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 countries
  • A significant number of M&A deals here in the U.S. 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, we always keep in mind that just because one EM company may not adhere to our ESG standards, it doesn’t mean another will not; 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 straightforward.

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 recognize 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.

 

In Practice…

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 last 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 and we have seen positive changes in this area.

 

Conclusion

 

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.

This is a financial promotion. Material in this publication is for general information only. The opinions expressed in this document are those of Newton and should not be construed as investment advice or recommendations for any purchase or sale of any specific security or commodity. Certain information contained herein is based on outside sources believed to be reliable, but its accuracy is not guaranteed. You should consult your advisor to determine whether any particular investment strategy is appropriate. This material is for institutional investors only. Any reference to a specific security, country or sector should not be construed as a recommendation to buy or sell this security, country or sector. Please note that strategy holdings and positioning are subject to change without notice. Compared to more established economies, the value of investments in emerging markets may be subject to greater volatility, owing to differences in generally accepted accounting principles or from economic, political instability or less developed market practices. 'Newton' and/or the "Newton Investment Management" brand refers to the following group of affiliated companies: Newton Investment Management Limited, Newton Investment Management (North America) Limited (NIMNA Ltd) and Newton Investment Management (North America) LLC (NIMNA LLC). NIMNA LLC personnel are supervised persons of NIMNA Ltd and NIMNA LLC does not provide investment advice, all of which is conducted by NIMNA Ltd. NIMNA LLC and NIMNA Ltd are the only Newton companies to offer services in the U.S. In the UK, NIMNA Ltd is authorized and regulated by the Financial Conduct Authority in the conduct of investment business and is a wholly owned subsidiary of The Bank of New York Mellon Corporation. Registered in England no. 2675952. NIMNA Ltd is registered as an investment adviser under the Investment Advisers Act of 1940. NIMNA Ltd investment business described in Form ADV, Part 1 and 2, which can be obtained from the SEC.gov website or obtained upon request. Certain information contained herein is based on outside sources believed to be reliable, but their accuracy is not guaranteed. Unless you are notified to the contrary, the products and services mentioned are not insured by the FDIC (or by any governmental entity) and are not guaranteed by or obligations of The Bank of New York or any of its affiliates. The Bank of New York assumes no responsibility for the accuracy or completeness of the above data and disclaims all expressed or implied warranties in connection therewith. © 2006 The Bank of New York Company, Inc. All rights reserved. Personnel of certain of our BNY Mellon affiliates may act as: (i) registered representatives of MBSC Securities Corporation (in its capacity as a registered broker-dealer) to offer securities, (ii) officers of the Bank of New York Mellon (a New York chartered bank) to offer bank-maintained collective investment funds and (iii) associated persons of MBSC Securities Corporation (in its capacity as a registered investment adviser) to offer separately managed accounts managed by BNY Mellon Investment Management firms.

Important information

This is a financial promotion. Material in this publication is for general information only. The opinions expressed in this document are those of Newton and should not be construed as investment advice or recommendations for any purchase or sale of any specific security or commodity. Certain information contained herein is based on outside sources believed to be reliable, but its accuracy is not guaranteed. You should consult your advisor to determine whether any particular investment strategy is appropriate. This material is for institutional investors only.

‘Newton’ and/or the “Newton Investment Management” brand refers to the following group of affiliated companies: Newton Investment Management Limited and Newton Investment Management (North America) Limited (NIMNA Ltd). In the UK, NIMNA Ltd is authorized and regulated by the Financial Conduct Authority in the conduct of investment business and is a wholly owned subsidiary of The Bank of New York Mellon Corporation. Registered in England no. 2675952. NIMNA Ltd is registered with the SEC as an investment adviser under the Investment Advisers Act of 1940. NIMNA Ltd’s investment business is described in Form ADV, Part 1 and 2, which can be obtained from the SEC.gov website or obtained upon request.

Personnel of certain of our BNY Mellon affiliates may act as: (i) registered representatives of BNY Mellon Securities Corporation (in its capacity as a registered broker-dealer) to offer securities, (ii) officers of the Bank of New York Mellon (a New York chartered bank) to offer bank-maintained collective investment funds, and (iii) Associated Persons of BNY Mellon Securities Corporation (in its capacity as a registered investment adviser) to offer separately managed accounts managed by BNY Mellon Investment Management firms, including NIMNA Ltd.

Certain information contained herein is based on outside sources believed to be reliable, but their accuracy is not guaranteed. Unless you are notified to the contrary, the products and services mentioned are not insured by the FDIC (or by any governmental entity) and are not guaranteed by or obligations of The Bank of New York or any of its affiliates. The Bank of New York assumes no responsibility for the accuracy or completeness of the above data and disclaims all expressed or implied warranties in connection therewith. © 2006 The Bank of New York Company, Inc. All rights reserved.

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