August, 2015 Print
Matthew Vaight, Global Emerging Markets Fund Manager, M&G Investments.
Corporate governance is an important factor to consider when investing in emerging markets. Matthew Vaight of M&G Investments examines the issues involved
Emerging markets have risen in prominence over the past few years as they have become ever more integrated into the global economy. However, investors’ optimism over the economic transformation is often tempered by their concerns regarding the corporate governance practices of companies in these markets.
Setting aside the fact that developed markets are not free from scandal, in our opinion, there is a positive trend taking place in emerging market companies. 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 assessing how firms are managed and allocate capital 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 use capital efficiently to create value for all their shareholders.
Controlling shareholders and the challenges they present
One of the principal challenges for emerging market investors is the influence of controlling shareholders such as the state or founding families. State-owned enterprises (SOE) in which the government retains a majority stake and exercises effective control are prevalent in emerging markets. In Brazil, China and Russia, for example, the state controls a large number of firms, enabling it to appoint personnel and direct corporate strategy. Concentrated equity ownership gives the largest shareholders substantial discretionary power to use the firm’s resources for their own objectives at the expense of other shareholders.
In many instances, SOEs are not necessarily run profitably or for the purpose of wealth maximisation. Instead, they focus on social benefits, such as providing employment, or exist to control 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 the government’s economic objectives. This raises doubts about whether the management team is actually in control of the banks’ activities and is adopting the best strategies to generate returns for its investors.
State involvement can create a conflict of interest between the state as 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 as minority shareholders are likely to be drowned out by a powerful majority shareholder.
Not all emerging markets are the same
The emerging markets universe is huge. It is also heterogeneous and there are big differences in corporate governance standards across regions and countries. For instance, in our opinion, South Africa has numerous businesses with 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 in markets 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, use capital efficiently and are focused on delivering returns to all their shareholders.
Conversely, there are markets where shareholders’ interests are often overlooked. South Korea’s economy is dominated by family-owned conglomerates, known as chaebol. These complex, inter-linked businesses tend to focus on growth rather than generating returns for minority investors. There is also no meaningful dividend culture in South Korea, which suggests that returning cash to shareholders is not a high priority for these businesses.
Given the diverse range of companies in emerging markets, an active approach that focuses on how firms are run can help identify the most promising investments.
Improving governance practices
Broadly speaking, in recent years, there have been steady improvements in corporate governance practices. As emerging market firms become more global, company management teams have become more professional and increasingly benchmark their businesses against global peers rather than just domestic competition. In terms of personnel, the presence of greater diversity and experience among senior management teams undoubtedly helps them to operate in a global marketplace. There is a greater focus on shareholder alignment, for example, through remuneration packages and the adoption of long-term incentive plans and rewards, based on profitability rather than growth.
The professionalisation of emerging market companies has been supported by increasing numbers of international investors that demand greater transparency and accountability, encouraging companies to adopt more shareholder-oriented practices. One area where investors have advocated change is South Korea’s low level of dividend payouts. There have been calls for successful Korean companies to return more cash to shareholders. This is starting slowly to deliver results, although there is a long way to go.
Brazil’s Novo Mercado
The advent of the Novo Mercado in Brazil is another 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.
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. In our view, it is essential that investors know that the firm they are considering investing in is run in the right way and the interests of company management are aligned with those of their investors. Investors should be able to trust the companies they invest in to use their capital efficiently and create value for all its shareholders.
In assessing corporate governance standards, we recommend investors pay close attention to company management teams because the decisions they make can have a huge influence on future profitability. 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?
- Does the company pay regular dividends?
- 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.
For investment professionals only. Not for onward distribution. No other persons should rely on any information contained within. This Financial Promotion is issued by M&G Securities Limited which is authorised and regulated by the Financial Conduct Authority in the UK and provides investment products. The registered office is Laurence Pountney Hill, London EC4R 0HH. Registered in England No. 90776. AUG 15 / 68229.