corporate governance in emerging markets: …

CORPORATE GOVERNANCE IN EMERGING MARKETS: HARNESSING WINDS OF CHANGE

Companies getting serious about shareholder value spell opportunities for investors

For Financial Professional Use Only. Not For Public Distribution.

2Corporate governance in emerging markets: Harnessing winds of change

• Emerging markets (EMs) are a rich source of investment opportunities, but their corporate governance shortfalls relative to developed markets also present challenges. Over the years, some EMs have moved faster than others to plug their governance gaps. We think improving governance has become a structural theme driving EM equities.

• Governance weaknesses suggest room for enhancements, as well as opportunities for investors to benefit from the positive trajectory of change. We see interesting opportunities to advocate change through relationship-driven engagement with companies.

KeyTakeaways

Mapping model behavior Corporate governance is a term that is easier to grasp than to define. Few investors would argue against the importance of good governance. But what exactly does it entail? Corporate governance is a sprawling subject, and its definition can vary from one investor to another.

Academic and industry research tends to view corporate governance at the country and company levels.1

• Country: Laws, regulations and policies that shape the investment environment typically take center stage. Investors look to the quality of a market’s public institutions, reflected in the strength of its property rights, disclosure standards and other features, to determine how much they can trust the market with their capital. These features also form the institutional framework in which companies operate.

• Company: Here, checks and balances between a company’s board, management and shareholders are key. We believe internal systems that help the board to effectively monitor management, incentivize managers to act in the best interests of all shareholders, or enable shareholders to hold the board to account should contribute to sound governance.

There is no single way to define corporate governance. We recognize that institutional quality can influence the level of accountability, transparency and trust in a market. At the same time, we invest in companies—not countries—and company fundamentals underpin our investment theses. We think at its core, corporate governance determines how well companies are able to operate in the longer-term interests of all shareholders. A study offers this definition: “Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment.”2

The search for alpha What makes good corporate governance vital? To start, it is integral to a company’s sustainability. A healthy system of controls, incentives and values, reflected in features such as a majority-independent board, well-designed executive remuneration scheme and sensible capital allocation framework, should enforce discipline on management to steer the business for the long haul.

Also striking is the impact governance often has on stock valuations. Companies with poor conduct or policies deemed to shortchange investors have typically been discounted by the market, and governance improvements give them a chance to achieve re-ratings.3

As a whole, studies have largely found a correlation between better governance and increased access to financing, lower cost of capital, stronger operational performance and higher valuations for companies.4 But to be clear, corporate governance is just one factor out of many that can affect a company’s prospects and share price. We think investors should assess a firm’s governance alongside traditional financial measures to form a comprehensive view of the potential investment returns and risks.


Governance in the EM context Corporate governance in EMs has come under the spotlight given their growing heft on the global financial stage. EMs’ share of global stock market capitalization has more than doubled in around 20 years,5 and stood at 30.0% in June 2019.6

Though EMs are a rich source of potential investment opportunities, their governance standards generally trail those in developed markets, deterring some investors. In a study by the


World Federation of Exchanges (WFE), investors identified governance concerns as a particular challenge in EM investing.7

Some said they would avoid investing in a company if they believed it had poor governance.

A unique challenge lies in the concentration of company ownership in EMs. Extensive research has flagged the dominance of family and state-controlled companies in these economies—and the potential for minority shareholders’ interests to be compromised.8 Without adequate safeguards, controlling shareholders would find it easier to direct corporate resources to serve their own purposes, and at minorities’ expense. Take for instance a related-party transaction in which a listed company pays an inflated price to purchase assets from another entity linked to its controlling shareholder. In another scenario, a state-owned enterprise could invest in a project that advances the country’s strategic objectives but compresses shareholder value.

Over the years, some EMs have moved faster than others to plug their governance gaps. We see two main drivers at work. First are the wake-up calls that followed economic storms and corporate scandals sparked by governance failures. The 1997 Asian financial crisis was a major turning point for economies and companies that had borrowed excessively, stoked in part by lax governance. The 2008–2009 global financial crisis reinforced the dangers of debt excesses and ineffective oversight.

