transportation 41 28 1.44 1.89 0.00 0.00 No 0.75 No
Apparel/Textile 291 34 2.34 2.89 0.00 0.00 No 0.40 No
Auto parts 145 28 2.15 2.88 0.00 0.51 No 0.03 Yes
Auto/Truck 41 15 2.59 1.87 0.00 0.15 No 0.51 No
Beverages 75 25 1.82 1.83 0.00 0.00 No 0.17 No
Biotechnology 25 45 2.74 3.53 0.00 0.00 No 0.05 Yes
Building materials 87 32 2.14 2.36 0.00 0.05 No 0.43 No
Cable TV/TV/Radio 40 11 1.96 1.73 0.00 0.07 No 0.30 No
Chemical-Basic 226 12 2.39 3.04 0.00 0.29 No 0.80 No
Chemical-Diversifed 46 23 2.55 2.29 0.03 0.00 No 0.03 Yes
Chemical-Specialty 153 58 2.29 2.46 0.00 0.00 No 0.56 No
Coal 35 16 4.17 2.78 0.00 0.62 No 0.63 No
Computer-Hardware/Equipment 175 79 3.33 3.46 0.00 0.00 No 0.45 No
Computer-Software/Services 372 163 2.66 2.85 0.00 0.00 No 0.55 No
Construction-Heavy/Engineering 362 11 2.14 2.84 0.00 0.53 No 0.73 No
Construction-Residential/Commercial 168 21 2.01 1.34 0.00 0.59 No 0.84 No
Cosmetics/Personal care 24 12 2.09 2.07 0.00 0.00 No 0.50 No
Educational services 15 22 2.35 2.70 0.05 0.77 No 0.21 No
Electric utility 155 59 1.56 0.87 0.00 0.00 No 0.00 Yes
Electrical equipment 238 58 2.63 2.75 0.00 0.00 No 0.34 No
Electronics 430 133 2.96 3.05 0.00 0.00 No 0.31 No
Entertainment 42 39 2.86 2.71 0.00 0.00 No 0.29 No
Environmental 39 37 2.79 2.81 0.00 0.03 No 0.13 Yes
Financial services-Brokerage/Investment banking 94 21 1.87 2.58 0.00 0.00 No 0.09 Yes
Financial services-Diversied 79 103 1.13 2.40 0.00 0.00 No 0.00 Yes
Food-Processing 271 74 1.70 1.79 0.00 0.00 No 0.48 No
Food-Retail/Supermarkets 25 12 1.81 1.70 0.00 0.25 No 0.81 No
Food-Wholesalers 15 13 2.08 1.55 0.05 0.02 No 0.09 Yes
Furniture/Home decoration 71 26 2.37 2.87 0.00 0.00 No 0.49 No
Hotel/Casino 153 41 1.91 2.44 0.00 0.57 No 0.28 No
Household products 66 20 2.17 1.83 0.00 0.05 No 0.42 No
Exhibit 3 Total Betas: Industry Medians in Emerging Markets and the U.S. Market, 2010

This exhibit shows median unlevered total betas for 66 industries as of January 1, 2010. All industries in the
exhibit have non-normally distributed betas in EM, the U.S. or both; and have therefore been tested with the
Wald-Wclfcvitz (W-W) Runs test. Sienicances cf 0.1 cr smaller lead tc re|ect the null hypcthesis that median tctal
betas in EMs and the U.S. are nct statistically different. The median cf medians in EMs, 2.16, is nct sienicantly
different frcm the U.S.'s, 2.45 (W-W statistic. -5.24, sienicance. 0.30).
120 Journal of Applied Corporate Finance Volume 22 Number 4 A Morgan Stanley Publication Fall 2010
Exhibit 3 continued Unlevered Total Betas Tests of Normality:
5hapiro-WiIk 5ienihcance
Test of the Difference of
Medians: 5ienihcances
Industry N
EM
N
US
Total
Beta
EM
Total
Beta
US
EM
Total Betas
US
Total Betas
Both
normal?
W-W Test Medians
different?
Industrial services 169 99 2.12 2.34 0.00 0.00 No 0.22 No
Information services 15 17 1.75 2.18 0.00 0.30 No 0.98 No
Internet 86 80 2.95 3.33 0.00 0.00 No 0.08 Yes
Machinery 251 92 2.42 2.42 0.00 0.00 No 0.46 No
Maritime transportation 112 34 1.72 1.13 0.00 0.00 No 0.49 No
Medical services 49 89 1.45 2.47 0.00 0.00 No 0.01 Yes
Medical supplies 45 157 2.29 2.91 0.00 0.00 No 0.27 No
Metal fabricating 42 20 1.65 2.50 0.00 0.53 No 0.18 No
Mining 156 52 2.78 3.47 0.00 0.00 No 0.01 Yes
Natural gas 48 68 1.28 1.05 0.00 0.00 No 0.40 No
0fce Equipment/Supplies 27 15 2.14 2.27 0.00 0.42 No 0.86 No
0ileld services/equipment 100 83 2.07 2.59 0.00 0.00 No 0.06 Yes
Oil-Integrated 18 24 1.95 2.01 0.04 0.31 No 0.49 No
Oil-Producing 32 93 2.21 2.77 0.00 0.00 No 0.35 No
Packaging/Container 77 20 1.69 1.90 0.00 0.69 No 0.00 Yes
Paper/Forest products 98 26 1.68 1.90 0.00 0.38 No 0.20 No
Pharmaceuticals 199 144 2.25 3.46 0.00 0.00 No 0.74 No
Pharmacy services 20 10 2.27 1.92 0.00 0.02 No 0.36 No
Printing/Publishing 61 16 2.27 2.61 0.00 0.70 No 0.59 No
Real Estate-Services/Development 480 8 2.09 1.55 0.00 0.76 No 0.65 No
Recreation/Leisure time 45 41 2.42 2.17 0.00 0.00 No 0.75 No
Retail Store 169 148 2.07 2.83 0.00 0.00 No 0.29 No
Retail-Automotive 20 14 1.57 1.80 0.00 0.03 No 0.02 Yes
Retail-Restaurant 26 52 2.48 2.44 0.00 0.00 No 0.53 No
Semiconductor 225 86 3.82 3.07 0.00 0.04 No
0.05 Yes
Semiconductor equipment 83 13 2.51 2.62 0.00 0.00 No
0.14 No
Shoe 22 17 1.62 2.52 0.01 0.06 No
0.29 No
Steel 182 27 1.81 2.64 0.00 0.77 No
0.62 No
Telecom-Equipment 191 69 2.74 2.89 0.00 0.00 No
0.09 Yes
Telecom-Services 80 69 1.48 2.04 0.00 0.00 No
0.37 No
Telecom-Wireless/Cellular/Satellite 47 32 1.41 2.79 0.00 0.00 No
0.00 Yes
Trucking 35 30 2.28 2.01 0.00 1.00 No
0.00 Yes
Water utility 29 11 3.21 1.11 0.00 0.00 No
0.28 No
Total (66 industries) 7,284 3,086

