Putting Governance at the Heart of Emerging Market Investing
Corporate governance improving in emerging markets
Emerging markets are attracting greater attention from investors as they become a more important part of the global economy. However, optimism about the opportunities that economic development could bring is usually accompanied by concerns about the corporate governance standards of companies in those markets.
In our opinion, however, there is a positive trend taking place in emerging markets. At an aggregate level, corporate governance practices are improving, although there is still a disparity between the best and worst companies. As such, we believe analysing corporate governance should be an integral part of the decision-making process when investing in emerging market equities. When engaging with emerging market firms we recommend investors emphasise the importance of better governance, in particular, the need to create value for all their shareholders.
The challenge of controlling shareholders
One of the principal challenges for emerging market investors is the influence of controlling shareholders such as the state or founding families. The chart below shows the percentage of a country’s index that is comprised of state-owned companies.
In Brazil, China and Russia, for example, the state controls a large number of firms, enabling it to appoint personnel and direct corporate strategy. In China, 75% of the stock market by value is made up of state-owned enterprises (SOEs), in which the government retains a majority stake and exercises effective control. Concentrated equity ownership gives the largest shareholders substantial discretionary power to use the firm’s resources for personal, or social, gain at the expense of other shareholders.
In many instances, SOEs are not necessarily run for the purpose of wealth maximisation, but rather for social benefits, such as providing employment, and controlling key industries, like banking or energy. The extent of political interference in Chinese state-owned banks, for instance, is a potential source of concern for investors. The government exerts considerable influence over banks’ lending policies and they are arguably used as an instrument to achieve its economic objectives. This raises doubts about whether the management team is actually in control of the banks’ activities and is able to make decisions in the best interest of all its investors.
State involvement creates a conflict of interest between the controlling shareholder and minority shareholders. Before committing capital to state-controlled firms, we suggest that investors consider carefully whether they will participate in that company’s success as there is a high probability that their voice and interests are likely to be drowned out by a powerful majority shareholder.
Not all emerging markets are the same
Given the size and diversity of the emerging markets universe, it is not surprising that there are big differences in corporate governance standards across regions and countries. In our opinion, South Africa has numerous businesses from banks to retailers that have exceptional operating practices as well as management teams that understand the importance of creating value for their shareholders and generate high returns on capital. It is even possible to find great companies where there is a high degree of state influence. Some SOEs are efficiently run with the state taking a back seat. In Brazil, we have encountered management teams that are transparent, using capital sensibly and are focused on delivering returns to all their shareholders.
Conversely, there are markets such as Korea where companies are often controlled by families. These conglomerates frequently have complex and sprawling organisational structures and can be focused on empire building rather than generating returns for minority investors. There is also no meaningful dividend culture in Korea, which suggests that returning cash to shareholders is not a high priority. In this environment, applying a discerning, active approach can help investors identify companies that are run in the right way.
Governance standards are improving
Broadly speaking, in recent years, there have been steady improvements in corporate governance as company management teams have become more professional and companies are now more global in their operations. This development has been supported by increasing numbers of international investors that demand greater transparency and accountability, encouraging companies to adopt more shareholder-oriented practices.
The advent of the Novo Mercado in Brazil is an example of these improving practices. The Novo Mercado is a listing segment of the Brazilian stock exchange, the BM&F Bovespa, for the trading of shares issued by companies that voluntarily undertake to reach corporate governance standards and transparency requirements over and above those required by law. The ‘good practices of corporate governance’ that the Novo Mercado requires include a minimum 25% free float, annual reporting to international standards (US GAAP or IFRS) and the issuance of common shares.
The basic premise of the Novo Mercado is that the value and liquidity of the shares are positively influenced by the degree of security offered by the rights granted to shareholders and the quality of information provided by the companies. Given that there are now over 100 companies listed on the Novo Mercado, it appears that many companies have seen the virtue of listing on the market in order to attract a more international investor base. Nor has the exchange’s success gone unnoticed – it has been imitated in India, Turkey and the Philippines.
At the company level, we have observed encouraging trends in the way businesses are run. The quality of company management teams is getting better, with an increasing number of international personnel joining emerging market firms, bringing valuable expertise and operational skills. Remuneration packages are a key sign of a management team’s alignment with shareholders’ interests. We are seeing increasing evidence of long-term incentive plans and rewards based on profitability and returns, rather than growth. Firms are also starting to recognise the need to allocate capital efficiently and share their success with investors in the form of dividends.
When assessing the suitability of potential investments, a good starting point is to look for companies that have high governance standards in place. However, investing in companies that are improving their practices could also be a successful long-term strategy. It is generally recognised that better governance can be rewarding for firms, leading potentially to a lower cost of capital, improved company performance and, most importantly, higher share prices. Therefore, investors might want to consider seeking companies with weak policies, but with plans to improve their governance framework.
The importance of trust
The whole premise of equity investing is founded upon the idea that providers of capital receive an adequate return on their investment. For this reason, investors should always take corporate governance into consideration, irrespective of where a company is based. It is essential that investors know that the firm they are considering investing in is run in the right way, with a focus on generating returns for its shareholders. Investors should be able to trust the companies they invest in.
In assessing corporate governance standards, we recommend investors pay close attention to company management teams. The decisions that management make have a huge impact on company performance. Therefore, in order to determine whether they will be good stewards of shareholders’ capital we suggest investors consider the following factors:
Does the firm allocate capital efficiently?
Has the management team delivered a strong record of value creation?
Is management remuneration aligned with shareholder interests?
Does the company have an international board with a broad range of experience?
What is the company’s dividend policy?
Does the company publish regular accounts in accordance with international standards?
These are just a selection of the extensive criteria that investors should look at when investing in emerging markets. The objective is to gain a sense of the company’s ‘culture’ and to discover whether it is focused on creating value for all its shareholders. Given the wide disparity in corporate governance standards within the emerging markets universe, it is essential to examine thoroughly potential investments on a case-by-case basis.
Positive trend creates opportunities
There is definitely a long way to go before we can say corporate governance standards in emerging markets are universally high. However, the positive trend that is taking place in emerging markets today should be a source of great opportunities. As companies improve their standards of corporate governance, they should see a significant increase in their corporate returns, which in turn should create wealth for their shareholders.
This article first appeared in ‘Investing in Emerging Market Equities 2013’ published by Clear Path Analysis. For more information, please visit www.clearpathanalysis.com