We would like to challenge what seems to be a common view that emerging-market (EM) companies are poorly governed. There are certainly many poorly governed companies in emerging markets, but in our view there are also many excellent companies on which we can focus our attention as active investment managers.
At Newton, we have a risk-adjusted return approach to integrating environmental, social and governance (ESG) analysis into our investment process. We focus on what we consider to be the material ESG risks and opportunities faced by a company, and factor these into our investment expectations and valuation. Should our analysis of a company’s ESG practices warrant sufficient concern, we can demand greater investment scrutiny and, in certain circumstances, obviously avoid the investment outright.
Governance risks are not just attached to EM companies. We all know about some of the poor governance practices and corporate failures in the developed world, including:
- The protectionist measures employed by some European
- A significant number of M&A deals in the US being structured to avoid the need to gain shareholder approval – not to mention shareholder inability to remove directors.
- The low level of independent oversight on some Japanese
In general, it is fair to say that EM countries are more prone than developed-market (DM) countries to macroeconomic risks such as political instability, civil unrest and bribery and corruption. However, once one is comfortable with these macroeconomic factors, we should look at individual companies on their own merits.
When investing in any market, we believe the very British saying of ‘don’t throw the baby out with the bath water’ is highly relevant; companies are not created equal, so they should not necessarily be treated equally – this is the very art of active management.
As investors, we believe gaining a thorough understanding of governance and wider environmental and social matters before committing our clients’ capital is crucial, but it is not necessarily easy or straight forward.
Many EM companies display some common characteristics that may be indicators of being poorly governed. In our experience, it is often the result of the company being fairly young. For such companies, it can be important to focus on:
- The company’s history and track record of value creation (or otherwise!)
- The corporate culture
- The corporate structure
- Historic capital allocation
- The motivations, incentives and ambitions of key individuals and shareholders
- Related party transactions – not all are bad!
- Where the company is placed in terms of minimum governance requirements versus best practice expectations
- Shareholder agreement, if any
- Ownership and control – potential for being disenfranchised
- Willingness to engage – not necessarily for change, but for information
The direction of travel is an important consideration, but we also need a minimum standard of corporate governance to protect our clients’ capital and to ensure wise investment by management teams in value-accretive investments.
Ours is certainly not a tick-box approach to corporate governance – we do not believe that such a formulaic analysis works adequately. At the very least, it would mean steering clear of excellent investment opportunities for misguided reasons.
One common issue in EMs is where there is a dominant company shareholder, such as a founding family, the state or an oligarch. Sometimes, this means minority shareholders can be a lowly consideration, leading to a potential misalignment of interests. We think such companies should be broadly avoided.
However, many others recognise the role of strong corporate governance in value creation and run the businesses in a way that benefits all shareholders equally. These are the ones in which we seek to invest, and we believe this is the advantage of truly active investment management.
Over the years, we have reviewed a number of EM companies that some investors consider to be poorly governed. While in some cases we found that the governance risks were too high, there have been plenty of examples where we have been able to become comfortable with the business.
One example from January this year was a company based in India. Our initial analysis of the firm’s ESG practices was of significant concern, such that the issues dwarfed the attractiveness of the company’s operational activities and its financials. However, after further research, and engaging with the board and management, we concluded that the significant governance discount at which the stock traded was not warranted.
Our investment case was largely based on our expectation of an improving governance profile. Since investing six months ago, the company has been improving its governance profile and the stock has outperformed its global peers by 80% – we don’t think this is a convenient coincidence!
Investors can get easily spooked when they perceive poor governance practices.
We would argue that investors would be better placed by not being too quick to dismiss companies for what appear, at first glance, to be flaws in the underlying company’s approach to governance.
Many companies are open to engaging with investors and happy to take suggestions for improving their ESG profile – those that will not engage may be best avoided!
There is a wide variation in company quality across emerging markets, and we would contend that this variation is wider than in developed markets. As such, we believe this provides even greater scope for an active investor to improve investment return prospects and to reduce risks taken in achieving these returns.