Foreign Direct Investment (FDI)

Foreign Direct Investment, or FDI, is a type of investment that involves the injection of foreign funds into an enterprise that operates in a different country of origin from the investor.

Investors are granted management and voting rights if the level of ownership is greater than or equal to 10% of ordinary shares. Shares ownership amounting to less that the stated amount is termed portfolio investment and is not categorized as FDI.

This does not include foreign investments in stock markets. Instead, FDI refers more specifically to the investment of foreign assets into domestic goods and services. FDIs are generally favored over equity investments which tend to flow out of an economy at the first sign of trouble which leaves countries more susceptible to shocks in their money markets. 

Classifications of Foreign Direct Investment

Inward FDI and Outward FDI, depending on the direction of flow of money.

Inward FDI occurs when foreign capital is invested in local resources. The factors propelling the growth of inward FDI include tax breaks, low interest rates and grants. Outward FDI, also referred to as "direct investment abroad", is backed by the government against all associated risk.

Determinants of Foreign Direct Investment

One of the most important determinants of foreign direct investment is the size as well as the growth prospects of the economy of the country where the foreign direct investment is being made. It is normally assumed that if the country has a big market, it can grow quickly from an economic point of view and it is concluded that the investors would be able to make the most of their investments in that country.

In case of foreign direct investments that are based on export, the dimensions of the host country are important as there are opportunities for bigger economies of scale, as well as spill-over effects.
The population of a country plays an important role in attracting foreign direct investors to a country. In such cases the investors are lured by the prospects of a huge customer base. Now if the country has a high per capita income or if the citizens have reasonably good spending capabilities then it would offer the foreign direct investors with the scope of excellent performances. 

The status of the human resources in a country is also instrumental in attracting direct investment from overseas. 

There are certain countries like China that have taken an active interest in increasing the quality of their workers. They have made it compulsory for every Chinese citizen to receive at least nine years of education. This has helped in enhancing the standards of the laborers in China.

If a particular country has plenty of natural resources it always finds investors willing to put their money in them. A good example would be Saudi Arabia and other oil rich countries that have had overseas companies investing in them in order to tap the unlimited oil resources at their disposal.

Inexpensive labor force is also an important determinant of attracting foreign direct investment. The BPO revolution, as well as the boom of the Information Technology companies in countries like India has been a proof of the fact that inexpensive labor force has played an important part in attracting overseas direct investment.

Infrastructural factors like the status of telecommunications and railways play an important part in having the foreign direct investors come into a particular country.

It has been observed that if the infrastructural facilities are properly in place in a country then that country receives a substantial amount of foreign direct investment. If a country has extended its arms to overseas investors and is also able to get access to the international markets then it stands a better chance of getting higher amounts of foreign direct investment.

It has been observed in the recent years that a couple of countries have altered their stance vis-a-vis overseas investment. They have reset their economic policies in order to suit the interests of the overseas investors. These companies have increased the transparency of the legal frameworks in place. This has been done so that the overseas companies can understand the implications of their investment in a particular country and take the appropriate decisions.

Chasing Warren Buffett’s Alpha

November 1976 to the end of 2011, Warren Buffett delivered an average annual return of 19% in excess of the Treasury bill rate, as measured by shares of his publicly traded conglomerate, Berkshire Hathaway (BRK.A, BRK.B), versus a 6.1% average excess return for the stock market. In addition, Berkshire's Sharpe ratio — a measure of return per unit of risk — is higher than all U.S. stocks that have been traded for more than 30 years from 1926 to 2011, as well as all U.S. mutual funds in existence for more than three decades.

So how does he do it?

If a newly published paper is any guide, the answer is pretty straightforward. According to "Buffett's Alpha," authored by AQR Capital Management's Andrea Frazzini, David Kabiller, CFA, and Lasse Pedersen, who also teaches finance at the NYU Stern School of Business, Buffett buys low-risk, cheap, and high-quality stocks; he employs modest leverage to magnify returns; and he sticks to his investment discipline even during rough periods in the markets that would force investors with less conviction or capital "into a fire sale or a career shift," as the authors put it.

Previous researchers analyzing Buffett's returns using conventional size, value, and momentum factors haven't been able to adequately explain his outperformance, the authors say, leaving admirers to conclude that Buffett's magic is pure alpha. So they extend the analysis by testing Buffett's impressive returns — as measured by Berkshire's stock — against two factors that better reflect his folksy investing wisdom: One called "Betting Against Beta," which represents safe, low-beta stocks, and another called "Quality Minus Junk," which represents the stocks of high-quality companies that are profitable, growing, and paying dividends.

The results? "Controlling for these factors," the authors write, "drives the alpha of Berkshire's public stock portfolio down to a statistically insignificant annualized 0.1%, meaning that these factors almost completely explain the performance of Buffett's public portfolio." The factors also explain "a large part" of Berkshire's overall stock return, the authors add, as well as Berkshire's private portfolio, insofar as their alphas also become statistically insignificant.

As one commentator put it, "It's some evidence that Buffett is doing what he says he's doing." But the takeaway is more nuanced. Buffett is in fact best known as a value investor par excellence, yet the authors' findings suggest that his focus on safe, quality stocks "may in fact be at least as important" as his value bent in accounting for his consistent outperformance.

One of the most interesting aspects of the paper is its analysis of Buffett's use of leverage. The authors deconstruct Berkshire's balance sheet and find that on average the conglomerate is levered 1.6 to 1, which they describe as "non-trivial" and say at least partly explains why the volatility of its stock is high relative to the market — 24.9% versus 15.8% — despite investing in many relatively stable businesses. Still, they note that leverage alone does not account for Buffett's stellar returns: Applying the same 1.6-to-1 leverage to the market yields an average excess return that is still nine percentage points below Buffett's over the time span studied by the authors.

Of course, cheap financing doesn't hurt. The authors note that Buffett benefited from Berkshire's AAA rating from 1989 to 2009 and that he reaps the benefit of its cheap insurance float, which checks in at an estimated average annual cost of 2.2% — more than 3 percentage points below the average Treasury bill rate. The authors find that 36% of Berkshire's liabilities, on average, consist of insurance float.

The paper also tackles a provocative question: Can Warren Buffett be reverse engineered? The authors take a stab at it by constructing a hypothetical "Buffett-style strategy" that is similarly leveraged and tracks Buffett's market exposure and stock-selection themes — and find that it "performs comparably" to the real Berkshire Hathaway. (In fact, it outperforms, but the authors caution that the simulated strategy does not account for transaction and other costs, and also benefits from hindsight. The main takeaway, they assert, is the high covariation between the actual and simulated Buffett strategies.)

So why don't investors just mirror Buffett's trades? Blame hubris: As detailed in a separate academic paper published a few years ago, between 1980 and 2006 an investor could have achieved investment results similar to Buffett's simply by following his trades as disclosed in public filings — yet the market seemed to under react to such disclosures. The authors of the paper surmise that analysts and fund managers overestimate their own stock-picking skill or the "precision of their independent private information" and underweight the value of public disclosures, even Buffett's.

There is at least one more very practical reason why investing like Buffett is harder than it may seem: Thanks to current U.S. Securities & Exchange Commission disclosure rules, he doesn't always have to tell us what he owns.

Source: http://blogs.cfainstitute.org/