Emerging markets (EMs) are frequently perceived as riskier than their developed counterparts. By extension, they are sometimes also thought of as inherently ‘wilder’, more unpredictable and maybe even dangerous.
Does this mean the managers of funds that invest in emerging markets are uncommonly intrepid – a kind of stockpicking mélange of Bear Grylls, Sir David Attenborough and Indiana Jones? Not exactly.
In reality, the notion that EM investments inevitably entail higher risk is outdated. The line between emerging and developed markets (DMs) has become increasingly blurred in recent years, and it is not hard to find evidence of the former delivering both superior returns and less volatility.
It remains true, though, that emerging markets can bring certain challenges. They undoubtedly constitute a broad canvas. Whereas developed markets might be viewed as relatively homogenous in many respects, EMs are remarkably varied.
There are likely to be noticeable differences, for example, between a business headquartered in Seoul’s fashionable Gangnam area and one based in rural Gujarat. The chances are that the first will seem dazzling and the second comparatively ramshackle.
But does it automatically follow that a company housed in a sparkling South Korean business district will represent a more promising investment than one tucked away in an Indian ‘backwater’? And would publicly available data be enough to confirm or deny as much?
We believe the most effective means of peeling back the layers and building an accurate picture of an emerging market company’s policies, practices and prospects is direct engagement. This demands an on-the-ground presence and face-to-face dialogue.
In our experience, with very few exceptions, visiting emerging market businesses really is far from the swashbuckling stuff of Grylls, Attenborough and Jones. But there are still various perils to be wary of – at least from an investment perspective.
Below are a few warning signs that set our alarm bells ringing.
Poor governance
In Asia, the need to improve governance and stewardship is earning ever-greater acknowledgement. Crucially, policymakers recognise companies must better align their actions with shareholder interests if they wish to successfully compete for investment and so contribute to economic growth.
Japan, a developed market, has led the way in this regard, with the Tokyo Stock Exchange introducing measures that compel businesses to enhance capital efficiency. The likes of South Korea and China have followed suit.
It would be unwise, however, to assume every company is obligingly meeting the tougher requirements imposed from above. Such an ideal is very rarely found even in developed markets. One of our key tasks is to separate those who simply talk the talk from those who actually walk the walk.
Disincentivised ownership
Cross-shareholding structures are a particularly controversial governance issue in Asia. They involve companies holding shares in their business partners or associates. Regulators in Japan and South Korea are especially determined to stamp them out.
Historically, one reason why cross-shareholding has been popular is that many ownership structures are dominated by wealthy families. These can have little or no incentive to disrupt the status quo and shareholder value tends to be low on their lists of priorities relative to retaining management control.
The attractions of companies whose ownership models deter innovation and progress are obviously extremely limited. This is why we look for businesses whose boards and management teams showcase independence and diversity.
Unsound fundamentals
Irrespective of geography or type of market, fundamentals are central to any company’s investment case. The devil is in the detail, as they say – and the detail is usually found in a balance sheet.
One way of boosting a company’s at-a-glance allure is to take on foreign currency debt – most often in US dollars – which enhances profit ratios and is often cheaper. This can make sense for a business that operates internationally and generates dollar revenues but one that has a domestic focus can leave itself open to the vicissitudes of currency fluctuations.
Many emerging market businesses have been damaged – or even destroyed – by this form of financial engineering. Some have been so weakened that competitors have snapped them up. Some have collapsed entirely. Such are the perils of ‘creative’ balance sheet management.
The Wizard of Oz effect
The degree to which appearances can be deceptive is one of the curious joys of an on-the-ground approach to investing in emerging markets. Hidden gems can lurk in the most unprepossessing settings, while the threat of style over substance is widespread.
There is no ever-reliable rule of thumb, of course, but it is safe to say that a marble-clad foyer and a car-park full of Lamborghinis should not be taken as guaranteed indications of long-term potential. Equally, a dilapidated façade is not always a precursor to a company with nothing to offer.
Like Dorothy in The Wizard of Oz, we have to find out what is behind the curtain.
Gabriel Sacks is co-manager of abrdn Asia Focus. The views expressed above should not be taken as investment advice.