Originally published by Cuffelinks
Investing in emerging markets is fraught with complex challenges and dealing with them calls for a new approach based on sustainability. Traditional fundamental analysis and quant models have come up short.
Investors encounter three key problems: the negative impact of state-owned enterprises (SOEs); a lack of emphasis on good governance and sustainability; and high fees and index constraints.
1. Alignment of interests by SOEs
State-owned enterprises, which make up about 30% of the emerging markets benchmark, usually have different objectives to minority investors. Investors need to understand whether their interests are aligned because shareholder wealth creation reduces risk and increases returns.
According to a report in The Economist, the SOEs among the world’s top 500 companies lost between 33% and 37% of their value between 2007 and 2014. Global shares rose by 5% over the period. The root of the problem, according to The Economist, is a “huge misallocation of capital.” With little need to meet the expectations of investors, SOEs invested trillions of dollars in non-core businesses that did not pay off. SOEs are also stingy when it comes to paying dividends and many have debt problems.
2. Poor governance and inadequate stewardship
Companies with poor governance and sustainability practices add cost to their operations. As a result, they have less capital for investment and less that can be distributed to shareholders. We believe ESG (Environment, Social and Governance) in emerging markets is under-researched and gives us a competitive advantage that adds value.
The single most important ESG factor is governance. Governance issues include audit quality, compensation policies, board independence, capital discipline, related party transactions, management quality, past violations and controversies involving the company.
There is strong evidence of the positive role governance plays in driving superior financial and market performance, while lowering risk. In 2012, Deutsche Bank (NYSE:DB) compiled research on more than 100 global studies on the merits of ESG. The studies found that companies with high ESG ratings have lower capital costs. The most important factor was governance, with an emphasis on stewardship of capital. Harvard Business School published research in 2015 (Serafein et al) which concluded: “We find that firms with strong ratings on material sustainability issues have better future performance than firms with inferior ratings on the same issues.”
Company sustainability reports and third-party research to assess the transparency and integrity of company disclosures are also important. We place the company’s environmental and social practices in their industry context and seek to identify cases of ‘greenwashing’.
3. Fees and difficulties constructing a good index
Quant funds have yet to make meaningful inroads into ESG investing in emerging markets. The available data sets are relatively immature and there are reliability issues resulting from the wide variability of company reporting. It can be difficult to compare companies on a like-for-like basis. It is expensive to source data in emerging markets which can often be corrupted by companies using ‘greenwashing’ and other techniques to disguise the true nature of their business practices.
There seems to be a price at which an active fundamental investment manager will tolerate certain poor qualities, hiding under the veils of ‘it being discounted into the price’ or ‘growth cures all problems’. There is a tendency to interpret information in a way that confirms already held preconceptions.
Sustainability issues often take a secondary role to price, growth and risk management considerations. Other investment managers look at valuations and short-term earnings expectations, and if they see a good deal they will explain away poor governance practices.
Index management is not a viable solution in emerging markets either, due to two fundamentally disqualifying facts mentioned above: the role of SOEs and the pervasive influence of poorly-governed companies. The inconsistent application of the rule of law across disparate geographies and weak sustainability practices ensure poor long-term returns from many companies represented by the benchmark.