Equity returns and economic freedom.

• Author: Stocker, Marshall L.

We often hear disparaging references to "paper entrepreneurs," with a sort of macho disdain for people who don't "make things" like steel and automobiles. But in an increasingly complex economy, no task is more important than allocating capital to the right projects, and it is entirely appropriate that the market rewards people handsomely for making the right investment decisions.

--David Boaz (1997: 163)

In an environment in which economic freedom varies widely from country to country, investors in global equity markets labor to identify attractive investment opportunities. To better understand the characteristics of such investments, this article first reviews previous research on the relationship between economic freedom and equity markets. Second, a construct is posited relating economic freedom to equity investment returns. Correlation analyses are presented that describe the relationship between observed equity market returns and economic freedom. Results show that the rate of increase in economic freedom is directly related to equity returns and that an investment strategy based on economic freedom earned attractive investment returns. Finally, an investment strategy is proposed for constructing a global investment portfolio based on economic freedom.

Previous Research

Previous research has focused on the relationship between economic freedom and the size of a country's equity market, as measured by total market capitalization as a percentage of gross domestic product. Li (2002) shows that developed countries with greater economic freedom and stronger shareholder protections have larger total equity market capitalizations as a percentage of GDP. In particular, the size of their equity markets is negatively correlated to the size of government, as measured by government consumption as a percentage of GDP. For developing countries, Li finds that openness to trade is conducive to the growth of the equity market.

Other research has shown that the observed size of a county's equity market is associated with institutions similar to those measured by the Fraser Institute's economic freedom of the world (EFW) index. La Porta et. al. (1997) show that the legal environment affects the size and extent of a country's capital markets (size is measured by total market capitalization as a percentage of gross national product, and extent is measured by the number of listed companies and initial public offerings per capita). The reason is simple: Countries with strong legal protections for investors have larger and broader capital markets.

Levine and Zervos (1998) conclude that total stock market capitalization becomes a larger percentage of GDP following capital control liberalization. Perotti and van Oijen (2001) achieve similar findings for privatization in emerging economies by demonstrating that the privatization process reduces political risk, which effects excess stock market returns in emerging economies.

In another study, which is narrowly focused on idiosyncratic events of equity market liberalization, Henry (2000: 553) relies on the international asset pricing model and concludes, "The standard IAPM makes a salient predication about an emerging country that does not allow foreigners to purchase shares in its stock market: The country's aggregate cost of equity capital [i.e., the discount rate] will fall when it opens its stock market to foreign investors ... and we should see an increase in an emerging country's equity price index when the market learns of an impending future stock market liberalization."

Unlike prior research, which examines relative equity market size and investment returns associated with idiosyncratic events, this article examines how broad measures of economic freedom are correlated to cross-country equity market rates of return. The analysis presented establishes a significant direct correlation between the rate of increase in economic freedoms and the rate of contemporaneous equity price index increases.

Effect of Economic Freedom on Equity Valuation

According to the discounted cash flow equity-pricing model, the value of each equity unit to investors is the present value of expected future cash flows:

[PV.sup.F] = [[infinity].summation over t=1] E([FCF.sub.t])/[(1 + [Er.sub.t]).sup.t]

where,

[PV.sup.F] is the estimated present value of the equity unit, E([FCF.sub.t]) is the expected nominal free cash flow from the firm's operations for period t, and

[Er.sub.t] is the expected average cost of capital in...