Second is the desire to gain entry to major market indexes and attract more capital. Notably, global competition for investments could pick up in the coming years as China’s current account surplus thins and boosts its need for foreign capital. For economies eyeing index inclusion, governance yardsticks feature among the range of criteria they have to meet. The accessibility, efficiency and transparency of their financial markets, plus the strength of their regulatory systems, are just some factors that index providers assess. Consider FTSE Russell’s decision in 2018 to add Saudi Arabia to its emerging market index. The country’s market reforms, as well as its efforts to enhance corporate governance, helped it secure the nod.9

Work in progressGovernance improvements across EMs have been uneven. Nonetheless, the overall progress we have observed in several areas is encouraging. Accounting standards are a case in point. Local standards have increasingly converged with internationally recognized ones, providing a boost for information quality and transparency. Brazil is among EMs that have fully adopted the International Accounting Standards Board’s IFRS Standards.

Regulators have also taken steps to empower minority shareholders, by giving them greater say on related-party transactions, for example. The World Bank, in its annual study on the ease of doing business around the world, noted that low-income economies have been catching up with their high-income peers when it comes to the transparency of related-party

Lessons from turmoil Asian financial crisis (AFC): Large capital inflows can signal trouble for countries that are ill-equipped to handle them. Markets in East Asia learned this the hard way in the late 1990s, when their over-reliance on short-term US-dollar borrowings sowed the seeds of the AFC. Weak corporate governance was among the multiple inter-related causes of the crisis. Banks accumulated exposures to over-heated industries and highly leveraged companies amid inadequate market supervision, loose internal controls and a culture of relationship-based lending. For as long as capital flowed, markets looked fine on the surface. But a sudden pullback of liquidity spawned bankruptcies and saddled banks with a heavy burden of non-performing loans.

The AFC was a powerful catalyst for governance reforms in the hardest-hit economies. South Korea, for example, witnessed the fall of several large family-controlled conglomerates, or chaebols. Complex ownership structures, intra-group loans and guarantees, and other poor practices enabled some chaebols to borrow and invest imprudently. In the wake of the AFC, struggling chaebols were forced to restructure. South Korea shored up its financial regulatory and supervisory framework and introduced measures to bolster governance within companies.

Global financial crisis (GFC): Some 10 years after the AFC, banking systems again came under pressure. This time, however, the impact was far wider. What started as a crash of the US subprime mortgage market in 2007 soon led to the collapse of major US and European financial institutions that had over-leveraged to invest in mortgage-backed securities. Panic spread throughout the cross-border financial system, triggering a liquidity crunch in developed and emerging economies. Behind the crisis were multiple governance lapses, including poor risk management in banks and ineffective regulatory oversight.

The GFC prompted sweeping policy responses on national and global scales. For instance, the Basel Committee on Banking Supervision, the world’s standard-setter for bank regulations, unveiled a Basel III framework aimed at bolstering the industry’s resilience. Basel III raised both the quantity and quality of banks’ regulatory capital base and contained requirements for sound risk management and adequate disclosures. Though the crisis did not start in EMs, it created momentum for policymakers in these economies to fix governance deficiencies that remain.

transactions over the last 10 years.10 In India, the securities regulator recently tightened rules around royalty payments made by listed companies to related parties—payments above a certain level would require approval from shareholders (with related parties excluded from voting).



Moreover, we have seen EM 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, as Exhibit 1 shows. Investors’ hunt for yield in an environment of low interest rates has turned up the heat on companies to distribute more cash to shareholders. Pressure from institutional investors has played a role at times. Companies that fulfilled investors’ demand were often rewarded with higher market valuations.11

EM companies have generated more cash Exhibit 1: EM free cash flows December 2007–June 2019

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2007 2009 2011 2013 2015 2017 Jun-19

For illustrative and discussion purposes only. Sources: FactSet and MSCI. As of June 30, 2019. Free cash flows are net cash from operating activities less capital expenditures (additions to fixed assets). Important data provider notices and terms available at www.franklintempletondatasources.com.

