Wednesday, May 26, 2010

Standard Chartered IDR issue: To apply or not?

I have done a bit of research on the Indian Depository Receipt (IDR) issue of Standard Chartered PLC. My analysis is based on following three high level concepts which need to be looked when we want to decide on an IDR:
  • Business Risk: It refers to the overall expected performance of the firm considering its portfolio composition, geographies of operation and its standalone performance metrics.
  • Systematic Risk: It refers to the correlation of the underlying stock’s performance with that of FTSE. Since the IDR’s value is ‘derived’ from the stock price of Standard Chartered PLC in FTSE, there would be a component of the IDR’s price impacted by the movements in FTSE – which would be captured in the Systematic risk associated.
  • Currency Risk: It refers to the relationship between the underlying stock’s currency and the IDR’s currency. Any big, multinational financial institution will have exposure to multiple currencies and there is an inherent currency risk element which should be analysed at a business-as-usual risk; however, since the investment in IDR is in Indian Rupee while the underlying is GBP, there has to be a considerable amount of analysis to assess the GBP/INR movements
Business Risk
Lots of research articles have come on this; in particular I read and liked the content in the following ones – however, not all of them addressed the systematic and currency risk components of the IDR issue.
The primary areas of focus of these articles have been:
  • the diversification benefits offered to an Indian investor,
  • the geographical coverage of Standard Chartered with presence in some of the faster developing countries. Following is the distribution of operating income across countries

  • Though it is understandable to state India and China (as captured in Other Asia & Pacific) and Korea are among the better placed economies coming out of the financial crisis; more thought and analysis needs to be undertaken before stating the same for Hong Kong and Singapore as both these city-states’ health is, more or less, derived from outside – an effect that can be gauged only after looking into the portfolio composition of Standard Chartered in these countries.
  • lower cost of capital,
  • better risk management system enabling it to be not adversely impacted by the financial crisis,
  • healthy proportion of fee based income contribution (22%) to the total operating income.
Systematic Risk
Though the business of Standard Chartered is more concentrated outside Europe, the current IDR represents 10% of the Standard Chartered stock traded in the London Stock exchange (Link). Through all of finance literature, it is continuously found that a major portion of risk-return profile of a stock is systematic factors – which is linked to the overall market – and the remaining portion of risk-return profile is the stock’s own – a.k.a. unsystematic factors. The unsystematic factors are addressed in the ‘Business Risk’ section as outlined in the previous section. Next the investors have to look into the systematic component of the risk in the Standard Chartered IDR issue.

With FTSE 100 being the major index for Standard Chartered, I computed the beta, using data from beginning of 2003, which came to about 1.46. Statistically speaking, a beta of 1.46 infers a high degree of impact of FTSE 100 is in the price of Standard Chartered. Considering the commotion in the Euro zone with respect to Greece and the fate of Euro as a currency hanging in balance and the obvious correlation of FTSE 100 with rest of Europe, the negative impact of the Greece crisis on FTSE 100 would be much more than that on the Indian indices. Numerically inferring from the beta number, a drop of 10% in FTSE 100 would lead to a drop of 14.6% in the Standard Chartered’s stock. This is a major risk which many articles I have come across have missed.

Currency Risk
By currency risk here, I am not referring to the risk the banks encounter as a result of foreign exchange currency movements of its assets, but to the difference in currency of the underlying stock and the IDR – the former being in GBP while the latter is in INR. This means the returns from the IDR is very much linked to the GBP/INR movements. Any appreciation in the INR value against GBP will adversely affect the returns from the IDR. Consider a simple scenario, say Standard Chartered PLC moves from 1630p today to 1800p in a year’s time – giving an appreciation of 10%, but the INR appreciates from 68 INR/GBP to 60 INR/GBP (an appreciation of 12%), the net return from the IDR would be, approximately, a negative 2%. It is very much open to question whether INR would appreciate so much in the next year, but considering the drop of GBP from 80 INR/GBP to 68 INR/GBP now, such a 12% drop does not seem incredulous. However, it is mandatory that the investors look into this factor as well before their decision on investing in the IDR is taken.

Final Call
Considering the above three broad categories of risk, the investors need to make a holistic view of the IDR in relevance to their respective portfolios and then take the final call on investing in the issue if and only if it serves to mitigate certain specific risk for their portfolio. For an individual investor, I would suggest not to invest in the Standard Chartered IDR, but do so with Indian banks.

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