Minimum 1.13 0.87

Maximum 4.17 3.53

Mean of Medians 2.22 2.39

Median of Medians 2.16 2.45
121 Journal of Applied Corporate Finance vclume 22 Number 4 A Mcrean Stanley Publicaticn Fall 2010
Exhibit 4 The Evolution of Industry Betas, 20072010

Panel A of this exhibit shows the evolution of the industry medians for three parameters: beta, total beta, and
correlation. Since over time some companies enter stock markets, while others exit them, analyzing all companies
quoting at a given time may yield a distorted view of the parameters evolution. To avoid this survivorship bias, the
parameters have been computed for groups of identical companies within each asset class. The U.S. panel
ccmprised 2,265 rms in 76 industries, the EM panel, 2,765 rms in 74 industries. Differences between
distributicns' medians were tested with the Wald-Wclfcvitz (W-W) test, whereby sienicances cf 0.1 cr smaller
imply that the distributicns' lccaticn and shape are sienicantly different between asset classes. Panel B eraphs
the evolution of beta and total beta waves in each asset class.
W-W Test, 2007 vs. 2010
Jan 2007 Jan 2010 W-W statistic Sienicance
Unlevered Beta U.S. 0.83 0.85 0.977 0.84
(median of medians) EM 0.94 0.39 -9.073 0.00
W-W Test, U.S. vs. EM W-W statistic 0.166 -8.52
Sienicance 0.57 0.00
Unlevered total beta U.S. 1.66 2.36 -1.953 0.03
(median of medians) EM 2.44 2.02 -4.619 0.00
W-W Test, U.S. vs. EM W-W statistic -3.112 -2.456
Sienicance 0.00 0.01
Correlation (Rho) U.S. 0.48 0.36 -4.720 0.00
(median of medians) EM 0.38 0.19 -6.104 0.00
W-W Test, U.S. vs. EM W-W statistic -3.603 -7.045
Sienicance 0.00 0.00
Panel A
0%
5%
10%
15%
20%
25%
0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 1.1 1.2 1.3 1.4 1.5
P
r
o
b
a
b
i
l
i
t
y

P
r
o
b
a
b
i
l
i
t
y

Median Unlevered Beta
B1. U.S. Industry Betas: 2007 (back) vs. 2010 (front)
0%
10%
20%
30%
40%
0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 1.1 1.2 1.3 1.4 1.5 1.6 1.7
P
r
o
b
a
b
i
l
i
t
y

Median Unlevered Beta
B2. EM Industry Betas: 2007 (back) vs. 2010 (front)
0%
10%
20%
30%
40%
50%
0.0 0.3 0.5 0.8 1.0 1.3 1.5 1.8 2.0 2.3 2.5 2.8 3.0 3.3 3.5
P
r
o
b
a
b
i
l
i
t
y

Median Unlevered Total Beta
B4. EM Total Industry Betas: 2007 (back) vs. 2010 (front)
0%
5%
10%
15%
20%
0.0 0.3 0.5 0.8 1.0 1.3 1.5 1.8 2.0 2.3 2.5 2.8 3.0 3.3 3.5
Median Unlevered Total Beta
B3. U.S. Total Industry Betas: 2007 (back) vs. 2010 (front)
Panel B
122 Journal of Applied Corporate Finance Volume 22 Number 4 A Morgan Stanley Publication Fall 2010
Exhibit 5 Choosing an Asset Pricing Model in Emerging Markets (EMs)


Choose a pricing
model
that uses...
...a local EM
industry beta
Is a good
industry beta
available in the EM?
Is the U.S.s
industry dynamics a
good proxy for that
of the EM in question?
Yes:
Use local industry
beta of EM
No:
Is there another
EM with a similar
industry dynamics
and good beta?
No:
Consider using
a pricing model
with a local EM
industry beta
Yes:
Use local industry
beta of EM
Yes:
Use industry
beta of EM class
Yes:
Use U.S. industry
beta
No:
Is the industry
dynamics in the
EM class a good
proxy for that of
the EM
in questions?
No:
Assimilate the
EM to a developed
market and use
a pricing model
with a U.S.
industry beta
...a U.S.
industry beta
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