There have been improvements in corporate governance in a number of emerging markets, but it remains a work in progress.
Governance improvements across emerging markets have been uneven. Nonetheless, the overall progress that we have observed in several areas is encouraging.
Accounting standards are a case in point. Local standards have increasingly converged with internationally recognised ones, providing a boost for information quality and transparency. Brazil, for example, is among the emerging markets that have fully adopted the International Accounting Standards Board’s International Financial Reporting Standards.
Regulators have also taken steps to empower minority shareholders by giving them greater say on related-party transactions, for example. In its annual study on the ease of doing business around the world, the World Bank noted that low-income economies have been catching up with their high-income peers when it comes to the transparency of related-party transactions over the last 10 years.
Moreover, we have seen emerging market companies pay greater attention to enhancing shareholder value, whether through dividend increases or share buybacks. And, they are generally in a good position to do so, thanks to surging free cash flows. Investors’ hunt for yield in an environment of low interest rates has turned up the heat on companies to distribute more cash to shareholders.
Critics note that corporate governance reforms in emerging markets have not gone far enough, and they have a point. While some economies have strengthened their public institutions, others seem to have done too little. In the latest Worldwide Governance Indicators study, low-income economies as a group continued to lag high-income markets considerably in terms of regulatory quality.
Previous financial crises have underscored the perils of regulatory slack, especially when it comes to debt monitoring. With emerging markets collectively piling on increasing amounts of foreign-currency debt in recent years, their abilities to service or refinance their borrowings bear close watching.
Meanwhile, minority shareholder protection remains a hot-button issue. We believe that regulators and companies can do more to promote the equitable treatment of minorities in emerging markets, by enhancing disclosures of related-party transactions or requiring shareholder approval for such deals, for example.
Pursuing greater shareholder value: two country case studies
South Korea’s stock market valuation has historically lagged those on average in Asia or the rest of the world. Governance concerns linked to a chaebol-dominated market often shoulder the blame for this “Korea discount”. But the situation could be looking up.
South Korea’s state pension fund and leading institutional investor, National Pension Service (NPS), raised hopes that it would inject governance rigor when it adopted a Stewardship Code in 2018. NPS has since said that it would exercise its voting rights to increase shareholder value. Last year, it voted against - and succeeded in blocking - the re-election of Korean Air’s chairman to the board. NPS also named companies that it thought were underpaying dividends.
NPS’s actions to promote shareholder value could prompt other institutional investors to take up a similar cause, and we expect South Korean companies to share more wealth with investors. They would be building on a positive trend.
We see many undervalued companies in South Korea, and healthier governance could help shrink the “Korea discount”. Companies that have shown progress in recent years include smartphone and semiconductor maker Samsung Electronics. It decided in 2015 to introduce a rolling three-year shareholder return policy that has resulted in higher dividends and share buybacks. It also started quarterly dividend payments in 2017 to provide shareholders with more evenly distributed payouts.
Most investors are unlikely to associate Russia with governance excellence. What often comes to mind is its patchy track record in privatisation, which began in the 1990s before its institutions were ready for a market-based economy. The government has also retained a sizable presence in corporate Russia.
Yet, many Russian companies have taken the initiative to set higher bars for their conduct and promote shareholder value. Some recognised the need to do so to appeal to foreign investors. Those that sought overseas listings adopted international standards.
One company that has sharpened its focus on shareholder value is Lukoil, one of the largest integrated oil and gas groups in Russia. Lukoil stands out to us for its clearly articulated capital allocation framework, which aims to distribute a significant portion of its free cash flow as dividends to shareholders. The company also announced a new share buyback programme, worth up to $3 billion (£2.2 billion) in 2019.
Tailwind for emerging market equities
We believe that improving governance has become a structural theme driving emerging market equities. We also think that active investors are in a favourable position to capture this tailwind. Differences in languages and disclosure rules can hinder information collection. Above all, screens tend to be backward-looking, which means that they are likely to filter out poorly rated companies that are nonetheless ready for change.
We see few substitutes for first-hand, bottom-up research when it comes to assessing corporate conduct. Through local company visits, face-to-face interactions with management and other forms of fieldwork, active investors are more likely to gain a richer understanding of companies’ attitudes to governance and their appetites for reform.
Corporate governance has come a long way in emerging markets, even as unfinished business remains. Individual economies and companies have moved at different speeds in narrowing their governance gaps with their developed market peers, and laggards striving to catch up could give rise to compelling investment opportunities.
Chetan Sehgal is lead portfolio manager and Andrew Ness is portfolio manager at Templeton Emerging Market Trust (TEMIT).
- Please click here to read the first article in this two-part series.