USD bn

Critics note that corporate governance reforms in EMs 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.12

Previous financial crises have underscored the perils of regulatory slack, especially when it comes to debt monitoring. With EMs collectively piling on increasing amounts of foreign-currency debt in recent years, their abilities to service or refinance their borrowings bears close watching.13

Meanwhile, minority shareholder protection remains a hot-button issue. In the WFE study, investors highlighted the large presence of family and state-owned companies as a challenge of EM investing, signaling that concerns about minorities’ rights persist. We believe that regulators and companies can do more to promote the equitable treatment of minorities in EMs, by enhancing disclosures of related-party transactions or requiring shareholder approval for such deals, for example.

Pursuing greater shareholder value South Korea: South Korea’s stock market valuation has historically lagged those 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 it would exercise its voting rights to increase shareholder value. Earlier this 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. The dividend payout ratio in South Korea rose from 11.1% at end-2013 to 20.6% at end-2018.14 And there could be scope for further growth, with the ratio remaining below the EM universe’s 36.8%.15

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.

Russia: Most investors are unlikely to associate Russia with governance excellence. What often comes to mind is its patchy track record in privatization, which began in the 1990s before its institutions were ready for a market-based economy.16 The government has also retained a sizeable presence in corporate Russia.17 Yet, many Russian companies have taken the initiative to set higher bars for their conduct and promote shareholder value. Some recognized the need to do so to appeal to foreign investors. Those that sought overseas listings adopted international standards. Indicating the shift in corporate mindsets, the dividend payout ratio in Russia increased from 21.8% at end-2013 to 33.0% at end-2018.18

Companies that have sharpened their focus on shareholder value include Lukoil, which is 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 deliver progressive dividends in a conservative oil price scenario, and distribute additional cash flows to shareholders if oil prices exceed its estimate. In 2018, it launched a US$3 billion share buyback program and approved the cancelation of treasury shares.



A tailwind for EM equities Governance gaps suggest room for improvement, together with opportunities for investors to benefit from the positive trajectory of change. We believe improving governance has become a structural theme driving EM equities. We also think active investors are in a favorable position to capture this tailwind.

Why active investors? Passive screening and other quantitative tools have made it seemingly easy for investors to shortlist companies with high governance scores or sidestep those with low ratings. But we see limitations with this approach, particularly in EMs. Standardized measures are likely to overlook market or company-specific nuances, such as the need for greater scrutiny of large family-controlled groups with cross-shareholdings. Differences in languages and disclosure rules can hinder information collection. Above all, screens tend to be backward-looking, which means 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.

Relationship-driven engagementWe think direct engagement with companies creates unique opportunities for investors to effect governance improvements. We strive to be responsible stewards of our clients’ capital, and we consider it our responsibility to promote stronger governance and pursue better outcomes for all stakeholders.

How do we advocate change? We see value in building trusting relationships with companies, forged through frequent and constructive conversations that reflect our understanding of their governance considerations, as well as our interest in their long-term success. We believe longstanding and credible relationships give us a competitive advantage in offering suggestions and seeding lasting governance improvements.

Building communicationWe have been engaging with a Brazil-based enterprise software company on its leadership succession plan, among other matters. The plan stalled after a newly appointed executive tapped to succeed the company’s founder as chief executive officer resigned following a brief stint. The episode coincided with a period of disappointing earnings as the company adjusted its business model, while coping with a recession in Brazil.

We nominated an independent member to the company’s board of directors, and his election brought in outside expertise on issues related to succession, executive compensation, business strategy and more. In 2018, the company’s succession plan got back on track as the board appointed a new head to take over from the founder. The company also took steps to improve certain governance processes. We have found these developments encouraging in our continued engagement with the company.

Our engagement activities can go further. This happens when governance concerns arise, and we believe working directly with companies to drive changes could enhance investment returns and serve the best interests of our clients. The circumstances of each case guide our responses, which can include the filing of shareholder resolutions and the nomination of directors.

