India Fund

Capturing the Governance Premium in less Developed Markets

Why should investors care about corporate governance? Aren’t stock prices of companies driven by their products, people and market opportunity, which drive their revenue and profitability? Whilst some of these factors are direct relationships to a company’s share prices, each business needs to have the appropriate structure in place for making decisions.The rules, systems, process and policies put in place by the management of a company, under scrutiny of its Board, is nothing but corporate governance!

When performing research on a company, failure to thoroughly understand the efficacy of its corporate governance can be costly to an investor. Determining the calibre of management, it’s Board and the robustness of its governance structure is likely to provide a significant contribution towards the true value of a business relative to its share price. Incentivisation and alignment to success of the management and the Board, is a key driver to whether capital and resources of the business are allocated effectively to maximise shareholder value.

Perception is that corporate governance violations are most frequently found in companies domiciled in emerging or frontier markets. How easy it is to forget that developed markets have had their fair share of corporate governance failures. Remember Worldcom, Enron and Tyco and more recent failures of Lehmann Brothers and Bear Stearns during the global financial crisis which led to systemic concerns for share markets around the world. Yes, it is true that the corporate governance for companies domiciled in emerging markets more often falls short compared to developed markets, however this should not be a surprise. This is part of the reasons as to why these markets may be classified as “emerging” rather than “developed’ What is more important to note, is that there have been substantial improvements over the last 10 years, which has seen the markets and its companies from emerging economies close the gap relative to their developed market counterparts.

India is one such market where significant advancements have been made, especially since the Companies Act of 2013 was passed in legislation. In fact, the corporate governance framework in India is primarily based on the Anglo Saxon model of governance, which adopts the principles from the Cadbury report (UK), The OECD principles of corporate governance and the Sarbanes Oxley Act (US).

Some of the improvements include:

  • Listed companies are required to have at least 50% of the board as independent directors. Furthermore, resolutions in company board meetings need to be ratified by at least one independent director
  • Total tenure of an independent director is not allowed to exceed 2 consecutive terms (5 years per term). In fact, a special resolution from shareholders is required to allow a second term
  • Independent directors are not allowed to receive stock options to maintain their independence
  • India is one of first countries to legislate social responsibility for corporations. For example, companies that meet a certain size filter are required to spend at least 2% of their average net profits made during the three immediately preceding financial years on socially impactful factors
  • Corporations must have at least one-woman director in the interests of diversity and thought

A common feature of emerging market companies, is a controlling shareholder, often referred to as the promoter or founder of a business. This is particularly prevalent in India where promoters own approximately 45% of the equity of publicly listed companies.   A deep understanding of the ownership structure, Board composition, promoter’s incentives, track record and character is crucial to determining the success of the business.

This requires specialist knowledge from those who have operated within the same market over time. Being on the ground, local experts can leverage off their experience, resources, strong relationships and networks to understand the following:

  • Is there a controlling shareholder and what is their ulterior motive?
  • Do their actions align with the interests of minority shareholders?
  • Are there any red flags in terms of a history of mistreating minority shareholders?

Another important factor to consider, where a controlling shareholder exists, is the ability of minority shareholders to partake and influence significant decisions (e.g. the nomination process, voting thresholds for various resolutions etc.). This can be a major concern for minority shareholders in capital markets where weak minority investor protection exits. In the most recent release of the World Bank’s “Doing Business” report, India ranks 8th in the world for protecting minority shareholders, ahead of many developed countries like the United States, Australia, Japan and across Europe. According to the report, India scores highly in terms of shareholder rights and governance, corporate transparency and conflict of interest regulations. Sometimes perception is not reality, especially for investors in developed markets who believe companies they know and understand are less likely to experience governance issues. Lack of familiarity does not necessarily equate to weak corporate governance.

The investment case for active management in emerging markets rests most heavily on the concept of market inefficiency. However, market inefficiency is not something investors should shy away from. The fact that the market is inefficient provides a ripe environment for strong value-add for active managers with local knowledge and experience. Whilst passive strategies are becoming increasingly available today given their low cost and ease of implementation, they have many important shortfalls, especially when it comes to investing in markets where there is a larger dispersion of governance practices. Passive investing means you are obliged to invest in all constituents of the index, preventing active avoidance of companies with lower governance standards.

Furthermore, given the higher levels of both risk and return potentially available from investing in emerging markets, investors who can identify companies undergoing a significant rate of advancement in corporate governance standards can find themselves in a sweet spot. These companies tend to re-rate quicker as the market acknowledges their advancement.

The chart below, assuming other influences are held constant, illustrates this “sweet spot” where the rate of advancement of a company’s corporate governance can have the most significant impact on its stock price.

Source: India Avenue

We believe that specialist, on the ground, stock pickers with an active approach can leverage their knowledge, experience, local resources and strong relationships and networks to make more informed decisions. This can lead to the identification of companies under going this “sweet spot” transition phase, resulting in significant out-performance of local benchmarks by navigating around unwanted corporate governance risks.

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