Watch this space Corporate governance has come a long way in EMs, 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. We view improving governance as a structural driver for EM equities, and we see potential opportunities to effect better governance through relationship-driven engagement with companies.

ContributorsAndrew Ness, ASIPPortfolio Manager

Franklin Templeton Emerging Markets Equity

Chetan Sehgal, CFADirector of Portfolio Management




Endnotes1. Sources: International Monetary Fund, “Corporate Governance, Investor Protection, and Financial Stability in Emerging Markets,” Global Financial Stability Report: Fostering

Stability in a Low-Growth, Low-Rate Era, October 2016; Claessens, S. and Yurtoglu, B., Corporate Governance in Emerging Markets: A Survey, January 15, 2012.2. Source: Shleifer, A. and Vishny, R. W., “A Survey of Corporate Governance,” Journal of Finance 52 (2): 737-783, 1997.3. Sources: Mazneva, E. and Khrennikova, D., “How Did Russia’s Gas Goliath Get Beaten by Its David?” Bloomberg, September 7, 2018; Astrasheuskaya, N., “Gazprom shares surge

on full-year dividend hike,” Financial Times, May 15, 2019; Song. J., “Higher South Korea dividends fuel hopes for Kospi re-rating,” Financial Times, February 11, 2015.4. Source: Claessens, S. and Yurtoglu, B., Corporate Governance in Emerging Markets: A Survey, January 15, 20125. Source: International Monetary Fund, “The Growing Importance of Financial Spillovers from Emerging Market Economies,” Global Financial Stability Report: Potent Policies for a

Successful Normalization, April 2016.6. Source: Bloomberg. As of June 2019. 7. Source: Cleary, S., Alderighi, S. and Boukai, B., Investing in Emerging and Frontier Markets—An Investor Viewpoint, World Federation of Exchanges, January 2019.8. Source: Aguilera, R.V. and Haxhi, I., “Comparative Corporate Governance in Emerging Markets”, forthcoming in Oxford Handbook on Management in Emerging Markets, (Eds.) R.

Grosse & K. Meyer, May 14, 2018.9. Source: Torchia, A. and French, D., “Saudi to join FTSE emerging index from next March, attract billions,” Reuters, March 29, 2018. 10. Source: World Bank, Doing Business 2019: Training for Reform, October 31, 2018.11. Sources: Quinn, A., “Russian Stocks Exorcise Ghosts of Crimea as Returns Surge,” Bloomberg, June 10, 2019; Lee, S. Y., “In transition, Samsung Group hands more cash to

investors,” Reuters, November 3, 2015.12. Source: Kaufmann, D., Kraay, A. and Mastruzzi, M., “The Worldwide Governance Indicators: Methodology and Analytical Issues,” World Bank Policy Research Working Paper No.

5430, September 2010. Last available data covers 2017. 13. Sources: Strohecker, K., “Emerging market debt soars to record $69.1 trillion in Q1 on falling interest rates – IIF,” Reuters, July 15, 2019; Bank for International Settlements,

Statistical release: BIS global liquidity indicators at end-March 2019, July 31, 2019.14. Sources: MSCI, Bloomberg. As of June 28, 2019.15. Ibid.16. Source: World Bank. 2013. Corporate Governance Country Assessment: Russian Federation. Washington, DC. © World Bank.

https://openknowledge.worldbank.org/handle/10986/21422 License: CC BY 3.0 IGO.17. Ibid.18. Sources: MSCI, Bloomberg. As of June 28, 2019.

Important data provider notices and terms available at www.franklintempletondatasources.com.

Local Knowledge, Global ReachEmerging markets are complex, heterogeneous, and constantly evolving. Our on-the-ground investment team of over 80 portfolio managers and analysts across nearly 20 countries distinguishes Franklin Templeton Emerging Markets Equity from the crowd. Investors benefit from our networks of local business contacts, in-person company visits and real-time response to local market events. Our global reach through Franklin Templeton Investments provides access to sophisticated risk management and trading resources.

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All investments involve risks, including possible loss of principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size and lesser liquidity.

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